Volume A2, Issue 2007

Given a choice between deducting 100% of an expense on their current year's tax return or spreading the deduction out over several years, taxpayers in most situations would choose the former. So it's no surprise that taxpayers who own rental properties and commercial buildings want to distinguish currently deductible repair and maintenance expenses from amounts that must be capitalized and depreciated as property improvements.

Much To Gain

Where large sums are involved, the stakes can be high. The depreciation period for a residential rental property is 27.5 years. It's 39 years for a nonresidential building. Taking into account the time value of money, a taxpayer has much to gain by classifying expenditures as repair and maintenance expenses whenever the tax rules permit.

Fewer Controversies?

The repair versus improvement issue has been a frequent source of controversy between taxpayers and the IRS. Last August, the IRS issued proposed regulations that address this issue, among others. Although the regulations won't take effect until after they are finalized, they reveal current IRS thinking. Here's a brief overview.

Building construction or erection.

Under the proposed regulations, amounts paid to construct or erect property are treated as production costs that have to be capitalized if the property has a useful life extending substantially beyond the taxable year.

Improvements.

Amounts paid to improve a unit of property would have to be capitalized. The proposed regulations define "improvement" as a material increase in value, which would occur when the work is performed before the unit of property is placed in service or when the amount paid:

Cost segregation.

A building and its structural components generally are considered one unit of property under the regulations. However, if the cost of a building component (an electrical system, for example) is segregated so that the component can be depreciated more quickly than the building itself, the component is treated as a separate unit of property in determining whether the amount spent on an overhaul results in a material increase in value, thus requiring capitalization.

Repair allowance method.

At their option, taxpayers could treat most amounts paid for repairing, maintaining, or improving property as deductible costs to the extent they don't exceed a repair allowance specified for that type of property. Amounts in excess of the allowance would have to be capitalized. Certain costs would be ineligible for the new method.