Whether building a new project, acquiring assets or making improvements to in-service assets, it’s important for developers to understand the rules, benefits and detriments of expensing or depreciating capital expenditures for tax purposes. With a clear view of what’s at stake, you can set policies that minimize your tax liability, maximize benefits for stakeholders or, ideally, both.
Generally, expensing an item immediately is often the most beneficial option for income tax purposes but may not provide the best financial statement results. Alternatively, expenses required to be capitalized may qualify for accelerated depreciation if certain criteria are met. Follow the steps below to decide how best to treat an expenditure.
Step 1: Capitalize or Expense?
The first step to determining the correct tax treatment of an expenditure is to identify whether the cost is required to be capitalized or may be deducted as an expense. The 2013 Tangible Property Regulations, also known as the Repair Regulations, provide guidance to help make this decision. While these rules are not new, they can be a complex yet key aspect of the decision making process.
The De Minimis Safe Harbor Election
Before reviewing every capital expenditure, it is important to be aware of an administrative convenience provided by the repair regulations. The de minimis safe harbor election allows taxpayers to expense any item under certain dollar thresholds that was deducted for financial accounting purposes. The threshold is $5,000 for taxpayers with an applicable financial statement (generally, an audited financial statement) or $2,500 for those without. Note the safe harbor requires an annual election on the tax return.
Understanding Units of Property and Building Systems
The repair regulations require a taxpayer to make the capitalization determination on a unit of property basis. They describe a unit of property as the smallest identifiable unit that is functionally interdependent. As this definition does not translate to real property clearly, the regulations provide for several separate building systems, each of which is considered a single unit of property. These systems include building structure, HVAC, plumbing systems, electrical systems, escalators, elevators, fire protection and alarm systems, security systems, gas system and any other system with functional interdependence.
Analyzing Expenses Above the Capitalization Policy
Expenses paid to improve tangible property above the de minimis safe harbor threshold, if elected, must be capitalized if they materially improve, materially restore or adapt a “unit of property” to a new or different use. As real property uses the defined “building systems” as its units of property, expenditures are measured with respect to the impact to the related system. Determining whether a cost materially improves or materially restores a building system is based on a number of factors, such as what percentage of the system was repaired or replaced, whether or not the system works more efficiently and if the useful life has been extended. Many examples in the repair regulations equate a material improvement in these factors to around 30 to 40% of the unit of property.
Step 2: Determining Depreciation
After you determine an expenditure must be capitalized, the next question is how should this new asset be depreciated? Most real property assets are required to be capitalized over long lives (39 year if non-residential, 27.5 years if residential) and are depreciated on a straight-line basis. Land improvements and Qualified Improvement Property (QIP) are two important exceptions to this general rule, and both have a 15-year depreciable life.
Land Improvements include assets you would expect — roads, parking lots, water retention basins, site work, etc. QIP is a defined term that includes any improvement to nonresidential real property after the date the property was first placed in service, provided the improvement is not attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework.
Assets other than real property commonly are classified as either five- or seven-year assets and may include machinery, equipment, computers, furniture and fixtures. Any asset with a depreciable life of less than 20 years (including land improvements and QIP) is eligible for bonus depreciation. Bonus depreciation is a special amount of accelerated depreciation, usually expressed in a percentage, which a taxpayer may take automatically in the year an asset is placed in service. Currently, bonus depreciation is set at 100% through the end of 2022.
If you are hoping to accelerate deductions, it is important to identify assets with a depreciable life of less than 20 years to qualify for bonus depreciation. This includes applying the QIP rules and potentially completing a cost segregation study to divide real property into smaller components, some of which may be considered five-, seven- or 15-year property.
Step 3: Exploring Section 179 Expensing
Section 179 expensing, like bonus depreciation, is an additional method of accelerating depreciation expense; however, it comes with many limiting factors:
- There is a limit on the amount of Section 179 expense a taxpayer may take in a year, based both on dollars as well as taxable income.
- There is also a limit on the amount of property you place in service for the current year.
These factors may lead developers to choose bonus depreciation in lieu of Section 179 expensing in terms of accelerating depreciation. It is important to note, however, that Section 179 expensing applies to improvements to certain building systems — such as roofs, HVAC, fire protection systems, alarm systems and security systems — that may be ineligible for bonus depreciation.
Step 4: Assessing the Results and Unintended Consequences
Expensing costs will generally provide the best tax answer available — meaning accelerated deductions with no real downside. However, expensing high value expenditures may negatively impact your balance sheet and net income, as well as investor relations.
While assets eligible for bonus depreciation may reflect more favorably on financial statements and achieve the same result of accelerating deductions, this treatment comes with state tax non-conformity issues and the potential for the depreciation to be recaptured upon sale at a higher tax rate.
The reality is, under the applicable rules you may not have an option as to whether you expense or capitalize many of your assets. But understanding those determinations will give insight into any current and future tax, and non-tax, implications and can assist in analyzing gray areas.
As a final note, keep in mind there are many alternatives and exceptions to the rules mentioned above. These may include optional elections, disallowance of bonus depreciation on certain assets, loss limitation rules and many others. It is important to discuss treatments and determinations with your tax team to assure you are using the most optimal treatment available.
Contact Jon Williamson at email@example.com, Peter Myeroff at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.