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Tax Tip: Changes in the Repair/Replace Tax Rules

Posted: April 16, 2012, 1:45 p.m. EDT

By Mark E. Battersby

Because the current tax rules fail to clearly address whether expenditures should be deducted currently (e.g., as repairs or as materials and supplies) or capitalized, the Internal Revenue Service has attempted to resolve the controversy by issuing new regulations. The IRS’s long-awaited expanded regulations govern whether certain expenditures made by a business are currently deductible as repair expenses, or whether they must be capitalized and deducted over the life of the underlying business asset.

The new regulations specify how repairs made simultaneously with improvements are treated. The new rules are also required reading for landlords and tenants that must capitalize expenses related to leased buildings. Also, because the new rules were issued in “temporary” form, every business will feel the impact immediately.

Since the Reconstruction Era Income Tax Act of 1870, taxpayers have been prohibited from deducting amounts paid for new buildings, permanent improvements or betterments made to increase the value of property. While this concept has been recognized as part of tax law almost from its inception, exactly what taxpayers must capitalize and what they may take as a current deduction as an expense has been at issue ever since.

tax rules
According to the IRS, expenditures are currently deductible as a repair expense if they are incidental in nature and neither materially add to the value of the property nor appreciably prolong its useful life. Expenditures are also currently deductible if they are for materials and supplies consumed during the year.

Conversely, expenses must be capitalized and written-off over a number of years if they are for permanent improvements or betterments that increase the value of the property.

The timing of the deduction remains the same under the new regulations. There is, however, a new definition of materials and supplies, which now encompass everything from components acquired to maintain, repair or improve business property; fuel, lubricants, water and similar items expected to be consumed in 12 months or less; property with an economic useful life of 12 months or less; or items with a cost of less than $100.

The recently issued “repairs versus improvements” regulations represent the IRS’s attempt to include the large body of court decisions and create all-encompassing guidelines on what constitutes an improvement.  They also adopt a maintenance safe harbor that will be useful for many retailers.

Whether the changes required under the new regulations will be treated as automatic accounting method changes, or whether affected businesses will be required to obtain the IRS’s approval are as yet unknown. However, the sheer volume and complexity of the new rules on deduction versus capitalization of tangible property costs will require professional assistance as the businesses begin looking at their repair and maintenance costs for 2012.


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