Building owners looking for ways to save taxes may find that the answer is as easy as 1-2-3.
The ability to deduct repairs versus capitalizing them can mean significant tax savings for property owners.
The key is determining which costs can be deducted against current income. Generally, taxpayers must capitalize expenditures that substantially prolong the life of the property, materially increase the value of the property, adapt property to a new use and put the property into a useful condition.
By contrast, taxpayers may be able to deduct expenditures for routine maintenance, incidental repairs, equipment and materials that keep the property in an ordinary, efficient operating condition
The difference between repairs and maintenance, and capital improvements can be subtle. For example, replacing damaged wooden roof shingles with new wooden shingles would be considered maintenance and repairs, which could be deductible. The same would be true if wooden shingles were replaced with asphalt shingles. But upgrading to a 50-year, maintenance-free roof system would have to be capitalized as a long-term improvement. The cost would be subject to depreciation over 39 years.
Based on prior IRS guidelines, many building owners have treated maintenance and repair costs as capital expenditures. The IRS has proposed more liberal standards for expensing large ticket items previously considered capital investments. The new rules create opportunities to go back and reclassify certain expenditures and recover previously paid taxes.
To claim the deduction for a prior year, the building owner must submit Form 3115 to request an automatic change in accounting method. This change allows the taxpayer to claim a current year deduction for expenditures that could have been deducted in a prior year under the revised rules.
Under IRS guidelines, most buildings constructed, purchased or renovated since 1986 are eligible for a cost segregation study. The goal is to make sure business owners are using the appropriate depreciable life for their assets. A cost segregation study allows a building owner to change the useful life of certain assets and take advantage of tax savings that may result.
The standard depreciation period for most commercial buildings is 39 years. When buildings are constructed or renovated many companies incorrectly use the 39-year depreciation life, even though parts of a building should be depreciated over a much shorter period of time. Special use items, such as millwork, certain plumbing, specialty electrical and HVAC equipment and exterior improvements can often be depreciated over a shorter term.
It is best to complete a cost segregation study in the year a building is constructed or acquired, although the IRS does allow adjustments to prior depreciation deductions. If the proper amount was not claimed in prior years, that additional depreciation is now allowed as a deduction in the current year by filing Form 3115. Depending on the overall cost of the property and its age, this “catch-up” deduction can be very large and result in substantial current year savings.
This popular deduction allows qualified commercial property owners to claim a $1.80-per-foot deduction for buildings that are constructed or renovated to save 50 percent or more of total annual energy costs as determined by national engineering standards.
Energy savings must be achieved by constructing or retrofitting any of the envelope (exterior walls, floor, roof, doors, windows), interior lighting, or heating, cooling and hot water systems. Buildings that do not meet the 50 percent savings requirement may still qualify for a portion of the deduction.
The primary beneficiaries of 179D are owners or lessees of commercial property (office buildings, retail space, restaurants, manufacturing facilities and warehouses) and certain residential buildings. Government buildings (such as schools and universities, courthouses, jails and offices) may also qualify. Because government entities do not pay tax, the deduction can be transferred in writing to a tax-paying entity, such as an architect or engineer.
To claim this deduction, the property owner must obtain independent certification of energy savings from a professional engineer or third-party contractor using software qualified by the Department of Energy.
Lee Johnson, CPA, is a partner in Clifton Gunderson’s Greenwood Village office. He has experience in tax planning and compliance, accounting and financial consulting. He is a member of the Colorado Society of Certified Public Accountants and the Institute of Certified Construction Industry Financial Professionals.