Tangible Property Regulations and the IRS

Repair regulations provide guidance for classifying repairs and improvements

Deductible Repairs or Capital Improvements?

Are your property repairs deductible? The Internal Revenue Code, the Internal Revenue Service (IRS), and taxpayers have been in conflict over whether expenditures on tangible property are deductible now, or must be capitalized and recovered through depreciation over time. The distinction between deductible repairs and capital improvements has been determined largely through case law and is based upon facts and circumstances.

In an effort to reduce disputes with taxpayers, the IRS issued final regulations in September 2013. These are commonly referred to as the “repair regulations”, and provide rules regarding the treatment of expenditures for acquiring, maintaining, or improving tangible property.

Under the repair regulations, the IRS provided guidance to  determine whether an expenditure made for a building is an improvement. The first step is to determine the identifying unit of property.  In real estate, the unit of property would commonly be considered the building; however, there are special rules to determine the unit of property for buildings.

Determining the Unit of Property

When applying the improvements standards, the unit of property for a building comprises the building and its structural components (doors, windows, roof, etc.) plus each of the eight specifically defined building systems:

  1. Heating, ventilation, and air conditioning systems (HVAC)
  2. Plumbing systems
  3. Electrical system
  4. All escalators
  5. All elevators
  6. Fire protection and alarm systems
  7. Building security systemsfire protection systems can be considered a capital improvement
  8. Gas distribution systems

Improvement Standards

Once you have determined the unit of property, the next step is to determine whether an expenditure for the unit of property is a deductible repair or capitalizable improvement. An expenditure is a capitalizable improvement if it can be qualified as a betterment, restoration, or adaptation. They are defined as follows:

  • Capitalizable betterment:
    • Corrects a material condition or defect that existed before the taxpayer’s acquisition of the unit of property.
    • Is a material addition (including physical enlargement, expansion, extension, or addition of a major component) or a material increase in capacity of a unit of property?
    • Is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of a unit of property.
  • Capitalizable restoration:
    • Returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use.
    • Results in the rebuilding of the unit of property to a like-new condition after the end of its class life.
    • Replaces a part or a combination of parts that are a major component or a substantial structural part of a unit of property.
  • Capitalizable adaptation:

The amounts paid to adapt a unit of property to a new or different use that is not consistent with the taxpayer’s ordinary use of the unit of property at the time it was originally placed in service. For a building to qualify for the adaptation standard, the amount paid to improve it must adapt the building structure or any one of its building systems to a new or different use.

The Takeaway

The repair regulations attempt to resolve the controversies that have arisen over the years between the IRS and taxpayers over how to classify certain costs that are deductible in a current tax year versus fixed assets that have to be capitalized and depreciated over a number of years.

If you have any questions about whether improvements to your tangible property are currently deductible or must be depreciated over time, contact Simon Filip for a consultation at 201.655.7411 or [email protected].