Managing Capitalization and Expense Depreciation
PRESENTED BY:
› TRACY MONROE, CPA, MT, PARTNER
› LISA LOYCHIK, CPA, PARTNER
› JON WILLIAMSON, CPA, MT, MANAGER
July 10, 2018
Welcome & Introductions
Jon Williamson, CPA, MTLisa Loychik, CPATracy Monroe, CPA, MTModerator
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CPE Credit Guidelines
› To receive CPE you must:
- Be logged in for at least 50 minutes
- Answer at least 3 of the 4 polling questions
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Questions During the Webinar
› If you have questions during the webinar:
- Use the “Questions” feature to “Enter a question for staff” then click send
- We will address during the program if there is time or will follow up after the program
Capitalization
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Overview
› The IRS issued final Tangible Property Regulations effective January 1, 2014
› The final regulations affect all taxpayers that acquire, produce or improve tangible property
› These regulations provide a general framework for distinguishing capital expenditures from other deductible business expenses
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Overview
› Assume all tangible property except inventory is capital property
› Capital property must be capitalized and depreciated unless the property qualifies for one of the following exceptions:
- Materials and supplies
- Rotable and temporary spare parts
- Improvements that do not result in BAR
- Routine maintenance
- Small building/small taxpayer safe harbor
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Why Are The Regulations Important?
› Explains how to classify costs: deductible vs. capitalize
- No longer entirely based on facts and circumstances
- Provides new definitions
- Set new standards
› Introduces new “disposition” rules
- Allows taxpayers to claim a loss on disposition vs. double depreciation
- Example: roof replacement
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Financial Statement Conformity
› Reviewing financial statements
- Only two areas require book conformity
- Safe harbor for capitalization policy
- Election to capitalize and depreciate repairs
- The repair reg rules may be applied for tax only, but may also impact financial statements
- Financial statements compared to the tax return may have large differences in assets/repairs and maintenance expenses
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Acquiring Property
› Material and supplies- A component to maintain, repair or improve a unit of property
- Fuel, lubricants, etc. expected to be consumed in 12 months or less
- A unit of property deemed to have an economic life of 12 months or less
- Safe harbor – a unit with a production or acquisition cost of $200 or less (ex: calculators, coffee makers, etc.)
› Types of materials and supplies- Non-incidental – supplies that are imperative to a business model and
for which an inventory is kept
- Incidental – supplies that are not imperative and no inventory is maintained
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Acquiring Property (cont.)
› Treatment of materials and supplies
- Non-incidental – deductible in the taxable year in which materials and supplies are first used
- Incidental – deductible in the taxable year in which material and supplies are purchased
› Rotable and temporary spare parts
- Deductible when the parts are disposed of
- An election is available to choose to capitalize
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Acquiring Property (cont.)
› De Minimis Safe Harbor
- Book conformity:
- Costs classified as expenses
- Capitalization policy
- Capitalization policy:
- In place at the beginning of the year (in writing if have applicable financial statement)
- Cost per item less than threshold
- Item has an economic useful life less than 12 months
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Acquiring Property (cont.)
› De Minimis Safe Harbor
- Two thresholds:
- $5,000 per-item or per-invoice with Applicable Financial Statement (AFS)
- $2,500 per-item or per-invoice without AFS
- Example: Bulk purchase of 10 computers for cost $40,000. Computers invoice in aggregate, not individually. De minimis safe harbor applies.
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Polling Question # 1
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Unit of Property (UOP)
› UOP – The level at which costs are aggregated and capitalized, as well as the level that costs are analyzed to determine if they are deductible
› Building and structural components
- Single unit of property
› Building systems
- Each separate unit of property
› Other property
- Generally a UOP consists of a group of functionally interdependent components
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UOP: Building Systems
› HVAC
› Plumbing systems
› Electrical systems
› Escalators
› Elevators
› Fire protection & alarm systems
› Security systems
› Gas distribution systems
› Other systems identified in published guidance
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Improving Property: Capitalize
› A unit of property is improved if amounts are paid for activities performed after the UOP is placed in service by the taxpayer resulting in:
- Betterment to the unit of property
- Adaptation of the unit of property to a new or different use
- Restoration of the unit of property
Property improvement costs that should be capitalized are commonly referred to as the “BAR” test
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Betterment: Capitalize
› Alleviates a material condition or defect that existed prior to the acquisition of property
› Results in a material addition or expansion
› Is expected to materially increase in productivity, efficiency, strength, output or quality of the UOP
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Betterment: Example
› ABC Corp. purchases a parcel of land. The soil was contaminated by leaking underground storage tanks left by a previous owner.
› ABC Corp.’s remediation costs to remove the contaminants result in a capitalized betterment to the land because ABC Corp. incurs the costs to ameliorate a material condition or defect that existed prior to its acquisition of the land.
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Adaption: Capitalize
› Adapt a UOP to a new or different use
› Adaption is inconsistent with intended use
› Analyze facts and circumstances
› Examples:
- Capital: expansion in retail drug store for a walk-in medical clinic
- Deductible: expansion in grocery store for a sushi bar that already includes counters for prepared food & deli meats
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Restoration: Capitalize
› Replaces a component, and adjusted basis has been taken into account in realizing gain/loss
› Returns a UOP to its ordinary efficient operating condition if the property is no longer functional
› Rebuilds a UOP to a like-new condition after end of its useful class life
› Replaces a part that comprises a significant portion of a major component or a large portion of a substantial structural part of a UOP
- No bright-line test only examples in regulations
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Restoration: Example
› ABC Corp. replaces the waterproof membrane of the roof
› Not a major component or substantial structural part of the building structure
› Improvement or repair? Depends if ABC Corp will recognize a loss on the replaced membrane
› Will ABC Corp. recognize a loss on the replaced membrane?
- Yes: Improvement = Capitalize
- No: Repair = Expense
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Restorations: Major Component or Substantial Structural Part
› No bright-line test to conclude whether a restoration has occurred; based on facts and circumstances. Examples in the final repair regulations include many quantitative facts that give insight into the IRS and Treasury’s view as to whether a replacement rises to the level of a capitalizable restoration.
- Major components of buildings or building systems – examples imply that a replacement of 40% or less of a major component may not be a significant portion of the major component; therefore not a restoration
- Large portion of a substantial structural part – examples imply that a replacement of 30% or more of the building structure was a large portion of a substantial structural part; therefore is a restoration
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Examples in Final Regulations - Restorations
› Office building 3 of 10 roof-mounted AC units are replaced yet were considered repairs
› Retail building where 8 of 20 sinks were replaced yet were considered repairs
› Office building where 100 of 300 windows were replaced yet were considered repairs
› Hotel replaces lobby floors; lobby comprises less than 10% of the entire building so were considered repairs
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Polling Question # 2
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Safe Harbor: Routine Maintenance
› Current deduction for certain on-going, routine maintenance expenditures applies only if:
- Activity is performed more than once over the property’s life
- The maintenance keeps the property in an efficient operating condition
- The need for the maintenance results from the taxpayer’s use of the property
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Safe Harbor: Routine Maintenance (cont.)
› Also applies to buildings and structural components
› For buildings:
- Maintenance is expected to be completed more than once in a 10-year period
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Safe Harbor: Small Taxpayers
› Applies to buildings
› Average gross receipts: less than $10,000,000
› Average unadjusted basis (cost) of building: $1,000,000 or less
› Deduct cost of improvements:
- That do not exceed the lessor of $10,000 or
- 2% of the unadjusted basis of the building
Depreciation
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Depreciation Overview - MACRS
› What is MACRS?- Modified Accelerated Cost Recovery System
- Assets generally have shorter lives under MACRS than for book purposes
- Assets generally are depreciated faster under MACRS than book
› Double Declining Balance (200%) for 5 and 7 year assets
› One and ½ Declining Balance (150%) for 15 year assets
› Straight-Line depreciation for 27.5 and 39 year assets
› Real Property is given a mid-month convention, while Personal Property receives a half-year convention- Possible to be forced into a mid-quarter convention on personal property if a
large portion of assets are placed in service in 4th quarter
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Depreciation Overview – MACRS – Asset Lives
› Non-Residential Real Property – 39 years (40 years under ADS)
› Residential Real Property – 27.5 years (30 years under ADS)
› Land Improvements – 15 years
› Furniture and Fixtures – 7 years- This group acts as a catch-all for assets not included in other groups
› Computer and Other Equipment – 5 years
› Alternative Depreciation System (ADS)- Can be elected
- Mandatory when assets are not located in U.S.
- Mandatory for real property when electing to be considered a “real estate trade or business” for interest expense limitation purposes
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Polling Question # 3
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Placed in Service and Written Binding Contract
› Generally, an asset is placed in service and depreciation begins when it is “ready and available for use”
› Does not mean an asset needs to be “in use”- Rental real estate with occupancy permits and is actively pursuing tenants can
be depreciated, even if there are no tenants currently- Equipment installed but not scheduled to be operated until the future can
begin depreciation after installation, assuming it could be operated
› Written Binding Contract Rule- Must be reviewed due to different rules applying to different periods- If a written binding contract exists to acquire property, the period that
contract was entered into determines the applicable rule set, not the date placed in service
- Only affects which rules to apply – not the date the asset begins depreciation
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Bonus Depreciation
› Allows for additional depreciation expense in the year a qualified asset is placed in service, expressed in terms of percentage
- 50% bonus depreciation for assets in service prior to 9/27/2017
- 100% bonus depreciation for assets in service between 9/27/2017 and 12/31/2022
- Percentage set to decrease 20% per year after 12/31/2022
› Qualified Assets
- Recovery period of 20 year or less
- Includes both new and used property
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Section 179 Expensing
› Similar to Bonus Depreciation, allows for additional depreciation expense in the year a qualified asset is placed in service
› Rather than a percentage of asset cost being expensed (as with bonus depreciation), Section 179 expensing is associated with various dollar value limitations- Expense Limitation – $1,000,000 for tax years beginning in 2018
- Qualified Expenditure Limitation – the expense limitation is reduced for every $1 over $2,500,000 of qualified assets acquired in the taxable year
- Taxable Income Limitation – the expense amount is limited to the taxable income of the taxpayer
› When incurred by a pass-through entity, limitations are reviewed both at the entity as well as the taxpayer level
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Section 179 Expensing (cont.)
› Assets that qualify include:- Tangible personal property
- Off-the shelf computer software
- Qualified real property
› “Qualified real property” includes:- Qualified Improvement Property (QIP)
- Roofs
- Heating, ventilation and air-conditioning property (HVAC)
- Fire protection, alarm systems and security systems
› Qualified assets must be acquired for business use and acquired by purchase
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Comparing Bonus Depreciation and Section 179
› Additional assets qualify for Section 179 that do not qualify for bonus depreciation- Including Roofs, HVAC property and Qualified Improvement Property
› Section 179 has a dollar value limit, while bonus depreciation is unlimited› Section 179 is applied on an asset by asset basis, while bonus depreciation
must be elected for all assets in a single class life› Bonus depreciation is generally a better alternative for real estate business
groups to avoid limitation issues› Treatment of expense in excess of income:
- Section 179 expense in excess of taxable income is carried forward and can be used in future years when the limitations allow
- Bonus depreciation in excess of taxable income creates a Net Operating Loss (NOL)
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Polling Question # 4
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Special Classification – Qualified Improvement Property (QIP)
› Reclassification of certain assets that would ordinarily be depreciated over 39 years as non-residential real property
- Must be an improvement to the interior portion of a building
- Must be placed in service after the date the building was originally placed in service
- Excludes improvements to an elevator or escalator or the internal structural framework of the building
- Excludes improvements that relate to the enlargement of the building
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Qualified Improvement Property (cont.)
› Treatment on QIP according to the Tax Cuts and Jobs Act of 2017 (TCJA) differs from the implied treatment understood by the tax community and joint committee reports
› Treatment based on TCJA- Qualifies for Section 179 expensing- Does not qualify for Bonus Depreciation- Depreciated over 39 years
› Treatment based on joint committee reports- Qualifies for Section 179 expensing- Qualifies for Bonus Depreciation- Depreciated over 15 years
› Requests have been made to congress to pass a technical correction for the deemed oversight, however no determination is currently available
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Removal of Special Asset Classes – Tax Cuts & Jobs Act
› The following asset classes have been removed by the TCJA in years starting after 1/1/2018
- Qualified Leasehold Improvements
- Qualified Restaurant Property
- Qualified Retail Improvements
› Many assets that qualified in any of the three groups above may be classified as Qualified Improvement Property
- May or may not receive beneficial treatment based on requested technical corrections
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Other Considerations – State Conformity
› Many states elect NOT to conform to federal rules in regards to bonus depreciation and Section 179 expensing- For most states, depreciation is calculated as if the special depreciation
deduction was not taken originally
- Some states have specialized rules (MN, NC, PA)
- Results in state addition to income in the year bonus depreciation is taken, and a state deduction in subsequent years
› States have different rules when an asset with a cumulative depreciation adjustment can be written off- Some states allow for the adjustment to affect gain/loss on sale
- Others are recognized over the remaining life of the underlying asset
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Other Considerations – Cost Segregation Studies
› Comprehensive engineering study to separate components of real property into shorter-life assets based on composition of structure
› Benefit analysis prior to TCJA- Provide ability for bonus depreciation on new construction
- Provide lower asset lives for purchases of used property
› Benefit analysis after TCJA- Same as above, and in addition may provide ability for bonus
depreciation on assets purchases after 9/27/2017
› In addition to increased depreciation expense, may provide more accurate data for analyzing potential capital assets and BAR tests discussed earlier
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Questions for our Presenters?
Tracy Monroe, [email protected]
Lisa Loychik, [email protected]
Jon Williamson, CPA, MT216.774.1103 [email protected]
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Thank you.
Information presented is not meant to constitute legal, accounting or other professional advice. Any action taken based on information in this presentation should be taken only after a detailed
review of the specific facts and circumstances. Information is current as of the date presented.July 10, 2018