Taxes and Capitalization of tangible assets – Part III

New proposed regs address complex issue capitalization of tangible assets Part III

Mike Habib, EA
myIRSTaxRelief.com
IRS has issued new comprehensive proposed regs on when amounts are treated as paid to acquire, produce, or improve tangible property. They replace controversial proposed regs that were issued on the same subject in 2006 and that IRS has now withdrawn. The new proposed regs would be effective for tax years beginning on or after the date that they are finalized.

Since the beginning of the week, we have included a series of articles on the topic. This article, the third in the series, explains how the proposed regs would differentiate between currently deductible repairs and improvement or betterments to property that have to be capitalized. For how the proposes regs would define materials and supplies that are deductible under Code Sec. 162, and prescribe new rules for when the deduction for these items may be claimed, see Part I . For how the proposed regs would treat amounts related to the acquisition or production of real or personal property, see Part II.

    Observation: The regs would make several significant liberalizations by doing away with the so-called “restoration principle” and putting in place a new routine maintenance safe harbor. They also attempt to reflect the large body of case law on repairs vs. improvements and adopt all-encompassing guidelines where none existed before. However, the regs if adopted nonetheless may be difficult to apply to a particular taxpayer’s facts and circumstances, as evidenced by the plethora of examples, many on them complex, that attempt to illustrate how the regs would affect “typical” capital and non-capital expenditures.

Out with the plan of rehabilitation doctrine. Under the judicially developed plan of rehabilitation doctrine, a taxpayer must capitalize otherwise deductible repair costs if they are incurred as part of a general plan of renovation or rehabilitation. The new proposed regs would specifically provide that repairs made at the same time as an improvement, but that do not directly benefit or are not incurred by reason of the improvement, don’t have to be capitalized under Code Sec. 263(a) . However, a taxpayer would have to capitalize under Code Sec. 263A otherwise deductible repair costs if the taxpayer improves a unit of property and the otherwise deductible repair costs directly benefit or are incurred by reason of the improvement to the property. (Prop Reg § 1.263(a)-3(d)(4)) The preamble adds that when the proposed regs are finalized, the judicially-created plan of rehabilitation doctrine will be obsolete, particularly with regard to the assertion that the doctrine transforms otherwise deductible repair costs into capital improvement costs solely because the repairs are performed at the same time as an improvement, or are pursuant to a maintenance plan, even though the repairs do not improve the property. (Preamble to Prop Reg 03/07/2008)

    Observation: Exs. 8 and 9 of Prop Reg § 1.263(a)-3(g)(4) illustrate how this rule is easier to state than to apply. In these examples, a company that owns a fleet of petroleum hauling trucks decides to replace the existing engine, cab, and petroleum tank of a truck with new components. All of these costs would have to be capitalized under the restoration rule, explained below. If the company decided to paint the truck cab and replace a broken tail-light (both deductible repairs if made separately) at the same time that the new components are installed, it would have to capitalize the painting cost (treated as an expense that directly benefits or is incurred by reason of the truck restoration), but it could currently deduct the cost of repairing the broken tail-light (treated as an expense that does not directly benefit and is not incurred by reason of the truck restoration).

Routine maintenance safe harbor. Under this new safe harbor, the cost of routine maintenance performed on a unit of property (see Part I) would be treated as not improving that unit of property (and therefore would be currently deductible). Routine maintenance would be the recurring activities that a taxpayer expects to perform as a result of its use of the unit of property to keep it in its ordinarily efficient operating condition. Examples: inspection, cleaning, and testing; and the replacement of parts of the unit of property with comparable and commercially available and reasonable replacement parts. Amounts paid for routine maintenance would include routine maintenance performed on (and with regard to) rotable and temporary spare parts (see Part I for the timing of the deduction for such parts).

The safe harbor would apply only if, at the time the unit of property is placed in service by the taxpayer, the taxpayer reasonably expects to perform the activities more than once during the class life (under the Code Sec. 168 alternative depreciation rules) of the unit of property.

Whether an expense is “routine maintenance” would depend on factors such as the recurring nature of the activity, industry practice, manufacturers’ recommendations, the taxpayer’s experience, and the taxpayer’s treatment of the activity on its applicable financial statement (AFS), such as one required to be filed with the Securities and Exchange Commission). (Prop Reg § 1.263(a)-3(e))

However, routine maintenance wouldn’t include amounts paid:

  • to replace a component of a unit of property where the taxpayer has (1) properly deducted a loss for that component (other than a casualty loss under Reg. § 1.165-7) or (2) properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
  • to replace a component of a unit of property if the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
  • to repair damage to a unit of property for which the taxpayer has taken a basis adjustment as a result of a casualty loss or casualty event under Code Sec. 165; and
  • to return a unit of property to its former ordinarily efficient operating condition, if the property has deteriorated to a state of disrepair and is no longer functional for its intended use. (Prop Reg § 1.263(a)-3(e)(2))

Capitalizing betterment costs. Taxpayers would have to capitalize betterment costs, a new term that consists of amounts paid:

  • to ameliorate a material condition or defect that either existed before the taxpayer acquired the unit of property or arose during its production, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production;
  • that results in a material addition (including a physical enlargement, expansion, or extension) to the unit of property; or
  • that results in a material increase in capacity (including additional cubic or square space), productivity, efficiency, strength, or quality of the unit of property or the output of the unit of property. (Prop Reg § 1.263(a)-3(f)(1))

The question of whether an expense results in a betterment would be determined based on the facts and circumstances, including: the purpose of the expense; the physical nature of the work performed; the effect of the expense on the unit of property; and the taxpayer’s treatment of the expense on its AFS. If a part can’t be replaced with the same part (e.g., due to technological advancements or product enhancements), replacing it with an improved but comparable part wouldn’t by itself, result in a betterment. In general, the appropriate comparison for determining whether an amount paid results in a betterment would be made by comparing the condition of the unit of property immediately after the expense with the condition of the property before the circumstances necessitating the expense. (Prop Reg § 1.263(a)-3(f)(2))

    Observation: Exs. 9 through 11 of Prop Reg § 1.263(a)-3(f)(3), illustrate how difficult it would be to apply these rules, even in straightforward situations. These examples involve a small retail shop that suffers storm damage to some of its roof shingles. Redoing the entire roof with wood shingles wouldn’t have to be capitalized as a betterment to the shop, and neither would redoing the entire roof with asbestos shingles if wood shingles became unavailable. However, redoing the entire roof with shingles made of a lightweight, composite material that’s maintenance free, non-absorptive, has a 50year life and a Class A fire rating, would have to be capitalized as a betterment to the shop.

Capitalizing restoration costs. Restoration costs, which would have to be capitalized, would be amounts paid to:

  • replace a component of a unit of property where the taxpayer has (1) properly deducted a loss for that component (other than a casualty loss under Reg. § 1.165-7 ) or (2) properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
  • repair damage to a unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss or casualty event under Code Sec. 165;
  • return the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;
  • result in the rebuilding of the unit of property to a like-new condition after the end of its economic useful life (the time it may reasonably be expected to be useful to the taxpayer); or
  • replace a major component or a substantial structural part of the unit of property (but this wouldn’t apply if the amount is paid during the property’s MACRS recovery period under Code Sec. 168(c)). (Prop Reg § 1.263(a)-3(g)(1))

The replacement of a major component or substantial structural part would be deemed to occur only if (a) the replacement costs are 50% or more of the replacement cost of the unit of property or (b) the replacement part or parts are 50% or more of the physical structure of the unit of property. (Prop Reg § 1.263(a)-3(g)(3)) These 50% thresholds would apply solely for purposes of the restoration rules (as opposed to the betterment or new or different use rules). (Preamble to Prop Reg 03/07/2008)

Capitalizing amounts to adapt property to a new or different use. Under this rule, the cost of adapting a unit of property to a new or different use would have to be capitalized. In general, a “new or different use” would mean a situation where the adaptation isn’t consistent with the taxpayer’s intended use of the property when he placed it in service. (Prop Reg § 1.263(a)-3(h)) For example, if the owner of a building consisting of 20 retail spaces converts three spaces into one larger space for an existing tenant by knocking down walls, the cost of the conversion wouldn’t be treated as a new or different use because the combination of spaces is consistent with the owner’s intended, ordinary use of the building. (Prop Reg § 1.263(a)-3(h)(2), Ex. 2)

Accounting method changes. Generally, a taxpayer’s treatment of an amount paid to conform with the new proposed regs (e.g., a change to the routine maintenance safe harbor) would be a change in method of accounting under Code Sec. 446(e). (Preamble to Prop Reg 03/07/2008)