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Capitalization of
Tangible Assets
Understanding the New IRS
Regulations and What
___________ needs to do in
Response
Presented by
xxxxxxx CPAs and Consultants
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xxxxxxxxxx, CPA and
xxxxxxx, CPA
August xx, 2013
Today’s Discussion Topics
Materials and supplies—definitions of materials and
supplies
Discussion of de minimis rule under Reg. Sec. 1.263(a)-2T
Repairs—deductions for amounts paid to repair and
maintain property not required to be capitalized under
263(a)
The expenditures required to be capitalized
 Betterments, Restorations, New Use
Building or component dispositions
Introduction on how to change accounting methods
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Today’s Learning Objectives
Understand what has Changed from the Temporary
Regulations (TR) to:
 Write offs:
 Repairs and maintenance
 Materials and supplies
 Capitalization Issues:
 Improvements to property
 Acquisitions
What you need to follow up on (changes in accounting
methods related to these regulations)
What is the impact of these TR to you (both tax and financial
statement)
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10,000-Feet Observations
Few objective rules
What you have done to date (asset groupings, cost
segregation, depreciation choices) matter
Cost segregation still relevant and needed(for write off
of old when new improvements are made) and still
important for other issues (ability to depreciate
different classes)
Multiple Code Sections changed, not just 263(a), but
also Sections 162, 168
Every taxpayer (TP) is affected, just about every TP will
have to file a 3115 or two
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Comments on the
Regulations from Others
Affects virtually all businesses
AICPA says about the TRs:
 Too few bright-line tests, too complex
 Have an AFS discriminates against smaller TPs
 Accounting method RPs should have examples
 Need to define “gross receipts”
 TPs do not currently track “capitalization threshold ceiling”
 Changes are not clear: change to book capitalization? Not have a
written policy in place? “should” verses “must” used in the change
RPs—which one is it?
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Depreciation Allowable or Taken – this
issue is “huge”.
Points: (1) Suggest that you use this
summer (2013) to correct any errors
in prior year depreciation, and note
that
(2) section 1.1016-3T is part of the
TPRs for a reason – that is the
“scary” part – the IRS will use this in
their audits of TPs to deny
depreciation deductions
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§1.1016-3T Exhaustion, Wear and Tear, Obsolescence, Amortization, and
Depletion
Determination of the amount properly allowable for exhaustion,
wear and tear, obsolescence, amortization, and depletion must
be made on the basis of facts reasonably known to exist at the
end of the taxable year.
A TP is not permitted to take advantage in a later year of the
TP's prior failure to take any such allowance or the TP's taking an
allowance plainly inadequate under the known facts in prior
years.
Caution: In the case of depr., if in prior years the TP has
consistently taken proper deductions under one method, the
amount allowable for such prior years must not be increased
even though a greater amount would have been allowable under
another proper method.
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Warnings for Taxpayers…if
(1) a TP does not identify all of the tangible property
issue(s),
(2) a TP does not implement the rules correctly, AND
(3) file all of the necessary 3115s under the correct new
method(s),
the TPs could have certain current and future tax
depreciation denied and/or miss the potential write-off on
previously capitalized assets.
This exposure is greatest for errors in bonus depreciation
and for building issues, since that is where the greatest
dollar amounts exist.
Your exposure for errors is great and the time to execute is
limited.
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Errors in
Depreciation Deductions
Correct by filing an amended return for that
year(s) (for certain errors)
If TP is not permitted to make the correction
with an amended return, may be able to
change accounting method to correct the
amount of depreciation (with a 3115 filing)
Cannot fix depreciation errors by “catching
up” on prior year errors
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What TPs Need to Do
Depreciation Schedules: fix them before the IRS disallows
missed depreciation
 Fix based upon the new TPR viewpoints – not why it was done
when it was added to the depreciation schedule
Assess conformity of your current policies and procedures
with these TPRs




Capitalization policies
Minimum capitalization thresholds
Routine maintenance expenditures
Internal tracking and capturing data
Current method(s) conform to TPRs?
 If not, need to file 3115s
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Depreciation Error Process
1. Find out what ‘activity’ the business is in by
reviewing Rev. Proc. 87-56
a) This will instruct us what the asset guideline class
lives should be, O/T asset classes 00.11 to 00.4. 00.11
to 00.4 are the “common” class lives.
b) Based on the business’ “activity” we may have class
lives that are different from the common class lives.
c) 00.11 to 00.4 state the following: office equipment is
7 years; computers =5, copiers=5, cars and trucks=5,
land improvements=15
d) But if an activity such as 33.3, land improvements are
7 years (which is client); if 57.0 (distributive trades
and services) assets are 5 years, unless they fit into
00.11 to 00.4.
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What After Depreciation Errors?
2.There are other issues that are not
depreciation errors, but rather are TPR issues
that are generated from a review of the
depreciation schedules. There are:
a) Repair items that were capitalized. (items that
were capitalized but viewed now under the TPRs
would have been written off).
b) Prior building write off issues. (new roof was
added but old roof should have been written off
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What you need to address first on most of the TR Issues
(after addressing
depreciation error corrections):
- two items –
TPR Issue(s) identification
Unit of Property
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Issue(s) Identification – “the list”
The actions a TP may need to take under these TRs
are not limited to:
 Change in unit of property: do we have buildings
grouped together in the depreciation schedule?
(example: multiple buildings in a car dealership)
 The need to breakout prior costs for property
capitalized (i.e. what is the detail in that 39 year asset
account where the roof was replaced years ago?)
 Write off or capitalize current year expenditures (and
if we capitalize, do we have prior to dispose of?
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Issue(s) Identification - 2
If we have to write off prior assets, do they still have
basis that can be written off?
 If fully depreciated, we are done with this asset. Just
capitalize the current expenditures and depreciate them
properly over future years
If we have to write off these prior assets and they still
have basis, we have to determine whether we are going
to write those assets off in a 3115 filing under the “cost
known” method (such as a cost segregation or being
able to recreate the original costs) or under a
“reasonable allocation” method (such as a CPI
“lookback”)
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Issue(s) Identification - 3
Do we need to correct depreciation errors (i.e. methods,
lives)? Every client’s depreciation schedule will need to be
“scrubbed” for errors. These will require 3115 filings in order
to take the (typical) negative 481(a) adjustments. We have
decided, in general, that this is summer work for 2013 and
that these changes will be attached to the 2013 income tax
returns.
Change asset groupings (i.e. building from SAA to GAA?)
Adopt new accounting method(s) – (numerous potential
methods!!!)
File 3115(s) (separately or together) for what?
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Unit of Property (UoP)
Is a very important element to these
and other regulations
Does the client first need to change its
UoP before it makes a method change
under the new Tangible Property Regs.?
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Unit of Property (UoP) - 1
UoP is a very important issue, why?:
 It is an important criteria in the decision whether a TP
can write off an expenditure
Generally:
 The smaller the UoP the more likely the expenditure
will be required to be capitalized
This issue should almost always be considered in TR
issues, most of the time, early. If it is a problem, it
must be changed and 3115 filed. If not, move on.
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Building UoP Examples - 2
Dealer with multiple floors in one building:
 UoP is the building (but capitalization
considerations on building components and/or
system are measured in comparison to that
building component that performs a unique
function or specifically enumerated system)
Dealer complex with multiple buildings:
 UoP is each individual separate building
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Review of the Temporary Tangible
Property Regulations Main Standards
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What the Tangible Property
Regulations (TPR) Do
Temporary TPRs provide guidance on the application of Sections 162(a)
(deduction) and 263(a) (requires capitalization) of the Code to amounts
paid to acquire, produce, or improve tangible property.
Regulations aim to clarify the difference between these two opposites
Temporary regulations = one that is current law and has to be followed
until the final regulations are issued
 Final expected to be issued in 2013
Clarify and expand the standards in the current regulations under
Sections 162(a) and 263(a)
Provide certain bright-line tests (for example, a de minimis rule for
certain acquisitions)
Provide guidance under Section 168 regarding the accounting for, and
dispositions of, property
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What the ‘Repair’
Regulations Do
Amend the general asset account (GAA)
regulations.
TR will affect all taxpayers that acquire,
produce, or improve tangible property
Regulations are effective on January 1, 2014
or for taxable years that begin after 1-12014, but can be applied for tax years 2012
to 2013 (so why not apply the “beneficial”
ones earlier?)
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What the ‘Repair’
Regulations Do
Splits the definition of tangible property into
two categories:
 Buildings
 Everything else
For Buildings: a building and its structural
components are treated as a single unit of
property, but when improving “building
systems,” can be separated out
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Building and Structural Components
1.263(a)-3T(e)(2) (UoP)
General rule that the UoP for a building is comprised of the
building and its structural components
Requires that a TP apply the improvement standards separately
to the primary components of the building, that is, the building
structure or any of the specifically defined building systems.
A cost is treated as a capital expenditure if it results in an
improvement to the building structure or to any of the
specifically enumerated building systems.
Defines the building structure as the building (§1.48-1(e)(1)) and
its structural components (§1.48-1(e)(2)) other than the
components specifically enumerated as building systems.
A UoP is a method of accounting
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Building and Structural Components
1.263(a)-3T(e)(2) (UoP)
Defines building systems to include (1) the heating,
ventilation, and air conditioning systems (“HVAC”);
(2) the plumbing systems; (3) the electrical systems;
(4) all escalators; (5) all elevators; (6) the fire
protection and alarm systems; (7) the security
systems; (8) the gas distribution systems; and (9) any
other systems identified in published guidance
These are considered improvements to the building:
Replacement of an entire roof, improvement to the
HVAC system
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Building and Structural Components
1.263(a)-3T(e)(2) (UoP)
Old Rule: Taxpayer was required to depreciate
building improvements over the life of the original
asset (39 years), even if building had been 29 years
into its depreciable life; no write off of the replaced
component
 If one replaced a roof, for example, you depreciated two
roofs—the original one and the replaced one, or three roofs,
etc.
New Rule: replace a roof, recover as a loss the
remaining basis of the old roof, book the new roof
and depreciate it
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Major Regulation
Sections and Subjects
Materials and Supplies
§1.162-4
Expanded definitions
De minimis rule
Rotable and temporary spare parts
Acquisitions
§1.263(a)-2T
Transaction costs
Costs before placed in service date
De minimis rule
Improvements
§1.263(a)-3T
Unit of Property
Betterments and Restorations
Adaptions to new use
Routine maintenance safe harbor
General Asset Accounts
§1.168(i)-1T
General asset elections
MACRS Dispositions
§1.168(i)-8T
Qualifying dispositions and losses
MACRS disposition and losses
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Background
Section 263(a) (relating to the capitalization
requirement) states that no deduction is
allowed for:
(1) Any amount paid out for new buildings or
permanent improvements or betterments made to
increase the value of any property, or
(2) Any amount expended in restoring property or in
making good the exhaustion thereof for which an
allowance has been made.
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Background
263(a) Regulations state that capital expenditures
include amounts paid or incurred to:
 Add to the value, or substantially prolong the useful life, of
property owned by the TP; or,
 Adapt the property to a new or different use.
 Amounts paid or incurred for incidental repairs and
maintenance of property (as defined by 162 and §1.162-4
(relating to the deduction for ordinary and necessary trade
or business expenses) are not capital expenditures under
§1.263(a)-1.
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U.S. Courts on
Capitalization Have
Recognized the highly factual nature of determining whether
expenditures are for capital improvements or for repairs
Articulated a number of ways to distinguish between deductible
repairs and non-deductible capital improvements.
Explained that R and M expenses are incurred for the purpose of
keeping property in an ordinarily efficient operating condition
over its probable useful life for the uses for which the property
was acquired.
Explained that capital expenditures, in contrast, are for
replacements, alterations, improvements, or additions that
appreciably prolong the life of the property, materially increase
its value, or make it adaptable to a different use
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U.S. Courts on
Capitalization Have
Explained that the relevant distinction between capital
improvements and repairs is whether the expenditures were
made to “put” or “keep” property in efficient operating
condition
Stated that if the expenditure merely restores the property to
the state it was in before the situation prompting the
expenditure arose and does not make the property more
valuable, more useful, or longer-lived, then such an expenditure
is usually considered a deductible repair.
Concluded that a capital expenditure is generally considered to
be a more permanent increment in the longevity, utility, or
worth of the property.
Key is that TR have attempted to match or meet these
“elements” outlined in those court cases ….
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Temporary Regulations
Do Not Change
§1.263(a), which requires TPs to capitalize amounts
paid to improve tangible property and
§263A and the regulations under §263A, which require
TPs to capitalize the direct and allocable indirect
costs, including the cost of materials and supplies, to
property produced or to property acquired for resale
§1.471-1, which requires TPs to include in inventory
certain materials and supplies
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Temporary Regulations
Do Adopt and Refine
1.
The definition and treatment of materials and supplies
2.
The de minimis rule for the acquisition and production of property
under §1.263(a)-2T ,
3.
An election to capitalize materials and supplies
4.
Safe harbor for routine maintenance under §1.263(a)-3T
5.
Rules for determining a unit of property (§1.263(a)-3T(e))
6.
Certain rule revisions for determining whether there has been an
improvement to a unit of property under §1.263(a)-3T
7.
Rules revisions for determining whether an amount is paid for an
improvement to a building.
8.
Rule revisions for determining whether an amount is paid for the
replacement of a major component or substantial structural part of
a unit of property
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Temporary Regulations
Do Adopt and Refine
9. Expanded definition of disposition for MACRS to include the
retirement of a structural component (loss recognition)
10. The general rule that incidental materials and supplies (for which
no inventories or records of consumption are maintained) are
deductible in the year purchased
11. Statements that non-incidental materials and supplies are not
deductible until the year in which they are used or consumed in the
TP's operations
12. New rules for rotable and temporary spare parts
13. A need for TPs to understand General Asset Groupings
14. Numerous new and revised examples
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Temporary Regulations
Make New Rules
Under §1.263(a)-3T(f) for the treatment of
amounts paid to improve leased property
Under §1.168(i)-8T that revise the definition
of disposition for property subject to Section
168 to include the retirement of a structural
component of a building
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Temporary Regulations
Have Hundreds of Examples
1. Examples of 1.161-3T (Materials and Supplies)
2. Examples of 1.168(i)-1T (General Asset Accounts)
3. Examples of 1.168(i)-1T(e)(2) (General Asset Accounts
Disposed of)
4. Examples of 1.168(i)-1T(e)(3)(ii) (General Asset Accounts
Disposed of)
5. Examples of 1.168(i)-1T(e)(3)(iii) (General Asset Accounts
Disposed of)
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Temporary Regulations
Have Hundreds of Examples
6. Examples of 1.168(i)-8T (Dispositions of MACRS property)
7. Examples of Amounts Paid to Sell Property (1.263(a)-1T)
8. Examples of Amounts Paid to Acquire or Produce Tangible
Property Under §1.263(a)-2T
9. Examples of Amounts Paid for Defense or Perfection of Title to
Tangible Property Under §1.263(a)-2T(e)
10.Examples of Transaction costs (1.263(a)-2T(f)
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Temporary Regulations
Have Hundreds of Examples
11.Example of Elections to deduct materials and supplies under
the de minimis rule (1.263(a)-2T(g))
12.Examples of Units of Property and Improvements Under
1.263(a)-3T(e)
13.Examples of Improvements to Leased Property: Leasehold
Improvements 1.263(a)-3T(f)
14.Examples Under Safe harbor for Routine Maintenance
1.263(a)-3T(g)
15.Examples of Betterments 1.263(a)-3T(h)
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Temporary Regulations
Have Hundreds of Examples
16.Examples of Capitalization of Restorations 1.263(a)-3T(i)
17.Examples of Capitalization of Amounts to Adapt Property to a
New or Different Use 1.263(a)-3T(j)
18.Examples of Capitalization or Expensing Under the Optional
Regulatory Accounting Method 1.263(a)-3T(k)
19.Example of §1.1016-3T Exhaustion, Wear and Tear,
Obsolescence, Amortization, and Depletion
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Material and Supplies
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Definition of
Material and Supplies
TR define and expand the definition of (the first category of)
materials and supplies as tangible property that is used or
consumed in the TP’s operations, not constituting a UoP, not
acquired as part of a single UoP, and is not inventory, and that:
1.
Is a component acquired to maintain, repair, or improve a unit of tangible
property owned, leased, or serviced by the TP and that is not acquired as
part of any single unit of tangible property;
2.
Consists of fuel, lubricants, water, and similar items, that are reasonably
expected to be consumed in 12 months or less, beginning when used in
TP's operations; (New Category)
3.
Is a UoP that has an economic useful life of 12 months or less, beginning
when the property is used or consumed in the TP's operations;
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Definition of
Material and Supplies
4. Is a UoP that has an acquisition cost or production cost (under
Section 263A ) of $100 or less (or other amount as identified in
published guidance in the Federal Register or in the IRB; or
5. Is identified in published guidance in the Federal Register or in the
IRB as materials and supplies for which treatment is permitted
6. Also provide an election to treat certain materials and supplies
under the de minimis rule of §1.263(a)-2T, and
7. Allow a TP to elect to capitalize certain materials and supplies.
8. Redefine the first category of materials and supplies by further
describing the types of components that qualify and by
9. Eliminating the requirement that such property not be a UoP under
Section §1.263(a)-3T(d)(2)
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Definition of
Material and Supplies
Specified acquisition or production cost threshold
 TR retains the $100 limitation
 Add language, however, that gives the IRS and the Treasury
Department the flexibility to change the amount of the limitation
 A TP with applicable financial statements (AFS) will be permitted to
deduct amounts paid for property up to higher thresholds if it
complies with the requirements set out in the de minimis rule
provided in §1.263(a)-2T .
 Designated (smallwares under Rev. Proc. 2002-12, or 2002-28 for
certain inventoriable items in the same manner as materials and
supplies that are not incidental under §1.162-3) property continues
to qualify as materials and supplies under the TR because the
property is identified in published guidance as materials and
supplies.
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Election to Capitalize
Material and Supplies
A TP may elect to treat as a capital expenditure and to treat as
an asset, subject to depreciation, the cost of any M and S
Election applies to amounts paid during the taxable year to
acquire or produce any M or S. Any asset for which this election
is made shall not be treated as a M or S.
Exceptions. A TP may not elect to capitalize
i. Any amount paid to acquire or produce a M or S if:
ii. The M or S is intended to be used as a component of a unit of property
and
iii. The TP has not elected to capitalize and depreciate that unit of
property; or
ii. Any amount paid to acquire or produce a rotable or temporary spare
part if the TP has applied its optional method of accounting
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Election to Capitalize
Material and Supplies
A TP makes the election by capitalizing the
amounts in the taxable year the amounts are
paid and by beginning to depreciate them
If a pass-through entity, the election is made
at the entity level
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De minimis
Units of Property
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De minimis Rule
Under §1.263(a)-2T
TP is not required to capitalize amounts paid for the acquisition or production
(including any amounts paid to facilitate the acquisition or production) of a UoP
if…
1. TP had an AFS (as defined in the regulations);
2. TP had, at the beginning of the taxable year, written accounting procedures
treating as an expense for non-tax purposes the amounts paid for property costing
less than a certain dollar amount;
3. TP treated the amounts paid during the taxable year as an expense on its AFS in
accordance with its written accounting procedures; and
4. Total aggregate of amounts paid and not capitalized under the de minimis rule
for the taxable year must be < or = to the greater of:
a) 0.1 percent of the TP’s gross receipts for the taxable year as determined for Federal
income tax purposes; or
b) 2.0 percent of the TP’s total depreciation and amortization expense for the taxable year
as determined in its AFS.
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De minimis Rule
Under §1.263(a)-2T
TP is not required to capitalize amounts paid for the acquisition or production
(including any amounts paid to facilitate the acquisition or production) of a UoP
if…
5. The de minimis rule does not apply to amounts paid for labor and overhead
incurred in repairing or improving property.
6. Permits a member to utilize the written accounting procedures provided on the
AFS of its affiliated group.
7. If examining agents and a TP agree that certain amounts in excess of the de
minimis rule ceiling are immaterial and should not be subject to review, that
agreement should be respected, notwithstanding the requirements of the de
minimis rule in the TR.
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De minimis Rule
Election Details
… of the de minimis material and supplies:
TP makes the election by deducting the amounts paid to
acquire or produce a material or supply in the taxable year
that the amounts are paid in its timely filed original federal
income tax return (including extensions) for the taxable year
that amounts are paid for the material or supply
May revoke an election only by filing a request for a private
letter ruling
Election may not be made or revoked through the filing of an
application for change in accounting method or by filing an
amended federal income tax return.
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De minimis Rule
Election Details
… of the de minimis material and supplies:
Note that the TR do not state that the “election”
of the de minimis rule is a method of accounting
That means that a TP can elect to apply the de
minimis rule in one year and not the next, and/or
apply it to certain assets and not to others.
Note, however, that electing a UoP is a method of
accounting …
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De minimis Rule
Election Example
Example 4. Facts: Election to apply de minimis rule to certain
materials and supplies. (i) X is a corporation that provides consulting
services to its customers. X has an AFS and a written policy at the
beginning of the taxable year to expense amounts paid for property
costing $500 or less. In Year 1, X purchases 200 computers at $500
each for a total cost of $100,000. Assume that each computer is a UoP
under §1.263(a)-3T(e) and is not a material or supply under §1.162-3T.
In addition, X purchases 200 office chairs at $100 each for a total cost
of $20,000 and 250 customized briefcases at $80 each for a total cost
of $20,000. Assume that each office chair and each briefcase is a
material or supply under §1.162-3T(c)(1). In Year 1, X also acquires 10
books at $100 each, which are also materials and supplies under
§1.162-3T(c)(1).
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De minimis Rule
Election Example
Example 4, continued:
X makes the election under §1.162-3T(f) to apply the de minimis rule
to the office chairs and briefcases, but does not make that election for
the books and treats the books as materials and supplies in accordance
with the provisions of §1.162-3T. X treats the amounts paid for the
computers, office chairs, and briefcases as expenses on its applicable
financial statement. Assume also that for Year 1, the amounts that X
paid for the computers, office chairs, and briefcases are the only
amounts that X intends to treat as de minimis costs not capitalized
under paragraph (g)(1) of this section. For its Year 1 taxable year, X has
gross receipts of $125,000,000 and reports $7,000,000 of depreciation
and amortization on its applicable financial statement.
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De minimis Rule
Election Example
Analysis:
In order to meet the requirements of de minimis, X’s total aggregate amounts paid
and not capitalized under paragraphs (g)(1)(i), (ii), and (iii) must be less than or
equal to the greater of $125,000 (0.1% of X's total gross receipts of $125,000,000) or
$140,000 (2% of X's total depreciation and amortization of $7,000,000).
X pays a total of $140,000 ($100,000 + $20,000 + $20,000) for the computers, office
chairs, and briefcases.
X is not required to include the amounts paid for the books in this computation
because X has not elected under §1.162-3T(f) to apply the de minimis rule to the
books.
Thus, the total aggregate amounts paid and not capitalized is equal to $140,000 (2%
of X’s total financial depreciation), the greater of the two limitations.
Accordingly, in Year 1, X may treat as de minimis and is not required to capitalize,
the $140,000 paid to acquire the computers, office chairs, and briefcases.
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Applicable Financial Statements
Defined as: TP’s FS that has the highest priority.
The FS are, in descending priority:
A. A FS required to be filed with the SEC;
B. A certified audited FS that is accompanied by the report of
an independent CPA, that is used for:
1) Credit purposes;
2) Reporting to shareholders, partners, or similar persons; or
3) Any other substantial non-tax purpose; or
C. A FS (other than a tax return) required to be provided to the
federal or a state government or any federal or state
agencies (other than the SEC or the Internal Revenue
Service).
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Improvements
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Leasehold Improvements
1.263(a)-3T(f) Example
Lessor Improvements; additions to building. T is a retailer of consumer
products. In Year 1, T leases a building from L, which T intends to use as
a retail sales facility. L provides a construction allowance to T, which T
intends to use to construct an extension to the retail sales facility for
additional warehouse space. Assume that the amount paid for any
improvement to the building does not exceed the construction
allowance and that L is treated as the owner of any improvement to the
building.
L must treat the leased building and its structural components as a
single UoP. An amount paid is for an improvement to the building if it
results in an improvement to the building structure or to any building
system.
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Leasehold Improvements
1.263(a)-3T(f) Example
In Year 2, T uses L’s construction allowance to construct an
extension to the leased building to provide additional
warehouse space in the building. Assume that the extension is a
betterment to the building structure, and therefore, the
amount paid for the extension results in an improvement to the
building structure.
L, the lessor and owner of the improvement, must capitalize
the amounts paid to T to construct the extension to the retail
sales facility. T is not permitted to capitalize the amounts paid
for the lessor-owned improvement.
The extension to L’s building is not a UoP separate from the
building and its structural components.
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Betterments
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Certain Costs Incurred During an
Improvement 1.263(a)-3T(f)(3)
263A and §1.263A-1(e) rules regarding the capitalization of indirect
costs require the capitalization of indirect costs that directly
benefit or are incurred by reason of an improvement to property.
TR adopt the §1.263A-1(e) standard for purposes of Section
263(a)—and set out a clearly articulated standard that provides
appropriate parameters for determining when otherwise deductible
indirect costs must be capitalized as part of an improvement to
property.
TR obsolete the “plan of rehabilitation doctrine” to the extent that
court-created doctrine provided different standards for
determining whether an otherwise deductible indirect cost must be
capitalized as part of an improvement.
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Certain Costs Incurred During an
Improvement 1.263(a)-3T(f)(3)
TR: a TP must capitalize all the direct costs of an
improvement and all the indirect costs (including, for
example, otherwise deductible repair or component removal
costs) that directly benefit or are incurred by reason of an
improvement in accordance with 263A.
Indirect costs that do not directly benefit and are not
incurred by reason of an improvement are not required to be
capitalized under Section 263(a), regardless of whether they
are made at the same time as an improvement.
These costs may be required to be aggregated over a period
of more than one year.
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Removal Costs
These costs for a UoP should be analyzed in the same manner as any other indirect
cost incurred during an improvement to property.
Similar to the treatment of otherwise deductible repair and maintenance costs
incurred during an improvement, the costs of removing a component of a UoP must
be capitalized if they directly benefit or are incurred by reason of an
improvement to a UoP.
TP may deduct the costs of removing a component if the TP can demonstrate that
such costs relate only to the disposition of the removed property and that the
costs do not have the requisite relationship to any improvement.
Because the costs of removing a retired asset typically relate to the depreciable
asset being removed and are not allocable to the improvements, §1.263(a)-3T
generally is not applicable to such removal costs.
TR do not change the treatment of any amounts addressed under Section 280B (which
governs amounts expended and losses sustained for the demolition of structures).
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Capitalization of Betterments
1.263(a)-3T(h)
Amount paid results in a betterment, and accordingly, an
improvement, if it [note the subjective determinates]:
Ameliorates a material condition or material defect that
existed prior to the acquisition of the property or arose
during the production of the property;
Results in a material addition to the UoP (including a
physical enlargement, expansion, extension, productivity,
efficiency, strength, quality); or,
Results in a material increase in the capacity, productivity,
efficiency, strength, or quality of the UoP or its output.
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Betterments to Buildings
Analysis of whether costs incurred to refresh or
remodel a building result in a betterment requires
an examination of all the facts and circumstances
including, but not limited to:
The purpose of the expenditure,
The physical nature of the work performed,
The effect of the expenditure on the UoP, and
The TP’s treatment of the expenditure on its AFS
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Betterments to Buildings
Other Rules:
If a TP needs to replace part of a UoP that cannot practicably
be replaced with the same type of part (for example, because
of technological advancements or product enhancements),
the replacement of the part with an improved, but
comparable, part does not, by itself, result in a betterment to
the UoP.
Determination of whether an expenditure results in a
betterment of the UoP is made by comparing the condition
of the property immediately after the expenditure with the
condition of the property immediately prior to the
circumstances necessitating the expenditure.
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Examples—Betterments
1.263(a)-3T(h)
Example: Amelioration of pre-existing material condition or defect.
In Year 1, X purchases a store located on a parcel of land that
contained underground gasoline storage tanks left by prior
occupants. Assume that the parcel of land is the UoP. The tanks had
leaked, causing soil contamination. X is not aware of the
contamination at the time of purchase. In Year 2, X discovers the
contamination and incurs costs to remediate the soil.
The remediation costs result in a betterment to the land under
paragraph (h)(1)(i) of this section because X incurred the costs to
ameliorate a material condition or defect that existed prior to X’s
acquisition of the land.
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Restorations
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Restorations 1.263(a)-3T(i)
An amount is paid to restore, and therefore
improve, a UoP if it:
1. It returns the UoP to its ordinarily efficient operating
condition if the property has deteriorated to a state of
disrepair and was no longer functional for its intended use;
2. It is rebuilding to like-new condition: results in the
rebuilding of the UoP to a like-new condition after the end of
its class life (brought to the status of new, rebuilt,
remanufactured, or similar status under the terms of any
federal regulatory guideline or the manufacturer’s original
specifications); or
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Restorations 1.263(a)-3T(i)
3.
Replaces a Major Component or Substantial Structural Part of
the UoP: In determining whether an amount is paid for the
replacement of a part or a combination of parts that comprise
a major component or a substantial structural part of the UoP,
the TP must consider all the facts and circumstances, including
the quantitative or qualitative significance of the part or
combination of parts in relation to the UoP or, in the case of a
building, in relation to the building structure or the relevant
building system.
Define a major component or substantial structural part to include a
part or combination of parts that comprise a large portion of the
physical structure of the UoP or that perform a discrete and critical
function in the operation of the UoP.
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Restorations 1.263(a)-3T(i)
3.
Replaces Major Component or Substantial Structural Part of
the UoP: (cont.)
TR revise the disposition and depreciation rules to minimize
the harsh result that occurs when an original part and any
subsequent replacements of the same part are required to be
capitalized and recovered simultaneously.
TR revise the definition of disposition so that a TP may treat
the retirement of a structural component of a building as a
disposition of property.
Clarify that a TP may recognize a loss on a component of a
UoP that is Section 1245 property if the TP consistently treats
the component as a separate asset for disposition purposes.
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Summary of Examples Restorations
Examples where items were written off:
Rebuild freight cars before the end of their class life
Repair a broken taillight, replace a power switch
assembly
Waterproof roof membrane
Two out of eight HVAC units, two out of twenty sinks,
and 30 out of 300 windows, wood flooring in hotel
lobby
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Summary of Examples Restorations
Examples where items were capitalized:
Shore up the walls and replace siding, 200 of 300 windows
Rebuild freight cars after the end of their class life
New engine and cab of a tractor, also paint the tractor cab
Underground tank removal and replace
Entire roof, and significant portion of a roof
Furnace replacement, the one HVAC system, also sprinkler system in a
building
Wiring throughout the building; plumbing fixtures in all of the restrooms;
all of the floors in the public areas of the hotel
Remodel hotel over several-year period
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Amounts to Adapt Property to a New or
Different Use 1.263(a)-3T(j)
TP must capitalize amounts paid to adapt a unit of
property to a new or different use.
Amount is paid to adapt a unit of property to a new or
different use if the adaptation is not consistent with the
TP’s intended ordinary use of the unit of property at the
time originally placed in service by the TP.
In the case of a building, an amount is paid to adapt the
UoP to a new or different use if it adapts to a new or
different use any of the properties designated in
paragraphs (e)(2)(ii)(building structure and systems),
(e)(2)(iii)(B)(condominium), (e)(2)(iv)(B)(cooperative), or
(e)(2)(v)(B) (leased building) of this section.
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Checklist of Improvements
Betterment Considerations:
Does routine maintenance safe harbor apply?
Does it ameliorate a pre-existing material condition or defect?
Does it ameliorate a material condition or defect prior to placing
the property in service?
Does it result in a material increase in capacity, productivity,
efficiency, quality, etc. of UoP?
Does it adapt to a new or different use?
Does Section 263A apply to the expenditure(s)?
If the answer to any of the above questions is YES, then the
expenditure has to be capitalized …
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Checklist of Improvements
Restoration Considerations:
Is the UoP no longer functional and did you return it to ordinary efficient
or operating condition?
Did you rebuild the UoP to a like-new condition after its useful life?
Did you replace a major component or substantial structural part?
Was the component previously deducted as a loss, before you replaced
it?
Was the component previously sold or exchanged before replacement?
Was the expenditure to the UoP previously taken as a casualty loss?
If the answer to any of the above questions is YES, then the expenditure
has to be capitalized …
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Disposition Rules
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Accounting and Disposition Rules
for MACRS Property
TR revise the rules for accounting for 168 assets (MACRS property)
and the rules for determining gain or loss upon the disposition of
MACRS property.
Before the TR, a TP may account for its MACRS property by
accounting for an asset:
 Individually in a single asset account (SAA),
 By combining two or more assets in a multiple asset account (or pool)
(MAA), or
 By electing to include the asset in a general asset account (GAA).
TR provide that each MMA must include, in most cases, assets that
have the same depreciation method, recovery period, and
convention, and that are placed in service in the same taxable
year.
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Accounting and Disposition Rules
for MACRS Property
TR:
 Expand the definition of disposition for MACRS
property to include the retirement of a structural
component of a building.
 Allow the recognition of a loss upon such retirement.
 State that if an asset is disposed of by physical
abandonment and that asset is subject to nonrecourse
indebtedness, the asset is treated in the same manner
as an asset disposed of by sale.
 Provide rules for determining the asset disposed of and
identifying which MAA includes the asset disposed of.
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MACRS
Definition of Disposition
Occurs when ownership of the asset is transferred; or,
Asset is permanently withdrawn from use either in the
taxpayer’s trade or business or in the production of income;
Includes the sale, exchange, retirement, physical
abandonment, or destruction of an asset;
Also includes the retirement of a structural component of a
building (defined by 1.48-1); and,
Finally, when an asset is transferred to a supplies, scrap, or
similar account.
Manner of Disposition—does not matter.
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MACRS
Disposition—Gain or Loss
TR new rule: If the TP accounts for the asset disposed of in
a MAA or pool, or the asset disposed of is a component of
a larger asset and if it is impracticable from the TP’s
records to determine the unadjusted depreciable basis of
the asset disposed of, the TP may use any reasonable
method that is consistently applied to the TP’s MAA pools
or to the TP’s larger assets for purposes of determining
the unadjusted depreciable basis of assets disposed of.
Have to use the method, period, conv., and 1st year depr.
deduction applicable.
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MACRS
Disposition Examples
Example 5. On July 1, 2009, D, a calendar TP, purchased and placed in service a
nonresidential multi-story office building that costs $20,000,000. The cost of each
structural component of the building was not separately stated. D accounts for
the building in its records as a single asset with a cost of $20,000,000. D uses the
optional depr. table that corresponds with the GDS, the SL method, a 39-year
period, and the mid-month convention. As of January 1, 2012, the depreciation
reserve for the building is $1,261,000.
On June 30, 2012, D replaces one of the building’s elevators. Because D cannot
identify the cost of the structural components of the office building from its
records, D uses a reasonable method, consistently applied to all of the structural
components of the office building, to determine the cost of the elevator. D
allocates $150,000 of the $20,000,000 purchase price for the building to the
retired elevator. Using the depr. table that corresponds with the GDS, the SL
method, a 39-year period, and the mid-month conv., the depr. allowed or
allowable for the retired elevator as of December 31, 2011, is $9,457.50.
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MACRS
Disposition Examples
Example 5, continued.
For D’s 2012 return, loss for the retired elevator is determined as follows. The depr. for
2012 for the retired elevator is $1,923 ((unadjusted depr. basis of $150,000 × depr. rate
of 2.564 percent for 2012) × 6/12). The adjusted depr. basis of the retired elevator is
$138,619.50 (the adjusted depr. basis of $140,542.50 removed from the building cost
less the depr. of $1,923 for 2012). As a result, D recognizes a loss of $138,619.50 for the
retired elevator in 2012, which is subject to Section 1231.
For D’s 2012 Federal return, the depr. allowance for the building is computed as
follows. As of January 1, 2012, the unadjusted depr. basis of the building is reduced
from $20,000,000 to $19,850,000 ($20,000,000 less the unadjusted depr. basis of
$150,000 for the retired elevator), and the depr. reserve of the building is reduced from
$1,261,000 to $1,251,542.50 ($1,261,000 less the depr. of $9,457.50 for the retired
elevator as of December 31, 2011). Consequently, the depr. allowance for the building
for 2012 is $508,954 ($19,850,000 × rate of 2.564 percent for 2012).
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MACRS
Disposition Examples
RP 2012-20 tells us that:
• Use the same facts as Example 5 from prior slides, but the
building was purchased in 2000 and the elevator was replaced in
2005. D completes a Form 3115 and files it with his tax return for
2012.
• D files the 3115 to change his method of accounting from continuing to
deduct depreciation for the disposed of building component to recognizing
gain or loss upon disposition of building components.
• D can deduct the cost of the replaced elevator in 3115. Using the facts
above, the accumulated depreciation on the elevator to 12-31-2011 is
$44,071.50. D can take a loss on the elevator disposition of $105,928.50 in
his 2011 tax return. This is a Section 1231 loss.
• D can take the loss on its 2013 tax return if it instead chooses to file the
3115 on its 2013 return. (this is an automatic number 177)
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CONCLUSION
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