Oh, no. We’re now halfway through 2016, I haven’t filed my 2015 tax returns (fortunately they are on extension) and I never did anything about the Tangible Property Regulations (“TPR”) that became effective in 2014. Is there anything I can do?
As a matter of fact, there are a number of things you can still do. There is no prohibition against adopting the TPR in 2015. You can still file for an automatic change of accounting method with your 2015 tax return. What you don’t get is the audit protection that was available to taxpayers who adopted the TPR in 2014. Most accounting method changes are granted with audit protection, which means that the Service will not require the taxpayer to change its method of accounting for the same item for a taxable year prior to the year of change. If your 2015 return is examined by the IRS, adjustments resulting from the method changes as well as the tax treatment of the same or similar items in prior years are subject to challenge.
You also don’t get to take full advantage of the new partial asset disposition (“PAD”) rules which allow taxpayers to claim a loss on a retired structural component of a unit of property when the asset is permanently withdrawn from use in the taxpayer’s trade or business or when ownership is transferred. A PAD is required when there is a casualty loss, tax-free exchange or a transfer of the property. One of the advantages of adopting the TPR in 2014 was the opportunity to take a deduction for PAD that occurred in prior years. Now taxpayers may take such a deduction only for current year PAD.
The TPR provide guidance on whether certain expenditures are currently deductible or require capitalization and apply to anyone who pays or incurs expenditures to acquire, produce or improve tangible real or personal property.
In general, when adopting the TPR, a taxpayer is adopting the following changes:
- Utilizing the Safe Harbor for Routine Maintenance;
- Defining the Unit of Property (“UoP”) for building(s), certain specified building systems and land improvements; and
- Determining the amount to be capitalized as an improvement to tangible property
The Routine Maintenance safe harbor allows for the deduction of certain costs incurred on a unit of tangible property. Repair or maintenance activities are considered routine if the taxpayer reasonably expects to perform the activities more than once over a ten-year period. The taxpayer can qualify for the safe harbor deduction even if the activity does not occur more than one time over that ten-year period if it can be established that, at the time the property was placed in service, it was reasonable for the taxpayer to expect that the repair or maintenance would be required more than once.
The UoP definition is important when determining whether expenditures incurred to improve upon tangible personal property must be capitalized or could be deducted as a repair. The larger the UoP, the more likely the expenditure will be deducted.
The UoP is a group of functionally interdependent components – when one component’s placement in service by the taxpayer is dependent on the placement in service of another component they are functionally interdependent. Amounts are treated as being paid for an improvement to a building if they improve any of the building’s systems (each of which is a separate UoP) or the building structure, which includes parts of a building such as walls, partitions, floors, ceilings, and other components relating to the operation or maintenance of the building.
Once the taxpayer has defined the UoP, the next step is to analyze whether any improvements made resulted in a betterment, restoration or adaptation. A betterment ameliorates a pre-existing material condition or defect, results in a material addition to the UoP, or a material increase in the capacity, productivity, strength, efficiency or quality or output of the UoP.
A restoration results in the rebuilding of the UoP to a like-new condition after the expiration of the property’s class life. It can be a replacement of a major component or a substantial structural part of the UoP including a component deducted because of a loss or restoration of damage when the taxpayer has properly taken a basis adjustment as a result of a casualty loss or casualty event. A restoration also may be an activity that returns the UoP to its ordinary efficient operating condition after the property has deteriorated to a state of disrepair and was no longer functional for its intended use.
Finally, amounts paid to adapt a UoP to a new or different use must be capitalized.
When adopting the regulations in 2014, taxpayers in general were granted permission to “scrub” depreciation schedules with the purpose of reviewing items that were previously capitalized to determine if when utilizing the regulations those items would have been deducted as repairs. Taxpayers were also supposed to review repairs deducted previously to determine if they would have been capitalized if the new rules had been in effect at the time.
There are certain elections that can be made that do not require the filing of a form to change the accounting method. These elections are made when filing the requisite tax returns. One main election is the safe harbor for materials and supplies. Any material or supply purchased for a cost of less than $200 may be currently deducted. In addition, there is a safe harbor allowing for higher cost items to be considered materials or supplies.
If you have audited financial statements you can adopt a written accounting policy at the beginning of the year to expense property costing $5,000 or less. Without audited financials, your safe harbor accounting policy is limited to $2,500. This election, made annually, requires that all qualified materials or supplies be deducted rather than capitalized. These amounts are safe harbors. It is possible for a taxpayer to use a higher amount in its accounting policy if justifiable, but such higher amount will not have the protection of the safe harbor.
The Tangible Property Regulations are quite complicated; however, we have become very knowledgeable with their provisions and can assist you with properly implementing them. If you need additional assistance, please contact your Friedman LLP professional.