New Capitalization & Repair Regulations Affect Business & Rental Property Tax Preparation
The Internal Revenue Service issued final regulations in 2013 regarding expenditures for tangible business property. The regulations pertain to the acquisition, improvement, production and sale of such property.
These regulations are voluminous, complex, and include a few terms to become familiar with. Here are some of the significant aspects as well as tax savings opportunities business and investors in rental property should know:
Acquisition Costs of Materials and Supplies
Incidental materials and supplies are deducted upon purchase; non-incidental materials and supplies may also be deducted upon purchase if allowed under a de minimus rule, otherwise they are deducted when used. The de minimus rule requires a written policy in place before the beginning of the tax year and an election included in the tax return filed for the year. Materials and supplies purchased on a single invoice of up to $5,000 are deducted for tax if expensed on an applicable financial statement (AFS) audited by a CPA or provided to any federal (other than IRS) or state agency; if a business does not have an AFS then the deduction limit per invoice is $500.
Acquisition of Rotable/Temporary Spare Parts
Parts used temporarily while awaiting new or repaired parts (for example a pump) and are then taken out of service are rotable. Generally, rotables are only allowed to be expensed upon their disposition. An election may be made to capitalize the cost of the rotables and depreciate them. Another alternative is to deduct rotables when placed in service and take into income at their fair market value when taken out of service (and deducting the balance upon disposition).
Repair and Maintenance Costs
Unit of Property (UOP) consists of tangible property that falls into one of two categories: 1) a building, or 2) some other type of asset. Generally being able to bundle assets into one UOP rather than many UOPs is to a taxpayer’s advantage. With some exceptions, expenditures on a UOP must be capitalized if they result in a betterment, restoration, or adaptation to a new or different use. Betterment means improvement of a condition or defect that existed when acquired or produced, an addition or expansion, or a significant increase in quality, capacity, productivity, efficiency or strength; restoration means restore to operating condition, rebuild to like new condition or replacement of a major component.
- Routine maintenance expected to be performed more than once in ten years beginning with the date placed in service may be expensed.
- Taxpayers with average annual gross receipts of less than $10 million (small taxpayer) for the prior three years and a building that has an unadjusted basis of $1 million or less may elect to expense repairs costing the lesser of $10,000 or 2% or less of the unadjusted basis of a building.
- Routine maintenance expected to be performed more than once during the Asset Depreciation Range (ADR) period for the asset may be expensed. ADR is the asset guideline period for the class of assets the UOP falls in.
Disposition of Real Estate
A disposition is a transfer of ownership or permanent withdrawal of an asset from business use. Disposition includes sale or exchange, retirement, physical abandonment (scrap yard or dump), destruction, or involuntary conversion (flood, fire, landslide, etc.). Buildings that are leased or used in a trade or business are required to be depreciated over a long period of years, generally 27.5 years for residential rental property and 39 years for commercial property. Previously if a portion of a building was replaced, the remaining cost basis for most taxpayers continued to be depreciated.
Under the new regulations, an election may be made to recognize loss on a component of a building or prior unrecovered basis remaining on books, that’s right, even for prior years! For example, if a major component of a building was restored or replaced in a prior year and a portion of the cost basis has yet to be expensed on the tax return, the taxpayer may be able to recognize a loss in the amount of the remaining cost basis for the portion previously disposed of through an Internal Revenue Code §481(a) adjustment (IRC §481(a) is too complex to fully explain in this article, it addresses a change in accounting method and application of IRC §481(a) in this instance essentially allows for recognizing the basis write-off in the current year).
Taxpayers Must Obtain IRS Consent for Accounting Changes Required to Comply with the new Regulations
The revenue procedures clearly indicate that taxpayers making any changes to comply with the new regulations must request consent from the IRS to make an accounting method change. Some of the changes qualify for automatic consent by timely filing IRS Form 3115 with the IRS in Ogden, UT.
Elections are underlined above, some of them are automatic by simply reporting a transaction, others require additional reporting, all must be timely made and usually cannot be undone after the return due date. Decisions to either make an election or pass on it should be made only after fully understanding the ramifications and with careful thought and consideration.
The above discussion is by no means a comprehensive review of the new regulations that apply to capitalization and repair expenditures. The goal is to alert you to the need to promptly address these changes and opportunities. In some cases policy changes are required before the tax year they take effect begins. Make certain you either understand the changes and opportunities or consult with a qualified tax professional. Taxpayers filing late returns thinking it is no big deal as they have $0 tax due may miss out on important opportunities.
Sue Price-Scott, CPA is a partner at Alegria & Company and specializes in business and personal income tax and is accredited in business valuation.
She can be reached at firstname.lastname@example.org