Chapter 4 Deduction v. Capitalization. Final & Prop. Regs.

Chapter 4 Deduction v. Capitalization Final & Prop. Regs. 1 IRC sec. 263(a) Reg. sec. 1.263(a)-1 Capital expenditures; in general. Reg. sec. 1.263(a)-2 Amounts paid to acquire or produce tangible property. 4-6 IRC sec. 162 Reg. sec. 1.263(a)-3 Amounts paid to improve tangible property. Reg. sec. 1.263(a)-6 Election to deduct or capitalize certain expenditures. Reg. sec. 1.162-3 Materials and supplies. Reg. sec 1.162-4 Repairs Reg. sec. 1.162-11 Rentals IRC sec. 165 Reg. sec. 1.165-2 Obsolescence of nondepreciable property. IRC sec. 167 IRC sec. 168 Reg. sec. 1.167(a)-4 Leased property Reg. sec. 1.167(a)-7 Accounting for depreciable property. Reg. sec. 1.167(a)-8 Retirements. Reg. sec. 1.168(i)-7 Accounting for MACRS property. IRC sec. 263A Reg. sec. 1.263A-1 Uniform capitalization of costs. IRC sec. 1016 Reg. sec. 1.1016-3 Exhaustion, wear and tear, obsolescence, amortization, and depletion for periods since February 28, 1913. 2

4-76 The final regs. are mandatory for TYB on or after January 1, 2014 but 3 4-76 Taxpayers can opt to apply the final regs. to TYB on or after January 1, 2012. 4

LB&I Directive 4-87 On Repair v. Capitalization Issues (March 22, 2013) 5 For taxable years beginning on or after January 1, 2012, and before the applicability dates provided in forthcoming [now published] final regulations (hereinafter, the Option Period ), taxpayers may choose to apply the temporary regulations 6

When you begin examining a return for a taxable year beginning on or after January 1, 2012, but before January 1, 2014, you should determine: 1. If the taxpayer has changed its method of accounting with respect to the Issues, with or without filing a Form 3115, Application for Change in Accounting Method; A. If yes, perform a risk assessment regarding the method change; B. If no, the Option Period is still open. Do not examine the issue. 7 When performing a risk assessment of the section 481(a) adjustment for the Issues, you should: 1. Consider if the adjustment properly accounts for amounts paid to acquire, produce, or improve tangible property that were computed under the taxpayer's prior method and previously deducted under section 162; 2. Determine if the section 481(a) adjustment(s) resulting from any prior year change was taken into account; and 3. Consider the accuracy of the section 481(a) adjustment. 8

Acquisition Costs 9 Acquisition Costs: 4-9 Inherently Facilitative Costs 10

Inherently Facilitative Costs: Transporting Appraisal fees Finders' fees or brokers' commissions Tax advice on acquisition Application, bidding Engineering, inspection, environmental services 11 Examining title Special rule for acquisitions of real property. 12

Abandoned Acquisitions: 4-11 Except for contingency fees, inherently facilitative costs capitalized to properties NOT Acquired can be treated as business losses 4-13 13 Example 9 Contin. Fees K owns several restaurant properties. 4-13 K decides to open a new restaurant in City X. In October, Year 1, K hires a real estate consultant to identify potential property upon which K may locate its restaurant, and is obligated to compensate the consultant upon the acquisition of property. 14

4-13 The real estate consultant identifies three properties, and K decides to acquire one of those properties. Upon closing of the acquisition of that property, K pays the consultant its fee. 15 The amount paid to the consultant constitutes a contingency fee because the payment is contingent on the successful closing of the acquisition of property. 4-13 Accordingly, K must include the amount paid to the consultant in the basis of the property acquired. 16

4-13 Unlike a non-contingent broker fee, K is not permitted to allocate the amount paid between the properties acquired and not acquired. 17 4-14 Repair v. Improvement 18

Improvements Must Be Capitalized 19 A unit of property is improved if the expenditures result in: 1) A restoration, or 2) An adaptation, or 3) A betterment. 20

Unit of Property For Buildings 4-14 The unit of property for a building is comprised of the building and its structural components. 21 Unit of Property Improvement v. Repair The building structure or any of the specifically defined building systems. 22

Building Systems 4-15 HVAC system Plumbing system Electrical system Escalators Elevators Fire-Protection & alarm system Security system Gas distribution system 23 Unit of Property Property Other Than Buildings 4-15 The Functional Interdependence Test 24

Repair Expense Restoration Capitalize 25 Restoration The replacement of a part or a combination of parts that comprise a: a major component or a substantial structural part of a unit of property. 4-43 26

Deduct: Replacement of one of four elevators in a building (Ex. 30, pg. 4-57) One of three furnaces within an HVAC system (Ex. 16, pg. 4-51) Roof membrane of building (Ex. 15, pg. 4-50) 27 Three of 10 roof-mounted units within HVAC system (Ex. 18, pg. 4-52) 30% of wiring within building (Ex. 21, pg. 4-52) Eight of 20 sinks (40%) within building s plumbing system (Ex. 23, pg. 4-53) 28

100 of 300 windows where windows are 25% of building structure. (Ex. 25, Pg. 4-54) All flooring in hotel lobby 10% of entire hotel square footage. (Ex. 28, pg. 4-55) 29 Fix Broken Tail light on truck. (Ex. 11, pg. 4-48) Drill press power switch assembly (Ex. 13, pg. 4-50) 30

Restoration: 100 of 300 windows where windows are 90% of building structure. (Ex. 27, Pt. 4-55) 200 of 300 windows on building where windows are 25% of building structure. (Ex. 26, Pg. 4-55) 31 All flooring in public areas of hotel 40% of square footage of hotel (Ex. 29, Pt. 4-56) All sinks or toilets in the bathrooms of a commercial bulding. (Ex. 22, Pt. 4-53) 32

Roof of building (Ex. 14, pg. 4-50) Engine or cab of truck (Ex. 10, pg. 4-48) 33 Underground storage tank in gas station (leaking). To comply with EPA. (Ex. 12; Pg. 4-49) 4-49 34

4-62 De Minimis Safe Harbor 35 4-62 Taxpayer With Applicable Financial Statement (AFS) 36

Met if: 1) T has an Applicable Financial Statement: 4-63 Fix Typo SEC Financial Statement Certified Audited Financial Statement Financial Statement to Federal or State Government (not SEC or IRS) 37 2) T has at the beginning of the tax year written accounting procedures treating as an expense for non-tax purposes a) Amounts paid for property costing less than a specified dollar amount; or b) Amounts paid for property with an economic useful life of 12 months or less; 38

3) The taxpayer treats the amount paid for the property as an expense on its AFS. 4) The amount paid for the property does not exceed $5,000 per invoice or other amount as identified by IRS published guidance. 39 Example 3 Taxpayer with AFS elects de minimis safe harbor and meets all conditions. Pays $6,250,000 to purchase 1,250 computers at $5,000 each. Deduct $6,250,000. 4-67 40

4-65 If the computers cost $5,001 each, then no safe harbor but maybe OK per preamble language. 41 Taxpayer 4-62 Without Applicable Financial Statement (no relief in temp. regs.) 42

1) No AFS 2) T has at the beginning of the tax year written accounting procedures treating as an expense for non-tax purposes a) Amounts paid for property costing less than a specified dollar amount; or b) Amounts paid for property with an economic useful life of 12 months or less; 43 3) The taxpayer treats the amount paid for the property as an expense on books. 4) The amount paid for the property does not exceed $5,000 X ($500) per invoice or other amount as identified by IRS published guidance. 44

4-63 & 64 Safe Harbor Applies to: Fixed asset purchases Materials and Supplies Improvements (repair and maintenance costs) (Reg. sec. 1.263(a)-3(d)) 45 Safe Harbor Does Not Apply To: Cost subject to the IRC sec. 263A uniform capitalization rules. Amounts paid for inventory Amounts paid for land If taxpayer elects special treatment for rotable or temporary spare parts. 4-63 & 64 46

Example 10 Taxpayer with AFS 4-70 Pays $1,000 for jig, die, mold, and pattern used in manufacturing products. Cost must be capitalized into product cost per IRC sec. 263A. 47 Example 11 Anti-abuse Taxpayer without AFS 4-70 K purchases truck for hauling business. 48

Seller provides K with four 4-70 invoices: one invoice of $500 for the cab, one invoice of $500 for the engine, one invoice of $300 for the trailer, and a fourth invoice of $200 for the tires. 49 K has applied the de minimis rule to amounts substantiated with invoices created to componentize property that is generally acquired as a single unit of tangible property Safe Harbor does not apply. 4-70 50

4-65 Time and Manner of Election (with or without AFS) 51 4-65 An annual, irrevocable election made by attaching a statement to the taxpayer's timely filed original Federal tax return (including extensions) Do not use Form 3115 52

The statement must: 4-65 be titled Section 1.263(a)-1(f) de minimis safe harbor election and include the taxpayer's name, address, taxpayer identification number, and a statement that the taxpayer is making the de minimis safe harbor election under 1.263(a)-1(f). 53 Annual changes to the taxpayer s accounting procedures are not accounting method changes. 4-66 54

4-71 Materials and Supplies 55 Modified Definition: 4-71 Is a unit of property that has an acquisition cost or production cost of $200 (up from $100) or less IRRELEVANT if de minimis safe harbor is elected 56

4-23 Per Building Safe Harbor For Small Taxpayers 57 A qualifying taxpayer may 4-23 elect to not apply the improvement rules if the total amount paid during the tax year for repairs, maintenance, improvements, and similar activities performed on the eligible building property does not exceed 58

The lesser of: 4-23 1) 2% of the unadjusted basis of the eligible building property; or 2) $10,000. 2% cap triggered if building costs under $500,000 59 A qualifying taxpayer means a taxpayer whose average annual gross receipts for the three preceding taxable years is less than or equal to $10,000,000. 4-23 60

4-23 Eligible building property refers to each unit of property, building, that has an unadjusted basis of $1,000,000 or less 61 Example 1 Office building with unadjusted basis of $750.000. T pays $5,500 for repairs, maintenance, and improvements T may elect to apply safe harbor for small taxpayers. 4-25 62

4-25 If the ceiling (the lesser of 2% or $10,000) is exceeded, then NO relief. Can still possibly qualify for de minimis safe harbor and routine maintenance safe harbor (discussed below). 63 Example 2 Office building with unadjusted basis of $750.000. T pays $10,500 for repairs, maintenance, and improvements 4-25 T may not elect to apply safe harbor for small taxpayers. 64

4-23 In determining if the ceiling, (the lesser of 2% or $10,000) is exceeded, you must include amounts expensed under the de minimis safe harbor and routine maintenance safe harbor. 65 If multiple buildings, one building may qualify and another not. See Example 3 4-26 66

67 4-24 For leased property, lessee determines unadjusted basis from rent payable (undiscounted) (See Example 4 below) 68

Example 4 4-26 C leases a building with a triple-net lease with a term of 20 years at $4,000 per month. C s unadjusted basis in leased property: $960,000 ($4,000 x 12 mos. x 20 yrs.) 69 4-24 Time and Manner of Election 70

4-24 An annual (building by building), irrevocable, election made by attaching a statement to the taxpayer's timely filed original Federal tax return (including extensions) Do not use Form 3115 71 The statement must: Be titled, Section 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers and include the taxpayer's name, address, taxpayer identification number, and A description of each eligible building property to which the taxpayer is applying the election. 4-65 72

4-25 An entity level election for Partnerships and S Corps. 73 Routine 4-27 Maintenance Safe Harbor (RMSH) Extended To Buildings 74

4-27 The final regulations extend the safe harbor to buildings. 75 4-27 Per Preamble: [t]he inclusion of a routine maintenance safe harbor for buildings is expected to alleviate some of the difficulties that could arise in applying the improvement standards for certain restorations to building structures and building systems. 76

Routine Maintenance 4-27 The recurring activities that a taxpayer expects to perform as a result of the taxpayer's use of the building to keep the building structure or each building system in its ordinarily efficient operating condition. 77 4-27 Building maintenance is routine only if the taxpayer reasonably expects to perform the activities 2 times or more in 10 years 78

4-28 Non-building maintenance is routine only if the taxpayer reasonably expects to perform the activities 2 times or more in class life 79 RMSH Exceptions: 4-28 Betterment to unit of prop. Adaptations to new or different use Replacement for which loss is claimed. See complete list on page 4-28 80

Example Rental Building Spend $7,000 on interior painting and $4,000 on flooring ever 4 years. Routine Maintenance Safe Harbor? 81 Example Purchase $400,000 of farming equipment. 7 Year MACRS Every third year spend $300,000 on maintenance. Safe Harbor? 82

Example 13 Escalator system in shoping mall. G reasonably expects to replace the escalator handrails every 4 years. 4-31 Handrail replacement meets RMSH. 83 Example 14 4-32 Escalator system in shopping mall. G reasonably expects to replace the escalator steps every 18 to 20 years Step replacement fails RMSH 84

Example 15 4-32 H reasonably expects that every 4 years, the HVAC system on H s commercial building must be inspected and preventive maintenance performed (mfg. specs). 85 Example 15 4-32 H performs the R&M in year 4 and year 11. H may apply the RMSH to both jobs (Yrs. 4 and 11) if H reasonably expected to perform the maintenance every 4 years when the HVAC system was placed in service in Year 1. 86

Sept. 2013 Proposed Regulations 87 The prop. regs. 4-78 generally mandate gain/loss recognition on disposition only when the entire asset is disposed of. 88

For example: Sell the entire building recognize gain or loss. Abandon the entire building recognize loss. 89 A partial disposition rule permits loss recognition for a disposition of a portion of an asset. 90

The partial disposition rule is mandatory in four specific transactions 91 1) A casualty event 2) Deferral of gain or loss under secs. 1031 or 1033 92

3) Transfer of a portion of an asset in step in shoes transaction per sec. 168(i)(7)(B) Ex: Transfer 50% of Bldg. to partnership. 93 4) A sale of a portion of the asset Ex: Sell 50% of Bldg. to Third Party 94

4-78 Otherwise, taxpayers can make an election to apply the partial disposition rules (without a GAA election) 95 Example 1 A owns a factory bldg. 4-21 A replaces columns and girders supporting second floor and increases load capacity 50%. 96

The replacement cost is clearly a betterment to the building structure. 97 No mandatory disposition 4-21 No partial disposition election (PDE) is made (a mistake malpractice?) 98

4-21 Capitalization of the Expenditure is required a betterment 99 4-21 No loss is allowed for the adjusted basis of the old columns and girders (no PDE) 100

4-21 How are Asset Removal Costs Treated Final Regs. 101 4-21 Deductible if a disposition and basis is taken into account in realizing gain or loss 102

4-21 If no disposition, then deduct only if the replacement cost is deductible. 103 In Example 1, removal costs 4-21 must be capitalized as part of the improvement (no disposition and a betterment) 104

Example 2 4-22 Same facts as Example (1) except A makes the partial disposition election (PDE) to treat the replacement as a partial disposition. 105 4-21 Capitalization of the expenditure is required a betterment Also a mandatory restoration due to the election which triggers loss recognition 106

Double Benefit of PDE: 1) A loss can be claimed for the adjusted basis of the old columns and girders 107 2) The removal costs are also deductible. 108

Example 3 A owns a retail building. 4-22 A replaces the shingles on the roof due to leakage. 109 No PDE 4-22 election so no disposition (a good idea) 110

111 The proposed regs. (unlike prior temp. regs.) do not require Ato claim a loss for the old shingles. 112

The prior temp. regs. required a GAA election to opt out of loss recognition. 113 In Example (3) IRS stipulates: Not a restoration Not a betterment Not an adaptation Therefore, cost of new shingles = repair expense 114

Removal Costs The cost of removing the old shingles is treated as part of the repair of the building structure. 115 Example 4 4-22 Same as 3 except A makes the PDE (a mistake malpractice?) 116

A claims a loss for remaining adjusted basis of old shingles. 117 However Making the PDE is A mistake 118

A must capitalize the cost of the new shingles 119 Restoration 4-43 The replacement of a component of a unit of property that the taxpayer has previously written off through a loss deduction 120

What about the cost of removing the old shingles? Expense because a disposition (Prop. Reg. 1.263(a)-3(g)(2)(i)) 121 With the facts of Examples 3 and 4, the partial disposition election was the wrong strategy (better to expense the cost of new shingles) 122

Compare where the fix must be capitalized 123 Another difference between the temp. regs. and the proposed regs. on dispositions: The election applies equally to a disposition of a portion of tangible personalty. 124

Example 6 Corporation replaces an engine on a truck The new engine is a major component or substantial structural part of the truck. 4-83 125 4-83 No partial disposition election is made (a mistake). 126

Conclusion No loss on retired engine Capitalize cost of new engine 4-83 Capitalize removal costs because no disposition and part of the improvement. 127 With Disposition Election Capitalize cost of new engine Deduct loss on disposition of old engine. Deduct cost of removing old engine. 128

4-80 Determination of Basis and Identification of Disposed or Converted Asset 129 4-80 Use any reasonable method that is consistently applied to determine unadjusted basis of the disposed portion of the asset 130

Example of reasonable method (not exclusive): 4-81 discount the cost of the replacement asset cost to its placed-in-service year cost using the Consumer Price Index (CPI) -- then depreciate it. 131 4-78 See Example 9 Elevator Replacement (CPI method used) 132

4-78 Time and Manner of Partial Disposition Election 133 Make the election by taking the position (a disposition loss) by the extended due date for the tax year in which the portion of the asset is disposed of. Do not use Form 3115. 134

IRS consent, via a private letter ruling, is needed to revoke the election. 135 4-79 Retroactive Election for 2012 or 2013. 136

Can claim on amended return for a taxable year beginning on or after January 1, 2012, and ending on or before September 19, 2013 ( applicable taxable year ) 137 Make the election by filing either 1) An amended Federal tax return for the applicable taxable year on or before 180 days from the due date including extensions notwithstanding that the taxpayer may not have extended the due date; or 138

2) An application for change in accounting method with the taxpayer s timely filed original Federal tax return for the first or second taxable year succeeding the applicable taxable year. 139 4-79 Election Following IRS Disallowance Of Repair 140

Return to Example 6 Corporation replaces an engine on a truck Say the taxpayer originally expensed as a repair, the cost of the new engine (and the cost of removing the old engine) 141 The taxpayer did not make a partial disposition election. The IRS subsequently audits the taxpayer and disallows the repair deduction and the deduction for the cost of removal. 142

4-79 The taxpayer may make the otherwise late partial disposition election by filing a Form 3115 143 Though not discussed in the proposed regs., the relief should also apply to the removal costs deductible because a disposition. 144

4-43 Casualty Losses 145 Restoration 4-43 Is for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss under section 165, or relating to a casualty event described in section 165, subject to the limitation in reg sec. 1.263(a)-3(k)(4); 146

Example 3 A storm damages B s business building at a time when the building has an adjusted basis of $500,000. B deducts a casualty loss of $50,000 and properly reduces B s basis in the building to $450,000. 4-45 B spends $50,000 on repairs and debris removal. 147 B must treat the $50,000 paid for repairs as a restoration of the building (capitalize) because B properly reduced B s adjusted basis in the building by $50,000 as the result of a casualty loss and, 4-45 the repair cost of $50,000 does not exceed the limit discussed below ($500,000 (AB) - $0 (improvements to building)) 148

Example 4 Same as Ex. 3 except B receives insurance proceeds of $50,000. No casualty loss deduction because the loss is compensated for with insurance. 4-45 The insurance proceeds reduce B s basis in the building. 149 B spends $50,000 on repairs and debris removal. 4-45 B must treat the $50,000 paid for repairs as a restoration of the building (capitalize) because B properly reduced B s adjusted basis in the building by $50,000 relating to a casualty event. The repair cost of $50,000 does not exceed the limit discussed below ($500,000 (AB) - $0 (improvements to building)) 150

4-43 Limited on Forced Capitalization with Casualty The amount paid for restoration of damage from a casualty to the unit of property that must be capitalized is limited to the excess (if any) of 151 a) The amount prescribed as the adjusted basis of the single, identifiable property for determining the loss allowable on account of the casualty, over 4-44 a) The amount paid for restoration of damage to the unit of property that also constitutes an improvement. 152

Example 5 (compare with 3) 4-46 A storm damages C s business building at a time when the building has an adjusted basis of $500,000. C determines that the cost of restoring its property is $750,000, deducts a casualty loss in the amount of $500,000, and properly reduces its basis in the building to $0. 153 4-46 C hires a contractor to repair the damage to the building and pays the contractor $750,000 for the work. The work involves replacing the entire roof structure of the building at a cost of $350,000 and pumping water from the building, cleaning debris from the interior and exterior, and replacing areas of damaged dry wall and flooring at a cost of $400,000. 154

4-46 C must capitalize as an improvement the $350,000 amount paid to the contractor to replace the roof structure because the roof structure constitutes a major component and a substantial structural part of the building. 155 In addition, C must treat as a restoration the remaining costs, limited to the $150,000 excess of the adjusted basis of the building ($500,000) over the amounts paid for the improvement ($350,000). 4-46 Accordingly, C must treat as a restoration $150,000 ($500,000 - $350,000) of the $400,000 paid for the portion of the costs related to repairing and cleaning the building. 156

Conclusion: 4-46 In addition to the $350,000 to replace the roof structure, C must also capitalize the $150,000 of repairs as an improvement to the building unit of property. C is not required to capitalize the remaining $250,000 repair and cleaning costs. 157 Election To Capitalize Repair Costs (Reg. sec. 1.263(a)-3(n)(1)) 4-62 Aimed at Big Companies 158

Annual irrevocable election when the improvement is place in service 4-61 Still eligible for de minimis safe harbor, the safe harbor for small taxpayers, and the routine maintenance safe harbor 159