DEFINITIONS
The following definitions and terms from the Internal Revenue Code are important to understand when considering whether an amount paid to acquire, produce, or improve tangible property is deductible or must be capitalized and depreciated.
Adaptation to a new or different use. An amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with your ordinary use of the unit of property at the time you originally placed it in service.
Unless one of the elections is made (discussed later in this chapter), any amount paid to adapt a unit of property to a new or different use is capitalized and depreciated.
Applicable financial statement (AFS). An AFS includes a financial statement required to be filed with the SEC, as well as other types of certified audited financial statements accompanied by a CPA report, including a financial statement provided for a loan, reporting to shareholders, or for other nontax purposes. An AFS also includes a financial statement required to be provided to a federal or state government or agency other than the IRS or the SEC.
Note. It is very rare for an individual taxpayer to have an AFS, but it may be somewhat common for small businesses. For example, if the terms of your bank loan require your business to have an annual audit by a CPA, the audited financial statement would be an AFS.
Betterments. A unit of tangible property is improved if the amounts paid are for a betterment to the unit of property. Unless one of the elections is made (discussed later in this chapter), amounts paid for betterments are capitalized and depreciated.
A betterment includes: (i) amounts paid to fix a material condition or material defect that existed before the acquisition or that arose during production of the unit of property; (ii) amounts paid for a material addition, including a physical enlargement, expansion, extension, or addition of a major component to the property, or a material increase in the unit of property’s capacity, including additional cubic or linear space; or (iii) amounts paid that are reasonably expected to materially increase productivity, efficiency, strength, quality, or output of the unit of property, where applicable.
Materials and supplies. The term “materials and supplies” means tangible property that is used or consumed in your business that is not inventory and that: (i) Is a component acquired to maintain, repair, or improve a unit of tangible property owned, leased, or serviced by you and that is not acquired as part of any single unit of tangible property; (ii) Consists of fuel, lubricants, water, or similar items, reasonably expected to be consumed in 12 months or less, beginning when used in your operations; (iii) Is a unit of property that has an economic useful life of 12 months or less, beginning when the property is used or consumed in your operations; (iv) Is a unit of property that has an acquisition cost or production cost of $200 or less; or (v) Is identified by the IRS in published guidance as materials and supplies. There are two types of materials and supplies: incidental and nonincidental.
Deductibility of amounts paid for nonincidental materials and supplies. If the materials and supplies are nonincidental, then you deduct the materials and supplies costs in the tax year in which the materials and supplies are first used or consumed in your operations, assuming they would not otherwise be capitalizable as an improvement. For example, you would deduct certain expendable spare parts in a trucking business for which records of consumption are kept and inventories are recorded in the tax year the part is removed from your storage area and installed in one of your trucks.
Deductibility of amounts paid for incidental materials and supplies. If the materials and supplies are incidental (i.e., of minor or secondary importance), carried on hand without keeping a record of consumption, and no beginning and ending inventories are recorded (e.g., pens, paper, staplers, toner, trash baskets), then you deduct the materials and supplies costs in the tax year in which the amounts are paid or incurred, provided taxable income is clearly reflected.
Note. If you elect to use the de minimis safe harbor (discussed later in this chapter) and any materials and supplies also qualify for the safe harbor, you must deduct amounts paid for these materials or supplies under the safe harbor in the tax year the amounts are paid or incurred. Such amounts are not treated as amounts paid for materials and supplies and may be deducted as business expenses in the tax year they are paid or incurred.
Restoration of property. Unless one of the elections is made (discussed later in this chapter), amounts paid to restore a unit of property are capitalized and depreciated. A restoration of property occurs when:
- Amounts are paid for the replacement of a part or combination of parts that make up a major component or a substantial structural part of the unit of property; or
- You have taken into account or adjusted the basis of the unit of property or component of the unit of property, including:
- Amounts paid for the replacement of a component of the unit of property, and you have properly deducted a loss for that component, other than a casualty loss; or
- Amounts paid for the replacement of a component of the unit of property, and you have properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component; or
- Amounts paid for the restoration of damage to the unit of property for which you are required to take a basis adjustment because of a casualty loss under Section 165, or relating to a casualty event described in Section 165, but limited to the basis in the unit of property; or
- Amounts paid to return the unit of property to its ordinarily efficient operating condition, if the unit of property has deteriorated to a state of disrepair and is no longer functional for its intended use; or
- Amounts paid to rebuilding the unit of property to a like-new condition after the end of its class life.
Routine maintenance. Any amount paid for routine maintenance of a unit of tangible property (including buildings, condominiums, cooperatives, and leased buildings) is not considered an improvement of the property. As a result, you can deduct the cost of routine maintenance in the year paid.
Costs that are not routine maintenance. Routine maintenance does not include the following: (i) Amounts paid for a betterment to a unit of property; (ii) Amounts paid for the replacement of a component of a unit of property for which the taxpayer has properly deducted a loss for that component; (iii) Amounts paid for the replacement of a component of a unit of property for which the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component; (iv) Amounts paid for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss; (v) Amounts paid to return a unit of property to its ordinarily efficient operating condition, if the property has deteriorated to a state of disrepair and is no longer functional for its intended use; and (vi) Amounts paid to adapt a unit of property to a new or different use.
Routine maintenance does, however, allow you to deduct amounts paid or incurred to replace a major component or substantial structural part that would otherwise result in capitalization. There are additional exceptions for routine maintenance for network assets and rotable and temporary spare parts that are beyond the scope of the Tax Guide.
Routine maintenance of buildings. Routine maintenance for a building or other unit of property is the recurring activity that a taxpayer expects to perform as a result of the taxpayer’s use of a building, condominium, cooperative, or leased building to keep the building structure or each building system in its ordinarily efficient operating condition. Routine maintenance activities include, for example, the inspection, cleaning, and testing of the building structure or each building system, and the replacement of damaged or worn parts with comparable and commercially available replacement parts. Routine maintenance may be performed any time during the useful life of the building structure or building systems.
The activities are routine if you reasonably expect to perform the activities more than once during the 10-year period beginning at the time you place in service the building structure or the building system upon which the routine maintenance is performed. However, your expectation will not be deemed unreasonable if you do not actually perform the maintenance a second time during the 10-year period, provided that you can otherwise substantiate that its expectation was reasonable at the time the property was placed in service. Factors to be considered in determining whether maintenance is routine and whether your expectation is reasonable include the recurring nature of the activity, industry practice, manufacturers’ recommendations, and your experience with similar or identical property.
Routine maintenance of nonbuildings. Routine maintenance for property other than buildings is the recurring activity that you expect to perform as a result of your use of the unit of property to keep the unit in its ordinarily efficient operating condition. Routine maintenance activities include, for example, the inspection, cleaning, and testing of the unit of property, and the replacement of damaged or worn parts of the unit of property with comparable and commercially available replacement parts. Routine maintenance may be performed any time during the useful life of the unit of property. However, the activities are routine only if, at the time you place the unit of property in service, you reasonably expect to perform the activities more than once during the class life (ADS recovery period for depreciation purposes) of the unit of property. For example, the ADS depreciable life of automobiles and light trucks is five years. At the time you place your new pickup truck in service, it is reasonable to expect that you will need to replace the tires twice because you anticipate that you will drive 200,000 miles during the five-year period. In this situation, replacing the tires is considered routine maintenance of the pickup truck. As a result, the cost of replacing the tires is deductible under the routine maintenance safe harbor.
Unit of property. The “unit of property” concept is used, in part, to determine whether certain costs are: (a) repairs that can be expensed; or (b) improvements/replacements that must be capitalized and depreciated. In general, if costs incurred with respect to a specific unit of property are not betterments, restorations, or adaptations for new or different use, they may be deductible.
There are special unit of property rules for plant property (industrial process such as manufacturing, warehousing, or distribution) and network assets (train tracks, pipelines, etc.) that are beyond the scope of the Tax Guide.
Buildings. The term “building” generally means any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space. It does not include such structures as oil and gas storage tanks, grain storage bins, silos, fractionating towers, blast furnaces, basic oxygen furnaces, coke ovens, brick kilns, and coal tipples.
Each building and its structural components is considered a single unit of property; however, the improvement rules must be applied separately to the building structure and each of the separate building systems. A “building structure” consists of the building and its structural components (other than the structural components designated as “buildings systems”). For this purpose, condominiums and cooperatives are considered buildings.
The term “structural components” includes parts of a building such as walls, partitions, floors, and ceilings, as well as any permanent coverings such as paneling or tiling, windows and doors, stairs, and other components relating to the operation or maintenance of a building.
Each of the following structural components, including the components thereof, is a “building system” that is separate from the building structure, and to which the improvement rules must be applied: (1) Heating, ventilation, and air conditioning (“HVAC”) systems; (2) Plumbing systems; (3) Electrical systems; (4) All escalators; (5) All elevators; (6) Fire-protection and alarm systems; (7) Security systems for the protection of the building and its occupants; (8) Gas distribution systems; and (9) Anything else the IRS determines to be a structural component in published guidance.
Note. Lessees of portions of buildings apply the analysis to the portion of the building structure and portion of each building system subject to the lease. Lessors of an entire building apply the improvement rules to the entire building structure and each of the key building systems.
Nonbuildings. A single unit of property is comprised of all its functionally interdependent components. Components of property are functionally interdependent if the taxpayer cannot place one component in service without placing another component in service. For example, a car is a single unit of property. The steering wheel, engine, brakes, and tires are functionally interdependent components of the car. You cannot use brake pads without attaching them to the rest of the car.
Chapter 48: Rules for expensing and capitalizing tangible property used in a trade or business
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Ernst & Young Tax Guide 2018, 33rd Edition