Repair, Replace or Not for Maximum Tax Savings

Understanding tax write-offs for what is or what isn’t a repair in a waterfront facility has long been an issue when dealing with the IRS. Tax rules allow a marina or boatyard business to deduct all the “ordinary and necessary” expenses incurred during the year, including the cost of repairs, maintenance, supplies and the like.

Another tax rule requires that the costs of acquiring, producing and improving equipment or other property, regardless of the amount of the cost, be capitalized and written off over a period of years.

Defining the Difference
The IRS usually defines a repair as an expenditure that keeps the property in normal operating condition. A capital improvement, on the other hand, is defined as an expense that either extends the useful life of the property or allows it to perform a new function.

When attempting to determine the difference between immediately deductible repairs and those improvements that should be written off over several years, the general rule of thumb is an improvement is work that prolongs the life of the equipment or property, enhances its use or adapts it to a different use. A repair merely keeps that property or equipment in efficient operating condition.

Routine Maintenance
There is also routine maintenance to be considered. Particularly prevalent is wear and tear at saltwater marinas. To mitigate these risks, marina operators incur maintenance costs to both ensure the safety of the operation and comply with all environmental regulations.

Expenditures for regularly scheduled, routine maintenance on property or equipment, including inspection, cleaning, testing, replacement of parts and other recurring activities performed to keep that property or equipment in its ordinary efficient operating condition don’t, according to the rules, need to be capitalized.

Of course, while routine maintenance can be performed any time during the property or equipment’s useful life, there must be a reasonable expectation when the property is first placed in service that the maintenance activities will be performed one or more times during its useful life. Failure to perform the maintenance more than once is not fatal, provided the marina or boatyard operation’s owner or manager can prove that its expectation was reasonable when the property or equipment was first placed in service.

Factors to consider when determining whether the operation’s expectation was reasonable include the recurring nature of the activity, practices within the industry, the manufacturer’s recommendations and the operation’s own experience with similar or identical property or equipment.

Just to confuse things, it should be noted that, according to the IRS, several expenses that otherwise might be considered as currently deductible must be capitalized if part of a more extensive plan. While painting is usually not considered a capital improvement, for example, it must be capitalized if it is part of a large-scale improvement plan.

Fortunately, the tax rules contain a relatively new de minimis safe harbor for expenditures that would ordinarily have to be capitalized. Instead of capitalizing and depreciating many of those expenditures, taking advantage of bonus depreciation or the Section 179 election to expense, many costs that ordinarily must be capitalized can simply be expensed thanks to any one of the tax law’s so-called “safe harbors.”

Safe harbors are “loopholes” built into the tax regulations for the treatment of specific expenditures. One such safe harbor, for example, allows purchases of less than $200 in either materials or supplies for use in the marina or boatyard operation to be treated as expenses and currently tax deductible. The deduction for materials and supplies is available in the tax year when the item is used or consumed so long as it has a useful economic life of less than 12 months.

Also in the tax rules is a safe harbor for amounts paid to acquire or produce tangible property. The so-called “de minimis safe harbor” is available to marinas and boatyards that do not have an “applicable financial statement” (generally an audited financial statement) that allows them to immediately expense expenditures of less than $2,500 per invoice.

For those operations that do have an applicable financial statement, the threshold is increased to $5,000 per invoice, regardless of whether the expenditure meets the definition of a capitalizable expense or not. Best of all, the de minimis safe harbor is available without the necessity of changing the operation’s accounting methods.

Although not strictly a safe harbor, as mentioned, the tax rules allow amounts paid for routine and recurring maintenance to keep property in working condition to be treated as repair costs. To use the “Routine Maintenance Safe Harbor,” the marina or boatyard operation should segregate amounts paid for real estate and other property. If the expenditure is paid to maintain that real estate or other property, the amount can be expensed so long as it is expected the repair will occur more than once during a 10-year period. If the amount is paid to maintain other property, the amount can be expensed so long as it is expected to occur more than once during the property’s useful life.

When an Immediate Write-off Won’t Help
Immediate write-offs, whether labeled as repairs, maintenance or accelerated depreciation, are not of much use to any business without taxable profits from which to deduct them. After all, very few businesses will benefit from more losses.

Capitalizing means treating the cost under the belief that benefits—and tax benefits—will be derived over the long run, whereas expensing a cost implies the benefits are short-lived. Whether an item is capitalized or expensed usually comes down to its useful life, i.e., the estimated amount of time that benefit is anticipated to be received. Who better to estimate than the marina or boatyard owner or operator?

To Capitalize or Not
The tax rules provide ways for determining whether repair should be deducted or deducted over a certain number of years. A marina’s property is improved only if the expenditures are for “betterment,” “restoration” or “adaptation” to a new or different use.

Many small businesses can elect to deduct the cost of what would otherwise be capital improvements as expenses. By expensing an expenditure, the operation ends up paying less tax because expenses are reported immediately (in the tax year when purchased). Capitalizing has the opposite effect on the tax bill.

To qualify, the business must have had less than $10 million in average annual gross receipts for the three preceding tax years. To be eligible for the safe harbor, the total amount of repairs, maintenance and improvements for the year cannot exceed the lesser of $10,000 or 2% of the property’s unadjusted basis. If the total amount paid exceeds the safe harbor threshold, the safe harbor does not apply to any amounts during the tax year.

Follow the Accountant
The tax rules allow a marina or boatyard to follow the financial accounting policies when it comes to choosing to capitalize repair and maintenance expenses as improvements, so long as they are treated as such for accounting purposes. The operation can choose to treat repair and maintenance costs paid during the tax year as amounts paid to improve property if:
Those amounts were paid in carrying on a trade or business; the amounts are treated as capital expenditures on the operation’s books and records; or if the election to capitalize is made for each taxable year in which qualifying amounts of repair and maintenance costs are a factor on the tax return.
Once again, this annual election is not a change in the method of accounting.

What and When to Write Off
It is the operation’s owner or manager that has the discretion of determining if expenditures should be capitalized and depreciated over time or whether the cost should be fully expensed and deducted in the current tax year. The operation is not required to capitalize as an improvement, and therefore may be permitted to immediately deduct the cost of repairs, maintenance, improvements or similar costs.

Some costs, such as maintenance plans and warranties, software licenses, training costs, operating supplies and consumables, etc., cannot be capitalized, even though they might appear to be part of the basic cost of an otherwise capitalizable asset. Obviously, the decision to deduct or capitalize requires professional help.