In late December 2011, the Internal Revenue Service (“IRS”) issued new regulations that have come to be known as the “repair and maintenance regulations”. Later, in March of 2012, the IRS issued procedural guidance for taxpayers to follow in complying with the new regulations.
Despite the name, the new regulations don’t just cover “repairs”. The reach of the regulations is actually much broader and cover the treatment of any expenditure related to all types of tangible property. The impact of the regulations transcends industry type and taxpayer size. They apply to nearly every business that owns or leases real estate, equipment, or any other type of tangible property.
The regulations are generally effective for taxable years beginning on or after January 1, 2012. The regulations were issued in both temporary and proposed format. This means that while the regulations could change before they are issued in final form, these regulations are currently the law of the land, and taxpayers must take steps to comply for the 2012 tax year.
With respect to improvements to tangible property, the regulations require taxpayers to perform a facts and circumstances analysis to determine whether an expense should either be capitalized and recovered through depreciation deductions in current and future tax years, or deducted in the current period. This analysis is required to be performed at the “unit of property” level as defined in the regulations. The regulations generally require an improvement expense to be capitalized if the improvement resulted in “a betterment”, “a restoration”, or an “an adaptation” of a unit of property, as each term is defined in the regulations.
The Current Opportunity
In the new regulations, the IRS has effectively changed the rules of the game in the improvement analysis as it applies to buildings. In the past, a building and its structural components constituted a single unit of property. The new regulations instead identify eight specific building systems (HVAC, plumbing, electrical, escalators, elevators, fire protection, security, and gas distribution), and in a departure from previous law and precedent, require that the improvement versus repair determination be made first at the building structural level and then at the separate building systems level.
This change is generally not a taxpayer-friendly development for taxpayers. As the improvement test is applied at a smaller level, it is more likely that an expense will have to be capitalized, delaying the deduction for the expenditure to future tax years and increasing current taxable income.
In contrast to this unfavorable change, this new building systems approach, along with revised disposition rules in the new regulations, create a new opportunity that taxpayers should be aware of. Under the new regulations, taxpayers are now able to recognize a loss on the disposition of a structural component of a building. This is a welcome change which wasn’t available under prior law.
In the past, for example, when a taxpayer replaced the roof of a building, the taxpayer generally had to capitalize the cost of the new roof. As a structural component of a building, the cost of the roof would be depreciated for tax purposes on a straight-line basis over a 39 year period. The cost of the old roof was typically buried in the original cost of the building and would continue to be recovered over the remaining recovery period of the building. In fact, it is common for a taxpayer to essentially have two or more of the same structural component (roofs, HVAC systems, etc.) being depreciated over lengthy recovery periods.
In the above situation, taxpayers now have the option of recognizing a loss on the disposition of the old roof. In determining the adjusted depreciable basis of the disposed component, the new regulations allow the taxpayer to determine the original cost of the component using “any reasonable method”.
The transition guidance from the IRS which came out in March of 2012 expanded this opportunity by allowing taxpayers to recognize losses in the current tax year (beginning in calendar year 2012) for prior dispositions of structural components that occurred in previous tax years. To take advantage of this opportunity, the taxpayer is required to file an application for a change in accounting method. Permission from the IRS to make the change and to claim the deduction in the current tax year is automatic as long as the taxpayer follows the procedures set out in the transition guidance.
If the taxpayer doesn’t want to expend the cost and effort required to determine the allocable basis for a component, or otherwise does not want to separately track dispositions of structural components, the new regulations allow the taxpayer to elect “general asset account” treatment. The substantially modified general asset account rules allow the taxpayer to choose not to recognize a loss on a disposition of a structural component and to continue depreciating the original basis of the property. The transition guidance provides procedures by which general asset account treatment can be elected retroactively for assets placed in service in prior tax years.
For certain taxpayers who have a substantial investment in buildings, we believe the new regulations have created an exciting opportunity to generate current year 2012 tax losses for roofs, HVAC systems, and other structural components which were disposed of in previous tax years.
Apart from this opportunity, as previously mentioned, the scope of the regulations is very broad, and many taxpayers need to adjust their accounting and capitalization policies in order to comply with the new regulations.
We strongly recommend that you contact a MCM tax professional soon who can assist you in dealing with the challenges and the opportunities these new regulations provide.