On December 23, 2011, the IRS issued comprehensive guidance, in the form of temporary regulations, on the tax treatment of costs incurred to acquire, repair, or improve tangible property. These regulations are commonly referred to as the "repair" regulations. It is likely that these regulations will apply to nearly all taxpayers. Two earlier Flashes discussed the materials and supplies and the costs to acquire tangible property portions of the regulations. This part 3 focuses on the costs to maintain or improve tangible property.
The most significant changes made by the temporary regulations to existing capitalization standards relate to costs incurred to maintain, improve, or repair tangible property. Among the more important changes made to the repair regulations are:
- The definition of unit of property;
- Changes in the capitalization standard, with specific standards for determining when an expenditure results in a betterment, a restoration, or the adaptation of a unit of property to a new or different use; and
- Safe harbors and optional simplified methods for determining whether an expenditure must be capitalized under Section 263(a).
The linchpin in determining whether an expenditure must be capitalized as an improvement, or may be deducted as a repair, is first identifying the relevant unit of property. The general rule is that a unit of property is determined under the functional interdependence test. However, the functional interdependence standard does not apply to a building, network assets, leased property, or to an improvement to property.
Functional interdependence for real and personal property other than buildings, exists where all components that are functionally interdependent make up a single unit of property. Two or more components of property are functionally interdependent if the taxpayer must place each component in service at the same time for them to perform their intended function. For example, a computer and a printer constitute two units of property because either could be placed in service without the other. However, the engine, generators, batteries and trucks of a railroad locomotive are all functionally interdependent, constituting a single unit of property.
The regulations retain the general rule that a building and its structural components constitute a single unit of property. Notwithstanding, for a building, the capitalization standards are applied to the smaller components of the overall unit of property; either the building structure or one of the specific "building systems". However, if capitalization is required, the costs are then capitalized to the entire building, rather than to the smaller component used in applying the capitalization standard.
A building's structural components consist of the HVAC system, plumbing system, electrical system, all escalators, all elevators, fire-protection and alarm systems, security systems that protect the building and gas distribution systems. Each of these is a building system that is separate from the building structure as to which the improvement rule must be separately applied.
Once the appropriate unit of property is identified, one must determine whether the expenditure is incurred in connection with maintaining that unit, creating a betterment, is restoring that unit of property, or adapting the unit of property to a new or different use.
The regulations require capitalization of costs that result in a betterment to a unit of property. An expenditure results in a "betterment" to a unit of property only if it:
- Improves a material condition or defect that either existed before the acquisition of the unit of property or arose during production of the property;
- Results in a material addition to the unit of property, including a physical enlargement, expansion, or extension of the unit; or
- Results in a material increase in capacity, productivity, efficiency, strength, quality, or output of the unit of property.
When applying the betterment standard all relevant facts and circumstances must be considered. Among the relevant considerations are the purpose of the expenditure, the physical nature of the work performed and the effect of the expenditure on the unit of property.
Restorations are the second category of costs required to be capitalized. This category essentially represents the former requirement that costs must be capitalized if they extend the useful life of the unit of property. The regulations provide examples of restorations and sets forth two standards of application, though whether a restoration has occurred is largely a factual inquiry.
First, a unit of property is rebuilt to a like-new condition if it is brought to the status of new, remanufactured, rebuilt, or a similar status under the terms of any federal regulatory guidelines or the manufacturer's original specifications. Second, the regulations provide guidance in determining whether the taxpayer has replaced a "major component or a substantial structural part" of a unit of property.
For example, the engine and cab of a truck are a "part or combination of parts" that make up a major component or substantial structural part of the tractor. Similarly the petroleum tank of a petroleum truck's trailer constitutes a "part or combination of parts" that make up a major component or substantial structural part of the entire trailer. As such, replacement of these major parts would constitute a restoration of the tractor or the trailer, respectively.
The replacement of a minor component to a unit of property generally will not by itself constitute a restoration under this standard.
If a unit of property is adapted to a new or different use the expenditure must be capitalized. The regulations restate the existing standards; an amount is paid to adapt a unit of property to a new or different use if the adaptation is inconsistent with the taxpayer's intended ordinary use of a unit of property at the time it was originally placed in service. For buildings, this is applied by considering the expenditures' effect on the building structure or any of the specific building systems. As with other capitalization standards (betterments or restorations), the regulations rely on examples to establish the application of this rule.
Therefore, a restoration will be found to occur if the expenditure:
- Returns a unit of property to its ordinary 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;
- Is for the replacement of a part or a combination of parts that constitutes a major component or a substantial structural part of a unit of property;
- 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; or
- 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 under Section 165.
Routine Maintenance Safe Harbor:
Under the routine maintenance safe harbor, an amount paid for routine maintenance performed on a unit of property, other than a building or structural component of a building, is deemed not to improve that unit of property and is generally currently deductible.
This safe harbor applies only if:
- The taxpayer expects to perform the activity more than once over the property's ADS class life;
- The maintenance keeps (rather than puts) the property in an ordinarily efficient operating condition; and
- The need for the maintenance results from the taxpayer's own use of the property.
Examples of routine maintenance are inspection, cleaning, and testing the unit of property and the replacement of parts with comparable and commercially available and reasonably priced replacement parts. This valuable safe harbor extends to replacements of substantial structural elements, as long as the taxpayer initially expects to effect such a replacement at least twice during the property's ADS class life.
This safe harbor does not apply to activities that improve the unit of property rather than keeping it in its ordinarily efficient operating condition. The safe harbor applies throughout the entire economic useful life of the property – not just during its ADS class life. As the property ages and the state of technology for that property progresses, the taxpayer's use of new and improved standard parts to replace worn or damaged parts will become particularly important when applying the routine maintenance safe harbor. The line between routine replacements using new improved standard parts and replacements constituting "betterments" will become increasingly important as the unit of property ages.
The routine maintenance safe harbor is an important tool in ensuring the deductibility of a wide range of routine maintenance activities, regardless of whether they occur before or after the end of the unit of property's economic useful life.
Retirement and Dispositions:
The regulations make substantial changes to the depreciation rules. Disposition now includes the retirement of a structural component of a building. By doing so, the regulations allow the recognition of a loss on retirement of a structural component.
The regulations also amend the rules applicable to "general asset accounts". Generally, a taxpayer cannot claim a loss on the disposition of an asset from a general asset account. The regulations now permit an election to recognize gain or loss on the disposition of an asset in a general asset account.
The new flexibility under the general asset account rules provides taxpayers an important tool in managing the recovery of basis in tangible assets that have been improved under the repair regulations. Under prior law, taxpayers were penalized by the statutory requirement that a taxpayer depreciate the capitalized costs as an improvement over the same recovery period as the underlying asset. For example, the cost of a new roof was depreciated over a full 39 years, rather than over the remaining depreciable life of the building whose roof was replaced. This rule, combined with the taxpayer's inability to recover the basis of the disposed-of structural components, resulted in situations in which taxpayers were required to begin depreciating the cost of a new roof over 39 years while continuing to recover the remaining basis of the roof that was replaced over the remainder of its own recovery period. Even though the taxpayer physically owned only a single roof at a time, it was depreciating the costs of two, and sometimes three roofs, simultaneously.
The regulations relieve taxpayers of this harsh result by allowing an immediate deduction for the remaining tax basis of the roof (or structural component) that has been replaced. Now, when a taxpayer incurs costs to replace an existing roof that has not been fully depreciated, that replacement will now create an immediate deduction for the remaining basis of the roof being replaced. The taxpayer will now only be depreciating the new roof.
These new rules create an important tax planning opportunities.
Should you have any questions on how the new regulations may affect your or your business, please contact your Marcum Tax Advisor.