Tangible Property Regulations
Your Guide to Tangible Property Regulations (TPR)
Since their implementation on January 1st, 2014, the Tangible Property Regulations (TPR) have brought welcome clarity to an important real estate decision-making process: whether the cost of an improvement can be expensed. Or must it be capitalized?
Various additional pieces of legislation have passed in the ensuing years—TCJA, CARES, CCA, and, most recently, OBBBA—bringing significant changes to the depreciation treatment of accelerated capitalized asset costs. These Acts have brought favorable treatments, such as bonus depreciation, to the forefront of tax planning. As such, many taxpayers and tax professionals have been quick to capitalize on favorable bonus rates rather than navigate the nuances of expensing under the TPRs.
Even with OBBBA’s reinstatement of 100% bonus depreciation, taxpayers should generally use expensing strategies before capitalizing, despite the current year’s bottom-line federal tax implications often appearing similar. Some reasons include depreciation recapture rules on the sale of assets and various states decoupling from Federal bonus rates, creating unfavorable addback rules.
Therefore, the TPRs remain very much in play. Understanding these rules and how to implement them correctly enables tax professionals to incorporate the TPRs into new legislation, thereby forming a comprehensive tax strategy.
Key Topics
TPR Safe Harbor Elections
The BAR Test
Unit of Property & Materiality Testing
Partial Asset Disposition
Incorporating TPRs in Tax Planning
TPR Safe Harbor Elections: Three Ways to Deduct Costs
The TPR provides three Safe Harbor elections that allow taxpayers to deduct certain costs without capitalizing them. These include:
- De Minimus Safe Harbor
- Routine Maintenance Safe Harbor
- Safe Harbor for Small Taxpayers
These are elections, not a change in accounting method, and do not require filing Form 3115.
De Minimus Safe Harbor §1.263(a)-1(f)(1)(i), & (ii)
The De Minimus Safe Harbor allows for the deduction of certain amounts paid to acquire tangible property. There are two versions of the election, one for taxpayers with an Applicable Financial Statement (AFS) and one for taxpayers without an AFS.
TAXPAYERS WITH AFS
Deduction Limit: Up to $5,000 per item or invoice
Requirements:
- Written capitalization policy in place on the first day of the tax year
- Policy must treat amounts below a threshold or assets with a useful life of 12 months or less as expense
- Consistent book and tax treatment
- Detailed, itemized invoices
Example
TAXPAYERS WITHOUT AFS
Deduction Limit: Up to $2,500 per item or invoice
Non-AFS taxpayer also needs to have a procedure in place at the beginning of the tax year with content comparable to that described above. However, this policy doesn’t have to be in writing.
AMOUNTS IN EXCESS of SAFE HARBOR AMOUNTS
According to the TPR preamble, a taxpayer that seeks a deduction for amounts in excess of the amount allowed by the safe harbor has the burden of showing that such treatment clearly reflects income.
Leveraging Tangible Property Regulations
Routine Maintenance Safe Harbor §1.263(a)-3(i)
Key Advantage: No dollar cap on deductions
Available to all taxpayers regardless of income, property size, or AFS status, this safe harbor allows taxpayers to deduct amounts spent on routine maintenance with no cap.
Routine maintenance is a “preventative or cyclic maintenance that is an essential part of the ongoing care and upkeep of a building and its systems.” Activities such as inspecting, cleaning, testing, and replacing worn assets with comparable ones fall under this heading. To be considered “routine,” the activity has to be one that you expect to repeat at least once every 10 years. Any replacement that improves the property, however, is not eligible.
Safe Harbor for Small Taxpayers §1.263(a)-3(h)
Eligibility Requirements:
- Average gross receipts below $10 million for the last three years
- Building with an unadjusted basis of less than $1 million
Deduction Limit: Eligible candidates can deduct the cost of work performed on owned or leased buildings in the amount of $10,000 or 2% of the unadjusted basis of the building, whichever is less.
Example
There’s one important caveat. If a taxpayer elects the Safe Harbor for Small Taxpayers, the maximum deduction allowed must include all repair-related deductions taken in a given year.
You can’t take $10K through Small Taxpayers, and another $5K through De Minimus, and another $3K through Routine Maintenance. Once you elect Safe Harbor for Small Taxpayers, the total of all three elections must not exceed $10K or 2% of the unadjusted building basis, whichever is less.
Let’s return to Taxpayer A and his small rental property. Imagine that $8,000 worth of property maintenance was required in a given year. This exceeds 2% of the building’s unadjusted basis ($6,000). If he takes the Small Business Safe Harbor, his total deduction will be capped at that $6,000, and will only cover 75% of his maintenance costs. In this case, the Routine Maintenance Safe Harbor is more advantageous, as he will be able to deduct his maintenance costs in full.
A Comprehensive Guide to Cost Segregation
The BAR Test: Betterment, Adaptation, or Restoration
After considering the Safe Harbors, expenditures must pass the BAR Test to determine whether they represent improvements requiring capitalization.
The purpose of the BAR Test is to determine whether the cost represents an improvement in the form of a betterment, adaptation, or restoration. If the improvement is determined to be a betterment, adaptation, or restoration, the cost of the improvement must be capitalized.
B is for Betterment
The first type of betterment is one that corrects a pre-existing amelioration of material condition or defect. For example, if a taxpayer purchased land and later discovered that the soil was tainted, remediation costs would constitute a betterment and must be capitalized.
The other types of betterment are improvements that increase physical space or capacity or increase efficiency, strength, or productivity.
Examples
If the old membrane is replaced with a new comparable membrane, returning it to its initial condition but not making it any better, this is not considered a betterment. According to the Regulations, in this situation, the new membrane could be expensed.
If the old membrane is replaced with a more energy-efficient one, the new membrane would be considered a betterment. In this case, the new membrane would have to be capitalized and depreciated.
Note: If the scenario is slightly changed and the replacement occurs immediately following acquisition, without the new owner causing any wear and tear, then the roof would need to be capitalized.
A is for Adaptation
An improvement is considered an adaptation if it adapts the Unit of Property (UoP) to a use other than the original use of the UoP at the time the building was placed-in-service.
Example
R is for Restoration
Restorations encompass several scenarios in which property returns to its ordinary operating condition after a decline or damage.
Restoration Categories:
Replacement of a major property component
-
- After the component was sold
- After the taxpayer deducted a loss for the component
- After the taxpayer claimed casualty loss
- Restoration of a UoP to like-new condition after the end of its class life
- Restoration of a UoP to its original operating condition
That last bullet might seem confusing. Above, we said that replacing the old roof membrane with a new, comparable one – restoring it to its original operating condition – is not a betterment and doesn’t have to be capitalized.
Now we’re saying that restoring a UoP to its original operating condition would be a restoration and would have to be capitalized. What’s the difference?
The deciding factor is what caused the deterioration of the component in the first place – was it just normal wear and tear, or had the component been actively neglected?
- If it were just normal wear and tear, like in the roof example, restoring the roof to its original operating condition is not considered a betterment and might not have to be capitalized.
- If the deterioration was caused by major neglect on the part of the owner, then restoring the component to its original operating condition is considered a restoration and must be capitalized.
Example
Navigating Bonus Depreciation
If an improvement is determined to be a betterment, an adaptation, or a restoration, it must be capitalized. But what if the improvement is determined to be none of the above?
Unit of Property (UoP) and Materiality Testing
If an improvement is not a betterment, adaptation, or restoration, it must be put to one more challenge – the materiality test. The materiality test weighs the impact of the cost as it relates to the building structure or appropriate building system to determine if the cost is high, or “material.”
If a cost is “material,” it must be capitalized.
What is a Unit of Property?
Section 1.263(a)-3 establishes asset categories known as Units of Property. The Regulations state that building structure is one UoP, and other major building systems (“designated systems”) constitute their own UoPs:
- Building Shell (floors, ceilings, roof, foundation)
- HVAC
- Plumbing
- Electrical
- Security Systems
- Fire Protection and Alarm Systems
- Gas Distribution Systems
- Escalators
- Elevators
During a cost segregation study, assets are generally segregated according to MACRS class lives. They can also be sorted by UoP, which is crucial for applying the Materiality Test.
Materiality Test
The Materiality test compares the cost of the improvement to the overall costs of the relevant UoP to determine if the improvement cost is significant, or “material.”
If pipes were replaced in Building B, you’d compare the cost of those pipes to the total cost of the plumbing UoP system. If wiring was replaced in Building W, you’d compare the cost of that wiring to the total cost of the electrical UoP system.
What Threshold Defines Material?
The obvious question is: how large does the spend need to be to be considered significant (or material) to its UoP?
Unfortunately, the IRS does not provide a bright-line answer. It does provide examples within the regs in which thresholds may range between 25% and 40% of the total UoP value, implying the following:
- If the cost of an improvement is GREATER than 25-40% of the total UoP value, the improvement is considered material, and must be capitalized.
- If the cost of an improvement is LESS than 25-40% of the total UoP value, the improvement is not material, and may be expensed.
Often, materiality is determined by examining “units,” and the thresholds above can be applied. Consider a taxpayer who has replaced two out of ten rooftop HVAC units on his property. Since he replaced only two of ten units, or 20% of the total HVAC UoP, the expenditure is immaterial and may be expensed.
Discrete Function
Sometimes, a group of assets within a UoP works together to perform a discrete function within that UoP. When performing the materiality test on these assets, you shouldn’t compare them to the value of the entire organization (UoP). Instead, you should compare them to the total value of assets that contribute to the discrete individual function.
Example
Consider a taxpayer who replaced 200 of the 300 windows in his building. The cost of 200 windows is likely not material relative to the value of the Building Shell UoP as a whole. However, because they are discrete functions, the windows are UoPs in their own right. We don’t compare them to the entire Building Shell UoP, but to the Window UoP. 200 out of 300 windows replaced represents 66%. This improvement is definitely material to its UoP, and the expenditure would have to be capitalized.
Why Cost Segregation is Essential for Materiality Testing
Not all building components can be simply counted up and divided. Cost segregation studies categorize all building assets and quantify appropriate monetary values, enabling dollar-based (not just unit-based) comparisons.
If the cost of the new wiring in Building W were only 10% of the value of the entire electrical UoP, the new wiring would not be material and may be expensed.
If the cost of the new plumbing in Building P was 50% of the value of the entire plumbing UoP, the new plumbing is material and must be capitalized.
The ability to make this comparison in dollars is crucial to the accurate performance of materiality tests, which, in turn, are crucial to making appropriate expense vs. capitalization decisions.
How Cost Segregation Studies Work
Partial Asset Disposition
If you’ve put your improvements to the tests above and determined that capitalization is required, there is still a way to get additional value out of this scenario.
How PAD Elections Work
There’s no getting around capitalizing the new asset, but you can address the asset that was replaced. Partial Asset Disposition (PAD) Elections permit the immediate write-off of the remaining depreciable basis of an asset that was replaced or removed from service. You don’t have to keep retired or replaced assets on your books for years. By using a PAD election in the year the asset was removed, you can remove it from the books immediately and deduct the remaining adjusted basis of the asset.
This results in benefits now and later:
- Lowers total income, taxable income, and tax burden immediately.
- Removes accumulated depreciation from the fixed asset schedule, reducing the amount of recapture in the event of a future sale. By reducing the amounts to be recaptured, the disposition election essentially establishes a tax rate arbitrage, allowing taxpayers to use normal capital gains treatment under Sec. 1250.
Consider the classic roof example. If you replaced a roof before the TPRs, you would capitalize the cost of the new roof and then depreciate it over the usual class life (39 years for commercial property). Most taxpayers would also continue to depreciate the old roof, which had been replaced. It wasn’t unusual to see two roofs on the books simultaneously. With a PAD election, the remaining depreciable basis of that old roof can be written off in the year it was removed from service.
An additional benefit of the PAD election is the removal of deductible costs. It costs money to remove all those old shingles and bad wood. The TPRs allow these costs to be deducted in addition to the remaining depreciable basis of the old roof. (Note that removal costs related to demolition are covered under Sec. 280B and are addressed differently.)
Determining the Basis of Disposed Assets
PAD Elections have tremendous implications for tax savings, but how do you know how much to write off? What quantifiable value remains in that old roof?
The IRS’ Audit Technique Guide on Tangible Property defines three acceptable methods by which the unadjusted basis of the replaced asset may be determined:
- Pro-Rata Allocation: Based on the replacement cost of the disposed asset and the replacement costs of all assets in the pool.
- Producer Price Index (PPI) Method: The Producer Price Index for Finished Goods (or Producer Price Index Final Demand) can be used to discount the cost of a replacement asset to its placed-in-service year cost.
- Cost Segregation: A thorough, high-quality study will break out all components of the property – including those that will be replaced. All assets will be assigned an accurate cost – including those that will be replaced. Determining the remaining depreciable basis on the replaced roof is a straightforward calculation based on the number of years the asset has been in service.
Note the importance of conducting a study before MACRS assets are removed to document their on-site presence and support the PAD election later.
The Role of Cost Segregation in PAD Elections
In the Cost Segregation Audit Technique Guideline, the IRS says that the engineering-based approach used in a cost segregation study is “the most methodical and accurate approach… and generally provides the most accurate cost allocations.”
With their unique focus on breaking out costs, cost segregation studies are the ideal way to generate the data required to justify PAD elections. Every time an improvement is capitalized, there is potential for additional disposition. A well-executed study is crucial for taxpayers seeking to maximize the benefits of the TPRs.
Key Takeaways
Incorporating the TPRs into Your Broader Tax Planning
The Tangible Property Regulations remain crucial to a thoughtful and comprehensive tax strategy, particularly in light of addback and depreciation recapture rules now impacting certain states.
Key Takeaways
- Prioritize Safe Harbor elections before considering capitalization
- Apply the BAR Test systematically for non-safe harbor expenditures
- Understand Unit of Property definitions and materiality thresholds
- Leverage cost segregation for accurate materiality testing
- Implement PAD elections to maximize tax benefits on capitalized improvements
- Consider state-specific rules that may differ from federal treatment