After close to 10 years of back and forth deliberation the Treasury finalized the new “repair regulations” on September 19, 2013. These regulations will have broad application to taxpayers and will significantly impact taxpayers in equipment intensive industries.
The repair regulations require an analysis to determine if there is a betterment, restoration or adaption to a new and different use when repairs or maintenance are completed on property. These three categories are described as capitalization standards.
In general, when doing the analysis required for the capitalization standards a taxpayer is required to make its determination based on the Unit of Property (UoP) which is being repaired. A UoP is determined via a functional interdependence test. This standard concludes that two components are a single UoP if the ability to place one component in service depends on whether the second component is placed is service. For example; an airplane’s frame cannot be placed in service unless the engine is also placed in service and vice-versa. Larger units of property would increase the potential that a particular repair would be deductible rather than treated as a capital improvement. However, there are three major diversions from the UoP standard:
1) Plant Property
2) Building Property
3) Network Assets
A Closer Look
The following paragraphs will provide you details on how the regulation will apply and some of the rules and standards set forth from the decision this fall.
Unit of Property Subgroups
The regulations define plant property as functionally interdependent machinery or equipment which is used to perform an industrial process such as manufacturing. Once it is determined that there are units of property which are required to be treated as plant property, these units of property must be further subdivided into smaller units comprised of each component (or group of components) that performs a discrete and major function.
Like plant property, building property is also subject to a subdivision from the general UoP (which would be the entire building). There are eight subdivisions of a building to which the capitalization standards must be applied to:
1) Building Structure
2) HVAC System
3) Plumbing System
4) Electrical Systems
7) Fire-Protection and Alarm Systems
8) Gas Distribution Systems
Network assets include property like railroad track, utility lines and oil pipelines. Network assets do not include property that would be included as part of a building system.
In general, a taxpayer must capitalize as an improvement any amount paid for a betterment to a UoP. This includes amounts paid which:
1) ameliorates a material condition or defect that either existed prior to the
acquisition of the property or arose during the production of the property
whether or not the taxpayer was aware of the condition or defect at the time of
2) is for a material addition including a physical enlargement, expansion,
extension, addition or a material increase in the capacity of the property
3) is reasonably expected to materially increase the productivity, efficiency,
strength, quality or output of the UoP
In determining if there is a betterment to the UoP due to normal wear and tear or damage to the property, one should compare the property after the repairs to the property prior to the wear and tear or damage that necessitated the repair.
There is an exception available to capitalization under the betterment standard if part of the UoP cannot reasonably be replaced with the same type of part (for example because of technological advancements or product enhancements).
In general, a taxpayer must capitalize as an improvement any amount paid to restore a UoP. An amount restores a UoP if it:
1) is for the replacement of a component of a UoP and a gain or loss has been
recognized for the replaced component
2) is for the restoration of damages which result in a casualty loss
3) returns the UoP to its ordinary operating condition if the property had
deteriorated to a state of disrepair and is no longer functional
4) results in the rebuilding of the UoP to a like-new condition after the end of its
5) is for the replacement of a part or combination of parts that comprise a major
component or substantial structural part of a UoP
a. A major component is a part or combination of parts that perform a
discrete and critical function in the operation of the UoP (except for
incidental components i.e. a power switch)
b. A substantial structural part is a part or combination of parts that comprises
a large portion of the physical structure of the UoP
In general, a taxpayer must also capitalize as an improvement any amount paid to adapt a unit of property to a new or different use. An amount is treated as paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer’s ordinary use of the UoP at the time it was originally placed in service.
De minimis & Safe Harbor Rules
There is a de minimis rule which applies to repair and maintenance expenses. This rule allows a taxpayer to follow its book policy for capitalization/deduction of repairs and maintenance if it is a written policy in place before the beginning of the tax year. If the taxpayer has an audited financial statement prepared, they can deduct expenses under $5,000. However, if they do not have one prepared, only expenses under $500 can be deducted. To make use of this de minimis rule an annual election must be filed by the taxpayer. The de minimis rule does not apply to rotable, temporary or emergency spare parts.
Note that repairs costing more than the de minimis threshold may still be deducted rather than capitalized if the cost would be deductible under the facts and circumstances.
There is also a safe harbor rule for routine maintenance. This rule allows that amounts paid for routine maintenance activities may be deducted if the taxpayer reasonably expects to perform them more than once during a testing period in order to keep the UoP in its ordinarily efficient operating condition. Routine maintenance activities include inspection, cleaning, testing and replacement of damaged or worn parts with comparable and commercially available replacement parts. The testing period for personal property is the class life and the testing period for buildings is 10 years.
Disposals Regulations Update
Rather than finalize regulations regarding the disposition of fixed assets the Treasury released new proposed regulations in September. The reason these were not finalized is that there were wholesale changes from the previous proposed regulations.
The important concept that is new in the disposition regulations is that taxpayers will be allowed to take a deduction for the disposal of a portion of an asset (partial dispositions). This was present in both forms of the proposed regulations, however the implementation of these changes are completely different. Taxpayers who implemented the old proposed regulations early will need to unwind what they have done so that they can comply with the new proposed regulations.
If you have any questions about the new regulations and how they will affect your organization this year, please do not hesitate to contact your MKS&H representative or call 866.202.1703 to speak to one of our tax experts.
Article provided by Tim Stolz, CPA
MKS&H Senior Tax Accountant
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