Managing Capitalization and Expense Depreciation PRESENTED BY: TRACY MONROE, CPA, MT, PARTNER LISA LOYCHIK, CPA, PARTNER JON WILLIAMSON, CPA, MT, MANAGER July 10, 2018
Welcome & Introductions Tracy Monroe, CPA, MT Moderator Lisa Loychik, CPA Jon Williamson, CPA, MT
CPE Credit Guidelines To receive CPE you must: - Be logged in for at least 50 minutes - Answer at least 3 of the 4 polling questions 3
Questions During the Webinar If you have questions during the webinar: - Use the Questions feature to Enter a question for staff then click send - We will address during the program if there is time or will follow up after the program 4
Capitalization
Overview The IRS issued final Tangible Property Regulations effective January 1, 2014 The final regulations affect all taxpayers that acquire, produce or improve tangible property These regulations provide a general framework for distinguishing capital expenditures from other deductible business expenses 6
Overview Assume all tangible property except inventory is capital property Capital property must be capitalized and depreciated unless the property qualifies for one of the following exceptions: - Materials and supplies - Rotable and temporary spare parts - Improvements that do not result in BAR - Routine maintenance - Small building/small taxpayer safe harbor 7
Why Are The Regulations Important? Explains how to classify costs: deductible vs. capitalize - No longer entirely based on facts and circumstances - Provides new definitions - Set new standards Introduces new disposition rules - Allows taxpayers to claim a loss on disposition vs. double depreciation - Example: roof replacement 8
Financial Statement Conformity Reviewing financial statements - Only two areas require book conformity - Safe harbor for capitalization policy - Election to capitalize and depreciate repairs - The repair reg rules may be applied for tax only, but may also impact financial statements - Financial statements compared to the tax return may have large differences in assets/repairs and maintenance expenses 9
Acquiring Property Material and supplies - A component to maintain, repair or improve a unit of property - Fuel, lubricants, etc. expected to be consumed in 12 months or less - A unit of property deemed to have an economic life of 12 months or less - Safe harbor a unit with a production or acquisition cost of $200 or less (ex: calculators, coffee makers, etc.) Types of materials and supplies - Non-incidental supplies that are imperative to a business model and for which an inventory is kept - Incidental supplies that are not imperative and no inventory is maintained 10
Acquiring Property (cont.) Treatment of materials and supplies - Non-incidental deductible in the taxable year in which materials and supplies are first used - Incidental deductible in the taxable year in which material and supplies are purchased Rotable and temporary spare parts - Deductible when the parts are disposed of - An election is available to choose to capitalize 11
Acquiring Property (cont.) De Minimis Safe Harbor - Book conformity: - Costs classified as expenses - Capitalization policy - Capitalization policy: - In place at the beginning of the year (in writing if have applicable financial statement) - Cost per item less than threshold - Item has an economic useful life less than 12 months 12
Acquiring Property (cont.) De Minimis Safe Harbor - Two thresholds: - $5,000 per-item or per-invoice with Applicable Financial Statement (AFS) - $2,500 per-item or per-invoice without AFS - Example: Bulk purchase of 10 computers for cost $40,000. Computers invoice in aggregate, not individually. De minimis safe harbor applies. 13
Polling Question # 1 14
Unit of Property (UOP) UOP The level at which costs are aggregated and capitalized, as well as the level that costs are analyzed to determine if they are deductible Building and structural components - Single unit of property Building systems - Each separate unit of property Other property - Generally a UOP consists of a group of functionally interdependent components 15
UOP: Building Systems HVAC Plumbing systems Electrical systems Escalators Elevators Fire protection & alarm systems Security systems Gas distribution systems Other systems identified in published guidance 16
Improving Property: Capitalize A unit of property is improved if amounts are paid for activities performed after the UOP is placed in service by the taxpayer resulting in: - Betterment to the unit of property - Adaptation of the unit of property to a new or different use - Restoration of the unit of property Property improvement costs that should be capitalized are commonly referred to as the BAR test 17
Betterment: Capitalize Alleviates a material condition or defect that existed prior to the acquisition of property Results in a material addition or expansion Is expected to materially increase in productivity, efficiency, strength, output or quality of the UOP 18
Betterment: Example ABC Corp. purchases a parcel of land. The soil was contaminated by leaking underground storage tanks left by a previous owner. ABC Corp. s remediation costs to remove the contaminants result in a capitalized betterment to the land because ABC Corp. incurs the costs to ameliorate a material condition or defect that existed prior to its acquisition of the land. 19
Adaption: Capitalize Adapt a UOP to a new or different use Adaption is inconsistent with intended use Analyze facts and circumstances Examples: - Capital: expansion in retail drug store for a walk-in medical clinic - Deductible: expansion in grocery store for a sushi bar that already includes counters for prepared food & deli meats 20
Restoration: Capitalize Replaces a component, and adjusted basis has been taken into account in realizing gain/loss Returns a UOP to its ordinary efficient operating condition if the property is no longer functional Rebuilds a UOP to a like-new condition after end of its useful class life Replaces a part that comprises a significant portion of a major component or a large portion of a substantial structural part of a UOP - No bright-line test only examples in regulations 21
Restoration: Example ABC Corp. replaces the waterproof membrane of the roof Not a major component or substantial structural part of the building structure Improvement or repair? Depends if ABC Corp will recognize a loss on the replaced membrane Will ABC Corp. recognize a loss on the replaced membrane? - Yes: Improvement = Capitalize - No: Repair = Expense 22
Restorations: Major Component or Substantial Structural Part No bright-line test to conclude whether a restoration has occurred; based on facts and circumstances. Examples in the final repair regulations include many quantitative facts that give insight into the IRS and Treasury s view as to whether a replacement rises to the level of a capitalizable restoration. - Major components of buildings or building systems examples imply that a replacement of 40% or less of a major component may not be a significant portion of the major component; therefore not a restoration - Large portion of a substantial structural part examples imply that a replacement of 30% or more of the building structure was a large portion of a substantial structural part; therefore is a restoration 23
Examples in Final Regulations - Restorations Office building 3 of 10 roof-mounted AC units are replaced yet were considered repairs Retail building where 8 of 20 sinks were replaced yet were considered repairs Office building where 100 of 300 windows were replaced yet were considered repairs Hotel replaces lobby floors; lobby comprises less than 10% of the entire building so were considered repairs 24
Polling Question # 2 25
Safe Harbor: Routine Maintenance Current deduction for certain on-going, routine maintenance expenditures applies only if: - Activity is performed more than once over the property s life - The maintenance keeps the property in an efficient operating condition - The need for the maintenance results from the taxpayer s use of the property 26
Safe Harbor: Routine Maintenance (cont.) Also applies to buildings and structural components For buildings: - Maintenance is expected to be completed more than once in a 10-year period 27
Safe Harbor: Small Taxpayers Applies to buildings Average gross receipts: less than $10,000,000 Average unadjusted basis (cost) of building: $1,000,000 or less Deduct cost of improvements: - That do not exceed the lessor of $10,000 or - 2% of the unadjusted basis of the building 28
Depreciation
Depreciation Overview - MACRS What is MACRS? - Modified Accelerated Cost Recovery System - Assets generally have shorter lives under MACRS than for book purposes - Assets generally are depreciated faster under MACRS than book Double Declining Balance (200%) for 5 and 7 year assets One and ½ Declining Balance (150%) for 15 year assets Straight-Line depreciation for 27.5 and 39 year assets Real Property is given a mid-month convention, while Personal Property receives a half-year convention - Possible to be forced into a mid-quarter convention on personal property if a large portion of assets are placed in service in 4 th quarter 30
Depreciation Overview MACRS Asset Lives Non-Residential Real Property 39 years (40 years under ADS) Residential Real Property 27.5 years (30 years under ADS) Land Improvements 15 years Furniture and Fixtures 7 years - This group acts as a catch-all for assets not included in other groups Computer and Other Equipment 5 years Alternative Depreciation System (ADS) - Can be elected - Mandatory when assets are not located in U.S. - Mandatory for real property when electing to be considered a real estate trade or business for interest expense limitation purposes 31
Polling Question # 3 32
Placed in Service and Written Binding Contract Generally, an asset is placed in service and depreciation begins when it is ready and available for use Does not mean an asset needs to be in use - Rental real estate with occupancy permits and is actively pursuing tenants can be depreciated, even if there are no tenants currently - Equipment installed but not scheduled to be operated until the future can begin depreciation after installation, assuming it could be operated Written Binding Contract Rule - Must be reviewed due to different rules applying to different periods - If a written binding contract exists to acquire property, the period that contract was entered into determines the applicable rule set, not the date placed in service - Only affects which rules to apply not the date the asset begins depreciation 33
Bonus Depreciation Allows for additional depreciation expense in the year a qualified asset is placed in service, expressed in terms of percentage - 50% bonus depreciation for assets in service prior to 9/27/2017-100% bonus depreciation for assets in service between 9/27/2017 and 12/31/2022 - Percentage set to decrease 20% per year after 12/31/2022 Qualified Assets - Recovery period of 20 year or less - Includes both new and used property 34
Section 179 Expensing Similar to Bonus Depreciation, allows for additional depreciation expense in the year a qualified asset is placed in service Rather than a percentage of asset cost being expensed (as with bonus depreciation), Section 179 expensing is associated with various dollar value limitations - Expense Limitation $1,000,000 for tax years beginning in 2018 - Qualified Expenditure Limitation the expense limitation is reduced for every $1 over $2,500,000 of qualified assets acquired in the taxable year - Taxable Income Limitation the expense amount is limited to the taxable income of the taxpayer When incurred by a pass-through entity, limitations are reviewed both at the entity as well as the taxpayer level 35
Section 179 Expensing (cont.) Assets that qualify include: - Tangible personal property - Off-the shelf computer software - Qualified real property Qualified real property includes: - Qualified Improvement Property (QIP) - Roofs - Heating, ventilation and air-conditioning property (HVAC) - Fire protection, alarm systems and security systems Qualified assets must be acquired for business use and acquired by purchase 36
Comparing Bonus Depreciation and Section 179 Additional assets qualify for Section 179 that do not qualify for bonus depreciation - Including Roofs, HVAC property and Qualified Improvement Property Section 179 has a dollar value limit, while bonus depreciation is unlimited Section 179 is applied on an asset by asset basis, while bonus depreciation must be elected for all assets in a single class life Bonus depreciation is generally a better alternative for real estate business groups to avoid limitation issues Treatment of expense in excess of income: - Section 179 expense in excess of taxable income is carried forward and can be used in future years when the limitations allow - Bonus depreciation in excess of taxable income creates a Net Operating Loss (NOL) 37
Polling Question # 4 38
Special Classification Qualified Improvement Property (QIP) Reclassification of certain assets that would ordinarily be depreciated over 39 years as non-residential real property - Must be an improvement to the interior portion of a building - Must be placed in service after the date the building was originally placed in service - Excludes improvements to an elevator or escalator or the internal structural framework of the building - Excludes improvements that relate to the enlargement of the building 39
Qualified Improvement Property (cont.) Treatment on QIP according to the Tax Cuts and Jobs Act of 2017 (TCJA) differs from the implied treatment understood by the tax community and joint committee reports Treatment based on TCJA - Qualifies for Section 179 expensing - Does not qualify for Bonus Depreciation - Depreciated over 39 years Treatment based on joint committee reports - Qualifies for Section 179 expensing - Qualifies for Bonus Depreciation - Depreciated over 15 years Requests have been made to congress to pass a technical correction for the deemed oversight, however no determination is currently available 40
Removal of Special Asset Classes Tax Cuts & Jobs Act The following asset classes have been removed by the TCJA in years starting after 1/1/2018 - Qualified Leasehold Improvements - Qualified Restaurant Property - Qualified Retail Improvements Many assets that qualified in any of the three groups above may be classified as Qualified Improvement Property - May or may not receive beneficial treatment based on requested technical corrections 41
Other Considerations State Conformity Many states elect NOT to conform to federal rules in regards to bonus depreciation and Section 179 expensing - For most states, depreciation is calculated as if the special depreciation deduction was not taken originally - Some states have specialized rules (MN, NC, PA) - Results in state addition to income in the year bonus depreciation is taken, and a state deduction in subsequent years States have different rules when an asset with a cumulative depreciation adjustment can be written off - Some states allow for the adjustment to affect gain/loss on sale - Others are recognized over the remaining life of the underlying asset 42
Other Considerations Cost Segregation Studies Comprehensive engineering study to separate components of real property into shorter-life assets based on composition of structure Benefit analysis prior to TCJA - Provide ability for bonus depreciation on new construction - Provide lower asset lives for purchases of used property Benefit analysis after TCJA - Same as above, and in addition may provide ability for bonus depreciation on assets purchases after 9/27/2017 In addition to increased depreciation expense, may provide more accurate data for analyzing potential capital assets and BAR tests discussed earlier 43
Questions for our Presenters? Tracy Monroe, CPA 330.255.4357 tmonroe@cohencpa.com Lisa Loychik, CPA 330.480.4636 lloychik@cohencpa.com Jon Williamson, CPA, MT 216.774.1103 jwilliamson@cohencpa.com 44
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Thank you. July 10, 2018 Information presented is not meant to constitute legal, accounting or other professional advice. Any action taken based on information in this presentation should be taken only after a detailed review of the specific facts and circumstances. Information is current as of the date presented.