New tax regulations effective January 1, 2014 will affect every taxpayer that uses tangible property in its business. The rules are complex, and implementation requires careful consideration. Why is this important? For one, these changes can significantly impact the cash flows of a business, because the new rules will likely change the timing of deductions (both positively and negatively). Secondly, they are mandated. They take away what previously may have been considered judgmental.
Generally speaking, expenditures that restore the property to its operating state are a deductible repair. However, expenditures that more permanently enhance the property, are probably capital. For example, rebuilding an engine is considered capital, since rebuilding an engine increases the value of the vehicle and prolongs its life. Alternatively, regularly scheduled maintenance is deductible. Some commentators say the regulations start with the proposition that all tangible property that is not inventory must be capitalized and depreciated unless there is an exception.
Materials and Supplies
One exception to the capitalization rule is for materials and supplies. Generally, an item that costs $200 or less or has an economic useful life of 12 months or less qualifies as a material or supply and may be expensed. The regulations provide (but don’t require) an annual election to substitute a taxpayer’s capitalization cost for the $200 limit under the de minimis rules. Rules become more complex if the $200 threshold is not selected.
Taxpayers generally must capitalize amounts paid to acquire or produce tangible property. Special rules exist for costs of acquiring real property and optional elections to capitalize deductible costs or exclude certain administrative costs from capitalization. Taxpayers need to confirm that they are adequately capturing all acquisition costs under the final regulations.
Unit of Property
The rules begin by defining a unit of property. Then, improvement standards determine whether expenditures improve the property to require capitalization. Special rules exist to identify units of property. When units of property are broken down into smaller components, different depreciation methods may come into play, providing planning opportunities.
An expenditure must be capitalized if it is a betterment to the unit of property, adapts the unit of property to a new or different use, or results in a restoration of the unit of property (referred to as the BAR tests). Expenditures on existing assets that do not meet the BAR tests are generally deductible repairs.
Taxpayers now must recognize a gain or loss when assets are withdrawn from use in the taxpayer’s business or from the production of income. A disposition includes the sale, exchange, retirement, physical abandonment, or destruction of an asset or when an asset is transferred to a supplies, scrap, or similar account. It also includes the retirement of a structural component of a building.
Special Issues with Buildings
Generally, a building is a unit of property, but there may be variations. For instance, if the building is a condominium complex, the unit of property is the individual unit owned by the. The rules require the application of the improvement standards separately to the primary components of the building or building systems. The primary components of a building generally include walls, partitions, floors, and ceilings, as well as any permanent coverings (paneling or tiling), windows, and doors. The building systems include (1) heating, ventilation, and air conditioning systems; (2) plumbing systems; (3) electrical systems; (4) all escalators; (5) all elevators; (6) fire protection and alarm systems; (7) security systems; (8) gas distribution systems; and (9) any other systems identified in published guidance.
There is an elective safe harbor for routine maintenance, whereby taxpayers may be able to deduct expenditures for activities that the taxpayer reasonably expects to occur more than once during the life of the asset and that do not result in a betterment. For example, if a taxpayer expects to resurface a parking lot every five years, under the safe harbor this is not an improvement, and is currently deductible. Also, there is a safe harbor for qualifying small taxpayers to expense costs of certain real property if the expenditures generally do not exceed the lower of 2% of the unadjusted basis of the building or $10,000 for buildings with a basis of $1 million or less.
Until Revenue Procedure 2015-20 was issued on February 13, 2015, the IRS considered these requirements to be accounting methods and required the filing of a Form 3115, Application for Change in Accounting Method, for this mandatory compliance. The IRS has waived this requirement for certain small business taxpayers.
Every Taxpayer Needs to Make a Thorough Assessment
These new repair regulations create significant changes to the treatment of tangible property. Business as usual will not be acceptable. Requirements pose both favorable and unfavorable results, but the changes are not optional. A thorough assessment of the treatment of tangible property acquisitions, improvements, repairs, and dispositions is necessary to comply with current law.
This summary in not intended to be nor can it be relied upon as guidance on any tax matter and is for informational purposes only. The reader is advised to consult with their own tax advisor for guidance on anything contained in this document.