Remodel and deduct: Tax-law changes shrink deduction timeline for capital expenses

When it's time to fix-up, remodel or redecorate the building, clinic or offices that house your veterinary practice, you will want to keep out-of-pocket expenditures to a minimum and recover as much of the funds spent as quickly as possible. Fortunately, both those veterinarians who own their own buildings and those who lease their property can take advantage of a variety of tax deductions, credits and other tax breaks to achieve those goals.

Under the basic tax rules, additions and improvements usually are depreciated in the same manner as the existing property would be depreciated if it were placed in service at the same as that addition or improvement. A roof replaced on a commercial building is, for example, usually treated as 39-year nonresidential real property, regardless of how that building is actually written-off or depreciated.

Imagine, however, that those expenditures for improvements, additions or remodeling could qualify for faster write-offs, even a direct reduction of the practice's tax bill. The result would be a reduction in the veterinary practice's out-of-pocket expenses, faster and larger write-offs to reduce its tax bill and most importantly, a much-improved business environment.

First, consider the unique, faster write-off for so-called "leasehold improvements" created by the American Jobs Creation Act of 2004.

Quite simply, the new law creates a 15-year recovery period for so-called "qualified leasehold-improvement property" placed in service between Oct. 22, 2004 and Jan. 1, 2006. All improvements must be made to the interior portion of the veterinary practice's building.

This write-off is not optional. The new law temporarily reduces the depreciation period to 15 years for the improvements made to leased business property (and for qualified restaurant property). Qualified leasehold-improvement property is an improvement to the interior portion of a building that is nonresidential real property — provided certain requirements are met, of course.

The improvements must be made under, or pursuant, to a lease either by the lessee (or sublessee), or by the lessor. The lessee and lessor cannot be related, and the improvement must be made to that portion of the building occupied exclusively by the lessee (or sublessee). Plus, the improvement must be placed in service more than three years after the date the building was first placed in service (i.e., the building must be more than three years old).

Expenditures for (1) the enlargement of a building, (2) any elevator or escalator, (3) any structural component that benefits a common area, or (4) the internal structural framework of the building do not qualify. However, because a lessee usually does not retain the improvement, upon termination of the lease, a loss normally results. This loss is computed by reference to the improvement's adjusted basis at the time of the lease termination. A lessor that disposes of, or abandons, a leasehold improvement (made by the lessor) upon termination of the lease may use the adjusted basis of the improvement at such time to determine its gain or loss.

Thanks to a special exception contained in the new rules, the 30- or 50-percent "bonus" depreciation allowance is available for "qualified leasehold-improvement property." Unfortunately, bonus depreciation may only be taken for leasehold improvements placed in service before Jan. 1.

Divide for a larger write-off

The Internal Revenue Service recently announced that it would go along with a ruling of U.S. Tax Court that permitted some elements of a building to be depreciated separately as personal property. The IRS has agreed with the court's method for determining whether an item is a structural component (i.e., real property) or personal property. The separate, shorter recovery period for the personal property elements of a building is referred to as "cost segregation."

The following items, at least if related to the operation and maintenance of a building, are examples of structural components: bathtubs, boilers, ceilings (including acoustical ceilings), central air conditioning and heating systems, chimneys, doors, electrical and wiring, fire escapes, floors, hot water heaters, HVAC units, lighting fixtures, paneling, partitions (if not readily removable), plumbing, roofs, sinks, sprinkler systems, stairs, tiling, walls and windows.

Expenditures for other improvements, not structural components and not related to the operation of the building, now can be written-off separately by a veterinary practice using much shorter recovery periods. In fact, many of those "personal property" items may qualify for the first-year using the Section 179 expensing deduction.

First-year expensing

In order to qualify as an immediately expensed or Section 179 allowance, property must be a tangible Section 1245 property, depreciable and acquired by purchase for use in the active conduct of a practice or business. The Section 179, first-year expensing allowance, does not include a building or its structural components. It can include many Section 1245 personal property costs but only to the limits.

Those limits mean that a veterinary practice can currently expense up to $100,000 in Section 179 expenditures every year. Should total expenditures for Section 179 property exceed $400,000 in any year, the deduction must be reduced dollar-by-dollar by any excess.

Rehabbing versus remodeling

The tax rules also contain a unique tax credit that can reduce the tax bill of any practice incurring so-called "rehabilitation expenditures" during the tax year. The rehabilitation investment tax credit equals 20 percent of the qualified rehabilitation expenses (QRE) for certified historic structures and 10 percent of QRE for qualified rehabilitated buildings first placed in service before 1936 (other than certified historic structures). No energy credit is allowed on that portion of the basis of property that is attributable to QRE.

A building and its structural components constitute a qualified rehabilitated building (QRB) if they are (1) substantially rehabilitated, (2) placed in service before the rehabilitation begins. Property other than a certified historic structure must also satisfy (3) a "wall retention" test, (4) an age requirement, and (5) a location of rehabilitation requirement. Property is considered substantially rehabilitated only if the expenditures during a self-selected 24-month measurement period (60-month period for phased rehabilitation) are more than the greater of the adjusted basis of the property or $5,000.

QRE does not include new construction, an enlargement, the cost of acquisition, noncertified rehabilitation of a certified historic structure, rehabilitation of tax-exempt use property, expenditures that are non-depreciable, or lessee-incurred expenditures if, on the date the rehabilitation of the building is completed, the remaining term of the lease (determined without regard to renewal periods) is less than the property's recovery period.

Energy investment credit

Another unique tax credit, a direct reduction of the veterinary practice's tax bill rather than a deduction from the income upon which that tax bill is computed, is available for so-called energy property. That's right, the business energy-investment credit is equal to 10 percent of the basis of energy property placed in service during the year (subject to reduction if the property is financed by tax-exempt private activity bonds or by subsidized energy financing).

No energy credit is allowed for that portion of the basis of property for which rehabilitation investment credit is claimed. An advance energy investment credit may be claimed under special rules for progress expenditures.

Energy property includes equipment that uses solar energy to generate electricity, heat or cool a structure or provide solar process heat. It also includes equipment that produces, distributes or uses energy derived from geothermal deposits (but only in the case of electricity generated by geothermal power, up to the electrical transmission stage). To qualify for the credit, the equipment must be depreciable (or amortizable) and must meet performance and quality standards prescribed by the regulations. No partial deductions are available, so a veterinary practice must complete the construction, reconstruction or erection of the property. If the property is acquired, then the practice must be the first to occupy it.

Reaping rewards of land repair

Under our tax rules, the cost of the land upon which the practice sits is not deductible. Fortunately, improvements made to that land often qualify for a tax deduction. Land improvements not specifically included in any other asset class or is otherwise depreciable qualifies as a 15-year property. Examples of land improvements include sidewalks, driveways, curbs, roads, parking lots, canals, waterways, drainage facilities, sewers (but not municipal sewers), wharves and docks, bridges and nonagricultural fences

Regardless of whether your veterinary practice's business premise is owned or leased, there are an abundance of tax deductions, credits and unique write-offs available to help offset the cost of remodeling, fixing-up or adding to it. The new but temporary 15-year write-off for leasehold improvements applies only to improvements placed in service before Jan. 1, 2006.

Mr. Battersby is a financial consultant in Ardmore, Pa.