Final repair regulations: What has changed and how will it impact you?

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Final repair regulations:What has changed and how will it impact you?

Original Broadcast Date: October 2013

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© 2013 Grant Thornton LLP. All rights reserved. 2

Presenters

Joe BrownMidwest Region LeaderStrategic Federal Tax ServicesChicago, Ill.

Jim WittmerNortheast Region Leader Strategic Federal Tax Services Philadelphia, Pa.

David AuclairNational Managing PrincipalWashington National Tax OfficeWashington, D.C.


Final repair regulations: What has changed and how will it impact you?Learning objectives

• Identify opportunities and challenges in implementing the new rules

• Determine action steps for applying the final regulations, temporary regulations or a combination thereof


What was issued?

• Final regulations under 162 and 263(a)

– Amounts paid to acquire, produce, or improve tangible property

• Re-proposed regulations under 168

– General asset accounts and disposition of depreciable property

• IRS and Treasury expect to finalize these regulations in 2014


Practical implications

Rules affect any business that owns or leases tangible property.

Therefore these rules affect all businesses


Final repair regulations: What has changed and how will it impact you?Agenda

• Improvements to tangible property

• Dispositions

• De Minimis

• Materials and supplies

• Effective dates

• Next steps


A taxpayer (TP) must generally capitalize an amount that IMPROVES a unit of property ("UOP") if the amount:

(1) Is for a betterment;

(2) Restores the UOP; or

(3) Adapts the UOP to a new or different use.

Improvements to propertyGeneral rule


Unit of property

• General rule: functional interdependence test

• Special rules: buildings, plant property, network assets, and leased property

– Improvement standards must be applied separately to building structure and building system

• Clarification of unit of property for leasehold improvements

– For work done on an addition previously made to a leased building, consider the entire leased structure, not merely the addition


Unit of property

Building systems include:

- HVAC systems - Fire protection and alarm systems- Plumbing systems - Security systems- Electrical systems - Gas distribution systems- All escalators - Any other structural components- All elevators in published guidance


Betterments

• General rule: A TP must capitalize an amount paid for a "betterment"

• An amount is paid for a betterment if it:

– Ameliorates a material condition or defect that either existed prior to the TP's acquisition of the property or arose during production of the UOP (regardless of whether the TP was aware of the condition);

– Results in a material addition to or addition of a major component to the UOP, or a material increase in the capacity of the UOP;

– Results in a material increase in productivity, strength, efficiency, or quality of the UOP or the output of the UOP.


BettermentsNew and revised examples

Retail store refresh/remodel

Ex. 6 (refresh):

No significant changes

Ex. 7 (limited improvement):

Significantly different facts, clear improvement separate from refresh activities

Ex. 8 (major remodel):

Significantly different facts, clear improvement impacting most of store

Future refresh/remodel guidance in retail Industry Issue Resolution project



Material increase in capacity/efficiency

Ex. 17: 25% increase in depth of channel = material increase in capacity

Ex. 20: 10% increase in energy efficiency of 2 out of 10 roof mounted HVAC units = no material increase in efficiency

Ex. 21: 50% reduction in energy and power costs from new insulation = material increase in efficiency



Material addition

Ex. 22: Drive through service area added = material addition (physical expansion, extension, and addition of a major component)


Restorations

An amount restores property if the amount:

1) Results in the rebuilding of the UOP to a like-new condition after the end of its class life;

2) Is for the replacement of a part or a combination of parts that comprise a major component or a structural part of the UOP;

3) Returns the 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;


Restorations

An amount restores property if the amount (continued):

4) Is for the replacement of a component of a UOP and the TP has properly deducted a loss for that component (other than a casualty loss);

5) Is for the replacement of a component of a UOP and the TP has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component; or

6) Is for the repair of damage to a UOP for which the TP has taken a basis adjustment as a result of a casualty loss.


Restorations

• Clarification of distinction between major component and substantial structural part

• Incidental component, even though performs discrete function, is not restoration

Major component

Part or combination of parts that perform a discrete and critical function in the operation of the UOP

Substantial structural part

Part or combination of parts that comprises a large portion of the physical structure of the UOP


RestorationsClarified definitions

New definition provided for major component and substantial structural parts of building

• The replacement includes a part or combination of parts that comprise a major component or a significant portion of a major component of the building structure or building system, or

• The replacement includes a part or combination of parts that comprises a large portion of the physical structure of the building structure or building system


RestorationsNew favorable casualty loss rule

• New casualty loss rule:– TP permitted to take a deduction, if otherwise

permissible, in excess of adjusted basis of the property damaged in the casualty event

• Still no deduction for replacement property to extent of adjusted basis in destroyed property due to the casualty loss rules in 165 which require the loss to be claimed and basis reduced, which triggers the restoration rules


RestorationsNew and revised examples

Restoration• 1 chiller in HVAC system

• Entire sprinkler system

• All wiring in building

• All restroom fixtures

• 200 of 300 windows

• 100 of 300 windows (windows cover 90% of building)

• 40% of sq ft of flooring

Not a restoration• 1 of 3 furnaces

• 3 of 10 roof HVAC units

• 30% of electrical wiring

• 8 of 20 sinks

• 100 of 300 windows (300 windows cover 25% of building surface area)

• 10% of sq ft of flooring

• 1 of 4 elevators


New or different use

An amount is paid to adapt a UOP to a new or different use if the adaptation is not consistent with the TP's ordinary use of the UOP at the time originally placed in service


New or different useNew and revised examples

New or different use:

• Manufacturing plant to showroom space

• Develop land used for manufacturing plant as residential housing

• Retail drug store converts area of pharmacy to walk-in medical clinic

Not a new or different use:

• 3 leased retail spaces into 1 leased retail space

• Preparing a building for sale

• Grocery store converts existing store space into sushi bar

• Hospital modifies emergency room to also provide outpatient surgery clinic


Other costs incurred during improvement263A retained; new rule for removal costs

• Section 263A standard to be applied:

– Costs that directly benefit or are incurred by reason of the improvement should be capitalized

• New special rule for removal costs:

– If a TP disposes of a depreciable asset (including partial disposition) and has taken into account adjusted basis, costs of removing that asset are not required to be capitalized

• Related amounts:

– Amounts paid over a period of more than one taxable year


Routine maintenance safe harborExpanded to buildings

• Amount paid for routine maintenance deemed not to improve property if a taxpayer reasonably expects to perform more than once during:

– 10 year period from PIS date for building property, or

– The ADS class life for all property other than building property

• Applied to building structure and each building system, or UOP for non-building property

• Routine activities include: inspecting, cleaning, testing and replacement of damaged parts


New election Safe harbor for buildings of small taxpayers

• Taxpayers with average annual gross receipts of $10 million or less may elect not to apply the improvement rules to a building with an unadjusted basis of $1 million or less if

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

• Elected annually for each building; and

• Amounts deducted under de minimis and routine maintenance safe harbors are included.


New election Election to capitalize repair and maintenance costs

• TP's may elect to capitalize amounts incurred during the year as costs of improvements if TP capitalizes the amounts on its books and records

• Election applies to all amounts treated as capital for books each year

• Election made by attaching a statement to the return each year


HighlightsImprovements to real property

Issues and opportunities• Annual elections need to be considered each

year – not available retroactively• New examples under restoration provide

increased replacement percentages over prior• §263A applies- no plan of rehabilitation

What's the effect?• Safe harbor elections made

each year = no 481(a) adjustment

• Repair or capitalize changes = 481(a) adjustment

New elections• Election to capitalize repair

costs

Significant changes• Addition of a major component and material

increase in capacity are betterments

• Replacement of significant portion of a major component of a building is restoration

• Treatment of removal costs

• New and revised examples

• Routine maintenance safe harbor now applies to buildings




• Dispositions

• De Minimis


• Effective dates

• Next steps


Dispositions

• Re-proposed regulations

• Retirement of a structural component no longer mandatory

– Need for general asset account election eliminated

• Disposition includes sale, exchange, retirement, physical abandonment or destruction of an asset

• Disposition also occurs when asset is transferred to a supplies or scrap account or when a portion of an asset is disposed of in sale, casualty event, like-kind exchange, involuntary conversion or tax-free transfer


DispositionsNew election

• TP may elect to dispose of a portion of an asset. Includes:

– Structural components (or components thereof) of a building

– Components or portions of 1245 assets

• Eliminates the need for TP to determine reasonable and consistent method for 1245 assets

• Election is made in year of partial disposal by claiming gain, loss or other deduction on the return


DispositionsNew election

• Partial disposition (other than required situations) is a not a method of accounting.

• Election can only be made in the year of disposition, with the exception of situations where a taxpayer deducts a replacement cost as a repair and later has that item adjusted by the IRS

– Method change can be filed after exam to go back and claim partial disposition for the basis of asset that was disposed of in the replacement


Dispositions

Determination of asset• General rule = facts and circumstances• Special rules:

– Each building is the asset– Each condo/coop unit is the asset– Each item in asset classes 00.11 to 00.4 or §168(e) is

the asset– Each addition or improvement to an asset after placed in

service is a separate asset


Dispositions

Identification of asset disposed• General rule = specific identification• Special rule for mass assets or partial disposition (where

impracticable to determine the taxable year the asset was placed in service)– FIFO– Modified FIFO– Mortality dispersion table– Any other method designated in subsequent guidance– LIFO is not allowed


Dispositions

Basis of asset disposed of

• General rule = adjusted depreciable basis at disposal

• Special rule for mass assets or partial disposition = any reasonable method

– Discounting the cost of replacement portion of the asset to its placed-in-service year cost using the consumer price index

– Pro rata allocation of the unadjusted depreciable basis of the asset based on replacement cost of disposed portion

– Study allocating the cost of the asset to individual components


DispositionsNew example

• TP replaces 60% of roof in 2012- capitalizes replacement and makes partial disposition election

• In 2022, TP replaces 55% of the roof of the building- capitalizes replacement makes the partial disposition election for the replaced portion

• TP cannot determine from its records whether the 55% is part of the 60% replaced in 2012 or whether it is part of the original 40% of the roof

• TP uses the FIFO method to identify the asset disposed of


DispositionsNew example - conclusion

How is the asset that is disposed of determined when TP replaces 55% of the roof?

• Building is asset (including original roof) and 60% of roof replacement in 2012 is a separate asset

• TP disposed of the remaining 40% of the original roof and 25% of the 60% of the roof replaced in 2012


HighlightsDISPOSITIONS

Issues and opportunities• For years starting after 1/1/14, partial disposition election can only be made in

the year disposition occurs- requirement for clients to track each year

• Regs. provide that reasonable methods can be used to determine basis of assets disposed (i.e. replacement trending, study, allocation methods)

New elections

Partial disposition election

What's the effect?

Awaiting guidance on availability of retroactive partial disposition election

Significant changes• Asset for disposal purposes is no longer building

structure and building components- building is the asset (eliminates need for general asset account election)

• Partial disposition election for buildings and personal property

• Required partial disposition for casualty, tax-free exchanges and sales




• Dispositions

• De Minimis


• Effective dates

• Next steps


De Minimis

• Ceiling limitation eliminated

– No need to track expenses

• Replaced with safe harbor election which is based on policies used for financial books and records at an invoice or item level

• Taxpayers without an applicable financial statement can now deduct reduced de minimis amount

• For amounts above safe harbor, taxpayer needs to demonstrate clear reflection of income


De Minimis

• Applicable financial statement

– A financial statement required to be filed with the Securities and Exchange Commission;

– A certified audited financial statement that is accompanied by the report of an independent certified public accountant that is used for credit purposes, reporting to shareholders, partners or similar persons, or any other substantial non-tax purpose; or

– A financial statement (other than a tax return) required to be provided to the federal or state government or any federal or state agency


De MinimisNew election

TP with an applicable financial statement

• Written policy in place at beginning of year

• Policy to expense property costing less than a certain dollar amount or property with an economic useful life of 12 months or less

• Deducts such amounts in applicable financial statements

• Amount paid does not exceed $5,000 per invoice (or per item as substantiated by invoice)



TP without an applicable financial statement

• Written policy in place at beginning of year

• Policy to expense property costing less than a certain dollar amount or property with an economic useful life of 12 months or less

• Deducts such amounts in applicable financial statements

• Amount paid does not exceed $500 per invoice (or per item as substantiated by invoice)



• Safe harbor is elective each year

– Must include statement in the return

• Election applies to all eligible materials and supplies

• Labor, overhead, transaction and other costs of acquisition can be included in de minimis safe harbor provided the invoice includes such costs

• Section 263A does still apply to amounts deductible under de minimis if expected to be used in production of other property


De MinimisNew election- applicable financial statements

With AFS Without AFS

• Written policy to deduct $10,000 or less

• Written policy to deduct $1,000 or less

• Purchase 1,000 computers for $5,000 each-substantiated by invoice

• Purchase 10 computers at $600 each

• Deduct each computer as de minimis

• Cannot use safe harbor because each item is above $500

• Would not be able to use safe harbor if computers over $5,000

• Would be able to deduct if computers were $500 each


De MinimisExample- additional invoice costs

• TP w/AFS has written policy to deduct amounts under $5,000

• Purchases wireless routers for office

• Invoice includes price per router of $2,500 and $20,000 total for delivery and installation

• $20,000 allocated on a pro-rata basis to each of the 10 routers

• Total cost for each router is $4,500 and can be deducted under the de minimis rule


HighlightsDE MINIMIS

Issues and opportunities• Election must be made each year- statement attached to return• Taxpayers without audited financial statements can now take advantage of a

de minimis deduction• Written accounting policy must be in place on first day of taxable year to

which election applies• Amounts not subject to de minimis must meet clear reflection or capitalize

New elections

De Minimis safe harbor

What's the effect?Only applies to amounts incurred in the year adopted: no retroactive adjustment

Significant changes• No ceiling limit or tracking requirement• Safe harbor based on invoice/item price:

– TP w/AFS = $5,000– TP w/o AFS = $500

• Includes transaction costs and other costs of acquisition (i.e. labor and OH)

• If elected, applies to all materials and supplies




• Dispositions

• De Minimis


• Effective dates

• Next steps


Materials and supplies

• Materials and supplies include:

• Components acquired to maintain, repair, or improve a unit of tangible property owned, leased, or serviced by the taxpayer that is not acquired as part of any single unit of property

• Fuel, lubricants, water and similar items expected to be consumed in 12 months or less

• Property with economic useful life of 12 months or less

• Property with acquisition cost of $200 or less



• Rules largely the same as temporary regulations

• Some changes

– Definition now includes property that has an acquisition or production cost of $200 or less (increased from $100)

– Definition of standby emergency spare parts included

– Election to capitalize certain materials and supplies now only applicable to rotable, temporary or standby emergency spare parts



• Non-incidental supplies– Deductible in the year in which the materials are first

used or consumed in the taxpayer's operations• Incidental supplies

– Deductible in the year in which amounts are paid

Incidental supplies are those for which no record of consumption is kept or physical inventories at beginning and end of year are not taken


HighlightsMATERIALS AND SUPPLIES

Issues and opportunities• Clear definition of materials and supplies

• Can elect to deduct under de minimis, applies to all eligible materials and supplies

New elections

Election to capitalize now only applies to rotable, temporary or emergency spare parts

What's the effect?

Final regulations only apply to amounts incurred on or after 1/1/14, unless early adopt.

No retroactive adjustment

Significant changes

• Definition now includes property with acquisition or production cost of $200 or less (increased from $100)

• Definition of emergency spare parts




• Dispositions

• De Minimis


• Effective dates

• Next steps


Effective dates

• Final and re-proposed regulations effective for years beginning on or after January 1, 2014

• TP may choose to apply the final, reproposed, temporary or any combination thereof for 2012 and 2013

• Transitional relief for elections in 2012 and 2013


Transitional rules

• Revenue procedures expected to be issued in November

• Expected to provide for late partial disposition election for 2012, 2013, and 2014 tax years

• Will provide guidance on changes made under the temporary regulations




• Dispositions

• De Minimis


• Effective dates

• Next steps


Next Steps

• Compare current policies– Acquisition policy (de minimis)– Capitalization policy (repairs)

• Consider modification to current procurement process– Capital expenditures request (CER)– Capital appropriations request (CAR)

• Consider current method change opportunities• Consider annual elections going forward


Next Steps

• Consider state and local tax impact– Possible sales and property tax differences

• Consider financial statement impact


Method change opportunities

• Deduct repair and maintenance costs– Use the routine maintenance safe harbor to deduct

routine costs• Possible late partial disposition election to recoup costs

from pre-2012 dispositions• Materials and supplies• Depreciation methods and lives• Possible tax reform impact


New annual elections

• Partial disposition• De Minimis safe harbor (statement required)• Capitalize repair and maintenance costs (statement

required)• Safe harbor for small taxpayers (statement required)• Capitalize and depreciate any rotable, temporary or

emergency spare part


Comments?Questions?


ContactInformation

Joe BrownMidwest Region LeaderStrategic Federal Tax [email protected]

Jim WittmerNortheast Region Leader Strategic Federal Tax Services [email protected]

David AuclairNational Managing PrincipalWashington National Tax [email protected]


The foregoing slides and any materials accompanying them are educational materials prepared by Grant Thornton LLP and are not intended as advice directed at any particular party or to a client-specific fact pattern. The information contained in this presentation provides background information about certain legal and accounting issues and should not be regarded as rendering legal or accounting advice to any person or entity. As such, the information is not privileged and does not create an attorney-client relationship or accountant-client relationship with you. You should not act, or refrain from acting, based upon any information so provided. In addition, the information contained in this presentation is not specific to any particular case or situation and may not reflect the most current legal developments, verdicts, or settlements.

You may contact us or an independent tax advisor to discuss the potential application of these issues to your particular situation. In the event that you have questions about and want to seek legal or professional advice concerning your particular situation in light of the matters discussed in the presentation, please contact us so that we can discuss the necessary steps to form a professional-client relationship if that is warranted. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein.

© 2013 Grant Thornton LLP, the U.S. member firm of Grant Thornton International. All rights reserved. Printed in the U.S.A. This material is the work of Grant Thornton LLP, the U.S. member firm of Grant Thornton International, Ltd.

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Final repair regulations: What has changed and how will it impact you?

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