Improvements vs. Repairs

The bulk of the new rules focus on changes in the Improvements vs Repair rules. Let’s review the “way it’s always been” so we have a basis for the changes. (§1.263(a)-3)

The general concept has always been if it’s an improvement (remember B.A.R.) it must be capitalized. The rules all go back to the definition of a UOP above. If an improvement is capitalized it may not be treated as its own UOP but must be treated as a part of the UOP it is improving. This is where we utilize the “component of” choice in selecting methods/class life of depreciable items.

Real property has some specific rules that do not apply to other tangible property. A building plus it’s structural components (building systems) equal one UOP referred to as “the building”. Improvements to “the building” must be capitalized. The building structure is one of those negative IRS definitions, anything not a building system is a building structure. Building systems include:

• HVAC systems
• Plumbing
• Electrical systems
• Elevators/escalators
• Fire Protection Systems
• Security Systems
• Gas Distribution systems

So how does all of this affect depreciation under MACRS? It doesn’t if the improvements are being capitalized and they have the same depreciable life as the UOP. If they have a different depreciable life it must be its own UOP for depreciation. (§1.263(a)-3(e)(5)(i))

Now for the changes. Before you get to the Improvement vs Repair decision, determine if the expense qualifies for one of the safe harbor elections. In addition to the de minimis safe harbor we discussed earlier there are two more safe harbors that may apply. Keep in mind that all of these safe harbors play off of each other. You may not double dip or mix and match. You must take the safe harbor in the order they qualify for and as an “all or nothing” equation.

Small Taxpayers Safe Harbor is for a taxpayer whose average gross receipts for the three preceding years is $10m or less. If the qualifications are met, then the taxpayer may expense the lesser of 2% of the unadjusted basis (of $1m or less) of the real property that the expenses were related to or $10,000. The figure from this calculation includes all safe harbors used in the tax year.

A statement must be included with the return electing this option saying “Section 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers”. As with the de minimis safe harbor this must be done on a timely filed original return, is irrevocable, and requires no Form 3115.

Routine Maintenance Safe Harbor is broken down into two categories. The first is for buildings, must be to keep or restore the building to its ordinary, efficient operating condition and must reasonably be expected to have to be performed at least twice in each ten year period the building is in service (even if the maintenance is not actually done twice).

The second category is for tangible property other than buildings and has the same qualifications except the time frame for the maintenance is more then once in the depreciable class life of the property. This safe harbor is not an election and a Form 3115 must be filed if used.

Examples of things this safe harbor may not be used for include casualty loss situations, partial dispositions, B.A.R., and network assets or rotable parts.

Tomorrow we talk about the B.A.R.

In accordance with Circular 230 Disclosure