In late 2013, the Internal Revenue Service issued final regulations containing rules governing repairs and capitalization. These regulations, effective January 1, 2014, contain a complex framework of rules which must be applied to determine if costs incurred in acquiring, maintaining, repairing, and improving tangible and real property must be capitalized or deducted. This alert will enable you to understand the approach to the new rules by providing an overview of these regulations.
The contents of the new regulations can be broadly categorized into four topics: (1) the treatment of amounts paid to acquire/produce tangible property; (2) the treatment of amounts paid for materials and supplies; (3) treatment of amounts paid to repair or improve tangible and real property; and (4) dispositions of property.
ACQUITISION OF PROPERTY AND MATERIALS AND SUPPLIES
Acquisition of Property – De minimis Safe Harbor
The regulations include a safe harbor de minimis rule allowing a deduction for costs incurred to acquire property that would otherwise be required to be capitalized. Under this rule, taxpayers with an “applicable financial statement” (AFS) may elect, on an annual basis, to expense up to $5,000 of the cost of an item provided they have a written accounting policy in place before January 1, 2014 indicating that such items will be expensed on their financial statements. We have included a sample policy at the end of this Alert. For taxpayers without an AFS, the threshold for this provision is reduced to $500 per item. We recommend that business taxpayers who wish to rely on this safe harbor provision execute a written policy before January 1, 2014.
For purposes of these rules, an AFS only includes an audited financial statement. Compiled and reviewed financial statements do not qualify.
The $5,000/$500 limit, whichever applies, is an all-or-nothing limit. If the invoice total (or the per item cost) exceeds the applicable limit then no portion is deductible under this safe-harbor provision. In a taxpayer friendly move, the regulations make clear that additional costs such as delivery fees, installation services, etc. do not have to be considered in the $5,000/$500 limit if these costs are not included on the same invoice as the acquired property. Accordingly, it may be beneficial to request vendors to separately bill for those charges
These safe harbor de minimis provisions are just that – – a safe harbor for the benefit of taxpayers. It is possible that taxpayers under IRS examination could assert that the use of a higher dollar amount threshold to expense property clearly reflects taxable income. However, the burden of proof in this circumstance would be on the taxpayer.
Materials and Supplies
Materials and supplies are defined as tangible property that is used or consumed in the taxpayer’s business, that is not inventory, and that is:
- A component acquired to maintain, repair, or improve a unit of tangible property;
- A unit of property that has an economic useful life of 12 months or less; or
- A unit of property having an acquisition or production cost of $200 or less
Items which meet one of these criteria are permitted to be deducted in the year in which they are first used in the taxpayer’s trade or business. If they are not used in the year purchased the cost must be capitalized until such time as they are used or consumed. If, however, a taxpayer elects to apply the de minimis safe harbor rule discussed above, they must also apply it to amounts paid for materials and supplies. This means that a taxpayer would be able to expense amounts paid for materials and supplies even though they have not yet been used or consumed.
Example: A has an AFS and a written accounting policy to expense amounts paid for items costing $5,000 or less. A purchases 50 computers at $1,000 each for a total of $50,000 (the computers are not materials and supplies because their unit cost exceeds $200), as well as 25 briefcases at $80 each for a total of $2,000 (the briefcases are materials and supplies because their unit cost is less than $200). A elects to apply the de minimis safe harbor and thus can expense the $50,000 paid for the computers since the cost of each is less than $5,000. It can also deduct the $2,000 paid for the briefcases since each cost less than $200. If, however, A did not have an AFS, the total cost of the computers would have to be capitalized and depreciated under the applicable tax depreciation rules as each item cost more than $500. However, the cost of the briefcases may be eligible to be expensed under the material and supplies rule discussed above.
REPAIRS AND IMPROVEMENTS
With regards to amounts spent to repair or improve property, taxpayers generally must capitalize costs that result in (1) a betterment to the unit of property; (2) a restoration of the unit of property; or (3) an adaptation of the unit of property to a new or different use. While these concepts have always been part of the tax code, the focus of the IRS, through these regulations, is to eliminate some of the subjectivity surrounding this issue by making it clearer that capitalization will be required in many cases.
In determining whether an expenditure should be capitalized or expensed, the “unit of property” concept is significant. In the context of real estate, the regulations have identified the following components of a building as being independent units of property separate and distinct from the building structure itself:
- Heating, ventilation, and air conditioning (HVAC)
- Plumbing systems
- Electrical systems
- All escalators
- All elevators
- Fire-protection and alarm systems
- Security systems protecting the building and/or occupants
- Gas distribution systems
- Other structural components identified in published guidance
This new partitioning of a building structure into these smaller components may cause what previously was considered a deductible repair to now being treated as a capital expenditure since the work performed relative to that smaller component is more likely to constitute a significant improvement to the component. While there are no bright-line tests to determine what constitutes a repair versus a betterment, restoration or adaptation, the following examples from the regulations provide some insight to an otherwise subjective determination:
Example: K owns a building, discovers several leaks in the roof and hires a contractor to inspect and fix the roof. It is discovered that a major portion of the decking has rotted and it is recommended that the entire roof (decking, insulation, asphalt and various coatings) be replaced. Amounts paid by K to replace the roof are treated as a restoration and must be capitalized and depreciated.
Example: Assume the same facts as above except that it is discovered that only the rubber membrane has begun to wear and it is recommended that the membrane be replaced with a new rubber membrane which is comparable to the old one. Amounts paid by K to replace the membrane are treated as repairs and can be expensed.
Example: M owns an apartment building containing 300 windows covering 25% of the building’s exterior surface. M replaces 100 of the 300 windows. The amounts spent by M are treated as a repair and can be expensed.
Example: Assume the same facts as above except that the windows cover 90% of the building’s surface. The amounts spent by M replacing 100 of the windows would be considered a restoration and must be capitalized and depreciated.
The regulations contain many more examples which may provide additional assistance with this determination.
The portion of the regulations addressing the disposition of a building component have not yet been finalized by the IRS. However, the temporary regulations contain rules related to the write-off available for the remaining “basis” of the replaced unit of property. These rules protect taxpayers from having to depreciate the same improvement twice by allowing for a disposition deduction for the replaced component. For example, if a new roof is required to be capitalized in the current year, there should be a loss allowed for the undepreciated portion of the old roof in the same year. Additional guidance on how to treat dispositions is expected by the end of 2013. There may be refund opportunities for taxpayers that have made significant improvements to property whereby there is still remaining basis in the property replaced. It is expected that these benefits will be able to be claimed on 2013 tax returns.
The above discussion addresses some of the underlying concepts contained in these new complex regulations. While businesses in most industries will be affected one way or another, the real estate industry will be especially impacted as these new rules will require many real estate companies to capitalize and depreciate over time amounts which they have previously treated as current expenses. Please contact your Wilkin & Guttenplan tax advisor in order to begin planning for the implementation of these new rules.
Note: This is provided as an example of a de minimis safe harbor expensing policy. This policy must be followed for a company’s books and records and, if applicable, for its financial statements if a company elects to follow the de minimis safe harbor. Companies must independently verify that this is a valid policy for financial accounting purposes.[COMPANY NAME]
DE MINIMIS EXPENSING POLICY
Adopted: [Date] *
The guidelines set forth in this policy are the company’s de minimis expensing policy, and is a necessary requirement for compliance with the Internal Revenue Code and the tangible property regulations promulgated thereunder. The guidelines are intended to be used for the company’s non-tax and tax reporting.
Effective January 1, 2014, [COMPANY NAME] will not capitalize amounts meeting the following criteria:
1) Amounts paid to acquire, produce, or improve tangible property not exceeding $X,XXX** are charged to the appropriate de minimis expense accounts. This threshold is applied at the per item or per invoice level and must include any allocable expenses included on the invoice, e.g. taxes, transportation, etc., or
2) Amounts paid to acquire, produce, or improve tangible property with an economic useful life of 12 months or less are charged to the appropriate de minimis expense accounts.
This policy does not apply to land, inventory or certain rotable, temporary, emergency spare parts
* Should be effective no later than the first day of 2014 tax year to be effective for that year.
** The amount can go up to $5,000 if the company has an applicable financial statement. This amount can go up to $500 if the company does not have an applicable financial statement.