Reprinted/posted with permission of Cohen & Company, Ltd. Original copyright “Taxonomics”, Spring, 2014
Just when you think you’ve figured out the rules of the game…
The IRS has adopted new regulations for business deductions on tangible property. It’s a sweeping
category covering everything from the purchase of computers to the repair and maintenance of buildings.
The process for adopting the new regulations was arduous, consisting of 10 years of hearings and public comments before final adoption this past September. As a result, the new regulations are complex. However, taxpayers may need to take a close look and assess the new rules to determine the potential impact.
The Parts are More than the Sum
While known in the industry as “repair regulations,” Cohen & Company Tax Partner Angelina Milo says, “these regulations really apply to the acquisition, production and improvement of tangible property.” Milo adds that although the regulations will impact all industries, they are significant to the real estate industry and to those who own real estate.
Prior to the new regulations, if your company owned a building and made substantial repairs or replaced parts of the facility, the decision to capitalize or deduct the cost was made primarily by comparing the cost of the improvements to that of the entire building. Other factors also came into play, such as the expected life of the property, overall value of the improvement, etc.
While other factors are still part of the equation under the new rules, the biggest change is that a building is no longer considered one unit of property, but is instead subdivided into separate “units of property.” Therefore, when a repair occurs, the cost of the improvement must be compared as it relates to the specific unit to which it belongs. The regulations identify nine building systems, each
as a separate unit of property: HVAC, plumbing, electrical, escalators, elevators, security systems, fire protection and alarms, gas systems and other structural components.
For example, a company owns an office building with a HVAC system that consists of 10 roof-mounted units. The company pays $75,000 for labor and materials to repair those units. The HVAC system, including the roof-mounted units and their components, comprise a unit of property under the new repair regulations. If the $75,000 in work done on the roof-mounted units is considered a significant improvement to the HVAC system, the $75,000 repair is treated as an improvement that should be capitalized. Whereas before these new regulations, the $75,000 compared to the cost of the entire building may have been insignificant enough to merely deduct the expense in the same year.
Safe Harbor Options
The regulations provide for a routine maintenance safe harbor, which looks at the frequency of the repair and maintenance. For a building, if the taxpayer reasonably expects to perform routine maintenance on a unit of property at least twice within 10 years, then the costs may be expensed. Milo says, additionally, taxpayers may now deduct the cost of acquiring an item under another new safe harbor provision; this safe harbor allows a taxpayer, with an applicable financial statement, to expense items costing $5,000 or less per invoice or item. (An applicable financial statement is one that is required to be filed with the SEC, is a certified audited financial statement that is accompanied by the report of an independent CPA, or is required to be provided to a federal or state government or agency other than the SEC or the IRS.)
The expense threshold changes to $500 per invoice or item for taxpayers without an applicable financial statement. So, if the cost to acquire a new HVAC unit was $5,000, then the cost could be expensed. Although unlikely for the purchase of HVAC units, this provision may be very helpful for less expensive items purchased.
Milo says to take advantage of the safe harbor provision for acquisitions, the taxpayer must have a written financial policy at the beginning of the tax year and must make an election with the taxpayer’s timely filed tax return. In addition, taxpayers may choose to have capitalization policies in place in excess of the safe harbor amounts. However, should the return be audited, the taxpayer will have to show that the amount in excess of the safe harbor is appropriate and clearly reflects income.
Out With the Old
In conjunction with the final repair regulations, regulations have also been proposed regarding the disposal of tangible property. Under the proposed rules, a taxpayer may elect to recognize a loss upon a partial disposition of tangible property. For example if the taxpayer replaced five of the 10 mounted HVAC units, a taxpayer will no longer need to dispose of an entire building to recognize a loss. The taxpayer would capitalize the costs of the new units while electing to deduct the remaining costs of the units replaced.
While compliance with repair regulations will be mandatory on 2014 returns, which by then could also include final regulations regarding the disposition of property, taxpayers have the option to voluntarily comply with both the repair and disposition regulations on their 2013 tax returns.
“Considering the expansive nature of these regulations, we have been meeting with clients so they understand the technical and practical application,” says Milo. “The ultimate impact will vary depending on each taxpayer’s existing policies and procedures.”
Ranked one of the top five accounting firms in northeast Ohio and top 100 nationally, Cohen and Company is a full service accounting firm with the following specialties: tax planning and compliance; accounting/auditing; business consulting; wealth management; transaction and litigation services; and corporate finance.
Angelina Milo, the author of this article is a partner with the firm, specializing in tax planning and general business consulting for individuals and closely held businesses. She is also experienced in assisting businesses through acquisitions, divestitures and succession planning. You can contact Angelina Milo of Cohen & Company for more information at email@example.com.