Repair, replace [or not] ... for maximum tax savings

The tax write-offs for repairs, improvements or adapting property or equipment to another use have long been an issue with the IRS. The tax rules are pretty cut and dried when it comes to expenditures for repairs, replacements, improvements or routine maintenance. It is the actual definition of each activity that causes the problem in most cases.

The tax rules allow a green industry business to deduct all the “ordinary and necessary” expenses incurred during the year, including the cost of repairs, maintenance, supplies and the like. Another tax rule requires the costs of acquiring, producing and improving equipment or other property, regardless of the amount of the cost, be capitalized — and written off only over a period of years.

Defining the difference

In the past, unless the property or equipment was old, the answer to the question of whether to repair or replace was usually to repair. Today, technological and functional obsolescence can occur within 10 years or less and the question grew more complicated for everyone. When the IRS began labeling many repairs as improvements deductible only over several tax years and accelerated depreciation write-offs entered the picture, the answer became more difficult.

The IRS’s usual definition of a repair is an expenditure that keeps the property in normal operating condition. A capital improvement, on the other hand, is defined as an expense that either extends the useful life of the property and allows it to perform a new function.

When attempting to figure the difference between immediately deductible repairs and those improvements that should be written-off over a number of years, the general rule of thumb is: an improvement is work that prolongs the life of the equipment or property, enhances its use or adapts it to a different use. A repair, on the other hand, merely keeps that property or equipment in efficient operating condition. But then, there is routine maintenance.

Routine maintenance

Expenditures for regularly scheduled, routine maintenance on property or equipment, including inspection, cleaning, testing, replacement of parts and other recurring activities performed to keep that property or equipment in its ordinary efficient operating condition don’t, according to the rules, must be capitalized.

Of course, while routine maintenance can be performed any time during the property or equipment’s useful life, there must be a reasonable expectation when the property is first placed in service that the maintenance activities will be performed one or more times during its useful life. Failure to actually perform the maintenance more than once is not fatal — provided the business owner can substantiate that its expectation was reasonable when the property or equipment was first placed in service.

Factors to consider when determining the expectation was reasonable include the recurring nature of the activity, practices within the industry, the manufacturer’s recommendations and the operation’s own experience with similar or identical property or equipment.

Belaboring the obvious

Quite simply, a green industry business can take tax deductions for certain expenses in the same year they are made by labeling them “current expenses.” For other expenses, those so-called “capital expenses,” the business must break up the deduction and take a portion of the total cost over a number of years.

A capital improvement is a permanent structural alteration or repair to equipment or property that substantially improves it, thereby increasing its overall value. This can involve updating the property or equipment to suit new needs or extending its life. But, again, basic maintenance and repairs are not considered capital improvements.

A repair is essentially maintenance that brings the property or equipment back to working condition but doesn’t improve its condition beyond the quality or usefulness that existed before the work was done. Just to confuse things, it should be noted that, according to the IRS, while painting is usually not considered a capital improvement, it must be capitalized if it is part of a large-scale improvement plan.

Fortunately, the tax rules contain a relatively new de minimis safe harbor for expenditures that would ordinarily have to be capitalized. Instead of capitalizing and depreciating many of those expenditures, taking advantage of bonus depreciation or the Section 179 election to expense, many otherwise costs ordinarily capitalized, can simply be expensed thanks to any one of the tax law’s so-called “safe harbors.”

Safe harbors

The tax regulations allow purchases of either materials or supplies for use in the wholesale nursery that cost less than $200 to be treated as currently tax deductible. The deduction for materials and supplies is available in the tax year when the item is used or consumed so long as it has a useful economic life of less than 12 months.

Also, in the tax rules is a unique “safe harbor” for amounts paid to acquire or produce tangible property. The so-called “de minimis safe harbor” is available to wholesale nurseries that do not have an “Applicable Financial Statement” allowing them to immediately expense expenditures or less than $2,500 per invoice.

For those operations that do have an “Applicable Financial Statement” (generally an audited financial statement), the threshold is increased to $5,000 per invoice — regardless of whether the expenditure meets the definition of a capitalized expense or not. Best of all, the de minimis safe harbor is available without the necessity of changing the operation’s accounting methods.

Not strictly a safe harbor, the tax rules allow amounts paid for routine and recurring maintenance to keep property in working condition to be treated as repair costs. In order to use the “Routine Maintenance Safe Harbor,” the business should segregate amounts paid for real estate and other property. If the expenditure is paid to maintain real estate, the amount can be expensed so long as it is expected the repair will occur more than once during a 10-year period. If the amount is paid to maintain other property, the amount can be expensed so long as it is expected to occur more than once during the property’s useful life.

When an immediate write-off won’t help

Immediate write-offs, whether labeled as repairs, maintenance or accelerated depreciation, are not of much use to any business without taxable profits from which to deduct them. After all, very few companies will actually benefit from more losses.

Many small businesses can elect to deduct the cost of what would otherwise be capital improvements as expenses. That’s right: the operation is not required to capitalize as an improvement, and therefore may be permitted to deduct the cost of work, such as repairs, maintenance, improvements or similar costs, performed under the safe harbor for small taxpayers.

By expensing an expenditure, the operation ends up paying less tax because expenses are reported immediately (in the tax year when purchased). Capitalizing has the opposite effect on the tax bill.

To qualify, the business must have had less than $10 million in average annual gross receipts for the three preceding tax years. To be eligible for the safe harbor, the total amount of repairs, maintenance and improvements for the year cannot exceed the lesser of $10,000 or 2% of the property’s unadjusted basis. If the total amount paid exceeds the safe harbor threshold, the safe harbor does not apply to any amounts during the tax year.

Follow the accountant

• The tax rules allow a green industry business to follow the financial accounting policies when it comes to choosing to capitalize repair and maintenance expenses as improvements — so long as they are treated as such for accounting purposes. The business owner can choose to treat repair and maintenance costs paid during the tax year as amounts paid to improve property if:
• Those amounts were paid in carrying on a trade or business, and
• The amounts are treated as capital expenditures on the operation’s books and records
• The election to capitalize is made for each taxable year in which qualifying amounts of repair and maintenance costs are a factor on the tax return.

Once again, this annual election is not a change in the method of accounting.

To capitalize or not

Capitalizing means treating the cost under the belief that benefits will be derived over the long run, whereas expensing a cost implies the benefits are short-lived. Whether an item is capitalized or expensed usually comes down to its useful life, i.e., the estimated amount of time that benefit is anticipated to be received. And, who better to estimate than the small business owner?

It is the owner or manager that has the discretion of determining if expenditures should be capitalized and depreciated over time or whether the cost should be fully expensed and deducted in the current tax year.

Keep in mind that some costs cannot be capitalized, such as maintenance plans and warranties, software licenses, training costs, operating supplies and consumables. The decision to deduct or capitalize requires professional help.

Mark Battersby is a financial writer and resides in Ardmore, Pennsylvania.