New IRS rules you need to know
In an attempt to simplify whether an expenditure on a property is a repair that can be expensed or an improvement that must be depreciated over time, the IRS has made the accounting for tangible property far more complex, more of an administrative headache and will push tax deductions to later in a project’s life. The new rules became effective for all tax years beginning on or after Jan. 1.
The new tangible property rules will add expense and complexity to filing tax returns by potentially requiring building owners to perform pricey cost segregation studies that identify the cost basis of each building components as a unit of property. Additionally, taxpayers may have to file multiple Form 3115’s, change in accounting method, with the IRS for each entity.
The accounting industry was not thrilled with the new regulations. In July 2012 when they were proposed, the American Institute of CPAs told the Internal Revenue Service that its proposed regulations for capitalization and deduction of tangible property expenditures are unnecessarily complex and burdensome (Accounting Today).
In addition, the new regulations also allow taxpayers, with an applicable financial statement (generally audited), and a written capitalization policy in place, to use the safe harbor rule provided under the regulations, which allows a deduction of property expenditures of less than $5,000 for each item. There is no limit on the total amount that can be deducted. Without a written policy already in place, the safe harbor deduction will be limited to $500. Most public companies already have written policies in place. However, smaller and private taxpayers may not have written capitalization policies.
Changes in the real estate area
The tangible property regulations, or “guidance regarding deduction and capitalization of expenditures related to tangible property,” as the IRS phrases it, apply to all buildings as well as other types of tangible property. Therefore, it directly impacts real estate operators and investors, particularly under the unit of property classification.
In the past, buildings were seen as one structural component (absent a cost segregation study), part of a general asset classification. For example, when owners replaced six out of 10 elevators, a minor component to the building structure, the elevators were potentially expensed in the current tax year as repairs and maintenance and not depreciated over the tax life of the asset.
Think about the new rules as a concept around the difference between improving an asset and repairing it. If you improve a property, you are increasing its value. When you increase a property’s value, the key determining factors, according to the IRS, are restoration, adapting for a different use and betterment.
On the other hand, if you make a repair, you are theoretically not improving the overall value of the property; you’re just keeping it at essentially the same state and not increasing its value. To be fair, there has been abuse on the “improvement” concept, where taxpayers were expensing improvements that should have been capitalized. Taxpayers were spending hundreds of thousands of dollars on a new roof or partial roof and HVAC system and expensing them as repairs, while they were actually extending the life of the building.
The IRS specifically identifies eight units of property items under the final regulations: HVAC, plumbing, electrical, escalators, elevators, fire protection systems, security, and gas distribution systems. If the majority of any one of these components was replaced, the entire unit most likely would need to be capitalized. The remaining value of the item that was repaired or replaced would be allowed a tax deduction in the current year. The issue with this scenario is that many building owners have not had a cost segregation study performed on their building, thus assigning costs to the repaired or replaced item could be difficult. Owners may then have to have a cost segregation study performed to determine the original cost value of the unit of property replaced.
The complexity comes in determining the difference between a repair and an improvement. If an elevator is rewired, that is probably a repair. If eight out of 10 elevators are completely replaced, then the replacement elevators would most likely have to be capitalized. Although tax courts will give us more guidance in the future, the intent of the law as it is written seems to come down to replacing a majority of a system requires capitalization.
The final regulations say routine maintenance doesn’t have to be capitalized, and they define routine maintenance on buildings as something expected to be performed more than once every 10 years. Additionally, there is a small taxpayer, small building exception (buildings with an adjusted basis of $1,000,000 or less) in the final regulations that give the owner the right to elect not to apply improvement rules for expenditures of less than $10,000.
Administrative hassle but not a disincentive
I don’t expect the new rules to incent owners not to repair their buildings, just based on paying more taxes now than in the future. Owners will still get deductions for building improvements; it will just be spread over time as depreciation instead of a current deduction. Owners may pay more tax up front and less on the back end of the investment. Despite the safe harbor and small owner exceptions, it will impact most real estate operators. The IRS is targeting the largest properties representing the largest expense and depreciation levels.
Owners can apply the rules retroactively for tax years beginning on or after Jan. 1, 2012 or 2013. Taxpayers also may decide that the complications are not worth the tax benefits of obtaining them, and elect to capitalize all expenditures to a property over its useful tax life. The taxpayer is not losing deductions; just accelerating the tax due.