By Andrea Mouw
January 27, 2017
For a Sept. 30th year end, when do the Repair Regulations become effective?
The Repair Regulations are effective for tax years beginning on or after Jan. 1, 2014.
What should the capitalization policy look like?
Capitalization policies are unique to each situation and business. While there are some sample policies available, no two will look the same. Your tax professional can assist in drafting a capitalization policy, discuss appropriate thresholds and provide a draft for your review and adoption. Please talk with your tax advisor.
Can we use different capitalization amounts for different items?
What’s the methodology of the repair study and how does the change get implemented?
During an Eide Bailly Repair Study, our Repair Regulation Specialist will review your depreciation schedule and financial statements for opportunities or changes to find items that should have previously been expensed. We anticipate we will implement those changes on the Form 3115.
Can a capitalization policy include different thresholds for different classes of equipment?
If we use the de minimis election, what happens to repairs/improvements over $5,000?
We then apply the “BAR” tests to determine whether the expenditure results in an improvement (requires capitalization) or is a repair/maintenance expense (current deduction).
What if a business’s capitalization policy was set at $5,000 prior to the new regulations and that particular business does not have audited financial statements?
You can keep the same policy for book, but for tax the $500 policy would apply. The business would need to keep track of every item expensed on its financial statements that is lower than $5,000, but higher than $500. If you did not want to keep track of items that fell between the different thresholds, you could either change the book capitalization policy to $500 to be in compliance with the tax policy or, you could bump up to audited financial statements and keep the $5,000 policy for book and tax.
Do you need a capitalization policy to take advantage of the partial disposition opportunities or the ability to file a Form 3115 to correct previous misclassifications of expenditures (i.e. capitalized an expenditure, when it should have been expensed)?
No, the capitalization policy is only necessary to be in place in order to take advantage of the de minimis rule.
Can a written capitalization policy that was in place as of Jan. 1, 2014, be amended mid-year? If so, do the amended guidelines take effect for tax purposes at that time or not until the beginning of the next tax year?
The regulations do not specify and appear to allow for modifications throughout the year. If you had a nontax reason to make an adjustment (i.e. new bank loan requires lower threshold) then the IRS may not challenge the change. The change should take effect at the time the change is made, not retroactively. The whole point is for tax to follow book, not tax to dictate book.
How high can the threshold for expensing in a policy go? For example, could it provide for a $10,000 or higher amount?
The threshold can be any level that makes sense for your financial statements. Of course a small business would probably not have the same threshold as Exxon. This is a topic to discuss with auditors in order to address financial statement materiality. The higher threshold would generally not be applicable for tax purposes.
If a written capitalization policy is drafted and “effective” as of Jan. 1, but Board approval doesn’t take place until later in January, is that ok?
As long as the policy is in writing at the beginning of the year and followed at the beginning of the year, it is unlikely the IRS will challenge it.
When considering whether an expenditure should be capitalized as a restoration, what time period should be considered?
All costs associated with the original plan of restoration would be considered. For example a taxpayer cannot circumvent the restoration rules by paying for part of a restoration in year one and delaying part of the restoration to year two.
Can a subsidiary of a parent in a consolidated group have their own capitalization policy and use that policy to expense costs under the de minimis rules?
Yes, a subsidiary of a parent can develop and follow their own capitalization policy separate from the parent company.
Recently we hosted two Repair Regulation webinars where professionals asked numerous questions. Below are our responses for your reference.
Is it too late to take a deduction for my roof repair for 2013?
Unless you have already filed your return, no, it is not too late to take the deduction. You can early adopt a portion of the regulations which would allow you to take a deduction for a roof repair, assuming it did not pass the BAR test; didn’t result in a betterment, adapt to new use, or restoration, you can adopt the improvement standards, you can take the deduction. Now you have to be careful, because the IRS expects that when you adopt the improvement standards, you calculate your 481(a) adjustment correctly, which means you have go through the items prior to 2013 to see if there is a difference in treatment under the final regulations. If there is, you need to recognize those differences with the Form 3115. Now, if you go through the process, and then next year you discover, oops, I forgot an item, you can still file a 3115 to pick up that other item. What the IRS doesn’t want you to do is take the 3115 for one deduction, and then realize, you have an additional 200 more items. You have to make a good faith effort to implement the regulations. If you happen to miss a few assets, you can still fix that.
Example: A business spent $40,000 on a new flat portion of a roof on a building (no structural components replaced). The business has owned the building for a while, so wear and tear of the roof was done while they owned the building. They are entitled that deduction under the final regulations, and to claim it, we take the deduction on the tax return. In order to do that, we suggest that a Form 3115 be filed to make sure that our capitalization standards and definition of unit of property (asset) are in compliance with the final repair regulations.
I work for an excavating company. We purchased an excavator in 2007 for $498,000 and have fully depreciated it. The turbo recently went out, and it will cost roughly $10,000 to replace. Do we have to capitalize?
The class life on an excavator is probably going to be nine years. So, if you look at that particular item, the turbo, would you expect that to be replaced more than once during that nine year timeframe? If yes, the turbo is probably a deductible repair. The other test we’ll look at is how significant of a component it is relative to the whole excavator.
If the turbo is not a significant component and all you’re doing is bringing it back to the condition it was in when you purchased it, then I would say that doesn’t improve it, deductible repair.
And again, the place in service date doesn’t make any difference if it’s new or used, when you place that service, that’s when the class life starts to run.
I have an invoice for $550 for an electrician who put lights above four workbenches and added outlets for the lights. Do we really have to capitalize this?
If there’s more than one light, if there’s two lights on a per-item basis that’s less that $500 you should be able to treat it as a repair. That is assuming you make the de minimis election, use a $500 dollar threshold, and that you’re looking at the invoice on a per-item basis.
Until you get to five digits in the invoice, more than likely, that is probably going to be treated as a deductible repair. You still have to go through and look at what was done, and do your measurement against what was replaced, but from a practical standpoint it’s pretty hard to do anything significant to a building if it’s under $10,000.
Will these rates apply to nonprofits as well as for-profit entities? Are there any exceptions or differences I should be aware of as a nonprofit entity?
The regulations apply equally to for-profits and nonprofits. However, since nonprofits don’t have taxable income, IRS agents aren’t likely to enforce it because often times, there’s no adjustment for the government. So, by and large, most nonprofits probably aren’t going to implement the regulations. The only time it will become an issue is either:
Absent those two circumstances, there’s little incentive for the IRS to enforce the regulations for nonprofits. We recommend that nonprofits at least have a capitalization policy, so if for some reason it ever does happen where they lose their exemption status or have UBI, they can at least fall back to the de minimis exception.
If I replace three out of 24 HVAC units for $7,000 each, are these deductible for tax purposes even though I capitalized them on my books?
You do not have to have book tax conformity with the improvement standards, unless you make an election. There is an election to treat deductible repair expenditures as a capital expenditure if you capitalize the expenditure on your financial statements. Absent this election and you have 21 units on a building, and you replace three of them, and they’re comparable—you don’t improve them, then yes, it may be a deductible expense that you can deduct for tax and capitalize for book.
The only time you have to be concerned is if you buy a building and replace three rooftop units, the result would be different. If you go through the tests, and you come to the conclusion that it’s a deductible repair, you can have book tax differences. It’s when you apply the de minimis election that you have to have consistency between book and tax.
What would be an example of an equipment repair that would need to be capitalized in an excavating/construction company?
Replacement of 100% of the motor would require capitalization. A list of what is a major component of a vehicle does not exist. However, the IRS has talked about it in the context of excise tax—tires, motor, transmission, those are items they’ve listed as major components.
In contrast, an overhaul of an engine, where you’re not pulling it out and putting a brand new engine in, but just an overhaul, that’s a deductible repair. There’s a different rule for property than for buildings. For property, you need to replace 100% of a major component for it to be capitalized.
We have a capitalization policy written for $5,000 that was in place for 1/1/2014. If we have a project that has an invoice total of $20,000, but all the line items are less than $5,000, it’s my understanding that we could expense. However, could we also capitalize it, or could we also expense it?
You’d have to determine how it was treated for your financial statements. If it was deducted on your financial statements, under the de minimis election, then you must follow your financial statements. Now, if it was capitalized for your financial statements, then you’d have to capitalize it for tax.
GAAP will probably trump tax if you make the de minimis election for fixed assets. If the auditors require capitalization on personal property items, you’re going to have to capitalize that too. That said, if it’s a repair item, and you fail the BAR test, you can deduct that for tax purposes even though it may be capitilizable on the financial statement. Book/tax conformity is not required for expenditures that have to meet the BAR tests.
We are buying classic pallets that will cost in total approximately $1.5 million, but classic pallets individually are $50. It’s a major asset, in the past, we’ve always capitalized things of that nature, but how does that work under the new rules?
Assuming you do not elect the de minimis, a pallet is going to be measured on a per-item basis. It falls under the $200 threshold, so it would be a material and supply, deductible when used or consumed. You could deduct it, even if you capitalize it on your financial statement.
If you elect the de minimis; it would still fall under the threshold (assuming your threshold is at least $50). So you’ve got the stage set where you could take that deduction, but if the auditors or you decide that it needs to be capitalized for financial statement purposes you’d be forced to capitalize for tax.
Can we have a Flexible Capitalization Policy, on an asset class-by-class basis?
Yes. Your capitalization policy can be as varied as you want for book. If you know you’re going to capitalize an item, then you can make an exception for the asset class. We suggest the capitalization policy be easy enough to read to where an IRS auditor can understand it.
We purchased some large harvest equipment in 2014, and that harvest equipment each year needs some annual maintenance, so we have to do about $15,000 of maintenance on it before we can use it this year. Do we need to capitalize that maintenance on that equipment that we bought this year, or could we expense it?
There’s a provision in the regulations that says if you’re going to incur an activity more than once during the class life, that is, by definition, routine maintenance, and deductible.
However, if you bought a used harvester and then immediately spent $15,000 on maintenance, that first scheduled maintenance where you are fixing someone else’s wear and tear, the answer would be different. But every subsequent year, maintenance would be deductible.
So this is the first year and we’re doing the repairs and maintenance to get it ready for service technically that would be capitalizable?
Yes. If you have not used that piece of equipment before, and you’re doing this to take care of wear-and-tear that was done by someone else, then yes, that would be capitalizable. The first $15,000 would be capitalizable; every subsequent year would be deductible.
If I elect the de minimis rules, can I break out each item on my construction invoices and deduct those under my capitalization policy? For example, each ceiling tile, each light fixture, and each 2x4 would be less than $500.
You can elect the de minimis, and as long as it’s under your threshold per item or less, you can deduct it as a current expense, as long as you also deduct it on your financial statements. But there are some things you need to be aware of. There’s also an anti-abuse provision that prevents the taxpayer from componentizing property that is generally acquired or produced as a single unit of tangible property. You can’t say each sheetrock panel is under $500, you need to look at all the sheetrock in the entire building. Also, if it’s the construction of a new building, IRC §263A or a similar provision may require you to capitalize it anyway.
And, if the auditors require capitalization, you also have to capitalize under the de minimis rule.
If you elect the de minimis, everything you capitalize on your financial statement has to be capitalized for tax when it relates to stand alone property.
In contrast, if you replace 10 ceiling lights or 10 overhead fixtures, and the cost of those are less than $500 per item, and it’s not part of a major construction project, there you can look at each of the items, and probably fall under the de minimis rule. You have a much better case of saying each light is its own individual asset whereas it’s really hard to say each sheetrock panel is its own individual asset.
Would past partial dispositions be a deduction for tax and book purposes?
Not necessarily. Book and tax, as far as the improvement standards, do not have to match. The only time they do is if you make the election to treat deductible repairs as improvements to the extent of book. Aside from that, you do not need to have book-tax conformity for the improvement standards. Now, if you’re looking at standalone tangible property, and you elect the de minimis, then you have to have book and tax the same, up to the threshold. So, if you have a partial disposition in the past, you can elect to recognize it when you adopt the regulations.
In the past, the IRS has required capitalization on grocery carts. Each individual cart had a cost of $150. Would these now fall under the de minimis rule?
If you elect the de minimis, as long as you do not capitalize them for book, you can deduct them for taxes. If you do not elect the de minimis, the carts are a material and supply since it’s under $200 per item.
Under the BAR test what is a “material increase in quality”?
The measuring point is generally what the item’s condition was before the event that necessitated the expenditure. For example: if you bought an item new, you have wear-and-tear, a year later you fix the item. You compare the item after you fixed it to the item when you placed it in service. Is there a difference? If there’s not, it’s probably a deductible repair. If there is a difference, then you get the question of is it a material difference? There really is no bright line.
You also need to consider the significance. For example: If you’ve got a fabricating type process where you can produce 100 units per hour, and you take the piece of equipment, modify it and maybe change up some motors, and all of the sudden you’ve gone from making 100 to 150, then you probably have increased the quality of the materials and you also increased the productivity of the output. In that particular case, you’d end up having to capitalize it. Look at the quality test as one of those things that if it’s just a little bit, it’s probably nothing to worry about, but if it’s going to significantly increase the intended use of that asset, or if it’s something that’s going to make that asset a more efficient piece of equipment, you’re probably going to know it. If it’s just keeping it in the same level of function as it was before, that’s probably not going to increase the quality even if a different kind of material was added on the repair. If you increase it by 10 percent, you’re probably fine; 60 percent, you’ll have a problem.
It’s similar to the shingle test, if you replace your roof shingles with a product that’s a little better now than it was 20 years ago, which would be the norm because almost all building products have improved in quality you won’t have an issue. However, if you go from a 20 year shingle to a 50 year shingle, that is probably going to be an issue.
We have heard that there is a loophole in the provisions that allow you to use $5,000 if you provide your financial statements to a state authority. Do you know if this is true?
In order to set your capitalization threshold up to $5,000, you have to have a statement provided to the SEC, a financial statement audited by an independent CPA firm, or if you submit your financial statement to a state or federal regulatory agency. For example: a bank has to submit their financial statements, or bank call reports, and those qualify the bank to use up to a $5,000 threshold. Now, if you had an SBA loan and provide them with your financial statements, it will probably not qualify. If you have to just simply fill in a couple of answers and numbers to a regulatory agency to just sort of let them know where you are at, that may not qualify.
If you take your Quickbooks statements and fax them off to a governmental entity, that’s probably not going to qualify. What is important is that if you look at the meaning of the regulations, the IRS is looking at an applicable financial statement as having some testing and internal controls so the IRS can trust the documents they’re receiving.
Our fiscal year is October 1 to September 30. Does this mean we will need to comply with the new fiscal year starting Oct. 1, 2013?
No, it is for tax years beginning on or after Jan. 1, 2014. You can early adopt and get it out of the way if you want, but the IRS would not expect you to be fully compliant until Oct. 1, 2014.
If we were making repairs to a leased property, at what point or how many years would it take to be considered our use and not the prior tenant’s use?
The longer the time period, the harder the IRS will have to assert it was a preexisting condition.
However, if you have a legitimate reason and can document it, then you can take the current deduction. For example, if you buy a used building, and you just don’t like the color of the inside or the outside, you’re not necessarily fixing someone else’s wear-and-tear, as long as it was in good shape at the time you took it.
There also may be situations where an expenditure clearly relates to a prior owner’s use. For example if you purchased land that used to have a gas station on it and you later discover gas contamination in the soil.
How are accounting departments managing this change? Such as, are they reviewing the GL for every item purchased each month and deciding how to treat it, or are they reviewing each time a purchase order is requested?
The more understanding in the accounting department as to how these rules work, the less professional time it’s going to take to master compliance with these regulations. It helps to have a relatively detailed capitalization policy, so whoever is coding it can look to the policy and know how an expenditure should be treated. A new account for new repairs over $500 is also a good idea. That way, you can easily locate those expenditures and review them all at once or when convenient.