Out of Chaos: The Repair Regulations One Year Later

Transcription

1 60TH ANNUAL MNCPA TAX CONFERENCE November 17-18, 2014 Minneapolis Convention Center ONLINE RESOURCES Session Handouts Most session handouts are available on the MNCPA website. To access: Go to Log in with your MNCPA username and password Note: Your conference registration fee must be paid in full to access session handouts online. CPE Transcript (Certificate of Attendance) Your official transcript will be available on the MNCPA website. To access: Go to Log in with your MNCPA username and password Note: Tax Conference transcripts will be available Friday, Nov. 21. MATERIALS DISCLAIMER These materials are provided for the exclusive, personal use of the customer. Any other reproduction, retransmission, republication or other use is expressly prohibited without prior written consent from the Minnesota Society of Certified Public Accountants (MNCPA) and/or the content author. The MNCPA makes no warranty, guarantee or representation as to the accuracy or completeness of these materials. The contents of these materials are subject to change without notice. The content authors and/or instructors are not engaged in rendering legal, accounting or professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Out of Chaos: The Repair Regulations One Year Later E. Lynn Nichols, CPA Nichols Patrick CPE, Inc. Hubbard, OH E. Lynn Nichols, CPA, is a practicing accountant, tax consultant and founder of Nichols Patrick CPE, Inc., a developer of continuing education programs for CPAs. He is a nationally recognized instructor, teaching seminars and speaking at conferences throughout the U.S. Nichols serves as an adviser to CPA firms across the country on matters of federal income taxation, tax practice quality control and IRS procedures. He regularly contributes to Bisk Education's CPE Network audio and video tax updates and monitors discussion groups for AccountantsWorld.

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3 Out of Chaos: The Repair Regulations One Year Later 60th Annual MNCPA Tax Conference November 17, 2014 E. Lynn Nichols, CPA Nichols Patrick CPE Timetable Mayo Foundation; 131 S Ct. 704; 1/11/2011 Courts must give deference to Treasury Regulations where statute is ambiguous or unclear Temporary and Proposed Regulations published on December 27, 2011, to be effective for years beginning after January 1, 2012 (now 2014) Significant changes to Regulations under IRC Secs. 162, 167, 168, and 263 Conforming changes to other code sections 2 Page 1

4 Revenue Procedure /7/2012 (Replaced by Rev. Proc ) Changes under IRC 162 and 263 in 2012 or 2013 Automatic, no user fee, new change numbers See section 6.02(b)(ii) of Rev. Proc for multiple changes on one Form separate items, including Materials and supplies Repair and maintenance Acquisition and production of tangible property Amounts paid to improve tangible property 3 Revenue Procedure /7/2012 (Replaced by Rev. Proc ) Changes under IRC 167 and 168 Automatic, no user fee, applies to 2012 or 2013 See section 6.02(b)(ii) of Rev. Proc for multiple changes on one Form separate items, including MACRS Class Lives, impermissible to permissible, permissible to permissible, leasehold property Dispositions of MACRS property 4 Page 2

5 11/20/2012 Notice IRS plans to finalize Repair Regulations in 2013 Temporary Regulations are to be amended to simplify compliance with regard to: De Minimis Rule Reg. Sec (a) 2T(g) Dispositions Reg. Secs (i) 1T and 8T Routine Maintenance Safe Harbor Reg. Sec (a) 3T(g) Effective in taxable years beginning on or after 1/1/ LB&I Memo /16/2012 (updated 3/22/2013) Exam must discontinue examination of tax years beginning before 1/ 1/ 2012, with respect to: 1. Whether costs incurred to maintain, replace, or improve tangible property must be capitalized 2. Correlative issues involving the disposition of structural components of a building or dispositions of depreciable assets (other than a building or its structural components) Taxpayers are expected to have submitted Forms 3115 and be in compliance with new rules no later than 1/1/ Page 3

6 Final Regulations Effective September 19, 2013 Remove temporary regulations for all but general asset accounts and disposition of property under IRC Sec. 168 Clarify regulations under 162(a) and 263(a) Final regulations under IRC 167 re: accounting for and retirement of depreciable property Final regulations under IRC Sec. 168 regarding accounting for MACRS property Permit taxpayer to apply the temporary regulations to taxable years beginning on or after 1/1/2012 and before 1/1/ MORE Final Regulations Effective August 18, 2014, provides... Rules for determining the disposed asset for tax disposition purposes A partial disposition rule Rules for determining gain or loss upon disposition of MACRS property For use of any reasonable method to determine basis of asset disposed of (c) Nichols Patrick CPE Page 4

7 Overview Latest attempt by IRS to provide guidance on the deductibility (or required capitalization) of amounts paid (or incurred) to acquire, produce, or improve tangible property Changes to fourteen regulation sections Eight relate to Code Secs Four relate to Code Sec. 263(a) One relates to Code Sec. 263A One relates to Code Sec Numerous examples All effective 1/1/ But can be applied now 9 Overview (continued) Treasury explanations use +/ 50 pages Regulations use more than 100 pages IRS acknowledges difficulty of applying the rules in practice, and offers these general distinctions Repair deduct Renovation capitalize ** Betterment capitalize ** Adapt capitalize ** ** Unless deductible under one or more Deminimis rules 10 Page 5

8 Overview (continued) The overriding purpose of these regulations is to change the approach to deductibility, from: Looking 1st to Sec Is it deductible? To... Looking 1st to Sec Is it capitalizable? Some of the rules changed by these regulations were last addressed in 1956 and 1960 New Rev. Procs. replacing those issued in March, 2012, offer instructions for changing accounting methods to comply with, or take advantage of, new rules and allow until 12/31/2014 to get that done. 11 Revenue Procedure (1 of 2) 1/24/2014 Modifies Appendix of Rev. Proc to make existing method changes consistent with final and temporary regs and to provide new method change procedures Supersedes Rev. Proc Describes procedures for obtaining automatic consent to change accounting methods required by final and temporary regulations 12 Page 6

9 Revenue Procedure (2 of 2) Includes procedures by which taxpayer can get automatic consent for a reasonable method for self constructed assets where there is interplay between 263(a) and 263A Includes procedure to change to a permissible method with respect to specified costs related to real property acquired through foreclosure 32 specific method changes Effective January 24, Ways To Change An Accounting Method (1 of 4) Annual Election De Minimis rules for Repairs, Renovations, etc. in general $500 without Applicable Financial Statement $5,000 with Applicable Financial Statement Deminimis rule for Repairs to Buildings used in a trade or business by a Small Taxpayer... Under $10 million in average gross receipts Accounting Method Change Permission Required Any change not covered by automatic rules Page 7

10 3 Ways To Change An Accounting Method (2 of 4) Accounting Method Change Automatic See Rev. Proc for automatic change procedures for over 140 items listed in its Appendix Rev. Proc , effective 1/24/2014, adds a number of automatic changes to the list at Section 10.11, for costs incurred to acquire, produce, or improve tangible property, including... Deminimis rule for both incidental and non incidental materials and supplies Accounting for rotable spare parts Deducting amounts paid or incurred for repair and maintenance including a change in identifying the unit of property to which the rule is applied or, in the case of a building, the building structure of system 3 Ways To Change An Accounting Method (3 of 4) To capitalize amounts paid or incurred for improvements to tangible property. If depreciable, to depreciate such property under IRC 167 or 168, including a change, if any, in identifying the unit of property under Reg (a) 3(e) or To capitalize amounts paid or incurred for improvements to tangible property [Reg (a) 3] In the case of a building, identifying the building structure or building systems under Reg (a) 3(e)(2) By dealer in property, to deduct amounts paid or incurred for commissions & other transaction costs that facilitate sale of property [Reg (a) 1(e)(2)] Page 8

11 3 Ways To Change An Accounting Method (4 of 4) By non dealer in property, to capitalize amounts paid or incurred for commissions and other costs that facilitate the sale of property [Reg (a) 1(e)] To capitalize amounts paid or incurred to acquire or produce property and, if depreciable, to depreciate such property under IRC 167 or 168 [Reg (a) 2] To deduct amounts paid or incurred in the process of investigating or otherwise pursuing the acquisition of real property if the amounts meet the requirements of Reg (a) 2(f)(2)(iii) Revenue Procedure (1 of 3) Rev. Proc , effective 1/24/2014 describes procedures a taxpayer should use to change its method of accounting... Accounting for leasehold improvements in which the taxpayer has a depreciable interest at the beginning of the year of change From a permissible MACRS method to another permissible method Accounting for the disposition of a building or structural component to which the partial disposition rule applies Accounting for disposition of Section 1245 property or a depreciable land improvement or a partial disposition 18 Page 9

12 Revenue Procedure (2 of 3) Method of accounting for disposition of an asset subject to general asset account election, and Describes how a taxpayer can make a late general asset account election for one or more items of MACRS property placed in service by the taxpayer in a tax year beginning before 1/1/2012 and owned by the taxpayer at the beginning of the year of change Change in method of accounting for leasehold improvements in which taxpayer has a depreciable interest at the beginning of the year of change, and change in method of depreciation for a specific asset 19 Revenue Procedure (3 of 3) Rev. Proc , also adds these automatic accounting method changes... Late partial disposition election for disposition of a portion of an asset Revocation of a general asset account election Partial disposition election specified in the proposed regs to which to which an IRS adjustment pertains 20 Page 10

13 How This Presentation is Organized Fourteen Regulation Sections Regulation , through Regulations T Color Coded! Analyzed and Explained Miscellaneous Developments Materials and Supplies: Defined Tangible property that is used or consumed in the taxpayer s operations, that is not inventory, and is: Required to maintain, repair, or improve a unit of tangible property [see 1.263(a) 3(e)] owned or leased or serviced by taxpayer, not acquired as part of a unit of tangible property, Fuel, lubricants, water and similar items expected to be consumed within 12 months of first use, A unit of property with economic useful life of 12 months or less after first use in taxpayer s operations, A unit of property costing less than $200 (de minimis rule), or Identified in other guidance as materials and supplies for which deductibility is permitted 22 Page 11

14 Materials and Supplies Non incidental materials and supplies: Deductible in taxable year in which used or consumed in taxpayers operations Incidental materials and supplies: Carried on hand, but no record of consumption and no inventories maintained Deductible in taxable year when amounts are paid or incurred subject to clear reflection of income Rotable and temporary spare parts (not part of today s program) Nothing in this section changes the treatment of any amount other than Sections 162(a) and Economic Useful Life... Not necessarily the useful life inherent in the property, but the period over which the property may reasonably be expected to be useful to the taxpayer or, if the taxpayer is engaged in a trade or business or an activity for the production of income, the period over which the property may reasonably be expected to be useful to the taxpayer in its trade or business or for the production of income... Cross referenced to 1.167(a) 1(b), consider: Wear & tear and decay from natural causes Normal economic changes, inventions, and developments Climate & other local conditions affecting taxpayers business Taxpayers repair & replacement policy Conformity required if taxpayer has applicable financial statement 24 Page 12

15 Applicable Financial Statement For the purpose of deducting the cost of an item of material and supplies, tax treatment must conform to applicable financial statement: Financial statement required to be filed with SEC, Certified audited statement used for Credit purposes Reporting to owners Other substantial non tax purpose, or Financial statement (other than tax return) required to be provided to federal or state government or agency (other than SEC or IRS) [Apparently, not required to be certified] Use of $200 deminimis rule for materials and supplies is an accounting method, not an annual election 25 Applicable Financial Statement Provisions defining an applicable financial statement and explaining two new safe harbors are found at 1.263(a) 1(f) Eleven examples are provided to assist in applying the two new de minimis rules Taxpayer electing to apply $500 or $5,000 deminimis rule, must apply $200 deminimis rule to materials and supplies 26 Page 13

16 Taxpayer With Applicable Financial Statement Taxpayer electing to apply the de minimis safe harbor may not capitalize nor treat as material or supply any amount paid during year if Taxpayer has written accounting procedures treating such items as an expense for non tax purposes and does so Item is less than specified dollar amount, or Useful life of 12 months or less Amount paid for property does not exceed $5,000 per invoice or per item, or other amount identified in published guidance 27 Taxpayer Without Applicable Financial Statement Taxpayer electing the de minimis safe harbor may not capitalize nor treat as material or supply any amount paid during year if Taxpayer has accounting procedures treating item as expense for non tax purposes and does so Item is less than specific dollar amount Economic useful life 12 months or less Amount paid for property does not exceed $500 per invoice, or per item, or other amount identified in published guidance 28 Page 14

17 Election to Capitalize and Depreciate Taxpayer may elect (by simply doing so) to capitalize and depreciate any material and supply except: Parts to be used in unit of property that will not be capitalized and depreciated, or Cost of a rotable or temporary spare part for which taxpayer has elected the optional method of accounting 29 Other Definitions, Elections, and Examples Elect to apply de minimis rule by taking deduction Disposition of materials and supplies is ordinary income transaction, not 1221 or 1231 Examples illustrate the new rules governing materials, supplies, and rotable spare parts Spare parts to maintain aircraft, deductible when used Consumable property, deduct if expected to be consumed within 12 months Materials and supplies used in improvements, coordinate with 1.263(a) 3 30 Page 15

18 More Examples Election to capitalize and depreciate (2 steps) Determine unit of property 1.263(a) 3(e) Address capital expenditure rules in 1.263(a) 2(h) Election to apply de minimis rule Briefcases & office chairs (less than $200 each) may be materials and supplies, In that case, the cost is deducted in the taxable year paid under the de minimis rule 31 Administration A change to comply with this section is a change in method of accounting (See Revenue Procedure ; 1/24/2014) Regulation Sec : Optional for taxable years beginning on or after 1/1/2012; Required for taxable years beginning on or after 12/31/ Page 16

19 Repairs Modifies repair rules in to be consistent with improvement rules in 1.263(a) 3 New rule... amounts paid to repair and maintain tangible property are deductible provided they are not otherwise required to be capitalized by any other provision of Code or regulations. (Think 263A UNICAP rules or temporary 263(a) rules adopted concurrently with these temporary 162 rules) 33 Rentals and Leases: Sec Improvements by lessee (tenant) on lessor s (landlord s) property Cost of buildings and improvements on leased land is not deductible as an expense See Reg. Sec (a) 3(f) for rules regarding capitalization of improvements that are tangible property For amortization of leasehold improvements: See 1.167(a) 4 34 Page 17

20 Obsolescence of Non Depreciable Property See 1.167(a) 8, 1.168(i) 1, or 1.168(i) 8 for losses arising from permanent withdrawal of depreciable property from use in trade or business or production of income See for casualty losses See 1.167(a) 9 for obsolescence of property depreciated under Sec. 167 But not 168, 1400I, 1400L(c), 168 prior to TRA 86, or any additional first year depreciation deduction (a) 4 Leased Property Capital expenditures by either lessee or lessor on leased property are recovered under applicable Code provisions, without regard to period of lease Sections 168, 167, or 197 as applicable Taxpayer may change method of accounting Procedure for change may be slightly different based on year in which capital expenditures were paid or incurred 36 Page 18

21 1.167(a) 7 Accounting for Depreciable Property Following paragraphs of regulation 1.167(a) 7 only apply to depreciation determined under Section 167 (a)... Permits grouping (b)... Explains operation of grouped accounts (c)... Does not apply to general asset accounts (d)... Requires redetermination of average useful life and rate when additions, retirements, replacements alter relative proportion types of assets in group accounts Only applies to property for which depreciation determined under Section 167 or of (i) 0T General Asset Account Rules Table of Contents for: 1.168(i) 1T 12 new sections are added and some paragraph references are changed Due to time constraints, operation of general asset accounts is not part of today s presentation. 38 Page 19

22 1.168(i) 7 Taxpayer may account for MACRS property by treating each individual asset as a separate item or by combining two or more assets in a multiple asset account or pool Does not apply to assets included in general asset accounts Assets to be grouped must have same recovery period, depreciation method, applicable convention, etc (a) 1 Capital Expenditures; In General General rule... Except as provided in chapter 1 of the IRC (elsewhere in the Code) no deduction is allowed for Any amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property Any amount paid to restore property or make good the exhaustion thereof for which an allowance is or has been made Produce has same definition as IRC Sec. 263A 40 Page 20

23 1.263(a) 1 (continued) Coordination with 263A (a) requires capitalization of costs to acquire produce or improve real or tangible property 263A prescribes direct and indirect costs that must be capitalized to property produced or acquired for resale by the taxpayer Examples of capital expenditures: Amount paid to acquire or produce a unit of property 1.263(a) 2 Amount paid to improve a unit of property 1.263(a) 3 Amount paid to acquire or create intangibles 1.263(a) 4 Amount paid or incurred to facilitate acquisition of a trade or business or changing capital structure of the same 1.263(a) 5 Amount paid to acquire or create interests in land; easements, life estates, mineral interests, zoning variances, etc. Various (a) 1 Amounts Paid to Sell Property In general... Commissions and other transaction costs to facilitate sale of property must be capitalized Dealers in property treat such amounts as 162 expenses Capitalized amounts are treated as reduction in amount realized and taken into account in year sale is abandoned if loss is permissible Amount paid... For accrual basis taxpayer means a liability incurred as defined in (c)(1)(ii) Taxpayer changing to a method of accounting allowed by these rules must follow admin. process 42 Page 21

24 Examples 1.263(a) 1 Amounts Paid to Sell Property All commissions, legal fees, etc. must be capitalized Dealer deducts as ordinary and necessary Capitalize sales costs to appraise personal property used in trade or business... Deduct when sold Write off any capitalized sales costs in year sale of business property is abandoned Capitalize amount paid to appraise non business property, deduct in year sold Appraisal costs of abandoned sale of non business asset must be capitalized and cannot be deducted 43 De Minimis Safe Harbor See explanation in connection with De minimis safe harbors are explained at: 1.263(a) 1(f)(1)(i) $5,000 for taxpayer with an applicable financial statement 1.263(a) 1(f)(1)(ii) $500 for taxpayer without an applicable financial statement 1.263(a) 1(f)(4) defines an applicable financial statement as a certified audited statement or by conditions that would require such a statement 44 Page 22

25 De Minimis Safe Harbor Election 1.263(a) 1(f)(5) Make the election by attaching a statement to timely filed, original federal tax return for the taxable year in which the amounts are paid. Election must be titled Section 1.263(a) 1(f) de minimis safe harbor election and include: Taxpayer name, address, and TIN, and Statement that the taxpayer is making the de minimis safe harbor election under Reg. Sec (a) 1(f) Cannot make election on amended return, nor revoke an election 45 De Minimis Safe Harbor Anti Abuse Rule 1.263(a) 1(f)(6) If a taxpayer attempts to manipulate transactions to achieve a tax benefit or avoid limitations, appropriate adjustments will be made Componentizing invoices to treat property that, if treated as a single unit of property would exceed the de minimis limitation 46 Page 23

26 De Minimis Safe Harbor: Examples 1.263(a) 1(f)(7) No Applicable Financial Statement 10 $200 ea.... Deduct 10 $600 ea.... Capitalize Applicable Financial Statement 1,250 $5,000 ea.... Deduct 800 elliptical $6,000 ea.... Capitalize Additional invoice costs... Must be added Non invoice facilitative costs... Not required to be added to cost of tangible personal property 47 De Minimis Safe Harbor: Examples 1.263(a) 1(f)(7) Materials and supplies... May be deducted under either or the de minimis rule Coordination with 263A... Items of materials and supplies, or that are otherwise deductible under a de minimis rule, must be capitalized under IRC Sec. 263A if a direct or allocable costs of production De minimis safe harbor is an ANNUAL election, not a method of accounting 48 Page 24

27 Sec (a) 2 Payments to Acquire or Produce Tangible Property Overview... 2provides rules for applying 263(a) to amounts paid to acquire or produce a unit of real or personal property (b)... definitions (c)... rules for coordinating with other provisions of the code (d)... general requirement to capitalize amounts paid to acquire or produce a unit of property (f)... rules for capitalizing transaction costs related to acquisition of property (g)... de minimis rule (a) 2 Definitions Amount paid... Amount paid or liability incurred by taxpayer using the accrual method of accounting Personal property... Tangible personal property as defined in (c) Real property... Land and improvements thereto Buildings or other inherently permanent structures (including structural components of the buildings or structures) Not personal property Tangible property under (d) Local law does not define real property Produce... Construct, build, install, manufacture, develop, create, raise, or grow [See 1.263A 2(a)(1)(i)] 50 Page 25

28 1.263(a) 2 Coordination with Other Provisions of Code In general... Nothing in 1.263(a) 2 changes the treatment of any amount specifically dealt with in the Code other than in 162(a) and 212 and their regulations Materials and supplies... Nothing in 1.263(a) 2 changes the treatment of amounts paid to acquire or produce property properly treated as materials and supplies under (a) 2 When to Capitalize Acquisition or Production Cost Requirement to capitalize... Except as provided in a de minimis rule, and in (relating to materials and supplies) a taxpayer must capitalize amounts paid to acquire or produce a unit of real or personal property (as determined under 1.263(a) 3(e), including: Leasehold improvements Land and land improvements Buildings Machinery and equipment amounts paid includes invoice price, transaction costs, and costs incurred prior to property placed in service 52 Page 26

29 1.263(a) 2 When to Capitalize Acquisition or Production Cost Examples capitalize...? New Cash Registers yes Stock of aircraft parts to be used for maintenance & repair no? Small items held for rent and held for replacement maybe! Jigs, dies, molds and patterns yes Acquisition of land and/or building (costs to facilitate) yes Acquisition of property for resale yes Production of building (See 263A for cost to capitalize) yes Section 1060 acquisition (capitalize FMV of tangible assets) Work prior to placed in service yes Testing prior to placed in service yes... After no (a) 2 When to Capitalize Payments for Defense of Title In general... Amounts paid to defend against taking, or perfect title to (as opposed to resist restriction on use of), real or personal property are considered paid to acquire or produce the property and must be capitalized Examples... Attorney fees paid to: Contest condemnation capitalize Invalidate ordinance deduct Challenge building line capitalize 54 Page 27

30 1.263(a) 2 Transaction Costs to Facilitate Acquisition or Production In general... Except as provided by a de minimis rule, costs to facilitate acquisition or production of real or personal property must be capitalized See 263A for rules relating to property produced by taxpayer See 1.263(a) 5 for rules relating to amounts paid to facilitate acquisition of assets constituting a trade or business See 1.167(a) 5 for allocation of facilitative costs between depreciable and non depreciable property Paid to facilitate an acquisition... Paid in process of investigating or otherwise pursuing an acquisition (a) 2 Transaction Costs to Facilitate Acquisition or Production Inherently facilitative costs include... Transporting property Appraisals and value determinations Negotiating terms and obtaining tax advice on acquisition Application fees, bidding costs, etc. Preparing and reviewing sales contract, etc. Examining and evaluating title to property Obtaining regulatory approval, costs of permits and fees Conveyance costs; transfer taxes and title registration Finders fee or brokers commission including contingencies Various inspection services performed before closing Services provided by Q I to facilitate 1031 exchange 56 Page 28

31 1.263(a) 2 Transaction Costs to Facilitate Acquisition or Production Special rules for acquisition of real property Cost is not facilitative if related to determining whether to acquire real property and which real property to acquire Use reasonable allocation method for costs incurred to acquire real and personal property in a single transaction Except as required by 263A, employee compensation and overhead are not required to be capitalized Taxpayer may elect to capitalize amounts otherwise deductible All facilitative costs are required to be capitalized (a) 2 Transaction Costs to Facilitate Acquisition or Production Examples... Broker s fees to facilitate acquisition capitalize Inspection and survey costs capitalize Moving costs to facilitate acquisition capitalize Fee to interior designer capitalize Architect's fees to evaluate alternative sites capitalize Fees for building plan capitalize as building cost, not land Fees to development consultant not capitalized Costs of tangible personal property purchasing function not capitalized 58 Page 29

32 1.263(a) 2 Recovery of Capital Expenditures Amounts required to be capitalized by this section are capital expenditures, to be recovered by a charge to the basis of capital assets or inclusion in inventory costs Such amounts are recovered through depreciation, cost of goods sold or an adjustment to basis when property is placed in service, sold, used, or otherwise disposed of 2 examples New refrigerator in apartment capitalize and depreciate Tractor/loader to move materials in manufacturing plant capitalize. Depreciation will be a cost of goods manufactured to be recovered through cost of goods sold (a) 2 Changes In Methods of Accounting Accounting method change to comply with this section requires application for change under current administrative procedures Revenue Procedures permit automatic changes of accounting methods to comply with these new rules 60 Page 30

33 1.263(a) 3 Payments to Improve Property Overview... 3provides rules for applying 263(a) to amounts paid to improve tangible property (b)... definitions (d)... requirement to capitalize amounts paid to improve property and tests to determine whether property is improved (e)... rules to determine appropriate unit of property (f)... Rules for determining improvement costs in particular contexts (a) 3 Overview (continued) (g)... Safe harbor for routine maintenance costs (h)... Rules to determine betterment (i)... Rules to determine restoration (j)... Rules to determine adaptation new or different use (k)... Optional regulatory accounting method (l)... Repair allowance or other methods of accounting identified in published guidance 62 Page 31

34 1.263(a) 3 Definitions Amount paid... Includes a liability incurred by an accrual basis taxpayer Personal property... Tangible personal property as defined in (c) Real property... Land and improvements, buildings and other inherently permanent structures (including their structural components). Also includes other tangible property under (d). Local law does not control. Owner... Taxpayer that has benefits and burdens of ownership for federal income tax purposes (a) 3 Coordination With Other Code Provisions In general... Nothing in this section changes treatment of any amount specifically provided for under any other provision of the Code or regulations other than 162(a) and 212 and their regulations Materials and supplies... A material or supply [as defined in (c)(1)], used to improve a unit of tangible property is subject to capitalization and not treated as a material or supply De minimis exception... Taxpayer may be required to capitalize amounts otherwise deductible under the de minimis rule of 1.263(a) 1(f) if used to improve a unit of tangible property 64 Page 32

35 1.263(a) 3 Amounts Paid to Improve Property Taxpayer must generally capitalize aggregate of amounts paid to improve a unit of property. Unit of property is improved if amounts paid for work done after property is placed in service: Result in a betterment of the unit of property Restore the unit of property Adapt the unit of property to a new or different use Note that amounts paid for repairs and routine maintenance continue to be deductible. It is the distinction between repair, betterment, restoration, and adaptation that will continue to be troublesome (a) 3 Appropriate Unit of Property Determining the unit of property is the first step in analyzing and classifying expenditure related to property Building structure... a building and its structural components (watch the definition) are a single unit of property. An amount is paid for an improvement to a building if it improves Building structure and/or its structural components [1.48 1(e)(2)] Building systems... These structural components are identified as separate from the building structure for the purpose of determining unit of property as required by these rules HVAC systems Plumbing systems Electrical systems 66 Page 33

36 1.263(a) 3 Appropriate Unit of Property (continued) Escalators Elevators Fire protection and alarm systems Security systems Gas distribution system Other structural components identified in published guidance may be excepted from the building structure and are specifically designated as building systems Condominium... Unit of property is individual unit owned by the taxpayer and its structural components [1.48 1(e)(2)] Amount paid for improvement to a condominium is not deductible if it results in a betterment, restoration, or adaptation Condominium Association must apply the improvement rules to the building structure or any building system (a) 3 Appropriate Unit of Property (continued) Cooperative... Unit of property is that portion of the building in which taxpayer has possessory rights and structural components that are part of that portion Amount paid for improvement to a cooperative unit is not deductible if it results in a betterment, restoration, or adaptation Cooperative housing corporation must apply the improvement rules to the building structure or any building system Leased building... Unit of property is that portion of a building subject to the lease and structural components associated with the leased portion Amount paid for improvement to leased premises is not deductible if it results in a betterment, restoration, or adaptation to entire building or the leased portion 68 Page 34

37 1.263(a) 3 Appropriate Unit of Property (continued) Property other than building... All the components that are functionally interdependent make up a single unit of property. Plant property... Functionally interdependent machinery or equipment, other than network assets, performing industrial process manufacturing, generation, warehousing, distribution, automated materials handling, etc. unit of property for plant property... Determined under the general rule but further divided into smaller units of each component (or group of components) that perform separate and major function or operation Network assets... Railroad track, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines. Unit of property determined by each taxpayer s facts and circumstances (a) 3 Appropriate Unit of Property (continued) Leased property other than buildings... Unit of property determined under general rules of this section but may not be larger than unit of leased property Improvement... except for lessee improvement, cannot be unit of property separate from property improved Additional rules... Year placed in service... Component may be treated as separate unit of property if properly in a different class Change in subsequent taxable year... If taxpayer or IRS changes the treatment of property in a subsequent year, then reclassified portion must be treated as a separate asset 70 Page 35

38 1.263(a) 3 Appropriate Unit of Property (continued) Examples... Replacement of roof mounted HVAC units capitalize Work on elevators capitalize if improvement Work on plumbing system capitalize if improvement Power plant boiler, generator, and turbine are separate systems Laundry sorter, boiler, washer, dryer, etc. are separate systems Complex tortilla making machine in restaurant is discrete system Locomotive is single unit of property because its systems are functionally interdependent Computer and printer are not functionally interdependent (a) 3 Appropriate Unit of Property (continued) Lease of entire building requires separate consideration of building structure and building systems, such as HVAC Driveway constructed by lessee, using construction allowance from lessor, is a separate unit of property Lessee responsible for maintenance of building systems must capitalize any improvements Expanding size of warehouse is capitalizable Semi truck tractor, including its tires, is single unit of property Leasehold improvement is separate unit of property from building in which it was constructed 72 Page 36

39 1.263(a) 3 Appropriate Unit of Property (continued) Change in classification based on cost segregation study requires parking lot to be treated as separate asset from associated building Change in classification of previously segregated cost to structural component of building requires change in depreciation method (a) 3 Improvement Costs Improvements to leased property generally follow same rules as improvements to property owned by taxpayer. Capitalize improvements, betterments, and adaptations, while deducting repairs and routine maintenance. Amount capitalized by lessee is separate unit of property Amount capitalized by lessor is not separate unit of property Landlord must capitalize a construction allowance...! Compliance with regulatory requirements is not relevant in determining whether cost improves unit of property Individual residence is not subject to these rules Related amounts must be aggregated even though incurred in different years 74 Page 37

40 1.263(a) 3 Improvement Costs In general, removal costs are deductible An exception is imposed where removal is not a disposition for federal tax purposes Examples include: Lease of entire building requires lessee to treat leased building and its structural components as separate units of property Extension of HVAC system into a building extension, by a lessee, involves capitalization of both HVAC system and building extension costs (a) 3 Improvement Costs Improvement paid for with construction allowance from lessor, is capitalized by the lessor Lessee may not capitalize building costs paid for with construction allowance from lessor, but may capitalize as separate asset any portion of costs paid with its own funds 76 Page 38

41 1.263(a) 3 Removal Costs Treatment of removal costs depends on prior classification of the asset or component and whether removal costs directly benefit, or are incurred by reason of, a repair or improvement to the unit of property (capitalization may be required under some other code section... e.g. 263A or 280B Amount paid to remove columns and girders to improve building may be partial disposition of building and therefore deductible... Not so if not a disposition (a) 3 Removal Costs Replacement of old with new shingles... Disposal of old shingles is not a disposition... Replacement of shingles is not a betterment or restoration of the building structure.. Cost of removing old shingles is part of deductible repair costs Replacement of old with new shingles... Taxpayer elects to treat disposal of shingles as a partial disposition of the building... Deduct cost of removing old shingles regardless of their relation to the improvement 78 Page 39

42 Safe Harbor for Small Taxpayers Taxpayer with average annual gross receipts for 3 preceding years not exceeding $10 million may deduct repairs, maintenance, and improvements to a building structure or building system if total building cost is less than $1 million, and amount paid during the year does not exceed the lesser of: 2% of the unadjusted (undepreciated) basis of the building structure or building system, or $10,000 Includes amounts deducted under other de minimis or safe harbor rules Applied building by building 79 Safe Harbor: Election Attach statement to timely filed (including extensions) original federal tax return for the taxable year in which such amounts are paid for repairs, maintenance, improvements, etc. that qualify for the safe harbor Statement must be titled Section 1.263(a) 3(h) Safe Harbor Election for Small Taxpayers and include: Taxpayer s name, address, and TIN A description of each eligible building property to which the taxpayer is applying the election Election is made at entity level and is irrevocable 80 Page 40

43 Safe Harbor Amounts The unadjusted basis of a leased building is the total rent payable over the lease term, plus likely renewal periods (e.g. 12 X $4,000 X 20 = $960,000) Amounts to which this safe harbor election is applied are not treated as improvements and may be deducted If the total of amounts paid with respect to an eligible building property exceeds the safe harbor threshold, the safe harbor election is not available for that property for that taxable year (a) 3 Routine Maintenance Costs Buildings Routine maintenance for a building unit of property or a building system is the recurring activities a taxpayer performs as a result of using the property, including: Inspection, cleaning, and testing Replacement of worn or damaged parts (with comparable commercially available replacements!) Expected to be performed more than once in the 10 year period beginning with building placed in service, or otherwise substantiate maintenance schedule 82 Page 41

44 1.263(a) 3 Routine Maintenance Costs Other In general... An amount paid for routine maintenance on a unit of property other than a building or structural component of the building is deemed not to improve that unit of property. Routine maintenance includes: Inspection, cleaning, and testing Replacement of parts with comparable, commercially available, and reasonable replacements Activities reasonably expected to be required more than once during the asset s class life Consider recurring nature of activity, industry practice, maker s recommendations, and taxpayer s experience 83 Examples (a) 3 Routine Maintenance Costs Routine maintenance of aircraft engine during its class life** is deductible (engine is not separate unit of property) Same maintenance after engine s class life is also deductible because it does not improve the aircraft Routine maintenance relating to prior owners use capitalize Routine maintenance new owners use deduct Routine maintenance scheduled replacement of substantial structural part coordinate with IRC Sec. 263A ** Class Life... See Rev. Proc or IRS Pub. 946, Appendix B 84 Page 42

45 1.263(a) 3 Routine Maintenance Costs Routine maintenance (reconditioning) performed only once during asset s class life... Capitalize Routine maintenance based on reasonable expectation of frequency may be an exception to the above rule if the expectation was that reconditioning would be required more than once during the asset s class life Scheduled preventive maintenance on towboat engines not required to be capitalized (Ingram Industries, T.C. Memo ; 10/18/2000) Unrelated improvements (other equipment) during routine maintenance on towboat engines must be capitalized (a) 3 Routine Maintenance Costs Routine maintenance not performed on schedule, allowing asset to fall into state of disrepair, not deductible Replacement of rubber handrails on some escalators after 4 years of service is routine maintenance Replacement of escalator steps in year 9 (years ahead of anticipated replacement schedule) and not recurring activity taxpayer expects to perform more than one during the 10 year period beginning when escalators (building system) were placed in service must be capitalized Reasonably expected building maintenance is deductible 86 Page 43

46 1.263(a) 3 Betterments In general... Taxpayer must capitalize amounts paid that result in betterment of a unit of property. A betterment: Corrects a material condition or defect regardless of when discovered by the taxpayer, Results in a material addition (physical enlargement, expansion, or extension) to a unit of property, or Results in a material increase in capacity (additional space), productivity, efficiency, strength, or quality of the unit of property or its output A building is made better by improvements and/or expansion of square footage (a) 3 Betterments Facts and circumstances... Consider all facts and circumstances including, but not limited to, purpose of the expenditure, physical nature of the work performed, effect of the expenditure on the unit of property Replacement with improved, but comparable part is not necessarily a betterment When particular event necessitates an expenditure determine whether a betterment is made by comparing condition of property immediately after expenditure with its condition immediately before the event necessitating the expenditure 88 Page 44

47 1.263(a) 3 Betterments Expenditure made to correct effects of normal wear and tear to the unit of property must be judged based on condition of the property after last correction of effects of normal wear and tear Condition of property requiring expenditure made as result of a particular event, is condition immediately before the event Examples Correcting pre existing soil contamination is a betterment Amount paid to remove and replace asbestos insulation is not a betterment (???) [See Norwest Corporation; 108 T.C. 265, CAPITALIZE and Cinergy Corp, Ct Fd Clms; T; 3/11/2003, DEDUCT] (a) 3 Betterments Amount paid for routine maintenance soon after purchase of used machine is a betterment Amount paid for special maintenance after purchase of used ice resurfacing machine is not a betterment due to purpose and minor nature of work performed Maintenance following acquisition of substandard building is betterment National retailer incurs costs to refresh retail locations. Costs are capitalized and amortized over five year period for financial statement purposes, and must be capitalized for tax purposes as well even though they might otherwise be deductible 90 Page 45

48 1.263(a) 3 Betterments Routine maintenance costs in building refreshment are deductible, replacement of plumbing fixtures is not. Substantial remodel costs must be capitalized as betterment Costs to move and reinstall cash registers when relocating retail store do not result in betterment Costs to relocate and reconfigure manufacturing equipment to expanded portion of factory are betterment Building owner replaces architectural elements otherwise in good condition to comply with city ordinance. Replacement elements materially increase structural soundness of the building and are betterments (a) 3 Betterments Taxpayer covers old roof membrane with new membrane of comparable quality to old membrane when it was placed in service... Not a betterment Amounts paid to replace columns and girders in factory building to expand storage space are a betterment Amounts paid to dredge a ship channel or otherwise to increase capacity must be capitalized as betterment Amounts paid to dredge same ship channel one year later due to siltation are deductible. Not a betterment Amount paid to remove drop ceiling not a betterment. Did not increase capacity, productivity, efficiency, strength, or quality of the building structure 92 Page 46

49 1.263(a) 3 Betterments Adding stairway and mezzanine within existing building is a betterment Two of ten roof mounted HVAC units are replaced after many years of service with comparable units... Not a betterment Amount paid to add insulation to building must be capitalized because it will materially increase the efficiency of the building Adding drive through window to restaurant = betterment All costs related to electrical upgrade, including patching holes caused by work and painting must be capitalized (a) 3 Restorations In general... Amounts paid to restore a unit of property, including making good the exhaustion for which an allowance is or has been made, must be capitalized if they exceed the safe harbor for repairs. An amount is paid to restore a unit of property only if it: Replaces a component of a unit of property for which the taxpayer has properly claimed a deduction, Replaces a component of a unit of property for which the taxpayer has taken the adjusted basis of the component into account in realizing gain or loss Is for repair of damage to the unit of property for which taxpayer has properly taken a basis adjustment for a casualty loss under Page 47

50 1.263(a) 3 Restorations Returns a deteriorated unit of property, no longer functional for its intended use, to its ordinarily efficient operating condition Results in rebuilding the unit of property to like new condition after the end of its class life Is for replacement of a part or combination of parts comprising a major component or substantial structural part of the unit of property An amount is paid to restore a building if it restores the building structure or any building system A unit of property is rebuilt to like new condition if it is brought to status of new, rebuilt, remanufactured or similar status under any federal guideline or manufacturer s original specifications Consider facts and circumstances to determine replacement of major component or substantial structural part (a) 3 Restorations Examples... Major points illustrated: Replacement of components abandoned, sold, lost in casualty is restoration and must be capitalized Restoration of property in state of disrepair must be capitalized Rebuild to like new condition before the end of class life is deductible, rebuild after the end of class life is not Replacement of major component or substantial structural part is a restoration, concurrent minor repairs are not Major expenses incurred to comply with state or federal regulations are required to be capitalized even though incurred in different years w/payments to multiple vendors 96 Page 48

51 1.263(a) 3 Restorations Replacement of broken part to keep machine functioning is not a restoration Roof replacement or major repair must be capitalized as restoration while simply replacing roof membrane is not Replacing components such as furnace or chiller is capitalized Replacing lesser components, such as individually mounted roof AC units, is not (a) 3 Restorations New sprinkler system is a restoration Replacing wiring to meet code requirements is a restoration Replacing plumbing fixtures in 20 restrooms is a restoration Replacing only cracked fixtures is not Phased renovation of hotel rooms over two years is restoration Replacing all windows is restoration, few windows is not Replacing complete floor is restoration, patching floor is not 98 Page 49

52 1.263(a) 3 Restorations Heavy maintenance on aircraft airframe, every 8 10 years is not a restoration, but is routine maintenance, subject to safe harbor and other rules New tank on petroleum tank truck is a restoration and must be capitalized Ordinary repairs, performed during restoration, are deductible (requires cost accounting system!) Replacement with no disposition election under Prop. Reg (i) 8(d)(2), do not deduct cost of replaced part and do deduct expenditure to restore Replacement when taxpayer makes partial disposition election permitted by Prop. Reg (i) 8(d)(2), deduct cost of replaced part and capitalize new part (a) 3 Adaptation to New or Different Use In general... Capitalize amounts paid to adapt a unit of property to a new or different use Building... Adapts to a new or different use building structure or any building system Four examples Manufacturing building into showroom is adaptation Moving interior partitions is not adaptation Refreshing paint and floors in anticipation of sale is not adaptation Costs incurred in environmental cleanup are not adaptation, but regrading site for residential development is More examples 100 Page 50

53 1.263(a) 3 Optional Regulatory Accounting Method In general... Taxpayer engaged in regulated industry may use the regulatory accounting method for repairs, maintenance, and improvements required by: Federal Energy Regulatory Commission Federal Communications Commission Surface Transportation Board Four examples restate above points (a) 3 Repair Allowance Or Other Allowable Methods Taxpayer may use a repair allowance method or any other method authorized in Federal Register or Internal Revenue Bulletin Amounts required to be capitalized under this section are capital expenditures Amounts capitalized under this section are recovered through depreciation, cost of goods sold, or adjustment to basis when property is disposed of Taxpayers may change their method of accounting to use the repair allowance method by following administrative procedures to request such a change Effective on or after 1/1/ Page 51

54 1.263(a) 3 Other Taxpayer may elect to capitalize amounts paid for repair and maintenance during the year by making an irrevocable election, similar to others described in this program for the taxable year in which the amounts are paid IF taxpayer also capitalizes such amounts in its books and records normally used to compute income. A taxpayer may choose to apply all these regulations to its first tax year beginning after 1/1/2012, but must apply them after 1/1/ A 1 Uniform Capitalization of Costs No changes to (a) through (b)(13)... New paragraphs define or explain following terms: (a)(14) A does not apply to cost of property to which taxpayer properly applies de minimis rule (c)(4)... Except for amounts paid to produce incidental materials and supplies, 263A costs are recovered through depreciation, amortization, COGS, or basis adjustment when property is used, placed in service, or disposed of (e)(2)(i)(a)... A cost described in , relating to a material or supply, may be a 263A direct material cost 104 Page 52

55 1.263A 1 Uniform Capitalization of Costs (continued) (e)(2)(i)(e)... A cost described in , relating to a material or supply, may be a 263A indirect material cost (e)(2)(ii)(f)(l)... A change in treatment of costs subject to de minimis rule is a change in method of accounting Changes listed above are optional in tax years beginning after 1/1/2012 and required after 1/1/2014 Certain changes, not part of these temporary regulations apply to taxable years ending on or after 8/2/2005 (h)(2)(i)(d) re: self constructed assets (k) re: Change in method of accounting Exhaustion, wear and tear, obsolescence, amortization, and depletion for periods since February 13, 1913 (a)(1)(ii)... Determination of amount properly allowable as deduction must be made based on facts reasonably known to exist at end of taxable year. (j)(1)... Except as provided in (j)(2) or (j)(3) this section applies on or after December 30, 2003 (j)(3)... (a)(1)(ii) applies to taxable years beginning on or after 1/1/2012 Provision expires on 12/23/ Page 53

56 IRS Officials Public Comments IRS public comments acknowledge need to apply facts and circumstances analysis to all capitalization questions and: IRS will work with industry to resolve issues Several Issue Resolution Papers already in the works Rules will be developed based on actual experience, and may change We should use common sense????? 107 IRS Officials Public Comments Application of new rules will require a fair amount of judgment by taxpayers... Disposition of a structural component... allow(s) for a loss... upon disposition... Under new rules, if roof is replaced the new roof is capitalized, and the old roof would be eligible for a loss under the disposition rules 108 Page 54

57 Thank You! (c) Nichols Patrick CPE Page 55

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59 60TH ANNUAL MNCPA TAX CONFERENCE November 17-18, 2014 Minneapolis Convention Center, Minneapolis, MN Please rate the following using the scale below: 5=Excellent, 4=Very Good, 3=Average, 2=Fair, 1=Poor D3. Out of Chaos: The Repair Regulations One Year Later Excellent Poor Relevancy of Topic Stated Objectives Met Overall Satisfaction E. Lynn Nichols, CPA Knowledge of Subject Presentation Skills Quality of Materials Engagement of Participants Do you have any additional feedback regarding the instructor and/or materials? If so, please share it with us. What would you like to learn at the 2015 conference? Who would you like to hear speak at the 2015 conference? Thank you for your feedback and suggestions. We appreciate your input. Minnesota Society of Certified Public Accountants