It’s a Material World: Materiality and UoP Under the TPRs

March 8, 2024

Introduction

Welcome back to our continued discussion of the complex Tangible Property Regulations. Our last blog focused on applying the BAR Test to determine whether a given cost represented an improvement in the form of a Betterment, Adaptation, or Restoration. The Capstan TPR flowchart is very helpful in stepping through this process.  

As we concluded, expenditures determined to be Betterments, Adaptations, or Restorations must be capitalized.  

So, what if an expenditure is not considered one of the above?  Can it just be expensed? 

Possibly, but there’s one more test that must be applied first – the Materiality Test. 

The Materiality Test weighs the impact of the cost as it relates to the building structure or appropriate building system to determine if the cost is significant, or “material.”  

If a cost is “material,” it must be capitalized.  

To Understand Materiality, Understand Unit of Property (UoP)

Section 1.263(a)-3 establishes asset categories known as “Units of Property.” The Regulations state that building structure is one UoP, and other major building systems constitute their own UoPs:  

  • Building Shell (floors, ceilings, roof, foundation) 
  • HVAC 
  • Plumbing 
  • Electrical  
  • Security Systems 
  • Fire Protection and Alarm Systems 
  • Gas Distribution Systems 
  • Escalators 
  • Elevators 

During a cost segregation study, assets are generally segregated according to MACRS class lives. They can also be sorted by UoP, which is crucial for applying the Materiality Test.  

Materiality Test 

The Materiality test compares the cost of the improvement to the overall costs of the relevant UoP to determine if the improvement cost is significant, or “material.” 

If pipes were replaced in Building B, you’d compare the cost of those pipes to the total cost of the plumbing UoP system.  

If wiring was replaced in Building W, you’d compare the cost of that wiring to the total cost of the electrical UoP system.  

The obvious question is, how big does the spend have to be to be considered significant (or “material”) to its UoP?  

Unfortunately, the IRS does not provide a bright-line answer. It does provide examples in which thresholds may range between 25% and 40% of the total UoP value, implying the following:   

  • If the cost of an improvement is GREATER than 25-40% of the total UoP value, the improvement is considered material, and must be capitalized. 
  • If the cost of an improvement is LESS than 25-40% of the total UoP value, the improvement is not material, and may be expensed. 

Often materiality is determined by looking at “units,” and the above thresholds can be employed. Consider a taxpayer that has replaced two out of ten rooftop HVAC units on his property. Since he only replaced two out of ten units, or 20% of the total HVAC UoP, the expenditure is not material and may be expensed.  

Discrete Function

Sometimes a group of assets within a UoP work together to perform a discrete function within that UoP. They are kind of like a little club within a big organization. When performing the Materiality test on these assets, you shouldn’t compare them to the value of the entire organization (UoP). Instead, you should compare them to the total value of the little club. 

Windows are the classic example. They are part of the building structure UoP, but also perform their own discrete function, so they have to be tested for materiality at the discrete function level.  

Consider a taxpayer that replaced 200 of the 300 windows in his building. Now, the cost of 200 windows is likely not material when compared to value of the Building Shell UoP as a whole.  

However, due to their discrete function, the windows are a UoP unto themselves – they’re the little club. We don’t compare them to the entire Building Shell UoP, but to the Window UoP. 200 out of 300 windows replaced represents 66%. This improvement is definitely material to its UoP, and the expenditure would have to be capitalized. 

The Role of Cost Segregation

The HVAC unit and windows examples are pretty basic. Not all building components can be simply counted up and divided. This is where cost segregation comes in handy. As mentioned earlier, cost segregation categorizes all building assets and assigns appropriate monetary values. The data can easily be aggregated by UoP, allowing for the comparison of an asset to its UoP in dollars, not units.  

If the cost of the new wiring in Building W was only say, 10% of the value of the entire electrical UoP, the new wiring is not material, and may be expensed.  

If the cost of the new plumbing in Building P was 50% of the value of the entire plumbing UoP, the new plumbing is material, and must be capitalized.  

The ability to make this comparison in dollars is crucial to the accurate performance of Materiality tests, which in turn are crucial in making appropriate expense vs. capitalization decisions. 

At this point UoP collection isn’t mandatory, but the data it provides is very powerful, allowing for ease of asset management and maximum tax savings. Every Capstan Cost Segregation Study comes with the UoP data required to make accurate decisions under the TPRs.  

Keep your eyes out for the fourth and final installment of our TPR Refresh series, coming soon. In the meantime, we’re here to help.  

 

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