On September 13, 2013, Treasury released the highly anticipated final tangible property regulations. These regulations will affect virtually all taxpayers that acquire, produce or improve tangible property. Real estate companies have many expenditures, including acquisitions, upgrades, remodels and repairs, which will be subject to this new guidance. These new regulations will likely have an impact on the tax accounting for these costs.
The new regulations have been in the works for almost a decade and are now available in final form. The regulations generally are effective for tax years beginning on or after January 1, 2014.
One of the most widely applicable provisions in the regulations is the tax treatment of improvements made to tangible property. The regulations provide a general framework for determining whether an expenditure is an improvement to property that must be capitalized, or a deductible repair expense. Determining the relevant “unit of property” (UOP) is important because it is the reference point for which all capitalization standards are applied. That is, what is the item being repaired or improved?
The smaller the UOP, the more likely an expense will be treated as a capitalized item, rather than a deductible repair expense. The new regulations define the UOP for real property as the building and its structural components. However, when applying the capitalization rules, each “building system” constitutes a separate UOP from the building structure. For purposes of the capitalization analysis, the UOP for a building is:
- The building structure (walls, roof, windows, doors, etc.)
- Each building system (High velocity air conditioning (HVAC), plumbing, electrical, escalators, elevators, fire protection and alarm, security and gas distribution)
Taxpayers must determine whether an improvement was made to the HVAC system or the elevator system, rather than the building as a whole. This smaller UOP will likely result in more capital expenditures. The regulations also provide detailed rules for determining the UOP for condominiums, cooperatives and leased property.
Once the UOP is determined, the improvement standards must be applied. The regulations require a taxpayer to capitalize amounts paid to improve a UOP if the amount results in a “betterment,” “restoration” or “adaption.”
The regulations provide a facts and circumstances test for determining capitalization requirements and provide many examples illustrating how to interpret and apply these rules. Opportunities may remain to deduct repair expenditures under these new regulations that companies often capitalize and depreciate.
The regulations for dispositions were released in proposed format. The definition of dispositions includes the retirement of a structural component of a building. A taxpayer can dispose of an old component upon replacement, such as a roof or HVAC replacement, resulting in a recognized loss for the undepreciated cost of the old component. Final regulations are anticipated in early 2014.
While this article focused only on real property provisions, there are many other provisions in the regulations that taxpayers should be mindful of, including revised rules for materials, supplies, spare parts, de minimis rules and investigatory and acquisition costs, among others.
What the New Regulations Mean for Taxpayers
Taxpayers should assess conformity of their current tax policies and procedures with these new regulations. Many of these changes will cause book/tax differences. Taxpayers should also review their current processes and information systems to make certain that necessary information is being captured. Lastly, complying with the new regulations will likely require many taxpayers to change their current methods of accounting. There are many opportunities and some pitfalls in these very comprehensive regulations. Taxpayers should carefully review this new law and consider how they will be affected.
By Marla Miller, Director in the Fixed Asset Advisory Services Group at BDO USA, LLP.
This article originally appeared in BDO USA, LLP's "Real Estate Monitor" newsletter (Winter 2014). Copyright © 2014 BDO USA, LLP. All rights reserved. www.bdo.com
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