Repair and Maintenance Regulations S. Andrew Smith Tax Principal - - PowerPoint PPT Presentation

• S. Andrew Smith

Tax Principal June 12, 2014

Repair and Maintenance Regulations

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• Overview
• Materials and Supplies
• De minimis Safe Harbor
• Routine Maintenance Safe Harbor
• Small Taxpayer Safe Harbor
• Changes to Capitalization Standards
• Proposed partial disposition regulations
• Compliance Items

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• Effective Date
• The final regulations (T.D. 9636) are generally effective for

tax years beginning on or after January 1, 2014.

• Taxpayers that did not file 3115s with their 2014 income tax

return to comply to changes are unable to make any retroactive adjustments.

• 3115 may NOT be filed with an Amended Return.

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• Materials and Supplies

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• Definition
• Tangible property used or consumed in the

taxpayer’s business operations that is NOT inventory and that is:

– A component to maintain, repair or improve property – Fuel, lubricants, water, and similar items expected to be consumed within 12 mos. – Property with an economic useful life of less than 12 months – Unit of property that costs less than $200

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• De minimis safe harbor

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• New Safe Harbor Rule
• May rely on the safe harbor to expense tangible property

under a certain dollar threshold.

• Must have a written accounting procedure in place at the

beginning of the taxable year with a specified dollar amount and does not exceed a per invoice or per item cost. – For taxpayers with an applicable financial statement, the dollar amount is not to exceed $5,000per item. – For taxpayers without an applicable financial statement, the dollar amount is not to exceed $500 per item.

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• Applicable Financial Statement
• A financial statement required to be filed with the Securities and

Exchange Commission (SEC) (the 10-K or the Annual Statement to Shareholders);

• A certified audited financial statement that is accompanied by the report
• f an independent certified public accountant (or, in the case of a foreign

entity, by the report of a similarly qualified independent professional) that is used for:

– Credit purposes; – Reporting to shareholders, partners, or similar persons; or – Any other substantial non-tax purpose; or

• A financial statement (other than a tax return) required to be provided to

the federal or a state government or any federal or state agency (other than the SEC or the IRS).

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• Election Details
• Safe harbor is elected annually by including a statement on a timely filed
• riginal federal return (including extensions) for the year elected.
• Must be applied to all amounts paid in the taxable year for tangible

property that meet the requirements of the de minimis safe harbor, including amounts paid for materials and supplies.

– Except for materials and supplies that the taxpayer elects to capitalize and depreciate;

• r

– Except for where the optional method of accounting is used for rotable and temporary spare parts.

• Election is irrevocable.
• An election may not be made by filing an application for change in

accounting method.

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• De minimis examples

Taxpayer without AFS Taxpayer with AFS FACTS:

• 10 Computers

purchased for $600 each - $6,000 Total

• Accounting policy

expenses amounts paid for property less than $1,000

• 1,250 Computers

purchased for $5,000 each, $6.25 Million Total

• Accounting Policy

expenses amounts paid for property costing $5,000 or less CONCLUSION:

• Amount exceeds $500

per invoice

• Does not meet

requirements for the de minimis safe harbor

• Amounts paid meet the

requirements for the de minimis safe harbor TREATMENT: Capitalize Expense

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• Routine Maintenance Safe Harbor

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• Routine Maintenance
• Defined as any activity that you can

reasonably expect to perform more than once during the useful life of an asset.

• Does not actually have to be performed more

than once during your ownership.

• Must factor in previous ownership for

acquisition of used assets.

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• Routine Maintenance Safe Harbor for

Buildings

• NEW:Extend the application of the routine maintenance safe harbor to buildings.
• 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 system in its

• rdinarily efficient operating condition.
• The taxpayer must reasonably expect to perform the activities more than once

during a 10-year period beginning at the time the building structure or building system is placed in service.

• Note: A taxpayer’s expectation will not be deemed unreasonable merely because

it does not actually perform the maintenance a second time during the 10-year period—as long as the taxpayer can otherwise substantiate that its expectation was reasonable when the property was placed in service.

• Amounts incurred for activities that do not meet the safe harbor are subject to

analysis under the general rules for improvements.

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• Routine Maintenance Examples

Qualifying Routine Maintenance Non-qualifying Routine Maintenance FACTS:

• Reasonably expected every 4

years HVAC system would require maintenance

• Contractor paid in Year 4 to

perform maintenance

• Maintenance not performed again

until year 15

• Purchased a used

machine and expected to perform maintenance every 3 years

• At time of purchase,

machine was close to 3 year scheduled maintenance CONCLUSION: Amounts paid for maintenance in years 4 and 15 are qualified because they were EXPECTED to be performed more than once during a 10 year period Costs incurred for maintenance in year 1 of

• wnership do not qualify

as they relate to prior

• wner’s use.

TREATMENT: Expense Capitalize

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• Election to Capitalize Repair and

Maintenance Costs

• May elect to treat amounts paid during the taxable year for repair and

maintenance to tangible property as amounts paid to improve that property if the taxpayer incurs these amounts in carrying on the taxpayer’s trade or business and if the taxpayer treats these amounts as capital expenditures on its books and records.

• Applies to all amounts paid for repair and maintenance to tangible

property that it treats as capital expenditures on its books and records in that taxable year.

• Annual irrevocable election made by attaching a statement to a timely

filed original federal tax return (including extensions) for the taxable year in which the taxpayer pays these amounts.

• Must begin to depreciate the costs of improvements when they are

placed in service.

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• Small Taxpayer Safe Harbor

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• Definition of Small Taxpayer
• A taxpayer whose average annual gross

receipts for the 3 preceding taxable years is less than or equal to $10 Million.

• Only applies to Eligible Building Property

– Unadjusted basis of $1 Million or less!

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• Small Taxpayer Safe Harbor Rule
• Qualifying taxpayer may elect to not apply the

capitalization rules to eligible building property if the TOTAL amount paid during the taxable year for repairs, maintenance, improvements, and similar activities performed on the eligible building property does not exceed the lesser of:

– 2% of the building’s unadjusted basis; or – $10,000

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• Small Taxpayer Safe Harbor Election
• Qualifying taxpayers that wish to utilize the

small taxpayer safe harbor rule must attach a statement to a timely filed original federal tax return for the year in which the costs are incurred.

– Elected annually on a building-by-building basis – Election is irrevocable

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• Small Taxpayer Safe Harbor Example

Example 1 Example 2 FACTS:

• Building has an

unadjusted basis of $750,000

• Costs of $5,500 for

repairs, maint., improvements, etc.

• 2 rental properties: Buildings A & B
• Both buildings have an

unadjusted basis of $300,000

• Costs for repairs, maint, and

improvements

• Building A: Costs of $5,000
• Building B: Costs of $7,000

CONCLUSION: Aggregate amount paid does not exceed:

• $15,000 (2% of $750k

unadjusted basis) – OR –

• $10,000

Building A:

• $6,000 (2% of $300,000) - OR -
• $10,000

Building B:

• $6,000 (2% of $300,000) - OR -
• $10,000

TREATMENT: EXPENSE Building A: EXPENSE Building B: CAPITALIZE

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• Capitalization Standards

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• RABI Rules
• If a cost represents an Improvement, it must

be capitalized!

• There are 3 types of improvements as

defined by the regulations

– Restoration (R) – Adaptation (A) – Betterment (B)

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• Improvement Standards

Improvement Betterment Adaptation Restoration

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• How to Apply RABI Rules
• Must be applied to the new Unit of Property

standards as defined by the Regs

• Complete change from former standards with

building being considered one unit of property

• Each Unit of Property must be considered by

itself when applying the RABI standards

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• Unit of Property

Buildings Single Unit

• f Property

Non Buildings

Default Rule

Functional Interdependence

Plant Property

Discrete and major function

Network assets

Industry – specific facts and circumstances

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• Unit of Property for Buildings

Building

Systems

HVAC Electrical Plumbing Gas Distribution Fire Suppression Elevators Escalators Security

Structure

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• Building Systems
• Building and structural components not designated in another system

Structure

• Motors, compressors, boilers, furnaces, chillers, pipes, ducts radiators

HVAC

• Pipes, drains, valves, sinks, bathtubs, toilets, exterior site utility equipment

Plumbing

• Wiring, junction boxes, lighting fixtures, exterior site utility equipment

Electrical

• All components associated with either elevators or escalators

Elevators/Escalators

• Sensing devices, sprinkler heads, associated piping and plumbing, pumps,

alarms, alarm controls, fire escapes, fire doors, emergency exit lighting

Fire Protection

• For protection of the building and its occupants: door locks, cameras, monitors,

alarm systems, entry and access systems, wiring and conduit

Security

• Associated pipes and equipment to distribute gas to and from property

Gas Distribution

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• Betterments
• Ameliorates a material condition or defect at

acquisition or production

• Material addition or expansion
• Reasonably expected to materially increase

the productivity, efficiency, strength, quality,

• r output

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• Betterment Examples

Non Material Increase in Efficiency Material Increase in Efficiency FACTS:

• HVAC System has 10 Roof

Mounted Units

• Replaces 2 Units
• Increase Energy Efficiency by

10%

• Added new insulation to

existing building

• Expected to reduce

energy costs by 50% CONCLUSION:

• 10% efficiency increase is not

expected to materially increase the productivity, efficiency, strength, quality, or output of the HVAC System.

• Costs may be expensed
• 50% energy efficiency

increase is considered material

• Costs will be capitalized

as a betterment

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• Adaptations
• Amounts paid to adapt a unit of property to a

new or different use must be capitalized

• A use is new or different based upon the

intended ordinary use of the unit of property at the time the property was placed in service

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• Adaptation Examples
• Amounts paid to convert manufacturing facility into a

showroom facility was adapting property to different use and had to be capitalized

• Reconfiguring retail space in a strip mall is not a new or

different use

• Expense to clean-up previous manufacturing site in order to

sell to developer is adapting for different use and the costs must be capitalized

• Adding a Medical Clinic to a Pharmacy is a change of use
• Salad bar to a grocery store is NOT an adaptation

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• Building Restorations
• NEW: Major component definition

– Part or combination of parts that performs discrete and critical function in the operation of the unit of property. – An incidental component of the unit of property, even though such component performs a discrete and critical function in the operation of the unit of property, generally will not, by itself, constitute a major component.

• NEW: Substantial structural part definition

– Part or combination of parts that comprises a large portion of the physical structure of the unit of property.

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• Restoration
• Recognition of a loss on component
• Gain/loss on sale of component
• Basis adjustment as a result of a casualty loss
• Return to former operating condition –no longer

functioning

• Rebuild the property to like-new condition after

class life

• CLARIFICATION:Replacement of a major

component/substantial structural part

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• Example: Major Component

Roof HVAC FACTS: Replaced roof membrane to fix leaky roof with a comparable part

• HVAC System includes

many components including one chiller unit

• Chiller Unit is replaced

with comparable unit CONCLUSION:

• Roof, including

membrane, is part of the building structure

• Replacement is not

considered a significant portion of the roof major component

• Chiller unit performs a

discrete and critical function of in the

• peration of the HVAC

system

• Chiller Unit is a major

component TREATMENT: Expense Capitalize

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• Improvement Standards

Examples: Not a new or different use New or Different Use FACTS: Grocery store adds sushi bar Retail drug store adds medical clinic CONCLUSION: Consistent with intended,

• rdinary use of the

building Not consistent with the intended ordinary use of the building at the time placed in service TREATMENT: Expense Capitalize

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• Temporary regulations

Final regulations

Unit of Property Building Building Building structure/ system HVAC HVAC Building system replacement cost new $150,000 $150,000 Major component performing discrete and critical function N/A RTUs Analysis

Cost of RTUs $15,000 = 10% Units replaced 3 = 30% Building system replacement cost $150,000 Total units 10

Treatment

DEDUCTIBLE DEDUCTIBLE Temporary regulations Final regulations

Building Building Electrical Electrical $300,000 $300,000 N/A Electrical wiring

Cost of wiring $30,000 = 10% 30% Building system replacement cost $300,000

DEDUCTIBLE DEDUCTIBLE

3 of 10 RTUs replaced, cost of $15,000 30% of electrical wiring replaced in a building, cost of $30,000

Major Component Example

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• Major Component Example

Temporary regulations Final regulations

UoP Building Building Building structure/ system Plumbing Plumbing Building system replacement cost new $200,000 $200,000 Major component performing discrete and critical function N/A Toilets AND sinks Analysis

Cost of replacement $40,000 = 20% Units replaced 20 30 = 100% Building system replacement cost $200,000 Total units 20 30

Treatment

DEDUCTIBLE CAPITALIZE Temporary regulations Final regulations

Building Building Plumbing Plumbing $200,000 $200,000 N/A Sinks

Cost of sinks $4,000 = 2% Units replaced 8 = 40% Building system replacement cost $200,000 Total units 20

DEDUCTIBLE DEDUCTIBLE

20 of 20 sinks replaced, cost of $10,000; 30 of 30 toilets replaced, cost of $30,000 8 of the 20 sinks are replaced, cost of $4,000

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• Major Component Example

Temporary regulations Final regulations

UoP Building Building Building structure/ system Building Structure Building Structure Building system replacement cost new $750,000 $750,000 Major component performing discrete and critical function N/A Windows Analysis

Cost of windows $50,000 = 6% Units replaced 100 = 33% Building system replacement cost $750,000 Total units 300

Treatment

DEDUCTIBLE DEDUCTIBLE Temporary regulations Final regulations

Building Building Building Structure Building Structure $750,000 $750,000 N/A Windows

Cost of windows $100,000 = 13% Units replaced 200 = 67% Building system replacement cost $750,000 Total units 300

DEDUCTIBLE CAPITALIZE

100 of 300 exterior windows replaced, cost of $50,000 200 of 300 exterior windows replaced, cost of $100,000

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• Proposed Partial Disposition

Regulations

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• Overview
• Proposed regulations include:

– General asset accounts – Accounting for MACRS property – Dispositions of MACRS property

• The 2013 proposed regulations apply to tax years beginning
• n or after Jan. 1, 2014.

– Taxpayers may apply the proposed regulations early to tax years beginning on or after Jan. 1, 2012.

• The 2011 temporary regulations have not been withdrawn.

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• New Disposition Rule
• NEW RULE: Taxpayers may take a loss on the disposition of a structural

component of a building—or a portion of a structural component of a building—without the GAA election. – Loss must be recognized in the tax year of the disposition.

• Also, taxpayers may forgo a loss on the disposition of a structural

component of a building—or a portion of a structural component of a building—without the GAA election.

• This PARTIAL DISPOSITION RULE is designed to minimize situations

where multiple versions of the same asset (e.g., building structural component) are on the books and being depreciated simultaneously.

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• Disposition Election
• Election is made by the due date (including extensions) of

the original return for the tax year of the disposition.

• Election is made by reporting the gain or loss on the timely

filed original return for the year of the disposition.

• Transition relief for 2012 and 2013 returns.

– Amended return on or before 180 days from the extended due date,

• r

– –Application for change in accounting method for first or second succeeding tax year.

• Election may be revoked only via request for PLR.

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• Reasonable Method
• Taxpayers may use any reasonable method to

determine the basis of the asset or the portion of the asset disposed of, including but not limited to:

– Discounting the replacement cost to the original placed- in-service year using the Producer Price Index. – Allocating the original cost pro rata based on a ratio of the replacement cost of the component to the replacement cost of the entire building. – Conducting a study to allocate the original cost of the asset to its various component (similar to a cost segregation study)

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• Disposition Example
• Taxpayer D replaces 60 percent of the roof of a retail building.
• Assume D must capitalize the costs incurred for replacing 60 percent of

the roof pursuant to §1.263(a)-3(k)(1)(vi).

• D makes the partial disposition election provided under Reg. §1.168(i)-

1(d)(2) for the 60 percent of the replaced roof.

• Thus, the retirement of 60 percent of the roof is a disposition.
• Depreciation for 60 percent of the roof ceases at the time of its retirement

(taking into account the applicable convention), and D recognizes a loss upon this retirement.

• Further, D must capitalize the amount paid for the 60 percent of the roof

pursuant to §1.263(a)-3(k)(1)(i) and (vi) and the replacement 60 percent

• f the roof is a separate asset.

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• Summary

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• Things to Consider
• Routine maintenance safe harbor for buildings

– Documentation – If costs do not meet safe harbor, can still analyze under improvement rules

• De minimis safe harbor

– Do you have a written financial accounting policy in place prior to Jan. 1, 2014? – Do you have an AFS? – Does your current financial accounting policy exceed the safe harbor amount?

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• Things to Consider (Cont.)
• Capitalization standards

– Major components and substantial structural parts

• Greater level of detail required
• Interaction with facilities required
• Physical counts of:

– HVAC units – Light fixtures – Toilets – Etc.

• –Annual election to capitalize repair costs

– Taxable income planning – Ability to implement repair study changes in fixed asset system – Avoid book/tax differences

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• Things to Consider (Cont.)
• Proposed partial disposition regulations

– No annual GAA election required for buildings! – Consider only when repair costs cannot be deducted – larger benefit. – Complexities in identifying basis of partially disposed assets. – Optional (You don’t need to take a PAD)

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• Annual Elections
• De minimis safe harbor – requires statement with

TP’s name, EIN, address to be attached to each tax return

• Small Taxpayer Safe Harbor – Same as DMSH but

must describe each eligible property

• Partial Asset Dispositions (PADS) – No statements

required, just report on 4797.

• 3 Elections to capitalize items that could be

expensed.

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• Abandoned Assets
• Assets that still have remaining basis but

have been disposed of in previous should be treated as abandonments under Code Section 165.

• No 3115 needed
• Follow rules under 165 – either take the

remaining depreciation or report the loss

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• Resources
• For a complete summary of the Tangible

Property Regulations in “plain English” complete with flowchart: http://www.bnncpa.com/resources/library/tangib le_property_regulations#specifics

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• S. Andrew Smith, CPA

Tax Principal

asmith@bnncpa.com 207-791-7545 Baker Newman Noyes 280 Fore Street Portland, ME 04112