Editor: Lori Anne Johnston, CPA, J.D.
The 2019 tax year brings a welcome opportunity to take a second look at reclassifying older assets as repairs and maintenance expenses under the tangible property regulations. These rules, finalized in September 2013 (T.D. 9636), affect a broad segment of taxpayers and provide considerable guidance on capitalizing and expensing costs related to tangible property. In the year of their implementation — 2014 for many taxpayers — the rules allowed an opportunity to correct certain past items not in compliance with the new regulations through an automatic change in accounting method. For taxpayers that implemented the tangible property regulations in 2014, the expiration of the five-year time limit on filing another automatic method change for the same item, found in Rev. Proc. 2015-13, may allow taxpayers a chance to reconsider expensing certain older assets through an automatic method change.
Changes in accounting methods
For the 2014 tax year, many taxpayers filed a Form 3115, Application for Change in Accounting Method, to adopt the new methods required by the tangible property regulations. Taxpayers reported a Sec. 481(a) adjustment to reflect a correction of under- or overcapitalization and expense for prior years. For some taxpayers the new regulations produced large, favorable Sec. 481(a) adjustments, but for a majority of taxpayers, the new rules resulted in a minimal or no Sec. 481(a) adjustment.
When taxpayers change their method of accounting for an item (e.g., the treatment of repairs and maintenance), they are generally prohibited from making a change in accounting method for the same item for five tax years (Section 5.01(1)(f) of Rev. Proc. 2015-13). If a taxpayer properly implemented the tangible property regulations and continues to correctly apply those rules, then the taxpayer does not need to take any additional action. If, however, a taxpayer did not properly implement the rules, the taxpayer may require a new accounting method change. For taxpayers that filed a method change in 2014 to implement the new regulations, the 2019 tax year provides the first opportunity to correct older items capitalized rather than expensed, or vice versa, through an automatic accounting method change.
Repairs and maintenance
Taxpayers that once again need to consider the tangible property regulations due to improper implementation may find that they overcapitalized items that qualify as repairs and maintenance expenses under the tangible property regulations.
To determine if it must capitalize an expenditure, a taxpayer must first determine the unit of property as outlined in Regs. Sec. 1.263(a)-3(e). In general, a unit of property comprises all the components that are functionally interdependent, meaning that the property's components all depend on the placing in service of all other components. Special rules, however, apply to building property, plant property, network assets, leased property, and improvements to property.
For buildings, each building and its structural components are the unit of property. An amount is paid to improve a building if the amount is paid for an improvement to the building structure or the building systems. The regulations designate the following nine building systems:
- Heating, ventilation, and air conditioning system;
- Plumbing system;
- Electrical system;
- Fire protection and alarm systems;
- Security systems;
- Gas distribution system; and
- Other structural components identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (Regs. Sec. 1.263(a)-3(e)(2)(ii)(B)).
Once a taxpayer determines the unit of property, the taxpayer must then examine if the expenditure qualifies as a betterment, adaptation, or restoration. The tangible property regulations state that betterments include amounts paid:
- To fix a material condition or material defect that existed before the acquisition or arose during production of the unit of property;
- For a material addition, including a physical enlargement, expansion, extension, or addition of a major component to the unit of property, or for a material increase in its capacity, including additional cubic or linear space; or
- That are reasonably expected to materially increase productivity, efficiency, strength, quality, or output of the unit of property, where applicable (Regs. Sec. 1.263(a)-3(j)).
Adaptations include amounts paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer's ordinary use of the unit of property at the time the taxpayer originally placed it in service (Regs. Sec. 1.263(a)-3(l)).
Restorations include amounts paid:
- To replace a component of a unit of property for which the taxpayer has properly (1) deducted a loss for that component (other than a casualty loss), or (2) taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
- To restore damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss under Sec. 165 or relating to a casualty event, subject to certain limitations;
- To return the unit of property to its ordinarily efficient operating condition, if the unit of property has deteriorated to a state of disrepair and is no longer functional for its intended use;
- To rebuild the unit of property to a like-new condition after the end of its class life; or
- To replace a part or combination of parts that make up a major component or a substantial structural part of the unit of property (Regs. Sec. 1.263(a)-3(k)).
If any one of these three improvement standards applies, the taxpayer must capitalize the expenditure as an improvement. The taxpayer may then determine if there has been a partial disposition of the original asset (see Regs. Sec. 1.168(i)-8). However, if none of the improvement standards apply, the taxpayer may generally treat the expenditure as a repairs and maintenance expense.
Taxpayers may also make an annual election to capitalize repairs and maintenance as improvements if the taxpayer also capitalizes those amounts on its books and records (Regs. Sec. 1.263(a)-3(n)). Once a taxpayer makes this election, the taxpayer may not treat any amounts for which the election is made as repairs and maintenance expenses.
Tax planning opportunity
The expiration of the five-year limitation on filing an automatic method change for repairs and improvements creates a great opportunity for taxpayers to reconsider the tangible property regulations. While taxpayers may not use an accounting method change to revisit previous elections concerning partial dispositions or capitalization based on books and records, prior decisions as to whether an expenditure requires expensing or capitalization remain open for reevaluation and change, given the five-year limitation expiration. For the 2019 tax year, taxpayers and their accountants should seriously consider revisiting repairs and maintenance when planning strategies for increased deductions.
Lori Anne Johnston, CPA, J.D., is a manager, Washington National Tax for RSM US LLP.
For additional information about these items, contact Duwayne Sibley (Duwayne.Sibley@rsmus.com).
Unless otherwise noted, contributors are members of or associated with RSM US LLP.