Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

Cost segregation is a popular tax compliance strategy for realizing cash tax savings through reclassifying assets from long to short depreciation recovery periods. SourceHOV|Tax brings a full-range of fixed asset service offerings to help clients realize these tax savings. For taxpayers in the manufacturing industries, these offerings include identifying Other Tangible Property, “building” structures that can be reclassified to tangible personal property, and fixed asset reclassification studies. The case studies below illustrate these opportunities.

Case Study 1: In 2013, a heavy manufacturer built a $19 million fabrication facility including a craneway structure, land improvements, and associated machinery and equipment. SourceHOV|Tax was engaged to perform a cost segregation study. After reclassifying the craneway structure as seven-year tangible personal property and the associated land improvements to a 10-year recovery period, the taxpayer was able to recognize $10 million in additional first year depreciation deductions compared to treating the facility and its improvements as 39-year property. While reviewing the client’s fixed asset schedules as part of the cost segregation engagement, SourceHOV|Tax identified additional opportunities to reclassify existing fixed assets to shorter recovery periods or to use bonus depreciation. This review identified an additional $8 million taxpayer-favorable section 481(a) adjustment after scrubbing the fixed assets.

Case Study 2: In 2014, a heavy manufacturer acquired an existing $15 million manufacturing facility. SourceHOV|Tax was retained to provide a cost segregation study of the facility. By reclassifying heavy manufacturing craneway structures as tangible personal property in addition to regular cost segregation techniques, SourceHOV|Tax was able to reclassify 66 percent of the purchase price as land improvements or tangible personal property. This resulted in increased first year cash flow of approximately $500,000 and a Net Present Value benefit of approximately $1.8 million.

How is this possible?

Taxpayers in most manufacturing industries are assigned a seven-year tax recovery period for their tangible personal property. For each million dollars of basis, reclassifying a structure from 39-year nonresidential real estate to seven-year tangible personal property results in additional first-year tax deductions of approximately $550,000 after taking into account 50 percent bonus depreciation and the much shorter recovery period. Assuming a 40 percent tax rate, this means first year cash savings of approximately $220,000.

The former Investment Tax Credit (“ITC”) was a tax credit for the construction or acquisition of most tangible personal property and certain other tangible property, not including buildings and their structural components, used as an integral part of certain industries such as manufacturing. The former ITC rules still govern MACRS property classifications to a large extent. The meaning of the former ITC regulations and rules were frequently litigated. Over the course of many years, the courts developed tests to determine whether a structure was a building, other tangible property, or tangible personal property. Using these tests, SourceHOV|Tax is able to properly reclassify manufacturer facilities as buildings, land improvements, other tangible property, and even tangible personal property.

If your clients have heavy manufacturing facilities or automated facilities with minimal worker accommodations, please contact us to discuss a cost segregation study to determine whether the entire facility qualifies as short-life property.

Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

On November 3, the Internal Revenue Service (IRS) released its first major update to the Cost Segregation Audit Techniques Guide (ATG) in more than a decade. First introduced in 2004, the Cost Segregation ATG has seen minor updates over the years as the IRS has added new industry directive grids and other sections, most notably the sections on open-air parking structures and electrical distribution systems. This most recent revision maintains the basic format of the original ATG, but heavily revises some sections, especially in the appendices. Today we will look at the highlights of the new ATG.

Major changes:

  1. Examiners are now referred to the IRS Deductible & Capital Expenditures Practice Network for technical and procedural assistance. Practice networks are groups of IRS personnel from LB&I, SB/SE, technical specialists, and Chief Counsel attorneys who specialize in particular topics or issues. These networks assist in knowledge dissemination and issue identification. Unlike specialist groups in large accounting firms, they generally do not control their issues.
  2. The ATG now incorporates both the 1995 and 2004 CSI MasterFormat Divisions. These divisions are published by the Construction Specifications Institute and allow communications between all stakeholders in a construction process. Divisions include areas such as site onstruction or electrical. Historically, most cost segregation studies followed contractor documentation in using the 16 divisions of the 1995 MasterFormat. The 2004 MasterFormat increased the number of divisions to 50.
  3. For acquired properties with existing improvements, the ATG now provides much more specific guidance on purchase price allocation issues. For example, the ATG provides a land-first residual method for determining the cost of improvements where land is valued first and then subtracted from the total purchase price to determine the cost of the depreciable improvements. Another example is a new, extensive write-up on Danielson rule issues from the Peco Foods In that case, a taxpayer with a binding written purchase price allocation was not permitted to further cost segregate its acquired properties.
  4. When discussing Rev. Proc. 87-56, the ATG has established the Clajon trilogy of cases as the touchstone for asset classification. Though not surprising in light of private letter rulings and technical advice memos issued over the last 10 years, this revision further confirms that prior IRS rulings on asset classifications have been abandoned.
  5. New or additional court cases have been added to the ATG. In addition to Peco Foods, other recent cases such as AmeriSouth XXXII, Trentadue, and PP&L have been added to the ATG. The ATG has also added older cases, such as Wood v. Comm’r, T.C. Memo 1991-205. The Wood case dealt with solar water-heating equipment, a topic with increasing importance. Property units from all cases now use both the 1995 and 2004 CSI MasterFormat divisions.
  6. The ATG now has an entire appendix section on the inherently permanent standard and how it varies between the Whiteco factors used under 168 and the tests used for other code sections, such as §263A or §199. Another new section has been added for bonus depreciation issues, while the statistical sampling section has been removed.
  7. The ATG now contains industry guidance for the auto manufacturing industry. This is the first industry guidance, commonly called a “grid”, to feature both the 1995 and 2004 CSI MasterFormat divisions. It is also the first grid to address research assets classified as five-year under 168(e)(3)(B)(v). In addition to these new features, this grid comprises a wider variety of assets than prior grids, which will make it useful for complex cost segregation situations.

This list presents only important highlights of the revised ATG. As the cost segregation industry and the IRS react to the new ATG, we will provide updates on any important new developments.

Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

As we have discussed in a prior issues of iTaxblog, the Tangible Property Regulations (TPRs) have focused practitioners’ attention on the treatment of tenant improvements. This new focus has led practitioners to pay more attention to existing issues with the leasing of property, especially how §110 treats construction allowances. Before examining how §110 and the TPR interact, it is important to understand the tax treatment of tenant improvements under prior law.

Prior Law Overview

The chart below captures the tax treatment of the tenant improvements (TI’s) under prior law. (Please note that the chart makes certain assumptions about the drafting of the lease agreement and that §467 does not apply.)

 

Situation Payor Tax Owner Tax Effect on Landlord Tax Effect on Tenant
Landlord constructs tenant improvements. Landlord Landlord Depreciate TI’s basis over 15 or 39 years under section 168. None
Landlord provides construction allowance to tenant for the construction of improvements. Landlord Tenant Amortize the basis of the improvements as a lease acquisition cost over the lease term under §178. Include construction allowance in gross income and depreciate the allowance over 15 or 39 years under §168.
Landlord provides rent reduction in lieu of construction allowance. Tenant Tenant The landlord’s gross income is decreased by the amount of the foregone rent. Lost rent deductions, but recovers the cost of the TI’s under §168.
Tenant constructs its own improvements. Tenant Tenant None Depreciate TI’s basis over 15 or 39 years under §168.
Tenant constructs improvements and then conveys them to landlord upon completion. Tenant Landlord Include basis of TI’s in gross income as a substitute for rent under §1.61-8(c) and depreciate over 15 or 39 years under §168. Amortize the basis of the TI’s as a lease acquisition cost over lease term under §178.

 

Code §110

As shown in the above chart, if a tenant receives a construction allowance, the tenant generally must include the amount of the allowance in income if it is the tax owner of the improvements. Given this harsh treatment, in 1997 Congress added §110 to the code. This code section provides limited relief to tenants who receive construction allowances for certain short-term, retail leases.

Though this section has been in place for almost 20 years, taxpayers rarely have qualifying leases. This is due to the many requirements for the section to apply.

  1. Under 1.110-1(b)(3), the lease agreement must expressly provide that the construction allowance is for the purpose of constructing or improving qualified long-term real property for use in the lessee’s trade or business at the retail space. If the original lease agreement does not include this provision, the taxpayer has until the payment of the construction allowance to enter into an ancillary agreement with the provision.
  2. The lease must be short-term, which is 15 years of less.[1]
  3. The lease must be for retail space, which is qualified long-term real property used by the lessee in its trade or business of selling tangible personal property or services to the general public. Retail space includes back office and storage areas plus showroom or sales areas.[2]
  4. The qualified long-term real property is nonresidential real property that reverts to the lessor at the end of the lease. It does not include 1245 property.[3]
  5. The lessor must have consistent tax treatment.[4]
  6. Both the lessor and lessee must include in their timely filed tax returns a statement that includes the other party’s name, EIN, and address; the location of the retail space, including any location and store names; the amount of the construction allowance and the amount treated as for nonresidential property owned by the lessor.[5]

Section 110 has become more prominent in recent years, since the TPRs provide specific rules relating to it. Specifically, lessees must capitalize all related amounts it pays to improve leased property unless §110 applies to a construction allowance or the improvements were a substitute for rent.[6] Similarly, lessors must capitalize the related amounts it pays for improvements to leased property, including via a §110 construction allowance.[7]

If you need assistance applying these provisions, please contact one of our directors of business development.

[1] Treas. Reg. section 1.110-1(b)(iii)(2)(ii).

[2] Treas. Reg. section 1.110-1(b)(iii)(2)(iii).

[3] Treas. Reg. section 1.110-1(b)(iii)(2)(i).

[4] Treas. Reg. section 1.110-1(b)(5).

[5] Treas. Reg. section 1.110-1(c).

[6] Treas. Reg. section 1.263(a)-3(f)(2)(i).

[7] Treas. Reg. section 1.263(a)-3(f)(3)(i).

Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

On September 14, 2016, the IRS released a new audit techniques guide for the Tangible Property Regulations. This guide provides IRS examiners with a tool to identify potential audit issues arising from the use and adoption of the Tangible Property Regulations and prior law provisions. The guide covers not only the substantive rules relating to acquisitions, betterments, adaptations, restorations, and improvements, but also the safe harbors, MACRS accounting, materials & supplies, dispositions, and related accounting method changes.

Overview: In 2010, the IRS released an audit techniques guide that dealt with capitalization issues for repairs and improvements. With the release of the final TPR in 2013 and the final disposition regulations in 2014, an update to the ATG was widely anticipated. The new TPR ATG, at 185 pages, is over six times longer than the prior ATG. Though most of this increase is explained by the greater breadth of coverage for dispositions and other issues, some of it is attributable to the voluminous detail given to procedural issues like accounting method changes and many useful charts. It is also important to note that many of the Examination Considerations or Audit Procedures identified at the end of each chapter relate to Large Business and International taxpayers, especially to public C corporations. Notwithstanding this focus, the very thorough steps provide an excellent guideline for practitioners to assess taxpayers of all sizes.

Even though the Service has provided a hitherto unseen level of written documentation in this ATG, there are no real surprises for regular readers of iTaxblog or attendees at our CPE sessions. The guidance is consistent with prior informal comments from Service personnel at conferences, the IRS TPR FAQ, and prior IRS webinars on the TPR. We will look at the highlights of some of these issues.

  • The De Minimis Safe Harbor.
    • The ATG confirms that, if the DMSH is elected, assets and improvements in excess of the DMSH safe harbor may be expensed, but subject to a clear reflection of income analysis unless the amounts are immaterial.
    • The ATG also provides that the safe harbor amount, ($5000 for taxpayers with an Applicable Financial Statement or $2500 for taxpayers without an AFS), also applies to items with a useful life of 12 months or less, though those items in excess of the safe harbor amount may be classified as material or supplies.
  • Leasehold or Tenant Improvements.
    • Following prior Service comments, the ATG explicitly describes breaking out section 1245 assets from possible section 1250 improvements as the first step when dealing with tenant improvements. Generally speaking, a newly acquired section 1245 asset like a desk, carpeting, or a file cabinet would be capitalized when replacing prior tenant improvements. In this situation, each item, (e.g. each desk or file cabinet), is a newly acquired asset and a separate Unit of Property. (These assets still may qualify for expensing under another provision, like the DMSH.) After breaking out section 1245 assets, taxpayers would then apply the improvement tests to section 1250 improvements.
    • The ATG continues the Service’s policy of applying section 263A as an independent capitalization provision. This means that even if a tenant improvement is not an improvement under the BAR rules of section 1.263(a)-3, its constructions still might constitute “production” under section 263A and require capitalization. Since this interpretation of section 263A is contrary to its historical treatment, we will keep you apprised of developments in this area.
  • Single Asset Accounts. The ATG confirms that a building can be in a Single Asset Account (assuming all other requirements are met). Though the example used involved an acquisition, there is no reason that a newly constructed building that is placed in service all at once would not also qualify for Single Asset Account treatment.

These highlights represent areas where the Service has been consistent in its pronouncements, but may be at odds with how many repair studies or TPR projects have been implemented. If you have any questions about how these areas or other TPR issues affect your clients or your firm, please reach out to one of our directors of business development.

Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

On December 18, 2015, President Obama signed the Protecting Americans from Tax Hikes (“PATH”) Act of 2015, Public Law No. 114-113. The PATH Act permanently extended the §179 small business expensing limitations and phase-out amounts of $500,000 and $2 million, respectively and made §179 elections revocable on amended returns.  Additionally, the act permanently extended the special rules that allow expensing qualified real property (QRP) which includes; qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. Beginning in 2016, the expensing limits and phase-outs will be indexed for inflation and the $250,000 cap on expensing qualified real property will be eliminated.  The PATH Act also removed the restriction on expensing heating and air-conditioning units. Some may interpret this as meaning that all HVAC units may now qualify for §179, but this is not the case. Those that are either tangible personal property or QRP will qualify while most will remain as 39-year §1250 real property, and will not qualify. With all these changes, now is a good time to review the opportunities to use §179 expensing in conjunction with cost segregation studies. Before looking at how cost segregation and §179 interact, it is important to understand the basics of how §179 works.

The Limitations

When trying to understand §179, there are three important parts: 1) the expensing limitation; 2) the phase-out amount; and, 3) the income limitation.

  • The expensing limitation is currently $500,000 per year but will be indexed for inflation beginning in 2016. For 2010 through 2015, there is a separate limitation of $250,000 for qualified real property, which counts towards the general $500,000 expensing limitation.
  • The phase-out applies if a taxpayer invests more than $2 million in §179 property. If so, the §179 deduction is reduced dollar-for-dollar, but not below zero. This is known as the phase-out amount and means that a taxpayer will not have a §179 deduction if it has invested more than $2.5 million in §179 property in a year.
  • Once a taxpayer has determined the available §179 deduction, it is further limited by the taxpayer’s income. Generally, the income limitation is the taxpayer’s net income, but does not include credits, tax-exempt income, the §179 deduction, shareholder compensation for S corporations or guaranteed payments to partners, and net operating loss deductions. Amounts disallowed under the income limitation are carried forward to later tax years. After looking at §179’s limitations, how it interacts with cost segregation will make more sense.
Year QRP Deductible? Expensing Limit Phase-Out  Starts At QRP Limit
2004 No $100,000 $410,000 N/A
2005 No $102,000 $420,000 N/A
2006 No $105,000 $430,000 N/A
2007 No $125,000 $500,000 N/A
2008-2009 No $250,000 $800,000 N/A
2010-2015 Yes $500,000 $2,000,000 $250,000
2016+ Yes $500,000 + Inflation Adj. $2M + Inflation Adj. No Separate Limit

 

Cost Segregation and §179

When a taxpayer has a cost segregation study, the results identify tangible personal property, short-life land improvements, and qualified real property. Both tangible personal property and qualified real property may qualify for the §179 deduction if they were acquired by purchase (including self-constructed assets). Unlike bonus depreciation, §179 can also apply to used assets. However, §179 is not allowed for non-corporate lessors unless the lessor constructs or manufactures the property or the lease meets certain, other requirements. Section 179 is also unavailable for investors in residential rental property who hold the property for the production of income. For acquired properties, the opportunities are limited to C corporations or where the stringent lease requirements are met.

Type of Property (Newly Constructed or Purchased) §1245 or §1250 Recovery Period 179 Eligible
Non-Residential Real Property 1250 39 No
Residential Rental Property 1250 27.5 No
Qualified Leasehold Improvements 1250 15 Yes
Qualified Restaurant Improvements 1250 15 Yes
Qualified Retail Improvements 1250 15 Yes
Tangible Personal Property 1250 5 or 7 (Typ.) Yes

Once the general requirements of §179 are met, taxpayers can use the expensing election to greatly enhance the results of a cost segregation study by immediately expensing some or all of the indentified tangible personal property or qualified real property. Unlike ordinary depreciation deductions, the §179 deductions cannot create a loss. Since these deductions cannot create a loss, but are carried over under the income limitation, §179 deductions can also be used to avoid suspended passive activity losses. This is due to the difference in how active businesses are identified for §179 purposes and for §469 purposes. For these reasons, the combination §179 and cost segregation can be a powerful tax-planning tool for small businesses.

Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

With the close of the 2014 calendar tax year filing season on October 15, many taxpayers have turned their attention away from the Tangible Property Regulations (TPR). The TPR still provide substantial benefits to many taxpayers such as fiscal-year taxpayers, taxpayers with current year partial asset dispositions, certain taxpayers in the retail and restaurant industries, taxpayers without prior repair reg studies and taxpayers without Applicable Financial Statements (AFS).

Fiscal Year Taxpayers PAD Possibilities

The TPR are effective for tax years beginning on or after January 1, 2014. Late partial asset disposition (PAD) elections may only be made through the automatic accounting change procedures for any tax year beginning on or after January 1, 2012 and beginning before January 1, 2015. For calendar year taxpayers, the ability to make late, prior-year PAD elections through the automatic accounting method change procedures ended with September or October 15, 2015. Fiscal year taxpayers, however, may file a DCN 196 late PAD election under the automatic change procedures for any fiscal 2015 tax year that began before January 1, 2015. For example, a retailer with an October 31 fiscal tax year-end has until June 15, 2016 to file a late PAD election through the automatic method change procedures. Both fiscal year and calendar year taxpayers can continue to file private letter ruling requests under regulation §301.9100-3 to make late PAD elections once the automatic accounting method change procedures are no longer available.

Ongoing PAD Opportunities

Under the TPR, taxpayers may identify current year partial asset dispositions in the same year in which they occur but will no longer be permitted to identify late PADs. Taxpayers need to be aware that this is a significant, taxpayer friendly expensing opportunity that may easily be missed. Anytime there is a major remodel/renovation project or even a reroofing project, the taxpayer needs to notify their CPA and/or cost segregation professional so that the scope of the opportunity can be assessed and the proper measures taken.

The best way to maximize the identification of PADs is to identify them prior to demolition. Once demolition has occurred, assigning a value to the assets may no longer be easy. For example, a CPA or cost segregation professional may have little recourse in identifying PADs in a showroom that has been remodeled if there is no evidence of what was once there. That is why it’s incumbent upon the taxpayer to notify their CPA prior to commencing major demolition so that PADs may be accurately identified and the tax benefit maximized. Once a remodel/renovation project is underway, it may no longer be possible to identify those PADs that have already been demolished.

Repair Reg Studies

Many taxpayers and tax practitioners are under the impression that there are no more TPR automatic method changes available after October 15, 2015. While the late PAD elections are no longer available as method changes once the extended filing deadline for the 2015 tax year has passed, other TPR method changes are still available. The primary limitation is for taxpayers with prior TPR method changes. If a taxpayer has previously made the same accounting method change for the same item in the past five years (including the year of change), the taxpayer would have to file a non-automatic method change and pay the IRS a user fee. The user fee is currently $8,600. For taxpayers who have not yet made any method changes under the TPR, most method changes will still be available under the automatic accounting method change procedures.

The Remodel-Refresh Safe Harbor

In Rev. Proc. 2015-56, the IRS provides a new safe harbor method of expensing repairs and capitalizing improvements for remodel-refresh projects. Under this safe harbor, taxpayers with an Applicable Financial Statement (AFS) and who primarily conduct activities within a qualifying retail or restaurant North American Industry Classification System (NAICS) code or lease a qualified building to a taxpayer that reports or conducts activities within a qualifying NAICS code must expense 75 percent, (and capitalize 25 percent), of qualifying remodel-refresh costs. Taxpayers using the safe harbor must also make (late) General Asset Account elections for the qualified building and its improvements. To use the safe harbor for prior years, taxpayers must unwind prior PADs and component dispositions under the proposed TPR. The primary benefits of the safe harbor are reduced controversy with the IRS and a simplified substantiation procedure for deducting remodel-refresh expenses.

Increased De Minimis Safe Harbor

The De Minimis Safe Harbor (DMSH) is a part of the TPR that allows taxpayers to deduct immediately:

  • the cost of Units of Property (UoP)
  • property with an economic useful life of less than a year
  • components of UoP that cost less than a certain dollar amount

To deduct a UoP, component, or short-life property under the DMSH, the taxpayer must have a book accounting procedure as of the beginning of the tax year under which it deducts items under a dollar threshold or with a short economic useful life and the taxpayer must make a DMSH election on that year’s tax return. In brief, the DMSH is a book conformity policy with a ceiling. When the TPRs were finalized the ceiling was $500 per invoice or invoice line item. In Notice 2015-82, the IRS has raised the ceiling to $2,500 for tax years beginning on or after January 1, 2016. If a taxpayer has used a higher book expensing threshold to deduct items on its returns for years prior to 2016, the IRS has provided retroactive audit protection for items under $2,500. This audit protection applies even if the issue is under exam or before appeals or the US Tax Court.

To learn more about these opportunities, please contact us at SourceHOV | Tax.

Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

On November 20, 2015, the Internal Revenue Service released an advance copy of Revenue Procedure 2015-56. This revenue procedure provides relief for some taxpayers that own retail and restaurant properties.  This relief comes in the form of a safe harbor accounting method where taxpayers are allowed to deduct 75 percent of the qualified costs of remodel-refresh projects instead of applying the facts and circumstances rules of the Tangible Property Regulations (“TPR”).

Who is Eligible?

To qualify for the safe harbor a taxpayer must meet three conditions:

  • The taxpayer must have an Applicable Financial Statement (“AFS”) or be consolidated on a related party’s applicable financial statement. An AFS is a;
    1. Financial statement filed with the SEC;
    2. Certified audited financial statement accompanied by the report of an independent CPA that is used for credit purposes, reporting to shareholders or partners, or other substantial non-tax purposes; or
    3. Non-tax return financial statement required to be provided to any state or federal agency other than the SEC or IRS.

 

  • The taxpayer must primarily report or conduct activities within a qualifying North American Industry Classification System (“NAICS”) code or lease a qualified building to a taxpayer that reports or conducts activities within a qualifying NAICS code.
    1. For taxpayers in the trade or business of selling merchandise to customers at retail, the qualifying NAICS codes are 44 and 45 with the exception of codes; 4411 (automotive dealers), 4412 (other motor vehicle dealers), 447 (gas stations), 45393 (manufactured home dealers), and 454 (nonstore retailers).
    2. For taxpayers in the trade or business of preparing and selling meals, snacks, or beverages to customer order for immediate on-premises or off-premises consumption, the qualifying NAICS code is 722. Code 7223 (Special food services like caterers and food trucks) are excluded. Taxpayers that are primarily in the business of operating hotels, motels, civic or social organization, amusement parks, theaters, casinos, country clubs, and similar recreation facilities are also excluded.

Practical Tip: Unlike under the UNICAP rules, selling merchandise at retail includes the sale of identical goods to resellers if the sales to resellers are conducted in the same building and in the same manner as retail sales to non-reseller customers (for example, warehouse clubs or  home improvement stores).

  • The taxpayer must incur remodel-refresh costs.

What is Eligible for the Safe Harbor?

Seventy-five percent of qualifying remodel-refresh costs that are paid by a qualified taxpayer for remodel, refresh, repair, maintenance, or similar activities performed on a qualified building as part of a remodel-refresh project are eligible for the safe harbor. The remaining 25 percent must be capitalized as a capitalizable improvement to the qualified building.

  • A qualified building means each building Unit of Property used by a qualified taxpayer primarily for selling merchandise at retail or as a restaurant. Just as under the TPR, there are special rules for condominiums, cooperatives, and leased property.
  • A remodel-refresh project is a planned undertaking to alter the physical appearance or layout of a qualified building for certain qualifying purposes. These qualifying purposes generally include maintaining a contemporary appearance, making the layout more efficient or conforming to current building standards or practices, standardizing the consumer experience across buildings, or offering the most relevant products or services based on popularity or changing demographics. A remodel-refresh project does not include planned projects involving only the repainting or cleaning of the interior or exterior of an existing qualified building.
  • Qualifying remodel-refresh costs are remodel-refresh costs less excluded remodel-refresh costs.
  • Excluded remodel-refresh costs are amounts paid during a remodel-refresh project for §1245 property (tangible personal property), intangibles (including computer software), land or land improvements, the initial acquisition, construction, or lease of a qualified building (including the initial buildout for a new tenant), ameliorating pre-existing defects, casualty event restorations, adapting more than 20 percent of the total square footage of the qualified building to a new or different use, material additions to the qualified building or its building systems, rebranding the building within two years of the acquisition or initial lease of the building, remodel-refresh costs during a closure of the business for at least 21 consecutive days, and deductions under §179, §179D, or §190.

Practical Tip: The safe harbor requires a cost segregation analysis to identify §1245 property, land improvements, and other costs not subject to the safe harbor.

Caution: Use of the safe harbor delays the deduction of the deductible 75 percent of qualifying remodel-refresh costs until the year the capital expenditure portion is placed in service.

How is the Safe Harbor Applied?

A taxpayer may adopt the safe harbor by filing a Form 3115, Application for Change in Accounting Method using DCN 222. This change requires the adoption of the safe harbor method and the (late) election of General Asset Accounts for the qualified building and its improvements. If the taxpayer has prior year partial asset disposition elections or dispositions of qualified building components under the temporary TPR, the taxpayer may unwind those method changes and take the resulting positive §481(a) adjustment into account entirely in the year of change using DCN 221, which should be filed on the same Form 3115 as DCN 222 for the first or second taxable year ending after December 31, 2013. Unwinding these prior dispositions permits the taxpayer to conduct a lookback study using the safe harbor. If the prior dispositions are not unwound, the taxpayer must use a cut-off method to adopt the safe harbor and may not apply the safe harbor to any qualifying remodel-refresh costs from prior to the year of change. The final year of a trade or business and the five-year item eligibility rules do not apply to either of these changes for the first or second taxable year beginning after December 31, 2013. The remodel-refresh safe harbor method change is available only for taxable years beginning on or after January 1, 2014.

Practical Tip: Taxpayers who already have performed detailed facts-and-circumstances TPR studies that include partial asset dispositions, repairs, and improvements have the option of unwinding the prior partial asset dispositions. This would be advisable if the sum of the repairs and partial asset dispositions are less than 75 percent of the qualifying remodel-refresh costs.

Caution: The safe harbor requires the use of General Asset Accounts, which limits the ability of the taxpayer to make partial asset disposition outside of remodel-refresh projects.

Caution: The Safe Harbor for small taxpayers is not available for any remodel-refresh costs. The routine maintenance safe harbor is not available for any qualifying remodel-refresh costs or amounts not related to a remodel-refresh project.

Overall Assessment

The remodel-refresh safe harbor promises to greatly reduce IRS examinations of taxpayers in the retail and restaurant industries. For taxpayers who have expensed less than 75 percent of qualifying remodel-refresh costs, there is also an opportunity. The safe harbor does come with two primary limitations:

  • Deferred expensing of qualifying remodel-refresh costs where the capital expenditure portion is placed in service in a later year and
  • The mandatory use of General Asset Accounts for qualified buildings which has its own drawbacks.
Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

Since our last post regarding the impact of Rev. Proc. 2015-20 on the 2014 filing season, we have fielded many questions about whether taxpayers need to file an election out of Rev. Proc. 2015-20. Below we discuss how Rev. Proc. 2015-20 interacts with the general method change procedures and whether it makes sense for a taxpayer to elect out of Rev. Proc. 2015-20.

General Rules for Method Changes and Rev. Proc. 2015-20

In general, taxpayers may make an automatic change in method of accounting if the change is described in Rev. Proc. 2015-14 and the taxpayer meets the eligibility requirements in §5 of Rev. Proc. 2015-13. These eligibility requirements include that the taxpayer has not engaged in a §381(a) transaction during the year of change, that the year of change is not the final year of the trade or business to which the method change applies, and that the taxpayer has not changed the same method of accounting within the prior five years (including the year of change). The IRS can waive these eligibility requirements. For example, the IRS has waived the eligibility requirements for TPR changes through the 2014 tax year. With the expiration of this waiver in 2015, the five-year item eligibility will once again be in force.

Under this rule, if the taxpayer makes a method change for the same item, for example, a change under DCN 184 from capitalizing costs as improvements to expensing them as repairs, the taxpayer would no longer be able to make the same method change within five years under the automatic consent procedures. For the qualifying small taxpayer under Rev. Proc. 2015-20 who does not file a Form 3115 or an election-out statement, this means that the taxpayer will not be able to file an automatic method change within the scope of Rev. Proc. 2015-20 until 2019. (The affected changes include DCNs 184-193, 205, and 206. Some changes under DCNs 200 and 207 are affected. Though not within the scope of Rev. Proc. 2015-20, filing a Form 3115 for DCN 196 makes the taxpayer ineligible for relief under Rev. Proc. 2015-20.)

Consider a qualifying small taxpayer under Rev. Proc. 2015-20 who has not filed any TPR Forms 3115 and has not filed an election out statement. The IRS will view the taxpayer as having adopted the TPR in 2014 with a §481(a) adjustment of zero. Because the taxpayer has already taken pre-2014 TPR §481(a) adjustments into account, even if the taxpayer files a non-automatic method change in 2016 to comply with the TPR, their §481(a) adjustment is limited to costs paid or incurred during the 2014 and 2015 tax years. The same limitation on the §481(a) adjustment applies even if the taxpayer waits until 2019 to file an automatic method change for affected TPR DCNs. For small taxpayers, this limited §481(a) adjustment presents a more difficult problem than the five-year prior item change rule.

This difficulty lies in how Forms 3115 are treated on exam. An examining agent is free to adjust the amount of a §481(a) adjustment. If the examining agent wants to reject a Form 3115 on exam, however, the agent has to put in a request for Technical Advice from the IRS National Office. Since challenging an invalid Form 3115 is discretionary on the IRS’s part, the most likely resolution of this situation is for an examining agent to adjust the §481(a) adjustment to include only amounts paid or incurred after January 1, 2014. If the IRS takes this approach, however, it may also open an opportunity for qualifying small taxpayers who face unfavorable §481(a) adjustments for pre-2014 years.

Under Rev. Proc. 2015-20, qualifying small taxpayers do not receive back year audit protection. Once the pre-2014 tax years have been closed by the statute of limitations, however, it is arguable that the IRS is limited to post-2013 TPR-related §481(a) adjustments when a taxpayer automatically qualifies for the relief provisions of Rev. Proc. 2015-20. Unfortunately, since this approach would require a practitioner to take a return filing position contrary to a regulation (presumably without a good faith challenge to the validity of the regulations and perhaps without a reasonable basis as well), it may not meet ethical or professional standards even with disclosure.

Given these different scenarios, how should a tax practitioner approach electing out of Rev. Proc. 2015-20?

First, practitioners should assess whether a taxpayer appears to have pre-2014 favorable, TPR-related adjustments by examining the fixed asset ledger and supporting records. If so, the taxpayer should be advised to elect out of Rev. Proc. 2015-20 to preserve these adjustments when filing a later method change. If the practitioner determines that the taxpayer appears to have pre-2014, TPR-related deficiencies, on the other hand, the taxpayer should be advised on the choice between filing under Rev. Proc. 2015-20 or Rev. Procs. 2015-13 and 2015-14 and how it relates to back year audit protection.

Second, the type of entity should be considered. Calendar-year corporations, (both C and S), will no longer be able to file an amended or superseding return under regulation §301.9100-2 to elect out of Rev. Proc. 2015-20 after the extended filing deadline of September 15th. Calendar year individuals and partnerships will be able to use this regulation to elect out of Rev. Proc. 2015-20 until October 15. Finally, if it is too late in the filing season to re-examine corporate returns, practitioners should ponder how the IRS’s approach to this issue might evolve and how the practitioner community might successfully challenge the scenarios we have described above. At the present time, electing out of Rev. Proc. 2015-20 is not required, but it appears to be the best way to preserve pre-2014 favorable, TPR-related §481(a) adjustments.

Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

On March 2, 2015, the Internal Revenue Service published long-awaited relief for small taxpayers implementing the new Tangible Property Regulations (“TPR”). This relief took the form of Rev. Proc. 2015-20. This revenue procedure allows each eligible small taxpayer to adopt most of the tangible property regulations on an effective cut-off basis, but without prior year audit protection. Relief is available for each qualifying separate and distinct trade or business and no taxpayer action is required to elect the relief provisions. The lack of an affirmative election has created a large problem for some taxpayers: Accidentally electing the relief provisions.

Background:

Rev. Proc. 2015-20 applies to a taxpayer with one or more separate or distinct trades or businesses that either has:

  • less than $10 million in assets on January 1, 2014 (for calendar year taxpayers), or,
  • average annual gross receipts of less than $10 million over the prior three years.

The revenue procedure requires no action on the part of a taxpayer’s qualifying trade or business to elect these provisions. For affected method changes, this is an all-or-nothing proposition: Use Rev. Proc. 2015-20 or use the normal method change procedures. The Service stated during an IRS webinar in July that taxpayers with qualifying trades or businesses that do nothing will be considered to have elected into the relief provisions of Rev. Proc. 2015-20.

The Problem:

If a taxpayer accidentally elects into Rev. Proc. 2015-20, there are three main issues for the taxpayer to confront.

  1. First, there is no back-year audit protection for years before the year of change, (pre-2014 years for calendar year taxpayers). While this may not be a problem for the majority of taxpayers whose methods mostly comply with the new TPR already, taxpayers with deficient methods who would like a de facto cut-off method change will be at risk.
  2. Second, the taxpayer would not be able to make any changes within the scope of Rev. Proc. 2015-20 on an automatic method change basis for five years. Depending on the taxpayer’s gross income, user fees for non-automatic method changes run from $2,200 to $8,600, with most taxpayers paying $8,600 per method change.
  3. Third, the taxpayer would lose all §481(a) adjustments attributable to pre-2014 tax years when making a subsequent method change. More than the user fee, the lack of pre-2014 favorable adjustments will discourage taxpayers from making a method change in post-2014 tax years.

The Solution:

While the IRS’s position is unfavorable, they have also provided a solution. The IRS has publicly suggested that eligible taxpayers may elect out of Rev. Proc. 2015-20 by filing a statement to that effect with their 2014 tax returns. Since this would be a regulatory election, taxpayers who have already filed their 2014 returns should be able to use the §9100 relief provisions to file this statement with an amended return. For calendar year taxpayers, this amended return would be due by September 15, 2015 for C corps and S corps and October 15, 2015 for partnerships and individuals. Alternatively, taxpayers can file their 2014 returns with a Form 3115 for a method otherwise within the scope of Rev. Proc. 2015-20 to elect out of Rev. Proc. 2015-20. The §9100 relief rules are also available to file a Form 3115 with an amended 2014 tax return.

Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

The release of final Treasury regulations on the disposition of MACRS property has increased interest in the current legal treatment of demolition costs. In general, taxpayers may now rely on the final regulations of Treasury Decision 9689 when determining how to treat asset dispositions. Though these final regulations describe when an asset disposition occurs, the related final regulations on tangible property capitalization in Treasury Decision 9636 control how to treat the demolition costs.

Under those final regulations, when a taxpayer realizes gain or loss on the disposition of an asset, the taxpayer may expense the demolition and removal costs for that asset. When the taxpayer does not realize gain or loss on an asset disposition, the costs of demolishing or removing the asset are capitalized. The following chart summarizes how to treat demolition and removal costs under the final regulations.

Transaction Type Gain or Loss Realized? Demolition/Removal Cost Treatment
Sale Yes Not capitalized (expensed)
Exchange Yes Not capitalized (expensed)
Involuntary conversion Yes Not capitalized (expensed)
Physical abandonment (whole asset) Loss only Not capitalized (expensed)
Partial asset retirement w/partial disposition election Loss only Not capitalized (expensed)
Partial asset retirement w/o partial disposition election No Capitalized to replacement asset if costs directly benefit or incurred by reason of new improvement. Otherwise, expensed.
Section 280B building demolition No Capitalized to non-depreciable land account
Conversion to personal use Gain only Not capitalized (expensed)
Transfer to supplies or scrap account Loss only Not capitalized (expensed)
GAA asset disposition, no partial disposition election and no GAA-terminating event Loss = Zero for removal cost purposes Not capitalized (expensed)

 

Please note that the above chart is based on realization, not recognition. Exchanges and involuntary conversions are often non-recognition events for federal income tax purposes. Nonetheless, they are dispositions and realization events, which dictates the treatment of asset removal costs.

Under the final regulations, demolition and removal costs are only capitalized when gain or loss is not realized. Examples of this type of situation include a building demolition that is capitalized to a non-depreciable land account under §280B or when a component of an asset is replaced without a partial disposition election. This provides taxpayers some flexibility to lower current year expenses when making structural improvements by capitalizing removal costs.

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