The IRS has issued a Notice that it expects to issue final regulations relating to repairs, depreciation, materials and supplies during 2013. (Notice 2012-73, November 20, 2012.)
The final regulations will include changes to the temporary regulations described below based on comments received by the IRS about the temporary regulations. Some of the areas for which changes are expected include
* The de minimis rule
* The safe harbor for routine maintenance
The final regulations will be effective for taxable years beginning on or after January 1, 2014, but taxpayers will be able to elect to apply them for taxable years beginning on or after January 1, 2012.
Here is a description of the temporary regulations that I wrote before the Notice postponing the effective date was issued.
The IRS has issued temporary regulations intended to clarify the rules about when repairs can be expensed and when they should be capitalized, changes in depreciation rules for when components of assets, especially buildings, are replaced, and when materials and supplies can be deducted. (T.D. 9564 issued 12/23/2011, corrected 3/27/2012.)
The regulations are generally effective for taxable years beginning on or after January 1, 2012.
The IRS has also issued procedures for making applications for automatic changes in accounting methods relating to the temporary regulations. Most businesses and taxpayers with rental real estate should include one or more of these accounting method changes with their 2012 or 2013 income tax returns. (Revenue Procedures 2012-19 and 2012-20 issued March 7, 2012.)
After a discussion with an IRS representative at the Washington National Tax Office, it appears best to wait until tax years beginning in 2013 to make the changes in accounting method. The IRS hopes to issue final regulations during 2013. They have issued an initiative suspending raising issues in areas covered by the temporary regulations for two years.
My printout of the regulations is 116 pages, so I won’t explain them in detail here. I will just hit a few highlights.
Under the temporary regulations, major repairs such as the replacement of a roof are required to be capitalized.
There is a major change in the rules for depreciable property — especially buildings. When a major component is replaced, the tax basis (cost for computing gain or loss for income tax reporting) and accumulated depreciation can be written off.
The rules for general asset accounts (GAA) have also been liberalized, permitting an election to write off a component or asset in the group when it is disposed. As a result, general asset accounts may become more popular for depreciable asset reporting.
The GAA will be the preferred method for accounting for a building, because if there is a replacement of a minor structural component (such as a broken window) that is accounted for as a repair, the original component will no longer be depreciable unless the asset is in a GAA and the taxpayer doesn’t elect to write off the tax basis and accumulated depreciation as a “qualified disposition”.
Guidelines are given for when repairs are routine maintenance qualifying for a current deduction. They don’t apply for buildings. When depreciable equipment isn’t maintained so that it stops functioning and then has to be rehabilitated, the repair has to be capitalized.
Improvements for “betterments”, “restorations” and “adaptations” must be capitalized and may be depreciable.
“Incidental” materials and supplies for which no physical inventories or records of consumption are kept are deductible when paid or accrued.
“Non-incidental” materials and supplies are generally deductible when used or consumed in operations, unless they are required to be capitalized to inventory as a production cost. Alternatively, the taxpayer may elect to capitalize and depreciate them, which can be combined with a Section 179 expense election. Another alternative for a few taxpayers is to deduct them under the di minimus rules – explained briefly below.
Rotable parts are generally deducted when they are disposed. Alternatively, taxpayers may elect to deduct them when they are installed and report income for the fair market value of the parts when they are removed. The cost of removal is added to the cost of the parts.
Under the di minimus rule, a taxpayer may deduct the cost of minor items when they are deducted for financial reporting purposes, but not more than the greater of (1) 0.1% of the taxpayers gross receipts for income tax reporting or (2) 2% of the the taxpayer’s total depreciation and amortization expense for the tax year reported on the financial statement. The election is only available if the taxpayer has an “applicable financial statement”, such as an audited financial statement or a financial statement submitted to a regulatory authority. Since most small businesses don’t have audited financial statements, they won’t benefit from the di minimus rule.
The new IRS rules for repairs, depreciation, materials and supplies include significant guidance, but the judgment of the tax return preparer will remain important in making the decision about whether an item may be deducted or must be capitalized.