Repairs regulations finally issued on capitalization of tangible asset costs

On March 7, 2008, the Treasury Department and IRS re-proposed regulations under section 263(a) dealing with the treatment of amounts paid to acquire, produce or improve tangible property (the 2008 proposed regulations). The 2008 proposed regulations replaced the previously proposed regulations, which were issued on Aug. 21, 2006, and took into account many of the comments received in response to the 2006 proposed regulations. On Dec. 23, 2011, the IRS released the highly anticipated regulations regarding the deduction and capitalization of tangible asset costs in temporary and proposed form (see TD 9564 and REG-168745-03) (the repairs regulations). As highlighted below, the repairs regulations take into account many of the comments received in response to the 2008 proposed regulations, while not revising the rules for certain other comments.

Discussion
The temporary regulations provide guidance under sections 162(a) and 263(a) in the following areas with respect to amounts paid to acquire, produce or improve tangible property:

• Definition and treatment of materials and supplies (Reg. section 1.162-3T)
• Deduction for repairs and maintenance to tangible property not required to be capitalized (Reg. section 1.162-4T)
• Rules regarding leaseholds (Reg. section 1.162-11T) and leased property (Reg. section 1.167(a)-4T)
• Rules regarding claiming section 165(a) losses when depreciable property is permanently withdrawn from use (Reg. section 1.165-2T and either Reg. section 1.167(a)-8T, 1.168(i)-1T, or 1.168(i)-8T, as applicable)
• Accounting for depreciable (Reg. sections 1.167(a)-7T) and MACRS property (Reg. section 1.168(i)-7T), including retirements (Reg. section 1.167(a)-8T) and general asset account rules (Reg. section 1.168(i)-1T),
• General rules for capital expenditures (Reg. section 1.263(a)-1T)
• Rules for amounts paid for the acquisition or production of tangible property, including a de minimis rule (Reg. section 1.263(a)-2T)
• Rules for amounts paid for the improvement of tangible property, including a safe harbor for routine maintenance (Reg. section 1.263(a)-3T)

Materials and supplies

The temporary regulations generally retain the rules provided by the 2008 proposed regulations for materials and supplies, but with the following changes:

• Modification and expansion of the definition of materials and supplies
• Provision of an alternative optional method of accounting for rotable and temporary spare parts
• Provision of an election to treat certain materials and supplies as de minimis

Specifically, Reg. section 1.162-3T describes the types of components that generally qualify as materials and supplies, eliminating the requirement from the 2008 proposed regulations that such property not be a unit of property. Thus, materials and supplies include components acquired to maintain, repair or improve a unit of tangible property that the taxpayer owns, leases or services and that are not acquired as part of any single unit of property. Materials and supplies also now include items generally not considered to constitute depreciable property or inventory, such as fuel, water, lubricants and similar items that are reasonably expected to be consumed within 12 months or less, beginning when used in the taxpayer's operations. In addition, the temporary regulations do not change the treatment of items that are deemed to constitute materials and supplies under other published guidance (see, e.g., Rev. Proc. 2002-12 (small wares safe harbor) and Rev. Proc. 2002-28 (inventory safe harbor for qualifying small business taxpayers)). With respect to other published guidance that allows taxpayers to elect to capitalize and depreciate certain materials and supplies (see, e.g., Rev. Rul. 2003-37 (treatment of rotable spare parts as depreciable assets); Rev. Rul. 81-185 (treatment of major standby emergency spare parts as depreciable assets); etc.), the temporary regulations permit taxpayers to elect to treat such items as depreciable assets in accordance with such rulings.

The temporary regulations provide an optional method of accounting for rotable and temporary spare parts, which may be used as an alternative method to treating the parts as used or consumed in the year of disposition or to electing to treat the parts as depreciable assets. Under the optional method, a taxpayer may (1) deduct the amount paid for a new rotable spare part in the year in which it is installed in equipment, (2) include in income and assign a cost basis equal to the fair market value of the used, non-functioning part, (3) capitalize the cost of repairing the part and (4) deduct the basis of the part when re-installed if it is later used as a replacement part.

The IRS and Treasury rejected comments requesting that the de minimis threshold be increased from $100 to either $500 or $1,000. Thus, the temporary regulations retain the $100 limitation set forth by the 2008 proposed regulations, but do give the IRS and Treasury authority to change such amount in future guidance. In addition, taxpayers with an applicable financial statement may be able to deduct higher amounts if they comply with the requirements set forth by the de minimis rule of Reg. section 1.263(a)-2T, as discussed below.

Leaseholds and leased property

The temporary regulations slightly modify the existing rules provided by Reg. section 1.162-11(b), which require the capitalization of the cost of erecting a building or making an improvement to property leased by the taxpayer, to use the term "capital expenditure" instead of "capital investment" and to cross-reference Reg. sections 1.263(a)-3T (f) (1) (improvements to leased property) and 1.167(a)-4T (depreciation or amortization deductions for leasehold improvements). In addition, the temporary regulations amend the rules in Reg. sections 1.162-11(b) and 1.167(a)-4 to provide that a lessee or lessor must depreciate or amortize its leasehold improvements under the cost recovery provisions applicable to the improvements, without regard to the lease term, consistent with sections 168(i)(6) and (8). These amendments were made because the previous language in Reg. sections 1.162-11(b) and 1.167(a)-4 did not reflect the changes made to section 168 by the Tax Reform Act of 1986, P.L. 99-514.

Acquisition or production of tangible property

The temporary regulations retain most of the rules provided by the 2008 proposed regulations with respect to the capitalization of amounts paid to acquire or produce units of tangible property (e.g., the requirement to capitalize acquisition and production costs and the requirement to capitalize amounts paid to defend and perfect title to property). In response to comments received, the temporary regulations:

• Provide examples illustrating application of the rules to moving and reinstallation costs (see Reg. section 1.263(a)-3T(h)(4))
• Retain the rule requiring the capitalization of costs incurred prior to placing property into service
• Add and clarify certain rules with respect to transaction costs (i.e., costs incurred to investigate whether to acquire real property and which real property to acquire)
• Modify and refine the de minimis rule

As highlighted above, the temporary regulations retain the rule that permits a taxpayer to deduct costs incurred to investigate the acquisition of real property. In response to comments that the regulations should provide guidance on appropriate methods to allocate transaction costs between personal property and real property acquired in a single transaction, the temporary regulations provide a "reasonable allocation" rule.

With respect to the de minimis rule for amounts paid to acquire a unit of property, the temporary regulations retain the requirement in the 2008 proposed regulations that a taxpayer may deduct certain amounts paid for tangible property if the taxpayer has an applicable financial statement (AFS), has written accounting procedures for expensing amounts paid for such property under certain dollar amounts and treats such amounts as expenses on its AFS in accordance with such written procedures. Under the 2008 proposed regulations, a taxpayer could only follow its AFS method if the deduction of such amounts did not distort its taxable income. The temporary regulations replace the no distortion of income requirement with an overall ceiling to limit the total amount a taxpayer may deduct under the de minimis rule. Specifically, the aggregate of amounts paid and not capitalized under the de minimis rule for the taxable year must be less than or equal to the greater of:

• 0.1 percent of the taxpayer's gross receipts for the taxable year as determined for federal income tax purposes; or
• 2.0 percent of the taxpayer's total depreciation and amortization expense for the taxable year as determined in its AFS.

In calculating a taxpayer's de minimis amount and determining whether it exceeds the ceiling, the temporary regulations provide that a taxpayer does not have to include amounts deducted under Reg. section 1.162-3T for materials and supplies costing $100 or less unless the taxpayer elects to treat such items under the de minimis rule of Reg. section 1.263(a)-2T. In addition, the de minimis rule may be applied to amounts for repairs and property acquired for improvements. However, it does not apply to amounts paid for labor and overhead incurred in repairing or improving property. With respect to members of a consolidated group, the temporary regulations provide that the members may use the written accounting procedures provided on the AFS of the affiliated group. The temporary regulations also provide that the de minimis rule is not intended to change agreements reached with IRS examining agents. The temporary regulations do not, however, expand the de minimis rule to taxpayers without an AFS. Small taxpayers without an AFS may only take advantage of the rule provided by Reg. section 1.162-3T for materials and supplies that cost $100 or less.

Improvement of tangible property

The temporary regulations retain many of the simplifying conventions from the 2008 proposed regulations, such as the routine maintenance safe harbor and the optional regulatory accounting method. The temporary regulations also revise certain rules from the 2008 proposed regulations with respect to determining whether there has been an improvement to a unit of property. For example, the temporary regulations revise and add rules for:

• Determining whether an amount is paid for an improvement to a building
• Determining whether an amount is paid for the replacement of a major component or substantial structural part of a unit of property
• Definition of disposition for property subject to section 168 (i.e., to include the retirement of a structural component of a building)
• Treatment of amounts paid to improve leased property

Specifically, the temporary regulations continue to treat the unit of property for a building as the building and its structural components. However, in determining whether an amount paid is for an improvement to a building, the temporary regulations require a taxpayer to consider the effect of the expenditure on certain significant and specifically defined components of the building (e.g., the building structure or any of the specifically defined building systems) instead of the building and its structural components as a whole. As a result, a taxpayer will be required to capitalize a cost that results in an improvement to the building structure (i.e., the building and its structural components) or any of the specifically enumerated building systems:

• Heating, ventilation and air conditioning (HVAC) systems
• Plumbing systems
• Electrical systems
• All escalators
• All elevators
• Fire protection and alarm systems
• Security systems
• Gas distribution systems
• Any other systems identified in published guidance

For example, under the temporary regulations, amounts paid for the following would generally constitute capital expenditures:

• Replacement of an entire roof (results in a restoration of a building structure)
• Improvement to the HVAC system (results in a betterment to a building system)

The temporary regulations also expand the definition of dispositions to include the retirement of a structural component of a building. This allows a taxpayer to recognize a loss on the disposition of a structural component of a building before the disposition of the entire building. Consequently, the taxpayer will not have to continue depreciating amounts allocable to structural components that have been removed from service (i.e., a taxpayer is not required to capitalize and depreciate amounts paid for both the removed and replacement properties). Comments are requested on computational methodologies or safe harbors for taxpayers to use in determining the amount of the adjusted basis of property that is allocable to a retired component.

With respect to real and personal property other than buildings, the temporary regulations retain the functional interdependence test but remove the book life consistency rule. That rule required a taxpayer to treat a functionally interdependent component as a separate unit of property if the taxpayer initially assigned a different economic useful life to the component for financial statement or regulatory purposes. The temporary regulations also continue to provide special rules for plant property and network assets. However, if a taxpayer or the IRS properly changes the MACRS class or depreciation method for any type of property (e.g., as a result of a cost segregation study or a change in use of the property) in a taxable year after the year the property was initially placed in service, the taxpayer must change the unit of property determination for the effected property for capitalization purposes to be consistent with the change in treatment for depreciation purposes.

The temporary regulations retain many of the rules provided by the 2008 proposed regulations regarding unit of property definitions, but also provide more detailed, as well as new and revised, rules for determining:

• The units of property for condominiums, cooperatives and leased property (including leased buildings, as well as leased property other than buildings)
• The treatment of leasehold improvements (i.e., whether amounts paid by a lessee or lessor are for the improvement of a unit of leased property and the definition of the unit of property)
• Costs incurred during an improvement, such as related repair and maintenance

For example, the temporary regulations provide that an amount initially capitalized as a lessee improvement is the unit of property separate from the leased property being improved. However, the cost of improving a lessee improvement is not a unit of property separate from the lessee improvement being improved. Alternatively, lessor improvements are not treated as a unit of property separate from the property being improved.

Consistent with the 2008 proposed regulations, the temporary regulations render as obsolete the plan of rehabilitation doctrine by adopting Reg. section 1.263A-1(e) standard for purposes of section 263(a) (i.e., a taxpayer must capitalize all the direct and indirect costs related to an improvement in accordance with the rules under section 263A). Thus, repairs and maintenance that do not directly benefit and are not incurred by reason of an improvement are not required to be capitalized under section 263(a), even if performed at the same time as an improvement. The temporary regulations also retain the exception for substantial improvements to individual residences (which permits individuals to capitalize repair and maintenance costs incurred at the time of a substantial remodel of a residence).

Similar to the treatment of indirect costs incurred during an improvement to property, the temporary regulations provide that the costs of removing a component of a unit of property must be capitalized if they directly benefit or are incurred by reason of an improvement to a unit of property. Alternatively, removal costs are not required to be capitalized if they relate only to the disposition of the removed property and do not have the requisite relationship to any improvement. In addition, the costs of removing an entire unit of property remain allocable to the removed asset and, therefore, are deductible when the asset is retired. The temporary regulations also do not change the treatment of amounts governed by section 280B (related to the demolition of structures).

Routine maintenance safe harbor

The temporary regulations retain the routine maintenance safe harbor provided by the 2008 proposed regulations, including the requirement that a taxpayer must expect to perform routine maintenance more than once during the defined class life of the unit of property, but clarify that the routine maintenance safe harbor is not appropriate for work performed on buildings.

Betterments

The temporary regulations retain the betterment rules provided by the 2008 proposed regulations. For example, expenditures to ameliorate a preexisting condition or defect must be capitalized whether or not the taxpayer was aware of the defect at the time of acquisition. In addition, taxpayers are required to capitalize environmental remediation costs in the situation where the taxpayer contaminated the property in the ordinary course of business, disposed of the property and later reacquired the property to clean up the contamination (unless such costs are eligible for deduction under section 198). While the temporary regulations do not change the definition of a betterment that includes expenditures resulting in a material increase in the capacity, productivity, efficiency, strength, or quality of the unit of property or its output, they do revise the examples from the 2008 proposed regulations and add new examples to help illustrate the application of the increase in quality standard. The temporary regulations also do not revise the betterment standard to provide an exception for minor and recurring store refresh or remodel costs, but do expand the examples to address various situations involving the refreshing and remodeling of retail buildings.

Restorations

The temporary regulations generally retain the restoration rules provided by the 2008 proposed regulations, with modifications as discussed below.

Casualty loss
The temporary regulations retain the casualty loss rule, which requires the capitalization of an amount paid to restore a unit of property if it is for the repair of damage to the unit of property for which the taxpayer had properly taken a basis adjustment as a result of a casualty loss under section 165, or if it is for the repair of damage relating to a casualty event described in section 165. As a result of retaining this rule, the temporary regulations provide taxpayers with the option to forgo claiming a section 165 loss in order to qualify for a section 162 deduction. Specifically, a taxpayer electing to use a general asset account under Reg. section 1.168(i)-1T may forgo recognizing a casualty loss without reducing basis and may claim a repair deduction under section 162 for the replacement property if the replacement cost is not treated as a capital expenditure under a different provision of the temporary regulations.

Rebuilding to like-new condition
The temporary regulations provide that, if an amount paid results in the rebuilding of a unit of property to a like-new condition after the end of the class life of the unit of property as defined under sections 168(g)(2) and (3), the amount must be capitalized as a restoration of the unit of property.

Replacement of major component or substantial structural part
The temporary regulations continue to require the capitalization of amounts paid for the replacement of a major component or substantial structural part of the unit of property, but require the taxpayer to consider all the facts and circumstances 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 unit of property (e.g., the quantitative or qualitative significance of the part of combination of parts in relation to the unit of property or, in the case of a building, in relation to the building structure or the relevant building system). The temporary regulations 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 unit of property or that perform a discrete and critical function in the operation of the unit of property.

The temporary regulations also (1) revise the definition of disposition such that a taxpayer may treat the retirement of a structural component of a building as a disposition of property and (2) clarify that a taxpayer may recognize a loss on a component of a unit of property that is section 1245 property if the taxpayer consistently treats the component as a separate asset for disposition purposes.

Accounting and disposition rules for MACRS property

The temporary regulations change the rules for accounting for and determining gain or loss upon the disposition of MACRS property. Specifically, the temporary regulations eliminate group accounts, classified accounts and composite accounts and instead provide that each multiple asset account must generally include assets that have the same depreciation method, recovery period, convention and placed in service year. The temporary regulations also provide rules for determining gain or loss upon the disposition of MACRS property that are consistent with the ACRS disposition rules under Prop. Reg. section 1.168-6. Consistent with the expansion of the definition of a disposition to include the retirement of a structural component of a building, the temporary regulations allow the recognition of a loss upon such retirement. Similarly, the temporary regulations amend the general asset account rules by expanding the definition of a disposition to include the retirement of a structural component of a building and by expanding the definition of a qualifying disposition to allow the recognition of gain or loss upon most dispositions of assets in general asset accounts. The temporary regulations also modify the rules for establishing general asset accounts and clarify the depreciation computations when the assets are eligible for bonus depreciation.

The temporary regulations amend Reg. section 1.167(a)-7 to provide that those rules only apply to section 167 property and not MACRS property. In addition, the temporary regulations under Reg. section 1.168(i)-7T permit taxpayers to either treat each asset as a single asset account or combine two or more assets in a multiple asset account if such assets have the same depreciation method, recovery period, convention and placed in service year. Special rules are provided for assets subject to section 280F, the mid-month convention, bonus depreciation and mixed use assets.

The temporary regulations also provide that a taxpayer must depreciate a building and all of its structural components using the same recovery period, depreciation method and convention even though each of the structural components is a separate asset under the temporary regulations. Consistent with the expansion of the definition of a disposition to include a retirement of a structural component of a building, the temporary regulations provide that each structural component of a building, condominium unit or cooperative unit is the asset for disposition purposes.

The temporary regulations generally require a specific identification method for determining when the asset disposed of was placed in service but permit the use of a FIFO method, a modified FIFO method or another method designated by the IRS, depending on the facts and circumstances, for taxpayers using multiple asset accounts.

Effective date/method changes

The temporary regulations will generally be effective on Jan. 1, 2012. A change to comply with the temporary regulations will constitute a change in method of accounting to which the provisions of sections 446(e) and 481(a) apply. Additional guidance regarding transition rules is expected to be released in early January 2012 in the form of two companion revenue procedures, which will provide automatic consent procedures for tax years beginning on or after Jan. 1, 2012.

Insights
As noted in the preamble, the temporary regulations "will affect all taxpayers that acquire, produce or improve tangible property." However, with a 2012 effective date, they should not necessarily impact the preparation of 2011 tax returns. Although prospective in application, the regulations generally require a section 481(a) adjustment to comply with the new rules. As noted above, additional guidance will be issued in the coming weeks to provide procedures for taxpayers to comply with the temporary regulations. In the meantime, taxpayers with AFS that are planning on taking advantage of the de minimis rule provided by the temporary regulations should take steps now to ensure their book accounting policies are properly documented such that their tax department/advisor has written book procedures with which to conform.

Natalie Tucker, director, Washington National Tax
Tom Windram, partner, Washington National Tax
Jeremy Rubischko, director, Minneapolis, Minn.
Kevin Johnson, director, Minneapolis, Minn.
Kari Peterson, manager, Minneapolis, Minn.

Disclaimer
The information contained herein is general in nature and based on authorities that are subject to change. McGladrey LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. McGladrey LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.