Final Regs Governing Repairs & Capitalization

8/12/2019 Final Regs Governing Repairs & Capitalization

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The IRS has released much-antici-pated final repair regulations (T.D.9636) governing when taxpayersmust capitalize and when they can

deduct their expenses for acquir-ing, maintaining, repairing and re-placing tangible property. The finalregulations make significant tax-payer-friendly changes to the 2011temporary regulations. Compliancewith the labyrinth of rules in thefinal regs, however, will challengevirtually every business, especiallyin light of an approaching January1, 2014 effective date.

The basic structure and require-ments within the temporary regula-tions remained intact. Although thefinal regulations have been sim-plified in several key areas, theyremain complex overall.

IMPACT. The final regulations are more taxpayer-favorable than the temporary regula-tions but, at over 200 pages, they still require

a significant investment in time and talentto assure compliance. Every business with

at least some fixed assets that is, virtuallyevery business must comply with these new rules for its first tax year beginning onor after January 1, 2014. Some industries,

such as retail, manufacturing, hospitality and utilities, are especially impacted. Thedifference between expensing and capital-

izing can mean the difference between an immediate deduction at full value versus a deduction spread out over 5, 10, 15, 20 years or more.

Delayed companion regsIn a surprise move, the IRS chose not to fi-nalize companion regs governing general as-set accounts and the disposition of deprecia-ble property under Code Sec. 168. Instead, itissued proposed regs that make significantchanges within this highly-controversial area.Nevertheless, the IRS reported that it aimsto issue final regs with these changes bythe end of 2013, with the same January 1,

2014 effective date as the final repair regs.Other portions of the temporary regs dealingwith MACRS were finalized with little or nochange.

IMPACT. The Preamble to the final regula-tions estimates that approximately 4 milliontaxpayers will be impacted by the new

regs, and that a combined 1.1 million hoursof their time will be needed to address the

new rules.

Tight timetable for complianceThe final regulations must be followed by alltaxpayers starting in tax years beginning onor after January 1, 2014; the final regulations or the former temporary regulationsmay (at a taxpayers discretion) be followedretroactively back to the start of 2012. TheIRS has promised critical transition guid-ance later this year to help taxpayers dealwith implementation regarding how to applythe regulations for years prior to 2014 as wellas what change-of-accounting proceduresshould be followed.

Final Regs GoverningRepairs & CapitalizationMake Significant Changes

EFFECTIVE JANUARY 1, 2014


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MPACT. As a result, some taxpayers woulde wise to put certain procedures into placeefore the start of 2014 to maximize benefits;thers should consider filing amended returnsor 2012 and 2013 to take advantage of certainlections provided in the final regulations.

Doing nothing is the least attractive optionecause taxpayers could discover that theyre using impermissible procedures in theirax years beginning in 2014.

COMMENT. In March 2013, the IRS issuedn updated directive to examiners instructinghem not to begin examining costs to main-

ain, replace or improve tangible property forax years beginning on or after December1, 2012 and before 2014. At that time, theRS instructed its examiners to apply theegulations in effect and follow normal examrocedures and enforce the final regulationsor examinations of tax years beginning on orfter January 1, 2014. The IRS is expected tolarify its instructions to examiners now thatnal regulations have been issued.

BackgroundThe IRSs stated goal in the final regulationss to reduce controversies with taxpayers bymoving away from a facts and circumstancesetermination whenever possible, as wells from the subjective nature of the existingtandards in general. Attempts to reduce con-oversy started with proposed amendments

o regulations in 2006 (REG-168745-03, August1, 2006), followed by new proposed regula-

ons in 2008 (REG-168745-03, March 10,008) and temporary regulations (T.D. 9564) in

December 2011. In 2012 the IRS moved the ef-ective date of the 2011 temporary regulationsrom tax years beginning on or after January 1,012 to tax years beginning on or after January, 2014. Now, the temporary regulations haveeen modified and finalized. The final regula-ons carry an effective date of January 1, 2014,

with taxpayers given the option to apply eitherhe final or temporary regulations to tax yearseginning after 2011 and before 2014.

IMPACT. Practitioners have generally praisedthe IRS for taking many suggestions seriously,

particularly including additional safe harbors and bright line tests in the final regulations.

However, some are disappointed that other safe harbors/bright lines were not adopted andthat the final regulations remain complex.

NOTICE: This Tax Briefing highlights importantchanges that the final regulations have madeto the 2011 temporary regulations. It does

not attempt to review all of those provisionsthat the final regulations have carried forwardfrom earlier versions. A grasp of those early,

retained provisions nevertheless remains criti-

cal to full compliance.

The final regulationsprovide a generalframework fordistinguishingcapital expenditures

from supplies, repairsand maintenance.

Overall approachCode Sec. 263 requires the capitalization ofamounts paid to acquire, produce, or improvetangible property. Code Sec. 162 allows thededuction of all ordinary and necessary busi-ness expenses, including the costs of certainsupplies, repairs, and maintenance. The finalregulations provide a general framework fordistinguishing capital expenditures from de-ductible supply, repair and maintenance costs.They also cover accounting for the retirementof depreciable property under Code Sec. 167and under Code Sec. 168s Modified Acceler-ated Cost Recovery System (MACRS).

Five main areasThe final regulations follow the basic outline ofthe proposed and temporary regulations, withchanges made within each of five main areas:

Materials and supplies (Reg. 1.162-3); Repairs and maintenance (Reg. 1.162-4) Capital expenditures (Reg. 1.263(a)-1); Amounts paid for the acquisition

or production of tangible property (Reg.1.263(a)-2); and Amounts paid for the improvement of

tangible property (Reg. 1.263(a)-3).

Clarifications and simplificationsChanges to the temporary regs were made to

clarify, simplify and refine, as well as to cre-ate several new safe harbors, according to theIRS. The changes singled out by the IRS in thePreamble include:

A revised and simplified de minimis safe harbor under Reg. 1.263(a)-1(f); The extension of the safe harbor for

routine maintenance to buildings; An annual election for buildings that cost $1 million or less to deduct up to $10,000 of maintenance costs or, if less, two percent

of the buildings adjusted basis; A new annual election to capitalize

repair costs that are capitalized ona taxpayers books and records; and

The refinement of the criteria fordefining betterments and restorationsto tangible property.

IMPACT. Many experts who have commentedon the final regs agree that these five changes

should be highlighted for their importance totaxpayers.

The final regulations also tackle accounting forand retirement of depreciable property underCode Sec. 167 and accounting for MACRSproperty, other than general assets accountsor the definition of disposition for propertysubject to Code Sec. 168.
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The two latter issues are covered in a new setf revised proposed regulations to addressignificant changes in this area.

Materials & suppliesThe cost of non-incidental materials and sup-lies are generally deducted in the tax year firstsed or consumed. The final and temporaryegulations define materials and supplies to

mean tangible property used or consumed inhe taxpayers business operations that is notnventory and that is:

A component that is acquired to maintain,repair, or improve a unit of tangible property

owned, leased, or serviced by the taxpayer,but is not acquired as part of any singleunit of tangible property;

Fuel, lubricants, water, and similar itemsthat are reasonably expected to beconsumed in 12 months or less, beginningwhen used in a taxpayers operations;A unit of property that has an economicuseful life of 12 months or less, beginningwhen the property is used or consumedin the taxpayers operations;

A unit of property with an acquisition orproduction cost less than $100 under thetemporary regulations and $200 under thefinal regulations; orIdentified by the IRS in published guidance.

MPACT. Listening to critics, the IRS expandedhe definition of materials and supplies that

may be expensed to include property with ancquisition or production cost of up to $200,ncreased from an original $100 limit set underhe temporary regs. The IRS reasoned that thisigher threshold amount will capture manyommon supplies such as calculators and cof-ee makers. The IRS rejected a call for a $500hreshold as too high, but retained languagerom the temporary regulations that wouldermit the IRS the flexibility to change themount in the future without going throughhe cumbersome steps to actually amend theegulation.

Spare partsThe final regulations retain the general rulethat rotable and temporary spare parts arematerials and supplies that are deducted in theyear used or consumed unless the taxpayer

elects an optional method of accounting forthe parts.However, the final regulations add standbyemergency parts to the definition of a materialor supply that is deducted in the year used orconsumed. The optional accounting methoddoes not apply to standby emergency parts.

A rotable spare part is a material or sup-ply which is installed on a unit of property,removed from the property, repaired or im-proved, and either reinstalled on the same orother property or stored for later installation.Temporary spare parts are components usedtemporarily until a new or repaired part canbe installed and then are removed and storedfor later installation. Standby emergencyspare parts are parts acquired for a particularmachine and set aside to avoid substantialoperational time loss. Standby spare parts areusually expensive, and they are not subjectto periodic replacement, acquired in quantity,repaired or reused.

Under the final regulations, only rotable, tem-porary or standby emergency spare parts qual-ify for the election to capitalize and depreciateas a separate asset amounts paid for materialsand supplies used to repair or improve a unitof property. Without this limitation, differentrecovery periods could apply to a capitalizedmaterial or supply and the property it improvesor repairs. The limitation is also consistent withprevious IRS rulings.

COMMENT. The procedure to revoke anelection to capitalize and depreciate materials and supplies is also clarified. The taxpayer must file a request for a private letter ruling toobtain IRS consent, which the IRS may grant

if the taxpayer acted reasonably and in goodfaith and the revocation will not prejudice the

government. The IRS can modify these proce-dures through published guidance.

COMMENT. The IRS rejected a recommenda-tion to expand the definition of rotable andtemporary spare parts to include rotable spare

parts that the taxpayer leases to customers inthe ordinary course of a leasing business. The

IRS concluded that such parts are outside the scope of regulations governing materials and supplies. The pro-taxpayer definition of standby emergency spare parts provided in Rev. Rul. 81-185, however, is adopted into thedefinition of materials and supplies eligible forthe optional capitalization election under Reg.1.162-3(d).

Consistency withbook treatment Recognizing that taxpayers may have pools ofrotable or temporary parts that are treateddifferently for financial statement purposes,the final regulations remove the requirementthat an electing taxpayer use the optionalmethod for all pools used in the same tradeor business. However, if a taxpayer choosesto use the optional method for a pool fortax purposes, but does not use the optionalmethod for that pool in its books and recordsfor the trade or business, the taxpayer mustuse the optional method for all of its pools in

that trade or business.

The IRS declined to make the optional methodthe default method as it would create an overlyburdensome recordkeeping requirement formany taxpayers.

Safe harbor coordination The final regulations seek to better coordinatethe application of the de minimis rule applica-ble to materials and supplies under Code Sec.162 and the general de minimis rule under

Code Sec. 263.
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Materials andupplies identifiedn Other Published Guidance The IRS clarifiedhat prior published guidance that permitsertain property to be treated as materials andupplies remains in effect, including small-

wares or certain inventoriable items used bymall businesses.

Routine maintenanceThe temporary regulations provide that theost of certain routine maintenance need note capitalized. Under a routine maintenanceafe harbor, an amount paid is deductible if it isor recurring activities that a taxpayer expectso perform to keep a unit of property in itsrdinarily efficient operating condition. The ac-vities are routine only if, at the time the unit ofroperty is placed in service, the taxpayereasonably expects to perform the activities

more than once during the class life of the unitf property.

Class life is the same as the MACRS alter-ative depreciation system (ADS) recoveryeriod. Generally, this is longer than the regular

MACRS recovery period.

Buildings now includedThe final regulations expand the routinemaintenance safe harbor to allow expensingor routine maintenance activities on a buildingnd its structural components (including build-ng systems). However, an activity is coverednly if the taxpayer reasonably expects toerform such maintenance more than oncever a 10-year period.

MPACT. The 10-year period may disqualifymany maintenance items, especially forsmart buildings and other low- or no-main-enance structures. However, the IRS assuredaxpayers that it would not apply hindsight inetermining whether the taxpayer properly an-cipated maintenance more than once over a0-year period. Thus, so long as the taxpayer easonably expected to perform the mainte-ance at least twice in the ten-year period, theafe harbor applies even if the maintenanceccurs only once.

COMMENT. The IRS reasoned that the inclusion of a routine maintenance safe harbor for buildings should alleviate some of the difficul-ties that could arise in applying the improve-

ment standards for restorations to building

structures and building systems.

In determining whether maintenance is rou-tine, the final regulations no longer considerthe taxpayers treatment of the costs on itsfinancial statements. The factor was removedbecause taxpayers may have different reasonsfor capitalizing maintenance activities on finan-cial statements so that the treatment is notparticularly indicative of whether the activitiesare routine.

Under the final regulations, the routine mainte-nance safe harbor does not apply to amountspaid for repairs, for maintenance, and for im-provements to network assets such as railroadtrack, oil and gas pipelines, water and sewagepipelines, power transmission and distributionlines, and telephone and cable lines. Networkassets were excluded from the safe harborbecause of the difficulty in defining the unit ofproperty and the IRS preference for resolvingnetwork asset issues through the IndustryIssue Resolution (IIR) program.

New election tocapitalize repair& maintenance costs

The final regulations allow taxpayers to makean annual election to opt out of expensingrepair and maintenance costs if the taxpayertreats the costs as capital expenditures onits books and records. A taxpayer must electto capitalize these expenses on its return. Anelecting taxpayer must also depreciate the

expenditures.

CAUTION. The preamble to the final regula-tions provides that this annual election may

not be revoked. The new election allows ataxpayer to treat amounts paid during thetax year for the repair and maintenance oftangible property as amounts paid to improvethat property and as an asset subject to the

allowance for depreciation.

The election applies only to amounts that thetaxpayer incurs in carrying on a trade or busi-

ness and treats as capital expenditures on its books and records used for regularly comput- ing income.

The election applies to all amounts paid forrepair and maintenance to tangible propertythat the taxpayer treats as capital expenditureson its books and records for the tax year. Anelecting taxpayer must begin to depreciatethe cost of such improvements when theyare placed in service by the taxpayer underthe applicable provisions of the Tax Code andregulations. The election is made by attach-ing a statement to the taxpayers timely filedoriginal tax return (including extensions) for the

tax year in which the repair and maintenanceexpenditures are paid. The election may notbe made by filing an application for a changein method of accounting or, unless permissionto file a late election is first obtained, on anamended return.

IMPACT. This election allows a taxpayer to align its tax treatment with capitalization policies used for its books and records, thuseliminating book-to-tax differences and reduc-

ing administrative costs. Taxpayers making this

election also can avoid the application of dif-ficult and often subjective rules in determiningwhether a particular expenditure is currentlydeductible as a repair or must be capitalized.

The election does not apply to amounts paidfor repairs or maintenance of rotable or tempo-rary spare parts that are subject to the electiveoptional method of accounting for them.

In the case of a partnership or S corporation,the election is made by the partnership or Scorporation and not by the partner or share-holder.


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De minimis safe harborto acquire or produce

A taxpayer is generally required to capitalizemounts paid to acquire or produce a unit ofeal or personal property. The IRS provided ae minimis exception in the temporary regula-ons and enhanced it in the final regulations.

Temporary regsThe de minimis exception in the temporaryegulations allowed the deduction of amountsup to a specified ceiling) paid for the acquisi-on or production of a unit of tangible propertythe taxpayer had an applicable financial

tatement, had written accounting proceduresor expensing amounts paid for property thatid not exceed specified dollar amounts,nd treated those amounts as expenses ons applicable financial statement. Under anggregate ceiling, a deduction allowed by thee minimis exception could not exceed thereater of:

1) 0.1 percent of the taxpayers gross receiptsor the tax year as determined for federalncome tax purposes, or

2) two percent of the taxpayers total deprecia-on and amortization expense for the tax years determined on the taxpayers applicablenancial statement.

Final regsThe final regulations remove the aggregateeiling to the de minimis rule and replace it

with a more manageable per-item or per-nvoice limit. A taxpayer with an applicablenancial statement may deduct up to $5,000f the cost of an item of property per invoiceor per item as substantiated by an invoice).

The required written accounting procedures inffect as of the beginning of the tax year maypecify a per item amount of less than $5,000.

As noted below, the final regulations allowaxpayers without an applicable financial state-ment to elect the de minimis safe harbor andxpense up to $500 per invoice / item.

IMPACT. The de minimis rule had been hailed as one of the most important provisions of thetemporary regulations. Previously, expensing

policies were not governed by any specific rules or requirements other than that the

policy could not materially distort income.The aggregate ceiling in the temporary regula-

tions was a step toward providing a bright-line standard, but the final regulations improve on

this by eliminating the overall ceiling in favor of

a per item or per invoice limit. The final regula-tions also extend the de minimis exception to

taxpayers that do not have applicable financial statements, albeit at a lower per invoice/item

limit ($500 instead of $5,000, as discussed in more detail below).

COMMENT. When accounting procedures

expense items that exceed the $5,000 limit, it may still make the case with its IRS exam team

that a greater amount is reasonable under its

facts and circumstances. The IRS remindedtaxpayers that the $5,000 limit is a safe harbor,

rather than an absolute limit.

IMPACT. To take advantage of the $5,000 de minimis rule, taxpayers must have written

book policies in place at the start of the tax year that specify a per-item dollar amount (up

to $5,000) that will be expensed for financial accounting purposes. Calendar-year taxpay-

ers, therefore, should work on having a policy in place by year-end 2013 to qualify for 2014.

Although many taxpayers did not have written

expensing policies in effect at the beginning

of their 2012 tax year (the temporary regula-tions were issued in December 2011), the IRSdeclined to grant transitional relief for taxpay-

ers who would otherwise have been able to apply the de minimis rule under the temporary

regulations to their 2012 tax year.

Changes to thetemporary regs weremade to clarify, simplify,and refine, as well asto create several newsafe harbors, according

to the IRS. De minimis safe harboris elective Under the temporary regulations, the deminimis rule appeared to apply to all qualify-ing expenses, unless the taxpayer electednot to apply the rule to a particular expenseby capitalizing it. The final regulations providethat the de minimis rule is a safe harbor that iselected annually by including a statement with

the taxpayers tax return for the year elected.The election applies to all qualifying expenses,including materials and supplies that meetthe requirements for qualification; an electingtaxpayer cannot exclude particular qualifyingexpenses. An election to use the safe harbormay not be made through the filing of anapplication for change in accounting method.A late election may be made on an amendedreturn only with IRS consent. The election isirrevocable.

COMMENT: A transitional rule allowstaxpayers to apply the de minimis rule con-tained in the final regulations to a tax year be-

ginning in 2012 or 2013 by filing an amended Federal tax return. This relief is also providedfor certain other provisions that require anelection.
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COMMENT. Regardless of whether or not he taxpayer has an applicable financial state-

ment, the de minimis safe harbor does notreclude a taxpayer from reaching an agree-

ment with the IRS that certain items will note reviewed. Examining agents do not needo revise their materiality thresholds in accor-ance with the safe harbor limitations.

Useful life of 12 months or less The final regulations also expand the safe har-or to include amounts paid for property withn economic useful life of 12 months or less ifhe taxpayers accounting procedures in placet the beginning of the tax year provide forhe current deduction of such amounts. The

ost of each item of shortlived property that iseductible under this de minimis rule may notxceed $5,000 ($500 for taxpayers without anpplicable financial statement). The taxpayersccounting procedures do not need to put aollar cap on the cost of an item of shortlivedroperty that it expenses under its account-ng procedures. For example, if the taxpayersccounting procedures expense all assets withuseful life of 12 months or less, the de mi-imis safe harbor applies to all such amounts

nless the property costs more than $5,000er invoice / item (or more than $500 if theaxpayer does not have an applicable financialtatement).

Materials and supplies n one of the few provisions in the final regula-ons that is more restrictive to taxpayers, thenal regulations require that an electing tax-ayer must apply the de minimis safe harboro all amounts, including eligible materials and

upplies. The IRS argued that doing so simpli-es the application of the de minimis rule andeduces its administrative burden.

The temporary regulations allowed a taxpayerhat elected the de minimis safe harbor to ap-ly it only to selected materials and supplies.

Thus, the taxpayer could either deduct materi-ls and supplies when used or consumed, or

make the de minimis election and deduct theirost when paid, assuming the costs otherwiseualified for deduction under the de minimisule.

Taxpayers without applicablefinancial statementsIn a concession principally to smaller busi-nesses, the final regulations add a safe harborfor taxpayers without an applicable financialstatement. The per-item or invoice thresholdamount in that case is $500. The IRS arguedthat it was justified in imposing that lowerthreshold since there would be less assurancethat the accounting procedures clearly reflectincome. The $500 limit (like the $5,000 ceilingfor taxpayers with applicable financial state-ments) is all or nothing; if the cost of an invoiceor item exceeds the applicable limit, then noportion of the cost is deductible under thesafe harbor.

Special rules fordetermining invoice price The final regulations provide an anti-abuserule that prohibits taxpayers from manipulat-ing a transaction to avoid the $5,000 or $500per item limit. The rule specifically prohibitscomponentization of an item of property. Forexample, a taxpayer who purchases a truckcannot split the cost of the truck into threecomponents (such as the engine, cab andchassis) on three invoices in order to avoid the

dollar limit. The final regulations also clarifythe treatment of transaction costs and certainother additional costs paid in connection withthe acquisition of property for purposes of the$5,000/$500 per item limit.

A taxpayer must include all additional costs,such as delivery fees, installation services, andsimilar costs that are included on the sameinvoice as the invoice for the cost of the prop-erty. If these additional costs are not includedon the same invoice as the property the tax-

payer may, but is not required to, include theadditional costs in the item of property.

COMMENT: The inclusion of additional costs by the vendor in the same invoice as the

property item could unnecessarily cause thecost of the property item to exceed the $5,000or $500 limit. The taxpayer should arrange in

advance for separate invoices for the property item and additional costs if possible in such a situation.

It does not appear that this strategy would vio- late the anti-abuse rule. An example included in the final regulations allows a taxpayer to include separately-invoiced related costs inthe de minimis election.

When multiple items of property are pur-chased on one invoice and additional costs arestated as a lump-sum, the taxpayer must usea reasonable method to allocate the additionalcosts among each item of property whencomputing the per item cost.

ImprovementsThe final regulations continue to require

capitalization of amounts paid to improve aunit of tangible property. A unit of propertyis improved if amounts are paid for activitiesperformed by the taxpayer resulting in:

A betterment to the unit of property; A restoration of the unit of property; or Adaptation of the unit of property to

a new or different use.

COMMENT. A unit of property for this purposconsists of a group of functionally interde-

pendent components, such as the parts of a machine, with the machine being treated as aunit of property. In the case of a building, the

building (including its structural components) is a unit of property. However, certain major systems of the building, such as heating, airconditioning, and ventilation (HVAC), plumb-

ing, and electrical, are treated as separateunits of property for purposes of determiningwhether there has been a capitalizable better-

ment, restoration, or adaptation to the system.

The final regulations retain the unit of propertyrules in the temporary regs. For real property,the regs continue to apply the rules to boththe building structure and to specified buildingsystems. They also keep certain simplifyingconventions, including a routine maintenancesafe harbor and the optional regulatory ac-counting method.


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MPACT. The IRS explained that applicationf the improvement rules to both the buildingtructure and the defined building systems isecessary to help ensure that the improve-

ment standards are applied equitably and

onsistently across building property.

MPACT. The IRS does recognize that someaxpayers may have particular facts andircumstances of a subset of buildingssed in one or more industries that present nique challenges to application of the build-ng structure or building system definitions.or them, the IRS suggested that they requestuidance under the Industry Issue ResolutionIIR) procedures.

Removal costs The final regulations clarify that the cost ofemoving a depreciable asset or a componentf a depreciable asset is not capitalized as anmprovement if the taxpayer realizes gain oross on the removed asset or component. Iftaxpayer disposes of a component of a unitf property and the disposal is not a disposi-on on which gain or loss is realized, then theaxpayer deducts the costs of removing theomponent if the removal costs directly ben-fit or are incurred by reason of a repair to the

nit of property. Otherwise the removal costsre capitalized as part of the improvementosts to the unit of property.

MPACT: Under proposed MACRS dispositionegulations that were issued in conjunction

with the final repair regulations,a taxpayer mayecognize a loss on the retirement of a compo-ent of an asset, such as a structural compo-ent of a building, if the taxpayer makes anlection to treat the retirement as a partialisposition of an asset and recognize the loss.

This election should be exercised with cautionecause the final regulations retain the rule inhe temporary regulations which requires theapitalization of any costs related to a repair s a restoration if a loss deduction is claimed.

Under the temporary MACRS regulations,which are optionally effective for tax years be-inning on or after January 1, 2012 and beforeanuary 1, 2014, loss recognition on the retire-

ment of a structural component is mandatorynless the taxpayer places the building in aeneral asset account.

Safe harbor for smalltaxpayers with buildingsSmall taxpayers complained that they couldnot afford to collect and maintain the docu-mentation necessary to apply the improve-

ment rules in the final regulations to theirbuildings. In response, the final regulationsinclude an annual safe harbor election forbuildings owned or leased by a taxpayerwith an unadjusted basis (i.e., generallycost) no greater than $1 million.

The taxpayer must have average annualgross receipts of $10 million or less duringthe three preceding tax years. Gross receiptsare specially defined and include income fromsales (unreduced by cost of goods), services,

and investments.

In the case of a lessee, the unadjusted basis ofthe building is equal to the total amount of (un-discounted) rent paid or expected to be paidover the entire lease term, including expectedrenewal periods.

The final regulations remove the aggregate

ceiling to the de minimisrule. In place of an aggregate ceiling,a more manageableper item or per invoiceceiling now applies.

Under the new exception, the small taxpayeris not required to capitalize improvements ifthe total amount paid for repairs, maintenance,improvements and similar activities duringthe year that are performed on the buildingdoes not exceed the lesser of $10,000 or twopercent of the unadjusted basis of the building.Amounts deducted under the de minimis ruleor the new safe harbor for routine mainte-nance are counted toward the $10,000 limit.

No amount is deductible under the safe harborfor buildings if this limit (or the $1 million ad-justed basis limit) is exceeded. The safe harboris applied separately to each building owned orleased by the taxpayer.

Eligible property includes a building (includingstructural components and building systems)owned or leased by a qualifying taxpayer andalso portions of buildings that are owned orleased and considered separate units of prop-erty under the regulations, such as an individ-ual condominium or cooperative unit or officespace. The safe harbor does not apply to costspaid with respect to exterior land improve-ments that are separate units of property.

IMPACT. Although the new safe harbor is helpful, small businesses continue tocomplain that the regulations require costly

accounting paperwork. Nevertheless, underthe final regulations, small taxpayers do not

have to analyze the building systems.

COMMENT. As with the $200 materials and supplies threshold, the IRS is giventhe authority to adjust the $10,000, 2

percent, and $1 million amounts in thefuture through published guidance.

The election is made annually on a timelyfiled (including extensions) original incometax return. In the case of a partnership or Scorporation that owns or leases a building, thepartnership or S corporation makes the elec-tion. The election may not be made by filing anapplication for a change in accounting methodor on an amended return unless permission tofile a late election on an amended return is firstobtained. The election is irrevocable.

COMMENT: A transitional rule allows taxpay-

ers, by filing an amended Federal tax return, to apply the safe harbor as contained in the final regulations to a tax year beginning in 2012 or 2013 even though a timely election was not initially made. This relief is also provided forcertain other provisions that require an elec-tion.


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Final repair / capitalization regulations:Targeted areas

The Preamble to the final regulations within TD 9636(September 13, 2013) focuses on what changes the IRS madeto the 2011 temporary regulations and the reasons behind them.The IRS also used the Preamble to explain the reasons whycertain requests for changes made by the public were notadopted by the final regulations. The following outline ofthe Preamble may be used as an aid in identifying the manyareas addressed by the IRS in drafting the final regulations:

II. Materials and supplies under 1.162-3A. Definition of materials and suppliesB. Election to capitalize certain materials and suppliesC. Optional method for rotable and temporary spare partsD. Materials and supplies under the de minimis safe harborE. Property treated as materials and supplies in published guidance

III. Repairs under 1.162-4

IV. De minimis safe harbor under1.263(a)-1(f) and 1.162-3(f)

A. De minimis safe harbor ceilingB. Taxpayers without an applicable financial statementC. Safe harbor electionD. Written accounting proceduresE. Application to consolidated group membersF. Transaction and other additional costsG. Materials and suppliesH. Coordination with section 263AI. Change in accounting procedures not

change in method of accounting

V. Amounts paid to acquire or producetangible property under 1.263(a)-2

VI. Amounts paid to improve property under 1.263(a)-3

A. OverviewB. Determining the unit of propertyC. Unit of property for leasehold improvementsD. Special rules for determining improvement costs 1. Costs incurred during an improvement 2. Removal costs

E. Safe harbor for small taxpayersF. Safe harbor for routine maintenance 1. Buildings 2. Other changes 3. Reasonable expectation that activities

will be performed more than once 4. Amounts not qualifying for the

routine maintenance safe harbor

G. Betterments

1. Overview 2. Amelioration of material condition or defect 3. Material addition or increase in productivity,

efficiency, strength, quality, or output 4. Application of Betterment Rule 5. Retail store refresh or remodels

H. Restorations 1. Overview 2. Replacement of a major component

or substantial structural part a. Definition of major component and

substantial structural part

b. General rule for major componentand substantial structural part c. Major component and substantial

structural part of buildings 3. Casualty Loss Rule 4. Salvage value exception 5. Rebuild to like-new condition

I. Adaptation to a new or different use

VII. Optional regulatory accounting method

VIII. Election to capitalize repairand maintenance costs

IX. Applicability dates

X. Change in method of accounting


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Bettermentsn the final regulations, the IRS has clarified theetterment rules and revised two of the better-

ments tests. Under the temporary regulations,

betterment is defined as an expenditure that:

1) ameliorates a material condition ordefect that existed prior to theacquisition of the property or aroseduring the production of the property;

2) results in a material addition to the unitof property (including a physicalenlargement, expansion, or extension); or

3) results in a material increase in the capacity,productivity, efficiency, strength, or qualityof the unit of property or its output.

Under the final regulations no change ismade to the first betterment test. However,he second and third tests are changed toliminate the results in standard. Specifically,nder the final regulations, a bettermentnder the two revised standards nowncludes an expenditure if it:

1) is for a material addition, including aphysical enlargement, expansion, extension,or addition of a major component to the unitof property or a material increase in thecapacity, including additional cubic or linearspace, of the unit of property; or

2) is reasonably expected to materiallyincrease the productivity, efficiency,strength, quality, or output of theunit of property.

MPACT. The elimination of the nonsubjectiveresults in standard should reduce controver-y for expenditures that span more than oneax year or when the outcome of the expen-iture is uncertain when the expenditure is

made.

The final regulations clarify that if an additionr increase in a particular factor cannot be

measured in the context of a specific typef property, then the factor is not relevant inetermining whether there has been a bet-erment to the property. For example, theproductivity or output standards, whileelevant in analyzing a machine, would nor-

mally have no relevance to a building structure

and, therefore, should be ignored whenconsidering whether expenditures result in abetterment to a building structure.

The final regulations also clarify situationsinvolving refreshing or remodeling retail storesin particular, by fine-tuning examples in whichsuch actions move from being maintenanceactivities to betterments that must be capital-ized.

IMPACT. The result of the IRSs clarificationof the betterment rules may be less wiggle

room for some taxpayers.

COMMENT. The IRS declined suggestions ofquantitative bright lines in applying the bet-

terment rules. However, it added detail in a number of examples within the final regula-tions to help taxpayers draw the necessarydistinctions.

COMMENT. Facts and circumstances taken into account in determining whether anexpenditure results in a betterment include

but are not limited to, the purpose of theexpenditure, the physical nature of the work

performed, and the effect of the expenditureon the unit of property. The treatment of an ex-

penditure on a taxpayers applicable financial statement is removed by the final regulations as a factor in considering whether an expendi-ture results in a betterment since taxpayers ap-

ply standards that may differ significantly thanthe standards in the regulations in determiningwhether to capitalize a cost for financial ac-counting purposes.

RestorationsThe final regulations provide some relief froma rule in the temporary regulations which re-quired a taxpayer to capitalize the entire cost ofrepairing property that was damaged in a ca-sualty if the taxpayer adjusted the basis of theproperty as a result of claiming a casualty loss.Capitalization was required even if the adjustedbasis of the building (generally, the amount towhich the casualty loss is limited) was less

than the amounts that could otherwise bededucted as a repair expense. Even if a tax-payer chooses not to claim a casualty loss,the basis adjustment for the loss that couldbe claimed is required and the deduction ofrelated repair expenses is prohibited underthe temporary regulations. The final regula-tions revise the casualty loss rule to permit adeduction for amounts spent in excess of theadjusted basis of the property damaged in acasualty event provided they would otherwisebe considered deductible repair expenses. Ataxpayer is still required to capitalize amountspaid to restore damage to property that wouldbe capitalized without regard to the casualtyloss rule, but the costs required to be capital-ized under the casualty loss rule are limited tothe excess of (1) the taxpayers basis adjust-

ments resulting from the casualty event, over(2) the amount paid for restoration of dam-age to the unit of property that are otherwiseconsidered capitalizable restorations. Casualty-related expenditures in excess of this limitationmay be deducted as repair expenses if they soqualify.

EXAMPLE: A storm damages a building with an adjusted basis of $500,000. The cost of re- storing the building is $750,000, consisting of a roof replacement ($350,000) and clean-up/

repair costs ($400,000). A $500,000 casualty loss is claimed. The cost of the roof must be capitalized as an improvement because it is a major component and substantial structural part of the building. The remaining $400,000 clean/up repair costs must be capi-talized to the extent of the $150,000 excess ofthe buildings adjusted basis ($500,000) overthe capitalized cost of the roof ($350,000). The

remaining $250,000 of repair/clean-up costs($400,000 - $150,000) may be currently deducted.

Rebuilt like newThe final regulations retain the rule that a capi-talizable restoration includes rebuilding a unitof property to a like-new condition after theend of its class life. A property is rebuilt to alike new condition if it is brought to the statusof new, rebuilt, remanufactured, or similar


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The proposed regulations that were issuedn September 13, 2013 adopt this positiony creating a partial disposition election forssets that are not in general asset accounts. Ifhe election is made, a taxpayer may recognizeloss on the retirement of a structural compo-ent. If the election is not made, the taxpayer

will continue to depreciate the basis of theetired component.

MPACT. The election allows a taxpayer toeat the retirement of any portion of an assets a disposition. In the case of a building, thentire building is treated as the asset. (Underhe temporary regulations, each structural

omponent was treated as an asset and tax-ayers were permitted to treat components oftructural components as assets). Thus, for ex-mple, the taxpayer can make the election toeat the retirement of an entire roof as a partialisposition or any portion of the roof, such ashe shingles, as a partial disposition, if it wantso recognize a loss. In the case of assets otherhan buildings, the partial disposition elec-on may also be made upon the dispositionf a component of the asset or a portion of a

omponent of an asset.

CAUTION. While the partial disposition rule isenerally elective, it is mandatory to recognizeain or loss in the case of certain specifiedispositions, including the disposition of aortion of an asset as a result of a casualty, aisposition which is not recognized in wholer part under Code Sec. 1031 or Code Sec.033, the transfer of a portion of an asset instep-in-the-shoes transaction described in

Code Sec. 168(i)(7)(B), or to a sale of a portionf an asset.

The proposed regulations contain an additionalrule which protects taxpayers who decide notto treat a retirement as a partial disposition in

order to claim a repair deduction but it laterturns out on audit that the repair deductionshould have been capitalized. The rule allows ataxpayer to file an accounting method changeto make the partial disposition election andclaim the loss on the replaced componentthrough a Code Sec. 481(a) adjustment in sucha situation.

COMMENT: The partial disposition electionfor a 2012 or 2013 tax year can be made on an

amended 2012 or 2013 return, or alternatively, by filing an accounting method change in thefirst or second tax year succeeding the ap-

plicable tax year.

Modified generalasset account rules The proposed regulations modify the generalasset account rules to redefine a qualifyingdisposition for which an election may be madeto recognize a gain or loss. A qualifying dispo-sition for which the recognition of gain or loss

may be elected under the proposed regula-tions now generally only includes the few se-lect types of dispositions that were treated asqualifying dispositions prior to the temporaryregulations. However, the recognition of gainor loss upon the partial disposition of a portionof an asset is required in the case of any of thetransactions described above for assets thatare not in a general asset account (i.e., casualtylosses, etc.). For other transactions, a disposi -tion includes a disposition of a portion of anasset in a general asset account only if the

taxpayer makes the election to terminate the

general asset account upon the dispositionof all assets, including the disposed portion, inthat general asset account.

Timing of finalization The IRS reported that it aims to finalize theproposed regulations quickly so that they canhave the same January 1, 2014 effective dateas the final repair regulations. Because the IRShas scheduled a hearing in late December onthe proposed regulations, it may not be ableto finalize them by January 1, 2014. However,the IRS could decide to apply the regulationsretroactively to January 1, 2014. In any case,taxpayers can rely on the proposed regulations

for tax years beginning on or after January 1,2012.

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F R E E D M A X I C K . C O M

Documents

Final Regs Governing Repairs & Capitalization