Individuals with real estate businesses often expect to deduct business-related expenses for tax purposes. But those tax deductions might not be a guarantee. Many real estate development costs are required to be capitalized and added to the cost of the building. In this case, there are additional rules to determine if building costs qualify for depreciation or deductible expenses due to the type of expenses. In other cases, you may need to consider a cost segregation study to separate costs into categories. This article summarizes the range of tax rules that apply to real estate and its component costs.
REAL ESTATE DEVELOPMENT COSTS
The Tax Cuts and Jobs Act of 2017 (TCJA) was the most recent discussion of real estate development. Real estate developers need to consider when to capitalize and when to expense costs incurred before, during and after production. Additional analysis may be required to determine the recognition of costs, depending on whether the taxpayer is considered a large business taxpayer or a small business taxpayer.
The threshold to follow whether small businesses meet the exception for capitalization guidelines under Section 263A was increased to $25 million. This provides an opportunity for small business taxpayers to potentially deduct certain indirect expenses related to the production of real property in the year the deductions are incurred. A small business taxpayer must meet the gross receipts test under Section 448(c) and not be considered a tax shelter. The gross receipts test is met if the taxpayer's average annual gross receipts for the past three taxable years do not exceed $25 million (this amount is adjusted for annual inflation). The taxpayer must consider the aggregation rules and include other entities to meet those rules in determining the gross receipts figure.
If an entity is under the $25 million gross receipts threshold, only direct costs associated with the production of real property are required to be capitalized. Other costs such as interest, real estate tax and insurance may be expensed as incurred and not capitalized in the basis of the real property. If the entity currently meets this exception threshold as a small business taxpayer (and previously did not under prior tax law), the taxpayer is required to file Form 3115 to elect a change in accounting method for new regulations. If a taxpayer does not file a change in accounting method, it will be treated as a large business taxpayer.
For those entities exceeding the gross receipts threshold of $25 million, the recording of costs is not as straightforward. These entities are required to follow the regulations under Code Section 263A which require capitalization of certain indirect costs related to the production of real property. Here is a summary of how those costs should be recorded before, during and after the production period.
The production period for the real property begins the date that any physical production activity takes place with respect to the unit of real property. A summary of examples include:
- Clearing, grading, or excavating of raw land;
- Demolishing or gutting a building;
- Engaging in the construction of infrastructure, such as roads, sewers, sidewalks, cables and wiring;
- Undertaking structural, mechanical, or electrical activities with respect to a building; or
- Engaging in landscaping activities.
In the case of real property constructed by the taxpayer for use in a trade or business, the production period ends when the property is placed in service. In the case of property developed for sale, the production period ends when the property is ready to be held for sale.
All direct production costs of the property must be capitalized. For real estate taxes, developers must capitalize them, even if no development has taken place if it is reasonably likely when the taxes are incurred that the property will be subsequently developed. For interest expense, interest incurred before the production period begins may be deducted as investment interest expense. Once the production period begins, interest expense should be capitalized using the avoided cost method. For this purpose, any interest that would have been avoided if production expenses had been used to repay or reduce outstanding debt must be capitalized. At the end of the production period, interest would again be deductible. For insurance expense properly allocable to the production, it must be capitalized and included in the basis of the asset when production is complete. These costs should be capitalized during the pre-production period if it is reasonably likely that production will occur at some future date.
REAL ESTATE ACQUISITION COSTS
When a taxpayer already has acquired a building or has recently added improvements to the building, there are many aspects that need more information. For example, real estate is often used for office space and depreciated over the tax life of the building. Commercial real estate is assigned a 39-year tax life under the modified accelerated cost recovery system (MACRS) and the cost of the building is often a small tax benefit allocated over the longer term. A building acquired and held for resale is not depreciated, so a sale results in the offset of building costs.
Early in 1997, the Tax Court held in the Hospital Corp of America case, that there are many components and structures in a building that should be viewed separately. For example, the case determined that air conditioning, heating, electrical, plumbing and elevators are separate structures with unique tax lives. When the tax life is 20 years or less, the benefit is not only a shorter life (and faster tax depreciation), but also accelerated tax depreciation is allowed. Since that time, the IRS has rewarded small businesses with bonus depreciation (up to 100% depreciation in the first year) or Section 179 expense (electing to claim depreciation against the profit). Many taxpayers choose the best option for them and a cost segregation study allows engineers to review and allocate costs to each component and structure.
REAL ESTATE REPAIRS AND MAINTENANCE COSTS
When a taxpayer spends on repairs and maintenance costs, it is difficult to determine whether the costs are new assets or a replacement of old costs. The IRS created tangible property rules to offer some new guidance when repairs are capitalized or deducted. These rules are based on what constitutes a Unit of Property and repairs are assigned based on the building, a component or structure, or separate units.
Generally, capitalized costs are required for repairs of units of property that result in:
- Betterment of property;
- Restoration of property; or
- Adaptation of use.
A betterment tries to ameliorate an old material condition or defect, including adding material size to the unit of property or adding a material increase in capacity, productivity, efficiency, quality, etc. A restoration tries to fix a unit of property not functional for use or reinstate a unit of the property after end of life, especially if there was a casualty loss. An adaption tries to update the property to a new or different use, including conversion of retail space to residential space. For example, a roof repair could be either a capitalized cost or expense, depending upon the extent of the repair and the replacement of the roof. Additional guidance is provided when the cost of the old roof has been replaced and can be written off.
Related Read: Did You Repair Your Real Estate Property or Improve it?
MANAGE YOUR BUSINESS EXPECTATION
If you are looking to deduct real estate expenses, be sure you are able to support your position that the costs are properly defined and applied to the proper category of expenses. In some cases, a building may require a cost segregation study to allocate the development costs to its components.
Related Read: Using Cost Segregation Studies for Like-Kind Exchanges
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.