Big changes in Depreciation, Section 179, and UOP (what is that? Read on)

Whenever you fix or replace something in a rental unit or building you need to decide whether the expense is a repair or improvement for tax purposes. Why is this important? Because you can deduct the cost of a repair in a single year, while you have to depreciate improvements over as many as 27.5 years.

For example, if you classify a $1,000 expense as a repair, you get to deduct $1,000 this year. If you classify it as an improvement, you'll likely have to depreciate it over 27.5 years and you'll get only a $35 deduction this year.

That's a big difference.

Unfortunately, telling the difference between a repair and an improvement can be difficult. In attempt to clarify matters, the IRS has issued lengthy regulations explaining how to tell the difference between repairs and improvements. Implementation of these rules has been delayed although anyone can opt to use them between now and their required effective date of January 1, 2014.

For more details on current vs. capital expenses refer to the article Current vs Capital Expenses.

If You are a Landlord

Maximize your tax deductions, including how to deduct repairs and losses, depreciate improvements.

Check out Every Landlord's Tax Deduction Guide »

What Is an Improvement under IRS Rules?

Under the new IRS regulations, property is improved whenever it undergoes a:

• Betterment
• Adaptation, or
• Restoration.

Think of the acronym B A R = Improvement = Depreciate.

If the need for the expense was caused by a particular event--for example, a storm--you must compare the property's condition just before the event and just after the work was done to make your determination. On the other hand, if you’re correcting normal wear and tear to property, you must compare its condition after the last time you corrected normal wear and tear (whether maintenance or an improvement) with its condition after the latest work was done. If you’ve never had any work done on the property, use its condition when placed in service as your point of comparison.

Betterments

An expenditure is for a betterment if it:

• ameliorates a “material condition or defect” in the property that existed before it was acquired or when it was produced--it makes no difference whether or not you were aware of the defect when you acquired the unit of property, or UOP (discussed below)
• results in a “material addition” to the property--for example, physically enlarges, expands, or extends it, or
• results in a “material increase” in the property's capacity, productivity, strength, or quality.

Restorations

An expenditure is for a restoration if it:

• returns a property that has fallen into disrepair to its “ordinarily efficient operating condition”
• rebuilds the property to a like-new condition after the end of its economic useful life, or
• replaces a major component or substantial structural part of the property
• replaces a component of a property for which the owner has taken a loss, or
• repairs damage to a property for which the owner has taken a basis adjustment for a casualty loss.

Adaptations

You must also depreciate amounts you spend to adapt property to a new or different use. A use is “new or different” if it is not consistent with your “intended ordinary use” of the property when you originally placed it into service.

What Does the IRS Consider a Unit of Property (UOP)?

To determine whether you’ve improved your business or rental property, you must determine what the property consists of. The IRS calls this the “unit of property” (UOP). How the UOP is defined is crucial. The larger the UOP, the more likely will work done on a component be a deductible repair rather than an improvement that must be depreciated.

For example, if the UOP for an apartment building is defined as the entire building structure as a whole, you could plausibly claim that replacing the fire escapes is a repair since it doesn’t seem that significant when compared with the whole building. On the other hand, if the UOP consists of the fire protection system alone, replacing fire escapes would likely be an improvement.

New IRS regulations require that buildings be divided up into as many as nine different UOPs: the entire structure and up to eight separate building systems. An improvement to any of these UOPs must be depreciated. As a result, more costs will have to be classified as improvements, rather than repairs.

UOP #1: The Entire Building

The entire building and its structural components as a whole are a single UOP. A building’s structural components include:

• walls, partitions, floors, and ceilings, and any permanent coverings on them such as paneling or tiling
• windows and doors
• all central air conditioning or heating system components
• plumbing and plumbing fixtures, such as sinks and bathtubs
• electric wiring and lighting fixtures
• chimneys
• stairs, escalators, and elevators
• sprinkler systems
• fire escapes
• other components relating to the operation or maintenance of the building, and
• roofs.

For example, replacement of a building’s roof is an improvement to the building UOP.

UOP #2-9: Building Systems

In addition, the following eight building systems are separate UOPs. An improvement to any one of these systems and must be depreciated:

• Heating , ventilation, and air conditioning (“HVAC”) systems: This includes motors, compressors, boilers, furnace, chillers, pipes, ducts, and radiators.
• Plumbing systems: This includes pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment, and site utility equipment used to distribute water and waste.
• Electrical systems: This includes wiring, outlets, junction boxes, lighting fixtures and connectors, and site utility equipment used to distribute electricity.
• All escalators.
• All elevators.
• Fire-protection and alarm systems: These includes sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detectors, fire escapes, fire doors, emergency exit lighting and signage, and fire fighting equipment, such as extinguishers and hoses.
• Security systems: These include window and door locks, security cameras, recorders, monitors, motion detectors, security lighting, alarm systems, entry and access systems, related junction boxes, associated wiring and conduit.
• Gas distribution system: This includes pipes and equipment used to distribute gas to and from the property line and between buildings.

Example: A landlord purchased an apartment building five years ago for $750,000. This year he spends $5,000 to fix wiring in the electrical system. Under the old IRS rules, the $5,000 likely would be considered a repair because it is relatively small compared to the overall cost of the building, which was treated as a single UOP. Under the new rules, the electrical system is a separate UOP. This means that the $5,000 must be compared with the cost of the electrical system alone, not the cost of the whole building. This makes the expense seem much more significant and likely to constitute an improvement.

For the latest IRS rules on repairs and improvements, see IRS Bulletin 2012-14, Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property.

Thanks to Stephen Fishman, J.D. for pulling a lot of this together!

New Depreciation and and capitalization rules-IRS 2014

Big changes are afoot in 2014 regarding depreciation.  Sec. 179 lowered to $25,000 and the very nature of depreciation is changing.
Just remember (I) BAR and (II)UOP!
 Whenever you fix or replace something in a rental unit or building you need to decide whether the expense is a repair or improvement for tax purposes. Why is this important? Because you can deduct the cost of a repair in a single year, while you have to depreciate improvements over as many as 27.5 years.

For example, if you classify a $1,000 expense as a repair, you get to deduct $1,000 this year. If you classify it as an improvement, you'll likely have to depreciate it over 27.5 years and you'll get only a $35 deduction this year.

That's a big difference.

Unfortunately, telling the difference between a repair and an improvement can be difficult. In attempt to clarify matters, the IRS has issued lengthy regulations explaining how to tell the difference between repairs and improvements. Implementation of these rules has been delayed although anyone can opt to use them between now and their required effective date of January 1, 2014.

For more details on current vs. capital expenses refer to the article Current vs Capital Expenses.

If You are a Landlord

Maximize your tax deductions, including how to deduct repairs and losses, depreciate improvements.

Check out Every Landlord's Tax Deduction Guide »

What Is an Improvement under IRS Rules?

Under the new IRS regulations, property is improved whenever it undergoes a:

• Betterment
• Adaptation, or
• Restoration.

Think of the acronym (I) B A R = Improvement = Depreciate.

If the need for the expense was caused by a particular event--for example, a storm--you must compare the property's condition just before the event and just after the work was done to make your determination. On the other hand, if you’re correcting normal wear and tear to property, you must compare its condition after the last time you corrected normal wear and tear (whether maintenance or an improvement) with its condition after the latest work was done. If you’ve never had any work done on the property, use its condition when placed in service as your point of comparison.

Betterments

An expenditure is for a betterment if it:

• ameliorates a “material condition or defect” in the property that existed before it was acquired or when it was produced--it makes no difference whether or not you were aware of the defect when you acquired the unit of property, or UOP (discussed below)
• results in a “material addition” to the property--for example, physically enlarges, expands, or extends it, or
• results in a “material increase” in the property's capacity, productivity, strength, or quality.

Restorations

An expenditure is for a restoration if it:

• returns a property that has fallen into disrepair to its “ordinarily efficient operating condition”
• rebuilds the property to a like-new condition after the end of its economic useful life, or
• replaces a major component or substantial structural part of the property
• replaces a component of a property for which the owner has taken a loss, or
• repairs damage to a property for which the owner has taken a basis adjustment for a casualty loss.

Adaptations

You must also depreciate amounts you spend to adapt property to a new or different use. A use is “new or different” if it is not consistent with your “intended ordinary use” of the property when you originally placed it into service.

What Does the IRS Consider a Unit of Property (II) (UOP)?

To determine whether you’ve improved your business or rental property, you must determine what the property consists of. The IRS calls this the “unit of property” (UOP). How the UOP is defined is crucial. The larger the UOP, the more likely will work done on a component be a deductible repair rather than an improvement that must be depreciated.

For example, if the UOP for an apartment building is defined as the entire building structure as a whole, you could plausibly claim that replacing the fire escapes is a repair since it doesn’t seem that significant when compared with the whole building. On the other hand, if the UOP consists of the fire protection system alone, replacing fire escapes would likely be an improvement.

New IRS regulations require that buildings be divided up into as many as nine different UOPs: the entire structure and up to eight separate building systems. An improvement to any of these UOPs must be depreciated. As a result, more costs will have to be classified as improvements, rather than repairs.

UOP #1: The Entire Building

The entire building and its structural components as a whole are a single UOP. A building’s structural components include:

• walls, partitions, floors, and ceilings, and any permanent coverings on them such as paneling or tiling
• windows and doors
• all central air conditioning or heating system components
• plumbing and plumbing fixtures, such as sinks and bathtubs
• electric wiring and lighting fixtures
• chimneys
• stairs, escalators, and elevators
• sprinkler systems
• fire escapes
• other components relating to the operation or maintenance of the building, and
• roofs.

For example, replacement of a building’s roof is an improvement to the building UOP.

UOP #2-9: Building Systems

In addition, the following eight building systems are separate UOPs. An improvement to any one of these systems and must be depreciated:

• Heating, ventilation, and air conditioning (“HVAC”) systems: This includes motors, compressors, boilers, furnace, chillers, pipes, ducts, and radiators.
• Plumbing systems: This includes pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment, and site utility equipment used to distribute water and waste.
• Electrical systems: This includes wiring, outlets, junction boxes, lighting fixtures and connectors, and site utility equipment used to distribute electricity.
• All escalators.
• All elevators.
• Fire-protection and alarm systems: These includes sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detectors, fire escapes, fire doors, emergency exit lighting and signage, and fire fighting equipment, such as extinguishers and hoses.
• Security systems: These include window and door locks, security cameras, recorders, monitors, motion detectors, security lighting, alarm systems, entry and access systems, related junction boxes, associated wiring and conduit.
• Gas distribution system: This includes pipes and equipment used to distribute gas to and from the property line and between buildings.

Example: A landlord purchased an apartment building five years ago for $750,000. This year he spends $5,000 to fix wiring in the electrical system. Under the old IRS rules, the $5,000 likely would be considered a repair because it is relatively small compared to the overall cost of the building, which was treated as a single UOP. Under the new rules, the electrical system is a separate UOP. This means that the $5,000 must be compared with the cost of the electrical system alone, not the cost of the whole building. This makes the expense seem much more significant and likely to constitute an improvement.

For the latest IRS rules on repairs and improvements, see IRS Bulletin 2012-14, Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property.

by: Stephen Fishman, J.D.

Tax items of interest for 2013 & 2014!

2013 1040 In Depth Manual:

• 2014 Section 179. Use this table:

Section 179 Limits after The 2007, 2010 and 2012 Tax Acts

Description	2007	2008	2009	2010-2013	2014
Section 179 Limit	$125,000	$250,000	$250,000	$500,000	$25,000
Section 179 Phase-out	$500,000	$800,000	$800,000	$2,000,000	$200,000

• High Income Earners  

The 39.6 percent marginal tax rate will affect single filers with annual income exceeding $406,750 ($457,600 for married couples filing jointly), up from $400,000 and $450,000, respectively, in tax year 2013. Changes to the other marginal tax brackets -- 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent -- are detailed in the release (Rev. Proc. 2013-35;IRS Revenue Procedures).

• Standard Deduction

The standard deduction for singles and married couples filing separately in tax year 2014 will rise to $6,200 (from $6,100 in tax year 2013), and to $12,400 for married couples filing jointly (from $12,200 a year ago). The standard deduction for heads of household will rise to $9,100 from $8,950.

• Limits on Itemized Deductions

The limit on itemized deductions claimed on tax year 2014 returns begins with incomes of $254,200 for singles and $302,050 for married couples filing jointly.

• Personal Exemption

The personal exemption will rise to $3,950, from $3,900 in 2013. However, the exemption will begin phasing out at adjusted gross incomes of $254,200 ($305,050 for married couples filing jointly), and phases out completely at $376,700 ($427,550 for married couples filing jointly).

• AMT

The alternative minimum tax exemption for tax year 2014 will be $52,800 ($82,100 for married couples filing jointly), up from $51,900 and $80,800, respectively, last tax year.

• Earned Income Credit

The maximum earned income tax credit will be $6,143 for taxpayers filing jointly who have three or more qualifying children. That's up from $6,044 in tax year 2013.

• Foreign earned income exclusion

The foreign earned income exclusion rises to $99,200 for tax year 2014, up from $97,600, for 2013.

 

• For filers who itemize

Schedule A

IRS Notice 2013-80 gives 2014 mileage rates at 56 cents for business, 14 cents for charity and 23.5 cents for medical and moving.

  

 

• New Depreciation measures being enacted.  Can not just expense replacements any longer....

• Form 4562 Depreciation
  Example Repair and Capitalization Policy
  
  Note this policy is an annual irrevocable election and must be included with the timely filed Federal Tax Return upon adoption.
  
  "XYZ Company hereby adopts for book and Federal income tax purposes the following policy regarding capitalization expenses for the year beginning January 1, 2014. In accordance with Internal Revenue Code Sections 167 and 168 and related Regulations XYZ Company has determined that amounts whose individual cost (including tax, installation and delivery costs) does not exceed $500 will be deducted as incurred as an operating expense. Amounts exceeding this dollar limit will be examined individually to determine if their use or purpose requires capitalization under the betterment, adaptation or restoration rules used by the Internal Revenue Service and will be capitalized or expensed as incurred as a result of the application of those rules." (Companies with audited financial statements should replace $500 with $5,000.
•  
•  
•  
• Net Investment Tax
•  Form 8960 Net Investment Income Tax
  On November 26, 2013 the IRS released final regulations at TD 9644 regarding the net investment income tax. The regulations included significant changes to the proposed regulations and addressed many concerns taxpayers had raised with the IRS, including rules on regrouping, self-rented property, self-charged interest income, trader's gains and losses, and real estate professionals. The new rules permit a single property to be a rental trade or business.
•  
• Regrouping
•  Regrouping
  In the original proposed regulations the IRS allowed taxpayers whose income exceeded the threshold limits and who had NII the ability to regroup activities one time for 2013 and report the regrouping via a new grouping election. This rule was retained.
  
  In the final regulations, the IRS allows a taxpayer to regroup activities if the otherwise non-qualifying taxpayer becomes qualifying upon an amended return or as a result of an IRS examination. The taxpayer can apply the regroup to the year of the amended return (reg. section 1.469-11(b)(3)(iv)(C)(1)).
  
  Also, if a taxpayer correctly elects to regroup and upon amending the return no longer qualifies for regrouping, the regroup is considered void.
  The final regulations do not allow regrouping for partnerships and S corporations.

 

1.  Self Rented Property
• Self Rented Property
  Reg. section 1.1411-4(g) provides special rules for self-rented property and self-charged interest income. The final regulations provide that, in the case of rental income that is treated as non-passive by reason of § 1.469-2(f)(6) (which generally re-characterizes what otherwise would be passive rental income from a taxpayer's property as non-passive when the taxpayer rents the property for use in an activity in which the taxpayer materially participates) the gross rental income is treated as derived in the ordinary course of a trade or business, meaning that self-rental income is not subject to the surtax! If the gain or loss from the disposition of property is treated as non-passive gain or loss under some conditions, the gain or loss is deemed to be derived from property used in the ordinary course of business also meaning that the sale of the property is not subject to the surtax!
•  
•  
• Interest of WC
•  Interest On Working Capital
  Generally exempted if normally charged as a business policy on all account
•  
• Self Charge Interest
•  Self Charged Interest
  The IRS added a special rule that permits taxpayers to exclude from net investment income the amount of interest income equal to the taxpayer's allocable share of the non-passive deduction for self charged interest expense. However, this special rule does not apply in situations when the interest deduction is taken into account in determining self-employment income that is subject to tax under section 1401(b).
• 
   
• R/E Professionals
•  Real Estate Professionals
  The final regs also offer limited relief from net investment income tax in the form of a safe harbor for rental income of real estate professionals that is derived in the ordinary course of a trade or business.
  
  The safe harbor test provides that, if a real estate professional (within the meaning of section 469(c)(7)) participates in rental real estate activities for more than 500 hours per year, the rental income associated with that activity will be deemed to be derived in the ordinary course of a trade or business. Alternatively, if the taxpayer has participated in rental real estate activities for more than 500 hours per year in five of the last ten taxable years (one or more of which may be taxable years prior to the effective date of section 1411), then the rental income associated with that activity will be deemed to be derived in the ordinary course of a trade or business. This means that most real estate professionals will not be subject to the NII surtax.
  
  Interestingly the IRS recognizes that some real estate professionals with substantial rental activities may derive such rental income in the ordinary course of a trade or business, even though they fail to satisfy the 500 hour requirement in the safe harbor test. As a result, the final regulations specifically provide that such failure will not preclude a taxpayer from establishing that such gross rental income and gain or loss from the disposition of real property, as applicable, is not included in net investment income. Special new rules are also provided for the treatment of suspended passive losses once an activity becomes active. The approved approach allows suspended losses from former passive activities in calculation of net investment income but only to the extent of the non-passive income from such former passive activity that is included in net investment income in that year.
•  
• Penalty Relief 
• Penalty Relief
  Although the surtax law was passed over three and 1/2 years ago, and the imposition of the tax began a year ago IRS failed to provide guidance on many surtax issues. They declined in these final regulations to provide penalty relief for late tax payments.
  
  The foreign tax credit is specifically not allowed to apply against the NII tax under 1.1411-1(e) of the Regulations.
•  
•  
• Attack on the Clergy?
• Clergy
  A U.S. district court held that section 107(2), which excludes the rental allowance paid to a minister from gross income, is an unconstitutional violation of the establishment clause and enjoined its enforcement, finding that it provides a benefit to religious persons that it does not give to others.
  
  The Freedom From Religion Foundation (FFRF) and its co-presidents filed a suit in U.S. district court challenging the availability of federal income tax exemptions for "ministers of the gospel" under section 107, arguing that the exemptions violate the Constitution's establishment and equal protection clauses.
  
  U.S. District Judge Barbara B. Crabb addressed the merits of the case and found that based on the Supreme Court's decision in Texas Monthly Inc. v. Bullock, 489 U.S. 1 (1989), the exemption in section 107(2) violates the establishment clause. In that decision, the Supreme Court held that a state sales tax exemption provided only to publishers of religious writings was unconstitutional. Crabb acknowledged that the withdrawal of the exemption would greatly affect ministers and their churches, but she said that only underscores the preferential treatment that she found to have violated the First Amendment. Crabb concluded her opinion by saying the government isn't powerless to provide exemptions to benefit religion and that Congress can rewrite the provision so that it complies with the principles established by the Supreme Court.
  
  The judge put a stay on enforcement of the case pending appeal. If the stay is lifted the case would apply in the 7^th circuit of Illinois, Indiana and Wisconsin.
•  
•  
• Fringe Benefits
• Fringe Benefits
  The IRS announced October 31 that it is modifying the "use it or lose it" rule that applies to health flexible spending accounts (FSAs) under section 125's proposed regulations.
  
  The modification announced in Notice 2013-71, 2013-47 IRB 1 2013 TNT 212-10: Internal Revenue Bulletin permits employers to amend section 125 cafeteria plans to carry over up to $500 of unused amounts remaining in a health FSA at the end of the plan year. Before the change, any amount remaining in an employee's FSA at the end of the plan year was forfeited and returned to the employer.
  
  The $500 carryover does not limit an employee's ability to elect the maximum in salary reduction contributions under section 125(i), which limits employee salary reduction contributions to $2,500.
  
  The annual dollar limit on employee contributions to employer-sponsored healthcare flexible spending arrangements (FSA) remains unchanged at $2,500.
  
  The change announced by the IRS is not automatic and will require employers to amend plans for the $500 carryover to apply to employee health FSAs. Any plan adopting a carryover provision is not also permitted to provide the 2 1/2-month grace period. A plan amendment adopting the carryover provision applies retroactively to the first day of the plan year. A plan may be amended to adopt the carryover provision for a plan year beginning in 2013 at any time on or before the last day of the plan year that begins in 2014.

 IRA,  Pensions

• The elective deferral (contribution) limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government's Thrift Savings Plan remains unchanged at $17,500.
•           The catch-up contribution limit for employees aged 50 and over who participate in 401(k), 403(b), most 457 plans, and the federal government's Thrift Savings Plan remains unchanged at $5,500.

The limit on annual contributions to an Individual  retirement Arrangement (IRA) remains unchanged at $5,500. The additional catch-up contribution limit for individuals aged 50 and over is not                    subject to an annual cost-of-living adjustment and remains $1,000.

•  
•            The deduction for taxpayers making contributions to a traditional IRA is phased out for singles and heads of household who are covered by a workplace retirement plan and have modified adjusted gross incomes (AGI) between $60,000 and $70,000, up from $59,000 and $69,000 in 2013. For married couples filing jointly, in which the spouse who makes the IRA contribution is covered by a workplace retirement plan, the income phase-out range is $96,000 to $116,000, up from $95,000 to $115,000. For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the deduction is phased out if the couple's income is between $181,000 and $191,000, up from $178,000 and $188,000. For a married individual filing a separate return who is covered by a workplace retirement plan, the phase-out range is not subject to an annual cost-of-living adjustment and remains $0 to $10,000.
•           The AGI phase-out range for taxpayers making contributions to a Roth IRA is $181,000 to $191,000 for married couples filing jointly, up from $178,000 to $188,000 in 2013. For singles and heads of household, the income phase-out range is $114,000 to $129,000, up from $112,000 to $127,000. For a married individual filing a separate return, the phase-out range is not subject to an annual cost-of-living adjustment and remains $0 to $10,000.
•            The AGI limit for the saver's credit (also known as the retirement savings contribution credit) for low- and moderate-income workers is $60,000 for married couples filing jointly, up from $59,000 in 2013; $45,000 for heads of household, up from $44,250; and $30,000 for married individuals filing separately and for singles, up from $29,500.

• IRS info
• IRS
  IRS Taxpayer Advocate, Nina Olson, announced that walk-in tax assistance at IRS offices will end December 31, 2013 due to budget cuts. At the same time, the IRS has been unable to regulate un-enrolled tax preparers due to litigation and the failure of Congress to pass applicable legislation. Ms. Olson also stated that the levels of tax return preparer fraud are "astonishing" and that much of it stems from un-enrolled preparers.
• Social Security

•  Social Security

  For 2014, maximum taxable earnings with respect to Social Security was increased from $113,700 to $117,000, and the tax rate for employees and self-employed individuals did not change, according to a fact sheet from the Social Security Administration.

I would like to thank my friend Jim Newland, CPA in Eastlake, Ohio for sharing this with us!