Game Changer: Repair vs. improvement: IRS final Regs. carry several safe harbors.

• Author: McBride, Gary
• Position: Federaltaxation

the IRS published massive final regulations Sept. 19, 2013, and overhauled the standards for determining if an expenditure constitutes a repair that can he expensed or an improvement that must be capitalized (T.D. 9564). The Following highlights several challenges and opportunities presented by the regulations. The final regulations retail] the structure of the 2011 temporary regulations. but contain several taxpayer Friendly safe harbors.

The Problem

The repair and maintenance line on tax returns has long been a favorite target of IRS auditors.

For example: Prior to the recent regulations, if an IRS auditor spotted a $25,000 repair and maintenance expenditure to replace all of the shingles on the leaky roof of a building, the agent would likely insist that the expenditure be capitalized .and depreciated over the modified accelerated cost recovery system life of the building'. Why? Because the IRS auditor would argue that replacement of all of the shingles on a roof did not merely keep the building in an ordinarily efficient operating condition, it also appreciably prolonged the lire of the property rind materially increased its value the standard for capitalization in the prior IRC Sec. 263 a regulations and case law such as Estate of Walling (3rd Cir. 1966) and Plainfield-Union Water Co. (T.C. 1962).

The IRS was generally undeterred by the fact that some judicial decisions, such as Campbell (T.C. Summary Opinion 2002-11), allowed the taxpayer to expense the replacement of a leaky roof covering. Plenty of other decisions, such as Tsakopoulos (T.C. Memo 2002-81. supported capitalization of a roof replacement caused by leaks. The case law was inconsistent. The prior standards were difficult to apply and "led to considerable uncertainty and controversy for taxpayers" [per the preamble to the temporary regulations published in 2011 (T.D. 9564)].

The Solution

The final regulation, similar to the 2011 temporary regulations, jettison the old standards discussed above and instead focus on three considerations. An expenditure is an improvement if it constitutes a:

* Betterment:

* Adaptation; or

* Restoration.

A betterment ameliorates a pre-acquisition material condition or defect in the unit-of-property (UOP: enlarges or expands the UOP; or increases the pruductivity, efficiency, strength or quality of the UOP.

An adaptation occurs when an .amount is paid to adapt the UOP to a new or different use, if the adaptation is inconsistent with the taxpayer's ordinary use of the UOP at the time originally placed in service by the taxpayer.

Distinguishing betterments and adaptations from repairs can be challenging, but the following focuses on restoration and, in particular, replacements of components of a UOP--often indistinguishable from a repair.

Replacements of Parts

Regarding replacements, a restoration includes "the replacement of a part or combination Of parts that comprise a major component Or a substantial structural part of a unit of property" [Reg. S. 1.263(a)-3(k)(1)(vi). So, what is a major component(MC) vs. incidental component (IC)? A substantial structure part (SSP)?

The regulations concede that the answer is generally driven by considering all the facts and circumstances...