– By Mark Battersby –
Don’t miss out on deductions for depreciation that you’re entitled to take.
As many rural builders have learned, our ever-changing tax rules make it difficult to get the full tax deduction they are entitled to for the tools, equipment and even the vehicles that are so essential to every building business. The so-called “Extenders” tax law passed late in 2014 did extend the first-year write-off for so-called “Section 179 expenses” and “bonus” depreciation—but only for the 2014 tax year.
In general, business property can be depreciated so long as it has a useful economic life exceeding one year and wears out or becomes obsolete over time. The Modified Accelerated Cost Recovery System (MACRS) is used to calculate depreciation deductions for U.S. tax purposes.
Depreciation begins when business property is placed in service; in other words when it is ready and available for use. Determining the amount of depreciation allowed also involves the building operation’s “basis,” the operation’s investment in the depreciable property. With purchased property, for instance, the basis is generally its cost.
MACRS dictates the class and depreciation method for all business property, prescribing the number of years over which the investment in depreciable business property may be recovered. Nine different property classes are defined under the MACRS General Depreciation System. In some situations, a builder or contractor can choose to use an Alternative Depreciation System (ADS) for some property. Figuring depreciation under the ADS method essentially slows annual depreciation, preserving larger depreciation deductions for later years.
Identifying the proper “class” of business property is essential under the MACRS depreciation system. Tractors used over the road are usually considered to be three-year property while trucks are classed as five-year property. Machinery and equipment fall into the seven-year category and commercial buildings have a 39 year “useful” life.
Depreciation deductions and write-offs can only be claimed by the “owner” of the property. Although it is not at all unusual for an owner or shareholder to purchase the equipment used by the building business, the IRS often sees a problem.
This type of transaction is not a problem for a sole proprietorship since the business and the owner are one in the same. An incorporated building business or a partnership, on the other hand, may run afoul of the tax rules. After all, the depreciation deduction belongs to the owner, as would the interest on the loan or any lease payments.
The dilemma commonly arises when a business owner can’t buy the equipment in the business’s name because of credit issues or when the equipment is purchased before the corporation or partnership exists. Our tax laws allow a tax-free transfer of equipment. Most states also contain sales tax exemption for such transfers.
There may be other options, such as retaining ownership of a vehicle and having the business reimburse the operator for the business use. Or having the business reimburse the owner for the purchase. To maintain flexibility, every building business should make sure all lease contracts or loan agreements allow the transfer of ownership.
There has long been an argument whether certain expenditures are “repairs,” or whether they are actually “capital expenditures” that must be capitalized and their cost recovered through annual depreciation deductions. In general, repairs to equipment, machinery and buildings, along with maintenance costs, are deducted in the year paid since their purpose is to keep the property in operating condition. Because “improvements” to equipment, machinery or buildings can add to its value, prolong its useful life and/or adapt it to a different or new use, they must be capitalized and depreciated.
The IRS, using a number of cumbersome and confusing Revenue Rulings, has attempted to clarify what is and what isn’t a repair. They’ve even created a “safe harbor” that allows a limited amount of capital expenditures to be labeled as repairs and immediately deducted.
The new simplified procedure is available to small building businesses, including sole proprietors, with assets of less than $10 million or average annual gross receipts totaling $10 million or less. The safe harbor deduction is for amounts paid for improvements and repairs to an eligible building. An eligible building is one with a tax basis, before depreciation, of $1 million or less. A qualifying “small” business can deduct the smaller of $10,000 or 2 percent of the cost of a qualifying building for improvements, no questions asked.
Another safe harbor, this one for expensing write-offs for so-called “routine maintenance,” covers the inspection, cleaning, and testing of the operation’s property and replacement of parts with comparable and commercially available and “reasonable” replacement parts. Unfortunately, to be considered routine maintenance, the builder or contractor must expect to perform these services more than once during the class life (generally the same period as depreciation).
To take advantage of the new IRS regulations and safe harbors, many builders and contractors may have to change the way they treat repairs, maintenance or capitalization, changes that may involve switching to a new accounting method. According to the IRS, a taxpayer that previously claimed a repair expense that should have been capitalized must request a change in accounting methods in order to capitalize the previously declared expense. This will also require an adjustment to the building operation’s income equal to the amount that was previously claimed on the repair.
Conversely, a previously capitalized repair may be deductible under the tax regulations and filing an accounting method change would result in a favorable adjustment equal to the capitalized amount reduced by any depreciation already claimed.
Fortunately, the IRS has made it easier for small building businesses to comply with the final tangible property regulations. The new procedure allows some builders and contractors to change a method of accounting under the final tangible property regulations. Also, the IRS has waived the requirement to complete and file a Form 3115, Application for Change in Accounting Method for building businesses that choose to use the new, simplified procedure.
Under Section 179 of the Internal Revenue Code, our basic tax law, builders, contractors and other businesses can elect to deduct all or part of the cost of qualifying depreciable assets in the year the assets are placed in service. Section 179 expense deductions are limited to the building operation’s income from all sources and a total dollar amount that varies by tax year.
Property purchased, and used over 50 percent of the time in the business, qualifies. In 2015, the Section 179 expense dollar limitation is $25,000. That limit is reduced, dollar-for-dollar, by the amount equipment acquisitions are in excess of $200,000. Any amount of a property’s cost deducted using Section 179 must be subtracted from the property’s basis before depreciation deductions are calculated.
Unfortunately, bonus depreciation was extended only for one year—2014—but can be taken in the 2015 tax year for completed buildings begun in 2014 or earlier.
From a business standpoint, now might be a good time to replace old, worn-out property. Regardless of how tight cash is, there comes a time when replacement is required such as when the efficiency of machinery has declined beyond a certain point and downtime and repair costs are rising rapidly. Naturally, seeking professional assistance is strongly recommended for any builder or contractor seeking smaller tax bills. RB
Mark Battersby has more than 35 years experience in small business issues, tax and financial matters. Contact him at 610-789-2480 or MCBatt12@Earthlink.net.