With 100% bonus depreciation phasing out in 2023, taxpayers are reminded of the benefits of Tangible Property Regulations. Since the passage of the Tax Cuts and Jobs Act, real estate owners have benefited from the immediate 100% bonus deprecation deduction for expenditures related to qualified improvement property (QIP). These include improvements to the interior of a building, such as the installation or replacement of drywall, ceilings, interior doors, fire protection, and mechanical, electrical and plumbing upgrades. However, beginning with the 2023 tax year, first-year bonus depreciation is 80% of the purchase price and is scheduled to fall to 60% in 2024, 40% in 2025 and 20% in 2026. Additionally, a real estate entity may also be subject to business interest expense limitation rules, which may preclude it from utilizing bonus depreciation on QIP purchases.
The gradual phasing out of bonus depreciation has prompted real estate owners to reassess their approach to property expenditures. Fortunately, the tangible property regulations issued by the Department of Treasury in 2014 are still in effect and allow for a full deduction of certain property expenses in the year of purchase.
The regulations provide taxpayers with a framework on how to account for expenses related to tangible property, including whether to deduct a property expenditure as a repair or capitalize and depreciate it as an improvement. To make this determination, a taxpayer must first define their units of property and then conduct an improvement analysis of each one.
Unit of Property Rules: Buildings are Special
The regulations introduced the concept of a unit of property, which is the tangible asset to which the tax rules apply. Determining the unit of property can be complex, but the regulations provide special rules for buildings that help simplify the process.
For a lessor of a building, the units of property are the entire building and its structural components, as well as the structural components designated as key building systems. For a lessee of a building, the units of property are the portion of the building structure and the portion of each key building system subject to the lessee’s lease. The analysis in this article focuses on building lessors.
Defining the Unit of Property
The building and its structural components comprise a single unit of property. This single unit of property includes the building's foundation, walls, partitions, floors, ceilings and any permanent coverings such as paneling, tiling, windows and doors.
The following nine key building systems are considered units of property separate from the building structure:
- Heating, ventilation and air conditioning (HVAC) systems
- Plumbing systems
- Electrical systems
- Fire protection and alarm systems
- Security systems for the protection of the building and its occupants
- Gas distribution system
- Other structural components identified in published guidance
The ultimate result of the regulations is to reduce the size of the unit of property, which increases the likelihood that an expenditure will need to be capitalized as an improvement. Therefore, if a taxpayer incurs an expense related to its windows and doors, the unit of property for determining whether the expenditure should be capitalized or expensed is the building and its structural components since windows and doors are not considered a key building system. For expenditures related to security cameras, however, the appropriate unit of property would be a key building system that falls under the category of security systems.
The property units are further subdivided into a category known as major components, defined as parts or combinations of parts that perform a discrete and critical function in the operation of the unit of property. Major components exist within the building, its structure unit of property, and the nine key building systems.
Generally, a taxpayer must capitalize expenses that result in the material addition of a major component or a replacement of a significant portion of a major component of a unit of property.
Improvement Analysis: Knowing When to Capitalize
Once the unit of property is determined, it is vital to understand whether expenses incurred on that unit of property should be capitalized and depreciated or expensed in the current year.
In general, a taxpayer must capitalize an expenditure made to a unit of property if it results in an improvement to that unit of property. The regulations define an improvement as a betterment, a restoration or an adaption for a new or different use.
- Betterments include expenses that:
- Are reasonably expected to materially increase the productivity, strength, quality or output of the unit of property,
- Represent a material addition to the asset, such as a physical enlargement, expansion, extension or a material increase in the property’s capacity, or
- Ameliorate (fix) a material condition or defect that existed prior to acquisition or that arose during production of the property.
The term material is the keyword in all three tests of a betterment. However, this term is not defined in the repair regulations. Taxpayers are expected to use reasonable judgment as applied to their specific set of facts and circumstances to determine which expenditures result in a betterment.
- Restorations, some examples include:
- Replacing a major component or substantial structural part of the unit of property,
- Restoring property to its ordinary efficient operating condition or rebuilding property to like-new condition after the end of its class life in the tax system or
- Restoring a damaged unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss.
- Adaptations, an amount must be capitalized if it is paid to adapt a unit of property to a new or different use that is not consistent with the ordinary use of the unit of property at the term that the taxpayer originally placed it in service.
An example of an adaptation would include a building that was mainly used since its inception for manufacturing items and has undergone a conversion to become a showroom. Since the structure and systems are converted to a new or different use that is inconsistent with the original use, an adaption has occurred and all adaptation costs must be capitalized.
Occurrences that do not constitute an adaptation include painting the walls and refinishing the floors of a building prior to the sale of the building or a hospital that modifies its emergency room space to have outpatient surgery. These expenses do not adapt a unit of property to a new or different purpose.
Owners of real property should analyze the cost of every repair or improvement separately under each improvement standard before determining how the expenses will be treated on their financial statements. Any amount could be subject to capitalization under one improvement standard, even if it fell outside of the scope under another.
The repair regulations provide a number of advantageous provisions for owners of real property to deduct repair expenses in the current year. While there are no bright-line rules for determining when an expenditure related to tangible property should be treated as an improvement or repair, owners of real property are advised to use a facts and circumstances test based on a framework, guidance and examples provided by the IRS.
The topics covered in this article are only a small part of the repair regulations, including rules for deducting costs of materials and supplies, de minimis safe harbors and deductions allowed for routine repair and maintenance costs. Contact a member of the CBIZ Marks Paneth Real Estate Group to learn more.
Published on September 11, 2023