Colorado Real Estate Journal - February 4, 2015
Many people will remember 2014 for its crazy weather or another news story that hit close to home. One thing that commercial property owners need to remember about 2014 is that the federal government made significant changes to tax rules that govern how businesses treat payments made to purchase, repair or maintain real property and other tangible assets. Business owners and executives need to be aware that these new rules will require many businesses to change their tax accounting methods before filing 2014 income tax returns. Some aspects of the rules apply to tax years before 2014. Any business that reported amounts for depreciation, repairs or materials and supplies related to tangible assets on tax returns prior to 2014 will almost certainly be affected by the retroactive changes. Those businesses will need to analyze prior year payments in order to calculate the correct basis for tangible assets and the correct amounts for related expenses based on the new rules. The process of filing the tax accounting method change includes a onetime adjustment to bring all of the prior year changes in asset costs and expenses into compliance with the method that the government now requires. These adjustments must be made before 2014 tax depreciation is calculated in order to make sure that asset values and related expenses are determined in compliance with the latest guidance. The guidance doesn’t really change the way that depreciation is calculated on buildings or other assets – it changes the way some payments related to the assets are treated. The retroactive provisions in the new rules can result in the reclassification of payments that were classified correctly under the old rules in prior years as expenses or adjustments to basis. Software that calculates tax depreciation on assets will generate incorrect amounts for businesses that fail to analyze prior year information and make the proper adjustments. Businesses that rely on that software will still need to review prior year payments for fixed assets and repairs to assure compliance under the new regulations. While the new rules will require many businesses to do some extra tax preparation work this year, they are not necessarily bad news. Many businesses will find that the prior year changes result in additional deductions that can be claimed as a one-time expense on 2014 tax returns. On the other hand, businesses that fail to file the required tax accounting method changes could face some very serious consequences. Benefits of the New Rules The recent guidance from the IRS changes how some payments made to repair and maintain commercial real property and other assets are classified. In many i n s t a n c e s , those changes may result in larger a m o u n t s written off as expenses in the year they are paid instead of amounts added to the cost of the asset and expensed over multiple years as depreciation. Here are a few examples: Partial Asset Disposition. Under previous rules, payments for substantial repairs were added to the basis of an asset without any adjustment for the value of what was replaced. Roof replacement is an excellent example. The old treatment was to add the cost of the new roof to the asset and depreciate. In so doing, taxpayers were actually depreciating the cost of the original roof and the new roof at the same time. The new rules provide a formula for expensing the remaining value of the old roof before adding the cost of the new roof to the asset. Units of Property. The total depreciable basis of a building will now be apportioned among some of the significant systems and structures within the building, such as HVAC, plumbing and electric. The rules refer to these new individual building components as “units of property.” Each unit of property is now deemed to be a separate and distinct asset and not part of the building as a whole. The decision to classify costs to repair or maintain a unit of property as a current expense or an addition to asset basis will be determined in part by the relationship of the repair cost to the unit of property cost, not to the whole building. Routine Maintenance Safe Harbor. The rules clarify treatment for routine maintenance to allow for expensing of payments for building repairs that businesses reasonably expect to make at least once every 10 years during the life of the building. For tangible assets other than real property, the rule provides the safe harbor for maintenance costs associated with events the business reasonably expects to occur at least once during the life of the asset. When combined with the “units of property” concept discussed above, many businesses will find that costs they were previously required to expense over time through depreciation may now be eligible for deduction in the year incurred. Safe Harbor for Small Taxpayers. Smaller businesses can make an annual election to expense in the current year costs that they might otherwise be required to add to a building’s basis and depreciate over time if they meet three criteria: • The building must have an unadjusted cost of less than $1 million; • The average gross receipts of the business in the last three years cannot exceed $10 million; and • The total cost of repairs and improvements for the year cannot exceed the lower of 2 percent of the b u i l d i n g ’ s unadjusted cost basis or $10,000. De Minimis Safe Harbor. A business that issues audited financial statements can elect to expense up to $5,000 per repair or acquisition in the current year, whereas the prior rules might have required those payments to be added to the basis of the asset and depreciated over time. To qualify, the business must maintain a written capitalization policy and the amount must be expensed pursuant to that policy.
Some of the new accounting methods and elections are optional, and businesses can choose to make them as appropriate. But many of the new tax accounting methods require that a business choose one of the options available and implement it consistently, both on new returns filed going forward and on prior returns for a period of time. If a business fails to make one of the required changes before filing its 2014 tax return, numerous problems can arise. Here are a few examples: Increased Audit Risk. The IRS is expecting to see accounting method change forms on nearly every 2014 business return. If a business that filed tax returns with depreciation expenses and repair deductions prior to 2014 fails to file an accounting method change under the new rules, that business will raise a red flag to the IRS that it is not complying with current tax law. Lost Deductions. The benefits discussed previously may be lost permanently if the business fails to make the necessary tax accounting method changes in a timely manner. Recharacterization of Prior Deductions. A business that does not make a timely accounting method change under the new rules runs the risk that the IRS may reclassify prior expenses as capital expenditures subject to depreciation. Not only will that business miss out on potential depreciation deductions from prior years, but it also will wind up with lost deductions and an income adjustment under audit that may result in tax owed. This article has presented a very high-level overview of just a few of the provisions in the new rules. The details of the regulations are much more complex and the consequences of misunderstanding them can be serious. The most important thing for business owners and executives to remember is that these accounting method changes must be made prior to filing the 2014 tax return. Every business should consult with a tax adviser who is familiar with the new rules to make sure that it makes the proper accounting method changes and elections for its circumstances. Businesses that have yet to begin the process of analyzing prior year calculations to determine what new method is appropriate need to do so immediately and may need to file for an extension of time to file 2014 returns.