The Internal Revenue Service (IRS) has issued the long-awaited Tangible Property Regulations, commonly known as the Repair Regulations. These new regulations may significantly impact how manufacturers account for expenditures incurred to acquire property, improve existing property, acquire materials and supplies and/or repair or maintain property. There are two significant aspects of these regulations that will directly impact the manufacturing industry: The tax treatment of repairs or improvements to tangible property has been significantly modified and potential deductions have been made available for the partial disposition of previously capitalized assets.
Repairs or Improvements to Tangible Property
Prior to the issuance of the new regulations, manufacturing companies have had little guidance on whether they should capitalize or expense repairs or improvements. Fortunately, the new regulations clarify how manufacturers can determine whether or not a repair or improvement should be capitalized. The categorization of an expenditure as a deductible repair or capitalized improvement is greatly impacted by the size of the unit of property that is being worked on. The final regulations provide specific definitions for a “unit of property” (UOP) in the case of buildings and a general rule (the functional interdependence test) for other types of property including manufacturing lines. Once the UOP is identified, manufacturers can determine if the repair should be capitalized based on these three categories:
- Betterment: When a repair to a UOP has enhanced a condition or defect that existed before the acquisition of the property, or arose during the production of the property, thus resulting in an increase in the property’s strength, productivity and efficiency.
- Adaptation: When an improvement to a UOP creates a new or different use inconsistent with the original intent of the space at the time the property first went into service.
- Restoration: When a restoration repairs the UOP back to working order, rebuilding to a “like-new” condition or replaces a major component or substantial structural part.
If a repair or improvement falls into one of the above categories, the IRS requires the repair or improvement to be capitalized. However, there are remedies built into the new law that provide some much needed relief:
- De Minimis Election: A taxpayer can elect, under a de minimis safe harbor election, to neither capitalize any amount paid in the tax year for the acquisition or production of a unit of tangible property nor treat as a material or supply any amount paid in the tax year for tangible property that meets certain requirements. If taxpayers have an applicable financial statement (AFS), tax deductions may be made up to $5,000 per invoice item. If an AFS does not exist, the threshold is $500. There are important steps that need to be taken to ensure the availability of this election which will require consultation with your tax advisor.
- Routine Maintenance: Taxpayers can generally deduct routine maintenance activities that are expected to be performed more than once over the class life of the affected property.
Deductions to an Asset Disposed During a Repair or Improvement
Portions of a tangible property lost due to casualty, or replaced as part of a renovation, have been a continued frustration for many. Prior to the new regulations, there was much debate among practitioners over whether manufacturers could or could not record a loss for these. Now, manufacturers may elect to recognize a gain or loss when portions of assets are disposed. A disposition includes the sale, exchange, retirement, physical abandonment or destruction of an asset or transferred to supplies, scrap or similar.
While the new repair regulations may bring some relief, it also brings concerns that existing tax practices may not be in compliance with the new regulations. Manufacturers should consult their tax practitioner and evaluate what needs to be done in order to make the repair regulations work for them.
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This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.