Repairs vs. Capital Improvements: IRS Issues Long-Awaited Rules on Tax Treatment

The IRS has released temporary regulations on the tax treatment of expenditures related to tangible property, such as buildings, machinery, vehicles, and furniture and equipment. The regulations directly address the often-confusing issue of how to determine whether an expenditure is considered a repair or a capital improvement. The answer will affect your tax bill now and in years to come. What Can You Deduct? Property owners often struggle with how to classify their repair and upkeep costs — are they routine maintenance costs, which are immediately deductible against current income? Or are they costs for improvements, betterment, restoration or adaptation of the property which, under the Internal Revenue Code (IRC), must be capitalized and recovered over time through depreciation? Under the new regulations, the unit of property (which will be analyzed to determine whether a repair or an improvement has occurred) for a building comprises the building and its structural components. When determining whether a cost incurred is for an improvement to the building, you must apply the improvement standard separately to the primary components of the building, the building structure or any of the specifically defined building systems, such as:

• Heating, ventilation and air conditioning (HVAC) system,
• Plumbing and electrical systems,
• Escalators and elevators,
• Security and fire protection systems,
• Gas distribution system, and
• Any other system identified in published guidance.

If a cost produces an improvement to the building structure or to any of these building systems, you must treat that cost as a capital expenditure. For example, if you own a building and update the restrooms by replacing plumbing fixtures with more modern options, that would be considered an improvement to the plumbing system and you’d treat the amount paid to replace the fixtures as a capital expenditure. But if you replace only three cracked sinks, you can treat the cost as a deductible expense. The sinks, by themselves, don’t constitute a large portion of the physical structure of the plumbing system, nor do they perform a discrete and critical function in the operation of the plumbing system. Dispositions of Structural Components The new regulations also include provisions that expand the definition of “dispositions” to include the retirement of a structural component of a building. That means you now can recognize a loss when you dispose of a structural component before you dispose of the entire building. Previously, you had to continue depreciating amounts allocable to structural components even if they were no longer in service. Suppose you own an office building with four elevators and decide to replace one. The retirement of the replaced elevator would be considered a disposition under the new regulations, so you can stop depreciating the elevator and write off its remaining tax basis. Materials and Supplies The regulations also modify and expand the definition of materials and supplies. The amounts spent to acquire or produce nonincidental materials and supplies can generally be deducted in the year they’re consumed or used. The regulations define “materials and supplies” as tangible property used or consumed in the taxpayer’s operations that is:

• A component acquired to maintain, repair or improve a unit of tangible property owned, leased or serviced by the taxpayer and that isn’t acquired as part of any single unit of property; or
• A unit of property that had an economic useful life of 12 months or less, beginning when the property was used or consumed; or
• A unit of property that had an acquisition or production cost of $100 or less; or
• Identified in published IRS guidance as materials and supplies falling under such regulations.

Also falling under the definition are fuels, lubricants, water and similar items reasonably expected to be consumed within 12 months. For example, let’s say you own an apartment building and pay for the acquisition and delivery of a new window to replace a broken one. The new window would be considered a material or supply because it’s a component acquired and used to repair a unit of property you own and use in your operations. You can deduct the amounts you paid for the acquisition and delivery of the window in the taxable year in which the window is installed. Next Steps The new regulations apply to expenditures made on or after January 1, 2012, so they don’t apply to your 2011 tax return. Moving forward, compliance with the regulations might require changes to your current capitalization procedures and may require you to file IRS Form 3115, “Application for Change to Accounting Method.” IRS consent to the change is automatic. Talk to your Marks Paneth advisor about how to proceed.

Leed-ing the Way in Green Building

Cities, businesses and individuals are continuing to catch the “green” fever, increasingly seeking out — and often happily paying a premium for — properties with Leadership in Energy and Environmental Design (LEED) certification. LEED certification offers independent, third-party verification that a building, home or community was designed and built using strategies aimed at achieving high levels of performance in sustainable site development, water savings, energy efficiency, materials selection and indoor environmental quality. Obtaining LEED certification is good not only for the environment but also for your bottom line. While a project’s initial costs may be higher, you’ll save on energy costs; might be able to attract tenants who are willing to pay higher rents in order to “go-green”; and possibly qualify for tax incentives and zoning allowances. Before embarking on a green project, look into the expected payback period to gauge its feasibility. The Point System The US Green Building Council’s (USGBC’s) LEED certification program has been providing accepted recognition for the construction or renovation of green buildings for more than a decade. The USGBC itself used to review all submissions for certification. But, as green building became more popular, the USGBC transferred responsibility for LEED certification reviews to the Green Building Certification Institute (GBCI), a nonprofit organization established with support from the USGBC. When LEED certification began in 2000, the system had a 69-point system for certification. The current system, LEED 2009, boasts 100 points, weighted by categories that reflect priorities. Climate change and indoor environmental quality have the heaviest weightings, while ozone depletion and acidification have the lowest weightings. Building projects now may qualify for up to 35 points related to protecting the atmosphere and 26 points for creating sustain¬able sites. With a maximum of 10 points, water efficiency is lowest on the point scale, though it’s double the previous 5-point maximum. Materials and resources now qualify for up to 14 points, and environmental quality is unchanged at 15 points. The four LEED certification categories are as follows: Certified projects must earn 40-49 points; Silver, 50-59; Gold, 60-79; and Platinum, 80 or more. Building types that are currently eligible for LEED certification include, but aren’t limited to, offices, retail and service establishments, institutional buildings, hotels, and residential buildings of four or more habitable stories. LEED 2012 A new version of LEED certification — dubbed LEED 2012 — goes into effect in November. More types of construction projects can pursue certification under LEED 2012, including data centers, warehouse and distribution centers, hospitality properties, and existing school and retail projects. Expect increased rigor and revised point distributions under the new plan, although the details won’t be finalized until LEED 2012 has undergone a ballot vote by USGBC membership. If you’re familiar with LEED 2009 or prefer a less stringent review, consider getting your application submitted before the new requirements go into effect. Projects that are already LEED certified will continue to qualify under the LEED program for which they are currently registered. Making the World a Better Place Right now, LEED certification may give you a competitive advantage over comparable properties, but someday it may become the norm, rather than the exception. According to the USGBC, nearly 9 billion square feet of building space is in the suite of rating systems, and 1.6 million feet are being certified each day around the world. I If you are thinking about “going green”, it’s important to consider the costs as well as the potential benefits.

C Corporation Acquisitions: Beward of the Tax Issues

While most buyers follow the traditional path of directly purchasing real estate, some take a more round-about route: they acquire the stock of the C corporation that holds the property as its primary asset. This approach comes with several tax pitfalls and complications, though. Issues to Consider Owners of a C corporation that holds real estate may prefer to sell the corporation’s stock rather than incur the double taxation that would be imposed if the real estate were sold and the proceeds were distributed to the stockholders. To facilitate a quick transaction, the owners might therefore offer a reduced price if you take on their corporate structure. Potential purchasers, however, need to look beyond the price. They should consider certain tax issues that wouldn’t ordinarily arise in a traditional real estate acquisition: Double taxation. One of the primary disadvantages of a C corporation is double taxation. The corporation’s profits are first taxed at the corporate level. Then, if the corporation pays out some of its profits as dividends, the dividend recipients are also taxed. On the flip side, ongoing tax losses — common with real estate activities — can’t be used to offset a shareholder’s other income because the losses are inside the corporation. It usually isn’t advantageous to convert a C corporation to S corporation status, because of the taxes owners would face on built-in gains. Converting to a limited liability company could also have substantial negative tax consequences because it would be treated as a liquidation. Basis. When you purchase a C corporation, the tax basis in its real estate holdings isn’t stepped up to reflect the purchase price as it would be in a direct purchase (assuming the purchase price was greater than the seller’s basis). While you, as the new owner, have tax basis in your stock equal to your purchase price, the depreciable assets inside the corporation simply continue to be depreciated as they were depreciated before. Transfer tax. The cost of the deal could be affected by transfer taxes that commonly range from 0.1% to 5.0% of the real estate’s value, depending on the location of the property. Sixteen states and numerous municipalities impose a transfer tax on indirect transfers of ownership in real estate. In such jurisdictions, the transfer of a “controlling interest” in a legal entity is considered a taxable transfer of real property. A controlling interest is usually defined as 50% or more of the ownership interests in the entity. Two general approaches are taken for determining whether a transaction triggers the transfer tax. Under the broad approach, the jurisdiction taxes any transfer of a controlling interest in an entity that owns real estate in the jurisdiction. Under the more narrow approach, the jurisdiction taxes transfers of controlling interests only if the entity being transferred was primarily in the business of owning real estate (often determined by comparing its real estate activity with its total activity). It’s the law of the jurisdiction where the real estate is located that applies, not the law of the jurisdiction of the C corporation’s incorporation or of the purchaser. Due Diligence Needed Taxes aren’t the only thing to be concerned about when considering a C corporation acquisition. Also keep in mind that the value of the real estate might be undermined by any pre-existing legal liabilities, such as slip-and-fall claims, tax delinquencies, and environmental issues, to name a few. Those liabilities stay with the corporation — they don’t go with the sellers. This is another reason why purchasing corporate stock can be a negative. Nevertheless, in certain circumstances, the purchase of C corporation stock may produce the best deal. But it will require enhanced due diligence and tax planning. Consult with your tax advisor before moving ahead with this type of transaction.

Ask the Advisor

Is Structured Financing Right for Me? Even in the tight credit market, many developers continue to seek financing in the form of debt and equity. But in some circumstances, you may be able to combine different offerings from commercial capital markets, thus maximizing your leverage and minimizing cash equity requirements. Benefits of Structured Financing Structured financing arrangements might incorporate a range of financing instruments, including commercial mortgage-backed securities (CMBS), subordinate debt, mezzanine debt, second mortgages, preferred equity structures and credit derivatives. They can address some project-specific needs that conventional financing simply can’t do. Structured financing can help you:

• Work around balance sheet constraints,
• Tap undervalued assets,
• Obtain more leverage at a reduced cost,
• Shift risk and increase control,
• Access equity stuck in single assets or portfolios, and
• Convert nonliquid assets into securities.

For example, an appropriate combination of senior debt, subordinated debt and third-party equity can give you leverage of more than 90% of the total project cost. The increased leverage reduces the amount of equity you must obtain from outside investors and better positions you to control the investment. Structured financing can also mean greater project ownership. You could, for example, use mezzanine financing to close much of the equity gap and reduce your overall costs of capital. The Critical Considerations Structured financing doesn’t come cheap. Mezzanine financing can cost from 9% to 15% — or more, depending on your leverage and credit. Preferred equity rates are even higher — for example, a 12% to 15% coupon payment plus profit participation. As you blur the lines between debt and equity financing, you may lose the tax benefits of traditional debt, thereby increasing your after-tax cost of capital. Mortgage interest payments are tax deductible; dividends paid to equity investors are not. Overleveraged properties that use structured financing may find themselves buried even deeper by these costs. The best candidates for structured financing offer future cash flow sufficient to pay off high yield debt capital. Other considerations include whether to search for an individual investor or use a more experienced pool of institutional investors. If your needs are only short-term, consider “one-off” financings. Finally, keep in mind that properties financed by Fannie Mae or Freddie Mac may be limited to preapproved providers for structured financing options. The Right Circumstances Structured financing might not be the best option when, for example, cash is readily available or you can easily secure conventional financing. But the benefits make such financing worth considering. Under the right circumstances, it can pay off not only for new construction, but also for acquisition, recapitalization and other business plans.

IRS Circular 230 Disclosure

Treasury Regulations require us to inform you that any Federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © Marks Paneth LLP 2012 MANHATTAN | LONG ISLAND | WESTCHESTER | CAYMAN ISLANDS