New Repair Regulations PRESENTED BY SCOT T H. GAMMILL

DECEMBER 5, 2014

Discussion Topics Background General Improvements to Property Unit of Property Materials and Supplies

De Minimis Safe Harbor Routine Maintenance Safe Harbor Small Taxpayer Safe Harbor Election to Capitalize Repair and Maintenance Costs Decision Tree

Background The subjective nature of whether work performed on property were repairs or improvements created significant controversy over the years. I.R.C. § 263(a) generally requires capitalization of amounts paid to acquire, produce, or improve tangible property. I.R.C. § 162 allows a current deduction for ordinary and necessary business expenses, including costs for materials, supplies, repairs, and maintenance.

The IRS issued final regulations in September 2013 in an effort to reduce this controversy after issuing proposed regulations in 2006 and 2008 then temporary regulations in 2011.

Summary of Final Regulations in T.D. 9636 Materials and supplies

Treas. Reg. § 1.162-3

Repairs

Treas. Reg. § 1.162-4

MACRS general asset accounts

Prop. Treas. Reg. § 1.168(i)-1

MACRS item and multiple asset accounts

Treas. Reg. § 1.168(i)-7

Dispositions of MACRS property

Prop. Treas. Reg. § 1.168(i)-8

Partial disposition election

Prop. Treas. Reg. §1.168(i)-8(d)

Capital expenditures in general

Treas. Reg. § 1.263(a)-1

Amounts paid to acquire or produce tangible property

Treas. Reg. §1.263(a)-2

Amounts paid to improve tangible property

Treas. Reg. §1.263(a)-3

Unit of Property

Treas. Reg. §1.263(a)-3(e)

Summary of Final Regulations in T.D. 9636 Safe Harbors

Regulation Citation

De minimis safe harbor

Treas. Reg. § 1.263(a)-1(f)

Small Taxpayer building safe harbor

Treas. Reg. §1.263(a)-3(h)

Routine maintenance safe harbor

Treas. Reg. §1.263(a)-3(i)

Regulatory accounting method safe harbor

Treas. Reg. §1.263(a)-3(m)

Book conformity safe harbor

Treas. Reg. §1.263(a)-3(n)

Improvements to Property Facts and circumstances will continue to play a major role in determining whether an expenditure is a currently deductible repair or a capital improvement. While the IRS integrated a considerable amount of the case law into the repair regulations, they fail to give us bright-line tests that we could apply.

Improvements to Property An amount paid is capital if it results in: Betterment to the unit of property Restoration of the unit of property Adapts the unit of property to a new or different use

Improvements to Property Taxpayers must capitalize all of an improvements direct and indirect costs. This includes amounts that otherwise would be a deductible repair if the costs directly benefit or are incurred by reason of the improvement. Indirect costs that don’t directly benefit the improvement, even though they were performed at the same time, are a currently deductible expense.

Homeowner Exception An individual taxpayer is allowed to increase the property’s basis by the amount of qualifying repairs expenses that are not used in a trade or business or for the production of income. Treas. Reg. §1.263(a)-3(g)(1)(ii)

Compliance with Regulatory Requirements A federal, state, or local regulator’s requirement that a taxpayer perform certain repairs or maintenance to continue operating property is not relevant in determining whether the amount paid is an improvement. Treas. Reg. §1.263(a)-3(g)(4)

Removal Costs  Costs to remove an asset or component of a unit of property is not required to be capitalized as part of the improvement.  Keep in mind that the treatment of demolition costs of buildings was not changed and goes to the basis in the land.

Betterment  Ameliorates a material condition or defect.  Is for a material addition, such as enlargement, expansion, or extension.  Material increase in capacity.  Reasonable expectation of a material in crease in productivity, efficiency, output, strength, or quality.

Betterment  While not one of the 4 points in the definition of betterment, it depends on quantitative, qualitative and materiality factors.  In applying the betterment factors it is important to compare the condition of the property immediately before and after the circumstances necessitating the expenditure.

Betterment  If a part cannot be replaced with the same

type of part due to technological advancements or product enhancements, replacing the part with an improved but comparable part does not, by itself, result in a betterment.

Betterment Building Refreshing  Layout and cosmetic changes  Refresh with minor improvements  Remodel costs with business model change

Restoration  Abandonment and replacement of a component for which the taxpayer has taken a loss.  Sale or exchange of a component for which the taxpayer has taken a gain or loss  Restoration due to a casualty loss (limited to the amount paid to restore the property to its adjusted basis before the loss)  Repairs to property that has deteriorated to a state of disrepair and is no longer functional for its intended use Rebuild to like new after its class life (ADS) Replacement of a major component or substantial structural part

Unit of Property  Establishing the unit of property is essential in determining whether alterations to tangible property can be classified as repairs or must be treated as capital expenditures. In general the UOP determination for property other than buildings is based on the functional interdependence standard.

Unit of Property  The regulation provides specific rules for buildings, plant property, network assets, leased property, and improvements to property. Special apply when a taxpayer assigns different MACRS classes or depreciation methods to components of property. Property in a multiple asset account cannot be treated as a single unit of property.

Buildings  An entire building is a single unit of property; however, the IRS has segregated the building and identified separate groups of components as building systems that are treated as individual units of property. This is contrary to the proposed regs. If a repair study was performed based on the proposed regs, then a 3115 will need to be filed to be in compliance with the final regs.

Building Systems  HVAC system

 Fire protection systems

 Plumbing system

 Security systems

 Electrical system

 Gas distribution systems

 All escalators

 Any other structural components designated as a building system in future published guidance

 All elevators

Leased Buildings  Each property leased under a separate lease is considered a separate unit of property. Combining leases within the same building will increase the size of the unit of property and building systems thereby increasing the likelihood that expenditures will qualify as deductible repairs.

Office Condominium  Each individual unit is considered a separate

unit of property.

Property Other Than Buildings     

Functionally Independent Components Plant Property Network Assets Leased Assets Different Depreciation Schedules

Cost Segregation  Is it as beneficial?

Yes, yes, and yes again.

 Same answer as before, do you want to keep your money now?  A cost segregation study could cause a building to qualify for the safe harbor election for small taxpayers.  A cost segregation study can determine the basis of assets for partial disposals.

Materials and Supplies  All taxpayers may deduct the cost of acquiring nonincidental materials and supplies in the year that they are first used or consumed if the item cost $200 or less. Gain on the disposition would be reportable as ordinary income.

Materials and Supplies  Materials and supplies are tangible property that is used or consumed in the taxpayer’s business, that is not in inventory and Is a unit of property costing less than $200 A component that is acquired to maintain, repair, or improve a unit of tangible property. Fuel, lubricants, water and similar items expected to be consumed in 12 months or less. A unit of property that has an economic life of less than 12 months. Any other tangible property published in other guidance as a material or supply such as restaurant smallwares (Rev. Proc. 2002-12) and inventoriable items of small business (Rev. Proc. 2002-28).

De Minimis Safe Harbor  A current year deduction for the acquisition or production of tangible property that have an economic useful life of less than 12 months and costs less a specified amount.  Limits - $500 w/o applicable financial statement, $5,000 with an applicable financial statement.

De Minimis Safe Harbor  This is an annual election.

 Written policy required for taxpayers with an applicable financial statement and recommended for all taxpayers.  If taxpayer’s financial results are reported as a group the group’s AFS and accounting procedures may be treated as the taxpayer’s.  A small business taxpayer that does not have an AFS is considered to have an AFS if its financial results are consolidated under FASB Variable Interest Entities models in its ASC topic 810 thereby allowing it to adopt the higher $5,000 per item deduction.  Expensing policies should be revisited annually. If modified it is not a change in accounting, but has to be in place at the beginning of the year.

De Minimis Safe Harbor  Unicap rules are not displaced. I.R.C. §263A  Expenditures must be expensed for book and tax. Taxpayers may not selectively choose items to expense. If elected, all units of property that meet the safe harbor must be deducted in the year paid(cash basis) or incurred(accrual basis).  Does not apply to rotable, temporary, or standby parts that taxpayer elects to capitalize.  Does not apply to land or to amounts paid for property that is includable in inventory. Don't forget about I.R.C. § 179  I.R.C. §1231 could be used as an alternative as well when an asset is sold or exchanged.

 Taxpayers that do not elect the safe harbor must treat the amount paid for materials and supplies as discussed earlier. Treas. Reg. § 1.162-3

Routine Maintenance Safe Harbor  Treas. Reg. § 1.263(a)-3(i) requires taxpayers to treat cost of performing routine maintenance activities on a unit of property as currently deductible repairs that are not capitalized.  The routine maintenance safe harbor is not an election.  It does not require book and tax conformity.  The book conformity election is available and discussed later.  Expenditures are deductible if they are for ongoing maintenance activities that are required to keep the unit of property in its ordinarily efficient operating condition.

Routine Maintenance Safe Harbor  Routine maintenance items include inspecting, cleaning, testing, and replacing damaged or worn parts with comparable and commercially available replacement parts.  Does not apply to maintenance performed shortly after purchase.  Taxpayer must reasonably expect to perform the maintenance activities more than once during the unit of properties class life (ADS).

Routine Maintenance Safe Harbor  Factors that are considered in determining whether maintenance is routine and the taxpayer’s expectation is reasonable include

 The nature of the reoccurring activity  Industry practice  Manufacturer’s recommendations  Taxpayer’s experience with similar or identical property

Routine Maintenance Safe Harbor  The depreciation rule for tax-exempt use property does not apply to this safe harbor.  If the property is composed of components with different class lives the unit of property is assumed to have the longest class life(ADS).  Maintenance on buildings is considered routine if the taxpayer expects to perform the maintenance more than once within 10 years. The taxpayer’s expectation will not be deemed unreasonable merely because the maintenance wasn’t performed a second time within 10 years.  Document maintenance program expectations for significant units of property whether owned or leased by the taxpayer.

 Just because activities fall outside this safe harbor, they will be subject to the general rules for distinguishing between improvements and repairs.  I.R.C. § 263A may still apply.

Routine Maintenance Safe Harbor  The depreciation rule for tax-exempt use property does not apply to this safe harbor.  If the property is composed of components with different class lives the unit of property is assumed to have the longest class life(ADS).  Maintenance on buildings is considered routine if the taxpayer expects to perform the maintenance more than once within 10 years. The taxpayer’s expectation will not be deemed unreasonable merely because the maintenance wasn’t performed a second time within 10 years.  Document maintenance program expectations for significant units of property whether owned or leased by the taxpayer.

 Just because activities fall outside this safe harbor, they will be subject to the general rules for distinguishing between improvements and repairs.  I.R.C. § 263A may still apply.

Routine Maintenance Safe Harbor  Election to capitalize repair and maintenance costs can be made for repairs and maintenance if the business also capitalizes the expenditures on its books and records.  The common parent makes the election for a consolidated group.  An S corporation or partnership makes the election on an entity level.  Depreciation begins when the asset is placed in service.  May avoid a complex analysis of expenditures.  IRS cannot challenge the treatment so it is effectively another safe harbor for taxpayers.

Small Taxpayer Safe Harbor  A safe harbor election that allows taxpayers with an average annual gross receipts of $10,000,000 or less to deduct a limited amount of expenditures for qualifying buildings with an unadjusted basis of $1,000,000 or less that otherwise would be treated as capital improvements.  This is a protective election for taxpayers that incurred a small amount for improvements and repair and maintenance.  Total amount paid during the tax year for repairs, maintenance, improvements does not exceed the lessor of $10,000, or 2% of the unadjusted basis of the eligible building.  Safe harbor can be applied by lessees.

 Safe harbor applies to residential rental property.  Multiple buildings apply individually as long as the gross receipts requirement is met.

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