Tangible property regulations impact businesses
Businesses make purchases of assets on a regular basis. Tax depreciation and other incentives assist businesses that make such purchases. On Sept. 19, 2013, the Department of the Treasury and Internal Revenue Service published final tangible property regulations. The final regulations provide guidance for taxpayers in determining whether a taxpayer must capitalize costs incurred in acquiring, maintaining, or improving tangible property. The IRS has also separately issued proposed regulations on the disposition of tangible depreciable property, including guidance and rules for general asset accounts.
The new rules affect all businesses that acquire, produce, or improve property. The regulations may result in tax savings for some business taxpayers. The final regulations are generally effective for taxable years beginning on or after Jan. 1, 2014. Early adoption is allowed for taxable years beginning on or after Jan. 1, 2012, with certain limitations. The early adoption may be beneficial for some business taxpayers
A longstanding issue for businesses is the dollar threshold of when to capitalize or expense purchases of tangible assets. Most businesses have set their own thresholds as the IRS didn’t have specific guidance on a safe harbor amount. The regulations provide a safe harbor mechanism. The de minimis safe harbor allows taxpayers to set a minimum capitalization threshold.
To comply with the safe harbor, a business’s capitalization policy must be in writing as of the beginning of the taxable year, and should have been in place Jan. 1, 2014, for calendar-year taxpayers. The policy must specify that amounts will be expensed for non-tax purposes if the amounts are below a specified dollar amount or if the amounts paid are for property with an economic useful life of 12 months or less. This policy must be followed on the taxpayer’s applicable financial statement, generally defined as a certified audited financial statement. The final regulations provide that if a taxpayer’s financial results are reported on the AFS of a group and the group follows a written de minimis safe harbor on its AFS, then the AFS and de minimis safe harbor of the group satisfy those requirements for the taxpayer that is a member of the group.
Taxpayers with an AFS that meet these criteria can deduct for tax purposes de minimis safe harbor amounts paid for property not to exceed $5,000 per invoice or item. Taxpayers without an AFS may also qualify for the de minimis safe harbor; however, the threshold amount is reduced to $500 per invoice or item. The IRS also included anti-abuse rules to prevent taxpayers from manipulating transactions to avoid the application of the de minimis limitations. The de minimis safe harbor requires an annual election statement be attached to the taxpayer’s timely-filed original federal tax return.
The final rules for the treatment of costs of materials and supplies were also recently issued. The definition of M&S was expanded, increasing the limit to $200, and introducing a definition for emergency spare parts, and now limiting the election to capitalize and depreciate M&S to rotable, temporary and emergency spare parts. Most significantly, if taxpayers make the de minimis safe harbor election, all materials and supplies must be treated as de minimis expenses, except where the taxpayer elects to capitalize and depreciate rotable, temporary, and emergency spare parts or follow the optional method.
One of the most widely applicable provisions in the regulations is the tax treatment of improvements made to tangible property. The regulations provide a general framework for determining whether expenditure is an improvement to property that must be capitalized or a deductible repair expense. Determining the relevant “unit of property” is important because it is the reference point for which all capitalization standards are applied. The smaller the UOP, the more likely it is that an expense will be treated as a capitalized item, rather than a deductible repair expense.
The new regulations define the UOP for real property as the building and its structural components. However, when applying the capitalization rules, each “building system” constitutes a separate UOP from the building structure. For purposes of the capitalization analysis, the UOP for a building is: the building structure (walls, roof, windows, doors, etc.); each building system (HVAC, plumbing, electrical, escalators, elevators, fire protection, security systems, and gas distribution).
Once the UOP is determined, the improvement standards must be applied. The regulations require a taxpayer to capitalize amounts paid to improve a UOP if the amount results in a “betterment,” “restoration,” or “adaption.” The regulations provide a facts and circumstances test for determining capitalization requirements and provide many examples illustrating how to interpret and apply these rules to specific situations.
The final regulations also introduce an option to capitalize repair and maintenance expenditures if the taxpayer also capitalizes those amounts for its books and records. The election is made by attaching an annual election statement to a timely-filed original federal tax return. Because this election is irrevocable, this election should be made only in unusual circumstances and with careful consideration.
Small taxpayers whose average annual gross receipts for the prior three years do not exceed $10 million may elect not to apply the improvement rules to an eligible building property when the amount paid for repairs, maintenance, and improvements does not exceed the lesser of $10,000 or two percent of the unadjusted basis of the building. This safe harbor is limited to buildings with an unadjusted basis not exceeding $1 million. The safe harbor for small taxpayers requires an annual election statement attached to the taxpayer’s timely-filed original federal tax return. This safe harbor election is made on a building-by-building basis.
A routine maintenance safe harbor was expanded to include building property. Maintenance costs can generally be deducted under this safe harbor if they are incurred: 1) for recurring activities a taxpayer expects to perform more than once in a 10-year period at the time the property is placed in service; 2) as a result of the taxpayer’s use of the property; and 3) to keep the property in its ordinarily efficient operating condition.
Many opportunities exist for increased tax deductions for repairs, materials and supplies, routine maintenance for buildings, maintenance on buildings for smaller taxpayers, and new safe harbor de minimis amounts. Implementation and compliance with the final regulations can also help you to identify, compute and track book/tax differences. Last, compliance with the regulations is required to reduce exposure areas and assist in preparation for any future tax audits.
Daniel Fuller is a tax partner in the local office of BDO USA LLP. The views expressed above are those of the author and not necessarily those of BDO. The comments are general in nature and not to be considered as specific tax or accounting advice. Readers are advised to consult with their professional advisers before acting on any items discussed herein.