One of the more vexing tax accounting issues for property owners has long been the proper treatment of expenditures related to improvements of tangible property, such as buildings, machinery, equipment, furniture and vehicles. Specifically, should you expense the cost, which provides a current deduction, or capitalize it, recovering the cost over time through depreciation?
The final IRS tangible property regulations released a few years ago generally require you to capitalize amounts paid to improve a property. But they also include some relief for smaller businesses in the form of the small taxpayer safe harbor. If you qualify, you can elect to deduct the costs of work performed on owned or leased buildings.
To qualify for the safe harbor, you must:
Gross receipts include your total sales (net of returns and allowances) and all amounts received for services, as well as income from investments (for example, dividends, rents and interest) and from incidental or outside sources. These amounts need not be related to your business. If, however, you’ve sold capital assets or property you used in your business, your gross receipts are reduced by the adjusted basis in the property. Eligible property includes buildings, condos, cooperatives and leased buildings, or part of a building.
In addition, the total amount paid during the taxable year for repairs, maintenance, improvements or similar activities performed on the building property can’t be more than the lesser of 2% of the unadjusted basis of the eligible building property (typically your original cost) or $10,000.
The total amounts paid include any amounts that you’ve deducted, instead of capitalized, under the final regulations’ de minimis or routine maintenance safe harbors.
Applying the Safe Harbor
If the small taxpayer safe harbor applies and you make the election, you can deduct your costs as business expenses or expenses for the production of income in the tax year you paid them, as long as they otherwise qualify for a deduction.
Bear in mind, though, that the passive activity loss rules could prevent you from enjoying the immediate benefit of the deduction. It’s typically better to carry forward the losses, though, than to capitalize costs and therefore run the risk of having to pay recapture tax on gain when you sell the property.
You must make the election annually and on a building-by-building basis. That means you can pick and choose which properties to apply it to each year, and the fact that one building doesn’t qualify has no effect on whether others do.
However, if your total amounts paid on a particular property exceed the limit, none of the amounts will qualify for the safe harbor. Some of those amounts might, however, qualify for expense treatment under the de minimis or routine maintenance safe harbors (although those safe harbors come with stricter limits on the amount you can deduct).
As with so many tax provisions, some planning is required to get the most out of the small taxpayer safe harbor. It pays to think ahead when it comes to getting the current deductions you need to offset income.