Material World: Part II in a Three-Part Series Exploring Decision Making Under the TPRs
Welcome back to our continued discussion of the complex Tangible Property Regulations. Our last blog post focused on applying the BAR Test to determine whether a given cost represented an improvement in the form of a Betterment, Adaptation, or Restoration. (If you’d like to take another look, feel free — http://capstantax.com/passing-bar-exploring-decision-making-tprs/. We’ll wait here.)
As we concluded, expenditures determined to be improvements must be capitalized. “Well,” one might think. “My expenditure is not an improvement. Looks like I’m heading for a visit to Expense-ville, USA.” Not so fast, my hypothetical friend. Just because your cost has successfully passed the BAR test, doesn’t mean it can be automatically expensed. You must first weigh 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.” Section 1.263(a)-3 establishes asset categories known as “Units of Property.” The regulations state that building structure is its own UoP — floors, ceilings, roof, foundations, everything that makes up the building shell. Other major systems constitute their own UoPs, such as the HVAC, electrical, and plumbing systems, to name a few. By establishing these asset categories the IRS has really shaken things up, as under prior guidance taxpayers had to consider the entire building and its systems as ONE very large UoP.
Consider a taxpayer that has replaced two out of ten rooftop HVAC units on his property. He’s already determined that this expenditure doesn’t represent an improvement under the BAR test. He now needs to compare the amount spent on the units to the total value of the HVAC Unit of Property, to determine if the amount spent on the units would be considered significant, or “material” to its Unit of Property as a whole. You’d expect that somewhere in the 200+ pages of the TPRs you’d find a hard and fast rule for determining materiality. You’d be wrong. The IRS does not explicitly state a magic number, but instead provides examples in which thresholds may range between 25% and 40% of the total UoP value. So, if the value of the asset is GREATER than 25-40% of the total UoP value, the asset is considered material, and must be capitalized. If the value of the asset is LESS than 25-40% of the total UoP value, the asset is not material, and may be expensed. In this example, the taxpayer replaced two out of ten units, representing 20% of the total UoP. This expenditure is therefore not material, and before you know it, you’re off to Expense-ville after all.
That was a pretty basic example, as clearly not all building components can be simply counted up and divided. This is where the significance of cost segregation comes into play. Cost segregation categorizes all building system and structure assets and assigns appropriate monetary values. This type of data can easily be aggregated to allow for the comparison of an asset to its UoP in dollars, not units. This is crucial to the accurate performance of Materiality tests, which in turn are crucial in making appropriate expense vs. capitalization decisions.
Sometimes groups of assets within a UoP have their own little sub-UoP, kind of like a VIP room. These assets are ones that work together to perform a discrete function within the UoP, and in Materiality tests shouldn’t be compared to the value of the UoP as a whole, but instead to the value of the sub-UoP assets in the VIP room. 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 structure UoP as a whole, and it might seem like the expenditure could be expensed. However, due to their discrete function, the windows are a UoP unto themselves, and must be compared at that level. 200 out of 300 windows replaced = 66% = definitely material to its UoP, and the expenditure would have to be capitalized.
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. The Capstan team is passionate about providing our clients with the most accurate data and with the knowledge required to apply that data effectively. Feel free to reach out at any time – we’d enjoy exploring how the power of UoP studies may enhance your bottom line.
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