June 15, 2012
The Internal Revenue Service (IRS) has released long-awaited Temporary and Proposed Regulations (in TD 9564 and REG-168745-03) to attempt to reduce confusion between “repairs” to tangible property which are generally currently deductible from taxable income and “improvements” to or “acquisitions” of tangible property which generally must be capitalized and deducted over a period of amortization. The new regulations follow Proposed Regulations released in 2006 and revised in 2008. The new regulations are in excess of 250 pages, but the following article highlights elements that we believe will be of interest to our clients and friends.
Scope of the Rules: For taxable years beginning in or after 2012, the new regulations provide guidance on whether and when a taxpayer must capitalize costs incurred in the acquisition, production or improvement of any tangible property.
Unit of Property (UOP) is an integral component of understanding and applying the new regulations to property already owned by taxpayers. The UOP concept was present in the 2008 proposed regulations, but has been revamped under the new regulations, particularly for buildings.
In terms of buildings, the new regulations treat a building as a single UOP comprised of the building, its structural components (e.g., walls, floors) and statutorily-defined “building systems.” To determine whether an expenditure should be capitalized, the effect on the structural component or building system (rather than the building as a whole) is the focal point of the analysis. The enumerated building systems contained in the new regulations encompass:
- Fire protection and alarm systems,
- Security systems,
- Gas distribution systems, and
- any other system identified in published guidance.
In general, any expenditures on structural components or building systems (whether betterment, restoration, or adaptation as discussed further below) will likely require capitalization under the new regulations.
Observation: Fortunately, the new regulations have also revised the definition of “disposition” – permitting expensing of the remaining unamortized cost – to include the retirement of structural components and systems. For example, if building management retires or removes its security system, it may expense the remaining cost rather than continue the underlying depreciation.
For real and personal property other than buildings, the new regulations generally define a UOP as all components that are functionally interdependent, unless the taxpayer used a different depreciation method or recovery period for a component at the time it was placed in service.
Observation: As a general rule of thumb, the larger the UOP, the more likely an expenditure will be treated as a deductible repair. To illustrate: If an automobile were deemed a UOP, any repairs to its seats would likely be deductible. By contrast, if the automobile’s engine itself were deemed an independent UOP, repairs or improvements to the engine would likely warrant capitalization.
Taxpayers should note that exceptions exist for “plant property” and “network assets” where the functional interdependence analysis will not apply.
As noted above, the new regulations require capitalization if an improvement has been made. The regulations provide further guidance by defining an improvement as a betterment, a restoration, or an adaption for a new or different use, and providing concrete standards to determine if any of the three have resulted from an expenditure.
Using a fact-sensitive analysis, under the new regulations a betterment occurs if the expenditure:
- Ameliorates a material condition or defect that existed prior to the taxpayer's acquisition of the UOP or arose during the production of the UOP (whether or not the taxpayer was aware of the defect at the time of acquisition or production);
- Results in a material addition (including a physical enlargement, expansion, or extension) to the UOP; or
- Results in a material increase in capacity, productivity, efficiency, strength, quality, or output of the UOP.
Under the new regulations, a restoration occurs if the expenditure:
- Is for the replacement of a component of a UOP and the taxpayer has properly deducted a loss for that component (other than a casualty loss under Treas. Reg. 1.165-7),
- Is for the replacement of a component of a UOP 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,
- Is for the repair of damage to a UOP for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss under Internal Revenue Code Section 165, or relating to a casualty event described in Section 165,
- Returns the UOP to its ordinarily efficient operating condition if it has deteriorated to a state of disrepair and is no longer functional for its intended use,
- Results in the rebuilding of the UOP to a like-new condition after the end of its class life, or
- Is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a UOP.
Observation: An improvement has also occurred where an expenditure has adapted the property for a new or different use. To illustrate, a car dealership that converts its showroom to a repair facility has improved the property.
The new regulations also pertain to tangible property acquisitions. In addition to the purchase price, taxpayers must capitalize investigatory and other acquisition costs.
Observations: Two exceptions apply:
- Taxpayers are not required to capitalize investigatory costs that occurred in a transaction’s infancy or so-called “pre-decisional” costs. For example, costs incurred prior to deciding to acquire real property in general do not have to be capitalized unless they are inherently facilitative in nature as delineated in the new regulations.
- The second exception pertains to employee compensation and overhead associated with a transaction. Nonetheless, taxpayers may elect to capitalize these costs on a transaction-specific basis.
The new regulations also provide a de minimis rule permitting a taxpayer to deduct currently certain expenditures – including purchase price, investigatory and other acquisition costs – which are otherwise required to be capitalized where:
- The taxpayer has an applicable financial statement as delineated in the new regulations and a written accounting policy requiring expensing of items that cost no more than a specified amount for book purposes and
- The policy is applied for book purposes.
Observation: The limit on the annual aggregate amount of deduction eligible for the de minimis exception is the greater of 0.1% of the taxpayer’s gross receipts for federal income tax purposes or 2% of the taxpayer’s depreciation and amortization expenses shown on its applicable financial statement.
The summary above highlights elements of the new regulations that we believe will be of interest to our clients and friends. Readers are encouraged to contact their tax advisors to determine how the new regulations will affect their specific business operations.
Aninda Dhar is a Manager in EisnerAmper’s Real Estate Services Group. Questions? Please contact him at 212.891.6859