A Texas Contractor's Key Issue: Is it an Improvement to Real Property or Not?

One of the most important questions a taxpayer must necessarily ask itself when performing work on real property is whether the work is an improvement to real property. The rules that apply to real property improvements for Texas tax purposes can differ significantly from those that apply to other transactions. As in many areas, getting this wrong can create significant exposure to liability.

The difference between real property improvements and other work can have significance not only for Texas sales and use tax but also for Texas franchise tax purposes and can manifest itself in several different situations. Below are just some examples where this can be relevant:

• Charges for the sale and installation of tangible personal property and real property services are generally subject to tax in their entirety, unless an exemption applies, whereas charges for some types of real property improvement projects are not taxed at all (e.g., lump-sum new construction contracts). Tex. Tax Code §151.007(a)(3); 34 Tex. Admin. Code §3.291(b)(3)(A).
• A charge for the installation of tangible personal property provided on a stand-alone basis (i.e., where the item installed is not also sold by the installer) is not subject to tax whereas commercial real property repair and/or remodeling is fully taxed, unless an exemption applies. 34 Tex. Admin. Code §3357(b); Comptroller Ltr. Ruling 9511755L (Nov. 28,1995).
• A charge for the repair, remodeling, maintenance, and restoration of tangible personal property is subject to Texas sales and use tax whereas the repair and remodeling of residential real property is not when billed on a “lump-sum” basis and only partially taxable when billed on a “separated” basis. Tex. Tax Code §151.0101(a)(5).
• Equipment used by a contractor to make improvements to real property may not qualify for the manufacturing exemption whereas improvements made to tangible personal property ultimately sold may in fact qualify, depending on the circumstances. See Tex. Tax Codes §151.056(f); 151.318
• For Texas franchise tax purposes, a taxable entity furnishing labor or materials to a project for the improvement of real property may qualify for the cost of goods sold deduction even where there is no subsequent sale of the real property improved whereas a sale of goods is generally required to claim a cost of goods sold deduction. Tex. Tax Code §171.1012(i).

For these and many other reasons, distinguishing between an improvement to real property and other work can be critical to establishing a taxpayer’s tax liability and related responsibilities under the Texas Tax Code.

The seminal case in Texas defining an improvement to real property dates back to shortly after the end of the Civil War in Hutchins v. Masterson, et al, 46 Tex. 551 (1877). In that case, the Texas Supreme Court established a three-part test for determining whether an item of tangible personal property has become a “fixture” and therefore part of the real property as follows:

1. Has there been a real or constructive annexation of the article in question to the realty;
2. Was there a fitness or adaptation of such article to the uses or purposes of the realty with which it is connected; and
3. Whether or not it was the intention of the party making the annexation that the chattel should become a permanent accession to the freehold?

The Court noted that, of these three tests, pre-eminence is to be given to the question of intention while the others are chiefly of value as evidence as to this intention.

Given the inherently factual nature of this three-part test, there are many situations where questions may arise as to the intention of the parties or whether the method of annexation or adaptation either does or does not provide adequate evidence of an intent to permanently affix an item to real property. For example, should wiring added to an existing building be treated as part of the building? Does it matter if the wiring is placed outside the walls instead of between the walls? Does it matter that the wiring does or does not run through conduit? Does it matter how that conduit is attached to the walls? These and many other questions can arise in determining questions of taxability. And the many situations where these type questions do arise are endless.

Perhaps not too surprisingly, disagreements often arise between taxpayers and Texas Comptroller personnel as to whether an item or structure is an improvement to real property. While proper planning can often help avoid these disagreements altogether, sometimes they are inevitable. Where disagreements do arise, developing a proper strategy and effectively implementing it to include for example timely and effectively presenting a taxpayer’s position and version of the facts can be critical to a successful outcome particularly when challenging an assessment or refund claim denial by the Texas Comptroller.

If you have questions regarding the information disclosed above or on any other State Tax related matter, please contact David Colmenero at dcolmenero@meadowscollier.com or Alex Pilawski at apilawski@meadowscollier.com. To contact them by phone, please call (214)744.3700.