If you like to put money in your pocket now rather than wait for years to get it, then you’ll want to become familiar with the Internal Revenue Service’s regulations on repair and maintenance. In a nutshell, if you classify an item as an expense, you will get to write the entire amount off in the current year. If you capitalize the item, it could take you between three and 39 years to write it all off.
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 prepare for a productive dialog with your accountant. Below are key actions you should take to ensure compliance and avoid unpleasant consequences.
To Deduct, or Not To Deduct…
As a general rule, 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.
On the other hand, 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 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. Your accountant can help you determine appropriate treatment for your individual circumstances.
Allowable Deductions for Small Amounts
A strict interpretation of the regulations could require the capitalization of a $300 windowpane replacement that has a useful life in excess of ten years and requires no intervening repair or maintenance. Fortunately, the rules set parameters under which selected expenses may be deducted in the current year. For the typical dental office, the threshold is $2,500 per invoice or for each item if listed separately on a single invoice.
If you are tempted to work with your vendors to limit all invoices to $2,500 or less, you are headed down the wrong road. The IRS will not reward your creativity! Rather, all reported expenses must relate to a “Unit of Property” (UOP) that is being improved, repaired, or maintained.
For property other than buildings, a single UOP consists of all components that are functionally interdependent, such that one component can’t be placed in service without the other components. A dental chair falls into this category as its seat, backrest, headrest, armrests, hydraulic lift system, footswitch (or touchpad), and baseplate could not be placed in service independently.
So, for example, if you refurbish an existing dental chair by replacing the hydraulic solenoid, brakes, foot switch, and headrest, you could not deduct all of the expenses related to the project by treating each of the component parts as separate items. Since the parts work interdependently, the total cost of the upgrade would be subject to the $2,500 threshold.
Special Treatment for Your Dental Building
The regulations look kindly upon small taxpayers whose average annual gross receipts were less than $10 million in the three preceding tax years. These taxpayers may deduct improvements made to building properties that have an unadjusted basis of $1 million or less. This provision applies only if the total amount paid during the tax year for repairs, maintenance, and improvements falls short of $10,000 or 2% of a building’s unadjusted basis.
Eligible Taxpayers Are Allowed to Make This Election Annually on a Building-By-Building Basis
If you lease your office space, you’ll treat repairs like you do for your dental chair. In this case, the regulations generally treat each building and its structural components (walls, windows, doors, floor, roof, etc.) as one UOP. The regulations also list specific building systems that are treated as independent UOPs—e.g., HVAC, plumbing, electrical, elevators, the fire suppression system, and the building alarm system.
Again, if you upgrade the building alarm system by replacing the controller, keypad, and motion sensors, you could not deduct all of the expenses related to the project by treating each of the component parts as separate items. As the parts work interdependently in service of a UOP called the “alarm system,” the total cost of the upgrade would be subject to the upper limit of $5000.
What You Need To Do
First And Foremost: It is recommended you have a written capitalization policy that has been signed and dated on or before December 31, 2013. You may be asked to produce this document should your return be audited. Using this sample, you should be able to check this crucial item off the list quickly.
Second: Establish a filing and recordkeeping system to distinguish clearly the various categories of expense subject to these new regulations. If you create a one or two-page “Quick Reference Guide” for commonly purchased items, you’ll increase the odds of consistent treatment throughout the year. This simple process will save time, effort, and expense when it’s time to prepare your annual tax returns.
Third: Make sure that your accountant has a clear understanding of these new regulations and how they apply to your dental practice. Your accountant can look out for your best interests and help you avoid the trouble and expense of re-filing tax returns and paying penalties and interest. With compliance well in hand, you can focus your attention on patient care and the overall health of your practice.
This article originally appeared in Catalyst Magazine, and this post was originally published on April 2, 2014. It was updated on May 1, 2017 to provide you the most current information.