By Michael D. Koppel
Gray, Gray & Gray, LLP
January 2013
Pay Attention to the New IRS Rules. If your company owns its own building you are, by default, in the property management business as well. Structures of all types – offices, warehouses, factories, retail stores – require maintenance and repairs on a frequent basis, and often call for upgrades to structural or mechanical systems.
How should you handle the cost of these repairs and improvements for tax purposes? The answer to that question has recently changed.
In the past, most expenditures made for repairs and maintenance could be written off as an expense against current year’s income. But in December 2011 the Internal Revenue Service (IRS) and Treasury issued new proposed and temporary regulations that detail when businesses can deduct an expenditure as repairs and when they must capitalize it and depreciate it over a period of years. The regulations apply to amounts paid to maintain, acquire, produce or improve tangible property and were effective January 1, 2012.
It is important to recognize that there are basically two types of tangible property: real property and personal property. Most businesses have both. The cornerstone of the new regulation is the concept of “unit of property.”
With regard to real property the units of property are defined as the structure itself and specifically defined building systems. The regulations define the separate building systems as:
- Heating, ventilation, and air conditioning systems (HVAC)
- Plumbing systems
- Electrical systems
- All escalators
- All elevators
- Fire protection and alarm systems
- Security systems
- Gas distribution systems
- Any other systems defined in published guidance
If an expenditure replaces, increases the life of, or returns the system to its original condition it must be capitalized. Although on its face this concept is more conservative than what we have been accustomed to, there is a silver lining when one of the building systems needs to be replaced.
The regulations revise the definition of disposition so that a taxpayer may treat the retirement of a structural component of a building as a disposition of property. This means, for example, that if a structure needs a new roof the depreciated value (book value) of the old roof can be expensed.
The importance of this cannot be overstated. Generally, business real property is depreciated over 39 years. (NOTE: It is unclear as of this time if the 15-year depreciation of certain real property will be reinstated for property placed in service after December 31, 2011.) Being able to expense this property when it is replaced offers significant tax advantages for many businesses.
The catch is that the cost of the disposed system (the old roof, in our example) must be determined by someone who is qualified to do so. Thus, specialized “cost segregation studies” have taken on more importance because of these new regulations. It is advisable to perform a cost segregation study before the asset is placed in service. However, if one was not done initially it can be done any time before the system component is disposed.
The question of whether expenditures for tangible personal property should be expensed or capitalized has also been clarified. Basically the regulations indicate that a taxpayer must capitalize amounts paid if the payment improves the property. An improvement can occur if any of the following occur:
- The payment results in a betterment
- Restores the property to its original condition
- Adapts the property to a new or different use
What is important in this area is that there are still no “bright line” tests that clearly define what should be expensed and what should be capitalized. You should work with your tax advisor to determine how improvements or repairs should be treated.
The new rules do include a de minimis provision. The aggregate of amounts paid and expensed (not capitalized) under the de minimis rule for the tax year must be less than or equal to the greater of 0.1% of the taxpayer’s gross receipts for the tax year as determined for federal income tax purposes; or 2% of the taxpayer’s total depreciation and amortization expense for the tax year as determined in its applicable financial statement.
Unfortunately, the definition of applicable financial statement is very restrictive. An applicable financial statement is defined as a audited financial statement accompanied by an independent CPA’s report that can be used for credit or reporting purposes, or a financial statement required to be filed with the Securities and Exchange Commission. The de minimus rule also has other procedural rules.
It is important to remember that, while the new regulations are only proposed and temporary, they are currently in effect and being enforced. You should consult with your tax advisor to determine you requirements and responsibilities under these regulations, and to explore ways in which you can best use them to minimize taxes.
Michael Koppel is a Tax Partner at Gray, Gray & Gray Certified Public Accountants, Westwood, MA (www.gggcpas.com). Gray, Gray & Gray has served the accounting, tax and business advisory needs of companies in the petroleum, c-store and energy industry for more than 67 years.