Property owners often wrestle with how to classify their repair and upkeep costs — are they routine maintenance costs, which are immediately deductible against current income? Or are they capital expenditures that must be recovered over time through depreciation? This article discusses proposed IRS regulations that would help clarify how such costs should be treated for tax purposes. As a sidebar explains, the regulations also provide that “inherently facilitative” transaction costs must be capitalized.
Maintenance vs. capital improvement
The difference can mean more money in your pocket
Property owners often wrestle with how to classify their repair and upkeep costs — are they routine maintenance costs, which are immediately deductible against current income? Or are they capital expenditures that must be recovered over time through depreciation?
Fortunately, proposed IRS regulations help clarify how such costs should be treated for tax purposes. Although not final as of this writing, they provide useful guidance because they’re based largely on previous guidance and rulings from the IRS and the courts.
The tax impact
Most taxpayers will pay less tax by classifying an expenditure as maintenance and taking a current deduction, rather than by capitalizing the expense and recovering it by way of depreciation.
On the other hand, capital improvements add to your basis in a property, thereby reducing capital gains when you sell it. And a large one-time maintenance expense lowers the profits reported by an income-producing property in the current year, making it appear less profitable and, therefore, harder to refinance.
A 3-part test
The proposed regs provide some rules on how to determine whether an amount paid for an “improvement” must be capitalized under Internal Revenue Code (IRC) Section 263(a). Generally, they require a taxpayer to capitalize amounts that result in a 1) betterment, 2) a restoration, or 3) a new or different use of a unit of property.
A cost results in a betterment if it:
- Remediates a material defect that existed before the property’s acquisition or arose during the property’s production,
- Causes a material addition to the property, or
- Causes a material increase in the property’s capacity, productivity, efficiency, strength, quality or output.
To illustrate, suppose a storm damages your building’s wooden roof. The IRS would likely allow you to deduct the cost of replacing a few shingles as maintenance expense. But if you upgrade to a new maintenance-free asphalt roof, it would qualify as a betterment, requiring you to capitalize it over 39 years.
A cost results in a restoration if it:
- Replaces a property component and the taxpayer either has properly deducted a loss for it or has taken into account its adjusted basis in realizing a gain or loss from the component’s sale or exchange,
- Is for the repair of property damage for which the taxpayer has taken a basis adjustment as a result of or relating to a casualty loss,
- Returns the property to its ordinarily efficient operating condition if the property had deteriorated to a state of disrepair and was no longer functional for its intended use,
- Results in rebuilding the property to a like-new condition after the end of its economic useful life, or
- Replaces a major component or a substantial structural part of the property.
A cost results in a new or different use if the adaptation isn’t consistent with the taxpayer’s intended ordinary use of the property at the time the taxpayer started using it. For example, suppose a taxpayer has owned a manufacturing facility since the early 1970s, using it for manufacturing. If the taxpayer decides to convert the facility to a showroom, the costs incurred are paid to adapt the building to a new or different use, so they must be capitalized.
Deciphering the regs
If you’re uncertain about past or current classifications of maintenance costs, your tax advisor can help you find your way through these regs. He or she can review your capitalization decisions to determine whether any of the capitalized expenditures can be reclassified as deductible maintenance expenses.
Moreover, your tax advisor can review your past tax returns and perform a cost segregation study to see if you qualify for a retroactive change of accounting method. Such a change would allow you to claim a deduction in the current year for costs that were mistakenly capitalized. However, you must obtain IRS consent in order to change your accounting method.
Sidebar: Treatment of property acquisition costs
IRS-proposed regulations (see main article) provide that “inherently facilitative” transaction costs must be capitalized. Acquirers should be aware that these costs (which can be thousands of dollars) often are inadvertently expensed by property owners, leading to surprise postacquisition IRS deficiencies and fines. These costs include:
- Securing an appraisal or determining the property’s value or price,
- Negotiating terms of the acquisition,
- Obtaining tax advice,
- Application fees, bidding costs and similar expenses,
- Preparing and reviewing documents that facilitate the acquisition of the property,
- Evaluating the property’s title,
- Obtaining regulatory approval of the acquisition or securing permits related to the acquisition, including application fees,
- Conveying property between the parties, including sales and transfer taxes and title registration,
- Finders’ fees or brokers’ commissions,
- Architectural, geological, engineering, environmental or inspection services pertaining to particular properties, and
- Services provided by a qualified intermediary or other facilitator of a like-kind exchange.
The regs do, however, provide an exception for costs relating to activities such as marketing studies that are performed to determine whether to acquire real property and which real property to acquire.
Warmest regards,
Douglas Rutherford, CPA, CGMA
© 2012 Douglas Rutherford, CPA, CGMA. All Rights Reserved. Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.
Visit RealEstateAnalysisSoftwareBlog.com for more information and resources for successful real estate investing.