The 2019 tax filing season presents a great opportunity for businesses that own or operate buildings and real estate to capture significant tax benefits due to potential overcapitalization of repair and maintenance expenditures from prior years.
Taxpayers were generally required to comply with the final tangible property regulations (TPR) in 2014. To do so, many taxpayers filed requests to change their accounting method to those required by the new rules. However, taxpayers may not have comprehensively analyzed their historical fixed asset records to properly reclassify assets to deductible repairs, or vice versa, in light of the new rules.
Additionally, taxpayers may not have appropriately implemented their new tax accounting method in the subsequent tax years and instead have continued to follow their prior method– most commonly their financial statement method–for tax purposes. Both of these situations can lead to overcapitalized repairs for tax purposes.
For taxpayers that requested an accounting method change for the 2014 tax year, the five-year eligibility restriction under the automatic accounting method change procedures will lapse for the 2019 tax year. These taxpayers may revisit the opportunity to apply the TPR framework to historical asset holdings. A review of your company’s existing fixed assets, including buildings and other real property, may reveal instances of overcapitalization, where the costs may be classified as tax-deductible repair and maintenance expenses.
Below, we review questions for your business to consider to address potential overcapitalization issues and tax savings opportunities.
What assets may qualify for a review?
Specific units of property are identified from existing tangible assets for purposes of applying the qualitative and quantitative considerations under the capital improvement framework in the TPR.
In the case of building assets, each building structure and its key building systems are treated as a separate unit of property. These include the following:
- Building structure
- Heating, ventilation, and air conditioning (HVAC) system
- Plumbing system
- Electrical system
- Fire alarm and protection system
- Elevator system
- Escalator system
- Security system
- Gas distribution system
In situations in which a company is the lessee of all or a portion of a building, the unit of property includes the portion of the building structure and building systems within the leased premises of the building.
In the case of machinery and equipment assets, each component that’s functionally interdependent is a separate unit of property.
How should different expenditure events be treated?
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.
Expenditures for events that don’t result in an improvement to existing tangible property can generally be deducted as a repair.
Events that result in the significant replacement of components, or material enhancements to components, under the building systems or the structure must be capitalized as an improvement.
Examples of these different events follow.
Replacement of a Minor Quantity of Components
Example: Roof Membrane
A warehouse building’s structure consists of a built-up roof assembly with a torch-down membrane. After 20 years of ownership, the owner replaces the existing membrane with a comparable, but new membrane due to wear and tear.
Although the entire roof assembly, including the purlins, framing, decking, sheathing, and membrane, are a major component of the building structure, replacing only the membrane generally won’t rise to the level of a capital improvement so it may generally be expensed as a repair.
Minor Additions or Enhancements
Example: HVAC System
An office building’s HVAC system includes 10 roof-mounted units that provide heating and air conditioning for different parts of the building. The HVAC system also consists of controls for the entire system and duct work that distributes the heated or cooled air to the various spaces in the building’s interior. After many years of use of the HVAC system, the company begins to experience climate control problems in various spaces throughout the office building and consults with a contractor to determine the cause.
The contractor recommends that the company replace two of the 10 roof-mounted units. The two new units are expected to eliminate the climate control problems and to be 10% more energy efficient. No work is performed on the other roof-mounted heating and cooling units, the duct work, or the controls. Given the 10% energy efficiency increase in the two units of the entire HVAC system, the replacement is not expected to materially increase the productivity, efficiency, strength, quality, or output of the HVAC system, and it generally may be expensed as a repair.
Routine Maintenance and Upkeep
A hospital building’s 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 may be deducted as routine maintenance.
Significant Replacements and Enhancements
When major building structures or system components are completely replaced or materially upgraded, the associated expenditure must generally be treated as a capital improvement. Examples are provided below:
- Elevator cabs and transmission equipment in a building
- Chiller units of a building’s HVAC system
- Water piping in a building from old steel piping to better copper pipe
- Existing metal-framed windows with energy efficient vinyl framed windows
Does my industry affect my overcapitalization opportunity?
Overcapitalization is common in industries in which real estate assets are involved. It helps to consider how specific trends of your industry may impact real estate assets. Some industry-specific considerations include the following:
- Health care companies continuously remodel hospitals for large equipment replacements, departmental layout changes, and ever-changing code compliance.
- Automobile dealerships periodically remodel to change branding.
- Retailers and restaurants often remodel locations for interior layout changes, display changes, and aesthetic updates.
- 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 continuously make repairs and updates due to high-use and exposure, such as restaining and resealing patios and decks, replacing siding and roof coverings, and replacing interior apartment unit components based on tenant turnover.
The intent and extent are critical factors between treatment as a capital improvement and deductible repair, so understanding an industry’s general practices and trends is important.
What information should be collected for a fixed asset review?
It helps to consider that older real estate asset holdings are generally correlated to a higher likelihood of overcapitalized repair issues.
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 framework under the regulations.
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.
Which employees need to be involved?
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.
Why is it important to work with a tax professional?
Correctly identifying potential overcapitalization issues can be difficult. 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.
We’re Here to Help
To learn more about how your company can review previous maintenance projects or for help beginning the process, contact your Moss Adams professional.