New IRS regulations can mean big tax savings
The rules feature big changes to fixed asset depreciation and repairs costs for 2014
Do you or your business deduct depreciation expenses for the cost of fixed assets? Do you purchase materials and supplies? Do you deduct repairs and maintenance costs?
If you answered “yes” to any of these questions, the final tangible property regulations, issued by the IRS on Sept. 13, 2013, will apply to you and/or your business. The rules are very complex and voluminous, requiring additional guidance addressing solely how to implement the new rules. Much like the regulations themselves, the implementation policies are lengthy and complex. Adopting and complying with the regulations beginning in 2014 is mandatory, and will require most taxpayers to go through the formal process of requesting a change in accounting method for the 2014 tax year.
A change in accounting method is accomplished by completing IRS Form 3115. Although the process can be a bit complicated and time-consuming, many taxpayers have the potential to reap substantial tax savings on both current and past expenditures.
Many of the changes created by the final regulations address whether or not certain costs should be capitalized and depreciated rather than expensed in the year incurred. Several “safe harbor” rules were created that may be adopted by making one or both of the following annual elections:
• Safe harbor rule for routine maintenance
• Safe harbor expensing rule for small taxpayers (defined as entities with $10 million or less in average annual receipts)
• De minimis safe harbor election to expense items below a certain per-item cost
These elections allow certain taxpayers to automatically expense the cost of certain qualifying items rather than consider the in-depth “RABI” (restoration, adaptation, betterment and improvement) rules outlined in the final regulations. Costs that do not qualify for safe harbor treatment must be evaluated to determine whether they restore, adapt, provide betterments or improve a unit of property.
If so, the costs must be capitalized and depreciated over the asset’s useful life. All other costs may be claimed as current expenses. Starting in 2014, taxpayers must apply these standards to current year costs and evaluate all outlays made in prior years to determine if the costs have been properly treated.
Prior costs that are rendered “improperly capitalized” as part of the rule change can be removed from depreciable cost basis as part of an accounting method change, thereby creating additional deductions when the change is filed.
For taxpayers with a considerable number of fixed assets, this evaluation process can be time-consuming but also quite beneficial.
The final regulations also allow taxpayers to record partial dispositions of tangible personal and real property, which also accelerates deductions.
This disposition will allow a taxpayer to deduct a portion of a previously capitalized asset when it is replaced by a new, capitalized item.
For example, assume a taxpayer purchases a residential rental property for $2.5 million in 2004. In 2014, the taxpayer replaces that building’s entire HVAC system for $200,000.
Tax professionals are able to currently determine, using any reasonable method, that $175,000 of the original $2.5 million purchase price was related to the original HVAC system, and that current accumulated depreciation related to the original HVAC system is $60,000. It therefore has an un-depreciated tax basis of $115,000.
Thus the taxpayer capitalizes the new HVAC system cost of $200,000 and begins depreciating it over 27.5 years, but is also entitled to claim an immediate $115,000 deduction in the current year relating to the “disposal” of the old HVAC system.
This result is much more favorable than the result achieved under the previous rules. The old rules would involve the capitalization of the new cost and depreciation of it over 27.5 years (similar to the new rules), but it also would force the continued depreciation of the original cost over the remaining 17.5 years of its own 27.5-year life. The time value of tax savings allowed by this current deduction can be very significant.
Considerable planning opportunities are available with the implementation of these new regulations. Although many taxpayers will properly address these changes beginning with their 2014 tax returns, it is imperative you review and align your internal capitalization policies as well as discuss them with your tax advisor.
Chris DeRosa is a senior manager and Andrew Smith is a principal in the tax practice of Baker Newman Noyes. They can be reached at 603-626-2200.