CREJ - Office Properties Quarterly

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April 2015 — Office Properties Quarterly — Page 7
Taxes
T ax professionals recently
have been bombarded with
questions about the new(ish)
Internal Revenue Service
rules, effective for 2014, relat-
ing to a boring part of tax account-
ing that is, for better or worse,
central to real estate tax planning
– capitalization policy.
As a review, capitalization policy
concerns whether money spent on
a property should be posted to the
balance sheet and the cost recovered
through depreciation over a term
of years, or expensed to the income
statement and deducted in the cur-
rent year. This is obviously quite a
distinction in result for tax-planning
purposes.
The IRS concluded in 2006 that
there was too much confusion in
this area and it has been working
feverishly since to compound the
confusion under the name of “sim-
plification.” As is often the case with
new tax rules, the germ of this idea
made perfect sense – to introduce
some order to an area that was
fraught with controversy. I am not
going to say that the IRS screwed
this up (but I wouldn’t necessarily
argue with someone who did), but
I recommend we taxpayers try to
make lemonade from the lemons we
were handed.
My approach is to emphasize that
the changes are truly a paradigm
shift in how your accounting team
should view your capitalization
policy. I think the best way to illus-
trate the change is with examples;
but first, a brief review. Most accoun-
tants judge an item that must be
capitalized on two
factors, its useful
life and its cost.
If something has
a long useful life
and costs a signifi-
cant amount it is
capitalized; if not
(on either count),
it is expensed. (For
example, a trash-
can may last longer
than a computer,
but it is expensed
and the computer
is capitalized).
Now this has changed. Here are four
examples:
1. An office building with a bank
of four elevators replaces one eleva-
tor, which was nearing the end of its
useful life, at a cost of $100,000.
• Traditional approach – Capitalize
– It is expensive and long-lived.
• New approach – Expense – The
building component is not enhanced
by the change.
2. A hotel lobby makes flooring and
other upgrades to refresh the look of
the property at a cost of $150,000.
• Traditional approach – Capitalize
– It is expensive and long-lived.
• New approach – Expense – Only
10 percent of total hotel surface is
affected, and the lobby has no more
utility than before the upgrades.
3. A large office building replaces
bathroom sinks in 40 percent of its
bathrooms at a cost of $100,000.
• Traditional approach – Capital-
ize – It is expensive, long-lived and
sounds like a program of improve-
ment.
• New approach – Expense – 40
percent of the building’s sinks is
not substantial relative to the total
plumbing system. After all, what has
changed? A sink is a sink. The build-
ing utility is the same.
4. A grocery store upgrades and
replaces older equipment, dresses
up the interior and offers new fea-
tures, including a coffee bar and
sushi bar, at a cost of $1 million.
• Traditional approach – Capital-
ize – It is expensive, long-lived and a
major upgrade.
• New approach – Expense (or a
good case to do so) – Nothing has
changed; a grocery store before and
a grocery store after.
And there is more. Even if you
have to capitalize a change or addi-
tion, you likely can write off the
undepreciated cost of the item that
is replaced, which can be estab-
lished based on estimates, and you
don’t need a cost-segregation study
to support the position. You should
also question whether you have
to capitalize tenant improvements
related to retenanting a leased space
(renewals or a new tenant).
Another important point here is
that you take advantage of the new
rules with your 2014 tax return, and
you have an opportunity to look
back as if these rules had always
been in effect. This means you can
take a deduction now for the unde-
preciated remaining cost of items
that was capitalized, but that could
have been deducted under the new
rules. (In fact, I would say if you
don’t do that, you are not really in
compliance with the new rules.) To
accomplish that, you have to file for
a change of accounting method (IRS
Form 3115), but you should be doing
that for 2014 anyway. (Also note that
you can do that for free for 2014, but
going forward it is likely to cost you
at least $7,000 in filing fees per form
filed.)
My point here is not to educate
you on the ins and outs of these
rules, as they are extensive and still
not as well defined as they should
be, but to give everyone in the real
estate industry pause. The new
rules are different and, in many
ways, turn capitalization policy on
its head, so you owe it to yourself
to verify that your accounting team
gives that area of your business a
fresh look.s
Zane Dennis
Tax partner and
real estate practice
leader, Richey May
& Co., Denver
My approach is
to emphasize that
the changes are
truly a paradigm
shift in how your
accounting team
should view your
capitalization policy.