The IRS has attempted to clarify what was once a very ‘grey area’ for taxpayers by issuing T.D. 9564. These temporary regulations have given businesses answers to long awaited questions, while at the same time, bringing to light a host of new complex questions and different interpretations. The temporary regulations are effective for tax years beginning on or after January 1, 2014, however, taxpayers may choose to apply them earlier.
The main points in the regulations are:
- Repair vs. Capitalization
- Treatment of Materials and Supplies
- De Minimis Expensing Rule
- Disposition of MACRS Property
The underlying topic impacting all of these areas is the fact that the implementation of any of these changes will require a business to file a Form 3115 “Change in Accounting Method” utilizing an automatic change of accounting method request.
Repair vs. Capitalization
The regulations require capitalization of amounts paid to improve a unit of tangible property. A unit of property is improved if amounts are paid for activities performed after the unit of property is placed into service by the taxpayer which results in one of the three categories:
- A betterment to the unit of property
- A restoration of the unity of property
- Adaptation of the unit of property to a new or different use
All three of these categories will be capitalized improvements to the property versus repairs. The new definition of when a repair is required to be capitalized is more taxpayer friendly then the old interpretations, and as such, there may be items capitalized in prior years that can be written off by filing a change of accounting method in the current year.
Treatment of Materials and Supplies
A material and supply is defined as tangible property used or consumed in the taxpayer’s business operations that is not in inventory and that is:
A component acquired to maintain, repair, or improve a unity of tangible property owned, leased, or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property
- A unit of property that has an economic useful life of 12 months or less
- A unit of property that has an acquisition cost or production cost of $100 or less
Materials and supplies can be expensed in the year used. With the new regulations, an election can be made to expense materials and supplies in the year paid or incurred under a de minimis rule. This election is made via Form 3115, utilizing an automatic accounting method change, and could result in the acceleration of deductions.
De Minimis Rule
This rule is one of the most taxpayer friendly provisions of the temporary repair regulations. It allows certain taxpayers to deduct de minimis amounts paid or incurred to acquire or produce a unit of tangible property if they have an Applicable Financial Statement, written accounting procedures for expensing amounts paid, or incurred for such property under certain dollar amounts, and treats such amounts as expenses on its Applicable Financial Statement in accordance with its written accounting procedures. An Applicable Financial Statement is one that is required to be filed with the SEC, a certified audited financial statement, or a financial statement required to be provided to the federal or state government or agency. This financial statement requirement presents a problem for businesses that do not have audited financial statements and, therefore, would not be eligible to take advantage of this de minimis expensing rule.
The limits for the de minimis rule are as follows: the total aggregate of amounts paid or incurred and not capitalized are less than or equal to the greater of:
- 0.1 percent of the taxpayer’s gross receipts for the tax year as determined for federal income tax purposes; or
- 2 percent of the taxpayer’s total depreciation and amortization expense for the tax year as determined in its applicable financial statement
Disposition of MACRS Property
Another key provision of the repair regulations is the treatment of the retirement of a structural component as a loss deduction. For tax purposes, when a component of a building is retired, the retirement is treated as a disposition that results in a loss deduction equal to the adjusted depreciable basis of the component. For example, if a new roof is added to a building, the undepreciated balance of the old roof must be written off. The complexity arises in calculating the value of the roof if it was not segregated initially in the taxpayer’s fixed asset records.
For those assets disposed of that were never written off, these regulations may provide an opportunity to take that deduction immediately by filing a change in accounting method. If a change of an accounting method is not filed, the taxpayer risks losing the depreciation related to the original roof because they did not write off the roof in the correct year (year the new roof was purchased).
The new rules impact most taxpayers and it is advised that fixed asset schedules and company repair policies be reviewed for all businesses to determine what changes should be made to take advantage of these rules by accelerating deductible items.