Chap 7 - Tax Regulations on Repairs and Improvements

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Questions and Answers

What is the maximum deductible amount for the removal of architectural barriers for elderly and handicapped persons?

$20,000

$15,000 (correct)

$10,000

$25,000

Which of the following is true regarding the treatment of materials and supplies for tax purposes?

They are not deductible under any circumstance.

They must always be included as inventory.

They must be capitalized regardless of use.

They are deductible when consumed. (correct)

What standard does the IRS use to evaluate the reasonableness of salaries paid to related business employees?

Historical payment trends

Employee performance reviews

Comparable compensation in similar businesses (correct)

Internal company salary structure

In terms of deductible expenses under Section 212, which of the following expenses is NOT deductible?

Salaries believed to be excessive paid to a related shareholder Signup and view all the answers

What defines materials and supplies as tangible property in a business context?

Items expected to be consumed in 12 months or less Signup and view all the answers

Which of the following thresholds relates to the capital expenditure treatment of materials and supplies?

Acquisition or production cost must be $200 or less Signup and view all the answers

Under the IRS Repair Regulations, repairs are generally defined as costs that do what?

Restore the property to its operating condition Signup and view all the answers

What is a common requirement for small taxpayer safe harbor criteria?

The average annual gross receipts must be $10 million or less. Signup and view all the answers

Which situations require improvement expenditures to be capitalized?

The improvement results in enhanced functionality or efficiency. Signup and view all the answers

What is the maximum deductible amount for a taxpayer with an audited financial statement under the De Minimis Safe Harbor rule?

$5,000 Signup and view all the answers

Which requirement is NOT necessary for a taxpayer to qualify for the Small Taxpayer Safe Harbor?

The taxpayer's average annual gross receipts must exceed $10 million. Signup and view all the answers

When can a taxpayer elect to apply De Minimis Safe Harbor rules?

When they have written accounting procedures for property costing less than a specified amount. Signup and view all the answers

Which of the following cannot be considered a repair under the IRS guidelines?

Upgrading HVAC systems to improve energy efficiency. Signup and view all the answers

What is the lesser amount that cannot be exceeded for repairs under the Small Taxpayer Safe Harbor?

$10,000. Signup and view all the answers

Which of the following statements about the De Minimis Safe Harbor is true?

Taxpayers without AFS must expense amounts according to their accounting procedures. Signup and view all the answers

Which improvement expenditure qualifies as adding to the value of a property?

Upgrading a plumbing system to a more modern standard. Signup and view all the answers

Which statement accurately describes the Small Taxpayer Safe Harbor criteria?

It is applicable only if the total amounts do not exceed specified limitations. Signup and view all the answers

How does the IRS classify routine maintenance expenditures?

They are deductible expenses under Section 212. Signup and view all the answers

What determines whether an expenditure is considered a repair or an improvement under IRS regulations?

Whether the expenditure enhances the property materially. Signup and view all the answers

Which of the following is a criterion for capitalizing routine maintenance expenditures?

It must be incurred in a trade or business. Signup and view all the answers

What can small taxpayers utilize to determine rent for leased properties?

The total expected rent over the term of the lease. Signup and view all the answers

Which of the following activities generally qualifies as routine maintenance under the IRS definition?

Inspecting the building HVAC system annually. Signup and view all the answers

Which factor is NOT considered when determining the treatment of an expenditure under repair regulations?

Whether the expenditure was anticipated in advance. Signup and view all the answers

Under the pre-repair regulations, which of the following expenditures is most likely to be capitalized?

Installing built-in shelving. Signup and view all the answers

What is a limitation of the de minimis safe harbor rule?

It is not available if total amounts exceed specified limits. Signup and view all the answers

What accounting period is most commonly used by taxpayers for computing taxable income?

Annual accounting period Signup and view all the answers

What dictates that partnerships must use the same tax year as their majority partners?

IRS guidelines only. Signup and view all the answers

Which condition requires a partnership to conform its tax year to that of its partners?

Deferral of reporting income. Signup and view all the answers

In what scenario can a partnership opt for a fiscal year different from its partners' tax year?

When a valid business purpose is demonstrated. Signup and view all the answers

What happens if a partnership cannot determine a tax year based on majority or principal partners?

It must choose a tax year with the least aggregate deferral of income. Signup and view all the answers

What is a limitation on the allowable tax deductions for real estate?

Application of at-risk rules and passive activity losses. Signup and view all the answers

What is generally the effect of partnerships adopting a lesser aggregate deferral compared to other tax years?

Lower immediate tax liability. Signup and view all the answers

Which type of year might a business use if it wants to close its books on a specific day of the week?

52/53 week-year Signup and view all the answers

What criteria must be met for equivalent payments to be deductible as taxes?

Payments must be imposed at the same rate as property taxes and used for public purposes Signup and view all the answers

How is an excess business loss determined for a taxpayer?

Total deductions attributed to the taxpayer’s businesses less total business income Signup and view all the answers

Which taxpayer group has a different threshold amount when calculating excess business losses?

Married couples filing jointly, with a threshold of $500,000 Signup and view all the answers

What types of income are excluded from calculating aggregate gross income for excess business loss purposes?

Income from employment services and capital asset sales Signup and view all the answers

How is the excess business loss limitation applied to partnerships or S corporations?

At the individual partner or shareholder level after applying passive loss rules Signup and view all the answers

What constitutes a home construction contract?

It attributes 80% or more of costs to dwelling units in buildings of 4 or fewer. Signup and view all the answers

Which taxpayer type generally has less control over the timing of income and deductions?

Accrual basis taxpayers Signup and view all the answers

When a transferor sells property to a related party and incurs a loss, what is the outcome for the transferor?

No benefit is received from the disallowed loss. Signup and view all the answers

Under what circumstance may an accrual method taxpayer deduct expenses owed to a cash basis taxpayer?

When the related taxpayer includes the amount in their income. Signup and view all the answers

What happens to the basis of property received by a transferee when a related party transaction involves a loss?

It remains the sales price paid for the property. Signup and view all the answers

Which strategy might taxpayers generally pursue regarding income and deductions?

Defer income and accelerate deductions. Signup and view all the answers

How is the gain recognized when an original transferee disposes of property received from a related party at a gain?

The already disallowed loss reduces the recognized gain. Signup and view all the answers

In related party transactions, why might losses on sales or exchanges be subject to disallowance?

To prevent tax avoidance through related entities. Signup and view all the answers

What is a common characteristic of expenses between partners in a partnership?

Special rules may apply for tax reporting. Signup and view all the answers

Which statement accurately reflects the timing control capabilities of cash basis taxpayers?

They typically have more control than accrual basis taxpayers. Signup and view all the answers

What happens when a partnership disguises a payment to a partner as a share of the partnership income?

It reduces the other partner’s share of income, effectively providing a deduction. Signup and view all the answers

When are commissions generally capitalized in a partnership context?

When commissions are for acquiring real estate. Signup and view all the answers

Which of the following payments is typically not deductible under normal circumstances?

Legal expenses for defending title. Signup and view all the answers

Which scenario allows for a kickback to be deductible?

If the kickback is customary and not illegal. Signup and view all the answers

What is the tax treatment of insurance premiums paid for a property still under construction?

Capitalized until the property is completed. Signup and view all the answers

How are real estate taxes treated for taxpayers?

Can be deducted as itemized deductions limited to $10,000. Signup and view all the answers

Under what condition can advertising expenses be considered non-deductible?

When they are related to promoting an illegal product. Signup and view all the answers

Which of the following correctly describes a capitalized expenditure?

A payment relating to long-term benefits such as leases. Signup and view all the answers

What is the treatment of commissions for a real estate dealer?

Selling commissions can offset the selling price for tax purposes. Signup and view all the answers

What is the general treatment of legal expenses not related to the improvement of land title?

Deductible as ordinary business expenses. Signup and view all the answers

Which of the following expenses can be deducted under Section 162 as an ordinary and necessary expense?

Pre-opening marketing expenses for a new location Signup and view all the answers

What distinguishes an active trade or business in the context of rental activities?

The inclusion of significant administrative services Signup and view all the answers

Under which scenario would the costs of maintaining rental property potentially be deductible under Section 212?

If the property is not currently producing income Signup and view all the answers

What criteria must be met for expenditures to be classified as repairs rather than improvements?

The expense is limited to incidental repairs only Signup and view all the answers

Costs incurred in which of the following activities would likely NOT be deductible under Section 162 or Section 212?

Contracting maintenance services that enhance property value Signup and view all the answers

Which factor would MOST influence the classification of expenditures under the IRS repair regulations?

The direct outcome of the repair Signup and view all the answers

What is a primary consideration when determining if rental activity qualifies as a business for expense deductions?

Nature and scope of ancillary services provided Signup and view all the answers

When are repairs considered ordinary and necessary under IRS guidelines?

When they sustain the current operational efficiency of the property Signup and view all the answers

Which statement accurately describes the impact of the IRS repair regulations effective from January 1, 2014?

They strictly define what constitutes an improvement versus a repair Signup and view all the answers

Which of the following conditions may lead to the disqualification of an expense as a tax deduction?

The expense significantly prolongs the useful life of the property Signup and view all the answers

Study Notes

Repair or Improvement

Expenditures for new buildings, permanent improvements, or betterments are not deductible.
The IRS historically has been aggressive in this area.
Repair regulations provide guidelines.
Improvements to a unit of property must be capitalized if they result in betterment, restoration, or adaptation to a new use.
Focus in this area is on repair regulations' safe harbor rules.

De Minimis Safe Harbor

May elect to not capitalize tangible property with a limited cost under section 263 repair regulations.
May still require capitalization under section 263A uniform capitalization rules (i.e. property produced or acquired for resale).
Taxpayers with an audited financial statement (AFS) may elect to deduct up to $5,000 per item.
Taxpayers without an AFS may only elect to deduct up to $2,500 per item.
De minimis expensing may be elected by a taxpayer with an AFS if they maintain written accounting procedures treating amounts paid for property costing less than a specified dollar amount (up to $5,000), with a useful life of less than 12 months, as an expense for non-tax purposes and the amounts are treated as an AFS expense.
Taxpayers without an AFS do not need written accounting procedures, but the amount must be expensed on its books and records in accordance with its accounting procedures.
An AFS is a financial statement filed with the SEC, a certified audited financial statement for a substantial non-tax purpose, or required to be filed with federal or state governments (other than the SEC or IRS).

Small Taxpayer Safe Harbor

Taxpayers with average annual gross receipts for the three preceding tax years of $10 million or less may elect to deduct amounts paid during the year for repairs, maintenance, or improvements for a building.
The total paid must not exceed the lesser of 2% of the unadjusted basis of the building or $10,000.
The safe harbor applies to the entire building or a separate unit of property with an unadjusted basis of $1 million or less.
If the total amount exceeds the limitations, the safe harbor is not available for that property.
This includes amounts not capitalized under the de minimis safe harbor election.
The unadjusted basis will generally be its cost, not reduced by depreciation or other amounts treated as expenses (e.g., section 179 deduction).
Leased property uses the total amount of rent (not discounted) that is expected to be paid over the term of the lease.
This may include renewal periods if there is a reasonable expectation of renewal.
Regulations provide a list of factors to consider when assessing reasonable expectation.

Routine Building Maintenance

Routine maintenance is deductible.
This includes recurring expenditures to keep the building structure or systems in efficient operating condition.
Considered routine if activities are reasonably expected to be performed more than once during a ten-year period (beginning when the property is placed in service).
Does not have to be actually performed a second time during the ten-year period.
Factors considered include the recurring nature of the activity, industry practice, manufacturer's recommendations, and taxpayer experience with similar or identical property.
Examples include inspection, cleaning, testing of systems, and replacement of damaged or worn parts.

Election to Capitalize

Routine maintenance or repairs may be capitalized if elected and if incurred in a trade or business and the amounts are treated as capital expenditures on its books and records.
The election applies to all expenditures treated as capital on the taxpayer's books and records.

Pre-Repair Regs

Repair regulations do not set forth a clear and bright-line test.
May still need to use the particular facts and circumstances for expenditures based upon older court cases before the current repair regulations.
The case law is extensive.
Many repairs will add value to property, but courts focus on whether the expenditure materially enhances the value, use, life, strength, or capacity.
Courts have also considered the size of an expenditure and whether the expenditure was forced on the property owner, although these factors have not generally been dispositive of the treatment.
Expenditures to prolong the life of property, adapt the property to a new or different use, or as part of a plan of overall renovation are generally capitalized.
The purpose of the expenditure will control with a focus on whether the expenditure added value to the property or resulted in a longer useful life.

Architectural Barriers

The cost of removing architectural or transportation barriers to provide access to business facilities or public transportation vehicles by elderly and handicapped persons may be deductible up to $15,000.
Any excess over $15,000 is capitalized.
Taxpayer must make an election and the removal must conform to standards set forth in the regulations.

Materials and Supplies

Addressed by the repair regulations and is effective for years after 1/1/2014.
May be applied for the 2012 or 2013 years.
Cost may be expensed unless the taxpayer maintains records of consumption or physical inventories.
Materials and supplies are deducted as consumed.
A special rule applies to rotable and temporary spare parts (allowed as a deduction when the part is disposed, but there is an optional method).
Materials and supplies are defined as tangible property that is consumed in a business that is not inventory.
Materials and supplies are also property that is a component acquired to maintain, repair, or improve tangible property owned or leased by the taxpayer and that is not acquired as part of any single unit of tangible property.
This also includes items that are reasonably expected to be consumed in 12 months or less (e.g., fuel, lubricants, water, etc.).
This includes a unit of property that has a useful life of 12 months or less.
This also includes a unit of property that has an acquisition or production cost of $200 or less (may be changed by the IRS in guidance).
This includes any other items otherwise identified in published guidance as materials and supplies (e.g., smallwares in the restaurant industry).
A taxpayer may elect to treat as a capital expenditure the cost of materials and supplies.

Compensation

Salaries and compensation paid for personal services are generally deductible.
Amounts must be reasonable and paid purely for services.
The IRS scrutinizes reasonableness when the business and employee are related.
The IRS will look to comparable compensation in similar businesses.
If excessive and paid to a shareholder, the excess is not deductible and treated as a dividend.
If paid to the seller/former owner, it may be treated as part of the sale.
Generally, may otherwise be freely bargained and includes salary, bonus, and vacation pay.

Reasonableness

Typically, a question of fact.

Tax Accounting Period

Taxpayers must use a consistent accounting method and period to calculate taxable income.
Most use a calendar year period, but some use a fiscal year or a 52/53 week-year.
The chosen accounting period is selected on the first tax return.
Fiscal year use is limited for certain entities.
Partnerships, S corporations and personal service corporations generally must use the same tax year as their owners unless a business purpose is shown.
The IRS has specific procedures for changing tax years and determining a “natural business year” for corporations, partnerships, S corporations and personal service corporations.

Partnerships

Partnerships typically adopt a fiscal year, which allows partners to defer reporting income.
However, now partnerships must conform their tax year to that of their partners unless there is a business purpose for a different tax year.
The partnership must use the same tax year as the majority partners (owners with 50%+ interest).
If no majority group exists, it must conform to the tax year of the principal partners (partners with 5% or more interest in profits and capital).
If a partnership still can’t determine a tax year based on majority or principal partners, it must select a tax year that results in the least aggregate deferral of income to the partners.

Timing of Income and Deductions

Taxpayers often control the timing of income and deductions to achieve a desired tax outcome.
Cash basis taxpayers have more control than accrual basis taxpayers.
Taxpayers may defer income and accelerate deductions, though this is not always beneficial.

Transactions between related parties to generate tax deductions or losses may not be deductible.
Often used when different accounting methods are applied.
Losses on sales or exchanges are disallowed; the transferee's basis in the property is its cost (sales price).
The transferor does not receive a benefit from the disallowed loss.
If the original transferee later sells or disposes of the property at a gain, the amount of gain is reduced by the loss previously disallowed. This applies only to the original transferee or property received in a tax-free exchange.
For expenses or interest owed by an accrual method taxpayer to a cash basis taxpayer, the expense may be deducted when the related taxpayer is required to include the amount in income. This is known as "matching".
There are additional rules for transactions between partners and partnerships, and S corporations and shareholders.

Start-up Expenses

Start-up expenses may be deductible under Section 162 as ordinary and necessary business expenses.
The opening of new stores is part of the retailer's long-term expansion plans.
New stores are operationally indistinguishable from each other and existing stores.
Opening a new store takes only a brief period of time, and the expenses are similar to operating established stores.
Start-up expenses must relate to an active trade or business.

Real Estate Operating Expenses

Operating expenses for a trade or business are normally deductible under Section 162 as an "ordinary and necessary expense".
Ordinary and necessary expenses are also deductible for the management, conservation, or maintenance of property held for the production of income under Section 212, even if the activity does not constitute a trade or business.
This does not necessarily require current income from the property.
This principle is broadly applied but is limited by facts and circumstances, with a focus on profit-motive.

Repairs

The cost of repairing or maintaining real property is deductible under either Section 162 or 212 if it is not otherwise required to be capitalized.
Expenditures beyond incidental repairs that keep the property in ordinary efficient condition, which instead add to its value or prolong its life, are not deductible.
The Supreme Court has focused on costs incurred in the original construction or subsequent enlargement and improvement.
The court also considers whether the expenditure generates significant long-term benefits beyond the taxable year.

Disguised Payment for Services

A partnership may attempt to disguise a payment to a partner as a partnership income share rather than as compensation for services. This can occur when the compensation must be capitalized, such as construction or organizational costs.
The partnership would make a distribution payment to the partner, reducing other partners' share of income and effectively providing a deduction to them.
If a partner provides services and receives a partnership allocation and distribution related to the performance of services, the transaction may be recharacterized as one between the partnership and an outsider.
The payment is treated as made to a non-partner and for services. If appropriate, the partnership will capitalize the expenditure.

Commissions and Fees

Commissions and fees are usually deductible for services that produce a short-term benefit (such as broker and management fees).
They are capitalized if they provide a long-term benefit (such as a fee for a long-term lease).
Commissions for the acquisition of real estate are capitalized.
Selling commissions may be deducted by a real estate dealer.
For a non-dealer, commissions offset the selling price.

Kickbacks

Kickbacks are typically illegal and not deductible.
They may be deductible if ordinary and necessary and not illegal or contrary to public policy.

Insurance, Advertising, and Legal Expenses

Insurance is generally deductible, but capitalized if paid for property under construction.
If insurance coverage exceeds one year, a cash basis taxpayer must spread the deduction ratably over the period it relates to.
Advertising and legal expenses are generally deductible.
Legal expenses to defend or perfect title are not deductible and are considered additional costs to the land.

Real Estate Taxes

Taxpayers may deduct state, local, foreign real property taxes; state and local personal property taxes; and either state and local income or sales taxes, whether or not connected with a trade or business or held for investment.
Individuals deduct these amounts as itemized deductions, subject to a $10,000 limit.
Taxes are fully deductible in carrying on a trade or business or for the production of income, even for an individual.
Equivalent payments are deductible as taxes if they are imposed at the same rate as property taxes, imposed by state law, and proceeds are used for a public purpose.

Excess Business Losses

If a non-corporate taxpayer has an “excess business loss” for the year, it is not allowed.
This provision is effective for tax years beginning after December 31, 2020 and before January 1, 2029.
Any disallowed loss is carried forward and treated as part of the taxpayer's net operating loss carryforward in subsequent years.
An “excess business loss” is defined as the aggregate deductions for the year attributable to the taxpayer's businesses, less the sum of the taxpayer's aggregate gross income or gain, less a threshold amount. The threshold amount is 500,000formarriedtaxpayersfilingajointreturnand500,000 for married taxpayers filing a joint return and 500,000formarriedtaxpayersfilingajointreturnand250,000 for all other taxpayers.
These amounts are indexed for inflation.
Aggregate deductions do not include net operating loss deductions or losses from the sales or exchanges of capital assets.
Aggregate gross income does not include income or gains in performing services as an employee.
Gains from the sales or exchanges of capital assets in determining aggregate gross income may not exceed the lesser of: (1) capital gain net income from the trade or business, or (2) overall capital gain net income.
This rule limits the amount of nonbusiness income that can be sheltered from tax as a result of business losses.
It applies to the aggregate gross income and deductions from all of a taxpayer's trades or businesses.
If a married couple files a joint return, information from all of the couple's trades or businesses must be consolidated.
The losses of one spouse can be used to offset the other spouse's nonbusiness income, up to the $500,000 limit.
For partnerships or S corporations, the excess business loss limitation applies at the partner or shareholder level.
The excess business loss limitation is applied after the application of the passive loss rules.

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Description

This quiz covers the tax regulations surrounding expenditures for repairs, improvements, and betterments according to IRS guidelines. It emphasizes the rules for capitalization and the de minimis safe harbor provisions applicable to tangible property costs. Test your understanding of how these regulations affect property owners and taxpayers.