If you have a business, and especially if that business has real estate, odds are very good that your tax advisor will talk to you about the “repair regulations” this filing season.
The IRS and taxpayers have spent decades arguing and going to court over whether an expenditure is a repair (and immediately deductible) or a capital improvement (which cannot be deducted immediately but rather must be depreciated over time). Eventually the IRS decided to pull back, review the existing court cases and develop some rhyme or reason for tax practice in this area. They were at it for years and years.
And now we have the “repair regulations.”
I debated whether to write on this topic, as one can leave the pavement and get lost in the weeds very quickly. It is like a romper room for tax nerds. Still, we have to at least discuss the high points.
Let’s set this up. Say that you have a tug boat. The boat is expected to last you approximately 40 years, if you maintain and keep it up. Every 4 or so years, you anchor the tug and give it a good overhaul, replace what needs replacing and rebuild the engine. This is going to cost you well over $100 grand.
Question: is this a repair (hence deductible) or a capital improvement (not immediately deductible but depreciable over time)?
It is not immediately clear. This costs a lot of money, so one’s first response is that it has to be capitalized and depreciated. However, regular use of a tug presumes heavy maintenance of this kind over its life. That sounds more like a repair expense.
The IRS has introduced the concept of a unit of property. We have to base the repair versus capitalization decision on the unit of property. Is the engine the unit of property (UOP) or is it the overall boat?
The main test for UOP is “functional interdependence.” The placing in service of one thing depends on the placing in service of something else.
Well, a tug boat engine without a tug boat to put it in is not of much use to anybody, so we would say that the overall boat is the unit of property.
Progress. Do we now know whether to capitalize or deduct the engine?
We next climb through a fence we will call the “BAR,” which stands for:
Let’s have a quick peek at which each term means:
- You made the thing larger,stronger, more efficient
We did not turn the thing into a “monster” tug. Let’s move on.
- You tweaked the thing for a different use or purpose.
Nope. It’s still a tug. Can’t fly it or drive it on a highway.
- Returning the thing to a usable condition after you have run it into the ground, either because you neglected it (and it fell apart) or it just got too old.
Doesn’t sound like it. We are not neglecting the tug in any way, and it still has many years of use left.
This is looking pretty good for our tug.
Let’s go through a few more rules, just in case.
If your CPA prepares audited financial statements for you, the IRS will not challenge your deducting something up to $5,000 as a repair as long as you did the same thing on your financial statements.
That tug thing costs way more than $5,000. Let’s continue.
NOTE: BTW, if you do not have an audit, the IRS drops that dollar limit down to $500.
If we are talking about “materials and supplies,” the IRS will not challenge your deducting something as long as it costs $200 or less. Fuel for that tug would be considered “materials and supplies.
That tug work blew past $200 like it was standing still. Let’s proceed.
If you capitalize the thing on your books and records, the IRS will not argue that you should have deducted it instead.
Downright charitable of them. Let’s move on.
If a repair is expected to be done more than once over the life of the UOP, then the IRS will not challenge your deducting it as a repair.
Whoa. We have something here. That boat is expected to last somewhere around four decades. The heavy maintenance has to be done every so many service hours, generally meaning every three or four years. Looks like we can deduct the repairs to our tug.
Let’s dock the tugboat and briefly discuss a building. Perhaps we can see our tug from our building.
The IRS is taking the position that a building is both one unit of property and more than one unit of property.
I do not make this up, folks.
The IRS wants certain systems of a building – like its HVAC or its elevators – to also be considered a separate UOP. Let’s take an example. Let’s say that you are replacing a bunch of windows on that building. You would then evaluate whether it is a repair or an improvement by reference to the building as a whole. This is a good thing, as it would take a lot to “improve” the building as a whole. This makes it more likely that the answer will be a deductible repair.
However, say that you replace an elevator. The IRS says that you have to look at elevators separately from the overall building. We’ll, it does not take much to improve an elevator if you are just comparing it to an elevator. This is a bad thing, as it makes it more likely that the result will be a capital improvement.
BTW there is a separate test if your building costs less than a $1 million when you bought it. The IRS will “spot” you a certain amount before it will challenge whether something is a repair or not. It’s for the smaller landlords, but it is something.
And there you have the highlights of the repair regulations.
Depending on your fact patterns, there may be elections and forms that you have to attach to your tax return. Your tax advisor may even request that you change your underlying bookkeeping – like expensing stuff under $5000/$500 on your general ledger, for example. Some of these will require extra work, and hence additional fees, by and from your advisor.
And there is one more thing.
Let’s go back to the tugboat.
Let’s say that you did the major overhaul four years ago and capitalized the cost. You are now deducting those repairs over time as depreciation. The new rules now allow you to deduct the cost immediately as a repair. Had we only known!
Is it too late for us? Four years back is one more year than the statute of limitations permits, so we cannot go back and amend your return.
The IRS – to their credit – realized the unfairness of this situation, and it will let you go back and apply these new rules to that old tax year. The IRS calls it a “partial disposition,” and you can deduct what’s left of that capitalized tugboat repair on your 2014 tax return. It is called a “Change in Accounting Method” and is yet another multi-page form with your return, but at least you can get the deduction. But only on 2014. Let it slip a year and you can forget about it.
If any of the above rings a bell, please discuss the “repair regulations” with your tax advisor. Seriously, after 2014 you may be stuck. Tax does not have to be fair.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.