Regulations bring clarity to treatment of tangible property expenses
Issuance of “repair regs” provides certainty to taxpayers, but effective date is fast approaching.
September 26, 2013
While many of us were working long hours in mid-September to wrap up the 2012 tax filings for our clients, the IRS was busy as well. On Sept. 13, 2013, the IRS issued the final, revised tangible property regulations (T.D. 9636). In doing so, the taxing authorities have provided clarity for taxpayers in many areas surrounding the treatment of capital expenditures.
These regulations govern the treatment of expenditures incurred in acquiring, producing, or improving tangible assets, including rules on determining whether costs related to tangible property are deductible repairs or capital improvements. The regulations have broad application—they affect all taxpayers that acquire, produce, or improve tangible property.
By issuing regulations, the IRS has sought to resolve the capitalization vs. expense conundrum that has befuddled taxpayers for years. These regulations have followed a tortuous path—the original proposed regulations from 2006 were withdrawn in 2008 after receiving a negative reception, and new proposed regulations were issued. Then, in 2011, the 2008 proposed regulations were withdrawn, and new regulations were issued in temporary and proposed forms. Those regulations were originally intended to be effective in 2012, but the difficulty of adopting the new rules prompted a postponement until 2014. In addition, the IRS announced that the final rules would amend certain sections of the temporary regulations—the de minimis rule, dispositions of tangible property, and the routine maintenance safe harbor.
The final regulations, which were published in the Federal Register on Sept. 19 and apply to tax years beginning on or after Jan. 1, 2014, do not finalize or remove the temporary regulations governing dispositions of property under Sec. 168. Instead, to address significant changes in this area, revised proposed regulations were issued at the same time as the final regulations.
According to the preamble, the final regulations adopt the temporary regulations issued in 2011 (T.D. 9564), with some changes. Many of the changes were in response to the many comments the IRS received after it issued the temporary regulations. This article focuses on those changes.
Threshold for property exempt from capitalization raised
One change was in response to comments that the $100 threshold for property that is exempt from capitalization was too low. Although many commenters suggested the amount be raised to $500 or $1,000, the final rules raise it to $200 and retain the original rule that the amount can be increased in IRS guidance.
De minimis safe harbor
Another dollar threshold that was changed in the final rules is for the de minimis safe harbor. Under the temporary regulations (Temp. Regs. Sec. 1.263(a)-2T(g)(1)(iv)), taxpayers with applicable financial statements (certified audited financial statements) were limited to a deduction for the tax year for incidental materials and supplies of the greater of
The IRS received many comments about this ceiling, and the final regulations expand this limitation.
For taxpayers with applicable financial statements, the de minimis safe harbor applies to property that does not exceed $5,000 per invoice or per item as substantiated by the invoice (and to property costing $5,000 or less with an economic useful life of 12 months or less). For taxpayers without an applicable financial statement, the safe harbor per invoice, or per item substantiated by an invoice, is $500—the amount is reduced for a taxpayer without an applicable financial statement because there is less assurance that the taxpayer’s accounting procedures clearly reflect income (Regs. Sec. 1.263(a)-1(f)(1)). Taxpayers should also note that the capitalization policy must be written and in place before the beginning of the year of implementation.
The final rules further clarify that the de minimis safe harbor may be elected each year, by including a statement on the taxpayer’s timely filed original federal tax return for the year elected. If elected, the de minimis safe harbor must be applied to all amounts paid in the tax year for tangible property that meet the requirements of the de minimis safe harbor, including amounts paid for materials and supplies that meet the requirements. In addition, the final regulations provide that a taxpayer may not revoke an election to use the de minimis safe harbor.
The final rules simplify the de minimis safe harbor by requiring that all materials and supplies be included if taxpayers elect to use the safe-harbor method and that taxpayers may deduct the removal cost when they remove a unit of property.
Standby emergency spare parts
The rules incorporate the definition of standby emergency spare parts contained in Rev. Rul. 81-185 (which addressed the treatment as depreciable property of major emergency standby parts used by an electric utility) and make these spare parts eligible for the optional election to capitalize certain materials and supplies (preamble).
Rotable spare parts
The final rules retain the rule from the temporary regulations permitting taxpayers to elect to capitalize certain materials and supplies but, in response to comments, limit the rule to rotable, temporary, or standby emergency spare parts. Many commenters noted that Rev. Rul. 2003-37, Rev. Rul. 81-185, Rev. Rul. 69-200, and Rev. Rul. 69-201 (all of which concern various types of property found to be eligible for depreciation) are inconsistent with the regulations, which characterize certain tangible properties addressed in these rulings as materials and supplies. However, the IRS believes that the treatment is consistent with the holdings of the revenue rulings, which permit taxpayers to treat rotable, temporary, or standby emergency spare parts as assets subject to the allowance for depreciation.
A taxpayer may revoke the election to capitalize these materials and supplies by filing a ruling request, which the IRS will grant if the taxpayer establishes that it acted reasonably and in good faith and that revocation will not prejudice the government.
The final rules change the requirement that taxpayers using the optional method for pools of rotable and temporary spare parts use it for all pools of rotable spare parts used in that trade or business to permit taxpayers to not use the optional method for those pools of rotable and temporary spare parts for which it does not use the optional method in its books and records for the trade or business.
Consolidated group members’ applicable financial statements
The final rules, in response to comments, now allow taxpayers that are members of consolidated groups for financial statement purposes but not for federal income tax purposes to use the applicable financial statements and accounting procedures of their group to qualify for the de minimis safe harbor.
Treatment of additional costs
The final rules change the treatment of additional costs of acquiring property subject to the safe harbor. A taxpayer that elects the safe harbor is not required to include in the cost of the tangible property the additional costs of acquiring or producing the property if these costs are not included in the same invoice as the tangible property. However, if these additional costs (e.g., delivery fees, installation services) are included on the same invoice with the tangible property, the de minimis safe harbor must include in the property’s cost all these additional costs of acquiring or producing the property. The regulations provide that an allocation of costs must be made for multiple properties included on the same invoice and allows any reasonable method of making the allocation.
Inherently facilitative amounts
The IRS received many comments objecting to the requirement to capitalize amounts paid to facilitate the acquisition or production of real or personal property contained in the temporary regulations. The final regulations generally retain the 2011 temporary regulation rules addressing facilitative amounts. As in the 2011 temporary regulations, the final regulations include the special rule for the acquisition of real property providing that, except for amounts specifically identified as inherently facilitative, an amount paid by a taxpayer in the process of investigating or otherwise pursuing the acquisition of real property does not facilitate the acquisition if it relates to activities performed in the process of determining whether to acquire real property and which real property to acquire.
The final regulations do not expand the deduction of such pre-decisional, investigatory costs to personal property, because unlike real property acquisitions, personal property acquisitions usually do not raise the issue whether the transaction costs should be characterized as deductible business expansion costs rather than costs to acquire a specific property. The final regulations clarify the meaning of finders’ fees and brokers’ commissions and define contingency fees as inherently facilitative costs in acquiring property that are required to be capitalized.
Small taxpayers’ building improvements
A significant change for small taxpayers is that taxpayers with gross receipts of $10 million or less can elect to deduct, for buildings that initially cost $1 million or less, the lesser of $10,000 or 2% of the adjusted basis of the property for repairs, maintenance, improvements, and similar costs each year.
This small-taxpayer safe harbor for building improvements can be elected annually on a building-by-building basis by including a statement on the taxpayer’s timely filed original federal tax return, including extensions, for the year the costs are incurred. The election is not revocable.
Proposed regulations on dispositions
The IRS also issued proposed regulations on dispositions of property depreciable under the modified accelerated cost recovery system (REG-110732-13). The IRS had announced in Notice 2012-73 that it intended to revise the disposition rules that appeared in the temporary regulations. These proposed regulations contain those revisions, but taxpayers can continue to apply the rules in Temp. Regs. Secs. 1.168(i)-1T and 1.168(i)-8T for tax years beginning on or after Jan. 1, 2012, and before Jan. 1, 2014.
While the proposed regulations contain many of the same property disposition rules as the 2011 temporary regulations, they make changes to the rules on determining the asset disposed of and the qualifying disposition of an asset in a general asset account. They also contain new rules for partial asset dispositions.
The proposed regulations provide that a building (including its structural components), a condominium (including its structural components), or a cooperative (including its structural components) is the asset for disposition purposes. This rule allows taxpayers to forgo a loss upon the disposition of a structural component of a building without making a general asset account election.
Another change from the temporary regulations is that the definition of a disposition includes the disposition of a structural component (or portion) of a building only if the partial disposition rule applies to that structural component (or portion).
To simplify the rules for general asset accounts, the proposed rules change the definition of a qualifying disposition so that it is the same as it was under the final regulations for general asset accounts under Regs. Sec. 1.168(i)-1 (as in effect before the temporary regulations were issued). As a result, a qualifying disposition is a disposition that does not involve all the assets, the last asset, or the remaining portion of the last asset, remaining in a general asset account that is (1) a direct result of a fire, storm, shipwreck, or other casualty, or from theft; (2) a charitable contribution; (3) a direct result of a cessation, termination, or disposition of a business, manufacturing, or other income-producing process, operation, facility, plant, or other unit (other than by transfer to a supplies, scrap, or similar account); or (4) a transaction to which a nonrecognition section of the Code applies.
Taxpayers have long awaited the finalization of the tangible property regulations. While the regulations for dispositions are still in proposed form, taxpayers who have not been working on implementing all of these regulations should do so, as the Jan. 1, 2014, effective date is fast approaching. As implementation of these regulations often requires accounting method changes, as well as revisions to capitalization policies, immediate action on the part of many taxpayers is necessary.
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Stephen J. Ehrenberg, CPA, is a tax principal in the Los Angeles office of Holthouse Carlin & Van Trigt LLP.