Updated August 12, 2022
On September 13 the IRS released its highly anticipated final regulations under Sections 162 and Section 263(a) regarding the deduction and capitalization of expenditures incurred to acquire, maintain and improve tangible property. Additionally, the IRS issued new proposed regulations concerning the disposition of tangible property. These updated regulations both refine and simplify some of the 2011 temporary rules, including creating a number of new safe harbors. The regulations will generally apply to tax years beginning on or after January 1, 2014 but may be applied to tax years beginning on or after January 1, 2012.
The new regulations have been under development for years. In 2006, the IRS released the first set of proposed regulations, which were subsequently withdrawn. The IRS released another set of proposed regulations in 2008, which never took effect. Then, in December 2011, the IRS issued expansive temporary regulations that provided a general framework for capitalization along with guidance concerning dispositions of tangible property. The final regulations replace those temporary regulations but retain many of their provisions.
The temporary regulations provided that a taxpayer who expensed the purchase price of tangible property for financial reporting purposes — according to written accounting procedures for expensing those amounts — on an applicable financial statement (AFS) could deduct the amount for tax purposes, up to an aggregate ceiling. The ceiling was set at the greater of 0.1% of the gross receipts for the tax year for income tax purposes or 2% of the total depreciation and amortization expense for the tax year. For this purpose, an AFS generally is a certified audited financial statement or one required to be submitted to a federal or state government or agency.
The final regulations replace the ceiling described above with a new safe harbor determined by an “invoice level test.” Specifically, a taxpayer with an AFS and a written capitalization policy in place for the effective year can deduct all amounts properly expensed for books as long as the amount paid for property doesn’t exceed $5,000 per invoice or per item. For those taxpayers without an AFS, the safe harbor threshold is reduced from $5,000 to $500. The regulations also expand the safe harbor to encompass amounts paid for property having a useful economic life of 12 months or less and expensed under a financial accounting policy as long as the amount per invoice (or item) doesn’t exceed $5,000.
Under the final regulations, the de minimis rule is an irrevocable elective safe harbor made by including a statement on the taxpayer’s return. If elected, it must be applied to all amounts paid in the taxable year for tangible property that meets the requirements, including amounts paid for all eligible materials and supplies.
Notwithstanding the safe harbor, amounts paid for tangible property may still be subject to capitalization under Section 263 if they include direct or indirect costs of other property produced by the taxpayer or acquired for resale.
The final regulations retain many of the 2011 rules regarding materials and supplies, but they increase the dollar threshold for property exempt from capitalization from $100 to $200. Taxpayers can continue to make an election to capitalize certain materials and supplies but only for rotable, temporary or standby emergency spare parts. Taxpayers can revoke this election by filing a ruling request.
A cost that results in an improvement to a building structure or to any of the enumerated building systems (for example, the plumbing or electrical system) must be capitalized. An improvement occurs if there was a betterment, restoration or adaptation of a unit of property. The final regulations make some significant changes and additions to the temporary regulations regarding improvements, including:
Routine maintenance safe harbor. An activity isn’t considered an improvement if the taxpayer expects to perform it as a result of its use of the property or to keep the property in its ordinarily efficient operating condition. Under the safe harbor, the activity is considered routine if, at the time the property was placed in service, the taxpayer reasonably expects to perform the activity more than once during the property’s life. Examples of routine maintenance activities include inspection, cleaning, testing and the replacement of parts.
While the temporary regulations limited the safe harbor to tangible property “other than buildings,” the final regulations extend it to buildings where the taxpayer must reasonably expect to perform the building-related activities more than once in 10 years.
New safe harbor for small businesses. The final regulations add a safe harbor for qualified small business taxpayers (generally, those with gross receipts of $10 million or less). For buildings that initially cost $1 million or less, taxpayers may elect to deduct the lesser of $10,000 or 2% of the adjusted basis of the property for repairs, maintenance, improvements and similar activity each year. The safe harbor is elected annually on a building-by-building basis.
Election to capitalize repair and maintenance costs. The final regulations also add a new election that permits taxpayers to capitalize amounts paid for repairs and maintenance to tangible property allowing the taxpayer to opt out of expensing and instead claim depreciation deductions. To elect this treatment, the taxpayer must also capitalize those expenditures on its books and records.
Betterment test. The final regulations clarify the temporary regulations’ test for determining whether an amount paid “results in” a betterment by stating that a taxpayer must capitalize amounts reasonably expected to materially increase the productivity, efficiency, strength, quality or output of a unit of property or that are a material addition to a unit of property.
Restoration test. An amount paid for the replacement of a major component or substantial structural part of a unit of property is an amount paid to restore that property. The final regulations include a new definition for use in determining whether an amount spent on replacement constitutes a restoration. Further, an amount is for the replacement of a major component or substantial structural part if the replacement includes a part or combination of parts that comprises 1) a major component or a significant portion of the building structure or any building system, or 2) a large portion of the physical structure of the building or any building system.
As part of these regulations, the IRS created the partial asset disposition (PAD) deduction. This deduction allows property owners to recognize a loss on the disposition of a portion of a building, which generally occurs when significant improvements are made to the building that include the replacement or "ripping-out" of existing building components.
Not all work done to a building's systems or structural components qualify as a PAD, and it is advisable to provide a threshold level of improvement or capital expenditure detail to determine if you qualify for a PAD deduction.
Often, a single line-item on your trial balance for "building improvements" is not enough to make this determination. Breaking down building improvements into different categories, such as electrical, plumbing, facade, roof, HVAC, elevator, etc., can help focus on areas where a PAD may be applicable. A brief description or narrative of the improvements done to the building can also be a valuable guide, especially if you can draw distinctions between improvements that entailed the replacement or ripping-out of existing building components vs. building expansions, additions, or significant system upgrades. Contractor invoices and AIA reports for larger projects can be a great starting point.
Since eligibility of a PAD deduction hangs on key details regarding the physical work done to a property, which cannot be captured in traditional accounting records, retaining substantiation for a PAD deduction is more challenging. The IRS PAD process unit lays out a five-step examination process as follows:
Number 4 on this list may be the most difficult, as the PAD rules allow for two (2) methods for determining the adjusted basis of the disposed portion of the asset (i.e., the undepreciated cost of the old roof in our previous example). The first and best way to make this determination is to have a cost segregation study done on the building/improvements by a qualified professional.
