Improvements to Tangible Property
Understanding how the IRS defines improvements to tangible property is an important component of filing taxes properly.
Generally, a taxpayer who owns a unit of property must capitalize the amounts paid to improve the UOP that result in a betterment to the UOP, restores the UOP or adapts the UOP to a new or different use. So, if a taxpayer restores a building structure or makes a betterment, the expense is treated as an improvement to the single UOP consisting of the building.
Betterment Costs
(Reg. Sec. 1.263(a)-3(j)) - Which must be capitalized, consist of amounts paid:
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To ameliorate (improve, perfect, upgrade, enhance) a material condition or defect that either existed before the taxpayer acquired the UOP or arose during its production, whether the taxpayer was aware of the condition or defect when it was acquired or produced;
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That results in a material addition (including a physical enlargement, expansion, or extension) to the UOP; or
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That results in a material increase in capacity, productivity, efficiency, strength, or quality of the UOP or the output of the UOP.
Whether an expense results in a betterment depends on the facts and circumstances, such as the purpose of the expense, the physical nature of the work performed, and the effect of the expense on the UOP. In the case of a building, an amount results in a betterment to the UOP if it results in a betterment to the building or any of the building system properties listed earlier.
“ Example: Kim owns a small retail shop. A storm damages the roof of Kim’s shop by displacing numerous wooden shingles. She pays a contractor to replace all the wooden shingles on the roof with new wooden shingles. Kim is not required to treat the amount paid to replace the shingles as a betterment because it does not result in a material addition, or material increase in the capacity, productivity, efficiency, strength, or quality of the building structure compared to the condition of the building structure prior to the storm.If wooden shingles were not available on the market and Kim paid the contractor to replace all the wooden shingles with comparable asphalt shingles, the replacement of the old shingles with asphalt shingles would not, by itself, result in a betterment (improvement) to the building structure. However, if the new shingles were made of a material that was a lightweight composite, was maintenance-free and did not absorb moisture, and came with a 50-year warranty and a Class A fire rating, the amount paid for these shingles is considered a betterment. It is a betterment because there was a material increase in the quality of the shop building structure as compared to the condition prior to the storm. Therefore, the amount Kim paid for the betterment to the building structure is an improvement and must be capitalized. ”
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Note
There are a total of 21 various examples of betterments in the regulations.
Restoration Costs
(Reg. Sec. 1.263(a)-3(k)) – Restoration costs must be capitalized. An amount restores a UOP if it:
(i) Is for the replacement of a component of a UOP for which the taxpayer has properly deducted a loss for that component, other than a casualty loss;
“ Example - Replacement of loss component - TP owns a freezer used in TP’s manufacturing business that is not part of a building structure or the HVAC system. Several components of the walk-in freezer cease to function and the taxpayer decides to replace them. The TP abandons the old freezer components and recognizes a loss from the abandonment of the components. The TP replaces the abandoned freezer components with new components and incurs costs to acquire and install the new components. The TP must capitalize the amounts paid to acquire and install the new freezer components because the TP replaced components for which it had properly deducted a loss. (Reg. Sec. 1.263(a)-7, Ex 1) ”
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(ii) Is 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;
“ Example - Replacement of sold component - Same facts as in the previous example, except that the TP did not abandon the components but instead sold them to another party and properly recognized a loss on the sale. The TP must capitalize the amounts paid to acquire and install the new freezer components because the TP replaced components for which it had properly taken into account the adjusted basis of the components in realizing a loss from the sale of the components. (Reg. Sec. 1.263(a)-7, Ex 2) Note: the new components also would have to be capitalized if the sale had resulted in a gain instead of a loss. ”
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(iii) Is 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 or relating to a casualty event. However, the amount paid for restoration of damage to the unit of property that must be capitalized under this paragraph (k) is limited to the excess (if any) of—
• The amount of the adjusted basis of the single, identifiable property for determining the loss allowable on account of the casualty, over
• The amount paid for restoration of damage to the UOP that also constitutes an improvement.
“ Example - Restoration after casualty loss - TP owns an office building that it uses in its trade or business. A storm damages the office building that has an adjusted basis of $500,000. The TP deducts a casualty loss of $50,000, and properly reduces its basis in the office building to $450,000. The TP hires a contractor to repair the damage to the building, including the repair of the building roof and the removal of debris from the building premises. The TP pays the contractor $50,000 for the work. The TP must treat the $50,000 amount paid to the contractor as a restoration of the building structure because the TP properly adjusted its basis in that amount as a result of a casualty loss, and the amount does not exceed the $50,000 ($500,000 - $450,000) limit. Therefore, the TP must treat the amount paid as an improvement to the building unit of property and must capitalize the amount paid. (Reg. Sec. 1.263(a)-7, Ex 3) ”
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(iv) Returns the 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;
“ Example - Restoration of property in a state of disrepair – The TP owns and operates a farm with several barns and outbuildings. The TP did not use or maintain one of the outbuildings on a regular basis, and the outbuilding fell into a state of disrepair. The outbuilding previously was used for storage but can no longer be used for that purpose because the building is not structurally sound. The TP decides to restore the outbuilding and pays an amount to shore up the walls and replace the siding. The walls and siding are part of the building structure, and the TP must treat the amount paid as a restoration of the building structure because the amounts return the building structure to its ordinarily efficient operating condition after it had deteriorated to a state of disrepair and was no longer functional for its intended use. Therefore, the TP must treat the amount paid to shore up the walls and replace the siding as an improvement to the building UOP and must capitalize the amount paid. (Reg. Sec. 1.263(a)-7, Ex 6) ”
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(v) Results in the rebuilding of the unit of property to a like-new condition after the end of its class life. A unit of property is rebuilt to a like-new condition if it is brought to the status of new, rebuilt, remanufactured, or a similar status under the terms of any federal regulatory guideline or the manufacturer's original specifications. Generally, a comprehensive maintenance program, even though substantial, does not return a unit of property to a like new condition.
(vi) Is for the replacement of a part or combination of parts that comprise a major component or a substantial structural part of a unit of property. Generally, a major component is a part or combination of parts that performs a discrete and critical function in the operation of the unit of property. A substantial structural part is a part or combination of parts that comprises a large portion of the physical structure of the unit of property.
Note
There are a total of 31 various examples of restorations in the regulations.
Adapting to a New or Different Use
(Reg. Sec. 1.263(a)-3(l)) - A taxpayer must capitalize as an improvement an amount paid to adapt a unit of property to a new or different use. In general, an amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer's ordinary use of the unit of property at the time originally placed in service by the taxpayer.
Note
There are a total of 7 examples of adaptations in the regulations.