Investor · Albany, GA · Member since 2014 · 70 posts · 8 votes
Hi Everyone,
On my last three tax returns my CPA surprised me by prorating several of my HUGE expenses, citing that they were improvements so the full amount can't be claimed on one year's return. (he diviede them over ten or twelve, I forget) He based this on the amount of the expense; that is how he defined it as an improvement.
Does the amount define which category it goes in? Is that accurate? I feel like I got hammered in the past three years but now I'm rethinking, considering getting a second opinion, perhaps file a revised 1040.
Here is an example:
In two separate units I had the same problem: rotting bathroom floor and some sub-structure. In each case we gutted the bathroom and rebuilt it from the joists up, new sheet rock, floor, shower stall, small vanity, paint etc. If all I did was to restore it to its original usefulness, without adding anything new, then why would that be considered a 'property improvement'? I don't get it.
If you were me based on the info given here, how would you proceed?
Cost Segregation Specialist · Naperville, IL · Member since 2016 · 204 posts · 168 votes
9y
Your CPA is right and wrong. The IRS doesn't care if your CPA is right or wrong, all they care about is if you paid what you're supposed to pay.
In your example your CPA has actually been under-conservative as opposed to the over-conservative stance he thinks he's taking. Bathrooms are specifically included in general maintenance or operation of a building for "human comfort" and are therefore considered 1250 property depreciated over 27.5 years for a rental or 39 years for commercial property. So even though many of the things in the bathroom that you replaced would be 1245 property elsewhere in the building, since it's in the bathroom it doesn't qualify. Say you remodeled the kitchen on the other hand: most of those improvements would be tangible personal property and qualify for 5 year accelerated depreciation as 1245 property. The problem is there are no bright line tests for reclassifying property as illustrated above. All sinks are not depreciated equally, it depends on where they are and how they're used. It's all based on the facts and circumstances of your individual situation.
Restorations are considered improvements, because you had an asset that had fallen into disrepair you improved it by restoring it to original usefulness. If the asset hadn't fallen into disrepair you wouldn't have had to restore it. Does that make sense? More broadly basically anything tangible in the property would be considered an improvement. The entire building is an improvement on the bare land.
Problems arise when you don't get it right. Depreciating that bathroom over 10 years (Very few things with 10 year lives unless you're manufacturing sugar or vegetable oil or using ADS which you shouldn't do unless required, not sure where he pulled that number) when it should be 27.5 years gives you almost triple your allowable depreciation per year. The IRS doesn't like that so it opens you up to fines and penalties. But inversely say it's the kitchen stuff and depreciating it over 10 years when it should be 5 years gives you half your allowable depreciation and then the IRS can disallow further depreciation in years 6-10. No fine or penalty but you only get half of what you should've.
You basically have three options when it comes to depreciation:
The easy way - lump everything together as 1250 property and depreciate over 27.5 years.
The Quasi-right way - Do simple cost segregation from your records with your CPA to classify some things as 1245 property depreciated over 5, 7 or 15 years and some as 1250 property depreciated over 27.5 years. The issue here is getting it right. Hint: this is never 100% accurate.
The best way - Have an engineered cost segregation study breakdown the property into tangible personal property depreciated over 5 years (7 year is rare, but possible), land improvements depreciated over 15 years and building components depreciated over 27.5 years. A study provides the necessary documentation to substantiate the reclassification.
You do need to bear in mind that if you are planning on doing a 1031 exchange in the future and do cost segregation the replacement property must have comparable levels of 1245 property and 1250 property or you could be looking at a big tax bill. The intelligent way to go about that would be to have a cost segregation study on the replacement property as well. This double cost segregation strategy works best when you are trading up in value considerably with the replacement property.
A nice thing about this is it doesn't require any amended returns and the IRS lets you catch up on previously unclaimed depreciation with a section 481(a) adjustment in the current year that is given automatic consent by the IRS Commissioner. I'd recommend never filing amended returns because that can cause an Audit.
The amount is the first test. If the amount spent is less than $2,500 per item (e.g 10 refrigerators at $500 each), it can be expensed. If not, it is a facts and circumstances test. I assume the work cost more than $2,500. It sounds like a betterment or a restoration based on the facts provided, in which case the work would need to be capitalized. You may be able to elect to treat the improvement as a partial disposition and scrub the depreciation schedule of the previously capitalized asset. Ask your CPA about this.
Writer | Attorney | Accountant · Dallas, TX · Member since 2016 · 150 posts · 116 votes
9y
You have to believe that your Accountant is doing what should be done with the situation you presented.
But you might consider changing the way you do things.
I'm not saying I have done this, but I know people who have.
If I have a 500-foot fence that could stand to be replaced, at $10/ft that's $5,000 and I have to depreciate it and recover the benefit of my cash outlay over a number of years.
But if I "repaired" a hundred foot of it each tax year, I have a $1,000 deductible repair. I could even do 250 foot in December and the rest in January.
Repairs and capital improvements look a lot alike.
Fairfield CT · Member since 2017 · 63 posts · 77 votes
9y
Your situation does sound like you made improvements but some of the bathroom stuff can be five year property instead of 27.5 year property.
I would break out the cost of the toilet, vanity, mirrors, shelving, sinks, etc as these are 5 year assets.
Then, you can take bonus depreciation or section 179 depreciation and get a similar expensing as it you called it a repair.
Plus, you should allocate a portion of the original purchase price of the house to this bathroom then take a write off for the assets you abandoned. If you have pictures of the original bathroom, this strategy might work as long as you can document it.
Send me a message if you want more info.
Hope that helps,
Ted
Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
9y
You actually can't take section 179 on rental property items.
I also wouldn't get into these aggressive cost segregation strategies. If you ever plan to utilize a 1031 on the property suddenly much of your basis is 1245 property instead of 1250 and that will cause issues, just keep that in mind.
You CAN elect the de minimus which allows you to expense repairs under $2,500 however- the IRS is likely going to look at an ENTIRE bathroom repair as one large capital improvement. If your sink broke and you replaced it, sure you could expense it or now just add a sink, or washer, or lamp to your depreciation schedule. but this was a full renovation and with the new tangible property regulations they've gotten pretty finicky about these things.
Cost Segregation Specialist · Naperville, IL · Member since 2016 · 204 posts · 168 votes
9y
Your CPA is right and wrong. The IRS doesn't care if your CPA is right or wrong, all they care about is if you paid what you're supposed to pay.
In your example your CPA has actually been under-conservative as opposed to the over-conservative stance he thinks he's taking. Bathrooms are specifically included in general maintenance or operation of a building for "human comfort" and are therefore considered 1250 property depreciated over 27.5 years for a rental or 39 years for commercial property. So even though many of the things in the bathroom that you replaced would be 1245 property elsewhere in the building, since it's in the bathroom it doesn't qualify. Say you remodeled the kitchen on the other hand: most of those improvements would be tangible personal property and qualify for 5 year accelerated depreciation as 1245 property. The problem is there are no bright line tests for reclassifying property as illustrated above. All sinks are not depreciated equally, it depends on where they are and how they're used. It's all based on the facts and circumstances of your individual situation.
Restorations are considered improvements, because you had an asset that had fallen into disrepair you improved it by restoring it to original usefulness. If the asset hadn't fallen into disrepair you wouldn't have had to restore it. Does that make sense? More broadly basically anything tangible in the property would be considered an improvement. The entire building is an improvement on the bare land.
Problems arise when you don't get it right. Depreciating that bathroom over 10 years (Very few things with 10 year lives unless you're manufacturing sugar or vegetable oil or using ADS which you shouldn't do unless required, not sure where he pulled that number) when it should be 27.5 years gives you almost triple your allowable depreciation per year. The IRS doesn't like that so it opens you up to fines and penalties. But inversely say it's the kitchen stuff and depreciating it over 10 years when it should be 5 years gives you half your allowable depreciation and then the IRS can disallow further depreciation in years 6-10. No fine or penalty but you only get half of what you should've.
You basically have three options when it comes to depreciation:
The easy way - lump everything together as 1250 property and depreciate over 27.5 years.
The Quasi-right way - Do simple cost segregation from your records with your CPA to classify some things as 1245 property depreciated over 5, 7 or 15 years and some as 1250 property depreciated over 27.5 years. The issue here is getting it right. Hint: this is never 100% accurate.
The best way - Have an engineered cost segregation study breakdown the property into tangible personal property depreciated over 5 years (7 year is rare, but possible), land improvements depreciated over 15 years and building components depreciated over 27.5 years. A study provides the necessary documentation to substantiate the reclassification.
You do need to bear in mind that if you are planning on doing a 1031 exchange in the future and do cost segregation the replacement property must have comparable levels of 1245 property and 1250 property or you could be looking at a big tax bill. The intelligent way to go about that would be to have a cost segregation study on the replacement property as well. This double cost segregation strategy works best when you are trading up in value considerably with the replacement property.
A nice thing about this is it doesn't require any amended returns and the IRS lets you catch up on previously unclaimed depreciation with a section 481(a) adjustment in the current year that is given automatic consent by the IRS Commissioner. I'd recommend never filing amended returns because that can cause an Audit.
Fairfield CT · Member since 2017 · 63 posts · 77 votes
9y
Natalie Kolodij is correct about the section 179 on rental property. I meant bonus depreciation.
Using cost segregation is not super aggressive. It is totally legal but like all tax strategy, it must be tailored to your specific situation so it may or may not be the right strategy depending on your situation and exit strategy.
For smaller properties, the quasi correct method described by Paul Caputo is fine assuming you document it correctly and consult with a CPA to make sure it makes sense for your situation and goals.
Hope that helps!
Ted
Your situation does sound like you made improvements but some of the bathroom stuff can be five year property instead of 27.5 year property.
I would break out the cost of the toilet, vanity, mirrors, shelving, sinks, etc as these are 5 year assets.
Then, you can take bonus depreciation or section 179 depreciation and get a similar expensing as it you called it a repair.
Plus, you should allocate a portion of the original purchase price of the house to this bathroom then take a write off for the assets you abandoned. If you have pictures of the original bathroom, this strategy might work as long as you can document it.
Fairfield CT · Member since 2017 · 63 posts · 77 votes
9y
Thank you, Steven. I already added a new post correcting my original post. I was typing on my phone in a busy restaurant trying to help a fellow investor with kids screaming all around me and I typed Section 179 instead of bonus depreciation.
Cost Segregation Specialist · Naperville, IL · Member since 2016 · 204 posts · 168 votes
9y
Bonus depreciation is great you get to take 50% bonus depreciation on property placed in service in 2017, 40% in 2018 and 30% in 2019. So if you need one more reason to do stuff now there it is.
Cost segregation isn't aggressive at all, it's accepted and approved by the IRS. It's simply putting together the documentation to depreciate property according to MACRS. The truth is it's bringing the taxpayer into full compliance with the tax code with respect to depreciation.
