Expenses, Repairs -vs- Improvements

[CL Ziegler]

Hi Everyone,

On my last three tax returns my CPA surprised me by prorating several of my HUGE expenses, citing that they were improvements so the full amount can't be claimed on one year's return. (he diviede them over ten or twelve, I forget) He based this on the amount of the expense; that is how he defined it as an improvement.

Does the amount define which category it goes in? Is that accurate? I feel like I got hammered in the past three years but now I'm rethinking, considering getting a second opinion, perhaps file a revised 1040.

Here is an example:

In two separate units I had the same problem: rotting bathroom floor and some sub-structure. In each case we gutted the bathroom and rebuilt it from the joists up, new sheet rock, floor, shower stall, small vanity, paint etc. If all I did was to restore it to its original usefulness, without adding anything new, then why would that be considered a 'property improvement'? I don't get it.

If you were me based on the info given here, how would you proceed?

Hope someone can offer some insight.

Thanks so much,

[Paul Caputo]

Your CPA is right and wrong. The IRS doesn't care if your CPA is right or wrong, all they care about is if you paid what you're supposed to pay. 

In your example your CPA has actually been under-conservative as opposed to the over-conservative stance he thinks he's taking. Bathrooms are specifically included in general maintenance or operation of a building for "human comfort" and are therefore considered 1250 property depreciated over 27.5 years for a rental or 39 years for commercial property. So even though many of the things in the bathroom that you replaced would be 1245 property elsewhere in the building, since it's in the bathroom it doesn't qualify. Say you remodeled the kitchen on the other hand: most of those improvements would be tangible personal property and qualify for 5 year accelerated depreciation as 1245 property. The problem is there are no bright line tests for reclassifying property as illustrated above. All sinks are not depreciated equally, it depends on where they are and how they're used. It's all based on the facts and circumstances of your individual situation. 

Restorations are considered improvements, because you had an asset that had fallen into disrepair you improved it by restoring it to original usefulness. If the asset hadn't fallen into disrepair you wouldn't have had to restore it. Does that make sense? More broadly basically anything tangible in the property would be considered an improvement. The entire building is an improvement on the bare land. 

Problems arise when you don't get it right. Depreciating that bathroom over 10 years (Very few things with 10 year lives unless you're manufacturing sugar or vegetable oil or using ADS which you shouldn't do unless required, not sure where he pulled that number) when it should be 27.5 years gives you almost triple your allowable depreciation per year. The IRS doesn't like that so it opens you up to fines and penalties. But inversely say it's the kitchen stuff and depreciating it over 10 years when it should be 5 years gives you half your allowable depreciation and then the IRS can disallow further depreciation in years 6-10. No fine or penalty but you only get half of what you should've. 

You basically have three options when it comes to depreciation: 

The easy way - lump everything together as 1250 property and depreciate over 27.5 years.

The Quasi-right way - Do simple cost segregation from your records with your CPA to classify some things as 1245 property depreciated over 5, 7 or 15 years and some as 1250 property depreciated over 27.5 years. The issue here is getting it right. Hint: this is never 100% accurate.

The best way - Have an engineered cost segregation study breakdown the property into tangible personal property depreciated over 5 years (7 year is rare, but possible), land improvements depreciated over 15 years and building components depreciated over 27.5 years. A study provides the necessary documentation to substantiate the reclassification. 

You do need to bear in mind that if you are planning on doing a 1031 exchange in the future and do cost segregation the replacement property must have comparable levels of 1245 property and 1250 property or you could be looking at a big tax bill. The intelligent way to go about that would be to have a cost segregation study on the replacement property as well. This double cost segregation strategy works best when you are trading up in value considerably with the replacement property.

A nice thing about this is it doesn't require any amended returns and the IRS lets you catch up on previously unclaimed depreciation with a section 481(a) adjustment in the current year that is given automatic consent by the IRS Commissioner. I'd recommend never filing amended returns because that can cause an Audit.