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Final Repair Regulations

Rödl & Partner Tax Matters Volume 2013-10, published July 2024

On September 13, 2013, the IRS and Treasury Department released the final regulations under Sections 162(a) and 263(a) regarding the deductibility and capitalization requirements for expenditures relating to tangible property (“Final Repair Regulations”). The Final Repair Regulations differ from the Temporary Repair Regulations (discussed below) in many ways including the following:

Expand the definition of “Materials and Supplies” to include property with an acquisition or production cost of $200 or less (increased from $100)
Simplify the de minimis rule and eliminate the ceiling for acquired property
Add a de minimis rule for taxpayers without Applicable Financial Statements
Restrict election to capitalize and depreciate materials and supplies to rotable, temporary or standby emergency spare parts.
Allow partial dispositions of property and full casualty loss deduction without the use of a GAA election
Codify deduction for investigatory costs for purchasing real property
Provide safe harbor for small taxpayers ($10M or less in gross receipts): not required to apply improvement rules to eligible building property under thresholds
Provides annual election to capitalize and depreciate all repairs and maintenance costs in given year if capitalized for book (does not apply to Materials and Supplies – see below)

The Final Repair Regulations apply to tax years beginning on or after January 1, 2014. For earlier tax years beginning before January 1, 2014 but on or after January 1, 2012, taxpayers have the option of: 1) early adoption of the Final Repair Regulations (although some rules only apply to expenditures made on or after January 1, 2014), 2) adopting the Temporary Regulations (discussed below) or 3) continuing with existing methods of accounting. Most of our clients should simply continue with existing methods of accounting in 2013 and should plan to comply with the Final Repair Regulations beginning January 1, 2014.

The ”Temporary Regulations” issued December 23, 2011 took effect for tax years beginning in 2012. Adoption of the Final Repair Regulations will require an accounting method change for tax purposes. Revenue procedures are expected to be issued to explain the process for making an accounting method change.

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

1. Deductible Expenses under the New Final Regulations

Materials and Supplies

Under Reg Section 1.162-3, a current deduction is allowed for amounts paid to produce and acquire incidental materials and supplies for which no record of consumption is kept or for which physical inventories are not taken. In addition, amounts paid to acquire or produce non-incidental materials and supplies are deductible in the taxable year in which the materials and supplies are used or consumed. Materials and supplies are defined as including five specific categories of property, not including inventory, used or consumed in the taxpayer’s business operations:

Components acquired to maintain or repair property
Fuel, lubricants, water, and similar items
Property with an economic useful life of 12 months or less
Property with an acquisition or production cost of $200 or less
Other property identified by the IRS

In general, unless the cost of a material or supply falls under one of the above categories, no current deduction is allowed. However, see the de minimis rule election noted below. Taxpayers should establish an accounting policy to expense the items listed above including, in particular, property with an acquisition or production cost of $200 or less or an economic useful life of 12 months or less.

De Minimis Safe Harbor Election

For taxpayers not meeting one of the categories defined above, the de minimis rule under regulations Section 1.263(a)-1(f) provides another deduction opportunity on amounts paid to acquire or produce tangible property. To be eligible a taxpayer must meet the following criteria: have an accounting policy at the beginning of the taxable year for deducting property costing less than the de minimis dollar amount and follow its accounting policy. The de minimis dollar amount is limited to $2,500 per item or invoice. If the taxpayer has an Applicable Financial Statement (which is generally an audited financial statement), the taxpayer must have a written accounting policy and the de minimis dollar amount is $5,000 per item or per invoice under the Safe Harbor rule.

The Final Repair Regulations do permit a taxpayer that does not prepare its own Applicable Financial Statements to rely on the $5,000 de minimis safe harbor if the taxpayer is included in the parent group’s Applicable Financial Statements. Foreign inbound companies should therefore be eligible to rely on the $5,000 rule if their results are reported in their foreign parent’s Applicable Financial Statements.

With the elimination of the ceiling rule in the Temporary Regulations and the additional safe harbor for taxpayers without Applicable Financial Statements, we expect more of our clients will be able to take advantage of the De Minimis Safe Harbor Election.

Taxpayers should establish a written accounting policy to expense acquired property not meeting the definition of a material or supply and costing less than $500 per item or invoice (or $5,000 for taxpayers with audited financial statements).

The taxpayer makes the de minimis election by deducting the cost of the material or supply in the taxable year in which payment is made.

Rotable and temporary spare parts

The new regulations provide more flexibility for taxpayers with rotable and temporary spare parts. Instead of deducting the cost of those parts when they are discarded or electing to capitalize and depreciate them, taxpayers can now choose to deduct the cost of the new part in the year of installation. If a taxpayer chooses this method, they must include in income the fair market value of the old part and add this amount to the new part’s basis. In addition, they must capitalize the part’s repair costs.

Alternatively, the taxpayer may elect to capitalize and depreciate the cost of such parts over the applicable recovery period, as introduced in the Temporary Regulations. The Final Regulations add the category “Standby Emergency Spare Parts” and limit this election strictly to Rotable, Temporary, and Standby Emergency Spare Parts.

Repairs

The regulations allow a current deduction for repairs and maintenance to property. Deductible repairs and maintenance expenses are defined in a negative way − they are deductible if not otherwise required to be capitalized (see below for “Expenses Requiring Capitalization” under the Final Repair Regulations).

Routine maintenance safe harbor

The Temporary Regulations adopted a new safe harbor that many businesses will find useful. Under this rule, the cost of routine maintenance performed on a unit of property (“UoP”) that isn’t a building or a structural component is currently deductible. Routine maintenance refers to the recurring activities that a taxpayer expects to perform to keep a UoP in ordinarily efficient operating condition. Examples are inspection, cleaning, testing, and replacing the parts of the UoP with comparable replacement parts.

The taxpayer must reasonably expect to perform the activities more than once during the class life (under the alternative depreciation rules) of the UoP.

In addition, the Final Repair Regulations include a new safe harbor for routine maintenance for buildings. In this case, the taxpayer must reasonably expect to perform the activities more than once in the 10 years following the date the building or building system upon which the maintenance will be performed is placed in service by the taxpayer.

Taxpayers should be prepared to substantiate to their auditors that: 1) routine maintenance meets the safe harbor criteria as defined above and 2) repairs are not required to be capitalized as defined below. Taxpayers should establish an accounting policy that includes the routine maintenance safe harbor as described above as well as a capitalization policy based on the criteria described below.

2. Expenses Requiring Capitalization Under the Final Repair Regulations

Generally, amounts paid to acquire or produce tangible property and amounts paid to improve tangible 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.

Betterments

A betterment is an amount paid that: 1) corrects a material condition or defect of the property, 2) results in either a material addition to the property (physical enlargement, expansion, or extension), or 3) results in a material increase in capacity, productivity, efficiency, strength, or quality of the property or the output of the property.

Restorations

An amount is paid to restore property if:

It is for the replacement of a component of the property where the taxpayer recognized gain or loss on the sale or exchange of the component or deducted a loss for the component (i.e. casualty loss);
The taxpayer returns the property to its ordinary efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional;
It results in the rebuilding of the property to a like-new condition after the end of its class life; or
It replaces a part or a combination of parts that comprise a major component or substantial structural part of the unit of property.

Adaptations

An amount is paid to adapt property to a new or different use if the adaptation is not consistent with the taxpayer’s intended ordinary use of the property at the time the property was originally placed in service by the taxpayer.

Unit of Property

One of the key issues in the temporary regulations is the definition of the “unit of property“ 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 a separate UoP. By contrast, if the UoP is the vehicle, the engine work has a better chance of being considered a repair.

Buildings

When it comes to buildings, the regulations generally treat each building and its structural components as one UoP. In addition, the regulations list nine specified building systems that are treated as separate from the building structure. A cost is treated as a capital expenditure if it results in an improvement to the building structure or to any of the specifically enumerated building systems.

An improvement to the building is defined by its effect on a building system, rather than its effect on the building as a whole. Thus, if a taxpayer replaces a roof, the expense 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 expense is also an improvement to the building UoP, even though the “improvement” analysis is applied at the building system level.

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 can’t be placed in service without the other components also being placed in service.

Changes to Depreciation Regulations

The Temporary Regulations modified the prior regulations relating to the depreciation of capital assets. Some, but not all, of the modifications were intended to coordinate depreciation rules with the other rules in the temporary regulations. 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.

The Final Repair Regulations were accompanied by Proposed Regulations in 2013 regarding “Dispositions, General Asset Accounts, Recovery of Certain Capital Improvements, and Removal Costs.” The Proposed Regulations modify the 2011 Temporary Regulations in one key area: partial dispositions will now be allowed without making a GAA election. In fact, the Proposed Regulations return to more restrictive rules regarding disposition of property within a GAA class.

State Tax Considerations

Individual states may or may not choose to adopt the changes implemented with the Final Repair Regulations. Similar to bonus depreciation adoption, states may decouple from the federal provisions and/or may add their own requirements for capitalizing/expensing certain costs. Discrepancies between federal and state treatment may result in taxable income differences for state purposes as well as in depreciation and tax basis of capitalized assets. Not much, if any, guidance or intent from the individual states has been published regarding this issue. It should be considered in performing tax compliance especially beginning with the 2014 tax year.

Accounting Method Changes

A change to conform to the temporary regulations is considered a change in accounting method for which an accounting adjustment is required. The IRS has issued procedures under which taxpayers can obtain automatic consent to the accounting method change. Revenue Procedure 2012-19 addresses repairs and maintenance, materials and supplies, and related method changes resulting from the temporary regulations. Revenue Procedure 2012-20 addresses depreciation, disposition, and related method changes resulting from the temporary regulations. These procedures are effective for tax years beginning on or after January 1, 2012. New Revenue Procedures are expected to be issued in the near future to address adopting the Final Repair Regulations.

Please let us know if you have any questions on this matter.

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