You can likely gain significant tax savings by revisiting accounting methods for repair and maintenance costs, especially for taxpayers that own, invest in, and operate real estate.
Although the Tangible Property Regulations (TPR), effective since 2014, provide guidance on capital improvements and repairs, many taxpayers find they have so-called over-capitalization issues, in which tax-deductible repair and maintenance expenses are capitalized as fixed assets and depreciated as 27.5 or 39 year property.
What Are Tangible Property Regulations?
The TPR provide guidance on the tax treatment of costs paid to acquire, produce, improve, or repair tangible property.
The TPR also provide simplified safe-harbors for expensing certain costs.
Why do TPR Challenges Exist?
Many tax and accounting professionals struggle with the framework guidance in the TPR for classifying costs as tax-deductible repairs or capital improvements requiring depreciation.
Their quantitative and qualitative tests require professionals to understand and identify specific components of an asset, and how a capital project impacted such asset.
Let’s consider an HVAC project. Aside from its cost, an accounting professional must also consider the intent and purpose, and whether it resulted in a material upgrade, addition, or restoration of specific components or the system overall.
Many accountants find the requirement to identify and understand specific building components challenging, and they often miss tax-deductible repairs as a result.
Additionally, accounting methods for financial reporting purposes sometimes differ from tax methods. You may capitalize some items for which GAAP requires capitalization without further consideration for tax expensing.
How Do You Identify Capitalized Repairs?
An analysis of fixed asset records can help identify repair and maintenance expenses capitalized in prior years. Items capitalized in building, leasehold improvement, and capital project accounts are most exposed to capitalized repair issues.
A tax professional may suggest a formal fixed asset analysis. This analysis entails a review of tax depreciation records, supporting fixed asset ledger detail and interviews with company personnel to understand real estate assets and capital project activity over time to identify deductible repairs and capital improvements.
Ideally, a cost segregation professional with an enhanced understanding of building components and industry-specific capital expenditure trends will conduct a fixed asset tax analysis. Following an analysis, a cost segregation professional can help craft policies and procedures to capture deductible repair and maintenance activities on a go-forward basis.
Good indicators that suggest overcapitalization could exist include:
- Companies that routinely perform large-scale capital projects to their existing buildings, plant, property, and equipment assets
- Companies that reflect many real estate assets on their tax depreciation reporting such as buildings, improvements to buildings, and building components
- Minimal or no amount of repair deductions reported in prior years disproportionate to asset capitalizations
Can I Claim Deductions for Repair and Maintenance Costs from Prior Years?
For any repair and maintenance costs being depreciated as a fixed asset, you may claim a deduction on a current tax return for the remaining tax basis of the asset without the need for amended returns.
For example, say a company repaired a roof in 2016 for $400,000 and has depreciated expenses of $50,000 as of year-end 2020. If the company later concludes this roof project was a capitalized repair and maintenance expense, they may deduct the remaining $350,000 immediately by filing an accounting method change request with their current tax return.
Below, we review the following questions and considerations about TPR for your business to address, including potential overcapitalization issues and tax savings opportunities:
- How Do Tangible Property Regulations Treat Different Expenditure Events?
- When Is an Expenditure Event a Deductible Repair?
- When Is an Expenditure Event a Capitalized Improvement?
- What Steps Can Your Organization Take to Address Overcapitalization?
- Does Your Industry Expose You to Overcapitalization Risk?
- What Is a Fixed Asset Analysis?
- Why Is It Important to Work with a Tax Professional to Address Overcapitalization?
How Do Tangible Property Regulations Treat Expenditure Events?
In general, you must capitalize an expenditure event as an asset if it results in an improvement to existing tangible property.
An improvement occurs when a betterment, restoration, or change-in-use (adaptation) occurs to existing property. Expenditure events that are not an improvement can generally be expensed as a repair.
When Is an Expenditure Event a Deductible Repair?
You can generally deduct as a repair and maintenance cost expenditures for events that don’t result in an improvement.
Examples of repairs include:
- Nonmaterial replacements of a building structure or building system component
- Minor additions or enhancements to a building structure or building system component
- Routine maintenance and upkeep
The following example illustrates nonmaterial replacement:
A warehouse building’s structure includes a built-up roof assembly with a torch-down membrane. After 20 years of ownership and wear and tear, the owner replaces the existing membrane with a comparable, but new membrane.
The entire roof assembly, including the framing, decking, sheathing, and membrane, is a major component of the building structure; however, the owner can expense this project as a repair since replacing only the membrane generally isn’t material compared to the roof assembly major component or the building structure.
Minor Additions or Enhancements
The regulations generally categorize minor additions or enhancements as a repair.
Imagine an office building’s HVAC system includes 10 roof-mounted units. The system also consists of controls for duct work that distribute the heated or cooled air.
After many years, the company begins to experience climate control problems and consults with a contractor.
The contractor recommends that the company replace two of the 10 roof-mounted units. The two new units should eliminate the climate control problems with 10% more energy efficiency. The other roof-mounted heating and cooling units, the duct work, and the controls had no changes.
Given the 10% energy efficiency increase in the two units of the entire HVAC system, the replacement wouldn’t materially increase the productivity, efficiency, strength, quality, or output of the HVAC system. Generally the owner can expense it as a repair.
Routine Maintenance and Upkeep
A hospital building’s plumbing system consists of two large boiler units. Every five years, the boilers undergo inspection and the disassembly of specific parts. Plus, workers apply a coating to the tanks to help with heat dispersion, tighten connections, and reseal parts.
Performing these routine but essential tasks keep the boiler and plumbing system in normal operating condition. This occurs more than once in a 10-year period, so the hospital may deduct the cost of the activity as repair or routine maintenance.
When Is an Expenditure Event a Capitalized Improvement?
The regulations require you to capitalize as an improvement events that result in significant replacement of components, or material enhancements to components, of the building, or to the structure.
Examples of a capitalized improvement could include the replacement of steel pipes to copper, or old windows with metal frames to energy-efficient models.
Significant Replacements and Enhancements
When owners completely replace or materially upgrade building structure or system components, they must generally treat associated expenditure as a capital improvement.
See the examples below:
- Elevator cabs and transmission equipment replaced
- Chiller units of a building’s HVAC system replaced
- Water piping in a building from old steel piping to better copper pipe
- Existing metal-framed windows with energy efficient vinyl framed windows
What Steps Can Your Organization Take to Address Overcapitalization?
Accounting for capital improvements, repairs, and maintenance may seem like a daunting task. However, you can take the following steps to enhance current methods for repairs and clean up prior years:
- Develop a formal capitalization policy, for book and tax purposes
- Consult a cost segregation professional, to leverage building and industry-specific experience to craft procedures and policies for capturing more deductible repairs
- Cost segregation and fixed asset analyses, to review capital assets and underlying detail from prior periods
- Review prior tax records for building, leasehold improvement, and general improvement accounts
Does Your Industry Expose You to Risk of Overcapitalization?
Most industries face overcapitalization issues, especially if they involve real estate assets and numerous capital project activities.
Below you can see examples of industry-specific capital projects classified as repairs.
Some industry-specific considerations include:
- Health care companies that continuously remodel facilities for departmental or workflow changes
- Automobile dealerships that periodically refresh and remodel
- Retailers and restaurants that often remodel locations for interior layout changes, display changes, and aesthetic updates
- Owners of multi-tenanted office buildings who often make updates to common areas as well as changes to suites based on tenant turnover and lease contingencies
- Owners of multifamily apartment properties who continuously make 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
The intent and extent are critical factors between treatment as a capital improvement and deductible repair, which makes it important to understand an industry’s general practices and trends.
What Is a Fixed Asset Tax Analysis?
A fixed asset analysis identifies opportunities to apply fixed asset changes that can provide immediate tax savings through accelerated tax methods for depreciation, repair, and maintenance expenses. Changes can apply to assets you placed in service in prior periods without amending tax returns.
Following an asset analysis and corresponding accounting method change filings, your business can report adjustments to catch up on missed depreciation and repair expenses on current tax returns, lowering your current tax liability. Learn more about fixed asset tax analysis services here.
What Information Will You Collect During a Fixed Asset Tax Analysis?
Tax depreciation schedules are the starting point of an analysis. You should also make available:
- Any available fixed asset accounting ledgers supporting the asset values for buildings, capital project assets, and leasehold improvements.
- Staff familiar with the scope, purpose, and history of the real estate assets, capital project activity, and maintenance plans.
A tax professional will reconcile and review any available ledger detail and interview available staff to understand the scope, purpose, and intent of capital project and repair activities to apply the framework guidance for identifying deductible repairs and capital improvement assets from the asset costs.
Why Is It Important to Work with a Tax Professional to Address Overcapitalization?
Tax and cost segregation professionals have enhanced understandings of buildings components as well as industry specific capital project trends. You can leverage this knowledge to craft accounting methods, policies, and procedures, and capture expenditures correctly for repair and capital asset treatment.
Several changes to tax depreciation since 2018 mean you can assess other asset classification and method issues to accelerate depreciation and lower current income tax liabilities. Further, they can assist in filing the proper accounting method change filings to report repair and depreciation changes prior tax years identified, without the complications of amending prior period returns.
We’re Here to Help
To learn more about how your organization can review previous maintenance projects and address its overcapitalization issues, or for help at the beginning of any planned projects that could result in expenditure events, contact your Moss Adams professional.