If you own rental property, or any other business or investment property, the Internal Revenue Service has bad news for you.
It has issued a massive new set of regulations (256 pages in all) with complex rules that, starting in 2012, all owners of business and investment property are supposed to follow to determine what constitutes a currently deductible repair versus an improvement that must be depreciated over several years.
Eight years in the making, the new regulations cover all types of tangible business and investment property, whether real or personal property, but they are particularly significant for owners of business and rental buildings.
Among many other things, the regulations will likely make it more difficult to classify fix-ups and other building expenses as currently deductible repairs. Instead, they will have to be treated as "improvements."
This is not good if you’re a building owner because, when it comes to taxes, repairs are far more valuable than improvements. There are two big reasons why:
- repairs are currently deductible in a single year, while improvements must be depreciated over many years (39 years for nonresidential buildings, 27.5 years for residential buildings); and
- if you sell a building at a gain, you must pay a recapture tax of up to 25 percent on the depreciation you claimed in prior years.
For example, if you spend $10,000 to replace a roof for an apartment building, the cost will have to be deducted a little at a time over 27.5 years. On the other hand, if it’s a repair, you can deduct the entire cost in one year.
As a result, a fix-up you can label as a repair can be up to 271 percent more valuable than an improvement.
So what’s the difference between a repair and an improvement? An improvement is a major change or alteration to property. According to the new regulations, there are three types of improvements:
- betterments — improving property or repairing defects;
- restorations — making older property like new; and
- adaptations — adapting property to a new use.
In contrast, a repair doesn’t make property better, restore it, or adapt it to a new use. A repair is a much more minor change that just keeps property in good running order.
Until now, due to a lack of clear IRS guidelines, some building owners were able to claim repair deductions for installing new roofs, replacing heating and air conditioning systems, and making major structural changes to building interiors.
When compared to the building and its structural components as a whole, these projects could be plausibly portrayed as relatively minor and therefore treated as deductible repairs.
This is no longer possible. In effect, the new regulations require that buildings be divided up into as many as nine separate properties for tax purposes: the entire structure and up to eight separate building systems.
A significant change to any of these must be treated as an improvement and depreciated over several years. As a result, more costs will have to be classified as improvements rather than repairs.
Under the regulations, an improvement to any one of eight separate building systems constitutes an improvement to the whole building and must be depreciated:
- Heating, ventilation and air conditioning ("HVAC") systems: This includes motors, compressors, boilers, furnace, chillers, pipes, ducts and radiators.
- Plumbing systems: This includes pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment, and site utility equipment used to distribute water and waste.
- Electrical systems: This includes wiring, outlets, junction boxes, lighting fixtures and connectors, and site utility equipment used to distribute electricity.
- All escalators.
- All elevators.
- Fire-protection and alarm systems: These includes sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detectors, fire escapes, fire doors, emergency exit lighting and signage, and firefighting equipment such as extinguishers and hoses.
- Security systems: These include window and door locks, security cameras, recorders, monitors, motion detectors, security lighting, alarm systems, entry and access systems, related junction boxes, associated wiring and conduit.
- Gas distribution system: This includes pipes and equipment used to distribute gas to and from the property line and between buildings.
For example, if a building’s HVAC system is upgraded, it must be classified an improvement to the whole building and depreciated. This is so even though the upgrade might not be extensive enough to constitute an improvement to the building as a whole.
If you own rental or business property, you should talk with your tax adviser about how these new regulations will affect you.
Stephen Fishman is a tax expert, attorney and author who has published 18 books, including "Working for Yourself: Law & Taxes for Contractors, Freelancers and Consultants," "Deduct It," "Working as an Independent Contractor," and "Working with Independent Contractors." He welcomes your questions for this weekly column.