Originally published on Forbes.com Mar 14th, 2014
“All the toilets together perform a discrete and critical function in the operation of the plumbing system: is the best line that I could find in the ninety-odd pages of Regulation 1.263(a)-3 Amounts paid to improve tangible property” commonly known as the “repair regs”. Oh well. I read Tax Court Summary Opinions, the reality TV of the system, for the laughs. I’ve been studying the repair regs for practical utility. I have some observations that may be useful to people working on returns and doing planning for ordinary mortals who own a couple of buildings but lack their own accounting staff. Also for owners who are wondering if their tax advisers are on the ball.
Why Just Buildings?
The regulations are about “tangible property” which includes both “personal” property, which means stuff that you can move around, and “real property” which is more or less stuck in one place. The range of businesses that I am familiar with, which after thirty-five years is pretty broad, mostly don’t have to worry about capitalizing personal property, because of Section 179, which allows immediate expensing.
Even when Section 179 does not apply for some reason, you are still able to write most things off over five or seven years making the stakes pretty low, particularly in the current low-interest environment. Finally, I don’t really see people spending much money fixing personal property. So if you or your client has a fleet of jets or a conglomeration of heavy construction equipment or a few tugboats, you are going to have to look elsewhere for guidance. I have just been worried about buildings.
If an expenditure is recovered as part of the cost of a building, you are talking about a very long recovery period – 39 years if commercial or 27.5 years if residential. Also, in real estate, you see property managers writing some pretty big checks for “repairs” or conservatively, from a tax viewpoint, capitalizing things that might be expensed. That is why it is really important to have somebody looking at these regulations for you.
How An Owner Can Tell If This Is Being Addressed
Has your accountant asked you if you have a written long term maintenance plan? Alternatively has your accountant, knowing that you are kind of seat-of-the-pants, told you that you will need one? There are two “safe harbors’ for taxpayers that don’t have audited financial statements. One is a dollar threshold that tops out at $10,000. That strikes me as pretty laughable. The other safe-harbor is a rule that indicates that anything that are you are planning to do to the building more than once in ten years can be expensed.
Most of the teaching in the regulation is done by example. The example illustrating the ten-year rule is a taxpayer who plans on replacing the handrails on the escalators every four years. The handrails are actually replaced in years four and eleven. The taxpayer is still allowed to expense both rounds of handrail replacement, since the plan to do both within ten years was reasonable. In order for that to stand up on audit, though, there should have been a written plan in year 1 and somebody,(Who else but the accountant?), should have made that part of the permanent file.
In the past, it would never occur to me to ask for long term maintenance plans to put in my workpapers and carry forward as part of the permanent file. When the question comes up six or seven years from now, people may win or lose the issue on audit, based on whether they have something like that. It reminds me a bit of the constantly revised business plan that people who win hobby loss cases have.
The other way you can tell whether the regulations are being addressed is whether the accounting people are asking operational people more questions. It has probably always been true to some extent, but the regulations make it crystal clear, that you cannot tell whether an expenditure needs to be capitalized just from looking at invoices and associated contracts.
Out Of The Safe Harbor
The expenditures that have to be capitalized are those for “betterment”. A betterment makes the overall unit of property better, different or like new. It also needs to be a big deal within that unit of property. In the context of buildings, there are as many as eight separate units to consider besides the basic structure:
(1) Heating, ventilation, and air conditioning (“HVAC”) systems (including motors, compressors, boilers, furnace, chillers, pipes, ducts, radiators);
(2) Plumbing systems (including pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment, and site utility equipment used to distribute water and waste to and from the property line and between buildings and other permanent structures);
(3) Electrical systems (including wiring, outlets, junction boxes, lighting fixtures and associated connectors, and site utility equipment used to distribute electricity from the property line to and between buildings and other permanent structures);
(4) All escalators;
(5) All elevators;
(6) Fire-protection and alarm systems (including sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detection devices, fire escapes, fire doors, emergency exit lighting and signage, and fire fighting equipment, such as extinguishers, and hoses);
(7)Security systems for the protection of the building and its occupants (including window and door locks, security cameras, recorders, monitors, motion detectors, security lighting, alarm systems, entry and access systems, related junction boxes, associated wiring and conduit);
(8) Gas distribution system (including associated pipes and equipment used to distribute gas to and from the property line and between buildings or permanent structures);
There may be more categories in the future. You need to determine whether a particular expenditure is a “big deal” within each of those categories. What is interesting is that the assessment is not made based on dollars, but rather on physical reality. The regulations appear to allow some very large expenditures that somebody just looking at invoices would capitalize. Most of the teaching is done by example. Here are the ones that struck me.
Roofs
Nothing new here really. Roofs have long been a matter of contention. The examples allow that applying a new rubber “membrane” could be expensed. Replacing the entire roof, including decking, insulation, asphalt and various coatings has to be capitalized. Of course, the regulations allow you to extract the cost of the original roof from the building and write-off the remaining undepreciated cost. I’m not going to try to explain how I would come up with that number, other than to say, that, in the event, I will come up with something and will end up comforting myself with the thought of “How wrong could it be?”. It would be nice to have something in the permanent file to support that.
Is There A Thirty Percent Rule?
So the tenants are complaining about it being too hot or too cold or too just right. You bring in a contractor and she tells you to replace three of your ten roof-mounted units. Three out of ten units is not a “significant portion” of the roof-mounted units which are a major component of the HVAC system. On the other hand, if there is a single “chiller” and you replace that you have to capitalize it.
If you replace all the wiring in the building, that being a major component of the electrical system you have to capitalize it. Thirty percent of the wiring, on the other hand, is not a “significant portion” of that major component and would not have to be capitalized.
If you decide to replace all the toilets and sinks you are going to have to capitalize that expenditure. As noted at the outset, “All the toilets together perform a discrete and critical function in the operation of the plumbing system”. On the other hand, if you replace 8 out of 20 sinks in the building, that is not “a significant portion” of the 20 sinks, which are a major component of the plumbing system, even though perhaps not as critical as “all the toilets together”. Interestingly, that brings us to 40% not being a “significant portion”.
So we don’t have a bright-line test with the thirty percent, more of a theme. Most important though, it is not a percentage of dollars. It is a percentage of some physical attribute such as feet of wiring.
Accounting People Can Be Too Abstract
Many accountants prefer numbers to words. Many, if not most of us, prefer to work in offices which kind of insulates us from tangible reality. You will not be able to make reasonable determinations under these rules without getting an understanding of the physicality of the building. You see an invoice for a substantial amount to entirely replace an elevator. Should you capitalize that?
Well, does this building that may be a thousand miles from where you are sitting have one elevator or four? You probably cannot tell that from your depreciation schedule. Even the accounting staff of the management company might not know. So if you are involved in owning a few buildings and your tax accountants are asking seemingly odd questions, that is a sign that they are on the ball.
There are already teams formed in large firms to “go to market” with specially trained staff to make a real production out of this stuff. In many cases, it may not be necessary, if regular accountants just widen their horizons a bit.
You can follow me on twitter @peterreillycpa.
Note
This is hardly a comprehensive treatment of the repair regulations. It is more the distillation that a tax geek would give to his less reading inclined brethren and his less than patient entrepreneurial clients. It may seem a tad cynical but some explanations that you encounter will be designed to make it seem as hard as possible to motivate you to spend money on a special study.