On December 23, 2011, the Treasury Department issued the most comprehensive changes to the capitalization regulations in 20 years, proposing for a third time in nearly five and a half years, new temporary regulations designed to reduce uncertainty and outline how building restoration and maintenance costs should be treated. The new rules are effective for amounts paid or incurred in tax years beginning on or after January 1st, 2012, therefore they will apply to expenses incurred in the current tax year.
Some of the key issues included in the package refer to the following:
Capitalizing business renovations
For many taxpayers, one of the most significant aspects of the new regulations is in regards to the treatment of amounts paid for building improvements or renovations.
The regulations retain the rule that a building and its structural components are still considered to be the "unit of property". Similarly, the tests used to determine which items are considered restoration/replacement, betterment or adaptation changes remain essentially the same; however the manner in which the improvement standard must be applied to the building and its structural components is revised. The tests must now be applied separately to the building structure and eight specific building systems that the regulations identified ? plumbing systems, HVAC, electrical systems, all escalator, all elevator, fire protection and alarm systems, security systems and gas distribution systems. This essentially results in a smaller unit of property, or component, to measure the expenditure against. If the expenditure results in an improvement to one of the eight building systems, than it is considered to be more than just an up-keep related repair and must be capitalized.
Disposition of a structural component of a building
One of the biggest potential benefits to taxpayers with the new Regulations deals with dispositions. Under prior law, a taxpayer was precluded from recovering basis on the disposal of a component of a building, yet was required to capitalize the cost of the new replacement component. The new law mitigates this unfair result by stating that if the replacement component is capitalized, taxpayers will generally be allowed to write off the remaining cost of the building component that is being replaced, prior to the disposition of the entire building. For example, this allows a taxpayer replacing a roof, or lighting system to dispose of the original system when it is removed from service.
Rules for leasehold improvements
The new regulations include clarification on how building renovations or repairs made by a lessee/renter or lessor/property owner should be treated. The lessees must consider their leased space as a separate unit of property. When a lessee makes an alteration to a leased space (a suite), the tests used to determine how the expenditure should be classified will be applied to the leased space/suite and its eight building systems, instead of the entire building that houses the space. The opposite is true for lessors. The lessor of a building applies the general rule for determining the unit of property and improvements. As the owner of the building, their interest in the building likely extends beyond the space/suite that is being modified, so they will have to apply the tests to the entire building and its eight building systems.
The new temporary regulations also include an expansion of the definition of "materials and supplies"; special rules for rotable and temporary spare parts, casualty loss rules and many others provisions. It is important to understand how the IRS rule modifications can affect expenditures incurred when property is remodeled or repaired in order to ensure that taxpayers are taking advantage of all the possible tax benefits associated with the new regulations. If you have any questions regarding these changes or any other tax or business related questions, please contact a MKS&H representative or call us at 886.649.1902 and ask to speak to one of our tax experts.
Article written by MKS&H's Staff Accountant, Anca Stradley