Taxpayers who own real property used in their business or rent real property to tenants, whether residential or commercial, often incur costs that can be immediately written off or capitalized and depreciated over the useful life of the capitalized asset. With the 2013 issuance of final tangible property regulations (repair regs) and other IRS guidance, determining what to immediately write off and what to capitalize for tax purposes can be challenging.
Additional IRS guidance issued in previous years supplements the repair regs in several ways:
- Allowing a reduced recovery period for “qualified leasehold improvement” property
- Providing a specific recovery period for land improvements
- Allowing certain tenant improvements to be disposed of upon the termination/expiration of the tenant lease
- Allowing to immediately deduct certain expenditures made to remodel or refresh a building used to operate a retail or restaurant establishment
- Allowing lease costs being amortized to be written off if the associated lease is terminated or expired
- Providing special depreciation methods such as bonus depreciation and Section 179 expensing for certain assets purchased
This article offers information for taxpayers who incur costs to maintain and improve their real property, purchase tangible property to be used in their business or dispose of certain capital assets previously used in their business. “Tangible property” refers to a building and nonbuilding property, e.g., equipment and furniture.
The repair regs must be carefully applied before deciding on the tax treatment of certain expenditures. The tax law is complex, so assistance from a CPA can help the taxpayer understand the tax treatment of certain costs.
The regulations provide tax opportunities to write off costs previously required to be capitalized, require certain costs to be capitalized and depreciated over the useful life of an asset and clarify the definition of a unit of property (UOP). Here are the questions to ask yourself when applying the repair regs and additional IRS guidance to a business that owns or rents real property.
1. What are my property’s UOPs?
A building is divided into the building structure and eight separate building systems:
- Heating, ventilation and air conditioning
- Fire and alarm systems
- Security systems
- Gas distribution
The building structure and each building system are treated as separate UOPs when applying the repair regs to determine if expenditures are deductible or should be capitalized.
2. Can I take the de minimis safe harbor election?
Does the taxpayer have an applicable financial statement (AFS)? An AFS can be a financial statement filed with the Securities and Exchange Commission, an audited financial statement or a financial statement required to be provided to a federal or state government. Taxpayers with an AFS and a written capitalization policy as of the first day of the tax year can elect to deduct capital expenditures up to $5,000 per invoice (or item) for that year.
Initially, taxpayers without an AFS could elect to deduct capital expenditures up to $500 per invoice (or item). However, IRS Notice 2015-82 recently raised the threshold from $500 to $2,500. A written capitalization policy isn’t required if there’s no AFS.
The safe harbor amounts may be further limited if the written capitalization policy has a threshold lower than the de minimus threshold ($5,000 or $2,500).
3. Can I make the routine maintenance safe harbor election?
Routine maintenance is defined as recurring activities to a UOP that a taxpayer expects to perform as a result of its use of the UOP to keep it in its ordinary efficient operating condition.
Routine maintenance generally may be deducted under this safe harbor if, at the date the building or nonbuilding property is placed in service, the routine maintenance is reasonably expected to occur more than once during the property’s class life (or 10 years for buildings).
4. Can I make the safe harbor election for small taxpayers?
A taxpayer isn’t required to capitalize the costs of work performed on owned or leased buildings that qualify for the safe harbor election for small taxpayers. For purposes of this election, a taxpayer must meet all of these requirements:
- Have average annual gross receipts of less than $10 million
- Own or lease building property with an unadjusted basis of less than $1 million
- The total amount paid during the taxable year for repairs, maintenance, improvements or similar activities performed on such building property doesn’t exceed the lesser of 2 percent of the unadjusted basis of the eligible building property or $10,000
5. Can I make the partial asset disposition election?
The partial asset disposition election is made for the tax year in which the portion of an asset is disposed of. If a partial asset disposition is reported, the taxpayer must capitalize the replacement portion of the asset under the same asset class as the disposed portion of the asset.
6. Do expenditures meet the BAR test?
If an expenditure is a betterment, adaptation or restoration (BAR) to a UOP, and the amount doesn’t qualify for one of the aforementioned safe harbors, the amount generally must be capitalized rather than immediately deducted.
An expenditure is considered a betterment if it’s made for a material addition, such as the enlargement of a building or a UOP. In addition, an expenditure made with the assumption that productivity, efficiency or quality of the business will increase also is considered a betterment.
An expenditure is considered an adaptation if made to modify a UOP to a new or different use—like when Doc Brown from “Back to the Future” modified a DeLorean to travel through time.
In general, an expenditure is considered a restoration when made to return a UOP to its ordinarily efficient operating condition, if the UOP is no longer functional for its intended use.
7. Can I make the book conformity election?
The election to capitalize repairs and maintenance costs, also called the “book conformity election,” requires the taxpayer to treat all capitalized repairs the same for both book and tax purposes. However, the taxpayer still would need to analyze items deducted for book purposes to see if they require capitalization for tax purposes.
There are many reasons a taxpayer would want to make this election, but the most common is to defer tax deductions to a future year. This may be part of a tax planning strategy if the taxpayer has an expiring net operating loss carryover and/or suspended passive activity loss carryover from prior years or plans on an increase in taxable income in future years.
If you need more information about how to answer these questions, or if you need to know more about the repair regulations, please contact your BKD advisor.