Treasury Decision 9636: Tangible Property Regulations

Treasury Decision 9636 finalized the Tangible Property Regulations (TPRs). These regulations provide guidance for businesses to distinguish between expenditures that must be capitalized and those that can be deducted as expenses. The rules address costs related to acquiring, maintaining, and improving tangible property like machinery, equipment, and buildings.

Capital Expenditures vs Deductible Expenses

Federal tax law, under Internal Revenue Code (IRC) Section 263, requires taxpayers to capitalize costs that improve a unit of property. In contrast, IRC Section 162 permits the immediate deduction of ordinary and necessary business expenses, including incidental repairs and maintenance. The regulations provide a structured analysis to determine if an expenditure results in an improvement that must be capitalized.

This analysis is referred to as the “BAR tests,” which stands for betterments, adaptations, and restorations. An expense that falls into any of these three categories is considered an improvement, and its cost must be capitalized and depreciated over time.

Betterments

An expenditure is a betterment if it remedies a material condition or defect that existed before the property was acquired or arose during its production. It also applies to a material addition, such as a physical enlargement, or an enhancement that increases the property’s capacity, productivity, efficiency, or quality. For example, constructing a new wing on a building or upgrading a machine to double its output would be considered betterments.

Adaptations

The adaptation test applies if an expenditure alters a property for a new or different use, inconsistent with its intended function when placed in service. A clear example of this would be converting a warehouse used for storage into a retail showroom for customers. The costs associated with this conversion, such as installing new walls, lighting, and flooring suitable for a retail environment, would be capitalized as an adaptation.

Restorations

A restoration involves replacing a significant component or a substantial structural part of a property. This test also applies when an expenditure brings a property back to operating condition after it has fallen into disrepair and is no longer functional. For instance, replacing the entire roof structure of a commercial building is a restoration, which is distinct from patching a minor leak, a deductible repair.

Available Safe Harbor Elections

The Tangible Property Regulations introduced several safe harbor elections to simplify compliance. These provisions allow taxpayers to deduct certain expenditures that might otherwise need to be capitalized. The elections are made annually and provide clear thresholds for their use.

De Minimis Safe Harbor

The De Minimis Safe Harbor allows businesses to expense low-cost property acquisitions. The threshold depends on whether the taxpayer has an Applicable Financial Statement (AFS), which is a certified audited financial statement. Taxpayers with an AFS can elect to deduct items costing up to $5,000 per item or invoice, while the limit for those without an AFS is $2,500. To use this safe harbor, the business must have an accounting policy in place at the beginning of the year that treats these small-cost items as expenses for non-tax purposes.

Routine Maintenance Safe Harbor

This safe harbor permits deducting expenses for recurring activities that keep a property in its ordinarily efficient operating condition. To qualify, the taxpayer must expect to perform the maintenance more than once during the property’s class life. For buildings, this means more than once during a 10-year period. Examples include scheduled inspections, cleaning, and replacing worn parts, but this safe harbor does not apply if the work results in a betterment.

Small Taxpayer Safe Harbor

The Small Taxpayer Safe Harbor is for businesses with average annual gross receipts of $10 million or less for the three preceding tax years. This election applies to building property with an unadjusted basis of $1 million or less. If these criteria are met, the taxpayer can deduct repair, maintenance, and improvement costs for that building, up to a limit. The total deduction cannot exceed the lesser of $10,000 or 2% of the building’s unadjusted basis, and the election is made annually for each building.

Determining the Unit of Property

Before applying the improvement rules, a taxpayer must identify the specific “Unit of Property” (UoP) being evaluated. The UoP is the asset or group of functionally interdependent assets. The significance of an expenditure is measured against the UoP to which it relates.

For most personal property, like machinery, the UoP is the individual asset. For buildings, the entire structure, including its foundation, walls, and roof, is a single UoP. However, regulations designate eight specific building systems as separate UoPs:

• The HVAC system
• The plumbing system
• The electrical system
• All elevators
• All escalators
• The fire protection and alarm system
• The security system
• The gas distribution system

This segmentation means replacing a major component of the HVAC system is analyzed against the HVAC UoP, not the entire building, making it more likely to be a capitalized restoration.

Implementing Accounting Method Changes

Adopting the Tangible Property Regulations or using a safe harbor for the first time is a change in a taxpayer’s method of accounting, which requires IRS permission. The procedures for adopting the TPRs allow for automatic consent if the proper steps are followed.

Information and Preparation

To implement an accounting method change, a taxpayer must file IRS Form 3115, Application for Change in Accounting Method, to obtain automatic consent. The taxpayer must identify the specific change by referencing its Designated Change Number (DCN). Preparation includes calculating the Section 481 adjustment, which quantifies the cumulative financial effect of the change to prevent distorting income or deductions.

Procedural Action

To finalize the change, Form 3115 must be attached to the taxpayer’s timely filed federal income tax return for the year of the change. A duplicate copy of Form 3115 must also be mailed separately to the IRS office in Ogden, UT. There is no user fee for filing an automatic change of accounting method.