The IRS has issued final regulations on the tax treatment of amounts paid to acquire, produce, or improve tangible property (i.e. buildings, furniture, equipment, supplies). These new regulations explain when those payments can be expensed and when they must be capitalized.
These regulations must be followed for tax years that begin after December 31, 2013. A change to conform to the regulations is considered a change in accounting method. These method changes will require filing Form 3115, Application for Change in Accounting Method. In order to assist you in implementing the new rules, we will need your insight.
These regulations will require an additional analysis of both current and future procedures used in determining amounts required to be capitalized or expensed for tax purposes that may not have been completed in prior years. The goal of the analyses will be to determine what changes of accounting methods may be required, what new elections should be made, and the most efficient and cost effective way for complying with these new regulations.
This is designed to communicate the portion of the regulations that will impact the majority of our clients and to communicate how these regulations will impact the preparation of your 2014 income tax returns. Under the new regulations there are changes to the definition of improvement costs and materials and supplies. The new regulations add a routine maintenance safe harbor, de minimis safe harbor election, and a safe harbor election for small taxpayers with buildings. All of these may allow you to expense qualifying items rather than capitalize them. Each of these items is discussed in detail below. In addition to the discussion below, please see the attached flowcharts.
Improvement Costs – The new regulations provide rules for distinguishing between costs than can be expensed and costs that must be capitalized. These rules, which are explained below, are retroactive and require each taxpayer to review the treatment of items expensed in prior years. The new rules for improvement costs are referred to as the BAR (Betterment, Adaptation and Restoration) test. Amounts paid that meet any portion of the BAR test must be capitalized. We ask that you please review these new rules, and answer the following questions. (If we maintain your depreciation schedule, we can send you a copy upon your request.)
1.) In any year prior to 2014 have you expensed an item that should have been capitalized and added to your deprecation schedule under the BAR test? If so, please provide us with a description of the item, the amount and year in which the item was expensed.
2.) Are there any assets on the depreciation schedule that you no longer own and should be removed? If so, please communicate which assets.
The new rules define an improvement as anything that is a Betterment, Adaptation or Restoration. This is referred to as the BAR test which is defined as:
- B = Betterment
- Improves a material condition or defect that existed prior to the taxpayer’s acquisition of the asset, whether or not the taxpayer was aware of the condition at the time of purchase
- Material addition to the unit of property, such as physical enlargement, expansion, extension, or addition of a new major component
- Material increase in the capacity of the asset
- Reasonably expected to materially increase the productivity, efficiency, strength, or quality of the asset or output of the asset
- A = Adaptation
- Adaptation to a new or different use that is not consistent with the taxpayer’s ordinary use of the asset at the time it was originally placed in service.
- R = Restoration
- Replaces a component of an asset and deducts a loss for that component (other than a casualty loss)
- Replaces a component of an asset and realizes a gain or loss by selling or exchanging the component
- Expenditure is for the restoration of damage to a unit of property caused by a casualty and the taxpayer is required to make a basis adjustment to the asset on account of casualty loss or receipt of insurance
- Expenditures return an asset to its ordinary efficient operating condition after the property has deteriorated to a state of disrepair and is no longer functional for its intended purpose
- Expenditures rebuild an asset to a like-new condition after the end of its class life
- Expenditures for the replacement of a part or combination of parts that comprise a major component or substantial structural part of an asset
NOTE: An item that meets any portion of the above definition must be capitalized. If you have previously expensed an item that meets this definition, under the new rules, the item will need to be capitalized as an asset. Therefore, please provide us with a description of the item, the amount and year in which the item was expensed.
Materials & Supplies – The new rules also define what the IRS considers “materials and supplies”. Materials and supplies are assets defined by the new rules as follows:
- Asset costing $200 or less
- Asset with an economic useful life of 12 months or less
- Component to maintain, repair or improve an asset, including rotable, temporary and stand-by emergency spare parts
- Fuel, lubricants, water, etc. reasonably expected to be consumed in 12 months or less
The new rules define when you can deduct materials and supplies. Materials and supplies that are considered “incidental supplies” are expensed when purchased. Incidental supplies are supplies which are carried on hand and for which no record of consumption is kept or for which beginning and ending inventories are not taken. If records (i.e., inventories of materials and supplies are maintained), these expenses are considered “non-incidental” and they are expensed when used or consumed (i.e. rather than when purchased).
These definitions did not exist prior to the release of the temporary regulations in 2011 and were changed slightly with the final regulations issued in 2013. It is unlikely that you already have an established method of accounting that is in accordance with the final regulations.
Routine Maintenance Safe Harbor – The new regulations allow for immediate expensing of items paid to keep an asset in ordinary and efficient working condition. This safe harbor applies to certain expenses that would otherwise be capitalized under the “R = Restoration” provisions described above. The following items may be expensed as repairs under the Routine Maintenance Safe Harbor:
- Building property (structural components or building systems) – expenditures for maintenance activities that you reasonably expect to perform more than once during a 10 year period.
- i.e. – Replacement of damaged or worn parts with comparable parts, such as replacing 2 windows in a building that has 10 windows or replacing 1 AC unit in a building that has 3 AC units.
- Non-building property – expenditures for maintenance activities that you reasonably expect to perform more than once during the asset’s depreciable class life, which is typically longer than an asset’s depreciable life for tax purposes.
De Minimis Safe Harbor Election – This is an annual election to expense amounts paid or incurred to acquire an asset, produce an asset or purchase materials and supplies. The amount that may be expensed for tax purposes is limited to $500 per item unless you have an applicable financial statement. Policies in excess of $500 are permissible if the increased threshold accurately reflects your income and can be supported upon IRS exam.
An applicable financial statement is defined as an annual independent audit report or a financial statement submitted to a governmental agency. Those with an applicable financial statement are also required to have a written capitalization policy in place. If you have an applicable financial statement and written capitalization policy you can elect to expense up to $5,000 per item. Policies in excess of $5,000 are permissible if the increased threshold accurately reflects your income and can be supported upon IRS exam.
Safe Harbor Election for Small Taxpayers with Buildings – This is an annual election to expense improvements that would otherwise be capitalized. To qualify for this safe harbor you must meet all of the following criteria:
- Taxpayer owned or leased building must have an unadjusted cost basis of $1 million or less. (cost without considering any depreciation)
- Taxpayer must have average gross receipts of less than $10 million for 3 previous tax years
- Total amount for repairs, maintenance and improvements must not exceed the lessor of $10,000 or 2% of the unadjusted basis in the building.
As you can surmise, complying with the new regulations for the 2014 tax year will be both complex and time consuming, with each return likely requiring the inclusion of one or more Forms 3115 to change accounting methods for the items explained above. Because of the additional complexity and time, we anticipate that the fee to prepare your 2014 return will increase. Fortunately, the inclusion of the Form(s) 3115 for tax compliance under these new regulations is generally applicable only for the 2014 year. We will be available to assist you in complying with the regulations for 2015 and later tax returns as needed.
As previously noted, if we maintain a copy of your depreciation schedule we can send you a copy upon your request. Please review the schedule and answer the questions related to improvement cost. If you have any additions or deletions, please communicate those to us as soon as possible.
These regulations are several years in the making and have been revised many times in response to comments from taxpayers and tax practitioners. Guidance on how to comply with them will continue to evolve. We would like to work with you to address any required changes as a result of the regulations. This can be done in person or by phone as you prefer.
Thank you for choosing us as your tax professionals. We sincerely appreciate your business and we look forward to discussing how these new regulations will impact your 2014 income tax return. If you have any questions please do not hesitate to call us at 216-348-9600.
