Final Capitalization Rules may help Real Estate Developers dig out

By Sheryl Brake, CPA, CVA

The Denver-Boulder corridor has experienced its share of boom and bust years. Back in 1992, barely 16 major property owners could be identified along U.S 36, and most of the developments were in the initial stages. By 1995, with a hot economy showing no signs of cooling down, business parks and big box retailers had sprouted up along U.S. 36, with more developments planned. A few years later, as everyone knows, the economy took a dive, and so did development and leasing activity. But U.S.36 remains one of the metropolitan area's most important corridors, largely as a commercial base for bedroom communities such as Broomfield, Louisville and Westminster. While darkened empty buildings briefly became the norm, opportunities will arise, as the economy slowly moves into recovery, for investors and developers to acquire and reposition office buildings formerly occupied by single-user technology and telecom clients. Investors looking for short-term acquisition and redevelopment capital may find that new IRS regulations governing capitalization of certain expenses can, in some cases, assist developers hoping to convert single use buildings into multi-tenant entities.

Capitalization of expenses was traditionally only required when expenses were for the creation, acquisition or enhancement of a separate and distinct asset, whether paid or incurred. In the latter part of 2003, the Treasury department and IRS issued final regulations regarding capitalization of certain expenses. In general, an expense is deductible as a business expense if the following four requirements are met: 1) it must be paid or incurred in the tax year, 2) it must be incurred for carrying on a trade or business, 3) it is a necessary expense; and 4) it is an ordinary expense.

Under the new regulations, expenses paid or incurred on or after December 31, 2003 in the connection with the acquisition or creation of intangible assets are not required to be capitalized solely on the ground that a "significant future benefit" is produced. There are, however, the following exceptions:

Acquired intangibles, Created intangibles, Separate and distinct intangibles, and "Significant future benefit" intangibles that will be specifically identified by the Treasury.

Amid the exceptions requiring capitalization are those allowing deductions. There are two exceptions to the created intangible exceptions that are taxpayer-friendly:

The first exception is the "12-month rule." This exception states that unless otherwise provided in the regulation, a taxpayer is not required to capitalize amounts paid in the connection with the creation of intangibles if the benefit of the expenditure does not extend beyond 12 months.

The second favorable exception is a de minimis rule. Under the de minimis rule expenditures are deductible if in total they do not exceed $5,000. It is important to note that an election is available, whereby the taxpayer can elect to capitalize such internal overhead and de minimis costs. This is an important election, if the taxpayer has a net operating loss (NOL) that is about to expire. By capitalizing the transaction costs, a taxpayer may raise taxable income and allow for absorption of some or all of the NOL. The taxpayer would still get the benefit of amortization expense in later years.

Included under the category of created intangibles that must be capitalized are certain contract rights. In general, a taxpayer must capitalize amounts paid to create, originate, enter into, renew or renegotiate an agreement. This includes amounts paid to enter into, modify, renegotiate or terminate a lease agreement, so long as the amounts paid exceed the $5,000 de minimis amount. Two specific examples are given where capitalization would not be required: One example provides for a deduction of a termination fee (as provided for in a lease) where the lessee terminates a lease without the lessor's approval. In another example, the same termination fee is still considered deductible even where the lessor agrees to reduce the termination fee.

Amounts paid for the purchase, production or improvement of real property generally require capitalization. Even where another owns the real property, taxpayers must capitalize amounts if it can reasonably be expected to produce economic benefits for the taxpayer. An important exception allows a deduction of impact fees and dedicated improvements. Capitalization is not required for "amounts paid to satisfy one-time charges imposed by a state or local government against a new development (or expansion of existing development), to finance specific offsite capital improvements for general public use that are necessitated by the new or expanded development." This exception also applies where improvements are made to real property, and then are immediately transferred to a state or local government for general public use.

What this means for investors and developers seeking to recycle U.S.36 real estate is that the regulations provide some planning opportunities for costs associated with the creation of certain intangibles, and costs normally incurred in development. Final rules generally follow the proposed regulations issued two years ago, but with modifications. More specific categories of costs, which must be capitalized, are described and illustrative examples are given. Additionally, they provide 'safe harbors' and simple assumptions that permit current deduction and reduction of record keeping. The regulations are not without complexity, however and require a closer look to ascertain how they apply to a particular situation. With consideration and planning, investors and developers can maximize the benefits of these new regulations and respond to opportunities arising in hard-hit markets such as the Denver/Boulder corridor.

Sheryl Brake, CPA, CVA, is a tax partner and valuation specialist in the Boulder office of Gordon, Hughes & Banks, LLP. She can be reached at (303) 443-1911. This article appeared in the March 2, 2004 issue of the Colorado Real Estate Journal.