Is it a repair, or a capital expense? IRS helps clarify whether costs can be deducted now or depreciated over years
Commercial Building Tax Deductions
Owning a commercial building has its tax advantages. Owners of these buildings can take a tax deduction against the income the building produces, for the expenditures they incur and for the improvement of their buildings. These deductions reduce the owners' taxable income, which will effectively reduce their annual tax liability.
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Improving Energy Efficiency
- Commercial building owners that improve the energy efficiency of the building they own can take a tax deduction of up to $1.80 per square foot of the building. The improvements must meet standards set forth by the American Society of Heating, Refrigerating and Air-Conditioning Engineers (ASHRAE). This deduction also applies to those building owners that construct their building to these standards in the first place.
According to the Internal Revenue Service, these improvements must reduce the total annual energy and power costs by at least 50 percent in order to qualify for the deduction. Check with the Internal Revenue Service or the Department of Energy before taking this deduction, as it is subject to change with each year.
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Building Improvements
- Not all improvements to a commercial building need to relate to energy efficiency to be deductible. Any improvement to the building that increase its value are deductible over its tax life. The cost of the improvement will increase the building's tax basis (total cost).The IRS says tthe owner can depreciate the tax basis of nonresidential real property over 39 years. The owner simply divides the total cost by 39 years and deducts the proportional amount each year.
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Repairs and Maintenance
- The cost of any repairs and maintenance the building owner incurs throughout the year is deductible in the year of the expenditure. Repairs are dubious improvements, because theier ability to increase the life of the building does not necessarily increase its value. A repair, by its nature, may increase or maintain the value of the building. Change in the value, however, is not necessarily its sole purpose.
Painting the building would be an example of this: The paint increases the life of the building and may also improve its value. The increase in value does not change the fact that paint is still maintenance of the building, not an improvement, so the entire cost is deductible in the current year.
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Loan Interest
- The interest from any loans the owner may incur for the operation, improvement or purchase of the building is deductible against income. These loans need to be for business purposes only, because the proceeds cannot be for the building owners' personal use.
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How to Report these Deductions
- Deductions for the commercial building are reportable on the owners' tax return. The type of tax return they file will depend upon the structure the business. For instance if the building is held by a sole proprietor, the deductions are reportable on a form 1040 schedule E. If the building owners are in a partnership with someone else, they will report the deductions on form 1065 or a form 1120S; if they have an election to report, they can do do on S-Corporation on file with the IRS..
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In this age of disposables, many veterinary practices still pay substantial sums for repairs and maintenance. However, instead of allowing immediate tax deductions, the Internal Revenue Service increasingly is labeling repair and maintenance expenses as "capital improvements," making them recoverable only through depreciation spread over a number of years.
It often seems that the IRS is the only entity able to tell the difference between a currently deductible maintenance expense and a long-term capital expenditure, but some newly released IRS guidelines may help clear the confusion.
One school of thought has been that any legitimate business expense that does not create an asset or benefit the practice for more than a year is immediately deductible. Examples might include normal inspection, cleaning and testing of equipment. The replacement of parts with comparable, commercially available ones would seem to be routine maintenance.
But in the eyes of the IRS, such expenditures all too often are considered capital improvements. The IRS says basically that any expenditure that contributes to prolonging the life of equipment, or any practice property, is a capital expense.
While lawmakers created the deduction for repairs and upkeep, the IRS is tasked with determining what expenditures qualify.
Capital means permanent — to some
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A simple fix or capital expense?
Capital expenditures include those for building improvements or other long-term betterments, new equipment, architect's fees — even the cost of defending or perfecting title to property.
Generally, a capital expenditure either adds an asset or increases the value of an existing one. In other words, the amounts paid to acquire new property for resale, such as inventory, or to keep for one or more years, are capital expenditures. That also includes whatever a practitioner pays to improve existing equipment or property.
Whether it's a deductible repair or a capital improvement often depends on the context. For instance, if an expenditure is part of a general plan of rehabilitation, modernization or improvement to equipment or other business property, it usually must be capitalized, even though by itself it would be currently deductible.
Planning not always a capital expense
Most courts in the past ruled that ordinary repairs made at the same time as capital improvements were capital expenditures. They often drew an analogy between constructing a new building and refurbishing an older one, reasoning that, during building construction, costs of carting away trash, painting windows or even washing windows could not realistically be separated from other building costs and therfore must be capitalized.
Repair work done as part of an overall program of rehabilitation and conditioning should, according to at least one court, be treated as a cost of acquiring a lease with a new tenant and must be capitalized. It's been called the "rehabilitation doctrine," and when invoked the distinction between repairs and capital improvements may disappear when such expenditures combine to change an asset's use, value or life.
New safe-harbor guidelines
Under one newly created safe harbor, however, maintenance performed on equipment or practice property generally is not considered as improving that unit of property (and, therefore, would be currently deductible).
Routine maintenance would include recurring activities that a practice principal or manager expects to perform to keep something in ordinarily efficient operating condition.
The newly proposed IRS rules allow repairs made at the same time as an improvement, but which do not directly benefit it or which were made strictly because of the improvement, to be deductible as repairs.
Using an IRS example, a company owning several trucks might decide to replace the engines and beds with new components. The cost would have to be capitalized because it is for "restoration" purposes. Should the company decide to paint the truck cabs and replace a broken tail light (both would be repair costs if made separately) at the same time the new components are installed, the painting would be a capital expenditure. But the company could currently deduct the cost of repairing the broken tail light because it does not directly benefit, and is not incurred, because of the truck restoration.
Another proposed safe harbor is designed to virtually guarantee the immediate deduction of repairs and maintenance. It applies if, at the time the equipment or property was placed in service, the veterinary practice reasonably expected to perform the activities more than once during the life of the equipment or property.
In other words, whether an expense is "routine maintenance" would depend on factors such as the recurring nature of the activity, industry practice, manufacturers' recommendations, the taxpayer's experience and the taxpayer's treatment of the activity on its applicable financial statements.
The balancing act
At the heart of our tax system is the principle that a practice's taxable income in any year should be offset or reduced only by expenses that contribute to that year's earnings. If, for example, floor space is added or a new vehicle is purchased, the practice has acquired an asset that will benefit it for a number of years.
If the practice were to deduct the full cost of that asset in the year it was acquired, income for that year would be understated — and overstated in all later years that asset remained part of the business. Thus, instead of permitting immediate deductions for equipment, assets or property of a more permanent nature, tax rules require such expenditures be capitalized.
How confusing is the IRS's reasoning? Consider its own example:
Some wooden roof shingles on a small veterinary clinic are damaged by a storm. Redoing the entire roof with wood shingles would not have to be capitalized as a betterment to the clinic, and neither would redoing the entire roof with another type of shingle if wooden ones were not available.
However, redoing the entire roof with shingles made of a lightweight, composite material that is maintenance-free, non-absorptive, has a 50-year life and a Class A fire rating would have to be capitalized as a betterment to the clinic.
For many veterinarians, the issue of how expenditures should be labeled is purely a tax question. Most want the immediate expense write-off. But, what about a new veterinary practice or one that is struggling to keep afloat? They may have little incentive to minimize taxable income and/or maximize current deductions.
In general, maintenance is defined as a periodic expenditure to preserve or retain an asset's operational status for its originally intended use, not to improve it or extend its life. A tune-up for a business vehicle, for example, would be maintenance; a new motor would be a capital expense.
The difference seemingly boils down to the impact on the practice.
Spelling out a periodic schedule for maintenance and regular routine repairs can help. Clearly separating routine maintenance or repair expenditures from a larger plan of rehabilitation or modernization can also help maximize the current tax deduction — assuming that will benefit the practice's tax bill the most.