Treasury issued final regulations in 2013 providing new rules for the capitalization of expenditures relating to tangible property. These regulations establish a general framework to distinguish capital expenditures from deductible supplies, repairs, maintenance expenses and costs incurred for tangible property. Final companion regulations dealing with dispositions of tangible property were promulgated in 2014. In tandem, these regulations impose significant compliance burdens but also provide many tax opportunities.
The new capitalization regulations are lengthy and provide examples to illustrate the analysis required to determine whether certain costs are currently deductible or are required to be capitalized and depreciated. They contain both favorable and unfavorable rules from a taxpayer’s perspective.
Summary of the Repair and Capitalization Rules
Materials and Supplies. Items acquired with a cost of up to $200 can be categorized as a material and supply and deducted under special rules. This is an increase from the $100 level established under Proposed and Temporary Regulations, but considerably less than the $500 or $1,000 limits suggested by commentators. The amounts expended for materials and supplies are deductible in the year of payment if they are “incidental” – i.e., where no record of consumption is maintained nor are they subject to physical count at the beginning and end of year due to administrative burden. However the items are deductible in the year of use or consumption where the materials and supplies are “nonincidental” and where such records are kept. However, even non-incidental materials and supplies may be deductible in the year of payment where the taxpayer elects to apply the de minimis rule (discussed below).
Special rules apply to rotable, temporary and emergency spare parts. These amounts are generally not deductible until disposition of the assets, which may be many years after their purchase. The regulations permit an election to capitalize and depreciate these spare parts. This can provide a faster writeoff costs of these items then under the general disposition rule. Alternatively, the taxpayer can utilize an Optional Method to account for these costs.
Acquisition Costs. Costs to acquire tangible property must normally be capitalized into the depreciable cost. These include costs incurred in the process of investigating or otherwise pursuing the acquisition. However, under a special rule, these types of investigatory costs do not have to be capitalized when related to the acquisition of real property, unless they are among a specific list of items defined as “Inherently Facilitative.” This creates different capitalization rules for real estate and personal property. Where both real property and personal property are acquired in the same transaction, an allocation of such costs must be made.
The regulations also provide that employee compensation and overhead costs related to the acquisition are not required to be capitalized. However, an election is provided where the taxpayer can elect to capitalize either category of cost or both.
De Minimis Rule. The final regulations provide a “de minimis” rule which avoids the need to capitalize certain costs where the taxpayer satisfies certain conditions.
For those taxpayers with an Applicable Financial Statement (AFS), the taxpayer must: a) have a written policy at the beginning of the tax year providing for the expensing of either (i) items costing less than $5,000; or (ii) items which have a useful life of not more than twelve months, but limited to $5,000 for each item. An AFS is defined as: 1) a financial statement required to be filed with the SEC (e.g., Form 10-K or annual shareholder statement); 2) certified audited financial statement with a report of an independent certified public accountant (or similar professional for a foreign entity) for credit purposes, reporting to shareholders, or other substantial non-tax purposes; or 3) a financial statement for a federal or state agency.
For those taxpayers without an AFS, the taxpayer must: a) have a policy at the beginning of the year to expense either (i) items costing less than $500; or (ii) items which have a useful life of not more than twelve months, but limited to $500 for each item.
The taxpayer is required to make an affirmative election on a timely filed tax return with respect to all items which are covered under the de minimis rule. This can include items which are materials and supplies.
The de minimis rule applies on a per item basis. Consequently, taxpayers must analyze invoices to determine the per item cost to determine which items can fall under this rule. The cost of an item includes its allocable share of additional costs invoiced (e.g., delivery charges, installation charges, etc.). If multiple items are covered by a single invoice, the additional charges must be “reasonably allocated” to each item. Reasonable methods can include specific identification, pro rata, weighted average based on relative costs. Under a surprising rule, the regulations provide that if the additional charges are separately billed, they do not have to be included in determining the per item charge.
Costs to Repair or Improve Tangible Property. The most difficult portion of the regulations involve whether costs to repair or improve currently owned tangible property can be deducted or must be capitalized. Prior to these regulations, case law provided that these types of costs were deductible as repair costs if they: a) were incidental in nature; b) did not materially add to the property’s value; c) did not appreciably prolong the property’s useful life; or d) did not adapt the asset to a new or different use.
The new regulations replace the judicial tests with what is commonly referred to as the BAR standard. Costs will have to be capitalized if they produce a Betterment to the property; an Adaptation to new use of the property; or a Restoration of the property. All costs must be examined in light of these three standards to determine if one is satisfied and, therefore, capitalization required.
The expenditure must be compared to a “Unit of Property,” generally defined as components of property which are functionally interdependent. However, for “plant property,” one cannot look solely to the manufacturing line (which would be comprised on functionally interdependent items), but must further break the equipment into components which serve a discrete and important function. This may effectively cause each piece of equipment on the manufacturing line to be treated as a separate Unit of Property.
With respect to a building, the Unit of Property is not only the overall structure, but also eight enumerated building systems: HVAC, plumbing, electrical, escalators, elevators, fire protection and alarm systems, security systems, and gas distribution system. Defining a Unit of Property into smaller components by the regulations increases the chances of having to capitalize an expenditure.
A Betterment constitutes an amount paid which either:
- Improves a material condition or defect which existed prior to the acquisition of the property or which arose during production.
- Is reasonably expected to materially increase the UOP (physical enlargement, expansion or extension).
- Is reasonably expected to produce a material increase in the capacity, productivity, efficiency, strength or quality of the Unit of Property.
Generally, there is no betterment if one is bringing the property back to its prior condition in the hands of the taxpayer. However, if the work corrects wear and tear in the hands of a different owner, this is considered a betterment of the property.
The regulations do not provide bright-line tests concerning how to define “material.” This requires a facts and circumstances analysis. The examples in the regulations suggest that a 10% increase in capacity or productively would not require capitalization.
An Adaptation to New Use generally means putting the property to a new or different function. For example, converting a manufacturing building into a showroom is such an adaptation. However, combining multiple spaces into a single space would not.
Many difficult issues will arise in identifying a restoration – i.e., costs which meet one of six tests:
- Replaces a component of the Unit of Property and a loss has been taken for the component.
- Replaces a component of the Unit of Property and the adjusted basis of the component is used to determine gain or loss on the disposition.
- Repairs damage to a Unit of Property for which a casualty loss has been taken.
- Replaces the Unit of Property to its ordinarily efficient operating condition – but only if the property had deteriorated to a state of disrepair and is no longer functional for its intended use.
- Results in a rebuild of the Unit of Property to a “like new” condition after the end of its class life.
- Replaces a “major component” or “substantial structural part” of the UOP.
A “major component” focuses on the function of the component in the Unit of Property. If it performs a discrete and critical function in the UOP, it is a Major Component. A “substantial structural part” compares the expenditure to the overall unit of property to determine if it is substantial.
Under the approach of the new regulations, replacing the roof of a commercial building may not constitute a betterment (since the roof is merely being brought back to its original conditions), but it may be a restoration since the roof performs a discrete and critical function in the building and can be a major component of the building.
The new framework contains some taxpayer-friendly rules.
- Elimination of the “Plan of Rehabilitation Doctrine.” Under old court cases, otherwise deductible repair or maintenance costs had to be capitalized if incurred at the same time there was rehabilitation, modernization or improvement to the property. The final regulations eliminate this doctrine so that repair costs which do not directly benefit and are not incurred by reason of the improvement can be currently deducted.
- Deduction of Removal Costs. The final regulations supported prior reasoning described in revenue rulings, which held that a taxpayer is not required to capitalize removal costs of a retired asset even when incurred in connection with the installation of a replacement asset. The removal cost is effectively allocated to the removed assets being retired. The final regs provide that removal costs can be deducted if a depreciable asset is disposed of (including a “partial disposition”). Where the cost of the old asset is not treated as a disposition for tax purposes, then treatment of the removal costs depends upon whether they directly benefit or are incurred by reason of a repair (deductible) or improvement (capitalized) to the Unit of Property.
- Small Taxpayer Safe Harbor. The new regulations permit the deduction of costs which would otherwise be considered improvements up to certain dollar amounts. This applies to taxpayers with average annual gross receipts over the prior 3 years of $10 million or less. If the taxpayer makes an affirmative election on the business tax return, then improvements and other costs related to a property with an unadjusted basis of $1 million or less can be deducted up to the extent of the lesser of $10,000 or 2% the Unadjusted Basis of the property. For lessees, the basis of the property is calculated as the non-discounted rent expected to be paid over the lease term, including reasonably anticipated lease extensions.
- Routine Maintenance. The final regulations provide for the deduction of costs for certain activities considered to be “routine.” So long as the cost is not a betterment nor an adaptation to a different use, then “routine maintenance” costs can be currently deducted. Costs with respect to tangible real estate or personal property are considered “routine” if at the time of acquisition of the property, the taxpayer reasonably expects:
- For tangible personal property, to perform the activity more than once during the asset’s Asset Depreciation System (ADS) class life.
- For real property, to perform the activity more than once during a ten-year period.
The taxpayer can substantiate its expectation as reasonable by referencing maintenance done to similar property, the manufacturer’s suggested maintenance program, or similar evidence.
Summary of the Disposition Regulations
Final regulations provide that a “disposition” occurs when an asset is transferred or when the asset is permanently withdrawn from use in a trade or business or production of income. A key provision of these regulations is recognition that a “partial disposition” of as asset (e.g., the disposition of a roof or portion of a roof on a building) can fall under the disposition rules.
The “partial disposition” rule permits a loss to be claimed on the disposition of a structural component (or portion thereof) of a building or other asset without having to identify the component as a separate asset prior to the disposition event. The intention of this rule is to minimize the situation where the original part and the replaced part are both capitalized into the current cost of an asset and are being simultaneously depreciated.
A “partial disposition election” must be made on a timely filed original federal income tax return for the tax year of disposition. Once made, the election of the tax year can be revoked only with the IRS Commissioner’s consent. Treatment as a disposition of the cost of the component will cause the replacement cost to be capitalized under the Restoration rule discussed above.
The IRS and Treasury provide that since the replaced asset is not separately identified in the depreciation records of the company, the taxpayer can use “reasonable methods” to determine what portion of the adjusted basis of an assets relates to the disposed of portion. The intention of this rule is to avoid the need for an expensive study.
The nonexclusive methods in the regulations include:
- Discounting the cost of the replacement asset by the Producer Price Index for Finished Goods (and its successor, the Producer Price Index for Final Demand). The Proposed Regulations had permitted use of the Consumer Price Index, but this index was abandoned in the Final Regulations. The Final Regulations provide that the discount method is appropriate only if the replacement is not a Betterment.
- Pro Rata allocation based on replacement cost of the disposed of asset and other assets held in a multiple asset account.
- Use of a study allocating cost of assets to the components.
Rev Proc 2014-54 permits the use of a “late partial disposition” election to write off the costs of assets disposed of in prior years. Under prior guidance, a late partial disposition election could only be made for tax years beginning in 2012 through 2013. However, the final regs extend this election by one year to include the tax year beginning in 2014.
The deduction of “ghost assets” disposed of in prior year can produce a substantial current deduction. Additionally, it may reduce the tax base for property taxes imposed on tangible property. It can also eliminate these assets from the depreciation schedules and reduce the amount subject to Section 1245, 1250 or unrecaptured section 1250 income consequences.
The repair and capitalization rules are applicable for tax years beginning in 2014. Generally, application of the new rules will be treated as changes of accounting method requiring the filing of a Form 3115 with the tax return for the year of change.
- Sec 481 adjustment. Many of the new rules in 2014 will require a determination of the retroactive effect of the change. For example, if items which should be capitalized under the current rules were expensed in prior years and the asset is still owned as of the beginning of the 2014 tax year, the taxpayer must calculate the difference between the deduction taken for the item and the amount of depreciation which would have been allowed. This difference is the IRC sec 481 adjustment which must be reported for the item on Form 3115. Some adjustments may be positive and others with be negative. Overall positive sec 481(a) adjustments normally are included in income over a four year period. Negative adjustments are allowed entirely in the year of change. The business records for prior periods must be reviewed and analyzed to determine the amount of these sec 481 adjustments, where applicable.
- A review of the company’s records must be done to determine if the details are being recorded to take advantage of the de minimis election rule and categorization of items as materials and supplies.
- Depreciation schedules should be reviewed to determine whether there are “ghost assets” – i.e., cost of assets which were replaced in prior years but not written off the business’ depreciation schedule. Even where the company has had a cost segregation study performed, the detail of such a study may not drill down to the portion of the cost which has been disposed.
The new repair and capitalization regulations will require considerable analysis to ensure compliance. In addition, businesses must make certain that they have systems in place which will take advantage of the several pro-taxpayer rules.