In September 2013 and August 2014, the IRS and the Treasury Department released final regulations governing the federal income tax treatment of costs paid or incurred with respect to tangible property. The final regulations provide the framework for determining the deductibility versus capitalization of costs incurred for materials and supplies, repairs and maintenance and other tangible assets.
Materials and supplies
Certain qualifying materials and supplies may be deducted when paid or incurred. To qualify, such an item must be consumable in operations. It also cannot consist of inventory. Then, it must also be one of the following:
- A unit of property costing less than $200
- Fuel, water, lubricants or similar items that are expected to be consumed within 12 months, and property with an economic useful life of less than 12 months,
- A component acquired separately to improve, repair or maintain tangible property, or
- Other items such as rotable, standby emergency, or temporary spare parts.
Capital expenditures and improvements
The new tangible property regulations generally require that you capitalize the costs of the tangible asset when acquired. If you incur subsequent expenditures to this property, you also should capitalize those costs as long as they constitute an improvement to the property. Improvements are considered:
- Betterment – increases properties, quality, strength or efficiency.
- Restoration – returns property to its ordinarily efficient operating condition, if it was in disrepair or non-functioning.
- Adaptation – alter the property so that it is suitable for new or different use.
If subsequent expenditures are not considered an improvement, they will be considered repair costs and therefore are deducted as an expense.
De Minimis Safe Harbor
Safe harbors are provision in laws that provide protection from a penalty, liability or other negative consequence. To elect to use these safe harbors, you must have a capitalization policy in effect at the beginning of the tax year.
- Safe Harbor Election / With Audited Financial Statement. If you have an applicable financial statement, you may deduct items that cost less than $5,000 (determined on a per-item basis) or have a useful life of less than 12 months. Safe Harbor Election / No Audited Financial Statement. If you don’t have an applicable financial statement, under the de minimis safe harbor you may deduct items that cost less than $2500 (determined on a per-item basis, as substantiated by the invoice) or have a useful life of less than 12 months. When calculating the cost of an item, include costs for transportation and installation.
- No Safe Harbor Election. If you don’t make a de minimis safe harbor election, the capitalization threshold is $200. This is because units of property that cost $200 or less are typically defined as materials and supplies.
Routine Maintenance Safe Harbor
The IRS recognizes that you’ll necessarily incur costs to keep your tangible property in an efficient operating condition, and so it created the routine maintenance safe harbor rule.
This safe harbor generally allows you to expense the cost of certain activities that are considered routine and are reasonably expected to occur more than once over a specified period of time.
For property other than buildings and their structural components, that period is the alternative depreciation system class life of the property. For buildings and/or their structural components, the time period is ten years.
Safe Harbor for Small Taxpayers with Buildings
If you qualify, you may deduct your annual expenses for repairs, maintenance, improvements, and other costs on a building you own or lease. This safe harbor is a small taxpayer’s best friend because it allows you to deduct improvements you would otherwise have to depreciate. If you can qualify for this safe harbor, you won’t need to worry about any of the other safe harbors or the regular repair vs. improvement regulations.
There are three considerable restrictions limiting those who may use this safe harbor. It is imperative that the taxpayer separately keep track of annual expenses for repairs, maintenance, and improvements. Note that the safe harbor is applied to each property separately rather than in the aggregate.
Restriction 1 – $1 Million Building Value Ceiling – You may only utilize the safe harbor for small taxpayers for buildings with an unadjusted basis of $1 million or less. Your unadjusted basis excludes depreciation and includes capital improvements.
Restriction 2 – Annual Expenses Cannot Exceed the Lesser of $10,000 or 2% of the Building’s unadjusted basis – When computing the annual expense amount, include every expense the building incurred during the year for repairs, maintenance, and improvements. Again, the beauty here is that you can make a capital improvement and expense it immediately rather than depreciate it as long as the annual expense falls within the limits described above.
If your expenses exceed the annual limit, you are disqualified from using the SHST but you can still utilize the other two safe harbors as discussed above.
Restriction 3 – Your Annual Gross Receipts are Limited to $10 Million – This includes sales, wages, investments, etc.
Partial Asset Dispositions
Under the new rules, you can now dispose of a portion of an asset. Historically you could not. For example, if you replaced a major portion of your roof and capitalized the roof replacement costs, under the old rule you were required to capitalize and depreciation the roof replacement and continue depreciating the portion of the roof that you replaced. Now you can write off the remaining basis for the portion of the old roof that you replaced.
The first step in taking advantage of these new regulations is to prepare a Capitalization Policy for your organization. This is where we can help. Give us a call and we will assist you in developing a capitalization policy or answer any of your questions regarding these new regulations.