Section 162 of the Internal Revenue Code (IRC) allows you to deduct all the ordinary and necessary expenses you incur during the taxable year in carrying on your trade or business, including the costs of certain materials, supplies, repairs, and maintenance. However, section 263(a) of the IRC requires you to capitalize the costs of acquiring, producing, and improving tangible property, regardless of the size or the cost incurred. The tax law has long required you to determine whether expenditures related to tangible property are currently deductible business expenses or non-deductible capital expenditures. Before the issuance of the final tangible property regulations on Sept. 17, 2013, [Treasury Decision 9636 ("final regulations")], your decisions were guided by decades of often conflicting case law, as well as administrative rulings on specific factual situations.

The final regulations combine the case law and other authorities into a framework to help you determine whether certain costs are currently deductible or must be capitalized. The final tangible property regulations also contain several simplifying provisions that are elective and prospective in application (for example, the election to apply the de minimis safe harbor, the election to utilize the safe harbor for small taxpayers, and the election to capitalize repair and maintenance costs in accordance with books and records).

Do the tangible property regulations apply to you?

The final regulations apply to anyone who pays or incurs amounts to acquire, produce, or improve tangible real or personal property. These regulations apply to corporations, S corporations, partnerships, LLCs, and individuals filing a Form 1040 with Schedule C, E, or F. The final regulations affect you if you incur amounts to acquire, produce or improve tangible real or personal property in carrying on your trades or businesses. The rules are most significant for those that regularly incur large capital expenditures, e.g., electric utilities, telecommunications companies, and businesses with substantial real estate holdings. The final regulations are effective for taxable years beginning on or after Jan. 1, 2014.

A de minimis safe harbor election

What is the de minimis safe harbor election?

Under the final regulations, you may elect to apply a de minimis safe harbor to amounts paid to acquire or produce tangible property to the extent such amounts are deducted by you for financial accounting purposes or in keeping your books and records. If you have an applicable financial statement (AFS), you may use this safe harbor to deduct amounts paid for tangible property up to $5,000 per invoice or item. If you don't have an AFS, you may use the safe harbor to deduct amounts up to $500 per item or invoice.

These limitations are for purposes of determining whether particular expenses qualify under the safe harbor; they aren't intended as a ceiling on the amount you can deduct as business expenses under the IRC.

Neither the IRC nor prior regulations included a de minimis safe harbor exception to capitalization; you were required to determine whether each expenditure for tangible property, regardless of amount, was required to be capitalized. The de minimis safe harbor election eliminates the burden of determining whether every small-dollar expenditure for the acquisition or production of property is properly deductible or capitalizable. If you elect to use the de minimis safe harbor, you don't have to capitalize the cost of qualifying de minimis acquisitions or improvements. However, de minimis amounts you pay for tangible property may be subject to capitalization under §263A, if the amounts include the direct or allocable indirect costs of other property you produced or acquired for resale. For example, you must capitalize all the direct and allocable indirect costs of constructing a new building.

If you use the de minimis safe harbor, do you have to capitalize all expenses that exceed the $500 or $5,000 limitations?

No. Amounts paid for the acquisition or production of tangible property that exceed the safe harbor limitations aren't subject to the de minimis safe harbor election. Therefore, the safe harbor doesn't require you to capitalize all amounts paid for tangible property in excess of the applicable limitation. If an amount doesn't qualify under the de minimis safe harbor, you should treat the amount under the normal rules that apply, i.e., currently deductible if paid for incidental materials and supplies or for repair and maintenance. This treatment is proper regardless of whether the amount exceeds the applicable de mininis safe harbor limitation. The de minimis safe harbor is simply an administrative convenience that generally allows you to elect to deduct small-dollar expenditures for the acquisition or production of property that otherwise must be capitalized under the general rules.

Are there financial statements other than those required to be filed with the SEC that qualify as an AFS, permitting you to apply the $5,000 de minimis limitation, rather than the $500 limitation?

An AFS includes a financial statement required to be filed with the SEC, as well as other types of certified audited financial statements accompanied by a CPA report, including a financial statement provided for a loan, reporting to shareholders, or for other non-tax purposes. An AFS also includes a financial statement required to be provided to a federal or state government or agency other than the IRS or the SEC.

If you don't have an AFS, are you required to have a written accounting procedure at the beginning of your taxable year to qualify for the de minimis safe harbor election in that year?

If you don't have an AFS, you are not required to have written accounting procedures; however, you must expense amounts on your books and records for the taxable year in accordance with a consistent accounting procedure or policy existing at the beginning of the taxable year.

What if you don't have an AFS but have had a policy for your books and records of deducting the costs of acquiring or improving tangible property less than a specified dollar amount but that amount exceeds the de minimis safe harbor ceiling of $500?

If you don't have an AFS and have a policy for your books and records of deducting amounts more than $500, you may properly deduct these amounts for federal tax purposes, as long as you can show that your reporting policy clearly reflects your income.

In these situations, you may want to elect the de minimis safe harbor for items costing $500 or less to assure that the deduction of the items costing $500 or less will not be questioned by the IRS.

How do you elect to use the de minimis safe harbor?

You should attach a statement titled "Section 1.263(a)-1(f) de minimis safe harbor election" to the timely filed original federal tax return including extensions for the taxable year in which the de minimis amounts are paid. The statement should include your name, address, and Taxpayer Identification Number, as well as a statement that you are making the de minimis safe harbor election. Under the election, you must apply the de minimis safe harbor to all expenditures meeting the criteria for the election in the taxable year. For more information, see When and how do you make an election provided under the final regulations?

An annual election is not a change in method of accounting. Therefore, you should not file Form 3115, Application for Change in Method of Accounting, to use the de minimis safe harbor for a particular tax year, and you should not file a Form 3115 to change the amount you deduct under your book policy. Similarly, you should not file a Form 3115 to stop applying the de minimis safe harbor for a subsequent tax year.

How does the de minimis safe harbor affect the deductions you typically take for materials and supplies or repairs and maintenance?

In general, when you elect the de minimis safe harbor, materials and supplies that also qualify under your de minimis safe harbor are treated as de minimis costs and are not treated as materials and supplies. However, the de minimis safe harbor doesn't change your ability to deduct costs for materials and supplies, incidental or nonincidental, that don't qualify under the de minimis safe harbor.

Similarly, the de minimis safe harbor doesn't change your ability to deduct repair and maintenance costs that don't qualify under the de minimis safe harbor, e.g., costs that exceed the safe harbor threshold. Therefore, for costs that don't qualify under the de minimis safe harbor, you apply the general rules for identifying and deducting repair and maintenance costs, incidental supplies, and nonincidental materials and supplies.

Clarified rules for the treatment of materials and supplies costs

How do the final regulations governing deductions for materials and supplies differ from previous rules?

In most cases, the final regulations don't change the general rules for deducting materials and supplies. The final regulations merely incorporate pre-existing precedents on the definition and treatment of materials and supplies and add some safe harbors to provide you with additional certainty. The final regulations also provide additional elections and methods for those using rotable spare parts.

What is included in the definition of materials and supplies?

Materials and supplies are tangible, non-inventory property used and consumed in your operations including:

  • Acquired components – Costs of components acquired to maintain, repair, or improve tangible property owned, leased, or serviced by you and that's not acquired as part of a larger item of tangible property; or
  • Consumables – Costs of fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months or less, beginning when used in operations; or
  • 12 month property – Costs of tangible property that has an economic useful life of 12 months or less, beginning when the property is used or consumed in your operations; or
  • $200 property – Costs of tangible property that has an acquisition cost or production cost of $200 or less.

The property need only fit into one of the above categories to qualify as a material or supply.

When can you deduct the costs of materials and supplies?

As under prior rules, you may deduct the costs of incidental and nonincidental materials and supplies in the following manner:

  • Incidental materials and supplies – If the materials and supplies are incidental, i.e., of minor or secondary importance, carried on hand without keeping a record of consumption, and no beginning and ending inventories are recorded, e.g., pens, paper, staplers, toner, trash baskets, then you deduct the materials and supplies costs in the taxable year in which the amounts are paid or incurred, provided taxable income is clearly reflected.
  • Nonincidental materials and supplies – If the materials and supplies are not incidental, then you deduct the materials and supplies costs in the taxable year in which the materials and supplies are first used or consumed in your operations. For example, deduct certain expendable spare parts in a trucking business for which records of consumption are kept and inventories are recorded in the taxable year the part is removed from your storage area and installed in one of your trucks. However, an otherwise deductible material or supply cost could be subject to capitalization under § 263(a) if you use the material or supply to improve property or under § 263A if you incorporate the material or supply into property you produce or acquire for resale.
  • Application with de minimis safe harbor – If you elect to use the de minimis safe harbor and any materials and supplies also qualify for the safe harbor, you must deduct amounts paid for these materials or supplies under the safe harbor in the taxable year the amounts are paid or incurred. Such amounts are not treated as amounts paid for materials and supplies and may be deducted as business expenses in the taxable year they are paid or incurred.

What must you do to apply the final regulations to materials and supplies?

Because the final regulations governing the treatment of materials and supplies are based primarily on prior law, if you were previously in compliance with the rules you generally will still be in compliance and generally no action will be required to continue to apply these rules on a prospective basis.

Also, the final regulations governing the treatment of material and supplies apply to amounts paid or incurred in taxable years beginning on or after Jan. 1, 2014. Therefore, for your first taxable year beginning Jan.1, 2014, most of you will not have a change in accounting method for your materials and supplies. If you desire to change your method of accounting for materials and supplies in a subsequent taxable year, you would file Form 3115 and compute a section 481(a) adjustment taking into account only amounts paid after Jan. 1, 2014.

For more information, including simplified procedures for accounting method changes for certain small business taxpayers, see When and how do you change a method of accounting to use the final regulations?

A regulatory framework for analyzing whether expenditures are for deductible repairs or capital improvements.

Have the final regulations changed the rules for determining whether an expenditure is a deductible repair or a capital improvement?

The final regulations synthesize existing case law and prior administrative rules into a framework to help you determine whether a cost is deductible as a repair and maintenance expense or must be capitalized because it's an improvement. If the amounts are not paid or incurred for an improvement to tangible property as determined under the final regulations, then the amounts generally are deductible as repairs and maintenance. Of course, whether a cost is for repair or an improvement will always require reviewing facts and circumstances, as required under prior rules. This facts and circumstances analysis is described in more detail below. The final regulations do not eliminate the requirements of section 263(a), which generally provides that you must capitalize the direct and allocable indirect costs of producing real or tangible personal property and acquiring property for resale. For more information, see How do these regulations coordinate with other provisions of the IRC?

In addition, the final regulations provide several simplifying safe harbors and elections (simplifying alternatives) to ease your compliance with these rules. See Safe Harbor Election for Small Taxpayers, Safe Harbor for Routine Maintenance, and Election to Capitalize Repair and Maintenance Costs.

What is the facts and circumstances analysis for distinguishing capital improvements from deductible repairs?

Step 1 – What is the unit of property to which you should apply the improvement rules?

For buildings – The unit of property is generally the entire building including its structural components. However, under the final regulations and for these purposes only, the improvement analysis applies to the building structure and each of the key building systems. The key building systems are the plumbing system, electrical system, HVAC system, elevator system, escalator system, fire protection and alarm system, gas distribution system, and the security system. Lessees of portions of buildings apply the analysis to the portion of the building structure and portion of each building system subject to the lease. Lessors of an entire building apply the improvement rules to the entire building structure and each of the key building systems.

For non-buildings – The unit of property is, and the analysis applies to, all components that are functionally interdependent. Components of property are functionally interdependent if you cannot place in service one component of property without placing in service another component of property.

For plant property, e.g., manufacturing plant, generation plant, etc. – The unit of property is, and the analysis applies to, each component or group of components within the plant that performs a discrete and major function or operation.

For network assets, e.g., railroad track, oil and gas pipelines, etc. – Your particular facts and circumstances or industry guidance from the Treasury Department and the IRS determines the unit of property and the application of the improvement analysis.

Step 2 – Is there an improvement to the unit of property, or in the case of a building, the building structure or any key building system, identified in Step 1?

A unit of tangible property is improved only if the amounts paid are:

  • For a betterment to the unit of property; or
  • To restore the unit of property; or
  • To adapt the unit of property to a new or different use.

What is a betterment?

  • Amounts paid to fix a material condition or material defect that existed before the acquisition or arose during production of the unit of property; or
  • Amounts paid for a material addition, including a physical enlargement, expansion, extension, or addition of a major component, to the property or a material increase in capacity, including additional cubic or linear space, of the unit of property; or
  • Amounts paid that are reasonably expected to materially increase productivity, efficiency, strength, quality, or output of the unit of property where applicable.

What are amounts to restore a unit of property?

  • Replacement of a major component or substantial structural part – Amounts paid for the replacement of a part or combination of parts that make up a major component or a substantial structural part of the unit of property; or
  • Recognition of gains or losses and basis adjustments - You have taken into account or adjusted the basis of the unit of property or component of the unit of property, including:
    • Deducted Loss – Amounts paid for the replacement of a component of the unit of property and you have properly deducted a loss for that component, other than a casualty loss; or
    • Sale or exchange – Amounts paid for the replacement of a component of the unit of property and you have properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component; or
    • Casualty loss or event – Amounts paid for the restoration of damage to the unit of property for which you are required to take a basis adjustment because of a casualty loss under section 165, or relating to a casualty event described in section 165, but limited to the basis in the unit of property; or
  • Deterioration to state of disrepair – Amount paid to return the unit of property to its ordinarily efficient operating condition, if the unit of property has deteriorated to a state of disrepair and is no longer functional for its intended use; or
  • Rebuilding to like-new condition – Amounts paid for the rebuilding of the unit of property to a like-new condition after the end of its class life.

What adapts the unit of property to a new or different use?

  • An amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with your ordinary use of the unit of property at the time you originally placed it in service.

What are the simplifying alternatives to the facts and circumstances analysis?

Safe Harbor Election for Small Taxpayers

You are not required to capitalize as an improvement, and therefore may deduct, the costs of work performed on owned or leased buildings, e.g., repairs, maintenance, improvements or similar costs, that fall into the safe harbor election for small taxpayers. The requirements of the safe harbor election for small taxpayers are:

  • Average annual gross receipts less than $10 million; and
  • Owns or leases building property with an unadjusted basis of less than $1 million; and
  • The total amount paid during the taxable year for repairs, maintenance, improvements, or similar activities performed on such building property doesn't exceed the lesser of-
    • Two percent of the unadjusted basis of the eligible building property; or
    • $10,000; and
  • You make the election to use the safe harbor for each taxable year in which qualifying amounts are incurred.
    • The election is made by attaching a statement to your income tax return for the taxable year. See When and how do you make an election provided under the final regulations?
    • An annual election is not a change in method of accounting. Therefore, you shouldn't file Form 3115, Application for Change in Method of Accounting, to make this election or to stop applying the safe harbor in a subsequent year.

Safe Harbor for Routine Maintenance

You are not required to capitalize as an improvement, and therefore may deduct, amounts that meet all of the following criteria:

  • Amounts paid for recurring activities that you expect to perform;
  • As a result of your use of the property in your trade or business;
  • To keep the property in its ordinarily efficient operating condition; and
  • You reasonably expect, at the time the property is placed in service, to perform the activities:
    • For building structures and building systems, more than once during the 10-year period beginning when placed in service, or
    • For property other than buildings, more than once during the class life of the unit of property.

If the amount doesn't meet all of the requirements for the routine maintenance safe harbor, you may still deduct the amount if the amount is not for an improvement under the facts and circumstances analysis.

What are the most important exceptions from and inclusions in the routine maintenance safe harbor?

  • The routine maintenance safe harbor doesn't apply to amounts paid for betterments.
  • The routine maintenance safe harbor does apply to certain restorations that would otherwise be improvements, including when you pay amounts to replace a major component or substantial structural part of a unit of property.

What must you do to apply the safe harbor for routine maintenance to amounts paid for repairs and maintenance?

Because these final regulations are based primarily on prior law, if you were previously in compliance with the rules you generally will be in compliance with the final regulations and generally no action is required. If you are not in compliance or otherwise want to change your method of accounting to use the safe harbor for routine maintenance, you should file Form 3115, Application for Change in Accounting Method, and compute a section 481(a) adjustment. For more information, including simplified accounting method change rules for certain small business taxpayers, see When and how do you change a method of accounting to use the final regulations?

Election to Capitalize Repair and Maintenance Costs

To reduce the difficulty with applying the facts and circumstances analysis to identify the tax treatment of costs and to recognize simpler administration by permitting you to follow financial accounting policies for federal tax purposes, the final regulations include an election to capitalize repair and maintenance expenses as improvements, if you treat such costs as capital expenditures for financial accounting purposes.

You may elect to treat repair and maintenance costs paid during the taxable year as amounts paid to improve property if you:

  • Pay these amounts in carrying on a trade or business; and
  • Treat these amounts as capital expenditures on your books and records regularly used in computing your income.
  • Make the election to capitalize for each taxable year in which qualifying amounts are incurred by attaching a statement to your timely filed original federal tax return including extensions for the taxable year that the amounts are paid.
    • If you make the election to capitalize repair and maintenance expenses, you must apply the election to all amounts paid for repair and maintenance that you treat as capital expenditures on your books and records in that taxable year. For more information see When and how do you make an election provided under the final regulations?
    • An annual election is not a change in method of accounting. Therefore, you shouldn't file Form 3115, Application for Change in Method of Accounting, to make this election or to stop capitalizing repairs and maintenance costs for a subsequent year.

     

    How do these regulations coordinate with other provisions of the IRC?

    Nothing in the final regulations under section 263(a) changes the treatment of any amount that is specifically provided for under any provision of the IRC or the Treasury regulations other than section 162(a) or section 212. For example, the final regulations do not eliminate the requirements of section 263(a), which generally provides that you must capitalize the direct and allocable indirect costs of producing real or tangible personal property and acquiring property for resale.

    When and how do you apply the final regulations?

    What is the effective date?

    Generally, the final regulations apply to taxable years beginning on or after Jan. 1, 2014, or in certain circumstances, apply to costs paid or incurred in taxable years beginning on or after Jan. 1, 2014.

    When and how do you make an election provided under the final regulations?

    The final regulations add certain annual elections that you can choose to make for a taxable year. These elections include:

    To make these elections, you should attach a statement for each election to your timely filed original federal tax return including any extension for the taxable year in which the amounts subject to the election are paid. Each statement should include your name, address, Taxpayer Identification Number, and a statement describing the election. For some elections, you will need to include a description of the property to which the election is applied. For example, if you qualify and desire to use the de minimis safe harbor election for qualifying amounts paid during your annual taxable year beginning Jan. 1, 2014, you must file a statement with your timely filed original federal tax return for 2014.

    An annual election is not a change in method of accounting. Therefore, you shouldn't file Form 3115, Application for Change in Method of Accounting, to make these elections or to stop applying the safe harbor or other election in a subsequent year.

    When and how do you change a method of accounting to use the final regulations?

    General Procedures

    Under the IRC, a change in method of accounting includes a change in the treatment of an item affecting the timing for including the item in income or taking the item as a deduction. For example, you are changing your method of accounting if you have been capitalizing certain amounts that you characterized as improvements and would like to currently deduct the amounts as repairs and maintenance costs pursuant to the final regulations.

    You must get the IRS Commissioner's consent to change a current accounting method to a new accounting method. The Treasury Department and the IRS provides automatic consent procedures for those who want to change to a method of accounting permitted under the final regulations.

    Generally, you receive automatic consent to change a method of accounting by completing and filing Form 3115, Application for Change in Accounting Method, and including it with your timely filed original federal tax return for the year of change. You also mail a duplicate copy of the Form 3115 to Ogden, Utah. The Form 3115 will identify the taxpayer, describe the methods that are being changed, identify the type of property involved in the change, and include a section 481(a) adjustment, if applicable.

    The section 481(a) adjustment takes into account how you treated certain expenditures in years before the effective date of the final regulations to avoid duplication or omission of amounts in your taxable income. For detailed instructions for filing applications for changes in methods of accounting under the tangibles regulations, see Rev. Proc. 2015-13, 2015-5 I.R.B. 419, and sections 6.37-6.40 and 10.11 of Rev. Proc. 2015-14, 2015-5 I.R.B. 450.

    Simplified Procedures for Small Business Taxpayers

    To ease the administrative burden faced by small business taxpayers that want to prospectively apply the final regulations, and do not wish to compute a section 481(a) adjustment, the IRS has provided a simplified procedure that you may use for your first taxable year beginning in 2014. Under this procedure, if you have a small business you may choose to change to certain methods of accounting under the final regulations by taking into account only amounts paid or incurred in taxable years beginning on or after Jan. 1, 2014. If you choose this procedure for your small business, then your small business will not have a section 481(a) adjustment for your first taxable year beginning 2014, and will not be required to file a Form 3115, Application for Change in Accounting Method. This procedure permits you to implement the final regulations on a prospective basis.

    Do you qualify for this simplified procedure?

    You apply this simplified procedure to each of your separate and distinct trades or businesses. Generally, a separate and distinct trade or business refers to each trade or business for which you keep a complete and separate set of books and records.

    You may choose to apply this procedure to each separate and distinct trade or business that meets one or both of the following criteria:

    • Total assets of less than $10 million; or
    • Average annual gross receipts of $10 million or less for the prior three taxable years

     

    What are total assets?

    Total assets are determined by the accounting method you regularly use in keeping the books and records of your trade or business at the end of the tax year.

    How do you determine annual gross receipts?

    Gross receipts for each taxable year generally are defined as the trade or business's receipts for the taxable year that are properly recognized under its method of accounting used for federal tax purposes. For more information, see § 1.263(a)-3 (h)(3)(iv) of the final regulations.

    What if you have multiple trades and businesses and only some qualify for the safe harbor?

    If you have more than one separate and distinct trade or business, you can only choose the simplified procedure for the trades or businesses that meet at least one of the criteria specified above. You may not choose the simplified procedure for any trade or business that does not meet at least one of the criteria above. Therefore, you may be in a situation where you can apply the simplified procedure to some of your trade or businesses but not to others.

    What should you consider in deciding whether to use the simplified procedure for your trade or business?

    • If you choose this procedure for a qualifying trade or business, for that business you may not take into account certain dispositions of tangible property occurring in taxable years beginning before Jan. 1, 2014, or make a late partial disposition election for a disposition during that period.
    • If you choose this procedure for a qualifying trade or business,
      • you don't receive audit protection for that trade or business for amounts paid or incurred in taxable years beginning before Jan. 1, 2014, and subject to the simplified method change procedures.
      • you must utilize this method for the trade or business for all changes specified under the procedure. Picking only some of the final regulation methods, but not all the changes specified under the procedure, is not permitted.
      • for your first taxable year beginning in 2014 and decide to change these accounting methods for your trade or business in a later taxable year by filing a Form 3115 and calculating a section 481(a) adjustment in the later year, then the section 481(a) adjustment is calculated by taking into account only amounts paid or incurred, and dispositions, in taxable years beginning in 2014.
    • While some may choose to file a Form 3115 in order to retain a clear record of a change in method of accounting, others may prefer the administrative convenience of complying with the final regulations in their 2014 taxable year solely through the filing of a federal tax return. For record keeping and substantiation,
      • If you choose the simplified procedure you should consider including, but are not required to include, a statement on your 2014 tax return indicating that the qualifying trade or business is utilizing the simplified procedure of Rev. Proc. 2015-20.
      • If you choose not to utilize the simplified procedure and do not file Form 3115 to change to the final regulations with your 2014 tax return, you should consider including, but you are not required to include, a statement on your 2014 tax return indicating that your qualifying trade or business is not applying the simplified procedure of Rev. Proc. 2015-20.
    • For more information on the simplified procedures, see Rev. Proc. 2015-20, 2015-09 I.R.B. 694.

Find out if the new Repair Regulations will benefit you