In December 2011, Internal Revenue Service (IRS) issued proposed and temporary regulations on the deduction and capitalization of expenses related to the repair, improvement, replacement, disposal and acquisition of tangible property.
These regulations impact both businesses and individuals. Individuals who own rental property or private jets, and businesses engaged in manufacturing, wholesale or retail activities, may be particularly concerned with the changes. The regulations, effective for 2012, will likely require proactive planning to identify the most favorable available treatments and to take the necessary steps to comply with the new rules. Application of the regulations may require special elections, internal documentation or submissions to IRS, all of which have due dates that must be met. This article provides a general overview of several of the key changes. Detailed discussions of complex areas, such as the impact on rental property, will be provided in future articles.
Under the old regulations and case law interpreting those regulations, amounts paid to improve a unit of property were generally required to be capitalized. In the case of a building, the unit of property was generally considered to be the building and its structural components as a whole. Additionally, taxpayers were required to continue to depreciate a structural component which may have in fact been removed and replaced as part of the improvement. As a consequence, the taxpayer could have been in the position of simultaneously depreciating multiple roofs or HVAC units because of periodic replacements over the 39-year depreciable life of the building.
Under the new regulations, a unit of property is still defined as a building and its structural components. However, the improvement is not viewed in light of the unit of property as a whole, but the effects of the expenditure on the building structure and specifically enumerated building systems and their components. Such building systems include, among others, HVAC, plumbing systems, electrical systems, elevators and security systems. Because the building is now carved into smaller units for purposes of judging whether a particular expenditure improves the asset, the new regulations arguably make it less likely a particular expenditure will be deductible for tax purposes. On the other hand, the new regulations allow taxpayers to elect to dispose of the component that has been replaced and therefore, claim a deduction that was not previously permitted.
Whether these new regulations help or hurt a particular taxpayer, however, depends on the taxpayer's previous method of accounting. Analysis is necessary to judge the impact of the regulations in any particular taxpayer's situation. Taxpayers that previously had repair studies performed under case law interpreting in earlier versions of the regulations may find that the new regulations are detrimental. Taxpayers that simply followed book reporting or utilized a policy of capitalizing all expenditures over a particular dollar amount may, by contrast, find the rules beneficial. Regardless of whether an earlier repairs study had been performed, the new regulations provide an electing taxpayer the opportunity to recognize a loss upon the retirement of a building component such as an HVAC unit, rather than continue to depreciate the retired unit as well as the replacement unit.
Specific to private jets, the new regulations were fairly consistent with the prior rules. Opportunities may exist to deduct the expenses of costly inspections and overhauls, such as engine maintenance and heavy maintenance on a plane's airframe that do not involve the replacement of major components or substantial structural parts.
General Asset Account Election
In general, under the old regulations, no loss is recognized upon the disposition of a component of an asset. Under the new regulations, the taxpayer may choose to claim a loss on a retired component of an asset for which the taxpayer has made a general asset account election. The new regulations permit the taxpayer to make a general asset account election for all assets in its fixed asset ledger as of its taxable year that begins in 2012. This election is beneficial because it gives the electing taxpayer a choice as to how it will treat the disposition of any particular component. The benefit of disposition treatment will vary depending on whether it relates to a major or minor component and whether the replacement is capitalizable or deductible under the regulations. Additional guidance on procedures for making this election is expected from the government.
Making the general asset account election for all potentially affected assets is anticipated to be advantageous for most taxpayers. The election permits flexibility with respect to both the treatment of retired components and the deductibility of repairs related to the retired components. Whether making the general asset election is appropriate in any particular situation for all assets in service in 2012 will depend upon the prospective tax savings, the cost of implementing the change and the documentation available.
Materials and Supplies
The definition and proper treatment of materials and supplies has been a recurring question addressed by various judicial and administrative authorities over the years. In 2008, proposed regulations defined materials and supplies as:
- Tangible property that generally is not a unit of property or acquired as part of a unit of property;
- If acquired as part of a unit of property, the economic useful life is either 12 months or less; or
- The property was acquired or produced for under $100.
The new regulations follow a similar framework, but modify the definition of materials and supplies by expanding the unit of property standard and providing a new category of materials and supplies for fuels, water, or lubricants consumed in 12 months or less. Additionally, the temporary regulations provide an optional method of accounting for rotable and temporary spare parts, an election to expense materials and supplies under an alternative de minimis rule, and an election to capitalize certain materials and supplies.
The alternative de minimis rule allows the taxpayer to elect to deduct the cost of materials or supplies over the $100 amount at the time the cost is incurred, instead of when the materials are used or consumed, so long as other administrative requirements and limitations are adhered to. The proposed regulations give the example of a company that provides consulting services to its customers. The company purchases 50 customized briefcases for its employees that have a useful life of less than 12 months and cost $120 each, and 50 office chairs for $80 each. The example assumes that the company meets the applicable administrative requirements and other cost limitations; thus, the company can elect to deduct the expense of the new briefcases and chairs in the year they are purchased. If the election is not made, the briefcases and chairs would be deductible in the year they are consumed.
The above discussion only begins to scratch the surface of the
new regulations. Taxpayers should consult with their tax advisor on
the applicability of these and other provisions in the regulations.
While there is some latitude in the timing of required elections,
taxpayers are well-advised to take a proactive approach to
addressing the new regulations, including collaboration and
consultation with their tax advisors for assistance in navigating
the uncertainties in the regulations and evaluating all available
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.