Third in a series of articles addressing the recent changes to Section 263(a).
The first article in this series introduced the 263a “repair” regulations, and went through the new rules for materials and supplies, including rotable and temporary spare parts. The second article went through the costs that need to be included in the basis of an acquired unit of property.
This article will cover what constitutes a Unit of Property (“UOP”).
Unit of Property
The cornerstone of the repair regulations is the concept of the unit of property (“UOP”). The unit of property is the level at which a taxpayer must analyze activity to determine whether an improvement has occurred. The bigger the UOP, the larger the amount that may be treated as repairs. The smaller the UOP, the more likely that the costs of work performed will need to be capitalized.
The General Rule
In general, a unit of property is defined as an item with functionally interdependent components. For example, a locomotive is a UOP even though it is composed of generators, engines, batteries and a truck. You need all these components together to form a UOP.
In addition to this general rule, there are special rules for plant property, buildings, and leased property:
Plant property is functionally interdependent machinery or equipment used to perform an industrial process. Industrial processes include manufacturing, warehousing, distribution, automated material handling in a service industry, or other similar activities.
The UOP for plant property is any component that performs a “major” and “discrete” function. In a manufacturing setting, the UOP will probably be each machine since each machine generally performs a major and discrete function.
X is an electric utility company that operates a power plant. The power plant includes the following:
- A structure that is not a building under 1.48-1(e)(1).
- Four pulverizers that grind coal.
- One boiler that produces steam.
- One generator that converts mechanical energy into electrical energy.
- Turbine containing blades that rotate when affected by steam.
What is the UOP?
Because the plant is composed of property other than a building, the initial determination is made under the general rule of functional interdependence: the entire power plant would be considered a single UOP.
However, since the power plant is plant property (“generating” is an industrial process), the UOP is further broken down into components that perform a discrete and major function:
- The structure
- Each of the four pulverizers
The turbine blades did not perform a discrete and major function; thus, they are not a UOP.
This taxpayer should document their UOP under the general rule and for plant property and develop a methodology to track costs by unit of property. This will make it easier in the future to determine if an improvement has been made to a unit of property.
The UOP for buildings is the building structure, without the building systems, and each building system enumerated in the regulations.
Below is a list of the building systems:
- All escalators
- All elevators
- Fire protection and alarm systems
- Security systems
- Gas distribution systems
- Other structural components identified in published guidance
Taxpayers will now have to track the type and amount of activities performed on each building system to determine whether it results in an improvement to that system that must be capitalized. This will require a significant change in recordkeeping for taxpayers in their maintenance/capital expenditure programs.
Cost segregation can be used to help a taxpayer properly allocate the total costs for the building into the proper building system category. An engineered cost segregation study will provide the most accurate cost breakdown. However, if an engineered cost segregation study is cost prohibitive, a cost segregation professional can assist in breaking out estimated costs for each system. The regulations rely heavily on quantitative and qualitative factors to determine whether an expenditure results in a capital improvement or not. A cost segregation study can both provide both types of information.
The last UOP rule relates to the UOP for leased property. In general, the unit of property for leased property is the proportionate amount of the building that is subject to the lease. If a lessee leases 10% of a building and he is responsible for all improvements, these improvements are capitalized and depreciated over the appropriate life.
The regulations also clarify that leasehold improvements are not to be depreciated over the period of the lease but rather over the recovery period for the leased property (usually 39 or 27.5 years).
Depreciation Consistency Rule
The general UOP rules above are modified if components of a UOP are depreciated over different lives. In other words, a UOP must consist of components that are depreciated over the same recovery period.
Trucking, Inc. owns over the road trucks, but depreciates the tires on the trucks over a different recovery period than the rest of the truck. As a general rule, the entire truck, including its tires, would be treated as a UOP, since all components are interdependent. However, because the tires and the truck are depreciated over different recovery periods, there are two UOPs for the purposes of the repair regulations: the tires, and the rest of the truck (other than the tires).
In 2011, A acquired a building. Initially the entire building was depreciated over 39 years. In 2012, A had a cost segregation study performed in which a portion of the original cost of the building is being depreciated over recovery periods less than 39 years (5, 7, and 15 years). As a result there will be fours UOPs after the cost segregation study: the building, five year property, seven year property, and fifteen year property.
Taxpayers will have to determine what their UOP is for repair purposes and you will have to develop a methodology to track those costs. If you have a change in UOP that changes what has to be capitalized as an improvement, you will be required to file a change in accounting method to capitalize those costs and to claim the proper depreciation on such improvements.
With regards to buildings, a taxpayer may want to contact a cost segregation professional to assist in breaking out the original costs into costs for the building systems categories.
Next month, we’ll cover improvements and the routine maintenance safe harbor.
Joe Schirger, CPA, MT, tax manager, has over twenty years of experience providing tax consulting and tax compliance solutions for businesses and individuals.