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By Patricia Hughes Mills J.D. LL.M
Determining the nature of expenditures on real estate for federal tax purposes is a fact-sensitive discipline. Capitalization Regulations effective for taxable years beginning on or after January 1, 2014, complement Tax Court decisions, the "general plan of rehabilitation" doctrine, and other elements to clarify the opaque distinction between currently deductible incidental expenses and capitalizable improvement/replacement expenses.
For federal taxation purposes, the distinction between repairs/maintenance, on the one hand, and capital expenditures, on the other hand, is 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 Plainfield-Union test is one standard used to determine if 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.
Whether an expenditure may be deducted or must be capitalized is a question of fact. The determination in any given case focuses less on harmonizing prior cases than on analyzing given facts and then engaging in a judicial line-drawing exercise.
The original Regulations did not clearly address the issue of whether expenses should be currently deducted as repairs or capitalized. Consequently the issue has been the focus of many court cases over the years. Recently the IRS has issued Regulations, effective January 1, 2014, which provide guidance on the application of IRC Section 162 and IRC Section 263(a), addressing when amounts paid to acquire, produce, or improve tangible property are deductible or capitalizable. Temporary and Proposed Regulations issued on December 27, 2011 were to be effective on January 1, 2012. However, the Treasury amended them to not take effect until taxable years beginning on or after January 1, 2014, in anticipation of issuing final regulations before that date that differed from the Temporary Regulations.
"General Plan of Rehabilitation"
The already unclear distinction between repairs and capital expenditures was made even murkier by the "general plan of rehabilitation" doctrine, which overlays the entire area. NOTE: This doctrine is replaced in the 2014 Capitalization Regulations.
Under this doctrine, an expense that was incurred as part of a plan of rehabilitation, improvement or modernization must be capitalized and added to basis, even though the same expense, standing alone, would be currently deductible as a repair. Thus, to discern the proper tax treatment for an item, one needed to know both the nature of the particular expenditure and the overall framework (i.e., alone, or in conjunction with other items) in which it is made. Whether a plan of rehabilitation exists and whether an item is a part of it are usually questions of fact to be determined by evaluating all surrounding facts and circumstances, including the purpose, nature, extent and value of the work done.
Patricia Hughes Mills received her Juris Doctorate degree, magna cum laude, from Syracuse University, and her LL.M. in Taxation, magna cum laude, from the University of San Diego. A past member of the Executive Committee of the State Bar of California Taxation section, Professor Mills practiced law for 15 years before joining Arthur Andersen for several years in their real estate and partnership tax practice. She is now a Professor of Clinical Accounting at the University of Southern California, where she teaches in the Masters of Business Taxation program. She has written several chapters for Powell on Real Property (Michael Allan Wolf, ed., LexisNexis), and is the update author for Federal Taxes Affecting Real Estate (Matthew Bender).
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