Business and real estate owners may be missing a valuable opportunity to accelerate deductions to offset current income. Manufacturers with large capital expenditures, retailers who frequently remodel their sales floors, dealerships that refurbish showrooms to enhance the customer’s buying experience, hotels that periodically refresh their premises, restaurants that reimage their dining rooms, and real estate owners who incur costs to keep their properties in good operating condition may be overpaying their current taxes because they misclassify deductible repairs and maintenance expense as capital improvements.
Business owners frequently misclassify deductible repairs and maintenance
Misclassification occurs because the tax rules are confusing. As a result of losing a number of important court decisions permitting generous deductions for certain repairs, the IRS has acknowledged that the rules have changed and has issued two sets of proposed regulations that simplify the rules and provide a number of bright line tests. Although the proposed regulations are not effective at the present time, business owners can use the principles espoused in those regulations because they are based on existing case law and published IRS rulings.
The overall effect of the cases and ruling (discussed below) is that expenditures related to maintenance and repair of assets may be currently deductible no matter how significant, extensive, or costly, and even if required by government authorities to continue operating the asset. However, to be deductible, the expenditure must not adapt the asset to a new or different use, substantially prolong its useful life, or materially add to the value of the asset (based on a comparison of the value of the asset before the repair was needed with the value of the asset after the repair). Surprisingly, in cases in which an event necessitates an expenditure, the determination of whether the amount paid results in the property’s improvement is made by comparing the property’s condition immediately after the expenditure with the property’s condition immediately prior to the event necessitating the expenditure.
How to take advantage of this opportunity
Generally, you need to work with a CPA firm that specializes in the careful analysis and application of the rules and proposed regulations governing repairs and maintenance. The advisor must understand the complex web of rules that determine when an expenditure may be deducted as a repair and maintenance expense . Essentially, the CPA will conduct a thorough review of your current capitalization policies and determine whether there is an opportunity to accelerate repairs and maintenance deductions. In addition, he or she will review previous year’s tax returns to determine if you qualify for a retroactive accounting method change. If you qualify for a retroactive accounting method change, you will be able to claim a deduction in the current year for repairs and maintenance that you erroneously capitalized in previous year.
Act now – this opportunity may be limited in the future
This opportunity currently relates to the current and all prior tax years. However, you need to act quickly since the IRS may limit the opportunity to “catch up” for prior years. In recent years, the IRS has begun to limit certain accounting method changes to apply on a prospective or cut-off basis.
Repair expenses versus capitalized costs – Technical Overview
An expenditure that creates additional life or increased value for an asset generally may not be claimed as a deduction in the year paid and must be capitalized and depreciated over the appropriate Modified Accelerate Cost Recovery System (MACRS) life. However, expenditures necessary to maintain equipment in an efficient operating condition are currently deductible as incidental repairs under §162. The determination as to whether a cost will be classified as a capital addition or an expense is based on the particular facts and circumstances.
Proposed regulations that will be effective when finalized provide guidance on the treatment of amounts paid to repair, improve, and rehabilitate tangible property. See discussion of proposed regulations below.
In the Ingram Industries, TC Memo 2000-323 (10/18/00) and FedEx Corporation,95 AFTR 2d 2005-1105 (2/16/2005) cases and Rev. Rul. 2001-4, 2001-1 CB 295 (12/22/00) the taxpayers were permitted to deduct major repairs made to heavy equipment that previously would have been required to be capitalized.
In Ingram Industries, Inc., the Tax Court allowed a current deduction for the cost of overhauling the taxpayer’s towboat engines. The court stated that the engine overhauls did not adapt the engines for a new or different use. The Court also found that the useful life of the engines was not appreciably prolonged. In this case completely serviceable engines were torn down, inspected part by part, cleaned, and only those parts in need of replacement were changed. This differed from a disabled engine that must be replaced or overhauled to be operational. The court held that the work performed by the taxpayer constituted routine preventive maintenance that did not extend the expected 40-year service life of the boat or engine. The fact that each procedure cost in the neighborhood of $100,000 was immaterial, particularly in light of the fact that a new or rebuilt engine would cost between $800,000 and $1 million.
In FedEx Corporation, the 6th Circuit Court of Appeals upheld a lower court decision allowing FedEx (an air freight carrier) to deduct currently as incidental repairs (rather than capitalizing) the costs of off-wing engine shop visits after the aircraft engines and auxiliary power units (APUs) were removed from the aircraft and repaired by third-party vendors. This case established two important positions. First, in identifying the appropriate unit of property for determining if an expense extends the life or increases the value of an asset, the courts consider whether the taxpayer and its industry treat the component part as part of a larger unit for regulatory, market, management, or accounting purposes; whether the economic useful life of the component part is coextensive with the economic useful life of the larger unit; whether the larger and smaller unit can function without each other; and whether the smaller unit can be and is maintained while affixed to the larger unit. Under this analysis, the court held that the determination of whether the expenses in question were repairs was a function of whether they extended the life of the larger unit—the airplane—not the engines or APUs. Secondly, the court found that the magnitude of an expense does not have any bearing on whether it is deemed an “incidental repair.” The only factors to be used in the determination were whether the expenses materially added to the value of the property, appreciably prolonged the life of the property, or adapted the property to a new or different use.
In Rev. Rul. 2001-4, the IRS allowed a current deduction to a commercial airline for an FAA-required heavy maintenance program. The program required extensive disassembly of the airframe, thorough inspection of numerous parts, and repair or replacement of those parts no longer in acceptable condition. The taxpayer also used this period for other preventive maintenance and to implement outstanding service bulletins issued by the manufacturer and the FAA. The IRS ruled that the maintenance program did not appreciably prolong the useful life of the aircraft, materially increase its value, or adapt it to a new or different use. The program merely kept the airframe in an ordinarily efficient operating condition over its anticipated useful life. The fact that the taxpayer was required to perform the work to maintain its airworthiness certificate did not affect this determination. Significantly, Rev. Rul. 2001-4 concluded that the costs of the regular maintenance visits were not part of a “plan of rehabilitation” – rather, such costs only “keep property in an ordinarily efficient operating condition.”
Note that the IRS cited Ingram Industries as a significant authority for its holding in Rev. Rul. 2001-4 two months after the Ingram opinion was issued, but then denied FedEx’s claim shortly thereafter.
The overall effect of the cases and ruling is that expenditures related to maintenance and repair of assets may be currently deductible no matter how significant, extensive, or costly, and even if required by government authorities to continue operating the asset. However, to be deductible, the expenditure must not adapt the asset to a new or different use, substantially prolong its useful life, or materially add to the value of the asset (based on a comparison of the value of the asset before the repair was needed with the value of the asset after the repair). Surprisingly, in cases in which an event necessitates expenditure, the determination of whether the amount paid results in the property’s improvement is made by comparing the property’s condition immediately after the expenditure with the property’s condition immediately prior to the event necessitating the expenditure.
In Plainfield-Union Water Company, 39 TC 333 (1962), nonacq. the IRS argued that the taxpayer’s costs for the cleaning and lining of water pipes were not deductible because the repairs increased the useful life, the value, and the capacity of the pipes. The Tax Court determined that the cost of the repairs did not increase the value, the useful life, or the capacity of the pipes, and ruled in favor of the taxpayer. It held that an expenditure which returns property to the state it was in before the situation prompting the expenditure arose, and which does not make the relevant property more valuable, more useful, or longer-lived is usually deemed a deductible repair. In addition, the Plainfield-Union court focused on comparing the condition of the property from one repaired state to the next repaired state to determine if there was an increase in the value of the repaired property. In FedEx, the court used the Plainfield-Union test to measure whether the property has met the increase in value test (i.e., since the expenses at best restored the engine to its previous freshly maintained condition, the overhaul did not materially increase the value or appreciably prolong the life of the aircraft or engines).
The Supreme Court’s decision in INDOPCO, Inc, 69 AFTR 2d 92-694 (2/26/1992), required the capitalization of certain expenditures that created significant benefits extending beyond the current year. In Rev. Rul. 94-12, 1994-1 CB 36, (2/21/1994), the IRS has concluded that INDOPCO, Inc. does not affect the deductibility of incidental repair costs as trade or business expenses. However, the ruling reiterated the Service’s position that amounts expended under a general plan of rehabilitation must be capitalized. This was true even though a portion of those expenses, standing alone, would otherwise be currently deductible. The ruling also reaffirms Regulations 1.263(a)-1(b), which requires capitalization (and subsequent depreciation) of any expenditure that materially adds to a property’s value, substantially prolongs its life, or adapts it to a different use.
The preamble to the Proposed Regulations (discussed below) confirm that when the new proposed regulations are finalized, the judicially-created plan of rehabilitation doctrine will be obsolete, particularly with regard to the assertion that the doctrine transform otherwise deductible repair costs into capital improvement costs solely because the repairs are performed at the same time as an improvement, or are pursuant to a maintenance plan, even though the repairs do not improve the property under §1.263(a)-3. The IRS had begun to move away from a strict interpretation of the plan of rehabilitation doctrine beginning with Rev. Rul. 2001-4 (see Situation 2).
2008 Second Set of Proposed Regulations
In 2006, the IRS and Treasury issued proposed regulations under §263(a) relating to amounts paid to acquire, produce, or improve tangible property. These regulations widely criticized and the IRS recognized a number of shortcomings. As a result, in 2008, the IRS and Treasury withdrew the 2006 regulations and replaced them with new proposed regulations that will apply to tax years beginning on or after the date the proposed regulations are published in final form.
Specifically, Proposed Regulations § 1.263(a)-3 provides:
- Rules for determining the appropriate unit of property to which the improvement provisions apply;
- General rules for taxing improvements;
- Rules for determining whether an amount materially increases the value of the unit of property;
- Rules for determining whether an amount paid restores the unit of property; and
- An optional repair allowance method.
The proposed regulations generally provide that no deduction is allowed for amounts paid for (a) new buildings, (b) permanent improvements or betterments made to increase the value of any property or estate, (c) restoring property, or (d) making good the exhaustion of property that has been depreciated, amortized, or depleted [Proposed Regulations §1.263(a)-1(a) and (c) and §1.263(a)-2(d)(2) and (3)].
Transaction costs to facilitate the acquisition of real or personal property, including shipping costs, bidding costs, sales and transfer taxes, legal and accounting fees, title fees, engineering fees, survey costs, inspection costs, appraisal fees, recording fees, application fees, commissions, and compensation paid to a qualified intermediary or facilitator in a §1031 exchange.
Unless a taxpayer is in a regulated industry and elects to use the optional regulatory method under Proposed Regulations §1.263(a)-3(i) or elects to use the repair allowance method (RAM), it would have to capitalize amounts paid to improve a unit of property, with improvement defined as the betterment or restoration of a unit of property [Proposed Regulations §1.263(a)-3(d)]. An improvement also includes a payment to adapt a unit of property to a new or different use. The smaller the unit of property, the more likely that amounts paid in connection with that unit would be treated as an expense that must be capitalized.
The proposed regulations provide rules for determining an appropriate unit of property in Proposed Regulations §1.263(a)-3(d)(2). These rules generally provide that a building and its structural components are a single unit of property. In the case of leasehold improvements made by a lessee that are not §1250 property, the leasehold improvements are a separate unit of property. In the case of a taxpayer that owns or occupies an individual unit in a building with multiple units (such as a condominium), the unit of property is the individual unit owned or occupied by the taxpayer.
For other tangible property, the threshold test in the unit-of-property determination would be to identify components that are functionally interdependent (i.e., placing one component in service is dependent on placing another component in service). However, a number of special rules are provided in the proposed regulations for buildings, plant property, and network assets that may require a smaller unit of property to be considered.
Under a de minimis rule, a taxpayer is not required to capitalize amounts paid for the acquisition or production of a unit of property if all of the following requirements are met [Proposed Regulations §1.263(a)-2(d)(4)]:
- The taxpayer has an applicable financial statement [an applicable financial statement generally is any financial statement required to be filed with the SEC; a certified financial statement accompanied by an auditor’s report that is used for credit purposes, reporting to owners, or any other substantial nontax purpose; or a financial statement (other than a tax return) required to be provided to the federal or a state government or any federal or state agencies (other than the SEC or the IRS).
- The taxpayer has, at the beginning of the tax year, written accounting procedures treating the amounts paid for property costing less than a certain dollar amount as an expense for nontax purposes.
- The taxpayer treats the amounts paid during the tax year as an expense on its applicable financial statement in accordance with its written accounting procedures.
- The total aggregate of amounts paid and not capitalized under these provisions for the tax year do not distort the taxpayer’s income for the tax year. The expensing of items does not distort the taxpayer’s income if the amount expensed, when added to the amount the taxpayer deducts in the tax year as materials and supplies, is less than or equal to the lesser of (1) .1% of the taxpayer’s gross receipts for the tax year or (2) 2% of the taxpayer’s total depreciation and amortization expense for the tax year reported on its applicable financial statement.
The proposed regulations provide exceptions to the de minimis rule for amounts paid (a) to improve property; (b) for property that is, or is intended to be, included in property produced or acquired for resale; and (c) for land.
Amounts paid to acquire or produce materials and supplies are deductible in the tax year in which the materials and supplies are used or consumed in the taxpayer’s operations [Proposed Regulations §1.162-3(a)]. Amounts paid for incidental materials and supplies that are carried on hand and for which no record of consumption is kept or physical inventories at the beginning and end of the year are not taken, are deductible in the tax year in which these amounts are paid, provided taxable income is clearly reflected. Materials and supplies means tangible property used or consumed in the taxpayer’s operations that (a) is not a unit of property and is not acquired as part of a single unit of property; (b) is a unit of property that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer’s operations; (c) is a unit of property that has an acquisition cost or production cost of $100 or less; or (d) is identified in published guidance in the Federal Register or Internal Revenue Bulletin as qualifying materials and supplies.
Under this provision, a unit of property’s economic useful life is its useful life initially assigned by the taxpayer for purposes of determining depreciation in its applicable financial statement.
A safe harbor exists for amounts paid for routine maintenance that are deemed not to improve a unit of property [Proposed Regulations §1.263(a)-3(e)]. Routine maintenance is the recurring activities that a taxpayer expects to perform to keep the unit of property in its ordinary efficient operating condition. Examples include the inspection, cleaning, and testing of the property and the replacement of parts with comparable and commercially available and reasonable parts. The activities are routine only if, at the time the property is placed in service, the taxpayer reasonably expects to perform the activities more than once during the unit of property’s class life. Among the factors to be considered in determining whether an expense is for routine maintenance are the recurring nature of the activity, industry practice, manufacturers’ recommendations, the taxpayer’s experience, and the taxpayer’s treatment of the activity on its applicable financial statement.
Routine maintenance does not include amounts paid (a) for the replacement of a component if the taxpayer has properly deducted a loss for the component (other than a casualty loss), (b) for the replacement of a component if the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component, (c) for the repair of damage to a unit of property for which the taxpayer has taken a basis adjustment as a result of a casualty loss, and (d) to return a unit of property to its former ordinarily efficient operating condition, if the property has deteriorated to a state of disrepair and is no longer functional for its intended use.
An amount provides a betterment to a unit of property and must be capitalized under Proposed Regulations §1.263(a)-3(f) if it:
- Improves a condition or defect that existed before the acquisition of the unit of property or arose during the production of the unit of property, whether the taxpayer was aware of the condition or defect when the property was acquired or produced;
- Results in a material addition to the unit of property (including a physical enlargement, expansion, or extension); or
- Results in a material increase in the capacity, productivity, efficiency, strength, or quality of the unit of property, or its output.
In cases in which an event necessitates an expenditure, the determination of whether the amount paid results in the property’s betterment is made by comparing the property’s condition immediately after the expenditure with the property’s condition immediately prior to the event necessitating the expenditure.
A taxpayer must capitalize amounts paid to restore a unit of property. An amount is paid to restore a unit of property under Proposed Regulations §1.263(a)-3(g) if the expense:
- Is for the replacement of a component of a unit of property and the taxpayer has properly deducted a loss for that component (other than a casualty loss under Regulations §1.165-7);
- Is for the replacement of a component of a unit of property and the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
- Is for the repair of damage to a unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss under §165, or relating to a casualty loss described in §165;
- Returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;
- Results in the rebuilding of the unit of property to a like-new condition after the end of its economic useful life; or
- Is for the replacement of a major component or a substantial structural part of the unit of property.
In applying these rules, the economic useful life of a unit of property is the period over which the property may reasonably be expected to be useful to the taxpayer, or if the taxpayer is engaged in a trade or business or in an activity for the production of income, the period over which the property may reasonably be expected to be useful to the taxpayer in its trade or business or for the production of income.
The proposed regulations provide that the replacement of a major component or a substantial structural part means the replacement of a part or a combination of parts of the unit of property, the cost of which comprises 50% or more of the replacement cost or the physical structure of the unit of property.
Taxpayers must capitalize amounts paid to adapt a unit of property to a new or different use [Proposed Regulations §1.263(a)-3(h)]. Generally, an amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer’s intended ordinary use of the property when originally placed in service by the taxpayer. An example of expenses paid to adapt a unit of property to a new use is amounts paid to convert a facility used by the taxpayer for manufacturing, into a showroom for its business. Conversely, expenses to paint and refinish the floors in a building consisting of 20 retail spaces are not made to adapt it to a new purpose if the motivation for the improvements is to prepare the building for sale.
The repair allowance method (RAM) included in the previous proposed §263(a) regulations on amounts paid to acquire, produce, or improve tangible real and personal property has been removed from the new proposed regulations. The newly proposed regulations do not contain a detailed repair allowance, but provide authority for issuing industry-specific repair allowance guidance in the future [Proposed Regulations §1.263(a)-3(j)]. Additionally, Proposed Regulations §1.263(a)-3(i) provides an optional simplified method (the regulatory accounting method) for regulated taxpayers. This method allows taxpayers in regulated industries to use the accounting rules of the regulatory entity [such as the Federal Energy Regulatory Commission (FERC), the Federal Communications Commission (FCC) or the Surface Transportation Board (STB)] to determine if such expenses should be capitalized or expensed.