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IRS’s Final Tangible Property Rules Benefit Taxpayers
After a decade of contention and proposed regulations, the IRS has finally released comprehensive guidance on a fundamental tax issue: is an expenditure relating to tangible property a deductible repair or a capital expenditure?
For the most part, the final regulations — under discussion since 2004 — are complete. They reflect a substantial effort on behalf of the IRS to address taxpayer concerns and will apply to virtually every business that incurs repair and maintenance costs and owns tangible property.
De minimis safe harbor election
One of the most positive developments in the final regulations is a more taxpayer-friendly de minimis safe harbor election. A taxpayer may elect a de minimis safe harbor to deduct the amounts paid to acquire or produce tangible property up to a certain dollar threshold.
There is a limit on this deduction; it is tied to either a maximum of $5,000 or $500, depending on whether the taxpayer has an applicable financial statement. Businesses with a certified audit or other narrow category of financial statement can expense up to $5,000 per item or invoice, but must expense the same amount for financial reporting purposes as well. For those without audited financials, the item or invoice amount generally cannot exceed $500.
For example, a small business purchases ten laptops at $300 each for a total cost of $3,000 per the invoice. It has adopted a written accounting procedure to expense amounts paid for property costing less than $500 at the beginning of the year. The amount paid for each laptop meets the de minimis safe harbor, and therefore the company may deduct the expenditure as a business expense.
One of the other favorable developments in the final regulations applies to building improvements. In the past, the IRS did not allow write-offs for replaced components of property (e.g., deducting the old roof when a new roof is installed). With the new rules, when a current repair is substantial enough to require capitalization, property owners may be able to claim a disposition loss for any underappreciated costs of the replaced asset.
For example, if all the windows of an existing building were replaced, it is now possible to segregate the original windows from the original building (assuming the building purchase or construction resides on one asset account) and take any remaining tax basis as a loss.
The IRS has also expanded the definition of “building systems” to include escalators, elevators, HVAC, plumbing, electrical, fire protection, alarm systems, security, gas distribution, and other systems. These separate systems require an additional level of review to determine the proper tax treatment for repair or replacement expenditures.
All remaining building structures, such as walls, foundations, doors, and windows, are categorized as the overall building and not as a building system. Items such as shingle replacement and roof membranes are now eligible to be expensed in qualifying situations. Leasehold improvements, such as tenant improvements and retail reconfigurations, are also covered under the new regulations, providing tax benefits under certain considerations.
In general, repairs and maintenance expenditures for tangible property are deducted, unless they fall under capitalization requirements. Requirements for capitalization center on whether the expenditure creates an improved asset, restores the asset after significant deterioration, or adapts the underlying asset to a new use. Routine maintenance on equipment and other personal property also may be deductible under a new safe harbor rule in the regulations, even if the amount is considered significant. There is also a routine maintenance safe harbor rule for building expenditures intended to be performed more than once in a 10-year period, which may include items such as repainting and retiling.
Classifying materials and supplies
The final rules also include a notable change for materials and supplies. These items must now be classified as either incidental or non-incidental.
Incidental materials and supplies are those whose consumption is not recorded and expensing does not distort income. These amounts can be deducted when paid. For example, this may include replacing a broken light fixture. Non-incidental materials and supplies, i.e., those whose consumption is recorded and budgeted, are deductible in the taxable year in which they are first used or consumed.
These and other changes under the new rules are sweeping in nature and require a review of prior property classifications, as well as an evaluation of new purchases. In order to maximize benefits, prior assets should be viewed holistically, with each asset evaluated for favorable treatment and overall savings potential. It’s important that each business carefully evaluate the new regulations for potential tax reduction opportunities.