Final Repair and Capitalization Regulations are in. These summarize the different, sometimes contradictory, regulations. Best of all, the IRS has established a hierarchy of the rules. Here are some important takeaways from the hundreds of pages of regs. This is NOT a comprehensive list by any measure.
- Materials and Supplies: Costs for supplies and rotable spare parts are expensed in the year purchased.
- $1 Million / 90 Day rule: Without regard to the nature of the repair or renovation, any project that costs $1M or more, OR takes 90 or more days to complete, requires capitalization.
- Note: Section 179 may still be applicable (and often is) for these capitalized items.
- De Minimus (small amount) Rules
- De Minimus rule: Purchases of $2,500 or less, on an invoice OR unit within the invoice basis, may be expensed in the year purchased. There are some takebacks possibly with this rule, but the impact for certain renovations is very favorable.
- Rule 2: These guidelines are NOT dollar based, they are based on the total physical modification or replacement to the property unit. This determination is clarified in the examples in the regs. The key question might be, “What % of the total unit of property has been altered? One example indicates that a taxpayer may expense 2 rooftop AC units because there are 10 total. The IRS has deemed the 20% change to be De Minimus; more in-fact in other examples. These examples are written in plain English, which is a nice touch.
- In one of the examples, the IRS indicates that incurring major costs in remodeling and/or refreshing existing functional assets does not on its face mean you need to capitalize those costs. Expanding or changing the nature of an existing floor space will likely require capitalization.
Why don’t I just take a 179 deduction?
Excellent question. A 179 deduction will indeed enable a tax deduction in the year assets are placed in service. However, that deduction is tentative and subject to a recapture upon sale or dissolution of the business. For example, a retail establishment taking the Section 179 deduction for leaseholds is still required to add back any depreciation that would not be deductible on those leasehold’s 15-year schedule. That is, if you find yourself selling that business 5 years later, you will be adding back the remaining 10 years depreciation to your taxable income. If you’re in Massachusetts, you will not get any equivalent of a 179 deduction for state taxes.
Global take aways:
- Proper documentation is critical. Contractors are not ever always diligent in detailing the work performed on their invoices and contracts. Insist on it and put that into your contract.
- A picture is worth a thousand words, perhaps even more dollars. We recommend taking before and after digital photos of refresh and renovation projects in order to demonstrate what work was performed. These digital images should be filed in a structured manner for retrieval upon a tax authority review. Examiners are not real estate experts per se and showing photographs of the work can help give the examiner comfort in supporting your deductions.
Note: This information above is for discussion purposes only and is not intended to constitute tax or business advice and should not be relied upon in lieu of consultation with appropriate tax advisers. Furthermore, the information above may not be current as regulations change frequently.