Over the years congress and the IRS have created a number of code sections describing the treatment of fixed assets, depreciation and when merchandise is inventory. These various code sections have become quite complex. Pieces of the investment tax credit rules for example are still part of the regulations, though for the most part the investment tax credit has been done away with.

In the last several years the IRS has been attempting to clarify and bring these various code sections back together. Several times they have issued proposed regulations. In December 2011 they finally issued temporary regulations that were supposed to fix many of these loopholes.

I believe that many investors will be surprised by what is in the new regulations. For one, investors will need to understand what the major components of a building are and track the extent of repairs to a major component. It will also be necessary to estimate the cost of a component that has been replaced.

You might ask, what does all of this mean in plain English and how does it impact your investments?

In the past an investor could replace nearly the entire roof of a building and it would be considered a repair. The new regulations see this differently. The roof would certainly be considered a major component of the building and so fixing and repairing 51% of the roof quite likely would need to be treated as a capital improvement. It will be necessary for investors to understand what the IRS might consider a major component. An example that I would clearly have expensed in the past might be adding a second layer of roofing over much or perhaps the entire roof.

Sea of gray?

The rules now allow for the disposal of a component of the building when it is replaced. This is going to be a challenging exercise for some. For those that have cost segregations it will be fairly easy to estimate the value of components that are disposed of. For the vast majority of investors in residential investment property this is going to be a quite tricky gray area. An investor who has all of the galvanized pipes in a home replaced is going to need to estimate the value of that component and capitalize the cost of the plumbing.
Some scenarios may actually not allow any disposal. A home that had little or no insulation might be such a situation. The new insulation would certainly need to be capitalized now, but if the home was purchased with no insulation it would not be possible to dispose of that component.

For those who can’t sleep here is some light reading on the new regulations:

http://www.journalofaccountancy.com/Web/20125301

You can also read Rev Procedure 2012-19 and 2012-20.

As the tax season winds down I will be spending more time reviewing these new regulations, some new case law on cost segregation, and a host of other issues. As some of this information gels in my mind I will share it and help you make some sense of it. There has been a surprising number of rules, proposals, cases, regulations passed that impact investors and I will help shed some light on how these impact you.