Understanding the New Tangible Property Regulations, Part 2 of 2

Published by Brent R. Parker on Tuesday, October 1, 2013
Journal thumb October 2013

In the world of multifamily rental real estate, capital assets are king. As such, the language the Treasury Department employs regarding how to treat capital assets are of paramount importance. On Sept. 19, Treasury released final regulations regarding deduction and capitalization of expenditures related to tangible property, which effectively replace temporary regulations issued in late 2011 and amended in 2012. In addition, Treasury issued proposed regulations regarding dispositions of depreciable property. Although new regulations have been issued, they generally adopt, with some changes, guidance of the prior temporary regulations.

Part one of this article in the September 2013 Novogradac Journal of Tax Credits summarized topics related to capitalization of tangible property, as reflected in the temporary regulations. This month, part two will introduce concepts related to property dispositions, review changes to the capitalization rules discussed in part one, and address how and when to implement the new regulations.

Dispositions of MACRS Property and General Asset Accounts
Dispositions of MACRS Property
When replacing an asset, historically, the new cost was capitalized and many taxpayers continued to depreciate the basis of the disposed asset. This treatment might produce an inflated asset as many costs are replaced several times over the course of their modified accelerated cost recovery system (MACRS) life. The proposed regulations allow the taxpayer to take a gain or loss on the adjusted basis of replaced property upon disposition.

Regarding real estate, although most taxpayers record gains or losses on entire building dispositions, many had not been recording gains or losses on partial building dispositions. The proposed regulations allow the taxpayer to generally elect for partial building dispositions to be recognized, by deducting the adjusted basis of the portion of building disposed even though the remainder of the building remains in service. In certain situations, recognition of gain or loss is required on partial dispositions, such as where the disposition is the result of a partial sale or casualty event and under certain non-recognition transactions. Taxpayers may want to consider making the partial disposition election and recognizing a gain or loss where replacement components are required to be capitalized or where the cost of the replacement component is less than the adjusted basis of the replaced component.

General Asset Accounts
A general asset account is a pool of like-assets that are depreciated together as one asset. Generally, assets in a general asset account are not written off when disposed and remain in the account until such time that the account is fully depreciated or until the last remaining asset is disposed. The taxpayer elects general asset account treatment on the tax return in which the assets included in the account are placed in service. On the 2012 Internal Revenue Service (IRS) Form 4562 Depreciation and Amortization, the election is made by simply checking the box on question #18. Items included in a general asset account must have the same MACRS life, depreciation convention and must be placed in service during the same tax year on the same tax return.

As previously mentioned, although the ability to deduct the adjusted basis of a replaced building component may be beneficial, often the cost to replace the disposed asset exceeds its adjusted basis. As alluded to in last month’s article, under the 2011 temporary regulations where the flexibility to elect gain or loss recognition on partial dispositions did not exist and therefore recognition on disposed of components was required, the taxpayer would not have the option to continue to depreciate the replaced asset and deduct the cost of the new asset unless the taxpayer elected use of a general asset account. However, under the new regulations, this general asset account benefit is effectively eliminated, as the ability to continue to depreciate a portion of the building is inherent in the elective nature of the component qualifying disposition provision.

If a taxpayer’s building is already included in a general asset account, under certain circumstances gains or losses on partial dispositions may be available. These exceptions include where the asset or component is disposed of in a casualty event, charitable contribution election, cessation of the business, certain non-recognition transactions, or upon the disposition of the last asset, all the assets or the remaining portion of assets in a general asset account. Generally, upon sale of the building, the inability to remove it from a general asset account is not applicable since there would be no remaining assets in the account and, as such, it would be closed by statute.

Final Regulation Updates
Part one of this article discussed how to address tangible property costs regarding capitalization for tax purposes. This article will address updates to that information in categories including:

  • Materials and supplies;
  • Repairs and routine maintenance;
  • De minimis rule limitation; and
  • Capital improvements.

Materials and Supplies
The final regulations increase the limit for which materials and supplies are defined from costs less than $100 to those under $200. However, this definition may not be relevant if the costs fall within the de minimis rule provisions, as discussed hereafter. The new regulations make other adjustments, including but not limited to, a provision wherein materials and supplies are no longer able to be capitalized, with certain exceptions pertaining to rotable, temporary or standby emergency spare parts.

Repairs and Routine Maintenance
The final regulations expand upon the temporary regulations in their application of the routine maintenance safe harbor provision to include building property. Unfortunately, the activity performed to keep the building property in its ordinarily efficient operating condition must be required more than once every 10 years, as this measurement has replaced a building’s depreciation class life for purposes of safe harbor applicability. If deemed to fall within the provisions of the routine maintenance safe harbor, the cost resultant from said activity may be deducted in the year incurred instead of being capitalized.

In addition to updates to the safe harbor provision, the new regulations have adopted a provision to allow for capitalization of repairs and maintenance costs under certain situations and subject to specific criteria, as detailed in the final regulations.

De Minimis Rule Limitation
Subject to a safe harbor, the final property regulations eliminate the de minimis rule ceiling limitation, thereby making the rule far more appealing to multifamily real estate owners and operators. Under the revised rule, taxpayers with applicable financial statements (e.g., audited financial statements) may follow book minimum capitalization policies, so long as:

  • Amounts paid do not exceed $5,000 per invoice ($500 if no applicable financials);
  • Policies in excess of this safe harbor limitation may be acceptable if the amount deducted clearly reflects income.
  • Amounts under consideration are treated as expenses on the applicable financial statements; and
  • Written accounting procedures are in place that:
  • ~ Were established as of the beginning of the year that the costs are paid;
  • ~ Address property with an economic life less than 12 months; and
  • ~ Identify a specific dollar amount for which costs under are expensed.

An annual election must be made to utilize the de minimis rule by including a statement (as provided in the regulations) on the taxpayer’s timely filed original federal tax return (including extensions) for the year elected. The de minimis rule is subject to certain caveats, including but not limited to rules regarding applicable financial statements of consolidated groups, how to treat costs to acquire the tangible property, how to treat multiple pieces of property within one invoice, and property produced by the taxpayer. Further, all materials and supplies are subject to an elected de minimis rule, other than certain instances involving rotable, temporary and emergency spare parts.

Capital Improvements
A more significant change made by the final regulations, pertaining to capital improvements, is that taxpayers may now elect to follow their book capitalization policies each year for amounts paid with respect to repairs and maintenance costs. The election is made by including a statement on the taxpayer’s timely filed tax return for the year in which the improvements are placed in service and must apply to all capitalized repairs and maintenance costs on the taxpayer’s books for that year. This benefit is meant to reduce the overall administrative burden associated with tracking a separate set of depreciable assets for tax purposes and the resulting book/tax differences that invariably trickle down through the property’s ownership structure. However, once made, the election may not be revoked and the provision only applies to amounts capitalized and not expensed, meaning that the IRS could potentially review repairs and maintenance expenses on the entity’s books and determine that items should be treated as capital improvements for tax purposes. Be aware that after an election is made, taxpayers will be unable to then treat the item so capitalized as a deduction by filing IRS Form 3115 Application for Change in Accounting Method (Form 3115) in a subsequent year.

Regarding the betterment, adaptation or restoration provisions explained in article one of this series, some adjustments have been made to the application of the betterment and restoration provisions. Despite requests for bright-line tests in the measurement of betterments, Treasury has retained the qualitative approach included in the temporary regulations and, overall, the betterment adjustments are considered minor. The restoration/replacement provisions present some adjustments including:

  • Major components rule – The definition of a major component when determining whether its replacement requires capitalization has been revised. For buildings a replacement component or combination of components is generally subject to capitalization if it comprises a major component or a significant portion of a major component of the building structure or any building system or comprises a large portion of the physical structure of the building structure or any building system; and
  • Casualty loss rule – Whereas the previous regulations required capitalization of the full amount of costs incurred because of a casualty loss event, the new regulations allow for deductions for costs in excess of the adjusted basis of the property damaged in the casualty.

The final regulations adopt a safe harbor for taxpayers that have $10 million or less in gross receipts. Such a taxpayer (also referred to as a qualifying small taxpayer) may elect, by filing an irrevocable annual statement on a building-by-building basis in their tax return, not to apply the improvement standards to a building with an unadjusted basis of $1 million or less, provided that all repairs and improvement costs associated with that building for the year in consideration do not exceed the greater of $10,000 or 2 percent of the unadjusted basis of the building.

Other, more specific changes have been made in addition to those discussed above, such as for leased property and leasehold improvement provisions. Generally, Treasury has expanded its coverage of fact patterns related to capitalization issues by providing a significant quantity of new examples in the final regulations. These examples are a result of the substantial participation in temporary regulation feedback from taxpayers and tax professionals since issuance of the 2011 temporary regulations.

Timing of Compliance and Change in Accounting Method
The final capitalization regulations and, once finalized, the proposed disposition and general asset account regulations require and are expected to require, respectively, compliance for tax periods beginning on or after Jan. 1, 2014 and may be adopted earlier under certain circumstances.

Many of the provisions contained in the proposed and final regulations allow for retroactive application and resulting adjustment with the remainder of provisions only allowed prospectively. In either event, if the new standards require a taxpayer to adjust their treatment of specific items that constitute an accounting method, then the taxpayer generally would want to consider filing Form 3115. Transition guidance, detailing how to apply these changes, has yet to be issued in final form by the IRS and is expected shortly.

Treasury has made the advanced copies of the final capitalization and proposed disposition regulations available on its website and taxpayers are encouraged to review the documentation and contact their tax professional for clarification of the new rules.