Deductibility of repairs.

There is a distinction in the tax code between deductible repair expenses and capital improvements. Normally, the costs of repair and maintenance to property used in a trade, business or profession, or held for investment (that is, the costs that keep the property in an ordinarily efficient operating condition), are fully deductible, while expenses that are in the nature of replacements, or that prolong the life of an asset, materially add to its value or make it adaptable to a different use, normally must be capitalized (and depreciated over the asset's life).

GENERAL GUIDELINES 

While this rule sounds simple enough, its application is not; the question of whether a specific expenditure is a deductible repair or a capital improvement is not nearly so clear and depends on the facts and circumstances of each situation. There are, however, certain common factors that should be examined.

Cost of the "repair" relative to the property's value. If the corrective action cost represents a large percentage of the property's overall value, the cost's deductibility almost certainly will be questioned. While current deductions for substantial amounts of repairs have been allowed, as a practical matter major items or major amounts spent usually are considered to be capital improvements.

Prolonging the property's useful life. When an expenditure substantially prolongs an asset's normal, expected useful life, it generally is treated as a capital expenditure. Typically, this measurement should consider the property's useful life before the incident necessitating the repair occurred or was discovered.

Increasing the value of the property. Generally, if the correction's cost increases the property's value, the expenditure could be considered a capital expense. However, since virtually all repairs increase the repaired property's value (and marketability), the proper standard in this determination is the property's value after the expenditure compared with its value before the corrective action was discovered.

A common guideline to keep in mind is that correcting a defect in the most inexpensive way may characterize the action as a repair.

Closely allied to this increased value rule is the rule that an expenditure creating or enhancing a tangible asset with a useful life of more than one year must be capitalized.

Adapting property to a different use. If the expenditure enables property to be put to a new, different use, the cost is a capital expenditure. Alterations that adapt an asset so it can function in a different manner are capital improvements.

Rehabilitation approach. If an otherwise deductible repair is part of an overall pattern of rehabilitation, the entire cost may be considered a capital expenditure. Usually this approach is limited to substantial capital improvements and repairs to the same specific assets.

ASBESTOS REMOVAL

Following the promulgation of significant environmental legislation and regulations within the last few years, businesses have had to spend large amounts of time and money removing asbestos from the work place. There has been considerable uncertainty over the tax treatment of these costs. It was thought they would be considered deductible, since such efforts were not due to any wrongdoing on the part of businesses but were based on government reaction to advances.

IRS letter ruling 9240004. In Internal Revenue Service technical advice memorandum 9240004, the IRS ruled otherwise, holding that asbestos removal costs had to be treated as capital expenditures. The IRS believed the taxpayer received long-term future benefits that would accrue beyond the year in which the costs were incurred. According to the service, these benefits were not incidental; after the asbestos was removed, the value of the taxpayer's machinery increased and it became more marketable. In addition, the likelihood the taxpayer would have to suspend operations was eliminated (again increasing the property's marketability). Finally, because the employees' health risks (as well as the employer's potential health care liability) were reduced, the IRS thought these costs clearly provided a benefit with future implications.

For a discussion of this ruling and other current developments, see the Tax Clinic department, edited by William C. Herrick, in the December 1992 issue of The Tax Adviser. --Nicholas Fiore, editor The Tax Adviser

Ed. note: The material discussed provides general information. Before you take any action in this area, the appropriate code sections, should be examined.