As discussed in the March 2012 edition of InTouch, the IRS has issued temporary regulations that provide guidance on the tax treatment of amounts paid to acquire, produce, or improve tangible property. Although the new regulations do not apply until 2012, the rules for deducting or capitalizing improvements to a building may have an immediate impact on tax accounting. The new regulations require that a taxpayer apply the improvement standards separately to the primary building structure and to any of the nine specifically defined building systems (as defined in the regulations). Effectively, this requires the bifurcation of building costs into more than one unit of property ("UOP"). Generally, the smaller the UOP, the greater the likelihood that a cost incurred on that UOP would need to be capitalized rather than expensed.
Expenditures are treated as an improvement to the building if they improve either the building structure or any of its structural components. The building structure consists of the building and its structural components unless the structural component is one of the nine defined "building systems" listed in the regulations. "Building and its structural components" is defined in Regulation §1.48-1(e) and generally consists of the roof, floors, walls, windows, doors and ceilings. The nine defined building systems listed in Regulation §1.263(a)-3T(e)(2)(ii)(B) are:
- HVAC
- Plumbing
- Electrical
- Escalators
- Elevators
- Fire protection and alarm
- Security
- Gas distribution
- Other components identified in published guidance
This multiple UOP concept for buildings as provided under the new regulations presents a significant change from the previous rules. For example, a roof replacement under the old rules may have qualified for a repair deduction. Under the new regulations, the roof replacement is likely required to be capitalized to the building. The new regulations under Reg. §1.168(i)-8T(b), however, provide that the retirement of a structural component is a disposition. Therefore, the remaining cost basis in the original roof can be written off. In effect, the taxpayer does not have to capitalize and depreciate expenditures for both the removed and the replacement roof.
Taxpayers may have difficulty in many cases determining the basis of a building component for purposes of taking a loss on disposition because the cost of the building component may be included in the building's total original cost under the previous rules. While the IRS has requested comments in this area, Regulation §1.168(i)-8T(e)(2) provides that if the asset disposed of is a component of a larger asset and it is impracticable from the taxpayer's records to determine the unadjusted depreciable basis, the taxpayer may use any reasonable method that is consistently applied to the taxpayer's larger assets for purposes of determining the unadjusted depreciable basis of disposed assets.
Many taxpayers will find themselves in a position where most building components are included in the original building cost. When a building component is replaced, the examples in the regulations illustrate that if the original cost of the building component can be reasonably determined, it can be split off from the larger building asset and the "allowed or allowable" depreciation applied to that component for purposes of determining the adjusted basis for loss purposes.
The above points can be further illustrated in the following example:
Assume a building was purchased five years ago for $2 million. In 2012, the taxpayer incurs $20,000 in costs to fix piping in the plumbing system. Under the old rules, the $20,000 likely would be considered a repair as it is relatively small compared to the overall building cost which was treated as a single UOP. Under the new rules, the plumbing system is one of the nine defined building systems and therefore is considered a separate UOP. As a result, the $20,000 needs to be measured against the plumbing system cost, not the building cost.
As provided in Regulation §1.168(i)-8T(e)(2), any reasonable method can be used to determine the original plumbing system cost. Assume that it is reasonably determined to be $50,000. The $20,000 piping expenditure is then compared to the $50,000 original cost of the plumbing system rather than to the original cost of the entire building. More than likely, this new expenditure is such a significant cost relative to the original cost of the plumbing system that it is required to be capitalized as an improvement.
The regulations also provide for any reasonable method for determining the basis of the asset being replaced. Assuming 25% of the piping was replaced, then a $12,500 asset ($50,000 x 25%) was disposed of. Assuming the remaining cost basis of the replaced asset was $11,000 after five years of depreciation, a loss on the disposition of assets of $11,000 is allowed.
The net result of the new regulations in this example is the capitalization of a new asset for $20,000 and a loss on the disposition of an old asset for $11,000. Under the old rules, there likely would have simply been a $20,000 repair expense.
For 2012, taxpayers should be aware of the new building and building component rules. Rather than simply capitalizing an improvement to "building improvements," a new asset for any of the nine defined building systems should be specifically set up in the company's fixed asset tracking system. Also, building improvement expenditures requiring capitalization may allow for the write off of old building components. A reasonable method should be developed that will be consistently applied in the future when determining the basis of an old building component.
The IRS is expected to issue guidance for any accounting method changes that may result from these new regulations. They have stated that these new rules cannot be applied retroactively; they can only be applied to tax years starting in 2012. So far, there have been two Revenue Procedures issued (Rev. Proc. 2012-19 and Rev. Proc. 2012-20) that provide guidance for making automatic accounting method changes.
Under §6.29 of Rev. Proc. 2012-20, there may be an opportunity to deduct a loss in 2012 on building components that have been disposed of in earlier years, but are still being depreciated on the books because they are included in a larger UOP (i.e., the building). As mentioned earlier, one benefit of these new regulations is the ability to dispose of a structural component when a new structural component replaces it. In Rev. Proc. 2012-20, §6.29(3)(a) and (b), an automatic change allows for a loss to be taken on a structural component that was disposed of in a prior year but is still being depreciated as part of the larger UOP. For example, if a full roof replacement was performed two years ago (and capitalized as a separate asset), the automatic accounting method change under §6.29(3)(a) and (b) would allow for a loss to be taken on the 2012 tax return for the unrecovered basis of the roof that was replaced two years ago. On Form 3115, Application for Change in Accounting Method, the designated automatic change number for this change is "177" and an originally signed Form 3115 must be sent to Ogden, Utah in lieu of sending the copy to the IRS National office.
The new tangible property regulations and the related guidance are complex and likely will require changes in your tax accounting practices, but they also may create some tax planning opportunities. If you have further questions on these new tangible property rules, please contact your local CBIZ MHM tax professional.
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