More than 20 years have passed since Congress implemented sweeping changes for the depreciation periods for nonresidential property and residential rental property. Although Congress wisely responded to real estate overcapacity and investor abuse, the current depreciation policy unfairly denies building owners and investors the ability to recover depreciation costs at the same rate as their properties lose value.
The depreciation periods for roof systems carry important tax ramifications for building owners. At 39 years for nonresidential property and 27 1/2 years for residential rental property, the current depreciation periods force building owners to wait an inordinately long time to realize the full depreciation of their properties. The periods also limit the amount of depreciation owners can claim per year.
Such limitations reduce owners' incentive to invest in improvements, such as having new roof systems installed, and inaccurately reflect the true economic life of a property.
As a result, the depreciation periods give roofing contractors and manufacturers fewer opportunities to sell products and perform needed roof system repairs.
However, the depreciation periods may change for the better if NRCA and other trade associations have their way. To understand this important and evolving issue, it is imperative roofing professionals understand what depreciation is and how it works. This will allow roofing contractors and manufacturers to explain potential tax savings and the importance of repair and replacement work to building owners.
What is depreciation?
Suppose a business owner buys a capital asset (a piece of equipment, building or vehicle that is used in a business) and expects to use the item for several years. The cost of the capital asset should be written off during the same period of time the business owner expects it to earn income. Therefore, the business owner must spread the cost across several tax years and deduct part of it each year as a business expense. As the asset wears out, loses value or becomes obsolete, the business owner recovers his cost as a business expense. This method of deducting the cost of business property is called depreciation.
Property can be depreciated if it meets the following requirements:
Roof system repairs or replacements that increase a property's value, make a property more useful or lengthen a property's life are capital expenses that must be depreciated. A depreciation period's length depends on whether a repair or replacement is being performed on a residential rental property or nonresidential property.
For regular tax purposes, the depreciation deduction amount for residential rental property is determined by using the straight-line method and a 27 1/2-year recovery period. The recovery period characterizes a property's useful life, and the straight-line method allows the same depreciation amount to be deducted each year during the useful life of the property. For nonresidential property, the method also is straight-line but with a 39-year recovery period. Nonresidential property includes office buildings, shopping malls and industrial buildings.
Reasons for the increase
As a partial result of the recession in the 1980s, the United States suffered from building overcapacity, which was reflected in high vacancy rates in many urban areas. To compound the issue, many building owners and investors used real estate as a tax shelter. To combat the oversupply of buildings and instances of tax-shelter abuse, Congress gradually extended the depreciation period for such buildings. (See "Depreciation history.")
After establishing a 15-year depreciation period in 1981, Congress became particularly concerned with building owners' and investors' abilities to claim passive activity losses, which concern losses from activities that do not require taking an active role in a business or investment. Such activities include owning a farm on which you do not work, renting out a house or investing in a limited partnership while letting others run the business.
Legislators reasoned that if a building owner could depreciate a building's entire value within 15 years and offset the expense against other income, he could use his real estate investment to claim little or no overall income tax. Moreover, if a building owner sells a building for a profit, he only would pay a 20 percent capital-gains tax on the profit though his other income might have placed him in a higher tax bracket. People in high tax brackets theoretically could avoid paying taxes for a few years before selling a building for a profit and pay only a 20 percent capital-gains tax on the profit.
As a result, in 1986, Congress passed a law that disallowed the ability to offset passive activity losses against other active income. In 1993, the ability to offset losses was reinstituted, but real estate investors had to be active participants and meet certain Internal Revenue Service threshold standards. However, Congress increased the depreciation period for commercial property to 39 years.
Recent developments
Roofing industry observers believe the current depreciation schedule has seen its day because it does not provide appropriate tax benefits to building owners and investors who are forced to recover their costs more slowly than actual losses of property value.
A recent study, "Analysis of the Economic and Tax Depreciation of Structures," by Deloitte & Touche, New York, confirmed that depreciation periods need to be shortened. The study, which was released in 2002, was commissioned by The American Institute of Architects, Association of Foreign Investors in Real Estate, Building Owners and Managers Association, International Council of Shopping Centers, Mortgage Bankers Association of America, National Association of Realtors, National Association of Industrial and Office Properties, and The Real Estate Roundtable.
The study concludes the 39-year nonresidential and 27 1/2-year residential rental property depreciation periods in current tax law provide building owners with investment recovery that is too slow and should be revised to be more economically justified.
The Deloitte & Touche study suggests tax depreciation periods should be updated to reflect the actual rates at which building investments lose value as they age. The study reports that if the straight-line method of depreciating an entire structure is retained, the recovery period necessary to make tax depreciation correspond to economic depreciation is 20 years or less, which is significantly shorter than the present 27 1/2- and 39-year periods.
In reaching new recovery periods, Deloitte & Touche offers the following estimated straight-line equivalent recovery periods for buildings using a methodology based on building values:
Using a methodology based on annual rents, Deloitte & Touche offers the following estimated straight-line equivalent recovery periods:
Deloitte & Touche argues certain components must be replaced well before the end of a building's depreciation period. For support, the study refers to the average life expectancies for replaceable roof system components as compiled in the 1999 Marshall Valuation Service Book, such as 16 years for composition shingles and 15 years for gutters and downspouts.
Depreciation vs. deduction
A shortened depreciation period would create incentives for building owners and investors because they would realize greater tax savings during a shorter time period. In turn, this would stimulate greater structural investment in properties, such as new roof systems or roofing-related expenditures, and drive roofing industry growth. The ability to claim deductions that more accurately reflect the economics of keeping property also would make real estate investments more viable.
When deciding to repair or replace roof systems, it is important building owners remember some decisions will result in a deduction taken during the tax year in which work was performed or depreciation expense taken over the future life of the property.
Repairs and replacements that do not increase a property's value, make a property more useful or lengthen a property's useful life cannot be depreciated. However, repairs and replacements may qualify as deductible expenses. Only payments that keep a property in ordinary, efficient operating condition, such as replacing short-lived parts, and do not add to its value or appreciably prolong its life are considered repairs. Examples of repairs include amounts expended for repainting, fixing leaks, plastering and conditioning gutters. However, if repairs or replacements increase a property's value, make it more useful or lengthen its life, they must be treated as improvements and depreciated.
When a roof system is replaced, the issue of why it was removed and how much of it was removed needs to be addressed to determine the tax treatment of the expenses.
For example, if a portion of a roof system is replaced to prevent further damage to a building, federal tax courts have concluded the cost of removing and replacing a portion of the defective roof system is a deductible expense. However, completely replacing a roof system is considered an improvement because a new roof system will increase property value and lengthen property life. The roof system replacement, therefore, must be capitalized and depreciated.
Usually, the cost of remodeling a building or replacing a major component, such as a roof system, constitutes a capital expenditure because there is a resulting increase in property value, extension of useful life or improvement in usability—all factors that tend to indicate a capital expenditure.
However, some roof system replacements may be deductible. For example, replacing part of a roof system is a deductible business expense when the replacement repairs a leak. Such a replacement is not a deductible business expense when it is part of a general rehabilitation plan or continuous rebuilding or remodeling project.
Learn how to plan
Building owners would do well to apprise themselves about how to treat roofing procedures for tax purposes, and you should tell clients about depreciation issues. A deduction for roof system repairs could come in handy at tax time, and the ability to write off a roof system replacement during the course of a property's life would offset income from other sources.
But something needs to be done to shorten depreciation time periods. Manufacturers and roofing contractors would agree industry growth could be spurred if building owners could recoup expensive roof system replacements in shorter time periods.
David Morris is an adjunct professor at DePaul University, Chicago, and free-lance writer.
The political score
by R. Craig Silvertooth
A consensus among tax professionals and construction, real estate and other related industry representatives is emerging in Washington, D.C. The consensus reflects an understanding held for years by property owners across the United States. Put simply, there's a huge disparity between the depreciation tax tables in the Internal Revenue Code and realities of true economic depreciation of commercial buildings.
It seems as if a week doesn't pass without a group questioning depreciation schedules' logic. Convenience-store owners realized the senselessness of a 39-year depreciation period for nonresidential property and managed, in the 1986 tax reform package, to carve out an exemption allowing convenience stores and gas stations to be depreciated during 15-year periods. Now, restaurant owners, commercial property owners, retailers and others are seeking similar treatment.
Equitable treatment for all commercial property owners seems fair and reasonable. But the prospect of meaningful depreciation reform hinges on a rather wieldy issue—the federal deficit. With the return of federal budget deficits, legislators are increasingly cautious about passing new legislation that would take money out of federal coffers.
What does this have to do with depreciation? The issue gets to the core of one of the most contentious debates in Washington revolving around a process called scoring. During the federal budget process, the government draws up its annual budget with an eye toward the 10-year horizon of forecasted revenues and outlays. Outlays are fairly easy to estimate, but revenues are significantly more difficult to project because actual intakes are, by and large, a measure of the annual national income.
Intakes are where scoring enters the equation. The Joint Committee on Taxation (JCT), a congressional staff team of economists and tax professionals, acts as the official scorekeeper to determine the revenue effects of any proposed tax changes. When JCT receives a request for revenue analysis about proposed tax legislation, it measures the anticipated changes in federal receipts that result from the proposed change. A good way to think about scoring is as a measure's official cost or price tag. As a result of the Budget Enforcement Act of 1990, any proposed reduction in taxes must be "paid for" with an offsetting tax increase or direct spending decrease.
If legislators introduce a bill that would, for example, increase the amount small businesses could expense each year, JCT would estimate the loss in projected revenue the government would have otherwise collected had the law not been changed. In turn, legislators would have to find an offset (tax increase or fee) or cut spending elsewhere. With the myriad of competing interests in Washington, this gets politically dicey.
Because it is difficult to accurately predict future growth, JCT traditionally has relied on a static scoring system that makes no assumptions about the macroeconomic consequences of any particular tax measure. The method seems straightforward, but there are serious questions regarding the static scoring system's ability to generate accurate figures. With the expensing example, for instance, JCT only would consider the revenue loss associated with collecting less money from the affected filing small businesses. But what about the additional revenue expected from the boost in growth among the manufacturing, sales and distribution sectors?
For years, this critical omission has prompted many observers—in and out of government—to urge JCT to account for the macroeconomic effects of tax law changes. This year, after strong encouragement from several senior Republican legislators, JCT is experimenting with "dynamic" scoring.
Dynamic scoring attempts to account for a bill's positive growth effects. If the model anticipates indirect generation of new receipts, the receipts are factored into the analysis and the final score correspondingly is adjusted downward. This is great news for NRCA's roof depreciation initiative because JCT will consider the effect of new income associated with increased construction activity coming into the federal treasury in the form of corporate and individual income tax receipts. Roofing professionals just have to hope the federal deficit numbers improve in the near term.
R. Craig Silvertooth is NRCA's director of federal affairs.
Depreciation history
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