IRS Form 3115 and Common Area Maintenance Charges

Is it a tenant-paid repair or a landlord-paid capital expenditure? This is an important question for landlords and tenants with common area maintenance provisions in their leases. The IRS now classifies many items long considered to be capital expenditures as repairs. Brace yourself for a surprise or two.

Many leases use common area maintenance charge provisions that exclude capital expenditures from the expenditures that a landlord may pass through to the tenants as part of their monthly or annual common area fees. For example, expenditures to resurface a parking lot, which might take place every four to six years, might be treated as a capital expenditure under Generally Accepted Accounting Principles. However, under the new IRS tangible property regulations, the resurfacing would be a repair, because it is work that would be done more than once during a 10 year period. If a landlord were to take the position that this work now constitutes a repair for purposes of the common area maintenance clause in the lease, the full amount of the expenditure, every four to six years, would be included in the tenant’s common area maintenance bill. Even in leases where capital expenditures are shared to some degree by the tenants, the formula applicable to such sharing could be skewed dramatically if the new IRS definition of capital expenditure were to be used. Similarly, under the new tax rules, any roof repair "above the membrane" is considered a repair and not a capital expenditure, even though this might differ substantially from the understanding that the tenant and landlord had when signing the lease. 

For the tax year 2014, many building owners and commercial tenants filed Form 3115 to confirm for the IRS that they are in compliance with these new tangible property regulations. For a thorough discussion of these regulations see “Tangible Property Regulations” by Baker Newman and Noyes’ Stan Rose and Andy Smith. The new regulations are required to be followed for tax reporting purposes but are not required for financial (book) reporting purposes. If an owner or tenant uses book accounting for financial reporting purposes, the new regulations should have no impact. However, if the owner or tenant bases its financial reporting on its tax returns, then the new regulations have an impact on operations because expenditures for repairs and capital improvements must be treated as required by the new tax regulations. The owner or tenant may want to change its financial accounting practices. 

What should a landlord or tenant do?

• If the company books are maintained solely on a tax basis, consult with your accountant and real estate attorney regarding the advisability of using both a GAAP-based and tax system in light of these rules. 

• Regardless of accounting method, landlord and tenant should consider amending the lease to make it clear which set of rules apply to repairs and operating expenses under the common area maintenance provisions.

• The company, whether tenant or landlord should meet with its lender to determine whether the new tax rules will cause an inadvertent violation of the net income or debt-equity ratio requirements in a loan agreement or mortgage.  

Today’s real estate tip is brought to you by Rick Smith, a LEED Accredited Professional and member of Bernstein Shur’s Real Estate Practice Group and Green Building Team. Stay tuned for more useful tips for real estate professionals.  

For more information, contact Rick at rs****@be***********.com or 207 228-7228 or at 603 665-8829.