Expenses & Deductions
The IRS recently released the long-awaited tangible property regulations, commonly referred to as the “repair” regulations. The “repair” label, however, is a misnomer. These regulations affect many areas in addition to repair or maintenance deductions.
The IRS first issued proposed tangible property regulations in 2006 and subsequently withdrew those regulations. In 2008, the IRS reissued the regulations in proposed form, and they were generally better accepted than the 2006 regulations. After receiving many comments, the IRS issued the tangible property regulations in temporary form on Dec. 23 (T.D. 9564). (The IRS simultaneously issued identical proposed regulations (REG-168745-03).) These regulations include new concepts as well as reinterpretations of the 2008 regulations, while also adopting some of the original proposed regulations.
Taxpayers Affected by the Regulations
Generally, the regulations affect all domestic and some foreign taxpayers that acquire, produce, or improve tangible property, regardless of whether the organization is a corporation, passthrough entity, or individual Schedule C filer.
Major Areas of the New Rules
Significant areas in the new rules include standards for (1) the revised unit of property (UOP) definitions for real and personal property, (2) improvements to property, and (3) modifications to the rules for dispositions of property. The regulations provide a general framework for determining whether an expenditure is an improvement to property or a deductible repair. Taxpayers must initially determine the UOP and then apply a series of tests to determine whether the expenditure was a capital improvement or a deductible repair.
Significant changes are made to the UOP criteria. Generally, the regulations make the UOP smaller, especially for buildings. As a general rule, the larger a UOP, the more likely expenditures will be deductible repairs because they are proportionally small compared with the larger UOP. As the UOP gets smaller, more expenditures become capital improvements to the smaller UOP.
In the case of real property, the new rules define a building and its structural components as a UOP. An expenditure is treated as a capital improvement if it improves the building structure or any individual “building system.” Building systems include water; electrical; heating, ventilation, and air conditioning; gas; plumbing; elevators; escalators; and fire protection and security systems.
For example, consider an elevator upgrade. The UOP for assessing whether a capital improvement has occurred is the entire elevator system in the building, not the entire building. This is a significant departure from the 2008 regulations, where the UOP was the building structure. Under the new regulations, where an expenditure is incurred on any building system in a building, the expenditure must be assessed against the respective building system—the elevators in this case—to determine whether the expenditure is a deductible repair or a capital improvement.
The UOP criteria for personal property also are modified. A single UOP for property other than buildings includes all components that are “functionally interdependent,” which means placing one component into service is dependent on placing another component into service. The regulations further stipulate that the UOP for assets used in an “industrial process” includes all components that perform a “discrete and major function” (Temp. Regs. Sec. 1.263(a)-3T(e)(3)). The definitions and many examples in the regulations guide taxpayers in understanding and applying these terms.
The regulations outline three tests to determine if an expenditure results in a “betterment,” “restoration,” or “adaptation” to a UOP that requires capitalization (Temp. Regs. Secs. 1.263(a)-3T(h), (i), and (j)). Characterizing an expenditure as an improvement requiring capitalization depends on the facts and circumstances in each case. Taxpayers should assess their current processes and information systems to ensure that the necessary information is captured to make these determinations. Many taxpayers will likely be required to revise existing processes to capture the information necessary to optimize compliance with these new rules.
The regulations also make significant changes to the rules governing dispositions of property. Before these regulations, a taxpayer was not permitted to claim a “partial” disposition. Therefore, taxpayers often capitalized and depreciated multiples of the same item when in actuality only one item existed, as in the case of multiple roof upgrades capitalized over time. The regulations revise the disposition rules to allow taxpayers to write off the old component if replaced with a capital improvement. This change in the law allows taxpayers the benefit of writing off replaced components, which was previously not permitted.
There are many other matters in the regulations taxpayers should be aware of, including revised rules for materials and supplies, spare parts, general and mass asset accounting, investigatory and acquisition costs, units of property for leased property, and the routine maintenance safe harbor, among others. The regulations also include more than 150 examples illustrating how to interpret and apply these rules.
Administration and Implementation of the Regulations
The regulations generally were effective beginning Jan. 1, 2012. On March 7, 2012, the IRS issued Rev. Procs. 2012-19 and 2012-20 providing guidance on filing accounting method changes to comply with the regulations. These revenue procedures also relax the scope restrictions to filing an automatic accounting method change and provide guidance on the use of statistical sampling and the manner of computing Sec. 481(a) adjustments. See News Notes.
What Should Taxpayers Do Now?
Many taxpayers want to know what they should be doing now. Taxpayers should first assess conformity of their current policies and procedures with these new regulations. Specific areas of focus should include capitalization policies, minimum capitalization thresholds, partial dispositions, routine maintenance expenditures, and internal challenges to tracking and capturing necessary information. Where nonconformity with the regulations exists, taxpayers should assess the tax effect, as well as the changes necessary to business processes, technology, and information tracking. In some cases, action may be required immediately, as in the case of a written financial accounting policy required as of the beginning of the year for deductible de minimis costs under Temp. Regs. Sec. 1.263(a)-2T(g)(1).
Where an accounting method change was filed prior to the issuance of these new regulations, taxpayers should determine whether the originally elected method conforms to the new regulations. Not all previously filed accounting method changes will necessitate revisions. However, where a prior accounting method change does not conform to the new regulations and is more taxpayer-favorable, taxpayers will likely need to change their accounting method and give back some of the original Sec. 481(a) adjustment.
These regulations represent a significant area of new law, affecting much more than simply repair or maintenance deductions. This new law expands and clarifies capitalization law, while also touching on many other sections of the Code outside of Secs. 162, 168, and 263. Taxpayers that purchase, improve, or produce property should carefully review this new law and consider how they will be affected.
Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.
For additional information about these items, contact Mr. Anderson at 301-634-0222 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.