Tax regulations: Deduct, or capitalize?
New tax regulations on replacing or repairing business property or equipment.
By Mark E. Battersby
The Internal Revenue Service (IRS) has finally released new regulations to determine whether certain business expenditures are currently deductible as repair expenses, or must be capitalized and deducted over the life of the underlying business asset. The long-awaited expanded regulations (for determining whether an expense must be capitalized because it betters or improves tangible business property or equipment, restores it or adapts it to a new and different use) will have a significant impact on every business that acquires, produces, or improves its tangible property.
In addition to clarifying and expanding the current rules, the new regulations create “bright-line” tests for applying the repair or capitalize standards, and provide guidance for accounting for—and disposing of—repaired property, as well as clarifying other aspects of the repair-or-capitalize dilemma.
The new regulations specify how repairs made simultaneously with improvements are to be treated, and provide a “safe harbor” for routine maintenance expenses such as materials and supplies. They’re also important for landlords and tenants who must capitalize expenses related to leased buildings. And, because the new rules were issued in “temporary” form, the impact will be felt immediately.
Current or future deductions
Since the Reconstruction Era Income Tax Act of 1870, taxpayers have been prohibited from deducting amounts paid for new buildings, permanent improvements or betterments made to increase the value of property. This concept has been recognized as part of tax law almost from its inception, but exactly what must be capitalized, and what may be currently deducted as an expense, has been at issue ever since.
According to the IRS, expenditures are currently deductible as a repair expense if they are incidental in nature and neither materially add to the value of the property nor appreciably prolong its useful life. Expenditures are also currently deductible if they are for materials and supplies consumed during the year.
Expenses must be capitalized and written off over a number of years if they are for permanent improvements or betterments that increase the value of the property, restore its value or use, substantially prolong its useful life, or adapt it to a new or different use.
Unfortunately, the current rules don’t clearly address the core issue of whether expenses should be deducted currently (for example, as repairs or as materials and supplies) or capitalized.
Repair or replace
The cost of incidental repairs is typically deductible. The regulations state that the cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient condition, may be deducted as an expense.
New additions are often made to already existing property. These additions are not replacement components, nor are they repairs to property, but are instead newly installed components. As such, these additions are required to be capitalized.
At other times, replacement parts or components are added. For example, a car’s engine is worn out and replaced. This replacement returns the car back to its original condition (before the part became worn out). It would be logical to consider this replacement as an increase in the car’s value, requiring capitalization; it would also make sense to say that by returning the car to its prior condition, it had been repaired. Under this theory, all repairs would be deductible, no matter how substantial.
The above interpretation renders meaningless any distinction between a deductible business expense and a capital expenditure. That means it’s often insufficient merely to look at increased value as the determing factor for characterizing the replacement of a part or component. An increase in value is only one of many factors that must be considered to determine deductibility or capitalization.
The latest changes
The new regulations are the IRS’s third attempt to provide comprehensive guidance under the repair or capitalize rules. They attempt to answer questions such as how to treat environmental remediation expenses and how to treat rotatable spare parts used in repairs. One significant rule change allows a business to deduct retirement losses for building components.
If, for example, a specialty fabric products operation replaces the roof on a building and disposes of the old roof, it now has the option of taking a retirement loss for the old roof. The roof replacement must be capitalized, but at least a retirement loss can be claimed.
Another change involves the “de minimis” expense rule, which allows a business to expense or write off the acquisition cost of property for financial reporting purposes. This immediate write-off is available to a business with a written policy in place to do that, but only up to a threshold or ceiling. The new regulations also include many types of materials and supplies that are eligible for the de minimis expense rule. Under earlier rules, many categories were not eligible
Material and supplies
Under the new rules, the costs of buying or producing materials and supplies remain deductible maintenance expenses in the year they are used or consumed. The costs of incidental materials and supplies, for which no record of consumption is kept, are generally deductible in the tax year in which they are paid.
However, while the timing rules for materials and supplies remain the same, the new rules provide a new definition. Materials and supplies may now be currently deducted as an expense if they: are acquired to maintain, repair or improve business property owned, leased, or serviced by the business; consist of fuel, lubricants, water and similar items that are reasonably expected to be consumed within 12 months; and have an economic useful life of less than 12 months or costing less than $100.
Under an elective de minimis rule, these amounts (other than inventory or land), along with money paid for any materials and supplies, don’t have to be capitalized. That is, these amounts do not have to be capitalized if: the operation has an applicable financial statement (AFS), such as the one required by the Securities and Exchange Commission, or a certified audited financial statement; written accounting procedures in place for treating the amounts as expenses on its AFS; and if the amounts paid and not capitalized are less than
- 0.1 percent of gross receipts, or
- 2 percent of the total depreciation expense as determined in the AFS.
Tracking costs
Every specialty fabrics business should have some way of tracking assets used and repair costs on a unit-by-unit basis. (It’s unlikely that those repair costs can be tracked mentally!) Increasing repair costs can be a strong indication that equipment is coming to the end of its useful life, or that it is a “lemon” that will continue to suck cash.
Generally, it‘s useful to maintain a spreadsheet listing the purchase date, identifying the equipment and listing repair or maintenance costs, along with a brief description of the work performed. This record keeping makes it relatively easy to determine which units or models are racking up costs.
Due to the new rules, business owners and operators may discover that they will have to modify how they account for expenditures, and how they collect the information necessary to determine whether these expenditures are capital or currently deductible in the year they’re incurred.
Typically, if a repair cost is not deductible in the year incurred, it would be capitalized and depreciated. If, for example, a business performed a capitalizable repair on a machine or piece of equipment, that additional repair cost would be capitalized and depreciated over the appropriate recovery period for tax purposes. If it’s a deductible repair cost, the business would then benefit from a deduction in the tax year the expense was incurred.
While awaiting IRS guidelines for implementing the new regulations, it’s already obvious that many professionals will need to implement these changes for the 2012 tax year. It’s unknown so far whether the IRS will treat the changes required under the new regulations as automatic accounting method changes, and whether affected businesses will be required to obtain approval for a change in accounting methods.
The sheer volume of the new rules on deduction vs. capitalization of tangible property costs could well require professional assistance; it’s a good idea to contact your accountant now for advice—and it’s a good time to begin looking at repair and maintenance costs for 2012.
