New IRS audit technique guide for examination of repair and maintenance costs.

• Author: Fitzpatrick, Ellen

Taxpayers are generally allowed to deduct the cost of making incidental repairs to their property under Sec. 162 and Regs. Sec. 1.162-4. However, in order to be deductible currently, a repair's cost must not be subject to capitalization under Sec. 263(a). Specifically, Regs. Sec. 1.263(a)-1(a) provides that no deduction will be allowed for:

* Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate; or

* Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made in the form of a deduction for depreciation, amortization, or depletion.

Regs. Sec. 1.263(a)-l(b) goes on to provide that capital expenditures include amounts paid or incurred to (1) add to the value, or substantially prolong the useful life, of property owned by the taxpayer or (2) adapt property to a new or different use. Therefore, the determination of whether a cost falls within the scope of the regulations under Secs. 263(a) or 162 is extremely important.

In an effort to provide clarity in this area, the IRS and Treasury published proposed regulations in 2006 and re-proposed regulations in 2008 (REG-168745-03). The IRS and Treasury are expected to release a regulations package in the near future that will include final regulations, temporary regulations, and proposed regulations covering numerous issues in this area. However, notwithstanding the pending guidance, the IRS Large Business and International Division recently released an audit technique guide (ATG) that provides a framework for an examining agent to follow when examining this issue.

This item briefly describes some important cases in this area and the proposed regulations before discussing the recently released ATG.

Background

There are numerous cases discussing whether a cost is a deductible repair cost or a capital expenditure. The IRS provided guidance on what constitutes a deductible repair expense and what constitutes a capital expenditure in Rev. Rul. 2001-4. In that ruling, the IRS favorably cites Plainfield-Union Water Co., 39 T.C. 333 (1962), in which the Tax Court held that the proper test to determine whether a cost is a capital expenditure is "whether the expenditure materially enhances the value, use, life expectancy, strength, or capacity as compared with the status of the asset prior to the condition necessitating the expense." The revenue ruling also cites the decision in Illinois Merchants Trust Co., 4 B.T.A. 103 (1926), which applied a "put vs. keep" standard. Applying that standard, taxpayers would deduct repair costs incurred to keep the property in an ordinarily efficient operating condition, whereas costs incurred to put the property in an efficient operating condition would be considered capital expenditures.

The revenue ruling also addresses...