The New & Great Frontier – The New Tangible Property Regulations
After nearly a decade in the works, the final tangible property regulations have arrived. These regulations will affect every taxpayer that owns, leases and/or uses tangible real or personal property in its business. The regulations are all-encompassing and complex. The new rules may, for many taxpayers, result in increased deductions than did the pre-existing rules. However, the regulations are extremely subjective in nature inasmuch as the question of whether expenditures are deductible or must be capitalized is inherently based on the specific facts and circumstances surrounding the expenditure. While this change in rules allows for more leeway in arriving at a taxpayer-favorable position, it could also open the door to IRS challenges of the treatment claimed if the income tax return is subsequently audited.
The last part of the regulations was finalized in August 2014. The regulations are generally effective for tax years beginning on or after January 1, 2014. Taxpayers can elect to apply the regulations retroactively to tax years beginning in 2012 and/or 2013.
The prior rules can be summarized as follows: Currently deductible repair and maintenance expenses are those incurred for the purpose of keeping property in an ordinarily efficient operating condition over its probable useful life for the uses for which the property was acquired. Capital expenditures, in contrast, are for replacements, alterations, improvements, or additions that appreciably prolong the life of the property, materially increase its value, or make it adaptable to a different use.
New Regulations – Capitalization
Under the new regulations, taxpayers generally must capitalize amounts paid to acquire or produce tangible property. Amounts paid to acquire or produce tangible property include all direct and indirect costs, including “inherently facilitative expenditures” (costs that facilitate the acquisition or production of tangible property – the regulations list eleven of them). It is important to note that all costs incurred prior to the property being placed in service must be capitalized, even if the expenditure could otherwise be deducted. Therefore, we would recommend that, if possible, delay incurring these type of costs (e.g., fix-up expenses and repairs) until after the property is placed in service.
In addition, the new regulations require the capitalization of expenditures relating to a “unit of property” (UOP) already owned if the expenditure meets the BAR test – i.e., it results in a Betterment (including the amelioration of a condition or defect that existed before the acquisition of the property or it arose during the production of the property), an Adaptation of the unit of property to a new or different use, or a Restoration of the UOP.
The concept of a UOP is one of the most important changes contained in the regulations, especially as it pertains to real estate. Each building and its structural components are considered to be one UOP. The term “structural components” includes such parts of a building as walls, partitions, floors, and ceilings, as well as any permanent coverings therefore such as paneling or tiling; windows and doors; and other components relating to the operation or maintenance of a building. The major change is that any component that constitutes a building system (there are nine of them including the HVAC system, the plumbing system, the electrical system, the fire-protection and alarm system, all escalators, and all elevators) is considered a separate UOP.
Condominium units, apartments in cooperative housing corporations and leased property are generally considered to be individual UOPs.
It is important to note that the treatment of all expenditures incurred for an already-owned unit of property is based on whether it meets the BAR test with respect to the UOP for which the expenditure was incurred. Even if an expenditure does not constitute a betterment, the taxpayer may still have to capitalize it if it qualifies as an adaptation to a new/different use or as a restoration.
Expenditures on existing assets that do not have to be capitalized under the rules mentioned above are generally deductible repairs.
The final regulations provide two elective safe harbors for deducting expenditures as repairs. Under the Routine Maintenance Safe Harbor, expenditures that a taxpayer expects to incur resulting from the normal use of the UOP so as to keep it in its ordinarily efficient operating condition are deductible. Under this safe harbor, expenditures are deemed to be routine if it is reasonably expected that, with respect to buildings, the expenditure will be incurred at least twice in the 10-year period beginning when the building structure or building system is placed in service by the taxpayer. For personal property, the same rule applies except the time period is the class life of the property.
Under the De Minimis Safe Harbor, an expenditure will be deductible if three requirements are satisfied: (1) the taxpayer has, at the beginning of the tax year, a written accounting policy treating as an expense for non-tax purposes amounts paid for property (i) costing less than a specified dollar amount; or (ii) that is expected to be useful in the business for 12 months or less; (2) the amount paid for the property is treated as an expense on the taxpayer’s “applicable financial statement” (AFS) if it has one (or on its books and records if it does not) in accordance with its accounting procedures; and (3) the amount paid for the property does not exceed $5,000 per invoice (or per item as substantiated by the invoice) if the taxpayer has an AFS, or it does not exceed $500 per invoice (or per item as substantiated by the invoice) if the taxpayer does not have an AFS.
Applicable financial statements include (in priority order): (i) financials filed with the SEC; (ii) a certified audited financial statement accompanied by a report by an independent CPA that is used for either credit purpose; reporting to shareholders, partners or similar persons; or any other substantial non-tax purpose; or (iii) a financial statement (other than a tax return) required to be provided to the Federal or a state government or any agency thereof (other than the SEC or IRS).
Probably the most beneficial rule in the final regulations involves the disposition of property. Taxpayers now can elect to recognize a loss when property is permanently withdrawn either from use in the taxpayer’s business or from the production of income. A disposition includes the sale, exchange, retirement, physical abandonment, or destruction of an asset. It also includes the retirement of a structural component of a building. The amount of the loss would be the adjusted tax basis of the component of the property that is abandoned or destroyed.
For example, assume ABC Corp replaces the roof on its warehouse. The roof replacement does not meet either of the safe harbor tests. Under the old rules, the cost of the new roof would have to be capitalized and no write-off would have been allowed for the old roof that was replaced (in essence, ABC would be depreciating two roofs going forward). Under the new regulations, ABC would be able to elect to deduct the adjusted basis of the old roof when it is replaced. The taxpayer will, however, have the burden of substantiating, if challenged by the IRS, the tax basis of the replaced roof (if it is not readily determinable, the taxpayer can reasonably estimate the tax basis). It is therefore strongly recommended that taxpayers improve their recordkeeping so as to have better support for these potential write-offs.
Adopting the new regulations will be done through filing requests with the IRS for a number of accounting method changes (many of them are automatic changes, but the requests must be filed nonetheless) and elections that should be made on timely-filed tax returns. In addition, taxpayers that want to adopt the de minimis safe harbor for 2015 needs to make certain the required written accounting policies are in place on or before January 1, 2015.
We Are Here To Help
As mentioned above, these new regulations may result in significant additional deductions for you. We can assist in analyzing your fixed asset schedules (prior year and current year) and in complying with the required filings and elections so as to optimize your tax deductions for 2014 and in the future.
As you can imagine, the expectation is that complying with these rules will be a tremendously burdensome and time-consuming effort. The good news is that there is the possibility that the time spent will achieve significant tax savings for you.