Transcript Ch 10 Repair Regulations

New Repair Regulation
Chapter 10
pp. 349 - 409
2015 National Income
TAX Workbook™
Rules Proposed and Proposed and
Proposed in 2006, 2008, 2011, 2012 AND
Finalized in 2014
 Notice 2004-6 asked for comments as to what is:
▪ A unit of property?
▪ The starting point to see if value or life are increased?
▪ What is a material increase in value?
▪ Etc….Etc…. Etc…
 2006 Proposed Regulations - Withdrawn
 2008 Proposed Regulations – Withdrawn
 2011 Temporary Regulations – Withdrawn
 2012 Temporary Regulations – Withdrawn
 Final Regulations effective for tax years beginning on or
after January 1, 2014 but can elect for years after 12/31/11
Repairs Regulations
Chapter 10
p. 349
 Improvements to property.
 Unit of Property.
 Materials & Supplies.
 De Minimis Safe Harbor.
 Routine Maintenance Safe Harbor.
 Small Taxpayer Safe Harbor.
 Election to Capitalize Repair & Maintenance
Costs.
 Change in Accounting Method.
 Decision Tree.
Repair Regulations
Introduction
p. 349
Final Regulations
TD 9636, 2013-43 IRB 331.
 Clarify whether costs are currently
deductible or need to be capitalized
 Provide safe harbor simplifications
& implement new rules for small
and large businesses.
New Repair Regulations
Introduction
pp. 349 - 350
 All Taxpayers must follow the repair Regulations
for years beginning on or after January 1, 2014.
 Small taxpayers are not exempt.
 For many the new Regulations formalized what
they have been doing.
 Taxpayers with assets less than $10M or 3-year
average gross receipts less than $10M can adopt
changes in method beginning 1-1-2014 without
filing Form 3115.
Observation: 2012 & 2013 Form
3115 Filing Deadline
p. 350
 Final Regs require making a formal election to use
the safe harbors or to capitalize certain costs.
 If the safe harbor or capitalization was claimed in
an earlier year and no election was made an
amended return with an election is required.
▪ Affects years beginning on or after 01/01/2012
and ending on or before 09/19/2013.
▪ Due within 180-days of due date of return
including extensions.
 This time may have passed but could still be open
to some fiscal year end taxpayers.
Background
p. 351
 §263 generally requires capitalizing
amounts paid to acquire, produce or
improve tangible property.
 §162 allows a current deduction for
ordinary and necessary expenses
including materials, supplies, repairs
and maintenance.
Background
p. 350
 Illinois Merchandise Trust Co., 4 BTA 103
(1926) provided the guiding principle:
 :To repair is to restore to a sound state or to
mend….to keep the property in an operating
condition….which are distinguishable from
those for replacements, alterations,
improvement or additions which prolong
the life of property….”
Background and Fig. 10.1
p. 351
 Reg. §1.162-3 – Rules for material & supplies.
 Reg. §1.162-4 – Addresses repairs & maintenance.
 Reg. §1.263(a)-1 – General rules for capital
expenditures.
 Reg. §1.263(a)-2 – Rules for acquisition &
production of tangible property.
 Reg. §1.263-(a)-3 – Rules for improvements to
tangible property.
 Fig 10.1 Summarizes final Regs and Safe Harbors
Background
p. 351- 352
 In the past deciding whether an expenditure
should be expensed or capitalized depended
upon all of the facts and circumstances.
 These new Regulations attempt to clarify whether
an expenditure is to be expensed or capitalized.
 In the future deciding whether an expenditure
should be expensed or capitalized depends upon
all of the facts and circumstances.
 Speaker’s Comment: Wait a minute….what’s
changed?
 Well there are safe havens & some specific rules.
Improvements to Property
p. 352
 The new Regs provide rules for
distinguishing between repairs and capital
improvements.
 The new Regs rely on past rules & concepts.
 There is no bright line and, as in the past,
facts and circumstances continue to be the
key factor.
Improvements to Property
p.352
 Improvements include:
1. Betterment to the unit of property, or
2. Restoration of a unit of property, or
3. Adapts a unit of property for a new or different
use.
 All such improvement costs must be capitalized
including:
▪ Direct costs, indirect costs that directly benefit
or are incurred for improvement HOWEVER….
Improvements to Property
p. 352
 The rule now differs from the prior rule that
all costs of a general improvement or
rehabilitation had to be capitalized.
 Now -- Indirect costs of a general
improvement plan must be capitalized BUT
▪ Indirect costs (such as repairs &
maintenance) not required by the
improvement and that do not add to
improvement are deductible.
Repairs Completed with Improvements
Ex. 10.1
p.352
 The engine, cab and petroleum tank of a
truck is replaced by new ones.
 The company logo is painted on the new
cab and a taillight on the tractor is replaced.
 Cost of painting the logo is required by the
improvement and so must be capitalized.
 Replacing the taillight was not part of or
required by the improvement and so is a
currently deductible repair.
Presenter’s Comment
 The chapter is filled with examples to
illustrate the various points.
 It is important to note that almost all of the
examples are taken from the Regulations.
 Regulation citations follow those examples
in the text.
 Thus, those examples can be relied upon.
Practitioner’s Note
p. 353
 Federal, State, etc regulatory
rules requiring repairs and
maintenance at certain intervals
is not a controlling factor in
deciding to deduct or capitalize.
Betterments
p. 353
Capitalization required for amounts that:
1. Ameliorate a condition or defect prior to
acquisition or production of the unit of property.
2. Are a material addition to the unit of property.
3. Materially increases a unit of property’s capacity
such as additional square footage, etc.
4. Materially increases a unit of property’s
productivity, efficiency, strength, quality or
output of a unit of property.
Preexisting Material Condition
Ex 10.2
p. 353
 Fast Food bought a store located on top of
gasoline storage tanks left by prior owner.
 The gas tanks leaked before the purchase
but Fast Fresh did not know this until a year
after the purchase.
 Costs to deal with damage must be
capitalized since incurred to ameliorate a
material condition or defect prior to
acquisition.
Absence of Material Condition
Ex 10.3
pp. 353 - 354
 Turner owns a building insulated with asbestos NOT
known to be a problem when the building was built.
 Insulation began to deteriorate and was replaced years
after building was in service.
 New Regs follow a Tax Court decision in an old case.
 Cost of removing & replacing insulation are a currently
deductible repairs because the costs did NOT:
1. Ameliorate a condition or defect prior to acquisition, or
2. Add to the unit of property, or
3. Increase a unit of property’s capacity or size, or
4. Materially increase a unit of property’s productivity,
efficiency, strength, quality or output of a unit of property.
Regulatory Requirement Not a Betterment
Ex. 10.4








p. 354
Lamb Chops owns meat processing plant.
Gov’t found that oil was seeping thru concrete floors.
Gov’t required Lamb Chop to stop oil seepage.
Lamb Chop added concrete lining to walls & concrete to
floor.
Lamb Chop can currently deduct the costs even though
required by the Gov’t.
Walls & floors were functional prior to seepage.
Seepage was not a pre-existing condition.
Costs did not increase effectiveness and were not a
material addition to the existing building.
Relocation and Reinstallation of Equipment
Ex. 10.5
p. 354
 Jazz operates a manufacturing facility in Bldg A.
 Jazz decided to expand by relocating a machine to
Bldg B.
 The new configuration and addition of
components increased the capacity of the
machine.
 Jazz must capitalize the cost of disassembling,
moving and reinstalling the machine because
capacity was increased.
Relocation and Reinstallation of Equipment
Ex. 10.6
pp. 354 - 355
 Peek owns bldg. used in its real estate business.
 The first floor has a drop ceiling.
 Peek removed the drop ceiling and repainted the
original ceiling.
 Peek can currently deduct the cost of removing
the drop ceiling or painting the old ceiling.
 No material addition or increase in capacity or
efficiency..
Relocation and Reinstallation of Equipment
Ex. 10.7
p. 355
 Star found it could reduce its energy costs by
adding insulation to its building’s attic, walls, and
crawl space.
 The insulation is expected to lower the energy
costs by 50%.
 Star must capitalize the costs since they make the
building more efficient.
 Question #1:
 Suppose the insulation was expected to lower
energy cost by 30%?
Relocation and Reinstallation of Equipment
Ex. 10.7



p. 355
Star found it could reduce its energy costs by adding insulation to its building’s attic,
walls, and crawl space.
The insulation is expected to lower the energy costs by 50%.
Star must capitalize the costs since they make the building more efficient.
 Question #1:
 Suppose the insulation was expected to
lower energy cost by 30%?
 According to the text this would not be a
material increase in efficiency and would be
deductible as a repair.
Comparison of Property Condition
p. 355
 Comparing condition before & after
expenditures helps in deciding if there was
a betterment that requires capitalization.
 There is no betterment if the property’s
condition after a repair is either its:
▪ Condition after the last time normal wear
and tear were corrected, or its
▪ Condition is the same as when the asset
was placed in service, if there were no
prior corrections for normal wear & tear.
Comparing the Property Condition
Ex. 10.8
pp. 355 - 356
 Roover’s bldg. has 10 roof mounted heat & air
conditioning units.
 The system includes a control system and duct
work with the units making up the HVAC system.
 After many years two of the units were replaced.
 The new units correct climate control problems
and are 10% more efficient than the old units.
 Replacement is deductible as a repair because
replacement of two units in the entire HVAC
system and 10% is not a material increase in
efficiency.
Damage to Unit of Property
p. 356
 If a unit of property is repaired as a result of
damage to the property its condition for
comparison is its condition before the damage
occurred.
 Practitioner’s Note:
 No betterment if damaged property is restored to
its condition before damage happened.
▪ Exception: Cost of restoring property damaged
by casualty must be capitalized to the extent the
property’s basis is reduced for a casualty loss.
Refreshing a Building
p. 356
 Costs of “refreshing” a building are
currently deductible.
 Tres. Regs give examples distinguishing
repairs from capital expenditures.
▪ Examples 6, 7, 8 from Tres Reg
§1.263(a)-3(j)(3) are illustrative of when
costs are deductible “refreshing” or
“improvements” that must be capitalized.
▪ See 2014 text book pages 328 – 329 on CD
Restorations
pp. 356 - 357
Capitalization required for amounts for:
1. Replacements where deduction was properly
taken for non-casualty loss of a component.
2. Replacement where gain or loss was properly
taken on disposition of the unit of property.
3. Repair of damage where basis was properly
adjusted as result of a casualty.
4. Return of property to use after not functional.
5. Rebuilding to like new after end of its class life.
6. Replacement of a major component.
Restore Deteriorated Unit of
Property
p. 357
 If a unit of property deteriorates to
where it is no longer fit for use:
▪ Cost of returning the unit of
property to its ordinary state of
operating is a capital cost.
Return to Like-New Condition
p. 357
 Cost to bring property to “like new”
condition after its class life are capital.
 Similar work before end of property’s
class life can be deductible repair if not
a replacement of a major component of
a unit of property.
 A comprehensive maintenance
program does not return a building to
“like new”.
Replace a Major Component or
Substantial Structural Part
pp. 357 -358
 Must capitalize as restoration expenses
placements of parts that are a major
component of a unit of property or a
substantial structural part of a unit of
property.
 To do this use facts and circumstances.
 The Regs try to distinguish “major” and
“incidental” components….both being parts
that perform a critical function of the unit of
property.
Significant Portion of a Major
Component
Ex 10.9
p. 358
 Building has 300 windows making up 25% of its
total surface.
 Year 1 – 100 windows are damaged and replaced.
 The windows are a major component of the
building.
 But, 100 windows is not a significant portion of the
window component.
 So the cost of replacing 100 is not capital.
 Treas Reg §1.263(a)-3(k)(7), Ex 25.
 But….How about if 200 windows are replaced?.....
Significant Portion of a Major
Component
Ex 10.9, Question 1
p. 358
 Building has 300 windows making up 25% of its
total surface.
 Year 1 – 200 windows are damaged and replaced.
 The windows are a major component of the bldg.
 200 windows is a significant portion of the window
component.
 So the cost of replacing 200 is a capital expense.
 Treas Reg §1.263(a)-3(k)(7), Ex 26.
 But….How about 125 windows? 150? 175? And
does the size of the windows make a difference?...
Significant Portion of a Major
Component
Ex 10.9, Question 2
p. 358
 Yes, Size can matter and make a difference.
 Building has 300 windows making up 90% of its
total surface. Year 1 – 100 damaged and replaced.
 The windows are a major component of the
building and because they make up 90% of the
building surface they are a substantial structural
component.
 So replacing 100 windows is replacing a
substantial structural component of the building
and the cost of replacing 100 is a capital expense.
 Treas Reg §1.263(a)-3(k)(7), Ex 27. (60%, 70%, ??)
Replacement of Furnace Not a Major
Component
Ex 10.10
pp. 358 - 359
 Master’s bldg.’s HVAC is comprised of 3
furnaces, 3 air conditioning units and duct
work.
 One furnace breaks down and is replaced.
 One furnace unit is not a substantial
structural part of the VAC system.
 Replacing the one unit is a deductible repair
expense.
Replacement of Furnace Not a Major
Component
Ex 10.11
p. 359
 Nimble’s bldg. has an HVAC that is made up
on one chiller unit, one boiler, pumps, duct
work, diffusers, air-handlers, etc, etc.
 The chiller unit includes compressor,
evaporator, condenser, & expansion valve.
 Replacing the chiller unit is a capital
expense.
 The chiller unit is a major component of the
HVAC system -- It cools the entire system.
Replacement of Plumbing System is a
Major Component
Ex 10.12
p. 359
 Star’s 3 story bldg. has men and women
restrooms on two floors.
 Star replaces all of the toilets and sinks but
not the plumbing pipes.
 The restoration must be capitalized because
all of the toilets and sinks are a major
component of the plumbing system.
 Question:
 Supposed only 8 of 20 sinks were replaced?
Replacement of Plumbing System is a
Major Component
Ex 10.12, Q1
p. 359



Star’s 3 story bldg. has men and women restrooms on two floors.
Star replaces all of the toilets and sinks but not the plumbing pipes.
The restoration must be capitalized because all of the toilets and sinks are a major
component of the plumbing system.
 Question:
 Suppose only 8 of 20 sinks were replaced?
 8 sinks out of 20 are not a significant
portion of a major component of the
plumbing system and so the cost is
deductible as a repair.
Flooring Replacement Not a Component
Ex 10.13
pp. 359 - 360
 Victor owns a hotel & decided to refresh the
lobby by replacing the lobby floors.
 The lobby makes up only 10% of bldg.
 The replacement of the flooring is a
deductible repair since it is not a significant
portion of a major component of the bldg.
and not a structural part of the bldg.
 Question #1:
 What if all public area flooring is replaced?
Flooring Replacement Not a Component
Ex 10.13, Q #1
pp. 359 - 360
 Question #1:
 What if all public area flooring is replaced?
 The public areas make up 40% of the hotel
flooring.
 Changing all public area flooring is a capital
expense because it is 40% (a significant portion a
major component) of flooring.
 Question #2:
 Supposed public areas make up 30% of flooring?
Flooring Replacement Not a Component
Ex 10.13, Q #2
pp. 359 - 360
 Question #2:
 Suppose public areas make up 30% of
flooring?
 The replacement of the flooring would be a
deductible repair.
 At 30% the public area flooring is not
considered a significant portion of a major
component.
Partial Disposition Election
p. 360
 Disposition of an asset can result from a sale or
exchange, abandonment, contribution.
 A taxpayer can election to report a gain or loss on
disposition of a portion of certain assets if the
taxpayer classifies the replacement portion of the
asset under the same asset class as the disposed
portion of the asset.
▪ Taxpayer gets to deduct the portion of an asset
abandoned in exchange for capitalizing the
replacement portion of the asset.
Partial Disposition Election
p. 360
 In certain instances the elect must be made:
1. Disposition of a portion of the asset was due to
casualty.
2. Disposition where gain is not recognized under
1031.
3. Certain transfers of assets.
4. A sale of a portion of an asset.
Thus, under these circumstances the taxpayer
reports the gain or loss on disposition and
capitalizes the replacement asset.
Partial Disposition Election
p. 360
 A taxpayer may use any reasonable method to
determine the adjusted basis of the disposed
portion of the asset.
 Permissible methods include:
1. Producer Price Index (PPI) rollback.
2. Cost segregation studies.
3. Factorial comparisons.
 Computations are demonstrated on pages 361 and
362.
 Page 362 lists changes that cannot use the PPI.
Removal Costs
p. 363
 Removal cost of a part of a unit of
property may be deductible or capital
costs if disposal is not a disposition of
the unit of property.
 Capitalization is not required if
removal costs of a capital asset are
taken into consideration in gain or
loss of the asset.
 Ex 10.18, page 363 explains…..
Reroofing an Apartment Complex
Ex. 10.18
p. 363







Apple owns 10 separate bldgs.
Roofs on each deteriorated after owned by Apple.
New shingles were put on top of the old in 2 bldgs.
Roof structure needed no work.
Cost are deductible repair and NOT capital exp.
Exceptions:
Taxpayer would have to capitalize costs if work
was due to casualty loss or if taxpayer elected to
deduct cost of old shingles using the partial asset
disposition rules.
Reroofing an Apartment Complex
Ex. 10.18, Q1
p. 363
 Apple owns 10 separate bldgs.
 Roofs on each deteriorated after owned by Apple.
 New shingles were put on top of the old in ALL 10
bldgs.
 Roof structure needed no work.
 Because deterioration occurred while Apple
owned the bldgs. there is no adaption, betterment
or improvement and cost are still a deductible
repair.
 Question # 2 -- But suppose deterioration was
only after Apple owned bldgs. for 1 or 2 years?
Reroofing an Apartment Complex
Ex. 10.18, Q2
p. 363
 Apple owns 10 separate bldgs.
 Roofs on each deteriorated 1 or 2 years after
Apple acquired the bldgs.
 New shingles were put on top of the old in ALL 10
bldgs.
 Roof structure needed no work.
 Because deterioration probably occurred before
Apple owned the bldgs. there is “restoration” and
cost should be capitalized.
 Taxpayer should probably elect partial disposition
& deduct adjusted basis of old shingles as a loss.
Reroofing an Apartment Complex
Ex. 10.18, Q3
pp. 363 - 364
 Apple owns 10 separate bldgs.
 Roofs on each deteriorated while after Apple
acquired the bldgs.
 New shingles were put on top of the old in ALL 10
bldgs.
 Roof structure needed no work.
 How should removal cost be treated if removal is a
repair?
 Taxpayer must deduct the removal costs.
Reroofing an Apartment Complex
Ex. 10.18, Q4
pp. 363 - 364
 Apple owns 10 separate bldgs.
 Roofs on each deteriorated while after Apple
acquired the bldgs.
 New shingles were put on top of the old in ALL 10
bldgs.
 Roof structure needed no work.
 How should removal cost be treated if removal is a
capital cost and taxpayer elected a partial
disposition?
 Taxpayer must deduct the removal costs of the old
shingles.
Component Removed during
Improvement
Ex. 10.19, Q #1
p.364
 Xavior owns bldg. with storage on 2nd floor.
 Replaced columns and girders to support 50%
more weight in 2nd floor storage area.
 Replacement is an improvement and a capital cost
 How are cost of removing old columns & girders
treated?
 Because this was an improvement the cost of
removing the old and installing the new are capital
costs.
Component Removed during
Improvement
Ex. 10.19, Q #2
p.364
 Xavior owns bldg. with storage on 2nd floor.
 Replaced columns and girders to support 50%
more weight in 2nd floor storage area.
 Replacement is an improvement and a capital cost
 How are cost of removing old columns & girders
treated if “partial disposition” treatment is
elected?
 The cost of removing the old are a deductible
repair.
 Cost of installing the new are capital costs.
Component Removed during
Improvement
Ex. 10.19, Q #3
p.364
 Xavior owns bldg. with storage on 2nd floor.
 Replaced columns and girders to support
25% more weight instead of 50% in 2nd floor
storage.
 Replacement may not be a “material
increase” in capacity.
 The costs are a deductible repair.
 How about 30%, 40%, 49%?
Component Removed during Repair or
Maintenance
Ex. 10.20
pp. 364 - 365
Shingles cover a retail building’s roof.
The roof begins to leak.
New shingles replaced the old shingles.
The new shingles stop the leaks but are not a
betterment or a restoration and do not adapt or
change the buildings use.
 Cost of removing the old shingles and installing
the new are a currently deductible repair.
 BUT….Suppose the owner deducts the adjusted
basis of the old shingles as a disposition of a unit
of property?




Component Removed during Repair or
Maintenance
Ex. 10.20, Question
p. 365
 If the owner deducts the adjusted basis of
the old shingles as a loss on disposition of
a unit of property the replacement costs is
considered a restoration which must be
capitalized as an improvement of the unit of
property.
 The cost of removing the old shingles is still
treated as a currently deductible expense.
Adaption to a New or Difference
p. 365
Cost of adaption to a new or
different use must be capitalized.
Combining Three Leased Spaces
Ex. 10.21
p.365
 Broadstone owns bldg. & leases 20 retail
spaces in the bldg.
 Bldg was designed so that spaces could be
adjusted within the bldg.
 A tenant renting one space expanded &
wanted the business to have 3 spaces.
 Broadstone removed walls and made
adjustments to increase tenants space.
 Costs are a deductible repair.
Preparing Building for Sale Not an
Adaption
Ex. 10.22
p.365
 Crystal owns bldg. & leases 20 retail spaces
in the bldg. and decided to sell the bldg.
 To sell bldg. the walls were painted and
flooring was refinished.
 Costs are not preparing for a different use.
 Costs are a deductible repair.
Modifying Part of Building
Ex. 10.23
pp. 365 - 366
 General Hospital owns a hospital bldg.
 General decided to modify the emergency
room to also do outpatient surgery.
 It moved walls, added wiring & outlets,
replaced flooring & doors, repainted, &
added equipment.
 Ordinary use of building did not change.
 Renovation costs a repair.
 Cost of new equipment are capital expense.
Unit of Property
p. 366
 Replacement of a major component or substantial
structural part of a unit of property must be
capitalized.
 Other than buildings use a:
▪ “Functional Interdependence” standard:
 Placing one component in service is
dependent on placing other components in
service.
 Functional interdependent components are
one single unit of property.
Buildings
p.366 - 367
 A building is a single unit of property.
 But, for purposes of improvement rules:
▪ The building structure is a unit of property and
▪ Building systems are each a separate unit of property
including:
 Heat, ventilation & air conditioning
 Plumbing systems (pipes, sinks, etc)
 Electrical systems (wiring, outlets, lighting, etc)
 Escalators
 Elevators
 Fire protection systems.
 Etc
Building Structure
p.367
 Except for “building systems” the building
structure is the building including:
▪ Walls
▪ Partitions
▪ Floors
▪ Ceilings
▪ Windows and Doors
▪ Components relating to the building’s
operation and maintenance.
Leased Buildings
p. 367
 Only part of a building is leased:
▪ Unit of property is the portion of the
building covered by lease.
 Where a whole building is leased:
▪ Improvement rule is same as if the
building is owned:
 Improvement rules apply to building
structure and separately to building
systems.
Alterations to Restroom
Ex. 10.24
p. 367 - 368
 Lessee rents space in a large office building
 If the Lessee pays to have new toilet and sink
installed in a restroom for its employees:
▪ Cost is capital expenditure because the work is
on a major portion of plumbing system in
lessee’s restroom.
 If Lessor pays cost:
▪ Cost could be a deductible repair since it only
affects a small portion of the buildings entire
plumbing system.
Building Improvement by Lessor
Ex. 10.25
p. 369
 Teddy leased a bldg. from Landmark.
 Landmark provided to Teddy a construction
allowance used to add to warehouse space.
 Landmark is owner of addition and:
▪ Must capitalize the “betterment” costs.
▪ The addition is not a separate unit of property
but part of the building
 Question / Answer:
 If Landmark were to remodel 2 of 6 restrooms next
year the cost would be a repair.
Property Other Than Buildings &
Ex. 10.26
p. 369
 Assets used together are not always
functionally interdependent.
Ex. 10.26
 Laptop computer and printer bought for use
by employees.
 The computer and printer are separate units
of property because one can be placed in
service without the other.
Functionally Interdependent
Components
Ex. 10.27
p.369
 A train locomotive is comprised of
an engine, generators, batteries,
chassis, etc.
 The locomotive is a single unit of
property.
 Its parts are functionally
interdependent.
Plant Property
p. 369
 Means functionally interdependent
machinery or equipment (not including
network assets) used in manufacturing,
warehousing, distribution, etc.
 The unit of property is divided into
smaller units.
 Let’s see example 10.28…..
Discrete and Major Functions
Ex 10.28
pp. 369 - 370
 A laundry plant treats and launders rental uniforms.
 It has two lines of operation.
 Each line has a sorter, boiler, washer, dryer, ironer, folder &
waste water treatment system.
 General rule –
▪ Each line is a separate unit of property.
▪ Under functional interdependence.
 Plant Property rule ▪ Each line is further divided into units of property.
▪ Each sorter, boiler, washer, dryer, etc is a separate unit
of property.
▪ Replacing a dryer in either line is a capital expenditure.
Network Assets
p. 370
 Functional interdependence test is NOT
controlling for Network Assets
 Unit of property for Network Assets is determined
by fact and circumstances.
 Network Assets Include - Railroad track; oil & gas
pipelines; water & sewage pipelines; power
transmission & distribution lines; and telephone &
cable lines......Excluding buildings & building
systems.
 See what a good lobbyist can do for an industry.
Limit for Lease Property and
Improvements and
Different Depreciation Schedules
p. 370
 A unit of property cannot be larger than the
property subject to a lease.
 Improvements to a unit of property do not
become separate units of property.
 Components of a unit of property with a
different depreciation methods or recovery
periods are separate units of property.
Components with Different Depreciation
Classes
Ex 10.29
p. 370




Truck company bought a tractor.
Treated tractor as 3-year property.
Treated tractor tires as 5-year property.
General rule – Tractor and tires are a unit of
property.
 BUT – Because tractor and tires are different
classes of property they are two separate
units of property.
Improvements with the Same
Depreciation Method
Ex 10.30
p. 371
 Additions to buildings are not
separate units of property from the
building if the same depreciation
method & period are used.
 Makes no difference that the placed
in service dates are different.
Cost Segregation
Ex 10.31
p. 371
 If the depreciation method for a portion of a
building or components of a building changes that
portion becomes a separate unit of property.
 Ex 10.31
 Depreciating building & parking lot as 39-year
property and as one unit of property.
 Cost segregation study done and as a result
parking lot changed to 15-year property.
 Parking lot is now a separate unit of property.
Cost Segregation
p. 371
 Practitioner Note:
▪ Cost segregation change assets into separate
units of property.
▪ This is a change in method of accounting
requiring Form 3115 and IRS consent.
 Planning Pointer:
▪ Cost segregation may provide larger
depreciation deductions BUT
▪ Because the unit of property is smaller what
might have been a repair later may be a capital
expenditure.
Materials and Supplies
p. 372
 Materials & Supplies are tangible property used or
consumed in a business that are not inventory and are
either:
1. Costing $200.00 or less, or
(Increased from $100.00 under the temporary regs.)
2. A component acquired to maintain or repair tangible
property, or
3. Fuel, lubricants, etc to be consumed in 12-months,
or
4. A unit of property with useful life less than 12months, or
5. Any other tangible property so designated by IRS.
Bulk Purchase
Ex. 10.32
p. 372
 Buys 10 toner cartridges for $500.
 8 will be used within 12-months & 2 are stored.
 Since each cartridge cost less than $200 those to
be used within 12-months are currently deductible.
 So $400 can be deducted currently.
▪ 8 cartridges X $50 cost for each.
 The remaining $50 for each cartridge can be
deducted when each remaining cartridge is used.
Improvements Using Materials
and Supplies
p. 372
 Costs of material and supplies used to
improve a unit of property must be
capitalized and depreciated as part of the
unit of property.
▪ §1.263-3(h), Ex 10
 Costs of material and supplies used to
repair a unit of property can be deducted as
a repair expense.
▪ §1.162-4 - See Ex 10.33, Text Page 372.
Incidental Materials and Supplies
pp. 372 - 373
 If no record is kept the costs are deductible
in the year paid if income is clearly
reflected.
 Planning Pointer:
 Under a “Safe Haven” an election can be
made to deduct material and supply costs
limited by a safe harbor amount.
 To be covered next.
De Minimis Safe Harbor
p. 373
 Deduction allowed for units of property that
are normally capitalized if:
▪ Useful life is less than 12 months OR
▪ Cost does not exceed a ceiling amount.
 < $500.00 where Applicable Financial
Statements are not prepared and
 < $5,000 where Applicable Financial
Statements are prepared.
De Minimis Safe Harbor Rules
p. 373 - 374
 Amounts deducted under Safe Harbor are an
ordinary §162 deduction.
 A later sale of a Safe Harbor item results in
ordinary income.
 If elected Safe Harbor applies to all applicable cost
items.
 Exceptions to the De Minimis Rule:
▪ Certain rotable, temporary or emergency spare
parts that are capitalized and depreciated.
▪ Property intended for inventory.
▪ Land.
De Minimis Safe Harbor Applied to
Materials and Supplies
Ex. 10.34
p.374
 TPs financial system requires a taxpayer to treat items
costing $500 or less as an expense.
 TP bought 1,000 calculators costing $100 each.
 Life expectancy is more than 12-months.
 Since each calculator cost less than $200 they can be
treated as materials and supplies and deducted in the year
used or consumed.
 OR
 Since the calculators cost less than $500 the cost can be
deducted under the De Minimis Safe Harbor in the year the
taxpayer paid or incurred the cost.
De Minimis Safe Harbor Applied to
Materials and Supplies
p. 375
 Planning Pointer:
▪ A §179 deduction could be taken
instead of the Safe Harbor
deduction.
▪ Under §179 a later gain on
disposition could be a capital
gain.
De Minimis Safe Harbor
Ex 10.35
p. 375
 TP does not have AFSs but does have a policy of
expensing property costing $500 or less.
 Buys 100 heifers that cost $400 each.
 Each heifer is a separate unit of property costing
less than $500.
 TP can deduct the $40,000.
 Practitioner Note:
 Subsequent sale of the heifers would be ordinary
income instead of capital gain.
Qualifications for Election
p. 375
 To use the De Minimis Safe Harbor the
business must have a policy in place for
expensing units of property costing a
certain amount.
 Policy must be in writing if have AFSs.
 Text suggests having a written policy even
if don’t have AFSs.
 Fig 10.2, page 377 provides a sample format
to establish an accounting practice.
Useful Life
p. 375
 In determining whether an item will
last more or less than 12-months
consider all of the facts,
circumstances, experiences, etc.
 Class life and recovery period of an
asset are not determinative.
Applicable Financial Statement
p. 376
Applicable Financial Statements (AFS)
▪ Those filed with the SEC.
▪ CPA Certified statements
▪ Those required by a Federal or State or
an agency other than the SEC or the IRS.
 The Safe Harbor limits are lower if the TPs
accounting procedures set a lower limit.
 Fig 10.2 provides a sample format to
establish an accounting practice.
Taxpayers With and Without an AFS
Ex 10.36 and 10.37
p. 377
 Ex. 10.36: TP has AFSs and written policy to expense
amounts up to $5,000.
 Buys 1,250 computers for $6.25M.
 Each is a separate unit of property & each cost no more
than the $5,000 limit.
 TP can deduct the $6.25M.
 Ex. 10.37: TP does not have AFSs but does have a policy
of expensing property costing $500 or less.
 Buys 10 printers for $2,500.
 Each printer is a separate unit of property costing less than
$500.
 TP must deduct the $2,500
Economic Useful Life
Ex 10.38
p.377 - 378
 No AFS but policy is to deduct property costing
$300 or less AND expense any property with a
useful life of 12-months or less.
 Bought a $400 device & a $600 computer both
having a useful life of less than 12-months.
 Can expense both items for accounting purposes
AND
 Can deduct the $400 for tax purposes BUT
 Must capitalize & depreciate the $600 for tax
purposes because it exceeds the safe harbor
limitation.
Transaction & Other Additional
Costs
p. 378
In determining if $500 or $5,000 safe harbor limit is
met or exceeded:
 Costs of acquiring property are included in the
cost of a unit of property ONLY if the additional
costs and property cost are on same invoice.
 If invoice includes multiple units of property and
the additional costs (shipping, etc) is on the
invoice the additional costs must be allocated to
the different units or property.
 See Exs. 10.39 and 10.40, text page 378.
De Minimis Rules
Annual Election
p. 379





Elect to come under safe harbor using the
De Minimis Rule:
Irrevocable election is made for each year.
Attach statement to original tax return.
▪ See Fig 10.3, text page 379.
Must be filed by due date including extensions.
Need to state: “Section 1.263(a)-1(f) de minimis
safe harbor election.”
S Corps and P/Ss make election on their return…
Not SH or Partner’s return.
Antiabuse Rule
p. 379
 If an invoice is divided for abuse of the rule
the safe harbor does not apply.
 If you purchase a truck that exceeds the
safe harbor limitation you cannot come
under the safe harbor by asking for and
getting separate invoices for the motor, cab,
tires, transmission, seats, etc.
 IRS can make adjustments to correct.
Routine Maintenance Safe Harbor
Nonelctive
p. 380 - 381
Deductible Routine Maintenance includes:
 Inspecting, cleaning, testing and replacing
damaged or worn parts.
 Other than buildings & structural components:
▪ Activities to be performed more than once
during the assets ADS class life.
 Building & structural components:
▪ Activities to be performed more than once in a
10-year period.
Routine Maintenance plus Upgrades
Ex 10.41
p. 381
 Boats class life is 18 years.
 Routine repairs & maintenance done every 4
years.
 At 8th year boats were also upgraded.
 The routine repairs and maintenance done
at 8th year directly benefitted the upgrades.
 None of the costs in the 8th year qualify as
routine maintenance and repairs and must
be capitalized.
Maintenance for Prior Owner’s Use
Ex 10.42, Q #1
pp. 381 - 382
 Bell bought a machine with 10 ADS life.
 Routine maintenance set for every 3-years by mfr.
 When the machine was bought it was due for
3-years maintenance work.
 Q#1 -- Do the costs qualify for the routine
maintenance safe harbor?
 No. Work was due to prior owner’s use.
 Costs must be capitalized if resulted in
betterment, improvement or ameliorated a defect.
Maintenance for Prior Owner’s Use
Ex 10.42, Q #2
p. 382
 Bell bought a machine with 10 ADS life.
 Routine maintenance set for every 3-years by mfg.
 When the machine was bought it was due for
3-years maintenance work.
 3-years later Bell did the next mfg suggested work.
 Q#2 -- Do these subsequent costs qualify for the
routine maintenance safe harbor?
 Yes and the costs are a deductible.
Escalator System
Ex. 10.43
p. 382





40 escalators in a mall.
Estimate replacing handrails every 4 years.
At 4th year the handrails were replaced.
The cost is a currently deductible expense.
Done to keep the escalator system in
operating condition.
 Reasonably expected to change the steps
during the 10 year period.
 How about if steps are replaced in 9th year?
Escalator System
Ex. 10.43, Question
p. 382
 Again, we have 40 escalators in a mall.
 Estimate replacing steps every 18-20 years.
 At 9th year the steps of the escalators need to be
replaced.
 Replacement not eligible for routine maintenance
safe harbor & must be capitalized IF replacement
improves the building system.
 BUT, may be deducted as a repair if replacement
does not result in building system improvement.
HVAC System
(Heat, Ventilation & Air Conditioning)
Ex. 10.44
p. 383
 Estimated work every 4 years to keep HVAC
systems running properly.
 Work done in 4th year but not done again
until year 11.
 If TP can show that expectation of work
every 4 years was reasonable it can deduct
the work that was postponed until year 11.
 Planning Pointer – Need to document
maintenance plan.
Small Taxpayer Safe Harbor
Eligible Building Property
pp. 383 - 384
 Small qualifying taxpayers (including renters):
▪ Those with 3-year average receipts < $10M.
 Can elect (annually) to deduct building repairs,
maintenance, improvements & similar activities if the cost
of these is the lesser of:
 $10,000 or 2% of property’s unadjusted basis for an
eligible building property which is:
 One owned or leased by small qualifying TP.
 With unadjusted basis < 1M.
 If the expenses exceed the safe harbor limit the general
rules apply to the expenses….Capitalize improvements.
Observation
P. 384
 2% x $500,000= $10,000
 So if a buildings unadjusted basis is:
▪ More than $500,000 the lower limit is
$10,000.
▪ Less than $500,000 the 2% limit will
be lower and apply.
Safe Harbor Applied to Lessor
Ex. 10.45
p. 385
 Rita owns rental house.
 Her 3-year average gross receipts are less
than $10,000,000.
 She elected no safe harbor.
 Let’s look at the facts and what happens….
Safe Harbor Applied to Lessor
Ex. 10.45, Fig 10.4
p. 385
Unadjusted basis
Land
$10,000
Building Unadjusted Basis
99,500
Prior Bldg Improvements
20,100
Lawn Mower
1,450
Appliances
1,700
Total Unadjusted Basis
$132,750
Current Yr Improvements
$
Current Yr Repairs & Main
Current Yr Expenses
2,000
3,275
$
5,275
Has she met the safe harbor? Can she deduct the
improvements?
Safe Harbor Applied to Lessor
Ex. 10.45, Fig 10.4
p. 385
Unadjusted basis
Land
Bldg
Only
$10,000
Result
Repairs, Maintenance,
Building Unadjusted Basis
99,500
$ 99,500
and Improvements are
Prior Bldg Improvements
20,100
20,100
less than $10,000 BUT
Lawn Mower
1,450
Appliances
1,700
Total Unadjusted Basis
they exceed the 2% of
________ the Buildings
$132,750 $119,600
X 2%
Limitation
Current Yr Improvements
$
$
Current Yr Repairs & Main
Current Yr Expenses
$
Unadjusted basis. So,
the Small TP Safe
2,392 Harbor is NOT met.
2,000
=
Must be Capitalized
3,275
=
Can Currently Deduct
5,275
Safe Harbor Applied by Lessee
Ex 10.46
pp. 385 - 386
 Unadjusted basis for the small taxpayer safe
harbor in a lease situation is the rent to be paid
over the life of the lease.
 Monthly rent of $4,000 over a 20-year lease gives
unadjusted basis of $960,000 ($4,000 x 240 Mos).
 Unadjusted basis is therefore less than $1M so
property qualifies as an eligible building.
 Current yearly maximum repair, maintenance &
improvement deduction under the building safe
harbor is the lesser of $10,000 or 2% X $960,000.
 Taxpayer may be able to deduct $10,000.
More Than One Building
Ex 10.47
p. 386
 If a taxpayer has more than one building the
Safe Harbor limitations are applied to each
building, separately.
 Taxpayer owns 2 buildings with unadjusted
basis of $300,000.
 Repairs, maintenance and improvements to
one are $5,000 and are $7,000 to the second
building.
 Let’s see if the Safe Harbor applies……
More Than One Building
Ex 10.47
p. 386
Leased Bldgs
Unadjusted Basis
Bldg #A
$300,000
Limitation %
Bldg #B
$300,000
X 2%
6,000
X 2%
2% Limitation
$
$
6,000
Maximum $ Limitation
$ 10,000
$ 10,000
Lesser of 2% or $10,000 =
$
6,000
$
6,000
Repairs & Improvements
$
5,000
$
7,000
Repairs are
Currently
Deductible
Currently
Deductible
Improvements are
Currently
Deductible
To Be
Capitalized
Annual Election
Eligible Building Safe Harbor




p. 386
To elect to come under safe harbor using the
Eligible Safe Harbor for a Building:
Attach statement to original tax return.
▪ See Fig 10.5, text page 386.
Must be filed by due date including extensions.
Need to state: “Section 1.263(a)-3(h) Safe
Harbor Election for Small Taxpayers.”
S Corps and P/Ss make election on their return…
Not SH or Partner’s return.
Election to Capitalize Repair &
Maintenance Costs
p. 387
 Can elect to capitalize and depreciate repairs and
maintenance. See sample Fig 10.6, page 388.
 Known as “Book Conformity”.
 Attach statement to original tax return.
 Must be filed by due date including extensions.
 Need to state: “Section 1.263(a)-3(n) Election”.
 S Corps and P/Ss make election on their return… Not SH or
Partner’s return.
 Can still use De Minimis Safe Harbor; Safe Harbor for Small
Taxpayers; and deduct Routine Maintenance that are not
capitalized on the return.
Change in Method of Accounting
pp. 388 - 389
 Here is where the confusion has been.
 When does a change in method Form 3115 need to
be filed.
 IRS issued Rev Proc 2014-16 to clarify.
 IRS then issued Rev Proc 2014-54 to further clarify
 IRS then issued Rev Proc 2015-13 to help.
 Finally, IRS issued Rev Proc 2015-20 stating that
“small taxpayers” could adopt the final
regulations on a prospective basis without filing a
Form 3115, or attaching a disclosure statement to
the return……………SO…….
Change in Method of Accounting
p. 389




Revenue Procedure 2015-20, 2015-9 IRB 694:
Taxpayers with less than either:
▪ $10M in assets OR
▪ $10M in a 3-year average of gross receipts
Do NOT have to file Form 3115 to use the final
repair regulations for tax years starting on or after
January 1, 2014 and
Do NOT need to attach a disclosure statement to
the tax return.
Small taxpayers are “deemed “ to have filed a 3115
Section 481(a) Adjustment &
Practitioner Note
p. 389
 The Section 481(a) adjustment
usually made with a change in
method of accounting is -0- for
small taxpayers using the new
repair Regulations on or after tax
years beginning January 1, 2014.
Separate Trade or Business
p. 389
 If the trades and businesses
are separate and distinct the
assets and incomes of the
businesses do not need to be
combined for purposes of the
$10M tests for being a small
taxpayer.
Consequences of Deemed Filing of
Form 3115 Under Rev Proc 2015-20
pp. 390 - 391
 Pages 390 – 391 list the accounting
changes that:
▪ Can be made without filing Form
3115 for small taxpayers “Deemed”
to have file Form 3115, and
▪ Cannot be made without filing Form
3115 for small taxpayers “Deemed”
to have file Form 3115.
To File or Not To File Form 3115
pp. 392 - 393
 Form 3115 is not required by
“Small Taxpayers”.
 The potential missed
opportunities and
recommendations for when
the Form 3115 should be filed
are listed on pages 392 - 393.
Concurrent Automatic Changes and
Signing & Filing the Form 3115
pp. 395 - 396
 One Form 3115 can be filed for several
changes to the new rules.
 Original goes with tax return.
 A signed copy must be sent to IRS, 1973
Rulon White Blvd., Mail Stop 4917, Ogden,
UT 84201-1000.
▪ Address in several Rev Procs is incorrect.
 Signing instructions are on Form 3115
instructions and in Rev Proc 2015-13.
Extension of Time to File Form 3115
p. 396
 There is an automatic 6-month extension to file
Form 3115.
 Must file 3115 within 6-months of due date
excluding extensions.
 In addition, taxpayer must:
▪ Timely file return for change year (including
extensions),
▪ Attach a statement that the Form 3115 is being:
“Filed Pursuant to 301.9100-2(b) of Procedure
and Administrative Regulations”
▪ See page 396 for further details.
Sample of a Completed Form 3115
pp. 396 - 402
 Sample of a Form 3115
completed for a small
business taxpayer choosing
to formally file accounting
method changes with a zero
section 481(a) adjustment.
List of Changes Not Considered a
Change in Method
p. 403
Safe Harbor
De Minimis Safe Harbor:
< $500 & < $5,000
Small Taxpayer Building:
Lesser of $10,000 or 2%
Form
Election
3115
Required
NOT
Required
No
Yes
No
If Exceed
Limits
For Others See Text Page 403
Summary of Method Changes Reported
on Form 3115
pp. 404 - 407
 These pages provide a
summary of the accounting
method changes that may be
made as a result of the new
repair regulations.
Decision Tree
pp. 408 - 409
New Regs have a lot of twists and turns
But there is HELP!
The Decision Tree on pages 408 &
footnotes on page 409 walk you
through the maze in deciding whether
an expenditure can be deducted or
should be capitalized.