For construction business owners who like to put money in their pockets now rather than wait for years to get it, it is beneficial to become familiar with the Internal Revenue Service’s regulations on repair and maintenance. Classify an item as an expense, and you get to write the entire amount off in the current year. Capitalize the item, and it could take you from three to 39 years to write it all off.
To Deduct, or Not To Deduct…
Here’s a simple example: suppose you are required to capitalize a $10,000 outlay and write it off over 20 years rather than expense it. Instead of gaining $4,000 in tax savings this year (assuming 40% tax rate), you’ll get a $500 write off each year for 20 years, or $200 in tax savings per year. You’ll eventually realize the $4,000 savings (assuming there are no other changes in tax law, but wouldn’t you rather take the $4,000 now?
We used to be able to set “reasonable” thresholds when determining which items could be expensed in the current tax year versus capitalized and depreciated over time. In 2014, however, the IRS set a very specific bar, and the onus is on business owners to conform.
It is important to have a working knowledge of these regulations to help you prepare for a productive dialog with your accountant. Here are key actions to ensure compliance and avoid unpleasant consequences:
- Amounts paid to improve a unit of property must be capitalized. An improvement is defined as an expenditure that betters a unit of property, restores it, or adapts it to a new and different use. For example, the cost to replace a roof would be capitalized and written off over the economic life of that investment.
- The regulations allow for a current deduction for repairs and maintenance to property. These recurring expenses keep the property in good working order – e.g., inspections, cleaning, testing, and replacement of damaged or worn parts. For a building structure or system, you must reasonably expect to perform these repair and maintenance activities more than once during the 10-year period that begins when the structure or system is placed in service. For property other than buildings, you must reasonably expect to perform said activities more than once during the property’s tax depreciation life.
- Deductions are also allowed for amounts paid for materials and supplies that you reasonably expect to consume during a 12-month period. You’ll need to take inventory and record usage of higher value materials and supplies, and deduct expenses in the year in which they are consumed. You’ll deduct expenses for other (incidental) materials and supplies in the year that they’re purchased. There are special rules that apply to removable, temporary and emergency standby spare parts.
Contact your accountant to help you determine appropriate treatment for your individual circumstances.
This post was originally published on May 21, 2014. It was updated on April 2, 2017 to provide you the most current information.