A Few Reminders Regarding the Tangible Property Regulations

Two years ago, taxpayers and preparers had to deal with the implementation of the Treasury Department’s final regulations regarding deducting repairs, capitalizing improvements, and depreciating and disposing of tangible property.  The regulations were and remain complex and in many instances, go contrary to the natural inclinations of accountants.  Some of the pro-taxpayer provisions of the regulations require an annual election and should be considered each year for tax planning purposes.  Here is a checklist of some of these provisions:

1.      De Minimis Safe Harbor.  This annual election statement must be made in a statement attached to a timely filed (including extensions) income tax return.  The election enables a taxpayer to deduct the purchase of any unit of property costing $2,500 or less pursuant to the taxpayer’s accounting policy.  The accounting policy should be in writing (although not technically required at the $2,500 level) by the start of the tax year.  For the election to be effective, purchases covered by the policy must also be expensed in the financial accounting records and statements (book conformity).

a.      The policy doesn’t need to be set as high as $2,500, it just can’t exceed this amount and remain in the “safe harbor.”  Because of the impact on book income, some businesses choose to set the policy at a lower amount, such as $1,000 for example.

b.     For taxpayers having an “applicable financial statement (AFS),” the threshold is $5,000.  The accounting policy for an AFS must be written.  An AFS is a financial statement that is provided to the SEC, or has been audited by an independent CPA, or is otherwise required to be provided to the government (excluding tax returns).

2.      Partial Asset Disposition.  This annual election must be made in a timely filed (including extensions) income tax return.  The election enables a taxpayer to deduct the adjusted tax basis (net tax book value) on the disposition of a portion of an asset.  The election is not made with a statement, rather it is made by deducting the adjusted basis.  In addition, the replacement asset must be classified in the same depreciable asset class as the disposed portion of the underlying asset.  Examples of partial dispositions for a building include replacing a roof and removing old tenant improvements to accommodate a new tenant.

a.      When it is impractical to determine the cost of the disposed portion of an asset, a reasonable method may be used to estimate the cost.  The regulations give three examples of reasonable methods:

                                                              i.      If the replacement asset is part of an overall “restoration” (and isn’t a “betterment” or an “adaptation”) of the underlying asset, the cost of the partial disposition may be estimated by deflating the cost of the replacement asset by the producer price index back to the year the disposed portion of the asset was originally placed in service.

                                                            ii.      The cost of the partial disposition may be estimated by prorating the cost of the underlying asset by dividing the cost of the replacement asset by the total estimated replacement cost of the entire underlying asset.

                                                          iii.      The cost of the partial disposition may be estimated by means of a cost segregation study.

3.      Capitalize and Depreciate Repairs and Maintenance Costs.  This annual election statement must be made in a timely filed (including extensions) income tax return.  This election appears to be applicable only to “trade or business” assets and not to property held for the production of income (e.g. real estate rental).  A taxpayer might consider this election if they have expiring tax loss carryovers or if the taxpayer does not want to deal with potential IRS audits over the subjective nature of whether an expenditure qualifies as a deductible repair or should be capitalized as an improvement.  A “book conformity” rule requires the costs be capitalized in the taxpayer’s financial books and records.  This requirement can be problematic for taxpayers using generally accepted accounting principles which require expensing of repairs.

4.      Routine Maintenance Safe Harbor.  Although not an election statement to be included with the tax return, a taxpayer should create a written maintenance plan for each significant asset acquired during the year.  If the plan indicates that the taxpayer reasonably expects to perform repairs and maintenance more than once during the asset’s depreciable life (as determined under the alternate depreciation system), then the IRS should accept the deduction of routine maintenance and repair expenses.  For real property, the time frame for conducting repairs and maintenance more than once in the written maintenance plan is 10 years.  The election to capitalize and depreciate repairs and maintenance costs will override the routine maintenance safe harbor.

5.      Small Taxpayer Safe Harbor for Real Estate.  This annual election statement must be made in a timely filed (including extensions) income tax return.  The election permits qualifying small taxpayers to deduct repairs, maintenance, and improvements without having to separately analyze the eight different building systems for purposes of deciding whether an expenditure must be capitalized or deducted.

a.      A small taxpayer has average annual gross receipts of $10 million or less for the three preceding tax years and

b.     Total repairs, maintenance, and improvement costs do not exceed the lesser of $10,000 or 2% of the unadjusted cost of the building.

                                                              i.      This limit applies to each building separately.

                                                            ii.      The building’s cost must be $1 million or less.  If the taxpayer leases the building, then the total undiscounted lease payments for the entire term of the lease, including renewals, are summed for this purpose.

                                                          iii.      Counted against the $10,000/2% limit are costs expensed under the de minimis safe harbor and the routine maintenance safe harbor.

                                                          iv.      If costs exceed the $10,000/2% threshold for a building, then the election is unavailable and regular rules apply to all the building’s repairs, maintenance, or improvements.

6.      Capitalize and Depreciate Rotable Spare Parts.  The taxpayer may elect in a timely filed (including extensions) income tax return to treat any rotable, temporary, and standby emergency spare parts acquired during the year as depreciable property rather than treating the parts as materials and supplies (M&S).  If spare parts are treated as M&S, their cost generally cannot be deducted until disposition.  The election is made on an asset-by-asset basis and once made, may not be revoked without IRS permission.  The election is made by depreciating the spare parts, there is no election statement.