In today’s soft economy, real estate, investment, and construction firms need all the cash flow they can get. But with the national slowdown still draining income and resources, many firms have had to get creative to repair their damaged cash flow. One place they’re turning to is their own balance sheets.
As they review their balance sheets, some companies are freeing up cash with tax savings. A West Coast real estate firm was able to deduct — as opposed to capitalize — more than $3 million in repairs on a multifamily property. That reduced the firm’s tax liability by more than $1 million.
In times of plenty, classic tax depreciation strategies are often overlooked, but in lean years, these tools can make or break critical improvements to the balance sheet.
Fortunately, the 50% bonus depreciation enacted in 2008 as a temporary boost to the economy that had been set to expire at the end of 2010 was instead extended and enhanced by Congress. Under tax laws passed in December, the bonus depreciation was increased from 50% to 100% for qualified investments made after September 8, 2010, through the end of 2011. The bonus depreciation falls back to 50% for calendar year 2012, and expires at the end of that year.
Assets should be evaluated for any applicable incentive, including bonus depreciation, to capture every available tax deduction.
Bonus depreciation: good deal
The two-year incentive period for bonus depreciation is especially beneficial for businesses because bonus depreciation, unlike some types of expensing, isn’t limited to smaller companies or capped at a certain dollar level. But there is a catch: Only new property qualifies for the 100% bonus depreciation.
For example, if a company buys $1 million of qualifying property eligible for the 100% bonus depreciation deduction, the company could claim a $1 million depreciation deduction for the property on its 2011 tax return.
Given the value of accelerated deduction versus recovery over time, and bonus-depreciation provisions of 2011–2012, real estate entities might find it well worth their time to dig in to the tax law and determine whether they can save money by freeing up more cash.
A change of tactics
Another technique to claim additional tax deductions in certain circumstances involves changing the company’s accounting method. For example, if a business is using its book method of accounting to determine deductible repair and maintenance costs of its real estate, it may be overpaying current income tax. By changing its tax accounting method for repair and maintenance expenses, the business may be able to deduct eligible costs now instead of later, reducing current taxes and strengthening its cash flow.
This opportunity applies to most any company with real estate assets — health care, banking, retail, and the like — but has particular relevance for real estate investors and operators whose primary business is commercial property.
The benefits could be substantial for businesses that own a great deal of real property or have other assets with long useful lives—such as heavy equipment—on their books. Examples that could be eligible for immediate deduction include repainting, repairing leaks, and repairing or replacing roofing materials on buildings.
Businesses that use their book capitalization policies for tax often capitalize more costs than they’re required to under the tax law, and this significantly delays the deduction for these costs. For instance, when a business repairs a building, it often capitalizes and depreciates the repair costs in the same manner it would for the building itself. That means the business will recover depreciation deductions over a period of up to 39 years. Yet these expenses are, in some cases, immediately deductible for tax purposes.
A thorough review of repair and maintenance expenses can often uncover capitalized assets that should originally have been expensed for tax purposes. If this is the case, the current tax law allows taxpayers to change their method of accounting for certain properties, and with that change eligible expenses previously capitalized may be deducted in the current tax year.
Deducting now can yield rewards
If a business is eligible, there’s no reason to wait to deduct these expenses over time.
Reviewing fixed assets can also identify other opportunities for tax deferral. Abandoned assets, for example, can be identified and removed from the books in order to reap any remaining deductions and potentially reduce property taxes.
The bottom line in this cash-critical period is that analyzing and changing the tax treatment of fixed assets can substantially reduce current federal and state tax liabilities or, for companies with net operating losses, increase the loss available for carryback to obtain refunds of taxes paid in prior years.
Deducting expenses today, as opposed to depreciating them over time, can make a significant and fairly immediate financial difference.
Example: a $560,000 cash flow
For instance, a company owns residential apartments where roofing and siding issues arose five years after construction. The company fixed the problems and capitalized the $4 million in costs associated with repairs.
After determining the costs could be expensed, the company deducted the remaining basis of $3.2 million.
Assuming a 35% marginal income tax rate and a 7% discount rate, the present value of taking the accelerated deduction in lieu of continuing to recover the costs without a cost segregation study is approximately $560,000, and thus reduces overall tax liability by over $1 million.
It Pays to Be Cautious
It’s important to note that the IRS has increased awareness of capitalization of repair and maintenance expenses in large part by issuing proposed regulations. The IRS also has raised repair and maintenance expenses to Tier 1 status, which means the agency will scrutinize them carefully.
Judgment calls and subjectivity are involved in this process. For example, it can be difficult to determine what constitutes a deductible roof replacement versus a capitalized roof replacement.
The following key questions provide a road map for making decisions, since these are actual representations a business must make to the IRS if it intends to go back in time and change accounting methods:
• Are the costs incurred to make the building or asset operational?
• Does the completed repair contribute to increasing the value in a material way or significantly extending the useful life of the building or asset?
• Does the completed repair or maintenance work adapt the building or asset to a new or different use?
• Does the work performed include any costs to replace any major components or substantial structural parts of any building or asset?
• Are the costs incurred part of an overall plan of rehabilitation, modernization, or improvement to the building or asset?
• Is the repair or maintenance work performed on the building or asset the result of any prior owner’s use of the property?
If the answer to all these questions is no, there might be an opportunity to expense those costs for tax purposes and realize a more immediate improvement in cash flow.
Aaron Faulk is a partner for Seattle-based Moss Adams LLP, a major accounting and consulting firm. Faulk provides assurance and consulting services to single- and multifamily homebuilders, commercial land developers, property managers, and other real estate entities.