Last year, the IRS issued new regs on the tax treatment of amounts paid to acquire, produce, or improve tangible property, including your rental property. The regs explain when those payments can be deducted, which confers an immediate tax benefit, and when they must be capitalized. These final regs retain many provisions of the temporary regs that were issued in 2011. However, the final regs refine and simplify the temporary regs and add new safe harbor provisions that will help you to nail down expense deductions.
The regs must be followed for tax years that begin after Dec. 31, 2013—whether a calendar year or a fiscal year, such as a fiscal year beginning July 1, 2014. Taxpayers have the option of applying the final regs retroactively to the 2012 and 2013 tax years. There’s also a third option to apply the temporary regs to the 2012 and 2013 tax years.
The regs set forth the general rule that amounts paid to improve a unit of property 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.
On the other hand, the regs allow a current deduction for repairs and maintenance to property. Deductible repair and maintenance expenses are defined in a negative way—they are deductible if not otherwise required to be capitalized.
One key concept in the regs is the “unit of property” (UOP) that is being improved or repaired. The smaller the UOP, the more likely it is that costs incurred in connection with it will have to be capitalized. For example, work on an engine of a vehicle is more likely to be classified as an expense that must be capitalized if the engine is classified a separate UOP. By contrast, if the UOP is the vehicle, the engine work has a better chance of passing muster as a repair.
The regs generally treat each building and its structural components as one UOP—the “building.” The regs also list nine specific building systems that are treated as separate from the building structure. An improvement to the building is defined by its effect on those systems, rather than on the building as a whole.
If a taxpayer restores a building structure, such as by replacing the entire roof, the expense is treated as an improvement to the single UOP consisting of the building. If the taxpayer makes an improvement to a building system, such as the heating, ventilation, and air conditioning (HVAC) system, that expense is also an improvement to the building UOP.
The regs include a safe harbor that allows certain expenses of routine maintenance to be deducted rather than capitalized. Routine maintenance means recurring activities that keep business property in ordinarily efficient operating condition, such as inspection, cleaning, testing, and replacement of damaged or worn parts.
Under the 2011 temporary regs, this safe harbor wasn’t available for building maintenance. The final regs expand the safe harbor to cover buildings as well.
For a building structure or system, the taxpayer must reasonably expect to perform the maintenance more than once during the 10-year period that begins when the structure or system is placed in service. For property other than buildings, the taxpayer must reasonably expect to perform the activities more than once during the property’s class life for depreciation purposes.
The final regs add a new safe harbor that allows qualifying small taxpayers —those with average annual gross receipts of $10 million or less in the three preceding tax years—to deduct improvements made to a building property with an unadjusted basis of $1 million or less. This safe harbor applies only if the total amount paid during the tax year for repairs, maintenance, and improvements to the building doesn’t exceed the lesser of $10,000 or 2% of the building’s unadjusted basis.
This safe harbor may be elected annually on a building-by-building basis. It is elected by including a statement on the tax return for the year the costs are incurred for the building. I can help you to take advantage of this rule by filing the necessary election.