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IRS Repair and Maintenance
Regulation Update
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mail: P.O. Box 509 Eau Claire, WI 54702-0509 • telephone: 866-352-9539 • fax: 715-833-3953email: [email protected] • website: www.lorman.com • seminar id: 400267
Jim Forbes, CPA and Dennis C. Murphy, Jr.CPA, Skoda Minotti
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mail: P.O. Box 509 Eau Claire, WI 54702-0509 • telephone: 866-352-9539 • fax: 715-833-3953email: [email protected] • website: www.lorman.com • seminar id: 400267
Prepared By:Jim Forbes, CPA and Dennis C. Murphy Jr., CPA
Skoda Minotti
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IRS Repair & Maintenance Regulations
Dennis Murphy, CPA, CCA
Jim Forbes, CPA
1
2
• Background
• Capitalization Standards Betterment
Restoration
Adaptation
• Unit of Property
• Materials & Supplies
• Safe Harbor Rules
• Disposition of Assets
AGENDA
USED TAX TERMSFREQUENTLY
• Accounting Method Change Must use Form 3115 to notify the IRS that the taxpayer is changing
their accounting method.
The Tangible Property Regulations require taxpayers to file Form 3115 to inform the IRS that they are following the required tax law.
The Method Changes we will be discussing today are “automatic”, which means there is no filing fee, no prior IRS approval is needed, and they are due with the tax returns.
3
USED TAX TERMSFREQUENTLY
• Accounting Elections Made on a current year tax return.
Usually in the form of a Statement attached to the return.
The elections we will be discussing need to be made annually.
THROUGH 2011REGULATIONS
You are required to capitalize expenditures that:
1. Materially increase the value of the PROPERTY
2. Substantially prolong the useful life of the PROPERTY, or
3. Adapt the PROPERTY to a new or different use
4
• Federal Express Corp., DC-TN, 2003-2 USTC Defines the unit of property (UOP)
4 factor test:− Is the component purchased/treated
separate from the larger asset?
− Is the expected useful life of a component coextensive with the larger asset?
− Can the component and larger asset function without each other?
− Does the component have to be removed from the larger asset to perform maintenance?
THE COURT CASE
OLD REGULATIONS• A taxpayer purchases a building: $1,000,000 = Purchase price of the
building− At the time the building was purchased,
it was known that the roof will need to be replaced.
$25,000 = Portion of cost basis attributed to the roof
$250,000 = Cost of replacing roof on building− Value of building after replacing the roof
is $1,250,000.
EXAMPLE:
5
OLD REGULATIONS• Questions: Should the cost of the new roof be
capitalized?
Can the adjusted basis of the old roof ($25,000) be written off:− If we do not capitalize the new roof?
− If we do capitalize the new roof?
What is the total cost basis of roof items that will be reported on the taxpayer’s depreciation schedules?
EXAMPLE:
• Answers: Should the cost of the new roof be
capitalized? − Yes, the new roof materially increased
the value of the building.
Can the adjusted basis of the old roof ($25,000) be written off?− If we do not capitalize the new roof?
− If we do capitalize the new roof?
No, based on the general rules this asset cannot be written-off and must continue to depreciate.
EXAMPLE: ANSWERS
6
• Answers: What is the total cost basis of roof
items that will be reported on the taxpayers depreciation schedules?− The total cost basis to depreciate is
$275,000 (basis of the original roof $25,000 plus the cost of the new roof $250,000).
− Therefore two separate roof items will be depreciated when only one is in use.
EXAMPLE: ANSWERS
SINCE FEDEXHAPPENINGS
• In 2004, the IRS requested comments regarding repairs and maintenance
• December 2011 – Temporary regulations issued
• September 2013 – Final regulations issued
• September 2013 – Proposed regulations issued related to partial asset disposition rules
• August 2014 – Final regulations issued related to partial asset disposition rules
7
NEW RULESOLD RULES TO
• Effective January 1, 2014• Transition years: 2012 and 2013 Option to adopt and apply final regulations retroactively to 2012
and/or 2013
• Five main areas affected by these final regulations (IRS Code Sec): Materials and supplies (1.162-3) Repairs and maintenance (1.162-4) Capital expenditures (1.263(a)-1) Amounts paid for the acquisition or production of
tangible property (1.263(a)-2) Amounts paid for the improvements of tangible property (1.263(a)-3)
• Nine individual structural components of a building
2014 AND BEYONDRULES & REGULATIONS
• You are required to capitalize expenditures that: Result in betterment of the UOP
Result in the restoration of the UOP
Adapt the UOP to a new or different use
• For all UOPs (other than buildings), all components of a piece of property that are functionally interdependent make up the single UOP Buildings are now split into nine structural components
• General Rule (writing off assets) A taxpayer is allowed to write-off the adjusted basis of an asset when
a new asset of the same type is capitalized
8
PROPERTY DEFINITIONUNIT OF
• Applying the four tests from the FedEx (and similar cases), the UOP usually ended up as a large asset or the whole building
• Different UOP definitions for: Real estate
Leased property
Network assets – utilities
Plant assets
Other property
REAL ESTATEUOP FOR
• Each of the following nine structural components of a building are each their own UOP: HVAC (heating, ventilation, and
air conditioning)
Plumbing systems – inside and outside; including water, storm, and sewer systems and related fixtures
Electrical systems – inside and outside; including fixtures, wiring, and distribution
Escalators
9
A BUILDINGCOMPONENTS OF
Elevators
Fire protection (sprinklers) and related alarm systems
Security systems – for the protection of the building and its occupants
Gas distribution system – inside and outside
Building structure (roof, walls, floors, windows, doors, etc.)
• An expenditure results in capitalization under betterment if it is expected to: Correct a material condition or defect at the time of acquisition
or production (not having previous knowledge of the defect is not an excuse)
Result in a material addition to the UOP
Result in a material increase in the capacity, productivity, strength, efficiency, or quality of the UOP or the output of the UOP
BETTERMENT
10
Dealing with Asbestos from the Final Regulations
• Poll Question – Taxpayer purchased a building that has asbestos insulation. At the time of construction, health dangers regarding asbestos were not widely known. After several years of ownership, taxpayer notices that there are areas where the insulation has deteriorated, leading to potential health issues.
• The owner has the asbestos insulation removed and replaced with a similar quality product.
Repair or Capitalize?
BETTERMENT EXAMPLE
WHAT IS MATERIAL?BETTERMENT:
• 50% increase in load capacity is material (1.263(a)-3(j)(3)example 14) CAPITALIZE
• 50% reduction in energy costs is material (1.263(a)-3(j)(3)example 21) CAPITALIZE
• 10% increase in energy efficiency of HVAC system is not material (1.263(a)-3(j)(3)example 20)REPAIR
• Unavailability of Replacement Parts – replacement with an improved but comparable part (1.263(a)-3(j)(2)(iii)) REPAIR
• New roof membrane (of comparable quality) (1.263(a)-3(j)(3)example 13) (not a replacement of the whole roof structure)REPAIR
Tax planning opportunity
11
REMODELINGMAJOR BUILDING
• Remodeling projects are broken down in to the nine Building Systems (listed earlier)
• The Betterment and Restoration tests are applied against the individual Building Systems, along with the safe harbor tests
REMODELINGMAJOR BUILDING
• Example: Should the following expenditures be capitalized or expensed? Building refresh (new paint, clean
up, other cosmetic changes)
Building refresh and limited improvements (replacing fixtures throughout the building, etc.)
Building refresh and substantial remodel (knock down walls and reconstruct parts of the building)
12
• An expenditure results in capitalization under restoration if it: Replaces a disposed component
Returns the UOP to its ordinary operating condition after the property has deteriorated to a state of disrepair and is no longer functional
Rebuilding to like-new condition after the UOP’s tax depreciation useful life ends
Replaces a major component or substantial structural part of the UOP
RESTORATION
• Replacement of a major component or substantial structural part of a UOP Major Component – part or
combination of parts that perform a discrete and critical function in the operation of the unit
Substantial Structural Part – part or combination of parts that comprise a large portion of the physical structure of the unit of property
RESTORATION
13
• Example: Should the following items be capitalized or expensed? Entire roof
Roof membrane
All 20 sinks in a building
Three of the 20 sinks in a building
200 of 300 windows in a building
30 of the 300 windows in a building
Floors in the lobby
Floors in all public areas
RESTORATION
LOSS RULECASUALTY
• Amount required to be capitalized as a restoration of damage to a UOP is limited to the excess of: The adjusted basis in the single identified property at the time of the
casualty
Amount paid for the restoration of damage to the UOP from the casualty that would otherwise be a capital improvement
• Total deduction between the Section 165 casualty loss and repairs cannot exceed out-of-pocket costs incurred in the year of the casualty event
14
ACCOUNT (GAA) RULESGENERAL ASSET
• The temporary regulations proposed the need to elect to place building components into General Asset Accounts
• The need for this election has been lifted with the final regulations
• Each component of a building will be evaluated on a combined basis (i.e. the treatment of the replacement of window(s) is determined on a combined basis) Need to evaluate the portion of the component
that is being replaced and determine if the replacement cost can be expensed (as repairs and maintenance) or if it is required to be capitalized
• If a GAA election was made in the past, the IRS has extended the opportunity to revoke the election through 2014 (change in accounting method)
• Make sure to consider Section 280B if there are plans to demolish the underlying assets
• Important for depreciable assets that have significant tax basis remaining
GAA RULES
15
• An expenditure results in capitalization under adaptation if: The adaptation is not consistent with the taxpayer’s ordinary use of
the UOP at the time it was originally placed in service
• Examples: Retail space
Grocery store/sushi bar
Land for residential purposes
ADAPTATION
PROPERTYUOP FOR LEASED
• Improvement standards are applied at the leased portion of the building and building systems subject to the lease
• Lessor incurs cost for tenant improvements The costs are included in UOP of
the building
• Lessee incurs costs for tenant improvements The costs are the UOP of the leased space, not of the entire building
• Example: Tenant wants a new HVAC unit and leases 10% of the space. There are 10 HVAC units on the building The costs are the UOP of the leased space, not of the entire building Common area maintenance impact
16
PROPERTYUOP FOR PLANT
• Applies to industries such as manufacturing; production of oil, gas, and chemicals; and mining
• Plant property that is functionally interdependent property has to be further divided into smaller units comprised of each component that performs a “discrete and major function” or operation
• Think “industrial process”
PROPERTYUOP FOR PLANT
• Example: Uniform and linen rental business All the property is functionally
interdependent; however, it is also plant property
Plant property has to be further divided into smaller units comprised of each component that performs a “discrete and major function” or operation
− Determine any Functionally Interdependent Property (FIP)
− Is the specific FIP performing an industrial process
− Must divide the FIP into discrete and major functions (IRS Audit Issue)
17
BUILDING ASSETSUOP FOR NON-
• All other property – use functional interdependence test
• Replacement of a major component or substantial structural part – replacing the engine in a tractor trailer = CAPITALIZE
• Not a replacement – replacing the power switch assembly to a drill press with comparable parts
• Not a replacement: Rebuilding property to “like-new conditions” before the end of its
class life
Performing “heavy maintenance” to a piece of equipment (even after the end of the equipment’s class life)
• Materials and supplies – tangible property that is used or consumed (that is not inventory) and that is any of the following: A component acquired to maintain, repair, or improve a UOP Fuels, lubricants, water, and similar items reasonably expected to
be consumed in 12 months or less A unit of property that has an economic useful life of 12 months
or less A UOP that has an acquisition or production cost of $200 or less Items identified in published IRS Guidance (restaurant small
wares, etc.)
• Taxpayers need to change their general ledger definition of materials and supplies to agree with the IRS definition
MATERIALS & SUPPLIES
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• Incidental Carried on hand
No record of consumption is kept
Deductible in the taxable year in which these amounts are paid, provided taxable income is clearly reflected
• Non-incidental Deductible in the taxable year in which the
materials and supplies are first used or consumed in the taxpayer’s operations
MATERIALS & SUPPLIES
• The IRS has set “safe harbor” amounts for expenditures to determine what should be capitalized
• This amount is dependent on the level of annual financials the taxpayer produces Audited/Government required financials - $5,000 per item limit
Any other level of financials - $500 per item limit ($2,500 for tax years beginning after January 1, 2016)
• Having this policy in place (written) and operating under it will eliminate the IRS questioning expenditure items under examination
DE MINIMIS RULE
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• This policy has to be the same for book and tax purposes (cannot be a tax-only policy)
• This safe harbor is elected annually by attaching a statement to a timely filed original Federal tax return
DE MINIMIS RULE
• Applying the “transaction and other additional costs” to the elective “de minimis rule” Floor Test (at both the $5,000 or $500/$2,500 level) Items such as delivery fees, installation costs, etc.
Same invoice vs. multiple invoices
• De Minimis Rule Example Taxpayer purchases from one vendor
− 20 printers for $190 each = $3,800
− 20 computers for $500 each = $10,000
DE MINIMIS RULE
20
• Taxpayers can elect to depreciate certain types of rotable, temporary, and standby emergency spare parts
• Direct impact to manufacturing companies
• Standby Emergency Spare Parts has a 12 part definition under Revenue Ruling 81-185
SPARE PARTS
SPARE PARTSTAX RETURN ACCOUNTING
EMERGENCY SPARE ELECTION METHOD CHANGEPART- Current year purchases
going forward - Depreciate prior years’
purchases
ROTABLE SPARE PART- Current year purchases - Depreciate prior years’
purchases Very difficult -purchased withequipment
21
SAFE HARBORROUTINE MAINTENANCE
• Routine maintenance (i.e. recurring expenditures to keep UOP in ordinary and efficient operating condition) can be expensed as incurred, rather than continuing to capitalize and write-off these expenditures Buildings – expenditure incurred more
than once over a 10-year period All other assets – expenditure incurred
more than once over the asset’s ADS life
• Accounting method change
SAFE HARBORSMALL TAXPAYER
• A small taxpayer can elect to deduct expenditures on an eligible building, if the total expenditures are less than a certain limit: Small taxpayer – Business gross
receipts of $10M or less
Eligible building – Original cost of building is $1M or less
Expenditure limit – Annual repair and maintenance expenditures for the building cannot exceed the lesser of $10,000 or 2% of the building’s unadjusted basis (original cost)
22
SAFE HARBORSMALL TAXPAYER
• Example – A qualifying Small Business Taxpayer has two buildings, each with an Adjusted cost basis of $800,000
• During Year 1: Building A incurs $8,000 of repairs
and improvements
Building B incurs $10,100 of repairs and improvement
SAFE HARBORSMALL TAXPAYER
• This is an annual election that has to be made to take the deduction
• Under this test, all amounts (including those written off as repairs due to other Safe Harbors) are included to determine the amount or repairs incurred
• If the safe harbor amount is exceeded, this particular safe harbor is not applicable to the amounts spent during the year for that specific property
• A cost segregation study could help
23
RETAILERS/RESTAURANTSSAFE HARBOR FOR
• Rev. Proc. 2015-56 issued November, 2015
• Provides a safe harbor approach to treating remodeling costs incurred by Retail and Restaurant Operators
• If a Qualified Taxpayer chooses to make an Automatic Method Change (Form 3115 will be required), they will be able to write off 75% of their remodeling costs as an expense, and capitalize (and depreciate) the remaining 25%.
• The good and the bad of this Rev. Proc.
FLOW CHARTCAPITALIZATION DECISION
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OF ASSETSDISPOSITION
• Taxpayers can now make a disposition election starting in 2014 on the retirement/ replacement of structural components/assets Relates to current year dispositions
• Allows the taxpayer to claim a loss
• Eliminates two of the same structural components capitalized and depreciated simultaneously
DISPOSITION OF ASSETSPARTIAL
• Final regulations give the taxpayer an option to write off retired structural components
• Why you should recognize dispositions: If the taxpayer recognizes the
Disposition, the taxpayer will be able to write off current year demolition or removal costs
If you do not recognize the disposition, these costs will have to be capitalized (i.e., 39 year property)
Under audit, if the IRS disallows a taxpayer’s characterization of a repair, and decides the cost has to be capitalized as a replacement, the taxpayer can file Form 3115 and write off the replaced component
25
NEW RULESEXAMPLE: REVISED
• A taxpayer purchases a building with the following details: $1,000,000 – Purchase price of the
building− At the time the building was purchased
it was determined that there were no issues with any building components (including the roof)
$25,000 – Portion of cost basis attributed to the roof
$250,000 – Cost of replacing significant portion of roof− This expenditure was detected after moving into the building. The value
of building after replacing the roof is $1,250,000
NEW RULESEXAMPLE: REVISED
• Questions: Should the cost of the new roof be
capitalized?
What is the total cost basis of roof items that will be reported on the taxpayers depreciation schedules?
26
NEW RULESEXAMPLE: ANSWERS
• Answers: Should the cost of the new roof be
capitalized? − Yes, the new roof is a separate
component of the building and the replacement restored that component.
What is the total cost basis of roof items that will be reported on the taxpayers depreciation schedules?
− The total cost basis to depreciate is $250,000 (the cost of the new roof).
− The adjusted basis of the old roof ($25,000 less depreciation previously taken) can be written-off in the year of replacement.
DISPOSITION OF ASSETSLATE PARTIAL
• Allows taxpayers to file an accounting method change to make a late partial disposition election
• 2014 is the last year to take advantage
• Tax planning tip
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OF ASSETSDISPOSITION
• Need to determine the adjusted basis of the asset/components that are disposed Specific asset
− Specific identification of the asset
− FIFO method
Partial disposition (component)− Any reasonable method can be used including: Producer Price Index (PPI) – discounts the cost of the retired component
» Can only be used for a restoration replacement
Pro rata allocation
Qualified cost segregation study
Whatever method is used must be consistently applied to all future partial dispositions of the same asset
• Most conservative approach• Your starting point of the current year’s expense consists
only of construction materials and installation• Your building’s original cost consists of a lot more factors• Varies on the location of the asset• Example In 2013, a Taxpayer spent $100,000 to replace a roof that was
10 years old PPI starting point = $100,000 less 10 years of PPI of 24.46%
= $75,540 (less depreciation taken) Constructed starting point = $94,425, due to the additional soft costs
(less depreciation taken)
PPI PROCESS
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• Provides a simplified method for qualifying small businesses to comply with the final tangible property regulations
• Available to small businesses with: Assets totaling $10M or less, or
Average annual gross receipts of $10M or less for the prior 3 years
• Automatic adoption
• Caution: no audit protection for prior tax years
BUSINESSES – 2015-20RELIEF FOR SMALL
SEGREGATION STUDYCOST
• Best option
• Breaks components of a building into different asset classes with shorter depreciation lives
• Depending on the use of the building, up to 80% of the cost of the building can be reclassified into asset classes with shorter depreciation lives than the typical 39 years
• Accounting method change required
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ELECTIONSACCOUNTING
• Accounting elections to consider for 2015: De Minimis
Small business taxpayer for buildings
Current year partial disposition
Capitalizing and depreciating certain materials and supplies
Capitalizing and depreciating repairs and maintenance
ACCOUNTING METHODSCHANGE IN
• Between Rev. Proc. 2014-16 and 54, there are 19 accounting method changes to consider
• Examples: Change in accounting for materials
and supplies
Routine maintenance Safe Harbor
Change the accounting for a UOP
Write off previously capitalized repairs
Write off dispositions that occurred in a prior year
Removal costs previously capitalized
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• Roof membrane write off
• 33% bright line for building repairs
• UOP assistance
• De minimis rule
• Depreciating materials and supplies
• Three safe harbors
• Partial dispositions
• Demolition write off costs
• Cost segregation studies
KEY TAKEAWAYS
• Establish a timeline for 2015 tax compliance
• Determine if current methods are compliant with the final regulations
• Quantify and document uncertain tax positions and potential tax savings
• Communicate with your auditor and tax accountant
• Develop sustainable processes and procedures to continue for future tax years
• Consider the accounting method changes and electionsto make
NEXT STEPS
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• Capitalization standards
• Materials and supplies
• Safe Harbor rules
• Taxpayer–friendly changes
• Complicated regulations
CONCLUSION
QUESTIONS?
Dennis Murphy Jr., CPA, CCASenior Manager
Jimmy A. Forbes, CPAPartner
www.skodaminotti.com
If you have any questions or need additional information, please contact:
32
Notes
