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New IRS Rules for Capitalization and Depreciation

Capitalization and Depreciation

The Internal Revenue Service (IRS) has released final repair regulations pertaining to capitalization and depreciation (T.D. 9636). It governs when taxpayers must capitalize and when they can deduct expenses for acquiring, maintaining, repairing or replacing tangible property.  The regulations are applicable to tax years beginning on or after January 1, 2014.

Five Main Areas of T.D. 9636

The regulations cover five main areas as follows:

  • Materials and supplies
  • Repairs and maintenance
  • Capital expenditures
  • Acquisition or production of tangible property
  • Improvement of tangible property

The final regulations provide an opportunity, the de minimis safe harbor election that allows businesses to immediately expense certain property that would otherwise require capitalization.  A taxpayer with an applicable financial statement (AFS) and a written accounting procedure in place at the beginning of the tax year may deduct up to $5,000 of the cost of an item per invoice if it is expensed in their AFS.  A taxpayer without an AFS but with an accounting procedure in place at the beginning of the tax year may deduct up to $500 of the cost of an item per invoice if it is expensed in their AFS.  In addition, an item costing $200 or lessor has an economic useful life of 12 months or less qualifies as a material or supply.

The final regulations require capitalization of an amount paid to improve a unit of tangible property.  A unit of property includes all components that are functionally independent.  A unit of property is improved if expenditure results in betterment, a restoration, or a change in a unit of property to a new or different use.  For real property, the regulations apply the rules to both the building structure and to specified building systems as follows:

  • Heating, ventilating and air conditioning systems
  • Plumbing systems
  • Electrical systems
  • Escalators
  • Elevators
  • Fire protection and alarm systems
  • Security systems
  • Gas distribution systems

The final regulations provide a routine maintenance safe harbor.  Costs incurred (expected to be performed more than once during the class life of the property) to keep a unit of property in ordinary efficient operating condition are deductible and are not capitalized.  For buildings and their structural components, the costs of routine maintenance can be expensed if the taxpayer reasonably expects the maintenance to be performed more than once over a 10 year period.

For taxpayers who own tangible personal property, most tax returns filed for tax years beginning on or after January 1, 2014, should have at least on Form 3115, Application for Change in Accounting Method or an election statement to adopt the rules under the final regulations.  Omission of the required Form 3115 or election statement from the taxpayers filed a return may indicate a failure to comply with the final regulations or the use of an unauthorized accounting method.

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