Tax Deductions

Three Safe Harbor Elections Could Save Thousands on Your Next Big Repair Project

Earmark Team · October 29, 2025 ·

When a rental property owner faces a $27,000 repair bill, can they deduct these costs immediately as repairs, or must they capitalize them as improvements and depreciate them over decades?

This exact situation confronted Jeremy Wells, CPA, EA, in his tax practice when a client’s simple plumbing leak turned into a complex restoration project. What started as a ceiling drip in a two-story rental property led to $4,000 in plumbing repairs, a $16,000 bathroom renovation, a $4,000 water heater replacement, and $3,000 in ceiling and floor repairs.

In this episode of Tax in Action, Wells walks through this real case to show how the IRS determines when expenditures qualify as immediately deductible repairs versus when they must capitalize them as improvements. The difference can mean thousands in tax savings if you understand the rules and make the right elections before filing your return.

The Framework That Changed Everything

For years, tax professionals struggled with the gap between two key code sections. Section 162 allows businesses to deduct ordinary and necessary expenses, including repairs. Section 263A requires businesses to capitalize amounts paid to improve tangible property. But the law didn’t clearly define when you’re repairing property versus when you’re improving it.

“If we want to know if a certain type of expense is ordinary or necessary, and if it’s therefore deductible by a business, we look to Section 162,” Wells explains. “We also have Section 263A, which tells us we have to capitalize amounts paid to acquire, produce, or improve tangible property.”

Treasury Decision 9636 finally bridged this gap. Released in the early 2010s, this collection of regulations established a clear framework for making repair versus improvement decisions. The document includes about 60 pages of explanation in its preamble, showing how the Treasury Department arrived at these rules and addressed public comments.

The framework centers on a two-part test. First, you must determine the “unit of property”—the actual asset you’re repairing or improving. Second, you must assess whether your expenditures constitute improvements to that unit of property.

Understanding Units of Property

Determining the unit of property isn’t always straightforward. Wells uses a car engine replacement to illustrate the concept.

“Think about a vehicle. I have to replace the engine. Is the unit of property the engine? Is it the entire vehicle?” The answer depends on what appears on your balance sheet or depreciation schedule. Since you typically depreciate the entire vehicle rather than individual components, the whole vehicle is the unit of property.

For buildings, the analysis is more complex. The regulations distinguish between building structure and building systems. The structure includes the building itself: walls, doors, windows, floors, ceilings, and permanent coverings like tile or brick. The systems include HVAC, plumbing, electrical, elevators, fire protection, gas distribution, and security systems.

“We have to distinguish between what is happening with the structure of this building versus what’s happening with the specific systems,” Wells notes. This distinction matters because repairs to different units of property receive independent analysis under the improvement rules.

In Wells’ rental property case, this meant treating the ceiling and floor repairs (building structure) separately from the plumbing work (plumbing system). Each unit of property required its own improvement analysis.

The Three Types of Improvements

Once you identify the unit of property, you must determine if your expenditures constitute improvements. The regulations define improvements as expenditures that produce one of three results: betterments, restorations, or adaptations.

Betterments

Betterments include three scenarios. First, fixing conditions or defects that existed before you acquired the property or arose during its use. Using the car engine example, Wells explains, “There is something in that engine that’s not quite working right, and that’s causing a problem for the operation of that vehicle.” Replacing that faulty engine improves the vehicle.

Second, betterments include additions like enlargements, expansions, or capacity increases. Wells draws from Florida real estate: “A lot of people have paved patios right outside the back door. They’ll want to turn that into some usable space that doesn’t have the heat and the direct sunlight and the bugs. So they wall that in and create a sunroom.” This transformation adds value and functionality.

Third, betterments cover changes that increase productivity, efficiency, strength, quality, or output. Replacing an old engine with a high-performance version that delivers better speed and efficiency would qualify.

Restorations

Restorations focus on returning property to proper working condition after damage or deterioration. “Think of some piece of property that has either been damaged or it’s just worn out over time to the point where it’s become either nonfunctional or just unusable,” Wells explains.

This concept applies especially to properties affected by natural disasters. If a tornado rips off your roof or a tree damages a wall, restoring the property to its pre-damage condition qualifies as an improvement under tax law, even though you’re not making it better than before.

Adaptations

Adaptations involve converting property to entirely different uses. Wells points to pandemic-era commercial real estate: “There were attempts to convert some of that office space into apartments.” This conversion requires extensive investment to add kitchens, appropriate bathrooms, and residential layouts, adapting the property for a new use.

When Related Costs Get Bundled Together

The regulations include a rule that often catches taxpayers off guard. When multiple expenditures stem from the same project, taxpayers must capitalize together costs that directly benefit and result from improvements.

In Wells’ case, this meant the $3,000 in ceiling and floor repairs couldn’t be treated separately from the bathroom renovation and plumbing restoration, despite appearing on different invoices from different contractors.

“When these kinds of expenses are all based around the same event, those costs that directly benefit and result from the improvement have to be capitalized as all part of that improvement as well,” Wells explains. “We can’t differentiate between the expenditures that went into fixing the plumbing versus fixing the floor and the ceiling versus improving the bathroom. This is all one project.”

The water heater replacement stood apart only because it was an independent decision. “All of the work done on the bathroom and the ceiling and the floor would have still happened exactly the same way, regardless of whether or not the taxpayer actually replaced that water heater.”

Three Safe Harbors Can Help

The IRS provides three safe harbors that can transform required capitalizations into immediate deductions. But all three are elective—you must actively choose to use them and document that election on your tax return.

The De Minimis Safe Harbor

The de minimis safe harbor election allows taxpayers to expense invoices or items below certain dollar thresholds. For businesses with applicable financial statements (SEC filings, audited financials, or non-tax statements required by government agencies), the threshold is $5,000 per invoice or item.

Most small businesses and rental property owners don’t have applicable financial statements. For these taxpayers, the threshold started at just $500 when the regulations were finalized. That amount proved so restrictive that business owners and tax advisors immediately complained.

“Even ten years ago, the cost of normal business equipment like computers, tablets, and cell phones were easily over $500,” Wells recalls. The IRS eventually increased the threshold to $2,500 through Notice 2015-82, providing more meaningful relief for routine business purchases.

The Safe Harbor for Small Taxpayers

The safe harbor election for small taxpayers specifically targets rental property owners. To qualify, you must have average annual gross receipts of $10 million or less over three years and own eligible building property with an unadjusted basis of $1 million or less.

This safe harbor works building by building. You can expense all repairs, maintenance, and improvements on a qualifying building if total annual costs don’t exceed $10,000 or 2% of the building’s unadjusted basis, whichever is less.

The Routine Maintenance Safe Harbor

The routine maintenance safe harbor election applies to activities you reasonably expect to perform at least once every ten years to keep building structures or systems operating efficiently. However, it explicitly excludes betterments, adaptations, and restorations.

Water heater replacements are a classic example. “Water heaters seem to last like every 6 to 8, maybe ten years,” Wells observes. “Every ten years or so, you need to plan on replacing a water heater.” In his practice, Wells regularly applies this safe harbor to water heater replacements.

Applying the Rules to Real Situations

In Wells’ $27,000 rental property case, applying the improvement framework reveals how the rules work in practice:

The $4,000 plumbing repairs constitute restoration, replacing worn, corroded components to return the system to working order
The $16,000 bathroom renovation represents betterment, improving the appearance and quality of fixtures that weren’t actually broken
The $3,000 ceiling and floor repairs must be capitalized with the other improvements as incidental costs
The $4,000 water heater replacement stands apart as an independent decision eligible for the routine maintenance safe harbor

None of the individual expenditures qualified for the de minimis safe harbor since all exceeded $2,500. The total project costs far surpassed the small taxpayer safe harbor limits as well.

But the water heater replacement offered a strategic opportunity. As an independent maintenance decision that falls within the routine ten-year replacement cycle, the taxpayer could immediately deduct it under the routine maintenance safe harbor if they make the proper election.

Making Elections Before It’s Too Late

All safe harbor elections require specific statements attached to timely filed returns, including extensions. Miss the election deadline, and the opportunity disappears permanently for that tax year. Make the election, and it applies to all qualifying expenditures—there’s no cherry-picking individual items.

“You need to attach a statement to the return saying the taxpayer makes the election,” Wells emphasizes. Renew these statements annually for continued use, because there’s flexibility to use safe harbors in some years but not others.

The Bottom Line for Tax Professionals

Wells’ case study demonstrates how identical expenditures can receive dramatically different tax treatment based on understanding available options and making proactive elections. The $4,000 water heater could provide immediate relief through the routine maintenance safe harbor, while the taxpayer had to capitalize the remaining $23,000 and depreciate it over decades.

“When it comes to the decision of whether to repair versus improve, it’s important to look at these regulations, to read through them, to ask yourself, are we bettering this property?” Wells concludes.

The framework offers practical guidance that can save thousands in immediate tax relief or cost clients decades of unnecessary capitalization. But it only helps those who understand the rules, recognize when safe harbors apply, and make the required elections before filing deadlines pass.

For tax professionals, this is the difference between reactive compliance and proactive planning. Your clients need advisors who anticipate these situations and structure approaches to maximize immediate deductions within regulatory boundaries. Understanding these repair versus improvement rules before you need them could save thousands when that next unexpected repair bill arrives.

The Hidden Traps in Clean Energy Credits That Could Cost Your Clients Thousands

Earmark Team · August 27, 2025 ·

Picture this scenario: You just finished a call with a client who mentioned installing solar panels on her vacation home. Now it’s tax time, and she’s dropped off her tax documents, including information about the solar installation. Among the paperwork, you find two invoices: one for the solar panels, equipment, and installation labor, and another from a building contractor for roof work. Your client included a note explaining that the solar panel installation required structural retrofitting to make the roof suitable for the panels.

This is your first time dealing with solar tax credits. You know there’s some special tax benefit, but you’re not sure how it works. Which expenses qualify? How do you calculate the credit? And what about those two different invoices? Does the roof work count toward the solar tax credit?

This scenario comes from Jeremy Wells’ Tax in Action podcast, where he walks tax professionals through the residential clean energy credit. Wells, a CPA and Enrolled Agent in Florida, has seen this situation repeatedly as more clients install solar panels and other clean energy property.

While the residential clean energy credit offers substantial savings—at least until it’s eliminated at the end of 2025— tax professionals must navigate complex qualification rules, timing requirements, and cost allocation issues, often with limited regulatory guidance beyond the basic code section.

Understanding the Clean Energy Credit Basics

The residential clean energy credit comes from Internal Revenue Code Section 25D. It provides a nonrefundable credit for up to 30% of qualifying expenses on residential clean energy property. The credit was initially designed to be worth 30% of qualifying expenses through 2032, then drop to 26% in 2033 and 22% in 2034. However, H.R. 1, commonly known as the “One Big Beautiful Bill Act,” eliminated the credit at the end of 2025.

Since this is a nonrefundable credit, it can’t reduce a taxpayer’s liability below zero or create a refund. However, if the credit exceeds the taxpayer’s current tax liability, the excess carries forward to future years.

The qualifying property includes several types of clean energy installations:

Solar panels (most common)
Solar water heaters
Small wind energy systems
Geothermal heat pumps
Fuel cell property
Battery storage property

It’s important not to confuse this with the residential energy efficiency improvements credit under IRC Section 25C, which covers items like new windows, insulation, or HVAC systems. Those fall under a completely separate credit.

What Makes a Residence Qualify

Unlike some residential tax benefits that only apply to primary residences, Section 25D has broader requirements. The property must be installed at a “dwelling unit,” a place the taxpayer actually lives in the United States and uses as a residence. This can include second homes, vacation homes, or summer homes, as long as the taxpayer uses them personally.

However, the credit doesn’t apply to rental properties or investment properties. If a client installs solar panels on a rental property, that falls under entirely different tax provisions.

Business use of the home creates additional considerations. If more than 20% of the property’s square footage is used for business purposes (like a large home office), you’ll need to allocate the expenses. The taxpayer can only claim the credit on the portion allocated to personal use of the home. For business use of 20% or less, no allocation is required.

Qualifying Costs and Technical Requirements

Determining which costs qualify for the credit requires careful analysis of invoices and documentation. Eligible expenditures include:

The cost of the property itself
On-site labor costs to prepare, assemble, and install the property
Costs to connect the property to the home’s electrical or plumbing systems
Sales tax paid on eligible costs

However, not all installation-related costs qualify. Wells explains the critical distinction: “If the panels actually become a structural part of the roof, then we can include that cost. That’s different from saying that we had to do some work to the roof to be able to install those panels.”

In the opening scenario, the solar panel installation costs would likely qualify, but the separate roof retrofitting work probably wouldn’t. The roof work represents preparation rather than panels becoming part of the roof structure.

Different types of property have specific technical requirements:

Solar water heaters must be certified by the Solar Rating Certification Corporation or a comparable state-endorsed entity.
Geothermal heat pumps must meet Energy Star requirements.
Battery storage needs a capacity of at least three kilowatt hours. As Wells notes, “I’m not an electrical expert. I’m a tax professional. I’m going to ask the client for some piece of paper from the installer showing me that it has a capacity of at least three kilowatt hours.”
Fuel cells face cost limitations of $1,667 per half-kilowatt of capacity.

Any property that serves additional functions beyond energy production, like a swimming pool or hot tub heated by solar energy, can’t include those additional components in the credit calculation.

Rebates, Incentives, and Excess Generation

Rebates and incentives can affect the credit calculation. Direct or indirect rebates from manufacturers, distributors, sellers, or installers reduce the eligible costs. However, state government incentives typically don’t reduce the federal credit calculation.

A particularly complex issue arises when solar installations generate more electricity than the home needs. If the taxpayer sells excess electricity back to the grid, only the portion of costs related to the home’s actual electricity needs qualifies for the credit.

Wells acknowledges the challenge this creates: “Do we allocate this based on actual electricity generated and over what period of time? Should we be using data from the home’s electrical usage prior to installation? These are all unanswered questions as far as the guidance we have now.”

Timing Rules That Matter

When a taxpayer can claim the credit depends on the type of installation:

For existing residences, the credit applies when the property is completely installed, when work crews are done, and when the property is ready for use. For new construction or reconstruction, the credit applies when the taxpayer begins using the dwelling unit, which may be later than when the clean energy property is installed.

This distinction can shift credits between tax years and impact tax planning. Wells sees many situations where taxpayers start work in one year but don’t complete installation until the next year, or where installation happens late in the year but certification doesn’t arrive until the following year.

If taxpayers finance the purchase through the seller, they can calculate the credit based on the full cost of their payment obligation, not just the amounts actually paid. However, interest on financing doesn’t count toward eligible costs.

Documentation and Reporting Requirements

Tax professionals often find themselves helping clients gather documentation that the client should have obtained during the purchase process. This includes:

Detailed invoices breaking down eligible and non-eligible costs
Certification documents showing technical specifications
Information about any rebates or incentives received
Details about excess electricity generation and sale back to the grid

Taxpayers report the credit on Form 5695, Residential Energy Credits, with different lines for different types of property. The form calculates the maximum credit amount and applies limitations based on the taxpayer’s tax liability.

Since this is a nonrefundable credit, it can offset the alternative minimum tax but can’t create a refund. Any unused credit carries forward to future years.

Practical Takeaways for Tax Professionals

Wells emphasizes that, unlike most areas of tax law, practitioners have limited guidance beyond the code section itself. “We really don’t have much guidance beyond what’s in the code section itself. We don’t have any Treasury regulations related to this code section, which is not very common.”

This means tax professionals must rely heavily on professional judgment when making determinations about qualification, cost allocation, and timing. The key is asking the right questions:

Is this the taxpayer’s personal residence, and what percentage do they use for business?
What costs did the homeowner pay, and are there any rebates or incentives?
For a solar electric property, is the property owner selling any electricity back to the grid?
When was the property completely installed, or when did the taxpayer move into a new residence?

Wells notes that sometimes by helping clients gather proper documentation, “we actually help them ensure they’ve gathered all the documentation they might need in the future.”

The residential clean energy credit offers significant tax savings for qualifying installations, but success depends on careful analysis of costs, proper documentation, and understanding the technical requirements that vary by property type. While the guidance may be limited, a systematic approach to qualification and documentation helps ensure clients can take advantage of these valuable credits while maintaining compliance with tax requirements.

To hear Wells’ complete analysis and additional examples of how to handle complex scenarios, listen to the full Tax in Action episode.