Maximize Your Deductions: “The Sequel” …It’s all about the application

Date: December 2, 2014

Speakers: Trinity Bradley-Anderson, CPABuddy Newton, Jr., CPAPatrick Stephens, CPA

This presentation and the material contained herein is the property of Stockman Kast Ryan + Co and may not be copied or used without permission.

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Legislative HistoryOn 9/13/2013, the IRS and Treasury Department released final regulations, effective 1/1/2014, which govern capitalization of:

Materials and supplies

Amounts paid to acquire or produce tangible property

Expenditures relating to the betterment, adaptation, and restoration of tangible property.

De Minimis Expensing Rule

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De Minimis Expensing RuleSafe Harbor

Required to have a written capitalization policy at the beginning of the taxable year expensing amounts paid for:

Property costing $5,000 (Audited Financial Statements) or $500 (no Audit) or less. Per item/invoice or

Property with a useful life of 12 months or less.Consider non-safe harbor policy based on business operation factors (revenues, industry, etc.)

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Capitalization Policy

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Cyber Café Refresh $1,000 Capitalization Treshhold

OTY Cyber Cafe Price per unit Total cost Expensed Capitalized

4 Lounge Chairs 500.85 2,003.40 2,003.40 1 Cocktail Table 135.00 135.00 135.00 2 Tablet Chairs 1,350.00 2,700.00 2,700.00 1 End Table 67.50 67.50 67.50 1 Table Lamp 135.00 135.00 135.00 2 Desks with Returns 1,283.85 2,567.70 2,567.70 2 Table Lamps for Desks 135.00 270.00 270.00 4 Client Chairs 338.85 1,355.40 1,355.40 2 Executive Chairs 291.78 583.55 583.55 1 Console Table 567.00 567.00 567.00 2 Banquettes 492.75 985.50 985.50 1 Cocktail Table 607.50 607.50 607.50 1 Rug 733.05 733.05 733.05 1 Misc. Accessories 405.00 405.00 405.00 4 Barstools 243.00 972.00 972.00 1 Mise. Accessories 270.00 270.00 270.00 1 Desk with Return 1,283.85 1,283.85 1,283.85 2 Filing Cabinets 506.25 1,012.50 1,012.50 1 Table Lamp 87.75 87.75 87.75 2 Client Chairs 338.85 677.70 677.70 1 Executive Chair 291.78 291.78 291.78 1 1 Art Piece 437.40 437.40 437.40

14,874.66 26,866.88 20,315.33 6,551.55

New Capitalization Standards BettermentAdaptationRestoration

as applied to a Unit of Property (UOP)

Gas Distributio

n

Electrical

Elevators

HVACStructural Component

sPlumbing

Escalators

Fire Protectio

n

Security Systems

Unit of Property - Buildings

Building Unit(s) of Property and Common ComponentsBuilding Structure

• Roof• Walls• Floors• Ceilings• Foundation

Heating Ventilation and Air “HVAC”

• Motors• Compress• Boilers• Furnace• Chillers• Pipes• Ducts• Radiators

Plumbing Systems

• Pipes• Drains• Valves• Sinks• Bathtubs• Toilets• Water and

Sanitary Sewer Collection Equip.

• Water Utility Equip.

Electrical Systems

• Wiring Outlets

• Junctions• Lighting

Fixtures & Connectors

• Elec. Utility Equip.

All Elevators

• Elevator boxes

• Control Equipment

• Cables and movement equipment

All Escalators

• Rails• Steps• Supporting

Equipment• Controls

Fire Protection and Alarm Systems

• Sensing & Detection Devices

• Computer Controls

• Sprinkler Heads & Mains

• Piping & Plumbing

• Alarms• Control

Panels

Security Systems to Protect Building and Occupants

• Window & Door Locks

• Security Cameras

• Recorders• Monitors• Motion

Detectors• Security

Lighting• Alarms• Entry

Access

Gas Distr. System

• Pipes• Gas Utility

Equipment

Unit of Property Common Examples of Building System Components

Was the expenditure for the repair or improvement of:

UOP is the portion of each building and building systems

subject to the lease

UOP is the individual unit owned and its

structural components

Is the taxpayer’s ownership interest the

entire building?

UOP is the entire building system or building structure

UOP is the portion of the building and/or building system in

which the taxpayer has possessory rights

Lessee Condo

Co-op

Yes No

Unit of PropertyLeased, Co-op or Condo Property

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Unit of PropertyProperty Other Than Buildings

General Rule: Functional Interdependence

Functionally Interdependent:

Comprises a single unit of property

when the placing in service of one

component by the taxpayer is

dependent on the placing in service

of the other component by the

taxpayer

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Real Property Expenditure UOPRetail Store – Stand

aloneStore Refresh – Lighting

replacementElectrical system

Retail Store – Shopping Mall (leased space)

Store Refresh – Lighting replacement

Leased portion of building electrical

system

Office – owned building Remove conference room wall

Building structure

Office – leased space Remove conference room wall

Building structure within leased space

Office condo HVAC Unit replacement Leased portion of building HVAC system

Apartment Building Single Unit Heat/Air replacement

Building HVAC System

Unit of Property ExamplesReal Property – Cost Segregation Guides

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Unit of Property Examples: Personal PropertyPersonal Property: Non

BuildingExpenditure UOP

Restaurant oven Burner replacement Oven

Garbage truck Engine repair/replacement Truck

Apartment unit furnishings New carpet for individual unit

Carpet

Donut bakery manufacturing line – interconnected mixers, ovens,

conveyers, loaf slicer, packaging

Knife replacement/ sharpening

Slicer component

Retail Donut Store Bakery – interconnected mixers, ovens,

conveyers, loaf slicer, packaging

Knife replacement/sharpening

Entire baking line

Power Plant – Coal pulverizer, boilers, turbine and a generator

Boiler tube replacement Boiler – Refer to Industry Guidance Rev. Proc. 2013-

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Improvement to Property

Betterment

Adaptation

Restoration

No bright line tests Driven by Facts and Circumstances

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Factors to consider Impact on size, capacity, efficiency and production

Degree of activities performed

Point in asset life cycle

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Improvement Standards

An amount is paid for a betterment to a UOP if it: Is for a material addition, including a physical

enlargement, expansion, extension, or addition of a major component to the UOP or a material increase in the capacity, including additional cubic or linear space, of the UOP, or

Is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the UOP, or

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Improvement Standards

Is to correct a material condition or inherent defect that either existed prior to the taxpayer’s acquisition of the unit of property or arose during the production of the unit of property.

(continued)

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Betterment Examples (continued)Retail Chain Periodic “Refresh” to maintain the appearance and functionality of retail space. Work includes: Lighting relocations, flooring repairs, moving one wall to

accommodate reconfigured tables, patching holes in the walls, repainting, replacing ceiling tiles, cleaning flooring, and power washing the building.

Replacement of display tables and racks

NOT a Betterment because no material increase to the productivity, efficiency, strength, quality, or output of the building structure or system. Taxpayer must capitalize the amounts paid for the Sec. 1245 property (tables & racks).

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Betterment Examples (continued)Retail Chain Periodic “Refresh” with Betterment:

In addition to the maintenance work, storage space, and second loading dock, a second overhead door and electrical system upgrades are added.

These additions are Betterments and must be capitalized. But, as discussed in the previous example, the “refresh” portion of the work is not a betterment and should not be capitalized.

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Improvement Standards

An amount is paid for an adaptation to a UOP if it: Adapts property to a new or different use that is not

consistent with the taxpayer’s ordinary use of the UOP at the time originally placed in service by the taxpayer.

Adaptation

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Adaptation ExamplesRetail Space Reconfiguration: Building retail space designed to be reconfigured.

Existing tenant to expand to two adjoining spaces.

Landlord pays to remove the walls between the three retail spaces. Unit of Property affected is the building structural components.

NOT AN ADAPTATION since the building is not converted to a new or different use. Potentially different answer if tenant pays for changes.

Note: Any new display cases and counters are Sec. 1245 property and must be capitalized.

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UCCS Parking Garage

Rental Remodel

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Improvement Standards

An amount is paid for a restoration to a UOP if it: Returns a UOP to its ordinarily efficient operating

condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use, or

Results in the rebuilding of the UOP to a like-new condition after the end of its class life, or

Restoration

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Improvement Standards

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, or

Is for the replacement of a component of a UOP for which the taxpayer has properly deducted a loss for that component. Casualty loss Loss from retirement or replacement Gain or loss from a sale or exchange

Restoration (continued)

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Black Forest Fire

Manitou Flooding

Engine Replacement

St. Patrick’s Cathedral New York

Improvement StandardsApply the following tests to the UOP to determine whether the expenditure is a capital expenditure:

Betterment?

• Correct pre-existing material condition or defect;• Material addition or expansion; or• Reasonably expected to materially increase the productivity, efficiency, strength, quality, or output.

Adaptation?

• New or different use inconsistent with the intended use when originally placed in service by the taxpayer

Restoration?

• Replace and recognize loss on replaced component;• Recognize gain/loss and make a basis adjustment from sale of a component;• Basis adjustment as a result of a casualty loss;• Returns 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• Returns UOP to “like-new” condition after the end of its class life; or • Replace major component or substantial structural part of UOP

CAPITALIZE Deduct as a repair expense

NO NO

NOYES

YES

YES

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Small Taxpayer Safe Harborwith Buildings

New Safe harbor provided for small taxpayers: Election to not capitalize R & M or improvements Applies to taxpayers whose

Three-year average gross receipts do not exceed $10 million, and

Unadjusted basis of owned or leased buildings does not exceed $1 million, and

Total amount paid during the tax year for repairs, maintenance, and improvements cannot exceed the lesser of: 2% of the unadjusted basis of the building, or $10,000

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Routine Maintenance Safe HarborReal and Personal Property

Amount paid is deemed NOT to improve the Unit Of Property (UOP) if it is for the recurring activities that a taxpayer expects to perform as a result of the taxpayer’s use of the UOP “to keep” the UOP in its ordinarily efficient operating condition

Routine maintenance for non-building property is an activity expected to be performed more than once in the Alternative Depreciation System (ADS) class life

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Routine Maintenance Safe Harbor Real and Personal Property (cont’d)

Expanded to include routine maintenance for buildings over a 10-year period

Does not apply to: Betterments Adaptations Restorations Network assets (pipelines, railroad tracks, etc.) Certain rotable spare parts

Routine Maintenance Safe HarborTaxpayers are permitted to deduct costs as routine maintenance under this safe harbor if the following tests are met:

Were costs incurred for routine

maintenance on a UOP?

Were the activities performed as a

result of the taxpayer’s use of the

property?

Were the costs to keep the UOP in

ordinary operating condition?

Did the activities include costs such as cleaning, inspecting,

testing and replacement of

components with comparable parts

Did the taxpayer expect to incur

these costs more than once during the asset’s class life or if building, more than once during 10-yr

period?

Routine Maintenance Safe Harbor does not

apply

Deductible Expense

YES YES YES YES

YESNO

NONO NO NO

Escalator handrails

replaced in year 4

The cost is DEDUCTIBLE

under the routine maintenance safe

harbor

Routine Maintenance Safe Harbor Example

Investor purchases a shopping mall in 2013.When the shopping mall was placed in service, investor expected to replace escalator handrails every 4 years.

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Recap: De Minimis < $500/$5,000? Yes Expense

Small Taxpayer Safe Harbor? Yes Expense

Routine Maintenance? Yes Expense

Betterment, Adaptation, Restoration? Capitalize

Sec. 179 currently $25,000 for 2014 and no Bonus Depreciation

Depreciate over life of asset.

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Computer Network

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Is the Computer Network the UOP?Are the components functionally interdependent?

What type of stored information?

Is information shared across users and programs?

Relative importance to taxpayer’s production?

What components make up the Network?

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Leasehold ExpendituresCapitalization only required for improvements

Tenant Pays Landlord Pays Initial use of tenant? Adaptation

standard applies – expenditures capitalized.

Continual use? Apply DMSH, RMSH, and BAR to UOP.

Initial purchase? Adaptation standard applies – expenditures capitalized.

Initial use of a particular tenant? Apply DMSH, RMSH, and BAR to UOP.

Continual use? Apply DMSH, RMSH, and BAR to Building.

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Lease Considerations Lease should clearly state who owns improvements if a

tenant allowance is provided. Sec. 109 safe harbor assumes 39 year depreciation.

Outside safe harbor if tenant allowance is used for personal property (5, 7 and 15yr property). Lease should state that tenant is landlord’s agent.

Consider Cost Segregation Study - $1M = $24,610 39Yr vs $1M = $200,000 5Yr.

Consider the taxpayer’s situation: passive investor vs. Real Estate Professional.

Credit: AICPA

Partial Disposition Election

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Partial Dispositions of Property

Taxpayers may elect to treat a partial disposition of an asset as a disposition even if the asset has not been previously depreciated as a separate component. Thus, the taxpayer claims a loss upon the disposition.

For example – replacing a roof that has not been listed as a separate item on the depreciation schedule.

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Why is this important? Current year tax loss on disposition Partial disposition eliminates the potential for 25%

unrecaptured Sec. 1250 gain on the disposed asset upon the sale of the entire building. Sec. 1245 recapture is taxed at ordinary income tax

rates (as high as 39.6%)

Unrecaptured Sec. 1250 gain is taxed at 25%

Plus 3.8% investment tax for certain taxpayers

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Partial Disposition Election Example Taxpayer owns an office building and decides to replace the roof. Taxpayer makes the partial disposition election. Depreciation for the retired roof ceases and a loss is

recognized upon retirement, preventing the taxpayer from depreciating two roofs.

Taxpayer must reduce the basis of the building and the related accumulated depreciation.

Taxpayer must capitalize the new roof.

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Tenant % affected sq ft. sq feet remodeledA 100% 3,169 3,169 B 25% 6,869 1,717 C 40% 2,789 1,116

6,002

Total offi ce space 22,995

Percent remodeled 26%

Cost A/D Loss AllowedBuilding Asset 1,107,700.00 477,733.00

Dispostion (26% of building) 289,117 122,409 (166,708)

Remaining asset 818,582.83 355,324.00

The remodel of 1st floor tenant space was significant. The client identified how much of the building was affected.

How does this affect 2014?

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Compliance Issues Each taxpayer is required to file at least one Form

3115, Change of Accounting Method, to elect new rules.

Multiple Forms 3115 may be required depending on the taxpayer’s situation.

Certain annual elections may be required to be attached.

Additional compliance burden = additional accounting costs. For 2014 only!

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Elections and Method ChangesIssue

Report on the

Tax Return

Attach an Annual Election to the

Tax ReturnAccounting

Method Change

De Minimis Policy XBook Capitalization Policy X

Safe Harbor for Small Taxpayers

X

Partial Disposition XCapitalization vs. Expense X

Materials & Supplies X

Annual Election to Capitalize & Depreciate Rotable & Temporary Spare Parts

X

Thank You for Coming!If you would like to contact us, call us at(719) 630-1186 or email us at:

Trinity Bradley-Anderson, tanderson@skrco.comBuddy Newton Jr., bnewton@skrco.comPatrick Stephens, pstephens@skrco.com