In late 2011, the Internal Revenue Service (IRS) issued long awaited, comprehensive regulations (The 2011 Regs) on the treatment of payments to “acquire, produce, or improve” tangible property. The essential question addressed is whether taxpayers such as moving companies, can deduct these payments up front as repairs under IRS Code Section 162(a), or if they must capitalize them under IRS Code Section 263(a) and then recover those costs as depreciation over a period of years.
Although this determination is a matter of timing, the stakes are high: taxpayers such as moving companies generally want to deduct expenses when paid, to minimize taxable income or even generate a loss in the current year. The difference in treatment can be substantial – for example, payments for work performed on a storage warehouse if not deductible as a repair, may have to be capitalized and then depreciated over a period of 39 years. Payments for work performed on rolling stock (such as a moving van) if not deductible as a repair, may have to be capitalized and then depreciated over a period of 5 years.
Historically, there has been a lot of controversy over repair and maintenance costs for tax purposes. The 2011 Regs provide a more defined framework for determining capital expenditures. For calendar year taxpayers, The 2011 Regs apply to amounts paid or incurred after January 1, 2012. Whether work performed on property is an improvement is the major question addressed by the IRS. Improvements must be capitalized and then depreciated over a certain number of years, whereas repairs can be deducted in the same year the work was performed. The IRS Tax Code and The 2011 Regs require capitalization of amounts paid for permanent improvements, betterments, and restorations, as well as payments that add to the property’s value, prolong its useful life, or adapt the property to a new use. See below for further information regarding Improvements, Betterments and Restorations that require capitalization of certain amounts paid.
The 2011 Regs requires that building improvements (and thus capital expenditures) be determined by considering the effect of the work on eight significant, specifically defined building components (Units of Property):
- Fire Protection
- Gas Distribution
This approach will require greater amounts to be capitalized and is a significant change. However, since the retirement of a structural component of a building is considered a disposition, this allows taxpayers to deduct expenditures upon disposition (the year of disposition) that originally had to be capitalized and depreciated over the life (normally 39 years) of the building. For example, if your company had capitalized roof expenditure and then began depreciating it over a 39 year period but then replaced that roof in say 10 years, your company could deduct the cost less accumulated depreciation for the roof that was replaced. The amounts paid for the “new” roof would then be capitalized and then depreciated.
- Amelioration (or to make better) of a material condition or defect
- Material addition or expansion
- Material increase in quality, capacity, efficiency, productivity, strength
- Costs incurred during an improvement – A taxpayer must capitalize all direct costs of an improvement and all the indirect costs, including otherwise deductible repair costs, that directly benefit or are incurred by reason of the improvement
- Replacement after recognizing a loss on disposal
- Replacement after a sale or exchange
- Repair after a casualty loss
- Return to ordinary operating condition if deteriorated to state of disrepair
- Rebuild to a like-new condition after end of class life
- Replacement of major component or substantial structural part of the Unit of Property. See Building Improvements above for list of Units of Property.
There are some items that can be deducted as repairs up front rather than be capitalized and then depreciated over a certain number of years. Here are a few of those examples:
- Components acquired to maintain, repair, or improve a unit of tangible property that is not acquired as part of that Unit of Property. See Building Improvements above for list of Units of Property.
- Fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months or less
- A Unit of Property with an economic useful life of 12 months or less
- A Unit of Property with an acquisition or production cost of $100 or less
Please note that this article does not address issues such as “Bonus Depreciation” and/or “Section 179 Expense Election” which may allow your business tax deductions for amounts paid subject to certain limitations. Please consult with your tax advisor regarding these issues.
Investing in business assets is never just a matter of taxes. A company must consider whether the investment makes economic sense for them. Please consult with your tax advisor before acting on any of the topics discussed in this article. Your tax advisor can ensure you receive the maximum tax benefits considering your company structure, income tax rates, etc.
Thomas L. Broderick, C. P. A. & CGMA is the Treasurer of Pickens-Kane Moving & Storage Co. in Chicago, Illinois. He has served as Chairman of the Board of Trustees of the Illinois Movers’ and Warehousemen’s Risk Management Trust since 1996. He has also served as president of the West Central Association Chamber of Commerce for the years 2007 thru 2009. Many individuals, small businesses and non-profit organizations consult him for various accounting, investment, insurance and tax issues.
Note 1: CCH Federal Tax Weekly dated 01/12/2012 was used as a resource for this article.
Note 2: Baker Tilly Virchow Krause LLP webinar dated 01/24/2012 was used as a resource for this article.
Note 3: Internal Revenue Service and Treasury Department notice dated 12/27/2011 was used as a resource for this article.
Revised: February 16, 2012