KPM CPAs & Advisors Summary of IRS Tangible Property Rules

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1 The IRS has issued long awaited regulations on the tax treatment of amounts paid to acquire, produce, or improve tangible property. These rules explain when those payments can be immediately expensed and when they must be capitalized. The new rules are lengthy and complex. These rules must be followed for tax years that begin after December 31, The summary below is being provided to give an overview of the various new rules and how they will affect you. Table of Contents Unit of Property Page 1 Materials & Supplies Page 2 Rotable or Spare Parts Page 2 De Minimis Safe Harbor Page 3 Routine Maintenance Safe Harbor Page 3 Small Taxpayer Safe Harbor Page 4 General Improvement Rules (Betterment, Adaptation, Restoration) Page 4 Disposition Rules Page 6 Unit of Property A unit of property consists of all components that are functionally interdependent and is the yardstick against which amounts paid must be measured to determine if they must be capitalized. Examples include: If a taxpayer purchases 100 computers, each computer is a unit of property. A truck may be a unit of property, which would include the seats, the engine, the tires, etc. Because a tractor trailer combo is comprised of two parts that have different tax lives, each part is considered a unit of property. There are special rules for plant equipment, network assets, leased property, and improvements to property. For buildings, the unit of property is each separately standing building. In addition to the structural envelope (walls, windows, roof, floors, ceiling, etc.) a building is further divided into the following building systems: Heating, Ventilation and Air Conditioning System (HVAC) Plumbing System Electrical System Escalators Elevators Fire Protection and Alarm System Security System Gas Distribution System The building systems or building structure are further broken down for any item that performs a major and discrete function, such as the roof. 1

2 Materials & Supplies Material and supplies are defined as tangible property used or consumed in business operations that is not inventory and meets one of the following: is a component acquired to maintain, repair, or improve a unit of property and is not acquired as part of a single unit of property; consists of fuel, lubricants, water, and similar items, that are reasonably expected to be consumed in 12 months or less; is a unit of property that has an economic useful life of 12 months or less; is a unit of property with a cost of $200 or less is a rotable or temporary spare part; or is identified in published guidance as supplies. Incidental supplies are carried on hand, but no record of consumption is kept and no inventories are taken at the end of the year. Non incidental supplies are carried on hand and either a record of consumption is kept or a physical inventory is taken at the end of the year. The new rules provide that incidental supplies are deductible when purchased and non incidental supplies are deductible when used or consumed. Supplies may still be subject to capitalization under Section 263A or as cost of improving a unit of tangible property. The rules also permit a taxpayer to elect to capitalize and depreciate supplies. Rotable or Spare Parts Rotable or temporary spare parts are included in the definition of supplies above. A rotable part is a component of a unit of property which is installed on the property, removed from the property, and either installed on the same or other property or stored for later installation. These parts are called rotable because they are rotated in and out of service. They do not have to be a part that rotates in a circle. Temporary spare parts are components used temporarily until a new or repaired part can be installed and then are removed and stored for later installation. The new rules provide several alternative methods to account for these parts: 1. Deduct when disposed of 2. Elect on a part by part basis to capitalize and depreciate 3. Elect the optional method, in which the taxpayer claims a deduction when the rotable is first placed in service, recognizes income equal to the fair market value of the rotable when it is removed from service for repair, capitalizes the repair costs, and claims a deduction for the income recognized plus the capitalized repair costs when the rotable is returned to service 4. Expense parts that do not exceed a dollar limit per invoice or item under the de minimis safe harbor. 2

3 De Minimis Safe Harbor The new rules introduced the concept of a safe harbor an amount under which the IRS won t question a taxpayer s decision to deduct an expenditure instead of capitalizing it. The De Minimis Safe Harbor will be calculated differently depending on which of three categories the taxpayer falls into. 1. If the taxpayer does not have an applicable financial statement and the taxpayer did not have a capitalization policy in place at the beginning of the year, they will be allowed to expense amounts below $200 under the safe harbor. An applicable financial statement (AFS) includes a financial statement required to be filed with the SEC, a certified audited financial statement, and any financial statement required to be provided to the federal or state government or agency. 2. If the taxpayer does not have an applicable financial statement, but did have a capitalization policy in place at the beginning of the year, they will be allowed to expense amounts stated in their capitalization policy, up to $500, and have safe harbor protection. 3. If the taxpayer has an applicable financial statement and had a WRITTEN capitalization policy in place at the beginning of the year, they will be allowed to expense amounts stated in their capitalization policy, up to $5,000, and have safe harbor protection. The safe harbor is applied on a per invoice, per item basis. For example, if a taxpayer with no AFS and a $500 capitalization policy in place at the beginning of the year purchased 10 computers for $500 each, they could expense the entire $5,000 expense. The expenditure must be deducted for book purposes in order to qualify as an expense for tax purposes. The De Minimis Safe Harbor is an annual election that must be made by attaching a statement to the tax return. Routine Maintenance Safe Harbor The new rules provide a deduction for amounts paid for routine maintenance activities that a taxpayer expects to perform as a result of use to keep a unit of property in ordinarily efficient operating condition. Activities are considered routine if, at the time the unit of property was placed in service, the taxpayer reasonably expected to perform the activities more than once during the asset s class life. For buildings the class life is 10 years. For other property, the class life is the ADS life found in Appendix B Table of Class Lives and Recovery Periods of IRS Publication 946, How to Depreciate Property. This class life may be the same or longer than the tax life listed on the tax depreciation schedule. Routine maintenance activities include inspecting, cleaning, testing, and replacement of damaged parts with comparable and commercially available parts. Routine maintenance may be performed at any time during the useful life of the building. When analyzing the activities, the taxpayer should consider recurring nature of activity, industry practice, manufacturer s recommendations, and taxpayer history or experience with similar property. For buildings, consideration applies to the building structure and each building system. For non building property, consideration applies to each unit of property The safe harbor does not apply if the property has deteriorated to a state of disrepair and is no longer functional for its intended use. The Routine Maintenance Safe Harbor is an annual election that must be made by attaching a statement to the tax return. 3

4 Small Taxpayer Safe Harbor Taxpayers with average annual gross receipts (for the 3 preceding taxable years) of $10 million or less may elect to not apply the improvement rules to a building with an unadjusted basis of $1 million or less if total amounts paid during the year for repairs, maintenance, improvements, and similar activities to the building do not exceed the lesser of $10,000 or 2% of the unadjusted basis of the building. Gross receipts is determined under the method of accounting used for tax purposes and includes total sales (net of returns and allowances), amounts received for services, interest, dividends, rents, royalties, and annuities even if not derived in the ordinary course of business. Unadjusted basis for leased property is determined to be the total amount of undiscounted rent paid or expected to be paid by the lessee under the lease for the entire term of the lease, including renewal periods if there is a reasonable expectancy of renewal. This safe harbor only applies to repairs, maintenance, improvements, etc. related to the building and not land improvements. Amounts expensed under the de minimis safe harbor and the routine maintenance safe harbor must be included as amounts paid in the calculation. The calculation applies to each building separately and there is no restriction on the number of buildings to which the safe harbor can apply. If amounts paid are below the safe harbor threshold (lesser of $10,000 or 2% of cost), then all amounts can be currently expensed. If amounts paid exceed the safe harbor threshold, then the safe harbor election is not available and taxpayer must apply general improvement rules. There is no proration of amounts allowed to be expensed. The Small Taxpayer Safe Harbor is an annual election that must be made by attaching a statement to the tax return. General Improvement Rules If amounts paid don t meet one of the safe harbor elections, the taxpayer must apply general improvement rules. Under these rules, a taxpayer must generally capitalize an amount that IMPROVES a unit of property if it: is for a betterment, restores the unit of property, or adapts the unit of property to a new or different use. Betterment An amount paid results in a betterment if it: Ameliorates a material condition or material defect that existed prior to the acquisition of the property or arose during the production of the property (whether or not the taxpayer was aware of the defect at the time of acquisition or production); Results in a material addition to the unit of property (including a physical enlargement, expansion, extension, productivity, efficiency, strength, quality); or Results in a material increase in the capacity, productivity, efficiency, strength, or quality of the unit of property or its output. 4

5 Analysis of whether costs paid to refresh or remodel a building result in a betterment requires an examination of all the facts and circumstances, including but not limited to the purpose of the expenditure, the physical nature of the work performed, the effect of the expenditure on the unit of property, and the taxpayer s treatment of the expenditure on its applicable financial statement. If the taxpayer needs to replace a part that cannot feasibly be replaced with the same type of part because of technological advancements or product enhancements, the replacement with an improved but comparable part does not, by itself, make the replacement a betterment. For example, if the only shingles that are available are a better quality than what you had, that alone will not make it a betterment if the new shingles are comparable to what was available when the shingles were originally installed. Determination of whether an expenditure results in a betterment is made by comparing the condition of the property immediately after the expenditure to the condition immediately prior to the circumstances necessitating the expenditure (before the wear and tear of use). Adaptation An amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the intended ordinary use of the unit of property at the time originally placed in service by the taxpayer. In the case of a building, an amount is paid to adapt the unit of property to a new or different use if it adapts any of the designated properties (building structure, building systems, condominium, cooperative, or leased building) to a new or different use. Examples of payments that were not treated as a betterment: The taxpayer is a landlord and leases space to commercial tenants. One of the tenants expanded and the landlord paid to remove the walls between three retail spaces, converting three spaces to one space. The payments are not treated as a betterment. The taxpayer is a landlord and leases space to a commercial tenant operating a restaurant. The landlord paid to convert the space to a retail space to secure a new tenant who wants to use the space for a retail store. The payments are not treated as a betterment because the landlord s use before and after the change was commercial rental. Restoration An amount paid is considered a restoration if: it returns a unit of property to its ordinary efficient operating condition and the property had deteriorated to a state of disrepair and was no longer functional for its intended use; it rebuilds a unit of property to like new condition after the end of its class life; it replaces a major component or substantial structural part of the unit of property; or it was paid for a replacement when the taxpayer had deducted a loss, taken into account the basis in a sale, or reported a casualty loss. 5

6 Examples that qualified for expensing Repair a broken tail light Replace wood flooring in a hotel lobby Replace a power switch assembly Replace 30 out of 300 windows Rebuild asset before end of class life Replace 2 out of 8 HVAC units Replace 2 out of 20 sinks Replace waterproof roof membrane Replace 30% of wiring in building Examples that had to be capitalized Replace siding Replace 200 out of 300 windows Shore up walls Remodel hotel over several years Rebuild asset after end of class life Paint tractor cab Replace building sprinkler system Replace all floors in public areas of hotel Replace entire roof Remove & replace underground tank Purchase new engine & cab of tractor Replace all restroom plumbing fixtures Replace significant portion of a roof (40%) Replace HVAC System Disposition Rules A disposition occurs when ownership of an asset is transferred or when the asset is permanently withdrawn from service. This can include the sale, exchange, retirement, physical abandonment, or destruction of an asset. Under the new rules, this can also include the retirement of a structural component (or portion thereof) of a building if the partial asset disposition election is made. Partial Asset Disposition The partial disposition rule allows a taxpayer to claim a loss upon disposition of a structural component of a building or upon the disposition of a component. This treatment minimizes the chances of an original part and any subsequent replacements of the same part being capitalized and depreciated simultaneously. The partial asset disposition rule is required to be applied to: Disposition of a portion of an asset as a result of a casualty loss; Disposition of a portion of an asset in which gain is not recognized under like kind exchange treatment or involuntary conversion treatment; A transfer of a portion of an asset in a step in the shoes transaction; Or a sale of a portion of an asset subject to non recourse debt. Partial asset disposition treatment is elected for current year dispositions by reporting the disposition on the tax return. For tax year 2014, partial asset disposition treatment may be made for prior year dispositions by filing the appropriate change in accounting method form. Removal Costs If a taxpayer disposes of a depreciable asset, including a partial asset disposition, and includes the basis of the asset in calculating a gain or loss, the cost of removing the asset is deducted. If a taxpayer disposes of a component of a unit of property, but does not treat the disposal as a disposition, then the taxpayer must determine if costs of removal must be capitalized under the improvement rules. 6