Do You Capitalize or Expense?

A question that frequently comes up for businesses is whether a cost can be immediately expensed in whole, or if it must be capitalized incrementally over different tax years. As with a lot of tax matters, the short answer is … it depends. Essentially, taxpayers have to evaluate all the individual facts and circumstances to see if they can immediately expense it (i.e., Sec. 179), are required to capitalize it, or if they can fall under an exception. Also, evaluating is made more difficult due to the various rules that can apply with any given situation. Below is a simplified summary of what would be important to distinguish.

Taxpayers must capitalize amounts paid for “improvements” to a unit of property. A unit of property (UoP) is considered improved if the expense results in—

• a betterment to the unit of property,
• a restoration to the unit of property, or
• an adaptation of the unit of property to a new or different use (see, Treas. Reg. 1.263 (a)-3(d)).

If expenses meet any of these three standards, they must be capitalized.

Expanding on this, under the repair regs, no deduction is allowed (and therefore capitalization is required) for:

• amounts paid for new buildings or for permanent improvements or betterments made to increase the value of any property or estate; or
• amounts paid in restoring property or in making good the exhaustion thereof for which an allowance is or has been made via a deduction for depreciation, amortization, or depletion.

So, the first step is provided for us under Treas. Reg. 1.263(a)-3. The ten tests for determining if something is an improvement are:

1. ameliorating a pre-existing condition or defect;
2. a material addition to, or material increase in the capacity of a unit of property;
3. a material increase in the productivity, efficiency, strength, quality, or output of a UoP;
4. a replacement of a component of UoP for which a loss deduction was claimed (other than a casualty loss);
5. adaptation to a new or different use;
6. a replacement of a component of a UoP for which the adjusted basis was taken into account in computing loss or gain following a sale or exchange of the component;
7. a restoration of a UoP for which there was a basis adjustment on account of a casualty loss;
8. a return of the UoP to its ordinarily efficient operating condition after deterioration to the point where it is no longer functional for its intended purpose;
9. a rebuilding of the UoP to a like-new condition after the end of its class life; and
10. a replacement of either a major component or a substantial structural part of a UoP.

If an activity fails any of these ten tests, it is capitalized.

De Minimis:

If the business has an accounting procedure or written policy under which assets or improvements with “de minimis” costs are expensed, they can make an election. This is a safe harbor limited to items under $5,000, if the taxpayer has an “applicable financial statement”; or, under $2,500, if it does not have an applicable financial statement.

Qualifying Small Taxpayer:

Those with an average annual gross receipts less than $10 million, may elect not to treat as capitalized expenses—in other words, to currently deduct—improvements made to an eligible building property (unadjusted basis less than $1 million) if the total amount paid during the tax year for repairs, maintenance, improvements, and similar activities performed on the eligible building doesn’t exceed the lesser of:

• 2% of the eligible building’s unadjusted basis;
• $10,000.

Refresh for Retail/Restaurants:

“Qualified costs” that are subject to the safe harbor accounting method for the remodel-refresh costs of retail and restaurant businesses are the qualified taxpayer’s remodel-refresh costs less the qualified taxpayer’s excluded remodel-refresh costs. For instance, removal and demolition, other than demolition subject to Code Sec. 280B, of structural components of a qualified building (for example, insulation, windows, drywall, and similar property) that directly benefit or are incurred by reason of a remodel-refresh project. A taxpayer who qualifies to use the safe harbor must treat 75% of its qualified costs paid during the tax year as deductible business expenses and must treat the remaining 25% as costs for improvements to a qualified building and as costs for the production of property for use in the taxpayer’s trade or business. (See, Rev. Proc. 2015-56, Sec. 4.05(16), 2015-49 IRB 827.)

The cost of remodeling a house that the taxpayer bought with the intention of rehabilitating and selling at a profit were determined to be capital expenses. The property was a capital asset, and taxpayer’s improvements, such as installing a well and adding insulation and central heat, added to its value and extended its life. (See, Jamieson, Charles, (1949) and Havener, Shane, (2018) TC Summary Opinion 2018-17.)