Tangible Property Regulations - FAQs

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How Do The Tangible Property Regulations Affect The Tax Treatment For Materials And Supplies?

In the past, the IRS did not allow for a dollar threshold for amounts to be classified as materials and supplies for a current year expense deduction.  The general rule was, if the tangible property purchased had a useful life of greater than one year, it should be capitalized and depreciated, regardless of cost.  Under the new regulations the IRS defined four types of materials and supplies and spare parts.  

  1. Incidental Supplies are items with a unit cost of $200 or less, regardless of their useful life, where the taxpayer is not keeping any type of record of inventory or usage of the supplies.  Incidental supplies are allowed to be expensed when purchased. Examples would typically be office supplies (pens and pencils), small parts (nails and screws), and general supplies (gauze and tape in a doctors office).    
  2. Non-Incidental Supplies have the same dollar thresholds but are items where an inventory of the item is maintained.  In these circumstances, the items become an expense when placed in service.  An example may be a spare computer monitor in “inventory” pulled out of the closet for use.
  3. Temporary and Rotable Spare Parts are items kept on hand for use when needed.  The spare part is removed, repaired and reused.  The IRS says items, such as this, should be expensed when disposed of.  
  4. Emergency Spare Parts are similar to temporary and rotable spare parts, except they are usually kept on hand because they are difficult to get quickly, are needed to prevent downtime, are typically very expensive, and cannot be repaired.  Such items are expensed as a repair when used in the related repair.

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Alternative Method To Account For Spare Parts For A Faster Write-Off

Taxpayers have the option of capitalizing spare parts and depreciating them.  This can allow for a quicker write off when: 1) an asset may sit on the shelf for several years before being used in a repair, especially for emergency spare parts, 2) an asset may be able to be repaired and reused for a number of years before it is disposed of and eligible to be expensed, 3) if an asset is capitalized and the taxpayer is eligible to take Section 179 or bonus depreciation, the taxpayer may get an immediate write off of the entire cost.  This election is made on a part by part basis by capitalizing and depreciating the asset.

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Do I Really Have To Capitalize All Purchases With A Cost Of $200 Or More?

The IRS has established a “De Minimis Safe Harbor Election”.  This election allows taxpayers without “audited financial statements” to elect on an annual basis to only capitalize individual items with a per item cost of greater than $500.  It overrides the materials and supplies rules.  However, if the taxpayer adopts this annual election, they must use the same threshold for internal book purposes as well as income tax reporting purposes.  IRS guidelines state that the taxpayer must have, at the beginning of the tax year, accounting procedures in place treating as an expense for non-tax purposes 1) amounts paid for property costing less than the specified dollar amount; or 2) amounts paid for property with an economic useful life of 12 months or less.  Taxpayers with audited financial statements have a different set of guidelines to follow.

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Do I Really Have To Use A $500 Threshold As My Capitalization Policy?

The de minimis safe harbor amount of $500 established by the IRS is the amount, if adopted, would stand up to IRS scrutiny.  However, a taxpayer can adopt a higher threshold if they can   demonstrate the higher threshold clearly reflects their income under IRS examination.

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How Do I Document That I Have Adopted the De Minimis Safe Harbor Election?

There is nothing in the regulations requiring your election has to be in writing if you do not have audited financial statements.  The rules are different for taxpayers with audited financial statements.  However, it is easier to argue you made the election if you have a written copy of the election in your files.  A sample of this type of election, where the $500 threshold is used, is below.  We recommend that you document the company’s intent was to have this policy effective as of January 1, 2014, whether written or not.

“It is the company’s policy to capitalize assets that cost $501 or more.  All capitalizable assets will be depreciated in accordance with the company’s policy.  Assets that cost less than $501 will be expensed in the period purchased.  Amounts paid for assets with an estimated useful life of 12 months or less with a value of $500 or less are expensed in the period purchased as well.  Management will periodically review these levels and make modifications as necessary.“

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What Is The Risk Of Not Following The New Rules For Materials Supplies Or For Saying I Am Going To Follow The New Rules And I Don’t?

The new rules and thresholds are safe harbor amounts that should hold up to any IRS scrutiny. However, if you have a legitimate reason for following some other method or threshold, and you can prove it as being reasonable for your business or industry, then you are free to argue that with the IRS.  However, remember the general statute of limitations runs for three years after you file a tax return.  Therefore, if a year gets audited, the IRS can go back as many as three years, no questions asked.  If the IRS finds your method results in a “material” miscalculation of taxable income, they can go back even further.  Any underpayment of tax could be subject to penalties and interest.

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Favorable Changes For Taxpayers Regarding Repairs And Maintenance

In prior years the IRS’s position was that significant amounts spent on tangible property should be capitalized rather than treated as a repair and expensed.  The theory was that as a property deteriorated, even through normal wear and tear, costs to bring the property back to its ordinarily efficient operating condition were to be capitalized as an improvement to the property.  The new regulations allow taxpayers to expense amounts that are considered costs for repairs and maintenance.  Only costs that result in a “Betterment”, “Adaption” for a new use, or a “Restoration” are required to be capitalized.

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What Are Betterments, Restorations and Adaptions?

Betterments:  An amount paid is considered a betterment or improvement to a piece of property if:

  • It ameliorates a material condition or defect that existed when the property was acquired or arose during the production of the property, regardless of whether the taxpayer was aware of the defect at the time.
  • Is a material addition to the property; an enlargement, expansion, or addition that is considered a major component to a unit of property that results in a material increase in capacity.
  • Is reasonably expected to materially increase the productivity, efficiency, strength, quality or output of the unit of property.

Restorations:  An amount paid is considered a restoration if it returns a unit or property to its ordinarily efficient operating condition because it has fallen into a state of disrepair due to neglect (rebuilding property to a like-new condition).

Adaption:  An amount paid to adapt a unit of property to a new or different use is considered a capitalizable cost.

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Do I Have To Capitalize All Costs For My Buildings That Are Considered Betterments, Restorations Or Adaptions, Regardless Of The Amount?

The IRS has established that small taxpayers can elect on an annual basis to expense up to $10,000 spent on any one building.  A small taxpayer is considered any taxpayer that has had average annual gross receipts of $10 million or less for the preceding three years.  The amount spent on the building cannot exceed the lesser of $10,000 or 2% of the unadjusted basis in the real estate.  Further, when determining the amount spent on the building, the amount spent for repairs and maintenance must be added to otherwise capitalizable amounts to see if expenditures for the property exceed the threshold.

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What Is Considered Routine Maintenance?

Taxpayers are allowed to deduct, rather than capitalize, amounts considered routine maintenance, regardless of the amount of the expense.  Routine maintenance is the recurring activities a taxpayer expects to perform to keep the unit of property in its ordinarily efficient operating condition.  

  1. Routine Maintenance For a Building - Amounts are considered routine maintenance for a building if the taxpayer reasonably expects to have to perform the maintenance more than once in a 10 year period.  The expectation has to be a reasonable expectation, however the fact that the second round of maintenance did not occur within the 10 year period does not necessarily invalidate the expense as routine if the facts and circumstances support the expectation.   
  2. Routine Maintenance For Property Other Than A Building – Amounts a taxpayer reasonably expects to pay for maintenance are considered routine if the taxpayers expects to perform the activity more than once in the IRS’s designated class life (ADS Life) for the unit of property.  The fact that the routine maintenance may not have occurred more than once in a class life does not necessarily invalidate the expectation, if the facts and circumstances support the expectation.  Factors to consider are:  manufacturer’s recommendation, recurring nature of the activity, industry practice, and the taxpayer’s experience.

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Common Examples Of Repairs For A Building That Previously Would Have Been Capitalized?

Under the current regulations taxpayers have the ability to treat items as “repairs and maintenance” that likely would have been capitalized under the old regulations, if incurred by the owner who has owned the property for a number of years.  Note:  If these amounts are spent immediately after placing the property in service, the costs would likely need to be capitalized.  The common examples are:
1.    Replacing the shingles on a roof due to deterioration or leaks.  However, if you completely replace the entire roof and not just a component of the roof, such as the shingles, then you probably are required to capitalize the cost.
2.    Replacing one of several HVAC units on a building.  If the HVAC unit is not a significant portion of the overall system, then you can expense the cost as a repair. However, if you replace two units when there are only three in total, then you may have to capitalize the new costs.
3.    A general facelift to the property is not necessarily a capitalizable cost.  Costs to update the “look of a property” such as painting, new carpet and replacing ceiling tiles under the old rules were considered a plan of improvement and were required to be capitalized.  Since these types of costs are considered necessary, due to normal wear and use, and they do not generally constitute an improvement under the betterment, adaption, or restoration rules they can be treated as repairs and maintenance costs.

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If I Am Required To Capitalize An Improvement, Such As A Roof, Can I Deduct A Loss For The Old Roof?

Under the old regulations, the IRS did not allow for a “partial disposition” of a part of a unit of property.  Since the roof is considered an integral part of the overall unit of property, the building, the replacement of the roof was required to be capitalized and depreciated.  However the old roof remained in the basis of the building and continued to be depreciated as well. Basically this resulted in there being duplicate items on your depreciation schedule when in reality you only have one roof or one HVAC system.

With the changes to the regulations, when an asset is required to be capitalized, such as a roof, the taxpayer is allowed to write off the remaining cost basis of the old roof.  This is known as a “partial disposition election”.  There must be a reasonable method for assigning a cost basis to the old roof.  This election is made by actually reporting the disposal and any associated loss on your return.    

Further, under the old rules, the costs of removing the old asset, such as a roof, were required to be capitalized as a part of the cost of the new asset (the new roof).  Under the new regulations, the removal costs associated with the old asset can be expensed, if you report the disposal of the old asset with the “partial disposition election”.

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What If I Have Improvements On My Depreciation Schedule That Could Have Been Expensed Under The New Regulations?  

It is important to know the IRS is allowing you to take a current year deduction for items previously recorded as improvements, which could have been recorded as a repair or written off in a prior year under the new law.  Further, if you have multiple versions of the same asset on your depreciation schedule, such as HVAC units, you can dispose of the original units and get a current year deduction for the balance of the asset cost.   However, the only way to take advantage of these write-offs in the current year is to file Form 3115 with the IRS.  Keep in mind, even if the disposal of a duplicate asset does not have a current year tax benefit, it may have a future benefit when you dispose of the affected assets (capital gain treatment versus ordinary income treatment due to depreciation recapture on an asset that should have been disposed of).

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If I Do Not Take Advantage Of The Disposal Regulations For Old Assets With My 2014 Tax Return, Can I Deal With It Next Year?

The IRS is allowing taxpayers to take advantage of these regulations, by filing a Form 3115, Change in Accounting Method request.  However, the automatic consent procedures for filing a Form 3115, Change in Accounting Method, expire after the 2014 tax year.  Therefore, any adjustment or write off benefits need to be included as a part of 2014 tax return filing.

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What Is A Change In Accounting Method And Why Do I Need To File Form 3115?

The IRS deems you have elected a method of accounting if you have filed two or more returns calculating taxable income in the same way.  Even if your previous method was acceptable and you are changing to a new acceptable method, you are required to file Form 3115.  This is known as changing from a permissible method to a new permissible method.  If you are changing because your previous method was impermissible under IRS regulations, you are required to file Form 3115 to request permission to change from the impermissible method to a permissible method.  As we said above, filing Form 3115 is a “request” for the IRS to approve your change in accounting method.  Some of the changes requested by taxpayers are eligible for “automatic consent” and therefore, the taxpayer does not have to wait for IRS approval before adopting and following the change when filing their income tax return for the affected year.  The updated IRS tangible property regulations fall into the automatic consent category, as long as, the request is filed in conjunction with your 2014 tax return.

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Do I Need To File Form 3115 If I Do Not Have A Taxable Income Adjustment?

The original guidance from the IRS indicated the IRS expected a Form 3115 to be filed by almost every taxpayer.  However, as of February 13, 2015, the IRS has changed its position on the filing requirements.  The IRS is allowing taxpayers to adopt the new tangible property regulations prospectively beginning January 1, 2014.  However, any taxpayer wishing to take advantage of the favorable changes in the legislation allowing a current year deduction of amounts previously capitalized will still be required to file Form 3115.

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Is Preparing A Form 3115 Difficult And How Will It Affect My Tax Preparation Costs?

Preparing a Form 3115 can be time consuming.  The entire form is approximately eight pages long.  The IRS is allowing taxpayers requesting automatic consent under the new tangible property regulations to complete only certain sections of the form.  Completing Form 3115 for taxpayers with a taxable income adjustment, will require additional time depending on the types of items requiring adjustment.  Explanations and schedules must be attached explaining and supporting the taxable income adjustment.

Because preparing a Form 3115 is not a standard part of recurring tax preparation service, additional costs will be associated with completing the request for a change in accounting method.  The amount of time required and the additional cost will be dependent on the complexity of your specific form.

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Is The Cost Of Preparing And Filing Form 3115 Worth The Benefit?

The standard answer we will give any client is “It Depends”.  It depends on factors and circumstances specific to each taxpayer, such as:

  1. Will it result in a current year negative taxable income adjustment?
  2. Will it potentially save me taxes in the future?
  3. Is the long term tax benefit greater than the current year cost?

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