On January 1, 2014 sweeping new IRS regulations governing the deductibility of repairs and improvements to business property went into effect. Eight years in the making, the voluminous regulations provide, for the first time ever, highly detailed guidance on how to classify expenses as improvements or repairs that the IRS is bound to follow.
How to classify such expenses is important because improvements to business property must ordinarily be depreciated over many years—as many as 39 years in the case of real property. On the other hand, no matter how much they cost, repairs to business property are currently deductible in a single year. For example, if you spend $1,000 to repair a business vehicle, you can deduct the entire amount in one year. However, if the $1,000 is for an improvement to the vehicle, you'll have to deduct the amount a little at a time over five years.
Obviously, it is usually preferable for an expense to be classified as a repair rather than an improvement so you can deduct the whole amount in one year. Unfortunately, telling the difference between a repair and an improvement isn't always easy. Indeed, for decades this issue has resulted in bitter disputes between business owners and the IRS.
The new IRS regulations attempt to clarify matters and avoid such disputes. For example, a landlord who wants to know whether he or she can deduct in a single year the money spent to replace all the windows in a rental property, replace the water heater, or repave the driveway can look to these regulations for the answer.
The gist of these regulations is that you must depreciate an expense you incur to:
- make a long-term asset much better then it was before
- restore it to operating condition, or
- adapt it to a new use.
Expenses that are not for betterments, restorations, or adaptations are currently deductible repairs. The new regulations also provide rules for determining the appropriate “unit of property” to consider when making these determinations.
Unfortunately, the regulations are long and complex and provide few clear "bright-line rules" explaining exactly how much an asset must be altered to constitute an improvement. Instead, you have to look at all the facts and circumstances and make a judgment call.
But, in their final revised form, the regulations do provide several benefits specially designed for small landlords and other smaller businesses. For example, under the new regs:
- items costing $200 or less are considered supplies and are currently deductible in a single year
- there is a special “de minimis safe harbor” that allows businesses to immediately write off items costing $500 or less (businesses with certified financial statements can write-off items costing up to $5,000)
- costs for “routine maintenance” are currently deductible, and
- business owners can deduct the unrecovered basis (cost) of business property that is replaced when performing improvements—for example, the unrecovered cost of an old roof can be deducted when a new roof is installed.
The regulations took effect on January 1, 2014. The IRS expects them to impact over 4 million taxpayers. Most will be required to file certain tax forms with the IRS and adopt certain accounting policies and/ or elections before the end of 2014.
These regulations are contained in Internal Revenue Bulletin 2013-43 (available at www.irs.gov/irb/2013-43_IRB/ar05.html). The IRS has also created a useful set of FAQs on the regulations, available at www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Tangible-Property-Final-Regulations