Final Tangible Property Regulations Take Shape

OCTOBER 2013

 

Final Tangible Property Regulations Take ShapeThe IRS has finally released final regulations regarding the tax treatment of expenditures related to tangible property, which impact all businesses that own or lease tangible property—including buildings, machinery, vehicles, furniture, and equipment. Generally applicable to tax years beginning on or after January 1, 2014, the regulations require the capitalization of amounts paid to acquire, produce, or improve tangible property but allow amounts for incidental repairs and maintenance of property to be deducted. Additionally, the regulations explain how to distinguish between capital expenditures and deductible business expenses.

The new regulations have been under development since 2006. At the end of 2011, the release of temporary regulations provided a general framework for capitalization. After four attempts, the final regulations replace those temporary regulations while retaining many of their provisions, modifying several sections, and creating many new safe harbors.

Squaring Away Property Improvements

The regulations contain guidance as to how taxpayers must treat expenditures related specifically to buildings, as well as rules on all types of property.

For buildings, the applicable rules encompass:

(1) Capitalization of improvements. A cost that results in an improvement to a building structure or to any of the enumerated building systems (e.g. plumbing or electrical system) must be capitalized. A betterment, restoration, or adaptation of a unit of property results in an improvement.

(2) New safe harbor for small businesses. The regulations add a safe harbor for qualified small business taxpayers (generally those with gross receipts of $10 million or less). For buildings with an unadjusted basis of $1 million or less, taxpayers may elect to deduct the lesser of $10,000 or 2% of the adjusted basis of the property for repairs, maintenance, improvements, and similar activity each year. (There are special rules for calculating the unadjusted basis of leased property).

(3) Restoration test. An amount paid for the replacement of a major component or substantial structural part of a property unit is an amount paid to restore it. These regulations define whether an amount spent on replacement constitutes a restoration. It is a replacement of a major component or substantial structural part if it includes a part or combination of parts that comprises a) a major component/significant portion of the building structure or any building system that performs a discrete and critical function in the operation of the unit of property, or b) a large portion of the physical structure of the building or any building system.

For other property, including buildings, the regulations cover:

(1) Routine maintenance safe harbor. An activity isn’t considered an improvement if the taxpayer expected to perform it as a result of property use or maintenance for ordinarily efficient operating condition. 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, then the activity is considered routine. Specific to buildings, the taxpayer must reasonably expect to perform the building-related activities more than once in 10 years. The regulations make several additional changes and clarifications to the routine maintenance safe harbor that applies to both buildings and other property.

However, amounts incurred for activities outside the safe harbor don’t necessarily have to be capitalized. These amounts are subject to analysis under the general rules for improvements.

(2) Betterment test. The final regulations address the temporary regulations’ test for determining whether an amount paid results in a betterment. The “result in” betterment phrase is no longer included; instead, a taxpayer must capitalize amounts reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of a unit of property—or that are a material addition to a property unit.

Circling Up Materials and Supplies

The final regulations increase the dollar threshold from $100 to $200 for property that’s exempt from capitalization. Taxpayers are also allowed to make an election to capitalize certain materials and supplies but limit it to rotable (parts that need periodic replacement), temporary, or standby emergency spare parts. Taxpayers can revoke this election by filing a ruling request.

The regulations also clarify the optional method in the temporary regulations, which allowed taxpayers to treat the rotable and temporary spare parts as used or consumed in the year of disposition or elect to treat them as depreciable assets. Taxpayers are no longer required to use the method for all pools of rotable spare parts used in that trade or business; they can opt not to use the method for those pools for which they don’t use the optional method on their books and records.

Triangulating De Minimis Rule for Expensing

The final regulations provide for a new safe harbor determined at the invoice or item level. The safe harbor is allowed for taxpayers that produce “applicable financial statements”—generally a certified audited financial statement or one that is required to be submitted to a federal or state government/agency. Such taxpayers can now apply the de minimis rule to deduct all amounts properly expensed—as long as the amount paid for property doesn’t exceed $5,000 per invoice or per item.

The final regulations allow taxpayers who are members of a consolidated group for financial statement purposes—but not federal income tax purposes—to use the group’s applicable financial statements and written accounting procedures to qualify for the de minimis safe harbor.

The regulations also expand the de minimis rule to encompass amounts paid for property having a useful economic life of 12 months or less as long as the amount per invoice (or item) doesn’t exceed $5,000. They also add a de minimis rule for taxpayers without applicable financial statements ($500 per invoice or item).

Additionally, these regulations provide that the de minimis rule is an irrevocable elective (not mandatory) safe harbor. If elected, it must be applied to all amounts paid in the taxable year for tangible property meeting the requirements, including amounts paid for materials and supplies.
The final regulations require that the de minimis safe harbor be applied to all eligible materials and supplies if elected. The temporary regulations allowed taxpayers to select materials and supplies for application of the rule.

Dispositions of Tangible Property

In addition the IRS has issued Proposed Regulations for Dispositions which change the rules for partial dispositions of assets. They also require making a qualifying disposition election for certain situations when assets are held in a general asset account. The IRS has addressed the confusion in the General Asset Account Election issue as this has been a source of major confusion for CPAs and taxpayers. The IRS has made significant changes to allow taxpayers that do not elect general asset account treatment to have the same flexibility to forgo a loss upon the disposition of a structural component as taxpayers that do elect GAA treatment. The IRS plans to issue final regulations in this area by the end of 2013, with the same January 1, 2014 effective date.

Creating Tangible Property Stars.

If your business has expenditures related to tangible property, then these regulations apply to you. Compliance may require changes to your current capitalization procedures and the filing of Form 3115: Application for Change in Accounting Method. Contact CRI with questions regarding the final regulations and guidance regarding the best steps for proceeding. Our tax professionals are ready to help you shape your compliance processes.