Section 263: What Costs Must Be Capitalized?

Section 263 of the Internal Revenue Code dictates how businesses treat their expenditures, differentiating between costs that offer a benefit over the long term and those that relate only to the current year. When a cost is determined to have a long-term benefit, it must be capitalized. Capitalization is the process of recording an expenditure as an asset on a company’s balance sheet. Instead of reducing taxable income all at once, the cost is gradually deducted over the asset’s useful life through depreciation or amortization. This process contrasts with immediately deducting an expense from income in the year it is paid.

The General Rule for Capitalization

Internal Revenue Code Section 263 prohibits the immediate deduction of amounts paid for new buildings or for permanent improvements and betterments that increase the value of any property. The intent is to prevent businesses from distorting their income by expensing large costs that will provide value for many years. These capitalized costs are recovered over time through depreciation for tangible assets or amortization for intangible assets.

This rule contrasts with Section 162, which permits the deduction of ordinary and necessary expenses like routine repairs and maintenance that keep property in its normal operating condition but do not materially add to its value. For example, patching a small leak in a roof is a deductible repair. However, replacing the entire roof of a building is a capital expenditure because a new roof is a permanent improvement that increases the property’s value and extends its useful life.

Costs to Acquire or Produce Tangible Property

When a business acquires or produces tangible property, such as buildings or machinery, all costs associated with placing that asset into service must be capitalized. These costs are added to the asset’s basis, the value from which depreciation deductions are calculated over the asset’s useful life.

For property that is acquired, the costs to be capitalized extend beyond the invoice price. They include all amounts necessary to make the asset ready for its intended use, such as sales tax, freight charges, and the costs of installation and testing. For instance, if a company purchases new machinery, the capitalized cost includes the purchase price, delivery fees, and the wages of the personnel who install and calibrate it.

The rules are similar for property a business produces for its own use. Under the Uniform Capitalization (UNICAP) rules of Section 263A, both direct and certain indirect costs must be capitalized. Direct costs include raw materials and direct labor, while indirect costs are those allocable to production, like factory overhead, insurance, and property taxes.

For example, if a company constructs a new warehouse, it must capitalize the cost of materials like lumber and steel. It must also capitalize the wages of the construction workers and an allocated portion of the salaries of supervisors who oversee the project.

Determining Improvement Costs

Determining whether an expenditure is a deductible repair or a capital improvement begins with identifying the “Unit of Property” (UoP). For a building, the UoP includes the structure and its distinct systems, like HVAC, plumbing, and electrical. The expenditure is then analyzed using three “BAR” tests to see if it results in a betterment, adaptation, or restoration.

Betterment

A betterment occurs if an expenditure fixes a material defect that existed before the property was acquired or results in a material increase in the capacity or efficiency of the UoP. For example, replacing standard windows with high-efficiency thermal pane windows is a betterment because it increases the building’s energy efficiency. Reinforcing a building’s foundation to correct a pre-existing structural flaw is also a betterment.

Adaptation

An expenditure is an adaptation if it modifies a UoP for a use inconsistent with its original intended use. Converting a warehouse into retail showroom space is a classic example. The costs to add walls, new flooring, and customer-facing lighting adapt the property to a new use and must be capitalized.

Restoration

A restoration involves replacing a major component or a substantial structural part of the UoP. This also includes costs to return a property to operating condition if it has fallen into disrepair. Replacing an entire roof membrane or a significant portion of a building’s plumbing system would be treated as a capitalized restoration.

Safe Harbor Elections for Tangible Property

The tax code provides several safe harbor elections that permit businesses to deduct certain expenditures that might otherwise need to be capitalized. These elections simplify compliance and must be elected annually by attaching a statement to a timely filed tax return.

De Minimis Safe Harbor (DMSH)

This election allows a business to deduct small-dollar purchases of tangible property if it has a policy at the start of the year to expense items under a certain amount. If the business has an applicable financial statement (AFS), it can deduct items costing up to $5,000 per item. For businesses without an AFS, the threshold is $2,500 per item.

Small Taxpayer Safe Harbor (STSH)

Available to businesses with average annual gross receipts of $10 million or less for the preceding three tax years, this safe harbor applies to building property with an unadjusted basis of $1 million or less. If these criteria are met, the taxpayer can deduct total annual expenditures for repairs, maintenance, and improvements up to a limit of the lesser of $10,000 or 2% of the building’s unadjusted basis.

Routine Maintenance Safe Harbor

This allows for the deduction of costs related to recurring activities that a business reasonably expects to perform to keep its property in operating condition. The safe harbor applies to maintenance that is expected to occur more than once during the property’s class life or, for buildings, more than once every ten years. The cost of periodically repainting interior walls would qualify under this safe harbor.

Application to Intangible Assets

The capitalization principles also extend to the acquisition and creation of intangible assets. Businesses must capitalize amounts paid to acquire or create intangibles that provide value over a future period. Common examples of intangible assets subject to capitalization include patents, copyrights, trademarks, and trade names.

The rules also require capitalization of amounts paid to another party to create or enhance an intangible asset, as well as costs paid to facilitate the acquisition of an intangible. A significant category of capitalized intangibles relates to business acquisitions. When one company buys another, the portion of the purchase price that exceeds the fair market value of the acquired assets is allocated to goodwill, which must be capitalized.

Other costs associated with these transactions, such as legal and professional fees to investigate or pursue the acquisition, must also be capitalized. Once capitalized, the costs of most acquired intangible assets, including goodwill, are recovered through amortization. Under Section 197, these costs are generally amortized on a straight-line basis over 15 years.