IRS Issues New Regulations on Tangible Property
Taxpayers who acquire, produce, or improve tangible property, take note: new temporary and proposed IRS regulations give guidance on how to deduct and capitalize related expenditures.
“Almost all businesses incur repair costs and are affected by the new regulations,” says Dan Greenhagen, a tax manager with CliftonLarsonAllen. “Many businesses will need to evaluate their current methods of accounting for tangible property to determine what changes are necessary to comply.”
The long awaited regulations were released on December 23, 2011, and are generally effective for taxable years beginning on or after January 1, 2012.
The line where deductible repairs under Section 162 ends and capitalized improvements under Section 263 begins has always been far from clear and has led to much controversy between taxpayers and the IRS. The new regulations do little to unwrap the mystery (generally eschewing bright-line tests for facts and circumstances analysis). However, they do make some substantive changes to the location of the line—some favor taxpayers, and some do not.
Complying with the new regulations generally requires a change in accounting methods. Taxpayers wanting to change to an allowable method must get the IRS’s consent. As of February 7, 2012, that procedure is expected to occur under automatic consent filing of Form 3115. The IRS will provide two revenue procedures (possibly around April 15, 2012) outlining the routes entities must pursue to get automatic consent when changing their accounting methods. (Stay tuned for that guidance.)
Deductible expenses under the new regulations
Materials and supplies
The regulations indicate that incidental materials and supplies may be deducted when purchased as long as no record of consumption is kept and expensing such items does not distort income. Non-incidental materials and supplies, however, are not expensed until they are used or consumed.
Items considered materials and supplies are:
- Components acquired to maintain or repair property
- Fuel, lubricants, water, and similar items
- Property with an economically useful life of 12 months or less
- Property with an acquisition or production cost of $100 or less
- Other property identified by the IRS
De minimis rule
The de minimis rule provides another deduction opportunity on amounts paid to acquire or produce tangible property. To be eligible, however, a taxpayer must: have an applicable financial statement (AFS—which is generally an audited financial statement); have a written accounting policy for deducting property costing less than a certain dollar amount for non-tax purposes; and follow its written accounting policy.
The total amount of such expensed items cannot exceed the greater of:
- 0.1 percent of the taxpayer’s gross receipts for the tax year as determined for federal income tax purposes; or
- 2 percent of the taxpayer’s total depreciation and amortization expense for such year as determined in its AFS.
“Many smaller, privately held taxpayers will not be able to take advantage of the de minimis rule because they don’t have an AFS,” notes Greenhagen.
The general rule is that a taxpayer may deduct amounts paid for repairs and maintenance to tangible property as long as the amounts are not otherwise required to be capitalized. Although the general rule is not very helpful, the regulations do, however, allow a safe harbor deduction for routine maintenance.
Routine maintenance safe harbor
Routine maintenance is the recurring activities that keep a unit of property in its ordinary operating condition. This includes the inspection, cleaning, testing, and replacing of parts. Activities are routine only if the taxpayer reasonably expects to perform the activities more than once during the class life of the property. The routine maintenance safe harbor applies to all property other than buildings.
Expenditures required to be capitalized
Amounts paid for tangible property that needs to be capitalized fall into two general buckets: amounts paid to acquire or produce tangible property, and amounts paid to improve it.
- Taxpayers must generally capitalize amounts paid to acquire or produce a unit of real or personal property, including leasehold improvement property. This includes the invoice price, transaction costs, and costs for work performed prior to the date the property is placed in service by the taxpayer.
- A taxpayer must capitalize amounts paid to improve property. Property is improved if the amounts paid result in betterment to the property, restore the property, or adapt the property to a new or different use.
A betterment is an amount paid to correct a material condition or defect of the property, which results in either:
- A material addition to the property (physical enlargement, expansion, or extension), or
- A material increase in capacity, productivity, efficiency, strength, or quality of the property or the output of the property.
An amount is paid to restore property if:
- It is for the replacement of a component of the property and the taxpayer recognized gain or loss on the sale or exchange of the component or deducted a loss for the component;
- The taxpayer returns the property to its ordinary efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional;
- It results in the rebuilding of the property to a like-new condition after the end of its class life; or
- It replaces a part or a combination of parts that comprise a major component or substantial structural part of the unit of property.
An amount is paid to adapt property to a new or different use if the adaptation is not consistent with the taxpayer’s intended ordinary use of the property at the time the property was originally placed in service by the taxpayer.
“The IRS included 19 examples in the regulations to illustrate what is and what is not a betterment, and 26 examples to illustrate what is and what is not a restoration,” notes Chris Hesse, a tax partner with CliftonLarsonAllen. “The number of examples demonstrates the difficulty of determining the fine line between a deductible expense and a capitalized item.”
Unit of property
Determining the relevant unit of property also plays a large role in shaping whether an amount paid is properly deducted as a repair—or must be capitalized as an improvement to the property.
“The larger the unit of property, the more likely the amount paid will be considered a deductible repair,” says Perry McGowan, a construction and real estate tax director with CliftonLarsonAllen.
For real and personal property (except buildings), a unit of property is comprised of all components that are functionally interdependent (the placing in service of one component is dependent on the placing in service of the other component.)
A new twist in the regulations is the unit of property determination for buildings. A building and its structural components are a single unit of property. For application of the improvement rules, however, “building systems” constitute separate units of property from the building structure. Consequently, for purposes of the improvement analysis the units of a building property are:
- The building structure (exterior walls, roof, windows, doors, etc.)
- The building systems (HVAC, plumbing, electrical, escalators, elevators, fire-protection and alarm systems, security systems, gas distribution systems, and other structural components identified as building systems by the IRS
“This componentizing of a building into several units of property is a significant change from the prior regulations,” notes Greenhagen. Consequently, taxpayers that deducted repairs in prior years relating to any of these building systems will need to determine whether such treatment is still appropriate. If not, it may be necessary to request a change in accounting method.
How we can help
The IRS is currently working on the revenue procedures on how taxpayers obtain IRS consent to conform accounting methods to the new rules. It is believed the procedures will be issued around April 15, 2012. We will provide you with practical tips on how to execute the changes after the procedures are announced. In the meantime, talk to your tax advisor to determine how these rules impact your situation.
Dan Greenhagen, Tax Manager
firstname.lastname@example.org or 612-376-4837
Chris Hesse, Tax Partner
email@example.com or 612-397-3071