In late December 2011, the Treasury Department issued temporary and proposed regulations— commonly referred to as the "repair regulations"—providing guidance on the tax treatment of costs incurred to acquire, repair, or improve tangible property.
The temporary regulations adopt many of the standards included in the 2006 and 2008 proposed regulations; however, they also include significant changes that will affect most taxpayers. Companies should determine the extent to which they will be required to change their current accounting methods to conform to the new regulations. Even if an accounting method change is not necessary, companies should analyze whether adopting the new standards will be more advantageous than their current methods.
Taxpayers who frequently renovate their property to keep it "fresh," will have the largest opportunity and will need to understand how the new rules affect them or risk missing valuable tax benefits.
Key changes included in the regulations
New building systems
One of the most significant changes made by the regulations is the new approach for applying the capitalization standards to a building.
Consistent with the 2006 and 2008 proposed regulations, the temporary regulations retain the general rule that a building and its structural components are a single "unit of property." Similarly, the tests used to determine which costs should be deducted as repair and maintenance costs or remain capitalized are essentially the same. However, the level at which these tests are applied has changed.
For buildings, the capitalization standards must now be applied separately to the building structure and eight specific building systems listed in the regulations: plumbing, HVAC, electrical, escalator, elevator, fire protection, security, and gas distribution.
In effect, by requiring taxpayers to apply the capitalization tests to structural components and systems, the new regulations create a smaller unit of property. The smaller the unit of property, the more likely repair and maintenance costs will have to be capitalized. If an expenditure results in a betterment or restoration to one or more of the eight building systems or the building structure, it must be capitalized. Under prior law, the same expenditure may not have resulted in a betterment or restoration in comparison to the building as a whole and may have been allowable as a deductible repair.
While the new guidelines offer numerous examples of how to apply the capitalization standards to buildings and structural components, the examples contain assumptions and stipulated facts. Taxpayers must consider their own specific facts and circumstances when applying the capitalization standards and reaching conclusions about the treatment of repair and maintenance costs.
Safe harbor for routine maintenance
The repair regulations allow companies to adopt the routine maintenance safe harbor which gives them a current deduction for maintenance activities that keep property in its ordinarily efficient operating condition and are expected to be performed at least twice during the property’s alternative depreciation system (ADS) class life.
There are three exceptions to the routine maintenance safe harbor. First, the safe harbor does not apply to buildings. Second, it does not apply to replacements of a component of property if gain or loss was recognized on the earlier disposition of that component. Lastly, the routine maintenance safe harbor does not apply if the activity resulted in a betterment of the property.
Despite these exceptions, many companies may benefit from the routine maintenance safe harbor and should review whether their existing capitalization policies overlook costs that may be deducted.
For manufacturers, potentially, the largest benefit of the safe harbor is it includes the replacement of major components of personal property. The example provided in the regulations refers to the replacement of aluminum smelter pots cell lining occurring several times during the ADS class life of the pots. Though the cell linings make up 60 percent of the total physical structure of the pot, the cell lining replacement costs are deductible throughout the entire life of the smelter under the safe harbor. Many companies, specifically those operating industrial plants that require regular replacements of large, costly components due to wear and tear or to maintain safety standards, may have capitalized similar large costs based on prior law. Under the new regulations these costs may now be deductible.
Book conformity de minimis rule
The regulations include a book conformity de minimis rule which provides that a taxpayer can expense amounts paid to acquire or produce a unit of property, or materials and supplies, under the following circumstances: 1) the taxpayer has an applicable financial statement (AFS); 2) the taxpayer has written book de minimis amount accounting procedures as of the beginning of the year; 3) the taxpayer treats amounts paid on its AFS per the written accounting procedures; and 4) the aggregate of amounts paid under the de minimis rule are less than the ceiling amount, which is the greater of 0.1 percent of gross receipts or 2 percent of book depreciation and amortization expense.
It is important to note that the ceiling is not a cliff, and if the taxpayer’s aggregate de minimis costs exceed the ceiling, the costs up to the ceiling may be deducted currently.
Companies may find it challenging to track the expenses currently deducted for book purposes, thus requiring coordination between tax and book fixed asset accounting.
Taxpayers can now treat the retirement of a building structural component as a disposition of property
The temporary regulations make numerous changes to the depreciation rules. Under the new regulations, a "disposition" now includes the retirement of a structural component of a building, giving taxpayers the ability to immediately recover the remaining basis of building components that are retired or replaced. The new rule mitigates the potentially unfair result that could occur when an original building component and its subsequent replacement are required to be capitalized and depreciated at the same time. This change will benefit most taxpayers that own buildings and/or improvements.
The change offers flexibility to taxpayers in managing their fixed asset accounting. For example, the cost of a new replacement roof is depreciated over 39 years versus the remaining depreciable life of the building, resulting in situations where taxpayers physically owned only one roof, but were depreciating two roofs at the same time. With the new rules, if the replacement roof is capitalized, taxpayers are now allowed to write off the remaining basis of the original roof.
The trade-off for this flexibility is a new level of complexity in fixed asset accounting since most taxpayers have not tracked the adjusted tax basis of building components. However, the regulations provide a solution to the complexity and potential administrative burden: the general asset account (GAA) election. Taxpayers that make the GAA election have the option of writing off the remaining basis of retired building components (using a reasonable allocation method) or continuing to depreciate the retired component.
Transition guidance provides many options
The transition guidance, issued by the IRS on March 7, 2012, in Revenue Procedures 2012-19 and 2012-20, discusses the steps companies need to follow when changing their methods of accounting to conform to the new regulations.
Revenue Procedure 2012-19 details the new capitalization rules, including the repair and maintenance costs, transaction costs, materials and supplies, and the de minimis rule; while Revenue Procedure 2012-20 outlines the new depreciation rules, including GAA elections and dispositions of structural components.
Both revenue procedures allow automatic consent for the accounting method changes. Most of the changes are made with a section 481(a) adjustment—the cumulative net difference between the old and new methods of accounting in prior years calculated as of the end of the tax year preceding the year of the change. Certain changes must be made on a cutoff basis and only apply to costs incurred after 2011; these include the de minimis rule, certain transaction costs, and materials and supplies. Item-by-item elections are required after 2011 for capitalizing and depreciating supplies, not applying the de minimis rule, otherwise deductible transaction costs and GAA elections.
The revenue procedures also waive the Revenue Procedure 2011-14 scope limitation for two years, which is especially important for two of the scope limitations. First, a company is allowed to make a change in accounting method even if it changed its method for the same item within the past five years. Many companies have filed repairs and maintenance accounting method changes under prior law in the past few years and this will give them the opportunity to conform to the new regulations.
Second, taxpayers who are under IRS examination are allowed to use the automatic consent procedures to change their method of accounting under the waiver. In addition, on March 15, 2012, the IRS issued a Large Business & International (LB&I) directive instructing examiners who are reviewing an income tax return, including repair and maintenance costs or dispositions for a tax year beginning prior to 2012, to stop all examination activity, not to commence any new examination activity related to these issues, and to withdraw any outstanding document requests or adjustments. Having the same items reviewed just once gives companies the opportunity to conform their methods of accounting to the new regulations and reduce the company’s—and IRS’s—time and resources during examination.
How to take advantage of the new regulations
The temporary regulations have the same binding effect as final regulations and are effective for tax years beginning on or after Jan. 1, 2012. Since it is likely most companies will need to file accounting method changes with their 2012 tax returns, consider the following:
- Review capitalization policies and current accounting methods. To maximize the potential impact of the new regulations, thoroughly analyze your repair and maintenance costs and unit of property designations—and your current accounting method.
- Review any recent automatic changes you have filed for repair and maintenance costs. Identify methods that may not be consistent with the new regulations and determine if filing a new change in accounting method may be required.
- Consult with a tax advisor. The transition guidance provides a two-year window to make accounting method changes and lets taxpayers make retroactive GAA elections for buildings and structural components.
The regulations could be unfavorable for companies that have already filed an accounting method change due to the introduction of building systems within the unit of property definition. However, this impact may be mitigated by the new disposition rules for building components. Companies that have not filed an accounting method change for repairs and maintenance likely will benefit from the regulations if they are following GAAP capitalization standards. Changes to comply with the regulations are accounting method changes made with a section 481(a) adjustment. The analysis of assets placed in service before 2012 can begin now.
If you decide to change your accounting method to recognize gain or loss on retired or disposed structural components or building systems, talk with a tax professional to establish a practical way to identify or estimate past costs and the remaining basis of the components.
Getting expert advice from a qualified, experienced tax advisor can help ensure you are capturing all possible tax benefits associated with the new repair and maintenance regulations.