What is a Repair v. Capitalization Review?
The IRS issued comprehensive Repair Regulations regarding the deduction and capitalization of expenditures related to tangible property. The regulations are commonly known as the Repair Regulations or the Tangible Property Regulations. The regs are applicable to businesses in all industries that acquire, produce, replace or improve tangible property. Application of the new Repair Regulations requires an in-depth understanding of various tax cases and circumstances that must be met.To put it simply, the IRS has placed new regulations on what you can expense and what you should capitalize.
The determining factor lies in the reason for certain repair costs rather than the amount spent on those repairs. It also takes into consideration what makes up a unit of property. The new regulations are complex, and our team of professionals is proficient at evaluating the new rules and applying them to your property and repair & maintenance items to provide a “clean start” based on these new regulations and in turn providing you with a significant increase in cash flow.
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What are Partial Dispositions?
Structural components of a building include items with a long tax life (generally 39, 27.5 or 15 years) such as lighting, roofs, HVAC systems, interior and exterior walls, etc. The new regulations (Regs. Sec. 1.168(i)-8(d)(2)) allow you to assign a value to those items and write them off when demolished, abandoned, or retired.The IRS has provided 3 ways to calculate dispositions:
1.Through a detailed cost-segregation study, which identifies all 39-year property, in addition to the typical 5, 7, or 15 year class life property; or
2.Discounting the cost of a replacement asset to its placed-in-service year cost using the Producer Price Index for Finished goods, the Producer Price Index (PPI) for Final Demand, or other index designated by guidance in the Internal Revenue Bulletin. This method can only be used if the replacement asset is a restoration as defined in § 1.263(a)-3(k); it cannot be used if the replacement is a betterment as defined in § 1.263(a)-3(j) or an adaption as defined in § 1.263(a)-3(l); or
3.Pro rata allocation of the unadjusted depreciable basis of the MAA based on the re-placement cost of the disposed asset and the replacement cost of all assets in the MAA (or pool); Similarly, if a portion of an asset is disposed of, a pro rata allocation of the unadjusted depreciable basis of the asset based on the replacement cost of the disposed portion of the asset and the replacement cost of the asset.
In order to take a partial disposition, the taxpayer should be able to verify the following:
1. Disposed of a portion of a MACRS asset owned by taxpayer
2. Identified the asset that was partially disposed
3. Determined the placed-in-service date of the partially disposed asset
4. Determined the adjusted basis of the disposed portion
5. Reduced the adjusted basis of the asset by the disposed portion
Green Summit Engineering has developed software to calculate partial dispositions using #2 above. The software can be found at: www.dispositioncalculator.com
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Who Can Benefit?
A variety of industries may benefit from these rules, including those in the banking, retail, hospitality, manufacturing, pharmaceutical, warehouse, distribution, and utility industries — to name a few. The rules may apply to most capital-intensive companies that invest significant dollars in routine and incidental repairs and maintenance expenses.Deductible Tangible Property Repair Expenses May Include:
• Roof repairs
• Replacing lighting
• Resurfacing parking lots
• Replacing doors and windows
• Resurfacing interior or external floors
• Painting (interior or exterior)
• Rekeying locks
Green Summit Engineering recommends reviewing projects if at least $300,000 is spent on renovations.
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Capital or Repair Expense?
Capital expenditures are costs incurred in acquiring long-lived real or personal property and include those for building improvements or other long-term betterments, new equipment, architectural fees and the cost of defending the title to your property. Once the building is placed in service, capital expenditures are also costs for betterments, restorations and costs that add to the value or prolong the useful life of property or to adapt the property to a new use. Capital expenditures are capitalized and recovered through depreciation or amortization over their useful lives.Repairs are deductible as ordinary and necessary business expenses. A repair does not materially add to the value of property or appreciably prolong its life. It simply keeps the property in an ordinarily efficient operating condition.
Unit of property
The categorization of an expenditure as a capitalized improvement or a deductible repair is greatly affected by the size of the unit of property that is being worked on. The temporary regulations provide specific definitions for a unit of property in the case of buildings and a general rule (the functional interdependence test) for other types of property (Temp. Reg. 1.263(a)-3T(e)). The rules for determining the unit of property are effective for tax years beginning on or after January 1, 2014, or at a taxpayer’s option, to tax years beginning on or after January 1, 2012 (Temp. Reg. §1.263(a)-3T(p); Notice 2012-73).
An item is a unit of property if it is "functionally interdependent" and it has a useful life greater than 12 months. One of the more important concept changes in the regulations is the definition of a unit of property. For repair purposes, the building category is divided into a building structure and nine designated building systems, which are:
• HVAC
• Plumbing
• Electrical Systems
• Escalators
• Elevators
• Fire Protection and Alarm Systems
• Security Systems
• Gas Distribution Systems
• Other Structural Components Later Defined
This new level of componentization is a significant change and will require an analyis of the repair relative to the building component or subsystem for purposes of determining if you can expense the repair.
Once a unit of property has been capitalized, the general rule is that taxpayers must further capitalize amounts paid to improve that unit of property. A unit of property is improved if the amounts paid for activities performed after the property is placed in service by the taxpayer:
• Result in a betterment to the unit of property;
• Restore the unit of property; or
• Adapt the unit of property to a new or different use
A betterment is an expenditure that results in a qualitative improvement to the asset as opposed to a quantitative increase in the unit of property’s value. An expenditure could result in a betterment when there is a remediation of a material defect, a material addition to the unit of property or a material increase in the capacity, productivity, efficiency, strength, quality, or output of the unit of property.
A restoration is an expenditure that materially prolongs the useful life of an asset. Rebuilding property to like-new condition or replacing a major component is an example of a restoration.
An expenditure paid to adapt a unit of property to a new or different use is required to be capitalized. These tests are commonly referred to as the "BAR" tests.
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