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

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

During recent weeks, the Internal Revenue Service has issued guidance to postpone certain deadlines for taxpayers in counties in Florida and Texas affected by Hurricanes Irma and Harvey. As with other federally declared disasters, these hurricanes have revived interest in the tax effects of destroyed assets and recovery efforts.

Who is Affected?

Taxpayers residing in, or with businesses in, the following counties automatically qualify for the relief.

  • Texas: Aransas, Austin, Bastrop, Bee, Brazoria, Calhoun, Chambers, Colorado, DeWitt, Fayette, Fort Bend, Galveston, Goliad, Gonzales, Hardin, Harris, Jackson, Jasper, Jefferson, Karnes, Kleberg, Lavaca, Lee, Liberty, Matagorda, Montgomery, Newton, Nueces, Orange, Polk, Refugio, Sabine, San Jacinto, San Patricio, Tyler, Victoria, Walker, Waller, and Wharton counties.
  • Florida: Alachua, Baker, Bradford, Brevard, Broward, Charlotte, Citrus, Clay, Collier, Columbia, DeSoto, Duval, Flagler, Gilchrist, Glades, Hardee, Hendry, Hernando, Highlands, Hillsborough, Indian River, Lake, Lee, Levy, Manatee, Marion, Martin, Miami-Dade, Monroe, Nassau, Okeechobee, Orange, Osceola, Palm Beach, Pasco, Pinellas, Polk, Putnam, Sarasota, Seminole, St. Johns, St. Lucie, Sumter, Suwannee, Union, and Volusia counties.

What is Affected?

The relief provided by the Service primarily relates to postponing certain time-sensitive acts. These acts include filing certain tax returns and making estimated tax payments and have been delayed until January 31, 2018.

  • Texas: For taxpayers affected by Hurricane Harvey, the acts needed to have been performed starting on August 23rd.
  • Florida: For taxpayers affected by Hurricane Irma, this time period starts on September 4th.

For more information on how to determine which taxpayers and which deadlines are affected, practitioners should consult Regulation section 301.7508A-1 and Rev. Proc. 2007-56. As relevant to taxpayers interested in cost segregation or fixed asset issues, the time sensitive acts include the deadlines for automatic accounting method changes and nonautomatic accounting method changes.

Opportunities and Risks?

Until (and unless) Congress enacts legislation providing otherwise, the normal rules for casualty losses, involuntary conversions of property, and capitalizing improvements apply.

  • 280B: The most notable rule to be aware of is section 280B which places severe limitations on expensing the demolition of buildings:

If a taxpayer demolishes at least 75% of the internal structural framework and 75% of the exterior walls of a building, it must capitalize the demolished structure and the costs of demolition to a nondepreciable land account.

Section 280B is certainly pertinent to both Florida and Texas where many buildings will fail the two part test due to the extent of the damage. Fortunately, Congress has introduced legislation that would avoid the application of section 280B and the normal capitalization rules of section 263(a) for affected taxpayers in many situations.

  • Dispositions: Even though section 280B severely limits the availability of deductions when demolishing entire buildings, tangible personal property, non-building land improvements, and partial dispositions of buildings and their structural components may still be available. To determine the amount of dispositions, taxpayers first must determine the casualty loss, that is the lesser of the property’s adjusted basis or decrease in fair market value that is unreimbursed by insurance. Under current law, this deduction will affect the capitalization of replacements. Consider the following example:

A taxpayer owns an office building. The building is damaged by a hurricane. The taxpayer either deducts a casualty loss under section 165 because of the damage or receives insurance proceeds after the accident to compensate for the loss. The taxpayer properly reduces the basis of the building by the amount of the loss or by the amount of the insurance proceeds. If the reduction in basis is less than or equal to the taxpayer’s adjusted basis in the building, amounts paid to restore the damage to the building must be treated as an improvement and must be capitalized. Note: If the amounts paid to restore the property exceed the adjusted basis of the property prior to the loss, the amount required to be capitalized may be limited.

Since casualty loss-related dispositions are a mandatory partial disposition event, taxpayers who fail to identify these partial dispositions currently may do so in the future using a method change.

  • Declaration of a federal disaster area: Without waiting for Congress, the mere declaration of a federal disaster area allows taxpayers to access an advantageous rule for claiming casualty losses.

Affected taxpayers in a federally declared disaster area may either claim disaster-related casualty losses on their federal income tax returns for the year in which the event occurred or the prior year. If electing to claim the loss on the prior year return, the taxpayer must include a statement on or with the return. The statement must include the name or a description of the disaster giving rise to the loss, the date or dates of the disaster, and the city, town, county, state, and ZIP code where the damaged or destroyed property was located at the time of the disaster. The election must be made on or before the date that is six months after the regular due date for filing your original return (without extensions) for the tax year in which the disaster actually occurred. This would generally be September or October 15th, 2018 (depending on the type of return involved).

For more than 30 years, SourceHOV | Tax has helped companies properly identify and sustain tax incentive strategies including R&D tax credits, cost segregation studies, 179D tax deductions and LIFO inventory accounting.  For more information, please call 800.806.7626 or visit www.sourcehovtax.com.

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

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

When taxpayers develop real estate for use in their trade or business, they frequently must construct improvements that allow customers to access their property. In some cases, taxpayers must acquire additional property or even easements from adjacent property owners to permit access to their property. In others, taxpayers must construct new improvements on-site or off-site and then dedicate the improvements to the state or local municipality. We will consider variations on these factual situations below.

Acquiring Additional Land and Constructing Improvements

Land is not a depreciable asset.[1] The acquisition of additional unimproved land, from adjacent property to permit access to the taxpayer’s property, is nondepreciable as well and has no immediate effect on taxable income.

  • General land preparation costs, such as rough grading, are also not depreciable.[2] Land preparation costs directly associated with the construction of depreciable property, however, are depreciable. Land preparation costs such as soil removal or fine grading directly attributable to the construction of depreciable improvements, however, are depreciable.[3]
  • Land preparation costs associated with depreciable assets such as roads are depreciable on the same basis as the depreciable assets, generally as 15-year property classified under asset class 00.3 of Rev. Proc. 87-56.

Easements

Frequently, taxpayers will acquire an easement from an adjoining property owner instead of purchasing the land need to construct access roads directly. The taxpayer will incur the cost to acquire the easement, (an intangible asset), clearing and grading costs, and construction costs for improvements on the easement, such as roads. In Revenue Ruling 72-403, the Service determined that electrical transmission easements have a limited useful life and that the associated clearing and grading costs were part of the construction cost of their associated electrical transmission lines.[4] The Service ruled that both the easement and the clearing and grading costs were depreciable.[5] When a taxpayer acquires an easement to construct a depreciable asset, such as a road, the easement and clearing and grading costs would thus be depreciable on the same basis as the depreciable asset.

Dedicated Improvements Transferred to Another Party

Sometimes taxpayers must construct on-site or off-site improvements that will be transferred to another party or to the state or the local municipality, which will maintain the improvements for public use.

  • In general: When a taxpayer constructs improvements on real property owned by another party and the real property is expected to produce significant economic benefits for the taxpayer, the taxpayer must capitalize the cost of the improvements as an intangible.[6]
  • Transfer to a 3rd Party: The same rule applies when the taxpayer pays for real property, transfers the property to a third party (except for a sale at fair market value) , and the real property is reasonably expected to produce significant economic benefits for the taxpayer.[7] These capitalized costs may be depreciated using a safe harbor 25-year life.[8]
  • Transfer to a Municipality: When the other party is the government, however, these rules may not apply. If a taxpayer pays for real property or real property improvements that will benefit new or existing developments, immediately transfers the property to a State or local government for dedication to the general public use, and where the property is maintained by the State or local government, the taxpayer does not have to capitalize the cost of the real property or its improvements as an intangible.[9] Instead, the taxpayer must capitalize these costs under the rules of Code section 263A.[10]

Code section 263A (“UNICAP”) was “enacted to provide a single, comprehensive set of rules to govern the capitalization of the costs of producing, acquiring, and holding property, subject to appropriate exceptions where application of the rules might be unduly burdensome. These rules are designed to more accurately reflect income and prevent unwarranted deferral of taxes by properly matching income with related expenses. These rules are also intended to make the tax system more neutral by eliminating the differences in the former capitalization rules that created distortions in the allocation of economic resources and in the manner in which certain economic activity is organized. See S. Rep. No. 313, 99th Cong., 2d Sess. 140 (1986), 1986-3 C.B. (Vol. 3), 140.”[11] UNICAP requires taxpayers who produce real property to capitalize all direct costs and the allocable portion of indirect costs associated with the production activity.[12] Indirect costs are “properly allocable to property produced… when the costs directly benefit or are incurred by reason of the performance of production…activities.”[13] In Von-Lusk v. Commissioner, the Tax Court held that permitting fees used to construct city-owned, public improvements are “ancillary to actual physical work on the land and are as much a part of a development project as digging a foundation or completing a structure’s frame,” and thus are categorized as indirect costs under UNICAP. [14] When a taxpayer constructs real property improvements that are transferred to a State or local government for dedicated public use, these improvements will generally be capitalized as indirect costs under UNICAP. That is, to borrow a phrase from cost segregation studies, these costs are capitalized as a project indirect.

This overview deals with some common situations encountered by property owners during the course of a cost segregation study. If you would like further information, please reach out to one of our cost segregation consultants or directors of business development.

[1] Treas. Reg. § 1.167(a)-2.

[2] Eastwood Mall Inc. v. United States, 95-1 USTC ¶ 50,236 (D.C. Oh. 1995), aff’d 59 F.3d 170 (6th Cir. 1995).

[3] Rev. Rul. 65-265, 1965-2 C.B. 52, Rev. Rul. 68-193, 1968-1 C.B. 79, Rev. Rul. 88-99, 1988-2 C.B. 33.

[4] 1972-2 C.B. 102.

[5] Id.

[6] Treas. Reg. § 1.263(a)-4(d)(8)(i).

[7] Id.

[8] Treas. Reg. § 1.167(a)-3(b)(1)(iv).

[9] Treas. Reg. § 1.263(a)-4(d)(8)(iv).

[10] Id.

[11] T.D. 8482, 58 F.R. 42198, 42199.

[12] I.R.C. § 263A(e).

[13] Treas. Reg. § 1.263A-1(e)(3)(i)(A).

[14]104 T.C. 207,  216 (T.C. 1995)

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

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

The De Minimis Safe Harbor (DMSH) of section 1.263(a)-1(f) provides a relatively straightforward way for taxpayers to avoid capitalizing assets and improvements under section 263(a). However, one obvious question is whether the De Minimis Safe Harbor may be applied to new construction. When dealing with newly constructed buildings, the simple rules can become incredibly complex. Below is an outline that discusses some of the most common issues with the DMSH and new construction.

  1. Accounting Procedure: Under section 1.263(a)-1(f)(1)(ii)(B) & (B)(1), the taxpayer must have an accounting procedure as of the beginning of the year under which they treat as an expense for non-tax purposes items under a specified dollar amount.
    • Please note that this specified dollar amount could be set at any level, but it must be for non-tax purposes such as financial or managerial accounting.
    • Please also note that this beginning of the year requirement may be difficult or impossible to meet for a new entity.
    • Start-up Issue: Under 1.263(a)-1(f)(3)(iv), amounts not capitalized under a DMSH election are deducted under section 162 only if they are ordinary and necessary expenses incurred in carrying on a trade or business. When dealing with new construction in a new entity, the taxpayer often falls under the rules for start-up expenditures found in section 195. In that situation, electing the DMSH may turn five-year assets into 15-year amortizable, start-up expenditures.
  2. Book Expensing: Under section 1.263(a)-1 (f)(1)(ii)(C), the taxpayer must treat the amount paid for the property as an expense on its books and records. When combining this requirement with the accounting procedure requirement, it appears that expensing treatment in books or journal entries prepared solely for income tax return filing purposes would not meet the requirements of the DMSH.
  3. Tax Dollar Limit: Under section 1.263(a)-1 (f)(1)(ii)(D) as updated by Notice 2015-82, the amount paid for the property must be $2500 or less per invoice or per invoice item.
  4. UNICAP Conformity: Under section 1.263(a)-1 (f)(3)(v), items that would otherwise be expensed under the DMSH may be capitalized under section 263A “if the amounts paid for tangible property comprise the direct or allocable indirect costs of other property produced by the taxpayer[.]”
    • Please note that this UNICAP conformity rule applies to the cost of “other property produced by the taxpayer.” Even if a single door, for example, is broken out on an invoice and otherwise meets the requirements of the DMSH, it would still be capitalized as part of the direct costs of producing the building Unit of Property.
    • Though the regulations do not provide a clear answer, capitalization under section 263A would presumably not apply beyond the level of a single UoP. For example, the purchase of a refrigerator that otherwise meets the requirements of the DMSH would not be capitalized under UNICAP as a direct or indirect cost of constructing a building.
  5. Anti-abuse rule: Under section 1.263(a)-1(f)(6), taxpayers cannot manipulate transactions so that property falls under the DMSH. Abuse is presumed when the taxpayer creates invoices to componentize an item generally acquired as a single unit that would exceed any of the DMSH dollar limits, both book and tax. This may create complications when dealing with new construction.
    • When dealing with a contractor, ordinary payment applications may show very limited details, so that the amounts invoiced do not substantiate the actual cost of an item. By asking for greater componentization from the contractor, the taxpayer may run afoul of the anti-abuse rule.
    • Frequently, an operating entity constructs a building and then sells it to a related entity; or, more often, distributes the property to its shareholders who then contribute it to a new entity. The latter often involves only entries on the book and the former often uses lump-sum purchase prices with marginal descriptions. The taxpayer changing its business practices to componentize a property in this case may run afoul of the anti-abuse rule.

So where does this leave us on using the DMSH for new construction? The taxpayer needs to make sure the most important, threshold requirements for the DMSH are met: 1) book expensing policy as of year-beginning; 2) actual expensing on the books, and 3) invoice-based substantiation. The taxpayer also needs to avoid using the DMSH prior to the active trade or business commencing under section 195. Once these obstacles are bypassed, the taxpayer will generally find that the DMSH election is restricted to the same items that would be cost segregated: section 1245 tangible personal property and some land improvements.

For more than 30 years, SourceHOV | Tax has helped companies properly identify and sustain tax incentive strategies including R&D tax credits, cost segregation studies, 179D tax deductions and LIFO inventory accounting.  For more information, please call 800.806.7626 or visit www.sourcehovtax.com.

If you enjoyed this post, click here to receive email updates.

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.