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Repair or Capital Improvement? Finally, Some Guidance


Recent Regulations and Revenue Procedures issued by the IRS provide guidance on whether an expenditure is a capital improvement, subject to depreciation over a number of years for tax purposes, or a repair, a current period deduction for taxes.  Additionally, the Regulations allow taxpayers to deduct the unrecovered cost of certain building components (roofing, HVAC, etc.) when they are replaced.

Temp. Reg. 1.263(a)-3T(d) requires the capitalization of costs that “improve” a piece of property.  For these purposes, an “improvement” is defined as a betterment or restoration to the property, or if the property is adapted to a new or different use.  However, there are two exceptions to the capitalization rules: the de minimis rule, and the routine maintenance safe harbor.  The de minimis rule allows a taxpayer to currently deduct costs that would otherwise be capitalized, subject to certain limitations.  In order to utilize the de minimis rule for taxes, taxpayers need to have an applicable financial statement (AFS), have a written accounting policy that requires expensing of items that cost no more than a specified dollar amount for book purposes, and apply that policy for book purposes.  Routine maintenance costs are exempt from the capitalization requirement, and are defined as the costs that a taxpayer expects to perform more than once during the property’s useful life as a result of the taxpayer’s use of the unit to keep it in its ordinarily efficient operating condition.

For building owners, there is a significant opportunity to accelerate deductions contained within the new rules.  Under the old rules, when a structural component of a building was replaced, the taxpayer was not allowed to write-off the remaining value.  Rather, they were forced to depreciate the unrecovered cost of the disposed property over the IRS-determined remaining useful life.  Under the new rules, taxpayers are allowed to write-off the costs for which they have not previous claimed a deduction when the property is replaced.

For example, a taxpayer places a $500,000 HVAC system in place in Year 1.  In Year 5, after claiming depreciation deductions of $64,100, the HVAC system is replaced by a more energy efficient system for an additional $500,000.  Under the old rules, the taxpayer would continue to depreciate the old HVAC system over the remaining life of 34 years.  Under the new rules, the taxpayer would be able to claim an additional deduction in Year 5 for $435,900.

Contained within the Revenue Procedures are provisions that allow a taxpayer to retroactively change their method of accounting and claim a deduction for previously disposed building components.