Tangible Property Regulations
Coauthored by Stanley Rose
Tax Considerations and an Implementation Guide in Plain English
The IRS’s capitalization and repair regulations completely change the methodology used to distinguish between capitalized costs and deductible repair expenses, and many taxpayers and practitioners are still struggling to understand these complex rules. Worse, some are of the mistaken (and potentially costly) belief that the rules merely provide a parallel scheme and that all of the “old” rules can instead be followed. Others are not aware of just how pervasive and complicated these rules are, and mistakenly expect that they can be learned with minimal effort or time commitment. Still others have truly tried to learn these rules, but discovered (as we have) that there appear to be no resources out there that make sense of these rules in readable fashion. The purpose of this material is to convince readers of the need to learn and implement the rules, and provide an easy-to-use resource that will enable them to do so.
How much information do you want?
Immediately below is an index to the material that follows. To better accommodate varying skill and interest levels, we provide readers with a choice between three levels of detail below, preceded by some history and commentary on the rules.
- History and background: This includes a brief history of the regulations, some legal citations, and a few of our observations.
- Executive summary: This only addresses the highlights.
- Generalities: This level of detail will provide general information regarding the new rules, such as what they try to accomplish and why taxpayers must implement them. Readers who want to gain a basic understanding of these changes but will not be involved with the mechanics of implementing them should read this section.
- Specifics: Readers who will be involved with the mechanics of the change, such as controllers, accounting managers, those who oversee fixed asset records, and practitioners who are just now coming to grips with the fact that this is really happening, should first read the other sections and then continue on to this one. Although hardly comprehensive, it will provide more specific information regarding the changes, and will do so in sequential fashion, guiding its readers through the steps needed to determine whether an asset must be capitalized. Its steps correspond to those of a flowchart that accompanies it.
- Flowchart: This flowchart depicts the basic steps involved with determining whether a cost is capitalized. Each step is explained in greater detail in the “specifics” section described above.
Many who deal with the tax treatment of fixed assets are frustrated with the new tangible property regulations (“TPR”) that overhaul existing capitalization and repair standards. Even some practitioners feel lost in the rules – unsure where to start and uncertain of when they are done. We believe this occurred for two reasons:
- First, these rules completely upend everything we know about capitalizing costs. Its analysis now has more steps, exceptions and volume. Accountants now entering the profession will have a lot more to learn with the new rules than most of us did while learning the old rules. Grizzled veterans have the added task of discerning what to retain vs. what to unlearn from the old regime.
- Second, these regulations morphed over time – a lot of time. They were cobbled together in proposed form with changes being made over the course of several years. They began with T.D. (Treasury Decision) 9564 in 2011, and include T.D. 9636 from 2013 and T.D. 9689 from 2014. Some minor but wide-reaching procedural updates were provided in several Revenue Procedures, including Rev. Proc. 2014-16 and most recently, Rev. Proc. 2015-20, delivered in February 2015. All of these rules alter numerous sections of the Treasury Regulations. Due to this long incubation period, normal sources of guidance (tax information services) responded by addressing the initial proposed rules, and then providing piecemeal updates as changes were made or proposed. To date, frustratingly few sources provide a cohesive summary of the cumulative results, and some that do leave the reader unsure whether he or she started in the right place or has truly finished all required parts of the analysis.
By contrast, this article will guide its readers through the process of determining how to apply the new rules in linear fashion, in a manner designed to keep the readers constantly aware of where they are in the overall process. In exchange, readers must accept our apologies for the length of this material. There simply is no possible way to educate anyone on these matters, even at a basic level, in the space of a page or two.
These regulations are taxpayer-friendly and practitioner-unfriendly. They will require a level of sophistication that was not previously needed on the part of anyone maintaining tax fixed asset records (and will sometimes require help from non-accountants, such as engineers) but will result in accelerated deductions relative to the rules they replace. This article will provide an overview of the most relevant portion of the rules in a way that a reader who is already reasonably familiar with tax depreciation can understand them.
The tangible property regulations represent an entirely new way of determining whether a cost should be capitalized and depreciated for tax purposes, or immediately deducted. They are more complex than the prior rules, but generally more favorable to taxpayers by frontloading deductions. Part of the law is optional, but much is required – in some cases, retroactively. Some taxpayers who fail to timely implement these rules will permanently lose deductions, including the expected remaining depreciation of previously-capitalized historical costs that remain partially depreciated as of the end of 2013. Many changes, including retroactive ones, must be reported on 2014 returns, and will often require completion of IRS Form 3115 – Change in Accounting Method. Retroactive implementation will require a thorough “scrub” of historical fixed asset records by someone familiar with these rules and potentially by someone familiar with that entity’s historical acquisitions and repairs. This exercise may be time-consuming, but beneficial and necessary to implement the rules.
In distinguishing from repair expenses, the old rules generally required capitalization for any outlay that extended the life or improved the value of the underlying asset. The new rules require capitalization for improvements, which consist of restorations, adaptations or betterments. From now on we must view potential capitalized costs in terms of “units of property.” The old rules contained little legal authority for deduction of immaterial costs, although in practice taxpayers and the IRS observed such deductions subjectively in varying degrees. The new rules provide several safe harbors that allow immediate deduction of many small costs. They also produce a more logical outcome than in the past, because we no longer must maintain multiple layers of a single asset. With more costs being expensed as repairs instead of depreciation, subsequent gains from property sales will consist of less ordinary income from “depreciation recapture” and more favorable long-term capital gains, thereby actually lowering tax rates, rather than merely impacting timing.
From now on, people who maintain tax fixed asset records will be working with a much more complex set of rules than in the past, complicating their task of determining proper treatment of costs.
Timing of deductions is the thrust of the TPR
What do the TPR seek to accomplish… do they represent a new deduction, or denial of a formerly-allowed deduction? The answer is neither. The rules address timing of deductions, generally in ways that greatly accelerate deductions relative to the former rules. As was the case before these rules, an outlay for property acquisition or repairs is deducted once. This can occur at the time of payment as a repair expense, or over a number of years by depreciating costs that are first capitalized. It can also occur when the property is later sold, disposed, abandoned or replaced, if any costs remain that have not yet been deducted.
In short, relative to the old regime, the TPR will simply frontload far more deductions. These rules will cause many outlays to be moved out of a “capitalized cost” category to an “immediately deductible” category. For real estate that otherwise would be depreciated over a 27.5 or 39 year life, the time value of the deferred taxes represents the primary benefit of these rules.
Taxpayers may be pleasantly surprised by their 2014 tax returns
These favorable changes apply prospectively, but most of them can be, and are required to be, implemented retroactively as well. This involves comparing historical deductions for repairs and depreciation to the amounts allowed had these new rules been used since a taxpayer’s inception, and taking a deduction in 2014 for the cumulative difference! Many taxpayers who own fixed assets will see such deductions on their 2014 tax returns resulting from this “true-up,” and some deductions will be very large. “Small” taxpayers with 3-year average gross revenue or total assets that do not exceed $10 million can choose to apply these changes on a prospective-only basis.
Additional filings are required
Most of these changes are not optional, but the IRS has selected a method of reporting most of them that normally is reserved for a taxpayer-initiated request or reporting of an error correction: The filing of Form 3115, Application for Change in Accounting Method. This form will capture most of the changes, while a statement attached to the return will capture some others. The IRS will receive millions of Forms 3115 this year as a result. Small taxpayers, as described above, can forgo use of Forms 3115 in most cases by choosing to apply changes on a prospective-only basis.
The consequences of a missed opportunity
Taxpayers who do not properly implement the retroactive changes described above in 2014 may permanently lose the ability to deduct otherwise deductible costs. Why? Because, as will be explained in more detail later, some previously “capitalizable” costs are now instead deductible as repair expenses in the year incurred. For costs that meet that criteria, repair expense is the only available treatment, and depreciation is no longer an option. Taxpayers who ignore the need to retroactively change this are not allowed to simply continue depreciating a previously capitalized cost (even though it was legitimately capitalized & depreciated under the rules that existed at the time). As noted above, small taxpayers are not required to apply changes retroactively, and can continue to depreciate existing assets using the “old” method until they are fully depreciated. But large taxpayers who fail to retroactively deduct such costs in 2014 (by use of Form 3115) may find themselves (1) unable to recover the cost through future depreciation deductions, and (2) due to an expired statute of limitations, unable to deduct it as a repair cost. 2014 is the year of the required change, and for some deductions, it truly is now or never. If you own fixed assets, you must pass through the 2014 gauntlet of analyzing these new rules – or forever hold your peace!
Under the former rules, any outlay that related to property with a life of more than one year, or a related cost that either improved the property’s value or extended its useful life, was required to be capitalized. There was no formal policy of materiality. In other words, if an outlay met the criteria for capitalization, the cost should have been capitalized, whether it was $10,000 or $10. In practice, taxpayers used, and IRS often quietly allowed, smaller amounts to be deducted when incurred rather than capitalized. But this subjective practice led to great disparity between taxpayers. It also resulted in subjective treatment by IRS agents during audits. The TPR solves this problem by providing an objective set of standards that recognizes varying levels of materiality.
The concept of layers
One of the most significant impacts of the TPR addresses repeat expenditures for the same property, or subset of property. This can best be explained by example: In year one, a building is acquired. Whether broken out & tracked separately or not, a finite portion of that cost is attributable to the roof, which generally is depreciable over 39 years. A decade later, the roof is repaired/replaced, as roofs often are. Another decade later, it is repaired/replaced again. Under the former rules, that taxpayer would be simultaneously depreciating three “layers” of roof costs: One original, and two later outlays, each with its own entry in the taxpayer’s fixed asset/depreciation schedules, and each being depreciated over its own 39 year period. Yet there is, of course, only one roof! Conceptually, the taxpayer should not be forced to depreciate (and therefore delay the cost recovery for) more than one layer at a time, and under the new rules this situation is remedied. The criteria will be explained later, but under the TPR, only one layer will be depreciated at a time, regardless of how many layers are in play. As part of the retroactive conversion, generally the remaining costs of all but one layer will be written off in 2014.
A significant portion of the TPR rules address whether it is the first layer or the last layer that will be capitalized and depreciated.
This concludes our general discussion of the rules. Brave readers who want more detailed information should continue by reading the specifics below.
This section provides a more detailed look at how the rules work, as well as some guidance designed to help readers know how to approach the required analysis.
Prior to the TPR, the general standard for determining whether a cost would be capitalized involved two questions. For new assets, any property with a useful life exceeding one year was capitalized, regardless of materiality, if interpreted literally. For modifications of existing property, costs that either extended the useful life or increased the value of the existing property were capitalized. Not only was this standard so easy to meet that it resulted in most costs being capitalized, it also led to multiple costs, or “layers,” related to the same asset being depreciated simultaneously, as noted above. These standards have been replaced.
In their place is an elaborate and complex set of rules. They appear daunting, but if approached methodically, they can be arranged in the form of sequential questions that offer multiple opportunities for the cost to qualify for immediate deduction, thus ending your analysis and that asset’s journey through the sequence that otherwise would end in capitalization. The balance of information below is arranged in such a sequence, and is accompanied by a flowchart that follows the same sequence.
Even for costs that do unfavorably make it to the end of the capitalization analysis sequence only to be capitalized there, a significant consolation prize is available in many cases because if that newly-capitalized cost represents one of two or more “layers” of costs related to a single asset, another step is available that in most cases will allow immediate deduction of the remaining undepreciated cost of the older layer(s).
Some of the steps in this sequence that allow immediate deduction are optional, but some are required. All of the new standards are applicable prospectively beginning no later than 1/1/14, but only some of them apply retroactively. Certain small taxpayers can avoid retroactive treatment entirely, if they so choose. These distinctions will be pointed out as the steps are explained below. Let’s start the first sequence.
Small costs can be deducted rather than capitalized – Steps 1 and 2
$200 materials and supplies deduction
Inexpensive, short-life materials and supplies represent the first instance capitalization can be avoided.
Certain qualifying materials and supplies may be deducted when paid or incurred. To qualify, such an item must be consumable in operations. It also cannot consist of inventory. Then, it must also be one of the following:
- A unit of property costing less than $200,
- Fuel, water, lubricants or similar items that are expected to be consumed within 12 months, and property with an economic useful life of less than 12 months,
- A component acquired separately to improve, repair or maintain tangible property, or
- Other items such as rotable, standby emergency, or temporary spare parts.
This deduction applies only prospectively, and deduction is mandatory.
An election is available that would defer deduction of these costs to the time of consumption for certain rotable, temporary or standby parts, but most taxpayers will opt for the default treatment that provides immediate deduction and avoids such tracking of the item’s use. Because more than one option exists, though, Form 3115 must be used to inform the IRS of the method chosen.
If not deductible under this rule, next consider the de minimis safe harbor described below.
De minimis safe harbor election – deductions of up to $5,000 or up to $500 per item
This deduction requires several things to be in alignment, but assuming they are, costs of up to $5,000 per item (regardless of how many items are acquired in total) may be deducted when incurred, rather than capitalized. The $5,000 per-item cap applies to a taxpayer for whom an “applicable financial statement” is provided by a CPA or foreign equivalent (such as an audited financial statement required to be provided to a bank, SEC or other government agency). For all other taxpayers, a $500 per-item cap currently applies, but the IRS has indicated that this smaller cap may increase in the future.
The safe harbor does not apply to inventory or land, but it does apply to material and supplies (other than rotable spare parts) that failed to qualify above due to the $200 limitation.
This safe harbor method is optional and elected annually, on a year-by-year basis, by attaching a statement to the taxpayer’s tax return (Form 3115 is not required). If applicable, deduction of qualifying costs is “all or nothing,” meaning that taxpayers cannot deduct costs of some qualifying assets while capitalizing others. This safe harbor is available only prospectively.
To qualify, the taxpayer must have a policy in place effective as of the beginning of the year that specifies the per-item dollar amount that will be used for that year (any amount that does not exceed the applicable $5,000 or $500 cap). For taxpayers with “applicable financial statements,” that policy must be written.
Finally, taxpayers can deduct such costs under this safe harbor method for tax purposes only if they also do so for book purposes. In certain instances, this could be problematic because Generally Acceptable Accounting Principles (“GAAP”) use entirely different criteria for determining deduction vs. capitalization. Those standards primarily involve the concept of “matching,” which calls for depreciation deductions over the useful life of the asset. In many cases this will not present a problem, but if taxpayers deduct these costs for book purposes to allow the related tax deduction, and the total of such costs are material to the financial statements as a whole (or if these and other potential departures from GAAP are material when combined), financial statement auditors may be forced to propose an adjustment to capitalize costs to result in better matching. If so, the costs must also be capitalized for tax purposes, even though they otherwise meet the criteria for deduction under this safe harbor.
Assuming no such GAAP conflicts exist, an example of this safe harbor could be represented by an invoice for the purchase of 50 laptops at $5,000 apiece. Assuming the criteria described above are met, a deduction of $250,000 would result.
Costs that are not eligible for deduction using the rules described above should continue to the next step in the sequence.
Routine maintenance costs can be deducted as repairs rather than capitalized – Step 3
Thus far in the sequence, the exceptions that allow deduction rather than capitalization have depended on the size of the outlay, but the next aspects apply to outlays of any size. The ability to deduct routine maintenance costs is one of the most significant changes in the repair regulations, because it will allow immediate expensing of many costs that until now were required to be capitalized.
Deductions for costs of a recurring nature
Costs that are expected to be incurred repeatedly in the normal course of business, simply to keep the underlying asset in efficient operating condition, are now to be deducted as repair expenses. This ability is known as the new “routine maintenance safe harbor.” The rules differ somewhat between real property and personal property, but the concept is the same.
- Buildings For buildings, costs that are associated with an activity that is expected to be repeated more than once in a 10-year period beginning when the property is placed into service are deductible.
- Non-buildings For personal property, the outlay must be expected to be incurred more than once during the useful life of the asset. For this purpose, “useful life” is defined as the MACRS alternative depreciation system (“ADS”) life. For instance, office furniture that is depreciated under MACRS using a 7-year life has a 10-year life under ADS. Computers and automobiles share a 5 year ADS life.
It is not necessary that the second expenditure described above actually take place, as long as a taxpayer can substantiate that such an expectation was reasonable when the first outlay was made, given all the facts and circumstances. Also, in making that determination for acquisition of “used” assets, the analysis must consider the previous ownership. In other words, if you acquire an asset knowing it needs some maintenance in the next year or two, that upcoming maintenance does not necessarily represent a deduction. It is deductible only if you legitimately expect to encounter another such cost within the following 10 years (or ADS life, in the case of personal property). The input of non-accountants (electricians, builders, etc.) may be needed to determine the normal frequency of maintenance.
Use of this safe harbor is mandatory for all taxpayers, but with some exceptions. First, large and small taxpayers are treated differently. Large taxpayers must apply this change retroactively and prospectively, and must file Form 3115, Change in Accounting Method, to accomplish it. Small taxpayers must apply this prospectively but have the option to forgo applying it retroactively. If applied only prospectively, small taxpayers do not need to file Forms 3115. They will simply make the change for costs incurred in 2014 and later years, and continue to depreciate previously-acquired assets until fully depreciated. To qualify as “small,” a taxpayer must have total assets of $10 million or less as of 1/1/14 or average annual gross receipts of $10 million or less for the prior 3 taxable years.
An election of convenience exists, but it comes at a cost: A taxpayer of any size may elect to capitalize costs for tax purposes in a manner that is consistent with its book capitalization policy, thereby delaying allowable deductions. This election is made on a year-by-year basis by attaching an election statement to that year’s tax return. If the election is made, the taxpayer must follow book treatment for any asset that was capitalized; the taxpayer cannot “pick and choose.” Note that this piggyback treatment applies only to costs that were capitalized for book purposes; it does not apply to costs that were expensed for book purposes, thereby allowing taxpayers to deduct costs for tax purposes in a way that circumvents the capitalization rules. In other words, this election is used to take a more conservative approach (capitalization); it cannot be used to take a more aggressive approach (immediate deduction).
Retroactive application of the routine maintenance safe harbor involves analyzing all previously capitalized costs and asking whether they would have been deductible (rather than capitalized) if the new rules were in place at the time of capitalization. If so, the remaining undepreciated cost as of 1/1/14 may be deducted on a taxpayer’s 2014 tax return.
This “scrub” of historical fixed asset records may prove to be time-consuming, but it also may result in greatly accelerating deductions. For example, if it applies to 39-year property that was placed in service in 2013, a taxpayer that would otherwise have had to wait nearly four decades to deduct the full cost via depreciation will instead fully recover the cost in 2014.
A hidden benefit
A potential hidden benefit can be seen by those who understand the concept of ordinary recapture, which generally converts gain on certain property sales from favorable long-term capital gains taxed federally at no more than 20% to ordinary income taxed at as much as 39.6%. The benefit is that these repair and maintenance deductions, including those resulting from the retroactive “true-up,” do not represent depreciation, and therefore do not generate ordinary recapture when property is sold. Mechanically, these deductions are not even reported on Form 4797, where such recapture is computed. The amount of this quiet benefit may be significant and represents a reason small taxpayers should consider retroactive application. Getting rid of those older cost “layers” also gets rid of the related accumulated depreciation, and when it is gone, some potential recapture that lurked in those numbers disappears with it.
If not deductible under the routine maintenance safe harbor, the cost should continue to the next step in the sequence.
Small taxpayer safe harbor for taxpayers with buildings – Step 4
Another exception exists for small taxpayers. Recall that the one described above allows small taxpayers to avoid retroactive application of the “routine maintenance” portion of these rules, and also lets them avoid filing Forms 3115 if they choose prospective-only application. The small taxpayer safe harbor described below is different, in spite of a similar name and some overlap in defining “small.”
This small taxpayer safe harbor applies to building improvements costs, and allows current deduction of costs if each the following criteria is met:
- The taxpayer’s average annual gross receipts for the prior three years do not exceed $10 million,
- The building in question has an unadjusted basis of $1 million or less, and
- The total amount paid during the year for repairs, maintenance and improvements on that building do not exceed the lesser of
- 2% of the building’s unadjusted basis or
In computing the $10,000 limit, costs deducted under the routine maintenance or de minimis safe harbors must be included.
This safe harbor is available only on a prospective basis, and is accomplished by attaching an election statement to the taxpayer’s income tax return. Use of it is optional, and the determination of whether to use it is made on a year-by-year and property-by-property basis. It is intended to benefit small taxpayers who have small investments in property and incur small annual costs.
Costs that have not qualified for deduction under any of the means provided above have “survived” to arguably the most complex portion of the new rules that follows.
RABI rules and “units of property” (the core of the capitalization standards) – Step 5
The new “RABI” standards represent the final means by which these new rules can require a cost to be capitalized. Costs that make it through this step will be deducted as repairs, with our congratulations. To be clear, though, if costs qualify for deduction under any of the other sections discussed above, they do not need to be analyzed again here.
These rules described below are incredibly voluminous and complex, and very facts and circumstances-dependent. The information that follows is only a summary.
RABI rules in a nutshell
The RABI standards (Restoration, Adaptation, Betterment and Improvement) simply state that if a cost represents an improvement (the “I”), it must be capitalized. They then explain that there are three types of improvements: Restorations, adaptations and betterments (the “RAB”).
If nothing was left but to elaborate on what goes into those categories, this analysis would be quite simple. However, the regulations also introduce the concept of a “unit of property,” and an understanding of that is essential to learning the RABI rules.
Unit of property
“Unit of property” represents an entirely new way of looking at capitalization of costs.
Much of the RABI rules determine whether or not a cost will be capitalized based on some measurement of the new item’s impact on the underlying property as a whole. However, the analysis generally is not based on cost. It instead is based on things like item headcount, square footage, efficiency or output. Regardless of the measurement, most will understand that small impacts generally will result in deductions and large impacts will result in capitalization. The unit of property concept compares a new item’s impact on a smaller, specific subset of the overall property, thereby increasing the likelihood that it has a significant impact that requires capitalization. Look at it as if the IRS changed the denominator. For real estate, instead of “buildings,” several “units of property” serve as denominators, and the units are established based on their functions. For personal property, a separate measurement exists that also is based on function.
The units of property for buildings are as follows:
- Gas distribution
- Fire suppression
- Other (including the structure itself)
The units of property for non-buildings is less straightforward: Generally a unit of property consists of functionally interdependent components. An automobile may be a good example: Its engine, battery, hood and tires are functionally dependent on each other, and therefore the automobile, rather than any of the components, represents a unit of property. For “plant property,” components that perform a discrete and major function of a large piece of machinery may make up a unit of property on that machine – and the machine may have more than one unit of property. Industry-specific rules apply to “network assets,” like railroad tracks; fuel, water and sewage pipelines; and power and communication lines.
Applying the unit of property concept to the RABI rules
Now that it is understood we are dealing with units of property rather than the entirety of the property itself, we can determine whether improvements have been made to those units that will require capitalization. Improvements consist of restorations, adaptations or betterments.
Costs that return a unit of property that has deteriorated into nonfunctional disrepair back into operating condition normally must be capitalized as a restoration.
Costs that rebuild a unit of property into “like-new” condition after the end of its class life must be capitalized as a restoration.
Replacement of a major component or substantial portion of a unit of property must be capitalized. A major component is one that performs a discrete and critical function of the unit of property’s operation. Replacement of a part or a combination of parts that represent a significant portion of the structure of the unit of property must be capitalized.
Remember the concept of “layers” described much earlier? If a taxpayer has deducted a loss related to an earlier layer of a unit of property resulting from damages, abandonment or a sale, a current expenditure likely will constitute a restoration that must be capitalized. (Otherwise, there would be a cost, but no depreciable layer.)
Amounts incurred to adapt a unit of property to a new or different use must be capitalized. An example of such a cost that must be capitalized is the addition of a medical clinic by a drug store. An example of a cost that does not require capitalization would be the addition of a salad bar by a grocery store. In the former case, the cost is not consistent with the intended use of the building, and in the latter case, it is.
Several forms of betterment exist. One remedies a material condition or defect that existed when the taxpayer acquired a unit of property. Another consists of a material addition or expansion of a unit of property (increased dimensions). Another results from a material increase in capacity, productivity, efficiency, strength, quality or output in a unit of production. Each of these requires capitalization.
The restoration, adaptation, betterment and improvement rules are mandatory, as is incorporation of the unit of property methodology. Retroactive and prospective treatment is required of large taxpayers, and the change must be reported on a Form 3115. Small taxpayers can forgo applying these rules retroactively (thereby also avoiding the need to file Form 3115), but must implement them prospectively. The characteristics of small taxpayers that applies here were described in greater detail in the “Implementation” portion of the section above that described how “Routine maintenance costs can be deducted as repairs rather than capitalized.”
Conclusion of “capitalization vs. expense” analysis
The RABI rules described immediately above, as viewed through the new unit of property lens, represent the last step in our sequence that analyzes whether costs must be capitalized, or whether they can be expensed as repairs. Following the exceptions that preceded it that offered numerous opportunities for immediate deduction, the web of RABI rules will entangle many costs into capitalization, in great part due to the new “micro” approach called for by the unit of property measurement. However, costs that make it to and through the RABI analysis in the sequence, and are not capitalized by any of those steps, are deductible as repair expenses.
There is one final concept to cover from the repair regulations: The partial asset disposition rule. It does not directly involve capitalization, but will often accompany it, naturally following the RABI step in many cases because as a new cost is capitalized, the now-defunct asset it replaces can be treated as if it were disposed. This was not the case under the “old” rules that predated these regulations.
Partial asset dispositions – Step 6
The previous references to “layers” is relevant in the context of partial asset dispositions (“PAD”). The primary intent of this rule is to prevent situations where a taxpayer is simultaneously depreciating an original asset and that same asset’s replacement (and potentially the replacement’s replacement) – a condition that was common under the depreciation rules that existed until now.
Under the “old” rules (which still can be used because PAD is optional), if a taxpayer replaced a building component (a part of a building, such as a roof), the taxpayer would be required to capitalize and depreciate the replacement while continuing to depreciate the original component. By doing so, it simultaneously was depreciating two “layers.” This occurred, curiously, even though only one such “layer” remained (in our example, there never was more than one roof). Under the new PAD rules, when the second layer is put into service and capitalized, the taxpayer has the opportunity to deduct the remaining undepreciated cost of the first layer, leaving only one layer to be depreciated at a time.
This ability brings about some practical concerns, which are best explained by continuing our example. In most cases, a taxpayer’s fixed asset records will not contain a separate entry for “roof” with a cost isolated and assigned to it. Instead, it may contain an entry labeled “building” with no allocation between the components, such as the roof. To undertake a partial asset disposition, the taxpayer must first allocate a portion of the building’s total cost to the roof (essentially breaking one asset into two), and then dispose of the roof. Taxpayers must make this allocation using any “reasonable” method. One such method, which does not involve the need to dig up invoices or related records from the property’s original acquisition date, involves simply discounting the cost of the replacement roof (the outlay that was just made) using the Producer Price Index. That method will be popular because it involves only current records and the index itself.
This benefit is entirely optional in every way conceivable: For large and small taxpayers alike, it can be applied retroactively, prospectively or both; it can be used one year and not used the next; and when employed, it can be used for some assets and not for others. For taxpayers who plan to use this retroactively, they must do so by reporting the deductions (for disposals that took place prior to 2014) on their 2014 tax returns. Form 3115 must be used if retroactive treatment is elected. In all other instances (such as 2014 disposals of 2009 “layers,”) PAD treatment is applied merely by reporting the disposals on Form 4797, as is usually done to report disposals of business assets.
Although in some cases it seems like these PAD rules would lend themselves well to applying the unit of property concept described earlier, it is not necessary to do so in determining whether a component was replaced. (It would be impractical to force that upon taxpayers, because the unit of property measurement did not exist for assets placed in service prior to 2014.) However, it is clear from the regulations that the unit of property concept represents how the IRS expects us to view properties in the future, and allocation of current property costs that break out expenditures into their units of property is highly advisable, and will result in easier analysis of future PAD deductions.
Obviously the tangible property regulations are more cumbersome than the rules they replace. In distinguishing between capitalization and repair expense, we no longer ask whether an outlay extends the life of the asset or improves its value; we test whether any of a number of safe harbor methods are applicable that allow current deduction, and apply the RABI rules to determine the proper treatment if not. Instead of no materiality threshold and a murky, subjective gray area, we now have several de minimis thresholds that offer a black-and-white, objective ability to deduct small outlays. We also must learn to view all future fixed asset additions in terms of units of property. The process produces a more logical outcome than in the past, because we no longer must depreciate multiple layers of a single asset. It sets in motion the potential for ever-growing variances between total fixed asset cost used for book purposes and a smaller cost now used for tax purposes. It front-loads tax deductions, and by characterizing many outlays as repairs rather than depreciable costs, it lowers some taxpayers’ effective tax rates by converting recapture income to long-term capital gain income.
Implementing these rules is difficult, but perhaps not as difficult as we thought, as long as we keep our bearings while moving through the sequence involved with the capitalization analysis. We hope this material makes that analysis a little easier.
Andy Smith is a tax principal who specializes in cost segregation studies and has extensive experience implementing the new repair regulations. Stan Rose is a tax senior manager and frequent author who serves as editor-in-chief of BNN’s monthly newsletter. Both are based in BNN’s Portland, Maine office. If you would like to discuss these matters further, please contact Andy Smith or your BNN professional at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.