In September of 2013, the IRS issued regulations required to be employed on 2014 tax year returns that created guidelines for treatment of tangible property expenditures, whether personal or real property. These new tangible property regulations (TPRs) provide guidance on the capitalization and depreciation of capital expenditures, the treatment of materials and supplies, and the opportunity to write off all or a portion of an asset when disposed. They present new risks and opportunities that affect taxpayers in every industry that either owns depreciable capital assets, spends funds on repairs and maintenance, and/or material and supplies.
The following two-part editorial will inform you of potential requirements related to these tangible property regulations for your 2014 return. Mueller Prost has also created a video series to help breakdown these complex regulations. You can view it here.
Required Tax Filings
Taxpayers who have significant fixed assets with remaining depreciable basis or real property will typically have large current and future tax deductions. In order to obtain these tax deductions, a significant amount of “one time” work and related IRS tax filings need to occur prior to filing your 2014 return.
On the other hand, taxpayers who have been able to write off their asset acquisitions under bonus depreciation or Section 179 deductions will see minimal tax deductions but are still subject to the “one time” new tax filing requirements for 2014. It is unfortunate that the IRS has required the majority of the TPRs to be implemented retroactively via the filings of numerous additional required special tax forms for tax year 2014.
Retroactive application of the TPRs requires taxpayers to revisit every asset on their depreciation schedule to see if it should have been capitalized under the new capitalization rules. If a prior asset/expenditure does not qualify as an asset under the new principals, it must be written off in 2014, or the opportunity to write off that item with the filing of your 2014 return will be lost.
EXAMPLE: ABC, Inc. capitalized a $40,000 parking lot expenditure 10 years ago. After applying the new criteria, it is determined that the remaining tax depreciation of $30,000 should be written off in 2014. If ABC does not properly complete the “one time” tax filings in their 2014 return, ABC will permanently lose $30,000 as a tax deduction. It is not allowed to continue to take annual depreciation for this item. ABC has to file those numerous “one time” tax forms. Additionally, the IRS requires that the accounting method change forms not all be filed on one form.
The scary part of the TPRs is the threat of the IRS to disallow any future depreciation for prior items that do not pass the new capitalization criteria.
There has always been a challenge of differentiating between capital improvements or repair and maintenance (R & M) expenses as they sought the balance between accurately reflecting business profits versus maximizing tax deductions. The new TPRs dictate that expenditures must be written off as repairs if they are not required to be capitalized. That is, repairs and maintenance are the opposite of what is required to be capitalized. Consequently, an understanding of the capitalization rules is imperative.
The employment of this guidance is heavily fact specific. While there are no bright line tests, there is now specific criteria that needs to be applied to the expenditures. The new criteria also requires a thorough review of the past and future expenditures on improvements. That review will determine whether prior capitalized expenditures should now be written off and will determine whether future ones will be capitalized.
Unit of Property (U of P)
The foundation of the capitalization rules is in the comparison of the expenditure to the Unit of Property (U of P). A U of P consists of a group of functionally interdependent components. In other words, if placing one component in service is dependent on placing another component in service, then they are functionally interdependent and considered one U of P. The regulations have special rules for buildings. In general, a building and its structural components are one U of P.
EXAMPLE: A truck and its components (engine, tires, etc.) are one unit of property because each of those components needs to be placed in service at the same time in order for the truck to function.
Examples of structural components would be roofs, walls, floors, ceilings and other items that relate to the operation of a building. There are also certain “building systems” that the regulations have defined as separate units of property. These building systems include HVAC system, plumbing, electrical, escalators, elevators, fire protection, alarm/security and gas distribution. Even though a building is one U of P, the capitalization criteria must be applied at the building structure or system level, and then even smaller comparisons for any item that performs a material and discrete function.
New Capitalization Criteria
Once a U of P is defined, a taxpayer then needs to determine if the amounts paid result in a betterment, restoration or adaption to new/different use, as follows:
- Betterment: Funds spent to correct a material defect/condition that existed prior to the acquisition of a U of P; result in a material addition to the U of P; and/or result in a material increase in capacity, productivity, efficiency, strength, quality or output of the U of P.
- Restoration: Funds spent to return the U of P to its ordinarily efficient operating condition if the property was in disrepair and no longer functional; replacement of a component of a U of P where a gain/loss is recognized on the component; rebuilding the U of P to a like-new condition after the end of its class life; or the replacement of part(s) that comprise a major component, large physical portion, or substantial structural part of the U of P.
- New/Different Use: Funds spent to adapt a U of P to a new or different use if the adaption is not consistent with the taxpayer’s original intended use of the U of P when acquired.
EXAMPLE: A contractor purchased a bulldozer in 2008. In 2014, it paid $20,000 to have the engine and transmission rebuilt and repainted. Under the new regs., this cost would fall under the restoration category discussed above and would be required to be capitalized. The applicable class life for a contractor is 6 years and in this example the item was rebuilt to a like-new condition after the end of its class life. If purchased in 2010, the class life of the tractor (6 years) does not end until 2015, the expenditures could be deducted.
Keep an eye out for the conclusion of this article next week. While the new regulations are complex, understanding how they impact your business is critical to maximizing tax deductions while maintaining tax compliance. These changes will require the filing of certain IRS tax forms no later than tax year 2014 while other changes are either new annual elections or choices. Your Mueller Prost advisor has the resources to assist you in determining how these new regulations will affect your business.