Navigating the IRS Tangible Property Regulations

Staying on top of IRS regulations can feel like a full-time job for small business owners and self-employed professionals. One complex set of rules you need to understand is the IRS tangible property regulations. These regulations play a major role in determining what property owners can deduct as an expense (and receive tax benefits immediately) versus costs that they must capitalize (and receive tax benefits over time, sometimes as long as 39 years).

The tangible property regulations apply to anyone who pays or incurs amounts to acquire, produce or improve tangible real or personal property. These regulations apply to corporations, S corporations, partnerships, LLCs and individuals filing a Form 1040 or 1040-SR with Schedule C, E or F.

Misunderstanding how to apply these regulations could lead to penalties, interest charges, and unwanted increases in your tax liability. On the other hand, developing a working knowledge of these specifications presents opportunities to maximize legitimate expenses and streamline your tax burden.

With the support of an experienced CPA like James Moore, real estate operators can feel confident they are compliant and are harnessing the power of these regulations – which are known for being friendly to taxpayers.

Understanding the Tangible Property Regulations

The IRS Tangible Property Regulations contain specifications around deducting or capitalizing expenses related to tangible business property. This includes the buildings, equipment, furniture and fittings used in your business activities.

Generally speaking, if costs extend the useful life of a property, restore its use or adapt it to a new use, they must be capitalized. This means that the costs should be depreciated over time rather than deducted as a one-time expense. Upgrades and new installations also generally fall under capitalization rules. Basic ongoing repairs and maintenance costs tend to be fully deductible in the year they occur.

These regulations evolved from previous IRS codes and court decisions around capital and ordinary expenses. Over decades, many ambiguities developed around proper classification. The tangible property regulations came into effect in 2013, creating clarity and uniformity about what could be deducted vs. capitalized.

The tangible property regulations are favorable to taxpayers, allowing for a lot more expensing and also providing improved classifications that allow taxpayers to accelerate deductions. However, they can be complex. So it’s important for real estate operators to build up a robust working knowledge of the regulations.

Key Provisions of the Tangible Property Regulations

The tangible property regulations are based on improvement standards that determine whether a restoration, adaptation or betterment has occurred. These are sometimes referred to as “RABI” standards (Restoration, Adaptation, Betterment, Improvement). If a restoration, adaptation or betterment has occurred, the property is considered to have been improved and the associated expenses should be capitalized.

Restorations occur when a unit of property is returned to a like-new condition that extends its useful life. An example would be replacing a leaky roof with an entirely new roof.

Adaptations occur when a property is converted to a new use. Here’s an example from the IRS. Let’s say that a taxpayer owned a commercial property previously used for manufacturing. They decide to adapt it into a showroom, incurring a variety of renovation costs in the process. The costs they incurred should be capitalized, since the property now has a new or different use from its original intended use as a manufacturing facility. In other words. an adaptation has occurred.

A betterment occurs when an amount is paid to fix a material condition or defect, make a material addition to the property, or increase the quality of the property. Examples may include extending the floor plan of a property, but it could also be replacing a failing material with a more premium material (for example, by upgrading a property’s insulation from one with a low R-value to insulation with a higher R-value).

The James Moore real estate team has a RABI flowchart that we apply to determine whether expenses meet the RABI criteria. Reach out today to learn more.

Simplifying the Maze: Safe Harbors to the Rescue

The IRS has a number of safe harbors that allow taxpayers to expense certain types of costs, even if they meet the criteria above. These simplify the process of determining whether costs are expenses or must be capitalized. Three main safe harbors come to the rescue:

De Minimis Safe Harbor

If the cost of acquiring or producing a unit of tangible property is less than $2,500 ($5,000 for businesses with applicable financial statements), taxpayers may simply deduct it as a current expense.

The unit of property is an important distinction here since the de minimis safe harbor can only be applied to one unit of property. If a taxpayer replaced a property’s roof, the roof is considered one unit of property. Taxpayers cannot apply the de minimis safe harbor several times to all of the costs associated with replacing the roof (the shingles, the membrane, labor, and so on). They can only apply it to the roof as a whole.

To use the de minimis safe harbor, taxpayers must have a formal capitalization policy in place at the beginning of the year. Record keeping is important too; make sure you have clear invoices for all expenses that fall under the de minimis safe harbor.

Small Taxpayer Safe Harbor

Taxpayers are permitted to deduct the costs of repairs, maintenance and improvements to owned or leased property if they meet the criteria to use the safe harbor election for small taxpayers:

• Average annual gross receipts of less than $10 million
• Owns or leases property with an unadjusted basis of less than $1 million

If a taxpayer meets these criteria, they may deduct up to $10,000 or 2% of the building’s unadjusted basis (whichever is lower) for repairs and improvements each year.

Routine Maintenance Safe Harbor

This safe harbor permits taxpayers to expense costs that are considered routine maintenance expenditures, such as replacing carpeting or repainting walls in between tenants. If the taxpayer expects to incur these costs every ten years or less, they may be eligible to be deducted under the routine maintenance safe harbor.

It’s important to note that the routine maintenance safe harbor typically does not apply to maintenance performed on major systems of a property (such as the roof, plumbing or electrical systems). These would more likely be considered a betterment, adaptation or restoration and would therefore have to be capitalized. A tax professional is best placed to advise on the specific nuances of each situation.

Safe harbors offer welcome simplification, and taxpayers should determine whether they can apply these to any expenses that may qualify. However, they’re not optimal for all situations. For larger expenses or complex projects, carefully evaluate how expenses should be classified under the full regulations. If there’s a gray area, consulting a tax professional is your best bet to ensure accuracy and maximize deductions.

By navigating the tangible property regulations with careful classification and strategic use of safe harbors, you can ensure compliance, optimize your deductions, and ultimately keep your hard-earned profits where they belong: in your pocket.

Partial Asset Disposition

Even when expenses are qualified as capital improvements, partial asset dispositions allow taxpayers an opportunity to expense some of the costs involved with the improvements being made to a property.

Consider the example of replacing a property’s roof. After completing the analysis, it’s determined that the replacement of the roof is a restoration (and therefore the associated costs should be capitalized). However, the taxpayer may deduct removal costs — such as the costs to remove the shingles from the old roof — and can also use the partial asset disposition rules to deduct the remaining undepreciated cost of the old roof.

This offers taxpayers a benefit for the remaining costs of the roof that were yet to be expensed through depreciation, while also reducing the potential for higher levels of depreciation recapture upon the sale of the property, ultimately reducing long-term tax rates.

James Moore: Experienced Real Estate Tax Professionals

For most real estate operators, the biggest challenges in complying with the tangible property regulations center around understanding the nuances of these regulations and maintaining appropriate records of expenses.

Without systemized accounting protocols, tracking costs related to repairs/maintenance, upgrades, renovations, etc., becomes complex quickly. Inconsistent categorization also arises easily without frameworks ensuring capitalization protocols are followed.

The IRS tangible property regulations contain extensive protocols distinguishing between immediately deductible repairs and capital expenses. These can be highly nuanced and it’s important real estate owners and operators work with sophisticated tax advisors.

While complex, these rules also offer planning opportunities to maximize legitimate deductions. Reach out to your real estate CPAs and consultants at James Moore for help. Our decades of niche experience and bespoke tax and accounting guidance help clients ensure compliance and capitalize on opportunities to build a more efficient tax strategy.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.