With the issuance of final regulations addressing how to account for expenditures related to tangible property, one of the critical concepts that taxpayers need to address is the determination of the appropriate unit-of-property. The unit-of-property must be identified before determining whether an expenditure can be deducted or must be capitalized. Generally, an expenditure must be capitalized if it improves a unit-of-property. An expenditure improves a unit-of-property if the amount paid results in a betterment, restoration, or an adaptation to a new or different use (the "improvement standards").
The final regulations have specific definitions of a unit-of-property. These regulations define the unit-of-property for buildings and the unit-of-property for tangible property other than buildings (typically personal property).
Each building and its structural components is a separate unit-of-property. In determining whether an expenditure is an improvement, the taxpayer must consider the effect of the expenditure on the building structure itself and on certain specifically defined components of the building (the "building systems"). Each of the following "building systems" is defined as a separate unit-of-property:
- HVAC system (including motors, compressors, boilers, furnace, chillers, pipes, ducts, radiators)
- Plumbing system (including pipes, drains, valves, sinks, bathtubs, toilets, etc.)
- Electrical systems (including wiring, outlets, junction boxes, lighting fixtures etc.)
- Fire-protection and alarm systems (including sensing devices, computer controls, sprinkler heads, sprinkler mains, etc.)
- Security systems for the protection of the building and its occupants (including window and door locks, security cameras, recorders, monitors, etc.)
- Gas distribution system (including associated pipes and equipment used to distribute gas)
- Other structural components identified in published guidance from the IRS
The ultimate result of the regulations is to reduce the size of the unit-of-property which increases the likelihood that an expenditure will need to be capitalized as an improvement. For example, if a taxpayer had an expenditure related to its building roof, the unit-of-property to use in determining if it is a capitalized improvement or a deductible repair is the building since the roof is not included in one of the separate building systems. For an expenditure to repair several of the building's rooftop air conditioner units, however, the appropriate unit-of-property to use in determining if it is a capitalized improvement or a deductible repair is the HVAC system (a smaller unit-of-property than the building) since the HVAC system is one of the specifically defined building systems.
Most taxpayers have previously treated the entire building as the unit-of-property. With the addition of these new regulations, most taxpayers that own buildings will need to make an accounting method change to adopt the new definition of unit-of-property as it relates to buildings.
For tangible property other than buildings, the components that are functionally interdependent comprise the unit-of-property. Components are functionally interdependent if the placing in service of one component by the taxpayer depends on the taxpayer's placing in service of the other component. Functional interdependence will require a facts and circumstances analysis. For example, a computer and printer are not functionally interdependent so each is a separate unit-of-property. The concept of functional interdependence is somewhat consistent with prior rules. Therefore, taxpayers may not need to make an accounting method change to adopt the unit-of-property rules for tangible property other than buildings.
Determining if there is functional interdependence is more difficult when "plant property" is involved. Plant property means functionally interdependent machinery or equipment used to perform an industrial process such as manufacturing, generation, warehousing, distribution, automated materials handling in service industries, or other similar activities. The unit-of-property for plant property is further divided into smaller units comprised of each component (or group of components) that performs a discrete and major function or operation within the functionally interdependent machinery or equipment. The regulations do not define what constitutes a discrete and major function or operation within the functionally interdependent machinery or equipment, but they do provide a few examples that taxpayers can look to for guidance.
In one of the examples, a taxpayer had a laundering line comprising a sorter, boiler, washer, dryer, ironer, and folder. Because the laundering line is deemed to be an industrial process, it is defined as plant property. Each component that performs a discreet and major function is to be treated as a separate unit of property. Effectively, each sorter, boiler, washer, dryer, ironer, folder is a separate unit-of-property. In another example, the taxpayer operates a restaurant with an assembly line process that prepares and cooks tortillas. In this example, the tortilla cooking line is not deemed to be an industrial process so the cooking line is not plant property. Therefore, the unit-of-property is the entire tortilla cooking line because the various components of the cooking line equipment are functionally interdependent.
As with buildings, the ultimate result of the regulations with respect to plant property is to reduce the size of the unit-of-property, thus increasing the likelihood that an expenditure will need to be capitalized as an improvement. The taxpayer's prior treatment of plant property may not be consistent with the new regulations. Therefore, taxpayers with plant property may need to make an accounting method change to adopt the unit-of-property rules for plant property.
The determination of the appropriate unit-of-property is the first step in determining the need to capitalize an expenditure related to tangible property. Once the unit-of-property is determined, the new improvement standards from the final regulations can be applied. Most taxpayers with buildings will need to file an accounting method change to adopt the new unit-of-property rules as they apply to buildings. Fortunately, this method change can be executed alongside most other accounting method changes required by the final tangible property regulations. Contact your local CBIZ MHM tax advisor for assistance in determining the appropriate unit-of-property for your assets and in implementing the other elements of the tangible property rules.