In September 2013, IRS released final regulations (“Regulations”) dealing with repair and capitalization of tangible property under IRC Sec. 162(a) and 263(a) and regulations relating to dispositions under IRC Sec. 168. These Regulations are effective for taxable years beginning on or after January 1, 2014. Every taxpayer with fixed assets is affected by these new rules; owners of real property are especially impacted. The Regulations are adopted through elections where indicated in the Regulations and by filing Form(s) 3115, Application for Change in Accounting Method, as indicated by the IRS in separate guidance.
A Form 3115, Application for Change in Accounting Method, is generally filed with a retroactive catch up adjustment that is the difference between the deductions claimed to date under the old method and the deductions that should have been claimed to date under the new method. Those owning or leasing real property will typically be required to file method change #184, which would include the following:
- A change in the unit of property (“UOP”) definition for applying the improvement standards (e.g., adopting the nine building system UOPs instead of the entire building UOP).
- Adopting the routine maintenance safe harbor method change, the taxpayer must reasonably expect to perform the activities more than once during a 10-year period for real property and more than once during the Alternative Depreciation System class life of the UOP for personal property. Making the method change provides audit protection.
- Deduction of repair and maintenance expenditures that have been historically capitalized or capitalizing expenditures that have been historically deducted not in compliance with the final regulations. A taxpayer will be required to capitalize expenditures if there is a betterment, restoration, or adaption.
- A change to an accounting method that is not in compliance with the Regulations, in a case where an accounting method change was previously filed under the temporary or proposed regulations.
The Regulations also provide for a new partial asset disposition election. Starting in 2014, taxpayers may elect to recognize a gain or loss on partial dispositions of a building that occur during the current year. For tax year 2014 only, taxpayers may file method change #196 to make a late partial disposition election and recognize a gain or loss on partial dispositions occurring in a prior year where the basis is still capitalized and depreciating.
Small Business Relief
The IRS recently released Revenue Procedure 2015-20, which provided relief to simplify the procedures for small businesses making accounting method changes. A “small business” is defined as a trade or business with average total revenues for the prior three years of not more than $10 million or total assets of not more than $10 million. If either of these tests is met, then a taxpayer may adopt the Regulations through these simplified procedures. For tax year 2014, the new guidance allows small businesses to change a method of accounting on a prospective basis without filing a Form 3115. Further, there is no calculation of a catch-up adjustment. No formal election or statement is required on the return. However, the IRS has recommended that small business taxpayers attach a statement reflecting that they are either implementing or opting out of the simplified procedures. There is no audit protection for pre-2014 years under the simplified procedures. Also, the late partial asset disposition method change is not permitted.
There are three new elections in the Regulations that each taxpayer should consider making.
De Minimis Expensing Safe Harbor
The Regulations introduce the De Minimis Safe Harbor which permits a taxpayer to currently deduct otherwise capital expenditures where:
- The organization has a capitalization policy in place at the beginning of the year specifying that amounts incurred for the purchase of tangible property beneath a fixed dollar amount will not be capitalized for financial accounting or tax purposes;
- The capitalization threshold cannot exceed $5,000 for audited financial statements or $500 if the organization’s financial statements are not audited; and
- The policy must be in writing if the organization has an audited financial statement.
Small Taxpayer Safe Harbor
The Regulations provide an election for a simplified repair versus improvement analysis for small taxpayers. A small taxpayer for purpose of this election is an organization with average annual revenue for the prior three years of not more than $10 million. Taxpayers meeting the revenue threshold may expense costs to repair, improve, or maintain building property(s), if those expenditures in aggregate, per building, do not exceed the lesser of $10,000 or two percent of the original building cost. This simplified analysis may be applied to each building a small taxpayer owns that has an original cost (or total amount of rent payments expected to be paid by the lessee under the term of the lease, including renewal periods) of not more than $1 million.
Conformity to Book Capitalization of Repair and Maintenance
This election allows a taxpayer to capitalize amounts that are deductible for taxable income purposes, if those amounts are capitalized for financial accounting purposes. This election permits a taxpayer to capitalize for taxable income purposes amounts already capitalized for financial accounting purposes.
Although the Regulations affect many issues related to tangible property, the Regulations do offer flexibility and options for determining the best course of action. Taxpayers should discuss the potential implications of these Regulations with their tax advisor to plan to reap the benefits and avoid potentially adverse consequences.
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