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IRS Sets Effective Date for Repair/Capitalization Regulations

On November 20, 2012, the Internal Revenue Service (IRS) issued Notice 2012-73 regarding the intent of Treasury to issue final regulations in 2013 regarding the deduction and capitalization of expenditures related to tangible property. It appears that this notice is in response to taxpayer comments regarding the scope of previously issued temporary regulations. Those regulations required significant modifications to accounting and depreciation systems and could not effectively be implemented in the originally proposed timeframe without significant implementation costs.

On December 23, 2011, the Internal Revenue Service issued temporary regulations that provide guidance on whether businesses can deduct or must capitalize amounts that they pay to acquire, produce, or improve tangible property. In Notice 2012-73 the Internal Revenue Service and the Treasury Department state that they will amend the temporary regulations to apply to taxable years beginning on or after January 1, 2014. These temporary regulations will serve as the basis for the final regulations, which are expected to become final in 2013.

The temporary regulations provide guidance in areas formerly covered by case law. In some cases, they simply codify the existing rules, while in other cases they break new ground. The regulations are lengthy and complex. The summary below is intended to give an overview of how the regulations treat issues of deduction and capitalization.

Amounts paid to improve a unit of property must be capitalized. The regulations create all-encompassing guidelines on what constitutes an improvement, namely an expenditure that betters or restores a unit of property or adapts it to a new and different use.

The regulations allow a current deduction for repairs and maintenance to property. Deductible repair and maintenance expenses are defined in a negative way—they are deductible if not otherwise required to be capitalized.

A current deduction is also allowed for amounts paid to produce and acquire materials and supplies that are consumed during the year. Materials and supplies are defined as including five specific categories of property used or consumed in the taxpayer’s business operations.

For example, as under prior law, units of property with an economic useful life of no more than 12 months qualify as materials and supplies under this rule. Likewise, units of property that cost $100 or less to acquire or produce qualify as materials and supplies.

One of the key issues in the temporary regulations is the definition of the “unit of property” (UOP) that is being repaired or improved. The smaller the UOP, the more likely it is that costs incurred in connection with it will have to be capitalized.

For example, work on an engine of a vehicle is more likely to be classified as an expense that must be capitalized if the engine is classified as a separate UOP. By contrast, if the UOP is the vehicle, the engine work has a better chance of passing muster as a repair.

In the past, taxpayers have increased their repair deductions by taking an expansive view of what is the UOP. The temporary regulations will curtail that tendency by applying detailed rules to the issue. Different rules apply to buildings and to other property.

Buildings: When it comes to buildings, the regulations generally treat each building and its structural components as one UOP—the “building.” In addition, the regulations list nine specified building systems that are treated as separate from the building structure. An improvement to the building is defined by its effect on those systems, rather than its effect on the building as a whole.

For example, if a taxpayer restores a building structure, such as by replacing the entire roof, the expenditure is treated as an improvement to the single UOP consisting of the building. If the taxpayer makes an improvement to a building system, such as the heating, ventilation, and air conditioning (HVAC) system, that expenditure is also an improvement to the building UOP. These improvements would be capitalized and not expensed as incurred.

Property other than buildings: In general, for property other than buildings, a single UOP consists of all components that are functionally interdependent, such that one component cannot be placed in service without the other components.

For instance, a business buys a battery-powered golf cart for use by its foreman to get around a large warehouse. It buys the cart chassis from one vendor and the battery from another, and then assembles the two components. Here, the UOP is the cart, since the chassis cannot be placed in service without the battery.

The temporary regulations modify the existing regulations on the depreciation of capital assets. Some, but not all, of the modifications are intended to coordinate depreciation rules with the other rules in the temporary regulations discussed above. Topics addressed in the modifications include the tax treatment of dispositions of depreciable assets; the maintenance of general asset accounts, and other multiple asset accounts, for depreciable assets; and the depreciation of leasehold improvements.

Changes to conform to the regulations are considered changes in accounting method, for which an accounting adjustment is required. The Internal Revenue Service has issued procedures under which taxpayers can obtain an automatic consent to the accounting method changes for conformity to the regulations. To determine the appropriate accounting method changes that are applicable to your company, an analysis of your fixed assets, repairs and maintenance, and materials and supplies would be necessary.

Although the final regulations will not be issued until 2013 and implementation applies to tax years beginning on or after January 1, 2014, it is important you are aware of the upcoming changes. We will keep our clients informed as the regulations are finalized in 2013, and we would be happy to assist you with the analysis and implementation of the regulations. Please feel free to contact us if you would like to discuss the impact of these regulations on your specific business situation.

IRS Circular 230 Disclosure – As required by IRS rules, although this written communication may address certain tax issues, the issuer of this document did not intend nor write the advice to be used to avoid any penalty imposed by a taxing authority, nor may the user/recipient of this document use this document’s written tax advice for that purpose. Nor may it be used to promote, market or recommend to another party any transaction or matter addressed herein.