Chapter 4 Deduction v. Capitalization Final & Prop. …mntaxclass.com/files/B4_Ded_v_Capitalize2.pdf · Chapter 4 Deduction v. Capitalization Final & Prop. Regs. 1 ... -7 Accounting

Chapter 4Deduction v.

Capitalization

Final & Prop. Regs.

1

IRC sec. 263(a) Reg. sec. 1.263(a)-1 Capital expenditures; in general.

Reg. sec. 1.263(a)-2 Amounts paid to acquire or produce tangible property.

Reg. sec. 1.263(a)-3 Amounts paid to improve tangible property.

Reg. sec. 1.263(a)-6 Election to deduct or capitalize certain expenditures.

IRC sec. 162 Reg. sec. 1.162-3 Materials and supplies.

Reg. sec 1.162-4 Repairs

Reg. sec. 1.162-11 Rentals

IRC sec. 165 Reg. sec. 1.165-2 Obsolescence of nondepreciable property.

IRC sec. 167 Reg. sec. 1.167(a)-4 Leased property

Reg. sec. 1.167(a)-7 Accounting for depreciable property.

Reg. sec. 1.167(a)-8 Retirements.

IRC sec. 168 Reg. sec. 1.168(i)-7 Accounting for MACRS property.

IRC sec. 263A Reg. sec. 1.263A-1 Uniform capitalization of costs.

IRC sec. 1016 Reg. sec. 1.1016-3 Exhaustion, wear and tear, obsolescence, amortization, and depletion for periods since February 28, 1913.

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The final regs. are mandatory

for TYB on or afterJanuary 1, 2014

but

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Taxpayers can opt to apply the

final regs. to TYB on or after

January 1, 2012.

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LB&I Directive On Repair v.

Capitalization Issues

(March 22, 2013)

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“For taxable years beginning on or after January 1, 2012, and before the applicability dates provided in forthcoming [now published] final regulations (hereinafter, the ‘Option Period’), taxpayers may choose to apply the temporary regulations…

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“When you begin examining a return for a taxable year beginning on or after January 1, 2012, but before January 1, 2014, you should determine:

1. If the taxpayer has changed its method of accounting with respect to the Issues, with or without filing a Form 3115, Application for Change in Accounting Method;

A. If yes, perform a risk assessment regarding the method change;

B. If no, the Option Period is still open. Do not examine the issue.”

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“When performing a risk assessment of the section 481(a) adjustment for the Issues, you should:1. Consider if the adjustment properly

accounts for amounts paid to acquire, produce, or improve tangible property that were computed under the taxpayer's prior method and previously deducted under section 162;

2. Determine if the section 481(a) adjustment(s) resulting from any prior year change was taken into account; and

3. Consider the accuracy of the section 481(a) adjustment.” 8

AcquisitionCosts

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Acquisition Costs:

“Inherently Facilitative”

Costs

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Inherently Facilitative Costs:• Transporting• Appraisal fees• Finders' fees or brokers'

commissions• Tax advice on acquisition• Application, bidding• Engineering, inspection,

environmental services• Examining title 11

Special rule for acquisitionsof real property.

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Abandoned Acquisitions:

Except for contingency fees, inherently facilitative

costs capitalized to properties NOT Acquired

can be treated as business losses

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Example 9 – Contin. Fees• K owns several restaurant

properties. • K decides to open a new restaurant

in City X.• In October, Year 1, K hires a real

estate consultant to identify potential property upon which K may locate its restaurant, and is obligated to compensate the consultant upon the acquisition of property.

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• The real estate consultant identifies three properties, and K decides to acquire one of those properties.

• Upon closing of the acquisition of that property, K pays the consultant its fee.

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• The amount paid to the consultant constitutes a contingency fee because the payment is contingent on the successful closing of the acquisition of property.

• Accordingly, K must include the amount paid to the consultant in the basis of the property acquired.

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Unlike a non-contingent broker fee, K is not

permitted to allocate the amount paid

between the properties acquired and not

acquired.

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De Minimis Safe Harbor

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Taxpayer With Applicable Financial

Statement (AFS)

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Met if:1) T has an Applicable

Financial Statement:

• SEC Financial Statement• Certified Audited Financial

Statement• Financial Statement to

Federal or State Government (not SEC or IRS)

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Typo

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2) T has at the beginning of the tax year written accounting procedures treating as an expense for non-tax purposes

a) Amounts paid for property costing less than a specified dollar amount; or

b) Amounts paid for property with an economic useful life of 12 months or less;

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3) The taxpayer treats the amount paid for the property as an expense on its AFS.

4) The amount paid for the property does not exceed $5,000 per invoice or other amount as identified by IRS published guidance.

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Example 3• Taxpayer with AFS elects de

minimis safe harbor and meets all conditions.

• Pays $6,250,000 to purchase 1,250 computers at $5,000 each.

• Deduct $6,250,000.

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If the computers cost $5,001 each, then no safe harbor but maybe OK per preamble language.

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Taxpayer Without

Applicable Financial

Statement(no relief in temp. regs.)

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1) No AFS2) T has at the beginning of the tax

year written accounting procedures treating as an expense for non-tax purposes

a) Amounts paid for property costing less than a specified dollar amount; or

b) Amounts paid for property with an economic useful life of 12 months or less;

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3) The taxpayer treats the amount paid for the property as an expense on books.

4) The amount paid for the property does not exceed $5,000 ($500) per invoice or other amount as identified by IRS published guidance.

X

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Safe Harbor Applies to:

• Fixed asset purchases

• Materials and Supplies

• Improvements (repair and maintenance costs)(Reg. sec. 1.263(a)-3(d))

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Safe Harbor Does Not Apply To:

• Cost subject to the IRC sec. 263A uniform capitalization rules.

• Amounts paid for inventory

• Amounts paid for land

• If taxpayer elects special treatment for rotable or temporary spare parts.

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Example 10• Taxpayer with AFS

• Pays $1,000 for jig, die, mold, and pattern used in manufacturing products.

• Cost must be capitalized into product cost per IRC sec. 263A.

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Example 11 – Anti-abuse• Taxpayer without AFS

• K purchases truck for hauling business.

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• Seller provides K with four invoices:• one invoice of $500 for the

cab, • one invoice of $500 for the

engine, • one invoice of $300 for the

trailer, • and a fourth invoice of $200

for the tires.

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• “K has applied the de minimisrule to amounts substantiated with invoices created to componentize property that is generally acquired as a single unit of tangible property…”

• Safe Harbor does not apply.

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Time andManner of Election

(with or without AFS)

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An annual, irrevocable election made by attaching a statement to the taxpayer's timely filed original Federal tax return (including extensions)

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Do not use Form 311535

The statement must:• be titled “Section 1.263(a)-1(f)

de minimis safe harbor election” and include• the taxpayer's name, address,

taxpayer identification number, and

• a statement that the taxpayer is making the de minimis safe harbor election under §1.263(a)-1(f).

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Annual changes to the taxpayer’s accounting

procedures are not accounting method

changes.

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Materials and Supplies

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Is a unit of property that has an acquisition cost or production cost of

$200 (up from $100) or less…

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IRRELEVANT if de minimissafe harbor is elected

Modified Definition:

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Repair v. Improvement

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ImprovementsMust Be

Capitalized

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A unit of property is improved if the expenditures result in:1)A restoration, or2)An adaptation, or3)A betterment.

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The unit of property for a building is comprised of the building and its structural components.

Unit of PropertyFor Buildings

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The building structure or

any of the specifically defined building systems.

Unit of PropertyImprovement v. Repair

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“Building Systems”• HVAC system• Plumbing system• Electrical system• Escalators• Elevators• Fire-Protection & alarm system• Security system• Gas distribution system

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The Functional Interdependence Test

Unit of PropertyProperty Other Than

Buildings

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RestorationCapitalize

Repair Expense

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The replacement of a part or a combination of parts that comprise a:

• a major component or• a substantial structural

part of a unit of property.

Restoration 4-43

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Deduct:• Replacement of one of four

elevators in a building(Ex. 30, pg. 4-57)

• One of three furnaces within an HVAC system(Ex. 16, pg. 4-51)

• Roof membrane of building(Ex. 15, pg. 4-50)

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• Three of 10 roof-mounted units within HVAC system(Ex. 18, pg. 4-52)

• 30% of wiring within building(Ex. 21, pg. 4-52)

• Eight of 20 sinks (40%) within building’s plumbing system(Ex. 23, pg. 4-53)

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• 100 of 300 windows where windows are 25% of building structure.(Ex. 25, Pg. 4-54)

• All flooring in hotel lobby –10% of entire hotel square footage.(Ex. 28, pg. 4-55)

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• Fix Broken Tail light on truck.(Ex. 11, pg. 4-48)

• Drill press power switch assembly (Ex. 13, pg. 4-50)

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Restoration:• 100 of 300 windows where

windows are 90% of building structure.(Ex. 27, Pt. 4-55)

• 200 of 300 windows on building where windows are 25% of building structure.(Ex. 26, Pg. 4-55)

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• All flooring in public areas of hotel – 40% of square footage of hotel (Ex. 29, Pt. 4-56)

• All sinks or toilets in the bathrooms of a commercial bulding. (Ex. 22, Pt. 4-53)

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• Roof of building(Ex. 14, pg. 4-50)

• Engine or cab of truck(Ex. 10, pg. 4-48)

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• Underground storage tank in gas station (leaking). To comply with EPA.(Ex. 12; Pg. 4-49)

Note: with a partial disposition election, the remaining adjusted basis could be deducted, AND the cost of removal could be deducted for all of these restorations.

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Normally a mistake to make the partial disposition election for a replacement that can otherwise be expensed as a repair.

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Replace 1 of 4 Elevators

Compare Ex. 30 --expense replacement elevator and

Ex. 31 – same as Ex 30 but with partial disposition election

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In Ex. 31, the partial disposition election allows a loss on adjusted basis of the (old) replaced elevator, but…

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The replacement of a component of a

unit of property that the taxpayer has

previously written off through a loss

deduction…

Restoration 4-43

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With Partial Disposition Election:

• The cost of (new) replacement elevator MUST be capitalized.

• Removal costs can still be expensed due to disposition.

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Per BuildingSafe Harbor For Small Taxpayers

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A qualifying taxpayer may elect to not apply the improvement rules if the total amount paid during the tax year for repairs, maintenance, improvements, and similar activities performed on the eligible building property does not exceed…

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The lesser of:

1) 2% of the unadjusted basis of the eligible building property; or

2) $10,000.

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2% cap triggered if building costs under $500,000

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A qualifying taxpayer means a taxpayer whose

average annual gross receipts for the three

preceding taxable years is less than or equal to

$10,000,000. 4-23

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Eligible building property refers to

each unit of property, building, that has an unadjusted basis of $1,000,000 or less

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Example 1• Office building with

unadjusted basis of $750.000.

• T pays $5,500 for repairs, maintenance, and improvements…

• T may elect to apply safe harbor for small taxpayers.

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If the ceiling (the lesser of 2% or $10,000) is exceeded, then NO relief.

Can still possibly qualify for de minimis safe harbor and routine maintenance safe harbor (discussed below).

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Example 2• Office building with

unadjusted basis of $750.000.

• T pays $10,500 for repairs, maintenance, and improvements…

• T may not elect to apply safe harbor for small taxpayers.

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In determining if the ceiling, (the lesser of 2% or $10,000) is exceeded, you must include amounts expensed under the de minimis safe harbor and routine maintenance safe harbor.

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If multiple buildings, one building may

qualify and another not.

See Example 3 4-26

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For leased property, lessee determines

unadjusted basis from rent payable

(undiscounted)

(See Example 4 below)

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Example 4• C leases a building with a

triple-net lease with a term of 20 years at $4,000 per month.

• C’s unadjusted basis in leased property: $960,000($4,000 x 12 mos. x 20 yrs.)

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Time andManner of Election

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An annual (building by building),

irrevocable, election made by attaching a statement to the taxpayer's timely filed original Federal tax return

(including extensions)

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Do not use Form 311576

The statement must:• Be titled, “Section 1.263(a)-3(h)

Safe Harbor Election for Small Taxpayers” and include• the taxpayer's name, address,

taxpayer identification number, and

• A description of each eligible building property to which the taxpayer is applying the election.

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An entity level election for

Partnerships and S Corps.

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Routine Maintenance Safe Harbor

(RMSH) Extended To

Buildings

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The final regulations extend

the safe harbor to buildings.

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Per Preamble:“[t]he inclusion of a routine

maintenance safe harbor for buildings is expected to

alleviate some of the difficulties that could arise in applying the

improvement standards for certain restorations to building

structures and building systems.”

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Routine Maintenance

The recurring activities that a taxpayer expects to perform as a result of the taxpayer's use of the building to keep the building

structure or each building system in its ordinarily efficient

operating condition.

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Building maintenance is routine only if the

taxpayer reasonably expects to perform the

activities 2 times or more

in 10 years

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Non-building maintenance is routine only if the taxpayer reasonably

expects to perform the activities

2 times or more in class life

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RMSH Exceptions:

• Betterment to unit of prop.• Adaptations to new or

different use• Replacement for which loss

is claimed.• See complete list on

page 4-28

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Example • Rental Building

• Spend $7,000 on interior painting and $4,000 on flooring ever 4 years.

• Routine Maintenance Safe Harbor?

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Example • Purchase $400,000 of

farming equipment.

• 7 Year MACRS

• Every third year spend $300,000 on maintenance.

• Safe Harbor?87

Example 13• Escalator system in shoping

mall.

• G reasonably expects to replace the escalator handrails every 4 years.

• Handrail replacement meets RMSH.

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Example 14

• Escalator system in shopping mall.

• G reasonably expects to replace the escalator steps every 18 to 20 years

• Step replacement fails RMSH

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Example 15

• H reasonably expects that every 4 years, the HVAC system on H’s commercial building must be inspected and preventive maintenance performed (mfg. specs).

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Example 15

• H performs the R&M in year 4 and year 11.

• H may apply the RMSH to both jobs (Yrs. 4 and 11) if H reasonably expected to perform the maintenance every 4 years when the HVAC system was placed in service in Year 1.

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CasualtyLosses

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Is for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss under section 165, or relating to a casualty event described in section 165, subject to the limitation in reg sec. 1.263(a)-3(k)(4);

Restoration 4-43

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Example 3• A storm damages B’s business

building at a time when the building has an adjusted basis of $500,000.

• B deducts a casualty loss of $50,000 and properly reduces B’s basis in the building to $450,000.

• B spends $50,000 on repairs and debris removal.

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• B must treat the $50,000 paid for repairs as a restoration of the building (capitalize) because B properly reduced B’s adjusted basis in the building by $50,000 as the result of a casualty loss

and,

the repair cost of $50,000 does not exceed the limit discussed below ($500,000 (AB) - $0 (improvements to building))

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Example 4 • Same as Ex. 3 except B

receives insurance proceeds of $50,000.

• No casualty loss deduction because the loss is compensated for with insurance.

• The insurance proceeds reduce B’s basis in the building.

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• B spends $50,000 on repairs and debris removal.

• B must treat the $50,000 paid for repairs as a restoration of the building (capitalize) because B properly reduced B’s adjusted basis in the building by $50,000 relating to a casualty event.

• The repair cost of $50,000 does not exceed the limit discussed below ($500,000 (AB) - $0 (improvements to building))

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Limited on Forced Capitalization with Casualty

The amount paid for restoration of damage from a casualty to the unit of property that must be capitalized is limited to the excess (if any) of…

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a) The amount prescribed as the adjusted basis of the single, identifiable property for determining the loss allowable on account of the casualty,

over

a) The amount paid for restoration of damage to the unit of property that also constitutes an improvement.

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Example 5 (compare with 3)

• A storm damages C’s business building at a time when the building has an adjusted basis of $500,000.

• C determines that the cost of restoring its property is $750,000, deducts a casualty loss in the amount of $500,000, and properly reduces its basis in the building to $0.

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• C hires a contractor to repair the damage to the building and pays the contractor $750,000 for the work.

• The work involves replacing the entire roof structure of the building at a cost of $350,000 and pumping water from the building, cleaning debris from the interior and exterior, and replacing areas of damaged dry wall and flooring at a cost of $400,000.

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• C must capitalize as an improvement the $350,000 amount paid to the contractor to replace the roof structure because the roof structure constitutes a major component and a substantial structural part of the building.

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• In addition, C must treat as a restoration the remaining costs, limited to the $150,000 excess of the adjusted basis of the building ($500,000) over the amounts paid for the improvement ($350,000).

• Accordingly, C must treat as a restoration $150,000 ($500,000 -$350,000) of the $400,000 paid for the portion of the costs related to repairing and cleaning the building.

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Conclusion:

• In addition to the $350,000 to replace the roof structure, C must also capitalize the $150,000 of repairs as an improvement to the building unit of property.

• C is not required to capitalize the remaining $250,000 repair and cleaning costs.

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Election To Capitalize Repair

Costs(Reg. sec. 1.263(a)-3(n)(1))

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Aimed at Big Companies

Annual irrevocable election when the improvement is place in service

Still eligible for• de minimis safe harbor, • the safe harbor for small

taxpayers, and • the routine maintenance safe

harbor

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