In 2015, many property owners were faced with the mandatory change over to a new methodology of accounting for capital expenditures on property as either an improvement to be depreciated or written off as a repair. The goal of simplifying the methodology to be qualitative versus quantitative has complicated the decision-making process much more than the ease it was trying to create.
Over time, both taxpayers and tax practitioners have slowly begun ignoring these changes' practices and implementation. Keeping these rules front and center is paramount for property owners as properly using the regulations can accelerate or create tax savings.
Capitalize or Expense
The regulations set forth the general rule that amounts paid to improve a property unit must be capitalized. An improvement is defined as an expenditure that betters a unit of property, restores it, or adapts it to a new and different use. The treasury regulations include various examples and explanations of betterment, restoration, and adaption tests.
Betterments look at whether the property is in a materially better condition above and beyond what the asset needed in repair after the incurred expenditure. Additions, expansions, and physical enlargements to the Unit of Property (defined below) must be capitalized. Strengthening, increasing productivity and efficiency, or the quality of the asset also reflect a betterment.
Restorations generally look at whether the taxpayer is replacing a major property component or substantial structural part that may perform a discrete and critical function to the asset's intended use. If an asset is in a state of disrepair and is brought back to life for its intended use, the costs will generally be capitalized and depreciated.
Adaptation is the simplest standard to understand and measure. The taxpayer solely looks at whether the asset is being used for a new or different use than its originally intended use.
If you fail to meet all three capitalization standards above, your costs are considered repair and maintenance expenses, regardless of the dollar amount. So, what previously you may have capitalized as a $50,000 improvement for fixing part of a roof or plumbing issue may be written off in the current year.
Unit of Property
A key concept in the regulations is defining the Unit of Property (UOP) being improved or repaired. The UOP is the level at which the determination is made between a repair that is required to be capitalized and can be expensed immediately. The smaller the UOP, the more likely it is that costs incurred will have to be capitalized.
For example, work on a vehicle's engine is more likely to be classified as a cost that must be capitalized if the engine is classified as the UOP. By contrast, if the vehicle instead is the UOP, the engine work has a better chance of being treated as a repair expense in the current year.
Property Other than Buildings
In general, for property other than buildings, a single UOP consists of all functionally interdependent components, such that one piece cannot be placed in service without the others.
For example, a business needs a battery‐powered golf cart for its foreman to travel around a large warehouse; it buys the chassis from one vendor and the battery from another and then assembles the two components. The cart is the UOP since the chassis cannot be placed in service without the battery.
When it comes to buildings, the regulations generally treat each building and its structural components (walls, windows, doors, floor, roof, etc.) as one UOP – the "building." The regulations also list nine specific building systems that are treated as separate UOPs, including HVAC, plumbing, electrical, elevators, fire protection and alarm systems, security systems, and gas distribution systems.
An expense incurred related to the building is considered with respect to the appropriate UOP. If a taxpayer restores a component of the building structure by replacing the entire roof, the expense is treated as an improvement to the building's single UOP. However, if a taxpayer replaced a furnace in the building, the cost would be considered with respect to the HVAC system UOP.
Deducting Materials and Supplies
A deduction is allowed for amounts paid to produce and acquire materials and supplies consumed during the year. Materials and supplies are defined as components acquired to maintain, repair, or improve tangible property that have a useful life of one year or less or has an acquisition or production cost of less than $200. Fuel, lubricants, water, and similar items are also considered to be materials and supplies. Taxpayers can expense non‐incidental materials and supplies in the year consumed if they fall under the de minimis safe harbor amount.
Incidental materials and supplies, those for which there is no record of consumption or physical inventory, are deductible in the year they are purchased. There are also special rules that apply to rotable, temporary, or emergency standby spare parts. The regulations dictate that a deduction is taken in the year disposed unless an election is made to capitalize and depreciate the spare parts or an optional exchange type method is adopted.
De Minimis Safe Harbor
One of the key changes in the regulations is the de minimis safe harbor, which allows a taxpayer to deduct certain limited amounts paid for tangible property that are expensed for financial accounting purposes that fall under a specified threshold amount. Taxpayers can use a de minimis threshold of $5,000 if they have an applicable financial statement‐ generally either an audited financial statement or another financial statement required to be provided to a federal or state government agency.
All other taxpayers, including those with reviewed or compiled financial statements, can use a $2,500 de minimis threshold. The de minimis safe‐harbor, either $5,000 or $2,500, is applied to each item on an invoice, allowing a taxpayer to expense those items falling under the threshold as long as they are also expensed for financial accounting purposes. If more than one item is listed on an invoice, the threshold applies separately to each item, and additional costs (delivery, etc.) should be allocated accordingly.
For example, assume a taxpayer does not have an applicable financial statement but has accounting procedures in place to expense tangible property purchased for less than $2,500. The taxpayer purchases five computers, costing $2,495 each, all included on the same invoice. All five computers are eligible to be expensed under the de minimis safe harbor. However, if the invoice also included delivery charges totaling $50, the computers would need to be capitalized as the delivery charges would be allocated pro rata amongst the assets acquired.
To use the de minimis safe harbor, you must have a capitalization policy in place at the beginning of the year, allowing you to expense the threshold amount.
Routine Maintenance Safe Harbor
The regulations include a safe harbor that allows certain expenses of routine maintenance to be deducted immediately rather than capitalized. Routine maintenance is defined as recurring activities that keep the property in ordinarily efficient operating condition, such as inspection, cleaning, testing, and replacement of damaged or worn parts.
For a building structure or system, the taxpayer can expense routine maintenance if they reasonably expect to perform the maintenance more than once during the 10‐year period that begins when the structure or system is placed in service.
Per‐Building Safe Harbor for Qualifying Small Taxpayers
The regulations also include a safe harbor for qualifying small taxpayers to deduct improvements made to a building property with a cost basis (excluding land) of $1 million or less. Qualifying small taxpayers are defined as those with average annual gross receipts of $10 million or less. This safe harbor applies only if the total amount paid during the tax year for repairs, maintenance, and improvements for each building does not exceed the lesser of $10,000 or 2% of the building's cost basis. This safe harbor may be elected annually on a building‐by‐building basis.
The disposal regulations create a "partial disposition" election for fixed assets. If the election is made, a taxpayer may recognize a loss on the retirement of a structural component of a building or any other asset component without identifying the component as a separate asset before disposition.
For example, if a taxpayer replaced the roof on their building during the year and capitalized the new roof. Under the partial disposition election, the taxpayer could lose the remaining adjusted basis of the old roof even if it was not separately identified when the original building was placed into service.
Both taxpayers and CPAs often miss this election due to its seemingly complex calculation. In many cases, however, the long-term tax benefits available can save, at a minimum, a 5 percent tax savings when it is time to sell the building.
Aldrich is Here to Help
Repair and capitalization regulations are challenging to understand and implement. Our real estate team is here to help you make informed decisions to better your business. If you have questions about managing various properties, reach out to your Aldrich Advisor.
About the Author:
Jonathan McGuire, CPA is real estate accountant with Aldrich Advisors who has over eight years of experience providing strategic tax planning and compliance expertise to private middle-market clients. He has a deep focus as a real estate accountant, working with investors, developers, realtors, property managers, and other professional service providers in real estate. Jonathan is an adjunct professor at Corban University’s business school and has been featured in Forbes Magazine.