New Repair Regulation Chapter 10 pp. 349 - 409

New Repair RegulationChapter 10 pp. 349 - 409 2015 National Income TAX Workbook™

Rules Proposed and Proposed and Proposed in 2006, 2008, 2011, 2012 ANDFinalized in 2014 • Notice 2004-6 asked for comments as to what is: • A unit of property? • The starting point to see if value or life are increased? • What is a material increase in value? • Etc….Etc…. Etc… • 2006 Proposed Regulations - Withdrawn • 2008 Proposed Regulations – Withdrawn • 2011 Temporary Regulations – Withdrawn • 2012 Temporary Regulations – Withdrawn • Final Regulations effective for tax years beginning on or after January 1, 2014 but can elect for years after 12/31/11

Repairs Regulations Chapter 10 p. 349 • Improvements to property. • Unit of Property. • Materials & Supplies. • De Minimis Safe Harbor. • Routine Maintenance Safe Harbor. • Small Taxpayer Safe Harbor. • Election to Capitalize Repair & Maintenance Costs. • Change in Accounting Method. • Decision Tree.

Repair RegulationsIntroduction p. 349 Final Regulations TD 9636, 2013-43 IRB 331. • Clarify whether costs are currently deductible or need to be capitalized • Provide safe harbor simplifications & implement new rules for small and large businesses.

New Repair RegulationsIntroduction pp. 349 - 350 • All Taxpayers must follow the repair Regulations for years beginning on or after January 1, 2014. • Small taxpayers are not exempt. • For many the new Regulations formalized what they have been doing. • Taxpayers with assets less than $10M or 3-year average gross receipts less than $10M can adopt changes in method beginning 1-1-2014 without filing Form 3115.

Observation: 2012 & 2013 Form 3115 Filing Deadline p. 350 • Final Regs require making a formal election to use the safe harbors or to capitalize certain costs. • If the safe harbor or capitalization was claimed in an earlier year and no election was made an amended return with an election is required. • Affects years beginning on or after 01/01/2012 and ending on or before 09/19/2013. • Due within 180-days of due date of return including extensions. • This time may have passed but could still be open to some fiscal year end taxpayers.

Background p. 351 • §263 generally requires capitalizing amounts paid to acquire, produce or improve tangible property. • §162 allows a current deduction for ordinary and necessary expenses including materials, supplies, repairs and maintenance.

Background p. 350 • Illinois Merchandise Trust Co., 4 BTA 103 (1926) provided the guiding principle: • :To repair is to restore to a sound state or to mend….to keep the property in an operating condition….which are distinguishable from those for replacements, alterations, improvement or additions which prolong the life of property….”

Background and Fig. 10.1 p. 351 • Reg. §1.162-3 – Rules for material & supplies. • Reg. §1.162-4 – Addresses repairs & maintenance. • Reg. §1.263(a)-1 – General rules for capital expenditures. • Reg. §1.263(a)-2 – Rules for acquisition & production of tangible property. • Reg. §1.263-(a)-3 – Rules for improvements to tangible property. • Fig 10.1 Summarizes final Regs and Safe Harbors

Background p. 351- 352 • In the past deciding whether an expenditure should be expensed or capitalized depended upon all of the facts and circumstances. • These new Regulations attempt to clarify whether an expenditure is to be expensed or capitalized. • In the future deciding whether an expenditure should be expensed or capitalized depends upon all of the facts and circumstances. • Speaker’s Comment: Wait a minute….what’s changed? • Well there are safe havens & some specific rules.

Improvements to Property p. 352 • The new Regs provide rules for distinguishing between repairs and capital improvements. • The new Regs rely on past rules & concepts. • There is no bright line and, as in the past, facts and circumstances continue to be the key factor.

Improvements to Property p.352 • Improvements include: • Betterment to the unit of property, or • Restoration of a unit of property, or • Adapts a unit of property for a new or different use. • All such improvement costs must be capitalized including: • Direct costs, indirect costs that directly benefit or are incurred for improvement HOWEVER….

Improvements to Property p. 352 • The rule now differs from the prior rule that all costs of a general improvement or rehabilitation had to be capitalized. • Now -- Indirect costs of a general improvement plan must be capitalized BUT • Indirect costs (such as repairs & maintenance) not required by the improvement and that do not add to improvement are deductible.

Repairs Completed with ImprovementsEx. 10.1 p.352 • The engine, cab and petroleum tank of a truck is replaced by new ones. • The company logo is painted on the new cab and a taillight on the tractor is replaced. • Cost of painting the logo is required by the improvement and so must be capitalized. • Replacing the taillight was not part of or required by the improvement and so is a currently deductible repair.

Presenter’s Comment • The chapter is filled with examples to illustrate the various points. • It is important to note that almost all of the examples are taken from the Regulations. • Regulation citations follow those examples in the text. • Thus, those examples can be relied upon.

Practitioner’s Note p. 353 • Federal, State, etc regulatory rules requiring repairs and maintenance at certain intervals is not a controlling factor in deciding to deduct or capitalize.

Betterments p. 353 Capitalization required for amounts that: • Ameliorate a condition or defect prior to acquisition or production of the unit of property. • Are a material addition to the unit of property. • Materially increases a unit of property’s capacity such as additional square footage, etc. • Materially increases a unit of property’s productivity, efficiency, strength, quality or output of a unit of property.

Preexisting Material ConditionEx 10.2 p. 353 • Fast Food bought a store located on top of gasoline storage tanks left by prior owner. • The gas tanks leaked before the purchase but Fast Fresh did not know this until a year after the purchase. • Costs to deal with damage must be capitalized since incurred to ameliorate a material condition or defect prior to acquisition.

Absence of Material ConditionEx 10.3 pp. 353 - 354 • Turner owns a building insulated with asbestos NOT known to be a problem when the building was built. • Insulation began to deteriorate and was replaced years after building was in service. • New Regs follow a Tax Court decision in an old case. • Cost of removing & replacing insulation are a currently deductible repairs because the costs did NOT: • Ameliorate a condition or defect prior to acquisition, or • Add to the unit of property, or • Increase a unit of property’s capacity or size, or • Materially increase a unit of property’s productivity, efficiency, strength, quality or output of a unit of property.

Regulatory Requirement Not a Betterment Ex. 10.4 p. 354 • Lamb Chops owns meat processing plant. • Gov’t found that oil was seeping thru concrete floors. • Gov’t required Lamb Chop to stop oil seepage. • Lamb Chop added concrete lining to walls & concrete to floor. • Lamb Chop can currently deduct the costs even though required by the Gov’t. • Walls & floors were functional prior to seepage. • Seepage was not a pre-existing condition. • Costs did not increase effectiveness and were not a material addition to the existing building.

Relocation and Reinstallation of Equipment Ex. 10.5 p. 354 • Jazz operates a manufacturing facility in Bldg A. • Jazz decided to expand by relocating a machine to Bldg B. • The new configuration and addition of components increased the capacity of the machine. • Jazz must capitalize the cost of disassembling, moving and reinstalling the machine because capacity was increased.

Relocation and Reinstallation of Equipment Ex. 10.6 pp. 354 - 355 • Peek owns bldg. used in its real estate business. • The first floor has a drop ceiling. • Peek removed the drop ceiling and repainted the original ceiling. • Peek can currently deduct the cost of removing the drop ceiling or painting the old ceiling. • No material addition or increase in capacity or efficiency..

Relocation and Reinstallation of Equipment Ex. 10.7 p. 355 • Star found it could reduce its energy costs by adding insulation to its building’s attic, walls, and crawl space. • The insulation is expected to lower the energy costs by 50%. • Star must capitalize the costs since they make the building more efficient. • Question #1: • Suppose the insulation was expected to lower energy cost by 30%?

Relocation and Reinstallation of Equipment Ex. 10.7 p. 355 • Star found it could reduce its energy costs by adding insulation to its building’s attic, walls, and crawl space. • The insulation is expected to lower the energy costs by 50%. • Star must capitalize the costs since they make the building more efficient. • Question #1: • Suppose the insulation was expected to lower energy cost by 30%? • According to the text this would not be a material increase in efficiency and would be deductible as a repair.

Comparison of Property Condition p. 355 • Comparing condition before & after expenditures helps in deciding if there was a betterment that requires capitalization. • There is no betterment if the property’s condition after a repair is either its: • Condition after the last time normal wear and tear were corrected, or its • Condition is the same as when the asset was placed in service, if there were no prior corrections for normal wear & tear.

Comparing the Property Condition Ex. 10.8 pp. 355 - 356 • Roover’s bldg. has 10 roof mounted heat & air conditioning units. • The system includes a control system and duct work with the units making up the HVAC system. • After many years two of the units were replaced. • The new units correct climate control problems and are 10% more efficient than the old units. • Replacement is deductible as a repair because replacement of two units in the entire HVAC system and 10% is not a material increase in efficiency.

Damage to Unit of Property p. 356 • If a unit of property is repaired as a result of damage to the property its condition for comparison is its condition before the damage occurred. • Practitioner’s Note: • No betterment if damaged property is restored to its condition before damage happened. • Exception: Cost of restoring property damaged by casualty must be capitalized to the extent the property’s basis is reduced for a casualty loss.

Refreshing a Building p. 356 • Costs of “refreshing” a building are currently deductible. • Tres. Regs give examples distinguishing repairs from capital expenditures. • Examples 6, 7, 8 from Tres Reg §1.263(a)-3(j)(3) are illustrative of when costs are deductible “refreshing” or “improvements” that must be capitalized. • See 2014 text book pages 328 – 329 on CD

Restorations pp. 356 - 357 Capitalization required for amounts for: • Replacements where deduction was properly taken for non-casualty lossof a component. • Replacement where gain or loss was properly taken on disposition of the unit of property. • Repair of damage where basis was properly adjusted as result of a casualty. • Return of property to use after not functional. • Rebuilding to like new after end of its class life. • Replacement of a major component.

Restore Deteriorated Unit of Property p. 357 • If a unit of property deteriorates to where it is no longer fit for use: • Cost of returning the unit of property to its ordinary state of operating is a capital cost.

Return to Like-New Condition p. 357 • Cost to bring property to “like new” condition after its class life are capital. • Similar work before end of property’s class life can be deductible repair if not a replacement of a major component of a unit of property. • A comprehensive maintenance program does not return a building to “like new”.

Replace a Major Component or Substantial Structural Part pp. 357 -358 • Must capitalize as restoration expenses placements of parts that are a major component of a unit of property or a substantial structural part of a unit of property. • To do this use facts and circumstances. • The Regs try to distinguish“major” and “incidental” components….both being parts that perform a critical function of the unit of property.

Significant Portion of a Major ComponentEx 10.9 p. 358 • Building has 300 windows making up 25% of its total surface. • Year 1 – 100 windows are damaged and replaced. • The windows are a major component of the building. • But, 100 windows is not a significant portion of the window component. • So the cost of replacing 100 is not capital. • Treas Reg §1.263(a)-3(k)(7), Ex 25. • But….How about if 200 windows are replaced?.....

Significant Portion of a Major ComponentEx 10.9, Question 1 p. 358 • Building has 300 windows making up 25% of its total surface. • Year 1 – 200 windows are damaged and replaced. • The windows are a major component of the bldg. • 200 windows is a significant portion of the window component. • So the cost of replacing 200 is a capital expense. • Treas Reg §1.263(a)-3(k)(7), Ex 26. • But….How about 125 windows? 150? 175? And does the size of the windows make a difference?...

Significant Portion of a Major ComponentEx 10.9, Question 2 p. 358 • Yes, Size can matter and make a difference. • Building has 300 windows making up 90% of its total surface. Year 1 – 100 damaged and replaced. • The windows are a major component of the building and because they make up 90% of the building surface they are a substantial structural component. • So replacing 100 windows is replacing a substantial structural component of the building and the cost of replacing 100 is a capital expense. • Treas Reg §1.263(a)-3(k)(7), Ex 27. (60%, 70%, ??)

Replacement of Furnace Not a Major ComponentEx 10.10 pp. 358 - 359 • Master’s bldg.’s HVAC is comprised of 3 furnaces, 3 air conditioning units and duct work. • One furnace breaks down and is replaced. • One furnace unit is not a substantial structural part of the VAC system. • Replacing the one unit is a deductible repair expense.

Replacement of Furnace Not a Major ComponentEx 10.11 p. 359 • Nimble’s bldg. has an HVAC that is made up on one chiller unit, one boiler, pumps, duct work, diffusers, air-handlers, etc, etc. • The chiller unit includes compressor, evaporator, condenser, & expansion valve. • Replacing the chiller unit is a capital expense. • The chiller unit is a major component of the HVAC system -- It cools the entire system.

Replacement of Plumbing System is a Major ComponentEx 10.12 p. 359 • Star’s 3 story bldg. has men and women restrooms on two floors. • Star replaces all of the toilets and sinks but not the plumbing pipes. • The restoration must be capitalized because all of the toilets and sinks are a major component of the plumbing system. • Question: • Supposed only 8 of 20 sinks were replaced?

Replacement of Plumbing System is a Major ComponentEx 10.12, Q1 p. 359 • Star’s 3 story bldg. has men and women restrooms on two floors. • Star replaces all of the toilets and sinks but not the plumbing pipes. • The restoration must be capitalized because all of the toilets and sinks are a major component of the plumbing system. • Question: • Suppose only 8 of 20 sinks were replaced? • 8 sinks out of 20 are not a significant portion of a major component of the plumbing system and so the cost is deductible as a repair.

Flooring Replacement Not a ComponentEx 10.13 pp. 359 - 360 • Victor owns a hotel & decided to refresh the lobby by replacing the lobby floors. • The lobby makes up only 10% of bldg. • The replacement of the flooring is a deductible repair since it is not a significant portion of a major component of the bldg. and not a structural part of the bldg. • Question #1: • What if all public area flooring is replaced?

Flooring Replacement Not a ComponentEx 10.13, Q #1 pp. 359 - 360 • Question #1: • What if all public area flooring is replaced? • The public areas make up 40% of the hotel flooring. • Changing all public area flooring is a capital expense because it is 40% (a significant portion a major component) of flooring. • Question #2: • Supposed public areas make up 30% of flooring?

Flooring Replacement Not a ComponentEx 10.13, Q #2 pp. 359 - 360 • Question #2: • Suppose public areas make up 30% of flooring? • The replacement of the flooring would be a deductible repair. • At 30% the public area flooring is not considered a significant portion of a major component.

Partial Disposition Election p. 360 • Disposition of an asset can result from a sale or exchange, abandonment, contribution. • A taxpayer can election to report a gain or loss on disposition of a portion of certain assets if the taxpayer classifies the replacement portion of the asset under the same asset class as the disposed portion of the asset. • Taxpayer gets to deduct the portion of an asset abandoned in exchange for capitalizing the replacement portion of the asset.

Partial Disposition Election p. 360 • In certain instances the elect must be made: • Disposition of a portion of the asset was due to casualty. • Disposition where gain is not recognized under 1031. • Certain transfers of assets. • A sale of a portion of an asset. Thus, under these circumstances the taxpayer reports the gain or loss on disposition and capitalizes the replacement asset.

Partial Disposition Election p. 360 • A taxpayer may use any reasonable method to determine the adjusted basis of the disposed portion of the asset. • Permissible methods include: • Producer Price Index (PPI) rollback. • Cost segregation studies. • Factorial comparisons. • Computations are demonstrated on pages 361 and 362. • Page 362 lists changes that cannot use the PPI.

Removal Costs p. 363 • Removal cost of a part of a unit of property may be deductible or capital costs if disposal is not a disposition of the unit of property. • Capitalization is not required if removal costs of a capital asset are taken into consideration in gain or loss of the asset. • Ex 10.18, page 363 explains…..

Reroofing an Apartment ComplexEx. 10.18 p. 363 • Apple owns 10 separate bldgs. • Roofs on each deteriorated after owned by Apple. • New shingles were put on top of the old in 2 bldgs. • Roof structure needed no work. • Cost are deductible repair and NOT capital exp. • Exceptions: • Taxpayer would have to capitalize costs if work was due to casualty loss or if taxpayer elected to deduct cost of old shingles using the partial asset disposition rules.

Reroofing an Apartment ComplexEx. 10.18, Q1 p. 363 • Apple owns 10 separate bldgs. • Roofs on each deteriorated after owned by Apple. • New shingles were put on top of the old in ALL 10 bldgs. • Roof structure needed no work. • Because deterioration occurred while Apple owned the bldgs. there is no adaption, betterment or improvement and cost are still a deductible repair. • Question # 2 -- But suppose deterioration was only after Apple owned bldgs. for 1 or 2 years?

Reroofing an Apartment ComplexEx. 10.18, Q2 p. 363 • Apple owns 10 separate bldgs. • Roofs on each deteriorated 1 or 2 years after Apple acquired the bldgs. • New shingles were put on top of the old in ALL 10 bldgs. • Roof structure needed no work. • Because deterioration probably occurred before Apple owned the bldgs. there is “restoration” and cost should be capitalized. • Taxpayer should probably elect partial disposition & deduct adjusted basis of old shingles as a loss.

Reroofing an Apartment ComplexEx. 10.18, Q3 pp. 363 - 364 • Apple owns 10 separate bldgs. • Roofs on each deteriorated while after Apple acquired the bldgs. • New shingles were put on top of the old in ALL 10 bldgs. • Roof structure needed no work. • How should removal cost be treated if removal is a repair? • Taxpayer must deduct the removal costs.

New Repair Regulation Chapter 10 pp. 349 - 409