IRS Final Tangible Property Regulations

SACRAMENTO-In a development that will affect almost all taxpayers, particularly those that hold real estate, the IRS has issued long-awaited final regulations affecting costs incurred to acquire, maintain, and improve tangible real and personal property and proposed regulations related to the disposition of assets. The new regulations will generally apply to tax years beginning on or after January 1, 2014.

The regulations are the result of a nearly 10-year project by the IRS that included several rounds of proposed and temporary rules. The changes are generally taxpayer-favorable, owing to the expansion of the rules to allow additional deductions and the simplification of some of the complex administrative issues considered too burdensome under the temporary regulations.

Let's look at some of the significant changes that will affect holders of real property.

De Minimis Expensing Rule

This area underwent significant changes from the temporary regulations. The final regulations provide a de minimis safe harbor election that generally allows a company to follow its financial statement capitalization policy for tax purposes for amounts paid to acquire or produce a unit of property if said amounts are below a specified threshold or if the property has an economic useful life of less than 12 months.

The requirements of the de minimis safe harbor vary based on whether your company has an applicable financial statement (AFS). A company has an AFS if its financial statement is either:

• Filed with the SEC

• Audited by an independent CPA and used for credit purposes, reporting to shareholders, or another nontax purpose (note that reviewed or compiled financial statements don't satisfy this requirement)

• Required to be provided to a federal or state government or agency

A company with an AFS may use the de minimis safe harbor to deduct costs for acquired or produced tangible property expensed under its financial statement capitalization policy if it has a written policy in place as of the beginning of the year and its capitalization threshold doesn't exceed $5,000.

A company without an AFS may use the de minimis safe harbor if it has accounting procedures in place as of the beginning of the year and its capitalization threshold doesn't exceed $500. There's no formal written requirement for companies without an AFS.

In either scenario a company with a capitalization policy in excess of the allowable thresholds may still follow its capitalization policy for tax purposes if it can demonstrate that its policy clearly reflects income. But since this is a subjective standard, in an IRS examination the company has the burden of supporting the deduction of amounts that exceed the $5,000 or $500 threshold, whichever is applicable.

The company must attach an election statement to its federal tax return, filed by the original due date (including extensions), to use the provision each tax year. This requirement applies to companies with or without an AFS.

Improvement Standards and Two Real Estate–Applicable Safe Harbors

The rules for property improvements didn't change substantially. Generally speaking, property is improved if there is a betterment, restoration, or adaptation to a new or different use for the unit of property. The relevant unit of property for buildings looks separately to the building structure and nine identified building systems.

There are two safe harbors real estate owners should be aware of. A new safe harbor allows small taxpayers to elect not to apply the improvement standards to costs incurred for minor building repairs. To qualify:

• Your average gross revenue for the three prior years must be less than $10 million.

• Your unadjusted basis in the owned or leased building must be less than $1 million. (For leased buildings, this is the amount of undiscounted rent expected to be paid over the entire lease term.)

• Total amounts paid during the year for repairs and improvements must not exceed the lesser of 2 percent of unadjusted basis of the building or $10,000.

A second safe harbor for routine maintenance now applies to building property. It allows for a deduction in the current year for recurring activities you expect to incur to keep the building property in ordinarily efficient operating condition—but only if the activities are expected to recur more than once within the 10-year period starting when the building is first placed in service.

Partial Disposition Election

The asset disposition rules underwent significant changes and consequently were issued in proposed form. These proposed regulations allow taxpayers to elect to report a partial disposition of a building. You make the election by claiming a loss upon disposition of the building component on an income tax return filed on time (including extensions). The proposed regulations provide for simplified methods to determine the income tax basis of the building component that has been partially disposed, and the election is required in certain situations, such as a casualty event, a like-kind exchange, or an involuntary conversion.

Conclusion

While the new regulations provide more clarity in certain areas, the final rules for betterments and restorations don't include any bright-line guidance and thus will likely remain a source of uncertainty for real estate owners and their advisors. In addition, many of the new safe harbors require taxpayers to attach an election statement to their return each year—this may present a trap for the unwary and result in inadvertent missteps.

Importantly, you may have actions you need to take during the remainder of 2013 even if you defer the full implementation to a later date. Taxpayers with an AFS that plan to use the de minimis safe harbor in 2014 must have documented their book capitalization policy before the end of 2013 to be able to use the provision next year. Your tax advisor should be able to guide you through the process as you evaluate the appropriate next steps for your business.

Chris Rouen has more than 20 years of experience in public accounting He provides tax planning and compliance services to construction and real estate companies, including identifying income tax planning opportunities for partnerships (LLCs) and S corporations. You can reach him at (916) 503-8159 or christopher.rouen@mossadams.com.

Jennifer Schmidt has over 15 years of experience in public accounting. She leads her firm's accounting methods practice, assisting clients with accounting method planning and, more recently, with assessing the impact of tangible property regulations on their business. You can reach her at (206) 302-6867 or jennifer.schmidt@mossadams.com. The views expressed in this column are the authors' own.