New Repair Regs - TP question

[BulldogTom]

I have to admit, I am not as up on the new regs as I should be, and of course it just bit me in the butt.  Please comment on the below scenario.

 

TP owns a commercial building that he rents to his Corp for office space.  He had a close call with the lighting wiring that nearly started a fire.  The fire department came out and identified the problem in the lighting fixtures.  The building is a little older and the lighting needs to be updated.  Electrical contractor to do the work and all the materials will total about 20K.

 

Since this is a safety issue, and the building cannot be used unless this work is done to it, can it be expensed?  Or must it be capitalized?  Under the old rules, I would have expensed because of the safety issues that require this to be done.

 

What do you think?

 

Tom

Newark, CA

[grmy2h]

From a webinar......

 

"A qualifying taxpayer may elect to deduct the total amount paid for repairs, maintenance, improvements, and similar activities performed on eligible building property if the total spent during the year does not exceed the lesser of

1. $10,000, or

2. 2% of the unadjusted basis of the eligible building property.

 

If the amount paid by the taxpayer for repairs, maintenance, improvements, and similar activities exceeds the limits, then the safe harbor election is not available for that property and the taxpayer must apply the general improvement rules. (The limits apply to each UOP, or each building, separately."

[Lee B]

Went to a tax seminar on Monday that went over this in depth.

 

First how much is the unadjusted basis of the building ?

 

Because under the Building Safe Harbor, expenditures cannot exceed the lesser of 2 % of unadjusted basis or $10,000

 

If you don't want to use the safe harbor then it gets more complicated:

 

1. What percentage of the building's electrical wiring will be replaced will be a key decision point?

 

2.  How long has the taxpayer owned building and did the condition exist without the taxpayer's knowledge before the taxpayer

     purchased the building , another key point ?

 

3.  Will the new wiring be an improvement or is it just returning the electrical system to it's previous functionality?

 

At this point I will stop because covering all the variables would a really long post.

[grmy2h]

Since it appears it doesn't qualify for the safe harbor, then it may fit here.

Restorations. Under Reg. 1.263(a)-3(k) , a taxpayer must capitalize expenditures made to restore a unit of property. For this purpose, an amount is paid to restore a unit of property only if it:

(1) Is for the replacement of a component of a unit of property and the taxpayer has properly

deducted a loss for that component (other than a casualty loss under Reg. 1.165-7 );

(2) Is for the replacement of a component of a unit of property and 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;

(3) Is for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss under Section 165 (subject to the limitation discussed below);

(4) Returns 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;

(5) Results in the rebuilding of the unit of property to a like-new condition after the end of its class life; or

(6) Is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property.

For a building, an amount is paid to restore the unit of property if it restores the building structure or one of the enumerated building systems.

What is a building system?

This new term consists of 9 structural components. Each of them is separate from the building structure, and the improvement rules must be separately applied.

1. HVAC systems (including motors, compressors, boilers, furnace, chillers, pipes,

ducts, radiators);

2. Plumbing systems (including pipes, drains, valves, sinks, bathtubs, toilets, water and

sanitary sewer collection equipment, and site utility equipment used to distribute

water and waste to and from the property line and between buildings and other

permanent structures);

3. Electrical systems (including wiring, outlets, junction boxes, lighting fixtures and

associated connectors, and site utility equipment used to distribute electricity from

property line to and between buildings and other permanent structures);

4. All escalators;

5. All elevators;

6. Fire-protection and alarm systems (including items such as sensing devices,

computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing,

pumps, visual and audible alarms, and alarm control panels);

7. Security systems that protect the building and its occupants (including items such as

locks, security cameras, motion detectors, security lighting, and alarm systems);

8. Gas distribution system (including associated pipes and equipment used to distribute

gas to and from property line and between buildings or permanent structures); and

9. Other structural components identified in published IRS guidance that aren't part of

the building structure and are specifically designated as building systems.

[Lee B]

This is a very dense area with a lot of meaty issues to consider.

My class spent over an hour on this subject with 25 pages of material.

I encourage you to find an online webinar or a self study course.

Even if I downloaded all 25 pages, it would be heavy slogging. 

[Lee B]

Here is a plain english article that I copied from the website of CliftonLarsonAllen which will give you an overview

of what you're dealing with:

Contractors may have an opportunity to save on construction and building costs based on the IRS’s recent overhaul of the regulations that govern the handling of expenditures to produce, acquire, or improve tangible property. But first you have to clarify whether your expenditure is considered a repair or improvement, among other considerations.

Also, on August 14, the IRS released final regulations on the disposition of tangible depreciable property. So if repairs or improvements were properly capitalized in prior years, a partial disposition loss for the old components might be claimed with an accounting method change to write-off what was previously capitalized.

Improvements or repairs

Improvements are attributed to one of three areas: betterments, adaptations, or restorations (often called the “BAR” test).

• Betterments are a material addition to a unit of property (UOP) or a material increase in capacity to correct a material condition or defect that exists prior to acquisition or during production.
• Adaptations are putting a UOP to a new or different use that is not consistent with the ordinary use of the property at the time it was first placed in service.
• Restorations include returning a UOP to its ordinary operating condition after it deteriorated to a state of disrepair, or rebuilding a UOP to like-new condition after the end of its IRS defined class life. Replacing a part that comprises a major component or substantial structural part of a UOP also constitutes a restoration.

When applying the BAR test to a building, the regulations separate the building into the building structure (roof, walls, windows, floors, and ceilings) and eight defined building systems (HVAC, plumbing, electrical, escalators, elevators, fire-protection and alarm, security, and gas distribution).

Activities that are not considered an improvement can often be deducted as a repair and maintenance expense. For instance, building refresh costs (e.g., cosmetic changes such as power washing walls and repainting, cleaning or resealing wood floors), most likely should be deductible. However, if remodeling involves replacing large parts of the exterior walls or upgrading the electrical system, these costs most likely should be capitalized.

BAR test example

A contractor uses equipment for highway and road construction operations. Each independently operable piece of equipment is a UOP with a class life of six years. The contractor does scheduled maintenance every so often such as cleaning the engine, oiling specific parts, inspecting parts for defects, and replacing items such as springs, bearings and seals.

The BAR test determines that these costs are deductible repairs and maintenance expenses, since they do not materially increase capacity, adapt the equipment to a new use, or rebuild to like-new condition. However, if the equipment was reconfigured with additional components that enhance its capacity, then it may be considered betterment and those costs would need to be capitalized as improvement.

De minimis safe harbor rule

If a company has an applicable financial statement (AFS) and a written book capitalization policy in place at the beginning of the tax year, then it can deduct items below this threshold but not in excess of $5,000 per invoice or per item.

An AFS is defined as a financial statement filed with the Securities Exchange Commission (SEC), a certified audited financial statement by an independent CPA, or a financial statement required to be provided to a federal or state government or agency. If you don't have an AFS, you may still be able to deduct up to $500 per invoice or per item if the other requirements are met. This is an annual election made on a timely filed original tax return.

Routine maintenance safe harbor rule

Recurring costs to keep property in ordinary operating condition can also be deducted, when the costs are reasonably expected to occur more than once within the class life of the property.

Safe harbor rule example

Machinery and equipment used in road construction may need to be serviced more than once during its class life (six years), which may require disassembly, cleaning, inspection, repairs, replacement, reassembly, and testing of its component parts. (Buildings use a 10-year period class life.)

So if you own a building and service the HVAC units every four years — especially if within the maintenance interval recommended by the manufacturer — these costs should be deductible. Finally, costs with longer intervals might still be deductible on a facts and circumstances basis, but would fall outside of the safe harbor rule.

Disposition rules applicable to 2013 and 2014 tax returns

Disposing of an entire unit of property requires the recognition of gain or loss. Partial dispositions (i.e., a disposition of less than an entire UOP) were generally not allowed in the past, but the new regulations allow for this if an election is made in the year of the disposition.

You can still make this election on 2013 and 2014 tax returns for dispositions that occurred in previous tax years. It would be beneficial to make this election where repairs to a roof were capitalized in prior years (regardless of the refund statute being closed for the year), so the net tax value of the old roof at the beginning of the 2013 or 2014 tax year can be written-off.

In addition, the costs of removing an asset should follow the initial treatment of the asset. So if the old asset is treated as disposed, then removal costs are part of the disposition (i.e., increase the loss or reduce the recognized gain). If the old asset is not treated as disposed, removal costs are deducted or capitalized based on whether they directly benefit a capitalized improvement.

How you can benefit from the new rules

If repairs or improvements have been performed on tangible property in prior years, there may be an opportunity for claiming additional deductions. Items that were capitalized in prior years due to a conservative approach and/or just following GAAP treatment might be claimed with an accounting method change to write-off what was previously capitalized as deductible repairs.

Also, if improvements were properly capitalized in prior years, there may be a chance to claim a partial disposition loss for the old components that were removed. On the flip side, you can get audit protection if you have been under-capitalizing repair expenditures and then finance the resulting taxes over a four-year period with no interest or penalties