Impact of upgrades on tax/depreciation
Member since 2019 · 258 posts · 35 votes
Impact of upgrades on tax/depreciation
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Michael PlaksPro Member
Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votesYour goal to understand depreciation is commendable but unfortunately only partially realistic.
You can understand the general concept, and some earlier replies on this thread are helpful in that respect. I'll add my non-technical version. If your business paid for something that you will use for several years but is relatively inexpensive, say a $1,000 computer, you can deduct this $1,000 immediately. If your business paid for something to be used for many years and is relatively expensive, say a $100,000 excavator, you spread the $100,000 deduction over 7 years, aka depreciate it over 7 years.
You can then dive into more complex aspects of depreciation:
- why 7 years? because there're different required lengths for depreciation, depending on the item, from 3 years to 40 years
- is it $100,000 divided by 7? no, because there're different methods and tables, also depending on the item
- can you deduct the whole $100,000 immediately? maybe, depending on several factors
- what happens if you sell it after 3 years? have to learn about the concepts of tax basis and depreciation recapture
- etc etc etc
I hope you can feel it's getting complicated fast. Now enter real estate. It's the above complexity times 10.
- if you treat the entire building as one item, you have to spread everything over a long period of time, and nothing can be deducted right away
- you can separate some components (for example, carpets, appliances, fences, driveways) and either depreciate them faster or even deduct them right away
- when you repair, replace or improve something (like HVAC), you have to understand extremely complex rules known as Tangible Property Regulations, so complex that even us tax professionals specializing in real estate do not always agree on specifics
- some rules are specific to the type of property, for example they only apply to non-residential property or only to brand new property
- and there is a whole lot more than that
So basically, everyone can understand the general concepts, such as the difference between virus and bacteria. But even the specialists do not agree on coronavirus. Depreciation may not be as deadly, but it is no less complicated.
13 Replies
- 6yAshish AcharyaBusiness MemberCPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
Originally posted by @Kumar Gaurav:
Hello,
I am trying to wrap my head around the concept of depreciation. Let's say I upgrade my HVAC to replace old if install new condensation units worth $10000 just for the sake of numbers, how does it impact my depreciation
What section of tax returns has information about depreciation.Appreciate your inputs
Thanks.
It is added as a separate asset in your tax asset detail and depreciated when paced in service.
The depreciation is reported on the Form 4562.Either you, your tax advisor, or whatever software you are using should be tracking the asset detail.
INVESTOR FRIENDLY CPA®5241 Reviews - Member since 2019 · 258 posts · 35 votes6y
@Ashish Acharya
Thank you.I understand it better now, even though HVAC is a major component of a home,it's dealt as a separate entity that depreciates, likewise I am assuming that would be the case with refrigerator, washing machine furniture etc
- 6yBasit SiddiqiBusiness MemberAccountant · New York, NY · Member since 2015 · 8k+ posts · 3k+ votes
Originally posted by @Kumar Gaurav:
@Ashish Acharya
Thank you.I understand it better now, even though HVAC is a major component of a home,it's dealt as a separate entity that depreciates, likewise I am assuming that would be the case with refrigerator, washing machine furniture etc
If the HVAC is part of the same house that you been renting out - there is no separate entity...
it is all listed under the same activity.
HVAC's are normally depreciated differently than refrigerator, washing machines and furniture.
Basit Siddiqi CPA4.979 Reviews - Real Estate Broker · Portland, OR · Member since 2019 · 4k+ posts · 2k+ votes6y
"I am trying to wrap my head around the concept of depreciation. "
Originally, when you buy eqpt for your business, usually you can expense it. Which means you can set off the price against your business income in the same tax year.
However, when you buy a building that is slowly decaying (implying it'll need to be replaced one day), they don't allow you to take the price of the building against your income in the same year. Otherwise, with carry-forwards, you prob wouldn't be paying income taxes for a while. They make you divide the price of the building (if an apt) over 27.5 years and use that amount each year as a set-off. Since dirt doesn't get any worse, you can't use depreciation on that.
When you make upgrades, you'll need a cost segregation guy to certify what sort of schedule (ie the number of years) you can add them to your annual depreciation. Roofs, for example, don't last 27.5 years, so you can get a shorter depreciation (again ask a specialist).
- Specialist · Raleigh, NC · Member since 2018 · 28 posts · 21 votes6y
@Kumar Gaurav Let's say I upgrade my HVAC to replace old if install new condensation units worth $10000 just for the sake of numbers, how does it impact my depreciation...
The Tax Cuts Jobs Act (TCJA) allows HVAC, Roof and Security Systems to fall into the 179 expense. So your $10K HVAC would not impact depreciation at all, and you can expense it right away. This is better! If you knew the remaining value/life of your existing HVAC units (via a cost seg study), then you could dispose/retire that asset as well (another expense). This is actually a requirement of the Tangible Property Regs. If you don't dispose of replaced items, then you will end up with ghost assets.
But your HVAC was one generic example without complete context, all components need to be analyzed based on the specific tax code, perhaps building type, your ownership/tax structure, etc.
- Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes6y
Basically, if something has a usable "life/usefulness" greater than 1 year, you can't expense the cost in one tax year. Accounting standards / IRS want you to slowly take the deduction as you "wear out" the item. Hope that helps put it in perspective. That's why a capital improvement has to be depreciated.
IRS pub946 is all about Depreciation if you want something to read.
Don't forget that while depreciation is a nice non-cash deduction, you do end up paying taxes on it when you sell via depreciation unrecapture.
Also, you can do "all the deductions" you want, but remember they are passive losses (unless you have a tremendous amount of rental income to stay positive). So, you may not be able to take the deduction immediately on your 1040.... But, I think we are a bit off topic here.
Good luck.
- 6yMichael PlaksPro MemberTax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
Originally posted by @Bill S.:
The Tax Cuts Jobs Act (TCJA) allows HVAC, Roof and Security Systems to fall into the 179 expense.
Only for NON-residential property, as in office buildings, warehouses etc
- Specialist · Raleigh, NC · Member since 2018 · 28 posts · 21 votes6y
@Michael Plaks, yes for nonresidential only, thanks for clarifying... hence my disclaimer on the circumstances. The assumption on BP should be residential/apartments of some sort. Kumar wasn't clear on property type in the initial question, though I should have been clear. Bel well.
- 6yMichael PlaksPro MemberTax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
Your goal to understand depreciation is commendable but unfortunately only partially realistic.
You can understand the general concept, and some earlier replies on this thread are helpful in that respect. I'll add my non-technical version. If your business paid for something that you will use for several years but is relatively inexpensive, say a $1,000 computer, you can deduct this $1,000 immediately. If your business paid for something to be used for many years and is relatively expensive, say a $100,000 excavator, you spread the $100,000 deduction over 7 years, aka depreciate it over 7 years.
You can then dive into more complex aspects of depreciation:
- why 7 years? because there're different required lengths for depreciation, depending on the item, from 3 years to 40 years
- is it $100,000 divided by 7? no, because there're different methods and tables, also depending on the item
- can you deduct the whole $100,000 immediately? maybe, depending on several factors
- what happens if you sell it after 3 years? have to learn about the concepts of tax basis and depreciation recapture
- etc etc etc
I hope you can feel it's getting complicated fast. Now enter real estate. It's the above complexity times 10.
- if you treat the entire building as one item, you have to spread everything over a long period of time, and nothing can be deducted right away
- you can separate some components (for example, carpets, appliances, fences, driveways) and either depreciate them faster or even deduct them right away
- when you repair, replace or improve something (like HVAC), you have to understand extremely complex rules known as Tangible Property Regulations, so complex that even us tax professionals specializing in real estate do not always agree on specifics
- some rules are specific to the type of property, for example they only apply to non-residential property or only to brand new property
- and there is a whole lot more than that
So basically, everyone can understand the general concepts, such as the difference between virus and bacteria. But even the specialists do not agree on coronavirus. Depreciation may not be as deadly, but it is no less complicated.
- Member since 2019 · 258 posts · 35 votes6y
Thank you everyone for your wonderful answers.
@Michael Plaks
Beautifully articulated on a complex subject.
- Accountant · Atlanta, GA · Member since 2015 · 1k+ posts · 1k+ votes6y
You would generally capitalize this expense under both the De Minimis Safe Harbor and the BAR tests. Your CPA should discuss a partial disposition election for the old unit if so. There may be an "if" to expense this for taxes under the Safe Harbor for Small Taxpayers, but that is a big "IF".
As a major component of the HVAC subsystem of the building unit of property, we'd place this in service with a recovery period of 27.5yr or 39yr under GDS, depending on fact and circumstance.
Form 4562 reports depreciation and amortization, as well as property put into service during the year, but you're unlikely to divine knowledge by examining the form. You'll either have to dedicate a material amount of your time or hire a professional advisor.
Why would an excavator used in a rental real estate trade or business be depreciable over 7 years instead of 5 years?
- 6yMichael PlaksPro MemberTax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
Originally posted by @Eamonn McElroy:
Why would an excavator used in a rental real estate trade or business be depreciable over 7 years instead of 5 years?
a. where did I say "rental real estate T&B"?
b. if you want to bring in the 5-yr rule for the personal property, then we also need to add "residential"
c. and even under that rule, I doubt that construction equipment would be included, however I'm not sure without double-checking, and you may be correct
Now see, Kumar, what I meant when I said it's so complex that even the experts are not always in agreement on details?
- Accountant · Atlanta, GA · Member since 2015 · 1k+ posts · 1k+ votes6y
a. You mentioned "your business" in your excavator example (addressing OP). OP is discussing a rental real estate trade or business. If then can be inferred you were also discussing a rental real estate trade or business. If that wasn't your intention, you should have been more specific.
b. No, we don't.
c. Under Rev Proc 87-56 we generally assign class life not by what the equipment is, but by what activity type it is used in, with limited exception (the "00" class lives).
I concede it would be rare for a rental operation to own construction equipment. Generally this is something that is either rented or contracted out. However, construction equipment is 1245 property that if exclusively used in a residential OR commercial rental trade or business would be appropriately classified as class life 57.0, Distributive Trades and Services, 5yr GDS asset.
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