Treasury Decision 9564 describes new temporary regulations effective for tax years beginning on or after January 1, 2012, which have the potential to effect all taxpayers who acquire, produce, or improve tangible property used in their trade or business. The purpose of the new regulations are:
- to help determine whether costs incurred in acquiring, maintaining, or improving tangible property may be deducted immediately or capitalized as new assets and depreciated over time; and
- to provide definite exemptions from the general requirement to capitalize. Two of these exemptions are for (1) amounts which are de minimis in nature and (2) amounts related to materials and supplies consumed in the taxpayer’s conduct of their trade or business.
Unit of Property Concept
The new regulations also expand on the “unit of property” rule and call for costs to be capitalized if the amount paid or incurred (1) results in the betterment to the unit of property, (2) results in the restoration to the unit of property, and/or (3) adapts the unit of property to a new or different use. The repeated reference to a “unit of property” highlights one of the most significant changes included in the new rules. Generally, under prior law, a building itself was deemed to be a unit of property. The larger the unit of property, the higher the capitalization threshold. The new rules break down a building into several potential smaller systems, and by treating each of these as a separate unit of property, it becomes more likely that costs related to that system will be considered betterments or restorations that must be capitalized. Examples of potential systems that may be separate units under the new regulations include:
- Heating and cooling units
- Plumbing systems
- Electrical systems
- Security systems
- Structural building components such as roof, walls, etc.
The treatment of these smaller components of a building as a
separate unit of property may increase the likelihood that related costs must be capitalized. The new regulations also present a possible upside because the taxpayers may take a deduction equal to the un-depreciated cost of replaced components.
A taxpayer constructed a building 10 years ago, and $390,000 of the construction costs related to the heating and cooling system. Under prior law, the system would have been considered part of the building and depreciated over 39 years. Today, the taxpayer needs to replace the system at a cost of $500,000. Prior to the new regulations, the taxpayer would capitalize the new system and depreciate it over 39 years, potentially while continuing to depreciate the old system. The new regulations still require the new system to be capitalized and depreciated over 39 years, but they also allow the taxpayer to write off the cost associated with the old system – $290,000 in this case. Cost segregation and repair studies can be crucial tools to identify and capture these costs.
The Treasury Decision addresses several other areas mentioned only briefly here. It provides some de minimis rules that previously were allowed in varying forms informally as a matter of convenience. The “de minimis rule” provides for an immediate deduction for amounts that are otherwise subject to capitalization. This rule applies so long as a taxpayer has a written policy at the beginning of the tax year identifying the minimum threshold for which an asset will be capitalized. Additionally, the amount expensed under the de minimis rule plus the amount expensed under the materials and supplies exception (discussed later) does not exceed 0.1 percent of the taxpayer’s gross receipts or 2 percent of the taxpayer’s total depreciation and amortization for the taxable year.
It also provides for new standards applicable to materials and supplies. Materials and supplies used or consumed in a taxpayer’s trade or business are deductible currently.
- Materials and supplies by definition includes the following:
- A component acquired to maintain, repair, or improve a unit of tangible property
- Fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months or less
- A unit of property that has an economic useful life of 12 months or less
- A unit of property that has an acquisition cost or production cost of $100 or less
The new regulations bring significant changes to the treatment of expenditures made for business property. The rules are quite complicated and the application to taxpayers is heavily dependent on facts and circumstances.
Additional guidance is expected from the IRS before the new regulations become effective. It is possible that procedural guidance may call for the filing of Form 3115, Change in Accounting Method, to implement the new changes.