Can businesses expense rental property improvements in the year incurred, or must they capitalize them?
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Businesses generally must capitalize the costs of improvements made to rental property, rather than deducting (expensing) them in the year incurred. The tax treatment of such expenditures is governed by several key provisions of the Internal Revenue Code and Treasury Regulations.
1. General Rule: Capitalization of Improvements
Under IRC § 263(a), no deduction is allowed for amounts paid for new buildings or for permanent improvements or betterments made to increase the value of any property. This rule applies to both owned and leased property, including rental property. The cost of erecting buildings or making permanent improvements on property of which the taxpayer is a lessee is a capital expenditure.
2. Regulations on Improvements to Tangible Property
Treasury Regulation § 1.263(a)-3 provides detailed rules for determining when amounts paid to improve tangible property (including rental property) must be capitalized. A taxpayer must capitalize amounts paid to improve a unit of property, which includes amounts paid for:
- Betterments (e.g., fixing a pre-existing defect, physical enlargement, or material increase in capacity or quality),
- Restorations (e.g., replacing a major component or substantial structural part, or returning property to like-new condition), or
- Adaptations to a new or different use.
These capitalized costs are then recovered over time through depreciation (for owned property) or amortization (for leasehold improvements), rather than being deducted in full in the year incurred.
3. Improvements by Lessees
If a business is a lessee and makes improvements to leased property, the cost is also a capital expenditure. The lessee must capitalize the cost and may recover it through depreciation or amortization over the appropriate period, generally the shorter of the useful life of the improvement or the remaining lease term (including reasonably certain renewal periods).
4. Exception: Routine Maintenance and Safe Harbors
There are limited exceptions where certain expenditures may be currently deductible:
- Routine Maintenance Safe Harbor: If the expenditure is for routine maintenance (i.e., recurring activities expected to be performed more than once during a 10-year period for buildings), it may be deductible as a repair rather than capitalized.
- De Minimis Safe Harbor: If the cost of the improvement is below a certain threshold and the taxpayer has an applicable financial statement and written accounting procedures, the cost may be expensed under the de minimis safe harbor election.
- Safe Harbor for Small Taxpayers: For qualifying small taxpayers, if the total amount paid for repairs, maintenance, improvements, and similar activities on an eligible building property does not exceed the lesser of 2% of the unadjusted basis or $10,000, the amounts may be expensed.
5. Distinction Between Repairs and Improvements
Routine repairs and maintenance that do not improve the property (i.e., do not result in a betterment, restoration, or adaptation to a new or different use) are generally deductible as ordinary and necessary business expenses under IRC § 162. However, improvements as defined above must be capitalized.
6. Leasehold Improvements
For leasehold improvements, the lessee must capitalize the cost and depreciate or amortize it over the appropriate period. The lessor may also be required to capitalize improvements depending on the facts and ownership of the improvement.
7. Conclusion
Businesses must generally capitalize the costs of improvements to rental property and recover those costs over time through depreciation or amortization. Immediate expensing in the year incurred is only permitted for certain routine maintenance, under the de minimis safe harbor, or for small taxpayers meeting specific requirements. Otherwise, improvements must be capitalized.
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