Expenditures – Part 8

In this article we continue our “Expenditures” series of articles with some discussion regarding capital expenditures.

Capital Expenditures

You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called “capital expenditures.” Capital expenditures are considered assets in your business. There are, in general, three types of costs you must capitalize.

1. Business start-up costs
2. New business assets
3. Improvements and      restorations

New Business Assets

There are many different kinds of business assets; for example, land, buildings, machinery, furniture, trucks, patents, and franchise rights. You must fully capitalize the cost of these assets, including freight and installation charges. Certain property you produce for use in your trade or business must be capitalized under the uniform capitalization rules.

Improvements or Restorations

You must separate the costs of repairs from the costs of improvements or restorations.

A repair keeps your property in good operating condition. Work done on your property that does not add much to either the value or the life of the property, but rather keeps the property in good condition, is considered a repair rather than an improvement. You can deduct the cost of repairs as a business expense that can be deducted in the year the work is performed.

Repainting your property inside or fixing gutters or floors, fixing leaks, plastering, replacing broken windows, or replacing parts of a machine that only keep it in a normal operating condition are examples of work that can usually be classified as repairs.

An improvement adds to the value of property, prolongs its useful life, or adapts it to new uses. Some examples of improvements are:

Exterior – heating/cooling systems or additions to existing ones, fencing or block walls, new landscaping, new water heater, new roof.

Interior – kitchen modernization, flooring, storm windows/doors, wall-to-wall carpeting, electric wiring or plumbing upgrades, adding insulation.

The costs of making improvements to a business or investment asset must be capitalized. The capitalized cost can generally be depreciated as if the improvement is separate property.

You must also capitalize the cost of reconditioning, improving, or altering your property as part of a general restoration project. Furthermore, if you make repairs as part of an extensive remodeling or restoration of your property, the whole job, including tasks that would by themselves usually be classified as a repair, must be capitalized.

For example, for the rehab of a unit that includes new carpeting and/or tile throughout, painting of the interior, new window coverings, and replacement of a broken kitchen faucet, the cost of the entire project is classified as a capital improvement even though replacement of a faucet and even the painting would usually be classified as a deductible expense when done alone.

Capital Expenditures vs. Deductible Expenses

To further help distinguish between capital expenditures and deductible expenses, some additional examples follow.

Motor vehicles – You usually capitalize the cost (or a percentage thereof) of a motor vehicle you use in your business. You can recover its cost through annual deductions for depreciation or under Section 179. There are dollar limits on the depreciation (or Section 179 deduction) you can claim each year on passenger automobiles used in your business. You can continue to deduct depreciation for the unrecovered basis resulting from these limits after the end of the recovery period.

A passenger automobile is defined as any four-wheeled vehicle made primarily for use on public streets, roads, and highways and rated at 6,000 pounds or less of unloaded gross vehicle weight (6,000 pounds or less of gross vehicle weight for trucks and vans). Larger vehicles or vehicles which have specialized uses are subject to different rules.

Generally, repairs you make to your business vehicle are currently deductible. However, amounts you pay to recondition and overhaul a business vehicle (e.g., a new or rebuilt engine or transmission) are capital expenditures and are recovered through depreciation.

Tools – Amounts spent for tools and equipment used in your business are capitalized unless they are deductible under Section 179 or are deductible expenses because the tools have a life expectancy of less than 1 year or their costs are “minor.” For example, a $500 table saw must be capitalized unless it is qualifies for a Section 179 deduction and it is desired to use Section 179 rather than depreciate it.

Heating equipment – The cost of repairing a leak in a Freon line and recharging Freon is a deductible expense. The cost of changing from one heating system to another is a capital expenditure. Replacement of a failed compressor must be capitalized.

Roof – The cost of maintaining or repairing an existing roof is a deductible expense, but the cost of re-shingling a roof is a capital improvement.

Cost Recovery

Although you generally cannot take a current deduction for a capital expenditure, you may be able to recover the amount you spend through depreciation, amortization, or depletion. These recovery methods allow you to deduct part of your cost each year. In this way, you are able to recover your capital expenditure. Depreciation is the method of most interest for rental property owners.

Because costs of capital improvements are added to cost basis of the property, you will need to know the cost of improvements when you sell your property in order to minimize income taxes on a gain from its sale.

Depreciation

Depreciation is an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property.

You can depreciate most types of tangible property (except land), such as buildings, machinery, vehicles, furniture, and equipment. You also can depreciate certain intangible property, such as patents, copyrights, and computer software. Land cannot be depreciated and remains part of the cost basis.

To be depreciable, the property must:

• Be property you own,
• Be used in your business      or income-producing activity,
• Have a determinable useful      life,
• Be expected to last more      than one year, and
• Not be excepted property.

You are considered as owning property even if it is subject to a debt. Therefore, items purchased with a credit card qualify.

If you use the property to produce income (investment use), the income must be taxable. You cannot depreciate property that you use solely for personal activities. For property that has both business and personal use, only the business use percentage of the basis can be depreciated each year.

To be depreciable, your property must have a determinable useful life that extends substantially beyond the year you place it in service. This means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.

There is certain property that cannot be depreciated even though it meets the above criteria. For example, you cannot depreciate property placed in service and disposed of in the same year.

The IRS provides for different methods of calculating depreciation, assigns useful lives for a variety of categories of depreciable items, and specifies recovery periods for each category. As examples, a new computer would usually have a recovery period of 5 years, software 3 years, office furniture 7 years, a residential building 27.5 years, and a commercial building 39 years.

You begin to depreciate your property when you place it in service for use in your trade or business or for the production of income. You stop depreciating property either when you have fully recovered your cost or other basis or when you retire it from service, whichever happens first.

Property is considered placed in service when it is ready and available for a specific use, whether in a business activity, an income-producing activity, a tax-exempt activity, or a personal activity. Even if you are not using the property, it is in service when it is ready and available for its specific use.

Question

A tenant moved out leaving a large unpaid water bill. The deposit was not nearly large enough to cover it, but the owner has to pay to continue getting water service to the property. I am considering two possible actions: 1. Turn the bill over to a collection agency; 2. File a case in small claims court.

Answer

You don’t state whether the water account was in your name or in the tenant’s name or, if the latter, whether the problem is that the water provider has the legal right to make the owner liable anyway. Also, in some states utility providers have a legal right to hold the owner liable for payment of a tenant contracted utility service; in other states don’t. You need to determine whether or not the law in your state allows the water provider to hold the owner responsible for tenant-contracted service. If the account is in your name then you can be held liable no matter who was supposed to pay the bills. In either case, you will need to pay the bill and, if the lease agreement adequately makes the tenant liable, you should file a suit against the tenant.

You can use a collection service, but you will usually be much better off attempting to collect it yourself by suing the tenant, obtaining a judgment, and taking appropriate actions – e.g., liening his assets and/or his garnishing his wages. Furthermore, even if the tenant might be considered judgment proof at the moment – i.e., has no known income or assets – an original judgment can be collected for 5 to 10 years, depending on the state, and it can be renewed for additional periods in most states. Judgments obtained in one state can usually be collected in any other state, although it can require significant effort. Furthermore, judgments appear on a debtor’s credit record and the judgment must often be paid before a debtor can obtain credit – e.g., a home loan or other financing, perhaps even renting an apartment. Finally, the judgment should include legal costs and the ongoing costs of attempting to collect can usually be added to the judgment, with interest continuing to accrue on debtor’s bill until paid. The legal interest rate varies among states, but at a significantly higher rate than can usually be found anywhere else. Rates by state laws are often as high as 10 percent, whereas, it’s difficult to get more than a couple percent on CDs these days.

Regarding using collection agencies, there are numerous disadvantages compared to doing your own collections. First, the collection agency will take a significant portion of anything collected – sometimes as much as one-half. Second, some of their costs may be deducted from the gross amount collected prior to splitting the collected amount. Third, the collection agency may do very little to pursue the debt – perhaps simply make a few phone calls and/or write a few letters to the debtor, the effort depending on the amount and their estimate regarding the chance and difficulty of being successful. Fourth, the collection agency may require that you first obtain a judgment before they will make serious effort to collect. The contract with the collection agency will likely give them the right to receive their share of any amount collected from the debtor when funds are collected through no effort on their part, but is the result of your own actions or simply voluntary payment by the debtor either because of bad conscience or the need to remove the judgment from his credit report.

For any service for which the property owner can be held liable, it is by far best that the owner pay the bills directly and charge enough rent to cover the service. This is true whether or not the owner can be held liable for services not paid by the tenant. It is usually easier to obtain a judgment and/or an eviction against a tenant for failure to pay rent than for any other matter for which the tenant owes the landlord.

Are there any reasons why I might not want to have Section 8 tenants?

Answer

Section 8 has both advantages and disadvantages. The main theoretical advantage is that the government guarantees the rent. However, in practice there are many ways in which this can become untrue. For example, if the tenant originally qualifies for 100 percent subsidy and a couple of months later the tenant qualifies for only 20 percent subsidy due to a change in financial circumstances (e.g., found a job), the landlord must depend upon the tenant for 80 percent. Furthermore, rent increases are limited and require permission of the housing agency and if the market rent (FMR) goes down the rent you’ll receive is reduced. There are circumstances where the landlord may not receive payments for certain periods of time.

You also have the same problems regarding unpaid rent and damages that you have with any other tenant because the government is not responsible for the tenant’s share of rent or what the tenant does to your property. In fact, you are less likely to collect for unpaid rent and damages beyond the amount of the security deposit than for non-Section 8 tenants because the typical Section 8 tenant has less financial resources.

The most basic disadvantage of the program is that the government gets more control of your business. There is an initial inspection, annual inspections, and inspections if the tenant complains about something. Section 8 standards are often higher than habitability laws and/or what the landlord must usually do in order to attract good tenants for the particular property.

If the tenant must be evicted it is the landlord’s problem and there will be little or no help from the agency that administers Section 8. In fact, they may terminate payments upon commencement of the eviction.

Be sure you understand the program before you get involved with Section 8 and, if you do, be sure that you select tenants using the same screening and selection standards as you would for an applicant who is not Section 8, only taking into account that Section 8 will initially be paying part of the rent.

Question

Do you have the forms I need to file for an eviction?

Answer

A landlord cannot file a complaint for eviction with the court until expiration of the required period after serving the tenant with the appropriate notice. The period varies among states – it can vary from 3 to 30 days, depending on the state – and in some states it can depend on the reason for eviction. The notice period required can also depend on whether serving a “Cure or Quit” or an “Unconditional Quit” notice. The manner of service required can also vary significantly among states.

Many states provide for posting of the notice at the property. Most states allow for U.S. mail, some requiring it be sent Certified. All states allow for personal service by either the landlord or by a representative, e.g., an authorized employee or a process server. Inadequate service can mean needing to start over if the issue doesn’t come up until you and the tenant (or his attorney) are in court.

When one is not experienced in evictions, particularly when it is thought that the tenant might choose to maximize occupancy, it is often more cost effective to turn the matter over to an attorney who specializes in evictions. In some states certain entities (e.g., corporations) must be represented by an attorney.

The cost of doing it this way is usually much less than doing it improperly and having a large delay because you must start over. Also, if the tenant is represented by an attorney or appeals the eviction judgment, an attorney can probably better deal with the matter on your behalf.

If you are talking about forms that are filed with the court – e.g., the Summons and the Complaint – it is always preferable to use forms provided by the court and in many jurisdictions those are the only ones allowed. It is even possible that requirements vary among different courts within the same state. Accordingly, landlords should use the forms provided by the particular court and follow the specified procedures, including proper preparation of the forms, attachment of required documents (many courts require copies of all lease documentation) and the proper method and the timelines related to service.