Second in a series of articles addressing the recent changes to Section 263(a)
The first article in this series introduced the Section 263a “repair regulations” and described the new rules for materials and supplies, including rotable and temporary spare parts.
This article will explain the costs required to be included in the basis of a unit of property (transaction costs), and the de minimis rule.
Which costs are required to be capitalized?
When your business acquires or produces a unit of real or personal property, you must capitalize costs that fall into any of the following three categories:
- the invoice price of the asset
- certain transaction costs
- any work performed prior to the date you placed that unit of property into service
The invoice price is simply the price agreed to by the seller and the purchaser. The other two categories of costs are a bit more complex in their calculation, however.
Calculating transaction costs
A transaction cost is an amount paid to facilitate the acquisition or production of a unit of property. These costs would be paid in the process of investigating or otherwise pursuing the transaction.
There are two categories of transaction costs:
- Facilitative transaction costs. A facilitative cost is a cost, other than an inherently facilitative cost, paid in the process of investigating or otherwise pursuing the acquisition of a unit of property. A facilitative transaction cost is treated as a part of the cost of the property acquired.
- Inherently facilitative costs. An inherently facilitative cost is a cost that by its nature is related to the process of investigating or otherwise pursuing the acquisition of a unit of property. These costs must be capitalized when incurred, even if the property has not been acquired, and can only be deducted if the transaction is not consummated. If the property is acquired, then the inherently facilitative costs are included in the cost of the unit of property acquired.
The following items are considered inherently facilitative costs:
- Transporting property
- Securing an appraisal or determining property value
- Negotiating terms or structure and obtaining tax advice on the acquisition
- Application fees, bidding costs, or similar expenses
- Preparing and reviewing documents that effectuate the acquisition
- Examining and evaluating the title of property
- Obtaining regulatory approval of the acquisition or securing permits related to the acquisition, including application fees
- Conveying property between parties, including sales and use tax and title registration
- Finders’ fees and brokers’ commissions, including contingent fees
- Architectural, geological, engineering, environmental, or inspection services pertaining to particular properties
- Fees to a Qualified Intermediary or other facilitator of a 1031 exchange
Some examples may help clarify the rules:
Example 1: A taxpayer acquires a building in which to relocate its offices. Prior to acquiring the building the taxpayer hired a broker to find property for the taxpayer to acquire. Upon the closing of the sale, the taxpayer paid the broker a commission. The taxpayer also hires a third party to perform a termite inspection and environmental survey of the building. The broker fees, termite inspection and environmental study are inherently facilitative costs and must be capitalized.
Example 2: A taxpayer who provides legal services wants to replace the table in its main conference room and hires an interior decorator to shop for, evaluate, and make recommendations regarding which new table to acquire. Even though the fees paid to the interior decorator are not inherently facilitative costs, they must still be capitalized since they were paid in the process of investigating or otherwise pursuing the acquisition of property.
Note: You’ll need to review your accounting records to determine whether transaction costs were incurred or paid on asset acquisition and not properly included in the basis of the asset. If transaction costs have been omitted, an accounting method change will be necessary to add the transaction cost to the acquired asset. If the acquired asset is depreciable, depreciation will be calculated on the transaction costs. This is true for all assets that you are depreciating, not just those purchased on or after January 1, 2012.
Transaction costs: the “whether and which” rule
There is an exception to the general rule that transaction costs must be added to the cost of an acquired asset when the taxpayer acquires real property. If the costs, other than inherently facilitative costs, are incurred in the process of determining whether to acquire real property and which property to acquire, they are currently deductible.
Example 3: Taxpayer owns several retail stores and decides to examine the feasibility of opening a new store in city A. In October, Year 1, X hires and incurs costs for a development consulting firm to study city A and perform market surveys, evaluate zoning and environmental requirements, and make preliminary reports and recommendations as to areas that X should consider for purposes of locating a new store. While still considering whether to purchase real property in city A and which property to acquire, taxpayer hires, and incurs fees for, an appraiser to perform appraisals on two different sites to determine a fair offering price for each site. In March, Year 2, X decides to acquire one of these two sites for the location of its new store.
The taxpayer is not required to capitalize the amounts paid to the development consultant in Year 1 because the amounts relate to activities performed in the process of determining whether to acquire real property and which real property to acquire and the amounts are not inherently facilitative costs. However, X must capitalize amounts paid to the appraiser in Year 1 because the appraisal costs are inherently facilitative costs. In Year 2, X must include the appraisal costs allocable to property acquired in the basis of the property acquired and may deduct the appraisal costs allocable to the property not acquired.
Note: If you’ve previously capitalized costs subject to the “whether and which” rule, you may file an accounting method change to deduct whether and which costs incurred in taxable years beginning on or after January 1, 2012.
Calculating costs incurred prior to placing the unit of property in service
The costs of work performed on a unit of property prior to placing it in service are considered a cost of getting the unit of property into a useable state. As described above, both must be capitalized.
Example 4: A taxpayer acquires a building and prior to placing it in service repairs cement steps, refinishes wood floors, patches holes in the walls, and paints the interior and exterior of the building. Assuming that these activities are not considered improvements to the building, since the costs were incurred prior to placing the building in service they must be included in the basis of the building.
Example 5: Atlas, a manufacturer, acquires a new machine for use in its existing production line. The machine is a unit of property under the repair regulations. After the machine is installed, Atlas performs a critical test to ensure that it will operate in accordance with quality standards. Atlas also performs periodic quality control testing on the machine after it is placed in service. The costs of installation and the critical test need to be capitalized as part of the cost of the machine. The costs of the periodic quality control tests are deductible as operating expenses because they occur after the machine is in service.
You may need to review your fixed asset records to determine whether costs occurred prior to placing a unit of property into service. This determines whether you should capitalize these costs in the basis of the unit of property.
Note: If upon review of your fixed asset records you determine that costs were incurred prior to placing a unit of property into service and the costs were not capitalized, you will need to file a change in accounting method. This applies to all assets that are being depreciated, not just those purchased on or after January 1, 2012.
The De Minimis Rule
If you meet certain requirements, you will be able to deduct the cost of acquired assets (or improvements) up to a ceiling amount. You can elect to deduct non-incidental materials and supplies under what’s known as the de minimis rule. The de minimis rule is mandatory, but you may choose to elect out of the deduction and capitalize assets otherwise qualifying for the de minimis rule.
You must meet the following four requirements to qualify the de minimis safe harbor:
- Your organization must have applicable financial statements (“AFS”)—audited or regulatory financial statements
- You must have written accounting procedures for your AFS capitalization threshold at the beginning of the year
- You must treat the amounts paid during the tax year as an expense on your AFS in accordance with your accounting procedures
- The amount deducted under the de minimis rule must not exceed the ceiling for the aggregate amount deducted
The ceiling limitation is the greater of .1% of the taxpayer’s gross receipts or 2% of the sum of book depreciation and amortization. Our final example helps to clarify how the de minimus rule is applied:
Example 6: A taxpayer has $50 million in gross receipts and $4 million in book depreciation and amortization. The taxpayer acquired 200 computers at $500 each for a total of $100,000. In addition, the taxpayer has $40,000 of non-incidental supplies on hand (remember from the first article that non-incidental supplies are only deducted when consumed).
The ceiling limitation is $80,000 (greater of .1% x $50,000,000 = $50,000 or 2% x 4,000,000 = $80,000) which can be applied entirely to the computer purchases with the remaining $20,000 capitalized. Or, it can be applied to deduct the $40,000 of non-incidental supplies and $40,000 of computers, capitalizing and depreciating the remaining $60,000 of either asset.
Note that if you do not have applicable financial statements, you are not under the de minimis safe harbor and will have to prove to the IRS that the deductions of assets below a certain dollar threshold clearly reflect income. This argument is supported by an accounting policy (preferably written) regarding a minimum threshold for capitalization (for example, $500 or $1,000) and the consistent application of this policy. The preamble to the regulations indicated that a deduction in excess of the ceiling amount could be allowed upon IRS audit if it resulted in the clear reflection of income.
Note: A taxpayer must file a change in accounting method to apply the de minimis rule to amounts paid for acquired assets. This change applies to amounts paid or incurred in taxable years beginning on or after January 1, 2012.
Under the new regulations taxpayers will have to track many transaction costs either to capitalize into the cost of the acquired unit of property or to deduct under the “whether and which” rule. While the de minimis rule is intended to provide partial relief from the capitalization rules, it is too complex and too narrow in its scope. You will now be recovering these costs over the depreciable life of an asset rather than currently deducting them. The regulations create a recordkeeping burden that is not offset by any “benefit” the taxpayer may receive.
Next month, we’ll explore the definition of “unit of property” and the special rules that apply to certain types of property.
Joe Schirger, CPA, MT, tax manager, has over twenty years of experience providing tax consulting and tax compliance solutions for businesses and individuals.