It has been several months since the new “Repair Regulations” were issued and many companies are still trying to figure out how this impacts their business. The IRS's intent was to clarify the existing rules for capitalization but the overwhelming sentiment among CPAs and taxpayers is that they are too cumbersome. The IRS initiated this project almost ten years ago and retracted two sets of proposed regulations since then. While some are hoping for more modifications to simplify this existing law, KBKG believes it is unlikely that changes will be made in the near future.
The new regulations define an improvement as a Betterment, Adaptation, or Restoration to a “Unit of Property”. Think of the acronym B A R = Improvement = Capitalize. The definition of a “Betterment” or “Restoration” is where the regulations can be confusing and KBKG suggests reading this section of the regulations carefully. For buildings, the Unit of Property is defined as the building and its structural components other than the structural components designated as building systems …” §1.263(a)-3T(e)(2)(ii)(A). The size of the "Unit of Property" is relevant because the extent of the expenditure must be evaluated within the context of a particular unit of property. The new regulations list eight building systems that must be evaluated as their own Unit of Property. These systems include:
1. HVAC
2. Plumbing systems
3. Electrical systems
4. All Escalators
5. All Elevators
6. Fire Protection & Alarm Systems
7. Security systems
8. Gas distribution systems
While the new regulations are significantly less tax friendly than the IRS Proposed Regs issued in 2008, the IRS has conceded in two areas that may provide significant benefits to taxpayers.
#1. Plan of Rehabilitation Doctrine” is now obsolete!
Old case law required taxpayers to capitalize “repair” costs if part of an overall plan of improvement. Now that this is no longer the case, consider this real life case study:
- A client spent $3M on “Renovations” in 2009
- Based on old rules, the client capitalized and depreciated the entire amount.
- KBKG performed a “Repair Analysis” by reviewing construction documents and interviewing the contractor. This process requires Unit of Property analysis (as stated above).
KBKG identified $350K of costs as “repair” deductions. The client then recognized an additional $328K of deductions in the 2011 tax year by filing Form 3115 (original cost basis less depreciation already taken).
#2. Removal of building structural component is a disposition.
The IRS has finally conceded on this! The Regs now specifically allow you to write off the remaining basis of 1250 building items removed during a renovation. How many of your clients are currently depreciating the new roof and the old roof on their building? Consider this example:
- KBKG client acquired a three story office building in 2004 for $5M. In 2009, they spent $1M to remodel the 2nd floor (ceilings, walls, lighting, plumbing, ducting, electrical wiring, etc).
- For the 2011 tax return, KBKG performed an Asset Retirement Study and identified $450k (from the original $5M building) of 39-year items that were removed during the 2009 renovation.
Client claims $369,234k of additional deductions on the 2011 tax return ($450,000 less previous depreciation of $80,766).
Author: Gian P. Pazzia, CCSP