Complex Regulations on Deducting or Capitalizing Repairs Now in Effect

As if constantly changing tax laws weren't complex enough, the IRS has also been issuing new forms, rulings, and regulations.  On December 23, 2011, temporary regulations were issued changing the tax rules (effective for tax years beginning on or after January 1, 2012) regarding whether costs incurred for tangible property must be capitalized as an asset or may be expensed as a repair.  Since all businesses own or lease tangible property, all businesses are affected by these regulations.  In some cases, businesses will need to change their method of tax accounting to comply with the new regulations.  Changing a tax accounting method is complex and often involves a cumulative adjustment to taxable income to change from the effects of the prior method.

The length and complexity of the regulations prohibit a full analysis.  Some of the highlights are:

1. New rules are set forth for deducting or capitalizing materials and supplies.
2. Several methods of accounting are provided for rotable and temporary spare parts.
3. Rules are provided for moving and reinstalling property.
4. To determine whether a cost incurred for property is an "improvement" requiring capitalization, it is necessary to refer to what is called a "unit of property."  A "unit of property" is somewhat subjective as demonstrated by numerous examples in the regulations.  Generally, the larger the unit of property the more likely the cost can be deducted as a repair.
5. For buildings, the IRS has identified eight component systems as "units of property" making improvements to these components (e.g., HVAC, plumbing, electricity, elevators, etc.) more likely to be capital expenditures (requiring lengthy depreciation) rather than repairs (permitting current deductions).
6. Leasehold improvements are a separate unit of property.
7. For machinery and equipment, a unit of property is one that performs a discrete and major function or operation.
8. While a "unit of property" is considered in accounting for repairs or improvements, the concept is not used for purposes of determining the property's depreciation period.
9. Improvements are required to be capitalized.  An improvement means that a unit of property has been bettered.  For example, a material defect prior to acquisition has been fixed, a material addition has been added, capacity has been increased, the unit of property has been restored, or the unit of property has been adapted to a new or different use.
10. Routine maintenance such as cleaning, testing, and reasonable replacement of parts is not considered an improvement and may be deducted as a repair.
11. The retirement of a structural component of a building may now be treated as a disposition separate from the overall building and a loss claimed for the adjusted tax basis.

The complexity and cost of complying with these regulations just to determine whether an expenditure is a repair or is a capital asset certainly won't make American business any more competitive in the global marketplace.  Taxpayers have been making these decisions for decades, and now the IRS comes along with new rules changing long-held accounting practices.  The increased intrusion of government regulators into normal business accounting practices drives up the cost of business.  These rules are currently in effect and must be dealt with in your accounting systems.