The IRS' tangible property regulations (Regs): Provisions will effect ongoing expenditures

The IRS has published final tangible property regulations (Regs) which address the distinctions between capital improvements and currently deductible repair expenses. Application of the regulations is mandatory for tax years beginning after 2013. The Regs are of particular importance to real estate owners and property managers as well as lessors and lessees, since they contain a number of provisions that will effect the treatment of ongoing expenditures for income tax purposes, and may require changes to existing policies and procedures. The general rule set forth requires that expenditures made for the improvement of a unit of property must be capitalized. An improvement is defined as an expenditure that betters, restores or adapts a unit of property to a new or different use. An expenditure is paid for a betterment if it corrects a material defect in the building that existed prior to the taxpayers acquisition or during construction of the property, is for a material addition (i.e. physical expansion, extension, or addition of a major component), or it is reasonably expected to increase the productivity, efficiency, strength, quality or output of the property. Although the Regs do not provide bright line tests in determining what is "material" there are numerous examples from which one may analogize in applying the aforementioned standards. Another concept addressed in the Regs is the "unit of property." With respect to a building, the unit of property is defined as the building and its structural components. In addition, the Regs also list nine specific building systems that are treated as separate from the building structure. An improvement to the building is defined by its effect on those systems rather than the building as a whole. The Regs define deductible repair and maintenance expenses in the negative i.e. such are deductible if they are not required to be capitalized. However there are a number of safe harbor provisions that may be adopted to ensure deductibility of specified items. Materials and supplies (the Regs define five categories) that are consumed during the year as well as property with an economic useful life of no more than 12 months may be expensed. Certain low cost items ($200 or less) may also qualify. There is also a de minimus safe harbor rule for limited amounts of other tangible property that are expensed on an applicable financial statement. Up to $5,000 per item may be expensed by issuers of applicable financial statements. In the alternative non issuers may expense up to $500 per item. In order to utilize either of the above, purchased amounts must be substantiated by invoice detail, and the taxpayer must have accounting procedures in place as of the beginning of the year that specify the expense treatment of items below certain dollar amounts, and having economic lives of 12 months or less. The Regs also contain a safe harbor for expensing routine building maintenance expenditures, which are defined as recurring activities that keep property in ordinary efficient operating condition such as inspection, cleaning and testing are eligible expenditures. In addition for a building structure or system, the taxpayer must reasonably expect to perform the maintenance more than once during the 10 year period beginning when the structure or system is placed in service. Annual elections are required to implement each of the above safe harbors. In addition to the above item specific safe harbors, the Regs contain an overall per building safe harbor for qualifying small taxpayers. A small taxpayer is defined as those with average annual gross receipts of $10 million or less in the three preceding tax years. A qualifying taxpayer may deduct improvements made to a building property with an unadjusted basis of $1 million or less, and only applies if the total amount paid during the year for repairs, maintenance and improvements to the building doesn't exceed the lesser of $10,000 or 2% of the buildings unadjusted basis. The limit is applied separately to each building owned by the taxpayer. The IRS has stated that any changes made to conform to the Regs are considered a change in accounting method for which an accounting adjustment is required. It is anticipated that the IRS will issue procedures under which taxpayers can get automatic consent to the method change. The above only provides a brief outline with respect to one aspect of the Regs, which are voluminous in scope and depth, and require careful planning and documentation to achieve optimal tax results. Sandy Klein, CPA, is a partner at Shanholt Glassman Klein Kramer & Co., New York, N.Y.