On December 23, 2011, the IRS issued comprehensive guidance, in the form of temporary regulations, on the tax treatment of costs incurred to acquire, repair, or improve tangible property. These regulations are commonly referred to as the “repair” regulations. It is likely that these regulations will apply to nearly all taxpayers.
The centerpiece of the repair regulations is a new and detailed set of rules governing the distinction between currently deductible maintenance costs and capital improvements.
The regulations make significant changes in the treatment and capitalization of these costs. As a consequence, taxpayers must consider the extent to which the new guidance might require a change in their current accounting method for costs paid or incurred to acquire, maintain or improve tangible property. Nearly all changes made to conform to the new standards require a change in accounting methods.
On March 7, 2012, the IRS issued two revenue procedures providing taxpayers guidelines for filing accounting method changes under the new "repair" regulations, which address these basic areas:
- Amounts paid for materials and supplies,
- Costs to acquire tangible property, and
- Costs to maintain or improve tangible property.
In addition, to these major areas, the repair regulations provide significant modifications in the depreciation rules. These changes include the ability to immediately deduct the remaining tax basis of building components that are retired or replaced. This is a fundamental change from prior law and one that could benefit most taxpayers undertaking capital improvements.
This Tax Flash focuses on how the new regulations impact materials and supplies. Marcum will issue future Tax Flash installments to expand on areas 2 and 3 listed above on this very important change.
Material and Supplies
"Incidental" materials and supplies are those that are carried on hand and for which there is no record of consumption and the taxpayer does not conduct an inventory at either the beginning or end of the year. "Incidental" materials and supplies are deductible in the year in which they are paid for. "Non-incidental" materials and supplies are those that are acquired to maintain, repair or improve a unit of property for which records are kept of consumption and the taxpayer conducts an inventory at the beginning and end of the year. "Non-incidental" materials and supplies are deductible when used or consumed.
Taxpayers may elect to capitalize and depreciate the cost of "non-incidental" materials and supplies. Taxpayers may cherry-pick specific materials and supplies to which capitalization election could apply.
A taxpayer makes this election by capitalizing and beginning to depreciate the asset on their timely filed original tax return. No specific form or statement is required to make this election.
The temporary regulations provide a book-conformity de minimis rule permitting a current deduction for items costing in the aggregate less than a prescribed ceiling amount. The de minimis rule and ceiling limits will be discussed in a later flash. If elected, the de minimis rule rather than the "used or consumed" rule, generally applicable to materials and supplies will govern the timing of the deduction.
The taxpayer must make an affirmative election to apply the de minimis rule to material and supplies. This election is made by simply deducting the amounts paid to acquire or produce the material or supply, while complying with the de minimis rule requirements.
The regulations clarify that materials and supplies also include rotable and temporary spare parts. Rotable spare parts are installed on a unit of property, removable from a unit of property, generally repaired or improved, and either installed on the same property or other property or stored for later installation. A typical example is an aircraft engine, which is removed when maintenance is required, replaced immediately with an identical engine, serviced, and then installed on a different aircraft.
A taxpayer has four options in accounting for rotable spare parts:
- deduct the cost on final disposition, or
- capitalize the cost and depreciate, or
- apply the de minimis rule, or
- apply the optional method for rotables
Under the optional method for rotables, the taxpayer deducts the amount paid to acquire or produce the part in the tax year that the part is first installed on a unit of property for use in their operation. In each tax year in which the part is removed, the taxpayer includes the fair market value in its gross income, and also adds the same amount to the rotables part's tax basis. The taxpayer also adds the amounts paid to remove the part to the part's tax basis. After removing the part, the taxpayer is not allowed to currently deduct any amounts spent in maintaining, repairing, or improving the part and instead must add those amounts to the tax basis of the part. When the part is later reinstalled, the taxpayer is allowed to deduct in the tax year the amounts paid to reinstall as well as the amounts added to the part's total tax basis.
When material and supplies are disposed of they may not be treated as capital assets or as property used in a trade or business. Any gain or loss from the disposition of materials and supplies must be reported as ordinary gains or losses.
The regulations are effective for tax years beginning on or after January 1, 2012. Even though the regulations issued are deemed to be temporary, they have the same binding effect as final regulations.
Since the "repair regulations" were very comprehensive we will follow up with additional articles reviewing "costs to acquire tangible property" and "costs to maintain or improve tangible property".
Should you have any questions related to how the new regulations may affect you or your business, please contact your Marcum Tax Advisor.