Ernst & Morris Consulting Group, Inc.
On December 21, 2011, the IRS issued temporary regulations governing amounts spent to acquire, repair and
improve business property. These regulations also provide changes to the rules governing the treatment of
materials and supplies used by taxpayers in their trade or business. These new regulations will affect virtually
Most significantly, these temp. regs. provide an assertive capitalization policy, giving specific guidance where
there has been none and eliminating the standard practice of writing off expenditures less than a certain dollar
amount. The temp. regs. formalize the write-off of de minimis amounts that were informally allowed by the IRS.
The taxpayer must have a formal policy in place by the beginning of the tax year.
These temporary regulations are effective now but could be further modified before becoming final. The general
consensus is that any modifications will not likely have significant changes to the December 2011 temp. regs.
What Clients Need To Do
Assess conformity of your current policies and procedures with these temporary regulations.
- Capitalization policies
- Minimum capitalization thresholds
- Routine maintenance expenditures
- Internal tracking and capturing data
If current methods do not conform to these temp. regs., the tax preparer will file a Form 3115. A Form 3115 will
also need to be filed if prior year’s building structural components will be capitalized.
Units Of Property For Buildings
An improvement to the structure of a building or a building system is considered an improvement to the building
and must be capitalized. This is a departure from a straight unit of property evaluation. The building is still
considered the unit of property—just not for evaluating structure and system improvements. Below are the
§1.263(a)3(e) Units of Property.
• Building Structure
• 9 Enumerated Building Systems
6. Fire Protection
7. Security Systems
8. Gas Distribution
9. Any other systems identified in public guidance
Disposition of MACRS Property The new temporary regulations expand the definition of disposition of MACRS
property to include the retirement of a structural component of a building. If a taxpayer is required to capitalize
a cost as an improvement, the temporary regulations §1.168(i)8 revise the disposition and depreciation rules to
minimize the harsh result that occurs when an original part and any subsequent replacements of the same part
are required to be capitalized and recovered simultaneously.
Before these temp. regs., taxpayers were required to capitalize and depreciate the costs to replace a structural
component and to continue to recover the cost of the original structural component.
Example: a taxpayer could not take a retirement loss on the disposition of a structural component of a building.
If a taxpayer was required to capitalize the costs of replacing an entire roof, it could not recover its basis in the
original roof that was removed. Rather, the taxpayer would have to continue depreciating the removed roof, and
at the same time, capitalize and depreciate the replacement roof over the same recovery period as the building.
The temporary regulations revise the definition of disposition so that a taxpayer may treat the retirement of a
structural component of a building as disposition of property. Furthermore, the temporary regulations clarify that
a taxpayer may recognize a loss on a component of a unit of property that is §1245 property if the taxpayer
consistently treats the component as a separate asset for disposition purposes. What the taxpayer has done to
date matters; asset groups, cost segregation and depreciation choices.
Example: a taxpayer owns a walk-in freezer. When several components of the freezer cease to function, they
“abandon” them and recognize a loss equal to the adjusted depreciable basis of the components because it
properly treats the components as assets. The taxpayer then spends $2,500 to purchase and install new
components. Since they replace components it is properly deducted as a loss, and must capitalize the $2,500
replacement cost. The result is the same if the taxpayer sells the used components at a gain or loss (Temp. Reg.
§1.263(a)3(i)(5), Exs.(1) and (2)).
Comment: If the freezer was placed in a MACRS general asset account (GAA), the taxpayer could choose not to
recognize the loss. They could then claim a repair deduction if the expenditures did not have to be capitalized for
a reason other than claiming a loss deduction.
Comment: If the taxpayer claims a loss deduction they must compute the basis of the replaced components using
any “reasonable method”.
The manner in which the appropriate basis of the replaced component is determined is based on facts and
circumstances and must enlist a consistent “reasonable method”. Cost Segregation is relevant and needed. Cost
Segregation is still important for other issues as well, such as the ability to depreciate different classes.
What is any “Reasonable Method” ?
- Cost Segregation
- Original costs broken out on depreciation schedule, when original building(s) was built.
- Taxpayer purchased the building from a prior taxpayer who had either one of the above.
Requirement To Capitalize Amounts Paid For Improvements
Paragraph §1.263(a)3(d) states: a unit of property is improved if the amounts paid for activities performed after
the property is place in service by the taxpayer:
- Result in a betterment to the unit of property (see paragraph (h) of the sections);
- Restore the unit of property (see paragraph (i) of this section); or
- Adapt the unit of property to a new or different use (see paragraph (j) of this section)
So, based on the unit of property, if an expenditure results in a betterment, a restoration or an adaptation for
different use, it must be capitalized because it is an “improvement”. There are of course, special applications of
Possibly, one of the more significant parts of these regulations is §1.263(a)3(o) states:
An expenditure that is considered for betterment, restoration or adaption (for new or different use of the unit of
property) will be treated as an improvement and therefore a capitalized cost, after the appropriate unit of
property is identified.
Capitalization of Betterments – Temporary regulation §1.263(a)3(h) outlines what constitutes a betterment of a
unit of property. It is something that ameliorates a material condition, results in a material addition or increases
its capacity. It is a facts and circumstances test. Correction of normal wear and tear is normally not a betterment.
Capitalization of Restorations – Temporary regulation §1.263(a)3(i) outlines what it means to restore a unit of
property. The words “replacement”, “repair” and “rebuilding” are used to describe the meaning of the term
restore. The exciting concept of this temporary reg. applies in situations where the capitalization of the
restoration cost is required. The taxpayer may now write-off the “old” asset being restored. The write-off of
retired assets is detailed in the §167/168 temporary regulations and discussed above.
Capitalization of Adaption Amounts to a new or different use – Temporary regulation §1.263(a)3(j) indicates a
use is new or different if it is not consistent with the taxpayer’s intended ordinary use of the unit of property at
the time originally place in service by the taxpayer.
Accounting method changes – A change to comply with this section is a change in method of accounting to which
the provisions of §446 and §481, and therefore the regulations apply. A taxpayer seeking to change to a method
of accounting permitted in this section must secure the consent of the Commission in accordance with §1.446-
1(e) and follow the administrative procedures issued under §1.446-1(e)(3)(ii) for obtaining the Commissioner’s
consent to change its accounting method.
So, in general, not only is the taxpayer required to follow the terms of §1.263(a)-3 on a prospective basis, they
are also required in most cases, to calculate a §481 adjustment (and take it into account) as if they had always
been following §1.263(a)-3. This might be one of the most difficult provisions of the temporary regulations.
BUT….in order to calculate the §481 adjustment for a building owned for many years, taxpayers are likely required
to evaluate all expenditures over the entire period of ownership to calculate the correct amount. Depending on
the facts, the §481 adjustment could be positive or negative. Negative is absorbed in one year of its deduction
for the taxpayer. Positive can be spread out over 4 years of its income. The time involved in evaluating long held
assets could be significant.
These temporary regulations are complicated and include many other provisions including; routine maintenance
and leasehold improvements. The purpose of this brief article is introductory and intended to encourage dialogue
regarding particular taxpayer situations. Please consult your tax professional for direction and questions.
According to a recent article in the AICPA’s Journal of Accountancy,
“Selecting a firm that uses qualified professionals with years of significant, relevant experience can be an important differentiator in the quality of a cost segregation study.”
Journal of Accountancy
© From the AICPA