Over the past few years, there has been increased tax planning in the area of repairs and maintenance. Taxpayers have been able to take advantage of favorable tax rules in this area, and accelerate the deductions for these types of expenditures. Unfortunately for the real estate world, the capitalization rules (compared to what can be expensed) have changed starting in 2012 and, as one may suspect, these changes are not in the favor of the taxpayer. I will review the changes from the old rules to the new and discuss certain aspects to focus on in further tax planning. Again, it is important to mention that the changes discussed are specific to real estate.
The center of the repairs vs. capitalization issue is and has been the definition of unit of property (UOP). Under the old rules, as supported by vague IRS code and various court cases, taxpayers were able to look at certain assets as a “whole” asset rather than looking at the parts that make it up. To illustrate this, we look at the 2003 Federal Express Corp. (FedEx) case. In this case, FedEx incurred costs of rebuilding the engines of its jets which were required regularly to keep the jet functional. The IRS proposed that the extensive cost of rebuilding an asset such as a jet engine should be capitalized and depreciated. Most looking at the type of asset and cost of the rebuild alone may agree with this, but FedEx contended that these costs were regular maintenance for the larger asset – the jet (as a whole).
The court ultimately decided on this case in favor of FedEx agreeing that the asset in question is the jet, and rebuilding the engines should be treated as normal repair of the asset. In coming to this decision, the court took the position of looking at the rebuilt jet engine and its relation to the jet both independently and together as one. A jet without an engine and vise-versa does not have the intended use one would expect. Based on this decision, it was clarified that taxpayers were able to look at assets as a whole and certain pieces or parts could be expensed when repaired as long as it did not meet one of the capitalization criteria (old rules) which will be covered later. While the FedEx situation is not one you see every day, this decision paved tax planning paths in more common areas such as real estate. The question then became when repairing or even replacing parts of a building could those be expensed as they are parts of a larger asset (the building as a whole). A straight forward comparison is a jet without an engine is comparable to a building without a roof.
The main change, starting in 2012, is the definition of a UOP. The taxpayer will no longer be able to look at the asset as a whole. Now the unit of property for a building will be applied to 9 individual structural components (listed below) that make up the building. This change in the capitalization rules focus on the individual assets that make up a building.
- HVAC (heating, ventilation, & air conditioning)
- Plumbing Systems – inside and outside; including water, storm, sewer, and related fixtures
- Electrical Systems – inside and outside; including fixtures, wiring, and distribution
- Fire Protection (sprinklers) and Alarm Systems
- Security Systems - for the protection of the building and its occupants
- Gas Distribution System – inside and outside
- Structural Components – roofs, walls, floors, windows, doors, etc.
In addition to the definition of a UOP, one also has to look the change in the capitalization rules. These changes relate to the change in the definition of a UOP. I have listed both the old and new rules below to show the focus of each.
Old Rules (You must capitalize expenditures that do one of the following):
- Materially increases the value of the property (the entire asset)
- Substantially prolongs the useful life of the property (the entire asset)
- Adapts the property (the entire asset) to a new or different use
New Rules (You must capitalize expenditures that do one of the following):
- Relates to the betterment of the unit of property
- Relates to the restoration of the unit of property
- Adapts the unit of property (or entire asset) to a new or different use
Looking at these rules you can see the focus shift from the asset as a whole (the building) to the specific components that make up the building. Under the old rules, you had to capitalize costs that changed (defined by old rules above) the entire asset. A simplistic example of this is the replacement of a building’s roof, which would not materially increase the value, prolong the life, or adapt the building. Based on these facts, this expenditure could be expensed in the year of replacement. Assuming the same facts now in 2012, with the roof being a UOP, replacing it would be an improvement (betterment) and these costs should be capitalized.
One item that should also be mentioned at this point is the change in the rules that relate the write-off of existing assets as they are repaired or replaced. Under the old rules, unless the replacement/improvement was related to a special circumstance (relation to the loss of a tenant), the pre-existing items could not be written off. With the new rules, the taxpayer is now allowed to write-off existing items that are replaced. To help illustrate, let’s use the example above of replacing the roof of a building. Under the old rules, if the replacement costs are capitalized you could not write-off the costs of the roof that was replaced. This could result in the depreciation of two roofs over a period of time while of course only one roof is on the building. Compare this to the new rules where the taxpayer is able to write-off the cost of a unit of property that is replaced. Therefore, while the new roof costs are capitalized the un-depreciated cost of the old roof can be written-off in the year of replacement.
To conclude, while it is too late to incorporate the old type of tax planning, it is important to know how the capitalization rules have changed and understand what affect they may have on you. While there are certain items that can still be expensed, that list became much shorter due to the refined definition of what a UOP. Proper knowledge of these rules will enable you to maximize your tax deductions as you replace or improve certain parts of your building. These rules are very fact specific and you should consult your tax advisor regarding your specific facts.
Have questions about how the new Repair Regulations will impact your business? Post a comment below or contact our Tax Planning and Preparation group at 440-449-6800.