In December 2011, the Internal Revenue Service ("IRS"/"Service") and the Treasury Department released new Temporary regulations – over 200 pages commonly referred to as the "Tangible Personal Property" regulations – which primarily impact tax code Sections 263(a) and 162(a). You might be asking: how does this impact me? The following are some key highlights:
- Generally speaking, these rules address whether taxpayers must capitalize their tangible property costs under tax code Section 263(a) or whether they can deduct them under Section 162(a). Therefore, if you own or lease long-lived property (e.g., buildings, parking lots, leasehold improvements) and you or others within your organization routinely make capitalization versus expense decisions with respect to this type of property and associated costs, then you are directly impacted by these rules.
- Regardless of your federal tax profile (e.g., you annually generate federal taxable income or you have current or recurring federal tax losses), the new rules can have current and/or long-term tax implications impacting the return on investment of your fixed assets. They contain provisions that likely restrict your ability to deduct certain expenditures as "repairs" and mandatorily apply new "partial disposition" concepts that can create unintended tax consequences with negative implications for the unwary.
- You will need to file at least one accounting method change in order to comply with this new law and doing nothing is deemed an affirmative action by the IRS thus allowing the Service to dictate your new methodology. Such inaction will result in a higher tax burden today and an unintended tax burden upon the eventual sale of the underlying property.
- The new law contains some optional compliance methods which you may be able to take advantage of to generate near term positive cash flow and maximize your return on investment. The Service considered the impact of the relatively restrictive nature of the new rules as compared to the old rules and thus, provided taxpayers with favorable alternatives to consider when implementing their new capitalization policies.
- The temporary rules originally became effective for your first tax period beginning on or after January 1, 2012. Recently, Tax Notice 2012-73 altered the effective date to January 1, 2014. However, the IRS has granted taxpayers the option of applying the new rules based on the original January 1, 2012 effective date. Therefore, taxpayers should ensure their capitalization policies are compliant with these new rules and where applicable, take advantage of some of the favorable options and tax beneficial opportunities available with a fully considered and optimally implemented plan of action.
Example: Taxpayer owns a terminal building that it purchased ten years ago for $1M. Today, taxpayer incurs $100,000 to replace the roof on the terminal building. Assume the original roof cost (likely embedded in the $1M building cost) was $75,000 but due to depreciation deductions taken over time now has an adjusted basis of $50,000.
Traditional capitalization policy - The taxpayer would have followed their existing capitalization policy and capitalized the $100,000 new roof. As such, the cost of the new roof would be depreciated over 39yrs and the cost of the original roof ($75,000) would also continue to be depreciated over the remaining depreciable life (29 years) of the original building.
Old Repairs methodology – If the taxpayer had filed a "Repairs" accounting method change, Taxpayer would likely have deducted the new roof cost of $100,000 as a qualifying repair expenditure and would have continued to depreciate the cost of the original roof ($75,000) over the remaining life of the building.
Traditional capitalization policy - If no action is taken, Taxpayer has no choice and the new rules would require Taxpayer to capitalize the new roof cost ($100,000) and would presume that the remaining adjusted basis in the original roof ($50,000) would be written off as a loss deduction – whether or not the adjusted basis was actually written off by Taxpayer. Without the retroactive General Asset Account election (discussed below), Taxpayer’s traditional capitalization policy would not recognize the loss deduction on the deemed disposal of the old roof resulting in the building’s basis being eroded by $50,000 without the taxpayer benefiting from the commensurate depreciation deduction/write off. Upon the eventual sale of the terminal building, Taxpayer would recognize more gain than expected as the IRS would calculate the building’s adjusted basis to have been reduced by the $50,000 and thus, taxpayer would have to recognize $50,000 more gain and a higher tax liability.
New "General Asset Account" ("GAA") election – By filing the new, "Retroactive GAA Election" method change, Taxpayer has a choice on how to handle both the new roof cost and the adjusted basis of the old roof:
Choice #1 (Status Quo) – Taxpayer can ignore the application of the new rules and simply capitalize the new roof cost and continue to depreciate the old roof cost as well without incurring the presumptive disposition loss and erosion of basis in the building as described above under the "Traditional Capitalization policy".
Choice #2 (Repair Opportunity) – If the new roof qualifies as a repair expenditure under the new more restrictive rules, Taxpayer can adopt the new Repairs methodology via an accounting method change and treat such expenditures as a current expense/deduction ($100,000) and continue to depreciate the original roof costs.
Choice #3 (Partial Disposition Opportunity) – If not a qualifying repair expenditure, Taxpayer can elect to follow the new "Partial Disposition" methodology via an accounting method change. The new roof cost ($100,000) would be capitalized and Taxpayer would account for the partial disposal of the old roof as a current deduction/loss by writing off the adjusted basis of the old roof ($50,000). The GAA and Partial Disposition method changes would allow Taxpayer to property account for the partial disposal of the old roof thus allowing Taxpayer to recognize the benefit of the $50,000 deduction.
We at Smith Moore Leatherwood would be pleased to discuss the various federal tax ramifications of the new Tangible Personal Property rules and further dialogue with you regarding specific action steps you should be considering with respect to these new rules.