If I Had A Pony, I Would Ride It On My (Tug) Boat

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 

IRAs and Nontraditional Investments

We have received several inquiries over the last year or so about using IRAs for nontraditional investments. This frequently means real estate, perhaps commercial real estate to house a closely-held business. It might also mean using the IRA to start the business itself.

These types of transactions are not without risk. One has the risk of business failure or decline in property value, of course, but also the risk of disqualifying the IRA itself. This would be very bad, as this makes the IRA immediately taxable. To protect against this, one should roll-over the required funds from the “main” IRA into a separate IRA. Should the unfortunate occur, only the roll-over IRA will blow-up. One has contained the damage.

A nontraditional investment requires a self-directed IRA. You will need to find a custodian that will permit nontraditional investments. Most will not. Let’s say you found one. Let’s use the acronym SDIRA for a self-directed IRA in our discussion.

A SDIRA can invest in a privately-owned business. We already know that an IRA can invest in a non-private business, as these are the publicly-traded companies whose stocks are in your IRA or are in the mutual funds in your IRA. This is your Google stock or your Fidelity Contrafund.

The type of business entity is important. The SDIRA can invest in a C corporation but not in an S corporation. Why not? Because the IRS does not permit an IRA to be a shareholder in an S corporation.

The level of involvement in the business owned by the SDIRA is also critical. There are two key tax issues here:

·         The SDIRA cannot enter into a “prohibited transaction.” This is a death sentence. The SDIRA will lose its tax-exempt status and become immediately taxable. If you are under age 59 ½, there will also be penalties.

·         The SDIRA might enter into investments which themselves trigger a tax. This is not as bad as a prohibited transaction, as the overall SDIRA does not become taxable. There is tax only on the income. If the deal is good enough, paying tax may be acceptable.

Prohibited Transactions

The IRS defines a disqualified person as

·         The IRA account holder

·         A family member of the account holder.

o   This goes vertical: grandparents, parents, children and spouses

·         An entity owned 50% or more by the account holder

Think about that last one. Here at Kruse & Crawford, I could theoretically use my IRA, buy an office building and rent it to the firm, as I am not a 50%-or-more owner. Rick Kruse however could not.

Let’s go though the prohibited transactions:

(A) Sale, exchange or leasing of any property between an IRA and a disqualified person

Example 1: My SDIRA purchases property from me or my wife.  This is prohibited. It doesn’t matter if it purchases the property in a “commercially reasonable” manner – i.e. obtain an appraisal. It is not allowed. Period.

Example 2: My SDIRA pays my daughter twenty-five dollars to mow the lawn on the property.  My daughter is a family member. It is prohibited. The amount of money is irrelevant. 

(B) Lending of money or other extension of credit between an IRA and a disqualified person

Example 3: I lend you $10,000 from my IRA.

Example 4: I personally guarantee a bank loan to my IRA.

Example 5: My IRA loans money to me. 

(C) furnishing of goods, services, or facilities between an IRA and a disqualified person

Example 6: I buy a piece of property through my SDIRA and hire my wife to manage the property.

(D) transfer to, use by or for the benefit of a disqualified person of IRA income or assets

Example 7: My SDIRA purchases real estate in Ireland. The SDIRA rents out the property for most of the year. However, my wife and I use the property for one week twice a year.   Even if my wife and I pay fair-market-value rent, this is a prohibited transaction.

(E) Act by a disqualified person who is a fiduciary whereby he deals with IRA income or assets in his own interest or for his own account

Example 8: I charge my SDIRA a fee to manage its stocks, bonds, mutual funds or other investments.

(F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the IRA in connection with a transaction involving IRA income or assets.

Example 9:  My SDIRA purchase a vacation house is in Augusta. I am offered the use of a Wyoming condo in exchange for use of the Augusta property during the Master’s tournament.

IRA Taxes

(1) Active Business Income (UBTI)

Earnings within an IRA are generally tax exempt. However, certain investments can create taxable income called “unrelated business taxable income” (UBTI).  Generally, UBTI is trade or business income which is not otherwise related to the tax-exempt purpose of the IRA. The idea here is that Congress does not want a tax-exempt entity competing with the taxable business enterprise next door to it.

So if you buy a Panera’s or a Caribou Coffee, you have UBTI.

There are some exceptions to UBTI, including but not limited to:

·         dividends

·         interest

·         royalties

·         rent from real property (however see debt-financed below)

·         sales of real property, if the property is not held as inventory or held in the ordinary course of business

Dividends and interest make immediate sense, as this means stocks and bonds - the traditional investments in an IRA.

UBTI Examples:

Example 1:  The SDIRA purchases a restaurant.  The income from the restaurant will be treated as UBTI.

Example 2:  The SDIRA purchases 25% of an LLC that flips (buys, fixes and sells) real estate. Since the real estate is considered inventory, the income to the SDIRA will be UBTI. 

(2) Debt-Financed Income ( UDFI)

If there is debt involved there will likely be UDFI.

Fortunately, UDFI refers only to the percentage of income resulting from the debt-financed portion of the property,

UDFI Example:

Example 3: My SDIRA purchases a B&B in Ireland putting down 75% and borrowing 25%. 

Note that if there was no debt, the rent would be tax-free to the SDIRA.

But there is 25% debt. This means that 25% of the rent is taxable to the SDIRA. The SDIRA does get to claim rental expenses, however.

Wealth Planning

You may have read that nontraditional IRAs are being used for wealth planning. For example, Max Levchin, the chairman of the social review site Yelp, sold over 3 million shares of Yelp held in his Roth IRA. There is no tax on Roth withdrawals if one waits until age 59 ½. Levchin is in his mid-30s. He will have to wait a while, but the money will be tax-free when it comes out.

Peter Thiel did a similar transaction. He bought shares of PayPal for approximately 30 cents per share while he was CEO of the company. In 2002 eBay bought PayPal for $19 a share. 

Now how did Levchin and Thiel avoid the prohibited transaction rules? Actually, it is very simple. You have to control the company to get into a prohibited transaction. Control is usually defined as at-least-50%. When you drain your IRA to buy that Five Guys Burgers and Fries location, chances are you will own 100%. Compare that to a publicly-traded company with tens if not hundreds of millions of shares. Neither Levchin nor Thiel came close to owning 50%. 

Is this fair? I would lead off by noting that “fair” is subjective, somewhat like asking what music one likes. Levchin and Thiel played the game between the lines. You or I could do the same. It might take a new skill set and a tractor-trailer load of luck, but you or I could (theoretically) do it.

Congress has noted these transactions. There is debate about whether this type of wealth accumulation should be permitted. Discussion has sometimes involved a “ceiling” on the amount invested/deferred in the Roth, but until now nothing has developed.