As the end of the year approaches, many property owners are taking a closer look at treasury regulations for possible tax savings. Mandatory changes in 2015 caused owners to begin accounting expenditures as either improvements or repairs.
In a previous article, we discussed when to capitalize versus when to expense under the general rules and guidelines. Here, we’ll be taking a closer look at special rules, safe harbors, and partial disposals that, if applicable, could generate significant tax savings.
Deducting Materials and Supplies
A deduction is allowed for amounts paid to produce and acquire materials and supplies consumed during the year. Materials and supplies are defined as components acquired to maintain, repair, or improve tangible property that have a useful life of one year or less or has an acquisition or production cost of less than $200. Fuel, lubricants, water, and similar items are also considered to be materials and supplies. Taxpayers can expense non‐incidental materials and supplies in the year consumed if they fall under the de minimis safe harbor amount.
Incidental materials and supplies, those for which there is no record of consumption or physical inventory, are deductible in the year they are purchased. There are also special rules that apply to rotable, temporary, or emergency standby spare parts. The regulations dictate that a deduction is taken in the year disposed unless an election is made to capitalize and depreciate the spare parts or an optional exchange type method is adopted.
De Minimis Safe Harbor
One of the key changes in the regulations is the de minimis safe harbor, which allows a taxpayer to deduct certain limited amounts paid for tangible property that are expensed for financial accounting purposes that fall under a specified threshold amount. Taxpayers can use a de minimis threshold of $5,000 if they have an applicable financial statement‐ generally either an audited financial statement or another financial statement required to be provided to a federal or state government agency.
All other taxpayers, including those with reviewed or compiled financial statements, can use a $2,500 de minimis threshold. The de minimis safe‐harbor, either $5,000 or $2,500, is applied to each item on an invoice, allowing a taxpayer to expense those items falling under the threshold as long as they are also expensed for financial accounting purposes. If more than one item is listed on an invoice, the threshold applies separately to each item, and additional costs (delivery, etc.) should be allocated accordingly.
For example, assume a taxpayer does not have an applicable financial statement but has accounting procedures in place to expense tangible property purchased for less than $2,500. The taxpayer purchases five computers, costing $2,495 each, all included on the same invoice. All five computers are eligible to be expensed under the de minimis safe harbor. However, if the invoice also included delivery charges totaling $50, the computers would need to be capitalized as the delivery charges would be allocated pro rata amongst the assets acquired.
To use the de minimis safe harbor, you must have a capitalization policy in place at the beginning of the year, allowing you to expense the threshold amount.
Routine Maintenance Safe Harbor
The regulations include a safe harbor that allows certain expenses of routine maintenance to be deducted immediately rather than capitalized. Routine maintenance is defined as recurring activities that keep the property in ordinarily efficient operating condition, such as inspection, cleaning, testing, and replacement of damaged or worn parts.
For a building structure or system, the taxpayer can expense routine maintenance if they reasonably expect to perform the maintenance more than once during the 10‐year period that begins when the structure or system is placed in service.
Per‐Building Safe Harbor for Qualifying Small Taxpayers
The regulations also include a safe harbor for qualifying small taxpayers to deduct improvements made to a building property with a cost basis (excluding land) of $1 million or less. Qualifying small taxpayers are defined as those with average annual gross receipts of $10 million or less. This safe harbor applies only if the total amount paid during the tax year for repairs, maintenance, and improvements for each building does not exceed the lesser of $10,000 or 2% of the building’s cost basis. This safe harbor may be elected annually on a building‐by‐building basis.
The disposal regulations create a “partial disposition” election for fixed assets. If the election is made, a taxpayer may recognize a loss on the retirement of a structural component of a building or any other asset component without identifying the component as a separate asset before disposition.
For example, if a taxpayer replaced the roof on their building during the year and capitalized the new roof. Under the partial disposition election, the taxpayer could lose the remaining adjusted basis of the old roof even if it was not separately identified when the original building was placed into service.
Both taxpayers and CPAs often miss this election due to its seemingly complex calculation. In many cases, however, the long-term tax benefits available can save, at a minimum, a 5 percent tax savings when it is time to sell the building.
Aldrich is Here to Help
While repair regulations present an opportunity to maximize tax savings, the guidelines tend to complicate the decision0making process. Our real estate team is here to help you make informed decisions to better your business. If you have questions about repairs, improvements, or partial disposals, reach out to your Aldrich Advisor.
Meet the Author
Senior Tax Manager - Real Estate
Jonathan McGuire, CPA
Aldrich CPAs + Advisors LLP
Jonathan McGuire has over eight years of experience providing strategic tax planning and compliance expertise to private middle-market clients. He has a deep focus as a real estate accountant, working with investors, developers, realtors, property managers, and other professional service providers in real estate. He works with a wide range of property types ranging from…
- Real estate
- Partnership taxation
- Tax planning and compliance
- Certified Public Accountant
- Repair regulations
- Qualified Opportunity Zones
- Qualified Opportunity Funds