Summary of Tangible Property Regulations

Deconstructing the Tangible
Property Temporary
Regulations
Understanding how the new
guidance may affect your
company

March 2012

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

Deconstructing the Tangible Property Temporary Regulations 1

Overview

Overview

On December 27, 2011, the Treasury Department (―Treasury‖) and the Internal Revenue
Service (―IRS‖) issued temporary 1 and proposed 2 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‖ 3); 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 Deconstructing the Tangible Property Temporary Regulations 2
3 73 FR 47 12838-01

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


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.

Automatic Method Change Guidance Chart 18


Method Changes for Materials and Supplies
Rev. Proc.
Rev. Proc.
2011-42
2011-14 Item Being Changed Inapplicability IRC § 481(a) Adjustment
Statistical
Appendix §
Sampling

Change to deduct non-incidental Yes, but includes only amounts paid
Does not apply to rotable or temporary spare parts
3.12 materials and supplies when used or incurred in tax years beginning Yes
described in Treas. Reg. §1.162-3T(a)(3)
or consumed on or after 1/1/2012

Change to deduct incidental Yes, but includes only amounts paid
3.13 materials and supplies when paid or incurred in tax years beginning Yes
or incurred on or after 1/1/2012

Change to deduct non-incidental Yes, but includes only amounts paid
3.14 rotable and temporary spare parts or incurred in tax years beginning Yes
when disposed of on or after 1/1/2012

Change to the optional method for
3.15 Yes Yes
rotable and temporary spare parts



Method Changes for Costs of Acquiring or Producing Tangible Property
Rev. Proc.
Rev. Proc.
2011-42
2011-14 Item Being Changed Inapplicability IRC § 481(a) Adjustment
Statistical
Appendix §
Sampling

Does not apply to—
Change to deduct dealer expenses  Non-dealers in property; or
3.16 Yes No
that facilitate the sale of property
 Liabilities incurred to facilitate the disposition of
assets that constitute a trade or business

 Amounts paid for property that is or is intended
Yes, but includes only amounts
Change to apply the de minimis rule to be included in inventory;
3.17 paid or incurred in tax years No
under Treas. Reg. § 1.263(a)-2T(g)
 Amounts paid for land; or beginning on or after 1/1/2012
 Start-up expenditures as defined in IRC §
195(c)(1)

Change to deduct certain costs for Yes, but includes only amounts
Does not apply to start-up expenditures as defined in
3.18 investigating or pursuing the paid or incurred in tax years No
IRC § 195(c)(1)
acquisition of real property beginning on or after 1/1/2012

Change to capitalize non-dealer
10.08 expenses that facilitate the sale of  Dealers in property; or Yes No
property  Liabilities incurred to facilitate the disposition of
assets that constitute a trade or business

Change to capitalize acquisition or
10.09 Yes Yes
production costs



Method Changes for Improvements to Tangible Property
Rev. Proc. Rev. Proc.
2011-14 2011-42
Item Being Changed Inapplicability IRC § 481(a) Adjustment
Appendix Statistical
§ Sampling
Change to deduct repair and  A change in method of accounting for Yes, but does not include any amount
maintenance costs/Change unit of dispositions of depreciable property, including a attributable to property for which a
3.10 Yes
property definition for applying change in the asset disposed of; or repair allowance election under Treas.
improvement standards Reg. § 1.167(a)-11(d)(2) was made
 Property for which a repair allowance election
under Treas. Reg. § 1.167(a)-11(d)(2) was made


 A change in method of accounting for
dispositions of depreciable property, including a
Yes, but does not include any amount
change in the asset disposed of;
Change to the regulatory accounting attributable to property for which a
3.11 Yes
method  Property for which a repair allowance election repair allowance election under Treas.
under Treas. Reg. § 1.167(a)-11(d)(2) was Reg. § 1.167(a)-11(d)(2) was made
made; or

 Property not subject to regulatory accounting
rules

Change to the safe harbor for routine Does not apply to—
maintenance on property other than
3.19  A building; or Yes Yes
buildings or structural components
thereof  A structural component of a building

Does not apply for any—

 Property for which a repair allowance election Yes, but does not include any amount
Change to capitalize improvements to under Treas. Reg. § 1.167(a)-11(d)(2) was attributable to property for which a
10.10 made; or Yes
tangible property repair allowance election under Treas.
 Change in method of accounting for dispositions Reg. § 1.167(a)-11(d)(2) was made
of depreciable property, including a change in
the asset disposed of



Method Changes for Dispositions & Asset Accounts
Rev. Rev.
Proc. Proc.
2011-14 Item Being Changed Inapplicability IRC § 481(a) Adjustment 2011-42
Appendix Statistical
§ Sampling
Change for the depreciation
6.27 or amortization of leasehold Yes No
improvements
Only applies to property that is:
Change in methods within
 Depreciated under IRC § 168; Depending on the change, made with:
single, multiple, or general
 Depreciated under a method permitted under Treas. Reg.  An IRC § 481(a) adjustment;
6.28 asset accounts, including No
§§ 1.168(i)-1T, 7T, or 8T; and  Cut-off method; or
dispositions
 Owned by the taxpayer as of the beginning of the year of  A modified cut-off method
change
Change in method of
 Property that is not depreciated under IRC § 168;
accounting for dispositions
 Property for which the taxpayer made a valid general
6.29 of buildings or structural Yes Yes
asset account election under IRC § 168(i)(4); or
components
 Any multiple buildings, condominium units, or cooperative
units that are treated or will be treated as a single building
Change in method of
 Property that is not depreciated under IRC § 168;
accounting for dispositions
 Any building, condominium unit, cooperative unit,
of tangible depreciable
6.30 structural component, or improvement or addition thereto; Yes Yes
assets (other than a building
or
or its structural components)
 Property for which the taxpayer made a valid general
asset account election under IRC § 168(i)(4)
Change in method of
accounting for dispositions Does not apply to—
of tangible depreciable  Property that is not depreciated under IRC § 168; or
6.31 Yes No
assets in a general asset  Property for which a valid general asset account election
account under IRC § 168(i)(4) was not made

 Change made using a modified cut-off
method if property is owned by
Does not apply to late general asset account elections made taxpayer at the beginning of year of
Change to make late general
for any taxable year other than the taxpayer’s first or second change
6.32 asset account elections No
taxable year beginning after 12/31/2011  Change made with an IRC § 481(a)
adjustment if property disposed of by
taxpayer as of the beginning of year of
change


Contacts

Jane Rohrs Chuck Kosal
Director Principal
Federal Tax Accouting Strategic Tax Advisory Team
Washington National Tax National Federal Tax Services

Tel: +1 202 370 2290 Tel: +1 313 396 3604
E-mail: jrohrs@deloitte.com E-mail: ckosal@deloitte.com

Bob Kilinskis
Partner
Federal Tax Accounting
Washington National Tax

Tel: +1 312 486 9855
E-mail: rkilinskis@deloitte.com

This document contains general information only and Deloitte is not, by means of this document, rendering accounting, business,
financial, investment, legal, tax, or other professional advice or services. This document is not a substitute for such professional advice
or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or
taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for
any loss sustained by any person who relies on this document.

About Deloitte
Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of
member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description
of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Please see www.deloitte.com/us/about for a detailed
description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the
rules and regulations of public accounting.

Deloitte provides audit, tax, consulting, and financial advisory services to public and private clients spanning multiple industries. With a
globally connected network of member firms in more than 150 countries, Deloitte brings world-class capabilities and high-quality service
to clients, delivering the insights they need to address their most complex business challenges. Deloitte’s approximately 182,000
professionals are committed to becoming the standard of excellence.

Copyright © 2012 Deloitte Development LLC. All rights reserved.
Member of Deloitte Touche Tohmatsu Limited Automatic Method Change Guidance Chart 23

Summary of Tangible Property Regulations

Recommended

Recommended

More Related Content

Viewers also liked

Viewers also liked (16)

Similar to Summary of Tangible Property Regulations

Similar to Summary of Tangible Property Regulations (20)

Summary of Tangible Property Regulations