It has been said that when people look at the Mona Lisa, they will feel or see something different every time. The painting doesn’t change, but the viewer’s perspective does. A similar effect can occur with tax rules. Taxpayers can revisit rules that have not been recently changed and apply them to their current tax situation to discover something new. This article would like to take you back to 2014 and the tangible property regulations, also known as the “repair regs.,” to explore how and why taxpayers may want to revisit the rules to plan for the future.
A QUICK REVIEW
In late 2013 the IRS published T.D. 9636, which contained final regulations under Secs. 162(a) and 263(a) that provide the rules regarding when costs incurred to acquire, produce, or improve tangible property must be capitalized or may be deducted. Then, in late 2014, the IRS published T.D. 9689, which contained final regulations under Sec. 168 that provide the rules regarding depreciation and dispositions, including partial dispositions of tangible depreciable property. They are generally effective for tax years beginning on or after Jan. 1, 2014. The rules in these regulations cover topics including materials and supplies; repairs and maintenance; and acquisitions, production, improvement, and dispositions of property, as well as providing general rules for capital expenditures on property.
Materials and supplies
Under Regs. Sec. 1.162-3, materials and supplies are generally defined as a unit of property costing $200 or less and units of property with economic useful lives of, or that would be used or consumed in, 12 months or less. Generally, amounts paid to acquire or produce incidental materials and supplies are deductible when paid, while amounts paid to acquire or produce nonincidental materials and supplies are deductible in the tax year in which they are used or consumed. The de minimis safe harbor, described below, generally is applied to amounts paid for materials and supplies prior to the rules of this regulation.
The regulations define spare parts (a special kind of material and supply) in three categories: rotable, temporary, and standby emergency spare parts. Rotable spare parts are acquired for installation on a unit of property, removable from that unit of property, generally repaired or improved, and either reinstalled on the same property or stored for later installation. Temporary spare parts are materials and supplies that are used temporarily until a new or repaired part can be installed and then are removed and stored for later installation. Standby emergency spare parts are generally acquired for a specific piece of machinery or equipment, are normally expensive and not acquired in quantity (e.g., may only acquire a single spare part), and are not repaired or reused.
Spare parts are generally deductible when disposed of by a taxpayer. Taxpayers may also elect annually to instead capitalize the cost of the spare parts and begin to depreciate the asset when placed in service.
General rules for capitalization
Under Regs. Secs. 1.263(a)-1 and -2, taxpayers are generally required to capitalize amounts paid or incurred to either acquire or produce tangible property — both real and personal — including the invoice price, transaction costs paid to facilitate the acquisition of the property, costs for work performed prior to the date that the unit of property was placed in service, and amounts paid to defend or perfect title to the property.
Regs. Sec. 1.263(a)-1(f) provides a de minimis safe-harbor election, which allows taxpayers to expense certain amounts paid to acquire or produce tangible property to the extent expensed for book purposes. Taxpayers with an applicable financial statement (AFS) (generally, audited financial statements) may deduct amounts up to $5,000 per item or per invoice, as long as the taxpayer has a written book accounting policy providing for such deductions as of the beginning of the tax year. Taxpayers without an AFS do not need to have a written policy, but the limit is only $2,500. (Regs. Sec. 1.263(a)-1(f)(1)(i) provides a limit of $500, but Notice 2015-82 increased the safe harbor for taxpayers without an AFS to $2,500 for tax years beginning on or after Jan. 1, 2016. The election is made annually by attaching a statement to the tax return.)
Improvements vs. repairs and maintenance
The rules under Regs. Secs. 1.162-4 and 1.263(a)-3 allow taxpayers to deduct amounts paid for repairs and maintenance to tangible property to the extent that the amount paid is not considered an improvement to a unit of property. The final regulations provide definitions and rules to analyze costs that are incurred to determine if they are improvements to a unit of property. An amount is an improvement if it results in a betterment, restoration, or adaptation to the unit of property.
The rules provide a safe harbor for routine maintenance activities and therefore not an improvement to the property. An amount qualifies as routine maintenance to a building if the taxpayer reasonably expects to perform the maintenance more than once during the 10-year period beginning when the building structure or system was placed in service. An amount is routine maintenance on tangible personal property if the taxpayer expects to perform the maintenance more than once during the class life of the property.
The rules also provide for a couple of elections. Small taxpayers (those with average annual gross receipts for the prior three years of $10 million or less) may elect to currently deduct amounts paid to improve building property up to the lesser of $10,000 or 2% of the building’s unadjusted basis. An eligible building is one with an unadjusted basis of $1 million or less. The taxpayer must include an election statement with its tax return. All taxpayers are provided with an election under Regs. Sec. 1.263(a)-3(n) to capitalize repair and maintenance costs. Generally, a taxpayer making this election treats otherwise deductible repairs as capital improvements to tangible property to the extent they are treated as capital expenditures for book purposes (this may be referred to as “following books”). This election is also made by filing an election statement with a timely filed federal income tax return.
Dispositions of depreciable property subject to the modified accelerated cost recovery system (MACRS) are covered under Regs. Secs. 1.168(i)-1 and -8. The regulations provide rules for determining the asset disposed of and the basis of the asset disposed of, including when the asset is in a multiple asset account or is a partial disposition of an asset. The final regulations include examples of reasonable methods for determining basis disposed of in partial dispositions and clarify that improvements and additions are separate assets from the underlying property improved for this purpose.
Generally, the partial-disposition rule is elective; however, taxpayers are required to apply this rule in certain instances, which include casualty losses under Sec. 165, dispositions resulting in nonrecognition treatment under Sec. 1031 or 1033, a transfer of a portion of an asset in a “stepin- the-shoes” transaction described in Sec. 168(i) (7)(B), and the sale of a portion of an asset. The partial-disposition election is made on a timely filed tax return for the year in which the disposition occurred. If a taxpayer does not make the election, the property continues to be depreciated until the taxpayer disposes of the entire asset.
SO WHY NOW?
Why would taxpayers want to revisit the tangible property regulations now? The rules are not new this year (and therefore are not a “required” change), and taxpayers may be following a routine with respect to maintaining the tax methods and elections chosen in prior years. Some taxpayers may have affirmatively made certain planning decisions in response to tax law changes (a couple will be discussed below) and may now need to reconsider those choices, as the tax laws are again changing. As noted above, the tangible property regulations have several optional elections that could have a meaningful effect on certain taxpayers. Some additional possible reasons to consider reengaging with the tangible property regulations include utilized or expired net operating losses (NOLs), large renovation projects to owned or leased buildings, and changes to book accounting policies.
Sec. 163(j) interest limitations
The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, limited the amount of interest expense that a taxpayer may deduct each year. Under Sec. 163(j)(1), the limitation is generally the sum of business interest income, 30% of adjusted taxable income (ATI), and floor plan financing interest for the tax year. For many taxpayers, the ATI component may be the largest portion of the computation. Sec. 163(j)(8) and Regs. Sec. 1.163(j)-1(b)(1) require certain adjustments to ATI, including adding back depreciation expense under Secs. 167 and 168 and subtracting the greater of the allowed or allowable depreciation (as provided under Sec. 1016(a)(2)) of property that is sold or disposed of. Each of these adjustments applies only to tax years beginning before Jan. 1, 2022.
For tax years beginning in 2018 through 2021, taxpayers may have seen a beneficial impact to their Sec. 163(j) interest limitation by electing to capitalize amounts that are otherwise deductible repairs and depreciating them, especially if the asset also qualified for bonus depreciation under Sec. 168(k). Similarly, taxpayers may have benefited from not making a partial-disposition election and continuing to depreciate the full asset and the replacement or improvement.
Now that taxpayers have been following the final rules since 2014, it may be time to review and refresh tax decisions to reflect the taxpayer’s current policies and practices.
An illustration of a potential benefit in prior years might be helpful:
Example: During its 2021 tax year, Taxpayer A pays $1 million to have its parking lot repaired, including sealing cracks, striping, and doing minor replacement of asphalt. For financial statement purposes, A capitalizes the $1 million and begins to depreciate it over its GAAP life. A analyzes the project under Regs. Sec. 1.263(a)-3 and determines that it is not an improvement to the parking lot and qualifies as a repair deduction. If A claims the deduction as a repair expense, it would reduce taxable income by $1 million. In computing its ATI, A makes no adjustment for the repair expense. If A instead elects to capitalize repair costs consistent with its financial statements, A will have a 100% bonus depreciation–eligible land improvement, which reduces taxable income by $1 million. In computing its ATI for purposes of the Sec. 163(j) interest deduction limitation, A will add back the depreciation deduction, thereby increasing the potential interest limitation by $300,000 (30% of $1 million), for an additional benefit.
In tax years beginning prior to Jan. 1, 2022, the taxpayer could have an overall benefit by capitalizing otherwise deductible repairs because of the depreciation addback required in computing ATI. (Of course, the benefit relies upon the capitalized amounts being eligible for bonus depreciation; the taxpayer would not have the same immediate impact if the repair was for a roof, which is ineligible for bonus depreciation and would be depreciated over 39 years under MACRS.) Beginning in 2022, however, because the addback of depreciation is phased out, the taxpayer would generally have the same federal income tax impact by claiming the $1 million as either a repair expense or a bonus depreciation deduction. Because the election to capitalize in any tax year applies to all amounts paid for repairs in that year, a taxpayer that incurs amounts to repair both bonus-eligible and bonusineligible property may now want to carefully weigh the costs and benefits of analyzing the amounts. Capitalizing and depreciating no longer provides the Sec. 163(j) benefit, but the taxpayer still has the “unfavorable” impact from capitalizing long-lived property (e.g., a roof) and depreciating it over a long period (e.g., 39 years) rather than taking an immediate repairs deduction.
Sec. 168(k) bonus depreciation phaseout
The TCJA made a number of changes to the additional first-year depreciation deduction under Sec. 168(k), including expanding it to include both original-use and “used” property and temporarily setting the rate at 100%. Under Sec. 168(k)(6), that rate applies to eligible property acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023. Eligible property placed in service during 2023 only has an 80% bonus rate, and the amount continues to decrease by 20% per year through 2026 (after which there would no longer be any bonus depreciation in the absence of future legislative action).
Returning to the parking lot example above, taxpayer A’s federal income tax deduction is the same whether the costs are capitalized and depreciated using 100% bonus depreciation or deducted as repair expenses (ignoring the Sec. 163(j) impact previously discussed). If the parking lot project is instead completed during 2023, the depreciation deduction is $810,000 ($1 million total cost times 80% bonus depreciation = $800,000, plus the remainder of $200,000 times the first-year rate for 15-year property of 5% = $10,000). Now, A increased taxable income by $190,000 by making the election to capitalize repairs. That balance is recovered over the remainder of the 15-year life of the asset. The difference only becomes greater as the bonus depreciation rate continues to phase down over the years. Of course, the aforementioned roof, which is ineligible for bonus depreciation, maintains the difference associated with expensing as a repair rather than capitalizing. As an offset, if a taxpayer wants to continue to capitalize and depreciate, a careful examination of the assets disposed of, including a partialdisposition election, can provide some offset to the unfavorable impact of capitalizing the repairs.
THE PASSAGE OF TIME
Nearly a decade has passed since the IRS first published the final regulations on capitalizing costs paid to acquire or improve tangible property. Taxpayers reviewed the rules and likely implemented them by filing several accounting method changes. Now that taxpayers have been following the final rules since 2014, it may be time to review and refresh tax decisions to reflect the taxpayer’s current policies and practices.
Did the taxpayer implement a new enterprise resource planning (ERP) system, acquire a business, or expand into a new trade or business? Was the taxpayer itself acquired by new owners? Have book policies changed with regard to expensing amounts as de minimis or as repairs? Did the book treatment of materials and supplies, including spare parts, change? Has the taxpayer’s tax position changed with respect to NOLs, interest expense limitations, or foreign taxes? These are just a few starting questions that may help determine whether a taxpayer wants or needs to consider accounting method changes that are related to small (or large) business changes over time.
ACCOUNTING METHOD CHANGES
If a taxpayer discovers it may need or want to make a change under the tangible property regulations, the next question is whether that change is automatic. Generally, Section 5.01(f ) of Rev. Proc. 2015-13 precludes a taxpayer from making an automatic method change for an item if a method change was filed for the same item in the prior five years. For taxpayers that filed method changes for the 2014 tax year, that limitation has now expired (probably after 2018). The good news is that, for most taxpayers, making changes in the method of accounting will likely be automatic rather than having to go through the nonautomatic filing procedures.
Section 11.08 of Rev. Proc. 2022-14 provides many of the automatic change procedures, including changes for deducting repairs or capitalizing improvements, treatment of materials and supplies, and capitalizing costs related to the acquisition or production of tangible property. Sections 6.12, 6.13, 6.14, and 6.15 of the same revenue procedure generally provide the automatic procedures for dispositions of tangible property, whether in single, multiple, or general asset accounts. Most of the elections, as noted above, are made annually and are therefore not changes to a method of accounting.
TIME TO REEXAMINE ELECTIONS AND METHODS
The tangible property regulations affected most business taxpayers in 2014. Taxpayers filed method changes, began making new elections annually, and developed procedures related to capitalizing tangible assets. Since then, a host of changes in tax law, regulations, and book standards have continued to affect taxpayers’ overall tax filing positions. The years 2022 and 2023 will be no exception, with certain provisions of the TCJA beginning to expire or phase out. As planning for 2022 tax returns (and 2023 estimates and provisions) begins, now may be the time to examine the methods and elections used to see if making a change may result in a better overall tax position now and in future years.
About the authors
Caleb Cordonnier, CPA, is a senior manager, and Jason Seo, J.D., LL.M., is a manager, both in the National Tax Office of Grant Thornton LLP in Washington, D.C. To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.
“Change Is Coming: Accounting Method Changes Under the Tangible Property Regulations,” JofA, April 13, 2015
“A Renewed Chance to Revisit Old Assets for Repairs and Maintenance Expense,” The Tax Adviser, April 2020
“Benefiting From New Tangible Property Regulations and Disposal Provisions,” The Tax Adviser, Sept. 2016
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