No one ever said that tax laws were simple. On the contrary, they can be especially complicated when you are trying to determine whether costs are deductible or must be capitalized. For decades, conflicting case law and administrative rulings on specific situations without formal guidance made tangible property regulations even more challenging to navigate.
Then, in 2013, The final tangible property regulations were issued, providing a framework to help businesses determine whether costs are deductible or must be capitalized. The final tangibles regulations are effective for taxable years beginning on or after 1-1-2014.
Do the Final Tangibles Regulations Apply To You?
The final tangibles regulations apply to anyone who pays for or incurs amounts to acquire, produce, or improve tangible real or personal property. They apply equally to all businesses subject to U.S. tax law, regardless of for-profit or exempt status, organization size, legal entity, or industry. This includes:
- S Corporations
- Individuals filing a Form 1040
- Individuals filing a Form 1040-SR with Schedule C, E, or F.
- Nonprofits that pay unrelated business income tax, have taxable subsidiaries, or lose their tax-exempt status
The rules are most significant for those entities that regularly incur large capital expenditures.
The De Minimis Safe Harbor: Repairs vs. Capitalization, Simplified
To simplify Repairs vs. Capitalization decisions, the IRS created a de minimis safe harbor election. The de minimis safe harbor allows costs of $2,500. or less per invoice or item to be deducted and not capitalized.
If there is an Applicable Financial Statement (AFS), the de minimis safe harbor can be used to deduct amounts of up to $5,000 per invoice or item. To qualify, a written statement titled “Section 1.263(a)-1(f) de minimis safe harbor election” must accompany a timely filed tax return, and each item deducted must be substantiated by an invoice.
When Invoices Exceed Safe Harbor Limitations
Amounts that exceed the safe harbor limitations should be treated by the standard rules that apply. For Example, an item is currently deductible if purchased as incidental materials and supplies or for repair and maintenance.
The IRS offers guidance on how to distinguish capital improvements from deductible repairs.
How to Determine Capital Improvements from Deductible Repairs
Step 1 Determine the Unit of Property
Although Unit of Property (UOP) is nothing new, the tangible property regulations have further complicated its use. Each building and its structural components make up a single Unit of Property. Therefore, if you conduct a cost segregation study and further break out components into 5, 7, and 15-year assets, each class life is a separate Unit of Property.
Step 2 – Apply Improvement Standards for Determining Capitalization or Repair and Maintenance
The final tangible property regulations require that, for all expenditures, the improvement standards are applied to the Unit of Property or any of the enumerated building systems determined by the IRS. The building systems include:
- Heating, Ventilation, and Air Conditioning (HVAC)
- Plumbing Systems
- Electrical Systems
- All Escalators
- All Elevators
- Fire Protection and Alarm Systems
- Security Systems; Gas Distribution Systems
- any other systems identified in published guidance
Betterment, Restoration, and Adaptation
An item of expenditure must be capitalized if it results in a betterment to the unit of property, restoration of the unit of property, or adaptation of the unit of property to a new or different use.
Betterment to the Unit of Property
Betterment to the unit of property includes:
- Costs paid to fix a material condition or defect that existed before the acquisition
- Costs paid for a material addition, including physical enlargement, expansion, extension, or addition to a major component
- Costs paid that are reasonably expected to materially increase productivity, efficiency, strength, quality, or output of the unit of property
Restoration of the Unit of Property
Restoration of the unit of property includes:
- Restoration of a major component or substantial structural part – including amounts paid for the replacement parts:
- Recognition of gains or losses and basis adjustments, including:
- Deducted Loss – Amount paid for the replacement of a component of the unit of property where a loss for the component is properly deducted; or
- Sale or Exchange – Amount paid for the replacement of a component of the unit of property where the gain or loss from the resulting sale or exchange of the component adjusts the basis; or
- Casualty Loss or Event – Amounts paid for the restoration of damage to the unit of property where a basis adjustment must be recognized as a casualty loss under section 165, or relating to a casualty event described in section 165, but is limited to the basis in the unit of property; or
- Deterioration to a State of Disrepair – Amount paid to return the unit of property to its ordinarily efficient operating condition, if the unit of property is deteriorated to a state of disrepair and is no longer functional for its intended use; or
- Rebuilding to Like-New Condition – Amounts paid to rebuild a unit of property to a like-new condition after the end of its class life.
Adaptation of the Unit of Property
Adaptation of the Unit of Property includes:
- An amount paid to adapt a unit of property to a new or different use if the adaption is not consistent with the ordinary use of the unit of property when it was originally placed into service.
If the expenditure does not result in the Betterment, Restoration, or Adaptation to the Unit of Property, it can be EXPENSED.
Every M&E Cost Segregation Study includes a Building Systems Summary & Detail Report that details the baseline costs of the Building Structure and its Building Systems.
Find out how much money you could be saving with a no-cost, no-obligation estimate from M&E Cost Segregation.