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Capitalize, Amortize or Deduct Adjusting for a New Recipe (263(a))

Capitalize, Amortize or Deduct Adjusting for a New Recipe (263(a)). Cameron L. Hess, CPA, Esq. Wagner Kirkman Blaine Klomparens & Youmans LLP Sacramento Walnut Creek chess@wkblaw.com (916) 920-5286. Review of 263(a). 9/19/2013 . Final R egs. (2103-13 IRB 331)

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Capitalize, Amortize or Deduct Adjusting for a New Recipe (263(a))

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  1. Capitalize, Amortize or Deduct Adjusting for aNew Recipe (263(a)) Cameron L. Hess, CPA, Esq. Wagner Kirkman Blaine Klomparens & Youmans LLP Sacramento Walnut Creek chess@wkblaw.com (916) 920-5286

  2. Review of 263(a) • 9/19/2013. Final Regs. (2103-13 IRB 331) • Effective 1/1/2014 • 64 pages, including preamble. WKBK&Y 1066733 C. Hess 916-920-5286

  3. Review of 263(a) • Why Important: Shifted the way we divide capitalizing improvements from repair deductions • “New” Concepts • Unit of Property (from Domestic Production Ded’n) • Building Systems WKBK&Y 1066733 C. Hess 916-920-5286

  4. Final 263 Regulations - Overview • Replacing a • Major Component (MP) or • Substantial Structural Part (SSP) usually means capitalization. WKBK&Y 1066733 C. Hess 916-920-5286

  5. Not Improvements – Safe Harbors • De Minimis Safe Harbor (“f”) election • Routine Maintenance (1.263(a)-3(i)) • Small Taxpayer Expenditures (“h”) election WKBK&Y 1066733 C. Hess 916-920-5286

  6. New De Minimis Rule • De Minimis Election • 1.263(a)-1(f): • Optional • Annual election: if elect, covers year’s purchases • Be consistent (financial statements/books) • Apply items on invoice-by-invoice basis. • Not for inventory, land, rotables WKBK&Y 1066733 C. Hess 916-920-5286

  7. New De Minimis Rule • Two Types: • “AFS” • “applicable financial statement” = FS for SEC, gov’t agency, general audit (attest) • $5,000 limit • Witten accounting policy at beginning of yearrequired • “No AFS” – Notice 2015-82 • $2,500 limit ($200 materials/supplies) • Taxpayer must adopt a “policy”, but it need not be written WKBK&Y 1066733 C. Hess 916-920-5286

  8. Not Improvements – Safe Harbors • Routine Maintenance (1.263(a)-3(i)) • Do more than once every 10 years. • Escalator hand rails (4/yrs), HVAC maint. (4./yrs) (repl. condenser). • Allowable for rotables. WKBK&Y 1066733 C. Hess 916-920-5286

  9. Fun Test: Routine Maintenance • Raj Wolowitz Apartments. Owner forgot to certify his elevator. It has not been working for 3 years. Maintenance is usually in 3 year cycles. • Sheldon Cooper complains to Penny, his manager. She gets Raj to do maintenance for $1,100 and to pay a $100 inspection fee. • According Example 12, the $1,100 paid probably is: a) deductible (repair) or b) capitalized. WKBK&Y 1066733 C. Hess 916-920-5286

  10. Not Improvements – Safe Harbors • Small taxpayers expenditures (1.263(a)-3(h) • Ave Gross Receipts < $10 Million (See Rev. Proc. 2002-28) • Un adjusted basis </= $1 million • Total repair/improvements = lesser of: • 2% of unadjusted basis • $10,000/building • All repairs/improvements lumped in for $10K limit WKBK&Y 1066733 C. Hess 916-920-5286

  11. Not Improvements – Safe Harbors • $10 Million Ave Gross Receipts Limit • All sources • Can deduct returns & allowances • Can exclude sales tax (if buyer imposed) – CA. • 3 Prior Year (shorter if < 3 years operating) • Annual election • If elect, but exceeds > $10K, only disqualified for that building WKBK&Y 1066733 C. Hess 916-920-5286

  12. Partial Disposition Election • 1.168(i)-8(d). • If capitalize an improvement, then taxpayer may election to write-off part of existing asset disposed of. • Example: Remodel pool in 2012 – pipe breaks, must do 2nd remodel in 2015. • No form of election required: “Just do it.” WKBK&Y 1066733 C. Hess 916-920-5286

  13. Unit of Property - Building • Buildings: IRS Takes “Split” Approach • Whole Building: Systems = parts of buildings). • Identify 9 common “systems” in buildings • Systems are NOT a Unit of Property; but decide capital improvement at a systems level. • Tenant: Tenant’s Unit – 1 Unit (unless divisions) • Condo/Co-op: (Each Unit = 1 Unit) WKBK&Y 1066733 C. Hess 916-920-5286

  14. Unit of Property - Building • Building systems (examples): • HVAC (heat, ventilation, and A.C.); • Plumbing • electrical systems; • Escalators and elevators; • fire protection, • alarm, security systems; • gas distribution systems; and • other systems identified in published guidance. WKBK&Y 1066733 C. Hess 916-920-5286

  15. Examples • Betterments – Major Component • Gas Stations. New tanks have leak detection. • Sprinkler System. New fire system • 100% Remodel. • All hotel bathrooms over 4 years (including furnishing replaced). • All flooring of public areas of hotel. (b/c not refreshment) WKBK&Y 1066733 C. Hess 916-920-5286

  16. Examples • Not Betterments • Replace 100 of 300 damaged exterior windows • Replace 4 of 10 old sinks (40%) • Replace Top Layer of “Roof” • M = Owner, replaces entire “membrane” (top layer). • Remove “drop ceiling” – paint exposed ducts. • Replace 2 of 10 roof-top worn HVAC systems, even if better! WKBK&Y 1066733 C. Hess 916-920-5286

  17. Fun Problems • The roof leaks. Out of 10 units, 3 are most affected. Just over the 3 units is membrane and 12 sheets of plywood are replaced. • Is this a repair? • Is this an improvement? • Tsakapoulous. • Would the result be different if the whole membrane was replaced, but not the plywood? WKBK&Y 1066733 C. Hess 916-920-5286

  18. Fun Problems • A’s office building (leased) has: • 10 A/C Units, each separately piped. • How many HVAC systems are there? i) 1 or ii) 10. • 1.263(a)-3(e)(2)(ii)(v)(B)(6), Example 1 • 2 banks of 3 lifts (6 total) and two escalators • How many systems are there: i) 1, ii) 2, iii) 3, iii) 7, iv) 8 • Example 2 • Tenant leases 2 Units, each w/ separate A/Cs • How many systems does tenant have: i) 1 or ii) 2. • Example 13 WKBK&Y 1066733 C. Hess 916-920-5286

  19. Purchases/Acquisition Costs • 1.263(a)-2. Basic Rule: Capitalize: • purchases, • build or create an improvement • Pre-development (Von-Lusk T.C. (1995) entitlements) • Repairs before placed in service • Acquisition costs (broker/attorney fees) • Defend/protect title WKBK&Y 1066733 C. Hess 916-920-5286

  20. Not Changed • Section 263A • Capitalization for property produced by taxpayer • Real or personal property (e.g., costs to perfect title) • Capitalization of property acquired for resale • Section 162 • Materials & supplies (under 1.163-3) WKBK&Y 1066733 C. Hess 916-920-5286

  21. Deductible Repairs/Maintenance • Examples (Deductible) 1. T undertakes an asbestos abatement project to remove and replace insulation. The removal does not improve insulation efficiency. 2. T does “Cosmetic” refreshing (minor improvement): • Hotel lobby floor changed (not whole hotel floor); • Retail store shelving changed (no greater storage). • IRS conceding some small cases. WKBK&Y 1066733 C. Hess 916-920-5286

  22. Retirement (New!) • New but it depends: • Before: Roof replaced = no deduction until whole building disposed. (IRC Section 168). • New: Replace part of a system/component: • If repair, may elect instead: • New basis capitalized • Old basis deducted (Section 1250/1231 loss) • Note: Enhances doing cost segregation studies. (still Section 1250 property.) WKBK&Y 1066733 C. Hess 916-920-5286

  23. Retirement (New!) 1.263(a)-3 • Cost of removal: • If not part of major replacement can deduct, rather than capitalize • If for major replacement, must capitalize • Example 30 – elevator. 1 of 4 retired/replaced • Option 1: No cost segmentation of old elevator, but can write-off replacement (not major replacement) • Option 2: Write-off old; capitalize new. WKBK&Y 1066733 C. Hess 916-920-5286

  24. Practical Steps • Spreadsheet – Accountant’s Best Friend • Purchases. WKBK&Y 1066733 C. Hess 916-920-5286

  25. Acquisition Costs • Legal Fees to Purchase • ALTA Survey Costs • Broker Fees (Paid by Buyer) • Deed Preparation WKBK&Y 1066733 C. Hess 916-920-5286

  26. Write It Off! – Failed Purchase • Can Write-off All Costs if a Failed Purchase (Section 165) – Rev. Rul. 79-346; Rev. Rul. 74-104. • General investigation costs – access to Zillow premium; investor subscriptions. WKBK&Y 1066733 C. Hess 916-920-5286

  27. Write It Off! – Bad Purchase • Obsolescence • Abandonment – Throw away; quit rights • Worthless -- No prospect of future value. Must show event. (softer standard) WKBK&Y 1066733 C. Hess 916-920-5286

  28. Write It Off! - Formation Costs • Section 195 – form New Entity • $5,000 – when formed • Amortize balance over 15-Years WKBK&Y 1066733 C. Hess 916-920-5286

  29. C.H. DeCou (1994) 103 TC 80 • Bought 3 bad buildings – thought could repair. • Discovered Repairs 150%-200% > Replace. (100% Rotted; raw sewage below building) • Court: 1.167(a)-8; Notice 90-21. • Usefulness “Suddenly and unexpectedly terminated” • 280B – Capitalization of demolished structure NOT required. • (Compare Linden Gates v. US (1998)– not sudden & unexpected) – abandoned school building. WKBK&Y 1066733 C. Hess 916-920-5286

  30. Tucker v. Com’r (11th Cir. 2016) • T owned Paragon Homes Corp – S Corp • Paragon: 13 Land Projects – 2008: Loans > FMV • 2008: Great Recession. Took $8.9 million in worthlessness loss. Closed office. • 2009/2010: But, sold lots (3)/built homes (2). • T’s expert witness: lots had “value”/desirable. • Court: No 165 Loss • Not a casualty loss. • Not proven that abandoned/worthless WKBK&Y 1066733 C. Hess 916-920-5286

  31. Hurricane Harvey • Casualty Loss – Section 165 – Demolition of Structure after hurricane or other disaster not subject to Section 280B capitalization to Land. WKBK&Y 1066733 C. Hess 916-920-5286

  32. Remodeling • Rev. Proc. 95-27. Partial Demolition • Capitalize to building • Continue to depreciate (when available for use) • Not subject to 280B. • Same: (i) Certified rehabilitation of historic structure or (ii) 1936 structure (75/75 rule.) WKBK&Y 1066733 C. Hess 916-920-5286

  33. Property Taxes & Interest • 164 Property Taxes • Deduct (not if purchase price credit) • Option to capitalize to unimproved land • Not subject to 280B. • 163 Interest • Special rules during construction • Generally deduct • OID Rules – Seller Carryback – may classify part of purchase price as interest expense. WKBK&Y 1066733 C. Hess 916-920-5286

  34. Construction Projects • Section 1012/263A • Must capitalize during construction • Rules may supersede 263(a) • Capitalize direct/indirect costs during production period: • Interest (avoided cost method) • Taxes • Insurance • Amortized loan fees • Production period – commence/end – regulations prescribe (example – per lot, ends if sufficient pause) WKBK&Y 1066733 C. Hess 916-920-5286

  35. Subdivision Development • Basic Rules • Capitalize direct/indirect costs during construction • Allocate community expenses to all lots ratably • 461(h): Expense not part of basis until paid. • Problem –Community expenses done in stages. e.g., club house not begun until ½ way done. • Alternative Cost Method (Rev. Proc. 92-29) • Allows greater allocation to earlier sold (completed) homes than otherwise allowed. WKBK&Y 1066733 C. Hess 916-920-5286

  36. Alternative Cost Method • Developer allocates expenses to bases of lots using “estimate” of community costs. • Limit: For lots sold, total community costs allocated to lots sold cannot exceed actual spent community costs. WKBK&Y 1066733 C. Hess 916-920-5286

  37. Alternative Cost Method • Example: John will build 10 houses. Community costs (streets, lighting) total $400,000. John elects Alternate Cost Method under Rev. Proc. 92-29. • Year 1. Sold 4; spent $200,000 common costs • Year 1. Allowed costs added to basis. Lesser of: • $40,000/per home x 4 = $160,000 • $200,000 • $160,000 of expenditures is treated as added to basis to reduce gain on sale. WKBK&Y 1066733 C. Hess 916-920-5286

  38. Alternative Cost Method • Note. (Example: If not elected, John would have only been allowed $80,000 [4 X ($200,000 spent X 10%)]. • Election • Due 1st year of sale – by return/extension date • Elect separately for each project; • Election:(i) separately file + (ii) copy with return. • Required information: Taxpayer, EIN, where filing, description, expense schedules, declaration – Statue of Limitations waiver Form 921. • Annual statements required. WKBK&Y 1066733 C. Hess 916-920-5286

  39. Thank You • Cameron L. Hess chess@wkblaw.com Wagner Kirkman Blaine Klomparens & Youmans LLP (916) 920-5286 WKBK&Y 1066733 C. Hess 916-920-5286

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