Deduction vs. Capitalization of Tangible Property Costs: What Contractors Need to Know About the New Temporary Regulations

In late December 2011, the IRS issued temporary regulations that provide guidance on expensing versus capitalizing amounts paid to acquire, produce or improve tangible property. These new regulations are generally effective January 1, 2012. Among other things, they clarify and expand the present standards, provide new bright-line tests for applying the standards, and provide guidance regarding the accounting for and dispositions of  property. The temporary regulations are long and complicated. This article addresses some of the more important concepts covered by the regulations as they apply to contractors.

As you read the material that follows, bear in mind that these regulations will affect virtually all taxpayers that acquire, produce or improve tangible property. To comply with the new rules, all affected taxpayers will need to request a change of accounting method, if for no other reason to make a general asset account election to manage dispositions on existing property (especially real estate structural components and corresponding building systems, as explained below).

MATERIALS AND SUPPLIES

Deductible or Capitalized Costs

Costs are currently deductible as repair expenses if they are incidental in nature, and neither materially add to the value of property nor appreciably prolong its useful life. Costs are also currently deductible if they are for materials and supplies consumed during the year. Expenses must be capitalized if they are for permanent improvements or betterments that increase the value of the property, restore its value or use, substantially prolong its useful life, or adapt it to a new or different use.

The temporary regulations distinguish between non-incidental and incidental material. Under the new temporary regulations, the cost of buying or producing non-incidental material and supplies are deductible in the tax year in which the materials and supplies are used or consumed. For incidental materials and supplies that are carried on-hand — for which no record of consumption nor physical inventories are kept — are deductible in the tax year in which they are paid, provided taxable income is clearly reflected.

What are materials and supplies?

The temporary regulations define materials and supplies as tangible property used or consumed in the taxpayer’s business operations that are not inventory and that fall within any of the following categories:

• It is a component acquired to maintain, repair or improve a unit of tangible property owned, leased or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property;
• It consists of fuel, lubricants, water and similar items that are reasonably expected to be consumed in 12 months or less; or
• It is a unit of property with an economic useful life of 12 months or less; or
• It is a unit of property with an acquisition cost or production cost of $100 or less; or
• It is identified in published IRS guidance as materials and supplies.

The above categories contain the terminology “unit of property” (UOP), a central theme throughout these temporary regulations. The concept will be discussed in more depth later in this article, but generally, all components that are functionally interdependent (i.e., one component’s placement in service is dependent on the placement in service of another component) comprises a single UOP.

Economic useful life of a UOP, for purposes of applying the 12-month rule, is the period over which the property may reasonably be expected to be useful to the taxpayer. Wear and tear, climatic and other conditions particular to the taxpayer’s business are to be considered in determining this period.

De minimis rule

A special rule applies for purposes of the 12-month economic useful life test to taxpayers with an applicable financial statement (AFS). These include a statement required to be filed with the US Securities and Exchange Commission or a certified financial statement accompanied by an independent CPA’s report used for credit reporting purposes. If an AFS is issued, the taxpayer determines economic useful life in a way that is consistent with the economic useful life used for purposes of determining depreciation in the books and records supporting the AFS.

A taxpayer may elect to apply the de minimis rule found in the capitalization regulations to any material or supply as defined above, and to any material or supply for which the election is made that is not treated as a material or supply. Under the elective de minimis rule, such amounts don’t have to be capitalized if:

• The taxpayer has an AFS, has written accounting procedures in place at the beginning of the year for expensing amounts paid for property under certain dollar amounts, and treats such amounts as expenses on its AFS in accordance with the written accounting procedures, and
• The aggregate of amounts paid and not capitalized under the de minimis rule for the tax year are less than or equal to the greater of:
  • 0.1% of the taxpayer’s gross receipts for the tax year as determined for federal income tax purposes, or
  • 2% of the taxpayer’s total depreciation and amortization as determined in its AFS.

For example, a taxpayer with a written policy to expense property costing $500 or less purchases 200 computers at a cost of $500 each, and immediately expenses the entire $100,000. With gross receipts of $50M and AFS depreciation of $4M, the ceiling based on depreciation results in $80K. Therefore, (subject to clarification anticipated with respect to whether all or nothing was intended in these regulations), unless the taxpayer elects to capitalize the excess $20,000, the entire $100,000 must be capitalized.

There is no de minimis rule for a business that does not have an AFS. Hopefully, the final regulations will provide some more flexibility for unaudited financial statements to be considered as an AFS.

The regulations give taxpayers the ability to elect to capitalize and depreciate the costs of any materials and supplies in the year paid, simply by beginning to depreciate the cost in that year.

Rotable and temporary spare parts

Rotable and temporary spare parts for your construction equipment are materials and supplies acquired for installation on a unit of property, removable from that UOP, generally repaired or improved, and either reinstalled on the same or other property or stored for later installation. The temporary regulations allow the following optional methods for all of the rotable and temporary spare parts in the same trade or business.

• Deduct the amount paid to buy or produce the part in the tax year that the part is first installed on a UOP.
• When the part is removed from the UOP, include the part’s fair market value in income.
• Include in the basis of the part its fair market value when removed, and the amount paid to remove the part from the UOP.
• Include in the basis of the part any amounts paid to maintain, repair or improve the part in the tax year these amounts are paid.
• In the tax year the part is reinstalled, deduct the amounts paid to reinstall the part and those amounts included in basis under the above rules.
• In the tax year the part is disposed of, deduct the amounts included in the basis of the part to the  extent those amounts have not been previously deducted.

ACQUISITION OR PRODUCTION OF REAL OR PERSONAL PROPERTY

The temporary regulations restate long-established concepts about which costs must be capitalized in connection with the acquisition or production of real or personal property. All costs that facilitate the acquisition or production of such property must be capitalized, with exceptions for employee compensation and overhead costs. Repair-type expenses incurred before the asset is placed in service must also be capitalized under the new rules.

Costs that may be capitalized

Under the general capitalization rule, a taxpayer must capitalize amounts paid to acquire or produce a unit of real or personal property, including leasehold improvement property, land and land improvements, buildings, machinery and equipment, and furniture and fixtures. Amounts paid to acquire or produce a unit of real or personal property include the invoice price and transaction costs. The taxpayer must also capitalize costs for work performed before the date that the unit of property (UOP) is placed in service.

Amounts paid to facilitate the acquisition or production of real or personal property must also be capitalized. Facilitative costs include items such as shipping, moving or appraising property, application fees, sales and transfer taxes, finder’s fees, and architectural, engineering, environmental or inspection services related to specific properties, brokers, or appraisers’ fees, as well as services provided by a qualified intermediary in a like-kind exchange.

Costs that may be expensed

However, “whether and which” expenses are deductible. These consist of activities performed in the process of determining whether to acquire real property and which real property to acquire. For example, a retailer would not have to capitalize costs associated with using a consulting firm to suggest locations in which to expand operations, but would have to capitalize appraisal costs to determine the value of properties recommended by the consulting firm.

Under the de minimis rules, amounts paid to acquire or produce a unit of real or personal property do not have to be capitalized if they meet certain standards, as discussed above in the materials and supplies section. However, the de minimis rule does not apply to amounts paid to improve property, acquire property for resale, or for land.

DEFINING A UNIT OF PROPERTY FOR CAPITALIZATION PURPOSES

A significant amount of the guidance in the temporary regulations revolves around what constitutes the unit of property (UOP) that is being placed in service, repaired or improved. The smaller the UOP, the more likely it is that the cost incurred in connection with that UOP will have to be capitalized. The temporary regulations include detailed and complex guidance on what constitutes the UOP.

In general, for real or personal property that is not classified as a building, all components that are functionally interdependent comprise a single UOP. Components of property are functionally interdependent if the placing-in-service of one component by the taxpayer is dependent on the placing-in-service of the other component by the taxpayer. For example, a business acquires a battery-powered cart from one vendor and the battery from another, and then assembles the two components. Thus, the UOP is the cart since the cart cannot be placed in service without the battery.

Real estate

Buildings are now separated into components for determination of what constitutes a UOP. The building and its structural components is one UOP. Structural components include the roof, walls, partitions, floors and ceilings as well as permanent coverings, windows and doors.

Each of the nine building systems constitutes a separate UOP. The systems enumerated in the temporary regulations are as follows:

• HVAC systems
• Plumbing systems
• Electrical systems
• All escalators
• All elevators
• Fire protection and alarm systems
• Security systems
• Gas distribution systems
• Any other system defined in published guidance

The temporary regulations permit taxpayers to treat the retirement of a structural component as a disposition. However, the IRS acknowledges that it may be difficult for taxpayers to determine the amount of the adjusted basis of the property that is allocable to a retired component under these rules. This rule implies that though the building and all of the building systems would have the same MACRS class life, the building and each of the nine systems would need to be separated for depreciation purposes going forward, which would require what could be an expensive cost segregation study upon acquisition of the building. In the past, cost segregation studies were performed primarily to segregate shorter-life property from the building itself to accelerate depreciation deductions. Under the temporary regulations, the studies will have to take extra steps to segregate building systems as well.

Routine maintenance is deductible

Routine maintenance remains deductible. Routine maintenance refers to the recurring activities that a taxpayer expects to perform as a result of its use of the UOP to keep it in its ordinary efficient operating condition. Examples include inspection, cleaning and testing, and the replacement of parts with comparable and commercially available and reasonable replacement parts. Whether an expense is considered routine maintenance depends on factors such as the recurring nature of the activity, industry practice, manufacturer’s recommendations, the taxpayer’s experience, and the taxpayer’s treatment of the activity on its applicable financial statement.

CAPITALIZATION OF REPAIRS: BETTERMENTS, RESTORING AND ADAPTING

The new temporary regulations attempt to determine what expenses must be capitalized. Expenses are treated as deductible if they are not otherwise required to be capitalized.

In general, repairs are capitalized because they better or improve a unit of property, restore it or adapt it to a new or different use. The major categories of capitalized expenses are those that better or improve a UOP, restore it or adapt it to a new and different use. However, under these regulations, a taxpayer will now have to trace through detailed, highly structured rules for each category to determine if an expense must be capitalized, and then wade through 49 examples in the regulations to find one similar to their situation.

Betterments

The first category requiring capitalization is betterment costs. “Betterment costs” is a new term that consists of amounts paid:

• To ameliorate a material condition or defect that either existed before the taxpayer acquired the UOP or arose during its production;
• That results in a material addition (including physical enlargement, expansion or extension) to the UOP; or
• Results in a material increase in capacity, productivity, efficiency, strength or quality of the UOP or the output of the UOP.

The question of whether an expense results in betterment is determined based on the facts and circumstances, including but not limited to the purpose of the expense, the physical nature of the work performed, the effect of the expense on the UOP, and the taxpayer’s treatment of the expense on its applicable financial statement.

Restoring property

Restoration costs is the second category that must be capitalized. There are five categories of restoration costs which need to be capitalized:

• Expenditures to replace a component of a UOP where the taxpayer has properly deducted a loss for that component or taken into account the adjusted basis of the component in realizing a gain or loss resulting from a sale or exchange of the component;
• Expenditures to repair damage to a UOP for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss or casualty event;
• Expenditures to return the UOP to its ordinary efficient operating condition where the property has deteriorated to a state of disrepair and is no longer functional for its intended use;
• Expenditures which result in rebuilding the UOP to a like-new condition after the end of its class life; and
• Expenditures to replace a part or a combination of parts that comprise a major component or a substantial structural part of the UOP.

Adapting the property

The third category for capitalization is costs incurred to adopt a UOP to a new or different use. A “new or different use” means a situation where the adaption isn’t consistent with the taxpayer’s intended ordinary use of the property when they placed it in service. For example, conversion of a manufacturing facility into a showroom would constitute a new and different use. However, if the owner of a building consisting of 20 retail spaces convers three spaces on one larger space for an existing tenant, the cost of conversion is not treated as a new or different use because the combination of spaces is consistent with the owner’s intended ordinary use of the building.

CAPITALIZATION OF EXPENDITURES RELATED TO LEASED BUILDINGS

Amounts paid to acquire or produce a UOP must be capitalized, along with improvement costs incurred to better a UOP, restore it, or adapt it to a new and different use. The new temporary regulations cover how a lessee-tenant or lessor-owner capitalizes costs related to leased property.

If the taxpayer is the lessee of all or part of a building, its UOP is each building and its structural components or that part of a building subject to the lease and the structural components associated with the leased part. An amount is paid for an improvement to a leased building if any of the amounts improve:

• The building structure or any building system, if the taxpayer is the lessee of the entire building; or
• That part of the building structure subject to the lease or that part of any building system associated with the leased part of the building structure if only part of the building is leased.

In general, the tenant must capitalize the aggregate of related amounts paid to improve a unit of leased property. However, amounts are not capitalized if:

• The lessee receives a construction allowance for the improvements, which can be excluded from income under Internal Revenue Code Section 110. This section excludes from income any amount received in cash or as a rent reduction from a landlord, if the amount is received under a short-term retail space lease, defined as 15 or less years, and made so that the tenant can build or improve qualified long-term property for its trade or business at the leased retail space; or
• The lessee’s improvement is a substitute for rent, whereby the improvements are considered as made by the landlord and not the tenant.

If the taxpayer is the lessor/landlord, they must capitalize the amounts as follows:

• Amounts paid directly to improve a unit of leased property where the lessor owns the improvement;
• Amounts paid indirectly through a construction allowance to the lessee, to improve a unit of leased property, to the extent that Code Section 110 applies to the construction allowance; or
• Amounts that the lessee pays to improve a unit of leased property, where the lessee’s improvement constitutes a substitute for rent.

CHANGING ACCOUNTING METHODS

Recognizing the fact that most taxpayers will need to adjust methods of accounting to comply with these complicated new rules, the Internal Revenue Service has issued two revenue procedures permitting automatic accounting method changes: one for repair-related items and the other for depreciation adjustments.

Revenue procedure 2012-19 permits material- and repair-related automatic method changes such as the following:

• Deducting repair and maintenance costs in situations where costs have been erroneously capitalized in the past;
• Changing to a regulatory accounting method;
• Deducting non-incidental or incidental materials and supplies as appropriate;
• Deducting de minimis amounts; and
• Capitalizing improvements to tangible property where repair and maintenance costs have been erroneously deducted in prior years.

Revenue procedure 2012-20 deals with automatic depreciation changes such as:

• Depreciation of leasehold improvements;
• Changing from one permissible method to another permissible method for depreciation of MACRS property;
• Disposition of a building or structural component;
• Disposition of tangible depreciable assets; and
• General asset account elections.

IRS AUDITS: SAFE FOR NOW?

The IRS has issued a directive to examiners in its Large Business & Industry Division for tax years beginning before January 1, 2012, to generally stop current exam activity on cost capitalization issues and not begin any new examinations with regard to the issue. For tax years starting in 2012 and 2013, they are to determine if the taxpayer applied for an accounting method change and perform a “risk assessment” to determine whether to start an examination.

Aprio’s Real Estate & Construction team can help you make sense of these new regulations and take action on the aspects that apply to you and your business. Schedule a consultation with us today.