Every landlord and small business client spends money on roofs, HVAC units, floors and equipment, and the first question at year end is whether to deduct it or capitalize it. The answer comes from Treas. Reg. 1.263(a)-3, the tangible property regulations. The regulations are detailed, but three tools solve most client situations: the improvement tests, the routine maintenance safe harbor and the small taxpayer safe harbor for buildings. The de minimis rule for small items is covered separately in the de minimis safe harbor and capitalization policy guide.
When a payment is an improvement
Under paragraph (d), a taxpayer generally must capitalize amounts paid to improve a unit of property it owns. A unit of property is improved if the amounts paid for activities performed after the property is placed in service:
- are for a betterment (paragraph (j));
- restore the unit of property (paragraph (k)); or
- adapt the unit of property to a new or different use (paragraph (l)).
Everything else, such as ordinary repair and maintenance that keeps property in operating condition, is a deductible expense under section 162 if it otherwise qualifies.
The unit of property for a building
For a building, the unit of property is the building structure and the structural components, plus a list of separate building systems. The regulation names the systems to which the improvement rules are applied separately: HVAC; plumbing; electrical; all escalators; elevators; fire-protection and alarm; security; and gas distribution. This matters because replacing a major component of the HVAC system is tested against the HVAC system, not against the whole building. A roof replacement is tested against the building structure.
Routine maintenance safe harbor
Paragraph (i) deems amounts paid for routine maintenance not to improve the property. For buildings, routine maintenance means recurring activities that the taxpayer expects to perform because of its use of the structure or building systems to keep them in ordinarily efficient operating condition, such as inspection, cleaning, testing and replacement of damaged or worn parts with comparable and commercially available parts. The activities are routine only if the taxpayer reasonably expects to perform them more than once during the 10-year period beginning when the structure or system is placed in service by the taxpayer.
The safe harbor does not cover betterments. The IRS notes it can cover certain restorations, including replacing a major component or substantial structural part, when the 10-year test is met. It excludes replacing components for which a loss was deducted or basis was taken into account, restoring property after a casualty, returning deteriorated property to operating condition, and adapting property to a new use.
Document the expectation. A landlord's written maintenance plan for a boiler, showing replacement of the same part every three years, supports the position.
Small taxpayer safe harbor for buildings
Paragraph (h) lets a qualifying taxpayer elect not to apply the improvement rules to eligible building property if total amounts paid during the year for repairs, maintenance, improvements and similar activities on that building do not exceed the lesser of 2 percent of the building's unadjusted basis or $10,000.
- Qualifying taxpayer. Average annual gross receipts for the three preceding years of $10,000,000 or less.
- Eligible building property. A building unit of property (and condominium, cooperative or leased building interests) with an unadjusted basis of $1,000,000 or less. For a leased building, unadjusted basis is the total undiscounted rent over the lease term, including renewal periods if renewal is reasonably expected.
- Election. Made each year by attaching a statement titled "Section 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers" to a timely filed original return, including extensions. It cannot be made through an accounting method change (no Form 3115), an amended return is not allowed unless the Commissioner consents to a late election, and an election made for a year cannot be revoked.
- If exceeded. If the total exceeds the limit for a building, the safe harbor is not available for that building, and the general rules apply to all of the spending.
Worked example
A client owns a small apartment building with an unadjusted basis of $800,000. Average gross receipts are well under $10,000,000.
- Limit: the lesser of 2 percent of $800,000, which is $16,000, or $10,000. The limit is $10,000.
- Year one spending on repairs, maintenance and improvements: $9,400. This is within the limit, so the client elects the safe harbor and deducts the full $9,400.
- Year two spending: $11,200. This exceeds the limit by $1,200, so the safe harbor is unavailable for the building, and the full $11,200 goes through the improvement tests. A $7,000 furnace replacement goes to the restoration test for the HVAC system, and a $4,200 roof repair goes to the betterment and restoration tests for the building structure.
Second example: a leased building
A client leases a retail building for $4,000 a month for 20 years. Unadjusted basis for the safe harbor is the total undiscounted rent: $4,000 times 12 months times 20 years, or $960,000. That is under $1,000,000, so the building is eligible.
- Limit: the lesser of 2 percent of $960,000, which is $19,200, or $10,000. The limit is $10,000.
- Spending on the leased space for the year: $10,300. This is $300 over, so the election is unavailable and the routine maintenance safe harbor and improvement tests apply instead.
The cliff is the lesson: $1,200 over the limit turns a clean deduction into a project-by-project analysis for the whole year.
Betterment tests
Under paragraph (j), an amount is for a betterment only if it:
- ameliorates a material condition or defect that existed before acquisition or arose during production, whether or not the taxpayer knew of it;
- is for a material addition, such as a physical enlargement, expansion, extension or addition of a major component, or a material increase in capacity; or
- is reasonably expected to materially increase productivity, efficiency, strength, quality or output.
For a building, an amount improves the property if it is a betterment to the building structure or to a building system.
Common errors
- Testing a whole building as one unit when the work is on the HVAC, electrical or plumbing system.
- Adding the year's repair and improvement spending without including every item on that building toward the limit.
- Trying to make the small taxpayer election on an amended return or with Form 3115.
- Claiming routine maintenance for a one-time project that the client does not expect to repeat within 10 years.
File checklist
- Fixed asset register with unit of property and unadjusted basis by building.
- Invoice detail for repair and improvement accounts, with scope and location.
- The written maintenance plan used for the routine maintenance position.
- A copy of any section 1.263(a)-3(h) election statement filed with the return.
- Gross receipts for the three preceding years.
Sources
- Legal Information Institute, 26 CFR 1.263(a)-3, Amounts paid to improve tangible property: https://www.law.cornell.edu/cfr/text/26/1.263(a)-3
- Internal Revenue Service, Tangible property final regulations: https://www.irs.gov/businesses/small-businesses-self-employed/tangible-property-final-regulations
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