In 2015, many property owners were faced with the mandatory change over to a new methodology of accounting for capital expenditures on property as either an improvement to be depreciated or written off as a repair. The goal of simplifying the methodology to be qualitative versus quantitative has complicated the decision-making process much more than the ease it was trying to create.
Over time, both taxpayers and tax practitioners have slowly begun ignoring these changes’ practices and implementation. Keeping these rules front and center is paramount for property owners as properly using the regulations can accelerate or create tax savings.
Capitalize or Expense
The regulations set forth the general rule that amounts paid to improve a property unit must be capitalized. An improvement is defined as an expenditure that betters a unit of property, restores it, or adapts it to a new and different use. The treasury regulations include various examples and explanations of betterment, restoration, and adaption tests.
Betterments look at whether the property is in a materially better condition above and beyond what the asset needed in repair after the incurred expenditure. Additions, expansions, and physical enlargements to the Unit of Property (defined below) must be capitalized. Strengthening, increasing productivity, and efficiency, or the quality of the asset also reflect a betterment.
Restorations generally look at whether the taxpayer is replacing a major property component or substantial structural part that may perform a discrete and critical function to the asset’s intended use. If an asset is in a state of disrepair and is brought back to life for its intended use, the costs will generally be capitalized and depreciated.
Adaptation is the simplest standard to understand and measure. The taxpayer solely looks at whether the asset is being used for a new or different use than its originally intended use.
If you fail to meet all three capitalization standards above, your costs are considered repair and maintenance expenses, regardless of the dollar amount. So, what previously you may have capitalized as a $50,000 improvement for fixing part of a roof or plumbing issue may be written off in the current year.
Unit of Property
A key concept in the regulations is defining the Unit of Property (UOP) being improved or repaired. The UOP is the level at which the determination is made between a repair that is required to be capitalized and can be expensed immediately. The smaller the UOP, the more likely it is that costs incurred will have to be capitalized.
For example, work on a vehicle’s engine is more likely to be classified as a cost that must be capitalized if the engine is classified as the UOP. By contrast, if the vehicle instead is the UOP, the engine work has a better chance of being treated as a repair expense in the current year.
Property Other than Buildings
In general, for property other than buildings, a single UOP consists of all functionally interdependent components, such that one piece cannot be placed in service without the others.
For example, a business needs a battery‐powered golf cart for its foreman to travel around a large warehouse; it buys the chassis from one vendor and the battery from another and then assembles the two components. The cart is the UOP since the chassis cannot be placed in service without the battery.
When it comes to buildings, the regulations generally treat each building and its structural components (walls, windows, doors, floor, roof, etc.) as one UOP – the “building.” The regulations also list nine specific building systems that are treated as separate UOPs, including HVAC, plumbing, electrical, elevators, fire protection and alarm systems, security systems, and gas distribution systems.
An expense incurred related to the building is considered with respect to the appropriate UOP. If a taxpayer restores a component of the building structure by replacing the entire roof, the expense is treated as an improvement to the building’s single UOP. However, if a taxpayer replaced a furnace in the building, the cost would be considered with respect to the HVAC system UOP.
Aldrich is Here to Help
Repair and capitalization regulations are challenging to understand and implement. We’ve created an additional article to help you understand more special rules and safe harbors involved. Our real estate team is here to help you make informed decisions to better your business. If you have questions about managing various properties, reach out to your Aldrich Advisor.
Meet the Author
Senior Tax Manager - Real Estate
Jonathan McGuire, CPA
Aldrich CPAs + Advisors LLP
Jonathan McGuire has over eight years of experience providing strategic tax planning and compliance expertise to private middle-market clients. He has a deep focus as a real estate accountant, working with investors, developers, realtors, property managers, and other professional service providers in real estate. He works with a wide range of property types ranging from…
- Real estate
- Partnership taxation
- Tax planning and compliance
- Certified Public Accountant
- Repair regulations
- Qualified Opportunity Zones
- Qualified Opportunity Funds