By Brad Eriksen
Effective January 1, 2014, new IRS regulations regarding the expensing and depreciation of tangible property for commercial property owners may change the cost of doing business for apartment owners. The new regulations have been long in coming, with the first set of proposed rules issued in 2006, only to be withdrawn and replaced with another set of proposed rules issued in 2008. The 2008 rules never took effect. In 2011, the IRS issued temporary regulations in order to clarify the proposed 2008 rules. In 2013, effective January 1, 2014, final regulations were issued.
Regulations Tilt Toward Capitalization, not Expensing
Costs incurred in repairing and maintaining residential rental property must either be capitalized or expensed. Expensing is preferred since it provides for an immediate deduction against income, whereas capitalized items must be depreciated over the useful life of the item, up to 39 years.
The Internal Revenue Code provides that costs incurred to acquire, produce, or improve property must be capitalized. Costs not required to be capitalized may be expensed each year, resulting in obvious tax benefits to the property owner. The new regulations tend to favor capitalization of costs rather than expensing. In general “improvements” must be capitalized, while “repairs” may be expensed.
To make the distinction between repairs and improvements easier to determine, the new regulations enacted several safe harbors. These safe harbor provisions may provide opportunities for apartment owners to expense a greater amount of repair and maintenance costs.
Routine Maintenance Expense Safe Harbor
The routine maintenance expense safe harbor provides that recurring activities for the purpose of using the property and assuring it is in operating condition may be expensed and immediately deducted. Routine maintenance for commercial buildings is defined as activities the owner reasonably expects to perform more than once every 10 years. Since apartment units experience a higher rate of turnover and wear and tear than other commercial properties, maintenance activities that might be performed less often on commercial properties, such as repainting, recarpeting, etc., can typically be expected to occur more than once every 10 years and are immediately deductable for residential rental property.
Small Tax Payer Safe Harbor
Taxpayers with less than $10 million of gross receipts are eligible to elect not to apply the capitalization of the new regulations. If annual repair, maintenance, and improvement costs preformed on an “eligible building” do not exceed the lesser of $10,000 or 2% of the cost basis of the building, these costs can be expensed each year. An eligible building is a building “unit of property” with a cost basis of $1,000,000 or less. The seeming low ceiling of $10,000 of annual costs and $1,000,000 of cost basis would appear to limit the usefulness of this safe harbor rule. However, the regulations treat separate building systems as individual “units of property.” Accordingly, electrical, plumbing, mechanical, elevators, pools, etc. can be considered separately for purposes of qualifying for the Small Taxpayer Safe Harbor. For taxpayers acquiring new residential rental property, this highlights the need for a detailed and accurate allocation of the purchase price among the various building systems and components.
De Minimis Safe Harbor
For taxpayers with applicable financial statements, written accounting procedures for expensing amounts under the specified dollar limits and who consistently treat such amounts as expenses on its applicable financial statements, a de minimis safe harbor may be available. This safe harbor is available for amounts paid for tangible personal property not exceeding $5,000 per invoice, or per item substantiated on the invoice. Properly structured, replacement of refrigerators, ranges, and other appliances may be expensed, rather than capitalized.
As you can see from the above discussion, each of the safe harbors is highly technical and takes careful planning and implementation to assure compliance with the regulations. Consulting with your tax professional in advance of incurring any repair, maintenance, or replacement costs is strongly recommended.
As published in The Northwest Apartmemt Investor Newsletter