CREJ - Office Properties Quarterly - April 2015
Tax professionals recently have been bombarded with questions about the new(ish)Internal Revenue Service rules, effective for 2014, relating to a boring part of tax accounting 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 current 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 “simplification.” 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 illustrate the change is with examples; but first, a brief review. Most accountants 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 significant amount it is capitalized; if not (on either count), it is expensed. (For example, a trashcan 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 elevator, 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 – Capitalize – It is expensive, long-lived and sounds like a program of improvement. • 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 building utility is the same. 4. A grocery store upgrades and replaces older equipment, dresses up the interior and offers new features, including a coffee bar and sushi bar, at a cost of $1 million. • Traditional approach – Capitalize – 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 addition, you likely can write off the undepreciated cost of the item that is replaced, which can be established 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 undepreciated 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.