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.