Two years ago,
taxpayers and preparers had to deal with the implementation of the Treasury
Department’s final regulations regarding deducting repairs, capitalizing
improvements, and depreciating and disposing of tangible property. The regulations were and remain complex and
in many instances, go contrary to the natural inclinations of accountants. Some of the pro-taxpayer provisions of the regulations
require an annual election and should be considered each year for tax planning
purposes. Here is a checklist of some of
these provisions:
1.
De Minimis Safe Harbor. This annual
election statement must be made in a statement attached to a timely filed
(including extensions) income tax return.
The election enables a taxpayer to deduct the purchase of any unit of
property costing $2,500 or less pursuant to the taxpayer’s accounting
policy. The accounting policy should be
in writing (although not technically required at the $2,500 level) by the start
of the tax year. For the election to be
effective, purchases covered by the policy must also be expensed in the
financial accounting records and statements (book conformity).
a. The policy doesn’t need to be set as high as $2,500,
it just can’t exceed this amount and remain in the “safe harbor.” Because of the impact on book income, some
businesses choose to set the policy at a lower amount, such as $1,000 for
example.
b. For taxpayers having an “applicable financial
statement (AFS),” the threshold is $5,000.
The accounting policy for an AFS must be written. An AFS is a financial statement that is
provided to the SEC, or has been audited by an independent CPA, or is otherwise
required to be provided to the government (excluding tax returns).
2.
Partial Asset Disposition. This annual
election must be made in a timely filed (including extensions) income tax
return. The election enables a taxpayer
to deduct the adjusted tax basis (net tax book value) on the disposition of a
portion of an asset. The election is not
made with a statement, rather it is made by deducting the adjusted basis. In addition, the replacement asset must be
classified in the same depreciable asset class as the disposed portion of the
underlying asset. Examples of partial
dispositions for a building include replacing a roof and removing old tenant
improvements to accommodate a new tenant.
a. When it is impractical to determine the cost of the
disposed portion of an asset, a reasonable method may be used to estimate the
cost. The regulations give three
examples of reasonable methods:
i.
If the replacement
asset is part of an overall “restoration” (and isn’t a “betterment” or an
“adaptation”) of the underlying asset, the cost of the partial disposition may
be estimated by deflating the cost of the replacement asset by the producer
price index back to the year the disposed portion of the asset was originally
placed in service.
ii.
The cost of the
partial disposition may be estimated by prorating the cost of the underlying
asset by dividing the cost of the replacement asset by the total estimated replacement
cost of the entire underlying asset.
iii.
The cost of the
partial disposition may be estimated by means of a cost segregation study.
3.
Capitalize and Depreciate Repairs and Maintenance
Costs. This annual election statement must be made
in a timely filed (including extensions) income tax return. This election appears to be applicable only
to “trade or business” assets and not to property held for the production of
income (e.g. real estate rental). A
taxpayer might consider this election if they have expiring tax loss carryovers
or if the taxpayer does not want to deal with potential IRS audits over the subjective
nature of whether an expenditure qualifies as a deductible repair or should be
capitalized as an improvement. A “book
conformity” rule requires the costs be capitalized in the taxpayer’s financial
books and records. This requirement can
be problematic for taxpayers using generally accepted accounting principles
which require expensing of repairs.
4.
Routine Maintenance Safe Harbor. Although not
an election statement to be included with the tax return, a taxpayer should
create a written maintenance plan for each significant asset acquired during
the year. If the plan indicates that the
taxpayer reasonably expects to perform repairs and maintenance more than once
during the asset’s depreciable life (as determined under the alternate
depreciation system), then the IRS should accept the deduction of routine
maintenance and repair expenses. For
real property, the time frame for conducting repairs and maintenance more than
once in the written maintenance plan is 10 years. The election to capitalize and depreciate
repairs and maintenance costs will override the routine maintenance safe
harbor.
5.
Small Taxpayer Safe Harbor for Real Estate. This annual
election statement must be made in a timely filed (including extensions) income
tax return. The election permits qualifying
small taxpayers to deduct repairs, maintenance, and improvements without having
to separately analyze the eight different building systems for purposes of
deciding whether an expenditure must be capitalized or deducted.
a. A small taxpayer has average annual gross receipts of
$10 million or less for the three preceding tax years and
b. Total repairs, maintenance, and improvement costs do
not exceed the lesser of $10,000 or 2% of the unadjusted cost of the building.
i.
This limit
applies to each building separately.
ii.
The building’s
cost must be $1 million or less. If the
taxpayer leases the building, then the total undiscounted lease payments for
the entire term of the lease, including renewals, are summed for this purpose.
iii.
Counted against
the $10,000/2% limit are costs expensed under the de minimis safe harbor and
the routine maintenance safe harbor.
iv.
If costs exceed
the $10,000/2% threshold for a building, then the election is unavailable and
regular rules apply to all the building’s repairs, maintenance, or improvements.
6.
Capitalize and Depreciate Rotable Spare Parts. The taxpayer
may elect in a timely filed (including extensions) income tax return to treat
any rotable, temporary, and standby emergency spare parts acquired during the
year as depreciable property rather than treating the parts as materials and
supplies (M&S). If spare parts are
treated as M&S, their cost generally cannot be deducted until disposition. The election is made on an asset-by-asset
basis and once made, may not be revoked without IRS permission. The election is made by depreciating the
spare parts, there is no election statement.
