summary of tangible property regulations

March 2012

Deconstructing the Tangible

Property Temporary

Regulations

Understanding how the new

guidance may affect your

company

Deconstructing the Tangible Property Temporary Regulations 1

Contents

Overview 2

Materials and Supplies 3

Amounts Paid to Acquire or Produce Tangible Property 4

Amounts Paid to Improve Tangible Property 6

Dispositions of MACRS Property 12

Transition Guidance – Revenue Procedures 2012-19 and 2012-20 15

Large Business and International Division Directive 17

Tangible Property Temporary Regulations Automatic Method Change Guidance Chart 18

Contacts 23

Overview


Overview

On December 27, 2011, the Treasury Department (―Treasury‖) and the Internal Revenue

Service (―IRS‖) issued temporary and proposed regulations (―the Temporary

Regulations‖) that provide guidance with respect to the treatment of materials and

supplies, dispositions of MACRS property, capitalization of amounts paid to acquire or

produce (or facilitate the acquisition or production of) tangible property, and the

determination of whether an expenditure with respect to tangible property is a deductible

repair or must capitalized. Thus, the Temporary Regulations address a broad range of

capitalization and deduction issues for expenditures related to tangible property and may

likely impact taxpayers in all industries.

The Temporary Regulations are generally effective for taxable years beginning on or after January

1, 2012; however, a number of provisions are effective for amounts paid or incurred in taxable years

beginning on or after January 1, 2012. Early adoption of the Temporary Regulations is not allowed.

Changes to comply with or adopt the provisions in the Temporary Regulations generally will be

made through an accounting method change, most of which require the computation of an

IRC § 481(a) adjustment. Rev. Proc. 2012-19 and Rev. Proc. 2012-20 provide guidance on

implementing the Temporary Regulations.

The Temporary Regulations retain many of the provisions included in the proposed regulations

issued in 2008 (―2008 Proposed Regulations‖ ); however, there are a number of new provisions and

changes from the 2008 Proposed Regulations as well as changes to pre-January 1, 2012 law. The

major changes include:

Disposition of structural components of a building

Rules for determining whether there is an improvement to a unit of property, including the

replacement of a major component or substantial structural part of a unit of property

Expansion of the definition of ―materials and supplies‖

Revision of the proposed de minimis rule allowing taxpayers to deduct certain amounts that cost

less than a minimum threshold amount

Numerous examples analyzing a variety of costs incurred to remodel or refresh stores

Simplifying conventions for amounts paid that facilitate the acquisition of certain tangible

property

Replacement of the ―plan of rehabilitation‖ doctrine with a ―benefit or incurred by reason of‖

standard from IRC § 263A

Various elections, including general asset account elections that interact with the rules for

restorations

Material changes to the routine maintenance safe harbor

The Temporary Regulations withdraw the 2008 Proposed Regulations and serve as the text of the

current proposed regulations. Treasury and the IRS have requested comments on the proposed

regulations by April 17, 2012, in advance of the public hearing on the regulations scheduled for May

9, 2012.

1 T.D. 9564

2 REG 168745-03

3 73 FR 47 12838-01

1

2

3

Materials and Supplies


Materials and Supplies

As under pre-January 1, 2012 law, incidental materials and supplies (i.e., materials and

supplies for which the taxpayer does not maintain a record of consumption or take

physical inventories at year end) are deductible when purchased. Non-incidental

materials and supplies are deductible when used or consumed.

In response to comments received with respect to the 2008 Proposed Regulations,

Treasury and the IRS clarify and expand the definition of materials and supplies in the

Temporary Regulations by eliminating the requirement that such property not be a unit of

property and including a new category of qualifying property. Accordingly, the Temporary

Regulations define a material and supply as tangible property used or consumed in the

taxpayer’s operations that is not inventory and is:

A component acquired to maintain, repair, or improve a unit of tangible property (includes

rotable and temporary spare parts);

Fuel, lubricants, water, or similar items that are reasonably expected to be consumed in 12

months or less, beginning when used in taxpayer’s operations (new category);

A unit of property that has an economic useful life of 12 months or less;

A unit of property with an acquisition or production cost of $100 or less; or

Property identified in future published guidance.

A taxpayer may elect to capitalize and depreciate each material or supply. A taxpayer makes the

election annually by capitalizing the particular material or supply in the taxable year the amounts are

paid and by beginning to recover the costs on its timely filed original federal income tax return

(including extensions) for the taxable year the asset is placed in service. A taxpayer may also elect

annually to treat each material or supply under the de minimis rule (discussed below), provided all

requirements under such rule are met for such material or supply.

The Temporary Regulations include special rules for rotable and temporary spare parts (―rotables‖).

The default treatment is to deduct rotables when used or consumed (i.e., when disposed of);

however, a taxpayer may elect to capitalize and depreciate rotables or elect an optional method

treatment. Under the optional method, the taxpayer deducts its basis in the rotable in the year it is

placed in service, recognizes income when the rotable is removed, capitalizes costs to fix the

rotable, and then claims a deduction for such basis when the rotable is once again placed in service.

Additionally, otherwise deductible materials and supplies may be subject to capitalization under

IRC § 263A, or as an improvement under Temp. Reg. § 1.263(a)-3T.

Amounts Paid to Acquire or Produce Tangible Property


Amounts Paid to Acquire or

Produce Tangible Property

Amounts paid to acquire or produce tangible property or to defend or perfect title to such property

must be capitalized. In addition, a taxpayer must capitalize amounts paid to facilitate the acquisition

or production of tangible property. The determination of whether costs associated with activities are

facilitative is based on facts and circumstances. However, the Temporary Regulations provide a list

of inherently facilitative activities that is similar to the list in Treas. Reg. § 1.263(a)-5, and include

bidding costs, finders’ fees or brokers’ commissions, and securing an appraisal, among other

activities.

Facilitative Costs

Under the Temporary Regulations non-inherently facilitative pre-decisional investigatory costs paid

in pursuing the acquisition of real property are not considered facilitative, and therefore are not

required to be capitalized, if paid for activities performed in the process of determining whether and

which real property to acquire. Because this special rule only applies to the acquisition of real

property, an allocation of facilitative costs between real and tangible personal properties may be

required if both real and tangible personal properties are acquired in a single transaction. The

amount of non-inherently facilitative pre-decisional investigatory costs reasonably allocated to the

real property can be deducted, while costs reasonably allocated to the acquisition of personal

property must be capitalized.

The Temporary Regulations also provide that employee compensation and overhead costs related

to the acquisition of tangible property are not subject to capitalization under IRC § 263(a); however,

such costs may be required to be capitalized under IRC § 263A.

De Minimis Rule

The de minimis rule provided in the Temporary Regulations permits a taxpayer to deduct certain

expenditures consistent with the treatment on its applicable financial statement (―AFS‖) subject to a

ceiling. An AFS is a financial statement provided to the Securities and Exchange Commission

(―SEC‖), an audited financial statement used for creditors or other non-tax purpose, or a financial

statement provided to a governmental agency other than the IRS or SEC. To be eligible for the de

minimis rule, the taxpayer must have in place at the beginning of the year, a written financial

accounting policy to deduct amounts below a certain dollar threshold and expense amounts on its

AFS consistent with the written policy.

The ceiling amount (i.e., the maximum deduction under the de minimis rule) is equal to the greater

of:

0.1% of the taxpayer’s gross receipts for federal income tax purposes, or

2% of the taxpayer’s total depreciation and amortization expense for the tax year reflected on its

AFS

If the amount expensed pursuant to the taxpayer’s AFS minimum capitalization threshold exceeds

the ceiling, then no amount is deductible under the de minimis rule. However, the taxpayer may

Amounts Paid to Acquire or Produce Tangible Property


elect to capitalize a portion of the amounts expensed under its AFS capitalization threshold so as to

allow it to deduct the ceiling amount.

For consolidated groups, the determination of whether the taxpayer has an AFS and a written policy

to expense amounts below a certain threshold can be made at the consolidated group level. The

determination and application of the ceiling amount is made separately for each consolidated group

member.

As noted above, amounts deducted as materials and supplies (discussed above) are not included in

the ceiling computation unless the taxpayer so elects.

Practice Consideration

The favorable de minimis rule likely comes with an additional compliance burden for taxpayers.

Specifically, many taxpayers do not currently track the total amount expensed under their

capitalization threshold. The revised ceiling test, and the flexibility afforded taxpayers in the form

of elections, requires that taxpayers track the total amount deducted under the de minimis rule.

The preamble to the Temporary Regulations indicates that the issuance of the regulations is not

intended to disturb the treatment of minimum capitalization threshold agreements between

examiners and taxpayers, provided such agreements clearly reflect income. There is speculation

that the IRS will view the ceiling in the Temporary Regulations as the test in determining whether

the previously agreed upon minimum capitalization threshold clearly reflects income. Taxpayers

should consider evaluating whether they are capable of capturing the information necessary to

apply the de minimis rule and whether amounts deducted pursuant to their present capitalization

policies exceed the ceiling.

Example

Assume the taxpayer is a member of a consolidated group that has an AFS and a written policy at

the beginning of Year 1, under which it expenses amounts paid for property costing less than

$500. In Year 1, the taxpayer pays $160,000 to purchase 400 computers at $400 each. Each

computer is a unit of property, is not a material or supply, and the taxpayer intends to treat the cost

of only the computers as de minimis. Assume that for its Year 1 taxable year, the taxpayer has tax

gross receipts of $125M and book depreciation/amortization of $7M.

To be eligible for the de minimis rule, the total aggregate amounts paid and not capitalized by

the taxpayer must be less than or equal to the greater of $125,000 (0.1 % of its total tax gross

receipts of $125M) or $140,000 (2% of its total book depreciation/amortization of $7M).

Because the taxpayer pays $160,000 for the computers and this amount exceeds $140,000, it

may not apply the de minimis rule to the total amounts paid for the 400 computers.

However, if the taxpayer makes an election to capitalize $20,000 (the amounts paid to acquire 50

of the 400 computers purchased in Year 1), it would not be required to capitalize the amounts paid

to acquire the 350 computers in Year 1.

Amounts Paid to Improve Tangible Property


Amounts Paid to Improve Tangible

Property

For many taxpayers, the more significant aspects of the Temporary Regulations are the provisions

addressing the treatment of amounts paid to improve tangible property (i.e., the so-called ―repair‖

regulations). The Temporary Regulations generally provide that amounts paid to improve a unit of

real or personal tangible property must be capitalized. An amount is considered paid to improve a

unit of property (―UoP‖) if it results in: (i) a betterment of the UoP, (ii) a restoration of the UoP, or (iii)

an adaptation of the UoP to a new or different use.

If a type of maintenance is a recurring activity that the taxpayer reasonably expects to perform as a

result of the taxpayer’s use of the UoP (other than a building or structural component of a building)

to keep the UoP in its ordinarily efficient operating condition, then the amount paid may qualify for

the routine maintenance safe harbor (discussed below).

Definition of Unit of Property

The Temporary Regulations provide that unless otherwise specified, the UoP is determined using a

functional interdependence standard, under which the placing in service of one component by the

taxpayer depends on the placing in service of the other component by the taxpayer. Special UoP

rules are provided for buildings, leased property, plant property, and network assets.

The Temporary Regulations also provide that a component of a UoP must be treated as a separate

UoP if that component (i) is properly treated as being within a different MACRS class (as determined

under IRC § 168(e)) than the class of the larger UoP, or (ii) has been properly depreciated using a

different depreciation method. This MACRS consistency rule applies during the placed in service

year of the asset and in future years (e.g., if the taxpayer completes a cost segregation study).

Building and its Structural Components

The Temporary Regulations define a building and its structural components as a single UoP, but

require that the improvement standards be applied separately to the building structure and the

following building systems:

Heating, ventilation, and air conditioning systems (HVAC);

Plumbing systems;

Electrical systems;

All escalators;

All elevators;

Fire protection and alarm systems;

Security systems;

Gas distribution systems; and

Any other structural component identified in published guidance.




Roof replacements are a common example used to illustrate the operation of the building UoP

rules. The work performed on the roof must be measured against the building structure (defined

as the building and its structural components, other than the building systems above) to determine

whether an improvement to the UoP occurs.

The requirement to apply the improvement standards to the building structure and building

systems is a significant change that will likely result in additional capitalizable improvements.

Taxpayers that previously categorized repair expenditures as deductible or capitalizable by

comparing work performed to the entire building should consider changing their method of

accounting to comply with the Temporary Regulations.

Plant Property

Plant property is "functionally interdependent machinery or equipment, other than network assets,

used to perform an industrial process, such as manufacturing, generation, warehousing, distribution,

automated materials handling in service industries, or similar activities."

The UoP for plant property is initially determined based on the functional interdependence standard.

However, the Temporary Regulations provide that functionally interdependent plant property is

further divided into smaller UoPs based on a component or a group of components that perform a

discrete and major function or operation.

The preamble to the Temporary Regulations states, ―The discrete and major function rule provides a

reasonable and administrable limitation on the functional interdependence standard, which

otherwise could be overly broad in its application to industrial equipment.‖


The discrete and major function standard often results in a UoP smaller than the taxpayer’s UoP

under its present method of accounting. This is particularly relevant for taxpayers whose

―industrial process‖ requires that a product move uninterrupted from one end of the production line

to another to produce a salable product. Taxpayers with functionally interdependent production

lines (e.g., aluminum milling or certain chemical manufacturers) often defined the entire line as the

UoP under prior law. Taxpayers with plant property that previously categorized repair

expenditures as deductible or capitalizable by comparing work performed to the entire production

line should consider changing their method of accounting to comply with the Temporary

Regulations.

Examples

Taxpayer uses many different machines in an assembly-line like process to treat, launder and

prepare linens. Because this equipment is plant property used in an industrial process, each sorter,

boiler, washer, dryer, etc. must be treated as a separate UoP.

Taxpayer, a restaurant, serves food to customers on its premises. The restaurant employs

equipment in an assembly-line like process to prepare and cook tortillas. Contrary to the example

above, because this equipment is property that is not used in an industrial process (i.e., it performs

a small-scale function in a restaurant), the UoP in this example is the tortilla making equipment

apparatus as a whole.



Network Assets

The Temporary Regulations provide that the UoP for network assets is determined by the

taxpayer’s particular facts and circumstances or as provided in published guidance (see e.g.,

Rev. Proc. 2011-27 for wireline network assets, Rev. Proc. 2011-28 for wireless networks assets

and Rev. Proc. 2011-43 for electric transmission and distribution property). It is anticipated that

the IRS will issue similar guidance for other industries with network assets (e.g., gas transmission

and distribution) in the coming year.

Leased Property

A taxpayer that is a lessor of a building or other non-building property applies the general rule for

determining the UoP and improvements. For a taxpayer that is a lessee of all or a portion of one or

more buildings, the UoP is each building and its structural components associated with the leased

portion of the building. Accordingly, a taxpayer-lessee must apply the improvement standards (as

discussed below) to the leased building or leased portion of the building and the related building

systems. Lessee improvement made to a unit of leased property is a separate UoP. For non-

building leased property, the general functional interdependence test applies except that the UoP

may not be larger than the unit of leased property.


The Temporary Regulations provide, for the first time, guidance for units of leased property.

Example

Taxpayer leases two office spaces in the same building under separate agreements. Each office

space contains a separate HVAC unit. The taxpayer must treat the HVAC unit associated with one

leased office space as a building system of that leased space and the HVAC unit associated with

the second leased office space as a building system of that second leased space.

Improvement Standards

Once a taxpayer has determined the appropriate UoP, the next step is to assess whether the

expenditure is an improvement to the UoP resulting in capitalization. As discussed above, an

amount is considered paid to improve a UoP if it results in: (i) a betterment of the UoP, (ii) a

restoration of the UoP, or (iii) an adaptation of the UoP to a new or different use. The Temporary

Regulations generally require a facts and circumstances analysis to determine whether an

expenditure is an improvement; however, the Temporary Regulations provide a conceptual

framework in applying the improvement standards including numerous examples. In applying the

standards, the Temporary Regulations provide that an amount is not necessarily deductible solely

because the repair is required to comply with regulatory requirements. Additionally, the Temporary

Regulations effectively replace the ―plan of rehabilitation doctrine‖ with the IRC § 263A ―directly

benefit or are incurred by reason of‖ standard.

Betterment

The Temporary Regulations provide that, in general, an amount paid results in a betterment of a

UoP if it:

Corrects a material condition or defect existing prior to the taxpayer’s acquisition of the UoP or

one that arose during the production of the UoP, whether or not the taxpayer was aware of the

condition or defect at the time of acquisition or production;

Results in a material addition to the UoP; or



Results in a material increase in capacity, productivity, efficiency, strength or quality of the UoP.

The Temporary Regulations provide an appropriate comparison rule instructing taxpayers how to

apply the betterment analysis. When a particular event necessitates the expenditure, the analysis is

performed by comparing the condition of the property after the expenditure with the condition of the

property immediately before the event. If an expenditure is necessitated by normal wear and tear,

the condition of the property after the expenditure is compared with the condition of the property

immediately after the last time the taxpayer corrected the effects of wear and tear.

In determining whether an expenditure results in a betterment, the purpose of the expenditure, the

physical nature of the work performed, the effect of the expenditure on the UoP, and the taxpayer’s

treatment of the expenditure on its AFS are all considered.


The betterment standard is highly factual, and combined with the revisions to certain UoP

definitions (discussed above), requires taxpayers to compare the repair cost against the UoP to

determine whether an amount paid results in a betterment to that UoP.

Three sequential examples in the Temporary Regulations (as summarized below) illustrate the

betterment standard, including the interplay of IRC § 263A (otherwise deductible amounts must be

capitalized if they directly benefit or are incurred by reason of an improvement to a UoP) by

analyzing the refresh and remodel of a chain of retail stores. In relevant part, the examples

conclude that the replacement of bathroom fixtures (e.g., sinks, toilets, etc.) results in a

capitalizable betterment to the plumbing system because the replacements result in material

increase in quality to the plumbing system.

Examples

Taxpayer owns a retail store and periodically refreshes the appearance and layout of its store by

replacing and reconfiguring a small number of display tables and racks, relocating lighting,

repairing floors, moving one wall to accommodate the reconfiguration of tables and racks and

repainting the interior structure. Assuming the work does not ameliorate any pre-existing material

conditions or defects, the amounts paid for the refresh of the building are not considered

betterments because they do not result in material increases in capacity, productivity, efficiency,

strength or quality of the building’s structure or building system compared to the condition before

the refresh. However, amounts paid to acquire and install each display table and rack (i.e. tangible

personal property) must be capitalized.

In the course of the store refresh, the taxpayer decides to update all the restroom facilities in the

building by removing the bathroom fixtures and replacing them with updated ones. The taxpayer

also pays amounts to replace floor and wall tiles that were damaged as a result of the installation

of the bathroom fixtures. Because the updated fixtures materially increase the quality of the

plumbing system of the building, the amounts paid to replace the fixtures are considered

betterments and must be capitalized. The replacement of floor and wall tiles must also be

capitalized because they directly benefit and are incurred by reason of the improvement to the

plumbing system.

If the taxpayer decides to substantially remodel the retail store by performing significant additional

work to alter the appearance and layout of its stores in order to increase customer traffic and sales

volume, then the amounts paid for the remodel result in betterments to the building’s structure and

system due to the increased efficiency as a result. In addition, the amounts paid to refresh the

appearance of the store (above) must also be capitalized because they directly benefit and are

incurred by reason of the remodel.



Restoration of Property

In general, the Temporary Regulations require the capitalization of amounts paid to restore a UoP.

For these purposes, restoration includes:

Replacing a component of a UoP if the taxpayer has properly deducted a loss for that

component (other than a casualty loss under Treas. Reg. § 1.165-7);

Replacing a component of a UoP if the taxpayer has properly taken into account the adjusted

basis of the component in realizing gain or loss from the sale or exchange of the component;

Repairing damage to a UoP for which the taxpayer has properly taken a basis adjustment as a

result of a casualty loss under IRC § 165, or relating to a casualty event described in IRC § 165;

Returning a property to its ordinarily efficient operating condition from a state of nonfunctional

disrepair;

Rebuilding the property to a like-new condition after the end of its class life;

Replacing a major component or substantial structural part of a UoP (where a major component

or substantial structural part includes a part or combination of parts that comprise a large portion

of the physical structure of the UoP or that perform a discrete and critical function in operation of

the UoP).


Basis recovery on the disposition of property is a critical component of the restoration improvement

standard. As a result, understanding the disposition rules (discussed below) is important for

making the appropriate asset account elections to maintain flexibility in determining whether to

claim a deduction for a retirement or for a repair.

Capitalizable restorations include an otherwise deductible repair when the taxpayer recovers

adjusted basis on the disposition of a replaced component or part. If a taxpayer has properly taken

a basis adjustment as a result of a casualty loss, or relating to a casualty event under IRC § 165,

then an amount paid to restore the damaged UoP is a capital expenditure. The impact of the

restoration improvement standard and the new disposition rules on casualty losses are further

discussed the disposition and General Asset Account section below.

Examples

Assume a taxpayer decides to replace several non-functional components of its walk-in freezer.

The taxpayer abandons the old freezer components and properly recognizes a loss from the

abandonment of the components. The taxpayer replaces the abandoned freezer components with

new components and incurs costs to acquire and install the new components. The costs to

acquire and install the replacement components are capitalized as a restoration because the

taxpayer replaced components for which it had properly deducted a loss.

Taxpayer owns an office building which has a HVAC system containing ten roof-mounted units,

controls and air ducts. Due to malfunction, the taxpayer replaces two of the roof-mounted units.

The two units do not comprise a large portion of the physical structure of the HVAC system or

perform a discrete and critical function in the operation of the system and therefore do not

constitute a major component or substantial structural part of the building system. The taxpayer

does not recover basis on the retirement of the two roof-mounted units. Accordingly, the taxpayer

is not required to treat the amount paid to replace the two units as a restoration of a building

system.



Adaption to New or Different Use

In general, a taxpayer must capitalize amounts paid to adapt a UoP to a new or different use. An

amount paid is considered for a new or different use if the adaptation is not consistent with the

taxpayer’s intended ordinary use of the UoP at the time originally placed in service by the taxpayer.

For example, the Temporary Regulations provide that in the case of a building, an amount is paid to

adapt the UoP to a new or different use if it adapts to a new or different use any of the properties

specifically designated in the Temporary Regulations (i.e., buildings, condominiums, cooperatives

and leased buildings).

Routine Maintenance Safe Harbor

A routine maintenance safe harbor is provided for routine and recurring activities that a taxpayer

expects to perform as a result of a taxpayer’s use of the property. The safe harbor is not applicable

to a building or its structural components or to certain rotables. An activity is considered recurring

only if at the time the property is placed in service the taxpayer reasonably expects to perform the

activity more than once during the Alternative Depreciation System (―ADS‖) class life of the UoP.

A taxpayer must take into consideration the recurring nature of the activity, industry practice,

manufacturers’ recommendations, the taxpayer’s experience and the taxpayer’s treatment of the

activity on its AFS when determining whether activities are considered routine maintenance. An

activity is not considered routine and recurring if it results in a betterment or adaptation, is performed

on property where a taxpayer has taken into account the adjusted basis of the property (e.g. by

claiming a loss), or if the property is in a state of nonfunctional disrepair prior to the expenditure.


The routine maintenance safe harbor effectively offers relief for certain expenditures that are

otherwise capitalizable as restorations. Thus, for example, the routine maintenance safe harbor

may allow a deductible repair for what was otherwise a replacement of a major component or

substantial structural part of a UoP (see definition of restoration above).

Examples

Aircraft engines undergo engine shop visits (―ESV‖) on a regular basis. Taxpayer performs ESV

during and after the class life of the aircraft. The costs associated with the ESV are deemed not to

improve the aircraft under the safe-harbor for routine maintenance because the ESV involved the

same routine maintenance activities (that also qualified under the safe harbor) that were performed

on the same aircraft engines during their class life.

Taxpayer replaced the lining of a container that constitutes 60% of the physical structure of the

container. These replacements occur on a regular basis throughout the life of the container.

Notwithstanding the substantial nature of the replacement, the costs qualify as repairs activities

under the routine maintenance safe harbor.

Dispositions of MACRS Property



Under the Temporary Regulations, a disposition occurs when ownership of the asset is transferred

or when the asset is permanently withdrawn from use. A disposition includes the sale, exchange,

retirement, physical abandonment, destruction of an asset or transfers of an asset to a supplies,

scrap, or similar account. In a significant change from prior law, the Temporary Regulations provide

that the retirement of a structural component of a building is a disposition of MACRS property.

Accordingly, the rules for accounting for assets to which IRC § 168 applies and determining the gain

or loss upon the disposition of the MACRS property are outlined in the Temporary Regulations.

Disposition of an Asset

The Temporary Regulations provide that the facts and circumstances of each disposition are

considered in determining the appropriate asset disposed. In general, the asset for disposition

purposes cannot be larger than the UoP. A taxpayer may generally use any reasonable, consistent

method to treat each of an asset’s components as the asset for disposition purposes unless

specifically described otherwise.

To maintain consistency with the UoP under the improvement standards, each structural component

of a building is the asset for disposition purposes. Under prior law, a taxpayer was precluded from

recovering basis on the disposal of a component of the building, yet was required to capitalize the

cost of the new replacement component. The new disposition rules work with the new restoration

rules to provide a more balanced approach. Under the Temporary Regulations, a taxpayer

generally recovers the adjusted basis of the disposed component, but must capitalize repair costs

for which the taxpayer has recovered the basis on the component of the UoP removed during the

repair.




The ability to dispose of a portion of a building is generally a taxpayer favorable provision intended

to alleviate certain inequities that existed in prior law (e.g., a taxpayer who replaced the roof on a

building was required to capitalize the new roof and also required to continue depreciating the old

roof over the remainder of the 39-year recovery period). Componentization of buildings for

purposes of dispositions allows taxpayers to accelerate the cost recovery of the retired building

component. As discussed above, the disposition rules significantly impact the operation of the

restoration improvement standard. The example highlights the relationship between the

restoration improvement standard and the revised disposition rules for structural components.

Example

On July 1, 2009, a calendar-year taxpayer, purchased and placed in service a multi-story office

building that costs $20,000,000. The cost of each structural component of the building was not

separately stated. Taxpayer accounts for the building in its records as a single asset with a cost of

$20,000,000. Taxpayer depreciates the building as nonresidential real property and uses the

straight-line method, a 39-year recovery period, and the mid-month convention.

On June 30, 2012, Taxpayer replaces one of the building’s elevators. Because Taxpayer cannot

identify the cost of the structural components of the office building from its records, Taxpayer uses

a reasonable method that is consistently applied to all of the structural components of the office

building to determine the cost of the elevator. Using this reasonable method, Taxpayer allocates

$150,000 of the $20,000,000 purchase price for the building to the retired elevator.

For Taxpayer’s 2012 Federal income tax return, loss for the retired elevator is the adjusted basis of

the retired elevator on the date of disposition. Using the straight-line method, a 39-year recovery

period, and the mid-month convention, the adjusted basis of the retired elevator on the date of

disposition is $138,782 (unadjusted depreciable basis of $150,000 less accumulated depreciation

allowed or allowable of $11,218 ( $150,000 x 35 months the asset is in service/ 468 total number

of months in the recovery period)). As a result, Taxpayer recognizes a loss of $138,782 for the

retired elevator in 2012, which is subject to IRC § 1231.

Because Taxpayer recognized a loss on the disposition of a structural component of a building, the

cost to replace the elevator is automatically capitalized as a restoration under

Temp. Reg. § 1.263(a)-3T(i)(1)(i).

General Asset Accounts

As an alternative to the general rule of depreciation is the election to use the general asset accounts

(―GAA‖). Under the Temporary Regulations, each GAA is effectively treated as the asset. However,

each GAA must include only assets that have the same depreciation method, recovery period,

convention and are placed-in-service in the same taxable year. Consistent with the expansion of the

definition of disposition of MACRS property, the retirement of a structural component of a building is

included in the definition of the disposition from a GAA and the same methods of identifying the

placed-in-service year of the asset disposed apply.

No loss is realized upon the disposition of an asset in a GAA. The disposed asset is treated as

having an adjusted depreciable basis of zero immediately before the disposition. Therefore, the

unadjusted depreciable basis and depreciation reserve of the GAA is unaffected by the disposition.

A taxpayer can elect to terminate GAA treatment for an asset in a GAA when the taxpayer disposes

of the asset in a qualifying disposition. The Temporary Regulations expand a qualifying disposition

to include generally any disposition (such as a structural component of a building) not involving all

assets or the last asset in the GAA.




Although a taxpayer is required to recognize the gain or loss on the disposition of structural

components of a building, the GAA election provides a taxpayer the flexibility to choose whether it

wants to recover basis on the disposition of the component and recover the related repair cost over

the life of the asset or forgo basis recovery on the disposition and currently deduct the replacement

costs as a repair (assuming the expenditure otherwise qualifies).

A taxpayer should also consider whether a GAA election is appropriate to reduce administrative

burden and protect its ability to deduct qualifying repair costs.

Example

Assume the same facts as the above example. If Taxpayer made a GAA election in the placed in

service year of the building, the subsequent removal of the elevator is not a disposition. Because

Taxpayer does not recover basis through a disposition, the restoration improvement rule does not

automatically characterize the replacement of the elevator as an improvement. Rather, Taxpayer

must evaluate the replacement of the elevator against the relevant building system (all of the

elevators) to determine if the replacement must be capitalized as a betterment, restoration, or

adaptation of the elevator building system.

Casualty Loss

The government received a number of comments regarding the treatment of expenditures following

a casualty event. A number of taxpayers have historically taken a casualty loss deduction under

IRC § 165 and deducted the costs to repair the damaged property under Treas. Reg. § 1.162-4.

Under the Temporary Regulations, the damaged part of a property is treated as retired, the basis

attributable to the damaged part is recovered, and the damaged part is restored or replaced. The

costs to restore or replace the portion of property for which the taxpayer has properly taken the basis

adjustment as a result of the casualty loss under IRC § 165 is treated as a capital expenditure.

The casualty loss rule does not limit a taxpayer’s ability to accelerate the recovery of the basis

attributable to the damaged property through the IRC § 165 loss provisions. Instead, it requires a

taxpayer to capitalize the costs of restoring the property, with recovery of such costs permitted

through depreciation over the proper recovery period. The Temporary Regulations permit taxpayers

(via the GAA election) to deduct qualifying expenditures as a repair under IRC § 162 rather than

recover basis as a casualty loss under IRC § 165 (thereby triggering the restoration capitalization

rule).

Transition Guidance – Revenue Procedures 2012-19 and 2012-20


Transition Guidance – Revenue

Procedures 2012-19 and 2012-20

General

On March 7, 2012, the IRS issued Rev. Proc. 2012-19 and Rev. Proc. 2012-20 (the ―Revenue

Procedures‖), which provide procedures for a taxpayer to obtain automatic consent of the

Commissioner to comply with the Temporary Regulations. The Revenue Procedures apply for

taxable years beginning on or after January 1, 2012. Accordingly, taxpayers may not early adopt the

provisions in the Temporary Regulations.

Complying with the Temporary Regulations generally requires a change in method of accounting

under IRC § 446. Method changes filed under the revenue procedures for a taxpayer’s first and

second tax year beginning after December 31, 2011, are not subject to the normal scope limitations

that apply to automatic method changes. Thus, for example, a taxpayer under examination is not

precluded from filing a method change to comply with the Temporary Regulations. Similarly, a

taxpayer that made a change for repairs in the prior five taxable years is not precluded from making

a change for the same items under the Revenue Procedures.

It is unlikely that a taxpayer’s present methods of accounting for tangible property are in full

compliance with the Temporary Regulations. Rev. Proc. 2012-19 provides guidance on obtaining

automatic consent for method changes related to repair and maintenance, materials and supplies,

capital expenditures, costs to acquire or produce tangible property or costs to improve tangible

property. Rev. Proc. 2012-20 provides guidance on obtaining automatic consent for method

changes related to depreciation, including single, mass or general asset accounts, as well as

dispositions of MACRS property.

Upon filing a change in method of accounting pursuant to the Revenue Procedures, a taxpayer

receives IRS audit protection on the treatment of such item for taxable years prior to the year of

change. Additionally, the back-year audit protection effectively stops the IRS from further examining

the issue covered by the Revenue Procedures. These changes can impact unrecognized tax

benefits for financial statement purposes.

IRC § 481(a) adjustment

In general, accounting method changes made pursuant to the Revenue Procedures are effectuated

with an IRC § 481(a) adjustment. However, for certain changes (e.g., materials and supplies, de

minimis rule, facilitative costs), the IRC § 481(a) adjustment is computed taking into account only

amounts paid or incurred in taxable years beginning on or after January 1, 2012. Additionally,

certain changes are made using a cut-off method (i.e., the new method is applied prospectively) or a

modified cut-off method (e.g., the unadjusted depreciable basis and the depreciation reserve for an

asset as of the beginning of the year of change are accounted for using the new accounting

method). The Revenue Procedures also expressly authorize the use of statistical sampling (using

the sampling methodologies described in Rev. Proc. 2011-42) to compute IRC § 481(a) adjustments

with respect to accounting method changes for certain items, and to support the item on a tax return

Transition Guidance – Revenue Procedures 2012-19 and 2012-20


(such items include, repair expenditures, materials and supplies, improvements, and certain

dispositions).


Rev. Proc. 2011-42 provides guidance on sampling plan standards, sampling documentation

standards and technical formulas used when applying statistical sampling to substantiate items on

the income tax returns.

Concurrent Method Changes

Rev. Proc. 2011-14 provides that certain method changes involving an IRC § 263A cost that was

previously excluded from capitalization must include a concurrent uniform capitalization (―UNICAP‖)

method change. As such, Rev. Proc. 2012-19 and Rev. Proc. 2012-20 generally allow a taxpayer to

make a concurrent UNICAP change when it makes a change to comply with the Temporary

Regulations.


The attached chart highlights certain aspects of the accounting method change procedures set

forth in Rev. Proc. 2012-19 and Rev. Proc. 2012-20.

Large Business and International Division Directive


Large Business and International

Division Directive

General

On March 15, 2012, the Large Business and International Division (―LB&I‖) at the IRS issued a

directive to discontinue any exam activity relating to positions taken on original returns for tax years

beginning before January 1, 2012, relating to—(1) whether costs incurred to maintain, replace, or

improve tangible property must be capitalized under IRC § 263(a); and (2) any correlative issues

involving the disposition of structural components of a building or tangible depreciable assets (other

than a building or its structural components).

The directive does not apply to current examination activity relating to costs for which the IRS

provided specific guidance separate from the Temporary Regulations (e.g., Rev. Procs. 2011-27,

2011-28, or 2011-43), or issues that do not address capitalization of costs under IRC § 263(a).

In addition to directing examiners to cease current exam activity, the directive instructs examiners:

Not to begin new exam activity with respect to the issues;

If the taxpayer has filed a method change on or after December 23, 2011, for a tax year before

the effective date of the Temporary Regulations, to assess and determine whether to review the

Form 3115;

For examination of tax years beginning on or after January 1, 2012 and before January 1, 2014,

to determine if Form 3115 is filed in accordance with the applicable guidance, and if so, to

perform the appropriate risk assessment; if no, and the scope limitation period has passed,

perform a risk assessment on the issue; and

For examination of tax years beginning on or after January 1, 2014, apply the guidance in effect,

and perform normal exam procedures.

Tangible Property Temporary Regulations Automatic Method Change Guidance

Automatic Method Change Guidance Chart 18

Tangible Property Temporary Regulations

Automatic Method Change Guidance

On March 7, 2012, the IRS issued Rev. Proc. 2012-19 and Rev. Proc. 2012-20, which provide the procedures for taxpayers to obtain automatic consent of the

Commissioner to comply with the tangible property Temporary Regulations. Rev. Proc. 2012-19 covers accounting method changes in Rev. Proc. 2011-14, App. §§

3.10-3.19 and §§ 10.08-10.10. Rev. Proc. 2012-20 covers accounting method changes in Rev. Proc. 2011-14, App. §§ 6.27-6.32. The following chart provides an

overview of the automatic method changes applicable to the Temporary Regulations.

For accounting method changes made pursuant to Rev. Procs. 2012-19 and 2012-20, the following general rules apply:

All changes have automatic consent under Rev. Proc. 2011-14;

The scope limitations under Section 4.02 of Rev. Proc. 2011-14 are waived for method changes filed for the taxpayer’s first or second taxable year beginning after

December 31, 2011;

The taxpayer may obtain audit protection for prior years with respect to the item for which the change is requested, provided the taxpayer timely files a copy of the

application with the national office, or if applicable the Ogden office, complies with the provisions of the applicable revenue procedures and complies with the

provisions of Rev. Proc. 2011-14;

For those items impacted by IRC § 263A, taxpayers who are not properly accounting for such items under IRC § 263A, the provisions of Rev. Procs. 2012-19 and

2012-20 are not available for such items, unless the taxpayer concurrently changes to a permissible UNICAP method under Appendix Section 11.01 or 11.02 of

Rev. Proc. 2011-14; and

A copy of the Form 3115 is to be filed with the Ogden, UT office in lieu of filing a copy with the national office.

The chart should be read together with ―Deconstructing the Tangible Property Temporary Regulations‖. The following chart provides a high level overview of the

automatic method changes available under Rev. Proc. 2012-19 and Rev. Proc. 2012-20.



Method Changes for Materials and Supplies

Rev. Proc.

2011-14

Appendix §

Item Being Changed Inapplicability IRC § 481(a) Adjustment

Rev. Proc.

2011-42

Statistical

Sampling

3.12

Change to deduct non-incidental

materials and supplies when used

or consumed

Does not apply to rotable or temporary spare parts

described in Treas. Reg. §1.162-3T(a)(3)

Yes, but includes only amounts paid

or incurred in tax years beginning

on or after 1/1/2012

Yes

3.13

Change to deduct incidental

materials and supplies when paid

or incurred




Yes

3.14

Change to deduct non-incidental

rotable and temporary spare parts

when disposed of




Yes

3.15 Change to the optional method for

rotable and temporary spare parts Yes Yes



Method Changes for Costs of Acquiring or Producing Tangible Property

Rev. Proc.

2011-14

Appendix §


Rev. Proc.

2011-42

Statistical

Sampling

3.16 Change to deduct dealer expenses

that facilitate the sale of property

Does not apply to—

Non-dealers in property; or

Liabilities incurred to facilitate the disposition of

assets that constitute a trade or business

Yes No

3.17 Change to apply the de minimis rule

under Treas. Reg. § 1.263(a)-2T(g)


Amounts paid for property that is or is intended

to be included in inventory;

Amounts paid for land; or

Start-up expenditures as defined in IRC §

195(c)(1)

Yes, but includes only amounts

paid or incurred in tax years

beginning on or after 1/1/2012

No

3.18

Change to deduct certain costs for

investigating or pursuing the

acquisition of real property

Does not apply to start-up expenditures as defined in

IRC § 195(c)(1)

Yes, but includes only amounts

paid or incurred in tax years

beginning on or after 1/1/2012

No

10.08

Change to capitalize non-dealer

expenses that facilitate the sale of

property


Dealers in property; or

Liabilities incurred to facilitate the disposition of

assets that constitute a trade or business

Yes No

10.09 Change to capitalize acquisition or

production costs Yes Yes



Method Changes for Improvements to Tangible Property

Rev. Proc.

2011-14

Appendix

§


Rev. Proc.

2011-42

Statistical

Sampling

3.10

Change to deduct repair and

maintenance costs/Change unit of

property definition for applying

improvement standards


A change in method of accounting for

dispositions of depreciable property, including a

change in the asset disposed of; or

Property for which a repair allowance election

under Treas. Reg. § 1.167(a)-11(d)(2) was made

Yes, but does not include any amount

attributable to property for which a

repair allowance election under Treas.

Reg. § 1.167(a)-11(d)(2) was made

Yes

3.11 Change to the regulatory accounting

method


A change in method of accounting for

dispositions of depreciable property, including a

change in the asset disposed of;


under Treas. Reg. § 1.167(a)-11(d)(2) was

made; or

Property not subject to regulatory accounting

rules




Reg. § 1.167(a)-11(d)(2) was made

Yes

3.19

Change to the safe harbor for routine

maintenance on property other than

buildings or structural components

thereof


A building; or

A structural component of a building

Yes Yes

10.10 Change to capitalize improvements to

tangible property

Does not apply for any—


under Treas. Reg. § 1.167(a)-11(d)(2) was

made; or

Change in method of accounting for dispositions

of depreciable property, including a change in

the asset disposed of




Reg. § 1.167(a)-11(d)(2) was made

Yes



Method Changes for Dispositions & Asset Accounts

Rev. Proc.

2011-14 Appendix

§


Rev. Proc.

2011-42 Statistical Sampling

6.27 Change for the depreciation or amortization of leasehold improvements

Yes No

6.28

Change in methods within single, multiple, or general asset accounts, including dispositions

Only applies to property that is:

Depreciated under IRC § 168;

Depreciated under a method permitted under Treas. Reg. §§ 1.168(i)-1T, 7T, or 8T; and

Owned by the taxpayer as of the beginning of the year of change

Depending on the change, made with:

An IRC § 481(a) adjustment;

Cut-off method; or

A modified cut-off method

No

6.29

Change in method of accounting for dispositions of buildings or structural components


Property that is not depreciated under IRC § 168;

Property for which the taxpayer made a valid general asset account election under IRC § 168(i)(4); or

Any multiple buildings, condominium units, or cooperative units that are treated or will be treated as a single building

Yes Yes

6.30

Change in method of accounting for dispositions of tangible depreciable assets (other than a building or its structural components)


Property that is not depreciated under IRC § 168;

Any building, condominium unit, cooperative unit, structural component, or improvement or addition thereto; or

Property for which the taxpayer made a valid general asset account election under IRC § 168(i)(4)

Yes Yes

6.31

Change in method of accounting for dispositions of tangible depreciable assets in a general asset account


Property that is not depreciated under IRC § 168; or

Property for which a valid general asset account election under IRC § 168(i)(4) was not made

Yes No

6.32 Change to make late general asset account elections

Does not apply to late general asset account elections made for any taxable year other than the taxpayer’s first or second taxable year beginning after 12/31/2011

Change made using a modified cut-off method if property is owned by taxpayer at the beginning of year of change

Change made with an IRC § 481(a) adjustment if property disposed of by taxpayer as of the beginning of year of change

No


Contacts

Jane Rohrs

Director

Federal Tax Accouting

Washington National Tax

Chuck Kosal

Principal

Strategic Tax Advisory Team

National Federal Tax Services

Tel: +1 202 370 2290

E-mail: [email protected]

Tel: +1 313 396 3604


Bob Kilinskis

Partner

Federal Tax Accounting

Washington National Tax

Tel: +1 312 486 9855


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summary of tangible property regulations

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definition of materials

temporary spare parts

new guidance

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certain amounts

treatment of materials

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