1 Tax Management Memorandum Reproduced with permission from, Vol. 56, No. 18, p. 325, 09/07/2015. Copyright 2015 by The Bureau of National Affairs, Inc. ( ) The Tangible Property Regulations: Considerations For the Real Estate Industry By James Atkinson and Lynn Afeman 1 KPMG LLP The so-called tangible property regulations (TPR) governing the treatment of costs incurred to acquire, produce, repair, and maintain tangible property have been a central focus of many in the federal tax community for several years. Finalized in September 2013, the breadth of the regulations scope has resulted in nearly all taxpayers owning any tangible property meaning most taxpayers being directly affected by the regulations. The real estate industry has been one of the most heavily affected. This article attempts to highlight some, but certainly not all, issues confronting the real estate industry in complying with the TPR. The article provides a high-level overview of the regulations, focusing on those elements most directly affecting and of greatest interest to the real estate industry. The article also provides insights into key issues affecting this industry, as well as some practical planning considerations. OVERVIEW The TPR potentially affect all costs incurred by a taxpayer during the entire life cycle of both real and personal tangible property, including costs to acquire and produce tangible property, as well as costs to repair, maintain, and improve that property during its operational life. A related set of regulations addresses how taxpayers may account for the remaining tax basis of that property upon its disposition, in whole or part. As will be discussed below, these related disposition regulations will have a direct bearing upon the application of the TPR to real estate. 1 The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP. ACQUISITION COSTS In general, the TPR standards applicable to costs of acquiring property largely reflect decades-old law, with certain clarifications. As before, a taxpayer must capitalize and recover through depreciation costs incurred to acquire or produce a unit of real or personal property, including leasehold improvements, land and land improvements, buildings, machinery and equipment, and furniture and fixtures. Amounts paid to acquire or produce tangible property include the invoice price, transaction costs, and costs for work performed prior to the date that the property is placed in service. The taxpayer also must capitalize the costs of purchasing property for resale. 2 In general, this standard is not new, and should be familiar to most taxpayers owning real property. Certain elements of this aspect of the regulations, however, are particularly noteworthy. De Minimis Rule Prior to the TPR, taxpayers generally were required to capitalize costs to acquire property having a useful life extending substantially beyond the end of the taxable year, regardless of the amount. Courts and the IRS applied this standard inconsistently, however, with some IRS exam teams reaching administrative agreements with taxpayers allowing deductions for relatively small expenditures, while others followed a more literalistic approach and required capitalizing costs even for relatively minor items. Some courts permitted a deduction for relatively inexpensive items so long as doing so clearly reflected the taxpayer s income, but prior to the TPR, the IRS never formally agreed. 3 In an effort to promote consistent treatment of all taxpayers and (hopefully) to further simplify this area, the TPR include an elective de minimis safe harbor. This annual election permits a taxpayer to deduct expenditures of up to a stated ceiling per item, provided certain conditions are met. The specific requirements and the permissible deduction depend upon whether the taxpayer has an applicable financial statement (AFS), such as audited financials submitted to 2 Reg (a)-2. 3 Alacare Home Health Services, Inc. v. Commissioner, T.C. Memo ; Cincinnati, New Orleans & Texas Pacific Ry. Co. v. United States, 424 F.2d 563 (Ct. Cl. 1970).
2 the SEC or that are used in reporting to shareholders or partners. A taxpayer having an AFS must have written procedures in effect as of the first day of the taxable year under which it expenses for financial accounting purposes either items costing up to a stated dollar amount, or items having a useful life of no more than a year. 4 If so, the taxpayer may elect to deduct for tax purposes any such items that are expensed for book purposes, up to $5,000 per item. The taxpayer must make the election annually. The TPR also permit taxpayers not having an AFS to elect the de minimis safe harbor, but limits the deduction to items costing no more than $500. While the ceiling is lower, these taxpayers are not required to have written procedures in place in order to make the election. If a taxpayer s financial results are reported on the applicable financial statements of a group of entities (e.g., the audited financial statements of a real estate fund comprised of multiple partnerships), and if the group has written accounting procedures that are used for purposes of those financial statements, the taxpayer may treat the group s written procedures as its own for purposes of the de minimis safe harbor. In the case of partnerships, the TPR do not specify whether the de minimis rule is applied at the partnership level, or instead is applied separately by each partner to amounts reported on their respective K-1s or other report. For example, if the partnership has a written policy of deducting items costing up to $2,500 per item and a partner has a policy of deducting up to $5,000 per item, the regulations do not specify whether that partner may apply its own $5,000 de minimis policy to partnership items allocated to it (assuming all other requirements of the election are satisfied). Similarly, if the partnership has both an AFS and a qualifying financial accounting policy, but a particular partner has neither, the TPR are unclear as to whether that partner remains eligible to deduct his or her share of the partnership s eligible de minimis expenditures. Because the TPR define an AFS to include audited financials used in reporting to shareholders and partners, however, the better view appears to be that the de minimis election is applied at the partnership level. This approach appears to be more administrable generally, while also permitting individual partners to benefit from a de minimis election applied to partnership expenditures, without needing to satisfy the requirements of the safe harbor independently. A different answer may be appropriate, however, where the ownership interests are held by the investors directly rather than through an intervening partnership, such as through a joint tenancy or as tenantsin-common. The TPR are silent on the application of the de minimis safe harbor in this situation, but the better answer appears to be that each individual owner must be eligible for, elect, and apply its own de minimis policy to its share of expenditures incurred in connection with the building. Transaction Costs The TPR provide special rules addressing the treatment of transaction costs incurred in connection with acquiring tangible property. The regulations define transaction costs for this purpose as amounts paid to facilitate the acquisition of the property, meaning the item is paid in the process of investigating or otherwise pursuing the acquisition 5 and require capitalization of these costs. Certain transaction costs are always deemed to facilitate the acquisition of tangible property and must be capitalized as a component of the property s tax basis. These inherently facilitative costs are those paid for: Transporting the property (shipping fees and moving costs) Securing an appraisal or determining the value or price of a property Negotiating the terms or structure of the acquisition and obtaining tax advice on the acquisition Application fees, bidding costs, or similar expenses Preparing and reviewing the documents that effectuate the acquisition (for example, preparing the bid, offer, sales contract, or purchase agreement) Examining and evaluating the title of the property Obtaining regulatory approval of the acquisition or securing permits related to the acquisition, including application fees Conveying property between parties, including sales and transfer taxes, and title registration costs Finders fees or brokers fees, including contingency fees Architectural, geological, survey, engineering, environmental, or inspection services pertaining to particular properties, or Services provided by a qualified intermediary or other facilitator of an exchange under Each of these costs will always be capitalized as a component of the purchase price of the acquired tangible property, whether real or personal. In the case of transaction costs that are not inherently facilitative, however, the TPR provide a special rule applicable to acquisitions of real property. There (except with respect to inherently facilitative costs) the taxpayer may deduct costs incurred in determining whether to ac- 5 Reg (a)-2(f). 6 Reg (a)-2(f)(2)(ii). 4 Reg (a)-1(f) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.
3 quire real property and which property to acquire. 7 Prior to the so-called whether and which dates, the taxpayer is required only to capitalize inherently facilitative transaction costs. Once the property has been identified, however, the taxpayer must apply the broader standard requiring capitalization of any transaction costs that are paid in the process of investigating or otherwise pursuing the acquisition. For real estate acquisitions subject to Financial Accounting Standard 141R (FAS 141R), these rules result in a mandatory book-tax difference. FAS 141R governs accounting for investment property acquisitions, generally treating them as business combinations. Real estate acquisitions of rental property with tenants in place are generally subject to this standard. FAS 141R requires the immediate expensing of acquisition costs for GAAP purposes, including many of the acquisition costs required to be capitalized by the TPR. Materials and Supplies Although of relatively minor importance to most real estate taxpayers, the other focal point for acquisition costs in the TPR is the treatment of costs to purchase materials and supplies. The TPR define materials and supplies generally to include four categories of tangible property: (i) a component acquired to repair, maintain, or improve a unit of tangible property (i.e., spare parts); (ii) fuel, lubricants, water, or similar items, reasonably expected to be consumed in 12 months or less; (iii) a unit of property having a useful life of 12 months or less from the date it is first used or consumed; (iv) a unit of property having an acquisition or production cost of $200 or less; or (v) other items identified as materials and supplies in future administrative guidance. The key changes to the law reflected in this definition is the incorporation of the so-called 12-month rule 8 as well as a de minimis rule for purchases of incidental items costing no more than $200. The general timing rules for materials and supplies remain unchanged from prior law. Costs incurred to purchase incidental materials and supplies (meaning those for which the taxpayer does not maintain a record of consumption or take physical inventories at the beginning and end of the year) are deducted immediately. Costs incurred for all other materials and supplies, however, are deducted only when the materials are first used or consumed. REPAIR AND MAINTENANCE ACTIVITIES UNIT OF PROPERTY The second major segment of the TPR addresses costs incurred to repair, maintain, or improve a unit of real or personal property. As under prior law, the two 7 Cf. Wells Fargo & Co. v. Commissioner, 224 F.3d 874 (8th Cir. 2000); Rev. Rul , C.B U.S. Freightways Corp. v. Commissioner, 270 F.3d 1137 (7th Cir. 2001). chief elements of the analysis are identifying the unit of property with respect to which the taxpayer is incurring costs, and applying the appropriate capitalization criteria to assess whether the costs materially improve that unit of property. One of the TPR s more noteworthy changes to prior law is a new definition of unit of property. Prior to the TPR, determining the appropriate unit of property in this context rested upon decades of frequently inconsistent case law. 9 The TPR seek to ameliorate at least some of this uncertainty by providing specific definitions of unit of property for building and nonbuilding property. For non-building property, the TPR adopt the functional interdependence standard as articulated in the interest capitalization rules. 10 Under this standard, components represent a single unit of property if the taxpayer must place each in service in order for them to serve their intended function. For example, an aircraft engine and an airframe must both be placed in service for either to function, and so are a single unit of property. The TPR provide special rules for plant property 11 (such as manufacturing plants, power plants, refineries, etc.), and for network assets 12 (such as pipelines, railroad track, telephone and electric power lines, etc.). For taxpayers with substantial capital investments in non-building property, correctly applying these new standards and defending those decisions before the IRS likely will be one of the greatest challenges in implementing the TPR. Of principal concern for the real estate industry, however, is the TPR s definition of unit of property for buildings. Although the regulations define the entire building as the unit of property, they apply the capitalization standards not to that unit of property (as is the case for non-building property), but instead to the building structure and to eight specific building systems. These systems are the building s: Heating, ventilation, and air conditioning ( HVAC ) systems (including motors, compressors, boilers, furnace, 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 other permanent structures); Electrical systems (including wiring, outlets, junction boxes, lighting fixtures and associated 9 See, e.g., FedEx Corp. v. United States, 291 F. Supp. 2d 699 (W.D. Tenn. 2003), aff d 412 F.3d 617 (6th Cir. 2005); Ingram Indus., Inc. v. Commissioner, T.C. Memo ; Smith v. Commissioner, 300 F.3d 1023 (9th Cir. 2002), aff g Vanalco, Inc. v. Commissioner, T.C. Memo ; Electric Energy, Inc. v. United States, 13 Cl. Ct. 644 (1987). 10 Reg (a)-3(e)(3)(i). See Reg A Reg (a)-3(e)(3)(ii). 12 Reg (a)-3(e)(3)(iii) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 3
4 connectors, 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 sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detection devices, fire escapes, fire doors, emergency exit lighting and signage, and fire-fighting equipment, such as extinguishers and hoses); Security systems for the 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 and permanent structures); and Other structural components subsequently identified as such in administrative guidance. 13 Significantly for the real estate industry, the TPR provide specific guidance for determining the units of property within a leased building. Lessees of an entire building apply the capitalization standards in the same manner as would the owner of the building the capitalization standards must be applied to the building s structure and to each of the enumerated building systems in their entirety. If the taxpayer leases only a portion of the building, however (such as an office, floor, or certain square footage), the capitalization standards apply only to the portion of the building structure under lease, and to the portion of the listed building systems subject to the lease. 14 For improvements made by the lessor, including tenant allowances, the TPR provide that the improvement is treated as part of the improved unit of property. Further, a building improvement does not occur as a result of lessor-incurred costs unless the entire building system or building structure is improved as a result of the cost incurred. 15 In other words, if a lessor incurs costs with respect to any portion of the building it owns e.g., to fit out tenant space through a tenant allowance that cost is only an improvement if the entire building system or building structure is improved as a result of the cost incurred. 13 Reg (a)-3(e)(2)(ii)(B). 14 Reg (a)-3(e)(2)(v)(B). 15 Reg (a)-3(f)(1), 1.263(a)-3(f)(3). For lessors interested in accelerating tax deductions, these rules, when applied to tenant improvements, can have very favorable results. The TPR provide additional rules that must be considered in determining the unit of property. 16 Significant among these rules is the requirement that if at the time the unit of property is initially placed in service by the taxpayer, the taxpayer has properly treated a component or group of components of the unit of property as being within a different MACRS class of property than the larger unit of property, that component or group of components must be treated as a separate unit of property for purposes of the TPR. This provision could affect real estate taxpayers if portions of a leased building are properly treated as qualified leasehold improvement property or qualified retail improvement property, but only if they qualify for such treatment at the time they are placed in service by the taxpayer. Since these special designations generally are available only for improvements placed in service at least three years after the entire building was placed in service, this issue is unlikely to arise so long as the building is acquired from a third party. For example, if a commercial building with tenants in place is acquired from an unrelated party, then the entire building, including leasehold and retail improvement property within the building, will be 39- year property when initially placed in service by the acquirer. Three years subsequent to the acquisition date, improvements meeting all requirements for qualified leasehold improvement property or qualified retail improvement property will be properly depreciated over 15 years, but will still be properly treated as components of the larger building unit of property for purposes of the TPR. Note that a different result may occur in acquisitions of property in certain tax-free transactions, particularly in technical terminations under 704(b). CAPITALIZATION STANDARDS In large measure, the TPR s capitalization standards are not markedly different from prior law. Whereas prior law required capitalizing costs that either materially increase the value or prolong the useful life of property, or adapt it to a new or different use, the TPR require capitalization if the activities better or restore the unit of property, or adapt it to a new or different use. The TPR provide numerous examples demonstrating the new criteria. Betterments Betterments generally occur if the expenditures ameliorate a pre-existing defect, materially increase the physical size of the property, or materially increase the property s productivity, efficiency, strength, quality, or output. 17 The TPR do not define the central concept of materiality, leaving taxpayers to wonder by how much 16 Reg (a)-3(e)(5). 17 Reg (a)-3(j) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.
5 18 Reg (a)-3(j)(3) Exs. 3 and Reg (a)-3(j)(3) Ex. 5. they can expand the size or improve the quality of a building system or the building structure before they have done so materially. In many cases, this will not present difficult issues. For example, costs incurred to add a new loading bay would be capitalized, as would most costs incurred to expand the physical footprint of the structure. Increases in productivity, efficiency, and quality are much more subjective and present significant challenges in determining materiality. For real estate companies, disparities in the portfolio may create significant difficulties in applying the betterment standards. For example, work done to improve the efficiency in a single elevator will be immaterial if performed in a large commercial office building with 20 elevators. The same work is likely material if performed in a suburban office building with a single elevator. The concept of pre-existing defects is likely to be of significant concern to the real estate industry. For example, while costs incurred to reverse the effects of wear and tear resulting from the taxpayer s own use of the property generally are deductible, reversing wear and tear present at the time a building is acquired presents a greater challenge. If the taxpayer has not previously incurred costs to reverse the effects of wear and tear on a previously owned building purchased by the taxpayer, the TPR permit a deduction only for returning the building to its condition when acquired by the taxpayer. Importantly, however, as with other elements of the betterment standard, the taxpayer is required to capitalize only those costs incurred to remediate a material condition or defect existing at the time of the taxpayer s acquisition. The purpose and nature of the maintenance required to reverse the building s wear and tear largely will determine the materiality of the activities. For example, minor scheduled maintenance or the replacement of minor components to reverse wear and tear present at the time of the building s purchase need not be capitalized because those activities generally are not material. 18 On the other hand, where the taxpayer performs extensive activities to improve the overall quality or appearance of a newly acquired property, capitalization may be required. For example, if a taxpayer purchases an existing assisted living facility that it will continue to use for that purpose, it must capitalize costs incurred to bring the facility up to the taxpayer s higher standard for its facilities, including repairing damaged drywall, repainting, re-wallpapering, replacing windows, repairing and replacing doors, replacing and re-grouting tile, repairing millwork, and repairing and replacing roofing materials. On these facts, the TPR conclude that, considering the purpose and the effect of the expenditures, they ameliorate material conditions that existed prior to the taxpayer s acquisition of the building, and as such must be capitalized as a betterment to the building. 19 The pre-existing defect concept also implicates costs incurred to remediate environmental contamination. The TPR provide that costs incurred to remove environmental contamination present when the taxpayer acquires the property must be capitalized as a betterment, regardless whether the taxpayer was aware of the contamination at the time of purchase. For example, if the taxpayer purchases a parcel of land without being aware of the presence of leaking underground storage tanks, costs later incurred to remove the tanks and to remediate environmental contamination must be capitalized as a betterment. The TPR require the taxpayer to capitalize these costs despite the taxpayer s lack of knowledge of the tanks and presumably the parties not having factored their presence and the associated liability into the property s purchase price. 20 In a break with the IRS s prior position, the TPR apply this pre-existing defect standard to environmental cleanup costs even if the taxpayer itself was responsible for the contamination during a prior period of ownership. Rev. Rul generally allows the taxpayer to deduct the costs of remediating contamination caused by the taxpayer s own activities (subject to the potential application of 263A 22 ). Previously, the IRS took the position that an interim break in the taxpayer s ownership of the property would not preclude such a deduction, so long as the taxpayer itself was the party that originally caused the contamination. 23 Under the TPR, however, if the taxpayer disposes of the property after contaminating it, and subsequently reacquires ownership (such as pursuant to an EPA consent order) in order to remediate the contamination, the TPR require the taxpayer to capitalize the cleanup costs, because the contamination was present at the time of that second acquisition. Over the objections of many commentators, Treasury and the IRS stated in the preamble to earlier temporary regulations that taxpayers must rely on 198 in order to deduct costs incurred to remediate preexisting environmental contamination, including contamination produced by the taxpayer during a prior period of ownership. 24 The TPR also clarify the treatment of costs incurred to remove asbestos from a building. The TPR provide that the removal and replacement of deteriorating as- 20 Reg (a)-3(j)(3) Ex. 1. See United Dairy Farmers, Inc. v. United States, 267 F.3d 510 (6th Cir. 2001) C.B Rev. Rul , C.B. 67; Rev. Rul , C.B. 509 (each applying 263A to environmental contamination resulting from taxpayer s manufacturing operations). See generally James Atkinson, A Bright-Line Rule Dims: Manufacturers Must Capitalize Environmental Cleanup Costs, 45 Tax Mgmt. Memo. 227 (June 14, 2004). 23 TAM , rev g TAM (interim break in ownership does not affect taxpayer s entitlement to deduct environmental cleanup costs pursuant to Rev. Rul ) Fed. Reg. 81,060, 81,071 (Dec. 27, 2011) (preamble to temporary regulations). Section 198 generally allows a taxpayer to elect to treat qualified environmental remediation expenditures as an expense, rather than as an improvement to the land being remediated Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 5
6 bestos insulation does not result in a betterment to the building structure. While positing that asbestos can be unsafe under certain conditions, the TPR conclude that the presence of asbestos in a building, by itself, is not a preexisting material condition or defect of the building structure. The TPR also conclude that the replacement of the asbestos is not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the building structure as compared to its condition prior to the discovery or deterioration of the asbestos. As such, the costs incurred to remove friable asbestos and replace it with another material are not required to be capitalized as a betterment to the structure. 25 This conclusion hopefully puts to rest years of controversy between the IRS and taxpayers as to the treatment of asbestos removal costs. 26 As always, however, even if the costs pass muster under the betterment criteria, the taxpayer also must ensure that they neither adapt the property to a new or different use nor result in a restoration. Restorations Repair and maintenance costs also must be capitalized to the extent they result in a restoration of the unit of property. Here, too, the TPR provide specific criteria for determining whether a restoration has occurred. Two of the six criteria are particularly relevant for the real estate industry. First, costs to repair a unit of property must be capitalized anytime the taxpayer properly recognizes gain or loss upon the disposition of the building elements that are being replaced. This requirement dovetails with the so-called disposition regulations issued in conjunction with the new repair and maintenance regulations. 27 As compared to prior law, the disposition regulations provide the taxpayer with considerable flexibility in determining whether to recognize a gain or loss upon the partial disposition of a tangible asset, including a structural component of a building. 28 Whenever the taxpayer either must or chooses to recognize gain or loss from a partial disposition, the repair regulations in turn require costs incurred to 25 Reg (a)-3(j)(3) Ex See, e.g., Cinergy Corp. v. United States, 55 Fed. Cl. 489 (2003) (permitting deduction for costs of removing or encapsulating asbestos as not bettering property); Norwest Corp. v. Commissioner, 108 T.C. 265 (1997) (denying deduction for asbestos remediation undertaken as part of plan of rehabilitation); TAM (costs of removing asbestos from building required to be capitalized; costs of encapsulating but not removing asbestos may be deducted); TAM (costs of removing asbestos must be capitalized). 27 Reg (i)-1, 1.168(i)-8. T.D. 9689, 79 Fed. Reg. 48,661 (Aug. 18, 2014). 28 As with prior law, however, gains or losses arising upon the disposition of an entire asset not held in a general asset account must always be recognized. replace that disposed of property to be capitalized as a restoration. 29 For example, the TPR normally permit the owner of a building to deduct as a repair the cost of replacing a roof s rubber membrane. 30 The disposition regulations, however, also permit the taxpayer to write off the portion of the building s tax basis allocable to the removed membrane. If the taxpayer chooses to write off that remaining basis, it must capitalize the otherwise deductible costs of the new membrane as a restoration of the building. Alternatively, the taxpayer may forego writing off the membrane s remaining basis and instead continue depreciating the building without change. Doing so allows the taxpayer to deduct the cost of the new membrane as a repair, because no gain or loss had been recognized upon the partial disposition. The choice between these two options necessarily requires comparing the respective tax benefits of writing off the remaining basis of the replaced building component with the costs incurred to replace it. Some companies express concern regarding the ability to identify the tax basis allocable to the building component being replaced. Doing so, however, helps the taxpayer make an informed choice as between the two options (even though deducting the repair is nearly always preferable), and is required if the taxpayer eventually chooses to write off the remaining basis. Application of these rules may be complicated if the taxpayer properly recognized dispositions of lessor-owned tenant improvements abandoned at the end of a lease. Since 1996, lessors have been allowed to write off the remaining basis of leasehold improvements abandoned at lease termination. 31 Most lessors recognize these abandonment losses. If they continue to do so, they will not be eligible to treat replacement tenant improvements as deductible repairs. The other element of the restoration standard likely to be of significance to the real estate industry requires capitalizing the costs of replacing either a major component or a substantial structural part of a unit of property. 32 In the context of buildings, the standard looks to whether the taxpayer has replaced either a major component or a substantial structural part of the building structure, or of any of the eight building systems listed above. Under a special rule applicable only to buildings, replacing a significant portion of either a major component or of a substantial structural part will be treated as a capital activity as well. The TPR do not define significant portion for this purpose. 33 The TPR define a major component as a part or combination of parts that performs a discrete and critical function in the operation of the unit of prop- 29 Reg (a)-3(k)(1)(vi). 30 Reg (a)-3(j)(3) Ex (i)(8)(B). 32 Reg (a)-3(k)(1)(vi). 33 Reg (a)-3(k)(6)(ii) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.
7 34 Reg (a)-3(k)(6)(i)(A). 35 Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(6)(i)(B). 43 Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex Reg (a)-3(k)(7) Ex. 28. erty. 34 Major components are defined by reference to function, not size. An incidental component of the unit of property (such as a power switch), is not a major component, even if the unit of property will not function without it. The TPR posit as examples of major components: all of a building s exterior windows (collectively); 35 all of a building s wiring; 36 a building s entire sprinkler system; 37 all of the furnaces (collectively) within an HVAC system; 38 the chiller unit of an HVAC system; 39 and all of the roofmounted heating and cooling units (collectively) within an HVAC system. 40 On the other hand, one of a building s four elevators is not a major component. 41 A substantial structural part is defined as a part or combination of parts that comprises a large portion of the physical structure of the unit of property. 42 Substantial structural parts are defined by reference to size, not function. For example, substantial structural parts of a building include the entire roof (including the decking); 43 all of the wiring within the building s electrical system; 44 all of the sinks in a building (collectively) and all of the toilets in a building (collectively); 45 40% of a building s flooring; 46 and onethird of the exterior windows of a building that in total represent 90% of the building s exterior surface area. 47 On the other hand, the TPR conclude that the following are not substantial structural parts of their respective building systems: a roof s rubber membrane; 48 one of three furnaces within a building s HVAC system; 49 three of 10 roof-mounted heating and cooling units within a building s HVAC system; 50 eight of a building s 20 sinks; 51 one of a building s four elevators; 52 30% of a building s wiring; 53 and 10% of a building s flooring. 54 Read together, a component of either the building structure or of any of the enumerated building systems may be either a major component (depending on its function), a substantial structural part (depending on its physical size), or both. In the context of real estate, some of these items may not be intuitive (such as the aggregation of all sinks as a major component of the plumbing system), but correctly identifying these elements is critical in properly applying the TPR to buildings. In determining whether a particular project constitutes an improvement to a unit of property (including the building structure and the eight building systems), the TPR require the taxpayer to consider all related costs of a planned project, even if the overall project spans multiple taxable years. 55 The TPR provide no criteria for determining whether costs incurred in different taxable years are related for this purpose, instructing taxpayers instead to consider the relevant facts and circumstances. For example, where a hotel owner plans to update all guest rooms on a floor-byfloor basis over a three-year period (closing an entire floor at a time), determining whether the taxpayer has improved the building structure or any of the building systems requires evaluating the entire multi-year project, rather than isolating the work performed within a particular taxable year. 56 Through examples, the TPR create some general guidelines suggesting that replacing less than 30% of a major component or substantial structural part of a building generally will not result in a restoration but replacing 40% or more generally will be a restoration. The treatment of the replacement of intervening percentages of a major component or substantial structural part of a building is seemingly left to be determined based on the surrounding facts and circumstances. Although some taxpayers and their advisors articulate this as a 30% rule, it is important to keep in mind that these tolerances are derived entirely from examples in the regulations, and are not stated as operable rules in the text of the regulations. While it would seem reasonable for taxpayers to apply tolerances derived from the regulations examples, because the TPR are inherently factual, there can be no guarantee that the IRS on examination will accept the percentages used in the examples as bright-line, universally applicable standards for identifying whether the taxpayer has replaced all or a significant portion of a major component or substantial structural part of a building. The building owner must keep in mind that even if the costs result in replacing less than 30% of a building s major component or substantial structural part, other elements of the TPR may independently require capitalization. For example, if the taxpayer replaces 20% of the building s restroom fixtures with higherquality fixtures, the costs likely would not have resulted in a restoration of the plumbing system, but might have resulted in a betterment to the plumbing system. A betterment to the unit of property will re- 55 Reg (a)-3(g)(3). 56 Reg (a)-3(k)(7) Ex Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 7
8 quire capitalization, even if there has not been a restoration of that property. Finally, the TPR provide a routine maintenance safe harbor to mitigate some of the uncertainties of the highly factual restoration standard. Under this safe harbor, a taxpayer may deduct the costs of replacing a major component or substantial structural part of a building (as well as certain other costs) so long as the taxpayer reasonably expected to replace that component at least twice within a 10-year period. 57 A more generous testing period is provided for non-building property. While this safe harbor is attractive in theory, as a practical matter its relatively short testing period is not likely to change the tax treatment of many material expenditures incurred in repairing and maintaining buildings. Adaptation to New or Different Use Taxpayers must capitalize costs incurred to adapt a unit of property to a new or different use. The TPR provide that a cost adapts a unit of property to a new or different use if the adaptation is not consistent with the taxpayer s ordinary use of the property at the time the taxpayer originally placed it in service. 58 This will allow retailers to move departments within their retail footprint, or even add new sales areas within the scope of the store s originally intended use. For example, a grocery store is not adapted to a new or different use by the addition of a new sushi counter (including the installation of new plumbing and electrical as well as changes to the flooring and wall coverings to reflect a new décor), where the grocery already sold food to customers at specialized counters, such as a deli. There, the new sushi bar is consistent with the owner s intended, ordinary use of the building structure. 59 Similarly, a taxpayer does not adapt a hospital building to a new or different use by converting a portion of its existing emergency room into an outpatient surgery center. The provision of outpatient surgery is consistent with the taxpayer s intended, ordinary use of the building structure and systems in its clinical medical care business. 60 On the other hand, a taxpayer operating a retail drug store is required to capitalize costs incurred to convert a portion of its retail drug store into a walk-in medical clinic staffed by nurse practitioners and physicians assistants providing basic medical services. There, the use of the building structure to provide clinical medical services is not consistent with the taxpayer s intended ordinary use of the building at the time it was placed in service. As such, the costs adapt the building to a new or different use under the TPR, and must be capitalized. 61 SPECIAL TOPICS Remodels and Refreshes Retailers, restaurants, the hospitality industry, and others had hoped that the TPR would provide definitive safe harbors or at least greater clarity regarding the circumstances under which changing the appearance or lay-out of an existing structure rises to the level of an improvement for purposes of 263(a). By and large, the TPR did not provide as much clarity as many had hoped. Instead, the regulations continue to require consideration of all of the surrounding facts and circumstances to determine the correct tax treatment of such costs. In lieu of specific standards, criteria, or safe harbors, the TPR provide three examples purporting to demonstrate the factual spectrum of remodel and refresh activities, and how the regulations would apply to each. By and large, the TPR analyze these situations using the betterment criteria discussed earlier. In the first example, a retailer periodically refreshes the appearance of its stores in order to maintain their appearance and functionality. The work involves a number of cosmetic and layout changes, including replacing and rearranging display fixtures, making corresponding lighting and flooring changes and repairs, moving a wall to accommodate the new display layout, repainting the interior with a new color scheme to coordinate with new signage, and various cleaning and repair activities. After stipulating that the work did not ameliorate any material conditions or defects existing when the retailer acquired the stores, the TPR conclude that the costs of this refresh activity may be deducted. The TPR states that considering the facts and circumstances including the purpose of the expenditures, the physical nature of the work performed, and the effect of the expenditures on the building s structure and systems, the refresh activity did not better the buildings for purposes of the TPR. Instead, echoing a standard long used by the courts and accepted by the IRS, the TPR conclude that the activities merely kept the stores building structures and their systems in their ordinarily efficient operating condition. 62 The store is required, of course, to capitalize the costs of new fixtures and other personalty purchased as part of the refresh. In the TPR s second example, the retailer performs the same refresh activities. At the same time, though, it constructs an addition at the rear of the store, adding additional storage space, a second loading dock, and a second overhead door. Although performed at 57 Reg (a)-3(i)(1)(i). 58 Reg (a)-3(l)(1). 59 Reg (a)-3(l)(3) Ex Reg (a)-3(l)(3) Ex Reg (a)-3(l)(3) Ex Reg (a)-3(j)(3) Ex. 6. See, e.g., Estate of Walling v. Commissioner, 373 F.2d 190 (3d Cir. 1966); Rev. Rul , C.B Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.
9 the same time as the interior refresh, the construction of the addition does not affect and is not otherwise related to the refresh of the retail space. The TPR s stipulation regarding the relationship between the deductible costs of the refresh and the capitalizable costs of the new addition is important. Elsewhere, the TPR provide that the costs of a capital project include not just the direct costs of that project, but also any indirect costs that directly benefit or are incurred by reason of the improvement. 63 Under the facts of this second example, even though the deductible refresh costs and the capitalizable construction costs occur simultaneously to the same store, because the retailer could have undertaken either project independently, neither project benefits or occurs by reason of the other. As a result, the TPR apply separately to each project, and the costs of the refresh remain deductible. 64 The TPR s third example demonstrates how the relationship to a capital project might preclude an otherwise permissible repair deduction. In this example, a retailer undertakes extensive remodeling activities in order to upgrade its stores to offer higher-end products to a different type of customer. The work is extensive and substantial, including replacing large portions of the exterior walls with windows, replacing the escalators with a monumental staircase, adding a new glass-enclosed elevator, rebuilding the interior and exterior facades, replacing vinyl flooring with ceramic flooring, and removing and rebuilding walls to move changing rooms and create specialty departments. The project also includes upgrades to the building s electrical system to accommodate the structural changes, as well as the remodeling of all of the building s restrooms by replacing contractor-grade plumbing fixtures with designer-grade fixtures that conserve water and energy. The retailer also incurs costs to clean construction-related debris, patch holes in walls that were made to upgrade the electrical system, repaint existing walls with a new color scheme to match the new interior construction, and power wash the building s exterior to enhance the new exterior façade. On these facts, the TPR conclude that the project added major components to the building and increased the quality of the building structure. The costs also resulted in upgrades to the electrical system and the plumbing system (by installing a higher grade of fixtures). Although the costs of cleaning debris, painting, patching walls, and cleaning the building s exterior normally would be deductible, because they were incurred by reason of the larger capital project, they too must be capitalized under these facts. 65 While these examples are useful on their particular facts, they leave open a number of questions regarding the countless scenarios along that factual spectrum that are neither as clearly deductible as the first example, nor as clearly capital as the third. In recognition of this, the IRS has worked jointly with the retail 63 Reg (a)-3(g)(1)(i). 64 Reg (a)-3(j)(3) Ex Reg (a)-3(j)(3) Ex. 8. and restaurant industries to develop industry-specific guidance under the IRS s Industry Issue Resolution ( IIR ) program. While use of the anticipated safe harbor will not be mandatory, taxpayers experiences with IIRs issued for other industries under the TPR suggests it likely will alleviate considerable burden, complexity, and potential controversies for those taxpayers within its scope. Among others, the hospitality and commercial leasing industries are expected to be excluded from the scope of the IIR. If so, major segments of the real estate community will be left to wrestle with the relatively amorphous guidance provided by the three examples described above in determining how to apply the TPR to the substantial costs incurred annually by those industries to remodel and refresh hotels, commercial office space (e.g., lobby refreshes to ensure continued Class A status), casinos, and other properties. Tenant Improvements The intersection of the TPR and the disposition regulations presents lessors with a new array of issues to consider. Application of the capitalization standards to tenant improvements will frequently result in determinations that the tenant improvements are deductible repairs. Take, for instance, a large commercial office building in which the majority of tenants each occupies less than five percent of the building s rentable square footage. In such a situation, it would be very unusual for a single tenant fit-out to result in a material betterment or a major component replacement of any of the eight building systems or of the building structure. These new or replacement tenant improvements (whether incurred directly or via a tenant allowance) would thus be deductible repairs, unless the lessor has properly recognized gain or loss upon the disposition of the prior tenant improvements. As discussed above, most lessors have historically done just that. They have taken a loss for the remaining basis in tenant improvements for a particular leased space when that lease is terminated. The only restriction to recognizing these losses is that the improvements in question must be irrevocably abandoned. 66 The allowance of these losses is not affected by the TPR, but taking these losses now precludes treating the new tenant improvements as repairs. While the solution is seemingly simple, at least prospectively i.e., the lessor may forego the disposition deduction related to the prior tenant improvements and instead take the repairs deduction for the new tenant improvements application of the disposition regulations further complicates matters. The disposition regulations require a loss to be recognized whenever there is a disposition of an asset through abandonment. 67 The only means of avoiding application of this rule is if the disposition is a socalled partial disposition, since partial dispositions (i)(8)(B). 67 Reg (i)-8(e)(2) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 9