Expenditures between Landlords and Tenants – Part 7
Expenditures – Part 7
In this article we explore a little further certain issues related to non-deductible expenditures, the subject introduced in Part 6 of this “Expenditures” series – that is, expenditures that must be depreciated, amortized, or added to basis rather than deducted in the year of expenditure. We’ll first briefly discuss a way of calculating depreciation that results in larger deductions in the early years of ownership. Then, we’ll take very brief looks at those expenditures that must be amortized and those that must be added to basis. Finally, we’ll briefly consider Section 179 of the IRS code, which provides a way to deduct the full cost of certain normally capitalized expenditures in the year made.
Component Depreciation
Real property, whether acquired or constructed, often consists of numerous asset types with different recovery periods.
One can usually increase the amount of depreciation in the early years of ownership by depreciating individual components of an improvement rather than the total value of the improvements which is the cost of the property less value of the land. This is often referred to as cost segregation.
Thus, property must be separated into individual components or asset groups having the same recovery periods and placed-in-service dates in order to properly compute depreciation.
When the actual cost of each individual component is available, this is a rather simple procedure. However, when only lump-sum costs are available, cost estimating techniques may be required to “segregate” or “allocate” costs to individual components of property (e.g., land, land improvements, buildings, equipment, furniture and fixtures, etc.). This type of analysis is generally called a “cost segregation study,” “cost segregation analysis,” or “cost allocation study.”
This method results in an accelerated depreciation method because it results in greater depreciation in the early years, with less in later years because many components of a building and other improvements have considerably shorter useful lives than the life allowed for the overall improvement, 27.5 years for residential property and 39 years for commercial property. The fact that useful lives for various components can be significantly less than that allowed for the entire property (e.g., 3, 5, 7 . . . . years), means significantly larger depreciation can result from cost segregation.
Although the procedure is simple in theory, utilizing it requires adequate knowledge of component costs as well as consideration of accrued depreciation if not new construction. Accordingly unless the subject property is new construction for which a breakdown of costs is available, determination of the depreciation schedule is usually best done by qualified experts so as to minimize the chance of disputes with the IRS in the event of an audit. The cost of such expertise can offset any benefit from the method, particularly for smaller properties that are not new construction.
Amortized Expenses
There are certain expenditures that cannot be deducted under IRS rules and yet can’t be depreciated because they are not property. Such expenditures can, however, be amortized. For real estate investment, the most common amortized items are related to loans. Certain items paid to obtain a mortgage on a rental property cannot be deducted in the year paid and must be amortized. Costs that must be amortized include:
- Mortgage broker commissions or other professional services related to financing,
- Abstract or title insurance fees related to financing rather than purchase, and
- Financing-related recording fees.
The Internal Revenue Code defines the period over which amortization must done.
Costs Added to Basis
There are other expenditures that cannot be deducted, depreciated, or amortized. These costs must be added to basis. Closing costs incurred when buying a rental property include a number of such items. The only deductible closing costs are those for interest, and deductible real estate taxes. Other settlement fees and closing costs for buying the property become additions to your basis in the property. These basis adjustments include:
- Abstract or title insurance fees related to purchase rather than financing,
- Charges for installing utility services,
- Legal fees related to purchase rather than to operations,
- Purchase-related recording fees,
- Surveys,
- Transfer taxes, and
- Any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.
Section 179 Deduction
Section 179 of the United States Internal Revenue Code allows a taxpayer to elect to deduct the cost of certain types of property on their income taxes as an expense, rather than requiring the cost of the property to be capitalized and depreciated. This property is generally limited to tangible, depreciable, personal property which is acquired by purchase for use in the active conduct of a trade or business.
Within the limits of IRS regulations, the costs of many items of tangible personal property that normally require depreciation can instead be wholly or partially expensed as a Section 179 deduction. The Section 179 deduction is limited by type of item and by both a fixed maximum amount and the fact that it cannot reduce net income below zero. However, the deduction not allowed for any year can be carried over to the next year.
Real property (land and land improvements) such as buildings and other permanent structures and their components are not personal property and do not qualify. Land improvements include swimming pools, paved driving and parking areas, docks, bridges, and fences. Both the ‘Tax Relief Act of 2010’ and the ‘Jobs Act of 2010’ that passed in late 2010 affected Section 179 for the 2012 tax year.
The maximum deduction a taxpayer could elect to take was $500,000 for 2010 and 2011, is $139,000 for 2012 (new and used equipment, as well as off-the-shelf software), and will be $25,000 for years beginning after 2012. The last amount will be adjusted for inflation as the rate of inflation for a given year becomes available. Buildings were not eligible for Section 179 deductions prior to the passage of the Small Business Jobs Act of 2010, whereas qualified real property may be deducted now.
Second, if a taxpayer places more than $2,000,000 worth of Section 179 property into service during a single taxable year, the Section 179 deduction is reduced, dollar for dollar, by the amount exceeding the $2,000,000 threshold. This threshold is reduced to $560,000 for years beginning in 2012, and $200,000 thereafter. The Section 179 Threshold for total of equipment and software that can be purchased has increased to $560,000 for 2012. This is the maximum amount that can be spent on equipment before the Section 179 Deduction available to your company begins to be reduced.
The new law allows 50% “Bonus Depreciation” on qualified assets placed in service during 2012. – can be taken on new equipment only (no used equipment, no software). Bonus Depreciation can also be taken by businesses that will have net operating losses in 2012.
To qualify for the Section 179 deduction, your property must be one of the following types of depreciable property.
1. Tangible personal property.
2. Other tangible property (except buildings and their structural components) used as:
- An integral part of manufacturing, production, or extraction or of furnishing transportation, communications, electricity, gas, water, or sewage disposal services,
- A research facility used in connection with any of the activities in (a) above, or
- A facility used in connection with any of the activities in (a) for the bulk storage of fungible commodities.
3. Single purpose agricultural (livestock) or horticultural structures. See chapter 7 of IRS Publication 225 for definitions and information regarding the use requirements that apply to these structures.
4. Storage facilities (except buildings and their structural components) used in connection with distributing petroleum or any primary product of petroleum.
5. Off-the-shelf computer software.
Tangible personal property is any tangible property that is not real property. It includes the following property.
- Machinery and equipment.
- Property contained in or attached to a building (other than structural components), such as refrigerators, grocery store counters, office equipment, printing presses, testing equipment, and signs,
- Gasoline storage tanks and pumps at retail service stations, and
- Livestock, including horses, cattle, hogs, sheep, goats, and mink and other furbearing animals.
The treatment of property as tangible personal property for the Section 179 deduction is not controlled by its treatment under local law. For example, property may not be tangible personal property for the deduction even if treated so under local law, and some property (such as fixtures) may be tangible personal property for the deduction even if treated as real property under local law.