Repair Regulations: What You Need to Know
On September 13, 2013, the Internal Revenue Service issued final regulations relating to expenditures for tangible fixed assets and for repairs and maintenance expenses. These new "repair regulations" are effective for tax years beginning on or after January 1, 2014. They are effective for all taxpayers, with no exceptions for small businesses, cash basis taxpayers or even farmers.
Materials and Supplies Defined
First, the regulations provide a definition of material and supplies expense. Prior to the new regulations, materials and supplies were generally items that did not last long nor had a minor cost (i.e., small tools, office supplies, nuts and bolts). Now, the IRS defines material and supplies as tangible personal property, other than inventory, used or consumed in the taxpayer's business that are in one of the following categories:
- Fuel, lubricants, water or similar items reasonably expected to be consumed in 12 months or less.
- Property with economic useful life of 12 months or less.
- Property with acquisition cost of $200 or less.
- A component required to maintain, repair or improve a unit of property that is not acquired as part of the unit of property.
The regulations also provide for a de minimis safe harbor election that applies to both materials and supplies, and repair and maintenance expenses. Under this election, a taxpayer may deduct expenditures up to $500 for tax purposes (or up to $5,000, if the taxpayer has an applicable financial statement, which is generally an audited financial statement).
Acquiring or Producing Tangible Property
The regulations also distinguish between amounts paid to acquire or produce tangible property and amounts paid to improve existing property. Always capitalize amounts paid to acquire or produce tangible property, unless:
- The property qualifies as a materials and supplies expense, or
- The property qualifies under the de minimis safe harbor election.
Improving Tangible Property
Lastly, the regulations provide further guidance on expenditures that result in an improvement to tangible property which must be capitalized. This approach may be conceptually different than the taxpayer's current approach. Those expenditures that do not improve other tangible property are deductible as repairs or maintenance expenses. In determining whether the expenditure results in an improvement (capitalizable) or deductible repair, consider the following:
- Betterment test: Does the expenditure correct a material defect that existed prior to the taxpayer placing the item in service, or does it result in a material addition or material increase in the functionality of the asset?
- Adaptation test: Does the expenditure adapt the property to a new or different use than before?
- Restoration test: Does the expenditure rebuild the item after the end of the class life or bring the item back from a state of nonfunctional disrepair?
Taxpayers will have to apply all three tests to all of the expenditures, to determine if it results in an improvement to an asset, or if it should be deducted as a repair and maintenance expense. Generally, expenditures that do not meet these tests are deducted as a repair or maintenance expense.
For further information on the new regulations and how they will impact your tax return, please contact your Eide Bailly tax advisor.
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Callie Beisch, CPA Tax Manager 605.940.0193
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