Recent years have seen multiple rounds of new Treasury regulations reshaping the landscape for treatment of repairs/improvements to all manner of tangible property, including aircraft. In September 2013, the Department of Treasury released long-expected final regulations governing what expenditures can be deducted as repairs in the year incurred, versus what must be depreciated over multiple years. These were supplemented in late 2014 with a new rule for dispositions of property that allows, for the first time, taxpayers making improvements that involve the replacement, or disposal, of a portion of the pre-existing piece of property to take an immediate write-off of the tax basis of the part/s removed in connection with the improvement. This could apply to aircraft in innumerable situations: when a propeller is replaced, the remaining basis in the older propeller could be written off; likewise for engines, interiors, or avionics suites. Note, however, that any value received for the disposed-of item (e.g., selling the replaced item for refurbishment) will need to be recognized and will diminish the tax advantage of the partial disposition.
Capitalized “Improvements” vs. Expensed Repairs
Taxpayers applying the new regulations must evaluate any work done to determine whether it counts as an “improvement” (which must be placed on the books and depreciated), or a repair (which can be written-off in the current year as an expense). The first step in evaluating the improvement vs. repair question is to identify the applicable “unit of property.” The regulations define the unit of property as comprising all components that are functionally interdependent in the sense that one component cannot be placed in service for its intended business function without placing the other components in service, as well. Following this test, each aircraft is a “unit of property.” As illustrations, neither an engine nor an avionics suite would be a unit of property, despite how valuable or complicated either may be. Nor could a fleet of aircraft be viewed as a single, collective unit of property. Each aircraft comprises one, and only one, unit of property.
Work performed on a unit of property constitutes an improvement that must be capitalized (rather than expensed) if the tax law considers it: (1) an adaptation to another use, (2) a betterment, or (3) a restoration.
Adaptations to new uses refer to cases where property is fitted to a use that is inconsistent with the use of the property at the time the taxpayer originally placed it in service. Examples would include converting an aircraft from passenger-carrying to cargo-carrying, or converting either of those to an air ambulance. Upgrading a Part 91 aircraft to fly under Part 135 would ordinarily not qualify because, even after the upgrades, the aircraft would remain suitable for the prior Part 91 use.
A betterment has occurred if work is done that: (1) ameliorates a material condition or defect that predates the taxpayer’s ownership of the property, (2) is for a material improvement to the property’s capacity, or (3) is expected to materially improve the property’s productivity, efficiency, strength, quality or output. Work that involves replacing parts with improved, but comparable, parts is not a betterment if the taxpayer cannot practically replace with the same type of part (for example, because of technological advancements or product enhancements).
There are several ways that work may fall within the category of a restoration, but the one that is most relevant to aircraft involves “replacement of a part or a combination of parts that comprises a major component or substantial structural part” of the property. (Note: “addition,” rather than “replacement,” of a major component is also an improvement, but as a betterment, not a restoration. Repair, without replacement, of a major component is not necessarily a restoration.) A “major component” is defined as “a part or combination of parts that performs a discrete and critical function.” However, an “incidental component,” even if it performs a discrete and critical function will not, by itself, constitute a major component.
The regulations also contain a safe harbor providing that restoration-type improvements will not be found in routine maintenance for non-building property. Routine maintenance is defined as the recurring activities that a taxpayer expects to perform as a result of the taxpayer’s use of the unit of property to keep it in its ordinary efficient operating condition, but only if, at the time the unit of property is placed in service by the taxpayer, the taxpayer reasonably expects to perform the activities more than once during the class life (6-years for non-commercial aircraft, 12 for commercial).
Partial Dispositions Associated with Improvements
Partial dispositions commonly occur in aircraft in connection with major-component replacements (which may or may not also constitute betterments). Engines, propellers, interiors, and avionics suites, are all major components of aircraft that are regularly replaced, with significant tax consequences. Engines are a particularly good example of the sometimes arbitrary aspects of the new regulations. All aircraft engines undergo routine, but costly, overhauls from time to time. Most owners do not fly their aircraft enough for the overhauls to count as “routine maintenance.” (They are not expected to be done more than once within the class life.) At overhaul time, the engines are typically running fine, with no indication that they would encounter problems in the foreseeable future, and the overhauls being performed out of the abundant caution that characterizes the aviation industry. As a result of these facts, a strong case can be made that engine overhauls do not generally constitute “betterments.” For some aircraft an engine overhaul is done with the engine in-place on the aircraft; it is never removed. On larger aircraft, what is considered an overhaul may involve replacing the engine with a freshly overhauled, but otherwise identical, engine. In the latter case, a major component has been replaced, thus creating an improvement that must be capitalized, whereas in the former case the work can likely be currently expensed.
In the absence of the new disposition regulation, the replaced-engine case would require the cost of the overhaul to be depreciated, with no offset to recognize that something of value (the old engine) has been removed. Thankfully, the new partial-disposition rule provides relief from this unfortunate outcome. In a partial disposition, the taxpayer receives a write-of based on a portion of the total value of the property allocated to the item/s being disposed of—e.g., part of the total basis of the aircraft is allotted to the engine being removed. The taxpayer is allowed to use “any reasonable method” in making this allocation, although the chosen method must be applied consistently. If the removal is associated with a major component replacement that is not also a betterment, a favorable, mechanical calculation is approved wherein the cost of doing the replacement is discounted based on the producer’s price index to the date the replaced item was placed in service (typical at the aircraft purchase).
Special 2014 Tax Opportunity
In this transitional year of the new rules going into effect, a one-time, use-it-or-lose-it opportunity is available. As mentioned above, the new partial disposition rule provides a benefit that was not available under prior law: a write-off of the replaced component/s. This means that some taxpayers currently have on their books items which they are still depreciating that, if the new law had been in effect at the time, they would have had the opportunity to write-off as a disposition. The new regulations provide a one-time opportunity to declare a change in accounting method and write off these items in tax year 2014. Some caution may be appropriate, however, in this regard. The special 2014 election requires taxpayers to prepare IRS Form 3115 and send it, in addition to attaching it to their returns, for special processing at an IRS facility in Ogden, Utah. The relatively short recovery periods already in place for aircraft mean that the time-value-of-money savings from current deduction rather than capitalization are often not great, which is a factor that should be weighed by taxpayers making election decisions as to the new partial-disposition rule.
March 9, 2015
Jonathan Levy, Esq.
Advocate Consulting Legal Group, PLLC
Advocate Consulting Legal Group, PLLC is a law firm whose practice is limited to serving the needs of aircraft owners and operators relating to issues of income tax, sales tax, federal aviation regulations, and other related organizational and operational issues.
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