Expensive repair bills are a necessary evil for businesses that own tangible property, such as buildings, equipment and vehicles. The ability to claim a current tax deduction can help dull the pain. The question, though, is whether a deduction is available in the current tax year — or whether the costs must be capitalized as an improvement and depreciated over time.

Defining “Improvement”

An improvement occurs when a unit of property — including, but not limited to, entire building structures and separate building systems — undergoes a betterment, restoration or adaptation.

Betterments include amounts paid:

• To fix a material condition or defect that existed before the property was acquired or that arose during its production,
• For a material addition to the property (for example, a physical enlargement) or a material increase in capacity (for example, additional cubic or linear space), or
• That are reasonably expected to materially increase the property’s productivity, efficiency, strength, quality or output.

The tax regulations don’t define “material.” Instead, the IRS instructs taxpayers to use “common sense and reasonable judgment” in making the determination based on their facts and circumstances.

Restoration refers to the replacement of a major component or substantial structural part (or combination of parts) of a property. It includes amounts paid to return the property to ordinarily efficient operating condition from a state of disrepair that left it no longer functional for its intended use (for example, after a casualty loss). It also covers rebuilding to like-new condition at the end of the asset’s “class life,” as determined by the IRS.

Adaptation converts a property to a new or different use inconsistent with the property’s ordinary use when you placed it in service. For example, the costs to convert a building placed in service for manufacturing purposes into a showroom would be considered an adaptation.

Qualifying for Safe Harbors

Tax regulations provide the following safe harbors that permit you to expense costs that otherwise would constitute capitalizable improvements.

Routine maintenance safe harbor. You needn’t capitalize amounts that:

• Were paid for recurring activities that you expect to perform as a result of your use of the property in your trade or business,
• Keep the property in its ordinarily efficient operating condition, and
• Are for activities that you reasonably expected, when you placed the property in service, to perform:
  • For building structures and building systems, more than once during the following 10 years, or
  • For property other than buildings, more than once during the property’s class life.

Costs that don’t satisfy these criteria still may be deductible under the general facts and circumstances of the improvements analysis.

Small business safe harbor. This carveout is available if you 1) have average annual gross receipts of $10 million or less, and 2) own or lease eligible building property with an unadjusted basis (typically your original cost) of $1 million or less.

In addition, your total amount paid during the tax year for repairs, maintenance, improvements or similar activities performed on the building property can’t exceed the lesser of:

• 2% of the unadjusted basis of the eligible building property, or
• $10,000.

The total amount paid includes any amounts you’ve deducted under the routine maintenance or de minimis safe harbor.

De minimis safe harbor. If you have an “applicable financial statement” (generally, a certified financial statement), you can elect to deduct all properly expensed amounts up to $5,000 per item or invoice. Taxpayers without applicable financial statements can apply this safe harbor on amounts that don’t exceed $2,500 per item or invoice.

Important note: To complicate matters, it sometimes may be advantageous to capitalize repair costs, rather than expense them right away. For example, a pass-through entity might prefer to capitalize repair costs it could otherwise expense to increase its unadjusted basis in qualified property, so it qualifies for the new deduction on qualified business income (QBI).

Planning Ahead

Deciding whether to expense or capitalize repair costs requires professional judgment and a clear understanding of the tax code. Contact our tax experts to help your business make the most of your repair and improvement expenses.

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