February 12, 2015
Real Estate Industry Particularly Affected by New IRS Repair, Capitalization and Disposition Regulations
New York City, NY - New IRS rules for the capitalization of expenditures relating to tangible property have particular ramifications for the real estate industry, according to Michael D'Addio, a Tax & Business Services Partner with Marcum LLP, a top accounting and advisory firm with a national real estate practice. The regulations impose significant compliance burdens upon business taxpayers, but also provide many tax opportunities, Mr. D'Addio says.
The new tangible property regulations provide guidance on the capitalization and depreciation of expenditures, treatment of materials and supplies, and deductions for disposals and repairs. Many of the provisions will provide future tax deductions, but in order to obtain these deductions and adhere to the new regulations, the IRS is requiring "one-time" tax filings and some annual elections that need to occur by tax year 2014. Taxpayers in every industry will be affected, but real estate taxpayers will be particularly affected.
"The new repair and capitalization regulations will require considerable analysis to insure compliance. In addition, businesses must make certain they have systems in place which will take advantage of the several pro-taxpayer rules," D'Addio cautions.
Highlights of the new repair and capitalization rules include the following:
- Materials and Supplies. Items acquired with a cost of up to $200 can be categorized as a material and supply and can be deducted under special rules. The amounts expended for materials and supplies are deductible in the year of payment if they are "incidental," i.e., where no record of consumption is maintained and there is no physical count at the beginning and end of year due to administrative burden. However, where the materials and supplies are "non-incidental" and where such records are kept, the items are deductible in the year of use or consumption. This may delay the timing of the deduction for non-incidental materials and supplies from current practice. This result can be avoided in many situations through the election of the De Minimis Rule (discussed below).
- Acquisition Costs. Costs to acquire tangible property must normally be capitalized into their depreciable cost. These include costs incurred in the process of investigating or otherwise pursuing the acquisition. However, under a special rule, these types of investigatory costs do not have to be capitalized when related to the acquisition of real property, unless they are among a specific list of items defined as "Inherently Facilitative." This creates a different capitalization rule for real estate and personal property. Where both real property and personal property are acquired in the same transaction, an allocation of such costs must be made.
- De Minimis Rule. The final regulations provide a "de minimis" rule which avoids the need to capitalize certain costs where the taxpayer satisfies certain conditions. The amounts deductible depend upon whether the taxpayer has an Applicable Financial Statement (AFS) or not. Those with an AFS can deduct items with costs up to $5,000 if there is a written accounting policy at the beginning of the year to expense such items. If there is no AFS, the amount deductible is limited to $500. The taxpayer is required to make an affirmative election on a timely filed tax return with respect to all items which are covered under the de minimis rule. This can include items which are non-incidental materials and supplies. The de minimis rule applies on a per item basis. Consequently taxpayers must analyze invoices to determine the per item cost to determine which items may be covered.
- Costs to Repair or Improve Tangible Property. The most difficult portion of the regulations involve whether costs to repair or improve currently owned tangible property can be deducted or must be capitalized. Costs will have to be capitalized if they produce a Betterment to the property; an Adaptation to new use of the property; or a Restoration of the property ("BAR" costs). If one of these standards is satisfied, capitalization is required.
The expenditure must be compared to a "Unit of Property," generally defined as components of property which are functionally interdependent. With respect to a building, the Unit of Property is not only the overall structure, but also includes eight enumerated building systems: HVAC, plumbing, electrical, escalators, elevators, fire protection and alarm systems, security systems, and gas distribution system. Defining a Unit of Property into smaller components by the regulations increases the chances of having to capitalize an expenditure.
The new regulations also contain some taxpayer-friendly rules:
- Elimination of the "Plan of Rehabilitation Doctrine"
- Deduction of Removal Costs
- Small Taxpayer Safe Harbor
- Routine Maintenance
The repair and capitalization rules are applicable for tax years beginning in 2014. Generally, application of the new rules will be treated as changes of accounting method requiring the filing of a Form 3115 with the tax return for the year of change.
"It is likely that almost all businesses will be required to file at least one Form 3115 with either the Company's internal accounting department or an outside CPA gathering the data and preparing the disclosure. This is a one-time form filing, outside the normal annual compliance in order to adhere to the new regulations," Mr. D'Addio said.
For Mr. D'Addio's complete explanation of the new IRS Repair and Capitalization Rules, visit http://www.marcumllp.com/publications-1/implementing-the-final-repair-capitalization-and-disposition-regulations.
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