Capitalization of repair costs mandated by law.

Business taxpayers who own buildings increasingly find it necessary to make repairs and improvements as these structures get older. Most expenditures are in the nature of repairs that generally maintain the structure, but do not add to its physical life. Such expenditures may be deducted as ordinary and necessary; see Sec. 162(a) and Regs. Sec. 1.162-4. However, if the expenditure is for a permanent improvement, or has the effect of increasing the property's value or appreciably prolonging its life, the expenditure must be capitalized (Sec. 263(a); Regs. Sec. 1.162-4). Often, the line between a repair and a permanent improvement is a fuzzy one. The distinction is further complicated if the taxpayer is mandated to make the repair by government ordinance.

In 1969, the City of San Francisco enacted an ordinance setting higher safety standards for parapets and cornices on buildings (due to the hazardous conditions resulting from earthquakes). The management of the Fairmont Hotel, a well-known historical landmark, was informed by city officials that its parapets and cornices were hazardous and that the hotel needed to take corrective action (e.g., strengthening, reconstructing, bracing or removing them). After a thorough study, the hotel decided to replace the old parapets and cornices with new ones made of glass fiber-reinforced concrete. The new parapets and cornices were welded to the hotel, replacing the prior wire supports. The cost of this reconstruction was in excess of $3 million, which the taxpayer deducted as an ordinary and necessary business expense on its corporate income tax return.

The IRS disallowed the deduction, saying it should be treated as a capital expenditure. The taxpayer paid the resulting tax and interest and, after denial of its refund claim, filed a refund suit with the Court of Federal Claims, where the Service's position was upheld. The Federal Circuit recently affirmed the lower court's ruling (Swig Investment Co., 10/10/96).

The Appeals Court found that the new parapets and cornices were lighter and stronger than the prior ones. They significantly improved the structural soundness of the hotel, thereby increasing the building's value. In addition, the court noted that these expenditures extended the useful life of the entire structure. Finally, the court noted that the effort constituted a major replacement project and could not be considered a repair.

The taxpayer argued that the replacement was an "incidental repair" that should be deductible as such. The taxpayer also argued that, since it was compelled by a city ordinance to bong its parapets and cornices into compliance, the cost of doing so should be deductible as an ordinary and necessary business expense. This argument was rejected, with the Appeals Court citing cases dealing with costs of (1) building a filtration plant to comply with antipollution laws and (2) converting electricity from direct current to alternating current.

Comment: For the past several years, taxpayers have expended billions of dollars on environmental clean-up costs. Although taxpayers have been encouraged (or even mandated by Federal and state governments) to make such expenditures, the Service has been reluctant in most cases to approve current deductibility because of the loss of tax revenue. Many of the factors cited by the Appeals Court in Swig have been used by the IRS to require capitalization of environmental cleanup costs. (See Rev. Rul. 94-38, in which environmental cleanup costs to remedy damage done by the taxpayer were deductible.) Needless to say, there has been great frustration on the part of many business taxpayers that their mandated costs do not qualify for a current tax deduction.