On Dec. 23, new regulations were issued on when costs are required to be capitalized to tangible property or may be deducted as repair and maintenance costs. The new regulations replace proposed regulations issued in March 2008.
This Tax Flash provides a summary of some of the highlights of the regulations.
What was issued
Treasury and the IRS issued temporary regulations ("Regulations") that provide guidance on amounts paid to improve tangible property (commonly referred to as the repair regulations). The Regulations also provide guidance on amounts paid to acquire or produce tangible property, as well as guidance regarding the disposition of property. The Regulations are generally effective for taxable years beginning on or after January 1, 2012. It is anticipated that sometime in January the IRS will issue revenue procedures containing transition rules for changing to methods described in the Regulations. The text of the Regulations was simultaneously issued as proposed regulations and the previous proposed regulations ("Proposed Regulations") were withdrawn.
Units of property
The rules in the Regulations for determining the proper unit of property for the most part are the same as the Proposed Regulations, including that a building and its structural components are a single unit of property. One significant change, however, is that the Regulations now provide that the tests to determine if property has been improved must also be applied to structural components of a building (for example a roof) and building systems. The Regulations define building systems to include:
(1) heating, ventilation and air conditioning (HVAC) systems;
(2) plumbing systems;
(3) electrical systems;
(4) escalators;
(5) elevators;
(6) fire8protection and alarm systems;
(7) security systems; and
(8) gas distribution systems.
The Regulations also provide expanded rules for determining the unit of property in situations where property is leased and provide special rules for determining improvement costs in lease situations.
Betterments
The rules in the Regulations for determining whether amounts result in a betterment of a unit of property—and therefore would result in capitalization of costs—are basically the same as the Proposed Regulations. One change, however, is that the Regulations specifically provide that an amount results in a betterment to a building if it results in a betterment to a structural component or a building system. The Regulations include more examples than were contained in the Proposed Regulations to illustrate the application of the betterment rules. Included in the examples are three fact situations involving costs incurred by retail stores that the Regulations label as:
(1) "building refresh";
(2) "building refresh" with "limited improvement"; and
(3) "substantial remodel."
The examples conclude that:
(1) none of the building costs are required to be capitalized in the building refresh example;
(2) some of the building costs are required to be capitalized in the building refresh with limited improvement example; and
(3) all of the building costs are required to be capitalized in the substantial remodel example.
These three examples illustrate the general rule in the Regulations that a determination of whether costs result in a betterment depends on the facts and circumstances related to the costs.
Restorations
The rules in the Regulations for determining whether an amount is paid to restore a unit of property, and therefore would result in capitalization of costs, are basically the same as the Proposed Regulations with a few notable exceptions. Consistent with the rules in other portions of the Regulations, the rules specifically provide that an amount is paid to restore a building if it restores a structural component or a building system. Also, the regulations significantly change the rules in the Proposed Regulations for determining whether the costs result in a replacement of a major component or a substantial structural part of a unit of property. The Proposed Regulations defined replacement of a major component or substantial structural part to mean either:
(1) costs that comprise 50 percent or more of the replacement costs of the unit of property, or
(2) replacement of 50 percent or more of the physical structure of the unit of property.
The Regulations instead provide a facts and circumstances test for determining whether a major component or substantial structural part is replaced. The Regulations also provide that a major component or substantial structural part includes:
(1) "a large portion" of the physical structure of the unit of property, or
(2) a part or combination of parts that perform a discrete and critical function in the operation of the unit of property that is more than "a minor component."
The Regulations contain more examples than the Proposed Regulations to illustrate the rules. Included are examples of costs related to the structural components of a roof, roof membrane, HVAC system, fire protection system, electrical system, plumbing system, windows and floors. The examples illustrate that the determination of whether costs are required to be capitalized depends on the nature and extent of the costs relative to the property.
Plan of rehabilitation
Consistent with the Proposed Regulations, the Regulations do not provide for a plan of rehabilitation doctrine as described in case law. Instead, the Regulations incorporate the Section 263A standard for the treatment of repair and maintenance costs performed during an improvement, and require capitalization of all indirect costs that directly benefit or are incurred by reason of an improvement. The Preamble to the Regulations provides that the plan of rehabilitation doctrine is obsolete to the extent that the court4 created doctrine provided different standards for determining whether an otherwise deductible indirect cost must be capitalized as part of an improvement.
Routine maintenance safe harbour
Also consistent with the Proposed Regulations, the Regulations provide a routine maintenance safe harbor rule. If, at the time the unit of property is placed in service, it is reasonably expected that the maintenance activities will be performed more than once during the class life of the unit of property, the maintenance is deemed not to improve the unit of property. The Regulations, however, specifically provide that the safe harbor does not apply to work performed on buildings.
Dispositions
The Regulations also provide rules for determining gain or loss on the disposition of depreciable property. Of significance is that the Regulations expand the definition of disposition of property to include the retirement of a structural component of a building.
Amount paid to acquire or produce Property
The Regulations also contain rules for amounts paid to acquire or produce property. These include rules related to material and supplies and rotable spare parts. In addition, the Regulations contain a de minimis rule that allows a taxpayer in certain situations to deduct amounts under a certain dollar amount if that is consistent with the method used for financial accounting purposes, provided that amounts under this rule do not exceed certain annual thresholds. The total amounts deducted under the de minimis rule for a taxable year must be less than or equal to the greater of:
(1) 0.1 percent of the taxpayer's gross receipts for the taxable year as determined for Federal income tax purposes; or
(2) 2.0 percent of the taxpayer's total depreciation and amortization expense for the taxable year as determined in its Applicable Financial Statements.
Next steps
Taxpayers will want to determine how the new rules may impact their methods of accounting for when to capitalize costs to tangible property and when to deduct the amounts as repair and maintenance costs. Please contact Grant Thornton LLP for questions or to discuss how the regulations may impact a specific situation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
