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 these regulations will apply to nearly all taxpayers. We previously discussed the materials and supplies portion of the regulations. This part 2 focuses on costs to acquire tangible property.
The temporary regulations did not change the long-standing rule that costs paid or incurred to either acquire or produce tangible property must be capitalized. The principle changes impact transaction costs and de minimis costs.
The general rule is that taxpayers must capitalize amounts paid to acquire or produce a unit of property, land and land improvements, buildings, machinery and equipment, and furniture and fixtures. The amounts required to be capitalized include the invoice price, transaction costs, and all costs incurred before the date the property is placed in service.
Taxpayers must capitalize amounts paid to facilitate the acquisition or production of real or personal property. An amount paid to facilitate the acquisition includes expenses incurred “in the process of investigating or otherwise pursuing” the acquisition.
Costs that are “inherently facilitative” must always be capitalized. These costs are inherently facilitative:
- transporting the propert
- securing an appraisal or determining the value
- negotiating the terms or structure of the acquisition
- preparing and reviewing the documents that effectuate the acquisition
- examining and evaluating the title of the property
- obtaining regulatory approval or securing permits
- conveying property between parties, including sales and transfer taxes
- finder’s fee or broker’s commissions
- architectural, geological, engineering, environmental, or inspection services
- services provided by a qualified intermediary or other facilitator of a Section 1031 exchange
These “inherently facilitative” costs are required to be capitalized even if the real or personal property to which it relates is not ultimately acquired.
For example, if a taxpayer pays for separate appraisals for two potential building sites, even though it intends to construct only one building, the costs of both appraisals must be capitalized. These costs can be recovered either through abandonment or depreciation. The cost of the appraisal for the real property is not acquired becomes deductible when the taxpayer abandons that potential transaction.
The temporary regulations do provide an exception to capitalization for some transaction costs incurred in connection with the acquisition of real property. Costs incurred in the process of investigating or pursuing the acquisition of real property do not facilitate the acquisition if they relate to activities performed in the process of determining whether to acquire real property and which real property to acquire. This exception reflects the “whether and which” rule the IRS adopted to distinguish deductible investigative costs from capitalizable acquisition costs. This exception does not apply to inherently facilitative costs.
This special “whether and which” rule applies only to acquisitions of real property. If the investigative costs relate to the acquisition of both real and personal property, an allocation is required. The taxpayer must make a “reasonable” allocation, since no standard for allocation is provided in the regulations.
The regulations also adopt a book-conformity de minimis rule. A taxpayer is not required to capitalize an amount paid for the acquisition or production of a unit of property or a material and supply if each of the following requirements is satisfied:
- Taxpayer has an applicable financial statement(AFS);
- Taxpayer has written accounting procedures treating as an expense for nontax purposes the amounts paid for property costing less than a specified dollar amount; and
- Taxpayer has treated the amounts paid during the tax year as an expense on its AFS in accordance with its written accounting procedures;
If these requirements are met, the cost of the property subject to the policy may be currently deductible for tax purposes.
An AFS is (1) a financial statement required to be filed with the SEC; (2) a certified, audited financial statement accompanied by the report of an independent CPA that is used for credit purposes, for reports to shareholders, partners, or similar persons, or for any other substantial nontax purpose; or (3) a financial statement, other than a tax return, required to be provided to a federal or state government or agency. The written accounting policy must be in place as of the beginning of the tax year to be effective.
The regulations place an absolute dollar ceiling on the annual aggregate amount of deductions eligible for the de minimis rule. The aggregate tax deduction is limited to the greater of
- .01% of the taxpayer’s gross receipts for the tax year as determined for federal income tax purposes; or
- 2% of the taxpayer’s total depreciation and amortization expense for the tax year as determined in the AFS.
The de minimis ceiling rule does not act like a cliff, i.e. all or none. If a taxpayer’s total amount otherwise deductible under its written policy exceeds the cap, the taxpayer is not barred from using the de minimis rule up to the ceiling amount. Remember when applying this ceiling any amounts paid or incurred for materials and supplies that the taxpayer elects to treat as de minimis costs must also be included.
The taxpayer may elect not to apply the de minimis rule to any or all property acquired during a particular tax year (that is, cherry-picking is allowed). Because the aggregate amount of the de minimis costs deductible in any year is capped, taxpayers having costs in excess of their ceiling amount may use this election to exclude from its de minimis costs for that year those items whose capitalized costs would otherwise be recovered over the shortest period. Proper planning under the de minimis rule would focus on immediately deducting the costs of longer-lived assets.
This is the second installment on the “repair regulations”. The third installment will cover “costs to maintain or improve tangible property”.
Should you have any questions on how the new regulations may affect you or your business, please contact your Marcum Tax Advisor.