Capitalization vs. deduction of costs starting in 2012
The IRS has issued its long-awaited regulations on the tax treatment of expenditures related to tangible property. The regulations are intended to simplify compliance with Section 263 of the Internal Revenue Code, which generally requires the capitalization of amounts paid to acquire, produce, or improve tangible property. They focus largely on how to determine whether expenditures are capital improvements or deductible as repairs.
The new temporary regulations (IRS TD 9564 and REG-168745-03) apply to expenditures made on or after January 1, 2012, so they don’t apply to 2011 tax returns. For 2012 and beyond, however, the regulations will affect a wide swath of businesses that purchase, lease, produce or improve tangible property, such as buildings, machinery, vehicles, furniture, and equipment.
The new regulations have been in the works for years. In 2006, after several court cases considered the tax treatment of expenditures related to tangible property, the IRS released the first set of proposed regulations, which were subsequently withdrawn. The IRS released another set of proposed regulations in 2008, which never took effect.
The latest regulations provide a general framework for capitalization and retain many of the provisions of the 2008 proposed regulations. In addition, they make some significant revisions, including revisions to certain rules for determining whether a unit of property has been repaired or improved. For example, the new regulations clarify the rules for determining the unit of property. They have integrated existing case law in this area and contain some new rules as well.
Perhaps the most widely applicable provisions are those related to building improvements. An improvement occurs if there was a betterment, restoration, or adaptation of a unit of property.
Under the new regulations, the unit of property for a building consists of the building and its structural components. In determining whether an expense is for an improvement to the building, the regulations require the taxpayer to apply the improvement standards separately to the primary components of the building — the building structure or any of the specifically defined building systems:
- Heating, ventilation, and air conditioning (HVAC) system
- Plumbing system
- Electrical system
- Fire protection system
- Security system
- Gas distribution system
- Any other system identified in published guidance.
COMMENT: This division of a building into components is a significant change from prior law, where taxpayers would likely have treated all components of a building as one collective asset. Going forward, taxpayers should consider capitalizing the different systems of buildings as separate assets. Furthermore, the new definitions of unit of property may require taxpayers to analyze their existing buildings to determine the impact of the new rules on prior year repair costs.
A cost is treated as a capital expenditure if it results in an improvement to the building structure or to any of the enumerated building systems. This standard is likely to mean more capitalization, because the regulations make clear that a taxpayer can’t, for example, deduct a project such as the replacement of an entire HVAC system.
On the positive side, the regulations include provisions that expand the definition of “dispositions” to include the retirement of a structural component of a building. As a result, a taxpayer can recognize a loss on the disposition of a structural component that occurs before the disposition of the entire building. For example, if you install a new roof and dispose of the previous roof. In other words, the taxpayer doesn’t have to continue depreciating amounts allocable to structural components that are no longer in service.
COMMENT: A change in accounting method to adopt the new regulations with respect to replacement of existing property may result in tax deductions to dispose of building components that have been subsequently replaced.
The regulations also incorporate more detailed rules for determining the units of property for condominiums, cooperatives and leased property; for the treatment of leasehold improvements (such as erecting a building on, or making a permanent improvement to, leased property); and for additional costs incurred during an improvement, such as related repair and maintenance costs.
Improvements to other tangible property
The regulations generally define the unit of property for real and personal property other than buildings to include all “functionally interdependent” components. Components are functionally interdependent if placing one component in service depends on placing the other component in service. The regulations include special rules for plant property and network assets (for example, railroad tracks, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines), as well as a rule for determining the unit of property for leased property other than buildings.
Unlike the 2008 proposed regulations, the new regulations don’t require taxpayers to treat a functionally interdependent component as a separate unit of property if the taxpayer initially assigned a different economic useful life to the component for financial reporting or regulatory purposes.
The regulations also provide a safe harbor from capitalization for certain routine maintenance costs for tangible property other than buildings. An activity isn’t considered an improvement if the taxpayer expected to perform it as a result of his or her use of the property to keep the property in its ordinarily efficient operating condition. The activity is considered routine if, at the time the property was placed in service, the taxpayer reasonably expected to perform the activity more than once during the property’s life.
Materials and supplies
Consistent with prior guidance, non-incidental materials and supplies are deductible when used or consumed, while incidental materials and supplies are deductible when purchased if no consumption records are maintained and no physical inventories are performed, so long as taxable income is clearly reflected. However, the temporary regulations modify and expand the definition of materials and supplies. They define “materials and supplies” as tangible property used or consumed in the taxpayer’s operations that is:
- A component acquired to maintain, repair or improve a unit of tangible property owned, leased, or serviced by the taxpayer and that isn’t acquired as part of any single unit of property,
- A unit of property that had an economic useful life of 12 months or less, beginning when the property was used or consumed, or
- A unit of property that had an acquisition or production cost of $100 or less.
Also falling under the definition are fuels, lubricants, water, and similar items reasonably expected to be consumed within 12 months.
The regulations also provide an alternative, optional method for accounting for rotable and temporary spare parts. The optional method may be used instead of treating the parts as used or consumed in the year of disposition or electing to treat the parts as depreciable assets.
De minimis rule for expensing
The regulations include an exception to capitalization for certain acquisitions. If a taxpayer expenses the purchase price of tangible property for financial reporting purposes, complying with a formal written accounting policy for expensing those amounts, the taxpayer can now deduct the amount for tax purposes (up to a threshold).
Taxpayers can elect to apply the de minimis rule to the purchase of certain categories of materials and supplies as well. Previously, a taxpayer generally couldn’t deduct these expenditures until the goods were used or consumed.
The aggregate amount paid and not capitalized must be less than or equal to the greater of 0.1 percent of the gross receipts for the tax year for income tax purposes or 2 percent of the total depreciation and amortization expense for the tax year.
COMMENT: The regulations have rejected a book-conformity standard to expensing tangible property costs for tax purposes, so taxpayers currently using a book-conformity approach should consider whether their current accounting method complies with the “bright-line” expense ceiling established by the regulations.
The de minimis rule is only available to taxpayers who have an applicable financial statement which is either a financial statement filed with the Securities and Exchange Commission (SEC), a certified audited financial statement, or a financial statement required to be provided to a Federal or state government or agency (other than a tax return).
If you have expenditures related to tangible property, the proposed regulations apply to you. Compliance with the new regulations may require changes to your current capitalization policies and procedures. Any such changes likely will require the filing of Form 3115, “Application for Change in Accounting Method.” IRS guidance on applying for these accounting method changes is still pending and is expected to be released in the coming months.
If you have any questions regarding this alert, please contact your Plante Moran client services representative.