NEW IRS REPAIR VS CAPITALIZATION REGULATIONS:
In 2013 the IRS issued final regulations pertaining to repair vs capitalization regulations. The regs are 222 pages long with 170 examples and is effective January 1, 2014. The following are highlights of the new regulations.
Improvements: The regulations require taxpayers to capitalize amounts paid to improve a “unit of property”. These result in:
Ø Betterment to the unit of property (UOP)
Ø Restoration to the UOP
Ø Adaptation of the UOP to a new or different use
A UOP is:
· In the case of all property except a building; all the components that are functionally interdependent comprise a UOP; and
· In the case of buildings, the building shell is treated as a UOP. Other “building systems” are treated as separate UOP’s, each one separate and distinct:
o HVAC SYSTEM
o PLUMBING SYSTEM
o ELECTRICAL SYSTEM
o FIRE PROTECTIONS AND ALARM
o SECURITY SYSTEM
o GAS DISTRIBUTION SYSTEM
What is a betterment? An expenditure is for a betterment if it
· Is for a material addition to the UOP including an enlargement, expansion, extension, or material increase in its capacity;
· Is reasonable expected to materially increase the productivity, efficiency or output of the property
What is a restoration? This occurs when a UOP is:
· Returned to operating condition if it has deteriorated to a state of disrepair and no longer functional;
· Rebuilt to like-new condition after is class life
· Repaired due to damage as a result of a casualty loss for which a basis adjustment was taken;
· Has a major component replaced
Example of RESTORATION: Taxpayer owns an office building having 300 exterior windows which represent 25% of the surface area of the building. He replaces 100 that become damaged with no future plans to replace any more. Although the 300 windows comprise a major component of the structure, the 100 do not. As such, the taxpayer would not treat this replacement as a restoration and would expense the cost in one year.
Assume instead that he replaced 200 windows. That does represent a significant portion of the major component and must be capitalized.
A new or different use is a use that was not intended when the owner of the property placed it in service.
SAFE HARBOR ELECTIONS:
In order to take advantage of this new election, ,a taxpayer must make the election on an annual basis by including a statement on the original timely filed return (including extensions).The election will apply to all qualifying expenses meeting the requirements. The statement must
· Be titled “Section 1.263(a)-1(f) de Minimis safe harbor election
· Include taxpayer’s name, address and Identification number
· Include a statement that the taxpayer is making the de Minimis safe harbor election under Treas. Regs §1.263 (a)-1(f)
SAFE HARBOR FOR BUILDINGS
There is a safe harbor of $10,000 for buildings owned or leased with an unadjusted basis no greater than $1 million. (unadjusted basis does not include land) The average annual gross receipts for this building must be less than $10 million for the preceding three years. No capitalization is required if the total amount paid does not exceed $10,000 or 2% of the building’s unadjusted basis. This is applied to each separate building.
The election is made on a timely filed return and must be titled “Section 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers” and include name, address and identification number as well as a description of each eligible building property elected.
Arnold is a qualifying taxpayer who owns an office building in which he provides accounting services. In 2014 Arnold’s building has an unadjusted basis of $750,000 and he pays $5,500 for repairs, maintenance and improvements to the office building. Because Arnold’s building has an unadjusted basis of $1,000,000 or less it constitutes eligible building. The $5,500 paid by Arnold during 2014 for repairs, maintenance, etc. on his building does not exceed the lesser of $15,000 (2% of $750,000, the building’s unadjusted basis) or $10,000. Therefore, Arnold may elect to immediately deduct the $5,500 paid for repair, maintenance, etc. on the office building in 2014 (§1.263(a)-3(h)(10), Exp. 1).
Safe harbor is applied building-by-building Betty is a qualifying taxpayer who owns two multi-family rental properties, one in Elkhart and one in Goshen. In 2014, each property has an unadjusted basis of $300,000 (less than the $1,000,000 threshold). Betty pays $5,000 and $7,000 for repairs and improvements in 2014 on the Elkhart and the Goshen buildings, respectively. The $5,000 paid by Betty for improvements on the Elkhart property does not exceed the lesser of $6,000 (2% of the building’s $300,000 unadjusted basis) or $10,000. Betty may elect to not apply the capitalization rules and currently deduct the improvement amounts on her 2014 tax return. However, the $7,000 Betty spent to improve her Goshen property exceeds $6,000, the lesser of the two limitations, and, therefore, she is not eligible to make the election for the Goshen property. Instead, the Goshen property improvements, but not repairs, must be capitalized and depreciated
Example – Safe harbor can be used on a leased building Clancy, who is a qualified taxpayer, leases retail space in the Westfield Mall. The $4,000 per month lease is a triple-net lease, and the lease term, with renewals, is 20 years. To determine Clancy’s unadjusted basis in the leased property, calculate the total rent he will pay over the lease (including reasonable renewals). His unadjusted basis is $960,000 ($4,000 monthly rent x 12 months ´ 20 years). Since it is under $1 million, the space is an eligible building under the safe harbor qualifications. In 2014, Clancy pays $1,000 for repairs and $6,000 for a new electrical box, totaling $7,000, which does not exceed the lesser of $19,200 (2% times $960,000) or $10,000. Therefore, Clancy may deduct the $7,000 without applying the repair vs. improvement rules if he properly, and timely, makes the safe harbor election (§1.263(a)
Sal Censoprano CPA
957 Laguna Circle
Foster City, CA 94404