On September 13, 2013, the Department of the Treasury and the IRS issued final tangible property regulations that provide guidance on the tax treatment of amounts paid to improve, acquire and produce tangible property.
The regulations are considered effective for tax years beginning on or after January 1, 2014, however taxpayers may consider early adoption of the final regulations for tax years beginning on or after January 1, 2012. The final regulations retain many of the provisions of the previously released temporary regulations with some distinct contrast.
Improvements to Tangible Property
One area of similarity between the temporary regulations and the final regulations is the definition of an improvement to a unit of property (UOP). Amounts incurred for betterments, restorations of the unit of property, or in order to adapt the unit of property to a new or different use must be capitalized. The general rule for determining a unit of property is the functional interdependence test, with special rules provided for certain types of property, including buildings and plant property. In the case of a building, similar to the provisions found within the temporary regulations, the improvements standards must be applied to a building and its structural components at the “system” level. The regulations list several independent building systems including:
1. Heating, ventilation and air conditioning (HVAC) systems
2. Plumbing systems
3. Electrical systems
6. Fire protection and alarm systems
7. Security systems
8. Gas distribution systems
9. Any other structural components identified in published guidance
The final regulations provide specific rules for determining whether expenditures result in a betterment to the unit of property. Betterments are defined as activities that:
• Ameliorate a material condition that existed prior to the taxpayer placing the property in service,
• Result in a material addition to the UOP or addition to a major component of the UOP,
• Result in a material increase in capacity of the UOP, or
• Result in a material increase in productivity, strength, efficiency, output, or quality of the UOP
Within the final regulations, taxpayers are provided with three examples of betterment activities. This should serve as a roadmap for how the service can be expected to examine betterment related activities on a go forward basis. The three examples are:
• Building Refresh - no costs are required to be capitalized
• Building refresh with Limited Improvement - some costs require capitalization while others do not
• Substantial Remodel - all costs are required to be capitalized. Certain otherwise deductible costs would require capitalization in this example as they are incurred by reason of an overall improvement.
Similar to the temporary regulations, costs incurred to restore a UOP must be capitalized. Generally restorations are defined as costs incurred which:
• Return a UOP to like new condition at the end of its class life,
• Replace a major component or structural part of the UOP,
• Return the UOP to its ordinary and efficient operating condition after it has deteriorated to a state of disrepair
• Are for the replacement of a component of a UOP and the taxpayer has properly deducted a loss for that component
• Are for the repair of damage to a UOP for which the taxpayer has taken a basis adjustment as a result of a casualty loss
A major component is defined as a part or combination of parts that perform a critical function in the operation of the unit of property. Although the regulations contain several examples to illustrate the restoration rules there is no bright-line test for determining restorations. Thus capitalization determinations should be made on a case by case basis according to the taxpayer’s facts and circumstances.
New or Different Use
The third type of expenditure requiring capitalization is costs which adapt a UOP to a new or different use. A UOP is considered to have been adapted to a new or different use if the adaption is not consistent with the intended use at the time the UOP was originally placed in service.
One significant area of change under the final regulations relates to the potential to recognize a gain or loss on the disposition of depreciable property. Under the final regulations, taxpayers now have a choice as to whether or not they will recognize a loss upon the disposition of an asset. If a building component is replaced and capitalization is required, the taxpayer now has the option of recognizing a loss or continuing to depreciate the replaced component. It is no longer mandatory to take a loss on disposition for a replaced building component.
This eliminates the need for General Asset Account elections to alleviate the administrative burdens imposed by the temporary regulations. There are only a few instances in which an asset disposition is required. These include a sale, casualty event, or a tax free transfer. The partial disposition election is an annual election. No statement is required for this election. Taxpayers have the ability to retroactively take partial dispositions in prior tax years through an accounting method change.
Materials and Supplies
Similar to the provisions within the temporary regulations taxpayers have the ability to expense materials and supplies in the year of purchase with an economic useful life of 12 months or less and a cost of $200 or less. This figure is up from $100 in the temporary regulations. The final regulations also provide for an election to capitalize certain materials and supplies. These include rotable, temporary, or standby emergency spare parts.
For some taxpayers who choose to make this election an accounting method change may be required. One other area of note within the final regulation is the distinction between incidental and non-incidental materials and supplies. Incidental supplies are those which are typically not tracked as inventory at the beginning and end of the year. Incidental supplies are deductible in the year of acquisition, while non-incidentals are deductible in the year in which the materials are first used or consumed in the taxpayer’s operations.
De Minimis Safe Harbor
The final regulations contain a de minimis safe harbor which allows a taxpayer to follow its book minimum capitalization policy. The dollar threshold allows a deduction of up to $5,000 per invoice or item if the treatment is consistent in the taxpayer’s “applicable financial statement.” For those taxpayers without an applicable financial statement, the final regulations provide a lower safe harbor amount of up to $500. The taxpayer must have a written policy in place as of the beginning of the year in order to utilize the safe harbor.
The election to apply the de minimis safe harbor is made annually by attaching a statement to the timely filed tax return.
Safe Harbor for Small Taxpayers
The final regulations provide a method for small taxpayers to avoid some of the administrative burdens inherent within the regulations. The small taxpayer safe harbor election allows a taxpayer with average annual gross receipts of $10,000,000 or less for the three proceeding tax years to expense repairs, maintenance and improvements that are made with respect to an eligible building property for which the total amount paid for the tax year is the lesser of $10,000 or 2% of the unadjusted basis of the property. An eligible building property is defined as a building with an unadjusted basis of $1,000,000 or less. If the taxpayer is leasing the building, the unadjusted basis of the leasehold interest is equal to the total amount of (undiscounted) rent paid or expected to be paid over the entire lease term, including expected renewals. It’s worth noting that the election and annual limit apply on a building by building basis. If the ceiling amount is exceeded on any one building, the safe harbor cannot be applied to that building. The taxpayer elects the small taxpayer safe harbor annually by attaching a statement to its tax return.
Routine Maintenance Safe Harbor
An amount paid for routine maintenance is deemed not to improve a unit of property if a taxpayer can reasonably expect to perform the activity more than once during the ADS life of the asset. In the case of a building a special rule applies which states that any costs a taxpayer could reasonably expect to incur more than once during the first ten years of ownership should fall under the safe harbor.
Election to Capitalize Repair and Maintenance Costs
A final noteworthy change from the reproposed regulations gives taxpayers the ability to elect to minimize book-tax differences. Taxpayers may capitalize repairs and maintenance amounts incurred during the year as improvements if the taxpayer treats such costs as capital expenditures on its books and records. This annual, irrevocable, written election applies to all amounts incurred for the repair and maintenance of tangible property the taxpayer capitalizes on its book and records. It should be noted that taxpayers who make this election will be precluded from deducting the aforementioned costs through an accounting method change in later years.
The final tangible property regulations can be quite complex and may require the filing of one or more IRS Forms 3115. Taxpayers are encouraged to consider any accounting method changes, annual elections, or changes to internal accounting policies that may be applicable to their business.