Special Alert: For our Business Clients- New Tangible Property Capitalization Regulations

The IRS has just granted taxpayers an extension of time to comply with a new and complex set of regulations that would have impacted almost all business taxpayers.  Commonly referred to as the “Repair Regs”, they have more to do with capitalization requirements than with repairs.  The regulations provide guidance on whether businesses can take a current year deduction or if they must capitalize amounts that they pay to acquire, produce, or improve tangible property.

Effective date. Initially, the temporary regs were to have taken effect with the 2012 tax year. The IRS has since delayed that implementation until 2014 and is giving taxpayers the option of applying the temporary regs now. So why would a business taxpayer want to adopt these regulations early?  Well, in some cases the transition to the new rules could actually create a deduction in 2012.  To make this determination you and your tax advisors would need to look at your current policies as they relate to fixed assets and compare them with new rules.  Pay special attention to number 7 below for losses allowed for the replacement of major building components such as roofs.

The IRS expects to issue final regs during 2013. While they have hinted that they may make the regs more user friendly towards small business, it is expected that the final regulations will not differ materially from the temporary regs.

Overview of regs. The regs provide guidance in areas which were formerly covered by court decisions. They are widely criticized as not having enough bright line tests.  They base the decision to expense or capitalize on facts and circumstances and how those facts compare to new betterment standards.  A warning to those who are not easily excited by IRS regulations, the regs are lengthy and complex. The summary below is just a brief overview of some of the main concepts.  Please reach out to your advisor if you have questions as to how these new rules will affect your business.

1.     Unit of property. One of the key issues in the regs is the definition of the “unit of property” (UOP) that is being repaired or improved. The smaller the UOP, the more likely it is that costs incurred in connection with it will have to be capitalized.  Before you make the decision to capitalize or expense you must first know what your unit of property is.

For example, work on an engine of a vehicle is more likely to be classified as an item that must be capitalized if the engine is classified as the UOP. In contrast, if the UOP is instead the vehicle, the engine work would have a better chance of passing muster as a repair.

In the past, taxpayers have increased their repair deductions by taking an expansive view of what is the UOP. The temporary regs will curtail that tendency by applying detailed rules to the issue. Different rules apply to buildings and to other property.

2.     Capitalization or deduction. Amounts paid to improve a unit of property must be capitalized.  The regs create all-encompassing guidelines on what constitutes an improvement. Specifically it is any expenditure that either 1) Betters the UOP 2) Adapts it to a different use or 3) Restores it to a like new condition, the so called BAR test.  If it meets any of these three criterions under the BAR test then it should be capitalized. There are also over 100 examples in the regs;  after all, your definition of “better” may not be that of the IRS.

A current deduction is also allowed for amounts paid to produce and acquire materials and supplies that are consumed during the year. The materials and supplies definition includes five specific categories of property used or consumed in the taxpayer’s business operations. One of these categories is a unit of property costing $100 or less.

3.   Buildings. When it comes to buildings, the regs generally treat each building and its structural components as one UOP, the “building.” In addition, the regs list nine building systems that are treated as separate from the building structure. These subsets of the overall building UOP include the HVAC system, plumbing system, electrical system, escalators, elevators, and 4 other systems. An improvement to the building is defined by its effect on those systems, rather than its effect on the building as a whole.

For example, if a taxpayer restores a building structure, such as by replacing the entire roof, the expense is treated as an improvement to the single UOP consisting of the building. If the taxpayer makes an improvement to a building system, such as the heating, ventilation, and air conditioning (HVAC) system, that expenditure is also an improvement to the building UOP. However, in determining whether the HVAC expenditure is required to be capitalized (see item 2 for the BAR test) you would look at the overall HVAC system and not the entire building to determine if there was a betterment, adaption or restoration.

4.     Property other than buildings. In general, for property other than buildings, a single UOP consists of all components that are functionally interdependent, such that one component can’t be placed in service without the other components.

For example, a business buys a battery-powered golf cart for use by its employee to get around a large complex. It buys the cart chassis from one vendor and the battery from another, and then assembles the two components. Here, the UOP is the cart, since the chassis can’t be placed in service without the battery.

5.   Routine maintenance safe harbor. The regs adopt a new safe harbor that many businesses will find useful. Under this rule, the cost of routine maintenance performed on a UOP is  deductible as an expense. This rule, however, does not apply to buildings or their structural components, which would still rely on the BAR test to determine if costs must be capitalized.

Routine maintenance refers to recurring activities that a taxpayer expects to perform to keep a UOP in ordinarily efficient operating condition. Examples are inspection, cleaning, testing, and replacing the parts of the UOP with comparable replacement parts. The taxpayer must reasonably expect to perform the activities more than once during the class life (under the alternative depreciation rules) of the UOP.

6.    Changes to depreciation regs. The temporary regs modify the existing regs on the depreciation of capital assets. Some, but not all, of the modifications are intended to coordinate depreciation rules with the other rules in the temporary regs discussed above. Topics addressed in the modifications include the tax treatment of dispositions of depreciable assets; the maintenance of general asset accounts and other multiple asset accounts, for depreciable assets; and the depreciation of leasehold improvements.

7.    Dispositions of MACRS property. This new provision could possibly provide the greatest current tax saving to taxpayers. The new temporary regs provide new rules for determining gain or loss upon the disposition of MACRS property. A Key provision of the regs treat the retirement of a structural component as a loss deduction.  Prior rules generally required a taxpayer to capitalize and depreciate multiple replacements of the same structural component while continuing to recover the cost of the original structural component as part of the asset.  Taxpayers are allowed to use a reasonable and consistent method to determine the separate adjusted basis of that component as a portion of the overall asset and then recognize a loss.

For example, if you purchased a building in a prior year, say 2000, and in 2012 you replace the roof and correctly capitalize it.  The new regs not only allow you, but require you, to recognize a loss equal to the portion of the old roof that has not yet been depreciated.  In determining what portion of the original purchase price is attributable to the roof the regs allow a “reasonable and consistent” approach.  In addition, the taxpayer could go back and take a current deduction and “catch up” if the new roof was capitalized in a year before 2012.

Changes to accounting methods. A change to early-adopt these temporary regs or adopt the final regulations in 2014 is considered a change in accounting method, for which an accounting adjustment is required. IRS has issued procedures under which taxpayers can obtain automatic consent to the accounting method change.  This automatic consent would require the filing of one or more forms 3115 with your tax return.  In many cases, the tax savings as a result of the favorable changes would far outweigh any additional cost to file the form 3115.

For more information or specific questions, please contact a KatzAbosch tax advisor at 410-828-CPAS (2727) or email sbishop@katzabosch.com.

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