On Nov. 20, 2012, the Internal Revenue Service and the treasury Department issued Notice 2012-73. This notice pushes back the effective date of the tangible property regulations (more commonly called the “repair regulations”) to tax years beginning or on or after Jan. 1, 2014, as opposed to Jan. 1, 2012.
As the genesis of this regulation project began in 2004, it is important to understand some of the key concepts behind this project as well as the IRS’ and Treasury’s thought processes. This article will address an overview of the temporary regulations, but without the urgency of adoption given Notice 2012-73.
Almost a year ago, Treasury and the IRS published the repair regulations. These rules will affect all taxpayers who file tax returns for a taxable year beginning on or after Jan. 1, 2014, regardless of their accounting methods (cash or accrual) or their business structure (corporation, S corporation, LLC, partnership, Schedule C, etc.). Therefore, it is critical for all taxpayers and their advisors to focus on these new rules.
Unit of property
A key to the new rules is to understand the correct “unit of property.” This is a core concept for determining whether an expenditure is a deductible repair or is capitalizable. Generally, the larger the unit of property, the more likely it is that the costs will be characterized as
What you need to know about the IRS repair regulations
a repair. For buildings, there are nine potential building systems that need to be treated as separate units of property: HVAC systems, plumbing systems, electrical systems, escalators, elevators, fire protection, security, gas distribution and other structural components. The building itself is treated as its own separate unit of property. For personal property, all components that are functionally interdependent are a single unit of property.
Once the unit of property is determined, the new rules turn to the concept that the regulations require capitalization of amounts paid to improve a unit of tangible property. A unit of property is improved if the amounts paid result in a betterment, restoration or adaptation of the unit of property to a new or different use. Although these concepts may seem fairly obvious, the regulations discuss dozens of examples that are very facts-and- circumstances oriented.
One area of concern in the new regulations is whether maintenance is required to be capitalized. Maintenance must be capitalized if the maintenance activity betters the unit of property, adapts it to a new or different use, or restores the unit of property. However, the regulations provide for a routine maintenance safe harbor (RMSH). The RMSH applies to the costs of any maintenance activity that the taxpayer expects to perform more than once during the alternative depreciation system class life of a unit of personal property. This safe harbor does not apply to
buildings. The unit of property cannot be improved under the RMSH and there are other limitations. The IRS notice that was just released mentions that there could be changes to the RMSH.
De minimis costs
Another area of the temporary regulations that has received quite a bit of attention and that may require affirmative action by taxpayers is the deduction for de minimis costs. The temporary regulations provide that a taxpayer with an applicable financial statement (audited financials at a minimum) may currently deduct de minimis costs that are subject to a written capitalization policy that is in place as of the first day of the taxable year. The regulations also provide that the taxpayer may not deduct de minimis costs in excess of a ceiling amount. The ceiling is the greater of 0.1 percent of the taxpayer’s gross receipts as reported on his or her tax returns or 2 percent of the taxpayer’s depreciation and amortization expense for financial statement purposes for the year. The IRS notice states that the de minimis rule may be revised when the regulations are finalized.
It is important to note that the de minimis rule focuses on the gross amount of costs deducted under the taxpayer’s written policy and the ceiling amount. The per-item dollar amount applied for book purposes is not important for this provision. Thus, whether an item under a certain amount, such as $500, is deductible for book purposes is not relevant.
Retirements of building structural components
A somewhat unexpected outcome of the repair regulations deals with dispositions on retirements of structural components of a building. Under prior rules, when a roof was replaced on a building, the replaced roof continued to be depreciated and there was no loss on the retirement of the old roof, even though the new roof was currently being depreciated as well. Accordingly, a taxpayer currently depreciating a retired structural component of a building will need to file an accounting method change to claim the remaining basis as a loss.
Due to the above, the concept of a general asset account (GAA) may become extremely important. A GAA is a depreciable account containing one or more similar units of property, which generally maybe included in the same GAA if they are acquired in the same year, depreciated the same way and must be Modified Accelerated Cost Recovery System (MACRS) property acquired after 1986. Again, the IRS notice states that there may be changes in the rules that relate to dispositions.
A GAA election allows a taxpayer to continue depreciating property in the same manner in which it was previously depreciated, even if the property has been disposed. By moving property into GAAs, a taxpayer may choose to continue depreciating the remaining basis in the property that has been disposed or, instead, the taxpayer may claim a loss deduction. This choice is only available if the asset is placed in a GAA. The repair regulations, which were to be effective for tax years beginning on or after Jan. 1, 2012, will affect all businesses. It is important that taxpayers and their advisors discuss the ramifications of these new mandatory rules and determine if the taxpayer’s accounting methods need to be changed or if various elections need to be made when the rules are finalized in 2013. Since a taxpayer may not file a federal tax return that it knows to include an improper tax accounting method, it is imperative that the new rules be addressed well in advance of the filing of 2014 tax returns.
It appears that the IRS and the Treasury Department are attempting to repair the “repair regulations.” These new rules, which were to be in effect now, have been extended to 2014, and speakers at hearings on these regulations in May 2012 suggested that these rules are “impractical and burdensome” and need a “major rethinking.”
In Notice 2012-73, the IRS and the Treasury Department recognized that taxpayers were expending resources to comply with the temporary regulations and that certain sections of the regulations such as the de minimis rule, dispositions, and the safe harbor for routine maintenance may be revised and may provide relief for small businesses.