We focus on the most important concepts governing what distinguishes a fixed asset from an expense, tax depreciation rules and certain current incentives for writing off capital expenditures.
Our focus is the big picture and major planning points when it comes to capital or near-capital expenditures and related expenses.
We’ll begin with an emphasis on current deductions – business expenses and the election to expense capital expenditures provided by Section 179.
The Relatively New Repair and Maintenance Regulations
One doesn’t reach the depreciation details if an item qualifies as an ordinary and necessary business expense under Section 162.
Is it an asset or business expense? The tax discussions following this question often focus on supplies, or repairs and maintenance.
Generally, taxpayers need to capitalize (call an asset) payments to acquire, produce or improve tangible property but they have an immediate deduction for supplies or repairs and maintenance.
There are definitions galore, but they often come with caveats. For example, there is a definition concerning “incidental materials and supplies” that asks whether the item is part of another unit of property and whether it costs $200 or less, but the rule sanctioning the deduction still comes with the caveat that “taxable income is clearly reflected.” ((Regs. 1.162-3(a)(2), (c).))
There has been a major IRS emphasis in recent years on achieving greater clarity in the tax rules but the discussions usually come with caveats. There are many borderline issues here.
One sometimes senses Congressional generosity when reading about the relatively new rules which may let the taxpayer expense up to (usually) $500,000 of capital expenditures but any sense of generosity goes away reading the surprisingly complex repair and maintenance regulations.
The no-questions-asked part of the definition of incidental materials and supplies was increased to $200 from $100. ((See “New Tangible Property Regulations: Simplified Option Available to Many Small Businesses,” FS-2015-20, July, 2015, referring to new regulations, T.D. 9636, October 21, 2013. See also the IRS site discussing “Tangible Property Regulations – Frequently Asked Questions.”
There are other more generous de minimis concepts focusing on small amounts of capital items – notably one that looks to a $2,500 safe harbor after December 31, 2015, or sometimes $5,000 depending on the details of the financial statements and the taxpayer’s treatment of such amounts.
This involves annual elections, and one would normally want to take advantage of this rule, thus limiting the areas of potential controversy with the IRS to larger amounts. Larger amounts may, of course, be currently deductible depending on the nature of the item.
One of the complexities is that accounting method change issues also arise in this context.
Section 179 – Expensing Fixed Assets Generally
Section 179 generally allows the taxpayer to expense costs that would otherwise be capitalized. The maximum deduction per year is $500,000 ($535,000 for qualified enterprise zone property). This is Part I of the IRS Form 4562, Depreciation and Amortization, a focus of President Trump’s proposals. There are reports that President Trump plans on keeping this and even wants to expand it to $1,000,000.
The provision is aimed at the small to upper-mid-sized firm. For 2016, if you placed in service qualifying Section 179 property that exceeded $2,010,000, the dollar limit of $500,000 was scaled back, eliminated at the level of $2,510,000. For 2017, if you place in service qualifying Section 179 property that exceeds $2,030,000, the dollar limit of $510,000 is scaled back, eliminated at the level of $2,540,000.
There is some provision for carryover but also note the deduction after applying the dollar limit is limited to aggregate amount of taxable income from any active trade or business. ((IRS Pub. 946, How to Depreciate Property, 2016, p. 20; Regs. 1.179-2(c’).))
There are analytical issues such as whether it is wise to maximize the deductions in the lower tax brackets.
To be eligible, the assets must be acquired by purchase for use in an active trade or business.
Tangible personal property and off the shelf computer software qualify.
Property eligible for expensing also includes other tangible property, except buildings and their structural components, when used for particular purposes – most notably when used as an integral part of manufacturing, production or of extraction, or in furnishing transportation or utilities. For example, large manufacturing equipment may qualify when attached to the building because this isn’t a structural component of the building.
There is an election under these rules to make them apply to “qualified section 179 real property” which encompasses qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property. ((Sec. 168(f).))
ACRS depreciation rules apply to assets from 1981-1986. These rules are rarely an issue because few assets are still on this system.
“MACRS” is the term for post-1986 depreciation rules. It consists of a General Depreciation System which is usually just referred to as MACRS, but there is also an Alternative Depreciation System (ADS) within MACRS which is basically longer lives. ((Form 4562, Part III, see sections B and C.))
Depreciation focuses on “basis,” which is usually but not always cost. There are exceptions, notably the general rule that basis steps up (or down) to fair market value upon the death of the owner. In a community property state, there is step-up for both halves of community property upon the death of the predeceasing spouse.
Particularly with real estate, there can be post-acquisition adjustments to basis. There are such details as transaction and installation costs as part of basis. ((See generally IRS Pub. 551 “Basis of Assets,” including its discussion of real estate basis.))
Depreciation reduces basis, thus increasing gain or reducing loss when the asset is sold. The nature of the gain is often capital gain in the case of realty, usually ordinary income in the case of equipment.
The general rule under MACRS is 200% declining balance method switching to straight line at some point but realty is an exception. The general rule for realty is straight line, and a 27 ½ year life for residential rental realty and 39 year life for commercial realty, or 40 years under ADS.
The lives of assets other than buildings are less and vary with the particular type of property.
Salvage value is ignored under MACRS; i.e., you basically use basis, usually cost as reduced by the Sec. 179 expensing election and bonus depreciation.
The basic idea of these tax rules is to let taxpayers just look up the depreciation rate from tables.
These rules move toward the goal of simplification but there are major complexities, including notably, drawing the line between what is basis and an expense, and the classification of an asset within the tables; for example, distinguishing a building from components that may qualify for quicker write off.
Our focus is not “listed property” but the Form 4562 demonstrates some of the added rules dealing with autos, computers and cell phones.
Important Concepts Concerning Buildings
The IRS definitions of a “building” include such basics as enclosing space within walls, usually having a roof…and other particulars. ((See Regs. 1.48-1(e)’, Regs. 1.263(a)-3(e)’, Regs. 1.263A-8(c’); see also Regs. 1,856-10.))
Capitalization generally applies to an “improvement” a term which asks whether the expenditure achieved a betterment, restoration or adaptation. An illustration in an IRS publication calls a new roof an improvement because it restores the building. ((IRS Pub. 946, How to Depreciate Property, 2016, p. 13.))
There is a “unit of property” concept within the rules relating to capitalizing improvements. ((Regs. 1.263(a)-3(e’)). The rules generally distinguish a building and its structural components from various systems in the building, such as heating or plumbing or electrical.
For purposes of what constitutes an improvement, the rules usually look not at whether the expenditure improved the building but, for example, whether the building’s electrical system was improved. The focus on systems is to make it more difficult to justify a current expense; i.e., a system might be improved whereas one wouldn’t think the building was improved.
Within these rules, generally skewed toward finding the highest level of capitalization, there is a general relief provision available for building improvements by taxpayers with gross receipts (on the average) of not more than $10 million. The rule generally sanctions writing off building improvements that would otherwise be capital to the extent of the lesser of 2% of the unadjusted basis of the property or $10,000. ((Regs. 1.263(a)-3(h).))
There are different rules in these regulations concerning building leases.
There are rules sanctioning deductions for “routine maintenance.” ((Regs. 1.263(a)-3(i).))
Segregation Studies of Building Costs
To distinguish the various categories of depreciable cost that might be buried within a building’s cost is the work of a “cost segregation study.”
There is much taxpayer effort (usually a professional’s efforts) along these lines as well as IRS work in making such distinctions.
The rules are sufficiently complex that in all but the most simple businesses or real estate investments, the taxpayer needs a study that looks at the particular facts and relates them to the maze of rules.
There is an IRS “Cost Segregation Audit Technique Guide” which refers to a group of specialists within the IRS called the “Deductible & Capital Expenditures Practice Network.”
Our topic is sufficiently complex that it is possible to make a living specializing in these issues, and the amounts involved may be large, particularly with larger real estate projects.
On this topic, we quote from this group within the IRS that specializes in such distinctions. In the following, “Section 1250” is a tax term dealing with buildings and “Section 1245” is a tax term usually meaning personal property. ((Sec. 1245(a)(3’.)) The IRS is basically teaching examining agents how to deal with this topic.
“The following example illustrates the tax benefits of a cost study. In general, a turnkey construction project includes elements of tangible personal property (e.g., phone system, computer system, process piping, storage tanks, etc.). It is relatively easy to segregation identify these items as § 1245 property and allocate a portion of the total project costs to them. However, a cost segregation study may also report certain building occupancy items (e.g., carpeting, wall coverings, partitions, millwork, lighting fixtures) as § 1245 property that would have likely been classified or grouped under § 1250 property without the completion of a cost segregation study. These items may or may not constitute as qualifying § 1245 property depending on the particular facts and circumstances for which the project was designed.
This next example illustrates the complexity of cost segregation issues. In addition to identifying specific project components that qualify as § 1245 property, cost segregation studies may treat portions of building components as § 1245 property. For example, some items of the building’s electrical system support § 1245 property and § 1250 property. The Study will typically identify the costs of the branch circuits feeding the § 1245 property and classify according to the recovery period of the § 1245 property (i.e. 5 or 7 year recovery). It may also identify that, for example, 15 percent of a building’s electrical distribution system (EDS) directly supports § 1245 property, such as specialized kitchen equipment. Based on that conclusion, the study will then treat 15 percent of the EDS cost as § 1245 property along with the identified § 1245 branch circuits…..The allocation of building components to § 1245 property is often a contentious issue.” ((IRS Cost Segregation Audit Techniques Guide, Chapter 1, Introduction.))
The IRS Guide has many helpful particulars. For example, their guidance on casinos would have helpful information as to the IRS perspective with respect to many types of issues concerning buildings.
This isn’t an exhaustive list, but we note the IRS also has guidelines on restaurants, auto dealers, retail industries, stand-alone open-air parking structures, and a building’s electrical distribution system.
Note that cost segregation studies aren’t just limited to new buildings, and as a practical matter may not be done until post-acquisition years.
Fifty percent bonus depreciation, also known as the special depreciation allowance, is available for certain property in the year placed in service, primarily new tangible property with a recovery period of 20 years or less. So it does not apply to buildings per se. ((The deduction is claimed on the 2016 Form 4562, Part II, line 14.))
We noted in the Section 179 discussion that it is phased out at higher levels of asset acquisition, such that it may not be available to larger taxpayers. The bonus depreciation rule is not phased out at higher levels of asset additions, and it is not subject to the active business requirement.
“Qualified improvement property” is eligible. “Generally, this is any improvement to an interior part of a building that is nonresidential real property. The improvement is placed in service after the date the building is first placed in service and is section 1250 property.” ((IRS Pub. 946, “How to Depreciate Property,” 2016, p. 26.)) This doesn’t apply to an enlargement of a building, an elevator or escalator, or the internal structural framework of the building.
In determining the basis of an asset, basis is reduced first by the expensing election, then this 50% bonus depreciation provision, then the normal depreciation rules apply.
A Hotel/Motel Stop
Residential rental property “does not include a unit in a hotel, motel or other establishment where more than half the units are used on a transient basis.” ((See IRS Pub. 946, “How to Depreciate Property,” 2016, p 31.)) Accordingly, a hotel/motel would be a nonresidential property generally subject to a 39 year MACRS life.
A hotel/motel is a good candidate for a cost segregation study toward the goal of primarily shifting portions of cost into the fifteen year category for land improvements, and the five or seven year category for personal property.
A hotel complex failed to gain bonus depreciation due to particular failures. It asserted bonus depreciation on components of a building classed with a life of 20 years or less following a cost segregation study. ((FAA 20140202F, 1/10/14.))
The Section 179 (immediate deduction) rules are generally not available to apartment owners but hotels/motels may deduct such property as appliances, carpets, drapes, etc. ((Section 179(d)(1), Section 50(b)(2)(B); IRS Pub. 946, How to Depreciate Property, 2016, p. 18.))
Hotels/motels often involve restaurants and leaseholds, and there is an election under the Section 179 rules that can even reach qualifying real property. ((Section 179(f).))
There have been efforts by the IRS at reducing the areas of contention for repairs and maintenance and capital expenditures generally, and there have been some efforts by politicians at stimulating the economy by quicker write offs with respect to capital items.
The issues remain extraordinarily complex and the potential tax savings are significant, justifying increased study, review of potential elections and depreciation choices, as well as general planning which may entail projections and judgments.