Finances: Capitalize vs. Deduct
When it comes to repairing or replacing business assets, should you write it off over time or deduct the expense?
In an effort to resolve the controversy over whether certain expenditures made by a tennis business are currently deductible as repair expenses, or whether they must be capitalized and deducted over the life of the underlying business asset, the Internal Revenue Service has finally released new regulations. These expanded regulations can have a significant impact on every tennis shop, facility, manufacturer, court builder or teaching pro that acquires, produces, or improves its tangible property.
In addition to clarifying and expanding the current rules, the new regulations create tests for applying the repair or capitalize standards, provides guidance for accounting for — and disposing of — repaired property, as well as clarifying other aspects of the repair/capitalize dilemma.
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 must be capitalized and what may be currently deducted as an expense has been at issue ever since.
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.
On the other hand, 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, restore its value or use, substantially prolong its useful life, or adapt it to a new or different use.
The basic tax rule hasn’t changed that much: Expenditures are currently tax 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.
Similarly the cost of incidental repairs is typically deductible. The regulations state that the cost of incidental repairs that neither materially add to the value of the property, nor appreciably prolong its life, but keep it in an ordinarily efficient condition, may be deducted as an expense.
Quite frequently, new additions are made to already existing property. These additions are not replacement components nor are they repairs, but are instead newly installed components, so they must be capitalized.
At other times, replacement parts or components are added to business property. For example, a car’s engine is worn out and replaced. This replacement returns the car back to its condition prior to the deterioration of the part. It would be logical to consider this replacement as an increase in the car’s value requiring capitalization. But it also would make sense to say that by returning the car back to its prior condition, it had been repaired. Under this theory, all repairs would be deductible, no matter how substantial they might be.
This example makes any distinction between a deductible business expense and a capital expenditure meaningless. Thus, it is often insufficient to merely look at increased value as the determining factor for characterizing the replacement of a part or component. An increase in value is only one of many factors that must be considered to determine deductibility or capitalization.
Changes in the Rules
The new regulations are the IRS’s third attempt to provide comprehensive guidance under the repair or capitalize rules. They attempt to answer such questions as how to treat environmental remediation expenses and how to treat rotatable spare parts used in repairs. One significant rule change allows a tennis business to deduct retirement losses for building components.
If, for example, you replace the roof on your shop or tennis facility and dispose of the old roof, you now have the option of taking a retirement loss for the old roof. Of course, the replacement must be capitalized, but at least taking a retirement loss can be claimed.
Another change involves the “de minimis” expensing rule, a rule that allows a tennis business to expense or write-off the acquisition cost of property on its books for financial reporting purposes. This immediate write-off is available to a tennis shop or facility with a written policy in place to do that, but only up to a threshold or ceiling. The new regulations also include more types of materials and supplies among those now eligible for the de minimis expensing rule.
Materials and supplies may now be currently deducted as an expense if they are acquired to maintain, repair or improve business property owned, leased, or serviced by the tennis business, consist of fuel, lubricants, water and similar items that are reasonably expected to be consumed within 12 months, with an economic useful life of less than 12 months or costing less than $100.
Under an elective “de minimis” rule, amounts (other than inventory or land) along with amounts paid for any materials and supplies don’t have to be capitalized. That is, the amounts do not have to be capitalized if the operation has an applicable financial statement (AFS), or a certified audited financial statement, written accounting procedures in place for treating the amounts as expenses on its AFS and if the amounts paid and not capitalized are either less than 0.1% of gross receipts or 2% of the total depreciation expense as determined in its AFS.
Leased and Rented Property
The temporary regulations retain a rule allowing your business to amortize and write-off the costs of acquiring a leasehold over the term of the lease and make only minor revisions to the rules for treating the cost of erecting a building or making a permanent improvement to property leased by the operation if it is a capital expenditure and is not deductible as a business expense. The temporary regulations do, however, require a lessee or lessor to depreciate or amortize its leasehold improvements under the cost recovery provisions without regard to the term of the lease. Removed under the new regulations are the rules permitting amortization over the shorter of the estimated useful life or the term of the lease.
A safe harbor has been created for routine maintenance on property other than buildings. Routine maintenance includes the inspection, cleaning, and testing of the unit of property and replacement of parts of the unit of property with comparable and commercially available and reasonable replacement parts. To be considered routine maintenance, you have to expect to perform these services more than once.
The new temporary regulations are generally effective for amounts paid or incurred in tax years beginning after 2011. The new rules generally require capitalization rather than deduction in close situations. For example, previous rules treated buildings as a single “unit of property” so that replacement of a structural component such as a roof was not a “substantial” modification and thus could be deducted. Under the new rules, however, primary components of a building structure or a specifically defined building system (such as HVAC, plumbing, electrical, etc.) must be treated separately, so that replacement of those components must be capitalized.
But some changes are business-friendly. For example, if the cost of an improvement is capitalized, it must be depreciated as a new asset and recovered over the life of the improved property. The old rules did not permit a tennis business to recognize losses upon the retirement of the old property following an improvement, which resulted in simultaneously depreciating multiple portions of the same property. The new regulations address this problem by expanding the definition of a disposition to include retirements of structural components of a building.
It’s never too late to look at what you’re doing for repair and maintenance costs for your tennis business. But the sheer volume of the new 255-page regulations on deduction vs. capitalization of tangible property costs makes professional assistance a necessity.
See all articles by Mark E. Battersby
About the Author
Mark E. Battersby is a tax advisor and author in Ardmore, Pa.