The IRS recently released final repair and capitalization regulations that will affect all taxpayers that acquire, produce or improve tangible property; i.e. just about everyone. For some industries, such as manufacturing, retail, hospitality and utilities, these new regulations are especially relevant. Planning for changes now—even making some in 2013—may have tax advantages.
The final repair regulations attempt to resolve some of the controversies that have arisen over the years between the IRS and taxpayers over how to classify certain costs for repairs or supplies that are deductible in a current tax year versus fixed assets that have to be capitalized and depreciated over a number of years. But in doing so, the IRS has generated pages and pages of complex regulations and elections that need to be considered. We have summarized some of the important provisions contained in the final regulations and their potential effects on businesses.
WHAT TAXPAYERS WILL NOTICE
In general, the biggest change taxpayers will have to evaluate and consider as they comply with the new final repair regulations is whether or not they have a change in their method of accounting.
While some of the provisions summarized below, including the de minimis rule, apply to amounts paid or incurred after January 1, 2014, taxpayers have the choice for tax years 2012 and 2013 of
- applying the final regulations,
- applying the temporary regulations that have been in place heretofore, or
- a combination of both.
Those who have been using a less favorable capitalization policy might find that a catch-up adjustment to change to the new rules will provide a favorable tax benefit. Others might not be so lucky. We are expecting the IRS to provide guidance shortly on how taxpayers may obtain automatic consent to change their method of accounting. In the meantime, Williams Benator & Libby can help you through this process.
SAFE HARBOR ELECTION – REMOVING SOME OF THE AMBIGUITY IN WHETHER TO EXPENSE OR CAPITALIZE
Generally, a taxpayer must capitalize and depreciate amounts used to acquire or produce property. However, under the final regulations, a taxpayer can elect to follow the minimum capitalization policy used for financial statement purposes, as long as the policy is in writing and in effect as of the beginning of the year for which the election is made, and requires that each invoice or item of $500 or more is capitalized. Note that the threshold is increased to $5,000 for taxpayers with “applicable financial statements,” which typically means financial statements that are audited by a CPA. So, if the required $500 or $5,000 policy is in place, the taxpayer can currently deduct amounts on a per-invoice or per-item basis if the cost is under the threshold. Otherwise, the item must be capitalized and depreciated over time like other fixed assets. But because these thresholds are just safe harbor amounts, the IRS has given its auditors leeway to accept higher thresholds on a taxpayer-by-taxpayer basis if it clearly reflects income.
The election to follow the policy used for financial statement purposes is made annually. But if made, it is important to note that the election also applies to materials and supplies as well as costs of items with a useful life of 12 months or less, making these items subject to the $500/$5,000 safe harbor rule for capitalization.
WHAT CAN BE DEDUCTED VS. CAPITALIZED FOR MATERIALS, SUPPLIES AND SPARE PARTS?
If the safe harbor de minimis rule discussed above is not elected, the cost of materials, supplies and certain spare parts are generally deducted in the year they are used or consumed. However, this rule generally assumes the items have a useful life of less than a year, cost $200 or less, or are acquired to maintain/repair another asset owned by the taxpayer. For rotable (assets routinely changed out for repair or overhaul), temporary or standby emergency spare parts, there is an election available to capitalize and depreciate such items. Note also that inventory is excluded from all of these rules.
WHAT QUALIFIES AS DEDUCTIBLE ROUTINE MAINTENANCE?
Amounts paid for recurring and routine maintenance on fixed assets are generally deductible when incurred. Activities are considered routine if the taxpayer reasonably expects to perform them more than once during the asset’s tax life (based on the alternative depreciation system or ADS tax life of the asset), or in the case of buildings, more than once over a 10-year period. For the purposes of what qualifies as routine maintenance, there is no requirement for financial statement conformity.
The regulations allow for an annual election to capitalize repair and maintenance costs, but only if such costs are capitalized on the taxpayer’s financial statements.
DEFINING THE IMPROVEMENTS OF PROPERTY AND SAFE HARBOR RULE FOR SMALL TAXPAYERS
Amounts paid to improve tangible property have to be capitalized and depreciated over time. This rule generally applies if the costs result in a material increase in the capacity, productivity, efficiency, strength or quality of the asset or its output. It also applies if there is a material addition, restoration or expansion to the asset.
The regulations have numerous examples attempting to define what might be capitalized as an improvement or restoration. But in doing so, they might have opened up an opportunity to currently deduct certain expenditures that would otherwise seem to be capitalizable. For example, under certain circumstances it might be possible to view an HVAC system as a unit of property separate from a building whereby the replacement of a small percentage of units in the HVAC system could be expensed as repairs or maintenance.
There is also an exception to the general rule for small taxpayers with $10 million or less of average gross receipts who make a safe harbor election with respect to their owned or leased buildings that have an unadjusted cost basis of $1 million or less. Such taxpayers can deduct building improvements if the total amount paid for repairs, maintenance and improvements on the building for the year does not exceed the lesser of $10,000 or two percent of the unadjusted basis.
Note that costs of removing a depreciable asset or a component from service can be deducted in the current tax year if the transaction results in realizing gain or loss. This underscores the importance of segregating costs of individual components or elements of an asset.
NEXT STEPS AND PLANNING
For those small businesses that have historically taken advantage of Section 179 expense deductions and bonus depreciation for fixed assets, a serious look at upcoming purchases/repairs is warranted. For 2013, Section 179 is available for a deduction up to $500,000 if total purchases are under $2 million. For 2014, this Section 179 amount will go down to $25,000 and phase out with purchases over $200,000 unless Congress acts to extend the more favorable rules. Further, the 50% bonus depreciation allowed for 2013 is currently set to expire for 2014 with limited exceptions. Clearly, with the changes discussed above to the capitalization rules in 2014 and the possible changes in Section 179 and bonus depreciation, taxpayers should consider accelerating purchases, repairs, etc., into 2013.
Williams Benator & Libby is well-versed in the new capitalization rules and can review your current or proposed policies for conformity. We can help analyze whether to retroactively change methods of accounting and can complete any necessary applications. We can also help assess the need for a formal cost segregation or repair/capitalization study and review whether disposals should generate current deductions. Please call any of your WBL tax advisors to further discuss your specific situation.