Repairs to tangible property, such as buildings, machinery, equipment or vehicles, can provide businesses a valuable current tax deduction — as long as the so-called repairs were not actually “improvements.”
The costs of incidental repairs and maintenance can be immediately expensed and deducted on the current year’s income tax return. But costs incurred to improve tangible property must be capitalized and recovered through depreciation. If the property qualifies for 100% bonus depreciation, the classification is the same for tax purposes, but when it is a 27- or 39-year property, the difference can be substantial.
Betterment, restoration or adaptation
Generally, a cost must be depreciated if it results in an improvement to a building structure, or any of its systems, (for example, the plumbing or electrical system) or to other tangible property. An improvement occurs if there was a betterment, restoration or adaptation of the unit of property.
Under the “betterment test,” you generally must depreciate amounts paid for work that is reasonably expected to materially increase the productivity, efficiency, strength, quality or output of a unit of property or that is a material addition to a unit of property. For example, replacing wooden balconies with iron or steel balconies.
Under the “restoration test,” you generally must depreciate amounts paid to replace a part (or combination of parts) that is a major component or a significant portion of the physical structure of a unit of property. For example, you replace the boiler, which is a part of an HVAC system.
Under the “adaptation test,” you generally must depreciate amounts paid to adapt a unit of property to a new or different use — one that is not consistent with your ordinary use of the unit of property at the time you originally placed it in service. An example of this would be converting commercial property to residential.
A couple of IRS safe harbors can help distinguish between repairs and improvements:
- Routine Maintenance Safe Harbor
Recurring activities dedicated to keeping property in efficient operating condition can be expensed. These are activities that your business reasonably expects to perform more than once during the property’s “class life,” as defined by the IRS – such as painting. Amounts incurred for activities outside the safe harbor do not necessarily have to be depreciated, though. These amounts are subject to analysis under the general rules for improvements.
- Small Business Safe Harbor
For buildings that initially cost $1 million or less, qualified small businesses may elect to deduct the lesser of $10,000 or 2% of the unadjusted basis of the property for repairs, maintenance, improvements and similar activities each year. A qualified small business is generally one with gross receipts of $10 million or less.
More to learn
For more information, contact Mike Kovacs or your ORBA advisor at 312.670.7444. Visit orba.com to learn more about our Real Estate Group.