Capital expenditure or deductible repair? New rules apply
The Internal Revenue Service and taxpayers long have battled over whether the purchase of tangible property is currently deductible or must be capitalized and recovered through depreciation over time.
The struggle over this often-encountered matter has existed since the inception of the Internal Revenue Code. The distinction between capital improvements and deductible repairs has been determined largely through case law based on facts and circumstances. Even the Supreme Court has weighed in on the matter.
Finally, after nearly a decade of drafts and proposed regulations, the IRS has issued final regulations dealing with the all-important question of whether an expenditure relating to tangible property is a deductible repair or capital expenditure.
These new regulations are all-encompassing and extremely complex. Implementation will require careful consideration of the facts and circumstances.
The new regulations were issued in September and are generally applicable to tax years beginning on or after Jan. 1, 2014. So it’s imperative any small business purchasing tangible property — meaning nearly all businesses — pay attention to these new regulations effective immediately.
The remainder of this article is certainly not an all-inclusive analysis of these complex regulations, but a brief discussion about a few key aspects. It’s critical every small business owner discuss these new regulations with their tax advisors to determine how the rules apply to their specific circumstances.
In trying to wrap your mind around the new regulations, an important concept to begin with is the concept that all tangible property that isn’t inventory must be capitalized and depreciated unless there’s an exception.
One such exception applies to items that qualify as materials and supplies. Generally, an item that costs $200 or less or has an economic useful life of 12 months or less qualifies as a material or supply. Therefore, if the purchase of a piece of tangible property qualifies as a material or supply, the taxpayer can immediately deduct the cost of the item instead of capitalizing the cost and recovering the cost over time through depreciation.
The regulations provide a very important election allowing the taxpayer to substitute a capitalization threshold — as evidenced by a capitalization policy — in certain circumstances for the $200 limit under what the regulations refer to as the de minimis safe harbor.
The de minimis safe harbor election is made annually, and the threshold maximum amount depends on whether the taxpayer had a capitalization policy in place at the beginning of the year and an applicable financial statement — generally, an audited financial statement. If a taxpayer has an applicable financial statement, the maximum threshold is $5,000 — items of tangible property $5,000 or less can be expensed. If the taxpayer doesn’t have an applicable financial statement, the threshold can’t exceed $500 — items of tangible property $500 or less can be expensed.
So, what does this all mean? If there’s one takeaway, it’s this: For a taxpayer to use the de minimis safe harbor, there must be a written accounting policy (capitalization policy) in place at the beginning of the tax year. For calendar year taxpayers to use the safe harbor provision, there must have been a written policy in place and effective as of Jan. 1, 2014.
The regulations provide another elective safe harbor for routine maintenance. Under this safe harbor, taxpayers may be able to deduct expenditures for activities the taxpayer reasonably expects to occur more than once during the class life of the asset and that don’t result in bettering the asset. For example, if a taxpayer expects to simply resurface a parking lot (15-year property) every five years, then under the safe harbor, this expenditure is not an improvement and the taxpayer may be able to deduct it currently.
So, how do you implement these new rules? While certain safe harbors and elections are implemented through filing statements or treatment of an item on a timely filed federal tax return, other provisions could involve changing a method of accounting and, therefore, filing Form 3115 — application for change in accounting method. Since the new regulations are effective for tax years beginning on or after Jan. 1, 2014, it’s likely almost every federal tax return for businesses that own tangible property should have at least one Form 3115 or an election statement taxpayers will need to file to adopt the rules under the final regulations.
As previously mentioned, these rules are extensive and complex. It’s critical business owners sit down with their trusted business and tax advisors to determine how best to proceed with the implementation of the new tangible property regulations.