New IRS Rules Offer Guidance for Property Owners
Submitted by S. Leonhard
In December of 2011, the U.S. Treasury Department and IRS issued temporary regulations on the treatment of amounts paid to acquire, produce, improve or repair tangible property. The regulations are effective for tax years beginning January 1, 2012.
Change in Accounting Method
The new regulations included significant changes from prior guidance, and many property owners will have to change their tax accounting methods to conform. Although the change will result in added administrative expense, a more favorable method of accounting for repairs costs may represent substantial savings. In most cases, the change of accounting method will be necessary for those property owners that incurred expenses in prior years for property repairs or improvements, to conform the prior years’ accounting to the new rules.
Unit of Property
The definition of a unit of property (UOP) is critical to the application of the capitalization standards under the new regulations. UOP is defined as the building and its structural components. The new regulations require that the improvement standards apply separately to the building structure and each of the building’s major components or systems. There are nine structural components and each component is a building system separate from the building structure. The regulations require capitalization of costs paid for improvements to a UOP and the UOP has been improved if the amounts paid result in betterment to the UOP, restore the UOP or adapt it to a new or different use.
The nine UOP under the new regulations include:
· Heating, ventilation and air conditioning (HVAC) systems
· Plumbing systems
· Electrical systems
· All escalators
· All elevators
· Fire protection and alarm systems
· Security systems
· Gas distribution systems
· Any other structural component defined as a building system in IRS guidance
Under prior rules, a property owner deducted certain costs for repairs or improvements to the building’s systems. Under the new rules, if a building system improvement is made, the property owner must treat the expense as an improvement to the building and capitalize the costs as part of the building. However, the property owner now may recognize loss on the disposition of a building’s structural component before disposing of the entire building and will not have to continue depreciating the costs of structural components no longer in use. A property owner previously had to simultaneously capitalize and depreciate costs of removed and replacement systems.
Materials & Supplies
Under current law, materials and supplies are deductible if incidental in nature and the costs neither materially add to the value of the property nor prolong the property’s useful life. These materials and supplies costs are deductible in the year used or consumed. The new regulations introduce several changes to the accounting for materials and supplies.
The following are defined as materials and supplies:
1. A component acquired to maintain, repair or improve a UOP
2. Fuel, lubricants, water and similar items reasonably expected to be consumed in 12 months or less
3. A UOP with an acquisition cost of $100 or less
4. A UOP with an economic useful life of 12 months or less
5. Property designated as materials and supplies in future IRS guidance
6. Rotatable and temporary spare parts
De Minimis Rule
Certain property owners may benefit from an elective de minimis rule that allows a deduction for amounts paid to acquire or produce tangible property, as well as the cost of materials and supplies, in the year purchased. To qualify for the de minimis rule, the property owner must have a certified audited financial statement accompanied by the report of an independent CPA, and a written accounting policy in place as of the beginning of the tax year to expense amounts paid for property below certain dollar amounts. In addition, the property owner also must expense the amounts on its applicable financial statement for the year. Small property owners without an applicable financial statement are not eligible for the elective de minimis rule and only can deduct amounts paid for materials and supplies that cost $100 or less.
Rotatable & Temporary Spare Parts
Rotatable spare parts are materials and supplies acquired for installation on a UOP, removable from that UOP, generally repaired or improved and reinstalled on the same or other property or stored for later installation. Temporary spare parts are materials and supplies used until a new or repaired part can be installed and then removed and stored for later temporary installation. The new regulations expand available options to property owners for accounting for rotatable and temporary spare parts resulting in three alternative methods:
1. Deduct part costs when the property owner disposes of the parts.
2. Elect to capitalize and depreciate the parts.
3. Elect a new optional method of accounting for rotatable and spare parts, which permits the property owner to do all of the following:
· Deduct the cost to produce or acquire the part upon initial installation
· Recognize as gross income the fair market value (FMV) of the damaged part when removed from the UOP and include the FMV and the cost to remove the part in the basis of the part
· Add to the basis of the damaged part any amounts paid to repair, maintain or improve the part
· Deduct the cost of re-installation and basis not previously deducted in the tax year the repaired part is reinstalled
· Deduct any remaining amount of basis in the part in the tax year in which it is disposed
Under the regulations, a property owner must capitalize amounts paid to acquire or produce a UOP, unless the materials and supplies rule or de minimis rule apply. Amounts paid to facilitate the acquisition or production of real or personal property must be capitalized. Facilitative costs are amounts paid in the process of investigating and pursuing the acquisition of property. Investigative costs to realty acquisition do not need to be capitalized unless the costs are inherently facilitative as discussed below. The new regulations also introduce a rule requiring the capitalization of costs for repair expenses made to property before it is placed in service.
Inherently facilitative costs for both real and personal property must be capitalized, even if the property is not acquired or produced, and are deductible when the acquisition is abandoned. The regulations list the following costs as inherently facilitative:
1. Costs to transport the property
2. Bidding costs, application fees and similar expenses
3. Costs to appraise or determine the property’s value
4. Architectural, engineering, environmental, geological or inspection services pertaining to a particular property
5. Expenses for preparing or reviewing the property’s acquisition documents, such as bids, offers, sales agreements or purchase contracts
6. Costs to negotiate the acquisition terms or structure, including tax advice on the acquisition
7. Expenses for evaluating and examining the property’s title
8. Costs to obtain regulatory approval or secure permits
9. Property conveyance costs, including sales and transfer taxes and title registration costs
10. Finders’ fee and brokers’ commissions, including amounts contingent on successful closing of the acquisition
11. The cost of services provided by a qualified intermediary in a like-kind exchange
Employee compensation and overhead costs are not considered costs that facilitate an acquisition of real or personal property. However, a property owner can elect, on a transaction-by-transaction basis, to capitalize employee compensation, overhead or both.
With respect to real property acquisition costs, expenses for activities performed to determine whether to acquire property, do not need to be capitalized unless the expenses are inherently facilitative.
Routine Maintenance Safe Harbor
Routine maintenance is defined as recurring activities expected to be performed to keep the UOP in its ordinary efficient operating condition. Such activities are considered routine if the property owner expects to perform the activities more than once during the class life of the UOP. In a change from the prior regulations, routine maintenance now includes amounts paid on certain rotatable and spare parts. Buildings are excluded from the safe harbor because the IRS determined that many remodeling projects normally thought of as capital in nature would have been deducted under a routine maintenance safe harbor.
The new regulations are voluminous and ambiguous. They offer numerous elections, many of which can be elected inadvertently simply by following a certain method of accounting on the property owner’s federal income tax return. Given the complexity of the new regulations and numerous elections to consider, property owners should contact their tax advisor to prepare for the new rules now versus waiting until preparation of their 2012 tax return.