The final regulations [PDF 578 KB] contain the standards for determining whether and when a taxpayer must capitalize costs incurred in acquiring, maintaining, or improving tangible property.
Treasury and the IRS also released proposed regulations [PDF 309 KB] that revise the rules for dispositions of tangible property and the rules for general asset accounts.
Most businesses will have to make one or more tax accounting method changes or elections to comply with these regulations.
The final regulations (T.D. 9636) are generally effective for tax years beginning on or after January 1, 2014, and may be adopted in earlier years under certain circumstances.
The proposed regulations (REG-110732-13) addressing dispositions and general asset accounts are also expected (when finalized) to be effective for tax years starting on or after January 1, 2014, and may be adopted in earlier years under certain circumstances.
The IRS is expected to issue transition guidance that will allow taxpayers to change their methods of accounting to comply with the regulations under automatic consent procedures. In addition, the IRS Large Business and International (LB&I) “stand-down” for auditing repairs and related dispositions will end starting in 2014, which means that most taxpayers will no longer have the option to defer compliance with the new rules.
Summary of the key aspects of the final regulations
The final regulations adopt the same general framework as the 2011 temporary regulations and retain many of the same provisions. However, the IRS and Treasury made several significant changes in the final regulations that taxpayers need to review carefully.
The following provides a summary of the key aspects of the final and proposed regulations.
De minimis rule – Safe harbor: $5,000 threshold
The safe harbor permits a taxpayer with an applicable financial statement to follow its book minimum capitalization policy for acquired tangible property as long as the policy does not exceed $5,000 per invoice or item (the threshold is $500 per invoice or item for a taxpayer without an applicable financial statement).
Notwithstanding the safe harbor, an examining agent may continue to accept a policy that exceeds the $5,000 threshold if the agent determines that the amount deducted clearly reflects income. Transaction costs (such as installation and transportation charges) not included in the invoice are not treated as part of the cost of the item.
The de minimis safe harbor must be elected annually by including a statement on the taxpayer’s timely filed original federal tax return for the year elected (the statement is provided in the regulations). The safe harbor must be applied to all amounts expensed under the taxpayer’s book policy, including materials and supplies. For the safe harbor to be effective, the taxpayer’s book policy must be in writing as of the beginning of the year.
In certain circumstances, a taxpayer may amend either 2012 or 2013 tax returns to elect the safe harbor in the de minimis rule. However, a taxpayer cannot amend if it did not have a written policy in place at the beginning of the tax year.
Election to follow book capital improvement costs
The final regulations permit a taxpayer to elect to follow its book capitalization policy for improvement costs with respect to amounts that were capitalized on its books and records for the tax year. The election is made by attaching a statement to the taxpayer’s timely filed original federal tax return (including extensions) for the tax year in which the improvement is placed in service. Once made, the election may not be revoked.
The book conformity rule applies only to amounts capitalized during the year and does not apply to repair and maintenance costs that are expensed on the taxpayer’s books and records. In other words, the IRS could potentially review items that are expensed on the books and records and determine that certain items should be treated as capital improvements for tax purposes.
Many taxpayers may elect to follow book capitalization policies to reduce the administrative burden associated with book tax differences. A taxpayer that makes the election will be unable to subsequently treat the capitalized items as repairs by filing a method change in a later year.
Routine maintenance safe harbor
The routine maintenance safe harbor provides that certain qualifying cyclical maintenance activities will be deemed not to result in a capital restoration under the final regulations. Activities qualify for the safe harbor if, at the time a unit of property is placed in service, the taxpayer reasonably expects to perform the activities more than once during the property’s Alternative Depreciation System (ADS) class life and the activities keep the property in its ordinarily efficient operating condition.
The final regulations expand the routine maintenance safe harbor to building property, but substitute a 10-year period for the building’s ADS life. The final regulations also specifically exclude network assets from the rule and therefore limit its applicability in comparison to the 2011 temporary regulations.
Although the routine maintenance safe harbor may now be applied to building property, it may not be that useful unless remodels and refreshes are regularly undertaken every five or fewer years.
Summary of the proposed disposition rules – Revamped and simplified
As anticipated by Notice 2012-73, Treasury and the IRS significantly revamped the rules for dispositions of tangible property subject to the Modified Accelerate Cost Recovery System (MACRS).
Due to the significant nature of the changes, the revised rules for dispositions of property were issued in proposed rather than final form, and the disposition rules in the temporary regulations continue to be effective until they are removed or sunset.
Taxpayers have the option to apply the proposed disposition rules for 2012 and 2013—but not beyond then—because Treasury and IRS expect to finalize the proposed regulations before the end of 2013, so the final rules will become the only option for 2014 and beyond.
Partial disposition elections
Under the proposed regulations, taxpayers will no longer have to elect general asset account treatment to achieve flexibility with respect to the treatment of component dispositions.
The proposed regulations allow a taxpayer to make a partial disposition election to recognize gain or loss on a disposition-by-disposition basis with respect to any portion of an asset. There are a few exceptions to this rule, however, in that the proposed regulations would make it mandatory for a taxpayer to recognize gain or loss upon the disposition of a portion of an entire asset: if the disposition is the result of casualty event, certain non-recognition transactions, or a sale of a portion of the asset.
In the case of buildings, the proposed regulations explicitly provide that the unit of property generally consists of an entire building, rather than each of its structural components. Thus, a taxpayer is not required to recognize a loss on the disposition of a structural component of a building as was the case under the temporary regulations.
In the case of disposition gains and losses, the proposed regulations replace the concept of “components” with “partial dispositions,” so that gains and losses may be recognized when components are partially replaced and it would not be necessary to define individual components. As a result, the proposed regulations also eliminate the consistency rule for defining the unit of property disposed of.
Making a partial disposition election
The proposed regulations make it easy to apply the partial disposition election. The election is made simply by claiming gain or loss on the taxpayer’s timely filed original return (including extensions) for the year in which the portion of an asset is disposed of.
An exception to the original return requirement is provided in the event that the IRS, on examination, disallows a replacement as a repair. In that case, a taxpayer may request a change in accounting method to make the partial disposition election.
In addition, the proposed regulations permit a taxpayer to make a partial disposition election for 2012 or 2013 either by filing an amended return for the year of election on or before 180 days from the extended due date of the return for that year, or by an application for change in accounting method filed with the original return for the first or second year succeeding the year of election.
Taxpayers will generally want to consider making partial disposition elections to recognize partial asset dispositions resulting from replacements that result in a betterment, restoration, or change in use. The proposed regulations provide specific allowable methods, including a discounted replacement cost concept, for determining the basis of partial dispositions when a partial disposition election is made.
Continued relevance of general asset accounts
Under the revised rules, general asset accounts will not be necessary to preserve the ability to choose whether to recognize a loss on a disposition of an asset or portion of an asset. This is important in that a taxpayer no longer has to place building property into a general asset account in order to choose whether to recognize a loss on the disposition of a building structural component.
The proposed regulations would generally reinstate the rules in effect prior to the temporary regulations, which would mean that a taxpayer would no longer have a choice to recognize a loss or continue to depreciate the basis of individual components that are disposed of, unless the component is disposed of in a casualty event, charitable contribution election, cessation of the business, certain non-recognition transactions, or upon the disposition of the last asset, all the assets, or the remaining portion of assets in a general asset account.
For those taxpayers that want the flexibility to generate additional income upon a disposition of an entire asset, the general asset account regime will continue to provide that flexibility if each asset is placed into a single general asset account.
Lastly, the procedures for making the late general asset account election to plan for NOLs, section 382, SRLY losses, or the stranded basis under the CBS case continue to be available after the issuance of the regulations. However, the late GAA option is expected to be removed upon the issuance of the transition guidance in the near future.
Summary of elections under the final and proposed regulations
Changes to comply with the regulations are generally to be treated as a change in method of accounting and generally require a section 481(a) adjustment.
However, several rules are applied on a cutoff basis to costs incurred on and after the beginning of the year of change and a number of affirmative elections are necessary under the final regulations—that is the elections require that a statement be included on a timely filed original return (with extensions). These elections include:
- The election to apply the de minimis safe harbor
- The election to apply the book conformity rule with respect to capital improvements
- The partial disposition election made under the default rules (i.e., non-general asset accounting) in the year of disposition (except in those cases as noted above when an IRS exam adjustment is made, or the taxpayer elects to apply the proposed regulations to 2012 or 2013)
- A general asset account election in the year the asset is placed in service
- A general asset account election to recognize gain or loss upon a qualifying disposition
Other changes under the final regulations
Partial relief from casualty loss rule
The final repair regulations retain the rule that a restoration requiring capitalization includes the replacement of an asset or portion of an asset resulting from a casualty event.
In addition, the proposed regulations would make the recognition of a casualty loss mandatory and not subject to the partial disposition election.
Under the final regulations, a taxpayer would not be required to treat as a restoration the amount of its post-casualty replacement expenditures that exceed the adjusted basis of the property damaged in the casualty.
Revisions to the capitalization standards
Although the final regulations do not change the unit of property definitions that were included in the temporary regulations, the final regulations revise and clarify certain aspects of the capitalization standards. These changes include minor changes to the application of the betterment standards as well as a more precise definition of a major component or substantial structural part under the restoration standards.
- The final regulations define a major component as a part or combination of parts that performs a discrete and critical function in the operation of the unit of property and a substantial structural part as a part or combination of parts that comprises a large portion of the physical structure of the unit of property.
- In the case of buildings, the final regulations provide that an amount is incurred for the replacement of a major component or substantial structural part if the replacement includes a part or combination of parts that: (1) comprises a major component or a significant portion of a major component of the building structure or any building system; or (2) comprises a large portion of the physical structure of the building structure or any building system.
Materials and supplies
- Unlike the temporary regulations, the final regulations do not permit a taxpayer to elect to capitalize and depreciate materials and supplies that are not rotable, temporary, or standby emergency spare parts. This removes some of the flexibility for obtaining cost recovery of non-incidental materials and supplies starting upon acquisition, or spreading the cost over a longer period as permitted under the temporary regulations.
- The final regulations expand the definition of materials and supplies to include property that has an acquisition or production cost of $200 or less (increased from $100 or less under the 2011 temporary regulations). Note that this change may be less relevant if these items are expensed under the revised de minimis safe harbor.
Printable version [PDF 131 KB] of the report
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