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Changes in Repair or Replace Tax Rules (Part 1 of 2)

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(Photo: © iStockphoto/John DeFeo)

Mark E. Battersby |

ARDMORE, Pa. — In an effort to resolve the controversy over whether certain expenditures made by a drycleaning 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.

The IRS’s long-awaited expanded regulations for determining whether an expense must be capitalized because it betters or improves tangible business property or equipment, restores it, or adapts it to a new and different use, will have a significant impact on every drycleaning business that acquires, produces, or improves its tangible property. 

In addition to clarifying and expanding the current rules, the new regulations create “bright-line” 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.

The new regulations specify how repairs made simultaneously with improvements are to be treated, and provide a “safe harbor” for routine maintenance expenses such as materials and supplies. The new rules are also must reading for landlords and tenants that must capitalize expenses related to leased buildings. And, because the new rules were issued in “temporary” form, every drycleaning plant owner and operator will feel the impact immediately.

CAPITALIZE-OR-REPAIR EXPENSE

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.

Unfortunately, the current rules don’t clearly address even the core issue of whether expenditures should be deducted currently (e.g., as repairs or as materials and supplies) or capitalized by the plant owner or operator.

REPAIR/REPLACE BASICS

Under the rules, the cost of work performed to return property to a former condition without extending its useful life is currently deductible as a repair expense, unlike capital improvements that extend its life or increase its usefulness or productivity and which must be depreciated.

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 existing property. These additions are not replacement components nor are they repairs to property, but are instead newly installed components. These additions are required to be capitalized.

At other times, replacement parts or components are added. For example, a car’s engine is worn out and replaced. This replacement returns the car 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. Conversely, it would also make sense to say that by returning the car to its prior condition, it had been repaired. Under this theory, all repairs would be deductible, no matter how substantial they might be.

The above interpretation renders meaningless any distinction between a deductible business expense and a capital expenditure. Thus, it is oftentimes 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, WE HAVE CHANGES

The new regulations are the IRS’ 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 drycleaning plant owner or operator to deduct retirement losses for building components.

If, for example, the drycleaning operation replaces the roof on a building and disposes of the old roof, it now has the option of taking a retirement loss for the old roof. Of course, the replacement must be capitalized, but at least a retirement loss can be claimed.

Another change involves the “de minimis” expensing rule, a rule that allows a drycleaning business to expense or write off the acquisition cost of property on his books for financial reporting purposes. This immediate write-off is available to a drycleaning business with a written policy in place to do that, but only up to a threshold or ceiling. The new regulations also include many types of materials and supplies among those eligible for the de minimis expensing rule. Under earlier rules they were not eligible, or only some categories were.

Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult a tax adviser for advice regarding your particular situation.

Check back Monday for Part 2!

About the author

Mark E. Battersby

Freelance Writer

Mark E. Battersby is a freelance writer specializing in finance and tax topics based in Ardmore, Pa.

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