Have the Tangible Property Regulations changed the rules for determining whether an expenditure is a deductible repair or a capital improvement?

The Tangible Property Regulations put existing case law and prior tax regulations into a structure to help you determine whether an expenditure is deductible or must be capitalized because it’s a major improvement, restoration, adaptation, or betterment.

If the amounts are not paid for a major improvement, restoration, adaptation, or betterment, which is determined under the final Tangible Property Regulations, then the amounts GENERALLY can be expensed as repairs and maintenance.

However, there are no bright lines to quickly and easily determine whether a cost is for a repair or an improvement. So, the facts and circumstances around each expenditure have to be reviewed. This is not optional.

Understand that the final regulations do not eliminate the requirements of ยง263A, which clearly state that you must capitalize the direct and apportionable indirect costs of producing or acquiring real or tangible property OR acquiring property for resale.

The Tangible Property Regulations provide three safe harbors and elections that can ease compliance with these rules. Each of these is discussed in other blogs. That being said, CPAs and building owners must understand and comply with the Tangible Property Regulations facts and circumstances test in case the expenditure does not qualify for the safe harbors.

What is the facts and circumstances analysis for distinguishing capital improvements from deductible repairs?

Step 1 โ€“ Determine the Unit of Property. For buildings โ€“ The unit of property is generally the entire building, including its structural components. Lessees of portions of buildings apply the analysis to the part of each building system the tenant is responsible for in the lease. Lessors of an entire building apply the rules for the whole building structure and each key building system.

If you do a Cost Segregation study to accelerate depreciation and add fifteen- or five-year class lives, then you must treat the accelerated components as a separate unit of property. Unfortunately, no Cost Segregation firms except TPTM understand this. 

Step 2 โ€“ Is there an improvement, betterment, restoration, or adaptation to the building, the building structure, or any building system?

A component is improved only if the amounts are:

  • Paid to fix a condition or material defect that existed before the purchase or arose during the first two years of occupancy. This is a Restoration.
  • Paid for a material addition, including physical enlargement to the building, or adding a major component or a material increase in space capacity. This is a Major Improvement.
  • Amounts paid that are reasonably expected to materially increase the efficiency, strength, or quality of the unit of property. This is a Betterment.
  • Amounts paid to change the original intended use of a building. This is an Adaptation.

The term “material” is not clear in the Tangible Property Regulations. Although the final regulations include examples that refer to percentages, these examples are offered to help you understand the rules. In determining whether a betterment is “material,” you should use common sense and reasonable judgment as applied to your facts and circumstances.

Kevin Jerry is a nationally recognized expert in Tax Method Changes. He specializes in Cost Segregation, Tangible Property Regulations, and revenue recognition changes. Kevin graduated cum laude from the University of Cincinnati with a Master of Science in Real Estate Taxation. Over the last seven years, he has worked with Eric Wallace on the Tangible Property Regulations with some of the largest property owners in the country.

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