If you have
a business, and especially if that business has real estate, odds are very good
that your tax advisor will talk to you about the “repair regulations” this
filing season.
The IRS and
taxpayers have spent decades arguing and going to court over whether an
expenditure is a repair (and immediately deductible) or a capital improvement (which
cannot be deducted immediately but rather must be depreciated over time).
Eventually the IRS decided to pull back, review the existing court cases and
develop some rhyme or reason for tax practice in this area. They were at it for
years and years.
And now we
have the “repair regulations.”
I debated
whether to write on this topic, as one can leave the pavement and get lost in
the weeds very quickly. It is like a romper room for tax nerds. Still, we have
to at least discuss the high points.
Let’s set
this up. Say that you have a tug boat. The boat is expected to last you
approximately 40 years, if you maintain and keep it up. Every 4 or so years,
you anchor the tug and give it a good overhaul, replace what needs replacing
and rebuild the engine. This is going to cost you well over $100 grand.
Question: is
this a repair (hence deductible) or a capital improvement (not immediately
deductible but depreciable over time)?
It is not
immediately clear. This costs a lot of money, so one’s first response is that
it has to be capitalized and depreciated. However, regular use of a tug
presumes heavy maintenance of this kind over its life. That sounds more like a repair
expense.
The IRS has
introduced the concept of a unit of property. We have to base the repair versus
capitalization decision on the unit of property. Is the engine the unit of property
(UOP) or is it the overall boat?
The main
test for UOP is “functional interdependence.” The placing in service of one
thing depends on the placing in service of something else.
Well, a tug boat engine without a tug boat to put it in is not of much use to anybody, so we would say that the overall boat is the unit of property.
Progress. Do
we now know whether to capitalize or deduct the engine?
Nope.
Onward.
We next climb
through a fence we will call the “BAR,” which stands for
·
Betterment
·
Adaptation
·
Restoration
If you get
stuck on any rung of the “BAR,” you have to capitalize the cost. Sorry.
Let’s have a
quick peek at which each term means:
·
Betterment
o
You
made the thing larger, stronger, more efficient.
We did not turn the thing into a “monster”
tug. Let’s move on.
·
Adaptation
o
You
tweaked the thing for a different use or purpose.
Nope. It’s
still a tug. Can’t fly it or drive it on a highway.
·
Restoration
o
Returning
the thing to a usable condition after you have run it into the ground, either
because you neglected it (and it fell apart) or it just got too old.
Doesn’t sound like it. We are not neglecting the tug in any
way, and it still has many years of use left.
This is
looking pretty good for our tug.
Let’s go
through a few more rules, just in case.
If your CPA
prepares audited financial statements for you, the IRS will not challenge your
deducting something up to $5,000 as a repair as long as you did the same thing
on your financial statements.
That tug thing costs way more than $5,000. Let’s continue.
NOTE: BTW, if you do not have an audit, the IRS drops that dollar limit down to $500.
If we are
talking about “materials and supplies,” the IRS will not challenge your
deducting something as long as it costs $200 or less. Fuel for that tug would be
considered “materials and supplies.”
That tug work blew past $200 like it was standing still. Let’s proceed.
If you
capitalize the thing on your books and records, the IRS will not argue that you
should have deducted it instead.
Downright charitable of them. Let’s
move on.
If a repair
is expected to be done more than once over the life of the UOP, then the IRS
will not challenge your deducting it as a repair.
Whoa. We have something here. That boat is expected to last somewhere
around four decades. The heavy maintenance has to be done every so many service
hours, generally meaning every three or four years. Looks like we can deduct
the repairs to our tug.
Let’s dock the
tugboat and briefly discuss a building. Perhaps we can see our tug from our
building.
The IRS is
taking the position that a building is both one unit of property and more than
one unit of property.
I do not
make this up, folks.
The IRS
wants certain systems of a building – like its HVAC or its elevators – to also
be considered a separate UOP. Let’s take an example. Let’s say that you are
replacing a bunch of windows on that building. You would then evaluate whether
it is a repair or an improvement by reference to the building as a whole. This
is a good thing, as it would take a lot to “improve” the building as a whole. This
makes it more likely that the answer will be a deductible repair.
However, say
that you replace an elevator. The IRS says that you have to look at elevators
separately from the overall building. We’ll, it does not take much to improve
an elevator if you are just comparing it to an elevator. This is a bad thing,
as it makes it more likely that the result will be a capital improvement.
BTW there is
a separate test if your building costs less than a $1 million when you bought
it. The IRS will “spot” you a certain amount before it will challenge whether
something is a repair or not. It’s for the smaller landlords, but it is
something.
And there
you have the highlights of the repair regulations.
Depending on
your fact patterns, there may be elections and forms that you have to attach to your tax return. Your tax advisor may even
request that you change your underlying bookkeeping – like expensing stuff
under $5000/$500 on your general ledger, for example. Some of these will
require extra work, and hence additional fees, by and from your advisor.
And there is
one more thing.
Let’s go
back to the tugboat.
Let’s say
that you did the major overhaul four years ago and capitalized the cost. You
are now deducting those repairs over time as depreciation. The new rules now allow you to
deduct the cost immediately as a repair. Had we only known!
Is it too
late for us? Four years back is one more year than the statute of limitations
permits, so we cannot go back and amend your return.
The IRS – to
their credit – realized the unfairness of this situation, and it will let you
go back and apply these new rules to that old tax year. The IRS calls it a “partial
disposition,” and you can deduct what’s left of that capitalized tugboat repair on your 2014 tax return. It is called a “Change in Accounting Method” and is
yet another multi-page form with your return, but at least you can get the
deduction. But only on 2014. Let it slip a year and you can forget about it.
If any of
the above rings a bell, please discuss the “repair regulations” with your tax
advisor. Seriously, after 2014 you may be stuck. Tax does not have to be fair.
Lyle Lovett - If I Had A Boat
Lyle Lovett - If I Had A Boat