IRS Tangible Property Rules May Help Construction and Real Estate Industry
Contractors may have an opportunity to save on construction and building costs based on the IRS’s recent overhaul of the regulations that govern the handling of expenditures to produce, acquire, or improve tangible property. But first you have to clarify whether your expenditure is considered a repair or improvement, among other considerations.
Also, on August 14, the IRS released final regulations on the disposition of tangible depreciable property. So if repairs or improvements were properly capitalized in prior years, a partial disposition loss for the old components might be claimed with an accounting method change to write-off what was previously capitalized.
Improvements or repairs
Improvements are attributed to one of three areas: betterments, adaptations, or restorations (often called the “BAR” test).
- Betterments are a material addition to a unit of property (UOP) or a material increase in capacity to correct a material condition or defect that exists prior to acquisition or during production.
- Adaptations are putting a UOP to a new or different use that is not consistent with the ordinary use of the property at the time it was first placed in service.
- Restorations include returning a UOP to its ordinary operating condition after it deteriorated to a state of disrepair, or rebuilding a UOP to like-new condition after the end of its IRS defined class life. Replacing a part that comprises a major component or substantial structural part of a UOP also constitutes a restoration.
When applying the BAR test to a building, the regulations separate the building into the building structure (roof, walls, windows, floors, and ceilings) and eight defined building systems (HVAC, plumbing, electrical, escalators, elevators, fire-protection and alarm, security, and gas distribution).
Activities that are not considered an improvement can often be deducted as a repair and maintenance expense. For instance, building refresh costs (e.g., cosmetic changes such as power washing walls and repainting, cleaning or resealing wood floors), most likely should be deductible. However, if remodeling involves replacing large parts of the exterior walls or upgrading the electrical system, these costs most likely should be capitalized.
BAR test example
A contractor uses equipment for highway and road construction operations. Each independently operable piece of equipment is a UOP with a class life of six years. The contractor does scheduled maintenance every so often such as cleaning the engine, oiling specific parts, inspecting parts for defects, and replacing items such as springs, bearings and seals.
The BAR test determines that these costs are deductible repairs and maintenance expenses, since they do not materially increase capacity, adapt the equipment to a new use, or rebuild to like-new condition. However, if the equipment was reconfigured with additional components that enhance its capacity, then it may be considered betterment and those costs would need to be capitalized as improvement.
De minimis safe harbor rule
If a company has an applicable financial statement (AFS) and a written book capitalization policy in place at the beginning of the tax year, then it can deduct items below this threshold but not in excess of $5,000 per invoice or per item.
An AFS is defined as a financial statement filed with the Securities Exchange Commission (SEC), a certified audited financial statement by an independent CPA, or a financial statement required to be provided to a federal or state government or agency. If you don't have an AFS, you may still be able to deduct up to $500 per invoice or per item if the other requirements are met. This is an annual election made on a timely filed original tax return.
Routine maintenance safe harbor rule
Recurring costs to keep property in ordinary operating condition can also be deducted, when the costs are reasonably expected to occur more than once within the class life of the property.
Safe harbor rule example
Machinery and equipment used in road construction may need to be serviced more than once during its class life (six years), which may require disassembly, cleaning, inspection, repairs, replacement, reassembly, and testing of its component parts. (Buildings use a 10-year period class life.)
So if you own a building and service the HVAC units every four years — especially if within the maintenance interval recommended by the manufacturer — these costs should be deductible. Finally, costs with longer intervals might still be deductible on a facts and circumstances basis, but would fall outside of the safe harbor rule.
Disposition rules applicable to 2013 and 2014 tax returns
Disposing of an entire unit of property requires the recognition of gain or loss. Partial dispositions (i.e., a disposition of less than an entire UOP) were generally not allowed in the past, but the new regulations allow for this if an election is made in the year of the disposition.
You can still make this election on 2013 and 2014 tax returns for dispositions that occurred in previous tax years. It would be beneficial to make this election where repairs to a roof were capitalized in prior years (regardless of the refund statute being closed for the year), so the net tax value of the old roof at the beginning of the 2013 or 2014 tax year can be written-off.
In addition, the costs of removing an asset should follow the initial treatment of the asset. So if the old asset is treated as disposed, then removal costs are part of the disposition (i.e., increase the loss or reduce the recognized gain). If the old asset is not treated as disposed, removal costs are deducted or capitalized based on whether they directly benefit a capitalized improvement.
How you can benefit from the new rules
If repairs or improvements have been performed on tangible property in prior years, there may be an opportunity for claiming additional deductions. Items that were capitalized in prior years due to a conservative approach and/or just following GAAP treatment might be claimed with an accounting method change to write-off what was previously capitalized as deductible repairs.
Also, if improvements were properly capitalized in prior years, there may be a chance to claim a partial disposition loss for the old components that were removed. On the flip side, you can get audit protection if you have been under-capitalizing repair expenditures and then finance the resulting taxes over a four-year period with no interest or penalties.
How we can help
This is a time-sensitive opportunity, and an analysis should be done before year-end as multiple tax year implications may be involved.
We can help you efficiently sort through the classes of expenditures and assets on your books to help you determine proper classification and the best course of action to minimize tax exposures or maximize tax savings. We can also evaluate your current accounting methods by conducting a repairs analysis, helping you navigate the tax rules, and discussing the options based on your unique tax position.