The Internal Revenue Service recently released regulations designed to reduce the uncertainties and controversies that have existed for some time regarding the capitalization versus repair rules under Internal Revenue Code Section 263(a). As background, proposed regulations were issued in 2006, then were revised again in 2008, and since then, have been the subject of considerable discussion and confusion. On December 23, 2011, the Internal Revenue Service and the Treasury issued temporary and proposed regulations that must be followed for expenditures made after January 1, 2012. That has left tax professionals pouring through 255 pages of regulations to try to determine their impact on current and future expenditures, as well as on accounting methods used for capitalized or repair expenditures made before the effective date of regulations.
Not surprisingly, the new rules are generally pro-Treasury, tending to require capitalization rather than deduction when in doubt. As an example, the previous proposed regulations treated buildings as a single “unit of property” so that replacement of a structural component such a roof was not necessarily a substantial modification (as compared to the entire building), and thus could be deducted as a repair. Under the new and complex regulations, the determination on what is “a unit of property” for building and their primary components is modified. Accordingly, this modification requires that changes to primary components of a building structure, or a specifically defined building system such as heating and air conditioning, plumbing, electric, etc., must be treated separately so that it is more likely that the replacement of those components must be capitalized under the new regulations.
On the other hand, the new regulations allow for the deductibility of the unrecovered costs of structural components upon their replacement or retirement.
The new regulations provide the following definition of a betterment that requires capitalization. A betterment is an amount paid that results in:
- A material addition, including a physical enlargement, expansion or extension to the property, or;
- A material increase in capacity, including additional cubic or square space, productivity, efficiency, strength or quality of the unit of property, or the output of the unit of property.
An interesting twist, which in practice is confusing, is that the new regulations are generally effective for expenditures after January 1, 2012, but taxpayers are not permitted to apply these regulations to the 2011 tax year. This means that the new rules for 2012 must be adopted as a change in accounting method, and therefore, opening accounts may have to be adjusted as if you had been following the new temporary regulations all along. We are expecting additional guidance to be released, including two or more Revenue Procedures to advise us how to transition to these new rules. We will update you as this guidance is released.
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