To Capitalize or Expense? That is the Question
With a manufacturing rebound underway, many companies are making acquisitions or much needed improvements and repairs to their real and personal properties. Decisions need to be made on what can be capitalized or expensed. In December 2011, the IRS issued the much anticipated temporary regulations addressing the application of Code �162(a) and �263(a) to amounts paid to acquire, produce or improve tangible property. These regulations are effective for tax years beginning after December 31, 2011, and are meant to clarify and expand on the regulations previously issued in 2006 and 2008. The new regulations are expansive and address many important areas. Among those areas covered are materials and supplies, repairs, rentals and leased property, amounts paid to acquire or produce tangible property, amounts paid to improve property, and also accounting and disposition rules for MACRS property.
Due to the fact that we are not able to cover all of these extensive rules in just one article, this article will focus on rules laid forth in Regulation 1.263(a)-3T, to determine if an amount paid related to personal or real property should be currently expensed or capitalized. The previous regulations contained ambiguity with regard to this decision and as a result, this topic frequently became the subject of litigation. The IRS has attempted to organize the rulings of these cases into a set of regulations that taxpayers may rely on when making this determination. The new rules for this section of the regulations are very detailed and complex, as well as contradictory on occasion, as illustrated by the abundance of examples (more than 80 in total).
Unit of Property (UOP)
The first step in this analysis is to determine the Unit of Property (UOP) that the transaction involves. The guidance is separated into two main sections-UOP rules related to building and its structural components and UOP rules for assets other than buildings.
Buildings and building systems
Generally, a UOP for a building consists of the building and the structural components of that building. Structural components include, among other items, the walls, floors, ceilings, and permanent coverings. Any amounts paid to improve that building or its structural components are treated as improvements to the building itself, since it is all considered one UOP. Under these new rules, a replacement of an entire roof would be required to be capitalized as an improvement to the building.
The regulations also defined a new term called "building systems" which includes all of the following: HVAC systems, plumbing systems, electrical systems, escalators, elevators, fire protecting and alarm systems, security systems, gas distribution systems, and other structural components. These building systems are also considered part of the UOP for the building. Under these new rules, any improvement to the above listed building systems would be capitalized as an improvement to the building UOP.
Clearly these new rules are not favorable to taxpayers, because they require capitalization of costs that may have been currently deductible under the previously issued regulations. The IRS attempts to soften this impact by explaining that when a replacement of a building system is necessary, the taxpayer can then dispose of the cost of the replaced system (and therefore recognize a loss on the remaining depreciable basis). Interestingly, the IRS has requested comments as to how to calculate this loss.
Assets other than buildings
For assets that are not classified as buildings or building systems, the key question in determining the UOP is whether the components involved are functionally interdependent. In other words, if Component A cannot function until Component B is also placed in service, then Component A and Component B consist of one UOP. Conversely, if Component A can be placed into service and operate without Component B, the units will be considered two separate UOP for purposes of these new regulations This is an important consideration because the smaller the unit of property, the more likely it will be for the costs incurred in connection with the UOP to be capitalized. For instance, if the UOP is an engine, it is likely that any costs paid for this UOP would be required to be capitalized as part of an improvement to the UOP. However, if the UOP is a truck, any expenses paid for work on the engine would have a better chance of being considered a repair and therefore, may be deducted currently.
Betterment, Restoration, or Repair
Once you have determined what the UOP is, the next step is to analyze the facts and circumstances surrounding the amount paid to determine if the costs should be capitalized as an improvement to the UOP or deducted as a repair. This would include considering the purpose of the expenditure, the physical nature of the work performed, the effect of the expenditure on the property, etc.
A UOP is improved if the amounts paid for activities performed after the property is placed in service by the taxpayer (a) result in betterment to the unit of property; (b) restore the unit of property; or, (c) adapt the unit of property to a new or different use.
Betterment
The regulations provide guidance addressing the definition of "betterment". An amount paid results in the betterment of a UOP only if it meets one of the following three criteria:
1) Ameliorates a material condition or defect that either existed prior to the taxpayer's acquisition of the unit of property or arose during the production of the unit of property, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production;
2) Results in a material addition (including a physical enlargement, expansion, or extension) to the unit of property; or,
3) Results in a material increase in capacity (including additional cubic or square space), productivity, efficiency, strength, or quality of the unit of property or the output of the unit of property.
Please note that despite the word "material" appearing throughout this regulation-the term is not defined.
This section is very complex and requires careful consideration. To illustrate, assume a company owns a small shop. A storm has damaged part of the roof and many of the wooden shingles have been displaced. If the company pays a contractor to replace the damaged wooden shingles with new wooden shingles, the cost would not be considered a betterment since it doesn't meet the definition of betterment above. However, if the company decided to have the shingles replaced with a better type of shingle (i.e. maintenance free, 50 year life, etc), the costs would be capitalized as betterment to the building.
One might conclude that after reading the betterment section and this example, the cost of the shingle replacement would be deductible as a repair. However, this cost may qualify as a restoration and require capitalization, as discussed below.
Restoration
Within the regulations, there are multiple definitions of what constitutes a restoration and therefore should be capitalized as an improvement to the UOP. One significant definition is the replacement of a major component or a substantial structural part. The major component or structural part includes a part, or a combination of parts that (a) comprise a large portion of the physical structure of the UOP; or (b) perform a discrete and critical function in the operation of the UOP. Again, this is a facts and circumstances analysis.
To demonstrate these rules, assume a company discovers a leak in the roof of their large building. Upon inspection, the hired contractor determines that the entire roof needs to be replaced. The roof is a part of the building structure and is a major component; therefore, the cost to replace the roof would need to be capitalized as an improvement to the building. Even if the contractor had decided to only replace a significant portion of the roof instead of the entire roof, it would still require capitalization under these regulations. The cost would only qualify as a repair if the contractor had recommended that only a single part of the roof, such as a membrane, would need to be replaced.
Repairs
The regulations provide a new safe harbor related to the cost of routine maintenance performed on a UOP other than buildings or structural components of a building. Routine maintenance is defined as a set of recurring activities that a taxpayer expects to perform in order to keep the property in its ordinarily efficient operating condition. Examples listed in the regulations include inspection, cleaning, testing, and typical replacement parts. This safe harbor is only allowed if, at the date placed in service, the taxpayer expects to perform these activities on the property more than once over its depreciable life (for federal tax purposes). Other factors to consider include the recurring nature of the activity, industry practice, manufacturer's recommendations, etc. There are specific exceptions listed within the regulations that are excluded from this safe harbor.
Clearly these new regulations are substantial and complex. Contact a professional at UHY LLP to discuss the application of these important rules for tax years beginning after December 31, 2011.
