Final Tangible Property Regulations

Final Tangible Property Regulations @dozcpa

Dauby O’Connor & Zaleski LLC • DOZ has been in business for 27 years, has 150 employees, and specializes in the multifamily/affordable housing industry

Welcome to DOZ’s “Not So De Minimis” Presentation • Objectives of Final Regulations • General Capitalization Rule • De Minimis Safe Harbor Election • Unit of Property • Routine Maintenance and Small Building Owner Safe Harbor • Capitalization of Improvements • Materials and Supplies • Other Issues, Considerations and Food for Thought • Final Thoughts….Final Regulations “Simplified”

Introduction, Background and Objectives • Final regulations culminates a seven year project: • Proposed Regulations in 2006; • Proposed Regulations modified in 2008; • Temporary Regulations issued in late 2011; and • Final Regulations issued September 13, 2013 • Revenue Procedure issued April 2014

History of Controversy • Subjective nature of prior standards created controversy • Conflict between requirement to capitalize and the ability to deduct ordinary and necessary expenses under IRC §162 • Requirement to capitalize based on facts and circumstances • Prior rules were based on subjective standards • Clearly, an objective of this seven year project is to reduce controversy between the taxpayer and the IRS

How the Final Regulations May Help to Reduce Controversy • How the new regulations help to reduce controversy: • Multiple taxpayer-friendly safe harbor rules • Repairs and maintenance • De minimis safe harbor with a fixed dollar threshold versus the temporary regulation percentage of revenue computation • Book-Tax conformity as a “control” • More generous de minimus threshold with an applicable financial statement • Emphasis on consistent policy, consistently applied • New controversies going forward? • No bright lines for building improvements versus repairs • Significant portion of major component; substantial structural part

Complexity of Final Regulations and PresentationFocus • Complexity of Final Regulations and PresentationFocus: • T.D. 9636 and the new final regulations represent over 200 pages of technical material • Approximately 70% of the examples relate to airlines, railroads and manufacturing facilities • Our focus is on §263(a) not §263(A) • § 263(a) applies to the multifamily housing industry • § 263(A) applies to inventory or active trade or businesses • DOZ is happy to assist you in working through the new final regulations as it relates to your industry

DOZ Observation • DOZ Observation • Providing a de minimis safe harbor threshold at a specific dollar amount versus a percentage of revenue is a clear win for the small and medium sized taxpayers; Designed to create bright lines and make taxpayer compliance easier • Many multifamily housing taxpayers may not want to take advantage of the full $5,000 de minimis safe harbor due to GAAP and materiality considerations; consider that the $5,000 threshold applies to small taxpayers and US Airways

General Capitalization Rule (§1.263(a)-1) • Taxpayer must capitalize amounts paid to acquire or produce a unit of property, including leasehold improvement property, land and land improvements, buildings, machinery, equipment and furniture and fixtures • Amounts paid include invoice price and transaction costs • Amounts paid to defend or perfect title • Costs that facilitate (including inherently facilitative) the acquisition or production of property must be capitalized • Repairs made to assets prior to placing them in service must be capitalized

General Capitalization Rule (§1.263(a)-1)… Cost to Be Capitalized • Contingency fees if contingent on closing of an acquisition • Exceptions: • Employee compensation or overhead: • Treated as amounts that don’t facilitate acquisition • Taxpayer may elect to capitalize employee compensation or overhead related to each acquisition • Effective dates: • January 1, 2014 • Elect to apply on or after January 1, 2012 and • Temporary regulations may be used if earlier application is elected • DOZ Observation: No, or very few, early adopters 

De Minimis Safe Harbor Election (§1.263(a)-1(f)) • Taxpayers may elect not to capitalize amounts paid to acquire or produce tangible property under §1.263(a)-2(d) or §1.263(a)-3(d) if: • Taxpayer has, at the beginning of the tax year, written accounting procedures treating as an expense amounts paid for property: • Costing less than a specified dollar amount; or • With an economic useful life of 12 months or less • Taxpayer must expense the amount paid for property on its books and records and/or applicable financial statement (“AFS”) • Amounts paid for property may not exceed the de minimis threshold: • $5,000 for taxpayers with an AFS • $500 for taxpayers without an AFS • Amount paid is “per invoice or per item as substantiated by the invoice” • An invoice for the acquisition of a Unit of Property (UOP) in the amount of $5,001 or $501 will cause the entire amount paid to be ineligible for the de minimis safe harbor election • Provision for the IRS to increase the maximum amount

De Minimis Safe Harbor Election (§1.263(a)-1(f))….. • DOZ Observation • The requirement that the capitalization policy be in writing technically applies only to taxpayer’s with an AFS. DOZ recommends that taxpayers have a written capitalization policy with or without an AFS. • See Appendix A for Sample Capitalization Policy Language • Final regulations give the IRS authority to make cost-of-living type adjustments to the de minimis threshold; could we have a $5,150 threshold next year? • DOZ Caution • The new regulations are clear that the written policy be in place at the beginning of the taxable year. The (written) policy must be effective as of January 1, 2014 and must apply to all 2014 transactions. • DOZ Caution • Anti-abuse rules apply… you can’t create a separate invoice for parts of a UOP to suddenly fall under the de minimis threshold • Example- truck purchase

De Minimis Safe Harbor Election (§1.263(a)-1(f))….. • Applicable Financial Statements are “Prioritized”: • Financial statements filed with SEC; • Certified audited financial statements but only if used for: • Credit purposes; • Reporting to shareholders, partners, or similar purposes; or • Any other substantive tax purpose • A financial statement (other than a tax return) required to be provided to the federal or a state government or any federal or state agency (other than the SEC or IRS) • DOZ Observation • An audited financial statement solely for the purposes of using the $5,000 de minimis threshold is not an AFS. • It is clear under the new regulations that an owner certified financial statement is an AFS. This seems inconsistent with regulatory intent and could change at some point in the future. • It is unclear how the above rules work in a partnership with related partners.

De Minimis Safe Harbor Election (§1.263(a)-1(f))…… • Transaction and Other Additional Costs: • Additional costs consist of facilitative costs of acquiring or producing property and costs for work performed before the date the acquired property is placed-in-service • Taxpayer electing the de minimis safe harbor would include any additional costs such as delivery or installation costs if such costs are included on the same invoice • Additional costs should be allocated if invoice is for multiple UOP • Safe Harbor rule must be applied to any amount paid to acquire or produce a UOP (or a material or supply) to which the safe harbor applies

De Minimis Safe Harbor Election (§1.263(a)-1(f))..… • DOZ Observation • One of the criteria to meet the safe harbor requirements is that the amount expensed must be expensed on the AFS (or the books and records for taxpayers without an AFS). Therefore, once amounts are capitalized for book (AFS) purposes, such costs are no longer eligible to be expensed under the de minimis safe harbor. • The required capitalization policy is a book (GAAP) policy. There is no such thing as a tax capitalization policy. Therefore, in determining the appropriate threshold for expensing amounts paid to acquire or produce property, GAAP and materiality must be considered.

De Minimis Safe Harbor Election (§1.263(a)-1(f))..… • Example Question • Assume a taxpayer has a written capitalization policy and an AFS. The written capitalization policy provides for expensing amounts paid to acquire a UOP up to $2,500 for each UOP. Taxpayer acquires 100 refrigerators for $250,000 (per unit cost of $2,500) and capitalizes the $250,000 on its AFS since the 100 refrigerators represent a significant portion of the total refrigerators (i.e. purchase is material). Taxpayer also replaces carpet in 10 dwelling units at a cost of $1,500 per UOP. The total cost of the replacement carpet, $15,000, is expensed on the AFS. Taxpayer makes the de minimis election. • Answer • Taxpayer must capitalize for tax purposes the amounts paid to acquire the 100 refrigerators since the amounts paid for the refrigerators have not been deducted on the AFS. • The cost of the replacement carpet for all ten dwelling units must be expensed.

Unit of Property (“UOP”) (§1.263(a)-3(e)) • UOP rules apply for the purposes of: • Barring current deductions for new buildings or permanent improvements made to increase the value of the property • Explaining types of expenses that must be capitalized • Explaining how to handle materials and supplies • An improvement to a UOP doesn’t create a separate UOP • UOP for personal or real property (other than a building) • Components that are functionally interdependent comprise a single UOP; components must be placed in service simultaneously • One UOP may be placed-in-service independent of another UOP • Example – refrigerator and its drawers • DOZ Observation • Includes each refrigerator, stove, kitchen cabinets, countertops, dwelling unit carpet

Unit of Property (“UOP”) (§1.263(a)-3(e))… • UOP – Buildings • A building and its structural components (including the building systems) are a single UOP • Amounts paid to improve are treated as improvements to the building if the building structure or any building system is improved • A building and its structural components (excluding the building systems) is defined in Reg 1.48-1(e)(1) and Reg 1.48-1(e)(2) and includes the structure or edifice enclosing a space within walls, roof, partitions, floors, ceilings, permanent coverings thereof such as paneling or tile, windows and doors

Unit of Property (“UOP”) (§1.263(a)-3(e))..… • UOP – Buildings (continued) • Building Systems • HVAC • Plumbing • Electrical • All Escalators • All Elevators • Fire- Protection and Alarm Systems • Security Systems • Gas Distribution System • Other Systems (TBD) • See Appendix B for Complete Detail

Unit of Property (“UOP”) (§1.263(a)-3(e))… • Special UOP Rules for leased property, condominiums and cooperatives • Characterization of assets for depreciation purposes overrides UOP Rules • Example – Tractor and tires • DOZ Key Point – A building and its structural components (including the building systems) is a single unit of property. However, the improvement rules apply separately to the building and the building systems of each UOP (building). • Example – Plumbing systems repair for one building • For new projects, costs for each building system will need to be accounted for separately (i.e. HVAC separate from plumbing)

Routine Maintenance Safe Harbor • Routine maintenance safe harbor: • Routine maintenance consists of recurring maintenance taxpayer expects to perform to maintain a UOP in its ordinary efficient operation • Routine maintenance includes inspection, cleaning, testing, and replacement of damaged or worn parts; however, • For a building UOP, maintenance is only routine when, at the time the building is placed in service, the taxpayer expects to perform such maintenance more than once in a ten-year period • Example – preventative maintenance • For a UOP that is not a building, maintenance is routine if taxpayer expects to perform such maintenance more than once during the UOP class-life (usually 5 years for multifamily housing personal property) • Example - refrigerator • The fact that the maintenance does not occur as often as expected is not compelling; it is the reasonable expectation of taxpayer at the time the property was placed-in-service

Routine Maintenance Safe Harbor….. • Routine maintenance safe harbor (continued) • Expenses ineligible for safe harbor: • Betterments and adaptations to a new or different use • Replacement of component where taxpayer has properly deducted a loss or otherwise taken into account the adjusted basis of the component in realizing gain or loss resulting from a sale or exchange • Restorations of damages to a UOP for which taxpayer has taken a basic adjustment as a result of a casualty loss • Once a UOP falls into a state of disrepair or is no longer functional, costs to return a UOP to its former efficient operating condition must be capitalized

Routine Maintenance Safe Harbor..… • DOZ Observations • Preventive maintenance contracts for HVAC and other building systems will likely meet the repairs and maintenance safe harbor without regard to the level of repairs made during such preventive maintenance. DOZ recommends documenting the “reasonable expectation” for routine maintenance services and frequency. • Preventive or routine maintenance contracts for personal property (such as for appliances) normally associated with multifamily housing projects do not normally occur. • DOZ Caution • Exception for prior owner’s use - Otherwise routine repairs and maintenance expenses made need to be capitalized if the “wear and tear” occurred prior to taxpayer placing the property in service (used machinery and equipment).

Small Building Owner Safe Harbor • Per-Building Safe Harbor Election for Small Taxpayers: • Small Taxpayers (average annual gross receipts of $10,000,000 or less for 3 preceding years) • Election not to capitalize building improvement costs up to the lesser of $10,000 or 2% of the unadjusted basis of the building • $10,000 includes amounts expensed under the de minimis safe harbor • Elected annually on a building-by-building basis • If improvement expenses are more than the lesser of 2% of the unadjusted basis or $10,000, taxpayer is not eligible for the election • DOZ Observation: Unlikely to be useful except for smallest of taxpayers

Capitalization of Improvements – Betterments • Taxpayers must capitalize amounts paid for betterment of a UOP. A betterment: • Ameliorates a material condition or defect that either existed before the taxpayer acquired the UOP or arose during production • Results in a material addition or material increase to capacity including additional cubic or linear space; or • Is reasonably expected to increase productivity, efficiency, strength, quality or output of the UOP • Property’s “Before and After” Condition • Normal wear and tear versus betterment • Expenses to correct damage

Capitalization of Improvements – Betterments..… • DOZ Observations • Amounts paid to repair property acquired must be capitalized if the condition or defect existed at the time the taxpayer acquired the property – even if the defect was unknown at the time of the acquisition. • Generally, the betterment rule will apply to multifamily housing for acquisition/rehab projects or when used machinery and equipment is acquired. • The “before and after” rule assists in distinguishing costs which are not required to be capitalized under Reg 1.263(a)-3(d) and are, therefore, deductible as repairs and maintenance expense. • Example 11 of Reg 1.263(a)-3(j)(3) makes it clear that the fact work undertaken to satisfy a regulatory requirement is not relevant.

Capitalization of Improvements - Restorations • Restorations • Taxpayers must capitalize amounts paid to restore a UOP • Special Rule for Restoration of Damage: • The amount paid to restore damage required to be capitalized is limited to the excess (if any) of: • Adjusted basis of the property damaged, over • The amount paid to restore the damage to the UOP • Excess amounts are treated under otherwise applicable rules (i.e. generally, repairs and maintenance) • Replacement of a part or combination of parts that comprise a major component or a substantial structural part of UOP • DOZ Observation • A common theme (and added layer of complexity) is the concept that amounts must be capitalized when taxpayer recognizes a gain or loss on the disposition of replaced assets whether due to a sale or exchange or casualty loss.

Capitalization of Improvements – Restorations… • Application of Restoration Rule to Building System • Plumbing System – pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer, collection equipment, site utility equipment used to distribute water and waste to and from the property line and between buildings and other permanent structures. • All bathroom sink faucets are replaced ($2,000) • All sink faucets are replaced (bathroom and kitchen) ($5,000) • All bathroom sinks are replaced ($5,000) • All sinks are replaced (bathroom and kitchen) ($10,000) • All toilets are replaced ($5,000) • All bathtubs are replaced ($7,500) • Unadjusted Basis of Plumbing System - $67k per building $7,500 per unit

Capitalization of Improvements - Adaptations • Adaptations to a New or Different Use • Taxpayers must capitalize amounts paid to adapt a UOP to a new or different use • “New or Different Use” means a situation where the adaptation is inconsistent with the taxpayer’s intended ordinary use of the property when it was originally placed in service • DOZ Observation • The multifamily housing industry is not likely to convert property to a new or different use. When such circumstances arise, the rules are fairly clear. Conversion of a storage area to a fitness center would be considered adaptation to a new or different use.

Materials and Supplies • Items which are considered materials and supplies may be deducted: • When paid or when consumed depending on: • Whether or not inventory or consumption records are maintained • This gives rise to the terms: • Incidental materials and supplies (no inventory/consumption records, expensed when paid) • Non-incidental materials and supplies (inventory/consumption records, expensed in the year first placed-in-service) • Generally, materials and supplies are: • Amounts paid or incurred to acquire components to maintain, repair, or improve a unit of property • Amounts paid or incurred to acquire a UOP with an economic useful life of less than 12 months; or • Amounts paid or incurred to acquire a UOP with an acquisition cost of $200 or less

Materials and Supplies….. • DOZ Observation • Properties may be keeping light bulbs and furnace filters on hand but not much else. It seems somewhat unlikely that properties are maintaining inventory or consumption records for any UOP qualifying as materials and supplies. • Taxpayers owning multifamily housing will, generally, make the de minimis safe harbor election (it is an annual election). This will prevent the taxpayer from deducting expenses as materials and supplies. • Practically, for a typical multifamily project, the final regulations relating to materials and supplies can be ignored.

Other Issues, Considerations and Food for Thought • Election to capitalize repairs and maintenance • At the request of tax practitioners, the final regulations include an election to capitalize repair and maintenance expenditures as improvements if: • Taxpayer treats such costs as capital expenditures for financial accounting purposes; and • Such costs are incurred in “carrying on a trade or business” • DOZ Caution • There are no uniform standards for whether taxpayer activities qualify as a trade or business. The question of whether rental property is a trade or business of a taxpayer is ultimately a question of fact.

Other Issues, Considerations and Food for Thought….. • Track preventive maintenance contracts as part of annual operating budget to document frequency of services provided • DOZ recommends tracking repairs and maintenance related to the building separately from repairs and maintenance relating to personal property • Taxpayers without an AFS should still have written accounting procedure: • Not required; but • Whether intentional or a drafting oversight remains to be seen • A change in procedures to comply with the de minimis safe harbor is not a change in accounting method

Revenue Procedure 2014-16 • Explains the procedures to obtain automatic consent for changes in accounting methods required or permitted under the regulations • Automatic consent for changes to: • Deducting materials/supplies (nonincidential - for 1st year used/consumed; incidental – year paid) • Deducting amounts paid for repairs and maintenance, including change in classification of unit of property (or for building, change in identifying building structure or building systems) • Taxpayers who want to apply de minimis rule do not have to obtain approval for change in accounting method since is an election. • May require a Sec. 481(a) adjustment to income.

Final thoughts…”Not-So-De Minimis” Regulations Simplified • Final regulations “simplified” • Personal Property- repairs to personal property that rise to the level of an improvement probably occur less frequently than replacement of personal property. Therefore: • Repairs to personal property will, most likely, be expensed • Replacement of personal property will be expensed under the de minimis safe harbor rule if the amount paid to acquire property is less than the de minimis threshold; otherwise such cost will be capitalized • Real Property • De minimis rule not likely to be an issue • Issue will generally be repairs versus improvements (no bright lines)

Final thoughts…”Not-So-De Minimis” Regulations Simplified… • Repairs Analysis • Is it preventive maintenance (safe harbor)? If not; • Is it a requirement to be capitalized? • Casualty losses • Before and after condition • Significant portion of major component or substantial structural part • If not; Repairs and maintenance deductible under §1.162-4

Questions? Steve Hise, CPA, shise@doz.net Steve Levy, CPA, JD, slevy@doz.net Contributing Editors: Kristie Richey, CPA and Cassia Kendall, CPA @dozcpa

Appendix A –Sample Capitalization Policy Language • Sample Capitalization Policy Language • Purpose • This accounting policy establishes the minimum cost (capitalization amount) that shall be used to determine the capital assets that are to be recorded in [name of your business]’s annual financial statements (or books). • Capital Asset Definition • A “Capital Asset” is defined as a unit of property that: (1) has an economic useful life that extends beyond 12 months; and (2) was acquired or produced for a cost of more than $______. Capital Assets must be capitalized and depreciated for financial statement (or bookkeeping) purposes.

Appendix A –Sample Capitalization Policy Language… • Sample Capitalization Policy Language(continued) • Capitalization Thresholds • [Name of your business] establishes $______ as the threshold amount for minimum capitalization. Any items costing below this amount should be expensed in [name of your business]’s financial statements (or books) unless such amounts are part of an overall replacement or rehabilitation plan. Amounts paid to acquire or improve property which results in a betterment, restoration or adaptation to a different use will be considered to be part of an overall replacement or rehabilitation plan and will be capitalized. • Capitalization Method and Procedure • All Capital Assets are recorded at historical cost as of the date acquired. • Tangible assets costing below the aforementioned threshold amount are recorded as an expense for [name of your business]’s annual financial statements. Similarly, assets with an economic useful life of less than 12 months are required to be expensed for financial statement purposes, regardless of the acquisition or production cost. • Recordkeeping • Invoice substantiating an acquisition cost of each unit of property shall be retained for a minimum of four years.

Appendix B – Building Systems Detail • Building Systems Detail • HVAC- heating, ventilation and air conditioning systems (including motors, compressors, boilers, furnace chillers, pipes, ducts, radiators) • Plumbing – including pipes, drains, valves sinks, bathtubs, toilets, water and sanitary sewer, collection equipment, site utility equipment used to distribute water and waste to and from the property line and between buildings and other permanent structures. • Electrical – wiring, outlets, junction boxes, lighting fixtures and associated connectors, site utility equipment used to distribute electricity from the property line to and between buildings and other permanent structures. • All Escalators • All Elevators

Appendix B – Building Systems Detail… • Building Systems Detail (continued) • Fire-Protection and Alarm Systems – including sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detection devices, fire escapes, fire doors, emergency exit lighting and signage, firefighting equipment (such as extinguishers and hoses) • Security Systems - for the protection of the building and its occupants – including window and door locks, security cameras, recorders, monitors, motion detectors, security lighting alarm systems, entry and access systems, related junction boxes, associated wiring and conduit. • Gas Distribution System – including associated pipes and equipment used to distribute gas to and from the property line and between buildings and permanent structures. • Other Systems – as published in the Federal Register or Internal Revenue Bulletins

Final Tangible Property Regulations