Few areas of the repair regulation generate as much controversy between taxpayers and the IRS as do the rules that relate to a unit of property (UOP). The ever-present dilemma for taxpayers is how to determine when an asset has been improved versus when it has merely been maintained or repaired. Because the accurate application of the final regulations is dependent upon defining the asset (i.e., the unit of property) with respect to which an expenditure is made, it is important for taxpayers to understand the conceptual framework of functional interdependence and UOP’s.
Components are functionally interdependent if the placing in service of one component is dependent on placing in service other components. The regulations generally define UOP as all components that are functionally interdependent on other components with reference to:
- Building structure (includes building shell and anything not included in a system
- Separate building systems
- Heating, ventilation and air conditioning systems
- Plumbing systems
- Electrical systems
- Fire protection and alarm systems
- Security systems
- Gas distribution systems
- Other systems identified in published IRS guidance
For plant property, used to perform an industrial process, a UOP is generally comprised of each component (or group of components) within the plant that performs a discrete and major function or operation within functionally interdependent machinery and equipment.
In the case of leasehold property for a lessee, the UOP is determined based on the portion of the building that is leased. If the entire building is leased, the lessee’s UOP will be defined as the building’s systems and structures that make up the entire building. However, if only a portion of the building is leased (such as an office, floor or certain square footage) then only the portion of the building’s systems or structures associated with that leased space will make up the lessees’ UOP. In the hands of the lessor, the UOP is the building and its building systems.
An amount paid is considered an improvement to a UOP and is required to be capitalized, if it results in one of the following three outcomes to any one functionally interdependent component:
- Results in a betterment or permanent improvement to the UOP
- Restores the UOP to its value or use
- Adapts the UOP to a new or different use
Taxpayers should understand that this is a significant change from previously issued proposed regulations, given that under prior guidance taxpayers treated the entire building, inclusive of the now separately identified systems, as a single UOP. For example, under prior guidance, expenditures related to heating, ventilation, and air conditioning (HVAC) systems may have been deducted based on the analysis that the UOP, the building, was not improved. Under final repair regulations the analysis must look at only the HVAC system as the UOP.
Routine maintenance remains deductible in the current year. Maintenance includes work that does not materially increase the capacity, productivity, efficiency, strength, quality or the output of the UOP. It also includes expenditures paid for maintenance that a taxpayer reasonably expects to perform more than once during the class life of the asset for non-buildings, and more than once during the 10 year period from when the building structure/system is placed in service for building structures/systems.
While taxpayers were hoping for bright line tests to answer these and similar questions, the final regulations still rely on analysis of facts and circumstances to determine how to treat such expenditures. The application of the new regulations to amounts paid will likely remain a source of contention between taxpayers and the IRS, but the final rules provide numerous examples of typical transactions and their treatment to help guide taxpayers. If you have questions on the repair regulations or a UOP, please contact an Anders advisor.