Passing the BAR: Part I in a Three-Part Series Exploring Decision Making Under the TPRs
Tax professionals have spent a great deal of time and effort attempting to clarify the complex Tangible Property Regulations. Unfortunately, many in the world of commercial real estate remain overwhelmed by the legislation, and haven’t been able to fully benefit from the powerful guidelines the regulations delineate. Here at Capstan we are passionate about sharing our knowledge, and we’ve developed a flowchart that depicts the complicated TPR decision making process in a streamlined, easy to follow graphic. We’re going to spend the next several blogs “walking through” this decision making process, exploring how, when applied correctly, the TPR guidelines determine precisely which costs require capitalization, and which may be expensed. Our flowchart would be a very useful resource for this discussion, and for everyday reference – please CLICK HERE TO REQUEST A COPY of our TPR Flowchart.
Regular readers might recall a blog we posted several months ago regarding three safe harbor elections established by the TPRs. (Feel free to refresh your memory by visiting). The FIRST STEP to success is indeed checking out these three safe harbors – if you can avail yourself of the Routine Maintenance Safe Harbor, DeMinimus Safe Harbor, or Small Taxpayer Safe Harbor, you may be able to expense your asset completely. Game over for you, you fortunate taxpayer.
What if your expenditures don’t meet any of the above exceptions to capitalization? Then it’s off to STEP TWO, referred to as the BAR Test. The purpose of the BAR Test is to determine whether the cost represents an improvement in the form of a Betterment, Adaptation, or Restoration. If the expenditure is determined to be an improvement, it must be capitalized. (If it is not determined to be an improvement, you’re off to STEP THREE, the Materiality Test, but we’ll save that for a different blog.)
So, if a cost is determined to be an improvement, it must be capitalized. Seems straightforward enough, but in fact there are a lot of subtleties involved, and hundreds of pages have been written on the subject. For our purposes, let’s look more closely at what makes a “B,” an “A,” and an “R,” and discuss some pertinent examples of real estate related costs that may or may not “pass the BAR.”
B is for Betterment
The first type of betterment is one that corrects a pre-existing material condition or defect. If a taxpayer purchased land and then discovered the soil was tainted, costs to remediate the soil would be a betterment and must be capitalized.
The other types of betterment are improvements that, well, make a property better. Assets that will increase the physical space or capacity of a property, or will increase the efficiency, strength, productivity or quality of the property are all considered betterments.
Expanding the seating area at your successful family restaurant? That’s a material addition to increase size, and is therefore a betterment that must be capitalized.
Sprayed insulation throughout your property, resulting in a tremendous decrease in energy costs? That’s a material increase to the property’s efficiency, and is therefore a betterment that must be capitalized.
Replaced your worn out roof membrane? Hold on, because this could go either way…
Imagine you purchased the property with a good condition, functioning roof membrane, and over time, due to normal wear and tear, the membrane began to wear out. If you replace the old membrane with a new comparable membrane, returning it to its initial condition but not making it any better, this is not considered a betterment. According to the regulations, in this situation the new membrane could be expensed.
However, imagine that you decide to replace the worn membrane with a more energy-efficient one, resulting in increased efficiency. In this situation, the new membrane would be considered a betterment, and would have to be capitalized and depreciated.
A is for Adaptation
An improvement is considered an adaptation if it adapts the Unit of Property to a use other than the original use of the UoP at the time the building was placed in service.
The classic example of an adaptation highlighted in the regulations considers a taxpayer who opens a manufacturing facility, which functions for several years manufacturing some type of item. The taxpayer decides to take a portion of the manufacturing space and convert it into to sales showroom space. The costs required to modify the building would be considered adaptations, since they are adapting a portion of the property to a different use.
R is for Restoration
A cost would be considered a restoration if it is paid for the:
- Replacement of a component of property after the taxpayer deducted a loss for that component
- Replacement of a property component that was sold, assuming the taxpayer has adjusted the basis of the component based on gain/loss realized from the sale
- Replacement of a property component after the taxpayer claimed casualty loss
- Restoration of a property component to like-new condition, after the end of its class life
- Replacement of a major component or significant portion of a UoP, building system, or subset of UoP that has its own discrete function (more on this next time)
Costs incurred when returning a property component to its ordinary operating condition would also be considered restorations, and would therefore require capitalization. It’s important to note that this doesn’t refer to normal maintenance performed to manage normal wear and tear, as in the roof example discussed above. In that case, the cost of the new roof was not considered a betterment and could be expensed. When we’re talking about restorations, we’re not referring to normal wear and tear on a component of property. We’re talking about complete neglect on the part of the owner, to the point that the property component has deteriorated and is entirely non-functional.
For example, imagine that a farmer has three outbuildings on his land for storing equipment and materials, and that he decided he only needs two. He completely neglects upkeep on the third, so that it falls into a state of disrepair and is not fit to store expensive equipment. If he eventually realizes he does indeed need three outbuildings, costs incurred for restoring the third outbuilding to its original operating condition would be considered restorations, and would require capitalization.
Has this provided any clarity on the alphabet soup that is the BAR test? If you’d like to hear more on this subject in person, please register to join us at our next webinar discussing the Tangible Property Regulations on Wednesday May 25th. Be sure to request your all-important copy of the TPR flowchart as well. The TPRs may pose a challenge, but they also offer a tremendous opportunity for tax savings – watch this space for Part II in this important series.