In late fall of last year, the IRS released final regulations that clarify how business expenditures related to tangible property should be treated from a tax perspective. This has been a gray area for many business owners for nearly a decade, as the first set of proposed IRS regulations goes all the way back to 2006.

The question: Should expenditures related to the repair and maintenance of tangible property be capitalized or expensed? Expensed property can be deducted immediately, but capitalized property must be depreciated over a period of up to 39 years. Therefore, any businesses would usually prefer to expense property rather than capitalize it.

MAKING EXPENSE DISTINCTIONS

IRS guidelines regarding capitalization and expensing of tangible property expenditures are contained in IRC Sections 162 and 263. These sections require that expenses allocated to acquiring, producing and improving tangible property be capitalized, while allowing funds allocated to incidental repairs and maintenance to be expensed.

The final regulations — IRS T.D. 9636 or the “Tangible Property Regs” — are intended to help you distinguish between these different kinds of expenses. The Tangible Property Regs apply to tax years beginning on or after January 1, 2014.

A safe harbor contained within the Tangible Property Regs covers routine property maintenance (including buildings). Recurring activities that would reasonably be expected to be performed more than once during the property’s life (10 years for commercial buildings) can be expensed and deducted immediately. These include activities like property inspection, cleaning and testing, and replacement of worn and damaged parts.

Meanwhile, materials and supplies (other than inventory) that are used to perform routine maintenance on property can be expensed and deducted if they meet certain criteria. The timing depends on the specific types of materials and supplies. You can deduct incidental supplies (like cleaning supplies) as soon as you buy them, but you cannot deduct non-incidental supplies (fuel, motor oil and small engine parts, for example) until they are used.

DE MINIMIS RULE

Taxpayers with applicable financial statements are allowed to expense immediately amounts not exceeding $5,000 per invoice or per item.  Applicable financial statements are:

  • Financial statements submitted to the Securities and Exchange Commission
  • Audited financial statements
  • Statements that are required to be submitted to a federal or state government or any federal or state agency

To take advantage of this opportunity, qualifying taxpayers must also:

  • Treat qualifying de minimis expenditures consistently for both financial and tax reporting.
  • Include an irrevocable annual election to expense these items with their timely filed federal income tax return.
  • Implement a written policy related to the expensing of de minimis expenditures prior to the beginning of the tax year.

Written policies must contain procedures indicating that amounts will be expensed for nontax purposes:

  • Amounts paid for property costing less than $5,000/$500 (as applicable): or
  • Amounts paid for property with an economic useful life of 12 months or less
  • For taxpayers who do not have applicable financial statements as defined above, the de minimis threshold is reduced to $500 per invoice or per item.

CHANGES IN UOPs

The Tangible Property Regs also made an important change in the application of units of property (UOPs). This will impact how improvements are distinguished from repairs in determining whether expenses related to commercial buildings must be capitalized or can be expensed.

A commercial building’s UOP consists of the building (its foundation, walls, roof, etc.) and all of its structural components (plumbing, electrical, HVAC, etc.) together. If work performed on a commercial building results in a betterment, restoration or adaption when applied to the building and its structural components together, the expenses must be capitalized.

The Tangible Property Regs consider a building and its components to be a single UOP, but they treat some building systems as separate UOPs when determining expensing vs. capitalization. As a result, you must now consider the effect of expenses on specifically defined components when making this determination, not on the building and components together.

For example, the commercial building owned by XYZ company has an HVAC system with four different exterior units that are not connected and have separate controls. Any expenses it incurs that are related to repairing and maintaining the units would have to be capitalized if the work resulted in a betterment, restoration or adaption of the system and/or the building, since the building and the HVAC system (a structural component) are considered a single UOP.

SAFE HARBOR FOR SMALL TAXPAYERS WITH REAL ESTATE

The Tangible Property Regs do contain a safe harbor for businesses with average annual gross receipts up to $10 million. Maintenance, repair and improvement costs can be expensed by these businesses if the building cost $1 million or less initially and the total expenses for the year don’t exceed $10,000 or 2 percent of the building’s adjusted basis (whichever is less).

NEXT STEPS

As you can see, there are many new broad based law changes from the Tangible Property Regulations that affect your business.  Taxpayers will need to understand the importance and benefits of getting into compliance and ask themselves, “How do I get in compliance?”.  Getting into compliance with the Tangible Property Regs may be burdensome for some taxpayers.  In the coming months, we will be sending a series of alerts labeled “TPR – Tax Advisor” where we will provide an in-depth discussion of the more significant points made above.

With respect  to the actual implementation of the rules, we can help taxpayers, large or small, with a streamlined efficient approach tailored to their facts and circumstances.  For our clients, we will be contacting you in the summer months to begin discussions and determine a timeline to help you implement your compliance plan.

The Tangible Property Regulations are detailed and complex. If you have additional questions about the Tangible Property Regulations, please contact us.

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