Capital vs. Cosmetic Knowing the Difference, Finding the Funds

Capital vs. Cosmetic

 Co-op, condo owners and board members understand certain truths; one is that  whether aesthetic, mechanical or otherwise, every building will require repair,  upgrades and improvements. Determining what is a capital project versus what is  a cosmetic project is often confusing and can cause significant problems when  determining budgets and project timelines.  

 Capital Ideas

 The New York State Department of Taxation and Finance (NYS DTF) spells out the  difference clearly in its Publication 862: Sales and Use Tax Classifications of  Capital Improvements and Repairs to Real Property.  

 A capital improvement is an addition or alteration to real property that:  

 • Substantially adds to the value of the real property, or appreciably prolongs  the useful life of the real property;  

 • Becomes part of the real property or is permanently affixed to the real property  so that removal would cause material damage to the property or article itself;  and is intended to become a permanent installation.  

 Carole Newman, CPA at the accounting firm of Newman, Newman & Kaufman, LLP, in Syosset, explains that “a capital project will extend the useful life of a physical facility by more  than five years or materially increase the market value of an existing  facility,” she continues. “A capital project will enlarge or structurally renovate buildings or install  major equipment and fixtures that become permanent additions to facilities.”  

 While a complete list of approved capital projects can be found in the NYS DTF  Publication 862, Newman sheds some light on common projects. “Generally, capital improvements may be building-wide improvements, equipment  upgrades and/or equipment purchases,” says Newman. Examples include restoration of the building façade, balcony restoration, roof replacement, sidewalk replacement, window  replacements and lobby and hall renovations. “Equipment upgrades or replacements might include elevator modernization, chiller  replacement, cooling tower replacement, house tank replacement, boiler  replacement, heating plant conversion and intercom replacement,” adds Newman.  

 Getting Rid of the Gray

 For many board members determining the scope of a project presents a gray area,  explains Richard Montanye, CPA at Marin & Montanye, LLP. Montanye uses a lobby renovation as an example, underscoring  that the first step for the board is to determine if the initiative is for  financing purposes, reserve purposes, or for the purposes of paying sales tax.  Is redesigning the lobby a capital improvement project? “Many items included in a lobby redesign may be repairs,” says Montanye. “For instance, painting and wallpapering are not capital improvements; however  construction, new lighting and new furniture are.”  

 Often there are particular elements of redesign or renovation projects that can  be considered a capital improvement.  

 “New lighting would be considered a capital improvement,” Montanye continues. “Painting and or new furniture can be considered a capital improvement for  financial statement purposes as long as it is part of an entire renovation,  however for sales tax purposes, both of these items would be considered  taxable. Labor costs, engineering and design fees as part of an entire project  are part of the capital improvement.”  

 Newman adds that projects that can be considered either capital improvements or  repair will generally be decided by the cost of the improvement and the  extension of the life of the asset being improved. “Every building will have its own materiality level for determining what is  capital versus what is repair,” she says. And cosmetic repairs means either tapping into the general fund or  increasing monthly fees; both of which are usually frowned upon by co-op and  condo owners.  

 While gray areas might exist, the NYS DTF offers straightforward guidance for  property owners. According to the Department's Publication 862, “If a contractor does a capital improvement for a customer and the customer  provides the contractor with a properly completed Form ST-124, Certificate of  Capital Improvement, no sales tax is required to be collected from the  customer.” Conversely, when a contractor performs a job that constitutes a repair, the  same report notes that maintenance, or installation service to real property,  sales tax must be collected from the customer, unless the contractor receives a  properly completed Form ST-119.1, Exempt Organization Certification, or other  applicable exemption document.  

 It’s important for board members to understand that federal tax regulations and  Generally Accepted Accounting Principles (GAAP) require the capitalization of  improvements. The benefit, notes Newman, is that for financial statement and tax purposes the  cost is spread out over the life of the improvement through depreciation of the  cost of the asset.  

 Stephen Beer of the Manhattan-based accounting firm Czarnowski & Beer LLP explains that in his practice, tax auditors are not overly concerned  with projects that fall into the “gray” area. For example, if a hallway needs to be repainted or requires new  wallpaper, these improvements are considered cosmetic but if the carpeting was  ruined during the process requiring construction to fix it, there could be a  cause for a capital improvement claim.  

 “Every board has a different philosophy and approach,” says Beer. “There are a fair number of boards that simply want to do the right thing because  they are in a fiduciary role and they do not want anyone to question them. We  do come across other [boards] that find ways to keep the common charges down  because some residents are on fixed incomes and can’t afford increases,” he continues. “There is a different philosophy between some of the higher-end buildings in  Manhattan and the more blue-collar buildings you might find in Brooklyn and  Queens.”  

 Freddie, Fannie, FHA, IRA and Taxes

 Since there is a high turnover rate of board members, not only do philosophies  change but so do priorities. When it comes to financing and costs, the litmus  test for determining whether or not a board is approving a capital improvement  is if the project is subject to sales tax. “If it’s capital improvement, it will reduce expenses which looks good and is a  motivator to boards as they want to make anything they can a capital  improvement,” says Beer. “With water, sewer and energy, all rising costs, boards are looking for any way  they can not to raise monthly charges.”  

 The recession and failing economy that gripped the nation has resulted in a  higher level of scrutiny from all participating parties. “We used to get a handful of questions on our financial statements,” says Beer. “Now every week we are getting questions from bankers, lawyers, property  managers, board members—people are becoming much more savvy.”  

 New regulations put forth by the Federal Housing Administration (FHA) and the  Government Sponsored Enterprises (GSE), better known as Fannie Mae and Freddie  Mac, have changed the playing field, explains Beer.  

 “Some states such as New Jersey, Florida and California require the funding of a  useful life study, and that those funds only be utilized for items in the  study. In lieu of a useful life study, Fannie Mae is requiring 10 percent of  annual expenses be set aside as reserves for capital projects for condominiums.  For cooperatives, Fannie Mae requires a reasonable reserve fund,” says Beer adding that number is subjective and hard to pin down.  

 GAAP requires disclosure if designated funds are utilized or loaned for other  purposes, notes Beer. “The IRS regulations require funds contributed for capital items to be segregated  and utilized solely for capital items in order allow the unit owner to add the  payment of such funds to the cost basis of their unit for capital gain taxation  purposes,” says Beer. “The utilization of those designated funds for other purposes disallows the  addition to the cost basis.”  

 While timing doesn’t necessarily play a significant role in determining the status of a project, a  board that plans for the future with a keen eye might be able to roll cosmetic  elements of a project into a larger capital project should they intertwine  structurally or operationally, such as electrical or plumbing.  

 “Normally timing is not an issue. Financial statement presentation might be  somewhat tricky for projects that span multiple financial reporting years,” says Montanye. “However, the treatment of a capital improvement should not vary greatly. In  situations, where design studies or engineering work takes place but the  capital improvement does not, the design and engineering fees are not  considered a capital improvement. If the hallway walls need to be cut open for  an electrical upgrade, logistically and financially it would make sense to  handle them at the same time.”  

 As with all projects there are many success stories that underscore how best to  approach a capital improvement project, but there exist examples of how  projects can go wrong without due diligence. “I have seen façade projects run 30 percent or more over budget,” says Montanye. “When this type of work gets started, often additional required work is  discovered along the way, resulting in significant cost overruns and financing  difficulties. In addition many components of this type of work are variable in  nature and not quoted on a fixed fee basis.”  

 Newman suggests that board members create improvement plans spanning five to  seven years, otherwise funding, project management and project allocation and  distinction (capital or cosmetic) can become troublesome. “Trying to generate funds for projects takes planning and time. With adequate  time, a board can borrow or assess, or do a combination of both. With  inadequate time, assessments can’t be spread out over time and will become burdensome to the owners,” says Newman. “Additionally, inadequate time doesn’t provide for borrowing money at optimum rates. The true success stories start  with a capital plan and both short and long-term funding.”  

 In the final analysis when approaching a capital improvement project, it comes  down to securing the bottom line, and that falls to the homeowner. “Overall there is generally only one place to come for money, that is the unit  owners,” says Beer. “They either pay now or later.” 

 Brad King is a New York-based freelance writer and a frequent contributor to The  Cooperator and other publications.

 

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