Tangible Property Capitalization

Regulations

Angelina Milo, CPA, MT Parnter, Cohen & Company

History & Effective Dates

Ten years in the making – Advance Notice: 2004

– Proposed regulations issued: 2006 & 2008

– Temporary regulations issued: December 2011 • Effective beginning on or after January 1, 2012

– Public hearing in May 2012

– Final regulations repair & proposed disposition regulations issued: September 2013

• Effective beginning on or after January 1, 2014

“The Repair Regulations”: A Misnomer

Applies to all costs incurred in connection with tangible property

(1) acquiring

(2a) improving

(2b) repairing

(2c) maintaining

(3) disposing

Why is it Important?

• Explains how to classify costs: deduct vs. capitalize – No longer based on facts & circumstances – Provides new definitions – Set new standards

• Introduces new “disposition” rules – Allows taxpayers to claim a loss on disposition vs.

double depreciation ** Mixed Results – may be beneficial and/or unfavorable **

Acquiring Property

• Material & Supplies – Tangible property that is used or consumed in the

operations that is not inventory

– Consumed in 12 months or less

– Has economic life of 12 months or less

– Costs of $200 or less

– Annual election to capitalize & depreciate spare parts

Acquiring Property

• De minimis Safe Harbor – Book conformity:

• Costs classified as expenses • Capitalization policy

– Capitalization policy: • In place at beginning of the year • Cost per item less than threshold • Item has an economic useful life of less than 12

months

Acquiring Property

• De minimis Safe Harbor – Two thresholds:

• $5,000 per-item or per-invoice with Applicable Financial Statements (AFS)

• $500 per-item or per-invoice without AFS

– Example: Bulk purchase of 10 computers for cost $40,000. Computers invoiced in aggregate, not individually. De minimis safe harbor applies.

Acquiring Property

• De minimis Safe Harbor – Applicable Financial Statement is:

1. A financial statement required to be filed with the Securities & Exchange Commission (SEC)

2. A certified audited financial statement

3. A financial statement (other than a tax return) required to be provided to the federal or state government (agency) other than SEC or IRS

Acquiring Property

• De minimis Safe Harbor – What if book policy is less than threshold?

• Limited to amount expensed per book

– What if book policy is more than threshold? • Limited to $5,000 to qualify for the safe harbor

• May deduct larger amount: upon audit must demonstrate amount is immaterial or clearly reflects income

Acquiring Property

• De minimis Safe Harbor – Annual Election – made with tax return

• Election is irrevocable

• Not an accounting method

– Election applies to all qualifying expenses • Cannot exclude certain expenses

• Applies to all repair & maintenance costs capitalized for book

Unit of Property (UOP)

• Building, structural components & roof – Single unit of property

• Building systems – Each a separate unit of property

• Other property – Generally a UOP consists of a group of functionally

interdependent components

Unit of Property (UOP)

• Building componentization

• Significant change

• Prior law: building & building systems were likely one UOP

• Each component viewed as a separate asset

• Required on buildings

Unit of Property: Building Each building system = a separate unit of property:

– HVAC – Plumbing systems – Electrical systems – Escalators – Elevators – Fire protection & alarm systems – Security systems – Gas distribution systems – Other systems identified in future published guidance

Unit of Property: Leased Building

• Lessee leases a portion of a building – The portion of the building structure subject to

the lease is the unit of property

– The portion of any building system associated with that portion of the leased property is a unit of property

Improving Property: Capitalize

• A unit of property is improved if amounts are paid for activities performed after the unit of property is placed in service by the taxpayer resulting in: – Adaptation of the unit of property to a new or

different use

– Betterment to the unit of property

– Restoration of the unit of property

Adaptation: Capitalize

• Adapt a UOP to a new or different use • Adaptation is inconsistent with intended use • Analyze facts & circumstances • Examples:

– Capital: Expansion in retail drug store for a walk-in medical clinic

– Deductible: expansion in grocery store for a sushi bar that already includes counters for prepared food & deli meats

Betterment: Capitalize

• Alleviates a material condition or defect that existed prior to the acquisition of property

• Results in a material addition or expansion

• Is expected to materially increase in productivity, efficiency, strength, output or quality of the unit of property

Betterment: Example

• ABC Corp. purchases a parcel of land. The soil was contaminated by leaking underground storage tanks left by a previous owner

• ABC Corp.’s remediation costs to remove the contaminants result in a capitalized betterment to the land because ABC Corp. incurs the costs to ameliorate a material condition or defect that existed prior to its acquisition of the land

Restoration: Capitalize

• Replaces a component, and adjusted basis has been taken into account in realizing gain/loss

• Returns a UOP to its ordinary efficient operating condition if the property is no longer functional

• Rebuilds a UOP to a like-new condition after end of its useful class life

• Replaces a part that comprises a major component or a substantial structural part of a UOP

Restoration: Example

• ABC Corp. replaces the waterproof membrane of the roof

• Not a major component or substantial structural part of the building structure

• Improvement or repair? Depends if ABC Corp. will recognize a loss on the replaced membrane

Restoration: Example (Cont.)

• Will ABC Corp. recognize a loss on the replaced membrane? – Yes: Improvement = Capitalize

– No: Repair = Expense

Restoration: Example (Cont.)

• ABC Corp. rebuilds a manufacturing machine with a seven-year class life: – After eight years: Restoration = Capitalize

– After five years: No Restoration = Repair = Expense

Safe Harbor: Routine Maintenance

• Current deduction for certain on-going, routine maintenance expenditures

• Applies only if: – Activity is performed more than once over the property’s life

– The maintenance keeps the property in an efficient operating condition

– The need for the maintenance results from the taxpayer’s use of the property

Safe Harbor: Routine Maintenance

• Also applies to buildings & structural components

• For buildings: – Maintenance is expected to be completed more

than once in a 10-year period

Safe Harbor: Small Taxpayers

• Applies to buildings

• Average gross receipts: less than $10,000,000

• Average unadjusted basis (cost) of building: less than $1,000,000

• Deduct costs of improvements: – that do not exceed the lesser of $10,000 or

– 2% of the unadjusted basis of the property

Proposed Disposition Regulations

• Temporary regulations were issued

• 2011 regulations too complex

• New proposed regulations issued in 2013

• Final regulations to be issued in 2014 – Effective for tax years beginning on or after

January 1, 2014

Proposed Disposition Regulations

• Prior to 2011 temporary regulations – Retirement of a structural component of a

building could not be treated as a disposition

– Continue depreciating retired component and begin depreciating replacement component

– Example: Replacing a roof – if capitalize new roof cannot write off old roof

Proposed Disposition Regulations

Revised Rule: • May recognize a loss on the retirement of a

portion of an asset

• Created a “partial disposition” election

• If election is made: recognize a loss on retirement

• If no election is made: continue to depreciate the basis of the retired asset

Proposed Disposition Regulations

Revised Rule: – Special rules for General Asset Accounts (GAA)

– Partial disposition rule is elective except for certain cases including

• Casualty event

• Like-kind exchange

• Involuntary conversion

Proposed Disposition Regulations

Tax basis of asset retired – May use any reasonable method to determine

value of retired asset including: • Cost segregation studies

• Replacement cost percentage extrapolation

• Original construction costs

Proposed Disposition Regulations

• Rev Proc 2014-17

• Change in accounting method

• Recognize a loss on assets that were physically retired in prior years

• “Ghost” or “phantom” assets

• No later than due date of 2013 return

• Consider GAAP treatment

Questions?

Thank you!