On Dec. 23, 2011, the Treasury Department issued the most comprehensive changes to the capitalization regulations in 20 years, withdrawing the 2008 proposed regulations on capitalization of tangible assets—the so-called "repair regs"—and proposing, for a third time in nearly five and a half years, new regulations designed to reduce uncertainty and controversy regarding section 263(a).
The new rules in the temporary regulations are generally effective for tax years beginning on or after Jan. 1, 2012. A Treasury official said at the end of October that transition rules in the form of two revenue procedures were due shortly, but no transition guidance was released with the temporary regulations. We expect that the additional guidance will be issued in the near future.
This Tax Alert focuses on the major changes in the regulations. There are many other details and nuances included in the guidance package, which we will analyze over the coming weeks. In the meantime, we will be presenting an overview of the regulations and key issues that may impact you on our webinar Tuesday, Jan. 24, 2012.
Effective date and potential retroactive section 481 adjustment. The temporary regulations generally are effective for taxable years beginning on or after Jan. 1, 2012. If a taxpayer previously filed a change in accounting method based on the proposed regulations (for example, treating an entire building as the unit of property), they will be required to change their accounting method to comply with the new regulations. This may require taxpayers to review previous repair and maintenance (R&M) studies and potentially reverse prior section 481 adjustments. However, as described below, the regulations provide more flexibility regarding dispositions and retirements of building components, which may help mitigate any adjustment. We are hopeful that the transition rules will address this issue in detail.
Unit of property for buildings. The major change from the 2008 proposed regulations involves the definition of the "unit of property" rules for buildings. Under the temporary regulations, a building and its structural components are still the unit of property; however, the regulations adopt a new framework for determining the treatment of building improvement costs. The improvement tests (betterment, restoration/replacement, adaptation) are applied separately to specific building systems and components listed in the regulations rather than the building as a whole. If the expenditure results in an improvement to a specific building system or component, it is deemed to improve the building/unit of property as a whole and, therefore, must be capitalized. The specific building systems listed in the regulations are HVAC, plumbing, electrical, escalators, elevators, fire protection and alarm, security, gas distribution, and any other system identified in published guidance.
Revised rule for retirements/dispositions of building components. The temporary regulations revise the definition of a disposition, so that a taxpayer may treat the retirement of a structural component of a building as a disposition of property. This new rule will help mitigate the result that occurs when an original building component and any subsequent replacement are required to be capitalized and depreciated simultaneously.
Depreciation consistency rule: cost segregation studies. If a taxpayer properly changes the MACRS class or depreciation method for any type of property in a year after the property was placed in service, the taxpayer must change the unit of property to be consistent with the change for depreciation purposes. For example, if a taxpayer performs a cost segregation study on building components and changes their classification from 1250 to 1245 property, the taxpayer must use the same classifications to define the unit of property for capitalization purposes.
Rules for leasehold improvements. The regulations clarify that an amount initially capitalized as a lessee improvement is treated as a cost of acquiring or producing a unit of property and constitutes a unit of property separate from the underlying leased property. This rule is based on the premise that the lessee should be treated as if they have acquired new property when they make a leasehold improvement. For lessors, the regulations clarify that an amount capitalized for a leasehold improvement owned by the lessor is not a unit of property separate from the underlying property. This is based on the premise that a lessor should be treated in the same manner as any other property owner when making an improvement to his or her property.
"Improvement" tests basically the same. The general analytical framework of betterment, restoration/replacement, and adaptation to a new or different use is still in place. The regulations contain numerous additional examples of how to apply these rules to buildings and structural components, including 45 separate betterment examples. For betterments requiring capitalization, the examples even explain conclusions where material increases in quality, productivity, or efficiency are the determining factor. These nuances were not previously disclosed.
Retail reimaging costs. Despite requests from commentators, the betterment standard has not been revised to provide an exception for retail store reimaging costs. Determining whether reimaging costs result in a betterment, and therefore, must be capitalized, is based on facts and circumstances. However, the regulations do provide examples that illustrate the application of the betterment standard to several common retail scenarios, including cosmetic and store layout changes, restroom upgrades/updates, and more extensive structural remodeling (e.g., upgrading entryways, facades, and lighting, replacing carpet with ceramic tile, etc.).
No more 50 percent tests for major components or substantial structural parts. The regulations retain the standard that costs to replace a major component or substantial structural part of a unit of property must be capitalized. In general, a major component or substantial structural part of a unit of property includes a part or combination of parts that comprise a large portion of the physical structure or perform a discrete and critical function. The regulations use a facts and circumstances approach, eliminating the 50 percent tests (replacement cost and physical structure) in the proposed regulations.
Routine maintenance safe harbor. Under the new regulations the routine maintenance safe harbor does not apply to buildings.
De minimis rule for acquisitions. The regulations contain a new de minimis rule for amounts paid to acquire or produce a unit of real or personal property (not inventory or land). Under this rule, expenditures do not have to be capitalized if they meet the following four conditions:
- The taxpayer has an applicable financial statement (note: there is no de minimis rule for taxpayers that do not have applicable financial statements);
- The taxpayer has written accounting procedures in place at the beginning of the tax year for expensing amounts paid for such property under certain dollar amounts;
- The taxpayer treats such amounts as expenses on their financial statements in accordance with their written accounting procedures; and
- The aggregate of amounts paid and not capitalized under the de minimis rule for the tax year is less than or equal to 0.1 percent of the taxpayer's gross receipts for the tax year as determined for federal income tax purposes; or 2 percent of the taxpayer's total depreciation and amortization expense for the tax year as determined in their financial statements, whichever is greater.
An election is available to deduct the de minimis value while capitalizing the excess amount.
Definition of materials and supplies. The new regulations define materials and supplies as tangible property used or consumed in a taxpayer’s business that is not inventory and that falls within any one of the following five categories:
- Components acquired to maintain, repair, or improve a unit of tangible property owned, leased, or serviced by the taxpayer and that are 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, beginning when used in taxpayer's operations;
- A unit of property with an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer's operations;
- A unit of property with an acquisition cost or production cost of $100 or less (or other amount identified in published guidance); or
- Items identified in published IRS guidance as materials and supplies eligible for the rules in the new regulations.
Rotable and temporary spare parts. Rotable spare parts are materials and supplies acquired for installation on a unit of property, removable from that unit of property, generally repaired or improved, and either reinstalled on the same or other property or stored for later installation. Temporary spare parts are materials and supplies that are used temporarily until a new or repaired part can be installed and then are removed and stored for later (emergency or temporary) installation.
Under the general rule in the new regulations, the cost of rotable and temporary spare parts is deducted when the taxpayer disposes of the parts. However, they also provide an optional method to account for the cost of these items which may benefit taxpayers with these parts. Under the optional method, a taxpayer can deduct the amount paid for the part (plus installation costs) when the part is first installed on a unit of property.
Casualty loss rules. The 2008 proposed regulations required capitalization of any repair or replacement costs for property for which a casualty loss has been taken (the "casualty loss rule"). The new regulations retain this rule, based on the premise that taxpayers must capitalize the cost of acquiring new property. The replacement of property damaged in a casualty may involve the replacement or restoration of the entire property or components of that property. In either event, the damaged part of the property is treated as retired, the basis attributable to the damaged part is removed, and the damaged part is restored or replaced. Thus, costs to restore or replace the portion of property for which basis has been recovered is analogous to the costs of acquiring new property and must be treated as capital expenditures.