To Capitalize or to Expense?
Interpreting the IRS's New Rules
by Jennifer Schmidt, Senior Manager, Accounting Methods Practice, and Mark Reis, Partner, and Randy Churchill, Senior Manager, Financial Institutions Practice
The IRS has issued new regulations for the capitalization and expensing of costs incurred to acquire, produce, repair, or improve real and personal property. And although they’re officially temporary, these new rules—the culmination of an almost eight-year project—may apply to tax years beginning on or after January 1, 2012. (The IRS recently announced a delay in the effective date to tax years beginning on or after January 1, 2014, with early adoption permitted.)
The new regulations are particularly significant for financial institutions because they can impact a bank’s IT expenditures, branding costs, headquarters and branch operations costs, and other real estate owned. Let’s examine some of the key aspects of the new regulations and their potential impact on a bank branch.
What's Considered a Unit of Property?
A key component of the regulations—one that had been a gray area in the past—is the definition of unit of property. In the past the whole building was often considered the unit of property. This meant upgrade expenditures were more likely to be considered deductible repairs because they were proportionally small compared with the larger unit of property.
The new regulations make the unit of property much smaller, breaking it down into the building structure and individual building systems such as HVAC, plumbing, electricity, elevators, gas, and security. As a result, more upgrade expenditures will be seen as capital improvements.
For example, assume that a portion of an HVAC system in a bank branch is replaced in year 15 of a 39-year depreciable life. In the past, when the old whole-building unit-of-property definition was the standard, this upgrade might well have been expensed as a deductible repair. Under the new rules, the bank will capitalize the new HVAC system and can identify the remaining basis of the original HVAC system and write it off, avoiding having duplicate depreciable assets on its books.
Repairs and Maintenance
The treatment of repair and maintenance costs has been a controversial issue, because the cost of a repair can be treated as a deduction in the tax year the repair is made, which generally is more attractive for the taxpayer. The cost of an improvement, meanwhile, must be capitalized and depreciated over the life of the asset—39 years for a commercial building.
The new regulations add clarity, stating that an upgrade expenditure will generally be considered an improvement if it results in the unit of property’s betterment, restoration, or adaption to a new or different use. This encompasses activities such as repainting, rebranding, and other work that historically may have been treated as repairs or maintenance. (See table below.)
Organizations that have been overly aggressive on repairs in the past will have to reevaluate those positions and may need to recapitalize certain costs to comply with the new regulations. Doing so by voluntarily changing their tax methods of accounting will allow those taxpayers to receive audit protection for prior years and to spread any positive adjustment to taxable income over a four-year period.
Capitalization
Another result of the new regulations is that we now have greater clarity when it comes to understanding which costs must be capitalized as property is being acquired, including certain facilitative transaction costs. The new rules also contain de minimis provisions that provide for expensing certain amounts under the written accounting policy of the organization for capital purchase (up to an overall threshold) as well as changes to depreciation methods, which may ease record keeping.
Evaluating and Adopting the New Rules
The IRS wants to encourage compliance with the new regulations and is offering taxpayers a host of ways to get automatic consent for accounting method changes. For example, if your bank makes its method change within the first two tax years that begin on or after January 1, 2012, it can gain automatic consent without having to observe the normal scope limitations associated with accounting method changes. It’s important to note that automatic consent is granted assuming you follow the IRS’s accounting method change procedures for each item being changed. (There are 19 changes in all.)
Given the recent IRS notice of a delay in the rules’ effective date, taxpayers may instead choose to wait to fully implement the new regulations until a later date. However, it’s important to use this delay to proactively assess the impact of the rules on your bank now and create an effective implementation plan to reduce disruptions when the rules become effective.
Clearly, the new regulations are sweeping and complex. To fully understand them, comply with them, and take advantage of the opportunities they offer, banks need solid, strong, and sophisticated tax advisors. They must also ask the right questions about the costs they’re now capitalizing and how they decide whether to capitalize or expense in the future.
In addition, banks must adopt a fresh mind-set, especially in light of the new unit-of-property definition. A large part of this requires breaking out costs for individual systems and components on the front end. This will enable banks to track basis costs and save records for the future, when follow-up repairs or improvements may be necessary and tax implications once again become a factor.
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Jennifer Schmidt leads the firm’s tax accounting methods practice and has over 15 years of experience helping companies with accounting methods planning.
Mark Reis has been in public accounting since 1986 and leads the firm’s tax practice for the Financial Institutions Practice.
Randy Churchill has been in the financial services industry since 1983 and specializes in IRS examinations, accounting methods, and accounting for income tax issues.
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