IRS issues new rules on the capitalization of tangible property costs

The IRS has withdrawn 2006 proposed regulations on the capitalization of payments to acquire, produce or improve tangible property, bowing to strong public reaction. In its place, the IRS has issued rules that follow some of the withdrawn regulations while adding significant depth and clarity to other sections. Since tangible property costs, whether they consist of machinery, equipment, or even office furniture, are common to most businesses, these rules will have a significant impact on many businesses almost immediately.

Materials and supplies

The new regulations describe the type of materials and supplies that can be deducted. The new regulations provide that the costs of non-incidental materials and supplies are deducted as they are used or consumed and the costs of incidental materials and supplies are deducted as the costs are incurred. A material and supply is defined as tangible property that (a) is not a unit of property, (2) is a unit of property with an economic useful life of 12 months or less, (c) is a unity of property that costs $100 or less, or (d) is identified as a material and supply in future guidance.

Unit of property

After a barrage of criticism, the revised regs significantly modify the definition of “a unit of property” to generally treat all components that are functionally interdependent as a single unit of property. However, machinery and equipment used in a manufacturing plant that is functionally interdependent will not be treated as a single unit of property. To be treated as such, they need to be part of a group that performs a discrete and major function or operation.

Improvements, betterments and restorations

Costs that improve a unity of property must be capitalized. However, repair costs that are otherwise deductible may still be deducted if the repairs do not improve the property. When determining a lasting improvement, the new rules introduce the concept of a betterment to determine if a repair may be deducted immediately. Also new is an attempt by the IRS to create a “bright-line” rule for restorations.

The differences among an improvement, a betterment and a restoration often may continue to be difficult to identify despite the new regulations that stretch over 15,000 words in an effort to clarify the situation. Unfortunately, despite many of these rules still being under construction by the IRS, businesses must make decisions now and be prepared to back them up, on each improvement/betterment/restoration and repair situation that they face.

Often, a decision to fix up something “for a while” or make a more lasting repair or improvement will depend upon the tax benefits that can be gained from an immediate tax deduction on the cost of such a project.  Please do not hesitate to contact this office if you have any questions before starting the next project your business may be considering.