Put Firm Logo or Letter head here Capitalization of Tangible Assets Understanding the New IRS Regulations and What ___________ needs to do in Response

Put Firm Logo or Letter head here

Capitalization of Tangible

AssetsUnderstanding the New IRS Regulations and What ___________ needs to do in

Response

Presented byxxxxxxx CPAs and Consultantsxxxxxxxxxx, CPA and

xxxxxxx, CPAAugust xx, 2013

Put Client Logo Here

2Capitalization of Tangible Assets

XXXXXXX CPA Firm for {Client Name] Put firm logo here

Today’s Discussion Topics

Materials and supplies—definitions of materials and supplies

Discussion of de minimis rule under Reg. Sec. 1.263(a)-2T

Repairs—deductions for amounts paid to repair and maintain property not required to be capitalized under 263(a)

The expenditures required to be capitalized

Betterments, Restorations, New Use

Building or component dispositions

Introduction on how to change accounting methods



Today’s Learning Objectives

Understand what has Changed from the Temporary Regulations (TR) to:

Write offs:

Repairs and maintenance

Materials and supplies

Capitalization Issues:

Improvements to property

Acquisitions

What you need to follow up on (changes in accounting methods related to these regulations)

What is the impact of these TR to you (both tax and financial statement)



10,000-Feet Observations

Few objective rules

What you have done to date (asset groupings, cost segregation, depreciation choices) matter

Cost segregation still relevant and needed(for write off of old when new improvements are made) and still important for other issues (ability to depreciate different classes)

Multiple Code Sections changed, not just 263(a), but also Sections 162, 168

Every taxpayer (TP) is affected, just about every TP will have to file a 3115 or two



Comments on the Regulations from Others

Affects virtually all businesses

AICPA says about the TRs:

Too few bright-line tests, too complex

Have an AFS discriminates against smaller TPs

Accounting method RPs should have examples

Need to define “gross receipts”

TPs do not currently track “capitalization threshold ceiling”

Changes are not clear: change to book capitalization? Not have a written policy in place? “should” verses “must” used in the change RPs—which one is it?

Put firm logo hereCapitalization of Tangible Assets

XXXXXXXX CPA Firm Name for [Client Name]

Depreciation Allowable or Taken – this issue is “huge”. Points: (1) Suggest that you use this summer (2013) to correct any errors in prior

year depreciation, and note that

(2) section 1.1016-3T is part of the TPRs for a reason –

that is the “scary” part – the IRS will use this in their

audits of TPs to deny depreciation deductions



§1.1016-3T Exhaustion, Wear and Tear, Obsolescence, Amortization,

and Depletion

Determination of the amount properly allowable for exhaustion, wear and tear, obsolescence, amortization, and depletion must be made on the basis of facts reasonably known to exist at the end of the taxable year.

A TP is not permitted to take advantage in a later year of the TP's prior failure to take any such allowance or the TP's taking an allowance plainly inadequate under the known facts in prior years.

Caution: In the case of depr., if in prior years the TP has consistently taken proper deductions under one method, the amount allowable for such prior years must not be increased even though a greater amount would have been allowable under another proper method.



Warnings for Taxpayers…if

(1) a TP does not identify all of the tangible property issue(s),

(2) a TP does not implement the rules correctly, AND

(3) file all of the necessary 3115s under the correct new method(s),

the TPs could have certain current and future tax depreciation denied and/or miss the potential write-off on previously capitalized assets.

This exposure is greatest for errors in bonus depreciation and for building issues, since that is where the greatest dollar amounts exist.

Your exposure for errors is great and the time to execute is limited.



Errors in Depreciation Deductions

Correct by filing an amended return for that year(s) (for certain errors)

If TP is not permitted to make the correction with an amended return, may be able to change accounting method to correct the amount of depreciation (with a 3115 filing)

Cannot fix depreciation errors by “catching up” on prior year errors



What TPs Need to Do

Depreciation Schedules: fix them before the IRS disallows missed depreciation Fix based upon the new TPR viewpoints – not why it was

done when it was added to the depreciation schedule

Assess conformity of your current policies and procedures with these TPRs Capitalization policies

Minimum capitalization thresholds

Routine maintenance expenditures

Internal tracking and capturing data

Current method(s) conform to TPRs? If not, need to file 3115s



Depreciation Error Process

1. Find out what ‘activity’ the business is in by reviewing Rev. Proc. 87-56

a) This will instruct us what the asset guideline class lives should be, O/T asset classes 00.11 to 00.4. 00.11 to 00.4 are the “common” class lives.

b) Based on the business’ “activity” we may have class lives that are different from the common class lives.

c) 00.11 to 00.4 state the following: office equipment is 7 years; computers =5, copiers=5, cars and trucks=5, land improvements=15

d) But if an activity such as 33.3, land improvements are 7 years (which is client); if 57.0 (distributive trades and services) assets are 5 years, unless they fit into 00.11 to 00.4.



What After Depreciation Errors?

2. There are other issues that are not depreciation errors, but rather are TPR issues that are generated from a review of the depreciation schedules. There are:

a) Repair items that were capitalized. (items that were capitalized but viewed now under the TPRs would have been written off).

b) Prior building write off issues. (new roof was added but old roof should have been written off



What you need to address first on most of

the TR Issues (after addressing depreciation error

corrections):- two items –

TPR Issue(s) identification Unit of Property



Issue(s) Identification – “the list”

The actions a TP may need to take under these TRs are not limited to:

Change in unit of property: do we have buildings grouped together in the depreciation schedule? (example: multiple buildings in a car dealership)

The need to breakout prior costs for property capitalized (i.e. what is the detail in that 39 year asset account where the roof was replaced years ago?)

Write off or capitalize current year expenditures (and if we capitalize, do we have prior to dispose of?



Issue(s) Identification - 2

If we have to write off prior assets, do they still have basis that can be written off?

If fully depreciated, we are done with this asset. Just capitalize the current expenditures and depreciate them properly over future years

If we have to write off these prior assets and they still have basis, we have to determine whether we are going to write those assets off in a 3115 filing under the “cost known” method (such as a cost segregation or being able to recreate the original costs) or under a “reasonable allocation” method (such as a CPI “lookback”)



Issue(s) Identification - 3

Do we need to correct depreciation errors (i.e. methods, lives)? Every client’s depreciation schedule will need to be “scrubbed” for errors. These will require 3115 filings in order to take the (typical) negative 481(a) adjustments. We have decided, in general, that this is summer work for 2013 and that these changes will be attached to the 2013 income tax returns.

Change asset groupings (i.e. building from SAA to GAA?)

Adopt new accounting method(s) – (numerous potential methods!!!)

File 3115(s) (separately or together) for what?



Unit of Property (UoP)

Is a very important element to these and other regulations

Does the client first need to change its UoP before it makes a method change under the new

Tangible Property Regs.?



Unit of Property (UoP) - 1

UoP is a very important issue, why?:

It is an important criteria in the decision whether a TP can write off an expenditure

Generally:

The smaller the UoP the more likely the expenditure will be required to be capitalized

This issue should almost always be considered in TR issues, most of the time, early. If it is a problem, it must be changed and 3115 filed. If not, move on.



Building UoP Examples - 2

Dealer with multiple floors in one building: UoP is the building (but capitalization

considerations on building components and/or system are measured in comparison to that building component that performs a unique function or specifically enumerated system)

Dealer complex with multiple buildings: UoP is each individual separate building



Review of the Temporary Tangible Property Regulations Main

Standards



What the Tangible Property

Regulations (TPR) DoTemporary TPRs provide guidance on the application of Sections 162(a) (deduction) and 263(a) (requires capitalization) of the Code to amounts paid to acquire, produce, or improve tangible property.

Regulations aim to clarify the difference between these two opposites

Temporary regulations = one that is current law and has to be followed until the final regulations are issued Final expected to be issued in 2013

Clarify and expand the standards in the current regulations under Sections 162(a) and 263(a)

Provide certain bright-line tests (for example, a de minimis rule for certain acquisitions)

Provide guidance under Section 168 regarding the accounting for, and dispositions of, property



What the ‘Repair’Regulations Do

Amend the general asset account (GAA) regulations.

TR will affect all taxpayers that acquire, produce, or improve tangible property

Regulations are effective on January 1, 2014 or for taxable years that begin after 1-1-2014, but can be applied for tax years 2012 to 2013 (so why not apply the “beneficial” ones earlier?)



What the ‘Repair’Regulations Do

Splits the definition of tangible property into two categories: Buildings

Everything else

For Buildings: a building and its structural components are treated as a single unit of property, but when improving “building systems,” can be separated out



Building and Structural Components 1.263(a)-3T(e)(2)

(UoP)General rule that the UoP for a building is comprised of the building and its structural components

Requires that a TP apply the improvement standards separately to the primary components of the building, that is, the building structure or any of the specifically defined building systems.

A cost is treated as a capital expenditure if it results in an improvement to the building structure or to any of the specifically enumerated building systems.

Defines the building structure as the building (§1.48-1(e)(1)) and its structural components (§1.48-1(e)(2)) other than the components specifically enumerated as building systems.

A UoP is a method of accounting




(UoP)Defines building systems to include (1) the heating, ventilation, and air conditioning systems (“HVAC”); (2) the plumbing systems; (3) the electrical systems; (4) all escalators; (5) all elevators; (6) the fire protection and alarm systems; (7) the security systems; (8) the gas distribution systems; and (9) any other systems identified in published guidance

These are considered improvements to the building: Replacement of an entire roof, improvement to the HVAC system




(UoP)Old Rule: Taxpayer was required to depreciate building improvements over the life of the original asset (39 years), even if building had been 29 years into its depreciable life; no write off of the replaced component If one replaced a roof, for example, you depreciated

two roofs—the original one and the replaced one, or three roofs, etc.

New Rule: replace a roof, recover as a loss the remaining basis of the old roof, book the new roof and depreciate it



Major Regulation Sections and Subjects

Materials and Supplies §1.162-4 Expanded definitionsDe minimis ruleRotable and temporary spare parts

Acquisitions §1.263(a)-2T Transaction costsCosts before placed in service dateDe minimis rule

Improvements §1.263(a)-3T Unit of PropertyBetterments and RestorationsAdaptions to new useRoutine maintenance safe harbor

General Asset Accounts §1.168(i)-1T General asset elections

MACRS Dispositions §1.168(i)-8T Qualifying dispositions and lossesMACRS disposition and losses



Background

Section 263(a) (relating to the capitalization requirement) states that no deduction is allowed for:

(1) Any amount paid out for new buildings or permanent improvements or betterments made to increase the value of any property, or

(2) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance has been made.



Background

263(a) Regulations state that capital expenditures include amounts paid or incurred to: Add to the value, or substantially prolong the useful

life, of property owned by the TP; or,

Adapt the property to a new or different use.

Amounts paid or incurred for incidental repairs and maintenance of property (as defined by 162 and §1.162-4 (relating to the deduction for ordinary and necessary trade or business expenses) are not capital expenditures under §1.263(a)-1.



U.S. Courts onCapitalization Have

Recognized the highly factual nature of determining whether expenditures are for capital improvements or for repairs

Articulated a number of ways to distinguish between deductible repairs and non-deductible capital improvements.

Explained that R and M expenses are incurred for the purpose of keeping property in an ordinarily efficient operating condition over its probable useful life for the uses for which the property was acquired.

Explained that capital expenditures, in contrast, are for replacements, alterations, improvements, or additions that appreciably prolong the life of the property, materially increase its value, or make it adaptable to a different use



U.S. Courts onCapitalization Have

Explained that the relevant distinction between capital improvements and repairs is whether the expenditures were made to “put” or “keep” property in efficient operating condition

Stated that if the expenditure merely restores the property to the state it was in before the situation prompting the expenditure arose and does not make the property more valuable, more useful, or longer-lived, then such an expenditure is usually considered a deductible repair.

Concluded that a capital expenditure is generally considered to be a more permanent increment in the longevity, utility, or worth of the property.

Key is that TR have attempted to match or meet these “elements” outlined in those court cases ….



Temporary RegulationsDo Not Change

§1.263(a), which requires TPs to capitalize amounts paid to improve tangible property and

§263A and the regulations under §263A, which require TPs to capitalize the direct and allocable indirect costs, including the cost of materials and supplies, to property produced or to property acquired for resale

§1.471-1, which requires TPs to include in inventory certain materials and supplies



Temporary RegulationsDo Adopt and Refine

1. The definition and treatment of materials and supplies

2. The de minimis rule for the acquisition and production of property under §1.263(a)-2T ,

3. An election to capitalize materials and supplies

4. Safe harbor for routine maintenance under §1.263(a)-3T

5. Rules for determining a unit of property (§1.263(a)-3T(e))

6. Certain rule revisions for determining whether there has been an improvement to a unit of property under §1.263(a)-3T

7. Rules revisions for determining whether an amount is paid for an improvement to a building.

8. Rule revisions for determining whether an amount is paid for the replacement of a major component or substantial structural part of a unit of property



Temporary RegulationsDo Adopt and Refine

9. Expanded definition of disposition for MACRS to include the retirement of a structural component (loss recognition)

10. The general rule that incidental materials and supplies (for which no inventories or records of consumption are maintained) are deductible in the year purchased

11. Statements that non-incidental materials and supplies are not deductible until the year in which they are used or consumed in the TP's operations

12. New rules for rotable and temporary spare parts

13. A need for TPs to understand General Asset Groupings

14. Numerous new and revised examples



Temporary RegulationsMake New Rules

Under §1.263(a)-3T(f) for the treatment of amounts paid to improve leased property

Under §1.168(i)-8T that revise the definition of disposition for property subject to Section 168 to include the retirement of a structural component of a building



Temporary RegulationsHave Hundreds of

Examples1. Examples of 1.161-3T (Materials and Supplies)

2. Examples of 1.168(i)-1T (General Asset Accounts)

3. Examples of 1.168(i)-1T(e)(2) (General Asset Accounts Disposed of)

4. Examples of 1.168(i)-1T(e)(3)(ii) (General Asset Accounts Disposed of)

5. Examples of 1.168(i)-1T(e)(3)(iii) (General Asset Accounts Disposed of)




Examples6. Examples of 1.168(i)-8T (Dispositions of MACRS

property)

7. Examples of Amounts Paid to Sell Property (1.263(a)-1T)

8. Examples of Amounts Paid to Acquire or Produce Tangible Property Under §1.263(a)-2T

9. Examples of Amounts Paid for Defense or Perfection of Title to Tangible Property Under §1.263(a)-2T(e)

10.Examples of Transaction costs (1.263(a)-2T(f)




Examples11.Example of Elections to deduct materials and

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

12.Examples of Units of Property and Improvements Under 1.263(a)-3T(e)

13.Examples of Improvements to Leased Property: Leasehold Improvements 1.263(a)-3T(f)

14.Examples Under Safe harbor for Routine Maintenance 1.263(a)-3T(g)

15.Examples of Betterments 1.263(a)-3T(h)




Examples16.Examples of Capitalization of Restorations 1.263(a)-

3T(i)

17.Examples of Capitalization of Amounts to Adapt Property to a New or Different Use 1.263(a)-3T(j)

18.Examples of Capitalization or Expensing Under the Optional Regulatory Accounting Method 1.263(a)-3T(k)

19.Example of §1.1016-3T Exhaustion, Wear and Tear, Obsolescence, Amortization, and Depletion



Material and Supplies



Definition ofMaterial and Supplies

TR define and expand the definition of (the first category of) materials and supplies as tangible property that is used or consumed in the TP’s operations, not constituting a UoP, not acquired as part of a single UoP, and is not inventory, and that:

1. Is a component acquired to maintain, repair, or improve a unit of tangible property owned, leased, or serviced by the TP and that is not acquired as part of any single unit of tangible property;

2. Consists of fuel, lubricants, water, and similar items, that are reasonably expected to be consumed in 12 months or less, beginning when used in TP's operations; (New Category)

3. Is a UoP that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the TP's operations;




4. Is a UoP that has an acquisition cost or production cost (under Section 263A ) of $100 or less (or other amount as identified in published guidance in the Federal Register or in the IRB; or

5. Is identified in published guidance in the Federal Register or in the IRB as materials and supplies for which treatment is permitted

6. Also provide an election to treat certain materials and supplies under the de minimis rule of §1.263(a)-2T, and

7. Allow a TP to elect to capitalize certain materials and supplies.

8. Redefine the first category of materials and supplies by further describing the types of components that qualify and by

9. Eliminating the requirement that such property not be a UoP under Section §1.263(a)-3T(d)(2)




Specified acquisition or production cost threshold

TR retains the $100 limitation

Add language, however, that gives the IRS and the Treasury Department the flexibility to change the amount of the limitation

A TP with applicable financial statements (AFS) will be permitted to deduct amounts paid for property up to higher thresholds if it complies with the requirements set out in the de minimis rule provided in §1.263(a)-2T .

Designated (smallwares under Rev. Proc. 2002-12, or 2002-28 for certain inventoriable items in the same manner as materials and supplies that are not incidental under §1.162-3) property continues to qualify as materials and supplies under the TR because the property is identified in published guidance as materials and supplies.



Election to CapitalizeMaterial and Supplies

A TP may elect to treat as a capital expenditure and to treat as an asset, subject to depreciation, the cost of any M and S

Election applies to amounts paid during the taxable year to acquire or produce any M or S. Any asset for which this election is made shall not be treated as a M or S.

Exceptions. A TP may not elect to capitalize

i. Any amount paid to acquire or produce a M or S if:

ii. The M or S is intended to be used as a component of a unit of property and

iii. The TP has not elected to capitalize and depreciate that unit of property; or

ii. Any amount paid to acquire or produce a rotable or temporary spare part if the TP has applied its optional method of accounting



Election to CapitalizeMaterial and Supplies

A TP makes the election by capitalizing the amounts in the taxable year the amounts are paid and by beginning to depreciate them

If a pass-through entity, the election is made at the entity level



De minimis Units of Property



TP is not required to capitalize amounts paid for the acquisition or production (including any amounts paid to facilitate the acquisition or production) of a UoP if…

1. TP had an AFS (as defined in the regulations);

2. TP had, at the beginning of the taxable year, written accounting procedures treating as an expense for non-tax purposes the amounts paid for property costing less than a certain dollar amount;

3. TP treated the amounts paid during the taxable year as an expense on its AFS in accordance with its written accounting procedures; and

4. Total aggregate of amounts paid and not capitalized under the de minimis rule for the taxable year must be < or = to the greater of:

a) 0.1 percent of the TP’s gross receipts for the taxable year as determined for Federal income tax purposes; or

b) 2.0 percent of the TP’s total depreciation and amortization expense for the taxable year as determined in its AFS.

De minimis RuleUnder §1.263(a)-2T



De minimis RuleUnder §1.263(a)-2T

TP is not required to capitalize amounts paid for the acquisition or production (including any amounts paid to facilitate the acquisition or production) of a UoP if…

5. The de minimis rule does not apply to amounts paid for labor and overhead incurred in repairing or improving property.

6. Permits a member to utilize the written accounting procedures provided on the AFS of its affiliated group.

7. If examining agents and a TP agree that certain amounts in excess of the de minimis rule ceiling are immaterial and should not be subject to review, that agreement should be respected, notwithstanding the requirements of the de minimis rule in the TR.



De minimis Rule Election Details

… of the de minimis material and supplies:

TP makes the election by deducting the amounts paid to acquire or produce a material or supply in the taxable year that the amounts are paid in its timely filed original federal income tax return (including extensions) for the taxable year that amounts are paid for the material or supply

May revoke an election only by filing a request for a private letter ruling

Election may not be made or revoked through the filing of an application for change in accounting method or by filing an amended federal income tax return.



De minimis Rule Election Details

… of the de minimis material and supplies:

Note that the TR do not state that the “election” of the de minimis rule is a method of accounting

That means that a TP can elect to apply the de minimis rule in one year and not the next, and/or apply it to certain assets and not to others.

Note, however, that electing a UoP is a method of accounting …



De minimis Rule Election Example

Example 4. Facts: Election to apply de minimis rule to certain materials and supplies. (i) X is a corporation that provides consulting services to its customers. X has an AFS and a written policy at the beginning of the taxable year to expense amounts paid for property costing $500 or less. In Year 1, X purchases 200 computers at $500 each for a total cost of $100,000. Assume that each computer is a UoP under §1.263(a)-3T(e) and is not a material or supply under §1.162-3T. In addition, X purchases 200 office chairs at $100 each for a total cost of $20,000 and 250 customized briefcases at $80 each for a total cost of $20,000. Assume that each office chair and each briefcase is a material or supply under §1.162-3T(c)(1). In Year 1, X also acquires 10 books at $100 each, which are also materials and supplies under §1.162-3T(c)(1).




Example 4, continued:

X makes the election under §1.162-3T(f) to apply the de minimis rule to the office chairs and briefcases, but does not make that election for the books and treats the books as materials and supplies in accordance with the provisions of §1.162-3T. X treats the amounts paid for the computers, office chairs, and briefcases as expenses on its applicable financial statement. Assume also that for Year 1, the amounts that X paid for the computers, office chairs, and briefcases are the only amounts that X intends to treat as de minimis costs not capitalized under paragraph (g)(1) of this section. For its Year 1 taxable year, X has gross receipts of $125,000,000 and reports $7,000,000 of depreciation and amortization on its applicable financial statement.




Analysis:

In order to meet the requirements of de minimis, X’s total aggregate amounts paid and not capitalized under paragraphs (g)(1)(i), (ii), and (iii) must be less than or equal to the greater of $125,000 (0.1% of X's total gross receipts of $125,000,000) or $140,000 (2% of X's total depreciation and amortization of $7,000,000).

X pays a total of $140,000 ($100,000 + $20,000 + $20,000) for the computers, office chairs, and briefcases.

X is not required to include the amounts paid for the books in this computation because X has not elected under §1.162-3T(f) to apply the de minimis rule to the books.

Thus, the total aggregate amounts paid and not capitalized is equal to $140,000 (2% of X’s total financial depreciation), the greater of the two limitations.

Accordingly, in Year 1, X may treat as de minimis and is not required to capitalize, the $140,000 paid to acquire the computers, office chairs, and briefcases.



Applicable Financial Statements

Defined as: TP’s FS that has the highest priority.

The FS are, in descending priority:

A. A FS required to be filed with the SEC;

B. A certified audited FS that is accompanied by the report of an independent CPA, that is used for:

1) Credit purposes;

2) Reporting to shareholders, partners, or similar persons; or

3) Any other substantial non-tax purpose; or

C. A FS (other than a tax return) required to be provided to the federal or a state government or any federal or state agencies (other than the SEC or the Internal Revenue Service).



Improvements



Leasehold Improvements 1.263(a)-3T(f) ExampleLessor Improvements; additions to building. T is a retailer of consumer products. In Year 1, T leases a building from L, which T intends to use as a retail sales facility. L provides a construction allowance to T, which T intends to use to construct an extension to the retail sales facility for additional warehouse space. Assume that the amount paid for any improvement to the building does not exceed the construction allowance and that L is treated as the owner of any improvement to the building.

L must treat the leased building and its structural components as a single UoP. An amount paid is for an improvement to the building if it results in an improvement to the building structure or to any building system.



Leasehold Improvements 1.263(a)-3T(f) Example

In Year 2, T uses L’s construction allowance to construct an extension to the leased building to provide additional warehouse space in the building. Assume that the extension is a betterment to the building structure, and therefore, the amount paid for the extension results in an improvement to the building structure.

L, the lessor and owner of the improvement, must capitalize the amounts paid to T to construct the extension to the retail sales facility. T is not permitted to capitalize the amounts paid for the lessor-owned improvement.

The extension to L’s building is not a UoP separate from the building and its structural components.



Betterments



Certain Costs Incurred During an Improvement

1.263(a)-3T(f)(3)263A and §1.263A-1(e) rules regarding the capitalization of indirect costs require the capitalization of indirect costs that directly benefit or are incurred by reason of an improvement to property.

TR adopt the §1.263A-1(e) standard for purposes of Section 263(a)—and set out a clearly articulated standard that provides appropriate parameters for determining when otherwise deductible indirect costs must be capitalized as part of an improvement to property.

TR obsolete the “plan of rehabilitation doctrine” to the extent that court-created doctrine provided different standards for determining whether an otherwise deductible indirect cost must be capitalized as part of an improvement.



Certain Costs Incurred During an Improvement

1.263(a)-3T(f)(3)TR: a TP must capitalize all the direct costs of an improvement and all the indirect costs (including, for example, otherwise deductible repair or component removal costs) that directly benefit or are incurred by reason of an improvement in accordance with 263A.

Indirect costs that do not directly benefit and are not incurred by reason of an improvement are not required to be capitalized under Section 263(a), regardless of whether they are made at the same time as an improvement.

These costs may be required to be aggregated over a period of more than one year.



Removal Costs

These costs for a UoP should be analyzed in the same manner as any other indirect cost incurred during an improvement to property.

Similar to the treatment of otherwise deductible repair and maintenance costs incurred during an improvement, the costs of removing a component of a UoP must be capitalized if they directly benefit or are incurred by reason of an improvement to a UoP.

TP may deduct the costs of removing a component if the TP can demonstrate that such costs relate only to the disposition of the removed property and that the costs do not have the requisite relationship to any improvement.

Because the costs of removing a retired asset typically relate to the depreciable asset being removed and are not allocable to the improvements, §1.263(a)-3T generally is not applicable to such removal costs.

TR do not change the treatment of any amounts addressed under Section 280B (which governs amounts expended and losses sustained for the demolition of structures).



Capitalization of Betterments 1.263(a)-

3T(h)Amount paid results in a betterment, and accordingly, an improvement, if it [note the subjective determinates]:

Ameliorates a material condition or material defect that existed prior to the acquisition of the property or arose during the production of the property;

Results in a material addition to the UoP (including a physical enlargement, expansion, extension, productivity, efficiency, strength, quality); or,

Results in a material increase in the capacity, productivity, efficiency, strength, or quality of the UoP or its output.



Betterments to Buildings

Analysis of whether costs incurred to refresh or remodel a building result in a betterment requires an examination of all the facts and circumstances including, but not limited to:

The purpose of the expenditure,

The physical nature of the work performed,

The effect of the expenditure on the UoP, and

The TP’s treatment of the expenditure on its AFS



Betterments to Buildings

Other Rules:

If a TP needs to replace part of a UoP that cannot practicably be replaced with the same type of part (for example, because of technological advancements or product enhancements), the replacement of the part with an improved, but comparable, part does not, by itself, result in a betterment to the UoP.

Determination of whether an expenditure results in a betterment of the UoP is made by comparing the condition of the property immediately after the expenditure with the condition of the property immediately prior to the circumstances necessitating the expenditure.



Examples—Betterments1.263(a)-3T(h)

Example: Amelioration of pre-existing material condition or defect.

In Year 1, X purchases a store located on a parcel of land that contained underground gasoline storage tanks left by prior occupants. Assume that the parcel of land is the UoP. The tanks had leaked, causing soil contamination. X is not aware of the contamination at the time of purchase. In Year 2, X discovers the contamination and incurs costs to remediate the soil.

The remediation costs result in a betterment to the land under paragraph (h)(1)(i) of this section because X incurred the costs to ameliorate a material condition or defect that existed prior to X’s acquisition of the land.



Restorations



Restorations 1.263(a)-3T(i)

An amount is paid to restore, and therefore improve, a UoP if it:

1. It returns the UoP 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;

2. It is rebuilding to like-new condition: results in the rebuilding of the UoP to a like-new condition after the end of its class life (brought to the status of new, rebuilt, remanufactured, or similar status under the terms of any federal regulatory guideline or the manufacturer’s original specifications); or




3. Replaces a Major Component or Substantial Structural Part of the UoP: In determining whether an amount is paid for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of the UoP, the TP must consider all the facts and circumstances, including the quantitative or qualitative significance of the part or combination of parts in relation to the UoP or, in the case of a building, in relation to the building structure or the relevant building system.

Define a major component or substantial structural part to include a part or combination of parts that comprise a large portion of the physical structure of the UoP or that perform a discrete and critical function in the operation of the UoP.




3. Replaces Major Component or Substantial Structural Part of the UoP: (cont.)

TR revise the disposition and depreciation rules to minimize the harsh result that occurs when an original part and any subsequent replacements of the same part are required to be capitalized and recovered simultaneously.

TR revise the definition of disposition so that a TP may treat the retirement of a structural component of a building as a disposition of property.

Clarify that a TP may recognize a loss on a component of a UoP that is Section 1245 property if the TP consistently treats the component as a separate asset for disposition purposes.



Summary of Examples Restorations

Examples where items were written off:

Rebuild freight cars before the end of their class life

Repair a broken taillight, replace a power switch assembly

Waterproof roof membrane

Two out of eight HVAC units, two out of twenty sinks, and 30 out of 300 windows, wood flooring in hotel lobby



Summary of Examples Restorations

Examples where items were capitalized:

Shore up the walls and replace siding, 200 of 300 windows

Rebuild freight cars after the end of their class life

New engine and cab of a tractor, also paint the tractor cab

Underground tank removal and replace

Entire roof, and significant portion of a roof

Furnace replacement, the one HVAC system, also sprinkler system in a building

Wiring throughout the building; plumbing fixtures in all of the restrooms; all of the floors in the public areas of the hotel

Remodel hotel over several-year period



Amounts to Adapt Property to a New or Different Use 1.263(a)-

3T(j)TP must capitalize amounts paid to adapt a unit of property to a new or different use.

Amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the TP’s intended ordinary use of the unit of property at the time originally placed in service by the TP.

In the case of a building, an amount is paid to adapt the UoP to a new or different use if it adapts to a new or different use any of the properties designated in paragraphs (e)(2)(ii)(building structure and systems), (e)(2)(iii)(B)(condominium), (e)(2)(iv)(B)(cooperative), or (e)(2)(v)(B) (leased building) of this section.



Checklist of Improvements

Betterment Considerations:

Does routine maintenance safe harbor apply?

Does it ameliorate a pre-existing material condition or defect?

Does it ameliorate a material condition or defect prior to placing the property in service?

Does it result in a material increase in capacity, productivity, efficiency, quality, etc. of UoP?

Does it adapt to a new or different use?

Does Section 263A apply to the expenditure(s)?

If the answer to any of the above questions is YES, then the expenditure has to be capitalized …



Checklist of Improvements

Restoration Considerations:

Is the UoP no longer functional and did you return it to ordinary efficient or operating condition?

Did you rebuild the UoP to a like-new condition after its useful life?

Did you replace a major component or substantial structural part?

Was the component previously deducted as a loss, before you replaced it?

Was the component previously sold or exchanged before replacement?

Was the expenditure to the UoP previously taken as a casualty loss?

If the answer to any of the above questions is YES, then the expenditure has to be capitalized …



Disposition Rules



Accounting and Disposition Rules for

MACRS PropertyTR revise the rules for accounting for 168 assets (MACRS property) and the rules for determining gain or loss upon the disposition of MACRS property.

Before the TR, a TP may account for its MACRS property by accounting for an asset:

Individually in a single asset account (SAA),

By combining two or more assets in a multiple asset account (or pool) (MAA), or

By electing to include the asset in a general asset account (GAA).

TR provide that each MMA must include, in most cases, assets that have the same depreciation method, recovery period, and convention, and that are placed in service in the same taxable year.



Accounting and Disposition Rules for

MACRS PropertyTR: Expand the definition of disposition for MACRS

property to include the retirement of a structural component of a building.

Allow the recognition of a loss upon such retirement.

State that if an asset is disposed of by physical abandonment and that asset is subject to nonrecourse indebtedness, the asset is treated in the same manner as an asset disposed of by sale.

Provide rules for determining the asset disposed of and identifying which MAA includes the asset disposed of.



MACRSDefinition of Disposition

Occurs when ownership of the asset is transferred; or,

Asset is permanently withdrawn from use either in the taxpayer’s trade or business or in the production of income;

Includes the sale, exchange, retirement, physical abandonment, or destruction of an asset;

Also includes the retirement of a structural component of a building (defined by 1.48-1); and,

Finally, when an asset is transferred to a supplies, scrap, or similar account.

Manner of Disposition—does not matter.



MACRSDisposition—Gain or Loss

TR new rule: If the TP accounts for the asset disposed of in a MAA or pool, or the asset disposed of is a component of a larger asset and if it is impracticable from the TP’s records to determine the unadjusted depreciable basis of the asset disposed of, the TP may use any reasonable method that is consistently applied to the TP’s MAA pools or to the TP’s larger assets for purposes of determining the unadjusted depreciable basis of assets disposed of.

Have to use the method, period, conv., and 1st year depr. deduction applicable.



MACRSDisposition Examples

Example 5. On July 1, 2009, D, a calendar TP, purchased and placed in service a nonresidential multi-story office building that costs $20,000,000. The cost of each structural component of the building was not separately stated. D accounts for the building in its records as a single asset with a cost of $20,000,000. D uses the optional depr. table that corresponds with the GDS, the SL method, a 39-year period, and the mid-month convention. As of January 1, 2012, the depreciation reserve for the building is $1,261,000.

On June 30, 2012, D replaces one of the building’s elevators. Because D cannot identify the cost of the structural components of the office building from its records, D uses a reasonable method, consistently applied to all of the structural components of the office building, to determine the cost of the elevator. D allocates $150,000 of the $20,000,000 purchase price for the building to the retired elevator. Using the depr. table that corresponds with the GDS, the SL method, a 39-year period, and the mid-month conv., the depr. allowed or allowable for the retired elevator as of December 31, 2011, is $9,457.50.




Example 5, continued.

For D’s 2012 return, loss for the retired elevator is determined as follows. The depr. for 2012 for the retired elevator is $1,923 ((unadjusted depr. basis of $150,000 × depr. rate of 2.564 percent for 2012) × 6/12). The adjusted depr. basis of the retired elevator is $138,619.50 (the adjusted depr. basis of $140,542.50 removed from the building cost less the depr. of $1,923 for 2012). As a result, D recognizes a loss of $138,619.50 for the retired elevator in 2012, which is subject to Section 1231.

For D’s 2012 Federal return, the depr. allowance for the building is computed as follows. As of January 1, 2012, the unadjusted depr. basis of the building is reduced from $20,000,000 to $19,850,000 ($20,000,000 less the unadjusted depr. basis of $150,000 for the retired elevator), and the depr. reserve of the building is reduced from $1,261,000 to $1,251,542.50 ($1,261,000 less the depr. of $9,457.50 for the retired elevator as of December 31, 2011). Consequently, the depr. allowance for the building for 2012 is $508,954 ($19,850,000 × rate of 2.564 percent for 2012).




RP 2012-20 tells us that:

• Use the same facts as Example 5 from prior slides, but the building was purchased in 2000 and the elevator was replaced in 2005. D completes a Form 3115 and files it with his tax return for 2012.

• D files the 3115 to change his method of accounting from continuing to deduct depreciation for the disposed of building component to recognizing gain or loss upon disposition of building components.

• D can deduct the cost of the replaced elevator in 3115. Using the facts above, the accumulated depreciation on the elevator to 12-31-2011 is $44,071.50. D can take a loss on the elevator disposition of $105,928.50 in his 2011 tax return. This is a Section 1231 loss.

• D can take the loss on its 2013 tax return if it instead chooses to file the 3115 on its 2013 return. (this is an automatic number 177)



CONCLUSION

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Documents

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