Source: https://www.spfinancialservicesinc.com/content/capitalize-or-not-capitalize-fixed-assets-0
Timestamp: 2019-04-20 06:53:05+00:00

Document:
Capitalize or Not Capitalize Fixed Assets | spFinancial Services, Inc.
The first item, the de minimis safe harbor election, applies when tangible property is acquired or produced, but does not apply to improvements to existing property. The other three safe harbors apply to repair vs. improvement determinations.
The annual de minimis safe harbor allows electing taxpayers to deduct amounts paid to acquire or produce tangible property to the extent such amounts are treated as expenses for financial accounting purposes or in keeping books and records. Taxpayers may use the safe harbor to deduct amounts up to $500 per invoice or item (up to $5,000 for taxpayers with an applicable financial statement (AFS)).
The de minimis safe harbor election is the subject of its own Quick Reference guide at ¶360,230. Alternatively, see ¶99,550 for an in-depth discussion, or ¶320,216 for a sample election statement.
(3) The total amount paid during the year for repairs, maintenance, improvements, or similar activities performed on such building property doesn't exceed the lesser of: (a) two percent of the unadjusted basis of the eligible building property; or (b) $10,000.
Taxpayers make the election to use the safe harbor for each year in which qualifying amounts are incurred by attaching a statement to the taxpayer's income tax return for the year.
See Parker ¶320,212 for a sample election statement. See ¶99,560.25 for an in-depth discussion of the safe harbor election for small taxpayers.
(4) The taxpayers reasonably expects, at the time the property is placed in service, to perform the activities: (a) For building structures and building systems, more than once during the 10-year period beginning when placed in service, or (b) For property other than buildings, more than once during the class life of the unit of property.
The routine maintenance safe harbor DOES NOT apply to amounts paid for betterments. However, it DOES apply to certain restorations that would otherwise be improvements, including when a taxpayer pay amounts to replace a major component or substantial structural part of a unit of property.
Observation: The safe harbor for routine maintenance is not an election but rather a method of accounting. Taxpayers who are adopting this method are generally required to file Form 3115, Application for Change in Accounting Method (change number 184). Small business taxpayers who have opted for relief under Rev. Proc. 2015-20, however, can change to this method in 2014 on a prospective basis without filing a Form 3115.
See Parker ¶99,560.30 for an in-depth discussion of the safe harbor for routine maintenance.
Taxpayers may make an annual election to capitalize repair and maintenance expenses as improvements, if the taxpayer treats such costs as capital expenditures for financial accounting purposes.
(2) Treats these amounts as capital expenditures on his or her books and records regularly used in computing income.
A taxpayer may make the election to capitalize for each year in which qualifying amounts are incurred by attaching a statement to a timely filed original federal tax return including extensions for the year that the amounts are paid.
If a taxpayer makes the election to capitalize repair and maintenance expenses, he or she must apply the election to all amounts paid for repair and maintenance that are treated as capitalexpenditures on the books and records in that year.
See Parker ¶320,214 for a sample election statement, and ¶99,560.55 for an in-depth discussion of the election to capitalize repair and maintenance expenses.
(14) rules for accounting method changes to comply with rules for improvements (see ¶99,560.70).
The provisions of Reg. Sec. 1.263(a)-3 cited in this ¶99,560 (the 2013 final regulations) - other than the provisions relating to the safe harbor for small employers (see ¶99,560.25) the optional regulatory accounting method (see ¶99,560.50) and the election to capitalize repair and maintenance costs (see ¶242,720.20) - generally apply to tax years beginning on or after January 1, 2014. The provisions of the 2013 final regulations relating to the safe harbor for small employers, the optional regulatory accounting method, and the election to capitalize repair and maintenance costs generally apply to amounts paid in tax years beginning on or after January 1, 2014. The version of Regulation Section 1.263(a)-3 as contained in 26 CFR part 1 edition revised as of April 1, 2011, generally applies to tax years beginning before January 1, 2014 (Reg. Sec. 1.263(a)-3(r)(1)).
A taxpayer may choose to apply the 2013 final regulations - other than the provisions relating to the safe harbor for small employers, the optional regulatory accounting method, and the election to capitalize repair and maintenance costs - to tax years beginning on or after January 1, 2012. A taxpayer may choose to apply the provisions of the 2013 final regulations relating to the safe harbor for small employers, the optional regulatory accounting method, and the election tocapitalize repair and maintenance costs to amounts paid in tax years beginning on or after January 1, 2012 (Reg. Sec. 1.263(a)-3(r)(2)). Alternatively, a taxpayer may choose to apply the provisions of Reg. Sec. 1.263(a)-3T cited in this ¶99,560 (the 2011 temporary regulations) to tax years beginning on or after January 1, 2012, and before January 1, 2014 (Reg. Sec. 1.263(a)-3(r)(3)).
Compliance Tip: Rev. Proc. 2012-19 (for changes applied for before January 24, 2014) and Rev. Proc. 2014-16 (for changes applied for on or after January 24, 2014) provide the procedures by which taxpayers who choose to apply the provisions of the temporary regulations to tax years beginning on or after January 1, 2012, and before January 1, 2014, may obtain automatic IRS consent to change to their methods of accounting to comply with the temporary regulations.
Caution: Nothing in the 2011 temporary or 2013 final regulations changes the treatment of any amount that is specifically provided for under any provision of the Code or regulations, other than Code Sec. 162(a) or Code Sec. 212 and the regulations under those sections (Reg. Sec.1.263(a)-3(c)(1); Reg. Sec. 1.263(a)-3T(c)(1)). Thus, for example, the regulations do not change the treatment of items that are subject to the uniform capitalization rules of Code Sec. 263A, which requires taxpayers to capitalize the direct and allocable indirect costs of certain property produced by the taxpayer and property acquired for resale. See ¶242,400. Nor do they change the treatment of items that are subject to Code Sec. 195, which generally requires taxpayers to capitalize certain costs as start-up expenditures. See ¶95,700. Further, they do not change the treatment of amounts paid to acquire or produce property that is properly treated as materials and supplies under Reg. Sec. 1.162-3. See ¶242,700.
Generally, a taxpayer must capitalize the related amounts paid to improve a unit of property owned by the taxpayer. Special rules apply, however, for the treatment of amounts paid to improve leased property (see ¶99,560.15). See ¶242,450 and ¶242,455 for the treatment of costs required to be capitalized to property produced by the taxpayer or to property acquired for resale.
(3) adapt the unit of property to a new or different use (see ¶99,560.45) (Reg. Sec. 1.263(a)-3(d); Reg. Sec. 1.263(a)-3T(d)).
For this purpose, amounts paid to improve a unit of property include amounts paid over a period of more than one tax year. Whether amounts are related to the same improvement depends on the facts and circumstances of the activities being performed (Reg. Sec. 1.263(a)-3(g)(4); Reg. Sec. 1.263(a)-3T(f)(4)).
The determination of what constitutes a "unit of property" is important for purposes of applying the capitalization rules. Generally, the determination of what constitutes a unit of property is based on the "functional interdependence" standard described in ¶99,560.10[d]. However, special rules apply for buildings, plant property, network assets, leased property, and improvements to property (Reg. Sec. 1.263(a)-3(e)(1); Reg. Sec. 1.263(a)-3T(e)(1)).
Special rules also apply if a taxpayer has assigned different MACRS classes or depreciation methods to components of property or subsequently changes the class or depreciation method of a component or other item of property. Property that is aggregated or subject to a general asset account election or accounted for in a multiple asset account (that is, pooled) may not be treated as a single unit of property (Reg. Sec. 1.263(a)-3(e)(1); Reg. Sec. 1.263(a)-3T(e)(1)). See ¶94,327 for a discussion of the general asset account election and ¶94,325.30 for a discussion of the multiple asset account rules.
Generally, in the case of a building, each building and its structural components is a single unit of property (Reg. Sec. 1.263(a)-3(e)(2)(i); Reg. Sec. 1.263(a)-3T(e)(2)(i)). However, in determining whether an amount paid is for an improvement to the building, a taxpayer must consider the effect of the expenditure on certain significant and specifically defined components of the building, rather than the building and its structural components as a whole.
(9) any other systems identified in published guidance (Reg. Sec. 1.263(a)-3(e)(2)(ii)(B); Reg. Sec. 1.263(a)-3T(e)(2)(ii)(B)).
Accordingly, if an amount paid results in a restoration of a building structure, such as the replacement of an entire roof, then the expenditure constitutes an improvement to the building unit of property. Similarly, if an amount paid is for a betterment to a building system, such as an improvement to the HVAC system, then the expenditure also constitutes an improvement to the building unit of property.
Observation: According to the IRS, this approach produces results that are consistent with case law. As examples, the IRS cited Smith v. Comm'r, 300 F.3d 1023 (9th Cir. 2002) (holding that costs to replace a substantial portion of floor were capital expenditures); Tsakopoulous v. Comm'r, T.C. Memo. 2002-8 (holding that costs to replace the roof on a portion of the suites of a shopping center were capital expenditures); Hill v. Comm'r, T.C. Memo. 1983-112 (holding that costs to replace the water heater and furnace in rental property were capital expenditures); Stewart Supply Co. v. Comm'r, T.C. Memo. 1963-62 (holding that costs to replace the front wall of a building and make electrical connections to that wall were capital expenditures); First Nat'l Bank v. Comm'r, 30 B.T.A. 632 (1934) (holding that costs of replacing the electrical system in a bank building were capital expenditures); Georgia Car and Locomotive Co., 2 B.T.A. 986 (1925) (holding that costs of a new roof on a building were capital expenditures). The approach for buildings, the IRS stated in the preamble to the temporary regulations, is conceptually similar to the plant property rule (discussed below), which segregates plant property into units of property that perform discrete and major functions within the plant.
Example: SalesCo owns a building that it uses in its retail business. The building contains two elevator banks in different locations in its building. Each elevator bank contains three elevators. SalesCo pays an amount for labor and materials for work performed on the elevators. SalesCo has not made a general asset account election with regard to the property or accounted for the property in a multiple asset account. SalesCo must treat the building and its structural components as a single unit of property. All of the elevators, including all their components, comprise a building system. Therefore, if an amount paid by SalesCo for work on the elevators results in an improvement (for example, a betterment) to the entire elevator system, SalesCo must treat these amounts as an improvement to the building.
Example: SmartCo owns an office building that contains a HVAC system. The HVAC system incorporates 10 roof-mounted units that service different parts of the building. The roof-mounted units are not connected and have separate controls and duct work that distribute the heated or cooled air to different spaces in the building's interior. SmartCo has not made a general asset account election with regard to the property or accounted for the property in a multiple asset account. SmartCo pays an amount for labor and materials for work performed on the roof-mounted units. SmartCo must treat the building and its structural components as a single unit of property. An amount is paid for an improvement to a building if it results in an improvement to the building structure or any designated building system. The entire HVAC system, including all of the roof-mounted units and their components, comprise a building system. Therefore, if an amount paid by SmartCo for work on the roof-mounted units results in an improvement (for example, a betterment) to the HVAC system, SmartCo must treat this amount as an improvement to the building.
For the owner of a condominium unit, the unit of property is the individual unit owned by the taxpayer and the structural components that are part of the condominium unit. Similarly, for a taxpayer that has an ownership interest in a cooperative housing corporation, the unit of property is the portion of the building in which the taxpayer has possessory rights and the structural components that are part of the portion of the building subject to the taxpayer's possessory rights. For both condominiums and cooperatives, however, an amount is paid for an improvement to these units of property if the amount results in an improvement to the building structure that is part of the condominium or cooperative unit or to the portion of any building system that is part of the condominium or cooperative unit (Reg. Sec. 1.263(a)-3(e)(2)(iii) and (iv); Reg. Sec. 1.263(a)-3T(e)(2)(iii) and (iv)).
Example: MediCo owns a condominium unit in a condominium office building. MediCo uses the condominium unit in its business of providing medical services. The condominium unit contains two restrooms, each of which contains a sink, a toilet, water and drainage pipes and bathroom fixtures. MediCo pays an amount for labor and materials to perform work on the pipes, sinks, toilets, and plumbing fixtures that are part of the condominium unit. MediCo has not made a general asset account election with regard to the property or accounted for the property in a multiple asset account. MediCo must treat the individual unit that it owns, including the structural components that are part of that unit, as a single unit of property. An amount is paid for an improvement to the condominium if it results in an improvement to the building structure that is part of the unit or to a portion of any designated building system that is part of the unit. The pipes, sinks, toilets, and plumbing fixtures that are part of MediCo's unit comprise the plumbing system for the condominium unit. Therefore, if an amount paid by MediCo for work on pipes, sinks, toilets, and plumbing fixtures results in an improvement (for example, a betterment) to the portion of the plumbing system that is part of MediCo's condominium unit, MediCo must treat this amount as an improvement to the condominium.
In the case of a condominium management association or a cooperative housing corporation, the association or corporation must apply the improvement rules to the building structure or to any building system (Reg. Sec. 1.263(a)-3(e)(2)(iii) and (iv); Reg. Sec. 1.263(a)-3T(e)(2)(iii) and (iv)).
Generally, in the case of a taxpayer that is a lessee of all or a portion of a building (such as an office, floor, or certain square footage), the unit of property is each building and its structural components or the portion of each building subject to the lease and the structural components associated with the leased portion (Reg. Sec. 1.263(a)-3(e)(2)(v)(A); Reg. Sec. 1.263(a)-3T(e)(2)(v)(A)).
If a taxpayer is a lessee of all or a portion of one or more buildings (such as an office, floor, or certain square footage), the unit of property is each building and its structural components or the portion of each building subject to the lease and the structural components associated with the leased portion. An amount is paid for an improvement to a leased building or a leased portion of a building if the amount paid results in an improvement to the leased building structure (or the portion thereof subject to the lease) or any of the leased building systems (or the portion thereof subject to the lease) (Reg. Sec. 1.263(a)-3(e)(2)(v)(B); Reg. Sec. 1.263(a)-3T(e)(2)(v)(B)).
In the case of real or personal property other than buildings, the general rule for determining what constitutes a unit of property is that all the components that are functionally interdependent comprise a single unit of property. Components of property are functionally interdependent if the placing in service of one component by the taxpayer is dependent on the placing in service of the other component by the taxpayer (Reg. Sec. 1.263(a)-3(e)(3)(i); Reg. Sec. 1.263(a)-3T(e)(3)(i)).
Example: LawCo provides legal services to its clients. LawCo purchased a laptop computer and a printer for its employees to use in providing legal services. When LawCo placed the computer and printer into service, it treated the computer and printer and all their components as being within the same class of property and depreciated all the components using the same depreciation method. LawCo has not made a general asset account election with regard to the property or accounted for the property in a multiple asset account. Because the computer and printer are property other than a building, the initial units of property are determined under the general rule and are comprised of the components that are functionally interdependent. The computer and the printer are separate units of property because the computer and the printer are not components that are functionally interdependent (that is, the placing in service of the computer is not dependent on the placing in service of the printer).
Plant property is functionally interdependent machinery or equipment, other than network assets, used to perform an industrial process, such as manufacturing, generation, warehousing, distribution, automated materials handling in service industries, or other similar activities (Reg. Sec. 1.263(a)-3(e)(3)(ii)(A); Reg. Sec. 1.263(a)-3T(e)(3)(ii)(A)).
For plant property, the unit of property determined under the general rule is further divided into smaller units comprised of each component (or group of components) that performs a discrete and major function or operation within the functionally interdependent machinery or equipment (Reg. Sec. 1.263(a)-3(e)(3)(ii)(B); Reg. Sec. 1.263(a)-3T(e)(3)(ii)(B)).
Example: FoodCo operates a restaurant that prepares and serves food to retail customers. Within its restaurant, FoodCo has a large piece of equipment that uses an assembly-line-like process to prepare and cook tortillas that FoodCo serves to its customers. FoodCo has not made a general asset account election with regard to the property or accounted for the property in a multiple asset account. Because the tortilla-making equipment is property other than a building, the unit of property for the equipment is initially determined under the general rule and is comprised of all the components that are functionally interdependent. Under this rule, the initial unit of property is the entire tortilla-making equipment because the various components of the equipment are functionally interdependent. The equipment is not plant property because the equipment is not used in an industrial process, as it performs a small-scale function in FoodCo's retail restaurant operations. Thus, FoodCo is not required to further divide the equipment into separate units of property based on the components that perform discrete and major functions.
The term "network assets" refers to railroad track, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines that are owned or leased by taxpayers in each of those respective industries. The term includes, for example, trunk and feeder lines, pole lines, and buried conduit. It does not include property that would be included as building structure or building systems, nor does it include separate property that is adjacent to, but not part of a network asset, such as bridges, culverts, or tunnels (Reg. Sec. 1.263(a)-3(e)(3)(iii)(A); Reg. Sec. 1.263(a)-3T(e)(3)(iii)(A)).
Because the functional interdependence standard, by itself, could lead to unit of property definitions for network assets that are overly broad, functional interdependence is not determinative for network assets. In the case of network assets, the unit of property is determined by the taxpayer's particular facts and circumstances except as otherwise provided in published guidance in the Federal Register or in the Internal Revenue Bulletin (Reg. Sec.1.263(a)-3(e)(3)(iii)(B); Reg. Sec. 1.263(a)-3T(e)(3)(iii)(B)).
In the case of a taxpayer that is a lessee of real or personal property other than buildings, the unit of property for the leased property is determined under the general rule, the rule for plant property, the rule for network assets, or the additional rules discussed in ¶99,560.10[f], below. However, after applying the applicable rules, the unit of property may not be larger than the property subject to the lease (Reg. Sec. 1.263(a)-3(e)(3)(iv); Reg. Sec. 1.263(a)-3T(e)(3)(iv)).
An improvement to a unit of property is not a unit of property separate from the unit of property improved (Reg. Sec. 1.263(a)-3(e)(4); Reg. Sec. 1.263(a)-3T(e)(4)). For the unit of property rules for lessee improvements, see ¶99,560.15[a]. If a taxpayer elects to treat as a capital expenditure under Reg. Sec. 1.162-3(d) the amount paid for a rotable spare part, temporary spare part, or standby emergency spare part, and that part is used in an improvement to a unit of property, then for purposes of applying capitalization standards of Reg. Sec. 1.263(a) to the unit of property improved, the part is not a unit of property separate from the unit of property improved (Reg. Sec. 1.263(a)-3(e)(4)).
Notwithstanding the rules for determining a unit of property discussed above, a component (or a group of components) of a unit property must be treated as a separate unit of property if, at the time the unit of property is initially placed in service by the taxpayer, the taxpayer has properly treated the component as being within a different class of property under Code Sec. 168(e)(MACRS classes) than the class of the unit of property of which the component is a part, or the taxpayer has properly depreciated the component using a different depreciation method than the depreciation method of the unit of property of which the component is a part (Reg. Sec.1.263(a)-3(e)(5)(i); Reg. Sec. 1.263(a)-3T(e)(5)(i)).
Generally, in any tax year after the unit of property is initially placed in service by the taxpayer, if the taxpayer or the IRS changes the treatment of that property (or any portion thereof) to a proper MACRS class or a proper depreciation method (for example, as a result of a cost segregation study or a change in the use of the property), then the taxpayer must change the unit of property determination for that property (or the portion thereof) to be consistent with the change in treatment for depreciation purposes. Thus, for example, if a portion of a unit of property is properly reclassified to a MACRS class different from the MACRS class of the unit of property of which it was previously treated as a part, then the reclassified portion of the property should be treated as a separate unit of property (Reg. Sec. 1.263(a)-3(e)(5)(ii); Reg. Sec. 1.263(a)-3T(e)(5)(ii)).
Special rules apply for determining whether amounts paid by a taxpayer are for the improvement to a unit of leased property and must be capitalized. Generally, in the case of a leased building or a leased portion of a building, an amount is paid to improve a leased property if the amount is paid for an improvement to any of the properties specified in ¶99,560.10[a] (for lessor improvements) or under ¶99,560.10[c] (for lessee improvements except as discussed below in ¶99,560.15[a] under lessee improvements).
The intangible rules of Reg. Sec. 1.263(a)-4 do not apply to amounts paid for improvements to units of leased property or to amounts paid for the acquisition or production of leasehold improvement property (Reg. Sec. 1.263(a)-3(f)(1); Reg. Sec. 1.263(a)-3T(f)(1)(i)).
A taxpayer lessee must capitalize the related amounts that it pays to improve (as defined in ¶99,560.05) a leased property except to the extent Code Sec. 110 applies to a construction allowance received by the lessee for the purpose of the improvement or where the improvement constitutes a substitute for rent. See ¶71,110 for the treatment of lessee expenditures that constitute a substitute for rent. A taxpayer lessee must also capitalize the related amounts that a lessor pays to improve a leased property if the lessee is the owner of the improvement, except to the extent Code Sec. 110 applies to a construction allowance received by the lessee for the purpose of the improvement. See ¶76,700 for a discussion of the tax treatment of construction allowances under Code Sec. 110. An amount paid for a lessee improvement is treated as an amount paid to acquire or produce a unit of real or personal property (see ¶99,540.10) (Reg. Sec.1.263(a)-3(f)(2)(i); Reg. Sec. 1.263(a)-3T(f)(1)(ii)(A)).
The 2011 temporary regulations provide that an amount capitalized as a lessee improvement comprises a unit of property separate from the leased property being improved. However, an amount that a lessee pays to improve a lessee improvement is not a unit of property separate from such lessee improvement (Reg. Sec. 1.263(a)-3T(f)(1)(ii)(B)).
The 2013 final regulations clarify that, for purposes of determining whether an amount paid by a lessee constitutes a lessee improvement to a leased property, the unit of property and the improvement rules are applied in accordance with the rules for leased buildings (or leased portions of building) under Reg. Sec. 1.263(a)-3(e)(2)(v) or for leased property other than buildings under Reg. Sec. 1.263(a)-3(e)(3)(iv). Thus, for example, if a lessee pays an amount for work on an addition that it previously made to a leased building, the taxpayer determines whether the work performed constitutes an improvement to the entire leased building structure, not merely to the addition. However, if a lessee improvement is comprised of an entire building erected on leased property, then the unit of property for the building and the application of the improvement rules to the building are determined under the rules for buildings under Reg. Sec.1.263(a)-3(e)(2)(i) and Reg. Sec. 1.263(a)-3(e)(2)(ii), rather than under the provisions for leased buildings (Reg. Sec. 1.263(a)-3(f)(2)(ii)). See ¶99,560.10[a].
Example: SalesCo is a retailer of consumer products. In 2014, SalesCo leases a building from LeaseCo, which SalesCo intends to use as a retail sales facility. The leased building consists of the building structure and various building systems, including a plumbing system, an electrical system, and an HVAC system. Under the terms of the lease, T is permitted to improve the building at its own expense. Because SalesCo leases the entire building, it must treat the leased building and its structural components as a single unit of property. An amount is paid to improve a leased building property if the amount is paid for an improvement to the leased building structure or to any building system within the leased building. Therefore, if SalesCo pays an amount that improves the building structure, the plumbing system, the electrical system, or the HVAC system, then SalesCo must treat this amount as an improvement to the entire leased building property.
In 2015, SalesCo pays an amount to construct an extension to the building to be used for additional warehouse space. This amount is for a betterment (¶99,560.35) to SalesCo's leased building structure and does not affect any building systems. Accordingly, the amount that SalesCo pays for the building extension is for a betterment to the leased building structure, and thus, is treated as an improvement to the entire leased building. Because SalesCo, the lessee, paid an amount to improve a leased building property, SalesCo must capitalize the amount paid for the building extension as a leasehold improvement. In addition, SalesCo must treat the amount paid for the improvement as the acquisition or production of a unit of property (leasehold improvement property).
In 2018, SalesCo pays an amount to add a large overhead door to the building extension that it constructed in 2015 to accommodate the loading of larger products into the warehouse space. To determine whether the amount paid by SalesCo is for a leasehold improvement, the unit of property and the improvement rules are applied and include SalesCo's previous improvements to the leased property. Therefore, the unit of property is the entire leased building, including the extension built in 2015. In addition, the leased building property is improved if the amount is paid for an improvement to the building structure or any building system. The amount paid to add the overhead door is for a betterment to the building structure, which includes the extension. Accordingly, SalesCo must capitalize the amounts paid to add the overhead door as a leasehold improvement to the leased building property. In addition, SalesCo must treat the amount paid for the improvement as the acquisition or production of a unit of property (leasehold improvement property). However, to determine whether a future amount paid by SalesCo is for a leasehold improvement to the leased building, the unit of property and the improvement rules are again applied and include the new overhead door.
A taxpayer lessor must capitalize the related amounts that it pays directly, or indirectly through a construction allowance to the lessee, to improve (as defined in ¶99,560.05) a leased property where the lessor is the owner of the improvement or to the extent Code Sec. 110 applies to the construction allowance. A lessor must also capitalize the related amounts that the lessee pays to improve a leased property where the lessee's improvement constitutes a substitute for rent. See ¶71,110 for treatment of expenditures by lessees that constitute a substitute for rent. Amounts the lessor capitalizes cannot be capitalized by the lessee (Reg. Sec. 1.263(a)-3(f)(3)(i); Reg. Sec.1.263(a)-3T(f)(1)(iii)(A)).
An amount capitalized as a lessor improvement is not a unit of property separate from the unit of property improved (Reg. Sec. 1.263(a)-3T(f)(1)(iii)(B)). However, the 2013 final regulations clarify that if a lessor improvement is comprised of an entire building erected on leased property, then the unit of property for the building and the application of the improvement rules to the building are determined under rules for buildings under Reg. Sec. 1.263(a)-3(e)(2)(i) and Reg. Sec. 1.263(a)-3(e)(2)(ii), rather than under the rules for leased buildings (Reg. Sec. 1.263(a)-3(f)(3)(ii)). See ¶99,560.10[a].
Example: SalesCo is a retailer of consumer products. In 2014, SalesCo leases a building from LeaseCo, which SalesCo intends to use as a retail sales facility. Pursuant to the lease, LeaseCo provides a construction allowance to SalesCo, which SalesCo intends to use to construct an extension to the retail sales facility for additional warehouse space. The amount paid for any improvement to the building does not exceed the construction allowance, and LeaseCo is treated as the owner of any improvement to the building. Under Reg. Sec. 1.263(a)-3(e)(2)(i), LeaseCo must treat the building and its structural components as a single unit of property. An amount is paid to improve a building if it is paid for an improvement to the building structure or to any building system.
SalesCo uses LeaseCo's construction allowance to construct an extension to the leased building to provide additional warehouse space in the building. The extension is a betterment (as defined in ¶99,560.35) to the building structure, and therefore, the amount paid for the extension results in an improvement to the building. LeaseCo, the lessor and owner of the improvement, must capitalize the amounts paid to SalesCo to construct the extension to the retail sales facility. SalesCo cannot capitalize the amounts paid for the lessor-owned improvement. Finally, the extension to LeaseCo's building is not a unit of property separate from the building and its structural components.
Neither the 2011 temporary regulations nor the 2013 final regulations prescribe rules related to the "plan of rehabilitation" doctrine as traditionally described in the case law. Under the judicially created plan of rehabilitation doctrine, a taxpayer must capitalize otherwise deductiblerepair or maintenance costs if they are incurred as part of a general plan of rehabilitation, modernization, and improvement to the property (Moss v. Comm'r, 831 F.2d 833 (9th Cir. 1987); U.S. v. Wehrli, 400 F.2d 686 (10th Cir. 1968); Norwest Corp. v. Comm'r, 108 T.C. 265(1997)).
The regulations do not restate the plan of rehabilitation doctrine. Rather, they use the language of the Code Sec. 263A rule providing that a taxpayer must capitalize all the direct costs of an improvement and all the indirect costs (including, for example, otherwise deductible repaircosts) that directly benefit or are incurred by reason of an improvement in accordance with the uniform capitalization rules of Code Sec. 263A (see ¶242,400). Therefore, indirect costs, such asrepair and maintenance costs, that do not directly benefit and are not incurred by reason of an improvement do not have to be capitalized under Code Sec. 263(a), regardless of whether they are incurred at the same time as an improvement (Reg. Sec. 1.263(a)-3(g)(1)(i); Reg. Sec.1.263(a)-3T(f)(3)(i)). The regulations also include an exception to this provision for an individual residence. Under this exception, an individual taxpayer can capitalize amounts paid for repairs and maintenance that are made at the same time as capital improvements to units of property not used in the taxpayer's trade or business or for the production of income if the amounts are paid as part of a remodeling of the taxpayer's residence (Reg. Sec. 1.263(a)-3(g)(1)(ii); Reg. Sec. 1.263(a)-3T(f)(3)(ii)).
Observation: By providing a standard based on the Code Sec. 263A language, the regulations set out a clear rule for determining when otherwise deductible indirect costs must be capitalized as part of an improvement to property and obsolete the plan of rehabilitation doctrine to the extent that the court-created doctrine provides different standards.
The 2011 temporary regulations did not provide a separate rule for the treatment of removal costs. Rather, the 2011 temporary regulations addressed component removal costs as an example of a type of indirect cost that must be capitalized if the removal costs directly benefit or are incurred by reason of an improvement (Reg. Sec. 1.263(a)-3T(f)(3)(i)).
The preamble to the 2011 temporary regulations stated that the costs of removing a component of a unit of property should be analyzed in the same manner as any other indirect cost (such as arepair cost) incurred during a repair or an improvement to property. Therefore, if the cost of removing a component of a unit of property directly benefitted or was incurred by reason of an improvement to the unit of property, the cost must be capitalized.
The preamble to the 2011 temporary regulations also noted that the 2011 temporary regulations were not intended to affect the holding of Rev. Rul. 2000-7 as it applied to the cost of removing an entire unit of property. Under Rev. Rul. 2000-7, a taxpayer is not required to capitalize the cost of removing a retired depreciable asset under Code Sec. 263(a) or Code Sec. 263A, even when the retirement and removal occur in connection with the installation of a replacement asset. Rev. Rul. 2000-7 reasoned that the costs of removing a depreciable asset generally have been allocable to the removed asset and, thus, generally have been deductible when the asset is retired.
Observation: The 2011 temporary regulations did not explicitly state that the costs incurred to remove an entire unit of property were not required to be capitalized, even when incurred in connection with the installation of a replacement asset. It was unclear whether the principles of Rev. Rul. 2000-7 applied to allow the deduction of removal costs when the taxpayer disposes of a component of a unit of property and the taxpayer takes into account the adjusted basis of the component in realizing loss. It was also unclear under the temporary regulations whether a taxpayer would be required to capitalize component removal costs if these costs were an indirect cost of a restoration (for example, the replacement of a component when the taxpayer has properly deducted a loss for that component) rather than a betterment to the underlying unit of property.
The 2013 final regulations provide a specific rule clarifying the treatment of removal costs in these contexts. Under the 2013 final regulations, if a taxpayer disposes of a depreciable asset (including a partial disposition under Reg. Sec. 1.168(i)-1(e)(1)(ii) or Reg. Sec. 1.168(i)-8(d)) for federal tax purposes and has taken into account the adjusted basis of the asset or component of the asset in realizing gain or loss, the costs of removing the asset or component are not required to be capitalized under Code Sec. 263(a). If a taxpayer disposes of a component of a unit of property and the disposal is not a disposition for federal tax purposes, then the taxpayer must deduct or capitalize the costs of removing the component based on whether the removal costs directly benefit or are incurred by reason of a repair to the unit of property or an improvement to the unit of property (Reg. Sec. 1.263(a)-3(g)(2)(i)).
Example: ManufactoCorp owns a factory building with a storage area on the second floor. ManufactoCorp pays an amount to remove the original columns and girders supporting the second floor and replace them with new columns and girders to permit storage of supplies with a gross weight 50 percent greater than the previous load-carrying capacity of the storage area. The replacement of the columns and girders constitutes a betterment to the building structure and is therefore an improvement to the building unit of property. ManufactoCorp disposes of the original columns and girders, and the disposal of these structural components is not a disposition under Reg. Sec. 1.168(i)-1(e) or Reg. Sec. 1.168(i)-8. The amount paid to remove the columns and girders must be capitalized as a cost of the improvement, because it directly benefits and is incurred by reason of the improvement to the building.
Example: The facts are the same facts as in the preceding example, except ManufactoCorp disposes of the original columns and girders and elects to treat the disposal of these structural components as a partial disposition of the factory building under Reg. Sec. 1.168(i)-8(d), taking into account the adjusted basis of the components in realizing loss on the disposition. The amount paid to remove the columns and girders is not required to be capitalized as part of the cost of the improvement regardless of their relation to the improvement. However, all the remaining costs of replacing the columns and girders must be capitalized as improvements to the building unit of property.
A federal, state, or local regulator's requirement that a taxpayer perform certain repairs or maintenance on a unit of property to continue operating the property is not relevant in determining whether the amount paid improves the unit of property (Reg. Sec. 1.263(a)-3(g)(4); Reg. Sec. 1.263(a)-3T(f)(2)).
The 2011 temporary regulations did not provide any special rules for small taxpayers to assist them in applying the general rules for improvements to buildings. The 2013 final regulation added a safe harbor election for building property held by taxpayers whose average annual gross receipts for the three preceding tax years is $10 million or less (a "qualifying small taxpayer"). For taxpayer that have been in existence for less than three tax years, the taxpayer determines its average annual gross receipts for the number of tax years (including short tax years) that the taxpayer (or its predecessor) has been in existence. In the case of any tax year of less than 12 months (a short tax year), the gross receipts must be annualized (Reg. Sec. 1.263(a)-3(h)(3)).
Under the safe harbor, a qualifying small taxpayer may elect to not apply the improvement rules to an eligible building property if the total amount paid during the tax year for repairs, maintenance, improvements, and similar activities performed on the eligible building does not exceed the lesser of $10,000 or 2 percent of the unadjusted basis of the building (Reg. Sec.1.263(a)-3(h)(1)). Eligible building property includes a building unit of property that is owned or leased by the qualifying taxpayer, provided the unadjusted basis of the building unit of property is $1 million or less (Reg. Sec. 1.263(a)-3(h)(4)). The IRS is authorized to adjust the amounts of the safe harbor and gross receipts limitations through published guidance (Reg. Sec.1.263(a)-3(h)(9)).
The final regulations provide simple rules for determining the unadjusted basis of both owned and leased building units of property. Specifically, the unadjusted basis of eligible building property owned by the taxpayer means the basis as determined under Code Sec. 1012, or other applicable sections of Chapter 1 of the Code. Unadjusted basis is determined without regard to any adjustments described in Code Sec. 1016(a)(2) or (3) or to amounts for which the taxpayer has elected to treat as an expense (for example, under Code Secs. 179, 179B, or 179C) (Reg. Sec. 1.263(a)-3(h)(5)).
Under the safe harbor, a taxpayer includes amounts not capitalized under the de minimis safe harbor election of Reg. Sec. 1.263(a)-1(f) (discussed in ¶99,550) and under the routine maintenance safe harbor for buildings (discussed in ¶99,560.30) to determine the annual amount paid for repairs, maintenance, improvements, and similar activities performed on the building (Reg. Sec. 1.263(a)-3(h)(7)). If the amount paid for repairs, maintenance, improvements, and similar activities performed on a building unit of property exceeds the safe harbor threshold for a tax year, then the safe harbor does not apply to any amounts spent during the tax year. In that case, the taxpayer must apply the general rules for determining improvements, including the routine maintenance safe harbor for buildings. The taxpayer may also elect to apply the de minimis safe harbor under Reg. Sec. 1.263(a)-1(f) (see ¶99,550) to amounts qualifying under the de minimis safe harbor, regardless of the application of the safe harbor for small taxpayers (Reg. Sec. 1.263(a)-3(h)(8)).
Example: AdviceCo is a qualifying small taxpayer. AdviceCo owns an office building in which it provides consulting services. In 2014, AdviceCo's building has an unadjusted basis of $750,000. In 2014, AdviceCo pays $5,500 for repairs, maintenance, improvements and similar activities to the office building. Because AdviceCo's building unit of property has an unadjusted basis of $1 million or less, AdviceCo's building constitutes eligible building property. The aggregate amount paid by AdviceCo during 2014 for repairs, maintenance, improvements and similar activities on this eligible building property does not exceed the lesser of $15,000 (2 percent of the building's unadjusted basis of $750,000) or $10,000. Therefore, AdviceCo may elect to not capitalize the amounts paid forrepair, maintenance, improvements, or similar activities on the office building in 2014. If AdviceCo properly makes that election for the office building and the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business, AdviceCo may deduct these amounts in 2014.
Example: The facts are the same as in the preceding example, except that AdviceCo pays $10,500 for repairs, maintenance, improvements, and similar activities performed on its office building in 2014. Because this amount exceeds $10,000, the lesser of the two limitations, AdviceCo cannot apply the safe harbor for qualifying small taxpayers to the total amounts paid for repairs, maintenance, improvements, and similar activities performed on the building. Therefore, AdviceCo must apply the general improvement rules to determine which of the aggregate amounts paid are for improvements and must be capitalized and which of the amounts are for repair and maintenance.
Compliance Tip: The safe harbor for building property held by small taxpayers may be elected annually on a building-by-building basis by including a statement on the taxpayer's timely filed original federal tax return, including extensions, for the year the costs are incurred for the building. The statement must be titled, "Section 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers" and include the taxpayer's name, address, taxpayer identification number, and a description of each eligible building property to which the taxpayer is applying the election. In the case of an S corporation or a partnership, the election is made by the S corporation or by the partnership, and not by the shareholders or partners. An election may not be made through the filing of an application for change in accounting method or, before obtaining the IRS's consent to make a late election, by filing an amended federal tax return. The election is irrevocable.
Amounts paid by the taxpayer to which the taxpayer properly applies and elects the safe harbor are not treated as improvements to the building under Reg. Sec. 1.263(a)-3 and may be deducted under Reg. Sec. 1.162-1 or Reg. Sec. 1.212-1, as applicable, in the tax year that the amounts are paid or incurred, provided the amounts otherwise qualify for deduction under those sections (Reg. Sec. 1.263(a)-3(h)(7)).
Both the 2011 temporary regulations and the 2013 final regulations provide a safe harbor under which the costs of performing certain routine maintenance activities for property other than a building or the structural components of a building are deemed not to improve that unit of property and thus are not required to be capitalized as an improvement. (Reg. Sec. 1.263(a)-3(i)(1); Reg. Sec. 1.263(a)-3T(g)(1)).
The 2013 final regulations added a safe harbor for routine maintenance for buildings. In the case of a building, an amount paid for routine maintenance performed on any of the properties designated in Reg. Sec. 1.263(a)-3(e)(2)(ii) (building), Reg. Sec. 1.263(a)-3(e)(2)(iii)(B)(condominium), Reg. Sec. 1.263(a)-3(e)(2)(iv)(B) (cooperative), or Reg. Sec. 1.263(a)-3(e)(2)(v)(B) (leased building) is deemed not to improve that unit of property (Reg. Sec. 1.263(a)-3(i)(1)).
Observation: The inclusion of a routine maintenance safe harbor for buildings is expected to alleviate some of the difficulties that could arise in applying the improvement standards for certain restorations to building structures and building systems.
In the case of a unit of tangible property other than a building, routine maintenance is the recurring activities that a taxpayer expects to perform as a result of the taxpayer's use of the unit of property to keep the unit of property in its ordinarily efficient operating condition. Routine maintenance activities include, for example, the inspection, cleaning, and testing of the unit of property, and the replacement of damaged or worn parts of the unit of property with comparable and commercially available replacement parts. Routine maintenance may be performed any time during the useful life of the building structure or building systems. However, the activities are routine only if, at the time the unit of property is placed in service by the taxpayer, the taxpayer reasonably expects to perform the activities more than once during the class life of the unit of property. Among the factors to be considered in determining whether maintenance is routine and whether the taxpayer's expectation is reasonable are the recurring nature of the activity, industry practice, manufacturers' recommendations, the taxpayer's experience with similar property, and under the 2011 temporary regulations (but not under the 2013 final regulations), the taxpayer's treatment of the activity on its applicable financial statement. With respect to a taxpayer that is a lessor of a unit of property, the taxpayer's use of the unit of property includes the lessee's use of the unit of property (Reg. Sec. 1.263(a)-3(i)(1)(ii); Reg. Sec. 1.263(a)-3T(g)(1)).
For this purpose, the class life of a unit of property is the recovery period prescribed for the property under Code Sec. 168(g)(2) and (3) for purposes of the alternative depreciation system, regardless of whether the property is depreciated under Code Sec. 168(g). For this purpose, Code Sec. 168(g)(3)(A) (relating to tax-exempt use property subject to lease) does not apply. If the unit of property is comprised of more than one component with different class lives, then the class life of the unit of property is deemed to be the same as the component with the longest class life (Reg. Sec. 1.263(a)-3(i)(4); Reg. Sec. 1.263(a)-3T(g)(4)).
Under the 2013 final regulations, a taxpayer's expectation of whether it will perform qualifying maintenance activities more than once during the class life of the unit of property will not be deemed unreasonable merely because the taxpayer does not actually perform the maintenance a second time during the relevant period, provided that the taxpayer can otherwise substantiate that its expectation was reasonable at the time the property was placed in service (Reg. Sec.1.263(a)-3(i)(1)(ii)). Thus, for a unit of property previously placed in service, whether the maintenance is actually performed more than once during the relevant period is not controlling for assessing the reasonableness of a taxpayer's original expectation. However, if a similar or identical unit of property is placed in service in a future tax year, the taxpayer's experience with the original property may be taken into account as a factor in assessing whether the taxpayer reasonably expects to perform the activities more than once during the relevant period for the similar or identical unit of property. The taxpayer's actual experience, therefore, may be used in assessing the reasonableness of the taxpayer's expectation of the frequency of restoration or replacement at the time a new unit of property is placed in service, but hindsight should not be used to invalidate a taxpayer's reasonable expectation as established at the time the unit of property was first placed in service when subsequent events do not conform to the taxpayer's reasonable expectation.
Example: In January, 2014, ManufactoCorp purchases a used machine for use in its manufacturing operations. The machine is the unit of property and has a class life of 10 years. ManufactoCorp places the machine in service in January, 2014, and at that time, ManufactoCorp expects to perform manufacturer recommended scheduled maintenance on the machine approximately every three years. The scheduled maintenance includes the cleaning and oiling of the machine, the inspection of parts for defects, and the replacement of minor items such as springs, bearings, and seals with comparable and commercially available replacement parts. At the time ManufactoCorp purchased the machine, the machine was approaching the end of a three-year scheduled maintenance period. As a result, in February 2014, ManufactoCorp pays amounts to perform the manufacturer recommended scheduled maintenance. None of the exceptions apply to the amounts paid for the scheduled maintenance. The majority of ManufactoCorp's costs do not qualify under the routine maintenance safe harbor because the costs were incurred primarily as a result of the prior owner's use of the property and not ManufactoCorp's use. ManufactoCorp acquired the machine just before it had received its three-year scheduled maintenance. Accordingly, the amounts paid for the scheduled maintenance resulted from the prior owner's, and not ManufactoCorp's, use of the property and must be capitalized if those amounts result in a betterment, including the amelioration of a material condition or defect, or otherwise result in an improvement.
In the case of a building, routine maintenance is the recurring activities that a taxpayer expects to perform as a result of the taxpayer's use of the designated properties to keep the building structure or each building system in its ordinarily efficient operating condition. Routine maintenance activities include, for example, the inspection, cleaning, and testing of the building structure or each building system, and the replacement of damaged or worn parts of the unit of property with comparable and commercially available replacement parts. The activities are routine only if, at the time the unit of property is placed in service by the taxpayer, the taxpayer reasonably expects to perform the activities more than once during the 10-year period beginning at the time the building structure or the building system upon which the routine maintenance is performed is placed in service by the taxpayer (Reg. Sec. 1.263(a)-3(i)(1)(i)).
Among the factors to be considered in determining whether maintenance is routine and whether the taxpayer's expectation is reasonable are the recurring nature of the activity, industry practice, manufacturers' recommendations, and the taxpayer's experience with similar property. With respect to a taxpayer that is a lessor of a building or a part of the building, the taxpayer's use of the building unit of property includes the lessee's use of the unit of property (Reg. Sec.1.263(a)-3(i)(1)(i)).
Under the 2013 final regulations, a taxpayer's expectation of whether it will perform qualifying maintenance activities more than once during the 10-year period is not deemed unreasonable merely because the taxpayer does not actually perform the maintenance a second time during the relevant period, provided that the taxpayer can otherwise substantiate that its expectation was reasonable at the time the property was placed in service (Reg. Sec. 1.263(a)-3(i)(1)(i)). Thus, for a unit of property previously placed in service, whether the maintenance is actually performed more than once during the relevant period is not controlling for assessing the reasonableness of a taxpayer's original expectation.
However, if a similar or identical unit of property is placed in service in a future tax year, the taxpayer's experience with the original property may be taken into account as a factor in assessing whether the taxpayer reasonably expects to perform the activities more than once during the relevant period for the similar or identical unit of property. The taxpayer's actual experience, therefore, may be used in assessing the reasonableness of the taxpayer's expectation of the frequency of restoration or replacement at the time a new unit of property is placed in service, but hindsight should not be used to invalidate a taxpayer's reasonable expectation as established at the time the unit of property was first placed in service when subsequent events do not conform to the taxpayer's reasonable expectation.
Example: In 2014, MallCo acquires a large retail mall in which it leases space to retailers. The mall contains an escalator system with 40 escalators, which includes landing platforms, trusses, tracks, steps, handrails, and safety brushes. In 2014, when MallCo placed its building into service, MallCo reasonably expected that it would need to replace the handrails on the escalators approximately every four years to keep the escalator system in its ordinarily efficient operating condition. After a routine inspection and test of the escalator system in 2017, MallCo determines that the handrails need to be replaced and pays an amount to replace the handrails with comparable and commercially available handrails. The escalator system, including the handrails, is a building system. None of the exceptions to what is considered routine maintenance apply to the scheduled maintenance costs. Because the replacement of the handrails involves recurring activities that MallCo expects to perform as a result of its use of the escalator system to keep the escalator system in an ordinarily efficient operating condition, and MallCo reasonably expects to perform these activities more than once during the 10-year period beginning at the time building system was placed in service, the amounts paid by MallCo for the handrail replacements are within the routine maintenance safe harbor. Accordingly, the amounts MallCo paid for the replacement of the handrails in 2017 are deemed not to improve the building unit of property and are not required to be capitalized.
Example: The facts are the same as in the preceding example, except that in 2022, MallCo pays amounts to replace the steps of the escalators. In 2014, when MallCo placed its building into service, MallCo reasonably expected that approximately every 18 to 20 years MallCo would need to replace the steps to keep the escalator system in its ordinarily efficient operating condition. Because the replacement does not involve recurring activities that MallCo expects to perform more than once during the 10-year period beginning at the time the building structure or the building system was placed in service, the costs of these activities do not fall within the routine maintenance safe harbor. Accordingly, amounts that MallCo pays to replace the steps in 2022 must be capitalized if they result in improvements.
Except as provided under the exceptions listed in ¶99,560.30[d] below, amounts paid for routine maintenance include routine maintenance performed on (and with regard to) rotable and temporary spare parts (Reg. Sec. 1.263(a)-3(i)(2); Reg. Sec. 1.263(a)-3T(g)(2)).
(9) amounts paid for repairs, maintenance, or improvement of rotable and temporary spare parts to which the taxpayer applies the optional method of accounting for rotable and temporary spare parts described in ¶242,710.10 (Reg. Sec. 1.263(a)-3(i)(3); Reg. Sec. 1.263(a)-3T(g)(3)).
A taxpayer must capitalize as an improvement amounts paid that are "for the betterment" of a unit of property.
(3) results in a material increase in capacity (including additional cubic or square space), productivity, efficiency, strength, or quality of the unit of property or the output of the unit of property (Reg. Sec. 1.263(a)-3T(h)(1)).
In CCM 201213023, the Chief Counsel's Office ruled that costs incurred for slot machine conversions generally did not rise to the level of capital expenditures because the conversions did not result in permanent improvements or betterments that materially increased the value of the machines.
(3) is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the unit of property (Reg. Sec. 1.263(a)-3(j)(1)).
Observation: Elimination of the "results in" standard is intended reduce controversy for expenditures that span more than one tax year or when the outcome of the expenditure is uncertain when the expenditure is made.
The 2011 temporary regulations provide that, to determine whether an amount paid results in a betterment, it is appropriate to consider 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 unit of property, and the taxpayer's treatment of the expenditure on its applicable financial statement (Reg. Sec. 1.263(a)-3T(h)(3)(i)). The 2013 final regulations clarify that not every single quantitative or qualitative factor listed in (2) and (3) above applies to every type of property. Whether any single factor applies to a particular unit of property depends on the nature of the property. For example, while amounts paid for work performed on an office building or a retail building may clearly comprise a physical enlargement or increase the capacity, efficiency, strength, or quality of the building under certain facts, it is unclear how to measure whether work performed on an office building or retail building increases the productivity or output of such buildings, as those terms are generally understood. Thus, the productivity and output factors would not generally apply to buildings. On the other hand, it is appropriate to evaluate many items of manufacturing equipment in terms of output or productivity as well as size, capacity, efficiency, strength, and quality. Thus, the final regulations clarify that the applicability of each quantitative and qualitative factor depends on the nature of the unit of property, and if an addition or increase in a particular factor cannot be measured in the context of a specific type of property, then the factor is not relevant in determining whether there has been a betterment to the property (Reg. Sec. 1.263(a)-3(j)(2)(iii)).
Observation: In recognition of the fact that taxpayers may apply different standards for capitalizing amounts on their applicable financial statements and such standards may not be controlling for whether the activities are betterments for federal tax purposes, the 2013 final regulations do not include the taxpayer's treatment of the expenditure on its financial statement as a factor to be considered in performing a betterment analysis.
Under the 2011 temporary regulations, in the case of a building, an amount results in a betterment to the unit of property if it results in a betterment to any of the properties designated in ¶99,560.10 as buildings (i.e., building, condominium, cooperative, or leased building or leased portion of building) (Reg. Sec. 1.263(a)-3T(h)(2)). Under the 2013 final regulations, an amount is paid to improve a building if it is paid for a betterment to such a property (Reg. Sec.1.263(a)-3(j)(2)). For example, an amount is paid to improve a building if it is paid for an increase in the efficiency of the building structure or any one of its building systems (for example, the HVAC system).
If a taxpayer replaces a part of a unit of property 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 unit of property (Reg. Sec. 1.263(a)-3(j)(2)(iii); Reg. Sec.1.263(a)-3T(h)(3)(ii)).
Under an "appropriate comparison rule," where an expenditure is necessitated by normal wear and tear or damage to the unit of property that occurred during the taxpayer's use of the unit of property, the determination of whether an expenditure is for the betterment of the unit of property is made by comparing the condition of the property immediately after the expenditure with the condition of the property immediately before the circumstances necessitating the expenditure (Reg. Sec. 1.263(a)-3(j)(2)(iv)(A); Reg. Sec. 1.263(a)-3T(h)(3)(iii)(A)). If the expenditure is made to correct the effects of normal wear and tear to the unit of property that occurred during the taxpayer's use of the unit of property, the condition of the property immediately before the circumstances necessitating the expenditure is the condition of the property after the last time the taxpayer corrected the effects of normal wear and tear (whether the amounts paid were for maintenance or improvements) or, if the taxpayer has not previously corrected the effects of normal wear and tear, the condition of the property when placed in service by the taxpayer (Reg. Sec. 1.263(a)-3(j)(2)(iv)(B); Reg. Sec. 1.263(a)-3T(h)(3)(iii)(B)). If the expenditure is made to correct damage to a unit of property that occurred during the taxpayer's use of the unit of property, the condition of the property immediately before the circumstances necessitating the expenditure is the condition of the property immediately before damage (Reg. Sec. 1.263(a)-3(j)(2)(iv)(C); Reg. Sec. 1.263(a)-3T(h)(3)(iii)(C)).
Example: In 2014, ShopCo purchased a store located on a parcel of land that contains underground gasoline storage tanks left by prior occupants. The parcel of land is the unit of property. The tanks had leaked before ShopCo's purchase, causing soil contamination. ShopCo was not aware of the contamination when it purchased the property. In 2015, ShopCo discovers the contamination and incurs costs to remediate the soil. The remediation costs result in a betterment to the land because ShopCo incurred the costs to ameliorate a material condition or defect that existed before ShopCo's acquisition of the land. This example does not address whether capitalization is required under any other Code provision (for example, the uniform capitalization rules of Code Sec. 263A).
Example: HelpCo acquires a building for use in its business of providing assisted living services. Before and after the purchase, the building functions as an assisted living facility. However, at the time of the purchase, HelpCo is aware that the building is in a condition that is below the standards that HelpCo requires for facilities used in its business. Immediately after the acquisition and during the following two years, while HelpCo continues to use the building as an assisted living facility, HelpCo pays amounts for extensive repairs, maintenance, and the acquisition of new property to bring the facility into the high-quality condition for which HelpCo's facilities are known. The work on HelpCo's building includes repairing damaged drywall, repainting, rewallpapering, replacing windows, repairing and replacing doors; replacing and regrouting tile; repairing millwork; and repairing and replacing roofing materials. The work also involves the replacement of Section 1245 property including window treatments, furniture, and cabinets. The work that HelpCo performs affects only the building structure and does not affect any of the building systems. Each Section 1245 property is a separate unit of property.
(6) is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property (Reg. Sec. 1.263(a)-3(k)(1); Reg. Sec.1.263(a)-3T(i)(1)).
A taxpayer does not have to treat as a restoration amounts paid under restoration standard (1) or (2) above if the unit of property has been fully depreciated and the loss is attributable only to remaining salvage value as computed for federal income tax purposes (Reg. Sec. 1.263(a)-3(k)(3)).
Under the 2013 final regulations, for purposes of restoration standard (3) above, the amount paid for restoration of damage to the unit of property that must be capitalized under the restoration rules is limited to the excess of (a) the taxpayer's basis adjustments resulting from the casualty event, over (2) the amount paid for restoration of damage to the unit of property that also constitutes a restoration under the other criteria of Reg. Sec. 1.263(a)-3(k)(1) (excluding the casualty loss rule). Casualty-related expenditures in excess of this limitation are not treated as restoration costs and may be properly deducted if they otherwise constitute ordinary and necessary business expenses (for example, repair and maintenance expenses) under Code Sec.162 (Reg. Sec. 1.263(a)-3(k)(4)).
For purposes of restoration standard (5) above, a unit of property is rebuilt to a like-new condition if it is brought to the status of new, rebuilt, remanufactured, or a similar status under the terms of any federal regulatory guideline or the manufacturer's original specifications (Reg. Sec. 1.263(a)-3(k)(5); Reg. Sec. 1.263(a)-3T(i)(3)). Generally, a comprehensive maintenance program, even though substantial, does not return a unit of property to a like-new condition (Reg. Sec. 1.263(a)-3(k)(5)).
Generally, to determine whether an amount is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of the unit of property under (6) in the list above, all the facts and circumstances are considered, including the quantitative and qualitative significance of the part or combination of parts in relation to the unit of property. Under the 2011 temporary regulations, a major component or substantial structural part includes a part or combination of parts that comprise a large portion of the physical structure of the unit of property or that perform a discrete and critical function in the operation of the unit of property. However, the replacement of a minor component of the unit of property, even though such component may affect the function of the unit of property, will not generally, by itself, constitute a major component or substantial structural part (Reg. Sec. 1.263(a)-3T(i)(4)).
Under the 2013 final regulations, a major component is a part or combination of parts that performs a discrete and critical function in the operation of the unit of property. An incidental component of the unit of property, even though such component performs a discrete and critical function in the operation of the unit of property, generally will not, by itself, constitute a major component (Reg. Sec. 1.263(a)-3(k)(6)(i)(A)). A substantial structural part is a part or combination of parts that comprises a large portion of the physical structure of the unit of property (Reg. Sec. 1.263(a)-3(k)(6)(i)(B)).
(2) the replacement includes a part or combination of parts that comprises a large portion of the physical structure of any of such designated properties (Reg. Sec. 1.263(a)-3(k)(6)(ii)).
The following examples illustrate the rules relating to capitalization of restorations. However, they do not address whether capitalization is required under another provision of the regulations or the Code (e.g., Code Sec. 263A).
Example: ManfactoCorp owns a manufacturing building containing various types of manufacturing equipment. ManfactoCorp does a cost segregation study of the manufacturing building and properly determines that a walk-in freezer in the manufacturing building is Code Section 1245 property. The freezer is not part of the building structure or the HVAC system. Several components of the walk-in freezer stop functioning and ManfactoCorp decides to replace them. ManfactoCorp abandons the old freezer components and properly recognizes a loss from the abandonment. ManfactoCorp replaces the abandoned freezer components with new components and incurs costs to acquire and install the new components. ManfactoCorp must capitalize the amounts paid to acquire and install the new freezer components because it replaced components for which it had properly deducted a loss.
Example: The facts are the same as the preceding example except that ManfactoCorp did not abandon the components, but instead sold them to another party and recognized a loss on the sale. ManfactoCorp must capitalize the amounts paid to acquire and install the new freezer components because it replaced components for which it had taken into account the adjusted basis of the components in realizing a loss from the sale of the components.
Example: BestCo owns an office building that it uses in its trade or business. A storm damages the building at a time when the building has an adjusted basis of $500,000. BestCo takes a $50,000 casualty loss and reduces its basis in the office building to $450,000. BestCo hires a contractor torepair the damage to the building including the repair of the building roof and the removal of debris from the building premises. BestCo pays the contractor $50,000 for the work. BestCo must treat the $50,000 amount paid to the contractor as a restoration of the building structure because BestCo properly adjusted its basis in that amount as a result of a casualty loss under Code Sec. 165, and the amount does not exceed the limit in Reg. Sec. 1.263(a)-3(k)(4). Therefore, BestCo must treat the amount paid as an improvement to the building unit of property and under Reg. Sec. 1.263(a)-3(d)(2), must capitalize the amount paid.
Example: The facts are the same as in the preceding example, except that BestCo receives insurance proceeds of $50,000 after the casualty to compensate for its loss. BestCo cannot take a casualty loss deduction because its loss was compensated by insurance. However, BestCo properly reduces its basis in the property by the amount of the insurance proceeds. BestCo must treat the $50,000 amount paid to the contractor as a restoration of the building structure because BestCo has properly taken a basis adjustment relating to a casualty event, and the amount does not exceed the limit in Reg. Sec. 1.263(a)-3(k)(4). Therefore, BestCo must treat the amount paid as an improvement to the building unit of property and must capitalize the amount paid.
Example: CrestCo owns a building that it uses in its trade or business. A storm damages the building at a time when the building has an adjusted basis of $500,000. CrestCo determines that the cost of restoring its property is $750,000, deducts a casualty loss under Code Sec. 165 in the amount of $500,000, and properly reduces its basis in the building to $0. CrestCo hires a contractor to repair the damage to the building and pays the contractor $750,000 for the work. The work involves replacing the entire roof structure of the building at a cost of $350,000 and pumping water from the building, cleaning debris from the interior and exterior, and replacing areas of damaged dry wall and flooring at a cost of $400,000. Although resulting from the casualty event, the pumping, cleaning, and replacing damaged drywall and flooring, does not directly benefit and is not incurred by reason of the roof replacement.
CrestCo must capitalize as an improvement the $350,000 amount paid to the contractor to replace the roof structure because the roof structure constitutes a major component and a substantial structural part of the building unit of property. In addition, CrestCo must treat as a restoration the remaining costs, limited to the excess of the adjusted basis of the building over the amounts paid for the improvement. Accordingly, CrestCo must treat as a restoration $150,000 ($500,000-$350,000) of the $400,000 paid for the portion of the costs related to repairing and cleaning the building structure. Thus, in addition to the $350,000 to replace the roof structure, CrestCo must also capitalize the $150,000 as an improvement to the building unit of property. CrestCo is not required to capitalize the remaining $250,000 repair and cleaning costs.
Example: Alan owns and operates a farm with several barns and outbuildings. Alan did not use or maintain one of the outbuildings on a regular basis, and the outbuilding fell into a state of disrepair. The outbuilding previously was used for storage but can no longer be used for that purpose because the building is not structurally sound. Alan decides to restore the outbuilding and pays an amount to shore up the walls and replace the siding. An amount is paid to improve a building if the amount is paid to restore the building structure or any building system, ABC must treat the amount as an improvement to the building. The walls and siding are part of the building structure. Alan must treat the amount paid to shore up the walls and replace the siding as a restoration of the building structure because the amounts return the building structure to its ordinarily efficient operating condition after it had deteriorated to a state of disrepair and was no longer functional for its intended use. Therefore, Alan must treat the amount paid to shore up the walls and replace the siding as an improvement to the building unit of property and, under Reg. Sec. 1.263(a)-3(d)(2), must capitalize the amount paid.
In Amerisouth XXXII, Ltd. v. Comm'r, T.C. Memo. 2012-67, the taxpayer commissioned a cost segregation study when it renovated a large apartment complex. As a result of the study, the taxpayer depreciated many items over five or 15 years rather than 27.5 years. While the Tax Court agreed with the IRS and denied most of the increased depreciation deductions, it did let the taxpayer apply reduced lives (thus increasing depreciation deductions) to two items: clothes dryer vents and duplex outlets that were four-feet above the ground in kitchen areas and that clearly accommodated refrigerators (i.e., tangible personal property).
Taxpayers must capitalize as an improvement amounts paid to adapt a unit of property to a new or different use. In general, an amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer's intended ordinary use of the unit of property at the time originally placed in service by the taxpayer (Reg. Sec. 1.263(a)-3(l)(1); Reg. Sec. 1.263(a)-3T(j)(1)).
In the case of a building, an amount is paid to adapt the unit of property to a new or different use if it adapts to a new or different use any of the properties designated as buildings in ¶99,560.10(i.e., building, condominium, cooperative, or leased building or leased portion of building) (Reg. Sec. 1.263(a)-3(l)(2); Reg. Sec. 1.263(a)-3T(j)(2)). For example, an amount is paid to improve a building if it is paid to adapt the building structure or any one of its buildings systems to a new or different use.
The following example illustrates these rules. However, even if capitalization is not required in these examples, the amounts paid in the examples may be subject to capitalization under a different provision of the regulations or the Code (e.g., Code Sec. 263A).
Example: ManufactoCorp is a manufacturer and owns a manufacturing building that it has used for manufacturing since 1985, when it placed the building in service. In 2014, ManufactoCorp pays an amount to convert the building into a showroom for its business. To convert the facility, ManufactoCorp removes and replaces various structural components to provide a better layout for the showroom and its offices. ManufactoCorp also repaints the building interiors as part of the conversion. When building materials are removed and replaced, ManufactoCorp uses comparable and commercially available replacement materials. An amount is paid to improve ManufactoCorp's manufacturing building if the amount adapts the building structure or any designated building system to a new or different use. The amount paid to convert the manufacturing facility into a showroom adapts the building structure to a new or different use because the conversion is not consistent with ABC's intended ordinary use of the building structure at the time it was placed in service. Therefore, ManufactoCorp must capitalize the amount paid to convert the building into a showroom as an improvement.
An optional simplified method (the regulatory accounting method) is provided for regulated taxpayers to determine whether amounts paid to repair, maintain, or improve tangible property are to be treated as deductible expenses or capital expenditures. A taxpayer that uses the regulatory accounting method must use that method for property subject to regulatory accounting instead of determining whether amounts paid to repair, maintain, or improve property are capital expenditures or deductible expenses under the general principles of Code Secs.162(a), 212, and 263(a). Thus, the capitalization rules in Reg. Sec. 1.263(a)-3(d) and Reg. Sec.1.263(a)-3T(d) and the routine maintenance safe harbor described in ¶99,560.30 do not apply to amounts paid to repair, maintain, or improve property subject to regulatory accounting by taxpayers that use the regulatory accounting method (Reg. Sec. 1.263(a)-3(m)(1); Reg. Sec.1.263(a)-3T(k)(1)). However, Code Sec. 263A continues to apply to costs required to becapitalized to property produced by the taxpayer or to property acquired for resale.
A taxpayer that is engaged in a trade or business in a regulated industry may use the regulatory accounting method. For this purpose, a taxpayer is in a regulated industry only if the taxpayer is subject to the regulatory accounting rules of the Federal Energy Regulatory Commission (FERC), the Federal Communications Commission (FCC), or the Surface Transportation Board (STB) (Reg. Sec. 1.263(a)-3(m)(2); Reg. Sec. 1.263(a)-3T(k)(2)).
Under the regulatory accounting method, a taxpayer must follow its method of accounting for regulatory accounting purposes that it is required to follow for FERC, FCC, or STB (whichever applies) in determining whether an amount paid repairs, maintains, or improves property. Therefore, a taxpayer must capitalize for federal income tax purposes an amount paid that iscapitalized as an improvement for regulatory accounting purposes. A taxpayer cannot capitalize for federal income tax purposes an amount paid that is not capitalized as an improvement for regulatory accounting purposes. A taxpayer that uses the regulatory accounting method must use that method for all of its tangible property that is subject to regulatory accounting rules. This method does not apply to tangible property that is not subject to regulatory accounting rules. This method also does not apply to property for the tax years in which the taxpayer elected to apply the repair allowance under Reg. Sec. 1.167(a)-11(d)(2) (Reg. Sec. 1.263(a)-3(m)(3); Reg. Sec. 1.263(a)-3T(k)(3)).
Example: UtiliCo is subject to regulatory accounting rules of FERC. UtiliCo is an electric utility company that operates a power plant that generates electricity and that owns and operates turbines and network assets to transmit and distribute the electricity to its customers. UtiliCo uses the regulatory accounting method. UtiliCo does not capitalize on its books and records for regulatory accounting purposes the cost of repairs and maintenance performed on its turbines or its network assets. Under the regulatory accounting method, UtiliCo cannot capitalize for amounts paid forrepairs performed on its turbines or its network assets.
The 2013 final regulations allow a taxpayer to elect to treat amounts paid during the tax year forrepair and maintenance to tangible property as amounts paid to improve that property and as an asset subject to the allowance for depreciation, as long as the taxpayer incurs the amounts in carrying on a trade or business and the taxpayer treats the amounts as capital expenditures on its books and records used for regularly computing income. A taxpayer that elects this treatment must apply the election to all amounts paid for repair and maintenance to tangible property that it treats as capital expenditures on its books and records in that tax year. A taxpayer making the election must begin to depreciate the cost of such improvements when the improvements are placed in service by the taxpayer under the applicable provisions of the Code and regulations (Reg. Sec. 1.263(a)-3(n)(1)).
A taxpayer makes this election by attaching a statement to the taxpayer's timely filed original federal tax return (including extensions) for the tax year in which the improvement is placed in service. The statement must be titled "Section 1.263(a)-3(n) Election" and include the taxpayer's name, address, taxpayer identification number, and a statement that the taxpayer is making the election to capitalize repair and maintenance costs under Reg. Sec. 1.263(a)-3(n). In the case of a consolidated group filing a consolidated income tax return, the election is made for each member of the consolidated group by the common parent, and the statement must also include the names and taxpayer identification numbers of each member for which the election is made. In the case of an S corporation or a partnership, the election is made by the S corporation or partnership and not by the shareholders or partners. The election cannot be made through the filing of an application for change in accounting method or, before obtaining the IRS's consent to make a late election, by filing an amended federal tax return. (Reg. Sec. 1.263(a)-3(n)(1)). Once made, the election may not be revoked.
Observation: A taxpayer that capitalizes repair and maintenance costs under the election is still eligible to apply the de minimis safe harbor, the safe harbor for small taxpayers, and the routine maintenance safe harbor to repair and maintenance costs that are not treated as capitalexpenditures on its books and records.
The election does not apply to amounts paid for repairs or maintenance of rotable or temporary spare parts to which the taxpayer applies the optional method of accounting for rotable and temporary spare parts discussed in ¶242,710.10.
Example: BoatCo is a towboat operator that owns a fleet of towboats that it uses in its trade or business. Each towboat is equipped with two diesel- powered engines. Each towboat, including its engines, is the unit of property and a towboat has a class life of 18 years. The towboat engines are not rotable spare parts. In 2014, BoatCo acquired a new towboat, including its two engines, and placed the towboat into service. In 2017, BoatCo pays amounts to perform scheduled maintenance on both engines in the towboat. None of the exceptions set out in Reg. Sec. 1.263(a)-3(i)(3) apply to the scheduled maintenance costs and the scheduled maintenance on BoatCo's towboat is within the routine maintenance safe harbor. Accordingly, the amounts paid for the scheduled maintenance to its towboat engines in 2017 are deemed not to improve the towboat and are not required to be capitalized.
On its books and records, BoatCo treats amounts paid for scheduled maintenance on its towboat engines as capital expenditures. For administrative convenience, BoatCo decides to account for these costs in the same way for federal income tax purposes. In 2017, BoatCo may elect to capitalize the amounts paid for the scheduled maintenance on its towboat engines. If BoatCo elects tocapitalize such amounts, BoatCo must capitalize all amounts paid for repair and maintenance to tangible property that BoatCo treats as capital expenditures on its books and records in 2017.
Amounts required to be capitalized under the rules for improvements are capital expenditures and must be taken into account through a charge to capital account or basis, or in the case of property that is inventory in the hands of a taxpayer, through inclusion in inventory costs (Reg. Sec. 1.263(a)-3(o); Reg. Sec. 1.263(a)-3T(m)).
Amounts that are capitalized under the rules for improvements are recovered through depreciation, cost of goods sold, or by an adjustment to basis at the time the property is placed in service, sold, used, or otherwise disposed of by the taxpayer. Cost recovery is determined by the applicable Code and regulations provisions relating to the use, sale, or disposition of property (Reg. Sec. 1.263(a)-3(p); Reg. Sec. 1.263(a)-3T(n)).
Generally, a change in accounting methods to comply with Reg. Sec. 1.263(a)-3T of the 2011 temporary regulations or Reg. Sec. 1.263(a)-3 of the 2013 final regulations is a change in method of accounting to which the provisions of Code Sec. 446 (see ¶241,590) and Code Sec.481 apply (see ¶241,595) (Reg. Sec. 1.263(a)-3(q); Reg. Sec. 1.263(a)-3T(p)).
2. Ameliorates - make (something bad or unsatisfactory) better. "the reform did much to ameliorate living standards"

References: v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 v.