Changes in federal tax regulations will impact how dairy farmers deduct repairs and maintenance. Does your CPA know about these changes?
In the past, it was unclear as to what constituted a repair expense and what should be capitalized. The new regulations issued in January of 2014 eliminate confusion and can actually allow taxpayers to deduct significant expenditures as repair and maintenance expenses.
Let’s take a closer look at how the new regulations will impact your farm.
Three types of expendituresthat must be capitalized
The regulation, 1.263(a)-3(n), identifies three types of expenditures that must be capitalized. Expenses that improve a piece of equipment or a building must be capitalized. An example would be buying improved milking technology or a larger storage capacity. These expenditures cannot be expensed unless they are capitalized and written off as a Section 179 expense.
The second type of capitalized expense is one that adapts a piece of equipment for a new use, such as converting an old silage wagon to a hay wagon or adding a cab or rollover protection to a tractor.
The last type of expense that must be capitalized is expenses incurred in restoring a piece of equipment. The regulations differentiate between those repairs needed to keep a piece of equipment in normal operating condition and those that are incurred to restore a piece of equipment that was not previously operational. The regulations are clear that repairs (in order to be deductible) must result from operation of the machine by the farmer.
If a farmer buys a piece of equipment and fixes it up so it can be used, that is a restoration and those expenses must be capitalized along with the purchase price of the tractor. This includes body repairs and painting expenses. If a farmer had a plow that had been sitting in a fencerow for several years and required expenditures to put it in operating condition, then those expenses would have to be capitalized.
What determines the deduction?
The good news is: Deductibility does not depend on how much the expense is. The determining factor is the purpose of the repair. If a repair is needed to keep a tractor or combine in normal operating condition, then it is deductible if the repair resulted from the tractor’s use.
The regulations specify that any repair which could have been anticipated to occur twice over the useful life of the equipment at the time it was acquired makes an expense deductible. An example would be if a piece of equipment used in the dairy barn required periodic maintenance to keep it in normal operating condition.
Those expenses would be deductible as repair and maintenance expenses, regardless of the amount of those repairs. Another example might involve having planter units serviced to keep them in operating condition.
Keep in mind that the useful life for most farm machinery is seven years. Electronic equipment is written off over five years. Tractor units for over-the-road use are written off over three years. It does not matter whether the piece of equipment is expensed in the year of acquisition or depreciated over its useful life; the rules assume that the piece of equipment is depreciated over its useful life.
A few additional considerations about the regulations
For most farmers, repairs on buildings (those with prior three years’ gross revenue under $10 million and whose buildings have an adjusted basis of less that $10 million) also have a safe harbor.
Repairs and improvements that do not exceed the lesser of 2 percent of the buildings’ original cost or $10,000 are deductible in the current year. Those that exceed that amount need to be capitalized and written off over the buildings’ useful life. This election is called the Small Building Safe Harbor under regulation 1.263(a)-3(h).
If you replace a component of a building (such as a roof or barn doors) and the original purchase had not been totally written off through depreciation, then the farmer is allowed to calculate what portion of the original purchase price represented the original replaced component and write that component off as if it was scrapped.
This deduction reduces the original basis of the building and depreciation previously taken and is written off on Form 4797. The logic is: You should not be depreciating two roofs on the same building at the same time. This could accelerate the deduction for the portion of the building that is being replaced and reduce taxable income.
The Internal Revenue Service considers these changes as a change in accounting method. Even though they are mandatory changes required by the IRS, the original regulations required that taxpayers make the election on their 2014 tax return and file a form 3115 with their returns.
Taxpayers are usually required to pay for permission to change their accounting method, but since the IRS is requiring the change, they are graciously waiving the fee. Taxpayers are also required to review their tax returns to see if any replaced items are still being depreciated. If so, they were allowed to take the deduction on their 2014 tax return. This deduction is called a Section 481 deduction and must be specified on Form 3115.
The IRS, after realizing the burdensome requirements of the regulations, issued revenue ruling 2014-20, which allowed taxpayers to make the elections on their 2014 tax return and not be required to file Form 3115. The regulation also eliminates the requirement that taxpayers make the Section 481 deduction and gave them audit protection for years preceding 2011.
Therefore, if a taxpayer is audited after April 15, 2015, and the auditor determines that an item being depreciated should have been written off as an expense, the auditor could have disallowed current and future depreciation but not disallow the original deduction because the time had passed to file for a refund.
Taxpayers can only amend their returns to receive refunds due for three years after the due date of the original tax return. It would still be necessary to review 2012 and 2013 to ensure the repairs regulations have been followed and amend tax returns if necessary.
What you shouldconsider doing next
If you have already filed your tax return and have not made the required elections, you can file a superseding tax return. To do this, you must file a form 1040X with the words “superseding” written at the top of the first page.
The 1040X does not require that you put any information in the body of the form unless changes occur in the calculations, but you must attach the original return and the required elections. This can be done until the extended due date of the return (Oct. 15 for most calendar-year taxpayers).
In summary, changes in how repairs and maintenance expenses are deducted affect every farmer. They are not elective but are required. The regulations even indicate that tax preparers are not to file tax returns that do not follow the new regulations.
For many farmers, the new regulations will allow larger expense deductions than were allowed in the past, but regardless, they must be followed. Not making the election in 2014 will require the taxpayer to file for a 3115 in subsequent years to make the election.
The user fee to file that form could be as high as $7,000. If you did not consider these regulations when you filed your original return, you should contact a tax preparer to make sure you do not end up filing a noncompliant tax return. If you did not make the election, the IRS may view it as a “red flag” and review your return. PD
Readers should not act upon the presented content or information without first seeking appropriate professional advice.
Jeff Baker is a CPA and certified financial planner. He is headquartered in Newburgh, Indiana.
Jeff Baker
Owner
Baker Retirement and Wealth Management
