When it comes to many of the expenditures related to tangible property, whether a business can expense or must capitalize hinges on the difference between a “repair” and an “improvement.” New, final IRS regulations — IRS T.D. 9636 — provide guidance to help businesses make this determination.
Advantages of expensing
Internal Revenue Code (IRC) Sections 162 and 263 dictate that costs incurred to acquire, produce or improve tangible property be capitalized, rather than expensed. (Tangible property includes buildings, machinery, equipment, vehicles and other real and personal property.) But the IRC sections allow expensing of costs incurred on incidental repairs and maintenance of tangible property.
Capitalized property must be depreciated and deducted over a period of up to 39 years, while expensed property can generally be deducted in the current year. Expensing, therefore, is generally preferable to capitalization in most situations.
To make distinguishing between repairs and improvements simpler, the final regulations include a safe harbor that covers routine property maintenance (including buildings). Recurring activities dedicated to using property and keeping it in efficient operating condition can be expensed and immediately deducted.
These activities include property inspection, cleaning and testing, and replacement of worn or damaged parts. Routine activities are those that your business reasonably expects to perform more than once during the property’s “class life,” as defined by the IRS. For commercial buildings, this is defined as more than once every 10 years.
Meanwhile, noninventory materials and supplies used in the course of performing routine property maintenance can be expensed and deducted if they are:
- Components acquired to maintain, repair or improve a unit of tangible property,
- Fuel, lubricants, water or similar items reasonably expected to be consumed in one year or less,
- Units of property with a useful life of one year or less,
- Units of property with an acquisition or production cost of $200 or less, or
- Property identified as materials or supplies in future regulations.
Incidental materials and supplies — for instance, office and cleaning supplies — can be deducted when they are purchased. But nonincidental materials and supplies can be deducted only after they are first used or consumed. These include things such as small engine parts, saw blades, fuel and motor oil. Rotable, temporary and standby emergency spare parts, meanwhile, are deductible when they’re disposed of. Or, you can elect to treat these as depreciable assets and capitalize them.
Identifying units of property
When it comes to commercial buildings, the final regulations require you to identify a building’s relevant “unit of property” (UOP) when distinguishing repairs from improvements.
The final regs treat a commercial building and its structural components as a single UOP. Any work performed on a building must be capitalized if the level of improvement results in a betterment, restoration or adaptation when applied to the building and its structural components as a whole.
But they treat certain building systems (including HVAC, plumbing, electrical and elevator systems) as separate UOPs that must be evaluated individually for expensing vs. capitalization purposes. This will potentially make it more difficult to deduct certain expenses. Consider an HVAC system, for example. If work done to an HVAC system is determined to be an improvement to the system, the expenses for that work must be capitalized — even if it’s not an improvement to the building itself.
The final regs contain a safe harbor for small businesses with gross receipts of $10 million or less. Such businesses can elect to expense and deduct (rather than capitalize) repair, maintenance, improvement and similar expenses if:
- The building’s initial cost is $1 million or less, and
- The total amount of these expenses for the tax year doesn’t exceed $10,000 or 2% of the building’s adjusted basis, whichever is less
Additionally, the final regs include a restoration test which states that an amount paid for the replacement of a major component of a UOP is an amount paid to restore that property. There is a new definition for use in determining whether money spent on replacement constitutes a restoration.
The final regulations apply to tax years beginning on or after Jan. 1, 2014. If your business owns or leases tangible property and incurs expenditures related to it, you’ll be affected by the final regs. Contact us if you have questions about your specific situation.