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Maintenance vs. Capital Improvement:
The Difference Can Mean Tax Savings for Building Owners
The difference between deductible repair and maintenance costs and capital expenditures can mean significant tax savings for property owners. Recent changes in IRS standards allow taxpayers to more easily clarify the difference for current and past years, creating opportunities for current year tax benefits.
Maintenance or capital improvement?
The key question is when a company must capitalize an expenditure, and when certain expenses can be deducted from current income.
Generally, taxpayers are required to capitalize expenditures that:
- Substantially prolong the life of the property
- Materially increase the value of the property
- Adapt property to a new or different use
- “Put” the property into a useful condition
By contrast, taxpayers may be able to deduct expenditures for:
- Routine maintenance
- Incidental repairs
- Equipment and materials that “keep” the property in an ordinary, efficient operating condition
In most cases, a taxpayer will pay less tax by classifying an expenditure as a repair and taking the current deduction, rather than capitalizing the expense and recovering the cost through depreciation. For this reason, it is often in the best interest of property owners to reclassify costs formerly capitalized and depreciated in order to reduce their tax liability.
Here are some examples of the subtle difference between repair and maintenance, and capital improvements:
- Example 1: The wooden roof shingles of an office building are damaged in a storm. Replacing the damaged shingles with new wooden shingles would be considered maintenance and repairs, which would be deductible as a current year expense. The same would be true if the wooden shingles were replaced with asphalt shingles. However, upgrading the wooden shingles to a 50-year, maintenance-free roofing system would have to be capitalized as a long-term improvement to the building. The cost would be subject to depreciation over 39 years.
- Example 2: To protect and maintain a concrete factory floor, ABC Manufacturing applies a new coat of epoxy sealer to the floor every year. This would typically be considered a deductible maintenance expense. However, if ABC Manufacturing purchases a previously occupied building and applies the same epoxy sealer to the floor in preparation for occupancy, it would be considered a capital improvement and the cost would have to be depreciated. The same would apply if the warehouse expands: the initial cost of epoxy floor sealer would be considered a capital improvement in the first year, and a maintenance cost in subsequent years.
- Example 3: When the weather breaks every spring, XYZ Distribution patches potholes and applies a fresh topcoat to the truck staging area near its dock. But after 10 years of making these annual repairs, XYZ decides to tear out the old asphalt and replace it with reinforced concrete that should last for 10 years without needing significant repairs. Expenditures for removing and replacing the material would be capitalized as a long-term improvement to the overall property.
Depending on the cost of the repairs and maintenance in any of these examples, the tax savings would be substantial. If the cost was $100,000, the taxpayer would save $40,000 in taxes ($100,000 multiplied by a combined, estimated federal and state tax rate of 40 percent).
Keep in mind that these are just examples. Other factors may lead to different conclusions. It’s best to consult a tax professional to make sure that all of the issues are covered before a reclassification is made.
Who can benefit?
Based on prior IRS guidelines, many building owners have treated maintenance and repair costs as capital expenditures. However, the IRS has proposed more liberal standards for expensing large-ticket items previously considered capital investments. The new rules create opportunities to go back and reclassify certain expenditures and recover previously paid taxes.
To claim the deduction without amending prior returns, the building owner must submit Form 3115 to change its accounting method. This change allows the taxpayer to claim a current year deduction for expenditures that could have been deducted in a prior year under the revised rules. There is no limitation on the period that is available for reclassifying repairs that were previously capitalized.
Contact your Clifton Gunderson tax professional to monitor and thoroughly understand the potential impact of these tax issues on your business and personal taxes.