Recently-issued tax regulations have revamped the rules with respect to the tax treatment of expenditures to improve, repair and maintain real property and tangible personal property used in a trade or business.
These regulations are effective for 2014 tax returns and will affect every taxpayer that owns, leases and/or uses tangible real or personal property in its business. The good news is that the new rules may, for many taxpayers, result in increased current deductions than did the previous rules.
The new regulations introduce an important new concept – the unit of property (UOP). All determinations as to whether to capitalize or expense an expenditure is made with respect to the specific UOP to which it relates.
A building and its structural components (including walls, partitions, floors, ceilings, any permanent coverings such as paneling or tiling, windows, doors, etc.) are considered to be one UOP. In addition, each “building system” is considered a separate UOP (there are eight building systems enumerated in the regulations including the building’s HVAC system, the plumbing system, and the electrical system).
The regulations require the capitalization of an expenditure if it satisfies the BAR test – i.e., it results in either a Betterment (including (i) the amelioration of a condition or defect that existed before the acquisition or production of the property and (ii) a material increase in the size or capacity of the UOP), an Adaptation of the unit of property to a new or different use, or a Restoration of the UOP (including replacing a part that comprises a material portion of a major component of the UOP) .
It is important to note that, under the new regulations, the materiality of the cost of an expenditure is not relevant in the analysis of whether it should be expensed or capitalized. Rather, it is the qualitative nature of the expenditure with respect to the related UOP that controls.
So, for example, the replacement of wiring throughout a building is a restoration of a building system and must be capitalized. Wiring is a major component of the building’s electrical system. However, if only 30% of the wiring is replaced, it would not be a restoration because it does not represent a significant portion of a major component of the electrical system. The cost of new wiring is not relevant.
Expenditures that do not have to be capitalized under the rules mentioned above are generally deductible repairs.
Safe Harbor Rules
There are two elective safe harbors for deducting expenditures as repairs. Under the Routine Maintenance Safe Harbor, an expenditure made with respect to real estate that is reasonably expected to be incurred at least twice in the 10-year period beginning when the UOP is placed in service is deductible. For personal property, the same rule applies except the time period is the class life of the property.
Under the De Minimis Safe Harbor, an election is available to expense expenditures that do not exceed a specified dollar amount ($5,000 if the taxpayer has a certified audited financial statement or $500 if it does not) and if certain other requirements are satisfied.
One of the most beneficial rules in the regulations involves the “disposition” of property. Taxpayers now can elect to recognize a loss when property is permanently retired, abandoned, or destroyed. The amount of the loss would be the adjusted tax basis of the property that is abandoned or destroyed.
For example, assume ABC Corp replaces the roof on its warehouse. The roof replacement does not meet either of the safe harbor tests. Under the old rules, the cost of the new roof would have to be capitalized and no write-off would have been allowed for the old roof that was replaced (in essence, ABC would be depreciating two roofs going forward). Under the new regulations, ABC can elect to deduct the adjusted basis of the old roof when it is replaced. If the tax basis of the replaced property is not readily determinable, the taxpayer can reasonably estimate the tax basis. It is therefore strongly recommended that taxpayers improve their recordkeeping so as to have better support for these potential write-offs.
Adopting the new regulations will be done through filing requests with the IRS for a number of accounting method changes (many of them are automatic changes, but the requests must be filed nonetheless) and elections that should be made on timely-filed tax returns.
This has been only a brief overview of the regulations. They are complex but can be very beneficial to taxpayers. The time to deal with these regulations is now.