Learn about the new capitalization regulations including the additional safe harbor elections for small taxpayers and the obsolescence of rehabilitation doctrine - O'Connor Davies CPA - New York CPA Firm

1. Tax Notes Newsletter
New Capitalization Regulations-Additional Safe
Harbor and Rehabilitation Rules
By Leo Parmegiani, Partner
In our October 2013 newsletter, we provided an overview and covered the highlights of the
newly-issued final regulations on amounts paid to acquire, produce or improve tangible
property (Cap Regs). In the December issue we focused on the de minimis safe harbor rules.
This article focuses on the “obsolescence” of the judicially-created plan of rehabilitation
doctrine that required taxpayers to capitalize otherwise deductible repair or maintenance
(R&M) costs if incurred as part of an overall general plan of rehabilitation, modernization or
improvement. We also cover the new safe harbor election for improvements to buildings as
long as the eligible property does not exceed the lesser of two percent (2%) of the property’s
unadjusted basis or $10,000.
Obsolescence of Rehabilitation Doctrine
The final regulations state that indirect costs, such as R&M, that do not directly benefit and
are not incurred by reason of the improvement are not required to be capitalized. These
costs can be expensed even though they are incurred at the same time as an overall
improvement to the property. Similarly, the final regulations provide that removal costs may
or may not be deductible dependent upon whether the cost directly benefitted or was
incurred by reason of an improvement. These final rules are in stark contrast to judicial
history.
Example (1): Y owns a building in which it conducts its retail business. The roof
over Y's building is covered with shingles. Over time, the shingles begin to wear
and Y begins to experience leaks. However, the building still functions in Y's
business. To eliminate the problems, Y pays a contractor to replace the old
shingles with new but comparable shingles to correct the leakage problems.
The amounts paid to remove the shingles are not required to be capitalized
because they directly benefit and are incurred by reason of repair or
maintenance to the building structure.
Example (2): X owns a factory building with a storage area on the second floor.
X pays an amount to remove the original columns and girders supporting the
second floor and replace them with new columns and girders with a gross
weight 50 percent greater than the previous load-carrying capacity. The
amount paid to remove the columns and girders must be capitalized as a cost
of the improvement, because it directly benefits and is incurred by reason of
the improvement to the building.
Example (3): Z (a trucking company) replaces the existing engine, cab and
petroleum tank of one of its trucks with a new engine, cab and tank. At the
same time, it paints the new cab with its company logo. The paint job must be
capitalized along with the cost of the new engine, cab and tank since the need
to paint the logo arose from the replacement of the cab. The paint expense
directly benefits and is incurred by reason of the replacement of the major
Leo Parmegiani
Partner
lparmegiani@odpkf.com
212.267-8000

2. components of the truck.
Example (4): Z also takes a truck out of service to overhaul its engine. During
the overhaul, the truck's broken taillights are replaced and tears in the driver's
seat are mended. These expenses are deductible as repairs even though
undertaken at the same time the engine is being overhauled. Under the now
obsolete rehabilitation doctrine, these expenses would have been capitalized.
Per Building Safe Harbor Election for Small Taxpayers
Qualifying “small” taxpayers may elect to not capitalize an eligible building's improvements if
the total amount paid during the tax year for repairs, maintenance and improvements
performed on "eligible property" does not exceed the lesser of two percent (2%) of the
building's unadjusted basis of the property, or $10,000.
Small Taxpayer – means a taxpayer whose average annual gross receipts for
the three preceding taxable years is less than or equal to $10 million. If a
taxpayer has been in existence for less than three years, the taxpayer
determines its average annual gross receipts for the number of taxable years
(including short taxable years) that the taxpayer (or its predecessor) has been
in existence.
Eligible Building Property – refers to each unit of property (generally "the
building") that has an unadjusted basis of $1 million or less.
Time and manner of election – A taxpayer makes this election by attaching a
statement to the taxpayer’s timely-filed original Federal tax return for the year
in which amounts are paid for repairs, maintenance and improvements. The
statement must be titled, “Section 1.263(a)-3(h) Safe Harbor Election for Small
Taxpayers” and include the taxpayer’s name, address, taxpayer identification
number and a description of each eligible building property to which the
taxpaper is applying the election.
Safe harbor exceeded – If total amounts paid by a qualifying taxpayer during
the taxable year for repairs, maintenance and similar activities performed on
an eligible building property exceed the safe harbor limitations, then the safe
harbor election is not available for that eligible building property.
Illustrations
Illustration A
Safe harbor for small taxpayers applicable. A is a qualifying taxpayer that owns
a building in which A provides consulting services. In Year 1, A’s building has an
unadjusted basis of $750,000. In Year 1, A pays $5,500 for repairs and
improvements to the office building.
Because A's building has an unadjusted basis of $1 million or less, it constitutes
eligible building property. The aggregate amount paid by A during Year 1 for
repairs and maintenance, does not exceed the lesser of $15,000 (2 percent of
the building's unadjusted basis of $750,000) or $10,000. Therefore, A may elect
to not apply the capitalization rule and treat these items as deductible ordinary
and necessary expenses.
Safe harbor for small taxpayers inapplicable. Assume the same facts as
Illustration A, except that A pays $10,500 for repairs and improvements.
Because this amount exceeds $10,000, the lesser of the two limitations, A may
not apply the safe harbor for small taxpayers. A must apply the general
improvement rules and must capitalize the $10,500.
Illustration B
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3. Safe harbor applied building-by-building. B is a qualifying taxpayer that owns
two rental properties; Building M and Building N. Building M and Building N are
both multi-family residential buildings. In Year 1, each property has an
unadjusted basis of $300,000. Because Building M and Building N each have an
unadjusted basis of $1 million or less, they both each constitute eligible
building property. In Year 1, B pays $5,000 for repairs, maintenance and
improvements performed on Building M. In Year 1, B also pays $7,000 for
repairs, maintenance and improvements performed on Building N.
Building M
The total amount paid by B in Year 1 on Building M ($5,000) does not exceed
the lesser of $6,000 (2 percent of the building's unadjusted basis of $300,000)
or $10,000. Therefore, B may elect to not apply the capitalization rule. If B
properly makes the election and the amounts otherwise constitute deductible
ordinary and necessary expenses, B may deduct these amounts.
Building N
The total amount paid by B during Year 1 for repairs, maintenance and
improvements on Building N ($7,000) exceeds $6,000 (2 percent of the
building's unadjusted basis of $300,000), the lesser of the two limitations.
Therefore, B may not apply the safe harbor to the total amounts paid for
Building N. Instead, B must apply the general improvement rules to determine
which of the total amounts paid for work performed on Building N are for
improvements and must be capitalized.
* * *
In future newsletters, we will cover the general capitalization rules and the tax treatment of
facilitative costs and material and supplies. We will also cover the procedures to request a
change in accounting method as required by the final regulations.
If you have any questions, please contact Leo Parmegiani at lparmegiani@odpkf.com or your
PKF O'Connor Davies tax advisor.
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