Expense or Capitalize: New IRS Rules

By Linda Clark Phillips, BPM Director and Kristie Carvalho, BPM Senior Manager
Originally published in the June edition of

June 5, 2012

The IRS recently released new guidance on capitalization of tangible property costs effective for tax years beginning after December 31, 2011. The new temporary, but binding, regulations are, in several respects, considerably different from the past "repair" regulations. Familiarize yourself now with the new rules so you're not caught off guard next year when filing your 2012 tax return.

The new regulations attempt to clarify when certain costs related to tangible property are "deductible repairs" or "capital improvements." Expense versus capitalization is simply an issue of timing, but capitalizing an expenditure and depreciating it over a period of years (generally up to 27.5 for a residential rental property and 39 years for nonresidential property) can make a significant difference in your 2012 bottom-line and federal tax bill.

In 2008, the proposed IRS regulations did away with old capitalization standards regarding "material" value and "substantially prolonging the useful life" of property. Instead, they redefined an improvement as a cost involving: a betterment of the unit of property, a restoration of the unit of property, or an adaptation of the unit of property to a new or different use.

The new regulations, effective January 1, 2012, keep this definition of an improvement around. In addition, the "Unit of Property" concept is still applicable, however the definition of what exactly constitutes a UOP in regards to a building and its structural components has changed. The new IRS improvement standards apply to the building structure and each of the building's major components or systems separately. Nine structural components have been identified in the new regulations: heating, ventilation, and air conditioning systems; plumbing systems; electrical systems; escalators; elevators; fire protection and alarm systems; security systems; gas distribution systems; and other structural components defined as a building system in IRS guidance.

The effects of a repair on a specific building system, rather than the building as a whole, must be evaluated under the new, narrower UOP definition. Generally speaking, the smaller, more closely defined a unit of property is, the more difficult a cost is to expense.

Let's consider an elevator under the new regulations. Under the old rules, significant repairs to an elevator may have "bettered" the elevator, but were not considered to "better" or extend the useful life of the UOP (the overall building). And so, the repairs to the elevator were expensed. Under the new regulations, the same repairs, evaluated relative to the elevator as the UOP (rather than the building) may not be considered significant to the building as a whole. However, the costs may be significant to the specific elevator system, and need to be capitalized.

The new regulations aren't all gloom and doom, though. Unlike the old rules requiring continued depreciation of the cost of old (replaced) components no longer in use, the new regulations allow us to recognize a loss on the old components. However, the calculation of the loss requires retroactive valuation of the old components.

For instance, assume you placed residential property into service in 2005. No cost segregation study was conducted, so you started depreciating the building over 27.5 years. In 2012, the HVAC unit was overhauled and those costs under the new rules were required to be capitalized. In order to write off the value of the old HVAC system, you will have to retroactively place a value on the old HVAC as of the purchase date of the building, and subtract its share of depreciation taken. This net value can be written off when the new asset is capitalized.

Be aware that if the expenditure must be capitalized under the new regulations, it doesn't mean that it needs to be depreciated over 27.5 years (39 years for commercial rental property). Tax incentives for shorter depreciable lives, bonus depreciation or availability of cost segregation studies to carve out shorter depreciable lives on certain assets still remain.

The new IRS rules also provide clarification on what constitutes a "betterment" and the required tax treatment according to the extent of work done on a property in the instances of "building refresh," "building refresh with limited improvement," and a "substantial remodel."

Generally, building refresh costs are not required to be capitalized; however, building refresh with limited improvements require capitalization of some of the building costs; and all the building costs are required to be capitalized in a substantial remodel. Keep in mind, no two improvements are the same and each needs to be examined on its facts and circumstances to determine appropriate classification.

Acquisition of Real Property

The new IRS regulations also offer clarifications on the rules addressing the acquisition of real property. All costs facilitating the acquisition or production of real property should be capitalized, with a few exceptions. The three groups of costs are investigatory, facilitative and costs incurred before putting the building into service.

Investigatory expenses are those that taxpayers incur in the earliest stage of acquisition. Typically, these are related to determining whether to buy real property or which real property to acquire. These costs, referred to as "whether or which" expenses, are eligible to be expensed if they are not "inherently facilitative" costs (defined below). For example, if you hire a consultant to determine the best location to buy a property, the cost of the consultant is considered a "whether or which" investigatory expense and thus is deductible.

Facilitative costs are amounts paid in the process of investigating or otherwise pursuing the acquisition of property, and are required to be capitalized. Likewise, amounts paid to facilitate the acquisition or production of real or personal property must be capitalized. Whether costs are facilitative is a facts and circumstances determination. "Inherently facilitative" costs for both real and personal property must be capitalized, even if the property is not acquired or produced. These costs are deductible when the acquisition is abandoned.

The regulations specifically designate the following costs as "inherently facilitative": costs to transport the property; bidding costs, application fees, and similar expenses; costs to appraise or determine the property's value; architectural, engineering, environmental, geological, or inspection services pertaining to a particular property; expenses for preparing or reviewing the property's acquisition documents, such as bids, offers, sales agreements, or purchase contracts; costs to negotiate the acquisition terms or structure, including tax advice on the acquisition; expenses for evaluating and examining the property's title; costs to obtain regulatory approval or secure permits; property conveyance costs, including sales and transfer taxes and title registration costs; finders' fees and brokers' commissions, including amounts contingent on successful closing of the acquisition; and the cost of services provided by a qualified intermediary in a like-kind exchange.

In the example above, after the consultant suggests a location, a specific property is identified and you pay an appraiser to determine the value of the property. The cost of an appraiser is specifically mentioned in the regulations as an "inherently facilitative" cost, therefore it must be capitalized as part of the building cost.

Employee compensation and overhead costs are not considered costs that facilitate the acquisition of real or personal property. However, a taxpayer can elect, on a transaction-by-transaction basis, to capitalize employee compensation, overhead or both. If both real and personal property are acquired in the same transaction, the repair regulations provide for allocation of acquisition costs between the property types.

Costs incurred after the acquisition of the real property, but prior to placing the property into service, are also addressed in the new IRS regulations. Expenses such as repainting the walls or refinishing the floors, which would normally be repair expenses, need to be capitalized into the basis of the property if incurred prior to placing the building into service. If the expenses are incurred after putting the building into service, they do not need to be capitalized.

Under the new IRS regulations, the routine "maintenance safe harbor" test does not apply to buildings. The IRS explained buildings were excluded from the safe harbor because it was determined that many building remodeling projects normally thought of as capital in nature would potentially be deducted under a routine maintenance safe harbor.

As a result of the IRS regulations taking effect in January 2012, some taxpayers may need to change their method of accounting to comply with the new regulations, and may also need to make adjustments to prevent duplicated or omitted tax benefits. Taxpayers will, in effect, have to apply the new rules to costs incurred prior to the effective date of the regulations.

These new IRS regulations, released at long last, are very welcome. Posing some significant changes, the new regulations provide substantial guidance and clarification to the repair or capitalize quandary that frequently faces rental property owners. Whatever your situation may be, it's important to be aware of these new guidelines and talk to your tax advisors now to ensure you are prepared when filing your 2012 tax return.

This publication contains information in summary form and is intended for general guidance only. It is not intended to be a substitute for detailed research nor the exercise of professional judgment. Neither BPM nor any member of the BPM firm can accept any responsibility for loss brought to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.