28
Wisconsin Community Banker
July/August 2014
IRS Makes Massive Changes to the Capitalization of
Certain Expenditures
Susan Rammer, CPA, Senior Manager,
Wipfli
In
September 2013, the Internal
Revenue Service released final
regulations governing what expenses
can be deducted as repairs versus what
must be capitalized and depreciated
over multiple years. The regulations
define the treatment of expenditures
for acquiring, producing, or improv-
ing tangible property. These new
regulations, commonly referred to as
the “Repairs Regulations” or “Tangible
Property Regulations,” went into effect
January 1. Since nearly all businesses
have some kind of fixed assets, every
business is affected by these new rules.
The fundamental concept of these
rules is property “improvement.” If
an expenditure for work performed
fits within the IRS definition of an
“improvement,” then the costs must
be capitalized. This includes costs that
facilitate the acquisition or produc-
tion of the property (except for
employee compensation and overhead
costs). These rules apply to buildings,
leasehold improvements, and land
and land improvements, as well as
other purchases, including comput-
ers, phone systems, vehicles, furniture,
equipment, carpeting, and even spare
parts.
What Is Considered an Improvement?
Before determining whether an
expense is for an “improvement,” the
appropriate “unit of property” (UOP)
must be identified. In general, the
benchmark for what constitutes a unit
is the functional interdependence test:
All components of property that are
functionally interdependent make up
a single unit of property. Components
are functionally interdependent if the
placing in service of one component is
dependent on the placing in service of
the other component.
For example, under the proposed
regulations, a building and its com-
ponents are considered a single unit
unless the component is a building
system. When considering whether
an expenditure is an improvement,
the IRS has identified as many as eight
building systems that it considers
functionally interdependent including
the plumbing systems, HVAC (heat-
ing, ventilation, air conditioning)
systems, electrical systems, elevators,
escalators, fire protection systems,
security systems, and gas distribution
systems. Structural components of the
building that are not considered func-
tionally interdependent include walls,
floors, and ceilings, as well as perma-
nent coverings such as paneling or
tiling, windows and doors, and other
components relating to the operation
or maintenance of the building.
Why Is This Important?
The unit of property is used to
determine whether an expenditure
must be capitalized as an improve-
ment. The regulations contain an
extremely subjective facts-and-cir-
cumstances approach and no longer
provide bright line tests. This makes
the unit of property identification
very important. In general, the larger
the unit of property, the more likely
it is that the expenditure related to
that property will not be considered
an improvement. For example, if the
entire building was the unit of prop-
erty, then major work on an HVAC
system might be a repair. However, if
the HVAC system is the unit of prop-
erty, then that work will probably need
to be capitalized.
Now that we have determined the
importance of the unit of property,
we can look at what is considered an
improvement by IRS definition. In
brief, the IRS has provided the fol-
lowing list of criteria it will use when
deciding whether an expenditure
is for an improvement and should
therefore be capitalized under the new
regulations.
An expenditure is an improvement
if it:
4
Results in a betterment of the
unit of property, which includes work
that:
4
Alleviates a material adverse
condition or defect that existed before
the business owned the property.
4
Results in a material addition.
4
Results in a material increase
in capacity, efficiency, strength, or
quality.
4
Restores the unit of property.
4
Adapts the unit of property to a
new or different use (Temp. Regs. Secs.
1.263(a)3T(d) and 1.263(a)-3T(h)).
The new regulations also include
a few safe harbor provisions that may
allow for certain expenditures to be
currently deducted as repairs.
The first safe harbor is for routine
maintenance. This allows for certain
expenditures that keep property
in good operating condition to be
expensed. In addition, the costs of
performing certain routine mainte-
nance activities for tangible property
(other than buildings) are allowed to
be expensed if, at the time the prop-
erty was placed in service, the tax-
payer reasonably expected to perform
the maintenance activity more than
once during the property’s life. This
can include inspection, cleaning, and
testing, as well as the replacement of
damaged or worn parts.
Another part of the routine mainte-
nance safe harbor allows for the costs
of performing certain routine main-
tenance activities for buildings to be
expensed if the activities are expected
to occur more than once over a ten-
year period. This can include paint-
ing, carpeting, or even parking lot
surfacing.
Routine maintenance costs are
deductible if they are necessary to
keep (as opposed to put) a unit of
property in its ordinarily efficient
operating condition. However, this
safe harbor only applies if the amounts
paid are not required to be capitalized
under the “improvement” standards as
a betterment, restoration, or adaption.
