“the new rules” expense or capitalize - … · today’s objectives a “12,000 foot review ”...

© 2012. Cost Seg Associates. Reproduction available by CSA at (888) 245-5613.

4600 West 77th Street Suite 350 Minneapolis, MN 55435

Office (952) 831-6300 Toll Free (888) 245-5613

Tuesday, January 17, 2012

“THE NEW RULES” EXPENSE OR CAPITALIZE ?

TODAY’S OBJECTIVES

A “12,000 foot review ” of the new temporary regulations (TD 9564)

that were issued to “provide guidance regarding deduction and

capitalization of expenditures related to tangible property”

To identify the opportunities within the new temporary regulations

Discuss how the “old rules” have changed where applicable

To take a “dent” out of the 255 pages of new regulations!

Questions & Answers (?)

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AGENDA – What We Will Cover Today

Overview of the changes

Cost to Maintain or Improve Tangible Property

Unit of Property “UOP” Concepts

Repair or Improvement Standards & Examples

New Rules for Dispositions

MACRS Accounting

Determining Loss on the Disposition

Transition Rules

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WHAT IS INCLUDED IN THE NEW TEMPORARY

REGULATIONS?

They clarify and expand the standards in the current regulations

under sections 162(a) and 263(a) and provide certain bright-line tests

(for example, a de minimis rule for certain acquisitions) for applying

these standards.

They also provide guidance under section 168 regarding the

accounting for, and dispositions of, property subject to section 168.

They also amend the general asset account regulations.

The temporary regulations will affect all taxpayers that acquire,

produce, or improve tangible property.

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TEMPORARY REGULATIONS – The New Law

They are effective on January 1, 2012.

Unlike “Proposed Regulations” they are effective immediately and

can be relied on for guidance.

Subject to a three-year period and they are either then finalized or

“sunset”.

Practitioners and taxpayers have until April 4, 2012 to make

comments on the temporary regulations.

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CURRENT LAW – Capitalization & Expense

Rules

Costs are currently deductible as a repair expense under Code §162 if they

“are incidental in nature, and neither materially add to the value of the

property nor appreciably prolong its useful life.”

Conversely, expenses must be capitalized under Code §263 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.”

Capitalization is the proper treatment for expenditures incurred in new

construction. See §263(a) and §263A. Capitalization is also generally required

for additions to existing buildings or for installations of material components

to buildings or equipment.

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THE NEW LAW – Capitalization & Expense

Rules

Reason for the change - “To achieve results more consistent with existing law

and to provide relief from the potential inequities that can result from the application of

the depreciation and disposition rules, the temporary regulations revise and amend the

2008 proposed regulations in several respects.”

First, the temporary regulations retain the rule from the 2008 proposed regulations that

the unit of property for a building consists of the building and its structural components.

The regulations revise the manner in which the improvement standards must be

applied to the building and its structural components and,

The regulations require a taxpayer to consider the effect of the expenditure on

certain significant and specifically defined components of the building, rather than

the building and its structural components as a whole.

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THE NEW LAW – Capitalization & Expense

Rules (Continued)

Second, the temporary regulations do not include the 50 percent thresholds and

recovery period limitation for determining whether a replacement rises to the level of a

major component or substantial structural part of a unit of property.

Finally, the temporary regulations include new provisions under section 168 that

expand the definition of dispositions to include the retirement of a structural component

of a building.

This change allows a taxpayer to recognize a loss on the disposition of a structural

component of a building before the disposition of the entire building, so that a

taxpayer will not have to continue to depreciate amounts allocable to structural

components that are no longer in service.

Thus, under the temporary regulations, a taxpayer is not required to capitalize and

depreciate simultaneously amounts paid for both the removed and the replacement

properties.

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UNIT OF PROPERTY (UOP)

Extremely Important Concept Expanded Upon in the Temporary

Regulations!

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Buildings

Single UOP

Systems

Everything Else (Non-Building)

Default Rule - Functional Interdependence

Plant Property - Discrete & Major Function

Network Assets – Facts & Circumstances &

Industry Specific


BUILDING (UOP)

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Building Structure- 9 Systems

1. HVAC

2. Plumbing

3. Electrical

4. Escalators

5. Elevators

6. Fire Protection

7. Security

8. Gas

9. Other systems identified in published guidance


WHY IS THE UOP IMPORTANT ?

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Any discussion for repair treatment is in part

determined by what the UOP is.

The UOP determines what can be “pulled” out for

determining the loss on disposition.

The UOP does not affect or determine the

depreciable recovery period.

Applies to both “real estate” and “personal

property”.

Get to know and understand these concepts!


Example 1- Building Systems: §1.263(a)-3T(e) Amounts

paid to improve tangible property (temporary)

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Fact Pattern:

Building systems. X owns an office building that contains a HVAC system that incorporates

ten roof-mounted units that service different parts of the building.

Project Work:

The taxpayer pays an amount for labor and materials for work performed on the roof-top

units.

Result:

Must treat the building and its structural components as a single unit of property

The entire HVAC system, including all of the roof-mounted units and their components,

comprise a building system.

Therefore, under paragraph (e)(2)(ii) of this section, if an amount paid by X for work on

the roof-mounted units results in an improvement (for example, a betterment) to the

HVAC system, X must treat this amount as an improvement to the building.


REPAIR VS. IMPROVEMENT

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An Amount Paid Must Be Capitalized if it Results in a:

Betterment

1. It ameliorates (fixes) a material condition or material defect

that existed prior to the acquisition of the property or

production

2. It results in a material addition to the unit of property

(including a physical enlargement, expansion, or

extension); or

3. Results in a material increase in the capacity, productivity,

efficiency, strength, or quality of the unit of property or its

output.

Adapts the property to a new or different use


REPAIR VS. IMPROVEMENT (Continued)

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Restoration (continued)

1. is for the replacement of a component of a unit of property and

the taxpayer has properly deducted a loss for that component

(other than a casualty loss under §1.165-7);

2. is for the replacement of a component of a unit of property and

the taxpayer had properly taken into account the adjusted basis

of the component in realizing gain or loss resulting from the sale

or exchange of the component;

3. is for the repair of damage to a unit of property for which the

taxpayer has properly taken a basis adjustment as a result of a

casualty loss under section 165, or relating to a casualty event

described in section 165;

4. returns the unit of property to its ordinarily efficient operating

condition if the property has deteriorated to a state of disrepair

and was no longer functional for its intended use;


REPAIR VS. IMPROVEMENT (Continued)

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Restoration (continued)

5. results in the rebuilding of the unit of property to a like-new condition after

the end of its economic useful life;

6. is for the replacement of a major component or a substantial structural

part of the unit of property.

Plan of “rehabilitation doctrine”- No Longer Applicable

Just because you are in the process of making substantial improvements

does not mean that everything has to be capitalized.


Example 6- Not a betterment- building refresh: §1.263(a)-

3T(h) Amounts paid to improve tangible property (temporary)

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Fact Pattern:

X owns a nationwide chain of retail stores that sell a wide variety of items. To remain

competitive in the industry and increase customer traffic and sales volume, X

periodically refreshes the appearance and layout of its stores.

Project Description:

The work that X performs to refresh a store consists of cosmetic and layout changes to the store’s interiors and general repairs and maintenance to the store building to make the stores more attractive and the merchandise more accessible to customers.

Work Performed:

The replacing and reconfiguring a small number of display tables and racks to provide better exposure of the merchandise,

Making corresponding lighting relocations and flooring repairs,

Moving one wall to accommodate the reconfiguration of tables and racks,

Patching holes in walls,

Repainting the interior structure with a new color scheme to coordinate with new signage,

Replacing damaged ceiling tiles,

Cleaning and repairing vinyl flooring throughout the store building,

Power washing building exteriors.


Example 6- Not a betterment- building refresh

(Continued)

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Result:

The amounts paid for the refresh of each building do not result in

material increases in capacity, productivity, efficiency, strength, or

quality of the buildings’ structures or any building systems as compared

to the condition of the buildings’ structures and systems after the

previous refresh.

Rather, the work performed keeps X’s store buildings’ structures and

buildings’ systems in the ordinary efficient operating condition that is

necessary for X to continue to attract customers to its stores.

Therefore, X is not required to treat the amounts paid for the refresh of

its store buildings’ structures and buildings’ systems as betterments

under paragraph (h)(1)(iii) of this section.

However, X is required to capitalize the amounts paid to acquire and

install each section 1245 property in accordance with §1.263(a)-2T(d)(1).


Example 7- Building refresh- limited improvement: §1.263(a)-

3T(h) Amounts paid to improve tangible property (temporary)

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Fact Pattern:

X owns a nationwide chain of retail stores that sell a wide variety of items. To remain

competitive in the industry and increase customer traffic and sales volume, X

periodically refreshes the appearance and layout of its stores.


In addition to the work in Example 6, X pays amounts to remove and replace the bathroom

fixtures (that is, the toilets, sinks, and plumbing fixtures) with upgraded bathroom fixtures in

all of the restrooms in X’s retail buildings in order to update the restroom facilities.

Result:

Therefore, in accordance with paragraph (e)(2)(ii) of this section, X must treat the amounts paid

for a betterment to each plumbing system as an improvement to X’s retail building to which the

costs relate, and must capitalize the amounts under paragraph (d)(1) of this section.

However, X is not required under paragraph (f)(3) of this section to capitalize the costs

described in Example 6 to refresh the appearance and layout of its stores because those costs

do not directly benefit and are not incurred by reason of the improvements to the stores’

plumbing systems.


Example 13- Not a betterment- replacement with same part:

§1.263(a)-3T(h) Amounts paid to improve tangible property

(temporary)

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Fact Pattern:

X owns a small retail shop. A storm damages the roof by displacing numerous

wooden shingles.

Project Work:

The taxpayer pays a contractor to replace all the wooden shingles on the roof with new

wooden shingles.

Result:

The roof is part of the building structure

The event necessitating the expenditure was a storm and prior to the storm the building

structure was functioning for its intended use.

X is not required to treat the amount paid to replace the shingles as a betterment under

paragraph (h) of this section because it does not result in a material addition, or material

increase in the capacity, productivity, efficiency, strength, or quality of the building

structure or the output of the building structure compared to the condition of the

building structure prior to the storm.


Example 14- Not a betterment- replacement with comparable part:

§1.263(a)-3T(h) Amounts paid to improve tangible property (temporary)

20

Fact Pattern:

Same as Example 13 but the taxpayer cannot find comparable wood

shingles and replaces them with a comparable asphalt shingle.

Result:

The amount that X pays to re-shingle the roof with asphalt shingles does not

result in a betterment to the shop building structure, even though the asphalt

shingles may be stronger than the wooden shingles.

Because the wooden shingles could not practicably be replaced with new

wooden shingles, the replacement of the old shingles with comparable

asphalt shingles does not, by itself, result in a betterment, and therefore, an

improvement, to the shop building structure under this paragraph (h).


Example 15- Betterment- replacement with improved parts:

§1.263(a)-3T(h) Amounts paid to improve tangible property

(temporary)

21

Fact Pattern:

Same as Example 13 but the taxpayer cannot find comparable wood shingles and

replaces them with upgraded shingles made of lightweight composite

materials that are maintenance-free and do not absorb moisture.

Result:

The amount paid for these shingles results in a betterment to the shop building structure

under paragraphs (h)(1)(iii) and (h)(3)(iii) of this section because it results in a material

increase in the quality of the shop building structure as compared to the condition of the

shop building structure prior to the storm.

Therefore, in accordance with paragraph (e)(2)(ii), X must treat the amount paid for the

betterment of the building structure as an improvement to the building and must

capitalize the amount paid under paragraph (d)(1) of this section.


Example 12- Replacement of a major component or

substantial structural part; roof: §1.263(a)-3T(i)

Amounts paid to improve tangible property (temporary)

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Fact Pattern:

X owns a large retail store. X discovers a leak in the roof of the store and hires a contractor to

inspect and fix the roof. The contractor discovers that a major portion of the sheathing and

rafters has rotted, and recommends the replacement of the entire roof.

Project Work:

The taxpayer pays a contractor to replace the entire roof with a new roof.

Result:

The roof is part of the building structure

Under paragraph (i)(1)(vi) of this section, X must treat the amount paid to replace the

roof as a restoration because X paid the amount to replace a major component or

substantial structural part of X’s building structure.


ACCOUNTING FOR MACRS PROPERTY

Single Asset Account (SAA’s)

Default Rule

A single computer

Multiple Asset Account (MAA’s)

Default Rule

Ten computers

General Asset Account (GAA’s)

Must be elected (at the top of Form 4562)

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ACCOUNTING FOR MACRS PROPERTY

(Continued)

General Asset Account (GAA’s)

Same depreciation method (can’t combine bonus with non-

bonus)

Same recovery period- 5-year, etc.

Same convention – HY, MQ, etc.

Placed in service in the same year

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DISPOSITIONS OF MACRS PROPERTY – GENERAL RULES

For all three accounts (SAA, MAA & GAA) defined as:

A transfer of ownership of the asset or the permanent withdrawal of an asset

from the trade or business.

A disposition includes:

Sale or exchange

Retirement

Physical abandonment

Destruction of the asset

Transfer to supplies, scrap or a similar account

Retirement of a structural component of a building (NEW)

Involuntary conversion

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DISPOSITIONS OF STRUCTURAL COMPONENTS

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The ACRS proposed regulations (which have generally applied to

MACRS property) provided that a disposition does not include a

retirement of a structural component of a building.

The new temporary regulations take an approach to achieve results

more consistent with existing case law and to avoid the potential

inequities resulting from the depreciation and disposition rules.

How many roofs are you depreciating?

The new rule- replace a roof, deduct a roof

The new loss deduction generally is now mandatory

May choose not to recognize a loss with the election of GAA


DETERMINING YOUR BASIS AND LOSS DEDUCTION

FROM RETIRING A STRUCTURAL COMPONENT

27

Specific Identification

Cost Segregation Study Results

The IRS and the Treasury Department recognize that it may be

impracticable for a taxpayer that accounts for assets in multiple

asset accounts (MAA) to determine from the taxpayer’s records the

unadjusted depreciable basis of the asset disposed of

Accordingly, the temporary regulations provide that the taxpayer

may use any reasonable, consistent method to make that

determination.

Similar rules are provided if the asset disposed of is a

component of a larger asset.


Example 1- Disposition §1.168(i)-8T(h) Dispositions of MACRS property (temporary)

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Fact Pattern:

A owns an office building with four elevators.


One of the elevators is replaced.

Results:

The retirement of the replaced elevator, which is a structural component of

the building, is a disposition.

As a result, depreciation for the retired elevator ceases at the time of its

retirement (taking into account the applicable convention) .

A recognizes a loss upon this retirement.


Example 5- Disposition §1.168(i)-8T(h)Dispositions of MACRS property (temporary)

29

Fact Pattern:

On July 1, 2009 a calendar year taxpayer, purchased and placed in service a multi-story office

building that costs $20,000,000


On June 30, 2012 the taxpayer replaces one of the building’s elevators

Results:

Because D cannot identify the cost of the structural components of the office building

from its records, D uses a reasonable method that is consistently applied to all of the

structural components of the office building to determine the cost of the elevator.

Using this reasonable method, D allocates $150,000 of the $20,000,000 purchase price

for the building to the retired elevator.

The retirement of the replaced elevator, which is a structural component of the building,

is a disposition.

Thus, the adjusted depreciable basis of the retired elevator is $138,619.50 and is

removed from the building cost resulting in a Section 1231 loss


DETERMINING YOUR BASIS AND LOSS DEDUCTION

FROM RETIRING A STRUCTURAL COMPONENT

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General Asset Accounts

Old rule- a loss was generally not recognized until the last asset

within the account was removed

New rule:

Defer the loss and not remove the disposed assets

Identify the disposed asset and take the loss


Transition Rules & Observations

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The Temporary Regulations are generally effective for amounts paid

or incurred in taxable years beginning on or after January 1, 2012

A Change to conform to these Temporary Regulations will be a

change in the method of accounting for some of the sections and a

3115 will be required

Do you need to do a 3115 if you had previously did a change for

resulting from a past repair study?

What if you had taken an aggressive approach and expensed

repairs in the past that are now considered to be capitalized

under the “BAR” tests?

Does it make sense to consider making a “GAA” election for

building components?

Transition rules will be forthcoming!


Changes Not Addressed Today

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De minimis rules

Leasehold improvements & leased buildings

Moving & reinstallation costs

Removal costs

Safe harbor for routine maintenance- not applicable to buildings

Work performed prior to placing property in service

Transaction costs

Network assets

Additional rules for determining UOP’s for property other than

buildings

Most of the examples included within the new temporary regulations


MATERIALS & SUPPLIES

The temporary regulations generally retain the framework set forth in the 2008

proposed regulations for materials and supplies

The 2008 proposed regulations defined materials and supplies as tangible

property that is used or consumed in the taxpayer’s operations that:

Is not a unit of property or acquired as part of a single unit of property;

Consists of fuel, lubricants, water, and similar items that are reasonable

expected to be consumed in 12 months or less

Is a unit of property that had an economic useful life of 12 months or less,

beginning when the property was used or consumed;

Is a unit of property that had an acquisition or production cost (as determined

under section 263A) of $100 or less; or

Is identified as a material and supply in future published guidance

33


MATERIALS & SUPPLIES

The temporary regulations changes include:

They modify and expand the definition of materials and supplies

They provide an alternative optional method of accounting for

rotable and temporary spare parts

They provide an election to treat certain materials and

supplies under the de minimis rule of §1.263(a)-2T

In addition, consistent with the 2008 proposed regulations,

the temporary regulations allow a taxpayer to elect to

capitalize certain materials and supplies.

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Rotable or Temporary Spare Parts

The 2008 proposed regulations proposed to allow a deduction for amounts paid

for rotable or temporary spare parts when the parts were discarded from the

taxpayer’s operations.

Alternatively, a taxpayer could elect to capitalize and depreciate rotable spare

parts over the parts’ applicable recovery period.

The temporary regulations attempt to ease the administrative accounting burden

and provides for an optional method

This optional method may be used as an alternative to treating the parts as

used or consumed in the year of disposition or electing to treat the parts as

depreciable assets.

If a taxpayer chooses to use the optional method, the method must be used

for all of the taxpayer’s rotable and temporary spare parts in the same trade or

business.

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CS

A T

EA

M

CSA TEAM

Rod Axtell CPA and Managing Partner (952) 831-6300 [email protected]

Robert Lehmann Partner and

Senior Vice President of Sales (612) 805-6648 [email protected]

Paula Carlson Vice President Marketing (612) 803-9554 [email protected]

Thomas Buettner Vice President Business Development (612) 281-0158 [email protected]

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Additional Resources

Q & A

CSA Partner Resources:

Techline Monthly Webinar Additional Resources

www.csateam.com/partner-resources

Log in Code CSAPR

Prof. John J. John Connors, J.D., C.P.A., LL.M.

Tax Educators Network (TEN) Inc

www.taxesprof.com [email protected] (414) 339-6718

Rod Axtell at [email protected] (888) 245-5613

Webinar handout e-mailed to you after the last question

CSA. Helping you be your clients’ most trusted advisor.

37


http://www.csateam.com/partner-resources



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mailto:[email protected]

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“the new rules” expense or capitalize - … · today’s objectives a “12,000 foot review ”...

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