Understanding Capitalization Regulations in Taxation
This document delves into the intricate world of capitalization regulations in taxation, covering topics such as safe harbors, routine maintenance, small taxpayers, partial disposition elections, and more. It discusses the evolution of the 263 regulations, changes in methods of accounting, and the challenges faced by taxpayers in complying with these standards. The content provides insights into the background, history, and reasons behind the new 263 regulations, offering clarity on the standards and their application to tangible personal property expenditures.
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Capitalization Regulations To Infinity and Beyond! Cameron L. Hess, CPA, Esq. Wagner Kirkman Blaine Klomparens & Youmans LLP Sacramento Walnut Creek chess@wkblaw.com (916) 920-5286
Items You Must Know Unit of Property Building Systems Safe Harbors De Minimis Election f election Routine Maintenance Small Taxpayers Expenditures (h) election Partial disposition election Rev. Proc. 2015-20 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 2
Items You Must Know [E]xcept as otherwise stated, a change to comply with the final regulations is a change in method of accounting to which the provisions of sections 446 and 481 and the accompanying regulations apply. (Preamble to TD 9636 Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Personal Property) 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 3
Evolution of 263 Regs History: 01/20/04. Announcement 08/21/06. 1st Proposed Regs 03/10/08. 2nd Proposed Regs 12/23/11. Temporary Regulations 9/19/2013. Final Regs. (2103-13 IRB 331) 64 pages, including preamble. More examples 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 4
Evolution of 263 Regs History: Rev. Proc. 2015-14, mandatorya no fee Form 3115 for new capitalization/repair regulations Rev. Proc. 2015-20, 2015-9 IRB 694. No Form 3115 ( non-filing option) for qualified small taxpayers No Safe Harbor Protection 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 5
Evolution of 263 Regs History: Warning Final Regs don t tell the whole story Concepts hidden in prior Proposed Regs. Casualty Loss issue Exploration of Continuing Rev. Procs History of 50% replacement rule tossed. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 6
New 263 Regs Why Change? IRS: The standards for Section 263 are difficult to discern and apply considerable uncertainty and controversy for taxpayers. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 7
Background Final Regs. Effective: Applies: Can elect retroactively some provisions Simplifies some objective standards Clarifies subjective standards (friendlier) 09/19/2013 1/1/14 (tax years beginning on/after) 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 8
Still Unchanged Some Basic Principles Unchanged (1.263(a)-1) Capitalize Improvements (263(a)) = Betterment Restoration New use Incidental repair/maint not an improvement (162) 263A applies to inventory and self-produced property. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 9
Still Unchanged Improvement = Betterment fixes, adds, increases capacity Restoration replaces item of loss (165) replaces item sold restores item nonfunctional rebuilds to like-new @ life end replaces a major component New Use adapts for a different use 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 10
Final 263 Regulations - Overview New Concepts (1.263(a)-3): Unit of Property Major Component (MP) (significant importance and value is material) Substantial Structural Part (SSP) (large) 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 11
Unit of Property - Overview Unit of Property - *** New A Unit = all parts functionally interdependent. Example: electric lathe + dedicated computer = 1 Unit. Real Property (2 types): Owner: = Whole Building + Its structural components Lessee: = Leased Unit improvement = primary components of building. (building broken into distinct parts, e.g., roof structure) 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 12
Final 263 Regulations - Overview Replacing a Major Component (MP) or Substantial Structural Part (SSP) usually means capitalization. But it is based on facts & circumstances. One may argue it s not betterment, restoration, like new. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 13
Improvement - Overview Improvements (real/personal) - includes = Major replacements . 2008 (proposed) - > 50 % cost test (cap vs deduct). 2008 Tossed (claims practitioners complained) Temp/Final Regs: Facts & Circumstances: quantitative and qualitative significance of the part or combination of parts in relation to the unit of property. Means we don t know - Subjective 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 14
Improvement - Overview Major Replacement includes (no surprise) Major Component (1.263-3(k)(6)(A)) Part performs a UOP critical function Substantial Structural Part (-3(k)(6)(B)) Major Replacement involves A large or critical part of the Unit of Property Facts & Circumstance Approach 36 examples replacement is capitalized or expensed. About 75 examples overall (all areas). 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 15
Unit of Property - Building Real Property - Buildings Replacements that are (i) an improvement to (ii) a building component or building system must be capitalized. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 16
Not Improvements Safe Harbors De Minimis Safe Harbor ( f ) election Routine Maintenance (1.263(a)-3(i)) Small Taxpayer Expenditures ( h ) election 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 17
New De Minimis Rule De Minimis Election 1.263(a)-1(f): Optional Annual election: if elect, covers year s purchases Be consistent (financial statements/books) Apply items on invoice-by-invoice basis. Not for inventory, land, rotables 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 18
New De Minimis Rule Election Statement: Section 1.263(a)-1(f) DeMinimis Safe Harbor Election Taxpayer Name Address Taxpayer Identification # Taxpayer is making the de minimis safe harbor election under 1.263(a)-1(f) 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 19
New De Minimis Rule Two Types: AFS applicable financial statement = FS for SEC, gov t agency, general audit (attest) $5,000 limit Witten accounting policy at beginning of year required No AFS $500 limit ($200 materials/supplies) Taxpayer must adopt a policy , but it need not be written 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 20
New De Minimis Rule AFS May deduct item if 1) Useful life = < 1 year; or 2) Cost </= X (written policy), n.t.e. $5,000/item. On each invoice, add integrated items (parts and installation) E.g., cannot buy a car, but itemize it as engine -$2,000, 4 seats 1,000, body - $3,000, tires - $800, A/C - $100. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 21
New De Minimis Rule Everybody Else (No AFS) Meet Basic requirements Procedure in place 1/1/xx (need not be written) Item </= $500.00 For capital items. (Same rule to add on separate invoice cost items that integrate to one unit) $200.00 for materials and supplies Tossed: Material Distortion Test in Temp Regs. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 22
New De Minimis Rule Warning: Later re-sale = 1245 property Example (no AFS): 1. All these are deductible: $2,500 for 10 printers (250.00 each). $4,000 for Conference room - $600 to designer, $400 table, 10 chairs - $300 each. (Split up designer fee). 10 hand held restaurant POS-$300 each; 3 tablets-$500 each 2. This must be capitalized: 10 computers/ tablets@ $600.00 each. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 23
New De Minimis Rule Note: No 3115 for (f) election: 1.263-1 Except for (f) a change to comply is a change in method of accounting .A taxpayer must secure...consent 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 24
Not Improvements Safe Harbors Routine Maintenance (1.263(a)-3(i)) Do more than once every 10 years. Escalator hand rails (4/yrs), HVAC maint. (4./yrs) (repl. condenser). Allowable for rotables. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 25
Fun Test: Routine Maintenace Raj Wolowitz Apartments. Owner forgot to certify his elevator. It has not been working for 3 years. Maintenance is usually in 3 year cycles. Sheldon Cooper complains to Penny, his manager. She gets Raj to do maintenance for $1,100 and to pay a $100 inspection fee. According Example 12, the $1,100 paid probably is: a) deductible (repair) or b) capitalized. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 26
Not Improvements Safe Harbors Small taxpayers expenditures (1.263(a)-3(h) Ave Gross Receipts < $10 Million (See Rev. Proc. 2002-28) Un adjusted basis </= $1 million Total repair/improvements = lesser of: 2% of unadjusted basis $10,000/building All repairs/improvements lumped in for $10K limit 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 27
Not Improvements Safe Harbors $10 Million Ave Gross Receipts Limit All sources Can deduct returns & allowances Can exclude sales tax (if buyer imposed) CA. 3 Prior Year (shorter if < 3 years operating) Annual election If elect, but exceeds > $10K, only disqualified for that building 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 28
Not Improvements Safe Harbors Form of Election: Section 1.263(a)-3(h) Safe Harbor Election for Qualified Small Taxpayers. Taxpayer s Name Address Identification Number Identify Each Building While not required by regulations add: Taxpayer is making the 1.263(a)-3(h) safe harbor election for qualified small taxpayers. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 29
Partial Disposition Election 1.168(i)-8(d). If capitalize an improvement, then taxpayer may election to write-off part of existing asset disposed of. Example: Remodel pool in 2012 pipe breaks, must do 2nd remodel in 2015. No form of election required: Just do it. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 30
Unit of Property - Building Buildings: IRS Takes Split Approach Whole Building: Systems = parts of buildings). Identify 9 common systems in buildings Systems are NOT a Unit of Property; but decide capital improvement at a systems level. Tenant: Tenant s Unit 1 Unit (unless divisions) Condo/Co-op: (Each Unit = 1 Unit) 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 31
Unit of Property - Building Building systems (examples): HVAC (heat, ventilation, and A.C.); Plumbing electrical systems; Escalators and elevators; fire protection, alarm, security systems; gas distribution systems; and other systems identified in published guidance. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 32
Unit of Property - Building Building systems Capitalize or Deduct Facts & Circumstances Approach No safe harbor Lots of examples provided to illustrate 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 33
Learning by Example Betterments Equipment If purchase and intend to fix. Tractor needing new motor Betterment Building (paper towel; refresh) Clean up environmental after purchase Building purchased below standard , then repaired Expand/improve in addition to a refresh . Abandon at loss; later restoration (casualty not req d) 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 34
Examples Betterments Major Component Gas Stations. New tanks have leak detection. Sprinkler System. New fire system 100% Remodel. All hotel bathrooms over 4 years (including furnishing replaced). All flooring of public areas of hotel. (b/c not refreshment) 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 35
Examples Not Betterments Equipment ( caps ) Relocation & reinstall (moved) Reconditioning to meet regulations (not restored) [new smog system] Not Betterments Building ( caps ) New mandated reg. Earthquake retrofit Safety. Oil seeping in from outside; fix to avoid health code closure. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 36
Test Your Knowledge (Real Story) PTSD Property Mang t, Inc. s owner puts 82-year old Dad to work. Dad attends seminar on soft understructure apartments . As a favor every apartment owner (about 100) receives a free quote - ($6,500) by an engineer/friend (lots of pictures of owner s building) and 12 newspaper articles. Letter says: You may be next. Act now to save $$. One Tenant got $2 million. County may soon set ordinances; costs will rise. Dad estimates that + $6,500, $100,000-$200,000 per building. Dad says I m just trying to help you. Question: To try to claim a deduction, does it make a different if owner acts now or waits for an ordinance to pass. (1.263(a)-3(j)(3),Example 12) Question: If building collapses, next EQ, is owner liable? 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 37
Examples Not Betterments Replace 100 of 300 damaged exterior windows Replace 4 of 10 old sinks (40%) Replace Top Layer of Roof M = Owner, replaces entire membrane (top layer). Remove drop ceiling paint exposed ducts. Replace 2 of 10 roof-top worn HVAC systems, even if better! 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 38
Examples Building Systems Betterment! (Surgery) Blown insulation into walls to improve efficiency Add in a new drive-through window Electrical load capacity upgrade Add stairs and mezzanine to make a 2nd floor. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 39
Leased Buildings Leased buildings Unit of Property. It is Both: Owner: the whole building and Lessee: each separate leased unit LH Improvements Capitalize whether as owner or tenant paid. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 40
Condos/Co-ops Condominiums/Coops Unit of Property. For the owner the unit owned and the structural components of the unit the portion possessed by the coop owner and the structural components of the unit possessed. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 41
Fun Problems The roof leaks. Out of 10 units, 3 are most affected. Just over the 3 units is membrane and 12 sheets of plywood are replaced. Is this a repair? Is this an improvement? Tsakapoulous. Would the result be different if the whole membrane was replaced, but not the plywood? 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 42
Fun Problems A s office building (leased) has: 10 A/C Units, each separately piped. How many HVAC systems are there? i) 1 or ii) 10. 1.263(a)-3(e)(2)(ii)(v)(B)(6), Example 1 2 banks of 3 lifts (6 total) and two escalators How many systems are there: i) 1, ii) 2, iii) 3, iii) 7, iv) 8 Example 2 Tenant leases 2 Units, each w/ separate A/Cs How many systems does tenant have: i) 1 or ii) 2. Example 13 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 43
Wait!: Before Covering More: Rev. Proc. 2015-14 New law is an accounting method change File Form 3115 Section 481 adjustments required. Rev. Proc. 2015- 20 (non-safe harbor) No Form 3115 Beginning Assets < $10 Million or Qualified small taxpayers (Ave Gross Receipts < $10 Mil) No audit protection for prior years 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 44
Acquisitions (1.263-2) No surprises in basics Must Capitalize Before Start Operations: Pre-commencement repairs Installation and pre-operational testing Facilitative costs Transport, secure, negotiate, costs to acquire, costs to examine, fees, studies, intermediary Optional may (not required to) capitalize employee payroll to facilitate acquisition 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 45
Purchases/Acquisition Costs 1.263(a)-2. Basic Rule: Capitalize: purchases, build or create an improvement Pre-development (builder rights/permits) Repairs before placed in service Acquisition costs (broker/attorney fees) Defend/protect title Need not capitalize: Cost to relocate (remove and reinstall). Failed acquisition Not related fight ordinance that would close business 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 46
Purchases/Acquisition What is adapting to a different use? 1.263(a)-3(l)(2) Pg. 57,752 Example 2 - Commercial retail building Removable walls Convert 3 lease spaces into 1 rental unit May deduct conversion, not a new or different use Example 3 Prep building for sale re-paint, refinish floors May deduct expenses 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 47
Improvement (263 Regs) What is new or different use? Example 4: Toxic land Prep for sale pre-existing contamination, when bought contamination that owner created Land contaminated, no longer in use; trying to sell Clean up to sell to developer for houses (Aerojet) Grade land IRS: Clean up to restore not an improvement deductible; but capitalize grading of land because adapts land for different use. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 48
Cams Rules (silly rules that work) Environmental (Paper Towel Theory). Wiping up the prior owner s mess is a betterment; therefore, just clean up your own mess. Significant deferred maintenance eliminated Environmental clean up Buy proximate to scheduled maintenance Not, clean your own or blocking some one else s mess. Freshen Up. A bit of evening make-up is deductible But, major surgery is probably a betterment. 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 49
Not Changed Section 263A Capitalization for property produced by taxpayer Real or personal property (e.g., costs to perfect title) Capitalization of property acquired for resale Section 162 Materials & supplies (under 1.163-3) 8/23/2016 WKBK&Y 1066733 C. Hess 916-920-5286 50
