An Overview of the New Tangible Property Regulations

The IRS issued new regulations for determining whether amounts paid to acquire, produce, or improve tangible property may be currently deducted as business expenses or must be capitalized. Among other things, they provide detailed definitions of “materials and supplies” and “rotable and temporary spare parts” and prescribe rules and elective de minimis and optional methods for handling their cost. They also have rules for differentiating between deductible repairs and capitalizable improvements, among many other items. The regulations generally are effective for tax years beginning on or after Jan. 1, 2014.

For decades, the regulations under § 162 provided that (1) the cost of incidental repairs that neither materially increase the value of the property nor appreciably prolong its useful life, but simply keep it in an ordinarily efficient operating condition, may be deducted as business expenses, provided the basis of the property is not increased by the amount expended, but that (2) repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the property’s life, must be capitalized and depreciated. The regulations under § 263 similarly distinguished between “incidental repairs” and capital expenditures that add to the value of or substantially prolong the useful life of property or adapt it to a new or different use.

In a December 2011 Treasury Decision, the Treasury Department criticized the vagueness of the rules for distinguishing repairs from capital expenditures: “The standards…set forth in the regulations, case law, and administrative guidance are difficult to discern and apply in practice, and have led to considerable uncertainty and controversy for taxpayers.” In the hopes of drawing a sharper line between deductible repairs and capital expenditures, the Treasury replaced the prior repair regulations with a much more elaborate set of temporary regulations. In September 2013, most of the temporary regulations were finalized.

These regulations are massive and will impact any business no matter its size, industry, or type of entity that acquires, produces, maintains, or improves tangible property, which is virtually all businesses. We will attempt to highlight changes that impact small businesses.

Materials and supplies

As stated earlier, businesses must generally capitalize expenditures relating to tangible property. Materials and supplies used to improve tangible property must generally be capitalized under the rules for improvements. Other materials and supplies can be deducted as follows:

  • Incidental Materials and Supplies —can be deducted in the year they are paid (or, incurred for accrual taxpayers). Material and supplies are incidental if they are carried on hand and no record of consumption is kept or physical inventories maintained. However, immediate deduction is allowed only if it clearly reflects income.
  • Nonincidental Materials and Supplies —are deducted in the year they are used or consumed in the taxpayer’s business operations. (This is referred to as the consumption method.)

Materials and supplies include any item of tangible property used or consumed in the taxpayer’s operations that is not inventory and is included in one of the following categories:

  1. A component acquired to maintain, repair, or improve a unit of tangible property that is not acquired as part of any single unit of tangible property.
  2. Fuel, lubricants, water, and similar items, that are reasonably expected to be consumed in 12 months or less, beginning when used in taxpayer’s operations.
  3. A unit of property that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer’s operations. The economic useful life is generally the period over which the property may reasonably be expected to be useful to the taxpayer considering the wear and tear, climatic, and other conditions particular to the taxpayer’s business
  4. A unit of property that has an acquisition or production cost (as determined under Section 263A) of $100 or less. (We’ll call this the de minimis qualification rule.)
  5. An item identified in future published IRS guidance as materials and supplies.

The general rule is that materials and supplies (as just defined) that are not used to improve tangible property are deductible when paid (or incurred) if they are incidental or when consumed if they are non-incidental. This is substantially the same rule that applied before the new regulations were issued.

Repairs verses Improvements

Expenditures related to tangible property must be capitalized if they are for permanent improvements or betterments that increase the property’s value or that restore its value or make good the exhaustion thereof for which an allowance has been made. On the other hand, expenses for repairs and maintenance to tangible property that are not otherwise required to be capitalized under Section 263 or any other Code section can be expensed.

The regulations require taxpayers to capitalize amounts paid to improve a unit of property. A unit of property is improved if the cost results in (1) a betterment (2) a restoration, or (3) an adaptation to a new or different use of the unit of property.

A unit of property is an essential term in the temporary regulations, as taxpayers must apply the improvement standards to the unit of property. The temporary regulations provide two definitions—one for buildings and another for property other than buildings.

Building and Structural Components

For buildings, a unit of property consists of the building and its structural components other than the components specifically listed as building systems. Building systems include the following:

  • Heating, ventilation, and air conditioning systems (“HVAC”).
  • Plumbing systems.
  • Electrical systems.
  • All escalators.
  • All elevators.
  • Fire protection and alarm systems.
  • Security systems.
  • Gas distribution systems.
  • Any other systems identified in published guidance.

A cost must be capitalized if it results in an improvement to (1) the building structure or (2) any of the specifically enumerated building systems. This is a significant change from the old regulations, which defined the unit of property as simply the building and its structural components and required capitalization only if a cost resulted in an improvement when applied to the building and its structural components as a whole. Under those rules, costs incurred for work performed on a component part of a building (such as an escalator or HVAC system) were often currently deductible as repairs because they didn’t improve the building as a whole. The broad definition of a unit of property for buildings and building systems requires the capitalization of improvements that previously may have been expensed as repair costs.

On the flip side, the new regulations now define dispositions to include the retirement of a structural component of a building. This change allows the adjusted basis of the structural component to be written off on its disposition. Previously, the retirement of a structural component of a building was not considered a disposition. Therefore, the retired component’s adjusted basis could not be immediately written off as long as the building was still being depreciated. Instead it had to continue to be depreciated as part of the building, even though it no longer existed.

Betterment of unit of property – Costs that result in the betterment to a unit of property must be capitalized. There is a betterment when the cost (1) ameliorates a material condition or defect that existed before the taxpayer acquired the property, or arose during the production of the property; (2) results in a material addition to the property; or (3) results in a material increase in capacity, productivity, efficiency, strength, quality, or output of the property.

All of the relevant facts and circumstances must be considered when determining whether an amount paid results in a betterment, including the purpose of the expenditure, the physical nature of the work performed, the effect of the expenditure on the unit of property.

Property Other Than Buildings

For property other than buildings, a unit of property consists of all components (real or personal property) that are functionally interdependent to one another. Generally, functionally interdependent denotes components that must be placed in service together at the same time in order to perform their intended function. For example, a computer and printer would not be functionally interdependent since either could be placed in service separately and function independently. Various components of a piece of equipment would be functionally interdependent.

Observation: The smaller the unit of property, the more likely a component part would materially add to the value of the property and prolong its useful life and therefore need to be capitalized. The larger the unit of property, the more likely the exchange or addition of a component part would be incidental to the unit of property and, therefore, currently deductible.

Safe Harbor for Routine Maintenance on Property Other Than Buildings – The temporary regulations provide a safe harbor for the cost of routine maintenance performed on a unit of property (other than to a building or its structural components) including inspection, cleaning, testing, replacement of parts, and other recurring activities performed to keep a unit of property in its ordinary efficient operating condition.

Activities are routine only if they are reasonably expected to be performed by the taxpayer more than once during the life of the unit of property and do not improve the unit of property. Factors to consider in making this determination include industry practice, manufacturers’ recommendations, taxpayer’s experiences, and treatment of the activity on the taxpayer’s AFS. Routine maintenance does not include any of the following:

  1. Amounts paid to replace a component of a unit of property if the taxpayer has properly deducted a loss for that component (other than a casualty loss under or taken into account the component’s adjusted basis in realizing gain or loss from the sale or exchange of the component.
  2. Amounts paid to repair damage to a unit of property for which the taxpayer has taken a basis adjustment as a result of a casualty loss or relating to a casualty event described in IRC Sec. 165.
  3. Amounts paid to return a unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use.
  4. Amounts paid for repairs, maintenance, or improvement of rotable and temporary spare parts for which the taxpayer applies the spare-parts-optional method.

Filing Form 3115

Changes to comply with the preceding provisions addressed in the regulations (i.e., amounts paid to improve tangible property, determining the appropriate unit of property, betterments to a unit of property, amounts paid to restore a unit of property, and amounts paid to adapt a unit of property to a new or different use) are changes in accounting methods that require IRS consent.

Rev. Proc. 2012-19 supplies procedures for requesting automatic IRS consent for changes other than changes related to the treatment of building structural component dispositions. This will entail filing Form 3115 (Application for Change in Accounting Method) with the taxpayer’s tax return for the year of the change and computing a Section 481(a) adjustment. The Section 481(a) adjustment must be calculated using only amounts paid or incurred in taxable years beginning after 2011. A copy of the Form 3115 is also filed with the IRS in Ogden, Utah.

These are only some of the highlights of the tangible property regulations that impact small businesses. These regulations are massive and filled with numerous examples.

By Don James, CPA/PFS, CFP


About Don James, CPA/PFS, CFP
Don is the Tax & Financial Planning partner with Kiplinger & Co., CPAs headquartered in sunny Cleveland, Ohio since 1982. He partners with business owners and families and specializes in goal achievement solutions, tax minimization strategies and serves in the role of gatekeeper of sound financial advice.

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