The Tangible Personal Property Regulations: Opportunities in Property Improvements and Repairs and Maintenance

In late fall of last year, the Internal Revenue Service released the highly anticipated final regulations regarding tangible personal property. The final regulations provide a myriad of new rules for many taxpayers that became effective Jan. 1 of this year. We have previously released Tax Advisors focusing on:

1. Opportunities in Materials & Supplies
2. Amounts Paid to Acquire or Produce Property
3. Clarifying Tangible Property Expenses

Since expenses can be deducted immediately, but capitalized costs must be depreciated over a period of up to 39 years, companies usually prefer to expense property improvements, and repairs and maintenance to maximize tax deductions. The critical question our clients are asking: what can we expense?

This Tax Advisor will focus on property improvements, and repairs and maintenance, which are another key area in the regulations that will require a high level of review and documentation by company personnel.

In general, amounts paid for the improvement of a tangible Unit of Property (UOP) will require capitalization. A building’s UOP is the structure plus its building systems (HVAC, plumbing, electrical, security, gas distribution, escalators, elevators, and fire protection).  Machinery and equipment that is functionally interdependent comprise a single UOP.  UOP’s are functionally interdependent if the placing in service of the equipment by the taxpayer is dependent on placing in service of other equipment by the taxpayer.  A safe harbor provision is included in the new regulations that can be relied upon for routine maintenance deductions. Otherwise, each taxpayer is required to evaluate the amount paid and determine if it is an improvement that is required to be capitalized under the new regulations. An improvement is now defined as a betterment, adaptation, or restoration of property. Below are the steps that should be analyzed and documented by company personnel for each transaction.

What is the Routine Maintenance Safe Harbor?

An amount paid is deductible if it was paid to keep a UOP operating in normal capacity and in ordinary operating condition. The routine maintenance safe harbor allows for the deduction of expenses paid for maintenance if it is expected to be performed more than once in the following time periods:

• Building maintenance: expected to be performed more than once in 10 years
• Non-building maintenance: expected to be performed more than once over the class life of the asset

If the improvement doesn’t fall within the safe harbor, it should then be evaluated to see if it is required to be capitalized.

What Improvements are Required to be Capitalized?

An improvement is required to be capitalized if it is a betterment to a UOP, adapts the UOP to a new or different use, or is a restoration of a UOP.  The following questions should be asked to determine if a particular transaction is an improvement vs. repairs & maintenance.  It will be considered an improvement that should be capitalized if it meets any of the tests below and does not qualify under the safe harbor.

Betterment – Does the improvement…

• Correct a pre-existing material condition or defect of the property?
• Result in a material increase in capacity or a material addition?
• Materially increases the productivity, efficiency, strength, quality or output?
• Examples of a betterment would include:
  • Remodeling a retail store
  • Disassembling, moving, reconfiguring, and adding components to equipment to increase capacity
  • Reinforcing the second floor of a building to increase its load–carrying capacity by 50%

Adaptation –

• Was the property adapted to a new or different use not consistent with the ordinary use at the time it was placed in service?
• Examples of an adaption would include:
  • Conversion of a manufacturing building into a showroom
  • Re-grading land used for manufacturing to be used for residential purposes
  • Reconfiguration to add a walk-in clinic to a retail drug store

Restoration – Does the improvement…

• Replace a component for which a loss is claimed?
• Replace a component for which a gain/loss was recognized?
• Restore a property for damages for which a casualty loss was claimed?
• Return a property to ordinarily efficient operating condition if the property deteriorated to a state of disrepair and is no longer functional for the intended use?
• Rebuild the property to a “like-new” condition at the end of a class life?
• Replace a major component or substantial structural part of the property?
• Examples of a restoration would include:
  • Replacing an engine and cab of a truck tractor
  • Replacing/rebuilding an entire roof of a manufacturing building
  • Replacing 200 of 300 exterior windows of a building

In general, if the amount paid does not meet any of the tests above it can be expensed. The evaluation of each of these items should be documented to support the treatment should the company be audited.

This is a new initiative set forth by the IRS that will be subject to a lot of interpretation. The IRS has provided numerous examples that can also be utilized in the analysis.

Election to Capitalize Repair & Maintenance Costs

An election is available under the regulations for taxpayers interested in making an annual election to capitalize repair & maintenance costs if they are capitalized on the books and records.  The capitalized amount would then be capitalized consistently with books, eliminating book to tax differences for the cost, and would be depreciated under the proper tax life.

Next Steps

Now is the time to begin the compliance process and develop a timeline for your Company to review the application of these regulations.

The tangible personal property regulations are detailed and complex. If you have any additional questions about the regulations, please contact us.