Historically, the Internal Revenue Service (IRS) and taxpayers have been at odds over whether expenditures on tangible or real property are currently deductible or must be capitalized and recovered through depreciation deductions. After a decade, the IRS has issued final rules on how to treat these expenditures. These rules are called the tangible property regulations, or as they are more commonly known, the “repair regs.”
Some of the changes are viewed as a departure from how taxpayers have treated these expenditures on prior tax returns. Taxpayers are now required, or have the opportunity on their 2014 tax returns, to make any necessary corrections by filing accounting method changes or to make various first time elections. Failure to make some of these changes may result in permanently losing the benefit of deducting these expenditures currently and in the future.
Many of the new rules are taxpayer friendly and provide opportunities to deduct expenditures that may have been considered to be capital under the old rules. To quantify these opportunities, taxpayers will need to spend more time reviewing their prior year depreciation schedules and tax accounting policies to determine how these expenditures were treated in the past and their current impact.
Here are some of these potential tax accounting method changes and elections:
- The new rules provide taxpayers another opportunity to review their prior year depreciation schedules and correct improper methods by filing a method change request to ensure depreciation deductions are not lost.
- A very favorable potential method change is the adoption of the routine maintenance safe harbor. Any expenditure that is required to be performed to a building more than once within a 10 year period or more than once within the class life for machinery and equipment can now be expensed immediately under this safe harbor. There is no dollar limitation, so this provides an opportunity to potentially expense more than what may have been allowed in the past. By not adopting these changes, these expenditures could be subject to capitalization.
- For buildings, taxpayers now have the opportunity to write off a portion of the old cost from a partial disposition. An example is the replacement of an old roof with a new roof for a building already placed in service. Let’s say a taxpayer purchases a building for $1 million and 10 years later replaces the roof. The undepreciated cost of the old roof imbedded in the $1 million original cost can now be written off. This can be applied retroactively, if desired, but there is a limited amount of time to do so.
- The annual election for de minimis safe harbor capitalization policy allows taxpayers to establish a policy to expense up to $5,000 per item per invoice for taxpayers that have an applicable financial statement (“AFS”) prepared, which includes audited financial statements. Taxpayers that do not have an AFS (i.e., reviewed and compiled financial statements) are limited to $500. This election may provide opportunities to expense more items in 2014 regardless of the current limitation on Section 179 expense election. Procedures must be in writing and in place at the beginning of the year and the election is made each year by filing an overt statement with the tax return.
- If materials and supplies are currently being capitalized for book purposes, an accounting method change may need to be made to currently expense those items.
- The rules provide for a new definition of a “unit of property,” which is the basis for examining whether an expenditure needs to be capitalized. The regulations provide dozens of examples that describe whether an expenditure needs to be capitalized as an adaptation, betterment or restoration, or can be deducted as an expense. This is another example of when a method change may be required.
- In addition to the routine maintenance safe harbor, there is a similar provision for small taxpayers for their buildings. If the amount expended during the year does not exceed the lesser of 2 percent of the unadjusted basis of the building ($1,000,000 or less) or $10,000, then those expenditures may be deducted regardless of whether the expenditure could be considered an improvement.
- A taxpayer can also elect to follow their book accounting method and otherwise not currently deduct repair and maintenance costs if the book policy is to capitalize these costs.
There are numerous potential accounting method changes and elections that could be made with taxpayers’ returns for the taxable years beginning on or after January 1, 2014. In many cases, actions not taken during this year may result in unfavorable consequences. We encourage all taxpayers to pay serious attention to these new rules and ensure that they are being addressed. Please contact your Kreischer Miller adviser to discuss these new rules and how they affect your business.
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