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Final Tangible Property Regulations: Understanding Key Concepts Applicable to the Affordable Housing Industry


First Quarter - 2015

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The final tangible property regulations (TPR), also commonly referred to as the final repair regulations, were published on September 19, 2013. Effective for tax years beginning on or after January 1, 2014, the final repair regulations will have widespread application as the rules apply to nearly all costs a taxpayer incurs in connection with tangible property. Specifically, they apply to acquisitions, dispositions, as well as repair costs.

The final tangible property regulations provide a comprehensive set of rules that must be applied throughout a property’s life cycle. In making a determination on how to apply the final regulations, a basic understanding of the final regulations and familiarity with certain terminology is necessary.

The following terms and capitalization concepts are relevant to the affordable housing industry.  Depending on the capitalization policies applied on prior year returns, a possible retrospective change (changing the treatment of a prior expenditure which requires a Section 481(a) adjustment), a prospective change (a change to comply with the regulations for present and future expenditures with no Section 481(a) adjustment), or the making of certain annual elections may come into play for the 2014 tax year.

The regulations address three specific types of costs relative to the ownership of tangible property which are summarized below:

Acquisition Costs

De Minimis Safe Harbor Election: The final regulations provide for an elective $5,000 maximum per-item book-conformity safe harbor for taxpayers with an applicable financial statement (AFS) (meaning a financial statement required to be filed with the SEC or that was audited). The safe harbor requires a written policy under which the taxpayer deducts items costing less than a stated amount (any amount $5,000 or less) for financial accounting purposes. This written policy must be in place as of the first day of the tax year, meaning it is too late for calendar 2014 or 2015, if not previously created. If the taxpayer does not have an AFS, the maximum stated amount is only $500. For taxpayers without AFS relying on the $500 threshold, the policy must have been in place as of the beginning of the year, but it does not have to be a written policy. However, CohnReznick recommends having a written policy in place for support if ever audited. In order to take the deduction, the taxpayer must make an annual irrevocable election; it is not a change in an accounting method. In addition to applying to tangible property additions, it will also apply to materials and supplies and repairs that are under the stated amount that have been deducted for book purposes.

Materials and Supplies: The final regulations define materials and supplies to include units of property costing no more than $200. They further define materials and supplies to be items that are not inventory and that have an economic useful life less than 12 months. The year in which materials and supplies are deductible will depend on whether the material and supplies are classified as incidental or non-incidental material and supplies.

Incidental materials and supplies are materials and supplies that are carried on hand for which no record of consumption is kept and for which physical inventories are not maintained. Incidental materials and supplies are deducted in the year paid, provided the deduction clearly reflects income.

Non-incidental materials and supplies are material and supplies for which records are kept relative to consumption and are deductible in the year used or consumed.

Any change in the treatment of materials and supplies will be a change in accounting method that requires the filing of Form 3115. It is anticipated that all taxpayers that accounted for materials and supplies differently than required by the regulations will need to file a Form 3115 to adopt compliance with the regulations. The good news is this change has prospective application only. No Section 481(a) adjustment is required.

Repair Costs

Book Conformity Election: The final regulations allow a taxpayer to elect to treat as capital expenditures, for federal income tax purposes, all repair and maintenance costs that it treats as capital improvements on its books and records. This is an annual election; it is not a change in method of accounting. This would be an election that is made by a conservative taxpayer that typically capitalizes costs that might otherwise qualify as repairs.  The book-conformity election does not protect a taxpayer that may have expensed costs that under the final regulations should have been capitalized.  Taxpayers with this potential exposure may need to reconsider using the book-conformity election in lieu of filing a Form 3115.

Unit of Property: The final regulations provide that repairs to major components and substantial structural parts of tangible property must be capitalized. The definitions for both of these terms are somewhat vague. The terms are clarified, however, in the numerous examples provided in the final regulations. The final regulations also clarify that for real property, the repair standards apply not only to the building’s structural components, but to eight separate building systems: 1) HVAC, 2) plumbing systems, 3) electrical systems, 4) all escalators, 5) all elevators, 6) fire protection and alarm systems, 7) Security systems and 8) gas distribution system.

In addition to the eight systems listed above, the regulations provide that replacing a major component also includes replacing a “significant portion” of the major component. This means that a building effectively has sub-systems that must be considered. For example, a roof is a major component of the building’s structure. Thus replacing a significant portion of the roof will be treated as the replacement of a major component, which must be tested to determine whether it is a “significant portion of the major component.” The term “significant portion” is not defined, although the regulations provide many examples. A general rule of thumb is if less than 20% of a major component is replaced, it can be expensed.

Adopting the new definition of a unit of property is a change in method of accounting. Furthermore, all taxpayers that determine that past expenditures were not treated in accordance with the regulations, must also file a Form 3115 and include the appropriate Section 481(a) adjustment.

Capitalization Standards: The final regulations provide that a taxpayer must capitalize costs incurred to: 1) better a unit of property, 2) restore a unit of property, or 3) adapt a unit of property to a new or different use. Betterments includes correcting a pre-existing defect, materially adding to or expanding property, or materially increasing the quality, capacity, productivity, or efficiency of the property. Restorations include replacing a component for which the taxpayer recognized gain/loss on sale or disposition, restoring damage resulting from a casualty event or returning the property to an operable condition after falling into disrepair. Any retrospective change will require the filing of Form 3115.

Routine Maintenance Safe Harbor: The final regulations provide for a routine maintenance safe harbor (RMSH) for both real property (i.e. buildings) and personal property (i.e. FF&E). The RMSH generally looks to the frequency of expected repair activities within the property’s alternative depreciation system (ADS) recovery period; the exception being for buildings.  For buildings the testing period is ten years. The RMSH will apply to repair activities on a building that the taxpayer expects to perform at least twice within that ten year period. For all personal property, the RMSH will apply if the taxpayer expects to make a repair more than once during its ADS recovery period. A Form 3115 is required to be filed to adopt the RMSH provisions even if there are no prior year adjustments.

Removal Costs: The regulations provide that removal costs are deductible if, for federal income tax purposes, the taxpayer disposes of a depreciable asset and recognizes gain or loss. If the removal is not associated with a disposal, the treatment will depend on whether the removal of the property is part of the repair of the property or a capital improvement to the property. A Form 3115 is required to be filed to apply this method of accounting either retroactively or prospectively.

Casualty Losses: The final regulations provide that if a taxpayer reduces the basis of damaged property (basis adjustment), costs incurred to restore the damage must be capitalized to the extent of that basis adjustment.  If costs exceed the amount of the basis adjustment, the deductibility of the excess costs will depend upon the capitalization standards explained above (betterment, restoration and adaptation). Any retrospective change will require the filing of Form 3115.

Late Partial Dispositions

The final regulations eliminate the need for taxpayers to make a General Asset Account (GAA) election in order to continue to depreciate assets replaced by a renovation. Taxpayers are allowed to make a current year partial disposition election to deduct the adjusted basis of an asset disposed of in 2014 and beyond. For example, if a taxpayer installs a new roof, they can elect to deduct the adjusted basis of the pre-existing roof if they capitalize the new roof. To take advantage of this rule for assets disposed of in a year previous to 2014, a 3115 must be filed (Late Partial Disposition).  This retroactive change will only be given automatic consent if a Form 3115 is filed with a taxpayer’s 2014 return. After 2014, any retroactive change will require IRS consent and a filing fee, which is a much more burdensome and costly.

There are a number of situations where filing the form 3115 can be advantageous on your affordable housing property, so please consult your CohnReznick tax advisor to assess the best course of action in applying these rules in 2014.

Contact

For more information, please contact Anthony Portal, CohnReznick partner, at 704-900-2617, or Ryan Halbrook, manager, at 704-315-5389. To learn more about CohnReznick’s Affordable Housing Industry Practice, visit our webpage.


Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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