Is this Big Risk Lurking on Your Building’s Depreciation Schedule?

You could be giving up significant tax deductions and setting yourself up for problems in the event of a federal tax audit if you own commercial or multifamily real estate and you have not filed the necessary paperwork to comply with the IRS Repair & Capitalization Regulations,

But it’s not too late to take action, get the deductions you deserve, and stay out of trouble with the IRS.

New Definition of Capital Expenditures under the TPRs

On January 1, 2014, sweeping changes to federal tax regulations came into effect. The new regulations redefine what costs must be capitalized versus what costs may be expensed. They affect all owners of “tangible property,” which includes real estate.

Prior to the rule changes, most property owners and their accountants employed simple rules of thumb to determine whether to capitalize and depreciate certain costs. Usually a dollar amount threshold was set. Any individual cost over that pre-set amount was capitalized and put on the books as a depreciating asset. That was the simple and widespread “capitalization policy” that many taxpayers employed.

The new rules, known as the IRS Repair & Capitalization Regulations, are also referred to as the Tangible Property Regulations, usually abbreviated as “the TPRs.”

Under the TPRs, a much more complex framework for deciding whether to capitalize or expense individual costs is now in place.

Taxpayer-Friendly Features

While the new regulations are highly complex and sometimes vague, they do contain several features that tax experts regard as “taxpayer friendly.” I will deal with two of those in this article:

  1. Repair and maintenance costs, as defined under the regulations, may be expensed in the year incurred. This is a significant change because even if the dollar amount is large (such as the cost of a roof membrane replacement, which could cost tens or hundreds of thousands of dollars), it may be possible to deduct it in the year the cost is incurred rather than capitalize it under common circumstances.
  2. Capital costs for building-related items that don’t fit the definition of “repair and maintenance” might still qualify for expensing treatment under the new regulations if the expenditure is not a “betterment” as illustrated in examples contained within the regulations, and if the cost is not considered “material” in comparison to the building system to which the cost relates. That’s a big gift for building owners. As an example, if 30 out of 100 windows are replaced, and if the windows are of the same type as those being replaced, the cost could be expensed rather than capitalized and depreciated.

Example: Writing Off a New Roof Job

Suppose a building owner bought a large warehouse building ten years ago. Five years later the roof needs work. A new roof membrane is installed at a cost of $400,000, which I understand is an average roof job cost for many commercial roofers. The owner’s accountant put the roof repair cost on the books as a 39-year real estate asset.

Since that time, five years’ worth of depreciation expense has been taken, and now there is $348,718 of undepreciated cost ($400,000 x 34/39) left on the new roof. The owner will continue to deduct 1/39th of the initial cost of the roof work over the next 34 years.

Prior to the new regulations, that was the right tax accounting treatment. But under the new TPRs, the accountant needs to evaluate several factors to determine whether the roof repair costs must be capitalized or, possibly, could be expensed.

Specifically, the accountant must determine whether the cost qualifies as “repair and maintenance” under the TPR’s routine repair and maintenance safe harbor, or whether it is considered a non-betterment (in simple terms, the same type of roof as the old one) and is not a “material” expenditure relative to the cost basis of the building structure. There’s a lot of detail behind that statement–too detailed to go into here–but that’s the basic idea.

Let’s suppose that one of those conditions is met (which would commonly be the case). That means the building owner, upon adopting the TPRs as their accounting method, gets to write off the remaining cost basis of the roof job ($348,718) in the current year as an expense, rather than continue to depreciate that cost over the remaining 34 years. That’s what I would call “taxpayer friendly.” It’s worth pointing out that the regulations in some cases (like this one) can (and must) be applied retroactively.

Taxpayers Ignore the TPRs – at Their Potential Peril

Despite potential bonanzas like this, many CPAs and their real estate clients have ignored the new regulations, have not filed the required paperwork and are still doing their tax accounting the old way. Tax experts I’ve talked with estimate that only about 25% of taxpayers who are subject to these new regulations have filed the paperwork that the IRS requires to adopt the new rules as their accounting method (IRS Form 3115) and have adapted their accounting policies.

For those that have filed the forms, many obtained immediate and sizable tax benefits because the new regulations were meant by the IRS to be applied retroactively. Property owners who understood the regulations had their accountants analyze past expenditures that were being depreciated to see if any of them could be reclassified as expenses. Whenever that condition was met, the taxpayers could write off the remaining undepreciated basis of those assets.

While not every building owner has a significant amount of depreciating assets that can benefit by applying the TPRs in this way, the fact remains that the regulations are in force and non-compliance with them could be hazardous. Although certain types of “small taxpayers” are exempt from the paperwork filing requirements, there are no exceptions to the requirement to analyze depreciation schedules to determine whether past capitalization and expensing decisions conform the new regulations. Taxpayers are no longer permitted to capitalize and depreciate costs that the regulations say should be treated as expenses, including prior year costs.

What’s the Risk of Non-Compliance?

Since the old treatment of repair and maintenance costs erred on the side of conservatism, for the most part, and correcting those old entries deprives the IRS of tax revenue, why should building owners care?

The first reason is that “it’s your money.” Why let the IRS hold on to it by treating costs they consider to be expenses as long term depreciating assets? Yes, it can be a hassle to figure out which assets need reclassification as expenses, but it may be well worth your while to have this done, in terms of the dollar payoff.

The second reason to care is this: The “carrot” of immediate expensing opportunities for past capital expenditures is accompanied, I think, by a big “stick.” And if you’re audited, the IRS could hit you with it for non-compliance.

If you miss this opportunity you may face the real risk that large future depreciation deductions for (prior year or current year) repair and maintenance items will be permanently disallowed by the IRS. I have checked with several tax experts who have had back-channel, private discussions with the principal author of these regulations at the IRS. They have all told me that the intent at the IRS is to enforce the new rules and disallow improper deductions that are discovered during audits. Since qualifying repair and maintenance costs are now considered expenses, any such costs that have been capitalized in the past and have not been corrected via Form 3115 potentially are at risk in an audit as far as depreciation expense taken after 1/1/2014,

IRS is Gearing Up for Compliance Checks of Building Owners

While there have been no enforcement actions to date of which I’m aware, it’s probably too soon in the life of these new regulations for that to have occurred. The regulations are still new, and it takes time for the IRS to train examiners. However, the IRS is steadily progressing in their efforts to prepare their examiners to apply the new regulations during audits. One major step forward in this regard was the publication in September, 2016 of a new Audit Techniques Guide for the TPRs.

When the IRS publishes these guides, they are not meant to be interpreted as regulations themselves but they do provide insight into how the IRS thinks about their actual application as practiced in the audit process. In the new guide, the IRS makes it clear that auditors are to thoroughly check for compliance with every facet of the new regulations.

What to Do

If you own commercial or multifamily real estate and have not yet formally adopted the TPRs as your accounting method, including scrubbing your depreciation schedule for capitalized repair and maintenance costs no longer required to be depreciated, it’s not too late. You can have your accountant conduct an assessment.

Your accounting firm might want to bring in a qualified cost segregation firm to help determine which of your past capitalized expenditures meet the tests for retroactive expensing treatment, because the new rules reach deep into subject matter that may be outside your accountant’s range of expertise.

In fact, the IRS notes in their Audit Techniques Guide that “With the issuance of the final regulations, the demand for cost segregation studies is on the rise…Taxpayers are hiring specialists with engineering expertise…for purposes of applying the improvement rules…Cost segregation studies now serve additional purposes. For example, not only do these studies reclassify a building’s components into assets with shorter class lives, but they also identify building systems for purposes of applying the improvement rules.”

Once you and your accountant are sure which of your historical costs are eligible for current expensing, based on the assessment, you would have the appropriate forms filed, claim whatever expenses are justified, and adjust your accounting method going forward. And you might end up with a big, unexpected write-off at tax time.

On the other hand, if you do nothing, you run the risk of losing improper depreciation deductions that you claimed after the regulations took effect and paying penalties and back taxes for understatement of income.

About the Author Jeff Glass

Jeff helps real estate owners increase their cash flow. He started his career as a Financial Analyst with the Irvine Company, and worked in various management/executive positions in the mortgage industry for many years. He's been a Cost Segregation consultant for several years and is considered one of the industry's top experts in TPRs. As Director of Business Development for Bedford Cost Segregation, Jeff helps his clients increase cash flow by accelerating their depreciation deductions, and by writing off assets that no longer need to be depreciated under recently changed tax rules. Jeff has a B.S. in Economics from Claremont McKenna College and an MBA with an emphasis in Finance from UC Berkeley.