The IRS has just given apartment owners several reasons to contact their accountants.
On September 19, 2013, the Internal Revenue Service issued new final Tangible Property Regulations which went into effect for tax years beginning on or after January 1, 2014. Some aspects of the new rules are taxpayer-friendly, while others are not. This could be a good time for you and your CPA to discuss how you may be affected and, if necessary, update your tax strategy.
The new regulations are complex and require owners of all types of commercial or residential investment properties to keep more detailed records for repairs, maintenance and supplies. Your accountant may be required to analyze each of your individual building expenditures to determine whether, under the new rules, each item needs to be capitalized and depreciated or may be expensed.
Cash for Trash
First, the good news – one positive feature in the new regulations provides a cash-for-trash deduction. Owners who have renovated or substantially remodeled their buildings at any time during their period of ownership now have an opportunity to write off any remaining book value of building components that were abandoned, resulting in potentially large deductions.
In the past, whenever a building component was removed or abandoned as a result of remodeling or renovation, it probably remained on the books, buried within the “building” line item on the depreciation schedule. The IRS now allows you to write off any remaining value in the current tax year rather than continuing to depreciate such “ghost assets.”
As an example, if a roof was replaced, most owners would be depreciating two roofs, the old one and the new one. If you and your accountant can place a valid figure on the separate cost of the old roof and determine its individual remaining depreciable cost, the cost now can be written off as an expense in tax year 2014, resulting in a one-time tax deduction.
Other typical examples of abandoned or disposed-of building components representing “renovation debris” that could lead to a deduction include flooring, decorative elements, wiring, lighting, concrete, asphalt, and even old paint covered by newer paint.
The IRS requires that a reasonable method of determining the cost of an abandoned building component be used. The most certain method of assigning a value, from the perspective of the IRS, is to have a qualified engineering firm, such as a cost segregation firm, perform an asset abandonment study. Typically, the cost of such a study will be paid for many times over by the value of the tax deduction obtained. Note that the option to write off abandoned assets is currently set to expire after 2014, so this is a “use it or lose it” opportunity.
What to Capitalize vs. Expense
The major focus of the new IRS rules, which technically are titled the “Repair and Capitalization” regulations, is to clarify what constitutes a short-term expense and what items should be considered capital improvements that should be depreciated over 27.5 years for apartment buildings and 39 years for commercial buildings.
The new rules may require that you capitalize some expenditures that you are accustomed to expensing as “repairs and maintenance” items. It is important that you check with your accountant to see how the new rules may apply to your specific building and income tax situation.
On the positive side, the IRS has established two “safe harbors” that may simplify compliance with the new regulations for owners of smaller apartment buildings.
First, there is now an allowance for writing off up to $500 per individual expenditure or invoice for tangible property purchases on your building, or up to $5,000 per invoice if you have audited financial statements. In order to qualify for this allowance, the IRS requires that you have a written “capitalization policy” on file and in place as of January 1, 2014. Your accountant can provide you with a template for this document, which you should sign, date, and keep in your file.
Second, for individual expenditures that exceed the above limits, you can avoid subjecting these larger expenditures to complex scrutiny as to whether they must be depreciated if you and your building fall into a second safe harbor category. You may qualify for theSmallTaxpayerSafeHarborif your building was purchased for less than $1 million, and your average income over the past three years is less than $10 million. For the many apartment owners that fit within this definition, annual building expenditures of $10,000 or less are deductible as expenses in the current year. Go above $10,000, however, and everything, including the first $10,000, may have be capitalized.
For owners that do not meet the SmallTaxpayerSafeHarbordefinition, it will no longer be permissible to simply expense items below a certain dollar amount. Instead, a new and more complicated analysis will need to be applied to each expenditure to determine whether it is considered a capital expenditure or not. In order to qualify as an expense, the expenditure may not:
- Create a betterment, defined as fixing a condition that existed at purchase, or an increase in the physical size or capacity of an asset;
- Extend the asset’s life;
- Adapt it to a new use;
- Replace an entire component;
- Be a substantial portion of the Unit of Property (UOP)
A detailed explanation of these terms is beyond the scope of this article, but the main point is that for building owners who are subject to these repair vs. capitalization tests, many will find that the new rules force them to capitalize items that they previously could expense. One reason for this is that most building owners and their accountants have not yet taken steps to quantify the “Units of Property” in their buildings. These are cost figures that would be assigned to each of the major structural systems within buildings. Without figures for Units of Property, it is impossible to apply test #5, and therefore all expenditures will need to be capitalized.
Cost Segregation Offers Compliance Help – and Tax Savings
This problem is likely to lead many building owners and their tax professionals to seek the services of qualified cost segregation firms. Such firms possess the engineering and tax law expertise to correctly identify the Units of Property (UOP) in buildings and assign valid cost figures to each unit according to IRS-accepted methods. Once these figures are provided, the tax professional can easily make the necessary determinations about capitalizing or expensing specific costs.
Without valid UOP figures, and if the property and business do not meet theSafeHarbortests, the only option will be to capitalize all expenses above the minimum thresholds.
Having cost segregation studies performed to comply with the new regulations will impose costs on apartment owners, both for the engineering studies and for the accounting services required to adjust depreciation schedules and make the necessary filings with the IRS. Fortunately, for most apartment owners, fees paid for a cost segregation study usually can be repaid many times over by the income taxes that may be deferred. If you are not familiar with how this works, your accountant can explain to you how cost segregation is a sound tax deferral technique that has been used since 1997. Cost segregation is the IRS-approved method of taking accelerated depreciation of certain building components that the IRS considers to have short-term asset lives. In addition, a cost segregation firm can provide tax-saving figures for the value of any abandoned assets, or renovation debris, as discussed above.
Other Tax Changes
Three other changes in the tax rules affecting apartment owners are these:
- Bonus Depreciation: The bonus depreciation deduction for assets with a depreciable life of less than 20 years has been reduced to $25,000 in 2014, from the previous limit of $500,000.
- Multi-Building Properties: For owners that do not meet the Safe Harbor test of $1 million or less in building cost, multi-building apartment complexes will need to have separate depreciation schedules for each building, because each building is considered by the IRS to be a separate “Unit of Property.”
- Routine Maintenance Exemption: If you can prove that you routinely renovate or repair rooms more than once every ten years you can possibly avoid the requirement to capitalize your next refresh or remodel. Apartment owners should keep records to document this in order to justify expensing these costs.
The overall effect of the new IRS Repair and Capitalization Regulations on you as an apartment owner greatly depends upon whether you fall into one or both of the Safe Harbor categories. If you do not, then these new regulations can adversely affect you by requiring more record-keeping, by limiting your ability to deduct expenditures as expenses, and by leading you to pay for more professional services for compliance reasons. Fortunately, there are measures you can take to lessen the burden and possibly obtain unexpected tax windfalls.
Regardless of whether you fall into the Safe Harbor categories, it may be in your best interests to talk with your accountant now, before they are busy preparing 2014 tax returns, about taking these tax-saving steps:
- Establish a written capitalization policy
- Implement appropriate changes to your record keeping systems
- Determine whether your depreciation schedule needs to be re-worked to comply with the new regulations
- Look for any opportunity to write off ghost assets while you still can (currently this option expires after 2014)
- Consider having a cost segregation study performed to not only quantify the Units of Property in your building but also to defer substantial amounts of taxes and increase cash flow
Jeff Glass is with Bedford Cost Segregation and may be reached at (510) 537-9900 or [email protected].