managing capitalization and expense depreciation · 2018-07-10 · bonus depreciation ›allows for...

Managing Capitalization and Expense Depreciation

PRESENTED BY:

› TRACY MONROE, CPA, MT, PARTNER

› LISA LOYCHIK, CPA, PARTNER

› JON WILLIAMSON, CPA, MT, MANAGER

July 10, 2018

Welcome & Introductions

Jon Williamson, CPA, MTLisa Loychik, CPATracy Monroe, CPA, MTModerator

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CPE Credit Guidelines

› To receive CPE you must:

- Be logged in for at least 50 minutes

- Answer at least 3 of the 4 polling questions

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Questions During the Webinar

› If you have questions during the webinar:

- Use the “Questions” feature to “Enter a question for staff” then click send

- We will address during the program if there is time or will follow up after the program

Capitalization

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Overview

› The IRS issued final Tangible Property Regulations effective January 1, 2014

› The final regulations affect all taxpayers that acquire, produce or improve tangible property

› These regulations provide a general framework for distinguishing capital expenditures from other deductible business expenses

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Overview

› Assume all tangible property except inventory is capital property

› Capital property must be capitalized and depreciated unless the property qualifies for one of the following exceptions:

- Materials and supplies

- Rotable and temporary spare parts

- Improvements that do not result in BAR

- Routine maintenance

- Small building/small taxpayer safe harbor

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Why Are The Regulations Important?

› Explains how to classify costs: deductible vs. capitalize

- No longer entirely based on facts and circumstances

- Provides new definitions

- Set new standards

› Introduces new “disposition” rules

- Allows taxpayers to claim a loss on disposition vs. double depreciation

- Example: roof replacement

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Financial Statement Conformity

› Reviewing financial statements

- Only two areas require book conformity

- Safe harbor for capitalization policy

- Election to capitalize and depreciate repairs

- The repair reg rules may be applied for tax only, but may also impact financial statements

- Financial statements compared to the tax return may have large differences in assets/repairs and maintenance expenses

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Acquiring Property

› Material and supplies- A component to maintain, repair or improve a unit of property

- Fuel, lubricants, etc. expected to be consumed in 12 months or less

- A unit of property deemed to have an economic life of 12 months or less

- Safe harbor – a unit with a production or acquisition cost of $200 or less (ex: calculators, coffee makers, etc.)

› Types of materials and supplies- Non-incidental – supplies that are imperative to a business model and

for which an inventory is kept

- Incidental – supplies that are not imperative and no inventory is maintained

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Acquiring Property (cont.)

› Treatment of materials and supplies

- Non-incidental – deductible in the taxable year in which materials and supplies are first used

- Incidental – deductible in the taxable year in which material and supplies are purchased

› Rotable and temporary spare parts

- Deductible when the parts are disposed of

- An election is available to choose to capitalize

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Acquiring Property (cont.)

› De Minimis Safe Harbor

- Book conformity:

- Costs classified as expenses

- Capitalization policy

- Capitalization policy:

- In place at the beginning of the year (in writing if have applicable financial statement)

- Cost per item less than threshold

- Item has an economic useful life less than 12 months

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Acquiring Property (cont.)

› De Minimis Safe Harbor

- Two thresholds:

- $5,000 per-item or per-invoice with Applicable Financial Statement (AFS)

- $2,500 per-item or per-invoice without AFS

- Example: Bulk purchase of 10 computers for cost $40,000. Computers invoice in aggregate, not individually. De minimis safe harbor applies.

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Polling Question # 1

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Unit of Property (UOP)

› UOP – The level at which costs are aggregated and capitalized, as well as the level that costs are analyzed to determine if they are deductible

› Building and structural components

- Single unit of property

› Building systems

- Each separate unit of property

› Other property

- Generally a UOP consists of a group of functionally interdependent components

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UOP: Building Systems

› HVAC

› Plumbing systems

› Electrical systems

› Escalators

› Elevators

› Fire protection & alarm systems

› Security systems

› Gas distribution systems

› Other systems identified in published guidance

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Improving Property: Capitalize

› A unit of property is improved if amounts are paid for activities performed after the UOP is placed in service by the taxpayer resulting in:

- Betterment to the unit of property

- Adaptation of the unit of property to a new or different use

- Restoration of the unit of property

Property improvement costs that should be capitalized are commonly referred to as the “BAR” test

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Betterment: Capitalize

› Alleviates a material condition or defect that existed prior to the acquisition of property

› Results in a material addition or expansion

› Is expected to materially increase in productivity, efficiency, strength, output or quality of the UOP

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Betterment: Example

› ABC Corp. purchases a parcel of land. The soil was contaminated by leaking underground storage tanks left by a previous owner.

› ABC Corp.’s remediation costs to remove the contaminants result in a capitalized betterment to the land because ABC Corp. incurs the costs to ameliorate a material condition or defect that existed prior to its acquisition of the land.

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Adaption: Capitalize

› Adapt a UOP to a new or different use

› Adaption is inconsistent with intended use

› Analyze facts and circumstances

› Examples:

- Capital: expansion in retail drug store for a walk-in medical clinic

- Deductible: expansion in grocery store for a sushi bar that already includes counters for prepared food & deli meats

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Restoration: Capitalize

› Replaces a component, and adjusted basis has been taken into account in realizing gain/loss

› Returns a UOP to its ordinary efficient operating condition if the property is no longer functional

› Rebuilds a UOP to a like-new condition after end of its useful class life

› Replaces a part that comprises a significant portion of a major component or a large portion of a substantial structural part of a UOP

- No bright-line test only examples in regulations

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Restoration: Example

› ABC Corp. replaces the waterproof membrane of the roof

› Not a major component or substantial structural part of the building structure

› Improvement or repair? Depends if ABC Corp will recognize a loss on the replaced membrane

› Will ABC Corp. recognize a loss on the replaced membrane?

- Yes: Improvement = Capitalize

- No: Repair = Expense

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Restorations: Major Component or Substantial Structural Part

› No bright-line test to conclude whether a restoration has occurred; based on facts and circumstances. Examples in the final repair regulations include many quantitative facts that give insight into the IRS and Treasury’s view as to whether a replacement rises to the level of a capitalizable restoration.

- Major components of buildings or building systems – examples imply that a replacement of 40% or less of a major component may not be a significant portion of the major component; therefore not a restoration

- Large portion of a substantial structural part – examples imply that a replacement of 30% or more of the building structure was a large portion of a substantial structural part; therefore is a restoration

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Examples in Final Regulations - Restorations

› Office building 3 of 10 roof-mounted AC units are replaced yet were considered repairs

› Retail building where 8 of 20 sinks were replaced yet were considered repairs

› Office building where 100 of 300 windows were replaced yet were considered repairs

› Hotel replaces lobby floors; lobby comprises less than 10% of the entire building so were considered repairs

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Polling Question # 2

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Safe Harbor: Routine Maintenance

› Current deduction for certain on-going, routine maintenance expenditures applies only if:

- Activity is performed more than once over the property’s life

- The maintenance keeps the property in an efficient operating condition

- The need for the maintenance results from the taxpayer’s use of the property

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Safe Harbor: Routine Maintenance (cont.)

› Also applies to buildings and structural components

› For buildings:

- Maintenance is expected to be completed more than once in a 10-year period

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Safe Harbor: Small Taxpayers

› Applies to buildings

› Average gross receipts: less than $10,000,000

› Average unadjusted basis (cost) of building: $1,000,000 or less

› Deduct cost of improvements:

- That do not exceed the lessor of $10,000 or

- 2% of the unadjusted basis of the building

Depreciation

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Depreciation Overview - MACRS

› What is MACRS?- Modified Accelerated Cost Recovery System

- Assets generally have shorter lives under MACRS than for book purposes

- Assets generally are depreciated faster under MACRS than book

› Double Declining Balance (200%) for 5 and 7 year assets

› One and ½ Declining Balance (150%) for 15 year assets

› Straight-Line depreciation for 27.5 and 39 year assets

› Real Property is given a mid-month convention, while Personal Property receives a half-year convention- Possible to be forced into a mid-quarter convention on personal property if a

large portion of assets are placed in service in 4th quarter

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Depreciation Overview – MACRS – Asset Lives

› Non-Residential Real Property – 39 years (40 years under ADS)

› Residential Real Property – 27.5 years (30 years under ADS)

› Land Improvements – 15 years

› Furniture and Fixtures – 7 years- This group acts as a catch-all for assets not included in other groups

› Computer and Other Equipment – 5 years

› Alternative Depreciation System (ADS)- Can be elected

- Mandatory when assets are not located in U.S.

- Mandatory for real property when electing to be considered a “real estate trade or business” for interest expense limitation purposes

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Polling Question # 3

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Placed in Service and Written Binding Contract

› Generally, an asset is placed in service and depreciation begins when it is “ready and available for use”

› Does not mean an asset needs to be “in use”- Rental real estate with occupancy permits and is actively pursuing tenants can

be depreciated, even if there are no tenants currently- Equipment installed but not scheduled to be operated until the future can

begin depreciation after installation, assuming it could be operated

› Written Binding Contract Rule- Must be reviewed due to different rules applying to different periods- If a written binding contract exists to acquire property, the period that

contract was entered into determines the applicable rule set, not the date placed in service

- Only affects which rules to apply – not the date the asset begins depreciation

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Bonus Depreciation

› Allows for additional depreciation expense in the year a qualified asset is placed in service, expressed in terms of percentage

- 50% bonus depreciation for assets in service prior to 9/27/2017

- 100% bonus depreciation for assets in service between 9/27/2017 and 12/31/2022

- Percentage set to decrease 20% per year after 12/31/2022

› Qualified Assets

- Recovery period of 20 year or less

- Includes both new and used property

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Section 179 Expensing

› Similar to Bonus Depreciation, allows for additional depreciation expense in the year a qualified asset is placed in service

› Rather than a percentage of asset cost being expensed (as with bonus depreciation), Section 179 expensing is associated with various dollar value limitations- Expense Limitation – $1,000,000 for tax years beginning in 2018

- Qualified Expenditure Limitation – the expense limitation is reduced for every $1 over $2,500,000 of qualified assets acquired in the taxable year

- Taxable Income Limitation – the expense amount is limited to the taxable income of the taxpayer

› When incurred by a pass-through entity, limitations are reviewed both at the entity as well as the taxpayer level

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Section 179 Expensing (cont.)

› Assets that qualify include:- Tangible personal property

- Off-the shelf computer software

- Qualified real property

› “Qualified real property” includes:- Qualified Improvement Property (QIP)

- Roofs

- Heating, ventilation and air-conditioning property (HVAC)

- Fire protection, alarm systems and security systems

› Qualified assets must be acquired for business use and acquired by purchase

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Comparing Bonus Depreciation and Section 179

› Additional assets qualify for Section 179 that do not qualify for bonus depreciation- Including Roofs, HVAC property and Qualified Improvement Property

› Section 179 has a dollar value limit, while bonus depreciation is unlimited› Section 179 is applied on an asset by asset basis, while bonus depreciation

must be elected for all assets in a single class life› Bonus depreciation is generally a better alternative for real estate business

groups to avoid limitation issues› Treatment of expense in excess of income:

- Section 179 expense in excess of taxable income is carried forward and can be used in future years when the limitations allow

- Bonus depreciation in excess of taxable income creates a Net Operating Loss (NOL)

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Polling Question # 4

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Special Classification – Qualified Improvement Property (QIP)

› Reclassification of certain assets that would ordinarily be depreciated over 39 years as non-residential real property

- Must be an improvement to the interior portion of a building

- Must be placed in service after the date the building was originally placed in service

- Excludes improvements to an elevator or escalator or the internal structural framework of the building

- Excludes improvements that relate to the enlargement of the building

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Qualified Improvement Property (cont.)

› Treatment on QIP according to the Tax Cuts and Jobs Act of 2017 (TCJA) differs from the implied treatment understood by the tax community and joint committee reports

› Treatment based on TCJA- Qualifies for Section 179 expensing- Does not qualify for Bonus Depreciation- Depreciated over 39 years

› Treatment based on joint committee reports- Qualifies for Section 179 expensing- Qualifies for Bonus Depreciation- Depreciated over 15 years

› Requests have been made to congress to pass a technical correction for the deemed oversight, however no determination is currently available

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Removal of Special Asset Classes – Tax Cuts & Jobs Act

› The following asset classes have been removed by the TCJA in years starting after 1/1/2018

- Qualified Leasehold Improvements

- Qualified Restaurant Property

- Qualified Retail Improvements

› Many assets that qualified in any of the three groups above may be classified as Qualified Improvement Property

- May or may not receive beneficial treatment based on requested technical corrections

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Other Considerations – State Conformity

› Many states elect NOT to conform to federal rules in regards to bonus depreciation and Section 179 expensing- For most states, depreciation is calculated as if the special depreciation

deduction was not taken originally

- Some states have specialized rules (MN, NC, PA)

- Results in state addition to income in the year bonus depreciation is taken, and a state deduction in subsequent years

› States have different rules when an asset with a cumulative depreciation adjustment can be written off- Some states allow for the adjustment to affect gain/loss on sale

- Others are recognized over the remaining life of the underlying asset

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Other Considerations – Cost Segregation Studies

› Comprehensive engineering study to separate components of real property into shorter-life assets based on composition of structure

› Benefit analysis prior to TCJA- Provide ability for bonus depreciation on new construction

- Provide lower asset lives for purchases of used property

› Benefit analysis after TCJA- Same as above, and in addition may provide ability for bonus

depreciation on assets purchases after 9/27/2017

› In addition to increased depreciation expense, may provide more accurate data for analyzing potential capital assets and BAR tests discussed earlier

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Questions for our Presenters?

Tracy Monroe, CPA330.255.4357tmonroe@cohencpa.com

Lisa Loychik, CPA330.480.4636lloychik@cohencpa.com

Jon Williamson, CPA, MT216.774.1103 jwilliamson@cohencpa.com

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Upcoming Webinars

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Thank you.

Information presented is not meant to constitute legal, accounting or other professional advice. Any action taken based on information in this presentation should be taken only after a detailed

review of the specific facts and circumstances. Information is current as of the date presented.July 10, 2018