Legislation included in the One Big Beautiful Bill Act (signed into law last July) adopts many new tax policies designed to incentivize real estate development. In addition, the Federal Reserve is expected to further reduce interest rates early this year, directly impacting new construction as well as renovations.
Accordingly, more real estate developers and investors will need to know true project costs. A key element of project costs are the sales tax costs applicable to the construction industry. These rules can often be complex or counterintuitive. The purpose of this article is to provide a general understanding of the rules in New York[1] along with the caveat that the best way to navigate these laws is with the assistance of trusted and knowledgeable tax counsel.
Whether or not a contractor collects sales tax from a customer depends on whether the work being performed is considered a capital improvement to real property or falls under a separate category of temporary installation, repair, or maintenance work. Work that is a capital improvement to real property is not taxable.
A capital improvement is any addition or alteration to real property that meets all three of the following conditions:
For example, building a deck, closing off or cutting of doorways, or installing kitchen cabinets are all capital improvement projects. By contrast, repairing a broken step, replacing a thermostat on a hot water heater, or painting existing cabinets are all examples of taxable repair and maintenance work.
Building materials and other tangible personal property purchased for capital improvement work are taxable, whether purchased by a contractor, subcontractor, repair technician or homeowner. The sales tax paid by a contractor or others becomes an expense that can be passed through to the customer as part of the overall charge for the capital improvement (but this expense may not be passed on to the customer as an itemized sales tax).
In summary, the significant benefit of a qualifying capital improvement is that all the embedded labor costs are not subject to sales tax, while only the material costs include a sales tax cost. This is a valuable benefit since labor costs often exceed material costs in building construction.
When performing capital improvement work, the contractor should get a properly completed Certificate of Capital Improvement from the customer.[2] Receiving the certificate relieves the contractor from liability for a tax due on the work. Interestingly, the law leaves it up to the customer to make the legal determination if the project qualifies for capital improvement treatment.
Additional alterations to real property made by or for a tenant, rather than the owner of the property, may not qualify if considered to be temporary in nature, rather than permanent. This is a common problem because leases typically require the tenant to return the property to its original state when the lease expires. In such a case, the work performed cannot qualify as a capital improvement.
On the other hand, it is important to note that charges for services such as window cleaning, pest control and trash removal are generally subject to tax. However, when performed in connection with the performance of a capital improvement, the charge becomes nontaxable.
To help in making these determinations, the regulations set forth the “End Result Test.” To wit, if the end result of the services is the repair or maintenance of real property, such services are taxable. However, if the end result of the same service is a capital improvement to the real property, such services are not taxable.
During an examination, auditors prefer not to apply the End Result Test. In order to tax the separate service, they often do not look at the complete set of facts and don’t acknowledge that the typically taxable item is actually a component of the larger capital improvement.
Contractors are relieved from collecting sales tax from qualified exempt organizations regardless of whether the work constitutes a capital improvement or a taxable installation, maintenance, or repair. Purchases by a contractor for an exempt organization present a more complex question.
It would be wrong to assume that a property owner’s tax-exempt status will automatically apply to the contractor and subcontractors so that all purchases of material, supplies and labor would be tax exempt. In fact, contractors working for an exempt organization may purchase materials and supplies tax-free only when the items will be incorporated into real property owned by the exempt organization. Not covered would be supplies, electricity, heavy equipment, etc. where the items are not incorporated into real property owned by the exempt organization.
However, all purchases such as those above could be made without tax if the contractor enters into an agency agreement with the exempt organization in accordance with the sales tax regulations. If the contractor qualifies as an agent of the tax-exempt organization, no tax would be incurred on any purchase. In other words, the property owner’s tax-exempt status would automatically include the contractor.
Leasehold Improvements
Additions or alterations to real property for or by a tenant of such property will be presumed to be temporary in nature, rather than permanent. Such improvements would not qualify as a capital improvement if the tenant’s lease does not transfer ownership of the improvement to the property owners, which implies the necessary performance. For example, some leases require the tenant to return the property to its original state.
Example: A contractor installs sinks and related plumbing fixtures for a hair salon that is a tenant in a building. Installing a sink normally qualifies as a capital improvement. However, the hair salon’s lease stipulates that the premises must be returned to their original condition when the lease ends. Because the sinks must be removed at the end of the lease, they do not qualify as a permanent installation, and their installation is not a capital improvement.
Conclusion
The basic rules presented here are fairly straightforward. However, during the course of a sales tax audit, the auditor may see things differently. From Barton’s extensive experience handling sales tax audits, we know there are particular areas auditors like to question. These include the End Result Test and whether a particular item is permanently affixed. And what audit would be complete without a review of capital improvement forms to determine if the correct certificate has been used as intended?
Engaging a tax attorney with familiarity regarding these rules and the sales tax audit process can be a highly beneficial, proactive step to ensuring that you are accurately assessing (and are able to defend) the taxability status of certain project costs.
If you have any further questions regarding capital improvement or sales tax rules for contractors, please contact Alvan Bobrow at abobrow@bartonesq.com or (212) 885.8878.
[1] New York rates are representative of those in most states.
[2] New York State Department of Taxation and Finance, Form ST-124.
Alvan L. Bobrow