The building system value, referred to as the unit of property, or UOP, is the reference point from which capitalization decisions are applied. Under the new UOP definition, expenditures relating to each building system must be evaluated as repairs or improvements only with respect to that particular system and not with respect to the entire building.
Taking advantage of cost segregation studies to provide significant tax benefits for their businesses by accelerating the depreciation on qualified fixed assets.
By depreciating the personal property costs of such assets over five or seven years (and land improvements over 15 years instead of the typical 39-year recovery period for general building property), the additional deductions can be used to offset taxable income. This accelerated depreciation, in turn, provides additional cash flow.
Now, due to the favorable tax law changes in the IRS tangible property regulations, those potential savings are more valuable than ever to your company’s financial future. These new IRS tangible repair regulations give taxpayers a second reason to engage in a cost segregation study: the future. Rather than focusing on the benefit of current or previous year tax deferral as in past studies, cost segregation studies have now become a multi-use tool now that can help ensure that taxpayers are complying with the final repair regulations.
More specifically, the new IRS rules made significant changes in the way companies deducted repairs and asset dispositions by setting more defined guidelines for what assets a business can expense and what assets can be capitalized.
The determining factor of what defines a repair expense versus a capitalized improvement cost now lies in a case-by-case analysis of the scenario requiring the expenditure, rather than a review of the overall costs incurred. In most cases, the tax benefits resulting from expensing versus capitalizing are significant. The difference means a company is able to take an immediate deduction of the full remaining asset basis versus an incremental deduction spread out over many years.
According to the new regulations, any expenditure resulting in the “betterment” of the facility must be capitalized. That means any costs simply relating to keeping the property in an ordinary operating condition or restoring it to the same condition when it was placed in service can be expensed.
Any time the expenditure creates a material increase in strength, capacity, productivity, efficiency, quality or output, those costs should be capitalized as a “betterment.” Some examples of repairs that may potentially qualify as an immediate expense would be roof membrane replacements, new HVAC system components and a “refresh” office remodeling where only the finishes are replaced.
In the past, cost segregation studies were used solely to break out the personal property and land improvement costs from the overall building construction or acquisition costs. The unit of property was generally the entire building, including the structural components. However, in the final IRS regulations, the improvement analysis requires businesses to segregate their real property building costs into the building structure along with eight additional defined building systems:
Heating, ventilation and air conditioning (HVAC) system;
• Electrical system;
• Plumbing system;
• Gas distribution system;
• Fire protection & alarm;
• Security system
The challenge for taxpayers seeking to take advantage of this change is clear: to benefit from these dispositions, they must develop a consistent and accepted method for placing a value on individual real property assets, which had previously been lumped into the 39-year “building” recovery period. A cost segregation study, when performed by qualified professionals, can break out real property assets into various additional categories to allow companies to write-off capitalized repairs and maintenance costs in future years.
In addition to the eight additional UOP systems required by the repair regs, additional levels of real property can be broken out for future retirement identification purposes. For example, a new hotel property might request to have their carpeting, light fixtures and bathroom tile by floor. In this way, if the hotel undergoes a remodeling of certain floors and that property is disposed at a later date, the owner will benefit from defined and accepted values for each those components.
Each building and its structural components is a separate unit-of-property. In determining whether an expenditure is an improvement, the taxpayer must consider the effect of the expenditure on the building structure itself and on certain specifically defined components of the building (the "building systems"). Each of the following "building systems" is defined as a separate unit-of-property:
The ultimate result of the regulations is to reduce the size of the unit-of-property which increases the likelihood that an expenditure will need to be capitalized as an improvement. For example, if a taxpayer had an expenditure related to its building roof, the unit-of-property to use in determining if it is a capitalized improvement or a deductible repair is the building since the roof is not included in one of the separate building systems. For an expenditure to repair several of the building's rooftop air conditioner units, however, the appropriate unit-of-property to use in determining if it is a capitalized improvement or a deductible repair is the HVAC system (a smaller unit-of-property than the building) since the HVAC system is one of the specifically defined building systems.
Most taxpayers have previously treated the entire building as the unit-of-property. With the addition of these new regulations, most taxpayers that own buildings will need to make an accounting method change to adopt the new definition of unit-of-property as it relates to buildings.
Under the new tax law (effective as of 01/01/2018) non-structural assets installed to the interior of a building after the building is originally placed in service are considered Qualified Improvement Property, or QIP. The intent of the law these assets were supposed to be considered bonus depreciation eligible.
In most cases, renovation project improvements expands not only interior improvements, but also other building component systems such as exterior facades, HVAC systems, Elevators, Escalators, load bearing walls, etc. A cost segregation study may be necessary to break out the assets that are not QIP. Without an analysis to break apart the QIP from the remaining assets a taxpayer will not be able to maximize the bonus eligible property.
Additionally if a renovation is combined with an expansion, a study will be required to separate the assets included in the expansion from the assets in the original space. When a taxpayer completes a renovation a discussion should be had with a trusted professional to determine if a study is necessary to determine the amount of QIP.
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