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IRS Issues Prop. Regs. on Capitalization of Improvements to Property

By Alistair M. Nevius, J.D.

Please note: This item is from our archives and was published in 2008. It is provided for historical reference. The content may be out of date and links may no longer function.

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The Service has issued proposed regulations under Sec. 263(a) that clarify the treatment of expenditures incurred in selling, acquiring, producing, or improving tangible assets (REG-168745-03). The new proposed regulations replace previous controversial proposed regulations that were issued in August 2006 and generated many comments from practitioners.

The proposed regulations wade into the issue of when an expense is a deductible repair or maintenance cost versus a capitalizable cost for improvement. The proposed regulations set forth factors to be used in determining whether an expenditure results in “a betterment or restoration” of the property, which would require the expense to be capitalized.

The prior proposed regulations defined a unit of property as “improved” if the costs paid materially increase the value of the unit of property or restore the unit of property. This treatment was criticized for not drawing enough of a bright line.

The new proposed regulations attempt to address that criticism by spelling out a new “betterment” standard for determining if there has been a material increase in value.

Under the new proposed regulations, taxpayers must capitalize amounts spent that

1. Result in a betterment to a unit of property;

2. Restore a unit of property; or

3. Adapt a unit of property to a new or different use.

The new proposed regulations also provide guidance on what is the proper unit of property to which to apply the “betterment or restoration” factors. The new unit-of-property rules are generally based on a “functional interdependence” standard, similar to that used for depreciation and Sec. 263A purposes.

The proposed regulations also provide a complicated de minimis rule under which certain small cost items can be deducted, and they provide a safe harbor for certain routine maintenance expenses (Prop. Regs. Sec. 1.263(a)-3). The de minimis rule will be discussed in the July 2008 Tax Clinic.

The new rules generally would apply after final regulations are issued. A public hearing has been scheduled for June 24.