The biggest news that came out in 2012 was the long awaited Temporary Regs under 263(a). This clarified the rules categorizing building expenditures into capital improvements or repair expenses. However, one of the most significant rules that has changed under these Regs is the disposition of structural components of buildings. In the past, when a taxpayer renovated an existing building, they were not allowed to write off the remaining basis of the structural components that were abandoned or “ripped out”. This might include things like the old roofs, HVAC units, lighting units and so forth.
Under the new rules, you can now assign a value to the old 39 year components that are replaced and write off the remaining tax basis. If a taxpayer made renovations over the last 10 years, you can now use form 3115 to go back and write off the components that were ripped out.
Client constructs a restaurant building in 2004 for $1M. In 2012, they spend $500k to remodel the entire floor (ceilings, walls, lighting, plumbing, ducting, electrical wiring, etc).
• Of course you can do a cost segregation study on the $500k of remodeling to identify the personal
property and assets that can be expensed, but the bigger benefit may be from the retirement of items
demolished / abandoned from the original building.
• Abandonment Study – Engineer identifies & quantifies an additional $100k (from the original $1M
building) of 39 year items that were removed.
• Writing off the remaining basis of these structural components yields $77,455k of additional deductions
($100,000 less previous depreciation of $22,545).
An offset to this provision is that when you claim a retirement loss on a building component, the cost of the replacement component will always be considered a restoration and therefore must be capitalized (Temp. Reg. §1.263(a)-3T(i)).
As the rules are written, a taxpayer is required to take a retirement loss when a component is removed; even if the new expenditure satisfies the criteria of a repair expense (Temp. Reg. §1.168(i)-8T). This can produce an unfavorable result since a retirement loss deduction will generally be less than the alternative repair cost of the new component.
To clarify, let us assume that a taxpayer owned a building for 15 years and spends $75,000 to replace their old roof shingles with new shingles. The new roof shingles are the same type and strength, so they are not considered a betterment. The cost of the old roof shingles is determined to be $50,000 and after 15 years, the remaining tax basis is $30,769. Generally, under the new regulations, replacing roof shingles is not considered an improvement. However in this case, the taxpayer is required to take the $30,769 retirement loss and then capitalize the $75,000 of new roof shingles (which would otherwise be deductible).
You could be stuck with similar treatment for all future replacement repairs unless an election to use General Asset Accounting (GAA) rules for your property is appointed. The newly modified GAA rules in the recent Repair vs. Capitalization Regulations provide the option to continue depreciating any asset that is disposed. Going back to our example above, if the building and original roof shingles were in a GAA, you could choose to continue depreciating the old roof shingles and take a repair deduction on the new roof shingles (a difference of $44,231 of additional deductions).
For those not familiar with GAA rules, they stipulate that only assets depreciated the same way can be in the same GAA (i.e. assets with the same MACRS tax life, recovery method, convention, and effective placed in service date). The GAA election is simply determined by checking a box on the Form 4562 and taxpayers will need to keep records of which assets are in which GAA. Further, a GAA election must be made on a timely filed tax return (including extensions) for the year the asset was placed in service.
On Friday, December 14, the IRS published the amended temporary Repair vs. Capitalization regulations to incorporate the changes announced in the recent Notice 2012-73. The changes include a two year delay of the effective date of the regulations to January 1, 2014.
While Notice 2012-73 indicated that taxpayers have the option to apply the temporary or final regulations for any tax year beginning after 1/1/2012, it was unclear whether taxpayers could pick and choose to apply only favorable portions of the regulations for those years. The formal amendments clarify this question and make clear that taxpayers can pick and choose to apply portions of the regulations. As such, taxpayers should not overlook the possible tax benefits of applying favorable portions of the regulations immediately.
With the delay of the effective date to 1/1/2014, some taxpayers are hesitant to file the necessary Change of Accounting Method forms for 2012 because of concern the rules will change. However, CPAs should advise taxpayers that even if the regulations do change and some deductions must be reversed in 2014, such deductions would be given back evenly over four years starting in 2014 (See Rev. Proc. 2011-14). In most cases this will not result in a significant difference in tax savings. However, depending on the situation, some taxpayers may benefit from applying the rules immediately.
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