Temporary Regulation TD 9564 Asset Disposition Temporary Regulation TD 9564

I. Temporary Regulation TD 9564 Purpose Repairs vs Improvements Unit of Property (UOP) Redefined Improvements Betterments Restoration Dispositions Defined Asset Disposition Procedure Asset Disposition Example

II. Cost Segregation Update A. Image Enhancement Programs B. GM EBE Program Opportunities C. Auto Dealership Audit Guide Changes D. Other Changes/Clarifications

A. Overview In 2008, IRS issued Proposed Regulations that substantially revised Section 263(a) – the so called “Repair Regulations”. In December 2011, the Service issued temporary regulations that superseded the proposed regs, and defined the treatment of expenditures related to tangible assets under Section 263(a) and 162(a). The temporary regulations are effective for tax years beginning on or after January 1, 2012.

B. Purpose The intent of the temporary regulation is to clarify the standards for determining whether/when a taxpayer must capitalize costs incurred in the acquisition, maintenance, or improvement of any tangible property.

C. Repairs vs. Improvements The temporary regulations refine the improvement standards to include not only the building and it structural components, but adds eight building systems:

C. Repairs vs. Improvements Heating/Ventilation/AC (HVAC) Systems Plumbing Systems Electrical Systems Escalators Elevators Fire Protection/Alarm Systems Security Systems Gas Distribution Systems

C. Repairs vs. Improvements These building systems, otherwise known as “units of property” (UOP) are important to a “repair” study since they serve as the reference point when applying the capitalization rules. Accordingly, if a repair in an improvement relative to a defined UOP, it is to be treated as an improvement to the entire building.

D. Improvements to Tangible Property The temporary regulations require taxpayers to capitalize amounts paid to improve a UOP if the amount: Results in a betterment to the UOP Results in a restoration to the UOP, or Adapts the UOP to a new or different use

D. Improvements to Tangible Property The 2008 Proposed Regulations and retained by the Temporary Regulations provided that an expenditure results in a betterment if it: Ameliorates a condition of defect existing prior to acquisition of the property Results in a material addition to a UOP including a physical enlargement, expansion or extension Results in a material increase in the capacity, productivity, efficiency, strength or quality of the UOP or its output.

Examples of Betterment 1. Not a betterment, replacement with same part. ARC owns an automobile dealership. A lightning bolt strikes a roof mounted makeup air unit causing its motor to burn out. ARC pays a contractor to replace the motor with exactly the same new motor in the unit. Prior to the lightning strike the makeup air unit was functioning for its intended use as a part of the HVAC system. The replacement of the motor does not result in a material addition or an increase in efficiency or productivity of the HVAC system; therefore, ARC is not required to treat the cost as a betterment.

Examples of Betterment 2. Not a betterment: replacement with comparable part. Assume the same facts as Example 1, except that the lightning strike fries the motor and the direct-fire burner. ARC pays a contractor to replace the makeup air unit with the same or equivalent unit. Replacing the system does not result in a betterment to the building HVAC system because the new makeup air unit is comparable with the unit that was “fried” by the lightning. Therefore, the replacement does not result in a betterment or improvement to the facility.

Examples of Betterment 3. Betterment; replacement with improved parts. Assume the same facts as in Example 2, except that, instead of replacing the makeup air unit with the same quality unit. ARC pays a contractor to replace the unit with an elite makeup air unit. The new unit is compact, more efficient, and uses less energy. The purchase amount for the new unit results in a betterment to the facility because it results in an increase in quality, capacity, productivity, and efficiency to the HVAC system.

Examples of Betterment 4. Betterment replacement with improvements. ARC owns a Chevrolet automobile dealership. ARC performs a significant remodeling of the facility to be compliant with the new image enhancement program. During the remodel ARC hired a contractor to perform cosmetic changes, repairs, and maintenance work.

4. Betterment, replacement with improvements Paint interior /exterior walls for aesthetics Upgraded electrical system to: Improve security system for inventory Replace recessed lighting with more efficient, brighter lighting. New entry portal element Expanded entry to add curb appeal Replace ceiling with acoustical tiles Replace flooring with VCT tiles Replaced entry doors with automatic doors

4. Betterment, replacement with improvements The work performed by the ARC dealership resulted in a material increase in the productivity, efficiency, and quality and therefore must be treated as a betterment or improvement to the facility and costs are to be capitalized.

RESTORATIONS The 2008 Proposed Regulations provided that an expenditure is made to restore a UOP if it: Is for the replacement of a component of a UOP and a loss had been properly deducted for the component, b. Is for the replacement of a component of a UOP and the adjusted basis of the component had been properly accounted, c. Is for the repair of damage to a UOP for which a basis adjustment resulting from a casualty loss,

RESTORATIONS d. Returns the UOP to its ordinary operating condition from a deteriorated state of disrepair causing it to no longer operate at its intended use, Results in the rebuilding of the UOP to a like-new condition after the end of its economic useful life, f. Is for the replacement of a major component or a substantial structural part of a UOP.

Example of Restoration ARC owns a large automobile dealership. ARC realizes that a portion of the exterior ACM paneling and insulation has deteriorated and hires a contractor to inspect and repair the exterior wall. The contractor must replace the entire south side paneling due to a substantial segment rotting. Since the exterior wall and insulation is part of the building structure, ARC must treat the amount paid to replace the siding as a restoration because they paid the amount to replace a major component of the building structure. ARC must capitalize the costs of the restoration.

Dispositions The temporary regulations amend the definition of disposition such that a structural component of a building may be retired as a disposition of property This change prevents the simultaneous depreciation of both the retired (removed) component and the replacement component that is to be capitalized Previously, taxpayers could not deduct the cost of removed components and had to continue depreciating these assets over their original depreciable life

Dispositions Now, taxpayers can deduct the cost of removed components even if the specific value of the component is not known Taxpayers may use a reasonable method that is applied to all structural components to determine the value of the removed asset Taxpayers may go back ten (10) years and deduct the cost of removed/demolished/abandoned components as a carry-forward deduction

F. Asset Disposition Procedure Purpose is to identify and quantify the cost of removed, abandoned, demolished components incidental to renovation projects. Requires the following steps (refer to attached worksheet): 1. Identification of the components comprising the facility (therefore demolition) and calculating their costs – Schedule 1. 2. Identifying/calculating the accumulated depreciation of each component and adjusting the individual component costs. 3. Calculating the ratio of the adjusted component cost to the component cost for each item or class of components. 4. Identification of the components removed or demolished and estimating the cost of each.

F. Asset Disposition Procedure (cont’d) 5. Calculating the adjusted removed component cost by applying the adjustment ratio for each component. 6. Calculating the retained component cost by subtracting the adjusted removed component cost from the adjust component cost. 7. Adjust the accumulated depreciation for each remaining component. 8. Sum the total “removed component” costs. This then becomes the deductible amount for the asset disposition.

G. Asset Disposition Example 1. ARC is an automobile dealership that purchased an existing retail sales outlet five years ago with the intent of converting it to an automobile dealership. The purchase price totaled $4.5M with $1.353M expended for land and $3.147M for the building and land improvements. The conversion to the auto dealership was completed after five years and included building components. In addition to a cost segregation study for the newly renovated facility, the owner wanted to investigate the advantages of an Asset Disposition study of the removed components. The following is a result of that study.

G. Asset Disposition Example 2. The first step was to determine the distribution of the assets in the original purchase of the property. This was accomplished by use of estimating manuals that determined the percentage contribution of each work division to the total cost of the facility – see Schedule 1.

G. Asset Disposition Example Among the components identified in the first step are personal and land improvement property items. These had to be identified and their estimated costs segregated from the real property items – see Schedule 2. The 39 yr. property was then inserted into Column (1) of Schedule 3.

G. Asset Disposition Example Step Two was to determine the accumulated depreciation of the components or classes of components. Since we are interested only in the 39 yr property, the depreciation can be calculated on a straight-line basis, thus the depreciation of each item will be 4.5/39 times the estimated value of each component. These values have been listed in Column (2) of Schedule 3.

G. Asset Disposition Example 4. The adjusted component cost was then calculated by subtracting the accumulated depreciation from the component cost – See Column (3) of Schedule 3.

G. Asset Disposition Example Because of the removed component costs are to be adjusted, it was necessary to calculate the ratio of the adjusted component cost to be the component cost or Column (3) divided by Column (2) and inserted in Column (4). The removed components were then quantified and the cost estimated and listed in Column (5) of Schedule 3.

G. Asset Disposition Example The removed component cost was then multiplied by the net component cost ratio to arrive at the Adjusted Removal Component Cost. These values were then listed in Column (6) of Schedule 3. The retained component cost in Column (7) is the remaining value of the components not removed or demolished and the adjust accumulated depreciation for each component is then calculated by subtracting the difference of Columns (5) & (4) from Column (2).

G. Asset Disposition Example The summed value in Column (6) is the amount of the Disposition to be deducted as an expense and represents the recovery of the cost of the removed/demolished components. Finally, the cumulative cash effect of the cost segregation on the original building and the asset disposition of the removed components is given on the Cash Effect Spreadsheet (Schedule 4). Note that the total cash effect does not include the cost segregation results for the renovation project subsequent to the removal/demolition activities.

H. Cost Segregation Update Image Enhancement Programs In general, the rules pertaining to improvements apply to the capitalization of new components, Rules related to Cost Segregation of qualified assets will also apply, Examples of Image Enhancement Programs: Ceiling Tile Replacement Floor Coverings Replacement Electrical System Upgrades Security System Improvements

H. COST SEGREGATION UPDATE Image Enhancement Programs Examples of Image Enhancement Programs: Upgrading Sales Area Lighting Front Entrance Portals/Expanded Doorways Upgrading Mural Graphics/Brand Exposure Improved/More Visible Signage/Graphics 4. The intent of the IEP was to increase brand awareness.

H. COST SEGREGATION UPDATE General Motors EBE Program (1) Essential Brand Elements (EBE) (2) Program Implemented to separate GM dealers from cohabitating import brands and to relocate to better locations. (3) Incentives offered to spruce up showrooms and present a more positive brand image (4) The intent was to become more competitive with imports

H. COST SEGREGATION UPDATE General Motors EBE Program (5) Items included more aesthetic colors, murals, brand advertising, cleanliness, customer-friendly atmosphere, (6) Incentives included monetary awards for meeting GM Standards, (7) Image Upgrade Payments have been deemed to be revenue for the dealers.

H. COST SEGREGATION UPDATE Cabinetry: counters and cabinets 5 yr related to retail activity; 39 yr. related to housing maintenance equipment. Floor Coverings: 5 yr VCT Tile, 39 yr. Epoxy Sealant. Loading Dock Equipment: 39 yr. property includes bumpers, levelers, seals, lights, canopies, and overhead doors.

H. COST SEGREGATION UPDATE 4. Security Systems: Formerly 39-year property – now is 5-year personal property if electronic equipment is used to track/monitor personal property and includes remote cameras. 5. Wall Coverings: Strippable wall paper that does not damage underlying surface is 5-year personal property. 6. Other Components: Pipe Bollards, Signage, Showroom Displays, Awnings/Canopies.