In September 2014, the IRS issued final regulations regarding the treatment of funds spent on tangible property. In addition to impacting how businesses will file their upcoming tax returns, the new regulations also influence accounting policies currently in place. The biggest change the regulations make is adding clarity around the definitions of what should be capitalized vs. expensed with regard to repairs, maintenance, and supplies.
For tax years beginning on or after January 1, 2014, all taxpayers are required to follow the new rules. Since these rules are changes to current accounting methods, formal elections will be required, and failure to reflect these formal changes will likely increase a company’s audit risk, and could lead to penalties and fines.
Betterment, Restoration, New/Different Use
The newly issued regulations communicate how taxpayers need to classify expenditures related to their expenditures. Funds expended will be currently written off or capitalized depending upon the nature of the work done to a Unit of Property (“UOP”). A UOP consists of a group of functionally interdependent components. There are certain rules that apply to how a UOP is determined in the case of real property. All expenditures will be treated as a current deduction unless they are associated with the following types of work:
- Correct a material defect/condition that existed prior to the acquisition of a UOP;
- A material addition to the UOP; and/or
- A material increase in capacity, productivity, efficiency, strength, quality, or output of the UOP.
- Returning the UOP to its ordinarily efficient operating condition if the property was in disrepair and no longer functional;
- Replacement of a component of a UOP where a gain/loss is recognized on the component;
- Rebuilding the UOP to a like-new condition after the end of its class life; or
- Replacement of part(s) that comprise a major component, large physical portion, or substantial structural part of the UOP.
- New/Different Use
- Adapting a UOP to a new or different use if the adaption is not consistent with the taxpayer’s original intended use of the UOP when acquired.
One Time “Catch Up”
The rules outlined above are applied retroactively. As a result, taxpayers who capitalized items in the past that would not currently result in capitalization must identify these items and file a change in accounting method to write off the remaining undepreciated cost. This will result in a current tax benefit for many taxpayers.
How far back should you look?
Cumulative accounting method changes obligate entities to look back to all prior capitalized amounts. Taxpayers likely will not have to look at the impact of the new regulations prior 1987, unless major repairs were made to fully depreciated properties after 1986.
With the new rules taking effect, the majority of tax filing entities will be required to file Form 3115. Form 3115 communicates to the IRS that a tax paying entity has changed their accounting method. The form must be filed with the taxpayer’s 2014 tax return.
Safe Harbor Rules: The regulations also added several safe harbor methodologies to the expense vs. capitalization analysis that taxpayers have to go through. This includes routine maintenance safe harbor rules; de minimis safe harbor rules; as well as rules related to materials and supplies.
Overall, the new rules are taxpayer favorable, however, there is a significant time and resource commitment that will be needed currently to bring taxpayers into compliance. The tax planning opportunities presented will be best obtained by implementing an expeditious and thorough assessment of your tangible property acquisitions, improvements, repairs, and dispositions. We therefore recommend that you contact your tax advisor to discuss a strategy to move forward.