When to Capitalize Repair and Maintenance Costs?

Businesses regularly incur costs for tangible property, from buildings to office furniture. A primary decision for these expenditures is whether to deduct them as a current expense or to capitalize them. Expensing a cost reduces taxable income in the current year, while capitalization treats the cost as an asset, spreading the deduction over several years. This distinction is governed by the Internal Revenue Code (IRC), which allows deductions for repairs and maintenance but mandates that costs to acquire, produce, or improve property must be capitalized. Making the correct determination directly impacts a company’s tax liability.

The Framework for Capitalization

To classify an expenditure, a business must first identify the “Unit of Property” (UoP) the cost relates to. For most property, the UoP includes all functionally interdependent components. For buildings, the structure is one UoP, while certain building systems are treated as separate UoPs. These systems include:

• HVAC
• Plumbing
• Electrical
• Elevators
• Fire protection systems

Once the UoP is identified, the analysis determines if the expenditure was an improvement using the “BAR” test. If a cost results in a Betterment, Adaptation, or Restoration of the UoP, it must be capitalized.

Betterment

A cost must be capitalized if it results in a betterment to the UoP. An expenditure is a betterment if it fixes a material defect that existed before acquisition, results in a material addition, or leads to a material increase in capacity, productivity, or quality. For example, replacing a few shingles is a repair, but replacing an entire shingle roof with a higher-quality slate roof is a betterment. This type of work improves the property beyond its original state, unlike a simple repair that just maintains its normal operating condition.

Adaptation

Costs to adapt a UoP to a new or different use must be capitalized. This applies when an expenditure changes the property’s function from its original intended purpose. For example, converting a manufacturing warehouse into a retail showroom is an adaptation. The costs for new walls, lighting, and flooring are not for maintenance but for adapting the property to a new business use and must be capitalized.

Restoration

An expenditure that restores a UoP must be capitalized. Restoration involves actions that return a property to a “like-new” condition or replace a significant portion of the asset. This includes replacing a major component or a substantial structural part, such as an entire HVAC system in a building. Costs to rebuild a property to its original condition after being damaged in a casualty event are also considered restorations. The analysis focuses on the scale of the work, distinguishing it from routine maintenance.

Safe Harbor Elections for Simplification

The Tangible Property Regulations provide several safe harbor elections to simplify the analysis required by the BAR test. These safe harbors allow taxpayers to deduct costs that might otherwise need to be capitalized. Two of the most widely used provisions are the De Minimis Safe Harbor and the Routine Maintenance Safe Harbor. These elections are not automatic and must be properly adopted by the taxpayer to be used.

De Minimis Safe Harbor

The De Minimis Safe Harbor (DMSH) allows businesses to expense small-dollar purchases of tangible property. The threshold for this safe harbor depends on whether the taxpayer has an Applicable Financial Statement (AFS), which is a certified audited financial statement. For taxpayers with an AFS, the maximum amount that can be expensed is $5,000 per item or invoice; for those without an AFS, the threshold is $2,500.

To use the DMSH, a business must have a policy in place at the beginning of the year that treats these small-dollar expenditures as expenses on its books. This policy must be written for taxpayers with an AFS. Additionally, a formal election must be made annually by attaching a statement to a timely filed federal tax return titled “Section 1.263(a)-1(f) de minimis safe harbor election.”

Routine Maintenance Safe Harbor

The Routine Maintenance Safe Harbor (RMSH) permits the deduction of expenses for recurring activities that keep property in its ordinarily efficient operating condition. To qualify, the maintenance must be expected to occur more than once during the 10-year period after a building is placed in service, or more than once during the class life for other types of property. Examples include scheduled inspections, cleaning, and replacing worn parts with comparable ones.

The RMSH does not apply to costs that result in a betterment or adapt the property to a new use. Unlike the De Minimis rule, this safe harbor does not require a formal election statement. A taxpayer adopts the RMSH by using it, but must maintain detailed records like invoices and work orders to prove the costs meet the criteria.

Accounting for Capitalized Costs

If an expenditure is a capital improvement, it cannot be deducted in the current year. Instead, the cost must be capitalized and recovered over time through depreciation.

Adding to Basis

The first step is to add the capitalized cost to the asset’s tax basis, which is the owner’s investment in the property for tax purposes. For a new asset, the initial basis is its cost. A capital improvement’s cost increases the property’s adjusted basis, which is used to calculate future depreciation deductions.

Depreciation

The capitalized cost is recovered over several years through annual depreciation deductions. The primary method for this is the Modified Accelerated Cost Recovery System (MACRS). MACRS assigns property to asset classes, each with a designated recovery period over which the cost is deducted. For example, office furniture is 7-year property, while a commercial building has a 39-year recovery period. The annual deduction is calculated using the asset’s basis, recovery period, and the applicable MACRS depreciation method.