Summary – The following is Part II of a multi-part series discussing the impact of new regulations governing when taxpayers deduct or capitalize expenditures related to tangible property. (View Part I.) With the effective date of Jan. 1, 2014, quickly approaching, taxpayers should give immediate attention to these new rules, as commentators agree that nearly all taxpayers will be affected. The new rules may require significant changes to a taxpayer’s practices with respect to the capitalization or deduction of certain expenditures.
On Sept. 13, 2013, the Internal Revenue Service (IRS) released final rules concerning when taxpayers must capitalize and when they may deduct an expenditure related to acquiring, producing, maintaining or repairing tangible property. The final rules replace and remove previously issued temporary regulations under Internal Revenue Code (Code) Sec. 263(a) and 162(a). These new regulations must be followed by all taxpayers for tax years beginning Jan. 1, 2014. At a taxpayer’s choosing, these rules may be followed by taxpayers for tax years beginning Jan. 1, 2012.
Code Sec. 263(a) requires the capitalization of amounts paid to acquire, produce or improve tangible property. A taxpayer generally recovers capital costs over time through depreciation or amortization deductions, or at the time of disposition, an inherently slower rate of recovery of any expenditure. Alternatively, Code Sec. 162(a) allows the deduction of ordinary and necessary business expenses incurred during the taxable year, including the cost of supplies, repairs and maintenance.
The new regulations attempt to provide guidance for distinguishing between deductible supplies, repairs, and maintenance, and capital expenditures. The new rules also discuss the disposition of depreciable property under Code Sec. 167 and 168. The final regulations cover five major topics:
- Capital expenditures (Reg. 1.263(a)-1)
- Amounts paid for acquisition or production of tangible property (Reg. 1.263(a)-2)
- Amounts paid for improvements to tangible property (Reg. 1.263(a)-3)
- Repairs and maintenance (Reg. 1.162-4)
- Materials and supplies (Reg 1.162-3)
Part II of this series discusses final rules related to amounts paid to acquire, produce, improve, repair or maintain tangible property.
Amounts Paid to Acquire or Produce Tangible Property
Under final regulations, §1.263(a)-2 requires that, except as allowed by rules relating to materials and supplies (Reg. 1.162-3) and de minimis expenditures (Reg. 1.2639(a)-1(f)), all amounts paid to acquire or produce tangible real or personal property must be capitalized. As compared to Reg. 1.263(a)-3, which primarily addresses expenditures made with respect to tangible property previously acquired by taxpayers, Reg. 1.263(a)-2 primarily addresses expenditures incurred to obtain or create an item of property not previously owned.
For purposes of analyzing expenditures under the final regulations, and for purposes of identifying the type of property to which an expenditure applies, the final 263(a) regulations refer to regulations under Code Section 48. “Tangible personal property” means any tangible property except land and improvements thereto, such as buildings or other inherently permanent structures (including structural components of such buildings or structures). Tangible personal property includes all property (other than structural components) which is contained in or attached to a building.
Real property is defined as land and improvements to land, including buildings and other inherently permanent structures. The term “building” generally means any structure enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display or sales space. For purposes of Reg. 1.263(a)-2, real property also includes other tangible property as defined by Reg. 1.48-1(d). The act of producing real or personal property is defined broadly and includes the acts of constructing, building, installing, manufacturing, developing, creating, raising or growing tangible property.
The final regulations capture and require the capitalization of both direct and indirect expenditures that result in the production or acquisition of property. In general, the amount paid to acquire or produce a unit of property (UOP) includes the invoice price (the cost of the item of property itself), transaction costs (referred to as “inherently facilitative costs” in the final rules), and amounts paid for work incurred prior to the date the subject property is placed in service. In an effort to minimize controversy with taxpayers regarding costs it considers to be facilitative, the IRS provides Reg. 1.263(a)-2(f). This section contains an extensive list of inherently facilitative costs that must be capitalized, including:
- Transportation costs;
- Appraisals or valuations;
- Costs of negotiation;
- Certain contingent fees (e.g., contingent broker commissions);
- Application fees and permits;
- Transfer taxes and other conveyance fees;
- Architectural, engineering and similar design fees; and
- Costs related to like kind exchanges
Taxpayers should be aware that certain indirect expenditures are expressly identified as not subject to capitalization under Reg. 1.263(a)-2:
Certain investigative and decision-making expenditures. Amounts paid by taxpayers in the process of investigating or evaluating the acquisition of real property are deductible, if the amount paid relates to activities performed in the process of determining whether to acquire real property and/or which real property to acquire (sometimes called the “whether or which rule”). This rule applies only to real property; amounts paid to evaluate personal property must be capitalized. It should be noted that expenditures that result in the acquisition of personal property together with real property (for example, the purchase of a building plus furniture contained therein) must be allocated between items of personal and real property, and the amount allocated to personal property must be capitalized into the basis of the subject personal property.
Amounts paid for employee compensation and overhead. Amounts related to employee compensation or overhead are not required to be capitalized. Taxpayers may elect to treat expenditures paid for employee compensation or overhead as facilitative costs, and therefore may capitalize those costs. The election is made by capitalizing the subject costs on the taxpayer’s timely filed original Federal tax return.
Amounts Paid to Improve, Repair or Maintain Tangible Property
The Unit of Property and Functional Interdependence Concepts
Few areas of the 263(a) regulations generate as much controversy between taxpayers and the IRS as do the rules under Reg. 1.263(a)-3. The ever-present dilemma for taxpayers is how to determine when an asset has been improved versus when it has merely been maintained or repaired. How does one discern when an asset has increased in value or had its useful life extended? What constitutes an “incidental” repair? What is “maintenance”? While taxpayers were hoping for bright line tests to answer these and similar questions, the final regulations still rely on analysis of facts and circumstances to determine how to treat such expenditures. The application of the new regulations to amounts paid will likely remain a source of contention between taxpayers and the IRS, but the final rules provide numerous examples of typical transactions and their treatment to help guide taxpayers. Central to any analysis under Reg. 1.263(a)-3 is understanding the concept of the “unit of property” and “functional interdependence.”
The general rule of Reg. 1.263(a)-3 requires that amounts paid to improve a unit of property must be capitalized. An amount paid is considered an improvement to a UOP if it results in one of the following three outcomes:
- Results in a betterment to the UOP;
- Restores the UOP; or
- Adapts the UOP to a new or different use.
The regulations generally define units of property by reference to: (1) buildings and structural components, and (2) assets other than buildings and structural components (i.e., everything else). Because the accurate application of the final regulations is dependent upon defining the asset (i.e., the unit of property) with respect to which an expenditure is made, it is important for taxpayers to understand the conceptual framework of functional interdependence and units of property.
In the case of buildings, the overall UOP is the building itself (as defined in Reg. 1.48-1(e)(1)) plus all structural components (as defined in Reg. 1.48-1(e)(2)). The IRS, in an effort to insure uniform application of the final rules to all types of buildings, further distinguish between elements of the building structure and certain specifically identified functional systems of a building. This further delineation establishes subsets of building components that must be analyzed as separate units of property. Under the new regulations, the units of property associated with buildings are:
- The building structure and structural components, except for those systems defined in items 2 through 9 hereunder
- Heating, ventilation and air conditioning systems (including motors, compressors, boilers, furnaces, chillers, pipes, ducts and radiators)
- Plumbing systems (including pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment, and site utility equipment used to distribute water and waste to and from the property line and between buildings and permanent structures)
- Electrical systems (including wiring, outlets, junction boxes, lighting fixtures, and site utility equipment used to distribute electricity from the property line to and between buildings and other permanent structures)
- All escalators
- All elevators
- Fire protection and alarm systems (including sensors, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm controls panels, heat and smoke detectors, fire escapes, fire doors, emergency exit lighting and signage, and fire fighting equipment such as extinguishers and hoses)
- Security systems for protection of the building and its occupants (including window and door locks, security cameras, recorders, monitors, motion detectors, security lighting, alarm systems, entry and access systems, related junction boxes, associated wiring and conduit)
- Gas distribution system (including associated pipes and equipment used to distribute gas to and from the property line and between buildings or permanent structures)
Taxpayers should understand that this is a significant change from previously issued proposed regulations, given that under prior guidance taxpayers treated the entire building, inclusive of the now separately identified systems, as a single unit of property. For example, under prior guidance expenditures related to heating, ventilation, and air conditioning (HVAC) systems may have been deducted based on the analysis that the UOP, the building, was not improved. Under final 263(a) rules the analysis must look at only the HVAC system as the UOP.
Rule for lessees. In the case of lessees of buildings, the unit of property is each building and its structural components where the lessee leases the entire building. Where the lessee leases a portion of a building (e.g., an office, a floor, or certain square footage), the unit of property is that portion of each building, and the structural components associated with that portion of each building, subject to the lease. With regard to the classification of an amount paid as a leasehold improvement, it should be noted that an expenditure related to work previously performed on a leased building (e.g., a change to a prior renovation) is analyzed with respect to its relation to the entire building, not the prior renovation.
In the case of property other than buildings (typically equipment and processing systems), all of the components that are functionally interdependent comprise a single unit of property. Functionally interdependent components are those where the placing in service of one component is dependent upon the placing in service of one or more other components, where such components together form a complete system. The final regulations discuss three basic classes of property other than buildings:
- “Plant property”, which means functionally interdependent machinery or equipment (other than network assets) used to perform an industrial process
- “Network assets”, which means railroad track, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines; and
- General purpose systems that are not plant property or network assets.
The final rules extend the analysis of functional interdependence to distinguish between separate components of plant property that perform discrete or major functions within the functionally interdependent system. Because understanding and defining the unit of property is critical to determining whether an amount is deductible or capital, manufacturers, utility operators and similar taxpayers should give particular attention to understanding the analysis of discrete or major functions in connection with the concept of functional interdependence.
See IRS Examples: Building Systems and Plant Property
After establishing the unit of property to which an expenditure relates, taxpayers must determine whether the expenditure constitutes:
- A betterment of the unit of property;
- Restoration of the unit of property; or
- An adaptation of the unit of property to a different use.
If the character of an expenditure is determined to align with any of the aforementioned categories of improvements, that expenditure must be capitalized. Before undertaking an analysis of whether an amount must be capitalized under §1.263(a)-3, taxpayers should take note of the following special rules.
Repairs and maintenance completed simultaneously with improvements are deductible. Under previous temporary regulations, the rehabilitation doctrine required that a taxpayer capitalize all costs (including, for example, otherwise deductible repair costs) incurred at the same time as an improvement. For example, if a taxpayer requested a paving contractor to patch potholes in an existing parking lot at the same time as the contractor was paving a new, expanded parking area, the patching work would be required to be capitalized. This treatment was required even though the patching work would otherwise be a deductible repair. Final regulations under 1.263(a) allow qualifying costs to be deducted as repairs or maintenance regardless whether such expenditures are incurred at the same time as an improvement project.
Removal costs may be deductible. If a taxpayer disposes of a depreciable asset and takes the adjusted basis of the asset or asset component into consideration for purposes of calculating gain or loss, then the costs to remove the asset or asset component are deductible.
Safe harbor for small taxpayers. Under certain circumstances, a small taxpayer may not have to capitalize an amount determined to be an improvement. A small taxpayer is one with: (1) less than $10 million in average gross receipts for the preceding three years; and (2) unadjusted basis in the building to which an expenditure relates of $1 million or less. If an eligible small taxpayer, then the taxpayer may annually deduct the lesser of $10,000 or 2 percent of the unadjusted building basis. In calculating total deductions related to tangible property the taxpayer must include all expenditures for repairs, maintenance, improvements and similar activities. A small taxpayer elects to deduct amounts paid for improvements by attaching a statement to the taxpayer’s timely filed original Federal tax return.
Safe harbor for routine maintenance. Any amount paid for routine maintenance on a unit of tangible personal property, a building, or a major system of a building, is not considered an improvement to that unit of property. Therefore, the amount paid may be deducted. In the case of buildings, maintenance activities can only be considered routine if the taxpayer reasonably expects to perform the activities more than once during the 10-year period beginning when the subject building structure or system is placed in service. In the case of property other than buildings, maintenance activities can only be considered routine if the taxpayer expects to perform the activities more than once during the class life of the unit of property.
Optional election to capitalize repair and maintenance costs. Taxpayers may treat maintenance expenditures differently for purposes of tax reporting versus financial statement reporting. If desired, taxpayers may elect to capitalize amounts otherwise deductible for tax purposes. This election allows taxpayers to align the tax treatment of an expenditure with the treatment for purposes of financial statements. It also relieves the administrative and reporting burden of tracking book-tax differences. The election is made annually by attaching a statement to the taxpayer’s timely filed original tax return.
An expenditure constitutes a betterment of a UOP if the expenditure:
- Ameliorates a material condition or defect that either existed prior to the taxpayer’s acquisition of the unit of property or arose during the production of the unit of property, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production;
- Is for a material addition, including a physical enlargement, expansion, extension, or addition of a major component to the unit of property or a material increase in the capacity, including additional cubic or linear space, of the unit of property; or
- Is reasonably expected to materially increase the productivity, efficiency, strength, quality or output of the unit of property.
Certain caveats to the requirement to capitalize costs exist under betterment rules, although an expenditure may be required to be capitalized under another provision of Internal Revenue Code. Specifically:
Changes in technology and replacement parts not a betterment. If an expenditure is made to replace a part of a unit of property, and a comparable replacement part is not available (e.g. due to technological changes or product enhancements), a betterment does not necessarily occur merely because the replacement part is improved over the part being replaced. Through this rule, a taxpayer is not deemed to have bettered a unit of property merely because a better quality component has succeeded a prior component as the standard replacement part to be used in the unit of property.
Correcting normal wear, tear and/or damage not a betterment. In cases where an expenditure is made to relieve the effects of normal wear, tear and/or damage occurring during a taxpayer’s use of the unit of property, the determination of whether a betterment has occurred is made by comparing the condition of the property immediately after the expenditure with the condition of the property immediately prior to the time period when the property incurred the normal wear, tear and/or damage. The result of this rule is that returning a unit of property to its condition immediately prior to use by the taxpayer does not, of itself, constitute a betterment.
See IRS Examples: Betterments
Under the final regulations, taxpayers must capitalize amounts paid to restore a unit of property. An expenditure restores a unit of property if it:
- Is for the replacement of a component of a unit of property for which the taxpayer has properly deducted a loss for that component, other than a casualty loss under Reg. 1.165-7;
- Is for the replacement of a component of a unit of property for which the 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;
- Is for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss under Code Section 165, or relating to a casualty event described in Code Section 165;
- Returns the unit of property 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;
- Results in the rebuilding of the unit of property to a like-new condition after the end of its class life; and
- 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
Restorations typically involve events that trigger recognition of a loss, as opposed to activities that generate ordinary deductions. As such, it is likely that the requirement to capitalize expenditures due to application of the restoration rules will be uncommon. Taxpayers should note that, in general, a comprehensive maintenance program, even if substantial, does not typically return a unit of property to like new condition.
Special rule related to casualty losses. Previous temporary regulations required the capitalization of the entire expenditure related to restorations of casualty losses. This created unfavorable results for taxpayers owning property with a high fair market value but low adjusted basis, where such property was destroyed by a casualty event. The final regulations limit the amount of restoration expenditures required to be capitalized to the taxpayer’s adjusted basis in the damaged property prior to the event. Expenditures in excess of the adjusted basis in the property may be deducted.
See IRS Examples: Restorations
Adaptation to different use
The rules of 1.263(a)-3(l) govern the capitalization of amounts paid to adapt a unit of property to a new or different use. An amount is deemed paid to adapt a UOP to a different use if the adaptation is inconsistent with the taxpayer’s ordinary use of the UOP at the time it was placed in service.
See IRS Examples: Different Use
The IRS has provided numerous examples in the final regulations to illustrate the concepts discussed above. Taxpayers are encouraged to review those examples as guidance for determining the treatment of expenditures made in the course of operating their business.
Please look for more information regarding the final repair and maintenance regulations in upcoming segments from this series. Please contact your KSM advisor with questions about new rules under Reg. 1.263(a).