Expenses & Deductions
Treasury published temporary regulations (T.D. 9564) on Dec. 23, 2011, that affect all taxpayers who acquire, produce, or improve tangible property. The temporary regulations represent almost eight years of effort to clarify the rules surrounding capital expenditures under Sec. 263(a).
The temporary regulations cover topics particularly relevant to real property owners, such as the definition of a building as a unit of property, building improvements, dispositions of building structural components, and special rules for leased property, condominiums, cooperatives, and leasehold improvements. Real property owners should consider the tax accounting options available in the regulations and how cost-segregation studies can ease compliance requirements. Historically, cost-segregation studies primarily focused on identifying and segregating personal property or land improvement assets embedded in the cost of real property assets. As taxpayers adopt the new regulations, some will find it beneficial to apply the information in these studies to future improvements and dispositions of their building structures.
Building Improvements and Repairs
The first opportunity the temporary regulations create for cost-segregation professionals and their clients springs from the capital improvement guidelines. Under Temp. Regs. Sec. 1.263(a)-3T(d), an improvement is an expenditure that betters a unit of property, restores a unit of property, or adapts a unit of property to a new or different use. Sec. 263(a) requires capitalization of improvements to tangible units of property. The temporary regulations expand the application of capital improvement guidelines to specific building systems in addition to building structures.
According to Temp. Regs. Sec. 1.263(a)-3T(e)(2)(ii), the building as a unit of property consists of the building structure and its enumerated building systems including: (1) heating, ventilation, and air conditioning (HVAC) systems; (2) plumbing systems; (3) electrical systems; (4) all escalators; (5) all elevators; (6) fire protection and alarm systems; (7) security systems; (8) gas distribution systems; and (9) other structural components identified in published guidance. Cost-segregation providers should work closely with their clients to determine whether further subdivision of the building into its functional systems would be beneficial. The potential benefits to the taxpayer are clear: A cost-segregation study enhanced with additional information regarding the building structure and building systems will assist the taxpayer in evaluating whether future expenditures are deductible repairs and maintenance expenses or capital improvements.
Cost-segregation service companies and property owners may also anticipate circumstances that warrant subdividing the building systems into even more detail. Temp. Regs. Sec. 1.263(a)-3T(i)(4) defines a major component or a substantial structural part of a unit of property as a part or a combination of parts that constitute a large portion of the physical structure of the unit of property or that perform a discrete and critical function in the operation of the unit of property. Replacement of these components may result in capital improvements. Taxpayers must consider all the facts and circumstances when determining whether expenditures rise to the level of capital improvements.
Example 1: A replaces 30 windows to her office building for which she previously engaged a cost-segregation study. Under the temporary regulations, A must determine whether the expenditures constitute improvements to the building structure or any building system. She refers to the cost-segregation study to find there are 300 windows in the building. Based on her analysis of the guidelines, replacement of 30 windows in her office building does not cover a large portion of the overall physical building structure; therefore, the replacement does not constitute an improvement to the office building. A may deduct as repair and maintenance costs any expenditures not otherwise required to be capitalized under other provisions of the Code or regulations.
Traditionally, a cost-segregation study includes a breakdown of the assets according to modified accelerated cost recovery system (MACRS) asset classifications and cost-recovery periods. A study usually includes supplemental support based on a review of the general contractor’s application for payment, construction invoices, appraisals, on-site inspections, a review of blueprints, etc.
After adopting the new regulations, taxpayers may desire additional qualitative information regarding a project because a large portion of the improvement rules are based on qualitative tests. For example, Temp. Regs. Sec. 1.263(a)-3T(h) states that a betterment to a unit of property occurs when a payment corrects a material defect to a unit of property; results in a material addition to a unit of property; or results in a material increase in capacity, productivity, efficiency, strength, or quality of the unit of property or the output of the unit of property.
The rules addressing the adaptation of components to new or different uses similarly require qualitative assessments. Occasionally, remodel or refresh projects include deductible repairs a taxpayer may only capture through an analysis of the project’s facts and circumstances. Under these circumstances, cost-segregation professionals are in a unique position to provide this qualitative consultation to their clients to facilitate taxpayer compliance with the temporary regulations.
Building Component Dispositions
The second opportunity the temporary regulations create for cost-segregation professionals and their users arises from the expansion of the definition of dispositions to include building structural components. This development is very important for owners of real property because, prior to Jan. 1, 2012, losses were not allowed for retired building structural components under Prop. Regs. Sec. 1.168-6(b). Consequently, replacement of building components resulted in the continued depreciation of both the replaced and replacement property. But new Temp. Regs. Sec. 1.168(i)-8T(b)(1) expands the definition of dispositions to include retired structural components. Under these new rules, the taxpayer can elect to (and in some cases is required to) end depreciation of building components upon removal and recognize a loss. Cost-segregation providers can include additional information to facilitate a taxpayer’s accurate reporting of losses when the taxpayer disposes of the components.
As mentioned previously, a cost-segregation study traditionally includes only a breakdown of the assets according to MACRS classifications and cost-recovery periods. To take advantage of the new regulations, providers should consider including complete cost details for individual building components. Additionally, enhanced reports with quantitative building component details, such as the square footage of roofing, number of windows, or linear feet of electrical conduit, would assist a taxpayer in calculating his or her unadjusted depreciable cost basis per unit at the time of disposition.
Enhanced cost-segregation reports with cost information per divisible section, such as per suite or per apartment, may be useful for owners of residential or commercial property and possibly even more useful to owners of buildings without uniform cost dispersions. For example, taxpayers who own automobile dealerships may desire to split costs between showrooms and service areas; taxpayers who own manufacturing plants may desire to split costs between administrative offices and assembly sections; and taxpayers who own mixed-use property may desire to split costs between office units, residential units, and retail units.
Example 2: B builds a new office building for $10 million and enlists an engineering firm to perform a cost-segregation study. B eventually renovates the office building and capitalizes its expenditures based on the improvement guidelines in the temporary regulations. The scope of this renovation includes the disposal of 4,500 square feet of interior walls, 1,000 square feet of ceiling tiles, and 500 linear feet of electrical wiring. The previously issued cost-segregation report includes details listing the unadjusted depreciable cost per unit of each retired component. B uses the specific identification method to identify to which capital accounts the disposition applies. Based on the details provided in the study, B calculates the loss she may recognize on the retired assets.
There are a number of considerations to be made in applying the temporary regulations. In addition to dispositions and structural improvements, the temporary regulations prescribe special rules for leased property, condominiums, cooperatives, and network assets. In March 2012, Treasury published Rev. Procs. 2012-19 and 2012-20 to guide taxpayers through the change in accounting method process. Owners of real estate should consider the implications of the new regulations when engaging firms to perform cost-segregation studies. Providers of cost-segregation studies should have a comprehensive understanding of the new regulations as well as an understanding of how these regulations will affect their clients. Providers should work closely with clients to ensure that the studies they provide are tailored to meet their clients’ needs.
Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, Ill.
For additional information about these items, contact Mr. O’Connell at 630-574-1619 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.