By George Roberts III
Utilizing the safe harbors that exist in the federal tax code can provide major dividends when it comes time to pay the annual tax bill! Safe harbors simplify tax preparation by spelling out the rules you need to follow to stay out of trouble with audits.
Capitalizing Expenses vs. Expensing
Business owners like to expense rather than capitalize expenditures for tax purposes because expensing provides immediate tax benefits. In many cases where you are able to capitalize operating expenses for the purposes of your financial accounting, you can still get the benefit of expensing on your tax return. This article will show you how.
For those that want a quick review on capitalizing versus expensing, consider an apartment complex with $1M in revenue that needs to pay $50,000 to resurface the asphalt parking lot and $200,000 to replace the roofs on seven buildings for a total charge of $250,000. Suppose that their operating expenses come in at $500,000 for the year. If they were to capitalize these expenditures, they would have $500K in profits for the year – not too shabby! However on your tax return, you may be able to expense the seven roofs and the parking lot so that you are only liable for $250,000 when it comes time to pay your taxes. Of course this vastly oversimplified example does not take into account depreciation or any of the multiple other factors that your tax professional will use to further reduce your tax bill. There are times that the decision to capitalize expenses for the purposes of financial accounting will affect your deductions under the Tangible Property Regulations so you will want to consult your tax professional before applying these deductions to your multifamily holdings.
Tangible Property Regulations (26 U.S. Code § 263a) offer building owners safe harbors that allow you to expense many of the costs of owning a building. These safe harbors provide building owners with a safe or simplified way to reduce their tax liability as long as certain guidelines are met.
- De Minimis (for purchases less than $2,500)
- Routine Maintenance Safe Harbor
- Small Business Taxpayer Safe Harbor
De mimimis is Latin for “trivial”. It is used for legal, tax or financial circumstances that are too trivial to merit consideration. You can expense any number of expenses up to $2,500. The limit recently increased from $500 starting with taxable years beginning January 1, 2016. Many building owners are still not taking full advantage of this deduction!
If taxes, freight or installation are on the invoice, they must be included in the total. These expenses can be placed on another invoice to bring the total cost under $2,500. If the total with freight and / or installation is under $2500, leave them on the invoice for maximum deduction. To apply the de minimis election, you will have to expense these same purchases for the purposes of financial accounting. The limit rises to $5,000 if you have an applicable financial statement (AFS).
De Minimis Example
Suppose that you replace all 25 windows of your building at $500 including installation for a total cost of $12,500. The entire window project could be expensed if the work were separately invoiced such that no invoice were over $2,500. This would in no way prevent you from also using the de minimis election that year for your computer or other purchases. You must expense these costs in the year in which they occurred. If you miss a year in electing de minimis, you will lose those benefits for that year.
Routine Maintenance Safe Harbor
Repairs that can reasonably be expected to be performed every 10 years or less can be expensed. The costs incurred have to be for a repair rather than a capital expenditure. To be a repair or maintenance these expenditures must simply restore or maintain the value of the building as opposed to increasing the value of the asset. Your CPA will cite 1.263(a)-3t(g). This is not an annual election. To substantiate a less than 10 year life of an installation, you can use the manufacturer’s warranty or other trade related knowledge such as commonly available life expectancy tables. Air conditioners, dishwashers and compactors all have life expectancies less than 10 years – hooray! Washing machines and dryers have life expectancies of 10 years or more, sorry!
Small Business Taxpayer Safe Harbor
If each building has an unadjusted cost basis of less than $1M. Yes, that means that you could elect this on a garden style complex with multiple 15-unit buildings (with each building’s cost basis less than $1M) as long as gross receipts are under $10M. You are limited to the lessor of 2% of the cost of the building or $10,000. The cost of the land will need to be subtracted from the cost basis of the building or complex. You can find the cost of the land on your local assessor’s webpage.
Small Business Taxpayer Safe Harbor Example
The cost basis of the apartment building is $800,000.
The land is valued at $210,000.
The value of building is $590,000 which is the cost basis minus the land value ($800,000 – $210,000).
2% of the cost of the building ($590,000 * 0.02) would be $11,800 so the $10,000 limit applies.
Partial Asset Disposition (PAD)
Anyone who has ever renovated a building knows that a lot ends up in the dumpster. But don’t let your depreciation go into the dumpster too! To get the maximum depreciation, you will want to do your cost segregation study before you renovate; it is hard to estimate the remaining value of items once they are in a 30-yarder! As for the value of what actually goes into the dumpster, this is where you need the cost segregation expert to estimate the value of the discarded items.
Removal costs (labor, dumpster, haul away) can be expensed if they are separately invoiced. This is an easy way to increase your profits by expensing the inevitable costs of owning a building!
The IRS has Tangible Property Regulation FAQs for those who would like to read further.
Disclaimer: This article has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for legal, tax, or accounting advice. You should consult your own legal, tax and accounting professionals.
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