By Ellen McElroy, Esq., and Clayton Garrett, Esq.

Pepper Hamilton LLP, Washington, DC

On September 13, 2013, the IRS and Treasury Department released final regulations regarding the deduction and capitalization of expenditures related to tangible property. Rules were also released regarding accounting for and retirement of depreciable property, which were issued as final regulations under §§167 and 168. A notice of proposed rulemaking was issued with respect to general asset accounts and the disposition of property. The package is collectively referred to as the "2013 Regulations."

The 2013 Regulations affect all taxpayers that acquire, produce, or improve tangible property (e.g., plants, buildings, equipment and machinery). Some of the most significant issues enumerated in the regulations involve the treatment of repair expenses associated with tangible property, which is why they are referred to as the "repair regulations." The rules have very broad application and most corporate taxpayers are affected by these regulations. The Preamble correctly notes that the final regulations clarify and expand the standards in earlier guidance.

In general, the final regulations apply to taxable years beginning on or after January 1, 2014. However, certain rules apply only to amounts paid or incurred in taxable years beginning on or after January 1, 2014. The final regulations provide that a change to comply with the final rules is a change in method of accounting and generally, a §481(a) adjustment is required for accounting method changes made to comply with the new regulations. Separate procedures will be issued to provide automatic consent for accounting method changes to comply with the final regulations.

By way of background, the rules reflect a long history. In late December 2011, the IRS published regulations addressing the tax treatment of the amounts paid to acquire, produce or improve tangible property (the 2011 Regulations). The 2011 Regulations represented significant modifications to earlier proposed regulations.1 The 2013 Regulations reflect an update to earlier guidance, and they were largely released in a final form. However, because proposed regulations were also released, it is clear that the government will continue to focus on addressing issues associated with tangible property.

Highlights of the Final Regulations.

According to the accompanying Preamble, the 2013 Regulations clarify and expand standards in the current regulations under §§162(a) and 263(a), expounding certain bright-line tests (e.g., a de minimis rule for certain acquisitions, a safe harbor for routine maintenance for buildings, etc.), and aim to facilitate application of the rules. Further, the 2013 Regulations set forth enhanced guidance regarding elections under the general asset account rules and provide guidance regarding accounting for, and dispositions of, certain depreciable property subject to §168:

 The de minimis safe harbor ceiling has been eliminated and amounts properly expensed under a taxpayer's financial accounting policies (up to $5,000) may now be expensed for tax purposes. The new safer harbor is determined at the invoice or item level depending on the taxpayer's financial accounting policies. The safe harbor election is made on an annual basis and applicable to all amounts paid in the year meeting the safe harbor. Further, for taxpayer's eligible for the safe harbor, a change in taxpayer's financial accounting procedures (e.g., financial capitalization policy) is not a change method of accounting.

•  The 2013 clarify the treatment of costs for leased property.
•  The 2011 Regulations included a routine maintenance safe harbor for equipment; the 2013 Regulations expand earlier guidance and provide a routine maintenance safe harbor for buildings. The new safe harbor covers activities that the taxpayer expects to perform more than once in a ten-year period.
•  The final regulations continue to provide that repair costs may be deductible, notwithstanding a general plan of rehabilitation. In this regard, however, repair costs may be capitalized under the principles of §263A. 
•  Recovery of depreciable property is allowed for property that has been disposed of, as long as the adjusted basis of the asset has been taken into account for realization purposes.
•  The final regulations soften somewhat the provisions in the 2011 Regulations regarding casualty losses. Although it was determined that the government lacked the authority to allow an election to forgo a casualty loss, the rules allow a deduction in certain circumstances for amounts spent in excess of the property damaged in a casualty event.
•  Additional examples are included regarding adapting property to a new or different use.
•  The final regulations fail to provide bright-line guidance about when replacement of a major component or substantial structural part has to be capitalized. However, to clarify application, the rules do define both terms, "major component," and "structural part" of a unit of property.

Other changes may be less well received by taxpayers and practitioners:

•  To clarify the types of activities that constitute a betterment, the final regulations provide that capitalization is required not when an activity results in a betterment but when "it is reasonably expected" to produce one.
•  The rules fail to provide an objective or bright-line standard for material additions.
•  With respect to betterments, the final regulations retain the 2011 Regulations' standard that a betterment is determined by comparing the property immediately after the expenditure with the condition prior to the condition necessitating the repair. The final regulations also clarify that this rule applies when the event necessitating repair is normal wear and tear. However, the regulations specify that this standard does not include wear, tear, or damage that occurs prior to the taxpayer's acquisition of the property.
•  The 2011 Regulations provided that the replacement of a "major component" or a "substantial structural part" of an item of property would result in capitalization as a restoration. However, these terms were unclear. The 2013 Regulations include specific definitions of the terms to assist taxpayers in evaluating whether a restoration has occurred. Although definitive terms are appreciated, a preliminary review of the regulatory provisions leads to the observation that they add complexity. The Preamble suggests that the changes to the final regulations will simplify these determinations for building owners. In particular, the Preamble points out that the addition of a routine safe harbor for buildings, modifications to the §168 disposition regulations, as well as the addition of many examples "should relieve much of the controversy in determining whether the replacement is of a major component or a significant structural part of a unit of property."

Highlights of the Rules Regarding Dispositions.

With respect to dispositions of tangible depreciable property, the new guidance reflects significant changes. For this reason, the rules were released largely in proposed form. Several commenters suggested that the use of general asset accounts be the default rule regarding asset disposition. It was suggested that requiring taxpayers to make a general asset account election when structural components are placed in service to then forgo the loss on dispositions for structural components occurring years later creates complexity. Although the government acknowledged the benefit of enhanced flexibility of making general asset accounts the default, they did not adopt these suggestions. Instead, significant changes were made to the disposition rules in an effort to provide taxpayers with enhanced flexibility regarding dispositions.

For example, the proposed regulations specify that the asset for disposition purposes is a building, condominium, or a cooperative, rather than individual structural components. The proposed regulations also provide that the disposition rules apply to a partial disposition of an asset (for example, the disposition of a roof), which allows taxpayers to claim a loss upon the disposition of a structural component without identifying the component as an asset before the disposition event occurs. Partial disposition rules are provided for assets both included and excluded from a General Asset Account.

For assets not included in a general asset account, the partial disposition election is made on a taxpayer's return for the taxable year in which the portion of the asset is disposed of. Taxpayers may choose to apply these rules to partial disposition rules in 2012 and 2013. Importantly, this provision may also be used when the Service disallows a repair deduction.

To determine assets included in general asset accounts, the proposed regulations provide that the disposition rules apply to a partial disposition of an asset included in a general asset account. Thus, a disposition as a result of a casualty event under §165, a disposition of a portion of an asset for which gain is not recognized in whole or in part under §1031 or §1033, a transfer of a portion of an asset in a transaction described in §168(i)(7)(B), a sale of a portion of an asset, or a disposition of a portion of an asset in a disposition includes a disposition of a portion of an asset only if the taxpayer makes the election to terminate the general asset account upon the disposition of all assets.

The Preamble to the proposed regulations notes that commenters requested that one or more specific methodologies be provided for reasonable methods of determining the basis of disposed or converted assets (e.g., replacement cost adjusted for inflation using an objective index, using third-party construction estimating and valuation services, or using relative fair market value of acquired components). Rather than provide the subjective guidance, the proposed regulations provide nonexclusive examples of reasonable methods.

The proposed regulations under also provide that if a taxpayer disposes of a portion of an asset and the partial disposition rule applies, the taxpayer must account for the disposed portion in a single asset account beginning in the taxable year in which the disposition occurs. Also, the proposed regulations provide examples demonstrating the interaction between the disposition rules and the capitalization of tangible property rules.

These proposed regulations apply to taxable years beginning on or after January 1, 2014. The regulations allow taxpayers to rely on the proposed regulations for taxable years beginning on or after January 1, 2012, and before final regulations are published. It is anticipated that taxpayers may apply the final regulations regarding dispositions to taxable years beginning on or after January 1, 2012. The temporary regulations under Regs. §§1.168(i)-1T and 1.168(i)-8T allow taxpayers to apply the temporary regulations to taxable years beginning on or after January 1, 2012. However, the final regulations will provide that taxpayers may not apply the temporary regulations to taxable years beginning on or after January 1, 2014.

Pepper Perspective

The final and proposed regulations are long-awaited and a wide range of taxpayers are subject to these new rules. The final and proposed package is significant and a couple of significant issues have been pointed out. However, there is no question that with further review and consideration, additional issues will certaintly be identified. We will be reviewing the new rules thoroughly so that we can offer greater insight and perspective regarding the application of the regulations.

For more information in the Tax Management Portfolios, see Maule, 504 T.M., Deduction Limitations: General, and Atkinson, Rohrs, and Walberg, 509 T.M., Principles of Capitalization, and in Tax Practice Series, see ¶2920, Capital Expenditures.

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