The Internal Revenue Service (IRS) has always required farmers and small business owners to determine whether an expenditure for repairs or maintenance to equipment or buildings was a current deduction or required to be capitalized and recovered through depreciation over its useful life. The area of controversy stemmed from a lack of definitiveness in the decision-making process as to whether to classify the expenditure as a repair or a capital asset.
To address this vague determination process, the IRS issued the first set of proposed regulations in 2006, followed by a temporary proposed regulation, including various transition procedures, which eventually lead to the final regulations issued on Sept. 13, 2013. Surprisingly, the final outcome resulted in a set of common sense principles that have been applied by farmers and small businesses owners for generations. The final regulations provide the distinction and guidance to apply a determinable standard. These regulations apply to all farmers who incur expenses to acquire, produce or improve real or personal property and are effective for taxable years beginning on or after Jan. 1, 2014.
On Feb. 13, 2015, the IRS announced new simplified procedures to address the administrative burden imposed by the regulations and provide relief to small business owners and farmers. These new procedures will allow a small business, defined as one with less than $10 million in assets and gross receipts, to change their method of accounting under the final tangible property regulations on a prospective basis for the first taxable year beginning on or after Jan. 1, 2014. The IRS is also waiving the requirement to complete and file IRS Form 3115 for small business taxpayers who choose to use this simplified procedure for 2014.
If the simplified procedures are elected, the taxpayer will lose certain opportunities that might exist to write off assets capitalized in prior years and could have been expensed or to report a late partial disposition. Most family farmers will qualify to elect the simplified procedures, so it is important to carefully consider the benefits and risks associated with this alternative before you make your final decision.
To distinguish capital improvements from deductible repairs, first determine the unit of property to which you should apply the improvement rules. Generally, the larger the unit of property, the more likely the expenditure will be considered a deductible repair.
For buildings, the unit of property is usually the entire building; however, under the final regulations, the improvement analysis applies to the building structure and each of the key building systems—for example, plumbing, electrical and HVAC.
For equipment, the unit of property is—and the analysis applies to—all components that are functionally interdependent. For example, a tractor is a complete unit of property, but a combine and its header are separate units of property.
The regulations require capitalization for:
- Any amount paid for new buildings or for permanent improvements or betterments made to increase the value of property or real estate; or
- Any amount paid to restore property or make good the exhaustion thereof for which an allowance has been made.
The amounts paid to improve a unit of property generally must be capitalized. A unit of property is improved if the amount paid is for a betterment, restoration or adaptation to a new or different use.
Carefully consider how these changes will impact your accounting and tax preparedness decisions.
For additional guidance on tangible property regulations, including frequently asked questions, visit www.FarmJournal.com/repair_regs
This column is not a substitute for tax advice.