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Howard Tax Insights: New Tangible Property Regulations

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Dallas, Texas, February 2015 Recently, the IRS issued long awaited final regulations on the tax treatment of amounts paid to acquire, produce, or improve tangible property.  These regulations explain which payments can be deducted immediately, and which must be capitalized and depreciated.  These regulations will affect any business that has ever depreciated property, had supplies, or repairs & maintenance.

The new regulations must be followed for tax years that begin on or after January 1, 2014.  The regulations are lengthy and complex, and in most situations, a change in accounting method is needed to conform to the regulations, and an accounting adjustment may be required.  The IRS has issued procedures under which taxpayers can get automatic consent to some accounting method changes. As a result of these procedures, almost every business will be required to make an additional filing with their 2014 tax return.

The summary below is intended to give a brief overview of how the IRS will address issues related to the deduction and capitalization of fixed assets, supplies, and repairs.

Capitalization or deduction:  The general rule in the new regulations state that amounts paid to improve a property must be capitalized.  Improvement is defined as an expenditure that betters a “Unit of Property,” restores it, or adapts it to a new and different use.  On the other hand, the regulations allow a current deduction for repairs and maintenance to property, if they are not otherwise required to be capitalized.

Under the new regulations, assets must be defined as separate units of property (UOP).  For property other than buildings, a single UOP consists of all components that are functionally interdependent, such that one component can’t be placed in service without the other components.  The smaller the UOP, the more likely it is that costs incurred in connection with it will have to be capitalized.  For example, replacing an engine in a vehicle is more likely to be a capitalized expense if the engine is classified as a separate UOP.  By contrast, if the UOP is the vehicle, the engine replacement is more likely to pass muster as a repair.

The rules regarding UOP definition for buildings is substantially more complex, and requires an in depth review of the building and its major components.  The regulations list nine specific building systems that are treated as separate from the building structure.  An improvement to the building is defined by its effect on those systems, rather than on the building as a whole.

Materials and Supplies:  A deduction is allowed for amounts paid to produce and acquire materials and supplies that are consumed, not purchased during the year.  UOPs with an economic useful life of no more than 12 months qualify as materials and supplies under this rule.  For UOPs that cost less than $200 to acquire or produce, you will be allowed to deduct the cost when purchased, those amounts in excess of $200 you will be allowed to deduct the cost of each item only when they are consumed in your business.

De minimis safe harbor:  The regulations allow a taxpayer to deduct certain limited amounts paid for tangible property that are expensed for financial accounting purposes.  A taxpayer with audited financial statements may rely on the de minimis safe harbor if no more than $5,000 per invoice, or per item as substantiated by the invoice, was paid for the property.  For businesses without audited financial statements, the maximum amount is $500 under the de minimis rules.

In order to use the de minimis safe harbor, businesses must have an accounting procedure in place at the beginning of the tax year that treat as an expense amounts paid for property that cost less than a specified dollar amount or has an economic useful life of 12 months or less.  Visit this link to review a sample of a capitalization policy which the Howard team would be happy to assist you with tailoring to your specific business.

Routine maintenance safe harbor:  The regulations include a safe harbor that allows certain expenses of routine maintenance to be deducted rather than capitalized.  This includes activities that keep business property in ordinary efficient operating condition, such as inspection, cleaning, testing, and replacement of damaged or worn parts.

In order to qualify for this safe harbor, you must reasonably expect to perform the maintenance more than once during the property’s class life for depreciation purposes for non-building assets, or more than once during the first 10 years after a building is placed in service.

For more information on how these regulations can affect your specific business situation, contact the Howard team today.