Mary Bernard
Mary Bernard

Capitalization vs. Repair Issue

The Internal Revenue Service recently made capitalization vs. repairs change in accounting method requests a "Tier 1" issue, meaning closer scrutiny.

March 24, 2011
by Mary Bernard, CPA

A new Internal Revenue Service (IRS) initiative is focusing on determining the proper capitalization or expensing of repair and maintenance costs. The IRS has gone so far as to make any change in accounting method requests involving capitalization vs. repair a Tier 1 issue, meaning that these costs will attract a lot of attention during an audit. IRS examiners will be looking specifically at change in accounting-method requests that would recharacterize previously capitalized expenses as currently deductible.

Costs would be considered currently deductible as repair costs under Internal Revenue Code (IRC) section 162 if they are incidental in nature and do not materially add to the value of the property or significantly prolong the useful life of the property. Materials and supplies consumed during the year are also currently deductible. Under IRC section 263, expenses must be capitalized and depreciated over the useful life of the property if they are for permanent improvements that increase the value of the property, restore its value or use, substantially prolong its useful life or adapt it to a new or different use.

A key issue in the decision to capitalize or deduct costs as repairs is the determination of the unit of property (UOP). The smaller the UOP, the greater the likelihood is that costs incurred in connection with that UOP should be capitalized. If a vehicle engine is classified as a separate UOP, an overhaul of the engine is likely to be classified as capitalizable asset. If, however, the vehicle is classified as the UOP, the overhaul could be more readily classified as a repair cost.

In order to lessen the ambiguity in current tax authorities, the IRS issued guidance to field auditors in the form of a new Audit Technique Guide to assist in the audit of a change in accounting-method request involving capitalization vs. repairs. The guide includes which documents to request and instructs examiners on how to review the taxpayer's books and records to determine if the change is appropriate. There are issues that should be considered in order to be prepared to defend a request to change accounting methods. These guidelines are also useful in correctly classifying expenses as repair costs or capital improvements.

Costs Reclassified As Repairs

The audit guide instructs the auditor to investigate the following for any costs reclassified as repairs:

  1. Analyze records to determine the reason the work was undertaken. Consider documentation such as management reports, engineering assessments and invoice language.
  2. Determine the extent to which costs were treated as a unit of property (UOP) separate from the primary UOP.
  3. Determine the age of the asset, acquisition date and any prior work completed related to that asset.
  4. Determine the purpose of the project, considering what was done, why it was done and the dates the project began and ended. Consider how soon the work will have to be repeated.
  5. Consider long term projects and determine whether expenditures:
    1. Result in new assets;
    2. Improve the property, putting it in better operating condition;
    3. Add new components;
    4. Add upgrades or modifications, enhance the value of the property;
    5. Extend the useful life of the property;
    6. Improve the efficiency, quality, strength or capacity of the property; or
    7. Adapt the property to a new use. These factors tend to indicate that an expense must be capitalized, not treated as a deductible repair.

Cost Segregation and Asset Reclassification

Whenever a cost segregation or asset reclassification study has been conducted, auditors are advised to review the assets identified to determine if the taxpayer is being consistent in classification of Section 1245 property (generally personal property) and Section 1250 property (generally, real property). Consistency should be apparent in both asset identification and classification as well as appropriate treatment of related expenses as a capitalized asset or repair expense.

Unit of Property (UOP) and Dispositions

During an audit, an attempt will be made to determine if the taxpayer is using the same definition for a UOP for purposes of both asset depreciation and disposition and determination of whether to capitalize or expense a cost related to the asset. If the taxpayer is using different definitions, then the new method of determining repairs, expenses and the section 481(a) adjustment for recognizing the income impact should be consistent with claimed dispositions in previous years.

Defining the UOP for Buildings

Many taxpayers have claimed that no permanent improvement resulted from work performed on buildings because the work only affected a small part of the building or, alternatively, that the entire building is the UOP. Under these circumstances, any work done on the building, including installing a new roof or replacing the heating system, would be immaterial when compared to the building and its structural components as a whole. The new audit guide essentially admits that there is no clear-cut guidance on this issue. Courts have used inconsistent approaches in addressing the issue of capitalizing costs of replacing structural components. Facts and circumstances must be analyzed to determine the correct UOP for a building or its structural components.

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Mary F. Bernard, CPA, is director — income/franchise tax, at the Dallas, Texas-headquartered tax services firm of Ryan. Bernard formerly worked as principal, director of State & Local Tax Services, at Providence, RI-basedKahn, Litwin, Renza & Co., Ltd.