By Jason Watson, CPA
Posted Monday, March 30, 2026

Now that you have survived the betterment and adaptation tests, you have arrived at the gray waters of restoration. Under the Tangible Property Regulations, you must capitalize an expenditure as a restoration if it replaces a “major component or substantial structural part” of your Unit of Property (UoP), as defined in Step 2 previously. Yeah, got it, now what?

Welcome to the jungle (aka, the Wiggle).

But how do you define “major” or “substantial”? Is it dollars? Is it physical size? The IRS refuses to give us a bright-line percentage, but they do give us a zillion examples. Let’s look at a famous one found in Treasury Regulations Section 1.263(a)-3(k)(7):

Example 25: Not replacement of major component or substantial structural part; windows. U owns a large office building… The building has 300 exterior windows that represent 25 percent of the total surface area of the building. In Year 1, U pays an amount to replace 100 of the exterior windows that had become damaged… Therefore, the replacement of the 100 windows does not constitute the replacement of a major component or substantial structural part of the building, and U is not required to treat the amount paid as a restoration…

Yawn. There are a total of 31 examples like this if you cannot get enough. But keep this specific 100-windows out of 300 total ratio in mind as we explore the maze.

The 33% Heuristic

When you are dealing with discrete, countable components within a system (like windows, doors, or individual condenser units), you can use physical math.

On one hand, the 100 out of 300 is a very specific percentage (33.3%). On the other hand, the IRS explicitly states that a hard bright-line rule does not exist. Regardless, practitioners use the 33% mark as a highly defensible barometer. Why? At the end of the day taxes become binary- yes or no? In other words, we must choose.

What if you need to replace an HVAC unit? In a single-family rental property, the HVAC system generally only has one component. Replacing it means replacing 100% of the system, which commonly triggers a restoration (capitalize). However, if you have an apartment building with 10 rooftop HVAC units all tied together as a system, and you replace 2 of them, you are only replacing 20% of the UoP. That falls well below the 33% barometer and can often be treated as a repair!

Sidebar: Using the window example, if you replaced all 300 windows at once, it would absolutely be a capital improvement. However, if you replace 100 each year for three years, you might be able to call it all routine maintenance/repairs. Spreading things out helps with cash flow and maximizes immediate deductions. This is a potential win-win, but don’t break out the bubbly quite yet. Substance? Form? Gaming the system? The IRS will look at the series of events holistically and could label it a wholesale improvement based on the overall facts and circumstances.

The Continuous System Dilemma

Counting windows and HVAC units is reasonably easy. But what happens when you are dealing with a continuous system like plumbing or electrical where the components aren’t easily countable? How many feet of wires does your rental have?

To have a reasonable tax position when you argue that what you did was not material or substantial, consider the following:

• Physical Segmentation (The Baseline): This is the most objective metric. If the building has 1,000 linear feet of plumbing supply lines and you replace 150 feet, you have a physical metric to point to (15%). Because 15% is well below our 33% heuristic, it leans heavily toward an expensed repair. Clearly this is a bit laughable since knowing the total amount of plumbing is silly, but it illustrates the math at any rate.
• Relative Cost and Value (The Fallback): Often, physical segmentation is impossible to calculate without ripping open the walls. In these cases, use value as a proxy. Compare the cost of the replaced portion against the estimated replacement cost of the entire system. If the total plumbing system would cost $50,000 to replace, a localized $5,000 repair falls well below the threshold of replacing a “substantial structural part.” Keep in mind that replacing an entire plumbing system is significantly more costly as a retrofitted renovation than as a new-build. This actually works to your advantage, as it inflates the replacement value (your denominator) and keeps your repair percentage lower.
• Qualitative Function (The IRS Suit Argument): This is where the rubber meets the road. Even if a replaced portion represents a tiny percentage of the total system’s physical footprint or value, capitalization might still be required if the component performs a discrete and critical function within the system (UoP).

On the qualitative function nonsense that is not taxpayer friendly, consider these bookends-

• Main Sewer Line: This is a critical choke point. If you replace the main sewer line connecting the rental property to the city system, it is usually a capital improvement (restoration), regardless of the cost relative to the whole system.
• Branch Lines: Conversely, if you replace the branch lines servicing the second-floor bathrooms, this is generally a repair. The system can still mostly function without those specific lines, meaning they do not hold the same critical functional weight as the main.

In practice, function often beats percentage.

If your expenditure survives the qualitative function test and falls below the 33% heuristic, congratulations: you have successfully navigated the gauntlet and you have a strong position to expense the repair!

No Bright Lines

When the IRS first proposed these rules, CPAs, tax attorneys, and industry groups flooded them with comment letters practically begging for a quantitative safe harbor on what constitutes the replacement of a “major component or substantial structural part.” Why not? As we just mentioned, we all like binary situations- Yes or No, and certainly not the Maybe So.

IRS declined.

Here is exactly how the IRS addressed it in the Final Tangible Property Regulations Preamble regarding Betterments and Restorations:

Several commenters requested that the final regulations provide a bright-line test for determining whether an amount results in a material increase in capacity, productivity, efficiency, strength, quality, or output… The IRS and the Treasury Department decline to adopt a bright-line rule for this purpose. Because of the inherently factual nature of the betterment inquiry and the varied nature of the property and situations… a single bright-line test would be inappropriate.

Regarding Restorations (specifically replacing a “major component”), they said the exact same thing:

The final regulations do not adopt a bright-line percentage… The IRS and the Treasury Department believe that a quantitative threshold for major components would be difficult to apply and would yield inappropriate results in many cases.

They ruled that determining a major component will forever remain a subjective “facts and circumstances” test based on qualitative function and relative size. To help taxpayers, if you can call it that, they pumped the regulations full of those 31 highly specific examples (like Example 25: the 100 out of 300 windows). More is not always better.

By Jason Watson, CPA
Posted Monday, March 30, 2026

If the expenditure meets the betterment, restoration, or adaptation tests, then it is generally considered a capital improvement, and therefore must be capitalized and depreciated (versus immediately deducted).

The final tangible property regulations define these terms in amazing detail, but here is a quick summary with the real estate investor in mind-

• Betterment. You fix a material defect in the rental property or UoP that existed prior to acquisition or arose during ownership, such as a cracked foundation. An addition or enlargement, such as finishing the basement, is also a betterment. A betterment also includes amounts paid that are reasonably expected to materially increase productivity, efficiency, strength, quality, or output of the unit of property (UoP).
• Restoration. You replace a major component such as replacing a roof. You restore a UoP that has deteriorated to a state of disrepair and is no longer in ordinarily efficient operating condition, including rebuilding after a casualty loss.
• Adaptation. According to the final tangible property regulations, “An amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with your ordinary use of the unit of property at the time you originally placed it in service.” Is converting a garage into a casita or another bedroom considered an adaptation or betterment? Hmmm…

You can think of BRA or BAR when trying to remember these. No one thinks of ARB or RAB, however. Like never.

Let’s focus on betterments and adaptations since those are the “dead in the water” buckets.

Betterments

With reference to betterment and the word “material,” the IRS offers this-

The term “material” is not defined in the final tangibles regulations. Although the final tangibles regulations include examples that refer to percentage increases, these examples are provided to assist you in understanding the rules. These percentages are not intended to set a standard, for example, a particular percentage increase in square footage or capacity, for determining whether the amount paid is a “material” betterment. In determining whether a betterment is “material”, you should use common sense and reasonable judgment as applied to your own facts and circumstances.

This is exactly why defining your Unit of Property in Step 2 was so critical. You cannot measure if an upgrade is material until you know the size of the denominator.

Imagine you have a large commercial rental with a massive, multi-zone HVAC system. One of the old 3-ton rooftop condenser units dies. New environmental codes require you to replace it with a modern, high-efficiency 4-ton unit.

If you look at the component: It has more capacity (4 tons vs 3 tons) and is vastly more energy-efficient. It looks exactly like a betterment. But wait, there’s more.

If you look at the UoP: You establish that the UoP is the entire building’s HVAC system (which has a total capacity of 100 tons). Great. Does upgrading one 3-ton unit to a 4-ton unit materially increase the capacity or efficiency of the entire 100-ton system? No. It’s a drop in the bucket. It bypasses the betterment test and survives to fight another day as safely lands in the “maybe” expense column and not automatically on the depreciation schedule.

In practice, betterment is often the IRS’s first argument when restoration is unclear.

Adaptations

According to the final Tangible Property Regulations, an expenditure is considered an adaptation if it adapts a Unit of Property to a new or different use that is not consistent with how you ordinarily used the property when you originally placed it in service. Adaptation is less about how much you changed and more about how the use of the property changed.

Wonderful, now what? Is converting a garage into a casita or another bedroom considered an adaptation or betterment? Hmmm… (Spoiler: Either way, you are capitalizing it because you are both increasing the utility of the property and changing how that portion of the property is used).

Restorations

If your expense is not a betterment or an adaptation, you move into the restoration analysis, which has some wiggle room. Cue up the music, Axl.

By Jason Watson, CPA
Posted Monday, March 30, 2026

This one is a bit trickier, but it is a fantastic and wildly underutilized safe harbor for rental property owners. Now that you’ve defined your Unit of Property (UoP) in Step 2, you can test if your expenditure qualifies as routine maintenance.

According to the Tangible Property Regulations, you are not required to capitalize (and therefore may immediately expense) repairs that:

• Are recurring activities that keep the property in its ordinarily efficient operating condition, AND
• You reasonably expect to perform more than once within a 10-year period.

Note: For building structures and systems, that 10-year clock begins when the rental property is placed in service.

The Reasonably Expect Reality Check

The rule explicitly reads “reasonably expect.” What if you expect to perform routine maintenance every 7 years, but by some miracle or sheer luck, you don’t actually do so, and it lasts 12 years? Do you lose the deduction?

It becomes a bit more challenging, but as long as you can demonstrate that, at the time of the expenditure, you reasonably expected to perform the activity more than once within 10 years, you have a valid argument to expense it.

A Pitfall: The “Major Component” Exception

Here is where skipping Step 2 (defining your UoP) will get you into trouble. The Routine Maintenance Safe Harbor has a pit of misery or hidden trapdoor baked into the rules: it explicitly does not apply if the work replaces a “major component or substantial structural part” of the UoP, which pushes you back into the improvement rules. Great! Not. How do you measure that?

You are never assessing a component in isolation; you are always assessing it against the whole system.

Let’s look at a water heater that you reasonably expect to replace every 7 years. Because 7 years is less than 10, it feels like an automatic win. But watch how the size of the UoP changes the outcome:

• Scenario A: Let’s say the water heater represents 20% of the entire plumbing UoP. You replace it every 7 years. So far so good. At 20%, it is likely not a major component of the overall plumbing system.
• Scenario B: The plumbing system is so small that the water heater represents 50% of the total plumbing UoP. You replace it every 7 years. Yet again, so far so good. However, at 50% of the system, it is very likely to be viewed as a major component.

Both the frequency and the nature of the activity matter. Replacing small, repeating components fits this safe harbor much more naturally than replacing central or critical components, even if both occur on a similar timeline.

Granted, this example illustrates the bookends in an unnecessarily dramatic way. But what is not dramatic is that it underscores the challenge. If you are arguing the major component or materiality tax position, then you are in a facts and circumstances argument. Don’t take this as being a bad thing- it’s just a thing. While we all like bright lines and safe harbors, they don’t always afford the “yeah, but my facts are unique” argument.

By Jason Watson, CPA
Posted Monday, March 30, 2026

If your expenditure was too big to slide into the de minimis or small taxpayer safe harbors from Step 1, welcome to the jungle- we’ve got fun and games, as Axl would say.

Before you can apply any math or functional tests to figure out if you repaired or improved something, you must define the playground. What exactly are you fixing? In tax terms, this is called determining your Unit of Property (UoP).

Historically, the UoP was generally considered the entire building, including all its structural components. However, under the final Tangible Property Regulations, specifically 1.263(a)-3(e), the IRS explicitly requires you to carve out the building’s major internal systems from the building and its structural components.

This is actually a good thing.

The improvement versus repair analysis must be applied independently to the building structure and each of the following 8 key building systems:

• plumbing system
• electrical system
• HVAC system
• elevator system
• escalator system
• fire protection and alarm system
• gas distribution system, and
• the security system.

So, you have 9 total Units of Property if you count the building structure itself.

Why Does This Matter? Defining the UoP is arguably the most critical step in defending a repair deduction. Why? Because the UoP becomes the denominator for every test that follows.

You do not measure the scope of a plumbing repair against the value of the whole building. You measure the scope of a plumbing repair against the total plumbing system. Replacing 20% of a building sounds small. Replacing 20% of a plumbing system starts to feel very different.

If you skip this step and use the wrong denominator, you will either incorrectly capitalize a valid repair, or you will take an aggressive deduction that perhaps some suits at the IRS would disagree with.

Sidebar: Ironically, the same real estate investor who will happily pay thousands of dollars for a cost segregation study to aggressively carve up a property into discrete components for accelerated depreciation often completely abandon that disciplined, system-level thinking when analyzing a $15,000 plumbing invoice. The UoP rules require the exact same level of granular, system-level thinking in both contexts.

We mentioned the word denominator, and that suggests a mathematical equation or formula. The problem is how you measure that denominator—by dollars? by physical scope? We dig into these head scratchers in a bit.

By Jason Watson, CPA
Posted Monday, March 30, 2026

Are your individual invoices small enough ($2,500 or less) to expense under the de minimis safe harbor? Are your total annual maintenance and repairs (which includes cleaning, by the way) under the strict $10,000 / 2% limit to deduct under the small taxpayer safe harbor?

The second one is frankly one that is often missed, but even the first one is missed quite a bit. We see lawnmowers and window air conditioners listed on depreciation schedules. Who knows? Maybe some tax professionals sell the valuation proposition by complicating the uncomplicated. Oh well.

Enough of the soap box- if you can slide your expenditure into one of these two safe harbors, you get to skip the rest of the madness and immediately reduce your rental income for the year. Yay!

De Minimis Safe Harbor Election

We’ll start with the easiest one. As outlined in IRS Notice 2015-82, the IRS increased the de minimis safe harbor threshold from $500 to $2,500 per invoice or item for taxpayers in 2015. What does this mean? Anything you purchase including repairs and maintenance that are $2,500 or less per invoice or per item as substantiated on the invoice may be expensed and therefore deducted immediately (versus capitalizing as a fixed asset and depreciating).

You buy four dishwashers for your 4-unit rental property. The total invoice is $4,000, however, each dishwasher is $1,000. As such, since $1,000 is under $2,500 (even in Canada that math is correct), you can use the de minimis safe harbor.

The de minimis safe harbor doesn’t change your ability to deduct repair and maintenance costs that don’t qualify under the de minimis safe harbor. Is that double-talk? Maybe. How about this- you can use other safe harbors should you be unable to qualify under de minimis. Some more yay!

Some fine print- If the de minimis safe harbor is elected under Treasury Regulations Section 1.263(a)-1(f), it must be applied to all materials and supplies, and more broadly to amounts paid to acquire or produce tangible property, that meet the de minimis requirements, except for those the taxpayer elects to capitalize and depreciate. This sounds ominous but is quite minor.

Safe Harbor Election for Small Taxpayers

For the little investor in the real estate investment world, we have a practical safe harbor for expenditures that would otherwise be deemed improvements requiring them to be listed as a fixed asset and depreciated. Yuck.

Sidebar: Don’t blame us. The safe harbor is truly called small taxpayer. Ok, perhaps we piled on with the little investor comment. Just having a little tax and accounting fun. It should be called small asset safe harbor.

Two criteria-

• You have less than $10 million in gross rental income across all activities.
• The building’s unadjusted cost basis is $1 million or less. This excludes land, land improvements (driveways, fencing, etc.), and personal property (IRC Section 1245 property) identified through a cost segregation study.

If you meet these, then if the total amount paid during the taxable year for repairs, maintenance, cleaning, improvements, or similar activities performed on such building property stay under $10,000 or 2% of the unadjusted cost basis, whichever is more restrictive, you can expense all of it immediately as repairs and maintenance.

Sidebar: Maintenance is beyond screwdrivers and drywall. Turn-cleaning is a standard maintenance expense that keeps your rental property in normal operating condition. Time and therefore expense related to washing linens or mopping floors is viewed the same as swapping out a door lock.

Read that again. It is the total amount for the tax year, not per item or per occurrence.

Quick example- you buy a rental for $600,000 and the building is $400,000 of the overall purchase price. You spend $5,000 replacing the HVAC (a misnomer since HVAC is a system, and you probably replaced the air handler of the system, but we digress) and have an additional $1,000 in routine repairs. Let’s calculate your small taxpayer safe harbor ceiling:

• Your 2% limit is $8,000 (2% of $400,000).
• The absolute cap is $10,000.
• You are bound by whichever is more restrictive. In this case, your limit is $8,000.

Keep in mind that this is all repairs and maintenance combined. If you spent $5,000 on the HVAC unit, plus another $7,000 on other repairs and maintenance, then you exceed the limit. Blow past the limit by a dollar, and you are back in the full repairs versus improvements analysis. No partial credit. In other words, you cannot take $10,000 and expense it, and capitalize the remaining $2,000.

What if a part of your HOA dues includes maintenance of the landscaping? Things that make you go hmmmmm.

Tax Return Mechanics

Both safe harbors require an annual election with your tax return; they do not apply automatically. Yawn.

By Jason Watson, CPA
Posted Monday, March 30, 2026

Generally, there are two ways to compress time and hurry the tax benefits when you purchase and deploy certain property- bonus depreciation and Section 179 deduction (what some people call instant expensing). To be certain, Section 179 can be viewed as a form of “accelerated depreciation” since a) you list the property on your fixed asset listing of your tax returns, and b) there is depreciation recapture should the business use fall to or below 50% or you sell property (either the property itself or the associated rental property).

Sidebar: Technically, IRC Section 179 is an expensing tool, but many in the accounting industry lump it with accelerated depreciation discussions. Also, the 50% rule is another tribal standard. The true language of IRC Section 179(d)(1) is “The Secretary shall, by regulations, provide for recapturing the benefit under any deduction allowable under subsection (a) with respect to any property which is not used predominantly in a trade or business at any time.”

Section 179 lost a lot of its sexiness in 2018 once bonus depreciation hit 100% for five years, and even 80% in 2023. For 2024, bonus depreciation is 60% and as such Section 179 was back as a great rental property tax deduction and tax savings tool when appropriately leveraged. Timberlake might be bringing sexy back, but Section 179 is in the mix. Did we take that too far? Whatever. Keep reading about bonus depreciation for 2025 through 2030 with the One Big Beautiful Bill Act.

Sidebar: Several states decouple from the federal tax code, and do not allow bonus depreciation. As such, regardless of how sexy bonus depreciation might be (see what we did there), Section 179 expensing might be better given your state.

If you are reading this without an understanding of Section 1245 property and how it differs from Section 1250, please check out our section on Cost Segregation. When it comes to rental properties and certain real estate investments, identifying Section 1245 property allows for a portion of the property (asset) to be instantly depreciated, or “bonused” as some say, or deducted with Section 179. Yes, there are some exceptions when referencing Qualified Improvement Property for nonresidential property which we discuss in a bit.

Let’s run through this from a residential rental property perspective first. Then we’ll tackle the nonresidential issues with Section 179 and qualified improvement property, and how short-term rentals and transient tenants flip the narrative.

Accelerated Depreciation with Bonus

To reiterate, certain property purchases allow for a portion of the property (asset) to be instantly depreciated, or “bonused.” What do we mean by a portion? 2022 was the last year of 100% bonus depreciation. 2023 was 80% and 2024 is 60%. However, thanks to the One Big Beautiful Bill (OBBB, OBBBA, or OB3 as some like to say), bonus depreciation is back to 100% for 2025 through 2030. 2023 and 2024 tax years are still hosed unfortunately.

To be eligible for bonus, the property’s useful life cannot exceed 20 years.

If you are reporting bonus depreciation on a pass-through entity (PTE) tax return, it will generally be mixed in with all depreciation, and listed as a deduction among other deductions. This contrasts to Section 179 which is listed as a separate item on the PTE’s K-1 issued to the members or shareholders. Why? Section 179 has personal limitations that are managed on Form 4562 of your individual tax returns (there are some other nuances with basis, but we’ll avoid that topic for now).

Bonus depreciation does not have a limit. However, as we’ve discussed in various places including our state problems with your rental property section, many states decouple from federal tax code and do not allow for bonus depreciation.

Electing Out of Bonus Depreciation

Additional first-year depreciation, or what is commonly referred to as bonus depreciation, is required unless you opt out. Why would you want to opt out? There are a handful of tiny reasons, but the biggest is planned future increase in taxable income and therefore higher tax rates. In other words, would you rather take a depreciation deduction at a low tax rate or a high tax rate?

There are also tax planning considerations when rental property losses might be limited this year, but fully deductible in future years (think real estate professional status or short-term rental loophole). This can be a bit of crystal ball type stuff and must be handled carefully.

Electing out of bonus can be done annually and is specific to an asset class such as 5-year, 7-year and 15-year. It is also specific to assets placed in service in that year. Therefore, you can elect out of 7-year bonus depreciation in 2025 because it made sense from a tax planning perspective, and then purchase another rental property and perform a cost segregation study in 2026 to take full advantage of all asset classes including 7-year assets for bonus depreciation.

Electing out can also be a problem. Let’s say you opted out in 2023 for whatever reason, and you want to do a cost segregation study paired with a Form 3115 Change in Accounting Method for a rental you placed in service in 2023. You do this in 2026 because a) you have high income and b) your rental property qualifies for the short-term rental loophole. So, 2026 is a nice time for a big deduction.

However, bonus depreciation is unavailable to you- rather, you would still do the cost seg but you would generally need to amend 2023’s tax returns and utilize Section 179 expensing. Then again, that option might not be attractive if 2023’s passive losses are being limited or if Section 179 is not providing the benefit that bonus depreciation would have.

There are rules to “opt back into” bonus depreciation by amending your originally filed tax return within 6 months or asking the IRS for permission through a Form 3115 Change in Accounting Method.

Section 179 Deduction

Generally, IRC Section 179 allows businesses to deduct the full purchase price of qualifying equipment and property bought or financed during the tax year. Here is the exact verbiage of IRC Section 179(a)–

(a) Treatment as expenses.
A taxpayer may elect to treat the cost of any section 179 property as an expense which is not chargeable to capital account. Any cost so treated shall be allowed as a deduction for the taxable year in which the section 179 property is placed in service.

Sounds simple enough, right?

However, rental properties are not automatically considered a trade or business. The definition of a “trade or business” comes from common law, where the concepts have been developed and refined by the courts over time. The Supreme Court has interpreted “trade or business” for purposes of Section 162 to mean an activity conducted with “continuity and regularity” and with the primary purpose of earning income or making a profit. We would argue that rentals and general real estate investments fall under this auspice otherwise you wouldn’t do it. Sure, we all want that short-term tax loss to offset other income, but ultimately you want to make money.

For rental properties in particular, the presumption is that they are passive and on the opposite end of the business spectrum.

As stated just a second ago, a business must have a profit motive; whether you actually earn a profit is irrelevant; it is your motivation and subsequent actions that dictate this determination. This is a critical distinction since most rental properties have a loss, especially in the early years with current market rent combined with depreciation and / or with relatively high mortgage interest, or both. Moreover, if you could raise rent to turn a loss into a profit, you would, but silly things like Adam Smith and market economy get in the way.

In addition to your profit motive, your participation in the business must be regular and continuous. Do not confuse this with material participation which has a series of bright line tests for short-term rental loophole or real estate professional status when viewed in the context of rental properties and real estate investments.

Armed with this knowledge, does your rental property qualify as a business?

Typically, owning a rental property should generally qualify- profit motive, and regular and continuous participation. However, it is not a slam dunk. By using Alvary v. United States, 302 F.2d 790 (2d Cir. 1962) and Gilford v. Commissioner, 201 F.2d 735 (2d Cir. 1953), the IRS and others have come up with a mini facts and circumstances checklist-

• the type of rented property (commercial versus residential property)

• the number of rental properties (volume)

• taxpayer reliance on the activity for lifestyle or income

• time and effort spent on daily operations

• the types and significance of any ancillary services provided within the activity (think short-term rental, hunting lodge, tours, etc.) the terms of the lease (for example, a short-term versus long-term lease), and

• conformity to Section 199A’s preamble

We will talk more about the Section 199A qualified business income deduction (QBID) in a bit, but here is a snippet from page 16 the final regulations which eerily look familiar to the list above-

In determining whether a rental real estate activity is a section 162 trade or business, relevant factors might include, but are not limited to (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner’s or the owner’s agents day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).

That doesn’t really stand out as helpful or definitive either. The good news is that both the courts and the IRS have consistently found in favor of rental property owners and have allowed broad support for the profit motive including the regular and continuous requirements. Yay! However, in Grier v. United States, 120 F.Supp. 395 (D.Conn. 1954) the taxpayer lost. How?

Edgar Grier inherited a house from his mother that she had rented out for many years to the same tenant. This same tenant continued to occupy the property until Grier sold it 14 years later. Over the years, little management work was required, but Grier did take care of such details as replacing the furnace. The IRS and court found that the house was an investment, not a business for Grier. The court noted that this was the only rental property Grier had ever owned and concluded that his landlord activities were too minimal to rise to the level of a business.

This court case can be problematic, right? The court recognized that this was Grier’s only rental. So, do you need more than one? A whole gaggle? Perhaps. Or do you just need to involve yourself more in your single rental property activity, and document the heck out of it? Doesn’t hurt. Then again, things have changed a bit since 1954.

Profit motive. Got it. Continuous and regular. Wonderful. Now what? In the past, Section 179 could not be used to deduct personal property used in residential rental property. However, the Tax Cuts and Jobs Act (TCJA) eliminated this restriction starting in 2018. This means that rental property owners can now use Section 179 to deduct the cost of personal property items they purchase for use inside rental properties. For example, kitchen appliances, carpets, drapes, or blinds, just to name a handful. See our section on rental property renovations. Fun!

There is a subtle difference between the above examples, and nonresidential rental property. Under TCJA, Section 179 expensing has been expanded to include nonresidential roofs, heating, ventilation, air conditioning, and fire / alarm protection systems. Therefore, a new HVAC system for single-family residence typically cannot be expensed with Section 179 but might be allowed for an office building.

But wait! There’s more. Always more, right? You may use Section 179 expensing on an HVAC system in a single-family home that is considered nonresidential. Nonresidential home? How does that work? See our section on Qualified Improvement Property.

When To Bonus? When To Use Section 179? Both?

As mentioned earlier, if or when bonus depreciation is no longer 100%, Section 179 might be a better tax deduction. However, there are two issues- your rental activities must be a business. The Alvary and Gilford mini checklist is nice but the underpinnings of “trade or business” are good to review again so you can correctly couch your facts (and not end up like Grier).

The other issue is that Section 179 has limits. The maximum Section 179 expense deduction is $2,580,000 (for the 2026 tax year). This limit is reduced by the amount by which the cost of Section 179 property placed in service during the tax year exceeds $3,220,000.

Section 179 has trapped benefits within business entities such as partnerships and it also has a pesky recapture trigger should the rental property (or underlying asset) no longer be predominantly used in business (often 50% or below business use). We expand on these in a bit. Back to IRC Section 179 versus IRC Section 168 bonus depreciation.

What’s the hair on bonus depreciation? Not much, except that many states do not allow a tax deduction for bonus depreciation. In accounting geek speak, several states decouple from federal tax code.

Can you use both? Yes. You can dictate to the dollar how much Section 179 expense you want to use “first” and then piggyback it with bonus depreciation. Technically, Section 179 is deducted first with bonus depreciation being second. The net-net is good tax planning by a qualified real estate-minded tax professional.

Sidebar: See our Section 179 or bonus depreciation section in our Cost Segregation chapter for a deeper look into the 179 versus bonus conundrum. There are a lot of moving parts, and some of the decision requires either faith, patience or crystal ball, or all three. Best of luck.

By the way, bonus depreciation and Section 179 deduction is not available on foreign property.

Section 179 Problems With Partnerships

There is a wrinkle with IRC Section 179 when you hold a rental property inside a multi-member LLC (MMLLC) taxed as a partnership. Unlike depreciation, which can freely create a loss, Section 179 has built-in limitations that can restrict how much benefit you actually get.

The instructions for Form 4562 Depreciation and Amortization, reads-

Partnerships. Enter the smaller of line 5 or the partnership’s total items of income and expense, described in section 702(a), from any trade or business the partnership actively conducted (other than credits, tax-exempt income, the section 179 expense deduction, and guaranteed payments under section 707(c)).

What does this mean? The partnership must first determine its trade or business income, and that income effectively caps how much Section 179 can be allocated. Unlike bonus depreciation, which can push the entity into a loss, Section 179 has a second layer of friction-this time at the partner level.

While the partnership allocates Section 179 deductions through the K-1, each partner must apply their own limitations under IRC Section 179(b)(3), along with basis, at-risk, and passive activity rules. Unlike depreciation, which often flows through more cleanly, Section 179 deductions from a partnership can become effectively trapped depending on the partner’s individual tax situation and the character of the income they have available to absorb it.

Section 179 Problems With Moving Into Your Rental Property

Who wants more bad news? Let’s look at IRC Section 179(D)(10)-

(10) Recapture of deduction. If the property ceases to be used predominantly in a trade or business during any taxable year, the taxpayer shall include in gross income for the taxable year an amount equal to the excess of—

(A) the amount of the deduction allowed under subsection (a) with respect to such property, over

(B) the amount which would have been allowable under section 168 if no election under this section had been made.

Treasury Regulations Section 1.179-1(e)(1) reads the same way-

If the property is not used predominantly in a trade or business at any time before the end of its recovery period, the taxpayer must recapture the excess deduction as ordinary income.

What does this mean for you? If you take the rental property out of service because you are converting it back into a primary residence or second home or anything other than its income producing purpose, you will have to recognize a portion of the IRC Section 179 expensing as ordinary income. Technically, a portion of the benefit received is recaptured as ordinary income.

The exact phrase is “ceases to be used predominantly in a trade or business” which commonly means 50% or less according to IRS Publication 946 How To Depreciate Property–

If the use of the property drops to 50% or less in a year after you have taken a section 179 deduction, you must recapture part of the deduction. You do this by recomputing the depreciation from the year you placed the property in service, and including the difference in income in the year the business use dropped.

This verbiage in the IRS publication comes from Treasury Regulations Section 1.179-1(e)(2).

The portion part requires some calculations- the amount recognized as income is the difference between the amount expensed using IRC Section 179 and the amount allowed using typical depreciation.

Sidebar: The same thing happens on a business vehicle. You buy a big truck and use Section 179 to expense $32,000 (for the 2026 tax year). You start racking up personal use of the truck that exceeds 49.9% the following year. You will trigger recapture and recognize a big chunk of the $32,000 as income. Yuck!

However, and this a big however, that is Section 179. What about bonus depreciation? You might like this- under IRC Section 280F(b)(2), only listed property (passenger automobiles, entertainment / recreation, computers and peripheral equipment, and cell phones / telecommunication equipment) have a similar recapture rule to Section 179 when business use falls to or below 50%.

As such, if you use bonus depreciation coupled with a cost segregation study, and then you don’t have this recapture issue. However, and as a reminder, there are state issues since several states decouple from federal tax code and do not recognize bonus depreciation. Ah, decisions decisions.

As a tax planning consideration, if you have intentions to move into the rental property in the future, you might want to steer clear of IRC Section 179 in favor of bonus depreciation, or find a tax professional who doesn’t know about this rule. Kidding.

Can I Use Section 179 Against W-2 Income?

Yes. Who wants more Form 4562 instructions?

Individuals. Enter the smaller of line 5 or the total taxable income from any trade or business you actively conducted, computed without regard to any section 179 expense deduction, the deduction for one-half of self-employment taxes under section 164(f), or any net operating loss deduction. Also, include all wages, salaries, tips, and other compensation you earned as an employee (from Form 1040, line 1). Do not reduce this amount by unreimbursed employee business expenses. If you are married filing a joint return, combine the total taxable incomes for you and your spouse.

In Bloomberg v. Commissioner, 74 Tax Court 1368 (1980), the court used the term “in the business of being an employee” and this has been pointed to often when applying Section 179 expensing against W-2 wages. Here is a common example that you’ll see all over the world wide webs-

Example: You have a business income of $10,000 and qualifying Section 179 expenses of $90,000. Your spouse has a W-2 income of $50,000. Your husband-and-wife business income limit for Section 179 expensing is $60,000 ($10,000 plus $50,000).

If you elect to expense the entire $90,000, you deduct $60,000 this year and carry the $30,000 excess over to next year, where it again enters into a Section 179 computation. You may carry over the excesses to any number of years, without limit.

While miscellaneous deductions on Schedule A are no longer permitted on your individual tax returns after the Tax Cuts and Jobs Act, Form 2106 Employee Business Expense remains a valid tax form. As such, tax law continues to support the “in the business of being an employee” as referred by the Bloomberg court above.

Some States Do Not Recognize Accelerated Depreciation

California, for example, does not recognize bonus depreciation and has different limits for Section 179 expensing. According to California’s FTB Publication 1001–

The TCJA increased the amount of the additional first-year depreciation allowance from 50% to 100% for certain qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. The 100% allowance is phased down by 20% per calendar year for property placed in service in taxable years beginning after 2022. The additional first-year depreciation deduction is allowed for new and used property. California does not conform to this provision.

It makes sense, right? The federal government can print money. States don’t have this luxury and must balance a budget (California notwithstanding). Don’t blame California necessarily- many states decouple from federal tax code and do not recognize bonus depreciation as a tax deduction. See our massive state problems with your rental property section for more painful information.

Accelerated Depreciation and Section 179 Recap

Some of this stuff can make you drool, and a simple net-net recap is all you need. Here we go-

• You can bonus depreciate 5-, 7- and 15-year property. This would be personal property that becomes Section 1245 property.

• You can Section 179 expense 5-, 7- and 15-year property connected with a residential property provided the activity is considered a business with regular and continuous participation with a profit motive.

• You can Section 179 expense certain items in nonresidential property that might otherwise not be eligible in a residential environment. Again, there is a cool nuance with nonresidential property that we review in our Qualified Improvement Property (QIP) section.

• You need to be mindful of Section 179 recapture should the rental property be taken out of service. This is where a portion of the previous benefit received is added back as ordinary income and taxed.

Here is a nice table (well, we think it is nice) to augment the summary-

Keep in mind that generally property with a useful life (recovery period) of 20 years or less is eligible for bonus depreciation. Also, the “Sect 179 carve out” above refers to IRC Section 179(e)(2). Oh, one more thing- nonresidential is a rental property with an average guest stay of 30 days or less (there are other provisions for mixed use commercial properties as well).

By Jason Watson, CPA
Posted Monday, March 30, 2026

Every time you pay a contractor or buy materials for your rental property, you face the exact same tax dilemma: Can I deduct this today, or do I have to depreciate it over decades? Yeah, sure, decades as in plural sounds dramatic, but it’s true- 27.5 or 39 years. Decades.

The answer lies in understanding the difference between a routine repair and a capital improvement. According to IRS Revenue Ruling 2000-4,

Section 263(a) and § 1.263(a)-1(a) provide that no deduction is allowed for any amount paid out for permanent improvements or betterments made to increase the value of any property or estate. Section 1.263(a)-2(a) provides that capital expenditures include the cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year.

Cool. The things you buy that have a useful life substantially greater than one year are considered a capital expenditure (capex) and must be capitalized in most situations. What the heck is capitalized? Is this a grammar thing?

There is capitalization in finance, and perhaps even in the deal structure on your rental property (debt versus cash versus investors). In accounting, and in tax return preparation, capitalization is an accounting method in which a cost is included in an asset’s value and expensed over the asset’s useful life, rather than expensed in the period the cost was incurred. Capitalization recognizes a cash outlay as an asset on the balance sheet rather than an expense on the income statement.

Yup, full on geek-speak.

Moreover, a capital improvement is an expenditure that increases a property’s value, useful life, or adapts it to a new use. The IRS often refers to these as betterments, restorations, and adaptations, or BRA for short. Fun!

Simply put, you can either expense or capitalize a purchase:

• Expensing the purchase is an immediate deduction and therefore an immediate reduction in rental income.
• Capitalizing the purchase requires listing the asset on your fixed asset schedule and slowly expensing it over time through depreciation.

Accelerated depreciation through bonus depreciation or Section 179, or both, can allow for an immediate deduction of an otherwise capital asset. We’ll talk about accelerated depreciation and Section 179 expensing in a bit.

Rental Property Repairs Safe Harbors

There are three safe harbors relevant to rental property owners and real estate investors. If your expenditure fits into one of these three categories, you can bypass the complex rules repairs versus improvements, expensed versus capitalized, and immediately deduct as an expense. Heck you might even get to collect $200 as you pass Go.

Here are the safe harbors. We will expand in nauseating detail later in the chapter:

• De Minimis Safe Harbor: The easiest one. If an item or invoice line-item costs $2,500 or less, you can generally expense it immediately.
• Small Taxpayer Safe Harbor: If your building’s unadjusted basis is $1 million or less, and your total annual maintenance and repairs (which includes cleaning, by the way) stay under $10,000 or 2% of the building’s basis, whichever is more restrictive, you can expense all of it.
• Routine Maintenance Safe Harbor: If you reasonably expect to perform this exact maintenance on a building system more than once every 10 years to keep it in normal operating condition, you can expense it.

Ok, neat. How do you use them? There is a 5-step process and just like the safe harbors, we will do a deep dive into each:

The 5-Step Repair Or Improvement Process

If your expenditure doesn’t neatly fit into a safe harbor, things get a bit more complicated. Here is the step-by-step roadmap to land at either expense or capital improvement:

• Step 1: De Minimis or Small Taxpayer Safe Harbor: First, you check the easy buttons like a stroll through Staples. Is your individual expenditure small enough to fit into the safe harbors that we just defined above?
• Step 2: Unit of Property (UoP) Analysis: Before you can test a repair, you must determine whether you are measuring the fix against the entire building structure or just one of its specific internal systems (like the plumbing or HVAC). Under the regulations, building systems like plumbing, HVAC, and electrical are treated as separate units of property from the building structure, which is why this step matters so much.
• Step 3: Routine Maintenance Safe Harbor: The 10-year rule. Next, test the repair against the system you defined in Step 2 to see if you expect to perform this maintenance more than once a decade. Water heaters is a wonderful example.
• Step 4: Betterment or Adaptation: The “dead in the water” tests. If your work materially increases capacity, strength, efficiency, or quality, it is called a betterment. Bad. Alternatively, if your work adapts the property to a totally new use, it is called an adaptation. Both are bad since they generally require you to capitalize. Also, the IRS loves to argue betterment when restoration is unclear, so even something that feels like a repair can get pulled into capitalization if there is any meaningful upgrade.
• Step 5: Restoration Guideline: The final gauntlet. If you made it this far, then functional tests are applied along with a “30%ish heuristic” to see if you merely repaired a system or completely replaced a major, critical component.

By Jason Watson, CPA
Posted Monday, September 29, 2025

Here are some FAQs you might find helpful as a chapter summary. There is just one question quiz at the end- Can you deduct a water heater as a repair?

What’s the difference between a repair and an improvement?
Repairs maintain a property’s current condition and can be deducted immediately. Improvements enhance value, extend life, or adapt the use of the property and must be capitalized and depreciated. Sounds simple enough, right?

What is the IRS “BRA” test?
BRA stands for Betterment, Restoration, and Adaptation—criteria used to determine if an expense must be capitalized as an improvement.

What is the IRS “BAR” test?
Trick question.

When must an expense be capitalized?
If it corrects a material defect, replaces a major component, or changes the use of the property, it likely meets BRA standards and must be capitalized. But there are exceptions under the three rental property safe harbors.

What’s the general definition of a capital expenditure?
An amount paid for permanent improvements or acquisitions that has a useful life substantially beyond one year.

What is the de minimis safe harbor?
You can deduct purchases under $2,500 per item or invoice line, even if they are technically improvements, if properly elected on your return.

What is the Safe Harbor for Small Taxpayers?
If the building cost is under $1 million and gross rental income under $10 million, you can deduct repairs that might other be considered improvements up to the lesser of $10,000 or 2% of unadjusted rental property basis (think acquisition costs plus prior improvements).

What’s the Safe Harbor for Routine Maintenance?
You can deduct costs if you reasonably expect to perform the maintenance more than once in 10 years for buildings and systems. This one is tricky, but often overlooked and underutilized.

Can I use multiple safe harbors in one year?
Yes. If you don’t qualify under one, another may still apply.

Do I need to file something to use these safe harbors?
Yes. The de minimis and small taxpayer elections must be formally made on a timely filed return.

Is replacing an HVAC system a repair or improvement?
Usually an improvement unless you can use the small taxpayer safe harbor. You might be able to use routine maintenance as well- for example, you’re replacing 2 out of 10 HVAC units in a multi-unit system. You might also be able to use Section 179 expensing under qualified improvement property.

What about repainting?
Standalone painting is typically a repair. If bundled with a larger remodel, it must be capitalized.

Is replacing windows a repair?
Depends on scale. Replacing all windows is a capital improvement; replacing a fraction, like 100 out of 300, may qualify as routine maintenance. That’s a lot of windows.

Is a water heater a repair or capital item?
If under $2,500, it may qualify under de minimis. Otherwise, it’s likely a capital item unless you meet routine maintenance criteria.

How does routine maintenance apply to water heaters?
If you reasonably expect to replace it more than once in 27.5 years, it might qualify under the routine maintenance safe harbor.

What’s partial asset disposition (PAD)?
When you replace part of a property (e.g., a roof), you can deduct as a loss the undepreciated value of the old component. Not common in non-commercial settings.

Is a cost segregation study required to do PAD?
Not required, but very helpful in estimating the original component’s basis and depreciation.

Can I use bonus depreciation on improvements?
Only if classified as 5-, 7-, or 15-year property—like appliances, landscaping, or qualified improvement property in some cases.

Can I use Section 179 on residential rental property?
Rarely. Section 179 applies only to certain types of asset classes (personal property), and if the rental property is considered non-residential (commercial or short-term rental under 30 days average guest stay).

What is Qualified Improvement Property (QIP)?
QIP is any non-structural improvements to nonresidential buildings after it is placed in service, excluding enlargements, elevators and escalators. It is eligible for bonus depreciation and Section 179 expending.

Can residential rental property qualify as QIP?
No, QIP only applies to nonresidential property, so residential rental property does not qualify.

How do short-term rentals affect whether it is considered residential or nonresidential for the purposes of QIP?
If guests stay 30 days or less, the property is treated as nonresidential, allowing interior improvements to qualify as QIP.

What happens if a kitchen renovation changes a structural component like a load-bearing wall?
Technically, you are hosed. Practically, it no longer qualifies as QIP and must instead be depreciated over 27.5 or 39 years.

What’s the difference between Section 179 and bonus depreciation?
Section 179 cannot create a loss and may be trapped at the entity level, while bonus depreciation can create a loss and is often more flexible.

Which improvements qualify for Section 179 but not as QIP?
Roofs, HVAC, fire protection, alarm systems, and security systems can qualify under Section 179 but are not considered QIP since they are not interior improvements.

Why do real estate investors favor short-term rentals for QIP and depreciation strategies?
Short-term rentals are classified as nonresidential, making them eligible for enhanced bonus depreciation and Section 179 expensing options beyond typical residential rentals.

What are examples of 5-year property?
Appliances, carpeting, kitchen cabinets, and telecom wiring. Yes, we just used the word telecom.

What are examples of 7-year property?
Furniture, decorative lighting, closet shelving, and wall coverings.

What are examples of 15-year property?
Landscaping, sidewalks, fences, patios, and irrigation systems. Throw in pools and hot tubs too.

What is a “unit of property”?
Generally the entire building. But for improvements, IRS rules require looking at each major building system separately for a total of 9. Electrical, plumbing and gas distribution are good examples.

Can I use both Section 179 and bonus depreciation in the same year?
Yes. You can choose how much Section 179 to apply first, and then use bonus depreciation for the remaining basis. Section 179 is applied before bonus by default.

Is Section 179 available for rental property owners?
Only if the rental activity qualifies as a trade or business meaning it’s conducted with continuity, regularity, and profit motive, and the property is either personal property or qualifies as qualified improvement property (QIP, which is specific and limited).

Can I use Section 179 against W-2 income?
Yes, the income limit includes W-2 wages for purposes of the deduction. There are some devils in the details of course.

What happens if I move into a rental after claiming Section 179?
You must recapture the excess deduction (difference between typical depreciation and Section 179) as ordinary income if the property is no longer used predominantly for business purposes.

What’s the difference between bonus depreciation and Section 179?
Bonus is a depreciation method and is automatic (unless you opt out) and has no dollar limit; Section 179 is an election to expense certain expenditures with limits and recapture rules, but you can choose the exact amount to expense first.

What property qualifies for bonus deprecation under IRC Section 168(k)?
Generally, property with a recovery period of 20 years or less.

When would I elect out of bonus depreciation?
If you expect higher future tax rates, or your rental property losses are limited this year but fully deductible later (e.g., STR loophole or future REP status), you might opt out by class and year. Tax planning anyone?

Do rental properties qualify for Section 179?
Yes, if the rental rises to a trade or business with profit motive and regular, continuous participation (facts and circumstances), and you have certain assets that qualify. In other words, you cannot use Section 179 expensing on the building itself.

Can I combine Section 179 and bonus depreciation?
Yes—179 is applied first, and bonus can piggyback on the remainder for strong planning flexibility.

Are 5-year and 7-year assets eligible for Section 179 or bonus?
Yes for both Section 179 and yes for bonus depreciation; these are standard IRC Section 1245 property.

Is Qualified Improvement Property (QIP) eligible?
Yes for both Section 179 and yes for bonus depreciation, but only for nonresidential interior improvements.

Do kitchen or bathroom renos qualify as QIP?
Yes for both Section 179 and bonus depreciation when they’re nonresidential interior improvements including large renovations such as a kitchen or bathroom.

Can I expense a new roof?
Under Section 179: Yes (nonresidential carve-out); bonus: No. If your rental property is a long-term rental, then No.

Can I deduct the replacement of HVAC (furnace, AC, mini-split)?
Under Section 179: Yes (nonresidential(carve-out); bonus: No.

Is bonus depreciation available on foreign rental property?
No. Both Section 179 and bonus depreciation are not available for property located outside the U.S.

Can Section 179 create a loss on a partnership return?
Generally, No. Section 179 cannot create or increase a loss on Form 1065. This is a key limitation for partnerships and multi-member LLCs.

Does bonus depreciation have recapture issues like Section 179?
Not directly. Bonus depreciation doesn’t require recapture upon a change in use, but the asset continues depreciating and recapture may apply at sale. While not an issue with rental properties, listed property does have a recapture component under IRC Section 280F as it intersects IRC Section 168.

Should I use Section 179 if I might move into the property later?
Probably not. If future personal use is planned in the next 20 years or so, avoid Section 179. Or at least understand the tax consequences.

By Jason Watson, CPA
Posted Monday, September 15, 2025

You might think this section is not too sexy since it primarily pertains to nonresidential property, but there is neat exception. We won’t discuss the mixed-use apartment building (residential) that has first-floor retail space (nonresidential); that is a can of facts and circumstance worms.

Qualified Improvement Property (QIP) is defined as any improvement made to the interior of a nonresidential building after the building is placed in service and is eligible for bonus depreciation. Improvements exclude expansion of the building, elevators and escalators (specifically called out, really?!), and changes made to a building’s internal structural framework. Oh, and let’s not forget that residential property also does not qualify.

Here is a bullet list of IRC Section 168(e)(6) for the ease of reading-

• Interior improvements only, to nonresidential real property.
• Excludes enlargements, elevators/escalators, structural framework.
• 15-year life so eligible for bonus depreciation under IRC Section 168(k).
• Also eligible for Section 179 expensing under IRC Section 179(f)(1).

What does this mean for you?

QIP on Short-Term Rentals

This nuance takes a bit of time to sort through. IRC Section 168(e)(2) reads-

Ok. What is a dwelling unit? IRC Section 168(e)(2)(a)(ii)(I) reads-

Great. What is transient basis? In Private Letter Ruling 139827-07, the IRS stated-

“Lodging facility” is defined in section 856(d)(9)(D)(ii) as a (l) hotel, (ll) motel, or (lll) other establishment more than one-half of the dwelling units in which are used on a transient basis. The term “transient” is not defined in section 856 or the regulations thereunder. However, for other purposes of the Code, a renter has generally been treated as “transient” if the rental period is less than 30 days. See section 1.48-1(h)(2)(ii) (which concerned definitions under old section 48 for purposes of the investment credit under former section 38); Shirley v. Commissioner, T.C. Memo 2004-188.

If your rental property has tenants or guests who stay 30 days or less, then they are considered transient. Subsequently, the rental property is not considered residential. Do you see how the tax code defines residential as receiving 80% of its income from dwelling units. Next, the code states that dwelling units do not include units if more than 50% of those units are used on a transient basis.

It’s defined in the negative. If you are not A, then you can only revert to B. This desire to be considered residential and to have the code respond with the criteria to be considered residential (versus wanting to be considered nonresidential) was not accidental. Huh?

Why did the IRS, Treasury, Congress and everyone define it this way? The original intent was to prevent real estate investors from using 27.5 years of depreciation versus 39.0 years. In other words, by calling a rental property a residential property, they were able to shrink the depreciation schedule (and increase current year depreciation deductions). There are all kinds of tax court cases involving nursing homes and dormitories discussing this residential versus nonresidential issue.

We can use this spat to our advantage. How?

If you have a rental property with an average guest stay of 30 days or less, and you drop $80,000 on a kitchen renovation after the property was originally placed in service (ready and available for occupancy, and held for rental use through advertising and related efforts), you can use either bonus depreciation or Section 179 expensing.

However, if you change structural components such as an exterior wall or load-bearing wall, then your kitchen renovation suddenly does not qualify, and must be depreciated over 27.5 or 39.0 years.

Sidebar: Don’t get twisted on short-term rental loophole and transient rental. Generally, short-term rentals are rentals where guests or tenants stay 30 days or less. However, for the short-term rental loophole where your rental property losses are no longer limited, the average guest stay must be 7 days or less and you must materially participate in the activity. We discuss this in detail in our section on the short-term rental (STR) loophole.

That’s bonus depreciation, Section 179 and qualified improvement property. If you do not use bonus depreciation or Section 179 on QIP, then you must depreciate the improvement property over 15 years for tax purposes. You don’t have a choice. In other words, if you have a nonresidential property and you shoot the money canon on that kitchen reno, then you will depreciate the cost over 15 years and not 39.

Consider this- it is unlikely you will have an interior improvement on a short-term rental that is depreciated over 39.0 unless there were structural components involved. Don’t forget the word “interior.”

Section 179 Expensing

The following blurb is often discussed when qualified improvement property is mentioned, but it is truly different (yet connected). IRC Section 179(e) reads-

So, IRC Section 179 is bringing in IRC Section 168 as we described earlier, and then adding specific items like roof, HVAC, fire and alarm systems and security systems that are specifically eligible for Section 179.

Neat. What does this mean for you? That kitchen reno we mentioned earlier would be eligible for bonus depreciation and Section 179 expensing. However, a roof or HVAC system is not QIP (because it is not an interior improvement) and would only be eligible for Section 179 expensing (not bonus depreciation). Again, this assumes a nonresidential rental property (average guest stay of 30 days or less).

There is some tax arbitrage available in replacing certain property since you can accelerate depreciation with bonus depreciation, or you can leverage Section 179 expensing. How? You purchase a rental property which naturally includes an HVAC system, and as such a part of the purchase price includes the value of the HVAC system. In turn, you depreciate the building and its components including the HVAC system. Neat.

Time goes by, and you replace the HVAC system. You might be able to immediately expense it with Section 179. However, the portion of the original building that included the HVAC system continues to depreciate. A double dip if you will. There is a thing called Partial Asset Disposition (PAD) that we will discuss in a bit where you might want to elect to dispose of the original HVAC system to recognize a tidy tax loss, and then also accelerate / expense the new HVAC system. Win win!

Short-Term Rental Benefits

Many real estate investors and rental property owners focus heavily on STRs because they are not subject to passive activity loss limits provided the activity qualifies (average guest stay of 7 days or less with material participation). However, short-term rentals, as you can see, are also designated as nonresidential and therefore have enhanced bonus depreciation and Section 179 expensing possibilities beyond typical rental properties.

Section 179 Versus Bonus Depreciation

For most interior improvements on nonresidential rental properties, you will have a choice between Section 179 and bonus depreciation. As we discuss in our accelerated depreciation and section 179 deduction section there are reasons to pick one over the other. Quickly-

• Section 179 cannot create a loss. It might still be fully deducted against other income sources depending on your situation. Bonus depreciation can create a loss (and impact the qualified business income deduction or QBID).
• Unused Section 179 at the entity level is trapped, and cannot be used against other income sources of the owners (for example, a rental property holding company). In other words, unlike owning a rental property in a single member LLC or in your own personal name, the unused Section 179 does not flow to the owners of a partnership (Form 1065) or S Corp (Form 1120S).
• Many states decouple from the federal tax code on bonus depreciation whereas many states allow for Section 179 expending with limitations.

Tax planning is a must.

Leveraging Qualified Improvement Property

Before the improvement, make sure your rental property is placed in service as we’ve discussed in our rental property in service defined section. The qualified improvement must be after the placed in service date. For example, you buy a rental property that you envision being a lovely short-term rental but you know the kitchen and bathrooms need some attention.

First, put the rental property into service where it is ready and available for its intended purpose. Otherwise, whatever you do will not be a qualified improvement but rather an improvement that is capitalized as a separate asset and depreciated over 39.0 years (assuming short-term rental).

Sidebar: Your material participation time clock starts at this time as well, and managing a large renovation can buttress your time log. See our time spent renovating section for more information since there are some pitfalls if your time is deemed investor time.

Next, ensure you have a few guest stays to get your average guest stay calculation. Large renovations might spill into the next tax year, and while your rental property is technically placed in service where expenses are tax deductible, it cannot be a short-term rental without the guest stays.

Next, take the rental property offline (it is still considered placed service since its intended purpose has not changed) and complete your qualified improvements. The smell of construction. Yum. Keep in mind that your reno cannot contain structural components or changes.

Next, take your big tax deduction against that high W-2 income through bonus depreciation or Section 179 expensing. No need for a cost segregation study since qualified improvement property is deemed 15-year property automagically.

Keep in mind that if you are improving the property to become a long-term rental immediately following the reno, that looks like a change in its intended purpose and might blow up your QIP deduction. The improvement must be done to a nonresidential property (30 days or less guest stays is nonresidential). Perhaps you muscle through a small period of short-term guest stays following the improvement to tick the box, and then change to a long-term rental.

Another consideration- you can also do this on a 30-day short-term rental (assuming no personal services are provided). Sure, your tax deduction will be limited by passive activity loss limitations, but if you have other rental income (profits) to offset or net against, then this works well. You can also build up a large passive loss carryover on Form 8582, and use that to chip away at future rental income. Huh?

Your rental property rents for 30 days at a time and earns $15,000 a year in taxable profit. You spend $100,000 on a kitchen renovation which creates a big tax loss yet limited by passive activity loss rules. In other words, you do not get an immediate tax deduction. However, this unallowed loss gets carried over into the future on Form 8582 as mentioned above, and will reduce your future rental profits to $0 until all the carryover losses are used.

By Jason Watson, CPA
Posted Sunday, May 25, 2025

Chapter 10 explains how to properly categorize property-related expenses for tax purposes. The key distinction is between repairs, which are generally deductible in the year incurred, and improvements, which must be capitalized and depreciated over time.

The chapter outlines the IRS standards for identifying improvements through the concepts of betterment, restoration, and adaptation (BRA or BAR, your choice). It also introduces several safe harbor elections—including the De Minimis Safe Harbor, Safe Harbor for Small Taxpayers, and Safe Harbor for Routine Maintenance—that allow certain expenditures to be treated as current deductions.

Examples and definitions are provided to help clarify gray areas, such as whether replacing windows, painting, or upgrading fixtures should be treated as a repair or an improvement. We also discuss common situations, such as roof replacements, appliance upgrades, and structural repairs, with reference to relevant IRS publications and rulings.

Other topics include qualified improvement property (QIP) which is essential for non-residential rental properties (including homes rented 30 days or less), and partial asset dispositions (PAD).

By Jason Watson, CPA
Posted Sunday, May 25, 2025

Here are some common expenditures that can leave everyone scratching their heads. Hopefully we can shed some light on the pathway. Here we go-

Water Heaters

The bane of all rental property owners! Given hard water in California and no more gas hookups in New York (electric elements fail often), water heaters will be replaced long before 27.5 and 39.0 years, and as such, what is the appropriate way to handle the new cost?

Step 1. Use the $2,500 de minimis safe harbor. Most water heaters can be installed for less than $2,500 unless you go big and install a tankless or some other fancy water heater, or if the installation is complex (converting from electric to gas or vice versa). Some people suggest having the plumber split the invoice between parts and labor- this gets a little hairy since an asset placed in service, such as a water heater, is bundled with the cost of the unit, transportation and installation. In other words, the IRS might not consider parts and labor to be bifurcated- one cannot exist without the other (inextricably connected). This is certainly a risk-based approach.

Step 2. Ok, let’s say $2,500 isn’t going to work. What about the small taxpayer’s safe harbor? At the risk of repeating ourselves from a previous section, the cost of the water heater plus all other repairs must be under 2% of the unadjusted cost basis of the building (before depreciation, such as the purchase price plus acquisition costs) or $10,000. Therefore, if $2,500 isn’t going to work in step 1, then your rental property building unadjusted cost basis must be at least $125,000 and less than $500,000 ($10,000 divided by 2%) to allow for a full tax deduction of the water heater.

Step 3. Burn the place down, and start over. Sure, this is not ideal and generally frowned upon by law enforcement and insurance adjusters, but we would be remiss not listing it as an option albeit not recommended.

Step 4. Have a drink, and mull over the routine maintenance safe harbor. This one might work, and here’s why- “The routine maintenance safe harbor does apply to certain restorations that would otherwise be improvements, including when you pay amounts to replace a major component or substantial structural part of a unit of property.” This is straight from the IRS blurb on tangible property regulations which summarizes the intersection of IRC Section 263(a), tax court cases and various simplified examples.

However, you have a small hurdle to get over when using the routine maintenance safe harbor. Here is some more verbiage (repeated from above) to mull over as you take a sip-

You reasonably expect, at the time the property is placed in service, to perform the activities:

For building structures and building systems, more than once during the 10-year period beginning when placed in service, or

more than once during the life of the unit of property for property other than buildings.

Could you argue that a water heater will be replaced more than once during a 10-year period of time? Possibly. Perhaps. Maybe. How about more than once during the life of the unit of property with the UOP being the plumbing system, which is 27.5 or 39.0 years. Sounding better, right?

Certain geographies have hard water with a lot of sediment, and if your water heater is not flushed and drained frequently, it might fail twice in a 27.5-year period (you’re better off maintaining the water heater than replacing it with a tax deduction).

Also, keep in mind that the standard is “reasonably expect.” Does it mean you must? No. Does it mean that after 27.5 years, the IRS can come back and say, “sorry Charlie, you only replaced the water heater once, so, that tax return from 20 years ago is being amended?” That would be a neat trick.

Step 5. You listen to the plumber who also does HVAC repair and installations, and they say a water heater is an HVAC item and therefore qualifies for Section 179 as qualified improvement property (QIP). Sure, while a lot of plumbing contractors also do HVAC work, these are separate units of property. HVAC is HVAC, plumbing is plumbing, and electrical is electrical. All different. A boiler that provides both heating and domestic hot water is a topic for another day.

Step 6. Suck it up, and consider the water heater to be a capitalized improvement that is depreciated over time. Some people have considered the water heater an appliance and suggested it is 5-year personal property. We doubt that would fly. A water heater is attached to the building’s plumbing system which is then integrated into the building itself, and is anything but easily removable and personal like a refrigerator.

Where does WCG CPAs & Advisors come down on all this? There are three solid pathways to deducting your water heater replacement as a repair. Step 1 and 2 are a snap, and step 4 has increase yet manageable risk.

Could you leverage a partial asset disposition (PAD) and calculate some losses on the water heater being replaced? For a single-family home, No. The juice is not worth the squeeze. On a multi-family property, perhaps. See our partial asset disposition section on page 296 for more information.

Roof

A roof is an easy one. If you cannot support the replacement as qualified improvement property (QIP) and leverage Section 179 expensing, then it is usually capitalized and depreciated over 27.5 or 39.0 years.

What about this QIP thing? If your rental property has tenants or guests who stay 30 days or less, then they are considered transient. Subsequently, the rental property is not considered residential. IRC Section 168(e)(6) defines qualified improvement property, and allows you to use Section 179 expensing on roof and HVAC expenditures, among other things, on non-residential properties.

Therefore, if you have a rental property that is either commercial or has an average guest stay of 30 days or less, and you operate the rental property like a business with continuous and regular participation with a profit motive, the roof expenditure is likely eligible for a Section 179 deduction. You would report the roof as an asset on your tax returns, but classify it as qualified improvement property.

Could you use a safe harbor such as small taxpayer or routine maintenance? Perhaps. Small taxpayer might work on a smaller, less expensive roof. Routine maintenance gets tricky since you need to reasonably expect to replace the roof more than once in a 27.5 or 39.0 period- might be tough one to support. Once? Sure. More than once? Hmmm.

HVAC

Your heating ventilation and air conditioning system is similar to a roof. It is unlikely to be under $2,500, so the de minimis safe harbor is out. However, the small taxpayer safe harbor and the qualified improvement property (QIP) paired with Section 179 expensing are the two most prominent pathways to deducting this expenditure.

In a commercial setting or multi-family rental property, there might also be a partial asset disposition and subsequent loss on the replaced property. See our partial asset disposition section on page 298 for more information.

Mini-Split Air Conditioner

Many rental property owners will convert an attic or garage into living space, and need to heat and cool the area. You might also use a mini-split in an ADU environment. Mini-splits are aptly named because they are small, and the air handler and compressor are separate units (i.e., split).

Replacing a mini-split is similar to the HVAC decision tree above with a twist (see appliance argument below). However, installing a new one, and especially when combined with an overall renovation of the attic or garage, or construction / installation of a new ADU, it is likely going to follow the depreciation schedule of the building.

Having said that, if you are bouncing along with a nice short-term rental and guests are giving good reviews but would like a little air conditioning from time to time (think mountain town or southern California beach), adding a mini-split air conditioner might be expensed either through the de minimis safe harbor (under $2,500) or through Section 179. A decent mini-split will probably exceed $2,500, however.

The hurdle with Section 179 is that you would either need to argue that the rental property is non-residential (average guest stay of 30 days or less, or commercial) or that a mini-split air conditioner is an appliance (personal property) and not a full-on HVAC system (real property). The IRS might claim that it is attached to the building, but then again so is a microwave or cooktop. You would be splitting hairs for sure. Is that a bad pun? Absolutely.

A window unit is easy cheesy lemon squeezy as it is certainly portable and therefore personal property, and is likely $2,500 or less.

Hot Tubs

This is not really a repair or improvement conundrum, but as good of a place as any for discussion. As anyone will tell you, a hot tub adds value to your short-term rental with more bookings and with higher nightly rates. No one asks how often the hot tub is drained or serviced- they just want it and are willing to pay for it.

The conundrum is how to handle the $12,000 expenditure. We can all agree that the hot tub will be capitalized as an asset associated with the rental property, but under what classification? Some argue that if you build a deck and attach it to the building, it is no longer a land improvement but rather a building improvement, and changes from 15 years to 27.5 or 39.0 years for depreciable life. Does this argument by extension apply to hot tubs that are cut into the deck and attached, and therefore become part of the building? Perhaps (likely).

In contrast, you pour a cement slab and crane a hot tub onto it, and suddenly this changes things? Again, another perhaps.

Practically and most frequently, hot tubs are considered 15-year land improvement property similar to driveways, fences and sidewalks. This, in turn, makes hot tubs eligible for bonus depreciation and Section 179 expensing where your rental activity is considered a business (regular and continuous involvement with a profit motive). But! Section 179 is unavailable to real property, right? Only personal property, yes?

So, the question then becomes- is it real property, under Section 1250, or is it personal property, under Section 1245? The tax code is a little weak on this specific question. However, if you review real estate appraiser opinions including cost segregation experts, and if you also consider real estate attorneys and agents who deal with the nuances of property transfers all day long, they mostly agree that if the hot tub is above ground (cement slab install) it is personal property. If the hot tub is in-ground, or if the hot tub is built into an attached deck such that if the hot tub is removed, there would be a big hole, then it is real property as a land improvement.

You can use bonus depreciation either way, but Section 179 expensing hinges on the install.

What about a detached gazebo with an above-grade deck surrounding the hot tub making it built-in? Oh geez. Grayest of the grays, right? Recall that losing a reasonable argument is fine, but pitching an unreasonable argument is bad news. Arguing that the gazebo hot tub with a big hole left behind if removed is personal property is reasonable. You might lose, but it is a reasonable argument in our opinion.

Here is a summary on hot tubs since they are such a big deal in the short-term rental / Airbnb / VRBO market-

This table is an excerpt from our accelerated depreciation and section 179 deduction section.

By Jason Watson, CPA
Posted Sunday, May 25, 2025

In a previous section, we discussed repairs versus improvements. In that section we listed three safe harbors for real estate investors plus the betterment, restoration or adaptation thresholds. We also discussed cost segregation in crazy detail.

We will smash all this up with renovations and rental property rehabs.

Excruciating Detail

The first consideration with renovating your rental property is to keep excruciating details on what was purchased. A refrigerator. A cabinet. A light fixture. Parse those out best you can. Why? As you learned with cost segregation, if we can clearly identify 5-, 7- and 15-year property, we can accelerate depreciation without the need of a cost segregation report.

Hospital Corp of America v. Commissioner

We mentioned the Hospital Corp of America v. Commissioner tax court case in our Cost Segregation Study section. This is the landmark case that allowed the property owner to detail their renovations line by line, and assign certain items to be 5-, 7- and 15-year property (and therefore eligible for accelerated depreciation with bonus depreciation or Section 179 expensing).

In summary, this tax court case and the various IRS memos state-

• a typical property’s structure has a 27.5- or 39.0-year depreciation schedule (recovery period),

• land improvements have a 15-year depreciation schedule; and

• certain other building components qualify as personal property with a 5- or 7-year depreciation schedule.

Nothing is mentioned that a rental property owner must use a cost segregation study or report provider.

Can you identify and accelerate depreciation on certain items? Yes. Keep in mind the IRS Publication 5653 Cost Segregation Audit Techniques Guide (ATG) which uses the phrase “factually intensive” seven times.

Examples of 5-Year Property

Here are some examples to consider-

• Removable Floor Coverings (Carpeting, Floating Laminate/Vinyl)

• Kitchen Cabinets and Countertops

• Appliances* (Ovens/Stoves, Refrigerator, Dishwasher, Washer / Dryer, etc.)

• Electrical Wiring and Outlets Related to Telecommunications

• Security Systems

• Window Air Conditioning Units

*Includes any mechanical, electrical, etc. work directly related to installation.

Examples of 7-Year Property

Here are some examples to consider-

• Furniture and Decorations

• Window Treatments

• Ceiling Fans

• Closet Shelving

• Decorative Trim and Wallcoverings

• Decorative Light Fixtures*

*Includes any mechanical, electrical, etc. work directly related to installation

Examples of 15-Year Property

Here are some examples to consider-

• Shrubbery (Landscaping, Tree Removal)

• Gutters

• Fences

• Retaining Wall

• Roads (Driveways, Walkways, Sidewalks)

• Trenching and Piping*

• Sprinkler and Irrigation Systems

• Drainage Facilities

• Swimming Pools and Hot Tubs**

• Patios and Decks

• Outdoor Lighting

* If NOT connected to existing piping system of the building.

** Hot tubs that are above-ground (i.e., not attached) might be considered 5- or 7- property.

Painting

Painting is a conundrum since it can either be considered maintenance or an improvement. Here is the blurb from the IRS-

By itself, the cost of painting the exterior of a building is generally a currently deductible repair expense because merely painting isn’t an improvement under the capitalization rules. However, if the painting directly benefits or is incurred as part of a larger project that’s a capital improvement to the building structure, then the cost of the painting is considered part of the capital improvement and is subject to capitalization.

Plumbing Fixtures

A noted item that is not listed is plumbing fixtures. If a ceiling fan is good to go, why isn’t a faucet? If a countertop is good to do, why isn’t a sink? In AmeriSouth XXXII, Ltd. V. Commissioner, T.C. Memo 2012-67 (2012), the tax court specifically called sinks, garbage disposals, and laundry drain and waste lines as Section 1250 property and therefore part of the building structures. Interestingly, dryer gas lines were considered Section 1245 property.

Tax Court Guidance

There is an incredible list of court cases from IRS Publication 5653 Cost Segregation Audit Techniques Guide (ATG) on pages 75-84. Starting on page 84 is a list by CSI MasterFormat Divisions. Here is a snippet of some of the divisions (2004 version superseding 1995)-

Division 03 – Concrete
Division 09 – Finishes
Division 10 – Specialties
Division 23 – HVAC
Division 26 – Electrical

There are over 30 divisions. Within each division are “subdivisions” with a check mark next to either Section 1245 property or Section 1250 property. Check it out!

Let’s not forget Whiteco Industries, Inc. v. Commissioner, 65 Tax Court 664 (1975) where the tax court set forth the following six questions that real estate investors can use to determine whether property is inherently permanent and thus a structural component excluded from the definition of tangible personal property-

• Can the property be moved? Has it been moved?

• How difficult is removal of the property, and how time-consuming is it?

• Is the property designed or constructed to remain permanently in place?

• Are there circumstances that tend to show the expected or intended length of affixation—or that the property may or will have to be moved?

• How much damage will the property sustain upon its removal?

• How is the property affixed to the land? (For example, permanently glued bathroom tile vs. removable billboard.)

Rental Property Renovations Summary

Here are some steps to take with your rental property rehabilitation or renovation-

• Keep line-item detail. Record keeping is a must!

• Classify the items into 5-, 7- and 15-year buckets.

• See if you have any wiggle room within the rental property safe harbors (de minimis, routine maintenance and small taxpayer). Unlikely, but check them out anyway.

• Add these buckets to your fixed asset listing and depreciation schedules.

Not sure how all this works? Give your depreciating buddies at WCG CPAs & Advisors a jingle.

By Jason Watson, CPA
Posted Monday, August 5 2024

Let’s say you purchase a rental property for $500,000 all-in. A portion of the real estate investment is considered land of course, but a portion of the value is tied up in the pool, the air conditioning system, the counters, and all kinds of other things. This is the crux of cost segregation that we discuss on page xx.

What’s the big deal? When you replace the air conditioning system, for example, you are replacing a part, albeit tiny, of the entire rental property. As such, and when accounting for depreciation, with a partial asset disposition (PAD) you might have a loss on the old system when you replace it. In nerdy accountant-speak, under the Tangible Property Regulations, a disposition of an asset occurs when ownership is transferred or the asset is permanently withdrawn from use. It includes-

• Sale

• Exchange

• Retirement

• Physical Abandonment

• Destruction (think Office Space printer)

Partial asset dispositions allow rental property owners to claim a loss on the disposition of a component (structural or otherwise) of an asset without having originally identified the component as an asset before the disposition.

Ok, so now what?

Can the New Asset Be Expensed?

The first step is to determine if the expenditure qualifies under one of the rental property safe harbors. Recall that there are three-

• De Minimis Safe Harbor Election

• Safe Harbor Election for Small Taxpayers (sounds a bit condescending)

• Safe Harbor for Routine Maintenance

We discussed these in fine detail in an earlier section on page xx. De minimis is the class favorite since it is quite simple and covers most purchases or situations. However, small taxpayers and routine maintenance have some teeth, but are commonly overlooked by even the most experienced tax professionals.

If you cannot immediately expense it, then it must be capitalized as a new asset and depreciated over time.

Problems With Only Adding A New Asset

There are a handful of problems with simply adding the new air conditioning system, let’s say, to your fixed asset listing, and firing up the depreciation calculator.

First, you are continuing to depreciate the previous asset that is tucked into the overall or primary asset. In our example above, the value of the building contains in part the value of the old air conditioning system. This means you could have phantom depreciation recapture on an asset that doesn’t exist upon sale. However, and depending on timing, you might have an artificially inflated cost basis to the rental property resulting in lower capital gains upon sale.

Second, if you double-down on depreciation between the original air conditioning system as part of the original purchase of the rental property and the new one, you might be missing out on some quick tax savings because of passive activity loss limits. For example, your rental has a loss mostly because of depreciation. Next, because you’re crushing it at your day job, none of your rental losses are deductible. By piling on more depreciation without a partial asset disposition, you are not getting an immediate tax benefit.

Sure, over the entire life of the rental property, you will end up in the same place. However, and this is the cornerstone to a cost segregation study as well, accelerating your cash flow is a good thing.

How To Compute The Unadjusted Basis Of The Replaced Asset

The IRS Publication 5712 Capitalization of Tangible Property Audit Technique Guide (ATG) define three methods for determining unadjusted basis, and therefore depreciation and possible tax benefit of a loss-

1. Discounting the cost of a replacement asset to its placed-in-service year cost using the Producer Price Index for Finished goods, the Producer Price Index (PPI) for Final Demand, or other index designated by guidance in the Internal Revenue Bulletin. This method can only be used if the replacement asset is a restoration as defined in § 1.263(a)-3(k); it cannot be used if the replacement is a betterment as defined in § 1.263(a)-3(j) or an adaption as defined in § 1.263(a)-3(l),

2. Pro rata allocation of the unadjusted depreciable basis of the MAA based on the replacement cost of the disposed asset and the replacement cost of all assets in the MAA (or pool), and

3. Study allocating the cost of the asset to its individual components.

What the heck is an MAA? Multiple Asset Accounts. Just think “entire rental property asset” for now. What are your thoughts on #3 above? Sounds like a cost segregation study doesn’t it? It does! Be weary of #1, since it is only available for restorations, and not betterments or adaptations (remember BRA or BAR, right)? This makes sense too from a theoretical perspective.

Example Using PPI Method

Here is an example of a rental building that was purchased for $500,000 (regardless of the value today), where the replacement air conditioning system cost $20,000.

The historical cost of the air conditioning system is computed by taking the historical PPI divided by the replacement month PPI, and multiplying the cost of the new system by this value. Tilt! You can find purchase price index (PPI) commodity data from the U.S. Bureau of Labor Statistics. Drool.

The PPI method might produce unreasonable results when the existing rental property had several components near the end of their actual or economic life. Then again, take a swim in those gray waters!

The PPI method might produce unfavorable results when the purchase of the rental property was at a discount.

WCG CPAs & Advisors recommends and uses KBKG for various calculations and tools including PPI. According to their website-

The KBKG Partial Disposition Calculator is designed to make calculations as simple as possible while minimizing unnecessary work. By providing basic data, the calculator provides a PPI adjusted value while considering the condition of the respective component at the time it was acquired (accomplished by considering the component’s normal life, quality, and age).

CAUTION: Using a PPI discounting method to establish tax basis for a retired building component may grossly overstate the taxpayer’s retirement loss deduction.

See IRS T.D. 9689 Guidance Regarding Dispositions of Tangible Depreciable Property for more riveting information.

Pro Rata Allocation

This one is not written about often. Can you take the replacement cost of the air conditioning system and divide by the fair market value of the rental property, and then apply that to the accumulated depreciation? Not really. An MAA, or multiple asset accounts, is made up of a group of assets that are similar.

Cost Segregation Study

If you had a cost segregation study prepared at the time or close to the time of purchase, you can use that report to determine the historical cost of each component, and in this case, the cost of the air conditioning system. You might still have to do some of the mental gymnastics above to determine the accumulated depreciation specific to the old air conditioning system. Alternatively, you can kick it to your tax professional.

Election Required

Treasure Regulations Section 1.168(i)-8(d)(2)(ii)(A) reads that a partial-asset-disposal election must be made by the due date (including extensions) of the original federal tax return for the year in which the taxpayer disposes of the portion of the asset.

The Cost Segregation Audit Technique Guide (ATG) reads that the engineering-based approach used in a cost segregation study is “the most methodical and accurate approach… and generally provides the most accurate cost allocations.”

In 2019 the IRS announced a partial asset disposition election compliance initiative, explaining that they will be training agents in a 5-step process to review partial asset disposition (PAD) elections by-

1. Determining if a partial disposition of a building occurred,

2. Identifying the disposed portion of the building,

3. Identifying the partially disposed asset and its placed-in-service date,

4. Determining the disposed portion’s adjusted basis, and

5. Reducing the adjusted basis of the asset.

Don’t let that dissuade you. Rather it should encourage you to understand the mechanics, line up your facts and data, and use partial asset disposition as a nice tax deduction.

Casualty Loss

If your rental property experiences a casualty loss through fire or flood, partial asset dispositions are handy for harvesting tax losses when insurance falls short. Technically, a casualty loss is the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual.