On September 13, 2013, the IRS issued the long awaited final regulations that govern how repair and maintenance expenditures should be treated. These final regulations replace the five different sets of temporary regulations that have been issued over the past nine years and are effective for tax years beginning on or after January 1, 2014. The regulations provide rules on how repair and maintenance expenditures should be treated (capitalized vs. expensed).
Even though these final regulations will affect most taxpayers, the largest effect will be felt by those taxpayers who own real estate. These final regulations define the term “Unit of Property” as it relates to real estate. Before these regulations many taxpayers viewed a building (including all pieces and parts that make it up) as the unit of property. Based on this view, any repairs and/or improvements made to a building had to be analyzed as to how it increased the value, prolonged the useful life, or changed the use of the building. If these improvements did not substantially increase the overall value, prolong the useful life, or changed the use of the building, taxpayers were deducting the expenditures as repairs and maintenance. This treatment was supported by case law which was the only official item in place before the final regulations.
With the final regulations a building will now be split into nine individual parts (eight building systems and an “everything else” category), and expenditures on each part will be evaluated as to what should be capitalized or expensed.
The nine individual parts of a building are:
- HVAC (heating, ventilation, and AC)
- Plumbing Systems – inside and outside, including water, storm, and sewer related fixtures.
- Electrical Systems – inside and outside, including fixtures, wiring, and distribution
- Fire Protection
- Security Systems for the protection of the building and its occupants
- Gas Distribution Systems – inside and outside
- Building Structure (everything else category) – roof, walls, floors, windows, doors, etc.
Capitalization Standards – The Three Tests
In addition to defining the components of a building, each of which is treated as a separate unit of property, the final regulations also introduced new capitalization standards that have to be applied to all assets (not just real estate). Now and going forward, expenditures that fall into one of the following categories has to be capitalized.
- A Betterment of a unit of property – corrects material condition or defect that existed at the time of acquisition or production (not having previous knowledge of the defect is not an excuse).
- A Restoration of a unit of property – replacement of a disposed unit of property, returns/rebuilds a unit of property to its original operating condition, replaces a major component of a unit of property
- An Adaptation of a unit of property to a new or different use – changes the use of a unit of property
While applying the standards above to certain expenditures will be clear as to what should capitalized and what can be expensed, the final regulations do not give defined guidelines as to how these standards should be applied. There will be decisions that taxpayers (with the assistance of their tax advisor) will have to make on how these standards should be applied.
One example of this revolves around the restoration standard. In that part it mentions replacement of a major component of a unit of property. As we apply this to a building we see (from the previous list) that windows are a separate unit of property. This produces the question if I replace one window do I have to capitalize that? The answer is based on whether the item(s) replaced is a major component. The new regulations do give some examples to help understand what would be considered a major component.
If 30 out of 300 windows (10%) are replaced, that would be considered a minor component and that expenditure can be expensed. In a case of replacing 200 of 300 windows (67%), that is deemed to be a major component and would be capitalized. While these guidelines are provided, the area in the middle becomes the question. If 40% of the windows are replaced, a taxpayer would have to make a decision if is a major or minor component.
Partial Disposal of Property
One change that comes with the new final regulations is the ability to write off components that have been retired or replaced. To help illustrate this, let’s look at the previous example where 200 of the 300 windows are replaced, and the cost of the new windows (including installation) would be capitalized. In that case, the taxpayer would be able to write-off the adjusted basis (original cost minus depreciation taken over the years) of the windows that were replaced. This change introduces an increased value of a cost segregation study on a building. In the past, the main value of a cost segregation study was the net present value of the accelerated tax savings that were produced. While those accelerated tax savings are still the main value, there is now some value of that study for the detail it provides breaking out the components of a building and the associated cost. In the cost segregation reports that we provide the buildings are broken down into more detail than the nine individual parts previously listed which helps the taxpayer see the cost of each component and enables them to calculate the depreciation on each.
Materials & Supplies
Beyond the new capitalization standards and definition of the units of property that make up a building the final regulations also provide strict governance on materials and supplies and how those items should be treated (capitalized or expensed). In these regulations the term materials and supplies are defined as:
- Components acquired to maintain, repair, or improve a unit of property;
- Fuel, lubricants, and similar items expected to be used in the next 12 months;
- Unit of property with a cost of $200 or less;
- Unit of property with an economic useful life of 12 months or less; or
- Items identified in published IRS Guidance.
Generally, non-incidental materials and supplies are deductible as used or consumed while incidental materials and supplies are deductible when purchased if no consumption records are maintained, provided taxable income is clearly reflected.
De Minimis Safe Harbor
With these new rules, at a minimum, taxpayers will need to change their accounting habits and make several elections to meet the IRS’s new definition and capitalization policy. It is also important to note that treatment of these items and the IRS’s safe harbor capitalization policy is dependent on the type of annual financials the company issues. Click here to read our prior article on this topic.
Now that we have analyzed many of the details of the new final regulations the question is what should you be doing? The first answer to this question is to not ignore these new regulations. Even though they are set to start for tax years beginning January 1, 2014 there are items that have to be considered and addressed before that date. For more information, please contact our Tax Planning and Preparation group at 440-449-6800.
To ensure compliance with the Internal Revenue Service and Treasury Department regulations, we wish to inform you that any tax advice that may be contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or applicable state or local tax or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.
Material discussed in this article is meant to provide general information and should not be acted on without professional advice tailored to your individual needs.