Every taxpayer that uses tangible real or personal property in a business needs to understand the tax rules relating to the distinction between a repair and capital expenditure, as well as the depreciation of those capitalized expenditures and other depreciable assets that are purchased or produced.
This briefing covers recent developments relating to repair, capitalization, and depreciation as embodied in the final “tangible property regulations,” also known as the “repair regulations.” In addition, significant changes to depreciation provisions, such as bonus depreciation and the Section 179 allowance, were made by the Protecting American from Tax Hikes Act of 2015 (PATH Act). Many of these changes first went into effect in 2016 and will need to be considered when preparing 2016 returns. This briefing also details these changes.
The final tangible property regulations were issued in 2013 under T.D. 9636 (9/13/2013) and provide rules for distinguishing between a currently deductible repair and a capitalized expenditure (the “repair regulations”). The tangible property regulations also include rules relating to MACRS general asset accounts, MACRS multiple asset and item accounts, and dispositions of MACRS property. These regulations were issued in 2014 under T.D. 9689 (8/14/2014). Although taxpayers—other than “small qualifying taxpayers” with total assets of less than $10 million and average annual gross receipts of less than $10 million, as described in Rev. Proc. 2015-20—should have filed accounting method changes on Form 3115, Application for Change in Accounting Method, to comply with the tangible property regulations for tax years beginning on or after January 1, 2014 (the effective date of the tangible property regulations), these changes may continue to be made for any subsequent tax year by taxpayers not under audit by using the automatic accounting method change procedure of Rev. Proc. 2016-29.
Recent developments to the repair regulations discussed in this briefing include an increase in the elective de minimis safe harbor per-item expensing limit for 2016 for taxpayers without an applicable financial statement (AFS) from $500 to $2,500, a new remodel-refresh safe harbor that allows certain taxpayers to deduct 75 percent of remodel-refresh costs (Rev. Proc. 2015-56), and the issuance of a new automatic accounting method procedure (Rev. Proc. 2016-29) that now governs changes to comply with the tangible property regulations.
The Protecting American from Tax Hikes Act of 2015 (PATH Act) extended the expiration date of many depreciation provisions and made other expiring provisions permanent. Significant substantive changes were made to bonus depreciation and the Section 179 expense allowance. These changes are also discussed in this briefing.
DE MINIMIS SAFE HARBOR
The tangible property regulations dealing with repairs include a de minimis expensing safe harbor that allows taxpayers to annually elect to deduct the cost of materials and supplies and units of property produced or acquired subject to a per-item dollar limit.
The maximum per-item de minimis safe harbor dollar limit is increased from $500 to $2,500 for taxpayers without an applicable financial statement (AFS), effective for tax years beginning on or after January 1, 2016. The maximum $5,000 per-item limit for taxpayers with an AFS is unchanged. In general, an AFS is a certified audited financial statement.
Although taxpayers without an AFS are not required to have a written accounting policy implementing the safe harbor, an unwritten policy employing a $2,500 per-item deduction limit must still be in effect as of the beginning of the 2016 tax year in order for the $2,500 limit to apply for the 2016 tax year. The per-item deduction limit may exceed $2,500 but only items costing $2,500 or less receive safe harbor protection. Similarly, for each tax year beginning after 2016, an unwritten policy with a $2,500 per-item limit must be in effect as of the beginning of that tax in order for the higher limit to apply.
For tax years beginning before January 1, 2016, the IRS will allow a taxpayer without an AFS to qualify for the $2,500 limit if all requirements for the safe harbor are satisfied. Consequently, if a taxpayer had a per-item deduction limit in excess of $500 in effect at the beginning of a pre-2016 tax year, items that cost no more than the limit set (but not in excess of $2,500) will receive safe harbor protection. The IRS will not challenge deductions within the $2,500 limit (or a lesser limit set by the taxpayer’s policy in effect at the beginning of the tax year) in an audit, assuming the taxpayer meets all requirements for the safe harbor. If an audit is currently being conducted solely on such deductions, it will be discontinued.
REMODEL-REFRESH SAFE HARBOR
This section makes occasional reference to “informal IRS guidance.” This refers to informal opinions expressed by IRS representatives during the Capital Recovery and Leasing panel discussion of the American Bar Association’s (ABA’s) Section of Taxation 2016 Mid-Year meeting held in Los Angeles, California, January 28–30, 2016.These opinions are not binding on the IRS.
The IRS supplemented the tangible property regulations with a safe harbor that allows a taxpayer operating a retail establishment or a restaurant to change to a method of accounting that allows the taxpayer to treat 25 percent of qualified remodel-refresh costs as capital expenditures under Code Sec. 263 and 75 percent of such costs as currently deductible repair and maintenance expenses (Rev. Proc. 2015-56; Rev. Proc. 2016-29, Section 10.10 (Accounting method change #222)). The 25 percent capitalization amount also applies for purposes of the uniform capitalization rules of Code Sec. 263A.
Once the accounting method change is filed, all future remodel-refreshes for all of a taxpayer’s qualified buildings in the same trade or business are subject to the safe harbor. A taxpayer would need to file a non-automatic method change seeking advance consent to switch out of the safe harbor.
The 75 percent allocation to current deductible expenditures is considered by most practitioners as generous when compared to the typical allocation that results when the repair regulations are applied on an item-by-item basis to remodel-refresh costs. However, the safe harbor imposes some complexities and restrictions that may discourage its use.
The 25 percent capitalized portion is generally treated as nonresidential real property depreciable over a 39-year recovery period. However, some or all of capitalized amount may instead be eligible for a 15-year recovery period as qualified leasehold improvement property, qualified retail improvement property, or qualified restaurant property. For example, if the remodel-refresh is made to the internal structure of the building pursuant to the terms of a lease and the building is at least three years old, some or all of the capitalized portion may be considered 15-qualified leasehold improvement property and is also eligible for bonus depreciation.
The safe harbor may only be used by taxpayers with an applicable financial statement (AFS). Consequently, the method is not usually available to small business taxpayers who typically operate one or two stores.
An AFS is an audited financial statement or certain other similar statements.
An IRS spokesperson indicated that the IRS limited the safe harbor to taxpayers with an AFS because such taxpayers were in greater need of relief due to the large number of remodel-refreshes conducted by these taxpayers. Small business taxpayers, on the other hand, can generally apply the tangible property regulation guidelines on the occasional remodel-refresh without undue burden.
Certain retailers may not use the remodel-refresh safe harbor (Sec. 4.01 of Rev. Proc. 2015-56). These excluded retailers include:
- Automotive dealers;
- Other motor vehicle dealers;
- Gas stations;
- Manufactured home dealers; and
- Nonstore retailers.
Certain costs paid during a remodel-refresh project are specifically excluded from the safe harbor (Sec. 6.04 of Rev. Proc. 2015-56). Excluded remodel-refresh costs must be deducted or capitalized in accordance with the provisions of the tax code and regulations that are otherwise applicable.
Code Sec. 110 construction allowances. Amounts paid by a lessor to a lessee for making improvements may constitute a qualified lessee construction allowance under Code Sec. 110. The allowance must be capitalized and depreciated by the owner-lessor in accordance with Code Sec. 110.
Section 1245 property. Amounts paid for section 1245 property during a remodel-refresh are not subject to the safe harbor. Thus, section 1245 property that would otherwise be treated as a separately depreciable asset must be capitalized and depreciated under the cost segregation rules, usually over a five-year period (Asset Class 57.0 of Rev. Proc. 87-56).