Just before the New Year, the Internal Revenue Service released much-anticipated temporary and proposed regulations on the capitalization of tangible property (so-called "repair regs").
These regulations, the IRS explained, are intended to clarify and expand existing standards for capitalization of specific expenses associated with tangible property and provide some bright-line tests for applying the standards. They are sweeping in scope, impacting virtually every business. They address a universal issue arising over repair and maintenance costs: whether a particular payment "to acquire, produce or improve" tangible property must be capitalized and recovered over time, or whether it can be deducted immediately.
Every business should review the new regs, not only to ensure ongoing compliance, but also to take advantage of some of the taxpayer-friendly safe harbors, elections, exceptions and bright-line tests that are now law. This article hopes to provide a heads-up on some of the opportunities, as well as warning about some of the changes that may make life more difficult.
The difference between repair and maintenance costs and improvement costs has been the subject of controversy for years. The new regs try to add some clarity to the area, although they take certain positions that remain controversial. Key definitions within the regulations, upon which operational rules are hung, include improvements, materials and supplies, and units of property.
As a general rule, improvements must be capitalized, while repairs can be deducted. Simplicity ends there, however, as the regulations apply this rule to specific standards and situations.
Because repairs to property improve it in common parlance, the degree of improvement becomes important. The regs address this distinction by requiring capitalization of permanent improvements, betterments and restorations, as well as payments that add to the property's value, prolong its useful life or adapt the property to a new use. The "property" subject to such evaluation is also carefully defined, albeit indirectly, by defining an improvement as an expenditure that betters or restores a "unit of property," or adapts it to a new and different use.
Exceptions. The new regs turn back the judicially created "plan of rehabilitation" doctrine that required repairs to be capitalized when performed at the same time as improvements that renovate or rehabilitate an asset. Costs that do not directly benefit or are incurred by reason of the improvement need no longer be capitalized.
The new regs also create a routine maintenance safe harbor for non-building assets. Any activity that a taxpayer expects to perform on a recurring basis to keep the unit of property in its ordinary, efficient operating condition qualifies as routine maintenance that is currently deductible. The regs also add a special optional method for treating rotable and temporary spare parts.
MATERIALS AND SUPPLIES
As a general rule of thumb, the costs of materials and supplies are currently deductible as expenses to the extent consumed and used in the operation of the business during the year. If materials and supplies are incidental, they are deductible in the year purchased if no record of their consumption is kept and they are not treated as inventory. These rules, which appeared in predecessor 2008 proposed regulations, are essentially repeated in the new regs.
However, the new temp regs go further by providing more specificity to what constitutes materials and supplies:
A component acquired to maintain, repair or improve a unit of tangible property owned, leased or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property;
Fuel, lubricants, water and similar items that are reasonably expected to be consumed in 12 months or less starting with when used in the taxpayer's operations;
A unit of property that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer's operations (and generally measured by usefulness to the taxpayer when considering wear and tear, climate, and conditions peculiar to the taxpayers' business); or,
A unit of property that has an acquisition or production cost of $100 or less (or in an amount specified in published guidance).
The new regs also allow taxpayers to treat as materials and supplies property conforming to specifications identified within earlier guidance and not subsequently withdrawn. Smallwares in the restaurant business identified in Rev. Proc. 2002-12 is an example.
De minimis rule. For businesses required to file an "applicable financial statement," a de minimis rule allows an election to deduct materials and supplies, irrespective of whether incidental or not, or whether or not used for an improvement, provided the deduction comes under a written accounting procedure and aggregate amounts so treated do not exceed the greater of 0.1 percent of gross receipts or 2 percent of total depreciation and amortization expense for the tax year. The taxpayer may choose which items to consider covered by applicable percentage ceiling. This replaces a proposed "material distortion" cap.
The new regs also carve out an additional exception for agreements between taxpayers and examining agents to permit dollar amounts greater than under the regulations' de minimis rule. Under this latter exception, however, the taxpayer retains the burden of showing that the treatment clearly reflects income.
Facilitative expenses. Unless deductible under the materials and supplies rule or the de minimis rule, amounts paid to acquire or produce a unit of property must be capitalized. Such amounts include transaction costs and facilitative expenses. Work performed before an asset is placed in service must be capitalized to the extent that it would be required to be capitalized if done after the placed-in-service date.
The regs carve out 11 categories of "inherently facilitative" expenses, including brokers' and appraisers' fees and services of a qualified Section 1031 intermediary. However, employee compensation and overhead related to an acquisition of property are not required to be capitalized under this provision, although they may be at the taxpayer's election.
UNITS OF PROPERTY
A "unit of property" is another key term defined more precisely (and, generally, more liberally) than under prior regulations. The significance of this definition is that the degree of repairs and maintenance must be evaluated within the context of a particular unit of property.
The new regs define a unit of property generally as consisting of all components of the property that are functionally interdependent. Components of property are functionally interdependent if the placing in service of one component by the taxpayer is dependent on the placing in service of the other component. For example, the fuselage of an airplane cannot operate independently of an airplane's engine.
Generally speaking, the larger a "unit of property," the greater the advantage to the taxpayer, since amounts spent on a portion of the property would be relatively smaller and therefore more likely not to rise to a level of significance sufficient to warrant being considered an improvement required to be capitalized. Stated otherwise, the smaller the unit of property, the more likely that a related expense must be capitalized.
Depreciation override. In a major exception, the regulations defer their general definition of a unit of property to the characterization of the asset for depreciation purposes. As such, a component generally can be treated as a separate unit of property if, when initially place in service (or subsequently due to reclassification), the taxpayer properly depreciated the component using a different class or method from the larger unit of property. The regs also offer flexibility by allowing assets to be grouped into one or more general asset accounts.
IIRs. While the regs paint broad rules, the IRS in the preamble admits that it cannot be comprehensive. For example, the regs define what constitutes a network asset as pipelines, railroad track, power lines, and telephone and cable lines. However, the regs do not take the next step and define a unit of property for network assets. Because of the factual differences among industries, a one-size-fits-all bright-line test is next to impossible to construct. Instead, the IRS encourages the use of Industry Issue Resolutions guidance to provide safe harbors for deductible maintenance in any particular network industry. Presumably, it would be receptive to requests from other industry groups as well.
The new regulations distinguish between rules applicable to buildings and structural components, and all other property (non-buildings). The treatment of building components and units of property in the new temporary regs represents a significant pullback from what is now viewed by the IRS as an overly liberal position.
A unit of property continues to be expansive, comprised of a building and all its structural components. However, in a retreat from prior treatment under 2008 proposed regs, the new 2011 regs remove a broad restoration rule under which the replacement of a major component or substantial structural part of a building could be deducted, rather than capitalized.
The new regulations view a typical commercial building as an entire, single unit of property. However, in applying the standards of capitalization, the regs initiate another major change by requiring eight major systems components to be analyzed against capitalization standards separately (heating, air conditioning, plumbing, electrical, elevators, escalators, fire protection and security systems). Any significant work on any of these components must be capitalized. The list also includes other structural components that may be identified by the IRS in guidance.
To compensate for this more rigorous treatment, however, the new regs provide a significant offsetting benefit. The taxpayer now is able to recognize a loss on the retirement of a structural component without having to dispose of the entire building. Rather than continue to depreciate the cost of the component that is replaced while simultaneously starting to depreciate the cost of the improvement (that is, the new component), the taxpayer may consider the retirement of a structural component of a building as a disposition. In most cases, that allows for the recognition of an immediate loss for that component for prior expenditures that had been capitalized. Those prior improvements no longer need to continue to be capitalized over their remaining useful life.
Of course, determining the adjusted basis of the retired component can get complicated when several overlapping improvements have been capitalized previously. The IRS has asked for comments on possible safe harbors that it might allow in the future to simplify this determination.
The new repair regulations are lengthy (over 250 pages) and complex. Each business' unique factual situation will require customized analysis. The temporary regs are effective in connection with amounts paid or incurred in tax years beginning on or after Jan. 1, 2012. Therefore, many taxpayers will face an immediate need to change methods of accounting. Transitional guidance is also expected to govern requirements such as when a written policy must be in place to qualify initially for the de minimis rule. Still other taxpayers are gearing up for the comment period on the temporary regulations, anticipating further changes when the final regulations are issued sometime post-2012.
All told, these regulations will make for a busy year.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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