On September 13, 2013 the IRS the Treasury Department announced the final tangible property regulations (TD 9636), which broaden the kinds of business expenditures that can be treated as deductible asset repairs, rather than as capital improvements. The long-awaited final regulations provide for simpler and clearer de minimis and safe harbor rules for many taxpayers, including a special rule for smaller businesses and a safe harbor for routine repairs and maintenance.
The final tangible property repair regulations for Sections 162(a) and 263(a) clarify and expand the temporary regulations that were issued by the IRS on Dec. 23, 2011, and are generally applicable to taxable years beginning on or after January 1, 2014. The regulations affect all taxpayers who acquire, produce, or improve tangible property, such as buildings, equipment, and machinery.
The subjective nature of the difference between a deductible repair and a non-deductible improvement to tangible property has historically been a point of frequent dispute between the IRS and businesses. Section 263(a) generally requires taxpayers to capitalize amounts paid to acquire, produce, or improve tangible property; including amounts paid or incurred to add to the value or substantially prolong the useful life of the property or to adapt it to a new or different use. Section 162(a), by contrast, allows taxpayers to deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including the costs of certain supplies and incidental repairs and maintenance. The determination of whether an expense may be deducted as a repair or must be capitalized generally required an examination of all of a taxpayer’s particular facts and circumstances, and has therefore been highly controversial.
The final regulations refine and simplify some of the rules contained in the 2011 temporary regulations, and create a number of new safe harbors. The main topics they address are rules for materials and supplies, rules for repairs and maintenance, general rules for capital expenditures, rules for amounts paid for the acquisition or production of tangible property, and rules for amounts paid for the improvement of tangible property.
For example, the final regulations eliminate the ceiling in the de minimis rule in the 2011 temporary regulations, replacing it with a new safe harbor determined at the invoice or item level, and based on the policies used by the taxpayer for their financial accounting books and records. Generally, taxpayers with an applicable financial statement may rely on the de minimis safe harbor, provided the amount paid for property having an economic useful life of less than 12 months does not exceed $5,000 per invoice, or per item as substantiated by the invoice. Meanwhile, for taxpayers without an applicable financial statement but who meet certain conditions, the de minimis safe harbor is set at $500 per invoice or item.
The final regulations also permit a qualifying small taxpayer with assets of less than $10 million to elect to not apply the improvement rules to an eligible building property if the total amount paid during the taxable year for repairs, maintenance, improvements, and similar activities performed on the eligible building does not exceed the lesser of $10,000 or 2% of the unadjusted basis of the building. The eligible building property includes a building unit of property that is owned or leased by the qualifying taxpayer, provided the unadjusted basis of the building unit of property is $1 million or less.
Under earlier versions of the regulations, a taxpayer carrying materials and supplies on hand was required to include in expenses the charges for materials and supplies only in the amount that was actually consumed and used in operation during the tax year for which the return was filed. The final regulations alter several of the criteria for defining betterments and restorations to tangible property, and they raise the threshold for materials and supplies that are exempt from capitalization from $100 to $200. The rules further incorporate the definition of standby emergency spare parts contained in Rev. Rul. 81-185, and make these spare parts eligible for the optional election to capitalize certain materials and supplies provided in Section 162.
In addition, a routine maintenance safe harbor provides that certain qualifying cyclical maintenance activities will be considered not to result in a capital restoration under the final regulations. Activities may qualify for the safe harbor if, at the time a unit of property is placed in service, the taxpayer reasonably expects to perform the activities more than once over a 10-year period.