The new tangible property regulations form a framework of rules for the capitalization of tangible property that affects the treatment of fixed asset additions and disposals, the expensing of materials and supplies, and the timing of deductions for repairs and maintenance expenses. The regulations are complex and far-reaching, and they require almost all businesses to make accounting method changes and review past decisions regarding whether to capitalize or expense tangible assets.
For the 2014 tax year, most businesses will need to make accounting method changes to comply with the new regulations. Understanding the new rules and their implementation requirements is a daunting task similar to visiting a foreign country. The traveler may have a map of the city and a dictionary to help with the language, but everything is foreign. Just as learning the language and terrain makes it easier for the traveler to get around, here, too, grasping the general concepts of the rule changes will help practitioners and taxpayers analyze their specific situation and plan a course of action.
Some of the accounting method changes can be applied retroactively and require adjustments to income under Sec. 481(a). Several accounting method changes should be considered—all are automatic for 2014. Taxpayers generally must file a Form 3115, Application for Change in Accounting Method, for these accounting method changes. However, due to the outcry from small businesses and practitioners about the amount of work required to comply with the repair regulations, the IRS issued guidance in February (Rev. Proc. 2015-20) that will simplify the determination of Sec. 481(a) adjustments for accounting method changes under the repair regulations for many taxpayers and allow them to make the changes without filing Forms 3115.
Under the revenue procedure, the IRS is allowing small businesses to make certain accounting method changes under the repair regulations on a cutoff basis, that is, with a Sec. 481(a) adjustment that takes into account only amounts paid or incurred, and dispositions, in tax years beginning on or after Jan. 1, 2014, the effective date of the regulations. In addition, for their first tax years beginning on or after that date, taxpayers generally are permitted to make these changes without filing Form 3115. For these purposes, a small business is defined as a business with total assets of less than $10 million on the first day of the tax year for which the accounting method change is effective or average annual gross receipts of $10 million or less for the prior three tax years.
For taxpayers that are required to make multiple accounting method changes, the regulations contain specific requirements for determining which changes can be filed concurrently on the same Form 3115 and which changes must be made by filing separate forms.
Changes that may be necessary to comply with the new regulations
Incorrect depreciation method
While taxpayers in the past have been able to make an accounting method change for incorrect depreciation, the new regulations make a significant change. The new wrinkle in having an incorrect depreciation method is found in Regs. Sec. 1.1016-3(a)(1)(ii), which states that “[a] taxpayer is not permitted to take advantage in a later year of the taxpayer’s prior failure to take any such allowance or the taxpayer’s taking an allowance plainly inadequate under the known facts in prior years.”
What this means is that after the 2014 tax year, the taxpayer must keep using an incorrect method and cannot go back and make the change in a later year. All taxpayers who have fixed assets subject to depreciation should make sure existing class lives are correct and that bonus depreciation was properly taken on prior returns. If incorrect depreciation methods are found, they should be corrected by an accounting method change.
Capitalized repair items (Regs. Sec. 1.162-4)
The repair regulations define which expenditures must be capitalized and which can be expensed based upon the newly defined unit-of-property rules. These new rules are adopted through an accounting method change and, if an item was capitalized in the past that should have been expensed using the new expensing criteria, the accounting method change is applied retroactively to that asset.
For example, in 2009, a taxpayer repaired the roof of a large commercial building. About 25% of the roof was replaced, and the full cost of the repair was capitalized and depreciated using a 39-year life. Under the current criteria, the roof is a structural component of the building under Regs. Sec. 1.263(a)-3(k)(6)(ii)(A), and the repair to that component was not substantial and was not an improvement or a betterment. Therefore, the expenditure qualifies as a repair. The taxpayer can make an automatic accounting method change and take the undepreciated balance of the asset as a negative Sec. 481(a) adjustment in the current year.
In addition to gaining the benefits of an immediate write-off, the taxpayer has effectively reduced the accumulated depreciation that may be subject to Sec. 1250 recapture. For this reason, there is a benefit to retroactively changing the treatment of any fully depreciated property that can be recharacterized as a repair, eliminating possible depreciation recapture in a subsequent sale.
This method change can cut both ways, however. If an amount was deducted as a repair but under the new criteria should have been capitalized, the taxpayer will be required to put the asset on the depreciation schedule, compute the depreciation that should have been taken in previous years, and make a positive Sec. 481(a) adjustment.
Leased property (Regs. Secs. 1.167(a)-4 and 1.162-11(b))
For a lessor, the general rules for defining a unit of property for purposes of applying the tangible property regulations are applied to leased property. Any past amounts incurred and capitalized for tenant improvements should be analyzed for incorrect accounting methods or possible recharacterization as a repair. Under Rev. Proc. 2014-54, the landlord can use the partial-asset-disposition rules to write off abandoned tenant improvements, but the chance to write off these assets as an accounting method change lasts only through 2014.
For a taxpayer that is a lessee, the unit of property is defined as each building and the structural components associated with the leased portion of the building, as defined in the lease agreement.
For example, if a taxpayer leases three units in the same building, all under separate lease agreements, the taxpayer has three units of property. Assume each of these units has a separate heating, ventilation, and air conditioning (HVAC) system. Because the lease agreement defines the unit of property, whether expenses are deductible repairs or must be capitalized will be determined on a leased-unit basis. If the HVAC system goes out in one unit and has to be replaced, the expenditure would require capitalization because the unit has only one HVAC unit and replacement of that unit would qualify as substantial. If three HVAC units are included in one lease agreement, the replacement of one unit is only one-third of the total units of the HVAC building component. In that case, the cost of the replacement would be deducted as a repair.
Unit-of-property changes (Regs. Sec. 1.263(a)-3(e))
The new regulations establish a functional interdependence standard for defining a unit of property under which all the components that are functionally interdependent constitute a single unit of property. Components of property are functionally interdependent if the placing in service of one component by the taxpayer is dependent on the placing in service of the other component by the taxpayer. Thus, for tangible property, this will require looking at an integrated piece of machinery as one unit of property. The decision to expense or capitalize will be made by determining whether the expenditure is substantial when compared to the entire unit of property.
The regulations provide special rules for buildings. Each building and its structural components are a single unit of property. However, the regulations designate nine building structural components to which the improvement rules apply separately. These are:
- HVAC systems;
- Plumbing systems;
- Electrical systems;
- Fire protection and alarm systems;
- Security systems;
- Gas distribution systems; and
- Other systems and components identified in published guidance.
The building structure must be divided into smaller units of property for each structural component that performs a separate function. Examples of structural components are windows, roofs, and flooring.
The accounting method change for a unit of property can be applied retroactively. Any assets on the depreciation schedule that are not grouped as required under the new standards should be changed to reflect a proper grouping. Once the new unit of property is identified, past capitalized expenditures should be scrutinized to determine whether the capitalization standard was met or they should have been expensed as repairs. If it is determined that the amount should not have been capitalized, then the item can be removed from the depreciation schedule with a negative Sec. 481(a) adjustment taken for the undepreciated asset balance.
Routine-maintenance safe harbor (Regs. Sec. 1.263(a)-3)
Under the routine-maintenance safe harbor, amounts paid for routine maintenance are deemed not to improve a unit of property and are therefore currently deductible. Routine maintenance includes recurring activities performed to keep a unit of property in an ordinarily efficient operating condition. However, to be routine, an activity must be one that the taxpayer reasonably expects (at the time the property is placed in service) to perform more than once during the alternative depreciation system (ADS) class life of the unit of property for property other than buildings and to be performed more than once during a 10-year period for buildings. The routine-maintenance rules do not apply to assets that are betterments, network assets (i.e., assets used by utilities, such as power plants and communications), or certain rotable, temporary spare parts.
This accounting method can be adopted retroactively with the new routine-maintenance safe-harbor criteria applied to past fixed-asset additions. If it is determined that an addition should have been a repair, the asset can be removed from the depreciation schedule and a negative Sec. 481(a) adjustment taken on the current tax return.
Prior-year partial disposition (Regs. Sec. 1.168(i)-8(d))
Prior-year losses from the disposition of a structural component of a building or a component of a unit of property can be recognized as a method change. Current-year partial asset dispositions are recognized with an election.
The partial-asset-disposition rules are mandatory for a casualty event, any nontaxable transaction, or the sale of a portion of an asset. If the partial disposition falls outside of these mandatory criteria, the recognition of the partial asset disposition is optional.
The main issue with this accounting method change is determining the basis of the disposed partial asset. The regulations call for the use of a reasonable method to determine the original cost. Three methods can be used for this purpose:
- Discounting the cost of the replacement property using the producer price index (PPI, which measures the average change over time of prices received by domestic sellers of goods and services);
- Pro rata allocation; and
- A prior cost-segregation study.
A Form 3115 is required for a prior-year partial asset disposition, and the change is automatic.
Removal costs (Regs. Sec. 1.263(a)-3(g)(2))
If a taxpayer disposes of a depreciable asset or a component of an asset and realizes a gain or loss on the disposition, the cost of removing the asset does not have to be capitalized. If the taxpayer disposes of a component of an asset, but the removal is not treated as a disposition, then the taxpayer must look to the treatment of the replacement property to determine whether the removal costs should be expensed or capitalized.
For example, if the taxpayer makes substantial changes to a building structure that result in a betterment, the taxpayer must capitalize the expenditure. The taxpayer can elect to treat the event as a partial asset disposition and write off the remaining undepreciated cost of the portion of the asset that was removed. If this treatment is elected, the removal of the old asset is a taxable disposition, and the cost of removing the asset does not have to be capitalized. But if a partial asset disposition is not elected, the removal costs must be capitalized into the cost of the improvement.
This method change should be adopted if a taxpayer wants to write off removal costs associated with the replacement of an old asset with a new asset that is required to be capitalized.
Materials and supplies (Regs. Sec. 1.162-3)
The regulations adopt new rules that differentiate the accounting treatment of incidental and nonincidental materials and supplies. If materials and supplies are incidental, a deduction is taken in the year they are paid for, but if the materials and supplies are nonincidental, a deduction is taken upon use or consumption.
The final regulations define materials and supplies as tangible property that is used or consumed in the taxpayer’s operations that is not inventory and that are:
- Components acquired to maintain, repair, or improve a unit of tangible property that are not acquired as part of any single unit of property;
- Fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months or less;
- Units of property with an economic useful life of 12 months or less;
- Units of property with an acquisition or production cost of $200 or less; or
- Identified in published guidance in the Federal Register or in the Internal Revenue Bulletin as materials and supplies.
These definitions apply to all taxpayers and will apply whether or not the taxpayer currently writes off all materials and supplies. This method change applies to amounts paid or incurred in tax years beginning on or after Jan. 1, 2014, so there is no retroactive application of the accounting method. For the 2014 tax return, the taxpayer will need to inventory non-incidental materials and supplies and either create a tax balance sheet account or defer the recognition of the expense through a Schedule M-1 or M-3 adjustment.
Form 3115 requirements
The new tangible property regulations will require most taxpayers to adopt multiple changes in accounting methods for 2014. The method changes are automatic and will require many taxpayers to file Forms 3115. However, as noted above, Rev. Proc. 2015-20 has eliminated the requirement for qualifying small business taxpayers to file Form 3115 in tax year 2014 for certain accounting method changes in the repair regulations, which will greatly reduce the number of taxpayers who must file the form.
Where a taxpayer is required to file a Form 3115, the tangible property regulation method changes have automatic change method numbers, and user fees are not required.
Care should be taken to determine which changes can be filed concurrently and which must be filed separately. Each taxpayer can have multiple Form 3115 filings, with some of those forms containing multiple method changes. Rev. Proc. 2015-14 lists procedures for filing a single Form 3115 for two or more method changes.
The new tangible property regulations are complex and require substantial resources for successful implementation. Practitioners should examine existing depreciation schedules and apply the new rules to these assets. Some of the method changes are prospective, while others can be applied retroactively and could generate negative Sec. 481(a) adjustments for 2014 tax filings.
Pamela Schuneman (firstname.lastname@example.org) is a tax manager for Kerkering, Barberio and Co. in Sarasota, Fla.
To comment on this article or to suggest an idea for another article, contact Sally P. Schreiber, senior editor, at email@example.com or 919-402-4828.
- “Tax Practice Corner: The De Minimis Safe Harbor Under the Repair Regulations,” May 2014, page 58
- “Tax Practice Corner: Automatic Consent for Changing Accounting Methods Under the ‘Repair Regs.,’ ” April 2014, page 58
- “Implementing the New Tangible Property Regulations,” Feb. 2014, page 22
- “A Closer Look at the IRS’s Final Tangible Property Regulations,” CPA Insider, Feb. 18, 2014
- “Regulations Bring Clarity to Treatment of Tangible Property Expenses,” Corporate Taxation Insider, Sept. 26, 2013
- “IRS Lets Taxpayers Choose When to Implement the New Tangible Property Regs.,” Corporate Taxation Insider, Dec. 13, 2012
- Accounting Methods and Periods, Tax Staff Essentials, Level 2, Experienced Staff (#157690, one-year online access)
- Capitalized Costs and Depreciation: Key Issues and Answers (#736960, text; #163570, one-year online access)
For more information or to make a purchase, go to cpa2biz.com or call the Institute at 888-777-7077.
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