Story by Cynthia L. Finkenbinder, CPA
Have you ever seen the movie The Money Pit, with Tom Hanks and Shelley Long? In this comedy movie (or was it a tragedy?) a young couple struggles to repair a hopelessly dilapidated house. We all have heard horror stories of what should have been a simple remodel gone horribly wrong. The second they move into the house it starts to fall apart, starting with the stairway collapsing and the bathtub crashing through the second floor into the living room! Finally, they have no choice but to completely renovate the house before the frame collapses, but the renovations also prove to be a disaster. That’s not something you need to have happen, especially if you are trying to start or expand a business.
Admittedly, you probably don’t have to worry about a bathtub falling through the floor when you are building a facility for your business, but aside from dust everywhere and things running behind schedule and over budget, what else do you need to be aware of? Whether you are building a brand new location on raw land, or leasing a facility that requires a build-out to customize the space and make it work for your business, one question you should ask yourself (or your accountant) about every part of the construction process is: Do I capitalize it or do I expense it?
First, you have to capitalize everything, with very few exceptions, until the building becomes operational. Understanding the mechanics gets technical, but we’re going to try and simplify things a bit (as if anyone could really do that with the federal tax code).
Let’s take a look at what kind of expenses to assign to capitalization, because most of the time the original build-out will fall into this category. Because the facility is not operational yet, you have two kinds of costs: start-up costs and other leasehold improvements (if you are renting a location or modifying an existing facility), or building costs for new construction. Keep in mind that none of these costs include the equipment, furniture and fixtures that will eventually go into the location after it is built. That is a completely different kind of expense, and we will talk about that in our article in the next issue.
Most businesses would just capitalize the entire thing, and then take the depreciation over 27.5 years for a commercial building. However, some are going to be smart about it and either do a cost segregation study or segregate the costs as it is built. The reason for this is that not everything that goes into erecting a building is required to be depreciated over the full 27.5 years; but you must be able to prove to the IRS why you chose not to include something as a part of the building. For a grow facility, this is especially important because farm buildings such as greenhouses are depreciated over 20 years, instead of 27.5 years. Leasehold improvements are normally on a 15-year depreciation, even if your lease is only two years.
Land is one asset that is always capitalized. It is also the only asset that is never depreciated or expensed. The things you do to improve the land and get it ready for either planting or building a facility—such as clearing the land, putting in a parking lot or drainage system, etc.—are considered land improvements, and are always categorized as a capital asset.
Thanks to the IRS, we get to complicate things more by bringing 280E compliance into the picture. Let’s say you have a 2000 square foot facility. You plan to dedicate 60% to growing your product, 20% to either converting the flower to edibles or other products, 10% for the actual sales floor for the dispensary, and the remaining 10% for offices, storage, restrooms and other non-direct areas. How much can you actually write off? First, the depreciation must be divided among the different uses of the building, so 60% would be expensed as a direct cost to the grow facility, 20% would go to the manufacturing facility and 10% to the retail areas, and those would all be eligible expenses for 280E compliance. However, the 10% for everything else would not qualify and would be considered an ordinary expense.
If you are doing straight depreciation, you can stop right there; but if you are segregating costs of the build-out, you have more options. Since you will have more demand for electricity in the grow area and will be putting special breakers and other lighting equipment there, you will want to keep track of those costs separately from the office and retail areas, where you’ll have more finishing touches to make things look nice for the public. If you can get your contractor to bill you based on the areas of the building he is actually working on, then you can put the depreciation of those areas completely toward 280E compliance. That means things like bathrooms and offices would go only to ordinary operating expenses.
Once you are up and running, it is advisable to have a written policy regarding when something is to be expensed as a repair (called an expense), and when something will be capitalized (called a capital asset). Several factors must be considered, such as the dollar amount and whether or not it extends the useable life of the property or equipment.
When making an expenditure to maintain your facility, the main difference between an expense and a capitalization is whether the expenditure is a repair that will bring something back into useable condition—such as patching a leaky roof, or a capital asset expense that would replace an old asset with something completely new—such as completely removing the roof and putting on a new one.
Repairs or maintenance are usually expenses taken in the year the work was done or paid for, depending on whether you do your taxes on a cash or accrual basis. Capitalized items must be depreciated over a period of years, although you can use a 179 election and expense them. It is worthwhile to have a discussion with your CPA and look at your tax situation closely before deciding to use a 179 election, because you may be better off spreading the expense over a few years through depreciation. Your written policy should cover a dollar amount that will be used to determine whether an expense is a repair or a capital asset expense. For example, everything under $5,000 is to be treated as a repair. Your accountant can advise you on what would be best for your situation.
The bottom line is that when building out a commercial property, you must not only consider the expenses but also how those expenses will affect your taxes—not just this year, but 20 years into the future, as well.
Cynthia L. Finkenbinder, CPA is the owner of Alpha Omega Accounting, LLC in located in Northern Colorado. With clients in 21 states and three countries, she is an expert in 280E compliance, accounting and multi-state taxes. If you have any questions on this article, would like her to address a question here in an upcoming article, or need professional advice on Schedule 179 elections, cost segregation studies, depreciation, or making sense of the 280E regulations, you can contact her at firstname.lastname@example.org or visit her website: http://alphaomega-acct.biz