In a recent two-part installment of our Real Estate Industry Update, JMCo partner John VanDuzer and director Kevin Golden covered how maintenance and operations affect your taxes. The CPAs, members of our Real Estate Services team, discussed depreciation-related subjects like capitalizing vs. repair, capitalization thresholds, partial asset disposition and qualified improvement property. We’ve summarized the highlights for you below.
Capitalization vs. Repair
One of the most common inquiries our real estate team gets is about whether to capitalize an item or classify it as a repair. Capitalized items must be depreciated over time, while repairs can be expensed in the current year.
IRS 2013 Tangible Property Regulations (TPR) brought about RABI rules, with “RABI” standing for “restoration, adaptation, betterment and improvement.” If an expenditure restores part of the property, adapts it for another use, or makes it better than original condition, it should be capitalized as an improvement. Otherwise, it’s considered a repair expense.
While that seems like a broad set of criteria, there are some narrow definitions involved. For example, many people would consider painting an improvement. But that’s not how the IRS sees it.
“We all know painting is needed all the time,” said Golden. “Well, that’s not really restoring; it’s not adapting or making that better. We’re just simply painting over after one tenant has left, so that’s just a normal routine maintenance item. It’s a repair and doesn’t fall underneath those RABI rules.” This can be a huge benefit especially when the repair expense is significant.
What would be considered improvement? Let’s say you replace an air conditioning unit with one that has a higher efficiency rating. That’s considered a betterment and would need to be capitalized.
Per RABI rules, if you replace less than 30-40% of a component of a building, it doesn’t qualify as restoration. This comes into play with partial repairs or replacements, such as fixing a portion of a roof instead of replacing it entirely.
The Capitalization Threshold
The IRS also stipulates that individual expenditures under $2,500 (per item) can be considered repairs and can be expensed even if they are capital in nature. Any amounts above that de minimis should be analyzed further.
“It’s important to understand when we can expense these because that’s going to not only lower your income but lower your taxes upon that,” said Golden. “If we add more expenses now and deduct more things now, it’s going to put more money back in your pocket now.”
This threshold is key with tangible property expenditures such as furnishings for an apartment complex. If you have 100 units and you replace all of the refrigerators at $1,000 each, that’s a $100,000 expenditure. But with the $2,500 per item de minimis, it’s not required to be capitalized.
That said, you also need to take your net operating income (NOI) into account. While you’ve expensed those refrigerator purchases, for example, your NOI on the property is taking a $100,000 hit. That could make your financials look worse than they actually are.
VanDuzer suggests segregating those type of costs so it’s very clear to banks, potential investors or purchasers that this amount was from capital items under $2,500. “This will reinforce that it’s a tax move and not a true indicator of the value of the property,” he said.
Partial Asset Dispositions
Before 2013, when you replaced a large asset such as a roof, you likely ended up depreciating both the previous roof and the new one. This resulted in a long depreciation time and reduced benefits for you. TPR, however, allow you to dispose of the old roof (even if lumped in with part of the building) based on actual cost or inflation factors specified by the IRS.
Here’s an example to illustrate this point:
- You purchased a building 10 years ago for $1 million.
- This year you’re spending $100,000 to replace the roof.
- If, according to the IRS’s inflation factors, a roof replacement ten years ago cost 80% of what it does today, you would discount today’s purchase by the inflation factor to determine an estimate of what it originally cost.
- Applying this percentage, you can write off $80,000 of the original cost of the building.
“If you’re having to capitalize a major component, like a roof or HVAC, underneath those [tangible property] rules,” said Golden. “There’s probably a partial asset disposition [with which] you can write off some older assets to go ahead and help offset and deduct a portion of those items today.”
Qualified Improvement Property
Improvements made to the interior of a non-residential building can qualify for shorter depreciation periods. While these were traditionally depreciated for as long as 39, recent rule changes have allowed real estate owners to depreciate qualified improvement property (QIP) over less time, such as 15 years or even accelerate the depreciation to the first year in service.
Thanks to the CARES Act’s technical correction of the Tax Cuts and Jobs Act (TCJA), this has become a great opportunity for retroactive tax savings. The TCJA intended to allow 100% first-year bonus depreciation for QIP placed in service in 2018 through 2022. A drafting error inadvertently left this out of the statutory language.
Since the CARES Act was passed in 2020, we’ve seen clients adjusting returns from 2018 and 2019 to take these previously-disallowed deductions. The result has been quite favorable to their bottom lines. Golden suggests that you review cost segregation study reports and other instances in which these expenditures are disclosed. Some instances might now be allowed to depreciate on much shorter timeframes.
VanDuzer and Golden closed out the conversation with an emphasis on taking a holistic view.
“These are tax answers, but they’re not the only answers,” said Golden. “As we suggest with everything else, look at your whole big picture. Have a conversation about it. There’s a lot of great benefits, but again, we don’t want to just look at just our tax answers. Look at overall answers and see what works best for you and your situation.”
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