Since the inception of the Internal Revenue Code, the IRS and
rural building businesses have been at odds over whether expenditures are
deductible repairs or a capital expenditure. Now, after seven years of drafts
and proposed rules, the IRS has issued final regulations addressing whether
costs are currently deductible or whether they must be capitalized and
recovered through depreciation over time.
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The IRS has also released a long-awaited Revenue Procedure that
details the procedures for obtaining the “automatic” consent of the IRS to
change accounting methods as required by the new repair regulations.
The IRS’s newly released regulations provide guidance on a
number of difficult questions, such as whether replacing a component of a
building is a current deduction or whether it must be depreciated over 39
years. Expenditures that restore property to its operating state are, according
to the IRS a deductible repair. However, expenditures that provide a more
permanent increment in longevity, utility, or worth of the property are more
likely capital in nature.
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If, for example, a building business rebuilds a vehicle’s
engine, the IRS usually considers that expenditure to be a capital expense. In
the IRS’s view, rebuilding an engine increases the value of the vehicle (the
unit of property) and prolongs its economic useful life. By comparison, the IRS
views regularly scheduled maintenance repairs as currently deductible, since
they do not materially increase the vehicle’s value or appreciably prolong its
useful life.
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In general, the new regulations distinguish between amounts paid
to acquire or produce business property, equipment or machinery, and amounts
paid to improve existing property. When it comes to “improvements” to business
property, capitalization is required if the expenditure is a betterment,
restoration, or adaptation of the unit of property.
A building business must generally capitalize amounts paid to
acquire or produce tangible property unless the property falls into the
category of materials and supplies, or qualifies for the so-called “de minimis”
safe harbor.
Incidental materials and supplies may be deducted when
purchased. Tax deductible materials or supplies are tangible personal property,
other than inventory, that is used or consumed in the taxpayer’s operations.
This includes fuel, lubricants, water, or similar items that can be reasonably
expected to be consumed in 12 months or less. It also includes:
1. Other property with an economic useful life of 12 months or
less
2. An item with an acquisition or production cost of $200 or
less
3. A component acquired to maintain, repair, or improve a unit
of tangible property that is not acquired as part of another unit of property
These are items for which records of consumption are not kept and
where immediately deducting or expensing them will not distort the building
operation’s income. Materials and supplies that do not fit these definitions
are deducted when used or consumed.
Safe Harbors can best be compared to legitimate “loopholes” designed
by our lawmakers to limit the full impact of a tax law or provision that might
be harmful to a particular group of taxpayers. Under the repair regulations,
some builders and contractors might benefit from Safe Harbors such as the
following:
DE MINIMIS SAFE HARBOR ELECTION: A building business may elect a
“de minimis” safe harbor to deduct amounts paid to acquire or produce property
up to a dollar threshold of $5,000 per invoice (or per item in some cases), but
only $500 for those without.
SMALL TAXPAYER SAFE HARBOR: The regulations add a new safe
harbor for builders and contractors with gross receipts of $10 million or less.
The safe harbor is intended to simplify small taxpayers’ compliance with the
rules requiring capitalization of building improvements. Qualifying small
taxpayers can elect not to capitalize building improvements with an unadjusted
cost basis of $1 million or less if the total amount paid during the year for
repairs, maintenance and improvements does not exceed the lesser of $10,000 or
2 percent of the unadjusted cost basis of the building. The safe harbor is
elected annually on a building-by-building basis.
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ROUTINE MAINTENANCE SAFE HARBOR: When it comes to expenditures
for the routine maintenance performed by so many builders and contractors,
there is another safe harbor. Routine maintenance includes the inspection,
cleaning, and testing of the property, machinery or equipment and replacement
with comparable and commercially available and reasonable replacement parts.
Unfortunately, in order to be considered “routine” maintenance, the builder or
contractor must expect to perform these services more than once during the
class life (generally the same as for depreciation) of the property.
The final regulations include an entirely new provision that
allows a business to treat amounts paid for repairs and maintenance to tangible
property as amounts paid to improve that property. Thus, if the building
business chooses, the amounts paid as property improvements become assets
subject to depreciation—as long as the expenditures are business-related and
the amounts are treated as capital expenditures on the operation’s books and
records.
Another significant change in the new regulations allows a building
business to take “retirement losses” on components. If, for example, a
building’s roof is replaced
and the old roof disposed
of, the operation now has the option of taking a retirement loss for the old roof. Of course, the
replacement roof must be
capitalized but while the replacement must be capitalized the retirement loss
can be claimed on the roof
replaced.
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Much of the guidance provided by the IRS revolves around what
constitutes a “Unit of Property” (UOP). In general, the smaller the UOP being placed
in service, repaired or improved, the more likely that the UOP’s cost will have
to be capitalized. For example, work on an engine of a vehicle is more likely
to be classified as an expense that must be capitalized if the engine is
classified a separate UOP. By contrast, if the UOP is the vehicle, the engine
work has a better chance of passing muster as a repair.
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The new repair regulations have been described as the most
comprehensive changes to the issues of capitalization and write-off in more than
20 years. Some of the new regulation’s safe harbors and elections can be
implemented on the building operation’s annual tax return. Unfortunately, since
the IRS considers many of the provisions to be accounting methods, many
builders and contractors will be required to file not one but numerous Form
3115s, Application for Change in Accounting Method.
A builder or contractor seeking to change to a method of
accounting permitted under the final regulations must get the IRS’s consent
before implementing that new method. Under the automatic consent procedures,
the IRS will consent when a Form 3115, Application for Change in Accounting
Method, is attached to the building business’s timely-filed tax return for the
year of change (with extensions). A signed copy must also be sent to the IRS’s
national office.
While the new repair regulations go a long way to answering the
question of what is a repair and what is an expenditure that must be
capitalized and depreciated, they also pose considerable compliance risks for
every building business. However, many builders and contractors businesses will
soon discover they need to elect new tax strategies that require an application
for an accounting method change, professional assistance is almost mandatory.
