iGeneral Capitalization Rules for Maintenance of Property
The Repair Regulations generally require taxpayers to capitalize all costs that “improve” their property and equipment. Property and equipment is improved if the taxpayer “betters” the property, “restores” the property, or adapts the property to a new or different use. Whether the taxpayer has improved property is determined by looking at the effect of the repairs to the “unit of property.” Under this determination, the larger the unit of property is, the less likely an expenditure will improve the property. The determination is based on all of the facts and circumstances.
The Unit of Property Explained
A unit of property includes all “functionally interdependent” components. Generally, if one component of property cannot be used without another component of property, the two components are functionally interdependent. There are several exceptions intended to reduce the size of the unit of property. For example, if a component performs a discrete and major function, it is a separate unit of property from all the other property and equipment, even if the component is otherwise functionally interdependent with the other property and equipment.
A special rule applies to buildings. Although the unit of property of a building includes the building and all of its structural components, to determine whether an expenditure “improves” the building, the regulations require the taxpayer to look at the numerous discrete systems, such as the heating and air conditioning systems, the plumbing system, the electrical system, etc. A repair to one of these discrete systems is more likely to be an improvement than if the taxpayer made the determination by looking only to the building.
Finally, if a taxpayer separately depreciates a property, the taxpayer must treat it as a separate unit of property.
Betterments
A betterment is work that ameliorates a material condition or defect that existed prior to the acquisition or production of the property, or contemplates a material addition or improvement to the property, including its enlargement, expansion or extension. A betterment is reasonably expected to materially increase the productivity, efficiency, strength, quality or output of the property.
Restorations
Similarly, taxpayers must capitalize all restorations costs. A restoration includes replacing component parts, repairing significant damage to property, returning property that was nonfunctional to its ordinary efficient use, rebuilding property to like-new condition, and replacing a “major component or substantial structural part.”
Adapt to New or Different Use
If work on a property adapts it for a new or different use, the taxpayer must capitalize those costs. The regulations contain numerous examples with helpful guidance outlining the contours of this rule.
The De Minimis Rule Offers Taxpayers Flexibility
Under the de minimis rule, each year taxpayers may elect to expense costs they would otherwise have to capitalize under the above rules. To take advantage of this treatment, the taxpayer must have a written expense policy at the beginning of the year and must expense for non-tax purposes the costs in accordance with that policy.
The regulations provide a “safe harbor” for costs of an invoice (or an item specifically listed on the invoice) up to $5,000 for taxpayers that issue audited financial statements. For taxpayers without such statements, the amount is reduced to $500. The regulations acknowledge that taxpayers may demonstrate that they should be allowed to expense amounts in excess of the safe harbor amounts based upon specific facts and circumstances.
Importantly, if a taxpayer elects the de minimis method, it must use this method for all amounts properly expensed under its written policy.
Routine Maintenance
The Repair Regulations permit taxpayers to deduct expenses incurred to maintain property in its ordinarily efficient operating condition. These expenses are deemed not to improve the property if the taxpayer expects to incur them more than once during the life of the property (more than once in a 10-year period for buildings). Exceptions to the rule are extensive and may make the safe harbor largely irrelevant for most taxpayers.
Casualty Losses
The Repair Regulations permit a taxpayer to deduct the cost of repairs after a casualty, but only the amount that is above the loss the taxpayer claims on the damaged property. In other words taxpayers can claim a deduction that covers the entire cost of the damages, but they cannot deduct both the loss on the damaged property and the overlapping cost of the repairs.
Treatment of Materials and Supplies
Materials and supplies include items such as fuel, lubricants and similar property expected to be used and consumed within 12 months or less, and a unit of property with a useful life of 12 months or less. Additionally, “materials and supplies” include so-called rotable, temporary and standby emergency spare parts.
Generally, a taxpayer may deduct the costs of materials and supplies when they are “used or consumed,” unless the materials and supplies are “incidental.” In that case, the taxpayer can deduct the cost of the material and supply when it purchases the item. A material and supply is incidental if the taxpayer does not otherwise track it and expensing it will not grossly distort the taxpayer’s income.
If a material and supply is not incidental, a taxpayer can still deduct its cost when it purchases it, if the taxpayer properly elected the de minimis rule and the material and supply costs less than the de minimis amount.
If a taxpayer uses a material and supply to improve a unit of property, however, the taxpayer must capitalize the cost of the material and supply into the cost of the improved property.
Flexibility for Rotables
Generally, a taxpayer may deduct the cost of rotable, temporary and standby emergency spare parts when it disposes of the spare parts (at which point they are considered used and consumed). This general rule, however, could defer the deduction for a very long time if, for example, the spare part has a long life or is not needed for a long time. Recognizing this, the Repair Regulations provide taxpayers with several options to recover the costs of these spare parts:
- Use the “Optional Method”
- Capitalize and depreciate the spare parts
- Elect the de minimis method
The Optional Method
The optional method permits a taxpayer to expense the entire cost of the rotable and temporary spare part when the taxpayer installs it. When the taxpayer removes the rotable, the taxpayer must include its fair-market value in income. Additionally, the taxpayer must add to the basis of the rotable the costs of removing and repairing it. If and when the taxpayer reinstalls the rotable, the taxpayer may deduct its new basis in the rotable. When the taxpayer finally disposes of the rotable and temporary spare part, the taxpayer may deduct any remaining basis.
Many taxpayers with rotables use this method for financial reporting purposes, so the availability of the optional method minimizes book/tax differences (in this same regard, the Repair Regulations allow taxpayers to elect to capitalize otherwise deductible costs in order to minimize book/tax differences).
All Taxpayers Must Change Their Methods of Accounting
Because of the significant differences between the new Repair Regulations and current law, taxpayers should expect to change their methods of accounting. Taxpayers should consult with their tax professional immediately to implement the new regulations and file an accounting method change to adopt the most favorable accounting methods. Taxpayers under audit should expect the IRS to examine the issue.
Closing Thoughts
The Repair Regulations provide welcome guidance in what was a murky, disjointed set of rules relating to the treatment of tangible property. Undoubtedly, however, these new rules will increase the administrative/recordkeeping burden for taxpayers. In addition, the lack of bright-line rules and the fact that many of the rules rely on a facts and circumstances determination likely will create tensions between the IRS and taxpayers. Nonetheless, with good planning, the Repair Regulations will provide taxpayers with clearer treatment of their costs.
