Beginning tax year 2014, the IRS issued what are called the “Final Tangible Property Regulations,” or TPR for short. These regulations will affect all businesses; Schedule C, Schedule E, Schedule F, Partnerships, S Corporations, or Corporations.
These final TPR govern the deduction and capitalization of costs incurred to acquire, maintain or improve tangible property, and also provides new rules regarding materials and supplies and the disposition of property. These regulations require that you keep adequate records for purchases, repairs and maintenance, materials and supplies, and require you to specifically analyze each of these items costing over $500. These new regulations do not affect general business expenses; only those expenditures that are made to acquire, maintain or improve property as well as materials and supplies.
The below summary is to help you understand that if you do not analyze these items and classify them appropriately, we will be required to spend the time to do so. These new rules will be applicable for all tax years going forward.
Materials and Supplies (M&S):
Part of these new regulations is guidance on deducting materials and supplies (M&S). The issue is whether or not a taxpayer can immediately deduct these cost of the M&S or if they must be capitalized and expensed when used or consumed. The treatment of M&S depends on whether they are incidental or non-incidental.
The IRS has specifically defined a material and supply (M&S) as:
Tax treatment of M&S:
De Minimis Safe Harbor (DMSH):
The De Minimis Safe Harbor (DMSH) is a very taxpayer friendly provision of these new Regulations that state if you follow the rules, as outlined below, you can deduct up to $500 for any item. In order to qualify for this $500 Safe Harbor, a taxpayer must:
In order to apply the Safe Harbor, you will need to have a capitalization policy.
The election will be made every year on your tax return, unless the IRS changes the rules.
Repairs and Maintenance: Equipment
A repair is anything that is not considered a restoration, adaptation, betterment, or improvement, (the R.A.B.I. rules) and may be deducted. Said another way, anything that passes the RABI rules must be capitalized and anything that fails the RABI rules must be expensed.
If you perform recurring activities to keep non-building property in ordinarily efficient operating condition, those expenses can be written off as long as the recurring maintenance is expected to be performed more than once during its useful life. Building rules are discussed below.
We suggest entering individual items costing $500 or less into your repairs account because of the DMSH rule, but refraining from adding any items above that cost to this account. Items costing more than the $500 this will generally be required to be individually analyzed under the RABI rules below to determine if they can be written off or must be capitalized.
Repairs & Maintenance: Buildings
If you have average annual gross receipts for the prior three tax years of $10 million or less and your unadjusted basis in your building is less than $1,000,000, there is a special rule. These taxpayers may elect to not capitalize any amount if the total amount paid during the taxable year for repairs, maintenance, improvements, and similar activities performed on the building does not exceed the lesser of: (i) $10,000; or (ii) 2 percent of the unadjusted basis of the building. This rule is called the Safe Harbor for Small Taxpayers (SHST), and is very beneficial if you qualify because it can turn items that generally must be capitalized into an immediate deduction. This election will be done annually on the tax return.
If you perform recurring activities to keep building property in ordinarily efficient operating condition, those items can be written off as long as the routine maintenance is expected to be performed more than once in a 10 year period.
Amounts paid to improve tangible property (RABI rules)
The most complex, yet most rule based part of these new Regulations, is determining if an amount paid to improve a unit of property should be expensed or capitalized. To do so, the IRS now requires you to examine each expenditure on each unit of property, outside of the above limits, to determine if there has been a betterment, restoration or adaptation to that unit of property (for short, the R.A.B.I tests). If the improvement is determined to be a betterment, restoration or adaption, then it must be capitalized. If not, it must be written off. There is no dollar amount, or threshold, to these categories either.
A unit of property is now defined as the inter-related parts composing one larger unit. For example, a car is one unit of property, a machine and all its parts are one unit of property, a building, its structure and the building systems are all one unit of property. For buildings, you must apply the rules first to the building itself, then to the building systems, such as HVAC, plumbing, electrical, elevators, security, fire protection or gas distribution. Anything that meets the RABI rules must be capitalized, otherwise it may be written off.
A Betterment results in fixing a condition that existed prior to your purchase or results in a material increase in capacity, productivity, efficiency, or quality. An example would be improving a machine with a part that materially increases its capacity/output.
A Restoration generally results in returning a non-functional asset to use, the cost of rebuilding an asset after the end of its depreciable life, replacing a major component of the unit of property, or comprises a large physical portion of the property. An example would be replacing the entire engine in a machine or truck.
Finally, Adaptation costs are amounts paid to change the piece of property that was not consistent with the intended ordinary use of the property when it was originally placed in service. Best example of this would be costs incurred to convert a warehouse to condo units.
As a practical matter, there will be few costs that are classified as adaptation costs. The main focus should be on whether or not the costs fall into the betterment or restoration categories.
If you have a question about any of the above, please contact us. When preparing your books, if you have a question about an expenditure, feel free to use a Suspense account that we can review and classify these costs appropriately.
These new regulations will affect every tax year going forward, so it’s important to know them and apply them correctly. We advise that you keep this document so that you can refer back to it in the future.
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