Revised regulations present new compliance measures, as well as opportunities, for taxpayers.
Virtually all taxpayers who own property are affected by the new temporary IRS guidance on the amounts paid to acquire, produce or improve tangible property. The final regulations are expected this year, with only limited modifications anticipated. Taxpayers will need to evaluate their current methods of accounting to determine what changes are necessary to comply with the new regulations. In many cases, they will also need to implement retroactive changes.
These temporary regulations significantly change how improvement rules apply to buildings. Although the IRS retained the general rule that defines a building and its structural components as a single unit of property, it effectively “sectioned” the building into major component parts under the improvement rules. These include:
- HVAC systems (motors, compressors, boilers, chillers, pipes)
- Plumbing systems (pipes, drains, bathtubs, toilets, water/sewer equipment)
- Electrical systems (wiring, outlets, junction boxes, lighting fixtures)
- All escalators
- All elevators
- Fire protections and alarm systems (sprinklers, computer controls, fire doors/escapes)
- Security systems (window/door locks, security cameras, security lighting, alarm system)
- Gas distribution systems (pipes and equipment used to distribute gas, etc.)
- Other building systems as identified by the IRS in federal guidance.
The “building structure” is treated as the remaining catch-all category for Section 1250 items not within the above categories—including the roof, walls, foundation, doors, windows and general finish items, such as flooring and ceilings. If an amount paid is a restoration or betterment of the building structure or any one of the above-identified building systems, or if it adapts the property to any new or different use, the expenditure is an improvement and must be capitalized.
Since roofs, doors, siding and window replacements are not among the nine structural sub-systems above, they need to be reviewed for their overall contribution to the building structure as a unit of property. Roof membrane/shingle replacements, windows and door replacements may now be expensed in certain situations.
The unit of property guidance and the disposition rules for buildings are a major development and will allow taxpayers to identify and dispose of certain building costs that are replaced over time. A more in-depth understanding of building and structural costs will allow taxpayers to write off any undepreciated costs of building components when the replacement requires capitalization. The previous rules did not let taxpayers write off portions of real property. Many taxpayers have been capitalizing various repairs to buildings and building systems, such as routine roof, HVAC and parking lot repairs, that now may be deductible. In essence, taxpayers should not have capitalized repairs for the same asset (i.e. two roofs) on their depreciations schedules. Taxpayers are encouraged to review their past practices for tax savings.
Improvements to leased property are also discussed in the new regulations and allow lessees similar benefits on certain leasehold improvements.
Formalized de minimus rules: The new regulations allow for amounts paid to acquire or produce tangible property, not exceeding a certain dollar threshold, to be deducted under a de minimis provision. These provisions are expected to be modified in their final form in 2013.
Under current language, once a taxpayer identifies certain expenditures as de minimis, the annual aggregation of these costs cannot exceed a threshold that is based on an entity’s applicable (audited) financial statements. The amounts paid and not capitalized under the de minimus rule for the year must be less than or equal to the greater of:
- 0.1 percent of the taxpayer’s gross receipts for the year, or
- Two percent of the taxpayer’s total depreciation and amortization expenses for the year on its audited financial statements.
Materials and supplies: Materials and supplies are now categorized either as incidental or non-incidental. Incidental materials and supplies may be deducted when purchased, as long as no record of consumption is kept and expensing such items does not distort income. Non-incidental materials and supplies are typically not expensed until they are used or consumed.
Spare parts: Additional rules apply to rotable/temporary spare parts. Taxpayers can capitalize and depreciate the cost of spare parts in the year they acquire them. However, they also have two additional alternatives. The first is to deduct the cost of the spare parts in the year they are consumed (used). The second alternative is a new method provided by the regulations that allows a taxpayer to elect to deduct the cost of the spare part when it is first installed, but will require capitalization (and income recognition) when removed from service.
Repairs: The general rule is that a taxpayer may deduct amounts paid for repairs and maintenance to tangible property as long as they are not otherwise required to be capitalized. The new regulations allow a deduction for routine maintenance. Costs that are expected to be performed more than once over the life of the asset may be acceptable as an expense deduction under many scenarios.
To maximize tax opportunities, taxpayers will need to review all prior property classifications for proper treatment. Various Internal Revenue Code sections will have to be considered in each situation. The following opportunities should be reviewed: normal depreciation expense—plus bonus depreciation opportunities—and Internal Revenue Code Section 179D (enhanced depreciation deductions and energy savings incentives). A coordinated effort is essential.
Additionally, the new regulations make consistency vitally important in the treatment of certain expenditures. A change in accounting method may be required to restate the treatment of historical assets. It is always advisable to obtain a comprehensive fixed-asset study when property is purchased, but now it is even more important to do so for tax benefits.
These temporary regulations do not provide bright-line tests for assessing whether an amount paid is considered an improvement/restoration to a building structure, building system or other real property. Instead, these determinations take into account the purpose of the expenditure, nature of the work, effect of the expenditure on the unit of property and the treatment of the expenditure on the financial statements. Each taxpayer’s unique facts and circumstances should be reviewed as they relate to the proposed and temporary regulations. Contact your tax advisor for assistance in maximizing the benefits available from these new regulations. iBi
Mark Colvin CPA is a tax senior manager for CliftonLarsonAllen in Peoria. He can be reached at [email protected] or (309) 495-8754.