Final Tangible Property Regulations Issued
By: Sandra Rodriguez, CPA – Senior Tax Accountant
On Friday, September 13, 2013, the Treasury Department issued long-awaited final regulations regarding tangible property expenditures. The regulations intend to provide a general framework for distinguishing capital expenditures from supplies, repairs, maintenance, and other deductible business expenses. The Treasury Department and IRS previously issued temporary regulations in late 2011. However, the temporary regulations were met with much criticism and implementation of the regulations was delayed until issuance of the final regulations.
The regulations became effective on September 19, 2013 and generally apply to tax years beginning on or after January 1, 2014. However the regulations do provide taxpayers with the option to retroactively apply the regulations to January 1, 2012. A summary of the final regulations is as follows:
§1.162-3 – provides guidance on materials and supplies
§1.162-4 – addresses repairs and maintenance
§1.263(a)-1 – general rules on capital expenditures
§1.263(a)-2 – provides guidance on amounts paid for acquiring and producing tangible property
§1.263(a)-3 – provides guidance on amounts paid for the improvement of tangible property
Material and Supplies
Pursuant to the final regulations, materials and supplies are generally deductible as ordinary and necessary business expenses in the year they are used or consumed and to the extent they are not included in a taxpayer’s inventory. The final regulations define materials and supplies to include property that has an acquisition or production cost of $200 or less.
In addition to general materials and supplies, the regulations also address expenditures for rotable and temporary spare parts, as well as “stand by emergency spare parts”. Such items are deemed to be used or consumed in the year of disposition unless an election is made to use an optional method of accounting which allows for deduction of the expenditure in the year originally placed in service but subject the parts to continued analysis if and when a part is removed, repaired, reinstalled, and disposed. In lieu of deducting the expenditure when used or consumed, taxpayers may elect to capitalize and depreciate rotable, temporary and emergency spare parts over an applicable life.
If the optional method is used (i.e. a taxpayer chooses to deduct the cost of the part in the year placed in service), a taxpayer must use the optional method for all of the pools of rotable, temporary, and emergency spare parts in the same trade or business. Similarly, if a taxpayer chooses to capitalize and depreciate the rotable, temporary, and emergency spare parts, the taxpayer is required to make an election on its original and timely filed return for the year in which the asset is placed into service.
Capital Expenditures / De Minimis Safe Harbor
Taxpayers are generally required to capitalize amounts paid to acquire or produce a unit of real or personal property, including the related transaction costs. Under the final regulations, taxpayers can deduct certain amounts paid for capital expenditures and can elect a de minimis safe harbor deduction if certain criteria are met.
The de minimis safe harbor allows taxpayers to expense the amounts paid to acquire or produce a unit of property in a similar manner the expenditures are expensed for financial statement purposes. The safe harbor is determined at the item or invoice level and may be deducted to the extent that the amount paid for the property does not exceed $5,000 (or $500 for certain taxpayers) per invoice, or per item, as substantiated by the invoice. This is a major change compared to the temporary regulations which instituted a de minimis expensing ceiling of 0.1% of gross receipts or 2% of a taxpayer's total depreciation and amortization expense for the year. For purposes of the per item, per invoice, thresholds list above, taxpayers should be mindful in applying the safe harbor rules as the final regulations distinguish between taxpayers with applicable financial statements (i.e. audited financial statements) and taxpayers without applicable financial statements (i.e. reviewed financial statements). Taxpayers with applicable financial statements are subject to the $5,000 threshold while taxpayers without applicable financial statements are limited to the $500 threshold.
The final regulations clarify that the de minimis rule is a safe harbor, elected annually by including a statement on a timely filed tax return for the taxable year elected. The election applies to all qualifying expenses, including materials and supplies. In order to use the safe harbor, a taxpayer must have written accounting procedures in place at the beginning of the taxable year for which the safe harbor treatment is being elected. Therefore, taxpayers without written accounting procedures should allow themselves time to prepare the appropriate accounting policies to make such election. Taxpayers should note that this election is a change in accounting procedure and not a change in an accounting method.
Amounts Paid to Acquire or Produce Tangible Property
In general, amounts paid to acquire or produce a unit of property are required to be capitalized under the rules of Section 263(a). The final regulations expand this general understanding to provide guidance for capitalizing amounts paid to defend or perfect title to real or personal property, and the rules for determining the portion of transaction costs to be capitalized that are related to the acquisition of production of property.
Transaction costs represent amounts paid to facilitate the acquisition of real or personal property if the amount is paid in the process of investigating or otherwise pursuing the acquisition. In determining whether a cost is facilitative in nature, taxpayers should be mindful of the distinction between facilitative costs and deductible pre-decisional/investigory costs. The regulations make clear that any amount incurred in the process of investigating or otherwise pursuing the acquisition of real property does not facilitate the acquisition if it is performed in the process of determining whether to acquire real property and/or which real property to acquire. The final regulations maintain a list of inherently facilitative costs to assist taxpayers in making this determination.
Amounts Paid for the Improvement of Tangible Property
The final regulations require the capitalization of costs incurred to improve a unit of tangible property. A unit of property consists of all the components of property that are functionally interdependent. In other words, a single unit of property is established if placing a piece of property into service requires its component pieces to be placed into service as well. Certain property, however, is further divided into smaller units comprised of each component. For example, a building does not constitute a single unit of property for the application of improvement rules. Instead a building is separated between the building structure and the building’s systems and thus analyzed as separate units when determining whether there has been a betterment, a restoration, or a new or different use/adaption to the property.
The following provides a brief overview of definitions for betterment, restoration, and adaption as defined in the final regulations:
A betterment exists if the amounts paid for the betterment to the unit:
- Ameliorates a material condition or defect that either existed prior to the taxpayers acquisition of the unit of property or arose during the during the production of that unit of property;
- Is a material addition, physical enlargement, expansion, extension, or addition of a major component to the unit of property, or materially increases the capacity of the unit of property; or
Is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the unit of property
A restoration exists when amounts paid to restore a unit of property:
- Is for the replacement of a component of a unit of property for which the taxpayer has properly deducted a loss for that component other than a casualty loss;
- Is for the replacement of a component for a unit of property for which the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
- Is for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss or event;
- Return the unit of property to its ordinarily efficient operating condition if the property had deteriorated and was no longer functional;
- Results in the rebuilding of the unit of property to a like-new condition after the end of its class life; or
Is for the replacement of a part or a combination of parts that comprise a major component or substantial structural part of a unit of property.
- Generally, an amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with a taxpayer’s ordinary use of the unit of property at the time it was originally placed into service.
The final regulations additionally clarify the treatment of removal costs and provide that, in general, if a taxpayer disposes or partially disposes an asset and a gain or loss on the disposition of property has been realized, then the cost of removing the asset or component is not required to be capitalized. However, if a component of property is disposed of or partially disposed of and no gain or loss is realized for tax purposes, then the taxpayer must deduct or capitalize the cost of removing the component.
A safe harbor rule has been provided by the regulations for small taxpayers in order to better assist them in applying the rules for improvements of buildings. The safe harbor is applicable to taxpayers with gross receipts of $10 million or less during the three preceding tax years. This rule allows certain taxpayers to opt out of applying improvement rules to eligible buildings (buildings with an initial cost of $1 million or less) and to deduct the expenses related to building improvements to the extent that the total amount paid for the maintenance and repairs does not exceed the lesser of $10,000 or two percent of the unadjusted basis of the building. The safe harbor is an annual election to be submitted upon the timely filing of a tax return and is irrevocable.
In addition, the final regulations establish a safe harbor for routine maintenance on buildings and other property. A deduction for routine maintenance will be allowed if the maintenance performed on a building is expected to occur more than once over a ten year period beginning on the date the building was placed into service. Maintenance performed on non-building property may meet the safeharbor if the maintenance is expected to be performed more than once over the class life of the non-building property.
While the final regulations regarding tangible property expenditures provide many opportunities for taxpayers, taking advantage of these opportunities requires a significant investment in time. Taxpayers must begin to analyze the regulations to better understand how the tangible property rules affect their business, the general accounting policies of their business, and what the next course of action should be prior to the regulations becoming effective on January 1, 2014.
The tax professionals of Alpern Rosenthal are constantly monitoring tax law changes and will keep you up-to-date with the most current issues and situations. Please contact your Alpern Rosenthal tax specialist to further discuss any or all of these matters.