What does a dispute between Federal Express and the IRS about aircraft maintenance back in the 1990s mean to banks with multiple branches? A landmark set of regulations that could mean deduction accelerations for tax purposes in 2012 and beyond.
The core issue, in fact, dates back to the Civil War: whether repair, renovation, and maintenance expenses can be deducted as an ordinary and necessary business expense during the year they occur (or a project is completed), or must they be treated as a capital improvement and depreciated over a longer recovery period?
In the past, a bank that renovated its branches to remain clean, bright, and fresh to attract customers generally deducted those expenses over 15 years or more, depending upon the nature of the project.
Put simply, many expenses that were formerly treated as a capital improvement and depreciated over a long recovery period may now be currently deductible as an ordinary and necessary business expense.
Although any company with a significant investment in property, plants, or equipment may benefit from these new regulations, banks with multiple branches, hotels, apartment complexes, and retailers will likely see particular benefits. The regulations apply to both owned and leased property.
For expenses that were previously capitalized over time, companies can make an accounting method change to take a current year deduction for the remaining depreciation for certain previous renovations. In addition, projects that began after January 1, 2012, subject to certain limitations, may qualify for a current deduction in 2012 (if completed this year) or in 2013 (if completed next year).
For banks with significant expenses from past renovations that are currently being depreciated on a 15-year or 39-year schedule, the accelerated depreciation deduction and related tax deferral can be huge.
In addition, banks may also be looking at future benefits. For instance, by taking a current deduction for repair costs, the ordinary income depreciation recapture is eliminated when property is sold. As a result, upon the sale of the property, ordinary income may be replaced with capital gains which could offset expiring capital loss carryforwards.
Protection through written policies
To satisfy IRS regulations and proactively avoid problems, banks must have a written accounting policy for expensing acquisition costs that fall below a certain dollar amount, the de minimis rule.
Put simply, the de minimis rule applies primarily to tangible personal property: desks, chairs, computers, and other office furnishings and equipment. Generally, for book purposes, anything underneath the capitalization policy threshold in place for these types of purchases is expensed. Under the de minimis rule, a bank can now deduct that amount for tax purposes as well, as long as:
- The taxpayer has an applicable financial statement (AFS);
- The taxpayer has written book de minimis amount accounting procedures as of the beginning of the year;
- The taxpayer treats amounts paid on its AFS per the written accounting procedures; and
- The aggregate of amounts paid under the de minimis rule fall below a ceiling of .1% of gross receipts or 2% of book depreciation and amortization expense.
The other major change relates to the tax treatment of structural components. Often a major renovation of a bank is so substantial that it doesn’t qualify as a deductible repair. These situations may result in having multiple structures—such as two sets of flooring or two roofs—capitalized for the same building. If certain requirements are met under the new regulations, the bank can write off the remaining tax basis of the old assets, instead of having two sets of assets on the books at the same time.
The unit of property
According to the IRS, repair and maintenance costs must be capitalized if they resulted in betterment to the unit of property, adaptation of the property to a new or different use, or restoration to the unit of property. Although the building itself and its structural components are still considered to be a unit of property, companies must now also apply the capitalization standards tests separately to the building structure and eight specific building systems that the regulations identify:
- Fire protection,
- Security, and
- Gas distribution systems.
If the expenditure results in an improvement to one of the eight building systems or the building structure, it’s considered to be more than just an upkeep-related repair — and must be capitalized.
Taking advantage of the new regulations
Although the new regulations are effective for tax years beginning on or after January 1, 2012, the regulations require retroactive adjustment for as far back as companies have documentation for repairs. This is typically seven years, based on the standard record retention policy.
The accelerated deductions allowed under the regulations related to the current and prior years, can be taken on the current year return (2012 or 2013, as applicable), by filing a Form 3115, Application for Change in Accounting Method. The analysis of the assets placed in service before 2012 can begin now.