The 2019 tax filing season presents a great opportunity for real estate businesses to capture significant tax benefits due to potential overcapitalization of repair and maintenance expenditures from prior years.
As part of the accounting method change requests introduced by the Tangible Property Regulations (TPR) in 2014, taxpayers were able to review existing asset holdings to identify and claim expenses on overcapitalizations. While many taxpayers filed accounting method change requests to apply the TPR framework for identifying capital asset improvements and deductible repairs on a prospective basis, fewer applied the framework retrospectively to report overcapitalized repairs.
Now that the five-year waiting period has expired to file the same accounting method change request, businesses may revisit the opportunity to apply the framework to historical asset holdings. A review of your company’s existing real estate fixed assets may reveal instances of overcapitalization, where the costs may be reclassified as tax-deductible repair and maintenance expenses.
Below, we review topics for your business to consider and steps you can take to address potential overcapitalization issues and tax savings opportunities.
Tangible Property Framework
In general, expenditure events that result in an improvement to existing tangible property must be capitalized as an asset. An improvement occurs when a betterment, restoration, or adaptation to a new or different use occurs to the existing property by way of the event. The TPR provide a framework for assessing several quantitative and qualitative factors of the expenditure event against a building structure or building system unit of property.
Expenditures for events that don’t result in an improvement to existing tangible property can generally be deducted as a repair.
Examples: Replace Components, Adding Enhancements, Routine Maintenance
Examples of different expenditure events and how they should be treated follow.
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Replacing Minor Quantity of Components: Consider for example, an office building’s HVAC system that includes 10 packaged rooftop air handler units. After 10 years of ownership, the owner replaces two of the 10 air-handler units with comparable, but new units due to wear and tear of the existing units. Although all air-handler units, together, perform a critical function of the building’s HVAC system, the replacement of this minor amount won’t rise to the level of a capital improvement. The cost of replacement can be expensed as a repair.
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Minor Additions or Enhancements: In an example utilizing minor additions for office space, a 330,000 square foot warehouse building has 15,000 square feet of finished office space. The remainder of the building is unfinished space. Based on the company’s operating needs, the owner constructs an additional 1,000 square feet of finished office space with added finishes, electrical fixtures, and plumbing fixtures. The additions to the building’s overall electrical and plumbing systems, as well as the building structure, would be deemed minor as the existing office space was only increased by 6.7%. The cost of this office expansion can be expensed as a repair.
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Routine Maintenance and Upkeep: Consider an example of a building whose plumbing system consists of two large boiler units. Every five years, the boilers are inspected and specific parts disassembled. A coating is applied to the tanks to help with heat dispersion, connections are tightened, and parts are resealed. The activity is reasonably expected to be performed to keep the boiler and plumbing system in normal operating condition and performed more than once in a 10-year period, so the cost of the activity can be deducted as routine maintenance.
Steps to Review Assets
Due to the time crunch for compliance with the TRP in 2014, your business may have overlooked the opportunity to identify expenses in prior years. With another chance to identify repair expenses and file method changes, considerations for an initial review are outlined below.
All facts and circumstances of the event, as well as the qualitative and quantitative impact to the underlying unit of tangible property must be considered in accordance with the TPR framework. At the starting point, it helps to consider that older real estate asset holdings are generally correlated to a higher likelihood of overcapitalized repair issues.
Considering the Assets
The overcapitalization issue is prevalent across multiple industries, so long as real estate assets are involved. Consider how the types of buildings you operate may be impacted.
Multitenant office buildings may have frequent tenant turnovers that require improvements. Owners of multitenanted office buildings often make changes to suites based on tenant turnover and lease contingencies, as well as updates to common areas.
Owners of multifamily apartment properties are continuously making repairs and updates due to high-use and exposure, such as re-staining and resealing patios and decks, replacing siding and roof coverings, and replacing interior apartment unit components based on tenant turnover.
Gathering the Documentation
The process should start with a tax depreciation report that details asset capitalizations owned by your company. Identify assets associated with original building assets, as well as subsequent capitalizations associated with expenditure events.
If general ledgers and invoices are available for the expenditure events, they should be reviewed as they often contain information regarding the scope of work, specific quantities, and other factual information.
Scheduling Personnel Interviews
Conduct interviews with key facility and maintenance personnel involved in the expenditure events. These personnel are instrumental in providing information regarding the scope, intent, and extent of the events, as well as the impact to the underlying building structure or system.
Seek the Services of an Advisor
Correctly identifying potential overcapitalization issues can be difficult. Companies that didn’t retrospectively apply the tangible property framework and methods may benefit from a consultation with a tax professional who can help guide them through the process.
A tax professional can help with documentation review, personnel interviews, and documenting facts and circumstances of the event and the building within the framework of the regulations, helping to make determinations on the tax treatment.
Accounting method change filings can also be prepared to report overcapitalized items with your federal tax returns.
Jason Thompson has practiced public accounting since 2003. He provides federal and state taxation services to individual and business clients, with particular emphasis on clients who own, operate, invest, and manage all types of real estate assets. He can be reached at (425) 317-3051 or [email protected]. Jarrid McAuliff has practiced public accounting since 2012. He provides federal tax consulting services to businesses in multiple industries and individual clients who invest in, develop, and manage real estate assets. He can be reached at 206-302-6258 or [email protected].