When businesses incur routine repair and maintenance costs, it stands to reason that the company would deduct those costs on its book basis profit and loss statement and on its tax return.
However, it’s not uncommon for businesses to incur substantial costs in the course of bettering their facilities or undergoing a business change (such as a rebranding campaign by a retail chain). These costs are often capitalized as assets by businesses for book purposes (since companies generally like to report as much net income as possible for book purposes) while the company would like to currently deduct as much as possible on their tax return.
When amounts are significant, distinguishing whether the cost is merely a repair as opposed to a capital expense for tax purposes could be subject to a wide variance of interpretation without reliable guidance by the IRS.
The U.S. Treasury and the IRS issued Temporary Regulations back in 2008 that provided guidance on amounts paid to improve tangible property (commonly referred to as the repair regulations). On December 23, 2011, those Temporary Regulations were withdrawn and new Regulations were issued which generally take effect for years beginning on or after January 1, 2012.
There will be new guidance issued by the IRS early in 2012, but in general, the new Regulations provide guidance for taxpayers to determine if they are able to currently deduct such costs, or if they must capitalize and depreciate the costs as described below.
Units of property
The rules in the Regulations for determining the proper unit of property for the most part are the same as the Proposed Regulations, including that a building and its structural components are a single unit of property. One significant change, however, is that the Regulations now provide that the tests to determine if property has been improved must also be applied to structural components of a building (for example a roof) and building systems. The Regulations define building systems to include:
- Heating, ventilation and air conditioning (HVAC) systems
- Plumbing systems
- Electrical systems
- Fire protection and alarm systems
- Security systems
- Gas distribution systems
The Regulations also provide rules for determining the unit of property in situations where property is leased and provide special rules for determining the treatment of tenant improvement costs.
Retail Reimaging and Betterments
The rules in the Regulations for determining whether amounts result in a betterment of a unit of property—and therefore would result in capitalization of costs—are basically the same as the Proposed Regulations. The Regulations specifically provide that an amount results in betterment to a building if it results in betterment to a structural component or a building system. The Regulations include more examples than were contained in the Proposed Regulations to illustrate the application of the betterment rules. Included in the examples are three fact situations involving costs incurred by retail stores that the Regulations label as:
- “Building refresh”
- “Building refresh” with “limited improvement”
- “Substantial remodel”
The examples conclude that:
- None of the building costs are required to be capitalized in the building refresh example
- Some of the building costs are required to be capitalized in the building refresh with limited improvement example
- All of the building costs are required to be capitalized in the substantial remodel example
These three examples illustrate the general rule in the Regulations that a determination of whether costs result in betterment depends on the facts and circumstances related to the costs. What these examples show is that it is difficult to make a determination of capitalization or current deduction with reviewing a company’s particular facts without advice by a qualified tax advisor.
The rules in the Regulations for determining whether an amount is paid to restore a unit of property, and therefore would result in capitalization of costs, specifically provided that an amount is paid to restore a building if it restores a structural component or a building system. Also, the regulations significantly change the rules in the Proposed Regulations for determining whether the costs result in a replacement of a major component or a substantial structural part of a unit of property. The Proposed Regulations defined replacement of a major component or substantial structural part to mean either:
- Costs that comprise 50 percent or more of the replacement costs of the unit of property, or
- Replacement of 50 percent or more of the physical structure of the unit of property
The Regulations instead provide a facts and circumstances test for determining whether a major component or substantial structural part is replaced. The Regulations also provide that a major component or substantial structural part includes:
- “A large portion” of the physical structure of the unit of property, or
- A part or combination of parts that perform a discrete and critical function in the operation of the unit of property that is more than “a minor component”
The Regulations contain more examples than the Proposed Regulations to illustrate the rules. Included are examples of costs related to the structural components of a roof, roof membrane, HVAC system, fire protection system, electrical system, plumbing system, windows and floors. The examples illustrate that the determination of whether costs are required to be capitalized depends on the nature and extent of the costs relative to the property.
Routine Maintenance Safe Harbor
The Regulations provide a routine maintenance safe harbor rule. If, at the time the unit of property is placed in service, it is reasonably expected that the maintenance activities will be performed more than once during the class life of the unit of property, the maintenance is deemed not to improve the unit of property (thus, the amount can be immediately expensed). The Regulations, however, specifically provide that the safe harbor does not apply to work performed on buildings.
The essence of these regulations is fairly simple. If a company incurs minor routing costs for repair and maintenance, they should deduct those costs on their profit and loss statement and on their tax return. If the costs are significant and/or non-recurring, the company should thoroughly assess the tax treatment of those costs by reviewing the new final Regulations and applying them to the facts of the company’s expenditures. Better yet, a qualified tax advisor should review the case and provide guidance to the company.Written by: Steve Arman TGG Accounting