After several years of struggle, the IRS has finally completed its “repair regulations” project and has issued the long-awaited final version of regulations (also known as the “regs” or “repair regs”) that will affect nearly all businesses for the 2014 tax year and beyond, since virtually all businesses have tangible assets. The regs explain the tax treatment of amounts paid to acquire, produce, or improve tangible property. The heart of the “repair regs,” Reg. §1.263(a)-3), provides a framework that integrates the basic rules and concepts that have been developed over the years in both court cases and IRS guidance for distinguishing capital expenditures from currently deductible repairs.
If the regs require an accounting method that is different from an accounting method the taxpayer currently uses, then an Application for Change in Accounting Method (Form 3115) must generally be filed for the tax year. Because many of the provisions are applicable to tax years starting after December 31, 2013, it creates an immediate compliance challenge for businesses that operate on a calendar year and are currently entering the filing season for 2014 tax returns.
The regs are lengthy and very complex. The summary below will provide a broad overview of how the regs treat the issues of capitalization vs. deduction of the costs of tangible property.
Capitalization vs. Deduction
The regs set forth the general rule that amounts paid to improve a “unit of property” must be capitalized. An improvement is defined as an expenditure that betters a unit of property, restores it, or adapts it to a new and different use. On the other hand, the regs allow a current deduction for repairs and maintenance to property. Deductible repair and maintenance expenses are defined as those which are not otherwise required to be capitalized.
“Unit of Property” – One key concept in the regs is the “unit of property” (UOP) that is being improved or repaired. The categorization of an expenditure as a capitalized improvement or as a deductible repair is greatly affected by the size of the UOP being worked on. The smaller the UOP, the more likely it is that costs incurred in connection with it will have to be capitalized. The larger the UOP, the more likely it is that costs will be characterized as a repair rather than as a capital expenditure.
In general, for property other than buildings, a single UOP consists of all components that are functionally interdependent, such that one component can’t be placed in service without the other components. For buildings, the regs generally treat each building and its structural components as one UOP – the “building.” Although an entire building is technically defined as a single UOP, the improvement rules are applied separately to each of nine enumerated building systems and to the remaining building structure. In effect, each building system and the remaining building structure are considered separate UOPs. The nine building systems are:
- HVAC systems
- Plumbing systems
- Electrical systems
- All escalators
- All elevators
- Fire-protection and alarm systems
- Security systems
- Gas distribution systems
- Other structural components that are specifically designated as building systems in future published guidance
If a taxpayer restores a building structure, such as by replacing the entire roof, the expense is treated as an improvement to the single UOP consisting of the building. If the taxpayer makes an improvement to a building system, such as the HVAC system, that expense is also an improvement to the building UOP.
In the case of a lessee who leases an entire building, the UOP is the entire building and the improvement rules are applied to the building structure and each building system in the same manner as if the lessee owned the building.
Deducting Materials and Supplies
A deduction is allowed for amounts paid to produce and acquire materials and supplies that are consumed during the year. “Materials and supplies” are defined to include five specific categories of property used or consumed in the business operations and that are not inventory. UOPs with an economic useful life of no more than 12 months qualified as materials and supplies under this rule. In addition, certain inexpensive items qualify as materials and supplies, such as a UOP that costs $200 or less to acquire or produce.
De minimis safe harbor – The regs allow a taxpayer to deduct certain limited amounts paid for tangible property that are expensed for financial accounting purposes. Under the 2011 temporary regs, this safe harbor was only available to taxpayer that had an applicable financial statement (an AFS, which can be a certified audited financial statement used for credit purposes, reporting to partners, or other non-tax purpose). The final regs change this by allowing businesses without an AFS to use the de minimis safe harbor. A taxpayer with an AFS can rely on the safe harbor if no more than $5,000 per invoice, or per item as substantiated by the invoice, was paid for the property. For businesses without an AFS, the maximum amount is $500 rather than $5,000.
Routine Maintenance Safe Harbor
The regs include a safe harbor that allows certain expenses of routine maintenance to be deducted rather than capitalized. Routine maintenance means recurring activities that keep business property in ordinarily efficient operating condition, such as inspection, cleaning, testing, and replacement of damaged or worn parts. The maintenance must be attributable to the taxpayer’s use of the property. Thus, the safe harbor does not apply to scheduled maintenance performed shortly after purchasing a used machine or an existing building. In the case of a building, the building structure and each building system is treated as a separate UOP. For a building structure or building system, the taxpayer must reasonably expect to perform the maintenance more than once during the 10-year period that begins when the structure or system is placed in service. For property other than buildings, the taxpayer must reasonably expect to perform the activities more than once during the property’s class life for depreciation purposes. The routine maintenance safe harbor is not elective and is considered an accounting method change.
Per-Building Safe Harbor for Qualifying Small Taxpayers
The final regs add a new safe harbor that allows qualifying small taxpayers (those with average annual gross receipts of $10 million or less in the three preceding tax years) to deduct improvements made to a building property with an unadjusted basis of $1 million or less. This safe harbor only applies if the total amount paid during the tax year for repairs, maintenance, and improvements to the building does not exceed the lesser of $10,000 or 2% of the building’s unadjusted basis. This safe harbor can be elected annually on a building-by-building basis. It is elected by including a statement on a timely filed tax return (including extensions) for the year the costs are incurred for the building. In the case of a partnership or S corporation that owns or leases a building, the partnership or S corporation makes the election. The election may not be made on an amended return unless permission to file a late election on an amended return is first obtained. The election is irrevocable. The safe harbor for qualifying small taxpayers is not considered an accounting method change.
Election to Capitalize In Accordance With Books
A new safe harbor under the final repair regs allow a taxpayer to confirm its tax capitalization policy to its book capitalization policy (Reg. §1.263(a)-3(n)). Rather than going through a potentially complicated analysis to determine whether a trade or business expenditure is a currently deductible repair or a capitalized improvement, the regs allow a taxpayer to make an annual election to capitalize and depreciate as a separate asset any expenditure for repair and maintenance if the taxpayer capitalizes the expenditure on the books and records it regularly uses to compute its trade or business income. The election applies to all amounts paid for repair and maintenance of tangible property that are treated as capital expenditures on the taxpayer’s books for the tax year that is covered by the election. These amounts are not treated as amounts paid for repair and maintenance, and, thus, are not currently deductible.
In effect, the election is a safe harbor, because the IRS cannot challenge an electing taxpayer’s characterization of a repair expense as a capital expenditure. However, the election works in only one direction. Amounts that are expensed as repairs on the taxpayer’s books may not be deducted as repairs for tax purposes under the protection of the book capitalization safe harbor. Repair deductions claimed for tax purposes must be allowable under the standards set forth in the repair regulations.
The election to capitalize in accordance with books is not an accounting method. However, a taxpayer that does not make this election is adopting an improper accounting method when it improperly capitalizes a repair expense. To change from an improper capitalization of a repair expense and from an improper deduction of a capital expenditure, taxpayers use change 184 of Rev. Proc. 2014-16.
Please contact our office if you would like to discuss any of the provisions of the final repair regulations or need more information about this important IRS guidance.
The Marston Group, PLC
January 2015