nearly a decade of issuing a long series of proposed and temporary regulations,
the IRS has finally issued final regulations providing guidance to help taxpayers determine how to treat repair and maintenance expenditures related
to tangible property from a tax perspective.
property includes buildings, machinery, equipment and vehicles, and such
expenses include the costs incurred to replace major components or substantial
structural parts of a unit of property (UOP). They also include expenses that
result in a UOP’s betterment, restoration or change in use.
final regs (IRS T.D. 9636, also known as the Repair Regs) help clear up the
confusion that has existed for many years with regard to whether taxpayers
can expense and deduct repair and maintenance costs, or if they must capitalize
these expenditures. Property and costs that are expensed can generally be
deducted in the year they are incurred, but those that are capitalized must be
depreciated and deducted over a period of years. Therefore, expensing is
usually preferred by most taxpayers.
Separating Repairs From Improvements
Revenue Code (IRC) Sections 162 and 263 distinguish between “repairs” and
“improvements” in determining whether taxpayers can expense and deduct tangible
property expenditures or must capitalize and depreciate them. Expenses
allocated to acquiring, producing and improving tangible property must be
capitalized and depreciated, while those allocated to incidental repairs and
maintenance can be expensed and deducted.
Regs provide clarification to help taxpayers make this distinction. They allow a taxpayer to deduct routine maintenance costs, which are defined as recurring
activities that are necessary to keep the property in “ordinarily efficient
operating condition.” These activities — which include inspection, cleaning,
testing and replacement of worn and damaged parts — should be expected to be
performed more than once during the property’s alternative depreciation system
that in the case of commercial and residential real estate, the measurement
period is 10 years.Therefore, such
activities should be expected to be performed more than once every 10 years.
materials and supplies are used to perform the routine maintenance, they can be
deducted under specific conditions. Fuel, lubricants, water and similar items
consumed within one year are deductible, as are UOPs with a useful life of no
more than one year and those with an acquisition or production cost of no more
materials and supplies (like cleaning supplies, for example) can be deducted as
soon as they are purchased. But non-incidentals can’t be deducted until they
are actually used or consumed — these include things like small engine parts
and saw blades, for example. And rotable, temporary and standby emergency spare
parts cannot be deducted until they are disposed.
Expenses That Must Be Capitalized
the Repair Regs define acquiring, producing or improving tangible property as
any activity that results in one of the following:
- A betterment of the property — It corrects a pre-existing defect or causes a material increase in capacity, productivity, efficiency, strength, quality or output.
- A restoration of the property — It returns a unit of property to ordinarily efficient operating condition after it had deteriorated and was no longer functional.
- An adaptation of the property — It makes it possible to use the asset for a new or different purpose.
expense meets any one of these criteria, it cannot be expensed and deducted —
it must be capitalized and depreciated over a period of years.
following examples help illustrate how the Repair Regs might apply in typical scenarios:
the compressor unit in a commercial building’s air conditioner has failed and
needs to be replaced. Would this be considered a repair or an improvement to
the air conditioning system? While on the surface it might seem like this would
be a repair that can be expensed and deducted, it would actually depend on the
facts and circumstances. Assuming the
compressor was replaced with a more efficient unit, this would be considered a
restoration or betterment and, therefore, must be capitalized and depreciated.
- On the
other hand, if the taxpayer had 10 rooftop units and two were replaced and no
work performed on the others or the controls, these would be expensed as they
do not constitute a major component or substantial structural part of the
key parts of the engine in an earthmover are damaged and need to be replaced.
This would likely qualify as a repair that can be expensed and deducted during
the year when the repair is made.
commercial buildings, the repair standards must be applied separately to the
overall structure as well as to the following specific building systems:
- Gas distribution
Safe Harbors for Taxpayers
Regs contain a safe harbor for taxpayers with gross receipts up to $10
million. These taxpayers can elect to expense and deduct, rather than
capitalize, repairs, maintenance and improvements if the building’s initial
cost is $1 million or less and the
total expenses for the tax year do not exceed $10,000 or two percent of the
unadjusted basis, whichever is less.
addition, the Repair Regs also provide a de minimis safe harbor of $5,000 for taxpayers that prepare applicable financial statements (these include audited
and certain other government-required statements). And certain taxpayers can
expense up to $500 per item if a written expenses policy was in place at the
beginning of the tax year.
Repair Regs apply to tax years beginning on or after January 1, 2014. They are
retroactive, so you may need to adjust for prior years’ repairs and
maintenance costs that were capitalized incorrectly. The good news is that this
adjustment could result in a current deduction equal to the undepreciated cost
of previously capitalized repair and maintenance expenses.
Steps for You to Take
Mueller Prost suggests the following actions. Contact your Mueller Prost advisor today for assistance with these activities:
- Review and update your depreciation schedules and calculations.
- Review your fixed asset files and determine if expenditures have been properly classified as a repair expense vs. capital asset.
- Compare allowable depreciation to what has been previously reported on prior years' tax returns.
Repair Regs will likely have some kind of impact on virtually every business, including the need to change how businesses account for repair and maintenance costs. They will result in significant new recordkeeping,
administrative and documentation requirements for most taxpayers.
Prost advisor can provide valuable assistance as you plan strategies for how
your business will comply with and adapt to the Repair Regs.