Recent Repair vs. Capitalization Regulations
The Internal Revenue Service issued temporary regulations in late 2011 regarding the treatment of expenditures incurred in selling, acquiring, producing or improving tangible assets. The temporary regulations are generally effective for tax years beginning on or after January 1, 2012.
Repair versus Capital Improvement
The regulations provide guidance as to whether costs related to tangible property are currently deductible repairs or capital improvements that are deducted over a period of years. The repairs expense versus capitalization issue is a timing issue, however, if the expenditure has to be capitalized and deducted over a period of years (up to 39 years), the time value of the tax savings/cost could be significant.
The regulations provide that a unit of property is improved if the amount paid or activities performed after the property is placed in service by the taxpayer (1) results in a betterment of the unit of property; (2) restores the unit of property; or (3) adapts the unit to a new or different use.
The temporary regulations treat the unit of property for a building as the building and its structural components (walls, partitions, floors, windows and doors, etc.). However, in determining whether an amount paid is for an improvement to a building, the temporary regulations require the taxpayer to consider the effect of the expenditure on certain significant and specifically defined components of the building instead of the building and its structural components as a whole.
As a result, a taxpayer will be required to capitalize a cost that results in an improvement to the building structure (building and its structural components) or any of the specifically enumerated building systems: (1) HVAC system; (2) plumbing system; (3) electrical system; (4) all escalators; (5) all elevators; (6) fire protection and alarm systems; (7) security systems; and (8) gas distribution systems.
The regulations provide numerous examples, but no two improvements are the same. The examples can be used as guidance, but each improvement needs to be examined on its on facts and circumstances for a determination of repair versus capitalization.
If it is determined that the expenditure must be capitalized, it is does not mean that the improvement must be deducted over 39 years. The temporary regulations do not change the rules for depreciable lives, bonus depreciation, or availability of cost segregation studies to take advantage of shorter depreciable lives.
Disposition of Structural Component
Prior to 2012, in the case of buildings, 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. For example, if a taxpayer capitalized the costs of replacing an entire roof 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 a disposition of property.
Change of Accounting Method
Most taxpayers will need to change their method of accounting to comply with the new regulations. The IRS has indicated that they will issue revenue procedures that provide transition rules for taxpayers changing their method of accounting. The regulations require that taxpayers make Code Section 481(a) adjustments to prevent duplicated or omitted tax benefits. Taxpayers will in effect have to apply the new rules to costs incurred prior to the effective date of the regulations.
As a result, some taxpayers may have to capitalize amounts they previously deducted, and recognize income based on the difference in treatment. Conversely, other taxpayers may be able to deduct amounts previously capitalized, and take a deduction for the difference.