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What’s New in Repair vs. Capital?
 
Written by: Steve Beaucaire, MST, CCSP
Director of Tax | Bedford Cost Segregation, LLC

Lately you can’t help but notice the increase in the advertising of Repair and Maintenance studies. A promotion usually starts with an announcement that some recent Tax Court case has ushered in the latest and greatest way to save taxes. The truth is there has been no recent Tax Court case pertaining to repair and maintenance. The Proposed Regulations for § 263(a) have not been finalized and to no one’s surprise, they are not the new tax haven that is being promoted by some firms. By way of reference, the Proposed Regulations mentioned were initially issued on March 10, 2008. Despite conjecture that these Proposed Regulations are expected to be released this year, it is important to note the same thing was said in 2008 and 2009. The reality is that we do not know when or if the IRS will make these Proposed Regulations final. The only significant development is that the IRS will allow the taxpayer to file an IRS Form 3115 (Request for Change in Accounting Method) under the automatic method to change the treatment of repairs from capital to expense in accordance with Revenue Procedure 2009-39.

The debate as to whether expenses are deducted or capitalized has been around for decades. In order to get an accurate picture, one must focus on the current Regulations under § 263(a) and not get distracted by the newer Proposed Regulations. The only significant change is that the IRS has made it a Tier 1 audit issue to examine any Form 3115 (Request for Change in Accounting Method) on the treatment of repairs. This is to ensure that the change requested is based on the old Regulations, not the Proposed Regulations for § 263(a).

In light of the recent hoopla regarding this subject, it is important to further clarify the current Regulations. The old Regulations state that no deduction is allowed for amounts paid that either a) add to the value or b) substantially prolong the life of property owned by the taxpayer, or c) adapt the property to a different use. The IRS states that one must also capitalize any amount paid “for new buildings or permanent improvements or betterments made to increase the value of any property or estate, or any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made in the form of a deduction for depreciation, amortization, or depletion.” In other words, if you replace a capital asset, the costs are capital not expense. The Regulations do however; allow the deduction of amounts for the incidental repair and maintenance of the property. Unfortunately the IRS fails to accurately define what this means from a practical standpoint.

As with many strategies, the facts and circumstances of each situation will determine the proper treatment in each year; expense, or capital. One might naturally turn to case law, but the courts are for all intents and purposes in the same position that we are in as they too, look to the facts and circumstances of each case in making their decision. A roof repair of $5,000 may be a classified as repair if it is not material to the cost of the entire roof and doesn’t materially extend its life. It gets even more complicated because you may determine that a repair should be properly expensed but then realize that it must be capitalized under § 263A, Uniform Capitalization. Taxpayers who acquire or produce property for re-sale are required to capitalize direct and some indirect expenses to inventory. These items are then deducted when the inventory is released i.e. sold.

In fairness, to those who are aggressively promoting Repair and Maintenance studies, most firms do discuss the current Regulations under § 1.263(a) but with a lack of depth. For instance, normally the issue of Uniform Capitalization is never mentioned in the treatment of items determined to be a repair and deductible under § 162. In spite of this fact, there may be an assumption that taxpayers aren’t expensing repairs now. Examples are often vague, giving the reader little indication as to how the numbers are calculated or where they come from. Some listing of potential repairs could be a listing of capital assets depending on whether they materially extend the life of the asset or substantially add to its value. Since most of the assets listed are depreciable, they are most likely capitalized assets since they represent an “amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made in the form of a deduction for depreciation, amortization, or depletion.”

What almost all of these advertisements miss is that it takes someone with tax expertise to do the final analysis, not just engineering experience. This is not a question of how a porte cochere is attached to a building or which circuit services a given machine. It is a determination of whether an expense adds to the value of capital property or materially extends its life. These fine distinctions demand that the taxpayer seek out specialized tax advice.

1. § 1.263(a)-1(b)
2. § 1.263(a)-1(a)

 
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