On September 13, 2013, the IRS issued final and proposed regulations (“regs”) which updated and removed previous temporary and proposed regs regarding which expenditures must be capitalized as amounts paid to acquire, produce, or improve tangible property and which expenditures can be expensed as repairs and maintenance or materials and supplies. These regs are commonly referred to as the “repair regs” and are extremely lengthy and complex. The final regs refine and simplify rules contained in the temporary regs released on December 23, 2011 and create a number of new safe harbors. The final regs are current law and are required to be in effect on 1/1/14 or for taxable years that begin after 1/1/14, but may be implemented sooner. Both the final and temporary regs allow for early implementation for tax years beginning on or after 1/1/12 through 12/31/13 (2012 & 2013 returns).
Below is a summary of the main topics to consider regarding the final and proposed tangible property regs:
General De Minimis Safe Harbor Election
Under the final regs, taxpayers will be eligible to expense a de minimis safe harbor amount paid for tangible property costing less than a specified dollar amount. This de minimis safe harbor election includes amounts paid for materials and supplies. Taxpayers without an applicable financial statement (“AFS”) who make the annual election to implement the de minimis safe harbor will be entitled to deduct all items $500 and under. Taxpayers with an AFS are entitled to deduct all amounts paid for property that do not exceed $5,000. An AFS is a certified audited financial statement which is accompanied by the report of an independent CPA or a financial statement required to be provided to the federal or a state government or any federal or state agency.
In order to utilize the de minimis safe harbor, taxpayers must have a written accounting procedure in place as of the beginning of the tax year for expensing amounts paid under a certain dollar amount and follow those procedures for financial accounting purposes. The safe harbor amount is applied per invoice. If the invoice is itemized, the de minimis safe harbor can be applied on an item by item basis. Any acquisition costs which would otherwise be required to be capitalized must be included in the calculation of the total cost of the item. The acquisition costs can be applied pro-rata if there are multiple items on one invoice. There is no ceiling on the aggregate amount of expense the taxpayer may deduct in a year under the de minimis safe harbor.
The final regulations clarify that amounts paid for tangible property eligible for the de minimis safe harbor may still be subject to capitalization under Code Section 263A if the amounts paid for the property are comprised of the direct or allocable indirect costs of other property produced by the taxpayer or property acquired for resale.
Repairs and Maintenance
Taxpayers may deduct amounts paid for repairs and maintenance to tangible property if the amounts paid are not otherwise required to be capitalized. In order to determine if amounts paid are required to be capitalized, a taxpayer must analyze each unit of property (“UoP”) and determine whether the costs incurred were for an improvement of that UoP.
Unit of Property
The UoP consists of all components of property that are functionally interdependent. Special rules apply when determining a UoP for buildings, plant property, network assets, condominiums, cooperatives, leased property, and for the treatment of improvements (including leasehold improvements).
The final regulations continue to apply the improvement rules to both the building structure and the defined building systems. The building structure consists of the building and its structural components, other than the structural components designated as building systems. Each of the following structural components constitutes a building system that is separate from the building structure and to which the improvement rules must be applied: HVAC systems, plumbing systems, electrical systems, escalators, elevators, fire protection and alarm systems, security systems, gas distribution systems and other systems and components identified in published guidance. Note that the building structure is required to be further divided into smaller units of property by determining the components that perform discrete and major functions, such as the roof, windows, and flooring.
Costs incurred that result in a betterment of the UoP, restoration of the UoP to its ordinarily efficient operating condition or adaptation of the UoP to a new or different use are required to be capitalized as an improvement.
Safe Harbor Provisions
In addition to the de minimis safe harbor, the final regs also permit the following safe harbor options to taxpayers which may allow a taxpayer to deduct improvements which would otherwise be required to be capitalized:
- Safe Harbor for Qualifying Small Taxpayers– A safe harbor election is available for building property held by taxpayers with gross receipts of $10 million or less (a “qualifying small taxpayer”). This annual election can be applied to each building that has a cost basis of $1 million or less. A taxpayer who properly applies and elects this safe harbor may deduct all improvements to the building as long as the total amount paid during the tax year for repairs, maintenance, improvements, and similar activities performed on the eligible building do not exceed the lesser of $10,000 or 2% of the cost basis of the building. If the amount paid for repairs, maintenance, improvements, and similar activities performed on a building UoP exceeds the safe harbor threshold for a tax year, then this safe harbor is not applicable to any amounts incurred during the tax year. Instead, the taxpayer must apply the general rules for determining improvements, including the routine maintenance safe harbor for buildings (see below).
- Safe Harbor for Routine Maintenance – Routine maintenance is the recurring activities that a taxpayer expects to perform as a result of the taxpayer’s use of the UoP to keep the UoP in its ordinarily efficient operating condition. The activities are routine only if, at the time the UoP is placed in service by the taxpayer, the taxpayer reasonably expects to perform the activities more than once during a 10 year period for buildings or more than once during the class life of the UoP for all property other than buildings. Qualifying routine maintenance expenses are deductible in the year in which the expenses are paid or incurred. A taxpayer’s expectation that it will perform qualifying maintenance activities more than once during the applicable period is not deemed unreasonable merely because the taxpayer does not actually perform the maintenance a second time during the applicable period. However, the taxpayer must be able to substantiate that its expectation was reasonable at the time the property was placed in service.
Alternatively, the final regs include a new provision that allows a taxpayer to elect to capitalize all repair and maintenance expenditures to tangible property and depreciate the costs of such improvements when they are placed in service. A taxpayer who elects to capitalize repair and maintenance costs for tax purposes must capitalize those costs for financial accounting purposes as well.
Materials and Supplies
The regs define materials and supplies as tangible property used or consumed in the taxpayer’s business that is not inventory and falls into any of the following categories:
- A component acquired to maintain, repair or improve a unit of tangible property owned, leased, or serviced by the taxpayer that is not acquired as part of any single unit of tangible property
- Fuels, lubricants, water, and similar items that are reasonable expected to be consumed in 12 months or less,
- It is a UoP with an economic life of 12 months or less
- It is a UoP with acquisition or production cost of $200 or less
- Other property identified as materials and supplies in published IRS guidance.
The regs further differentiate between incidental and non-incidental supplies. Incidental supplies are carried on hand, there is no record of consumption and no inventory is taken. The cost of incidental supplies is deductible when the amounts are paid or incurred. Records of consumption and inventory are kept for non-incidental supplies. The cost of non-incidental supplies is deductible when these supplies are used or consumed. Similar to repairs and maintenance, the final regs also allow for taxpayers to capitalize all materials and supplies if the taxpayer elects to do so.
Rotable and temporary spare parts are materials and supplies acquired for installation on a UoP, are removable, and either repaired or improved and reinstalled or stored for later installation. The regs allow three options for the tax treatment of these parts:
- Deduct costs upon disposition,
- Capitalize and depreciate, or
- Elect an optional method which includes five parts to follow from initial installation, removal, repair or improvement of the part, reinstallation to disposal.
Prior to the temporary regulations, a taxpayer that retired a structural component of a building could not treat the retirement as a disposition and take a loss. Instead, the taxpayer had to continue depreciating the retired component and begin depreciating the replacement component (such as a retired roof). The following regs discussed are proposed regs, and, therefore, the following summary is subject to change.
Partial Dispositions of Assets not in General Asset Account
A taxpayer is allowed to claim a loss upon the disposition of a structural component of a building or upon the disposition of a component of any other asset without identifying the component as an asset before the disposition event by making an annual partial disposition election. If a loss has been taken, the replacement must be capitalized (i.e. taxpayers cannot take both a loss on disposition of the old asset and a repair deduction for the replacement).
Taxpayers must use a reasonable method to determine the basis for the partial disposition, and this method must be consistently applied to all dispositions.
General Asset Accounts
Under the temporary regs released in 2011, a taxpayer who placed a building or other asset in a general asset account (GAA) had the ability to choose whether to claim a loss on the retirement of a structural or other component of an asset when there was a “qualifying disposition,” which was virtually any disposition, or to continue to depreciate the asset and deduct the repair cost. This treatment was similar to the partial disposition rules above. However, under the newly-issued proposed regulations, a qualifying disposition would be restricted to a disposition that does not involve all the assets, the last asset, or the portion of the last asset remaining in a GAA that is:
- A direct result of a fire, storm, shipwreck, or other casualty, or from theft;
- A charitable contribution for which a deduction is allowable;
- A direct result of a cessation, termination, or disposition of a business, manufacturing or other income-producing process, operation, facility, plant or other unit (other than by transfer to a supplies, scrap, or similar account); or
- Generally, a transaction to which a nonrecognition provision applies.
Since the proposed regulations concerning GAA’s drastically limit a taxpayer’s ability to partially dispose of an asset which is included in a GAA, it may no longer be beneficial to place assets in GAA’s.
If a taxpayer disposes of a depreciable asset for federal tax purposes, including a partial disposition, and the adjusted basis of the asset was taken into account in realizing gain or loss, the costs of removing the asset or asset component are not required to be capitalized.
Changes to Comply with the Tangible Property Regulations
A change to conform to the regs is a change in accounting method which will require the taxpayer to file Form 3115. As of the date of this newsletter, the IRS has not yet issued Revenue Procedures providing detailed information on how to make the changes in accounting methods.
Some of the regs simply require an annual election be attached to the tax return each year the reg is exercised rather than a change in accounting method. Generally, these regs require a modified cut-off or cut-off adjustment, for such items as deducting de minimis materials and supplies. Only items that arise on or after the beginning of the year the election is made will be accounted for under the new method.
If you would like to discuss how these regs apply to your business, please contact Beth Van Leeuwen at firstname.lastname@example.org or your Marks Nelson professional.