Regulations distinguish repairs from improvements
In a decision that could impact the tax planning and accounting practices of real property owners, developers and tenants, the Internal Revenue Service has issued a new set of regulations that seek to clarify the manner by which the cost of certain building improvements qualify for a federal tax deduction.
At issue is the distinction between repairs — eligible for a full-value deduction in that same tax year — and capital improvements, which receive a tax deduction over several years along with the depreciable life of the asset.
While the guidance helps brings clarity to a long-contentious issue that has reached as far as the U.S. Supreme Court, accounting leaders in the North Bay and beyond stress that those involved in property improvements should familiarize themselves with the regulations and anticipate a potential change to the flow of tax deductions to their federal tax bill.
“This will have a big effect on people who are extremely active in the real estate industry and making a lot of improvements, but also the industries that own or lease their property,” said Christopher Paris, partner in tax services at Moss Adams LLP in Santa Rosa. An increasing number of companies seek property ownership in a low-interest-rate environment, and many have improvement agreements with a landlord, he noted.
Nearly eight years in the making, the new rules clarify a sometimes litigious case in which property owners and the IRS were at odds over which expenses, including those related to property acquisition, improvement or maintenance, qualified for an immediate or long-term tax deduction. Released in April, the rules apply to 2012 and following tax years.
Property owners would typically see a greater benefit in a one-time income tax deduction, with an incentive to argue that capital improvements qualified as repairs, according to experts in the field. In its 250-page regulation, the IRS cited five cases since the early 1930s when a legal battle over the distinction between capital improvements and ordinary repairs has received judgment by the U.S. Supreme Court.
Yet despite that judicial guidance, disputes remained, and the IRS and the Treasury Department began taking public comment for a clarifying rule on the matter in 2004. Proposed amendments were revised in 2008. The current regulations, which provide guidance on the application of sections 162(a) and 263(a) of the Internal Revenue Code, are considered temporary and binding but are up for public comment and final adoption.
“These regulations are more reflective of what case law has been over the years,” said Linda Clark Phillips, CPA, a director with Burr Pilger Mayer accountants and consultants in San Francisco.
“Many items that you used to be able to expense, you now have to capitalize,” she added.
While former regulations allowed an entire building and its systems to be evaluated as a single “unit of property” when applying metrics to determine if work qualifies as a capital improvement or repair for tax purposes, the new standards establish a number of categories of building “systems” that must be evaluated individually, according to Ms. Clark Phillips. By narrowing that definition, the new regulations would generally lead to a decrease in the amount of work that would qualify as a repair and receive a more immediate tax benefit.
“It does reduce immediate writeoffs, because you’re looking at a repair relative to a system, rather than over the whole building,” she said.
Systems defined in the IRS guidance include climate control and ventilation, plumbing, escalators and elevators, gas distribution, fire and security systems. Under the new guidance, each system is more likely to be designated as a capital expense with a long-term tax benefit.
“It’s purely a time-value-of-money consideration,” Mr. Paris said. “You still realize the full benefit, just over a longer period of time.”
Those periods can be quite long — up to 39 years for a nonresidential property. For those who seek to realize some of that tax benefit sooner, Mr. Paris and others noted that property owners could determine the depreciable lives of individual components in a building system and realize an earlier tax benefit from components that have a shorter depreciation.
“I think that will be an opportunity — breaking down the building components,” Mr. Paris said. “We fully expect an increase in demand for cost-segregation analysis.”
Other opportunities exist for tax and accounting purposes in the new regulation. Previously, replacing an asset like a climate control system would require that the property owner continue to account for the remaining depreciation of the old components. Now, owners can immediately write off the remaining cost of the old system, a move that may require a retroactive determination of the component’s value and depreciation rate, according to Ms. Clark Phillips.
“There’s a little gem hidden in there — the fact that you can write off the remaining depreciation on a piece of equipment all at once,” she said. “I would suggest that an individual look at each of their properties and their current depreciating systems.”
While the regulations are still very new, accounting leaders said that the changes are expected to have the greatest impact on record-keeping, requiring more extensive tracking of depreciation and improvements across the newly established system categories. Tax considerations do influence the real estate industry, but cash flow and regular business considerations remain a primary concern.
“You’ve got some things that you have to do to update your property, whether or not you capitalize your work,” said Jon Dal Poggetto, managing partner of Dal Poggetto & Company, LLP. “If you have to a repair a roof so that your tenant doesn’t get water on their computers, you have to fix a roof.”
To encourage compliance, the IRS is granting automatic consent for accounting method changes made in the first two tax years after the new regulations took effect, assuming method-change procedures are followed.
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