On Sept. 13, 2013, the IRS released final regulations regarding the question of whether an expenditure relating to tangible property is a deductible repair or capital expenditure (commonly known as the repair regulations). The final regulations will affect all taxpayers that:
- Produce; or
- Improve tangible property.
In the case of any prior expenditures that may need adjustment under these regulations, corrections can be made under favorable accounting method change procedures for the 2014 tax year. But some businesses will need to adopt new written accounting policies before January 1, 2014.
The heart of the repair regulations contains rules that distinguish deductible repair expenditures from those that must be capitalized and depreciated. This broad framework integrates the basic rules and concepts that have been developed over many years in court cases and IRS guidance. Misclassification is common due to the complexity of these rules and a heavy reliance on facts and circumstances rather than bright-line tests. The changes brought about by the final regulations provide much-needed clarification, while other provisions may well increase administrative burdens and be a continued source of controversy.
Taxpayers should begin preparing for the impact of these changes as soon as possible. Additional training for accounting staff and changes to processes may be necessary for full compliance. In addition, early adoption of select portions of the final regulations prior to 2014 may be advantageous, depending on your situation.
A – Amounts paid to improve property
In general, a taxpayer must capitalize amounts paid to improve a unit of property (UOP). Generally, a UOP has been improved if the activities performed on the property:
- Result in a betterment to the UOP (Betterments);
- Restore the UOP (Restorations); or
- Adapt the UOP to a new or different use.
A taxpayer must capitalize the direct and indirect costs of an improvement, including otherwise deductible repair and removal costs that directly benefit or are incurred by reason of the improvement.
The starting point in this analysis is to determine what the UOP that is the subject of the improvement. Inherent in this inquiry is the “put versus keep” test developed by the courts under which the repair expenditure must be:
- Capitalized if it “puts” the UOP into an ordinarily efficient operating condition; or
- Deducted if it “keeps” the UOP in its ordinarily efficient operating condition.
For buildings, the UOP is comprised of the building and its structural components. However, these improvement standards must be applied separately to the building structure and to each specifically defined building system, which include:
- Structure – structural components other than those designated below;
- Heating, ventilation, and air conditioning systems (HVAC);
- Plumbing systems;
- Electrical systems;
- All escalators and elevators;
- Fire protection and alarm systems;
- Security systems; and
- Gas distribution systems
This is a significant change from prior law, as most taxpayers normally treated these building systems as a single UOP. Due to a smaller UOP measurement for buildings and building systems, expenditures are more likely to be capitalized. For example, if the entire building is the UOP, then major work on a HVAC system might be a repair. Alternatively, if the HVAC system is the UOP, then that work probably will need to be capitalized.
The UOP guidance as it relates to real property will require taxpayers to identify and track building system costs—which to date were not required to be accounted for in this manner—if the taxpayer wants to analyze and determine efficiently whether a future expenditure is a Betterment to a specific building system or to the building structure (e.g., as in the case of renovations involving several building systems). The building systems generally correspond to the Construction Standard Index, with certain exceptions. A greater breakdown of construction costs and the basis of acquired property similar to a cost segregation study for the real property costs will be needed in many cases to perform the proper analysis.
For all other real and personal property other than buildings, the UOP is defined as all the components that are functionally interdependent. Personal property would normally include manufacturing equipment, office equipment, and furniture and vehicles. For real property, this would include parking lots, driveways, and sidewalks.
Example: a computer and printer, even though purchased together, are not functionally interdependent, as placing one asset in service is not dependent on placing the other asset in service.
For property other than buildings, this may result in larger UOP’s than those used for financial accounting purposes. As a result, if taxpayers follow their financial accounting method, they may be capitalizing repair expenditures that should be deducted for tax purposes.
An expenditure that results in a Betterment must be capitalized as an improvement if it:
- Ameliorates a material condition or defect that existed prior to acquisition of the UOP, whether or not the taxpayer was aware of the condition or defect;
- Results in a material addition (including a physical enlargement, expansion, or extension) to the UOP; or
- Results in a material increase in capacity, productivity, efficiency, strength, quality, or output of the UOP.
The taxpayer must compare the condition of the property immediately before the circumstances that necessitated the expenditure to the condition immediately after to determine if there was a Betterment.
The second category of capitalized improvements involve amounts paid to restore a UOP if:
- A component of the UOP is replaced and a loss is deducted or a gain or loss is realized by selling or exchanging the replaced component;
- A casualty loss resulting in any basis adjustment is claimed on the repaired UOP;
- The expenditure returns the UOP to its ordinary efficient operating condition after the property has deteriorated to a state of disrepair and was no longer functional for its intended use; or
- The expenditure was for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a UOP.
For the first two criteria above, the damaged property is treated as retired, the remaining basis is recovered, and the property that replaces the damage property is capitalized. For casualty losses, taxpayers can claim a tax deduction or loss for the full amount paid to correct the damage (if not a Betterment or if not adapted to a new or different use).
The final regulations provide some quantitative guidance for major components of buildings or building systems. The examples imply that a replacement of 40% or less is not a Restoration, while 66% or more is a Restoration.
Example: the replacement of 30 out of 300 exterior windows of a building does not constitute the replacement of a major component or substantial structural part of the building structure and are not a Restoration or improvement to the building. Conversely, replacement of 200 out of 300 exterior windows must be capitalized.
In general, an amount paid to adapt a UOP to a new or different use is capitalized if the adaptation is not consistent with the intended ordinary use of the UOP at the time it was originally place
d in service. This analysis should take into account any broadly accepted industry norms when evaluating what is considered “ordinary use”.
B – Simplifying conventions and safe harbors dealing with improvements to property
Safe harbor for small taxpayers
Qualifying small taxpayers with annual gross receipts of $10 million or less can elect to not apply the improvement rules to an eligible building property if the amount paid during the tax year for repairs, maintenance, and improvements on the building is less than the lesser of:
- $10,000; or
- 2% of the unadjusted basis of the building
Eligible building property generally includes buildings and leased buildings with a tax basis, before depreciation, of $1.0 million or less. If the amounts paid for repairs and improvements exceed the annual limit for a building, the safe harbor is not available for that year.
Election to Capitalize Repair and Maintenance Costs
If a taxpayer incurs repair and maintenance costs to improve property and treats these amounts as capital expenditures on its books and records, then he may elect to apply this same method for tax purposes to all amounts paid by treating these same costs as capitalized and depreciated for tax purposes.
This election is made by attaching a statement to the taxpayer’s timely filed original tax return (including extensions) for the tax year in which such amounts are paid.
This election may be welcome simplification for taxpayers that tend to overcapitalize repair costs and cannot deal with the compliance burden present by the repair regulations. Nevertheless, this election will not release the taxpayer from the obligation to capitalize for tax purposes the amounts required under the repair regulations that have been expensed on their books and records.
Routine Maintenance Safe Harbor
Under this Safe Harbor, amounts paid for routine maintenance on a UOP are not required to be capitalized as an improvement to the property. Routine maintenance typically are expenditures the taxpayer expects to perform in order to keep (as opposed to put) the building or other property in its ordinarily efficient operating condition.
The routine maintenance safe harbor should have limited applicability because:
- Most taxpayers already expense these items;
- The regulations contain a long list of costs which do not qualify; and
- Betterments, Restorations, and Adaptations do not qualify.
C – Amounts paid to acquire or produce tangible property
The regulations distinguish amounts paid to acquire and produce new tangible property from amounts paid to improve existing property. The taxpayer must capitalize the amount paid to acquire or produce real or personal property and to defend or perfect title to such property, including:
- Invoice costs;
- Transaction costs; and
- Costs for work performed prior to the actual date that the UOP is placed in service (for example, repairs, installation, and testing costs).
Whether an amount is paid or incurred to facilitate the acquisition of property in the process of investigating or otherwise pursuing the acquisition is determined based on the facts and circumstances. Below is a list of inherently facilitative costs that must be capitalized as transaction costs:
- Transporting the property (for example, shipping fees and moving costs);
- Securing an appraisal or determining the value or price of property;
- Negotiating the terms or structure of the acquisition and obtaining tax advice on the acquisition;
- Application fees, bidding costs, or similar expenses;
- Preparing and reviewing documents that effectuate the acquisition of the property (for example, preparing the bid, offer, sales contract, or purchase agreement);
- Examining and evaluating the title of property;
- Obtaining regulatory approval of the acquisition or securing permits related to the acquisition, including application fees;
- Conveying property between the parties, including sales and transfer taxes, and title registration costs;
- Finders’ fees or brokers’ commissions, including fees contingent on the successful closing of the acquisition;
- Architectural, geological, survey, engineering, environmental, or inspection services pertaining to particular properties; or
- Services provided by a qualified intermediary or other facilitator of an exchange under §1031.
Important note: Transaction cost must be capitalized even if the real or personal property is not acquired. If the acquisition is later abandoned, such costs may be recovered under §165. Employee compensation and overhead costs are not facilitative costs unless the taxpayer elects to capitalize those costs separately for each transaction, subject to other conditions under §263A. In addition, some of the above facilitative expenses may qualify as amortizable startup expenditures under §195 which may result in a shorter depreciable life.
Real property investigatory costs
Activities that are performed to determine whether to acquire real property, and which real property to acquire (so-called “whether and which” expenses), generally are not treated as facilitative costs unless specifically included above or the taxpayer elects to capitalize those costs. Such pre-decisional costs are deductible in the case of real property. An allocation of such costs will allow taxpayers to deduct investigatory costs related to the acquisition of real property, while capitalizing such costs related to personal property. In addition, contingency fees are included in the basis of property acquired (amounts paid that are contingent on the successful closing of the acquisition).
Example: a retailer would not have to capitalize the cost of hiring a consulting firm to suggest which areas of a city it should expand into (these costs are not included in the inherently facilitative list), but it would have to capitalize the cost of paying an appraiser to determine the value of properties that the consulting firm recommends. Special allocation rules apply to real and personal property acquired in one transaction.
De minimis safe harbor election
A taxpayer may elect a de minimis safe harbor to deduct amounts paid to acquire or produce tangible property up to a dollar threshold. That limit is $5,000 per invoice (or per item in the case of a taxpayer with an Applicable Financial Statement (AFS)), but only $500 for those without an AFS. An AFS is one of three types of financial statements:
- A 10-K required to be filed with the SEC;
- A certified audited financial statement prepared by an independent CPA; or
- A financial statement required for a federal or state governmental agency.
In order for a taxpayer to use the de minimis safe harbor, there must be a written accounting procedure in place at the beginning of the tax year. In order for a calendar year taxpayer to use this provision, there must be a written policy in place by January 1, 2014. The expenditure must always be treated as a deduction in the AFS for property costing less than the dollar figures above in order to qualify for the safe harbor. This safe harbor may be elected annually on a timely filed tax return.
Taxpayers often have informal agreements with IRS agents regarding immaterial asset acquisition thresholds. Generally, such agreements should be respected, however the preamble to th
e final regulations states that if taxpayers deduct amounts above the de minimis rule that they will have the burden of showing that such treatment clearly reflects income.
Example: Beta Company, a small business, purchases 10 laptops at $300 each for a total cost of $3,000 per the invoice. Beta does not have an AFS, but has adopted a written accounting procedure to expense amounts paid for property costing less than $500. The amount paid for each laptop meets the de minimis safe harbor, and Alpha may deduct the expenditure as a business expense.
Example: Alpha Corporation is part of a consolidated AFS. Alpha acquires 200 computers at $4,000 each for the current year. Alpha has a written accounting procedure in place to expense amounts paid for property costing $5,000 or less. Alpha may deduct the purchase of the computers as an ordinary business expense.
Materials and supplies
Incidental materials and supplies may be deducted when purchased. These are items for which no record of consumption is kept and expensing the items does not distort income. Materials and supplies that do not fit these definitions are deducted when used or consumed.
A deductible material or supply is tangible personal property, other than inventory, used or consumed in the taxpayer’s operations. This includes fuel, lubricants, water, or similar items reasonably expected to be consumed in 12 months or less. It also includes:
- Other property with an economic useful life of 12 months or less;
- An item with an acquisition or production cost of $200 or less;
- A component acquired to maintain, repair, or improve a UOP that is not acquired as part of a single UOP
Rotable and temporary spare parts
This category is a subset of materials and supplies. Taxpayers are allowed several alternative methods, with the third choice being a new option in the final regulations:
- Deduct the cost of these parts only when they are disposed of;
- Capitalize and depreciate the spare parts; or
- Deduct the cost of the spare part when first installed, but record income at its fair market value when removed, and continue that process until claiming a final loss at disposition.
D – Dispositions of Property
Proposed regulations under §168 were released providing guidance regarding dispositions of tangible depreciable property that intersect with the final repair regulations. These proposed regulations will affect all taxpayers that dispose of property. They also amend the general asset account regulations and the accounting for MACRS property regulations.
The most significant change in this area is the inclusion of new rules related to partial dispositions, which may now permit the deduction of certain capitalized depreciable assets to be written off that were not allowed in the past.
As a consequence, one can anticipate that many taxpayers will elect general asset accounting when appropriate. This election will give taxpayers the ability to deduct disposed building components if a related repair or maintenance activity expenditure is capitalized under the improvement rules. Conversely, if the repair or maintenance activity of a building component is deductible, no disposition loss on the building component would be available. Absent such election, building components must be deducted when disposed of, with the result that the related repair or maintenance expenditure is treated as a capital restoration under the improvement rules.
What is the “asset” that is disposed?
A key new provision in these disposition rules deals with what the “asset” is for this purpose. Generally, the asset may not be larger than the UOP. Under new proposed rules for buildings, each building, including its structural components, is the asset for disposition purposes. For property other than buildings or structural components, each item in asset classes 00.11 through 00.4 of Rev. Proc. 87-56 is considered a separate asset.
Under new proposed rules, the partial disposition of an asset would allow taxpayers to claim a loss upon the disposition of a structural component (or a portion thereof) of a building or a component of any other asset without identifying the component as an asset before the disposition event.
Generally, this partial disposition rule would be elective except in the following cases:
- The disposition of a portion of an asset resulting from a casualty event described in §165;
- The disposition of an asset for which gain is not recognized under §1031 or §1033;
- The transfer of a portion of an asset in a “step-in-the-shoes” transaction under §168(i)(7); or
- The sale of a portion of an asset
Example: the partial disposition election is made for an elevator that was replaced in an office building. Although the office building and its structural components is the “asset” for the disposition purposes, the result of making the partial disposition election for the elevator is that the retirement of the replaced elevator is in a disposition. As a result, depreciation for the retired elevator ceases at the time of its retirement and the taxpayer recognized a loss. Furthermore, the taxpayer must capitalize the amount paid for the replacement elevator, and the replacement elevator is a separate asset for disposition purposes.
A disposition of an asset includes a:
- Physical abandonment;
- Destruction; and
- Transfers to scrap or a similar account.
The proposed regulations provide examples of reasonable methods that taxpayers may use to determine the adjusted basis of disposed assets including:
- Discounting the cost of the replacement asset using the Consumer Pirce Index;
- Allocating the original unadjusted basis of the building based on the replacement cost of the component versus the replacement cost of the building as a whole; or
- Conducting a segregation study.
The entirety of the final repair regulations apply to tax years beginning on or after January 1, 2014. However, taxpayers must be careful, as certain provisions only apply to amounts paid or incurred on or after January 1, 2014.
Alternatively, taxpayers may choose to apply the final regulations to taxable years beginning on or after Jan. 1, 2012. For taxpayers choosing this early application, certain provisions only apply to amounts paid or incurred in taxable years beginning on or after Jan. 1, 2012. The final regulations provide transition relief for taxpayers that did not make certain elections (for example, the election to apply the de minimis safe harbor or the election to apply the safe harbor for small taxpayers) on their timely filed original federal tax return for their 2012 or 2013 taxable year (the applicable taxable year).
Finally, taxpayers may also choose to apply the 2011 temporary regulations to taxable years beginning on or after Jan. 1, 2012, and before Jan. 1, 2014. For taxpayers choosing to apply the temporary regulations to these taxable years, certain provisions of the temporary regulations only apply to amounts paid or incurred in taxable years beginning on or after Jan. 1, 2012, and before Jan. 1, 2014.
How we can help
Generally, you need to work with a CPA firm that specializes in the analysis and application of these rules governing repairs and maintenance. The advisor must understand the complex web of rules that determine when an expenditure may be deducted as a repair and maintenance expense.
Convergence will conduct a thorough review of your cu
rrent capitalization policies and determine whether there is an opportunity to accelerate repairs and maintenance deductions. In addition, our specialists will review the previous year’s tax returns to determine if you qualify for a retroactive accounting method change. If you qualify, you may be able to claim a deduction in the current year for repairs and maintenance that were erroneously capitalized in prior years.
Should you have any questions about this topic or related issues, please contact me at 303-951-2059 or firstname.lastname@example.org.
IRS Circular 230 Disclaimer: To ensure compliance with IRS Circular 230, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (1) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer, or (2) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.