Tax Notes Newsletter New Capitalization Regulations-Additional Safe Harbor and Rehabilitation Rules

By Leo Parmegiani, Partner

In our October 2013 newsletter, we provided an overview and covered the highlights of the newly-issued final regulations on amounts paid to acquire, produce or improve tangible property (Cap Regs). In the December issue we focused on the de minimis safe harbor rules. This article focuses on the obsolescence of the judicially -created plan of rehabilitation doctrine that required taxpayers to capitalize otherwise deductible repair or maintenance (R&M) costs if incurred as part of an overall general plan of rehabilitation, modernization or improvement. We also cover the new safe harbor election for improvements to buildings as long as the eligible property does not exceed the lesser of two percent (2%) of the propertys unadjusted basis or $10,000. Obsolescence of Rehabilitation Doctrine

Leo Parmegiani Partner

lparmegiani@odpkf.com 212.267-8000

The final regulations state that indirect costs, such as R&M, that do not directly benefit and are not incurred by reason of the improvement are not required to be capitalized. These costs can be expensed even though they are incurred at the same time as an overall improvement to the property. Similarly, the final regulations provide that removal costs may or may not be deductible dependent upon whether the cost directly benefitted or was incurred by reason of an improvement. These final rules are in stark contrast to judicial history. Example (1): Y owns a building in which it conducts its retail business. The roof over Y's building is covered with shingles. Over time, the shingles begin to wear and Y begins to experience leaks. However, the building still functions in Y's business. To eliminate the problems, Y pays a contractor to replace the old shingles with new but comparable shingles to correct the leakage problems. The amounts paid to remove the shingles are not required to be capitalized because they directly benefit and are incurred by reason of repair or maintenance to the building structure. Example (2): X owns a factory building with a storage area on the second floor. X pays an amount to remove the original columns and girders supporting the second floor and replace them with new columns and girders with a gross weight 50 percent greater than the previous load-carrying capacity. The amount paid to remove the columns and girders must be capitalized as a cost of the improvement, because it directly benefits and is incurred by reason of the improvement to the building. Example (3): Z (a trucking company) replaces the existing engine, cab and petroleum tank of one of its trucks with a new engine, cab and tank. At the same time, it paints the new cab with its company logo. The paint job must be capitalized along with the cost of the new engine, cab and tank since the need to paint the logo arose from the replacement of the cab. The paint expense directly benefits and is incurred by reason of the replacement of the major

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components of the truck. Example (4): Z also takes a truck out of service to overhaul its engine. During the overhaul, the truck's broken taillights are replaced and tears in the driver's seat are mended. These expenses are deductible as repairs even though undertaken at the same time the engine is being overhauled. Under the now obsolete rehabilitation doctrine, these expenses would have been capitalized. Per Building Safe Harbor Election for Small Taxpayers Qualifying small taxpayers may elect to not capitalize an eligible building's improvements if the total amount paid during the tax year for repairs, maintenance and improvements performed on "eligible property" does not exceed the lesser of two percent (2%) of the building's unadjusted basis of the property, or $10,000. Small Taxpayer means a taxpayer whose average annual gross receipts for the three preceding taxable years is less than or equal to $10 million. If a taxpayer has been in existence for less than three years, the taxpayer determines its average annual gross receipts for the number of taxable years (including short taxable years) that the taxpayer (or its predecessor) has been in existence. Eligible Building Property refers to each unit of property (generally "the building") that has an unadjusted basis of $1 million or less. Time and manner of election A taxpayer makes this election by attaching a statement to the taxpayers timely-filed original Federal tax return for the year in which amounts are paid for repairs, maintenance and improvements. The statement must be titled, Section 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers and include the taxpayers name, address, taxpayer identification number and a description of each eligible building property to which the taxpaper is applying the election. Safe harbor exceeded If total amounts paid by a qualifying taxpayer during the taxable year for repairs, maintenance and similar activities performed on an eligible building property exceed the safe harbor limitations, then the safe harbor election is not available for that eligible building property. Illustrations Illustration A Safe harbor for small taxpayers applicable. A is a qualifying taxpayer that owns a building in which A provides consulting services. In Year 1, As building has an unadjusted basis of $750,000. In Year 1, A pays $5,500 for repairs and improvements to the office building. Because A's building has an unadjusted basis of $1 million or less, it constitutes eligible building property. The aggregate amount paid by A during Year 1 for repairs and maintenance, does not exceed the lesser of $15,000 (2 percent of the building's unadjusted basis of $750,000) or $10,000. Therefore, A may elect to not apply the capitalization rule and treat these items as deductible ordinary and necessary expenses. Safe harbor for small taxpayers inapplicable. Assume the same facts as Illustration A, except that A pays $10,500 for repairs and improvements. Because this amount exceeds $10,000, the lesser of the two limitations, A may not apply the safe harbor for small taxpayers. A must apply the general improvement rules and must capitalize the $10,500. Illustration B

Safe harbor applied building-by-building. B is a qualifying taxpayer that owns two rental properties; Building M and Building N. Building M and Building N are both multi-family residential buildings. In Year 1, each property has an unadjusted basis of $300,000. Because Building M and Building N each have an unadjusted basis of $1 million or less, they both each constitute eligible building property. In Year 1, B pays $5,000 for repairs, maintenance and improvements performed on Building M. In Year 1, B also pays $7,000 for repairs, maintenance and improvements performed on Building N. Building M The total amount paid by B in Year 1 on Building M ($5,000) does not exceed the lesser of $6,000 (2 percent of the building's unadjusted basis of $300,000) or $10,000. Therefore, B may elect to not apply the capitalization rule. If B properly makes the election and the amounts otherwise constitute deductible ordinary and necessary expenses, B may deduct these amounts. Building N The total amount paid by B during Year 1 for repairs, maintenance and improvements on Building N ($7,000) exceeds $6,000 (2 percent of the building's unadjusted basis of $300,000), the lesser of the two limitations. Therefore, B may not apply the safe harbor to the total amounts paid for Building N. Instead, B must apply the general improvement rules to determine which of the total amounts paid for work performed on Building N are for improvements and must be capitalized. *** In future newsletters, we will cover the general capitalization rules and the tax treatment of facilitative costs and material and supplies. We will also cover the procedures to request a change in accounting method as required by the final regulations. If you have any questions, please contact Leo Parmegiani at lparmegiani@odpkf.com or your PKF O'Connor Davies tax advisor.
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