Improvement or repair? A distinction with a difference.
Business owners are constantly asking me whether a certain expenditure is classified for tax purposes as a capital improvement or a repair. Unfortunately, the distinction is unclear.
The IRS defines a capital improvement as an expenditure that adds value, prolongs useful life, or adapts the property for new uses. Repairs are expenses that keep property in normal working condition and do not materially add value or increase the propertys useful life.
Why are business owners so concerned with these types of expenditures? Because their taxable income is directly affected by how they classify these expenditures.
Capital improvements are deductible as depreciation over their useful life. The cost of repairs is fully deductible in the year in which it was paid.
Classifying expenditures as repairs results in lower taxes in the current year. Since most businesses owners want to reduce their taxable income, many take an aggressive approach by classifying certain expenditures as repairs.
Please note that the IRS is very aware of this, so they pay close attention to the amount of repairs deducted on tax returns.
Over the years the courts have ruled on several cases related to this topic. Since there is no clear distinction, the courts have adopted a case-by-case approach, generally turning to the taxpayers specific facts and circumstances.
Lets look at two court cases that resulted in different conclusions because of those facts and circumstances.
Midland Empire Packing Co. v. Commissioner
Midland was a meat-packing company with a plant in Montana. The basement of the plant was used to store meat. Midland discovered that oil from a neighboring refinery was seeping into the basement. To prevent any contamination, Midland sealed the basement walls and floor by lining them with concrete.
The court ruled that the expenditure was necessary in order for Midland to continue using the basement for its normal operations. The court allowed the cost of sealing the basement to be expensed immediately as a repair.