Accounting for Your Success
By Vince Fini, CPA, Partner
Late last year, the IRS and the Treasury Department released temporary regulations under Section 162 and Section 263(a) that clarify and expand proposed regulations that were put in place in 2008. While the temporary regs retain the basic framework of the proposed regs, some key provisions have been modified that, in general, are less beneficial for contractors.
The IRS recently held a hearing on these regulations to solicit feedback on certain issues. While the experts made several suggestions for change to the IRS, it is difficult to know if the IRS will act on the suggestions.
The temporary regulations impact the construction, acquisition and improvement of tangible property, both personal and real. They apply to tax years and/or costs incurred beginning on or after January 1, 2012. The IRS also recently issued two Revenue Procedures communicating how taxpayers may obtain automatic consent to change their accounting methods to comply with the temporary regulations.
A Little Background
For many years, the IRS and contractors have waged an undeclared battle over expensing vs. capitalizing various expenditures. Expensed property can generally be deducted immediately as a current expense, while capitalized property must be depreciated and deducted over a period of up to 39 years (for some commercial real estate).
By changing the application of a “unit of property,” the temporary regulations may make it more difficult for contractors to expense some costs related to personal and real property. These changes have a profound impact on real estate in particular.
The proposed regulations defined a building’s unit of property as the building and its structural components. So generally, work performed on a building would only be capitalized if the level of improvement resulted in a betterment or restoration when applied to the building and its structural components taken as a whole.
While the temporary regs retain the rule that a unit of property consists of a building and its structural components, they revise the manner in which improvement standards are applied to a building and its structural components. The temporary regs require contractors to consider the effect of expenses on specifically defined building components, not on the building and its components as a whole.
A number of different structural components in a building must now be evaluated separately, including HVAC, plumbing and electrical systems; escalators and elevators; fire protection, alarm and security systems; and gas distribution systems, among others. The remaining building — including the roof, walls, foundation, doors, windows and general finishes — is treated as one unit of property.
An example helps clarify: An office building contains an HVAC system with 10 roof-mounted units, which are not connected and have separate controls and duct work. Recently, the building’s owner had some repair and maintenance work performed on the units. Should this work be capitalized or depreciated?
The building and all of its structural components are considered to be a single unit of property, while the entire HVAC system — including all of the roof-mounted units and their components — is considered to be one building system. Therefore, the money spent to repair and maintain the units must be treated as an improvement and capitalized if the expenditure incurred results in an improvement (i.e., betterment, restoration or adaption for different use) to the HVAC system and/or building.
Other Tangible Property
For non-buildings and other tangible property, the proposed regulations defined a unit of property to include all “functionally interdependent” components. Components are considered to be functionally interdependent if placing one component in service depends on placing the others in service.
The temporary regs retain this functional interdependence test for determining a unit of tangible property (other than buildings). However, they remove a rule requiring contractors to treat functionally interdependent components as separate units of property if the contractor initially assigned a different economic useful life to the component for financial statement or regulatory purposes.
Contractors must treat a component of a unit of property separately if they treated the component as a different class of property other than the property to which it belongs, or if they depreciated the component using a different method from the one used on the unit of property to which the component belongs. As a result, qualified leasehold improvements are now considered to be a separate unit of property from the rest of the building.
An example helps illustrate: XYZ Contractor recently purchased several different pieces of heavy earth-moving equipment, which are considered to be non-building tangible property. Therefore, the initial unit of property is determined under the general rule and is comprised of the components that are functionally interdependent.
Can the contractor treat the pieces of earth-moving equipment and all their components as being within the same class of property and depreciate them using the same depreciation method? It generally cannot, because the pieces of equipment would be considered to be separate units of property, since they are not functionally interdependent. In other words, placing one piece of equipment in service is not dependent on placing another piece in service.
Other Capitalization Guidance
The new temporary regulations provide guidance with regard to capitalization of expenses related to the betterment, restoration and adapting of property for a new or different use (if any of the three is considered an improvement). The new temporary regulations also discuss such matters as a revised definition of some disposition and rehabilitations of tangible property. A betterment includes expenses that:
• Ameliorate a material condition or defect that existed prior to the acquisition of, or arose during the production of, the property;
• Result in a material addition to the unit of property; or
• Result in a material increase in the capacity, productivity, efficiency, strength or quality of the unit of property or its output.
With regard to restorations, the temporary regs generally retain the framework established by the proposed regs, but they make a significant modification to the definition of what constitutes “a major component or substantial structure part” that should be capitalized, removing the “50% threshold” and “recovery period” limitations.
In addition, the temporary regs do not include a bright-line alternative. Instead, they rely on particular facts and circumstances and a number of examples within the regulations to help taxpayers reach conclusions.
The temporary regs revise the proposed regs’ definition of disposition, allowing contractors to treat the retirement of a structural component of a building as a disposition of property. They also retain the proposed regs’ incorporation of reference to the Section 263A rules for the treatment of rehabilitation expenses. All indirect costs (including repairs and maintenance) that are subject to a Section 263A standard must be capitalized.
Finally, the temporary regs retain the proposed regs’ rule providing safe harbor from capitalization for the costs of performing routine maintenance, but for tangible personal property only. This safe harbor does not apply to buildings and their structural components.