New IRS regulations offer real estate owners, operators and developers a new way to save money related to repairs and dispositions of structural improvements.
The pro-taxpayer regulations address the age-old question of whether owners can write off previously capitalized improvements that were abandoned, demolished and/or replaced. They also address long-debated gray areas of real estate tax law (i.e., whether improvements need to be capitalized or expensed for tax purposes).
The new regulations are generally effective as of January 1, 2014, but taxpayers can apply certain of the taxpayer friendly provisions to tax years 2012 and 2013 as well. The regulations now allow taxpayers to write off improvements that still remained on their books even after removal or abandonment.
The new rules, which encompass over 200 pages, provide more detailed guidance and taxpayer friendly parameters. The rules related to expensing or capitalizing improvements are finalized, but although the rules related to writing off disposed of structural improvements are in proposed form, the IRS is allowing taxpayers to use them for 2012, 2013 and 2014. Final approval is optimistically possible by the time 2013 tax returns are filed.
Clarity is one major benefit of the changes. For example, say you bought a property in 2006 for $10 million, and $1 million of it was attributed to the roof (presumably through a cost segregation study). In 2011, you installed solar panels, but the original roof couldn’t support them, so you spent $1.5 million to replace the entire roofing system. Under the old rules, you had two roofs being depreciated within your depreciation schedules accounting for $2.5 million of costs which were depreciated over 39 years. The new rules allow taxpayers to change their accounting method for either tax year 2012, 2013, or 2014 to write off the remaining tax basis (cost of $1 million less depreciation to date) of the old roof while still gaining the full tax benefit of investing in the new roof. The old rules did not allow taxpayers to write off the tax basis attributable to the old roof .
The benefit of hindsight in identifying additional deductions/write-offs can be applied to all types of structural components (e.g., plumbing system, electrical system, HVAC, walls, etc). The change offers taxpayers the opportunity to write off abandoned or demolished structural components in one year rather than over a period of years. Additionally, there is no year better than tax year 2013 for identifying these additional write-offs as tax rates have increased for tax year 2013. As a result, claiming these deductions in tax year 2013 (as opposed to 2012), may shelter dollars that are taxed at higher rates and increase your after tax return on investment.
As with all deductions, substantiation and documentation are critical. As a result, cost segregation studies have never been more important! The new regulations make cost segregation studies a high-value investment for savvy real estate businesses and investors. Such studies segregate and quantify assets that have shorter tax lives — carpeting, millwork, decorative lighting, specialty electric, certain plumbing and special purpose HVAC and certain other non-realty assets. Additionally, taxpayers should request that the cost segregation study segregate and quantify longer tax-lived assets by location, floor and by tenant as well – HVAC, roof, drywall, sprinkler system, elevators, etc. Taxpayers will now have the required documentation to substantiate a write-off related to disposed of structural improvements in past years or future.
For more information, please contact Scott O’Sullivan.