Dock Your Money Boat in the IRS' De Minimis Safe Harbor

In the IRS tax code, there is a hugely powerful tool called ‘De minimis safe harbor election’. You may not have heard of this unless you read the tax code for fun. However, we are talking about it today because the IRS recently revised the de minimis safe harbor election rules in 2016. You can read all about it on the IRS website, click here. Now commercial real estate operators can DEDUCT remodeling expenses in year one as long as each line item or invoice is approximately $2,500. This is in stark contrast to DEPRECIATING those expenses over the traditional 27.5 year period. Prior to 2016, this deduction was limited to $500 dollars, meaning it was a lot of work for tax planners and not much reward.

As it is in the name, de minimis “safe harbor” is a tax harbor safety threshold granted by the IRS. The IRS has given clear guidance that $2,500 now is a minimum safety threshold. Remodeling expense deductions greater than $2,500 may be questioned by the IRS such as a $10,000 dollar refrigerator. Tax experts generally agree that $3,000 is still a safe threshold and should be considered a hard cap. The purpose of tracking these expenditures is to utilize remodeling costs as a means to reduce taxable income while simultaneously adding value to the property, which will be realized at sale. Employing this tax strategy will help generate passive paper losses which can be used to offset passive income from other investments. Alternatively, investors can choose to carry over these paper losses into subsequent tax years.

A few items which fit nicely into the safe harbor are: paint, flooring, doors, locks, counters, cabinets, appliances, toilets, and showers. Here is example of de minimis safe harbor in application: let’s say we have a $3,000,000 property consisting of 50 units and is operating at a 6% cap rate which generates $180,000 of taxable income. This income is typically deferred via interest deductions and depreciation. However, with de minimis safe harbor, this income can be completely ELIMINATED. Let’s say we spend $10,000 per unit for a total of $500,000. These rehab costs immediately reduce year one taxable income to $0 and allows us to carry forward a $320,000 loss into future tax years. Based on these numbers, this tax strategy remains effective for approximately three years. After these three years of tax-free income, the income of the building becomes tax deferred via depreciation and other tax planning strategies.

This new exciting tax strategy boosts returns especially for investors in higher tax brackets. Another benefit is that de minimis safe harbor motivates real estate operators to be more active and shortens the investment horizon, encouraging the buying and selling of investments to repeat the process to maximize the tax benefits available to this type of investment. An added benefit is that apartment owners are encouraged to spend money on improvements, keeping people’s homes in the nicest condition possible.