Knowledge Center

  • RSS Feed
  • Contact
  • Print

KNOWLEDGE CENTER >

The Tangible Property "Repair" Regulations : Improvement to Tangible Property

June 08, 2012

Crystal Germanese, CPA
Tax Manager
BlumShapiro

The temporary regulations provide that generally a taxpayer must capitalize amounts paid to improve a unit of property owned by the taxpayer. Aunit of property is improved if the amounts paid for activities performed after the property is placed in service by the taxpayer:

  • Result in a betterment to the unit of property,
  • Restore the unit of property,or
  • Adapt the unit of property to a new or different use.

Betterments

In general, an amount paid results in the betterment if it:

  • Ameliorates a material condition or defect that either existed prior to the taxpayer's acquisition of the unit of property;
  • Results in a material addition (including a physical enlargement, expansion or extension) to the unit of property; or
  • Results in a material increase in capacity (including additional cubic or square space), productivity, efficiency, strength or quality of the unit of property or the output of the unit of property.

The determination of whether an amount paid results in a betterment is a facts and circumstancestest. All facts and circumstances should be consideredincluding, but not limited to, the purpose of the expenditure, the physical nature of the work performed, the effect of the expenditure on the unit of property and the taxpayer's treatment of the expenditure on its applicable financial statement. If a taxpayer needs to replace part of a unit of property that cannot practicably be replaced with the same type of part (e.g., because of technological advancements or product enhancements), the replacement of the part with an improved, but comparable, part does not, by itself, result in a betterment to the unit of property.

In cases in which a particular event necessitates expenditure, the determination of whether expenditure results in a betterment of the unit of property is made by comparing the condition of the property immediately after the expenditure with the condition of the property immediately prior to the circumstances necessitating the expenditure. If the expenditure is made to correct the effects of normal wear and tear, the condition of the property immediately prior to the circumstances necessitating the expenditure is the condition of the property after the last time the taxpayer corrected the effects of normal wear and tear.  

Example 1: Not a betterment; replacement with same part. X owns a small retail shop. A storm damages the roof of X's shop by displacing numerous wooden shingles. X pays a contractor to replace all the wooden shingles on the roof with new wooden shingles. The roof is part of the building structure. The event necessitating the expenditure was the storm. Prior to the storm, the building structure was functioning for its intended use. X is not required to treat the amount paid to replace the shingles as a betterment because it does not result in a material addition, or material increase in the capacity, productivity, efficiency, strength, or quality of the building structure or the output of the building structure compared to the condition of the building structure prior to the storm.

Example 2: Not a betterment; replacement with comparable part.Assume the same facts as in Example 1, except that wooden shingles are not available on the market. X pays a contractor to replace all the wooden shingles with comparable asphalt shingles. The amount that X pays to reshingle the roof with asphalt shingles does not result in a betterment to the shop building structure, even though the asphalt shingles may be stronger than the wooden shingles. Because the wooden shingles could not practicably be replaced with new wooden shingles, the replacement of the old shingles with comparable asphalt shingles does not, by itself, result in a betterment, and therefore, an improvement, to the shop building structure.

Example 3: Betterment; replacement with improved parts.Assume the same facts as in Example 2, except that, instead of replacing the wooden shingles with asphalt shingles, X pays a contractor to replace all the wooden shingles with shingles made of lightweight composite materials that are maintenance-free and do not absorb moisture. The new shingles have a 50-year warranty and a Class A fire rating. The amount paid for these shingles results in a betterment to the shop building structure because it results in a material increase in the quality of the shop building structure as compared to the condition of the shop building structure prior to the storm. Therefore, X must treat the amount paid for the betterment of the building structure as an improvement to the building and must capitalize the amount paid.

Restorations

An amount is considered paid to restore a unit of property if it:

  • Is for the replacement of a component of a unit of property and the taxpayer has properly deducted a loss for that component or has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
  • Is for the repair of damage to a unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss;
  • Returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;
  • Results in the rebuilding of the unit of property to a like-new condition after the end of its class life; or
  • Is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property.

In the case of a building, an amount is considered a restoration if it restores the building structure or any of the building systems.

The determination of whether an amount is a major component or a substantial structural part of the unit of property is a facts and circumstances test. The facts and circumstances that should be considered include the quantitative or qualitative significance of the replacement part in relation to the unit of property. A major component or substantial structural part includes a part or combination of parts that comprise a large portion of the physical structure of the unit of property or that perform a discrete and critical function in the operation of the unit of property. The replacement of a minor component of the unit of property, even though such component may affect the function of the unit of property, will not generally, by itself, constitute a major component or substantial structural part.

Example 1:Restoration of property in a state of disrepair.X owns and operates a farm with several barns and outbuildings. X did not use or maintain one of the outbuildings on a regular basis, and the outbuilding fell into a state of disrepair. The outbuilding previously was used for storage but can no longer be used for that purpose because the building is not structurally sound. X decides to restore the outbuilding and pays an amount to shore up the walls and replace the siding.  X must treat the amount paid to shore up the walls and replace the siding as a restoration of the building structure because the amounts return the building structure to its ordinarily efficient operating condition after it had deteriorated to a state of disrepair and was no longer functional for its intended use. Therefore, X must treat the amount paid as an improvement to the building and must capitalize the amount paid.

Example 2: Rebuild of property to like-new condition before end of class life.X owns a fleet of freight cars. Freight cars have a depreciation recovery period of seven years and a class life of 14 years. Every eight to ten years, X rebuilds its freight cars. Ten years after X places the freight car in service, X performs a rebuild, which includes a complete disassembly, inspection and reconditioning or replacement of components of the suspension and draft systems, trailer hitches and other special equipment. X modifies the car to upgrade various components to the latest engineering standards. The freight car essentially is stripped to the frame with all of its substantial components either reconditioned or replaced. The frame itself is the longest-lasting part of the car and is reconditioned. The walls of the freight car are replaced or are sandblasted and repainted. New wheels are installed on the car. All the remaining components of the car are restored before they are reassembled. At the end of the rebuild, the freight car has been restored to rebuilt condition under the manufacturer's specifications. Assume the freight car is the unit of property. X is not required to capitalize the amounts paid to rebuild the freight car because, although the amounts paid restore the freight car to like-new condition, the amounts were not paid after the end of the class life of the freight car.

Example 3: Rebuild of property to like-new condition after end of class life.Assume the same facts as in Example 6, except that X rebuilds the freight car 15 years after X places it in service. X must capitalize the amounts paid to rebuild the freight car because the amounts paid restore the freight car to like-new condition after the end of the class life of the freight car.

Example 4: Replacement of major component or substantial structural part: roof.X owns a large retail store. X discovers a leak in the roof of the store and hires a contractor to inspect and fix the roof. The contractor discovers that a major portion of the sheathing and rafters has rotted and recommends the replacement of the entire roof. X pays the contractor to replace the entire roof with a new roof. The roof is part of the building structure and comprises a major component or substantial structural part of X's building structure. X must treat the amount paid to replace the roof as a restoration because X paid the amount to replace a major component or substantial structural part of X's building structure. Therefore, X must treat the amount paid to restore the building structure as an improvement to the building and must capitalize the amount.

Example 5: Replacement of major component or substantial structural part: roof.Assume the same facts as Example 6 except the contractor recommends replacement of a significant portion of the roof, but not the entire roof. Accordingly, X pays an amount to replace a large portion of the decking, insulation and membrane of the roof of X's retail building. X must treat the amount paid for the roof work as a restoration of the building structure because X paid the amount to replace a major component or substantial structural part of the building structure. Therefore, X must treat the amount paid as an improvement to the building and must capitalize the amount paid.

Example 6: Not replacement of major component or substantial structural part: roof membrane. X is in the business of manufacturing parts. X owns a factory facility in which the parts are manufactured. The roof over X's facility is comprised of structural elements, insulation and a waterproof membrane. Over time, the waterproof membrane began to wear and leakage began to occur. Consequently, X pays an amount to replace the plant's worn roof membrane with a similar but new membrane. The roof, including the membrane, is part of the building structure. Although the roof membrane may affect the function of the building structure, it is not, by itself, a major component or substantial structural part of X's building structure. Because the roof membrane is not a major component or substantial structural part of the building structure, X is not required to treat the amount paid to replace the roof membrane as a restoration of the building structure.

Adaption to New or Different Use

In general, an amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer's intended ordinary use of the unit of property at the time originally placed in service by the taxpayer.

Example 1: New or different use.X is a manufacturer and owns a manufacturing building that it has used for manufacturing since Year 1, when X placed it in service. In Year 30, X pays an amount to convert its manufacturing building into a showroom for its business. To convert the facility, X removes and replaces various structural components to provide a better layout for the showroom and its offices. X also repaints the building interiors as part of the conversion. None of the materials used are better than existing materials in the building. The amount paid to convert the manufacturing facility into a showroom adapts the building structure to a new or different use because the conversion is not consistent with X's intended ordinary use of the building structure at the time it was placed in service. Therefore, X must treat the amount paid for the adaptation of the building structure as an amount that improves the building. Accordingly, X must capitalize the amount as an improvement.

Example 2: Not a new or different use.X owns a building consisting of 20 retail spaces. The space was designed to be reconfigured; that is, adjoining spaces could be combined into one space. One of the tenants expands its occupancy to include two adjoining retail spaces. To facilitate the new lease, X pays an amount to remove the walls between the three retail spaces. The amount paid to convert three retail spaces into one larger space for an existing tenant does not adapt X's building structure to a new or different use because the combination of retail spaces is consistent with X's intended, ordinary use of the building structure. Therefore, the amount paid by X to remove the walls does not improve the building.

Safe Harbor for Routine Maintenance

The temporary regulations provide for a routine maintenance safe harbor. An amount paid for routine maintenance performed on a unit of property is deemed not to improve that unit of property and, therefore, is not required to be capitalized. The routine maintenance safe harbor does not apply to buildings.

Routine maintenance is defined as the recurring activities that a taxpayer expects to perform as a result of the taxpayer's use of the unit of property to keep the unit of property in its ordinarily efficient operating condition. Routine maintenance activities include, for example, the inspection, cleaning and testing of the unit of property and the replacement of parts of the unit of property with comparable and commercially available and reasonable replacement parts. The activities are routine only if, at the time the unit of property is placed in service by the taxpayer, the taxpayer reasonably expects to perform the activities more than once during the class life of the unit of property.

Note: The class life is determined under the ADR system, without regard to whether the property is depreciated under MACRS. If the unit of property consists of more than one component with different class lives, then the class life of the unit of property if deemed to be the same as the component with the longest class life.

Note: Unlike under the de minimis rule for new acquisitions, there is not a dollar threshold or cap for items qualifying as routine maintenance.

Routine maintenance does not include amounts paid for the replacement of a component of a unit of property for which the taxpayer takes a loss or basis adjustment or amounts paid to return a unit of property to its former operating condition after the property deteriorated to a state of disrepair.

Example 1:  In January, Year 1, X purchases and places in service in its manufacturing operations a used machine that is a unit of property and has a class life of 10 years. X expects to perform manufacturer-recommended scheduled maintenance on the machine approximately every three years. The scheduled maintenance includes the cleaning and oiling of the machine, the inspection of parts for defects and the replacement of minor items such as springs, bearings and seals with comparable and commercially available and reasonable replacement parts.

At the time X purchased the machine, it was approaching the end of a three-year scheduled maintenance period. As a result, in February, Year 1, X pays amounts to perform the manufacturer-recommended scheduled maintenance.

X's costs do not qualify under the routine maintenance safe harbor because they were incurred primarily as a result of the prior owner's use of the property and not X's use. Accordingly, the amounts paid for the scheduled maintenance must be capitalized since those amounts result in a betterment, including the amelioration of a material condition or defect.

Example 2: Same facts as Example 1, except that X continues to operate the machine in its manufacturing business and, in Year 4, X incurs costs to perform the same scheduled manufacturer-recommended maintenance on the machine.

Since the scheduled maintenance performed in Year 4 involves the recurring activities that X performs as a result of its use of the machine, keeps the machine in an ordinarily efficient operating condition and consists of maintenance activities that X expects to perform more than once during the ten-year class life of the machine, X's scheduled maintenance is within the routine maintenance safe harbor. The amounts paid by X for the scheduled maintenance are deemed not to improve the machine and do not have to be capitalized.

The new regulations require virtually every business to review how repairs, maintenance, improvements and replacements are handled for tax purposes. BlumShapiro will continue to provide additional information as to how this change will affect your business and what steps you need to take.

If you have additional questions, please contact Crystal Germanese at cgermanese@blumshapiro.com or 860-570-6496.

We have compiled a series of additional articles to help taxpayers understand the new rules and understand how they will be implemented.

 

Advisors | Auditors | Consultants | CPAs - Blum Shapiro is one of the premier public accounting firms in the northeast and a Top 100 CPA Firm in the U.S. Our professionals serve businesses, individuals and organizations in Boston (MA), Hartford (CT), Cranston (RI), Shelton (CT) ,Quincy (MA) and Newton (MA) with audit, tax and business consulting services. Our firm has developed practice areas in automotive, construction, education, government, healthcare, hospitality, manufacturing, nonprofit organizations and professional service firms. New Haven CT, Fairfield CT, Norwalk CT, Waterbury CT.