A local business purchased a building for an upcoming warehouse operation, and – 15 years later – the business discovered the roof of its building had started to leak. The leak, according to a quote from a roofing company, would cost the company $200,000 to repair. It’s a flat roof and only one section seems to be in need of repair. Otherwise the roof structure is in good shape, according to the roofing company, so the business decides to replace the entire roof’s rubber membrane with a new, waterproof membrane. A partial fix did not make sense.
How should the business treat the expenditure for tax and financial statement purposes? The financial statements for the bank are prepared according to Generally Accepted Accounting Principles (GAAP). As far as profits and losses go, the business had a good year and could use the deduction for tax purposes.
After conferring with its tax advisors and accountants, the business decided it would expense the roof repair for tax purposes and capitalize the repair for GAAP. Aware that the IRS came out with new regulations effective in 2014 for repairs and maintenance, the business understood it would need to comply with the new repair and maintenance regulations.
A few years after the building’s initial purchase, the business had conducted a cost segregation study in order to maximize depreciation. The report contained information on the approximate value assigned to the original roof, and the building’s depreciable life allowed for tax was 39 years. The roof, being part of the building, is also being depreciated over the same 39 years.
For tax purposes, the new IRS regulations define the roof as an integral part of the building structure – it is tough to argue that it is not. The building is the unit of property, so the company needed to consider three tests in order to conclude whether or not the expenditure is an improvement that has to be capitalized for tax purposes. If it met any one of the tests, as described below, it would have to capitalize the cost as an improvement to the building.
Test 1: Does the expenditure adapt the building for a new or different use?
In this case, there is no change in the building’s use as the building will still be used for the same warehouse operations.
Test 2: Does the expenditure qualify as a betterment of the building?
Because the roof’s damage did not exist (pre-existing defect) at the time of the building’s purchase, the roof repair would not be a “betterment” as defined in the regulations. Also, the expenditure is not part of an expansion or material addition to the building, and it will not materially increase the productivity, efficiency, quality or capacity of the building.
Test 3: Does the expenditure qualify as a restoration of the building?
The final test is whether the expenditure is a replacement of a part or combination of parts that comprise a major component or substantial structural part of the building. Two examples in the regulations seem to be on point for this business’s situation. The replacement of the membrane can be expensed since it, of itself, is not considered to be a substantial structural part of the building. On the other hand, the replacement of the entire roofing structure would be considered a substantial structural part, and the expenditure would have to be capitalized.
At this point, more than half of the cost allocated to the building’s original roof remains on the books.
In this situation, it seems the business can deduct the repair of the roof. The proposed regulations seem to allow for a partial disposition, but if the business goes that route they will have to capitalize the expenditure according to the final repair regulations. If the business capitalizes the roof repair, then it would make sense to write off or create a loss for the undepreciated cost of the old roof. Fortunately, the business’ aforementioned cost segregation study helps them identify this cost.
Without a cost segregation study, the proposed regulations seem to indicate that taxpayers can use a consumer discount index to zero in on a cost to remove the depreciation schedules.
The new repair and maintenance regulations, effective January 1, 2014, are complex and require a great deal of analysis for any business. Business owners should consult with their tax advisors on the new regulations.