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IRS Issues Final "Repair" Regulations On Tangible Property Costs

The IRS has issued long-awaited final regulations on the treatment of costs to acquire, produce or improve tangible property. Taxpayers will need to apply these regulations going forward to determine whether they can deduct costs as repairs and maintenance or must capitalize the costs and depreciate or amortize them over a period of years.

The final regulations retain the basic requirements and the structure of the temporary and proposed regulations issued in December 2011 (the 2011 regulations). At a length of over 200 pages, the final regulations are complex. At the same time, they make significant changes that will benefit taxpayers, including new and revised safe harbors, as well as new relief provisions for small business.

As expected, the regulations take effect January 1, 2014. Some provisions apply only to amounts paid or incurred in tax years beginning on or after January 1, 2014. The IRS is not expected to delay these effective dates, since taxpayers were informed of the impending changes in the rules almost two years ago. Complying with the final regulations will require significant time and effort, despite several taxpayer-friendly changes. Every business with significant fixed assets should develop an understanding of the regulations and their requirements.

The regulations will provide simplification and reduce controversy to the extent they allow taxpayers to follow their financial accounting (“book”) policies. For example, the de minimis rules provide a $5,000 safe harbor per item, provided taxpayers have a policy on their books to deduct items within the safe harbor. The rules for repairs and maintenance also allow taxpayers to follow their book policies.

Retroactive election. While the final regulations take effect January 1, 2014, taxpayers can choose to apply them retroactively for their 2012 or 2013 tax years. Taxpayers can also choose to apply the 2011 regulations to 2012 or 2013. The IRS must provide additional guidance for taxpayers to change their methods of accounting to elect to apply either set of regulations retroactively and to comply with the 2014 effective date. Some accounting method changes will require taxpayers to, in effect, apply the regulations to past years and calculate the impact on income.

More to come. The IRS did not finalize every portion of the 2011 regulations. To address some problems with the temporary regulations on the disposition of depreciable property, the IRS issued new proposed regulations. The new proposed regulations relieve many taxpayers of the requirement to set up general asset accounts and make retroactive elections so that they can deduct the cost of building components and other portions of property that they replace.

Among the significant provisions in the final regulations are the following:

Materials and supplies – The threshold for deducting materials and supplies was increased from $100 to $200. Materials and supplies include many items that are expected to be consumed in 12 months or less, or that have an economically useful life of 12 months or less.

De minimis safe harbor – The final regulations eliminate a controversial ceiling on the use of this safe harbor. Taxpayers with financial statements can apply the safe harbor to an item that costs $5,000 or less. The regulations extend the safe harbor to taxpayers without a financial statement, but only for property that costs $500 or less. Taxpayers must have written book policies in place at the beginning of the year to use this safe harbor. This puts a premium on taxpayers developing a policy by the beginning of 2014.

Routine maintenance and improvements – The final regulations retain controversial unit of property rules that apply the rules for real property to eight separate building systems, as well as to the overall structure. However, the rules do provide some relief by extending the routine maintenance safe harbor to real property and by providing a new safe harbor for small taxpayers. While the routine maintenance safe harbor usually looks at whether taxpayers will have recurring maintenance over the class life of the property, the regulations limit the measuring period to 10 years, rather than the 40-year class life, for real property.

Small taxpayers’ building improvements - A significant change for small taxpayers is that taxpayers with gross receipts of $10 million or less can elect to deduct, for buildings that initially cost $1 million or less, the lesser of $10,000 or 2% of the adjusted basis of the property for repairs, maintenance, improvements, and similar costs each year. This small-taxpayer safe harbor for building improvements can be elected annually on a building-by-building basis by including a statement on the taxpayer’s timely filed original federal tax return, including extensions, for the year the costs are incurred. The election is not revocable.

Capitalization election – The final regulations allow taxpayers to capitalize repair and maintenance costs if they are capitalized for financial accounting purposes. This is a significant simplification over the temporary regulations.

As you can see, the repair regulations are extensive and complex. Determining whether particular costs should be deducted or capitalized will be challenging, especially with the January 1, 2014 effective date looming. We are ready to help you understand the regulations, determine what accounting policies you may need, and make appropriate elections to comply with the regulations. Please contact our office so we can help you address these rules.