Warning: The following article attempts to clarify important changes to the tax code. While pertinent to property owners, no amount of artistry could make this material more exciting. We recommend that readers use patience to digest this complex topic.
The federal government recently made major changes to tax regulations with a specific focus on the capitalization of tangible assets. Not only do these changes impact all taxpayers that acquire, produce or improve tangible property, they provide specific rules for buildings versus other tangible property and provide guidance on the application of Sections 162 (a) – deduction, versus 263 (a) – capitalization.
To start, the IRS clarified the definitions of different types or property that are important in the decision to write off or capitalize on expenditure. To understand the new regulations, we must first refine what determines a unit of property. According to the IRS, a unit of property is real or personal property consisting of all of the components of property that, functionally interdependent, comprise a single unit of property. For example, a truck is a unit of property because all the parts are interdependent; however, each building in an apartment complex with multiple buildings is a single unit of property.
Materials & Supplies
The new tangible property regulations also define the treatment of materials and supplies.
Materials and supplies are NOT: a unit of property, acquired as part of a single unit of property, or inventory.
Materials and supplies ARE:
- consumed in the taxpayer’s operations
- a component acquired to maintain, repair or improve a unit of tangible property owned, leased or serviced by the taxpayer
- items that are reasonably expected to be consumed in 12 months or less
- items with an economic useful life of 12 months or less
- items with an acquisition cost or production cost of $200 or less
- identified in the Federal Register or in the IRB as materials and supplies
Safe Harbor Rules
The new 2014 tax changes provide an election to treat certain materials and supplies under the de minims safe harbor rule. The de minims safe harbor rule allows taxpayers to deduct items up to $500 or those with a useful life of less than 12 months. The limit can be increased to $5,000 with an applicable financial statement. (Examples of applicable financial statements are: Financial statements required to be filed with the Securities and Exchange Commission (SEC), independent certified public accountant (VPA) audited financial statement (not a compilation or review prepared by a CPA), and financial statements (other than a tax return) required to be provided to a state government or any federal or state agency (other than the SEC or the IRS)). Safe Harbor can be applied on a per-item, per-invoice basis but the taxpayer must have an accounting policy and it must be applied to all eligible materials and supplies.
For Example: Josh owns an apartment complex with a rental office onsite. The rental office purchased a new printer for $199 and desk for $499 in 2014. Josh makes the de minims safe harbor election on his 2014 tax return. Because of the election he can deduct the full $698, instead of capitalizing and depreciating over the life of the property. This is an annual election.
Form 3115 – Annual Accounting Policy Election
Josh must elect an accounting policy to do this correctly. As of 2014, all taxpayers that acquire, produce or improve tangible property will now be required to file form 3115 declaring the current accounting method for depreciation. The IRS did grant a reprieve to “small” businesses (which are defined as 10 million in assets and 10 million in revenue) from filing form 3115 for the 2014 tax year. Initially there was also a $3,500 per property penalty if form 3115 was not filed.
For Example: Jake inherited a residential rental in June of 2013. When preparing his tax return in 2013 he didn’t report the step-up as his basis in the rental house. In 2014, Jake realized this mistake and wanted to reclaim the additional depreciation that was missed on the 2013 tax return. Jake can now file IRS Form 3115, changing the accounting method. This will give him the audit protection for 2013 and correct for the missed depreciation in 2014.
Capitalizing Improvements
The requirement to capitalize amounts paid for improvements to a unit of property depend on the purpose of the improvement. Betterments ameliorate an existing material condition or defect and can include expansions. Restorations assume that the property being restored has fallen into disrepair and is no longer functional or has caused a major component to cease functioning. Improvements adapting the property to a new or different use can also be capitalized.
For Example: If the landlord of a manufacturing space decided to convert it to apartments, the cost to regrade the land would need to be capitalized but the amount paid to clean up the site (which does not adapt the land) does not need to be capitalized. Likewise, if a tenant leased adjoining spaces in a commercial office building, the cost to combine the two spaces would be deductible because it does not adapt the use of the space.
Deductible repairs and maintenance are activities not required to be capitalized as tax improvements. However, you can elect to capitalize for tax purposes if capitalizing for book. Routine maintenance and small taxpayers enjoy safe harbor protection. An activity is routine maintenance under the safe harbor rules if the activity is performed more than once during the class life of the (non-building) property. In the case of buildings, the activity is performed more than once during a 10 year period. If unsure whether something can be claimed as routine maintenance, consider the recurring nature of the activity, if it is industry practice, whether it coincides with the manufacturer’s recommendations and whether you have had experience with it at a similar or identical property.
Taxpayers may elect not to apply the capitalization requirements to an eligible building property if the total amount paid during the taxable year for repairs, maintenance, improvements and similar activities performed on the building property does not exceed the lesser of 2% of the unadjusted basis of the eligible property or $10,000.
For Example: John and Jane own a residential rental which originally cost $305,000. During 2014, they had a plumber fix a leaking pipe for $250 and replaced the home’s water heater for $1,900, and repaired the siding from a wind storm for $1,400. John and Jane filed the small taxpayer safe harbor election with their 2014 return and then deducted the entire $3,550 since it’s less than 2% of the unadjusted basis (cost) of the home. This is an annual election.
What’s ahead for 2015?
On December 16, 2014, the tax extenders were passed bringing back the higher Section 179 limits and bonus depreciation at 50% effective January 1, 2014 to December 31, 2014. So as of right now, we are at the reduced Section 179 amount ($25,000) and lower limits ($200,000) and no bonus deprecation for 2015. This makes some taxpayers susceptible to the Alternative Minimum Tax which was permanently fixed a few years ago. With bonus depreciation gone, the tax and AMT depreciation are no longer the same. This may cause someone to fall into AMT where in the past, bonus depreciation prevented this.
This article attempts to summarize recent tax changes using examples for clarification purposes only. Every investor has a different tax situation; please consult your tax advisor for your specific situation.
Clifford A. Hockley is President of Bluestone & Hockley Real Estate Services, greater Portland’s full service real estate brokerage and property management company.. He is a Certified Property Manager and has achieved his Certified Commercial Investment Member designation (CCIM). Bluestone & Hockley Real Estate Services is an Accredited Management Organization (AMO) by the Institute of Real Estate Management (IREM).