The Internal Revenue Service (“IRS”) issued final regulations governing repairs to and capitalization of tangible property effective January 1, 2014 that will affect and challenge nearly every business. These final regulations were crafted to provide a general framework for distinguishing between capital expenditures and deductible supply, repair and maintenance costs.
Generally, taxpayers (e.g. sole proprietors, partnerships, or corporations) must capitalize all amounts paid to acquire or produce tangible property including the:
- Invoice price;
- Transaction costs (i.e., freight, title searches, appraisals, brokerage fees, etc.); and
- Costs for work performed before the property is placed in service (e.g. installation fees).
Taxpayers who have accounting procedures in effect at the beginning of the year that allow the expense for non-tax purposes of amounts paid for property less than a specific dollar amount or for property that has a useful life of 12 months or less can elect a de minimis safe harbor for tax purposes. The safe harbor election allows costs up to $500 per item included in the taxpayer’s books and records under this accounting procedure to be expensed for tax purposes as well. If the taxpayer either files a Form 10-K with the Securities and Exchange Commission or has audited financial statements prepared, they can expense items up to $5,000 per item.
Once tangible property is placed in service, costs associated with improvements to the property are capitalized whereas regularly-scheduled, routine maintenance is expensed.
- A betterment to the property;
- A restoration of the property to its intended use; or
- An adaptation of the property to a new or different use.
To determine if the expenditure results in an improvement, the taxpayer must analyze how it affects the unit of property. The IRS defines a unit of property as a grouping of functionally interdependent components that must be placed in service together and at the same time in order to perform their intended function. For buildings, the improvement test is met if the improvement occurs to either (1) the building and its structural components, or (2) any one of the following newly-defined building systems:
- Heating, ventilation and air condition system;
- Plumbing system;
- Electrical system;
- All escalators;
- All elevators;
- Fire protection and alarm system;
- Security system;
- Gas distribution system; and
- Other systems identified in IRS published guidance.
Routine maintenance includes:
- Replacing parts; and
- Other recurring maintenance that keeps property in its ordinary efficient operating condition.
Factors for determining whether maintenance costs are routine include (1) industry practice, (2) manufacturers’ recommendations and (3) the taxpayer’s experience. Activities are considered routine only when the taxpayer reasonably expects to perform them more than once during the asset’s life or once every 10 years in the case of buildings.
Small taxpayers with average gross receipts of 10 million or less can elect not to capitalize improvements to eligible building property (i.e. buildings with unadjusted basis of 1 million or less) if the total amount paid during the year for repairs, maintenance and improvements does not exceed the lessor (1) $10,000 or (2) 2% of the building’s unadjusted basis.
The new IRS regulations dictating when to repair or capitalize costs can be complex. Contact Flexible Accounting Services of the Triangle to assist you with your fixed asset management so you can maximize the costs you may deduct on your tax return.