Dec. 30, 2011
By David L. Strong, CPA, and Edward D. Meyette, CPA
The Internal Revenue Service (IRS) issued on Dec. 23, 2011, the much-anticipated regulations that govern the capitalization of amounts paid to acquire, produce, or improve tangible property. The regulations were issued in temporary form and generally are effective for tax years beginning on or after Jan. 1, 2012. They replace the proposed regulations issue in March 2008.
A large focus of the regulations is to provide guidance for determining whether expenditures are repairs, (which can be currently expensed) or capitalized improvements (which must be depreciated for tax purposes). The regulations are very comprehensive, cover the different aspects of capitalization of costs related to acquiring, improving, and disposing of tangible property, and will affect the vast majority of taxpayers.
The temporary regulations generally follow the proposed regulations issued during 2008 but do include changes made by the IRS that could have an impact on taxpayers. Many provisions in these regulations will require a change of accounting method request and a Section 481(a) adjustment. The IRS has stated that additional guidance on implementing the regulations is forthcoming via the issuance of two revenue procedures.
Amounts to Improve Tangible Property – Unit of Property
A taxpayer generally must capitalize expenditures paid to improve a unit of property owned by the taxpayer. A unit of property is improved if the amounts paid:
- Result in a betterment of the property;
- Restore the unit of property; or
- Adapt the unit of property to a new or different use.
One of the most significant changes from the proposed regulations issued in 2008 relates to the definition of a unit of property used to determine if an improvement or betterment has occurred. Under the 2008 regulations, a building and its structural components were a single unit of property analyzed to determine if expenditures were to be capitalized as an improvement or considered deductible repairs and maintenance expenses.
Under the new temporary regulations, a building and its structural components are still treated as a single unit of property; however, an expenditure is to be treated as an improvement if the amount paid results in an improvement to any of the following:
- Building structure
- Building systems:
- HVAC systems
- Plumbing systems
- Electrical systems
- Fire protection and alarm systems
- Security systems
- Gas distribution systems
- Other structural components identified by the IRS in published guidance
In connection with this more targeted approach regarding improvements to building property, the temporary regulations allow taxpayers to immediately deduct the unrecovered basis of structural components that are replaced and disposed.
The temporary regulations also clarify that in the case of the owner of a condominium or cooperative, the unit of property is that portion of the building the taxpayer owns (for a condominium) or has rights to possess (in a cooperative).
For property other than a building, generally all the components that are functionally interdependent constitute a single unit of property. Functional interdependence is defined by looking at whether placing one component in service is dependent on placing another component in service. Additional guidance specific to plant property and network assets is provided in the regulations.
The temporary regulations also address special rules that apply to improvements to leased property for both the lessee and lessor as it relates to determining the proper unit of property for capitalization purposes.
- Ameliorates a material condition or defect that either existed prior to the taxpayer's acquisition of the unit of property or arose during the production of the unit of property, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production;
- Results in a material addition (including a physical enlargement, expansion, or extension) to the unit of property; or
- Results in a material increase in capacity (including additional cubic or square space), productivity, efficiency, strength, or quality of the unit of property or the output of the unit of property.
The determination of whether a betterment has occurred is based on the facts and circumstances of the situation. Factors to consider include:
- Purpose of the expenditure
- Physical nature of work performed
- Effect of the expenditure on the unit of property
- Taxpayer's treatment of the expenditure on its applicable financial statement
To determine if a betterment has occurred a comparison is made between the condition of the property immediately after the expenditure and the condition of the property immediately before the circumstance triggering the need for the expenditure. If the situation involves normal wear and tear, the comparison is made to the property immediately after either the last time the maintenance for wear and tear was performed or, if such maintenance has not previously taken place, to the condition of the property when placed in service by the taxpayer.
The temporary regulations provide several examples that deal with circumstances considered to be betterments to property and those that are not. Many examples are provided on topics ranging from the treatment of a "refresh" of a retail facility to the replacement of parts with those that are comparable in nature.
The regulations also stipulate that if a taxpayer is unable to obtain a comparable replacement part (due to technological advancements or product improvements, for example), the mere fact that the part is replaced with an improved part will not, by itself, cause the expenditure to be treated as a betterment of the property.
Restoration of Tangible Property
One of the significant changes the temporary regulations made to the restoration standard is the elimination of the "bright-line" measurement. The 2008 proposed regulations established a standard that allowed a taxpayer to deduct an expenditure to restore property if less than 50 percent of the structure was replaced or less than 50 percent of the value of the unit of property was replaced. The new regulations provide that the determination of whether a restoration has occurred will be based on the facts and circumstances surrounding the expenditure. The temporary regulations provide several examples to provide taxpayers with guidance in making that determination.
Expenditures to restore a unit of property must be capitalized. For purposes of these rules, an amount is paid to restore a unit of property only if it:
- Is for the replacement of a component of a unit of property and the taxpayer has properly deducted a loss for that component (other than a casualty loss);
- Is for the replacement of a component of a unit of property and the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
- Is for the repair of damage to a unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss or relating to a casualty event;
- Returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;
- Results in the rebuilding of the unit of property to a like-new condition after the end of its class life; or
- Is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property.
As with betterments, the rules regarding restorations of buildings are applied either to the building structure or any of the building systems, with a restoration of either having to be capitalized.
Restoration to a "like-new" condition occurs if the unit of property is brought to "the status of new, rebuilt, remanufactured, or similar status under the terms of any federal regulatory guideline or the manufacturer's original specifications."
The analysis regarding the replacement of a major component or substantial part of a unit of property is based on the specific taxpayer facts and circumstances. This analysis should use both the qualitative and quantitative significance of the replaced component(s) in relation to the unit of property taken as a whole. A major component or structural part "includes a part or combination of parts that comprise a large portion of the physical structure of the unit of property or that perform a discrete and critical function in the operation of the unit of property." The regulations provide many examples to help taxpayers determine about when a particular expenditure rises to the level of a restoration of a unit of property, including many examples in the context of building components and building systems.
Consistent with the 2008 proposed regulations, the temporary regulations eliminate the "plan of rehabilitation" doctrine outlined in case law that required capitalization of repair costs incurred at the same time an improvement was completed. Under the temporary regulations, a taxpayer generally must capitalize all direct costs of an improvement and indirect costs that directly benefit or are incurred by reason of an improvement using the rules of IRC Section 263A. Other costs, such as indirect repair costs that do not directly benefit and are not incurred by a reason of an improvement, are not to be capitalized. In other words, costs that are not incurred by reason of an improvement, betterment, or restoration generally are not required to be capitalized. The temporary regulations also provide an elective exception to capitalize repair costs for property used as a residence.
Routine Maintenance Safe Harbor
A safe harbor is provided for routine maintenance on property other than buildings. The safe harbor allows taxpayers to treat routine maintenance costs as currently deductible and deemed not to improve that unit of property. To be considered routine maintenance, the taxpayer has to expect to perform these services more than once during the class life of the unit of property. Routine maintenance includes inspecting, cleaning, and testing a unit of property and replacing parts of the unit of property with comparable and commercially available and reasonable replacement parts.
De Minimis Rule
The temporary regulations establish a threshold that allows taxpayers who meet certain criteria the option of not capitalizing costs for items under a specified amount that have a useful life greater than 12 months. A special de minimis rule can be applied by a taxpayer who meets all of the following criteria:
- Has an applicable financial statement that is either:
- Filed with the Securities and Exchange Commission (SEC);
- A statement audited by an independent certified public accountant that is used for credit purposes, reporting to equity holders, or for any substantial nontax purpose; or
- A statement other than a tax return required to be provided to an agency of the federal or a state government (other than the IRS or the SEC);
- The taxpayer had written accounting procedures in place at the beginning of the taxable year treating amounts below a certain figure as an expense for nontax purposes;
- The amounts are treated as an expense on the applicable financial statement; and
- The total amount of such expensed items is less than or equal to the greater of:
- 0.1 percent of federal income tax reported gross receipts for the year, or
- 2 percent of the taxpayer's depreciation and amortization expense reported on the applicable financial statement.
Not all taxpayers have an "applicable financial statement" under these rules and thus will not qualify for the de minimis method.
The de minimis method cannot be used for inventory or for land costs. A taxpayer can elect not to apply the de minimis rule to any unit of property acquired during the year simply by capitalizing the amounts in question on its timely filed federal income tax return for the year in question.
Materials, Supplies, and Rotable Spare Parts
The temporary regulations generally follow the existing rules for "nonincidental" materials and supplies (those deducted in the year in which they are used or consumed) and "incidental" materials and supplies (those expensed in the year in which they are acquired). The regulations clarify the definition of materials and supplies as tangible personal property other than inventory that meets the following criteria:
- A component acquired to maintain, repair, or improve a unit of tangible property owned, leased, or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property;
- Fuel, lubricants, water, and similar items reasonably expected to be consumed within 12 months;
- A unit of property that has an economic useful life of 12 months or less; or
- A unit of property that has an acquisition or production cost of $100 or less.
The most noteworthy aspect of the temporary regulations related to materials and supplies is the treatment of rotable and temporary spare parts. Rotable spare parts are defined as materials and supplies "that are acquired for installation on a unit of property, removable from that unit of property, generally repaired or improved, and either reinstalled on the same or other property or stored for later installation." Temporary spare parts are materials and supplies "that are used temporarily until a new or repaired part can be installed and then are removed and stored for later (emergency or temporary) installation." Such items generally are treated as expensed in the year in which the taxpayer disposes of such parts.
The regulations provide an alternative method that can be used for such parts. The taxpayer can deduct the cost of the part when the part is first installed. If such a part is later removed from a piece of property, however, the taxpayer must include the fair value of the part in income at that point, deducting that amount only when the part is installed in another piece of equipment or is disposed. The taxpayer also may not currently deduct any amounts paid to maintain, repair, or improve the part, but must add those amounts to the basis of the part. Both of the permissible methods are considered a method of accounting for income tax purposes, and thus a taxpayer must ask for permission before switching from one method to the other.
The new temporary regulations likely will affect the vast majority of taxpayers who own or lease tangible personal or real property. Taxpayers should review the temporary regulations and related examples to assess the impact they might have on the treatment of costs considered to be capitalized versus expensed. In addition, taxpayers should review what changes, if any, will need to be made to costs currently capitalized or their own capitalization procedures to comply with the new regulation. Changes made to comply with these new regulations will require the filing of Form 3115, "Application for Change in Accounting Method." You should work with your tax professional to determine how the new rules apply to your facts and circumstances and to assess the requirement to file an accounting method change.
Dave Strong is with Crowe in the Grand Rapids, Mich., office. He can be reached at 616.752.4251 or email@example.com.
Ed Meyette is a partner with Crowe in the Grand Rapids, Mich., office. He can be reached at 616.752.4234 or firstname.lastname@example.org,