Nonprofit Organizations and the Tangible Property Regulations (Part One)

What are the tangible property regulations, and what should nonprofits know about them?

For background, these regulations were issued by the Internal Revenue Service (IRS) to provide guidance for the acquisition, production or improvement of tangible property—buildings, furniture, fixtures and equipment assets, typically—which must be capitalized and depreciated, deducted in the future or deducted immediately. On a more granular level, these rules dictate how to establish a basic capitalization policy (“de minimis expenses”), identify repair and maintenance costs, account for materials and supplies, determine which costs must be capitalized for the improvement or acquisition of buildings and equipment, and when disposed property may be written off.

These regulations apply equally to all businesses subject to U.S. tax law, regardless of for-profit or exempt status, organization size, legal entity, or industry. They apply to taxable years beginning on or after January 1, 2014. However, in certain situations, the regulations could affect capitalization of costs incurred in years prior to 2014, regardless of a tax return’s normal statute period.

Prior to this new guidance, the previous regulations governing tangible property were a subject of constant disagreement between taxpayers and the IRS, which led to a patchwork of court cases, rulings and other guidance that was not always consistent, nor easily applicable across industries. The IRS, with much feedback and input from taxpayers, rewrote these regulations, which included proposed and temporary regulations, before finalizing the regulations. The prior guidance applied to nonprofits just as the new regulations do. Many for-profit and nonprofit organizations are addressing these regulations now because of the broad application and complexity over the old guidance.

But My Organization is Tax-Exempt!

The primary impact of the tangible property regulations is the capitalization of tangible property on the statement of financial position (balance sheet) and the computation of taxable income. Expenditures could be capitalized as improvements to existing buildings, leasehold improvements or equipment assets and deducted over time through depreciation, or conversely, deducted as a repair and maintenance expense, de minimis property, or as materials and supplies.

Nonprofits that pay unrelated business income tax, have taxable subsidiaries, or lose their tax exempt status will need to consider the impact of these regulations and determine if there is a change to current methods of calculating taxable income. Amounts may be re-characterized as capital improvements that were historically deducted, or vice versa.

For example, consider a nonprofit university that operates a convention center and hotel, resulting in unrelated business income tax for the nonprofit university. In 2012, the hotel underwent a renovation to repaint guest rooms, replace broken lighting and plumbing fixtures, and replace the roof, among other miscellaneous expenditures. The university in this example must compare the facts and circumstances of the expenditures to the regulations to determine if the expenditures were improvements that must be capitalized and depreciated, or repair costs that were deductible when incurred. Depending on the scope of the work performed, these amounts could have been capital improvements or deductible repairs. The regulations introduce the concept of “Unit(s) of Property”, which is how the regulations identify the asset that is being repaired or improved. Historically, an entire building was the unit of property. However, now the regulations subdivide building property into nine different “building systems”. When evaluating an expenditure to determine if it is a repair or an improvement, the expenditure must be compared to the relevant “building system” as opposed to the entire building. This change in how we define the asset that is being repaired or improved can result in characterization of expenditures as capital or deductible that is different from the historical characterization.

Optional Elections

Elections are a formalized manner of adopting tax return positions provided by the Internal Revenue Code and regulations. There are three new elections in the regulations that each nonprofit should consider making. All of the elections described below require a statement to be attached to the organization’s timely filed federal income tax return, including extensions. Further, these are annual elections that will need to be considered for 2014 and every subsequent tax year.

De Minimis Expensing Safe Harbor

Most organizations have historically had a capitalization policy or practice where amounts beneath a specified amount were not capitalized as fixed assets. Prior to these regulations, there was no guidance on establishing such a practice. The regulations introduce the De Minimis Safe Harbor to establish a basic capitalization policy. The key requirements are as follows:

1. The organization must have a capitalization policy in place at the beginning of the year specifying that amounts incurred for the purchase of tangible property beneath a fixed dollar amount will not be capitalized for financial accounting or tax purposes;

2. The capitalization threshold cannot exceed $5,000 if the organization’s financial statements are audited by external auditors, or $500 if the organization’s financial statements are not audited; and

3. The policy must be in writing if the organization has an audited financial statement.

If an organization follows the above practices—and most importantly, follows the practice equally for financial accounting and tax purposes—then the IRS will not question the expensing of amounts beneath the threshold. The capitalization threshold may change (but not exceed the safe harbor limits above) as necessary to meet the changing business practices and needs of the organization.

Stay tuned to the Nonprofit Standard blog next week for Part Two of this article, which will discuss considerations surrounding taxpayer safe harbors, manner of adoption and how nonprofits can plan for the future.

This article originally appeared in the Spring 2015 Nonprofit Standard newsletter.