On September 13, 2013, the Internal Revenue Service issued final tangible property regulations that provide guidance with respect to the treatment of materials and supplies; capitalization of amounts paid to acquire or produce tangible property; the determination of whether an expenditure with respect to tangible property is a deductible repair or must be capitalized; and dispositions of Modified Accelerated Cost Recovery System (“MACRS”) property.

The final regulations require the taxpayer to implement the new rules for tax years beginning on or after January 1, 2014.

Some of the major provisions in the new regulations include the following:

• Capital improvements to tangible property
• Capitalization policy election
• Small taxpayer safe harbor election
• De minimus safe harbor election
• Routine maintenance and building systems repairs
• Partial disposition provision

These broad Regulations will likely impact most taxpayers in all industries, with a significant burden placed on small family owned businesses in implementing the new regulations.

Capital improvements:

The regulations clarify that an expenditure must be capitalized if it improves the property or any of its primary components, prolongs or restores the life of the property or adapts it for a different use (rather than simply keeping it in working order). Expenditures that restore the property to its original operating state will be currently deductible as repairs and maintenance.

Taxpayers must divide buildings into separate structural components; 1) primary components and 2) enumerated building systems.

Primary components of a building will generally include:

• Walls
• Partitions
• Floors and ceilings
• Windows
• Doors

Enumerated building systems include:

• Electrical systems,
• Plumbing, and
• HVAC systems.
• Fire protection and alarm systems
• Security systems
• Gas distribution system

Definitions:

1.)    Improvement or betterment: corrects a material defect, a material addition (physical enlargement, expansion, extension or addition of a major component or space). Reasonably expected to materially increase strength, productivity, efficiency, quality, or output.

2.)    Restoration: replacement of a component, returning the property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use, rebuilding it to a like new condition after the end of its depreciable life, replacement of a major component.

3.)    Adaptation: a new or different use, inconsistent with intended use when originally placed in service.

Small taxpayer safe harbor:

A small taxpayer safe harbor is available by making an annual election not to capitalize improvements. In order to qualify for the “small taxpayer safe harbor” the taxpayer must meet the following requirements:

• The taxpayer must have average annual gross receipts of $10M or less (over 3 previous years)
• Eligible expenditures must not exceed the lesser of $10,000 or 2% of the unadjusted cost basis of the building
• The building must be owned or leased and have an unadjusted basis of $1M or less
• Attach an election statement to the timely filed original return

De minimus safe harbor:

The regulations establish a de minimis safe harbor for tangible property (does not apply to intangibles, land and inventory) which allows taxpayers to expense otherwise capital expenditures. The safe harbor is divided into two separate thresholds; one for those taxpayers with certified audited financial statements and one for taxpayers without certified audited financial statements. Taxpayers with certified audited financial statements can elect a threshold of up to $5,000 per invoice or per item as substantiated on the invoice. Taxpayers without certified audited financial statements can elect a threshold of up to $500 per invoice or per item as substantiated on the invoice. A taxpayer must have a written accounting procedure in place at the beginning of the tax year and attach an annual election to their timely filed tax return in order to use the de minimis safe harbor.

Routine maintenance and building systems repairs:

Up to this point I have generally discussed types of expenditures that must be capitalized, but the new regulations also outline items that are generally not required to be capitalized. Routine and recurring amounts paid to keep an item in ordinary and efficient working condition are treated as repair costs. You must consider the nature of the recurring activity, manufacturer recommendations, industry practice and the following guidelines set by the regulations:    

• Costs incurred to non-building property that are reasonably expected to reoccur more than once during the assets depreciable life.   
• Expenditures for building property (structural components or building systems) must reasonably expect to reoccur more than once during a 10 year period starting with the date of the original cost.

Documentation of your determination of capitalizing vs. expensing costs should be maintained to support your conclusions. Acceptable documentation could include maintenance manuals, warranties, and any information regarding industry practice. Maintenance logs can also be used to support eligibility for the routine-maintenance safe harbor. When purchasing used property, taxpayers will want to obtain evaluations of the property’s condition in order to show that subsequent expenditures are not incurred to correct an existing defect.

Partial disposition provision:

The regulations allow a taxpayer to claim a loss when disposing of a portion of an asset. For example, if the roof of a building is replaced, the taxpayer can value the undepreciated portion of the building attributable to the old roof and claim a disposition loss. The valuation allocation can be done using any reasonable method. If the taxpayer uses this tax treatment, the cost of the new roof must be capitalized (it cannot be considered a current period repair cost). 

How to implement the rules:

The new regulations may create the need to make current year adjustments to prior year’s transactions. For example, if you adopt the materials–and-supplies provision or the de minimis rules in the regulations, the adjustments are made under the accounting method change (Form 3115) and related adjustments to taxable income (section 481(a) adjustment). The section 481(a) adjustment is the calculation of the cumulative impact of the change in taxable income as of the beginning of the tax year. Positive (income) and negative (deduction) 481(a) adjustments will flow thru current and future year’s income and expenses. Most every taxpayer that files a business return and owns tangible property will need to attach at least one form 3115 to their 2014 return.  

The first step in the process is to identify specific property (buildings, property and other assets) to be tested. You must then examine all expenditures associated with the identified property and based on the new guidelines you must determine if the expenditure is required to be capitalized or falls into one of the exclusion categories and can be expensed as a period cost. Once these steps have been completed you must then calculate the current period income or expense amount (481(a) adjustment). Most changes needed to comply with the new regulations are considered a change in accounting method. The new regulations state that any accounting method changes will require the consent of the IRS Commissioner before the taxpayer will be permitted to make the changes. In general, Revenue Procedure 2011-14 provides that automatic consent can be acquired by preparing and filing Form 3115 with the taxpayer's timely filed tax return (including extensions) for the year of change (tax year 2014) and filing a separate duplicate copy with the IRS National Office. Additionally, no user fee is required for automatic consent changes. The most common types of changes will include:

• Change to deducting amounts paid for repair and maintenance. Accounting change #184
• Change to deducting non-incidental materials and supplies when used or consumed. Accounting change #186
• Change in depreciation life and or method, Accounting change #192
• Change to use general asset accounts, Accounting change #180

Additionally, the following annual elections will be required:

• Apply the de minimus safe harbor
• Apply the small taxpayer safe harbor
• Capitalize repair and maintenance costs
• Capitalize materials and supplies
• Capitalize employee compensation and overhead on self-constructed assets.

Complying with the new regulations and taking full advantage of available tax savings opportunities will require detailed planning and analysis. The rules are very complex and each individual’s facts and circumstances can be different. Please contact the tax professionals at Dermody, Burke & Brown, CPAs so that they can assist you in taking advantage of any potentially favorable elections and method changes.

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.