Dealer Insights - September/October 2011 - Is it a Maintenance Expense or a Capital Improvement?
You put a new roof on your dealership, tile your showroom floor or make cosmetic changes. Soon you must determine whether it’s a maintenance expense you can fully deduct on your 2011 tax return or a capital improvement you must depreciate over a longer period. The wrong approach may mean more money in your pocket now but could get you in trouble with the IRS later.
Why is this important?
The IRS has declared the treatment of repairs and maintenance spending a Tier 1 issue, meaning positions taken by taxpayers in this area face heavy scrutiny upon IRS audit.
The IRS also has issued Proposed Regulation Section 1.263(a)-3 on this topic. Although proposed regulations can’t be relied upon by taxpayers, they do provide guidance on the IRS’s position and potential final regulations. Further, the proposed regulations are largely based on U.S. Tax Court cases.
What is a capital improvement?
Rather than create an exhaustive list of which expenditures are maintenance expenses, the IRS indicates what constitutes a capital improvement, including:
- Fixing a defect or condition that existed before purchasing an asset,
- Creating a material addition (physical enlargement, expansion or extension),
- Creating a material increase in capacity, productivity, efficiency, strength or quality,
- Replacing or repairing property for which a tax loss was taken through disposal or casualty,
- Returning the property to its ordinarily efficient operating condition if it has deteriorated to a state of disrepair and is no longer functional for its intended use,
- Rebuilding property to a like-new condition after the end of its economic useful life,
- Replacing a major component or substantial structural part of the property, or
- Adapting property to a new or different use.
The proposed regulation offers numerous examples of deductible and capitalizable expenditures. Although it doesn’t specifically list maintenance expenses, the proposed regulation provides a “safe harbor” for routine maintenance. It indicates that recurring activities (inspection, cleaning, testing, replacing parts, and so on) that are expected to be performed as a result of the use of property and to keep the property in its ordinarily operating condition aren’t capital improvements.
In some cases, the factory may assist in facilitating repairs or improvements. Be aware that the IRS doesn’t permit netting these payments against the expense.
If you’re unsure of how to classify a repair or maintenance expense, consult your tax advisor. He or she can help you make a tax treatment decision based on current IRS regulations and practices and past Tax Court decisions.
Dealer Insights - September/October 2011