Deduct or Capitalize? New Definition for Property Expenditures

Deduct or Capitalize? New Definition for Property Expenditures

Temporary Regulations, effective January 1, 2012, provide guidance on IRC Sections 162 and 263(a), address when amounts paid to acquire, produce, or improve tangible property are deductible or capitalizable. The Regulations modify the "general plan of rehabilitation" doctrine, define a safe harbor for routine maintenance on property other than buildings, and explain how landlords and tenants must capitalize expenses related to leased buildings. In this Analysis, Patricia Mills J.D. LL.M. discusses and clarifies the guidance provided by the Temporary Regs. She writes:

     Repairs and maintenance are expenditures that are intended to maintain the operating efficiency of an asset over its useful life. Capital additions, however, are intended to add to the asset's value, extend its useful life, or adapt it to a different use. The difference between maintenance and repairs (a difference that is of academic interest only) is that maintenance generally is continuing and designed to prevent disruption in service, whereas repairs usually occur in connection with a disruption in service. For example, the cost of lubricating the circulator pump in a hot water heating system is maintenance; the cost of fixing the unlubricated pump that has failed is repairs.

     The distinction between repairs/maintenance, on the one hand, and capital expenditures, on the other hand, is much more significant. The Tax Court has described the test for distinguishing between deductible repair expenses and improvements that must be capitalized as the difference between "keeping" and "putting" a capital asset in good condition. The Tax Court has also used a test (the Plainfield-Union test) for determining whether an expenditure is capital by comparing the value, use, life expectancy, strength or capacity of the property after the expenditure with the status of the property before the condition necessitating the expenditure. A merely incidental expense is currently deductible, but if the repair is an improvement or replacement, or if it increases the property's value or substantially prolongs its useful life, it is capital in nature and is not deductible. A repair in the nature of a replacement, to the extent that it arrests deterioration and appreciably prolongs the life of the property, must either be capitalized and depreciated or charged against a depreciation reserve. Under this rationale, the cost of replacements of tile, tubs, sinks, faucets, showers, toilets, baseboards, cabinets, countertops, and flooring have been held to be capital expenditures and not deductible repairs. Even the installation of new cabinet doors and countertops in a kitchen has been held to be a capital improvement and not just an incidental repair.

     ....

     The Temporary Regulations also attempt to reflect the large body of case law on the repair versus improvement question. The Temporary Regulations somewhat modify the judicially developed "general plan of rehabilitation" doctrine, providing that indirect costs made at the same time as an improvement, but that do not directly benefit or are not incurred by reason of the improvement, do not have to be capitalized under IRC Section 263(a). Under a safe harbor,routine maintenance on property other than buildings is deemed not to improve that unit of property. Routine maintenance is defined as the recurring activities that a taxpayer expects to perform as a result of the taxpayer's use of the unit of property to keep the unit of property in its ordinarily efficient operating condition.

(footnotes omitted)

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