New Rules Provide Flexibility in Treatment of Replacement Costs for Building Components

December 18, 2012

Generally, taxpayers are permitted to deduct currently (or “expense”) the cost of repairs to property, but must capitalize the costs of capital improvements to property and recover those costs over the applicable recovery period under the depreciation rules.

Recent temporary regulations change the “unit of property” in the case of buildings, by designating the major structural components of a building (roof, floors, walls, doors, windows, ceilings and building and building systems as defined in the regulations, including HVAC, plumbing, electrical systems, etc.) as the “units of property” with respect to which the repair/improvement determination must be made.

Having smaller units of property generally makes it more likely that a replacement will be considered an improvement as opposed to a repair, and therefore that the cost will have to be capitalized and depreciated instead of being expensed (deducted) in the year the replacement is placed in service.  For example, a new roof would likely have qualified as a repair under prior rules, but under the temporary regulations would likely have to be capitalized.

But the increase in the number of units of property with respect to a building in conjunction with the temporary regulations’ expansion of the definition of “qualifying dispositions,” permits (actually, requires) a taxpayer to recognize a loss on the replacement of a structural component.  Under the prior rules, if the taxpayer replaced a structural component of a building, the taxpayer did not recognize a loss on the component and continued to depreciate the component even after it was destroyed or transferred to scrap. The taxpayer began to depreciate the replacement structural component.

Now that the disposition of a structural component (or a component of a structural component defined as an asset by the taxpayer) is a qualifying distribution, the taxpayer claims a loss on the disposition.  Because the taxpayer claims a loss on the replaced asset, the taxpayer may not treat the cost of the replacement asset as a repair, even if it would otherwise qualify as a repair. If the cost of the replacement asset exceeds the undepreciated basis of the replaced asset, this is not the optimal result.

If, however, the taxpayer has elected to place the building in a general asset account, the default rule is no loss, which the taxpayer can follow for assets for which a repair deduction is available.  If the expenditure must be capitalized regardless of whether a loss is claimed, the taxpayer can elect to claim the loss.  Thus, maximum flexibility is obtained by placing the building in a general asset account.

Example.  If a taxpayer replaces a roof, it must recognize a loss unless the building is in a general asset account and the taxpayer elects not to recognize a loss.  If the taxpayer recognizes a loss, the loss is equal to the taxpayer’s adjusted depreciable basis in the roof (determined under any reasonable method).  If the building is in a general asset account, absent an election, taxpayer does not recognize the loss and continues to depreciate the replaced roof.  Regardless of whether the taxpayer recognizes the loss, it must capitalize the cost of the replacement roof because the roof is a substantial structural part of the building. Therefore, the taxpayer is likely to elect to recognize the loss.

On the other hand, if the taxpayer treated various components of the roof as assets, and the replacement was of less than a substantial structural part, the taxpayer could choose not to elect to recognize the loss (because the building is in a general asset account) and could expense the replacement as a repair.

The IRS announced on November 20, 2012 that final regulations will be released in 2013 and will be effective for tax years beginning on or after January 1, 2014.  The IRS, however, will permit taxpayers to apply the temporary regulations for tax years beginning on or after January 1, 2012.  If a taxpayer does adopt the methods set out in the temporary regulations, the taxpayer may need to file a second accounting method change after the final regulations are released for areas where the final regulations vary from the temporary regulations.