Capitalized improvements vs. deductible repairs

Taxpayers generally must capitalize amounts paid to improve a unit of property. A unit of property is improved if the cost is made for (1) a betterment to the unit of property; (2) a restoration of the unit of property; or (3) an adaptation of the unit of property to a new or different use (Regs. Sec. 1.263(a)-3(d)).

Observation: The regulations do not provide bright-line tests for whether an expenditure results in a betterment, restoration, or adaptation to a different use. However, they do contain numerous detailed examples that should help practitioners make this determination.

Unit of property is an essential term and, except in the case of a building and its structural components, is defined as all components (real or personal property) that are functionally interdependent. Generally, components of property are functionally interdependent if the placing in service of one component is dependent on the placing in service of the other component (Regs. Sec. 1.263(a)-3(e)(3)(i)).For example, a computer and printer would not be functionally interdependent because either one could be placed in service and perform their intended function independently from the other.

If they are not required to be capitalized under the rules discussed in this section or any other provision (such as the UNICAP rules under Sec. 263A), amounts paid for repairs and maintenance can be deducted currently (Regs. Sec. 1.162-4(a)).

Buildings and building systems

Generally, each building and its structural components constitute the unit of property. If the taxpayer leases part of a building, the unit of property is the portion of the building subject to the lease along with the structural components associated with the leased portion (Regs. Sec. 1.263(a)-3(e)(2)). However, a cost must be capitalized if it results in an improvement to the building structure or to any of the specifically enumerated building systems. For this purpose, a building structure consists of the building (as defined in Regs. Sec. 1.48-1(e)(1)) and its structural components (as defined in Regs. Sec. 1.48-1(e)(2)), other than the structural components designated as building systems. Building systems include the heating, ventilation, and air conditioning (HVAC) systems; plumbing systems; electrical systems; escalators; elevators; fire protection, alarm, and security systems; gas distribution systems; and other systems identified in published guidance.

Example 1. Improvements to a building’s HVAC system: D LLC, an LLC classified as a partnership, owns an office building. The building’s HVAC system incorporates 10 roof-mounted units that service different parts of the building. The roof-mounted units are not connected and have separate controls and duct work that distribute the heated or cooled air to different spaces in the building’s interior. D has work performed on the roof-mounted units.

An expenditure improves a building if it results in an improvement to the building structure or any designated building system. The entire HVAC system, including the roof-mounted units and their components, makes up a building system. If the payment results in an improvement (for example, a betterment) to the HVAC system, D must treat this amount as an improvement to the building and capitalize the expenditure.

Observation: Although improvements to a building may have to be capitalized under Sec. 263, qualified real property (which includes qualified improvement property (as defined in Sec. 168(e)(6)) and improvements to a nonresidential building’s HVAC system, roof, and fire protection/alarm system and security system) may qualify for Sec. 179 expensing (Sec. 179(d)(1)(B)(ii)).

Routine maintenance

Amounts paid for regularly scheduled, routine maintenance on a unit of property, including inspection, cleaning, testing, replacement of parts, and other recurring activities performed to keep a unit of property in its ordinary efficient operating condition, need not be capitalized. While routine maintenance can be performed any time during the property’s useful life, there must be a reasonable expectation when the property is placed in service that the activities will be performed more than once during the property’s class life (more than once during a 10-year period in the case of buildings and their structural components).

Failure to actually perform the maintenance more than once is not fatal, provided that the taxpayer can substantiate that its expectation was reasonable when the property was placed in service. Factors to consider in determining whether a taxpayer’s expectation was reasonable include the recurring nature of the activity, industry practice, the manufacturer’s recommendations, and the taxpayer’s experience with similar or identical property (Regs. Sec. 1.263(a)-3(i)).

Small taxpayer exception for eligible building property

Qualifying small taxpayers can elect to deduct the cost of improvements made to eligible building property (Regs. Sec. 1.263(a)-3(h)). Qualifying small taxpayers have $10 million or less in average annual gross receipts for the three preceding tax years, and eligible building property includes a unit of property constituting a building, condominium, cooperative, or leased building or portion of a building with an unadjusted basis of $1 million or less. To be eligible for the exception, the total amount of repairs, maintenance, and improvements for the property for the tax year may not 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 spent during the tax year.

Costs for a betterment to property

Costs paid for a betterment to a unit of property must be capitalized. An amount is paid for a betterment when the cost (1) ameliorates a material condition or defect that existed before the taxpayer’s acquisition of the unit of property or arose during the production of the property; (2) is for a material addition to the unit of property; or (3) is reasonably expected to result in a material increase in the unit of property’s capacity, productivity, efficiency, strength, quality, or output (Regs. Sec. 1.263(a)-3(j)).

If an expenditure is necessitated by normal wear and tear or damage to the property, the determination of whether an expenditure is for a betterment is made by comparing the property’s condition immediately after the expenditure with its condition immediately before the circumstances necessitating the expenditure. If the expenditure is to correct the effects of normal wear and tear, the property’s condition immediately before the circumstances necessitating the expenditure is its condition after the last time the taxpayer corrected the effects of normal wear and tear (or, if the taxpayer has never corrected the effects of normal wear and tear, its condition when it was placed in service) (Regs. Sec. 1.263(a)-3(j)(2)(iv)).

Example 2. Roof repairs are not a betterment to a unit of property: M LLC owns a building that it uses for its retail business. M began to have leaks throughout the building due to wear to the roof membrane (top layer). M paid a contractor to replace the worn membrane with a new one that is comparable to the worn membrane when it was originally placed in service. The roof is part of the building structure. To determine whether the amount paid was for a betterment, M compares the structure’s condition when it was placed in service (since M has not previously corrected the effects of normal wear and tear) to its condition immediately after the expenditure. M need not treat the amount paid to replace the membrane as a betterment to the building structure because the work was not for a material addition or a material increase to the building’s productivity, efficiency, strength, or quality.

Costs to restore property

Taxpayers must capitalize amounts paid to restore a unit of property (Regs. Sec. 1.263(a)-3(k)). (See below for capitalization limits when amounts are paid to restore property after a casualty.) An amount restores a unit of property only if it:

1. Is for the replacement of a component of a unit of property that has been properly written off (other than a casualty) or sold;
2. Restores damage to a unit of property after a casualty event;
3. Returns a unit of property that had deteriorated to a state of disrepair (and can no longer be used for its intended purpose) to its ordinarily efficient operating condition;
4. Results in the rebuilding of the unit of property to a like-new condition after the end of its class life (that is, it is considered to be new, rebuilt, remanufactured, or has a similar status under a federal regulation or the manufacturer’s specifications); or
5. Replaces a part or a combination of parts that comprise a major component or substantial structural part of a unit of property.

The last situation requires the consideration of the facts and circumstances. For example, the replacement of a minor part, even one that affects the function of the unit of property, generally will not constitute a major component.

Example 3. Roof replacement as restoration: P LLC operates a retail clothing store. The company discovers several leaks in the roof and hires a contractor to inspect and fix it. The contractor determines that a major portion of the decking has rotted and recommends the replacement of the entire roof. The company has the contractor replace the entire roof. The roof is part of the building structure. Because it performs a discrete and central function, it comprises a major component and a substantial structural part of the building. Accordingly, under either analysis, the company must treat the amount paid to replace the roof as a restoration of the building that must be capitalized.

Example 4. Variation: Assume, instead, that the contractor recommends replacement of the waterproof rubber membrane that covers the roof decking. P pays the contractor to replace the membrane with a new one that is comparable to the original and corrects the leakage problem. Although the new membrane aids in the function of the building structure, it is not, by itself, a significant portion of the roof, nor is it a substantial structural part of the building. So, P is not required to capitalize the amount paid for the roof work as a restoration.

Restorations after a casualty

The amount that must be capitalized when amounts are paid to restore damage to a unit of property due to a casualty event (as described in Sec. 165) is limited to the excess (if any) of (Regs. Sec. 1.263(a)-3(k)(4)):

• The adjusted basis (before the casualty event) of the single, identifiable property damaged by the casualty, over
• The amount paid for restoration of damage to the property that also constitutes an improvement.

Costs to adapt the property to a new or different use

Taxpayers must capitalize amounts paid to adapt a unit of property to a new or different use. This occurs when the adaptation is not consistent with the taxpayer’s intended ordinary use of the property at the time it was originally placed in service (Regs. Sec. 1.263(a)-3(l)). An example would be the conversion of a manufacturing building into a showroom. The amounts paid to convert the manufacturing facility adapt the building structure to a new or different use because the new use is not consistent with the intended use of the building when it was placed in service. In that case, the amounts paid would have to be capitalized.

This case study has been adapted from PPC’s Guide to Limited Liability Companies, 26th edition (October 2020), by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, and Gregory A. Porcaro. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).