The Tangible Property Regulations: Amounts Paid to Acquire or Produce Property
The IRS released the highly anticipated final regulations regarding tangible property late last year. The final regulations provide a myriad of new rules for many taxpayers that became effective Jan. 1 of this year for calendar year-end taxpayers. The IRS provided guidance on what needs to be capitalized and included in the costs to acquire or produce tangible property, including further defining the “Unit of Property” concept for use with the new regulations. The regulations also introduced the small taxpayer safe harbor for real estate.
Acquire or produce a unit of real or personal property
Generally, the costs to capitalize when acquiring or producing property are pretty straightforward. First, we must determine if an exception to capitalization applies. If the property qualifies as a material or supply or whose cost is below the de minimis safe harbor amounts, then capitalization will not be required. These two concepts were outlined in our previous alert (“The Tangible Personal Property Regulations: Opportunities in Materials and Supplies”) on the new regulations. The main cost to acquire property is the invoice cost, including the costs for sales taxes, freight and installation charges. Beyond this cost, there are inherently facilitative costs that must also be capitalized. Some of these are not obvious items to add to the capitalized costs.
What costs are inherently facilitative?
- Transporting the property prior to placement into service
- Securing an appraisal to determine value
- Application fees, bidding costs and other similar expenses
- Negotiating terms of the acquisition, including related tax advice
- Preparing and reviewing documents that effectuate the purchase (for example: sales contract or purchase agreement)
- Examination of title
- Obtaining regulatory approval of purchase and securing permits
- Conveying property, including sales and transfer taxes, and title registration
- Brokers’ or finders’ fees including contingency fees
- Architectural, survey, environmental or other inspection services
- Services of a qualified intermediary for a like-kind exchange
There are some notable exceptions to requiring these inherently facilitative costs to be capitalized. Employee compensation and overhead costs are not required to be capitalized as part of the cost of the property when company personnel helped facilitate its acquisition. Expenses incurred to determine whether to acquire property and which property to acquire, are not required to be capitalized. These “whether or which” type costs are pre-decisional investigatory costs incurred with respect to the acquisition of property and may be expensed. This is true as long as the expenses are not specifically enumerated in the inherently facilitative list of costs. For example, if several appraisals were performed in the process of deciding which property to purchase, those appraisal costs would require capitalization until it is determined which property is chosen. Since they are inherently facilitative, a loss will result for the costs of appraisals on properties not chosen.
What is the Unit of Property and why does it matter?
Think of a vehicle and all of the components to make the vehicle operable. All of the components of the vehicle are needed to make it operate. Without a unit of property (UOP) concept, every tiny repair to a vehicle would require capitalization. A vehicle is a unit of property as it is a collection of all the functionally interdependent parts that are required for its proper function. Whether the repair or replacement of a particular part, the engine for example, requires capitalization depends on whether the part’s replacement is considered an improvement to the vehicle, the UOP. Larger UOPs are advantageous for the taxpayer as more expenditures will be currently deductible. By relating expenditures to the repair of a larger rather than a smaller unit of property, the taxpayer is in a better position to expense the repair. This can be particularly important for buildings. The new regulations have some special rules for buildings.
Special unit of property definitions apply for buildings, leased property, and plant property. Facts and circumstances determine what the unit of property is for these assets. Plant property means functionally interdependent machinery and equipment used to perform an industrial process. Based on this definition a manufacturing line could be one unit of property. For plant property the unit of property is the discreet and major function within the plant (all of the functionally interdependent machinery and equipment). The unit of property for leased property is the portion of the property leased by the lessee and the related purchases made by the lessee.
Building structure and their nine systems
For unit of property purposes, a building and its structural components is one unit of property. However, for purposes of determining if an improvement has occurred a building is made up of 10 units of property, one for each system plus the structure. The nine systems are as follows:
- Heating and air conditioning system
- Plumbing system
- Electrical system
- All escalators
- All elevators
- Fire-protection and alarm system
- Security system
- Gas distribution system
Other structural components identified in IRS guidance as systems and not building structure
As discussed earlier, this segregation of what is truly one unit of property, the building, causes more “repairs” to be “improvements” requiring capitalization. Replacing one sink in a building with two sinks would likely be a repair if the unit of property were the building. As the new regulations have it now, the sink is a significant part of the building’s plumbing system that could require capitalization.
Small Taxpayer Safe Harbor for Real Estate
Taxpayers with buildings costing less than $1 million and having under $10 million of average gross receipts can take advantage of this safe harbor benefit. To qualify gross receipts must average under $10 million over the last 3 year tax years. The property’s unadjusted cost (no depreciation reduction) must also be under $1 million. Once qualified, the taxpayer may expense expenditures for repairs, maintenance, improvements and similar activities that are under the threshold. The threshold is the lesser of 2 percent of the unadjusted basis in the building or $10,000.
The Next Steps
In order to make sure your company is properly complying with the new regulations, care needs to be taken when looking at expenditures that may be inherently facilitative under the regulations. It is also important to make sure all the costs that need to be capitalized as part of a property acquisition are captured appropriately. There may be a need for an update to the written policy regarding expenditures and capitalization. Also a company might want to consider a detailed review of general ledger accounts related to tangible property to see if any changes need to be made for how expenditures are tracked and grouped together. There may be costs that have been previously expensed that now must be capitalized under the tangible property regulations. Every taxpayer’s situation is unique to their facts and circumstances. For our clients, we will be contacting you in the summer months to begin discussions and determine a timeline to implement your compliance plan.
The tangible property regulations are detailed and complex. Please look for our next alert in our Tangible Property Regulations series. If you have any additional questions about the Tangible Property Regulations, please contact us.
John E. Jenkins?>
Robert M. Burak?>
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