The question of whether to capitalize or expense repairs and maintenance costs has plagued sole proprietorships, businesses, and rental property owners alike. Prior to 2013, conflicting case law rulings and complex, temporary Internal Revenue Service (IRS) regulations left taxpayers with the daunting task of determining the proper course of action with little definitive guidance. Luckily, in September 2013, the IRS issued T.D. 9636, applicable for tax years beginning on or after January 1, 2014. This served to replace the temporary regulations and finalize the guidance on the application of sections 162(a) and 263(a) of the Internal Revenue Code, which address amounts paid to acquire, produce, or improve tangible property. While the decision-making process has arguably become clearer since 2014, the process for answering the longstanding “capitalize or expense” question is still multi-pronged.
Expensing (deducting), while frequently the taxpayer-preferred route, is not the automatic route. Taxpayers should ensure their costs do not fall into one of the capitalization categories before deducting. Generally, costs incurred will require capitalization, in order to do the following to tangible property:
- Fixing defects
- Enlarging, expanding, or adding
- Increasing ability
- Restoring deteriorated property
- Replacing major parts
- Rebuilding to pristine condition
- Included property in the which the basis was adjusted based on gains and losses incurred
- Converting to a new or different use
Repairs and maintenance costs that do not fall into one of the three categories above generally can be expensed for tax purposes and are fully deductible in the year incurred or paid at the formal election of the taxpayer. The IRS has indicated three safe harbor elections that allow for expense treatment automatically, without the extensive analysis previously identified:
- Safe harbor for de minimis costs
- Safe harbor for small taxpayers
- Safe harbor for routine maintenance
The de minimis safe harbor election allows for the immediate deductibility of repairs and maintenance costs up to $2,500 ($5,000 for applicable financial statements) per invoice or item. It is worth noting, however, that if the taxpayer’s accounting policy states a lower threshold for capitalization, their de minimis deductible amount is limited to that threshold. This is the only caveat for this otherwise simple election, unlike the safe harbor for small taxpayers, which is riddled with various requirements.
In order to elect the safe harbor for small taxpayers and deduct repairs and maintenance costs for owned or leased buildings that would otherwise require capitalization, the taxpayer must fulfill the following requirements:
- $10,000,000 or less in average gross receipts
- $1,000,000 or less unadjusted basis in the owned or leased building
- Total amount paid during the year for repairs and maintenance on the building does not exceed the lesser of:
- 2% of the unadjusted basis of the building
- The election is made every year in which qualifying amounts are incurred
If the taxpayer does not meet all the criteria above, the small taxpayer safe harbor election will not be a viable option for achieving deductibility. Assuming the taxpayer is not able to meet the requirements of either of the first two aforementioned safe harbor elections, depending on the nature of the costs, the third safe harbor election for routine maintenance might still be available.
Routine maintenance, while seemingly straightforward, is well defined by the IRS as repairs and maintenance costs that meet all the following criteria:
- Resulting from use of the property in the course of the business
- Keeping the property in its ordinarily efficient operating condition
- Reasonably expected when the property was placed into service
- Buildings/Building Structures: More than once during the 10-year period beginning when placed into service
- Other Property: more than once during the class life of the unit of property
While the requirements in first two safe harbor elections were defined by dollar value, the routine maintenance election is based on the character and intent of the costs incurred. Because of this, taxpayers should be wary when opting for this election that the nature of their costs meets all the criteria and does not fall into any of the categories that would require capitalization (betterments, restorations, or adaptations).
Taxpayers will always be left with the question of whether to capitalize or expense, often with the hope of taking the deduction. Even if the taxpayer does not automatically qualify for one of the three safe harbor election options, as long as the taxpayer’s costs do not fall into the betterments, restorations, or adaptations categories, the general answer to the age-old question is to expense.
For more information, contact one of Aronson’s construction specialists at 301.231.6200.