Final Tangible Property Regulations (TPR) Summary

(commonly referred to as the “Repair Regs”)

What Were the “Old” Rules?• Capitalize amounts paid to acquire , produce or improve tangible

property.– Generally required to capitalize amounts paid to either a.) increase the

fair market value of the property, b.) substantially prolong the useful life of the property, or c.) adapt property to a new or different use.

• Expense all ordinary and necessary expenses including materials, supplies, and repairs.– Amounts paid to keep property in an “ordinarily efficient operating

condition” may be deducted as an expense.• Taxpayers and the IRS have been at odds over these rules for

decades with taxpayers wanting to expense expenditures and the IRS wanting to capitalize as improvements.

• The result has been a confusing mix of court rulings that utilize a “facts and circumstances” method to determine how to treat an expenditure.

Where Are We Now?• Generally required to capitalize amounts paid that result in either a

betterment, adaptation or restoration (B.A.R. test) of a unit of property (UOP).– Specific rules define what comprises a UOP.– Betterment, adaptation and restoration are defined in general terms with

numerous, specific examples provided in the regulations as guidance.– De minimis safe harbors were created to simplify the process for smaller

expenditures.

• New rules were created for the treatment of materials and supplies that require the identification of incidental and non-incidental materials and supplies.

• Most taxpayers will need to file one or more accounting method changes and elections to become compliant with the new regulations.

Critical Points• Distinguish between unit of property (UOP) and building system

– Distinguish between structural component (Regs. §1.48-1(e)(2))and major component or substantial structural part.

• Properly identify materials and supplies.• Partial asset dispositions are now permitted. Guidance has been

provided to determine the basis of the partial asset disposed.• Going forward, generally a good idea to determine and then track cost

of building and the 8 building systems identified in the final regulations.

• Cost segregation studies will continue to be an important tool and more focus should be placed on using them to accurately separate and classify fixed assets.

• Annual elections will likely be required in the tax return.• Automatic change in accounting methods (Form 3115) will likely be

required along with 2014 tax return.

What is the Property being Improved?• Analysis must start with determining the unit of property (UOP).

Have to know the UOP to determine if the expenditure results in: • Betterment• Adaptation of the property to new or different use• Restoration

• By relating expenditures to the repair of a larger UOP rather than a smaller UOP, taxpayer is in a better position to argue there is not a betterment, change in use or restoration.

UOP - Buildings• Special rules apply to buildings• Unit of property = building and its structural components• Expenditures restore UOP if they restore the building structure or

one of nine defined “building systems.”• A roof is considered part of the building structure (shell)• Apply repairs standards separately to the building structure and the

nine defined “building systems”.1. HVAC2. Plumbing systems3. Electrical Systems4. Escalators5. Elevators6. Fire protection and alarm systems7. Security systems for protection of building and occupants8. Gas distribution system9. Any other system defined in published guidance

UOP Continued• If a UOP is not currently properly classified on a taxpayer’s

depreciation schedule, an automatic change in accounting method (Form 3115) will be required with the 2014 tax return.– Most likely this will not result in a §481(a) adjustment.

• A common example would be a multi-building apartment development when the first three buildings were placed in service together as one single asset.– The cost of the three buildings will need to be broken out into

individual buildings and a Form 3115 will need to be filed with the 2014 return.

– Assuming depreciation was properly computed on the original asset, there will likely be no §481(a) adjustment from this change.

UOP Examples• Example 1: HVAC system incorporating 10 roof-mounted units is a

building system and treated as a UOP.• Example 2: Two elevator banks consisting of 3 elevators each is a

building system and treated as a UOP.• Example 3: Plumbing system in a office condominium is a building

system and treated as a UOP.• Example 4: Extension to office building is compared to the building

structure and the buildings systems to determine if it is an improvement.

• Example 5: Power plant’s boiler, turbine, generator and pulverizer are each treated as separate UOPs. Turbine blades are not separate UOPs.

• Example 6: Laundry plant’s sorter, boiler, washer, dryer, ironer, folder and waste water treatment plant are separate UOPs.

• Example 7: Tortilla-making equipment is a UOP. Not plant property, so not broken into components.

UOP Examples• Example 8: HVAC system of leased building is a building system and

is treated as a UOP.• Example 9: Driveway constructed by lessee adjacent to leased

building is separate UOP.• Example 10: Driveway constructed by lessee but owned by lessor

adjacent to leased building is separate UOP.• Example 11: Two separate office spaces in same building subject to

separate leases treated as two separate UOPs.• Example 12: Warehouse extension added to retail sales facility is not

a separate UOP.• Example 13: Change in class of property as result of cost segregation

study results in separate UOP because portion of property reclassified from nonresidential real property (with a 39 year life) to qualified retail improvement property (with a 15 year life).

Betterment• An amount paid results in a betterment only if it:

1. Ameliorates (fixes) a pre-existing material condition or defect at the time you acquired the property (regardless of whether taxpayer was aware of the defect),

2. Results in a material addition, or3. Results in a material increase in capacity, productivity, efficiency,

strength, quality or output.

• Replacements due to technological improvements or product enhancements do not necessarily require capitalization.

• Key is compare the condition of the property after the expenditure to the condition of the property when initially placed in service.

• Taxpayer’s treatment of the expenditure on its financial statements is not a factor to be considered.

Summary of conclusions from the 23 betterment examples

Not a Betterment• Replacement of asbestos insulation with

similar non-asbestos insulation (Ex 2)• Minor repairs and maintenance shortly

after purchase (Ex 3, 4)• Retail refresh limited to cosmetic and

layout changes (Ex 6, 7)• Relocate cash registers (Ex 9)• Add concrete lining to meat plant (Ex

12)• Roof membrane (Ex 13)• Removal of drop ceiling (Ex 18)• Replace 2 of 10 HVAC units that are

10% more efficient (Ex 20)

Betterment• Remediation of soil by previous

owner (Ex 1)• Bring assisted living building up to

higher standards (Ex 5)• Retail refresh along with increased

storage, second loading dock (Ex 7)• Major remodel of retail (Ex 8)• Relocate machines to increase

capacity (Ex 10)• Doubling depth of channel (Ex 15)• 25% increase in depth of channel

(Ex 17)• 50% reduction in energy or power

costs (Ex 21)• Add restaurant drive through

Example 1: Building refresh is not a betterment• Replace and reconfiguring display tables and racks to provide better

exposure of the merchandise• Make corresponding lighting relocations and flooring repairs,• Move one wall to accommodate the reconfiguration of tables and

racks• Patch holes in walls• Repaint the interior structure with a new color scheme to coordinate

with new signage• Replace damaged ceiling tiles• Clean and repair wood flooring throughout the store building, and• Power washing building exteriors.

Adaptation to New or Different Use• Improvement needs to be capitalized if paid to adapt a UOP to a new or

different use.

• Improvement needs to be capitalized if the adaptation is not consistent with the taxpayer’s ordinary use of the unit of property at the time originally placed in service by the taxpayer.

Summary of change in use examplesNot a Change in Use• Combine 3 leased retail spaces

into 1 leased retail space (Ex 2)• Minor refresh of building in

anticipation of sale (Ex 3)• Clean up contamination after

closing manufacturing plant (Ex 4)

• Convert a portion of grocery store space to a sushi bar (Ex 6)

• Convert a portion of hospital emergency room to an outpatient surgery center (Ex 7)

Change in Use• Convert manufacturing

plant to showroom space (Ex 1)

• Regrade land to accommodate sale of land for residential development (Ex 4)

• Reconfigure part of a retail pharmacy to a walk-in clinic (Ex 5)

Restoration• Amount is paid to restore UOP if it:

1. Is a replacement of a UOP and the taxpayer has properly deducted a loss for that component;

2. Is for the replacement of a component of a UOP and taxpayer 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.

3. Is for the repair of damage to a UOP for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss or casualty event (but only to the extent of the claimed casualty loss).

4. 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;

5. Results in the rebuilding of the UOP to a like-new condition after the end of its ADS class life; or

6. Is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property.

– It is this provision the IRS uses to say roof replacements now must be capitalized.

Summary of conclusions from 31 restoration examples

Not a Restoration• Replace power switch (Ex 13)• Roof membrane (Ex 15)• Replace 1 of 3 furnaces in HVAC system (Ex 16)• Replace of 3 of 10 roof-mounted HVAC units

(Ex 18)• Replace 30% of electrical (Ex 21)• Replace 8 of 20 sinks (Ex 23)• Replace 100 of 300 exterior windows

comprising 8.3% surface area (Ex 25)• Replace lobby floors which comprise <

10% square footage (Ex 28)• Replace 1 of 4 elevators (Ex 30)

Restoration• Replace entire roof (Ex 14)• Replace single chiller in HVAC (Ex 17)• Replace sprinkler system (Ex 19)• Replace entire electrical system (Ex 20)• Replace all toilets and sinks with similar quality

and function (Ex 22)• Replace 200 of 300 exterior windows comprising

16.67% surface (Ex 26)• Replace 100 of 300 exterior windows comprising

30% of surface area (Ex 27)• Replace floors in all public areas comprising 40%

of sq footage (Ex 29)• Replace 1 of 4 elevators and claim partial

disposition loss (Ex 31)

Expenditures Over a Period of Time• Amounts paid to improve a unit of property over a period of time

are required to be capitalized.– Provision covers a plan of improvement taking place over a period of

time.

• Whether the amounts paid are related to the same improvement is based upon facts and circumstances.

• How is “period of time” defined?– Regulations do not define; based upon facts and circumstances.– 1 to 3 year period most likely need to treat as related and capitalize.– More than 5 year period most likely treat as unrelated.– 3 to 5 year period will rely on facts and circumstances.– But remember individual facts and circumstances are key!

Routine Maintenance Safe Harbor• Routine maintenance consists of recurring activities that are

expected to be performed on a building or other unit of property (UOP) as a result of its use to keep the asset in its ordinary efficient operating condition.

• Taxpayer must reasonably expect to perform the activities more than once during the useful life of the asset (or a 10 year period for a building) beginning at the time the asset is placed in service.

• Routine maintenance includes inspections, cleanings, and replacement of damaged or worn parts with comparable parts.

• The safe harbor does not apply to any expenditure that would be considered betterment, restoration or adaptation.

• Must file an automatic change in accounting method (Form 3115) to adopt the safe harbor method.

Acquisition CostsAcquisition costs – the new rules• Taxpayer must capitalize amounts paid to acquire or produce a UOP.

Generally the invoice price.

• Amounts paid to defend or perfect title must be capitalized into the cost of the property.

• Must capitalize amounts paid to facilitate the acquisition of real or personal property

• Must capitalize “inherently facilitative” costs (accounting, legal, appraisals, environmental, etc.)

• Must capitalize costs for work performed prior to placed in service dates

Removal Costs• Removal costs are not capitalized if basis of the asset is taken into

account in realizing gain or loss.• Costs of removing a component of a UOP are treated as any other

indirect cost incurred during the improvement of property.• Removal costs are capitalized if they directly benefit or are incurred

by reason of an improvement.• Removal costs unrelated to any improvement may be deducted.• This provision provides an opportunity to claim prior year losses

when capitalizing replacement and did not previously take into account remaining basis.

Removal Costs – Example Summaries• Example 1 – Removal costs incurred to replace original columns and

girders supporting a second floor thereby permitting greater storage of supplies must be capitalized as a betterment because the taxpayer did not elect to treat the disposed items as a partial disposition.

• Example 2 – Same facts as Example 1, except the taxpayer elects to treat the disposal of the structural components as a disposition. In this case, the removal costs do not have to be capitalized, but the other costs of the betterment still must be capitalized.

• Example 3 – Costs to remove old shingle and replace with new shingles do not have to be capitalized as long as the replacement of the shingles does not constitute an improvement to the building – in this example they are assumed to not improve the building because they were comparable to the original shingles.

• Example 4 – Same facts as Example 3, except taxpayer elects to treat the replacement as a partial disposition. In this case the new shingles must be capitalized. However, the cost of removing the old shingles does not have to be capitalized regardless of their relation to the improvement.

Materials and Supplies• Defined as tangible property that is used or consumed in the taxpayer’s operations

that is not inventory and that are:1. Components acquired to maintain, repair, or improve a UOP;2. Consists of fuel, lubricants, water, and similar items that are reasonably expected to be

consumed in 12 months of less;3. A UOP with an economic useful life of 12 months or less;4. A UOP costing $200 or less; OR5. Identified as such in guidance

• General rule for when deducted:– Incidental (not inventoried) – deduct when paid (provided clearly reflects income)– Non-incidental (tracking consumption) – deduct when first used or consumed in

taxpayer’s operations– Rotable, temporary, emergency spare parts – deduct when part is disposed; deduct

when used (and include in income when removed from service); treat as depreciable property.

• Required method change (Form 3115) to adopt new rules

Materials and Supplies – Examples• Taxpayer purchases 3 microwaves for a total cost of $500. Each

microwave is considered a UOP and costs less than $200 and therefore would be considered materials and supplies. Deductible when first placed in service (unless the taxpayer has a de minimis safe harbor election in place).

• Items purchased for rental costing less than $200 each are materials and supplies and deductible when first used in the rental business. So if purchased in year 1, but not used until year 2, then deductible in year 2.

• Appliances – separate UOP; may qualify as materials and supplies.• Carpeting – not a separate UOP; part of a building component; may

be deductible.• Windows – not a separate UOP; part of a building component; may

be deductible.

De Minimis Safe Harbor (DMSH) Election• Annual election made in tax return.• Allows taxpayer to deduct expenditures below a set threshold.• Threshold is $500 per invoice or per item unless the taxpayer has an

applicable financial statement (AFS). If AFS, threshold is $5,000.– AFS = audited or government-required financial statement.

• Taxpayer must maintain a written accounting policy.• Book treatment must match tax treatment.• Applies to property with a useful life of 12 months or less if the

amount per invoice (or item) does not exceed the $500/$5,000 threshold.

• The $500/$5,000 threshold are safe harbor amounts – taxpayers may elect a higher capitalization threshold if they can justify the amount.

• Threshold is $200 if the taxpayer does not have an accounting policy or if the annual election is not made.

Safe Harbor for Small Taxpayers• Taxpayers with average annual gross receipt for the 3 preceding tax year of

$10 million or less may elect to not capitalize improvement to property if the total amount paid during the tax year for repairs, maintenance, improvements, and similar activities performed on eligible building property does not exceed the LESSER of: (1) 2% of the unadjusted basis of the eligible building or (2) $10,000.

• Eligible building property – building, condominium, cooperative, or leased building or portion of building that has an unadjusted basis of $1 million or less.– In case of lease, the unadjusted basis is deemed to be the total amount payable

over the expected lease term without any discounting.

• Must make annual election in the tax return.

Small Taxpayer–Example Summaries• Example 1 –Taxpayer who incurs $5,500 of repairs can expense under small

taxpayer safe harbor because the expenses do not exceed the lesser of 2 % of the building’s unadjusted basis of $750,000 or $10,000.

• Example 2 – Taxpayer who incurs $10,500 of repairs cannot expense under the small taxpayer safe harbor because while the expenses do not exceed 2% of the building’s unadjusted basis of $750,000 (which is $15,000), they do exceed $10,000. The limitations is the lesser of 2% of the unadjusted basis or $10,000.

• Example 3 – Taxpayer with two rental properties, both of which have an unadjusted basis of $1 million or less, may test each building separately to determine if the expenses applicable to each can be deducted under the small taxpayer safe harbor. In the case of building 1, the taxpayer can expense under the safe harbor because the lesser of limitation is met; however, in the case of building 2, the taxpayer cannot deduct under the safe harbor because while the expense is less than $10,000, it also is not less than 2% of the unadjusted basis of the building which was $300,000 in the example. Point here is that it is a building by building analysis.

Election to Capitalize Repairs• Taxpayer may elect to capitalize repair and maintenance costs on an

annual basis.– Costs must be incurred in the taxpayer’s trade or business.– Book and tax treatment must be the same.

• Taxpayer is not required to capitalize ALL repairs and maintenance.– Election only applies to those repairs and maintenance costs treated as

capital expenditures by the taxpayer for books.• Annual election attached to tax return.• Election may be beneficial if the taxpayer capitalizes certain

expenditures which potentially could be classified as repairs and maintenance – provides a backup plan in the event of an IRS auditor attempts to disallow depreciation claiming the asset should have been expense as a repair.

Partial Asset Dispositions• New regulations provide that the disposition rules apply to a partial disposition of an asset.

• This rule allows taxpayers to elect to claim a loss upon the disposition of a structural component of a building or upon the disposition of a component of any other asset (properly included in one of the asset classes 00.11 through 00.4 of Rev. Proc. 87-56) without identifying the component as an asset before the disposition event

• For 2014, ability exists to review depreciation schedules and record partial asset dispositions that occurred in prior years.– Most commonly this will apply when roofs and other major building components were replaced in a

prior year.

• Will require an automatic change in accounting method (Form 3115) be filed with the 2014 return.

• The undepreciated basis of the PAD will result in a negative §481(a) adjustment which will be deductible in 2014.

• Additional benefit of eliminating depreciation recapture upon sale of the building.

Dispositions – Example Summaries • Example 1: Taxpayer replaces 1 of 4 elevators in office building and

does not make the special partial disposition election to claim a loss on the remaining basis of the disposed elevator. Replacement of the elevator must be capitalized as a betterment or restoration (example doesn’t say which) and the remaining cost of the disposed elevator continues to be depreciated as part of the building.

• Example 2: Same facts as Example 1, but the taxpayer has componentized the building in its fixed asset systems. If no election is made to claim a loss on partial disposition, no loss is claimed and the results are the same as Example 1.

• Example 3: Same facts as Example 1, but in this case the taxpayer makes the special partial disposition election. In this case, the taxpayer can claim a loss on the remaining basis of the elevator and must capitalize the cost of the new elevator.

Prior Year Classifications• Regulations provide a method for taxpayers to correct prior year

classifications in the treatment of expenditures.

• Review depreciation schedules and identify any expenditures for repairs and maintenance that were capitalized under prior rules.– The ability to write these off eliminates potential future depreciation

recapture.

• Review repair and maintenance account for any expenditures treated as repairs that should have been capitalized..

• Need to file an automatic change in accounting method (Form 3115) with the 2014 tax return to take advantage of this provision.– A net negative adjustment will be deductible in 2014.– A net positive adjustment will be taken into income over 4 years

starting in 2014.

Action Steps• Determine if the de minimis safe harbor (DMSH) election will be

adopted and the appropriate threshold to be used.– Should the capitalization policy use an amount higher than $500 or

$5,000?• Ensure the appropriate written accounting policy is in place.• Modify internal processes to comply with the Regulations regarding

capitalization, repairs and materials and supplies.• Review depreciation schedules to identify potential prior year partial

asset dispositions, depreciation methods and lives needing correction, and repairs that should be expensed.

• Consider reviewing prior repair and maintenance expenses for expenditures that should have been capitalized.– This will probably depend upon how aggressive the company was in

expensing repair and maintenance in prior years.• Consider the financial statement impact of current, past and future

changes to treatment of expenditures. – Keep in mind any loan covenants.

Action Steps continued• Prepare appropriate Form 3115s for automatic changes in accounting

methods. Some will be required; others will be optional based upon the taxpayer’s circumstances. Changes most commonly needed will be:– Treatment of materials and supplies– Capitalization versus repairs and maintenance– Identify the unit of property– Change depreciation methods and bonus– Prior year partial asset dispositions– Proper treatment of removal costs– Adopting the routine maintenance safe harbor