THE NEW RULES EXPENSE OR CAPITALIZE? Tuesday, January 17, 2012 4600 West 77 th Street Suite 350 Minneapolis, MN 55435 Office (952) 831-6300 Toll Free (888) 245-5613
TODAY S OBJECTIVES A 12,000 foot review of the new temporary regulations (TD 9564) that were issued to provide guidance regarding deduction and capitalization of expenditures related to tangible property To identify the opportunities within the new temporary regulations Discuss how the old rules have changed where applicable To take a dent out of the 255 pages of new regulations! Questions & Answers (?) 2
AGENDA What We Will Cover Today Overview of the changes Cost to Maintain or Improve Tangible Property Unit of Property UOP Concepts Repair or Improvement Standards & Examples New Rules for Dispositions MACRS Accounting Determining Loss on the Disposition Transition Rules 3
WHAT IS INCLUDED IN THE NEW TEMPORARY REGULATIONS? They clarify and expand the standards in the current regulations under sections 162(a) and 263(a) and provide certain bright-line tests (for example, a de minimis rule for certain acquisitions) for applying these standards. They also provide guidance under section 168 regarding the accounting for, and dispositions of, property subject to section 168. They also amend the general asset account regulations. The temporary regulations will affect all taxpayers that acquire, produce, or improve tangible property. 4
TEMPORARY REGULATIONS The New Law They are effective on January 1, 2012. Unlike Proposed Regulations they are effective immediately and can be relied on for guidance. Subject to a three-year period and they are either then finalized or sunset. Practitioners and taxpayers have until April 4, 2012 to make comments on the temporary regulations. 5
CURRENT LAW Capitalization & Expense Rules Costs are currently deductible as a repair expense under Code 162 if they are incidental in nature, and neither materially add to the value of the property nor appreciably prolong its useful life. Conversely, expenses must be capitalized under Code 263 if they are for permanent improvements or betterments that increase the value of the property, restore its value or use, substantially prolong its useful life, or adapt it to a new or different use. Capitalization is the proper treatment for expenditures incurred in new construction. See 263(a) and 263A. Capitalization is also generally required for additions to existing buildings or for installations of material components to buildings or equipment. 6
THE NEW LAW Capitalization & Expense Rules Reason for the change - To achieve results more consistent with existing law and to provide relief from the potential inequities that can result from the application of the depreciation and disposition rules, the temporary regulations revise and amend the 2008 proposed regulations in several respects. First, the temporary regulations retain the rule from the 2008 proposed regulations that the unit of property for a building consists of the building and its structural components. The regulations revise the manner in which the improvement standards must be applied to the building and its structural components and, The regulations require a taxpayer to consider the effect of the expenditure on certain significant and specifically defined components of the building, rather than the building and its structural components as a whole. 7
THE NEW LAW Capitalization & Expense Rules (Continued) Second, the temporary regulations do not include the 50 percent thresholds and recovery period limitation for determining whether a replacement rises to the level of a major component or substantial structural part of a unit of property. Finally, the temporary regulations include new provisions under section 168 that expand the definition of dispositions to include the retirement of a structural component of a building. This change allows a taxpayer to recognize a loss on the disposition of a structural component of a building before the disposition of the entire building, so that a taxpayer will not have to continue to depreciate amounts allocable to structural components that are no longer in service. Thus, under the temporary regulations, a taxpayer is not required to capitalize and depreciate simultaneously amounts paid for both the removed and the replacement properties. 8
UNIT OF PROPERTY (UOP) Extremely Important Concept Expanded Upon in the Temporary Regulations! Buildings Single UOP Systems Everything Else (Non-Building) Default Rule - Functional Interdependence Plant Property - Discrete & Major Function Network Assets Facts & Circumstances & Industry Specific 9
BUILDING (UOP) Building Structure- 9 Systems 1. HVAC 2. Plumbing 3. Electrical 4. Escalators 5. Elevators 6. Fire Protection 7. Security 8. Gas 9. Other systems identified in published guidance 10
WHY IS THE UOP IMPORTANT? Any discussion for repair treatment is in part determined by what the UOP is. The UOP determines what can be pulled out for determining the loss on disposition. The UOP does not affect or determine the depreciable recovery period. Applies to both real estate and personal property. Get to know and understand these concepts! 11
Example 1- Building Systems: 1.263(a)-3T(e) Amounts paid to improve tangible property (temporary) Fact Pattern: Building systems. X owns an office building that contains a HVAC system that incorporates ten roof-mounted units that service different parts of the building. Project Work: The taxpayer pays an amount for labor and materials for work performed on the roof-top units. Result: Must treat the building and its structural components as a single unit of property The entire HVAC system, including all of the roof-mounted units and their components, comprise a building system. Therefore, under paragraph (e)(2)(ii) of this section, if an amount paid by X for work on the roof-mounted units results in an improvement (for example, a betterment) to the HVAC system, X must treat this amount as an improvement to the building. 12
REPAIR VS. IMPROVEMENT An Amount Paid Must Be Capitalized if it Results in a: Betterment 1. It ameliorates (fixes) a material condition or material defect that existed prior to the acquisition of the property or production 2. It results in a material addition to the unit of property (including a physical enlargement, expansion, or extension); or 3. Results in a material increase in the capacity, productivity, efficiency, strength, or quality of the unit of property or its output. Adapts the property to a new or different use 13
REPAIR VS. IMPROVEMENT (Continued) An Amount Paid Must Be Capitalized if it Results in a: Restoration (continued) 1. is for the replacement of a component of a unit of property and the taxpayer has properly deducted a loss for that component (other than a casualty loss under 1.165-7); 2. is for the replacement of a component of a unit of property and the taxpayer had properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component; 3. is for the repair of damage to a unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss under section 165, or relating to a casualty event described in section 165; 4. returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and was no longer functional for its intended use; 14
REPAIR VS. IMPROVEMENT (Continued) An Amount Paid Must Be Capitalized if it Results in a: Restoration (continued) 5. results in the rebuilding of the unit of property to a like-new condition after the end of its economic useful life; 6. is for the replacement of a major component or a substantial structural part of the unit of property. Plan of rehabilitation doctrine - No Longer Applicable Just because you are in the process of making substantial improvements does not mean that everything has to be capitalized. 15
Example 6- Not a betterment- building refresh: 1.263(a)- 3T(h) Amounts paid to improve tangible property (temporary) Fact Pattern: X owns a nationwide chain of retail stores that sell a wide variety of items. To remain competitive in the industry and increase customer traffic and sales volume, X periodically refreshes the appearance and layout of its stores. Project Description: The work that X performs to refresh a store consists of cosmetic and layout changes to the store s interiors and general repairs and maintenance to the store building to make the stores more attractive and the merchandise more accessible to customers. Work Performed: The replacing and reconfiguring a small number of display tables and racks to provide better exposure of the merchandise, Making corresponding lighting relocations and flooring repairs, Moving one wall to accommodate the reconfiguration of tables and racks, Patching holes in walls, Repainting the interior structure with a new color scheme to coordinate with new signage, Replacing damaged ceiling tiles, Cleaning and repairing vinyl flooring throughout the store building, Power washing building exteriors. 16
Example 6- Not a betterment- building refresh (Continued) Result: The amounts paid for the refresh of each building do not result in material increases in capacity, productivity, efficiency, strength, or quality of the buildings structures or any building systems as compared to the condition of the buildings structures and systems after the previous refresh. Rather, the work performed keeps X s store buildings structures and buildings systems in the ordinary efficient operating condition that is necessary for X to continue to attract customers to its stores. Therefore, X is not required to treat the amounts paid for the refresh of its store buildings structures and buildings systems as betterments under paragraph (h)(1)(iii) of this section. However, X is required to capitalize the amounts paid to acquire and install each section 1245 property in accordance with 1.263(a)-2T(d)(1). 17
Example 7- Building refresh- limited improvement: 1.263(a)- 3T(h) Amounts paid to improve tangible property (temporary) Fact Pattern: X owns a nationwide chain of retail stores that sell a wide variety of items. To remain competitive in the industry and increase customer traffic and sales volume, X periodically refreshes the appearance and layout of its stores. Project Description: In addition to the work in Example 6, X pays amounts to remove and replace the bathroom fixtures (that is, the toilets, sinks, and plumbing fixtures) with upgraded bathroom fixtures in all of the restrooms in X s retail buildings in order to update the restroom facilities. Result: Therefore, in accordance with paragraph (e)(2)(ii) of this section, X must treat the amounts paid for a betterment to each plumbing system as an improvement to X s retail building to which the costs relate, and must capitalize the amounts under paragraph (d)(1) of this section. However, X is not required under paragraph (f)(3) of this section to capitalize the costs described in Example 6 to refresh the appearance and layout of its stores because those costs do not directly benefit and are not incurred by reason of the improvements to the stores plumbing systems. 18
Example 13- Not a betterment- replacement with same part: 1.263(a)-3T(h) Amounts paid to improve tangible property (temporary) Fact Pattern: X owns a small retail shop. A storm damages the roof by displacing numerous wooden shingles. Project Work: The taxpayer pays a contractor to replace all the wooden shingles on the roof with new wooden shingles. Result: The roof is part of the building structure The event necessitating the expenditure was a storm and prior to the storm the building structure was functioning for its intended use. X is not required to treat the amount paid to replace the shingles as a betterment under paragraph (h) of this section because it does not result in a material addition, or material increase in the capacity, productivity, efficiency, strength, or quality of the building structure or the output of the building structure compared to the condition of the building structure prior to the storm. 19
Example 14- Not a betterment- replacement with comparable part: 1.263(a)-3T(h) Amounts paid to improve tangible property (temporary) Fact Pattern: Same as Example 13 but the taxpayer cannot find comparable wood Result: shingles and replaces them with a comparable asphalt shingle. The amount that X pays to re-shingle the roof with asphalt shingles does not result in a betterment to the shop building structure, even though the asphalt shingles may be stronger than the wooden shingles. Because the wooden shingles could not practicably be replaced with new wooden shingles, the replacement of the old shingles with comparable asphalt shingles does not, by itself, result in a betterment, and therefore, an improvement, to the shop building structure under this paragraph (h). 20
Example 15- Betterment- replacement with improved parts: 1.263(a)-3T(h) Amounts paid to improve tangible property (temporary) Fact Pattern: Same as Example 13 but the taxpayer cannot find comparable wood shingles and replaces them with upgraded shingles made of lightweight composite materials that are maintenance-free and do not absorb moisture. Result: The amount paid for these shingles results in a betterment to the shop building structure under paragraphs (h)(1)(iii) and (h)(3)(iii) of this section because it results in a material increase in the quality of the shop building structure as compared to the condition of the shop building structure prior to the storm. Therefore, in accordance with paragraph (e)(2)(ii), X must treat the amount paid for the betterment of the building structure as an improvement to the building and must capitalize the amount paid under paragraph (d)(1) of this section. 21
Example 12- Replacement of a major component or substantial structural part; roof: 1.263(a)-3T(i) Amounts paid to improve tangible property (temporary) Fact Pattern: X owns a large retail store. X discovers a leak in the roof of the store and hires a contractor to inspect and fix the roof. The contractor discovers that a major portion of the sheathing and rafters has rotted, and recommends the replacement of the entire roof. Project Work: The taxpayer pays a contractor to replace the entire roof with a new roof. Result: The roof is part of the building structure Under paragraph (i)(1)(vi) of this section, X must treat the amount paid to replace the roof as a restoration because X paid the amount to replace a major component or substantial structural part of X s building structure. 22
ACCOUNTING FOR MACRS PROPERTY Single Asset Account (SAA s) Default Rule A single computer Multiple Asset Account (MAA s) Default Rule Ten computers General Asset Account (GAA s) Must be elected (at the top of Form 4562) 23
ACCOUNTING FOR MACRS PROPERTY (Continued) General Asset Account (GAA s) Same depreciation method (can t combine bonus with nonbonus) Same recovery period- 5-year, etc. Same convention HY, MQ, etc. Placed in service in the same year 24
DISPOSITIONS OF MACRS PROPERTY GENERAL RULES For all three accounts (SAA, MAA & GAA) defined as: A transfer of ownership of the asset or the permanent withdrawal of an asset from the trade or business. A disposition includes: Sale or exchange Retirement Physical abandonment Destruction of the asset Transfer to supplies, scrap or a similar account Retirement of a structural component of a building (NEW) Involuntary conversion 25
DISPOSITIONS OF STRUCTURAL COMPONENTS The ACRS proposed regulations (which have generally applied to MACRS property) provided that a disposition does not include a retirement of a structural component of a building. The new temporary regulations take an approach to achieve results more consistent with existing case law and to avoid the potential inequities resulting from the depreciation and disposition rules. How many roofs are you depreciating? The new rule- replace a roof, deduct a roof The new loss deduction generally is now mandatory May choose not to recognize a loss with the election of GAA 26
DETERMINING YOUR BASIS AND LOSS DEDUCTION FROM RETIRING A STRUCTURAL COMPONENT Specific Identification Cost Segregation Study Results The IRS and the Treasury Department recognize that it may be impracticable for a taxpayer that accounts for assets in multiple asset accounts (MAA) to determine from the taxpayer s records the unadjusted depreciable basis of the asset disposed of Accordingly, the temporary regulations provide that the taxpayer may use any reasonable, consistent method to make that determination. Similar rules are provided if the asset disposed of is a component of a larger asset. 27
Example 1- Disposition 1.168(i)-8T(h) Dispositions of MACRS property (temporary) Fact Pattern: A owns an office building with four elevators. Project Description: One of the elevators is replaced. Results: The retirement of the replaced elevator, which is a structural component of the building, is a disposition. As a result, depreciation for the retired elevator ceases at the time of its retirement (taking into account the applicable convention). A recognizes a loss upon this retirement. 28
Example 5- Disposition 1.168(i)-8T(h)Dispositions of MACRS property (temporary) Fact Pattern: On July 1, 2009 a calendar year taxpayer, purchased and placed in service a multi-story office building that costs $20,000,000 Project Description: On June 30, 2012 the taxpayer replaces one of the building s elevators Results: Because D cannot identify the cost of the structural components of the office building from its records, D uses a reasonable method that is consistently applied to all of the structural components of the office building to determine the cost of the elevator. Using this reasonable method, D allocates $150,000 of the $20,000,000 purchase price for the building to the retired elevator. The retirement of the replaced elevator, which is a structural component of the building, is a disposition. Thus, the adjusted depreciable basis of the retired elevator is $138,619.50 and is removed from the building cost resulting in a Section 1231 loss 29
DETERMINING YOUR BASIS AND LOSS DEDUCTION FROM RETIRING A STRUCTURAL COMPONENT General Asset Accounts Old rule- a loss was generally not recognized until the last asset within the account was removed New rule: Defer the loss and not remove the disposed assets Identify the disposed asset and take the loss 30
Transition Rules & Observations The Temporary Regulations are generally effective for amounts paid or incurred in taxable years beginning on or after January 1, 2012 A Change to conform to these Temporary Regulations will be a change in the method of accounting for some of the sections and a 3115 will be required Do you need to do a 3115 if you had previously did a change for resulting from a past repair study? What if you had taken an aggressive approach and expensed repairs in the past that are now considered to be capitalized under the BAR tests? Does it make sense to consider making a GAA election for building components? Transition rules will be forthcoming! 31
Changes Not Addressed Today De minimis rules Leasehold improvements & leased buildings Moving & reinstallation costs Removal costs Safe harbor for routine maintenance- not applicable to buildings Work performed prior to placing property in service Transaction costs Network assets Additional rules for determining UOP s for property other than buildings Most of the examples included within the new temporary regulations 32
MATERIALS & SUPPLIES The temporary regulations generally retain the framework set forth in the 2008 proposed regulations for materials and supplies The 2008 proposed regulations defined materials and supplies as tangible property that is used or consumed in the taxpayer s operations that: Is not a unit of property or acquired as part of a single unit of property; Consists of fuel, lubricants, water, and similar items that are reasonable expected to be consumed in 12 months or less Is a unit of property that had an economic useful life of 12 months or less, beginning when the property was used or consumed; Is a unit of property that had an acquisition or production cost (as determined under section 263A) of $100 or less; or Is identified as a material and supply in future published guidance 33
MATERIALS & SUPPLIES The temporary regulations changes include: They modify and expand the definition of materials and supplies They provide an alternative optional method of accounting for rotable and temporary spare parts They provide an election to treat certain materials and supplies under the de minimis rule of 1.263(a)-2T In addition, consistent with the 2008 proposed regulations, the temporary regulations allow a taxpayer to elect to capitalize certain materials and supplies. 34
Rotable or Temporary Spare Parts The 2008 proposed regulations proposed to allow a deduction for amounts paid for rotable or temporary spare parts when the parts were discarded from the taxpayer s operations. Alternatively, a taxpayer could elect to capitalize and depreciate rotable spare parts over the parts applicable recovery period. The temporary regulations attempt to ease the administrative accounting burden and provides for an optional method This optional method may be used as an alternative to treating the parts as used or consumed in the year of disposition or electing to treat the parts as depreciable assets. If a taxpayer chooses to use the optional method, the method must be used for all of the taxpayer s rotable and temporary spare parts in the same trade or business. 35
CSA TEAM Rod Axtell CPA and Managing Partner (952) 831-6300 raxtell@csateam.com CSA TEAM Robert Lehmann Partner and Senior Vice President of Sales (612) 805-6648 rlehmann@csateam.com Paula Carlson Vice President Marketing (612) 803-9554 pcarlson@csateam.com Thomas Buettner Vice President Business Development (612) 281-0158 tbuettner@csateam.com 36
Additional Resources Q & A CSA Partner Resources: Techline Monthly Webinar Additional Resources www.csateam.com/partner-resources Log in Code CSAPR Prof. John J. John Connors, J.D., C.P.A., LL.M. Tax Educators Network (TEN) Inc www.taxesprof.com TaxesProf@msn.com (414) 339-6718 Rod Axtell at raxtell@csateam.com (888) 245-5613 Webinar handout e-mailed to you after the last question CSA. Helping you be your clients most trusted advisor. 37
THANK YOU 4600 West 77 th Street Suite 350 Minneapolis, MN 55435 Office (952) 831-6300 Toll Free (888) 245-5613