Tax Insights: IRS releases long-awaited ‘repair’ regulations On Dec. 23, 2011, new regulations were issued addressing when costs are required to be capitalized to tangible property or may be deducted as repair and maintenance costs. The new regulations replace proposed regulations issued in March 2008.

On March 7, 2012, the IRS issued two revenue procedures (Rev. Procs. 2012-19 and 2012-20) that provide taxpayers with rules for filing method changes under the new “repair” regulations.

This document provides a summary of some of the highlights of the regulations and revenue procedures.

What was issuedTreasury and the IRS issued temporary regulations (regulations) that provide guidance on amounts paid to improve tangible property (commonly referred to as the repair regulations). The regulations also provide guidance on amounts paid to acquire or produce tangible property, as well as guidance regarding the disposition of property. The regulations are generally effective for taxable years beginning on or after Jan. 1, 2012. The text of the regulations was simultaneously issued as proposed regulations and the previous proposed regulations were withdrawn. The regulations include rules that are significantly different from current regulations and the previously issued

proposed regulations. The revenue procedures contain transition rules and procedures for changing to the methods described in the regulations.

Units of propertyThe regulations provide detailed rules for determining the proper unit of property. Although these rules generally provide that a building and its structural components are a single unit of property, the tests to determine if property has been improved must be applied to the building structure (which is defined as the building and its structural components other than specifically identified building systems) and each of the following building systems: (1) Heating, ventilation and air

conditioning (HVAC) systems (2) Plumbing systems (3) Electrical systems (4) Escalators (5) Elevators (6) Fire-protection and alarm systems (7) Security systems (8) Gas distribution systems

The regulations also provide expanded rules for determining the unit of property in situations where property is leased and provide special rules for determining improvement costs in lease situations.

BettermentsThe regulations provide specific rules for determining whether expenditures result in a betterment of a unit of property and therefore would result in capitalization of costs. Of note, the regulations specifically provide that an amount results in a betterment to a building if it results in a betterment to a structural component or a building system. The regulations contain a number of examples to illustrate the application of the betterment rules. Included in the examples are three fact situations involving costs incurred by retail stores that the regulations label as: (1) building refresh, (2) building refresh with limited

improvement, and (3) substantial remodel.

The examples conclude that: (1) none of the building costs are required

to be capitalized in the building refresh example;

(2) some of the building costs are required to be capitalized in the building refresh with limited improvement example; and

(3) all of the building costs are required to be capitalized in the substantial remodel example.

These three examples illustrate the general rule in the regulations that a determination of whether costs result in a betterment depends on the facts and circumstances related to the costs.

RestorationsThe regulations also address whether an amount is paid to restore a unit of property and therefore would result in capitalization of costs. These rules specifically provide that an amount is paid to restore a building if it restores a structural component or a building system. Unlike the rules in prior proposed regulations, the regulations fail to provide a bright-line test for determining whether the costs result in a replacement of a major component or a substantial structural part of a unit of property. The prior proposed regulations defined replacement of a major component or substantial structural part to mean either: (1) costs that comprise 50 percent or more

of the replacement costs of the unit of property, or

(2) replacement of 50 percent or more of the physical structure of the unit of property.

The regulations instead provide a facts- and-circumstances test for determining whether a major component or substantial structural part is replaced. The regulations also provide that a major component or substantial structural part includes:(1) a “large portion” of the physical

structure of the unit of property, or(2) a part or combination of parts

that perform a discrete and critical function in the operation of the unit of property that is more than a “minor component.”

The regulations also contain the requirement that costs expended for the replacement of a component of a unit of property must be capitalized if the taxpayer has properly deducted a loss for that component.

The regulations contain examples to illustrate the restoration rules. Included are examples of costs related to the structural components of a roof, a roof membrane, an HVAC system, a fire protection system, an electrical system, a plumbing system, windows and floors. The examples illustrate that the determination of whether costs are required to be capitalized depends on the nature and extent of the costs relative to the property.

Plan of rehabilitationThe regulations do not provide for a plan of rehabilitation doctrine as described in case law. Instead, the regulations incorporate the Section 263A standard for the treatment of repair and maintenance costs performed during an improvement and require capitalization of all indirect costs that directly benefit or are incurred by reason of an improvement. The preamble to the regulations provides that the plan of rehabilitation doctrine is obsolete to the extent that the court-created doctrine provided different standards for determining whether an otherwise deductible indirect cost must be capitalized as part of an improvement.

Routine maintenance safe harbor The regulations introduce a routine maintenance safe harbor rule. If, at the time the unit of property is placed in service, it is reasonably expected that the maintenance activities will be performed more than once during the class life of the unit of property, the maintenance is deemed to not improve the unit of property. The regulations, however, specifically provide that the safe harbor does not apply to work performed on buildings.

IRS releases long-awaited ‘repair’ regulations

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Dispositions The regulations also provide new rules for determining gain or loss on the disposition of depreciable property. Of significance is that the regulations expand the definition of disposition of property to include the retirement of a structural component of a building. This requirement will cause any amount expended to replace a structural component of a building to be capitalized, even if the component is minor, because of the restoration rules requiring capitalization if a loss on a component is properly deducted. To avoid burdensome results under this rule, taxpayers will need to understand and apply new rules relating to general asset accounts as discussed in the following. The regulations do not require componentization of property other than buildings, but will allow such componentization if the taxpayer is consistent in identification of the asset.

General asset account electionThe regulations also expand the rules related to general asset accounts (GAA), which allow taxpayers to group one or many assets in a GAA for depreciation purposes. Under the general rule, no gain or loss is recognized upon the disposition of an asset from a GAA. Special elections allow taxpayers to recover the basis of disposals from the GAA at their discretion.

Amount paid to acquire or produce propertyThe regulations also contain rules for amounts paid to acquire or produce property. These include rules related to material and supplies and rotable spare parts. In addition, the regulations contain a de minimis rule that allows a taxpayer in certain situations to deduct amounts under a certain dollar amount if that is consistent with a written policy used for financial accounting purposes, provided that amounts under this rule do not exceed certain annual thresholds. The annual threshold amount is the greater of: (1) 0.1 percent of the taxpayer’s gross

receipts for the taxable year as determined for Federal income tax purposes, or

(2) 2.0 percent of the taxpayer’s total depreciation and amortization expense for the taxable year as determined in its applicable financial statements.

Tax Insights: IRS releases long-awaited ‘repair’ regulations

New automatic changesThe new revenue procedures modify the comprehensive list of automatic method changes in Rev. Proc. 2011-14 by deleting several method changes and adding 19 new automatic method changes, including the following:• Deductingde minimis amounts• Changingtothesafeharborforroutine

maintenance on property other than buildings

• Capitalizingimprovementstotangibleproperty

• Disposingofabuildingorstructuralcomponent

• Disposingoftangibledepreciableassets (other than a building or its structural components)

• Electinggeneralassetaccounttreatment

The new method changes are generally made using a Section 481(a) adjustment. However, the adjustment for method changes relating to the acquisition of tangible property is made using a modified cut-off approach, which means that only amounts paid or incurred after Jan. 1, 2012, are included in the Section 481(a) adjustment. In addition, certain of the disposal and depreciation changes are made using a modified cut-off approach. The new revenue procedures specifically allow statistical sampling for certain method changes. The new revenue procedures do not, however, allow taxpayers to extrapolate data to an earlier taxpayer year.

For all of the new method changes, certain scope limitations under the general automatic method change procedures are waived for the taxpayer’s first and second taxable year beginning after Dec. 31, 2011.

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Tax Insights: IRS releases long-awaited ‘repair’ regulations

For more information, contact:

Scott Hamilton Strategic Federal Tax Group Director, Southern California T 213.596.8426 E scott.hamilton@us.gt.com

Rich ShevakStrategic Federal Tax Group Senior Manager, SeattleT 206.398.2489E rich.shevak@us.gt.com

www.GrantThornton.com/tax

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General asset account late election reliefMost taxpayers have not previously made a general asset election under Section 168(i)(4) for their assets, including buildings and structural components.

Under these new rules, however, it is anticipated that all taxpayers who own or lease buildings will want to make such an election for previous and future years. The revenue procedures allow taxpayers to make a retroactive general asset election for years prior to Jan. 1, 2012, by filing an automatic method change, but only for the taxpayer’s first two taxable years beginning after Dec. 31, 2011. It is important for taxpayers to be aware of this limited time frame for making the retroactive election through the automatic method change. After this time, retroactive elections will not be allowed as method changes.

Next steps Taxpayers will want to determine how the new rules provided in the regulations may affect their current methods of capitalizing or deducting costs to acquire or improve tangible property. Taxpayers will also want to determine the timing for making automatic method changes to comply with the new rules under the revenue procedures. It is expected that most taxpayers will need to file method changes to make the late general asset account election and to change their methods of accounting for disposition of property and capitalization of amounts paid to improve property. Although method changes cannot be filed for years beginning prior to Jan. 1, 2012, taxpayers will want to understand as soon as possible how adjustments relating to method changes will affect financial accounting and estimated payment purposes.

Please contact Grant Thornton LLP for questions or to discuss how the regulations may affect a specific situation.

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