One of the questions asked most often from clients is whether they can currently deduct improvements to their property or must they capitalize and deduct ratably over many years.
In September, 2013, the IRS provided guidance when they issued the New Tangible Property Regulations (T.D. 9636). The regulations are applicable to tax years beginning on or after January 1, 2014.
Under the regulations dealing with improvements, an expenditure must be capitalized if it meets any of the “BAR” tests. That is, the expenditure results in a betterment to the unit of property, adapts the unit of property to a new or different use, or results in a restoration of the unit of property.
- Betterment – an expenditure results in a betterment if it ameliorates a condition or defect that existed before the acquisition of the property or arose during the production of the property; is for a material addition to the property; or increases the property’s productivity, efficiency, strength, etc. For an example of an amelioration of a pre-existing condition assume in Year 1, “A” purchases a store located on a parcel of land that contains underground gasoline storage tanks left by prior occupants. The tanks had leaked prior to “A’s” purchase, causing soil contamination. “A” is not aware of the contamination at the time of purchase. In Year 2, “A” discovers the contamination and incurs costs to remediate the soil. The remediation costs are for a betterment to the land because “A” incurred the costs to ameliorate a material condition or defect that existed prior to “A’s” acquisition of the land.
- Adapts - An expenditure results in an adaptation to a new or different use if it adapts the unit of property to a use inconsistent with the taxpayer’s intended ordinary use at the time the taxpayer originally placed the property into service. For an example of an adaptation to a new or different use, assume “A” is a manufacturer and owns a manufacturing building that it has used for manufacturing since Year 1, when “A” placed it in service. In Year 30, “A” pays an amount to convert its manufacturing building into a showroom for its business. To convert the facility, “A” removes and replaces various structural components to provide a better layout for the showroom and its offices. The amount paid to convert the manufacturing building into a showroom adapts the building structure to a new or different use because the conversion to a showroom is not consistent with “A’s” ordinary use of the building structure at the time it was placed in service. Therefore, “A” must capitalize the amount paid to convert the building into a showroom as an improvement to the building.
- Restoration - An expenditure results in a restoration of an asset if the expenditure (1) restores basis that has been taken into account (e.g., as a loss or in computing gain or loss); (2) returns the unit of property to working order from a state of nonfunctional disrepair; (3) results in a rebuilding of the unit of property to a like-new condition after the end of the property’s alternative depreciation system class life; or (4) replaces a major component or substantial structural part of the unit of property. For an example of a restoration, assume “A” owns a manufacturing building containing various types of manufacturing equipment. “A” does a cost segregation study of the manufacturing building and properly determines that a walk-in freezer in the manufacturing building is section 1245 property as defined in section 1245(a)(3). Several components of the walk-in freezer cease to function, and “A” decides to replace them. “A” abandons the old freezer components and properly recognizes a loss from the abandonment of the components. “A” replaces the abandoned freezer components with new components and incurs costs to acquire and install the new components. “A” must capitalize the amounts paid to acquire and install the new freezer components because “A” replaced components for which it had properly deducted a loss.
Please note that the expenditure is tested against all the BAR tests. As such, if an expenditure does not constitute a betterment, the taxpayer may still have to capitalize it as an adaptation to a new use or as a restoration. Expenditures on existing assets that do not meet the BAR tests are generally deductible repairs.
David Poillucci/Darren Thomas