Accounting method changes related to new repair regulations

Presumably you have a better understanding of the accounting procedures of a long-term client.

Yeah, but do you really think you remember everything that happened over the last 20-years for 200/300 taxpayers?

The change in the regulations imposes no greater obligation to investigate everything back to day one than does taking on a new client.

And where did you get that from?

And whose potential obligation are you referring to - the client's or ours?

This is the letter that I intended to complete and post a few weeks ago. You are all welcome to any part of it. Please let me know if I have any typos or conceptual errors. I have written it with incomplete knowledge. I could spend the rest of 2015 reading about this stuff. We all have work to do. I will shorten it for most of my clients. I will post this in sections – I’m not sure how much this forum can accommodate in one post.

Thanks to golfinz for posting his fabulous letter and for his permission to use his letter - I plagiarized his explanation of RABI almost word for word. Thanks to both Brians for their ongoing assistance with this complicated subject.


Dear client,

The IRS issued final regulations regarding the treatment of certain costs related to tangible property. The new rules are intended to provide consistency in an area of law that has largely developed in the courts as the IRS and taxpayers litigate these issues. These final regulations are intended to provide a framework for distinguishing capital expenditures from supplies, repairs, maintenance, and other deductible business expenses.

This project has been in process for roughly a decade. The new rules are comprehensive. They have been compared to the passive activity loss rules in terms of their scope and their far-reaching effect. We will be bound by these rules for many years. Therefore, I am sending you this letter in order to make you aware of these rules so that your treatment of costs incurred related to tangible property will be correct and to discuss an additional 2014 tax filing that may be required. The regulations were issued in a very long Treasury Decision. The TD includes well over one hundred detailed examples. I have summarized and streamlined the issues to the best of my ability.

I hope that you will at least scan my summary of the rules and contact me with any questions. Please review the discussion regarding the additional filing requirement closely. There may be substantial deductions available to you. This is an issue that we will have to address this tax season.

The rules

Determining whether a cost must be capitalized or expensed

You are familiar with the rules requiring capitalization of costs to acquire or improve property. The regulations require us to apply the “RABI” standards. Costs incurred related to a restoration, adaptation, betterment, or improvement must be capitalized.

A Betterment results in fixing a condition that existed prior to your purchase of the asset or results in a material increase in capacity, productivity, efficiency, or quality. An example would be improving a machine with a part that materially increases its capacity/output.

A Restoration generally results in returning a non-functional asset to use. It includes the cost of rebuilding an asset after the end of its depreciable life or replacing a major component of the unit of property. Replacing the entire engine in a machine or truck is a restoration.

Adaptation costs are amounts paid to change the piece of property that was not consistent with the intended ordinary use of the property when it was originally placed in service. Costs incurred to convert a warehouse to condo units are adaptation costs.

In order to determine whether the cost has resulted in an improvement, we must determine the unit of property. For example, if the taxpayer replaces the tires on his business automobile, has he incurred a repair expense related to the automobile or a capitalized cost since he has improved his tires? Is the unit of property the automobile or the tires?

In this example, the unit of property is the automobile. The RABI standards are applied in relation to the auto, not the tires. A unit of property is all of the components of the property that are functionally interdependent. The tires are not especially useful without the automobile. The automobile is not especially useful without tires. They are placed in service at the same time. The more substantial the unit of property, the more likely that a cost may be treated as a deductible expense instead of as an item that must be capitalized.

Costs related to buildings

Evaluating costs related to buildings is a bit more complicated. The building is defined as a unit of property, but the RABI standards are applied separately to the building and its structural components and certain building systems. Each of the following components is considered a separate building system to which the RABI rules must be applied:

1. HVAC systems,
2. plumbing systems,
3. electrical systems,
4. escalators,
5. elevators,
6. fire protection and alarm systems,
7. security systems, and
8. gas distribution systems.

This separation of the building into component parts increases the chance that a cost will have to be capitalized since the cost is evaluated in relation to a smaller unit of property than if it were evaluated in relation to the whole building. Let’s discuss a couple of examples in the regulations.

The cost of replacing a roof membrane is compared to the whole building structure. The membrane aids in the function of the building structure. However, by itself, it does not comprise a significant portion of the roof. It does not comprise a substantial structural part of the building structure. Therefore, the cost of replacing the roof membrane may be expensed. This is in contrast with the treatment of the cost to replace an entire roof. The entire roof performs a discreet and critical function in the building structure. The cost of replacing the roof must be capitalized.

In another example, a commercial building has ten HVAC units. The HVAC system is one unit of property. The taxpayer replaces two units. This is not an improvement, and the cost may be expensed. This treatment is in contrast with another example that discusses the replacement of the chiller unit. The chiller unit performs a discrete and critical function in the operation of the HVAC system because it provides a cooling mechanism for the entire system. The chiller unit comprises a major component of a building system, and its replacement cost must be capitalized.

In one example, the taxpayer replaces 30% of the wiring throughout his building. The wiring is part of the electrical system, a building system listed above. The replacement of 30% of the wiring is not the replacement of a major component or substantial structural part of the building. The cost may be expensed. However, the cost to replace all of the wiring throughout the building must be capitalized because the wiring comprises a major component and a substantial structural part of the building system.

The cost of moving walls in a commercial building to accommodate retail tenants who are expanding does not have to be capitalized if the intended, ordinary use of the building is to provide retail space. The cost of adapting a retail drug store to a medical clinic must be capitalized because the building structure is adapted to a new and different use.

As I mentioned above, the regulations have hundreds of examples. Please give me a call if you anticipate undertaking any projects so that we may determine the proper treatment of the related costs.

Plant property

Plant property is functionally interdependent machinery or equipment used to perform an industrial process such as manufacturing. The unit of property is comprised of each component or group of components that perform a discrete and major function.

Asset removal costs

The final regulations state that if a taxpayer disposes of a depreciable asset and realizes gain or loss on that disposition, then the costs of removing that asset do not have to be capitalized. If you are removing any assets or components in the process of making improvements to property, it is prudent to ask the contractor to separately state those costs on his invoice.

Safe harbors for costs related to depreciable assets

Qualifying small taxpayers have a safe harbor election available for building property. Taxpayers with average annual gross receipts for the three preceding taxable years of less than or equal to $10 million qualify for the election. If the unadjusted basis of the building is $1 million or less and the total paid during the year for repairs, maintenance, and improvements does not exceed the lesser of $10,000 or 2% of the basis of the building, then the taxpayer may expense the amount paid and avoid the above improvement rules. This safe harbor election is made annually on a building by building basis.

The regulations provide a safe harbor for routine maintenance costs. It is not an election; it is mandatory. If, at the time property other than a building was placed in service, the taxpayer reasonably expected to perform the activities more than once during the asset’s class life, then that cost does not have to be capitalized. For example, if at the time the taxpayer constructs a parking lot, he expects to have to repave the parking lot more than once during the parking lot’s class life, then the cost of the repaving does not have to be capitalized.

For buildings, the safe harbor is a 10 year measurement period. If a taxpayer reasonably expects to perform the activity more than once in a 10 year period of time, then the cost of the activity does not have to be capitalized.

RABI costs are not eligible to be expensed under the routine maintenance safe harbor. This safe harbor applies to routing maintenance activities required to keep the unit of property in its ordinarily efficient operating condition. In other words, the IRS has provided us with a safe harbor that should shelter various expenditures from controversy in case of an audit. However, the underlying theory remains unchanged. Costs that improve property must be capitalized. Costs to maintain property may be expensed.

Partial disposition election

Restoration costs that are required to be capitalized may trigger loss recognition on the replaced component if the taxpayer makes the partial disposition election. The effect of the combination of the RABI rules and the partial disposition election is that the replacement of a component part of an asset may result in a deduction one way or the other – either the cost of the replacement will not have to be capitalized under the RABI standards or the cost of the original component may be expensed if the taxpayer makes the partial disposition election. The regulations provide for a method to estimate the cost of the replaced component if its basis wasn’t separately tracked on the depreciation schedule.

Materials and supplies

Materials and supplies are generally deductible. This applies to property that has an acquisition or production cost of $200 or less or has an economic useful life of 12 months or less. If you keep a physical inventory of materials and supplies or otherwise track the timing of your use of these items, then different rules apply. There are also different rules for rotable and temporary spare parts and standby emergency parts. If your materials and supplies don’t fall under the general rule, please give me a call so that we can discuss this in further detail.

Building acquisition costs

Amounts paid to determine whether to acquire real property and which real property to acquire are deductible. Let’s call this the “whether or which” test. This treatment is in contrast with amounts paid to facilitate the acquisition of specific property.

Safe harbor election related to acquisition costs of inexpensive property

There is a de minimis safe harbor election available that applies to property that costs no more than $500 or that has an economic useful life of 12 months or less. If the taxpayer has accounting procedures in place to deduct amounts paid for property costing $500 or less or for property with an economic useful life of 12 months or less, and if the taxpayer makes the annual election, the taxpayer meets the safe harbor requirements. These accounting procedures must be in place as of the beginning of the taxable year. It is prudent to document these procedures in writing.

You have a choice regarding these accounting procedures; you do not have to use the safe harbor method. You may use a reasonable, consistent methodology that clearly reflects income. However, this methodology may be subject to challenge in an audit.

Please remember that section 263A and the inventory costing rules trump the above rules. For example, if you purchase a $495 power drill that will be used to produce depreciable property or property for sale, then that item must be capitalized as an indirect cost of property being produced. On the other hand, if you pay $495 for a printer to be used in your office, and if you makes the safe harbor election, then you may expense the cost of that printer.

The additional tax filing

Let’s discuss the difference between accounting procedures and accounting methods. Some of these new rules, such as adopting $500 as the threshold for expensing items, are considered accounting procedures. A change in accounting procedure does not require specific tax filings. Many of these new rules are considered accounting methods. When a taxpayer changes his method of accounting, he must file Form 3115, Application for Change in Accounting Method, to request the IRS’s permission to change his accounting method. As part of filing this form, the taxpayer must review his prior books and records. He must apply the new rules to the prior years and calculate an adjustment to be reported in the year of change, which is 2014 in this case.

Here are the potential changes in your accounting method that the IRS requires be reported on Form 3115:

1. Accounting for material and supplies, as explained above. If your accounting method is to expense items that cost $200 or less and that have an economic useful life of 12 months or less, and if you do not keep a physical inventory of these items, then we may comfortably take the position that you already comply with the new, required accounting method for materials and supplies.

2. Determining the unit of property that is the basis for classifying costs as either subject to capitalization or eligible for deduction, as explained above. It is possible that a taxpayer whose business assets do not include buildings may have accounting methods in place that conform to these new rules. Is it possible that the taxpayer whose business assets include buildings already conforms to these new rules? Considering the uniqueness and specificity of these rules, it seems unlikely. A taxpayer who has historically evaluated costs based upon a different definition of a unit of property is required to file Form 3115.

3. The partial disposition election, discussed above, is in annual election. However, taxpayers have the option of making a late partial disposition election this year. For example, if you capitalized the cost of a new roof in 2005 and continued to depreciate the old roof from 1995 over 40 years, you now have the option of deducting the remaining cost basis of that old roof.

This election may result in a permanent tax benefit. When you sell property at a gain, the amount of depreciation claimed over the life of the property causes that portion of the gain to be taxed at rates that generally exceed the capital gains rates. If you write off components of your asset, then there is less accumulated depreciation to trigger those higher tax rates when the asset is ultimately sold.

4. The routine maintenance safe harbor, discussed above, is an accounting method change. Items that were capitalized as depreciable assets in the past are now deductible under these new rules.

5. The treatment of costs paid in the process of determining whether to acquire real property or which property to acquire is an accounting method change. If you capitalized these investigative costs, we need to reduce the basis of the asset and claim a deduction for the undepreciated portion of those costs.

It is absurd that the IRS issues these complicated and extensive regulations, requires you to comply with them, and requires you to file a form with the IRS requesting permission to comply, which has the effect of causing you to pay me more money to comply with the IRS’s filing requirements, isn’t it? The tax preparer community and its professional organizations agree with you. The American Institute of CPAs issued a letter to the IRS on October 8, 2014 urging the IRS to eliminate this burden on small business taxpayers. A summary of the letter may be found here http://www.aicpa.org/press/pressrelease ... esses.aspx, and the letter itself may be found by clicking on the link on that page. The IRS has not responded.

As implied on page 4 of the letter, the IRS has stated that it expects that most businesses will file Form 3115 to comply with these new regulations. This includes large corporations and partnerships along with individuals reporting self-employment income or rental income. There are some in the tax preparer community who believe that taxpayers who do not file will have an increased audit risk. The thought is that the IRS will easily be able to make audit adjustments because those taxpayers will be using impermissible methods of accounting. They either retained their old methods of accounting that no longer comply with the rules or they changed to comply with the new rules but without having requested permission. A change in method of accounting without requesting permission is, by law, an impermissible method of accounting. In addition, a taxpayer could be required to file for permission in a later year. Taxpayers who timely file for 2014 will not have to pay a fee and are automatically granted permission to change. The same will not apply to taxpayers who file late.

The most time-consuming task in filing this form is reviewing prior records to quantify the required adjustment. Again, this involves applying the new rules to prior years. For example, a taxpayer who paid $15,000 to resurface his parking lot and who capitalized the cost under prior rules is entitled to a deduction in 2014 if that resurfacing cost has not been fully depreciated. Let’s say that there is $7,000 in basis remaining. We need to remove that asset from the depreciation schedule and deduct that remaining basis as an expense in 2014.

Similarly, an amount expensed in prior years that should be capitalized under these new rules must be included in the adjustment. This might apply to a taxpayer who two years ago paid $15,000 to replace his HVAC system and treated it as an expense. Let’s say that the HVAC system is 15-year property. Let’s oversimplify the depreciation rules for purposes of this example. We would set up a $15,000 depreciable asset with $2,000 of accumulated depreciation and add back $13,000 to income in 2014.

Based upon my knowledge of your books and records, I believe that it is unlikely that there are any material costs that were previously expensed that should have been capitalized. If there is an adjustment required, it is almost certainly an amount that will reduce your 2014 taxable income.

If you take the lead on reviewing your prior records and providing me with the details of the adjustment, I will cap my charge for generating the paperwork at $600. This is a substantial discount for the preparation of a complicated eight-page form compared to the fees being charged by many firms. Form instructions are 20 pages, and the IRS’s own estimate of the time to prepare the form is over 23 hours, excluding preparation of several of its schedules.

A signed copy of Form 3115 must be attached to your 2014 income tax return. The original form must be filed before your 2014 income tax return is filed. You have the option of extending your 2014 income tax return in the hopes that the IRS will remove this administrative burden. Please let me know if you have any questions. I will be in touch to discuss how best to proceed.

My ophthalmologist is moving to California!

Wow. Just wow.

California CPA Jim Counts has confirmed with the Service that they are writing an FAQ on the TPR. I'll be submitting questions based on what I've seen here, elsewhere, and in practice. Anything new?

Nice! I suspect they won't do anything with the requests from the AICPA/state boards to make it easier for smaller TP to comply

Brian, in the information I had received, one of the things mentioned was a FAQ that was being put together. This is good news but I imagine it will simply create additional muddied waters.

I've put together a list of questions on my blog here. Please let me know if you have additional questions I haven't covered.

JAD, excellent letter. Thanks for sharing!

Dave is right, JAD, it is a great letter.

A colleague just returned from a Spidell seminar. According to him, Spidell feels that this issue is being over-thought and misunderstood. They believe that most small businesses and landlords will not have to file a form 3115. Interesting, very interesting. Agree with the above. Wow just wow, and the plot thickens!

I wouldn't say it is being over-thought, but they are right to a certain degree. Many small businesses should not have more than one Form 3115 for materials and supplies. Others may need just a couple for UoPs and materials and supplies. Some may not need one for M&S.

Why would a business need more than one 3115? The RPs seem to say that the method changes can be disclosed on one 3115.

Yep, you caught me. They can be done on one. I was thinking of a different method change.

Edit: You know it is hard to undo the habits of a lifetime, when different method changes generally went on different Forms 3115.