Repair Regulations: When to Capitalize or Expense

The Internal Revenue Service’s (IRS) Tangible Property Regulations provide a framework for businesses and individuals who own or lease tangible property. These rules address whether an expense related to property like buildings, equipment, or vehicles should be deducted immediately or capitalized and depreciated over many years. This distinction directly impacts the timing and amount of tax deductions, and the regulations apply broadly to nearly every business, including individuals filing a Schedule C or E.

The Capitalize vs Deduct Framework

The general rule under Internal Revenue Code (IRC) Section 263 requires taxpayers to capitalize costs paid to acquire, produce, or improve tangible property. While ordinary and necessary repair and maintenance expenses are deductible under IRC Section 162, the regulations provide a structured analysis to distinguish between the two. This analysis begins with identifying the correct “Unit of Property” (UoP) and then applying a series of tests.

The UoP is the specific asset against which all expenditures are measured to determine if an improvement has occurred. For real property, the building and its structural components are a single UoP, but the regulations break down a building into nine distinct systems, each treated as a separate UoP. These systems are:

• HVAC systems
• Plumbing systems
• Electrical systems
• Escalators
• Elevators
• Fire protection and alarm systems
• Security systems
• Gas distribution systems
• Any other system defined in published guidance

This componentization is significant because an expenditure is measured against the smaller building system, not the entire building, making it more likely to be classified as a capital improvement. Once the UoP is identified, the “BAR test” is applied to determine if an expenditure results in a Betterment, an Adaptation, or a Restoration. If the expenditure falls into any of these three categories, it must be capitalized.

Betterments

An expenditure is a betterment if it remedies a material defect that existed before acquisition, results in a material addition to the UoP, or materially increases the property’s capacity, productivity, or quality. For example, replacing a few shingles is a repair, but replacing an entire wood-shingled roof with a higher-quality slate roof is a betterment. An expenditure that corrects damage that occurred during the taxpayer’s use is not considered a betterment. A new coat of paint is a deductible repair, whereas a project that significantly upgrades the building’s physical structure would be capitalized.

Adaptations

An amount is capitalized if it adapts a UoP to a new or different use. A use is considered new or different if it is inconsistent with the taxpayer’s originally intended use of the property when it was first placed in service. For instance, converting a warehouse used for storing inventory into a customer showroom would be an adaptation. In contrast, a grocery store adding a salad bar would likely not be an adaptation, as this is consistent with its intended use of selling food products.

Restorations

An expenditure must be capitalized if it restores the UoP. This includes replacing a major component or a substantial structural part of the UoP, returning the property to a like-new condition after its depreciable life has ended, or rebuilding the property after it has fallen into disrepair. For example, the complete replacement of a building’s roof is a restoration because the roof is a major component of the building structure UoP. Costs incurred to restore a property to its pre-loss condition after a casualty event are also considered restorations.

Safe Harbors for Immediate Expensing

The tangible property regulations provide several safe harbor elections that allow taxpayers to deduct certain expenditures without undergoing the BAR test analysis. These provisions simplify compliance for common, lower-cost activities. Making an election under a safe harbor is done annually by attaching a statement to a timely filed tax return.

De Minimis Safe Harbor (DMSH)

The De Minimis Safe Harbor (DMSH) permits the immediate deduction of small-dollar acquisitions or improvements. To use this safe harbor, a taxpayer must have a written accounting policy at the beginning of the year to expense property under a certain dollar amount for their non-tax books and records. For taxpayers with an applicable financial statement (AFS), the DMSH allows for deducting items costing up to $5,000 per item or invoice. For those without an AFS, the threshold is $2,500 per item or invoice.

Routine Maintenance Safe Harbor (RMSH)

The Routine Maintenance Safe Harbor (RMSH) allows for deducting expenses for recurring activities that keep property in its ordinarily efficient operating condition. For this safe harbor to apply, the taxpayer must reasonably expect to perform the activities more than once during the property’s life. For buildings, the taxpayer must expect to perform the maintenance more than once in a 10-year period. For other property, the expectation is that maintenance will occur more than once during its alternative depreciation system (ADS) class life.

Safe Harbor for Small Taxpayers (SHST)

A specific safe harbor exists for smaller taxpayers who own or lease buildings. The Safe Harbor for Small Taxpayers (SHST) allows qualifying taxpayers to deduct all repairs, maintenance, and improvements for an eligible building. To qualify, the taxpayer must have average annual gross receipts of $10 million or less for the three preceding tax years. The building must also have an unadjusted basis of $1 million or less. If these criteria are met, the total deduction cannot exceed the lesser of $10,000 or 2% of the building’s unadjusted basis.

Treatment of Materials and Supplies

The regulations have distinct rules for materials and supplies, which are deducted in the year they are used or consumed. Materials and supplies include non-incidental items, incidental items, and components acquired to maintain or repair tangible property. A specific rule allows for the immediate deduction of any material or supply that costs $200 or less. For items costing more than $200, the general rule of deducting them upon use or consumption applies. Incidental materials and supplies, like basic office supplies, can be deducted in the year they are paid for.

Changing an Accounting Method with Form 3115

Adopting these regulations or changing from an incorrect method of accounting for repairs is a change in accounting method, which requires filing Form 3115, Application for Change in Accounting Method. A central component of the filing is the calculation of the Section 481 adjustment. This adjustment represents the cumulative effect of the accounting method change and is calculated as the net difference between deductions taken under the old method and what would have been allowed under the new method for all prior years. A negative adjustment results in a one-time deduction, while a positive adjustment is additional income typically spread over four years.

These changes can generally be made with the IRS’s automatic consent, which simplifies the process. The filing requires a dual submission. A copy of the completed Form 3115 must be attached to the taxpayer’s timely filed federal income tax return for the year of the change. A signed duplicate copy must be mailed to the IRS address listed in the form’s instructions. The deadline for an automatic change is the same as the due date for the tax return to which it is attached, including extensions.