IRS clarifies capital improvement vs repair expense?

By: Thomas R. Tartaglia, CPA (Mar, 2012)

You may often find yourself asking the question "How do I distinguish a capital purchase from a repair expense"? There has been much debate and controversy not to mention a number of court cases regarding whether, or to what extent, the amounts paid to restore or improve property are capital expenditures or deductible ordinary and necessary repair and maintenance expenses. Well, on December 23, 2011 the IRS provided guidance to help us answer this question by issuing temporary and proposed regulations (T.D 9564; REG-168745-03). These regulations are effective on January 1, 2012 and provide some "bright-line" tests to clarify what is capital as opposed to what would be considered a repair and routine maintenance.

General Principle of Capitalization:

The IRS indicates what constitutes a real property capital improvement as follows:

  • Fixing a defect or design flaw
  • Creating an addition, physical enlargement or expansion
  • Creating an increase in capacity, productivity or efficiency
  • Rebuilding property after the end of its economic useful life
  • Replacing a major component or structural part of the property
  • Adapting property to a new or different use

The proposed regulations require capitalization of amounts paid to acquire, produce, or improve tangible real and personal property, including amounts paid to facilitate (closing costs) the acquisition of tangible property. Amounts paid to repair and main property and equipment are deductable if those amounts are not required to be capitalized under §1.263(a)-3, which states in part that any amounts paid for permanent improvements or betterments made to increase the value of such property must be capitalized. Under the proposed regulations these improvement standards are applied to the building itself and individually to its structural components such as heating and ventilation, plumbing, electrical, fire protection and security systems and escalators and elevators. Also the new regulations will allow the dispositions of component parts of a building resulting in the recognition of a gain or loss upon the retirement of such component.

The proposed regulation also provides a "safe harbor" for routine maintenance. It indicates that recurring activities (inspection, cleaning, testing, replacing parts, and so on) that are expected to be performed as a result of the use of property to keep the property in its ordinarily operating condition aren't capital improvements. The activity is considered routine if, at the time the property was placed in service, the taxpayer reasonably expected to perform the activity more than once during the property's life.

The following table summarizes many of the factual considerations used by the courts. These factors, although not exhaustive, should be considered in your analysis to distinguish between capital expenditures and deductible repairs.

Capital Repair
Improvements that "put" property in a better operating condition Improvements that "keep" property in efficient operating condition
Restores the property to a "like new" condition Restores the property to its previous condition
Addition of new or replacement components or material sub-components to property Protects the underlying property through routine maintenance
Addition of upgrades or modifications to property Incidental Repair to property
Enhances the value of the property in the nature of a betterment  
Extends the useful life of the property  
Improves the efficiency of the property  
Improves the quality of the property  
Increases the strength of the property  
Increases the capacity of the property  
Ameliorates a material condition or defec  
Adapts the property to a new use  
Plan of Rehabilitation Doctrine  

The new regulations also address amounts paid to acquire or produce tangible property under §1.263(a)-2T, this section contains a de minimis rule. Under the proposed de minimis rule, a taxpayer is not required to capitalize amounts paid for the acquisition or production (including any amounts paid to facilitate the acquisition or production) of a unit of property if:

  1. The taxpayer had an applicable financial statement (AFS) as defined in the regulation;
  2. The taxpayer had, at the beginning of the taxable year, written accounting procedures treating as an expense for non-tax purposes the amounts paid for property costing less than a certain dollar amount;
  3. The taxpayer treated the amounts paid during the taxable year as an expense on its AFS in accordance with its written accounting procedures; and
  4. The total aggregate of amounts paid and not capitalized for the taxable year under this provision did not distort the taxpayer's income for the taxable year (the "no distortion requirement"). The aggregate of amounts paid and not capitalized must be less than or equal to the greater of 0.1% of the taxpayer's gross receipts for the taxable year or 2.0% of the taxpayer's total AFS depreciation and amortization for the taxable year.

These temporary and proposed regulations are very complex and must be applied using individual facts and circumstances. Please contact the tax professionals at Dermody, Burke and Brown CPAs with any questions you have regarding the new regulations.

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