Purchasing a medical building or equipment, such as an MRI machine, can be a savvy investment move for physicians seeking to build their personal wealth portfolio.
Purchasing a medical building or equipment, such as an MRI machine, can be a savvy investment move for physicians seeking to build their personal wealth portfolio. When evaluating these investments, the returns are often impacted by the ability and timing of depreciation as well as the deduction of expenses to maintain them.
Newly issued IRS regulations on the tax treatment of amounts paid to acquire, produce or improve tangible property may impact those decisions. The regulations explain when those payments can be deducted, which results in an immediate tax benefit, and when they must be capitalized.
Capitalize or to deduct?
The regulations set forth the general rule that amounts paid to improve a unit of property must be capitalized and deducted over a period of time through depreciation. An improvement is defined as an expenditure that betters a unit of property, restores it or adapts it to a new and different use. The narrowing of the scope allowing deductions could negatively alter the return on your investment.
On the other hand, the regulations still allow a current deduction for repairs and maintenance to a property. The navigation of these rules will impact the immediate benefit of updating carpets, repairing your roof, reupholstering furniture in your lobby or upgrading a component of your medical equipment.
Unit of property defined
One key concept in the new regulation is the definition of "unit of property" (UOP) that is being improved or repaired. The smaller the UOP, the more likely it is that costs incurred in connection with it will have to be capitalized. For example, work on an engine of a vehicle is more likely to be classified as a cost that must be capitalized if the engine is classified a separate UOP. By contrast, if the UOP is the vehicle, the engine work has a better chance of passing muster as a repair.
Property other than buildings
In general, for property other than buildings, a single UOP consists of all components that are functionally interdependent, such that one component can't be placed in service without the other components. Meaning equipment has to be fully installed and functional in all capacities before it can be considered “placed in service” for deduction or capitalization.
When it comes to buildings, the regulations generally treat each building and its structural components as one UOP-the "building." The regulations also list nine specific building systems that are treated as separate from the building structure. An improvement to the building is defined by its effect on those systems, rather than on the building as a whole. Those systems include HVAC, plumbing, electrical, escalators, elevators, fire protection/alarm, security, gas distribution, and other components as specifically identified in published guidance.
Under old rules, a building owner that incurs $20,000 in costs to fix piping in the plumbing system likely would be able to consider a repair as it is relatively small compared to the overall building cost, which was treated as a single UOP. Under the new rules, the plumbing system is one of the nine defined building systems and therefore is considered a separate UOP. As a result, the $20,000 needs to be measured against the plumbing system cost, not the building cost potentially resulting in a capitalization and depreciation over 39 years.
Deducting materials and supplies
A deduction is allowed for amounts paid to produce and acquire materials and supplies that are consumed during the year. Materials and supplies are defined to include five specific categories of property used or consumed in the business operations. Under the final regulations, this rule applies to UOPs that cost $200 or less to acquire or produce.
De minimis safe harbor
The regulations allow a taxpayer to deduct certain limited amounts paid for tangible property that are expensed for financial accounting purposes. A taxpayer with an AFS may rely on the de minimis safe harbor if no more than $5,000 per invoice, or per item as substantiated by the invoice, was paid for the property. For businesses without an AFS, the maximum figure is $500 rather than $5,000.
To use the safe harbor, the business must have accounting procedures in place at the beginning of the tax year that treat as an expense amounts paid for property that costs less than a specified dollar amount or has an economic useful life of 12 months or less.
Routine maintenance safe harbor
The regulations include a safe harbor that allows certain expenses of routine maintenance to be deducted rather than capitalized. Routine maintenance means recurring activities that keep business property in ordinarily efficient operating condition, such as inspection, cleaning, testing, and replacement of damaged or worn parts.
For a building structure or system, the taxpayer must reasonably expect to perform the maintenance more than once during the 10-year period that begins when the structure or system is placed in service. For property other than buildings, the taxpayer must reasonably expect to perform the activities more than once during the property's class life for depreciation purposes.
Per-building safe harbor for qualifying small taxpayers
The final regulations add a new safe harbor that allows qualifying small taxpayers-those with average annual gross receipts of $10 million or less in the three preceding tax years-to deduct improvements made to a building property with an unadjusted basis of $1 million or less. This safe harbor applies only if the total amount paid during the tax year for repairs, maintenance, and improvements to the building doesn't exceed the lesser of $10,000 or 2% of the building's unadjusted basis. This safe harbor may be elected annually on a building-by-building basis. It is elected by including a statement on the tax return for the year the costs are incurred for the building.
The regulations aren’t all bad news, the IRS is expected to issue additional guidance, but there may be an opportunity under §6.29 of Rev. Proc. 2012-20 to deduct a loss of the building component that is being replaced. For instance, in the event of the plumbing improvement above of $20,000, the original component that failed may be separated from the UOP and disposed of allowing for a loss to be taken for the unrecovered basis with a change in accounting method.
The new regulations must be followed for tax years that begin after Dec. 31, 2013 — whether a calendar year or a fiscal year, such as a fiscal year beginning July 1, 2014. Taxpayers have the option of applying the final regulations retroactively to the 2012 and 2013 tax years. There's also a third option to apply the temporary regulations to the 2012 and 2013 tax years.
New regulations are complex and will likely require changes to your accounting practices like drafting a capitalization policy, but they also may create tax planning opportunities as well.
Gregory L. Gandy, CPA, is a Director at BiggsKofford, CPAs, a Colorado Springs based accounting and consulting firm. Mr. Gandy leads the Real Estate Services Group, services include structuring the acquisition and disposition of real estate, entity structuring, and tax deferred exchanges, conservation easements, and cost segregation studies. Mr. Gandy can be reached at (719) 579-9090 ext 216, or via email at GGandy@BiggsKofford.com.