New Internal Revenue Service (IRS) repair regulations to impact all property owners

Determining whether an expenditure is an improvement that should be capitalized, or expensed as a repair, has long been a confusing task for many property owners and accountants. Property owners generally prefer the immediate tax benefit associated with an expense, instead of recovering the cost over as much as 39 years. New Internal Revenue Service (IRS) regulations, effective for 2012 tax returns, have made it more difficult to expense costs, while also creating several new opportunities to generate deductions for retired building components. These opportunities can provide much needed tax relief for commercial property owners through a review of previous expenditures. Repair and capitalization treatment remains a Tier 1 issue with the IRS, meaning it has the highest compliance risk in their eyes, and undoubtedly receiving the most scrutiny from IRS agents. The importance of properly analyzing and documenting costs that property owners expense has never been greater. Retirement of Structural Components Property owners are now allowed to recognize a loss on the disposition of a structural component of a building instead of continuing to depreciate the retired component while simultaneously depreciating the replacement component. They were previously required to continue depreciating structural components that were removed from service. Common scenarios that will trigger this opportunity include roof replacements, major interior renovations, rooftop HVAC unit replacements and elevator replacements. This opportunity is available for future improvements as well as retirements that have occurred in previous years. The challenge becomes identifying the cost basis of retired components to accurately calculate the disposition loss. Most property owners do not have this information readily available, so cost estimating techniques will need to be utilized. Example: Property owner acquired a building in 2010 and allocated costs to five/seven-year personal property and 15-year land improvements through a cost segregation study, but did not identify the structural components. The roof was replaced in 2012. Cost estimating retroactively allocated $250,000 of the property purchase price to the roof. Under the new regulations, the owner will capitalize the cost of the new roof and recover the remaining basis ($237,438) of the demolished roof, instead of depreciating both. Retirement of Leasehold Improvements Property owners can recognize a loss on the disposition of leasehold improvements that are abandoned at the end of a lease. Most owners cannot easily identify the cost basis of leasehold improvements on a tenant by tenant basis, especially for a multi-tenant property that was acquired with tenants already in place. Cost estimating procedures can identify basis allocable to the fit-out for individual tenant spaces, even if the property has been in service for many years. Common scenarios that will trigger this opportunity include demolition of interior tenant space, tenant allowance negotiations with an existing tenant and a retail or office property that has experienced tenant turnover within the last few years. Example: Property owner acquired a six tenant retail strip mall in 2009. Two retail tenants vacated their spaces in 2012 and the interiors were demolished for a new restaurant tenant. Cost estimating retroactively allocated $450,000 of the purchase price to the demolished tenant spaces. Under the new regulations, the owner will recover the remaining basis ($415,549) of the demolished leasehold improvements. Building System Identification Requirement Property owners are now required to analyze improvement costs relative to eight building systems defined in the regulations. This requirement will result in more costs being capitalized than under the prior guidelines. Expenditures must be capitalized if they result in an improvement to the building structure or to any of the following building systems. 1. Heating, ventilation, and air conditioning systems 2. Plumbing systems 3. Electrical systems 4. Escalators 5. Elevators 6. Fire protection & alarm systems 7. Security systems 8. Gas distribution systems The challenge is how to allocate costs to the building systems to ensure compliance and help justify expensing for eligible improvements. Cost estimating techniques will assist property owners and their CPAs as they take advantage of these opportunities to maximize deductions and increase cash flow, and ensure compliance with the new IRS regulations. Robert Rahner, CFA, ASA, SCSP is the engineering director for Cost Recovery Solutions, LLC, Metuchen, N.J.