Repair Regulations: When to Capitalize or Expense

The tax treatment of costs for tangible property is governed by the Tangible Property Regulations, often called the repair regulations. These rules provide a framework to distinguish between expenditures deducted immediately as repairs and those that must be capitalized as improvements. Capitalized costs are recovered over time through depreciation, sometimes for as long as 39 years, whereas repair expenses reduce taxable income in the current year. The regulations, found within Internal Revenue Code sections 162 and 263, apply broadly to anyone who pays to acquire, produce, or improve tangible property, including corporations, partnerships, and individuals filing business schedules with their tax returns.

Defining the Unit of Property

Before analyzing whether a cost is a deductible repair or a capital improvement, one must first identify the specific “Unit of Property” (UoP) to which the expense relates. The regulations provide distinct definitions for what constitutes a UoP depending on the type of asset involved. For buildings, the building structure itself is considered a single UoP, including its foundation, walls, floors, roof, windows, and doors. An expense to repair a few broken windows would be evaluated against the entire building structure as the relevant UoP.

A building must also be broken down into nine distinct building systems, each of which is treated as a separate UoP. These systems are:

• HVAC systems
• Plumbing systems
• Electrical systems
• All escalators
• All elevators
• Fire protection and alarm systems
• Security systems
• Gas distribution systems
• Any other systems defined in published guidance

For example, replacing a single air conditioning condenser would be analyzed in relation to the entire HVAC system UoP, not the building as a whole. This separation is significant because replacing a major component of a building system UoP may require capitalization, even if the cost is minor relative to the entire building.

For tangible property other than buildings, such as equipment and machinery, the UoP consists of all components that are functionally interdependent. A delivery truck, for instance, is a single UoP because its engine, chassis, and cargo hold are all functionally interdependent parts of the whole vehicle.

The Improvement Rules

Once the Unit of Property (UoP) has been correctly identified, the next step is to determine if an expenditure results in an improvement to that UoP. The regulations establish a framework for this analysis, often remembered by the acronym “BAR,” which stands for Betterment, Adaptation, and Restoration. If an expense falls into any of these three categories, it must be capitalized and depreciated over time.

A betterment is an expenditure that materially enhances the UoP. This can occur if it fixes a material condition or defect that existed before the property was acquired, results in a material addition, or materially increases the capacity, productivity, efficiency, or quality of the UoP. For example, replacing a building’s original wooden windows with high-efficiency thermal pane windows is a betterment because it improves the building’s energy efficiency.

An adaptation involves modifying a UoP for a use that is not consistent with its intended ordinary use at the time it was originally placed in service. For instance, if a company converts a portion of its manufacturing facility into a public-facing retail showroom, the costs associated with this conversion would be for an adaptation.

A restoration is an expenditure that brings a UoP back to its operational state or to a like-new condition after its useful life. The regulations specify that replacing a component that is a major part of the UoP’s physical structure or a substantial structural part of the UoP is a restoration. For example, replacing the entire roof on a building is a restoration of the building structure UoP. Capitalization is also required for costs to restore a property to working condition if it was purchased in a state of disrepair or to rebuild it to a like-new condition after a casualty event.

Safe Harbor Provisions for Expensing

The Tangible Property Regulations provide several safe harbor provisions that allow taxpayers to deduct certain expenditures that might otherwise need to be capitalized under the main improvement rules. These safe harbors are elective and are designed to simplify record-keeping and reduce administrative burdens.

De Minimis Safe Harbor

The De Minimis Safe Harbor (DMSH) permits taxpayers to expense low-cost acquisitions or improvements of property. To use this safe harbor, a taxpayer must have a policy at the beginning of the year to expense property under a certain dollar amount. If a taxpayer has an Applicable Financial Statement (AFS), they can elect to expense items costing up to $5,000 per item or per invoice. For taxpayers without an AFS, the limit is lower, at $2,500 per item or per invoice. This election is made annually by attaching a statement to a timely filed tax return.

Routine Maintenance Safe Harbor

The Routine Maintenance Safe Harbor allows for the current deduction of expenses for recurring activities that a taxpayer reasonably expects to perform to keep a UoP in its ordinarily efficient operating condition. Two tests must be met for an activity to qualify. First, the maintenance must be recurring, meaning the taxpayer expects to perform it more than once during the property’s class life for non-building property or more than once during a 10-year period for building UoPs. Second, the activities must stem from the wear and tear of the property’s use. The periodic replacement of worn belts and filters on an HVAC system would qualify as deductible routine maintenance.

Safe Harbor for Small Taxpayers

The Safe Harbor for Small Taxpayers (SHST) is available to taxpayers whose average annual gross receipts for the three preceding tax years are $10 million or less. If a taxpayer qualifies, they can deduct repair, maintenance, and improvement costs for an eligible building property on their annual tax return. An eligible building is one with an unadjusted basis of $1 million or less. The total amount deducted under this safe harbor for a single building cannot exceed the lesser of $10,000 or 2% of the building’s unadjusted basis.

Changing an Accounting Method

After reviewing the tangible property rules, a taxpayer might discover that their previous method of accounting for repairs and improvements was incorrect. Correcting this requires a formal change in accounting method, which cannot be done by simply amending a prior tax return.

The required procedure involves filing Form 3115, Application for Change in Accounting Method. For many changes related to the repair regulations, the change is considered automatic, meaning prior consent from the IRS is not needed before filing.

A completed copy of Form 3115 must be attached to the taxpayer’s timely filed federal income tax return for the year the change is being made. A separate, signed copy of the Form 3115 must also be mailed to the IRS office in Ogden, Utah.

When a change in accounting method is made, an adjustment known as a Section 481(a) adjustment is calculated. This adjustment accounts for the cumulative difference between the old, improper method and the new, proper method up to the beginning of the year of change. Its purpose is to prevent the duplication or omission of deductions or income that would otherwise result from switching methods.