Property Improvement Analysis for Building OwnersJuly 27, 2018
By: Eduard Suleymanov, CPA
When the final details of the Tax Cuts and Jobs Act were released late last year, real estate professionals celebrated the industry’s exclusion from the 30 percent business interest expense limitation. However, they soon learned that the downside of electing out of this limitation was the forfeiture of the 100 percent immediate bonus depreciation also included in the new tax law.
Fortunately, the tangible property regulations, issued by the Department of Treasury in 2014, are still in effect post-tax reform and allow for a full deduction of certain property expenses in the year of purchase.
These regulations provide taxpayers with a framework on how to account for expenses related to tangible property, including whether to deduct a property expense as a repair or capitalize and depreciate it as an improvement. To make this determination, a taxpayer must first define their units of property and then conduct an improvement analysis of each one.
UNIT OF PROPERTY RULES: BUILDINGS ARE SPECIAL
The tangible property regulations introduced the concept of “unit of property” which is the tangible asset to which the tax rules apply. Determining the unit of property can be complex, but the regulations provide special rules for buildings that help simplify the process.
For a lessor of a building, the units of property are the entire building and its structural components, as well as the structural components designated as key building systems. For a lessee of a building, the units of property are the portion of the building structure and portion of each key building system subject to the lessee’s lease.
DEFINING UNITS OF PROPERTY
The building and its structural components are comprised of a single unit of property and its foundation, parts (e.g. walls, partitions, floors, ceilings) and any permanent coverings such as paneling, tiling, windows and doors.
The following nine key building systems are considered units of property separate from the building structure:
• Heating, ventilation, and air conditioning (HVAC) systems
• Plumbing systems
• Electrical systems
• Fire protection and alarm systems
• Security systems for the protection of the building and its occupants
• Gas distribution system
• Other structural components identified in published guidance
Therefore, if a taxpayer incurs an expense related to its windows and doors, the unit of property for determining whether the expenditure should be capitalized or expensed is the building and its structural components, since windows and doors are not considered a key building system. For expenditures related to security cameras, however, the appropriate unit of property would be a key building system that falls under the category of security systems.
The units of property are further subdivided into a category known as “major components” which are defined as parts or combinations of parts that perform a discrete and critical function in the operation of the unit of property. Major components exist within both the building and its structure unit of property, as well as the nine key building systems.
Generally, a taxpayer must capitalize expenses that result in the replacement of a significant portion of a major component of a unit of property.
IMPROVEMENT ANALYSIS: KNOWING WHEN TO CAPITALIZE
Once the units of property for the building are determined, it is vital to understand whether expenses incurred on each unit of property should be capitalized and depreciated or expensed in the current year.
In general, a taxpayer must capitalize an expense made to a unit of property if the expense resulted in an improvement to that unit of property. An improvement is defined as any expense that results in one of the following:
- Betterments, which include expenses that:
- Are reasonably expected to materially increase the productivity, strength, quality or output of the unit of property,
- Represent a material addition to the asset, such as a physical enlargement, expansion, extension or a material increase in the property’s capacity, or
- Ameliorate (fix) a material condition or defect that existed prior to acquisition or that arose during production of the property.
“Material” is the key term in all three tests of a betterment but is not defined in the repair regulations. Taxpayers are expected to use reasonable judgment as applied to their specific set of facts and circumstances to determine which expenditures result in a betterment.
2. Restorations, which include:
- Replacing a major component or substantial structural part of the unit of property
- Replacing a component on which the taxpayer recognized a gain or loss on disposition
- Restoring property to its ordinary efficient operating condition or rebuilding property to like-new condition after the end of its class life in the tax system
- Replacement of a component of unit of property for which the taxpayer has properly taken into account the adjustment basis of the component in realizing gain or loss from the sale or exchange of such component
- Restoring a damaged unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss
3. Adaptations, An amount must be capitalized if it is paid to adapt a unit of property to a new or different use that is not consistent with the ordinary use of the unit of property at the term that the taxpayer originally placed it in service.
An example of an adaptation would include a building that was mainly used since inception for manufacturing items and has undergone a conversion to become a showroom. Since the structure and systems are converted to a new or different use that is inconsistent with the original use, an adaption has occurred and all costs of the adaptation will need to be capitalized.
Occurrences that do not constitute an adaptation include: painting the walls and refinishing the floors of a building prior to sale of the building, or a hospital that modifies its emergency room space to also include an outpatient surgery. These expenses do not “adapt” a unit of property to a new or different purpose.
Owners of real property should analyze the cost of every repair or improvement separately under each improvement standard before determining how the expenses will be treated on their financial statement. Any amount could be subject to capitalization under one improvement standard, even if it fell outside of the scope under another.
The repair regulations provide a number of advantageous provisions for owners of real property to deduct repair expenses in the current year. While there are no bright-line rules for determining when an expenditure related to tangible property should be treated as an improvement or repair, owners of real property are advised to use a facts and circumstances test based on a framework, guidance and examples provided by the IRS.
The topics covered in this article are only a small part of the repair regulations, which also include rules for deducting costs of materials and supplies, de minimis safe harbors and deductions allowed for routine repair and maintenance costs. Contact a member of the Marks Paneth Real Estate Group to learn more.