Capitalized improvements vs. deductible repairs.

• Author: Owen, Sheila

Taxpayers generally must capitalize amounts paid to improve a unit of property. A unit of property is improved if the cost is made for (1) a betterment to the unit of property; (2) a restoration of the unit of property; or (3) an adaptation of the unit of property to a new or different use (Regs. Sec. 1.263(a)-3(d)).

Observation: The regulations do not provide bright-line tests for whether an expenditure results in a betterment, restoration, or adaptation to a different use. However, they do contain numerous detailed examples that should help practitioners make this determination.

Unit of property is an essential term and, except in the case of a building and its structural components, is defined as all components (real or personal property) that are functionally interdependent. Generally, components of property are functionally interdependent if the placing in service of one component is dependent on the placing in service of the other component (Regs. Sec. 1.263(a)-3(e)(3)(i)).For example, a computer and printer would not be functionally interdependent because either one could be placed in service and perform their intended function independently from the other.

If they are not required to be capitalized under the rules discussed in this section or any other provision (such as the UNICAP rules under Sec. 263A), amounts paid for repairs and maintenance can be deducted currently (Regs. Sec. 1.162-4(a)).

Buildings and building systems

Generally, each building and its structural components constitute the unit of property. If the taxpayer leases part of a building, the unit of property is the portion of the building subject to the lease along with the structural components associated with the leased portion (Regs. Sec. 1.263(a)-3(e)(2)). However, a cost must be capitalized if it results in an improvement to the building structure or to any of the specifically enumerated building systems. For this purpose, a building structure consists of the building (as defined in Regs. Sec. 1.48-1(e)(1)) and its structural components (as defined in Regs. Sec. 1.48-1(e)(2)), other than the structural components designated as building systems. Building systems include the heating, ventilation, and air conditioning (HVAC) systems; plumbing systems; electrical systems; escalators; elevators; fire protection, alarm, and security systems; gas distribution systems; and other systems identified in published guidance.

Example 1. Improvements to a building's HVAC system: D LLC, an LLC classified as a partnership, owns an office building. The building's HVAC system incorporates 10...