In what situations does property improvement depreciation not apply to building upgrades?

Property improvement depreciation generally applies to building upgrades that are capitalized as improvements under the tax rules. However, there are several situations where depreciation for property improvements does not apply to building upgrades. These situations are governed by both the capitalization rules under Treasury Regulations and the specific definitions and eligibility requirements for depreciation under the Internal Revenue Code. The main situations where depreciation does not apply are as follows:

1. The Expenditure is Not a Capital Improvement

• Repairs vs. Improvements: If the expenditure is for a repair or maintenance (not a betterment, restoration, or adaptation to a new or different use), it is deductible as a current expense and not capitalized. Therefore, depreciation does not apply. For example, patching a small section of a roof is a repair, not an improvement, and is expensed rather than depreciated.
• Safe Harbors: Small taxpayers may elect the safe harbor for small taxpayers or the de minimis safe harbor, allowing certain expenditures to be deducted rather than capitalized and depreciated.

2. The Property is Not Depreciable

• Land: Land is not depreciable. Costs associated with land (such as grading or landscaping not closely associated with a depreciable building) are not depreciated.
• Property Placed in Service and Disposed of in the Same Year: If an improvement is placed in service and disposed of in the same tax year, it is not depreciable.
• Inventory: If the improvement is to property held as inventory, depreciation does not apply.

3. The Improvement is Not to Depreciable Property

• Personal Use Property: If the building is used solely for personal purposes, improvements are not depreciable.
• Property Not Used in a Trade or Business or for the Production of Income: Depreciation only applies to property used in a trade or business or held for the production of income.

4. The Improvement is Not Capitalized by the Taxpayer

• Tenant Improvements Not Owned by the Tenant: If a lessee makes an improvement but is not considered the owner for tax purposes, the lessee cannot depreciate the improvement. Instead, the lessor may be required to capitalize and depreciate the improvement.
• Short-Term Leases: If the lease term is less than the recovery period and the lessee is not considered the owner, depreciation may not apply to the lessee.

5. The Improvement is Not Eligible for the Chosen Depreciation System

• Election Out of MACRS: If the taxpayer elects to use a method other than MACRS (such as the unit-of-production method), depreciation under MACRS does not apply.
• Alternative Depreciation System (ADS): Certain property (e.g., used predominantly outside the U.S., tax-exempt use property, tax-exempt bond-financed property) must use ADS, which may have longer recovery periods and different methods, or may not be eligible for bonus depreciation.

6. The Improvement is Not Qualified Improvement Property (QIP) or is Otherwise Excluded

• Improvements to Residential Rental Property: QIP only applies to improvements to nonresidential real property. Improvements to residential rental property are not QIP and do not qualify for bonus depreciation.
• Excluded Improvements: Expenditures attributable to the enlargement of the building, elevators or escalators, or the internal structural framework are not QIP and may not be eligible for bonus depreciation or Section 179 expensing.
• Improvements Made by a Previous Owner: Only improvements made by the taxpayer (or for the taxpayer under a contract) qualify as QIP. If a taxpayer acquires a building with prior improvements, those costs are not QIP for the new owner.

7. The Improvement is Expensed Instead of Capitalized

• Section 179 Expensing: If the taxpayer elects to expense the cost of the improvement under Section 179, depreciation does not apply to the expensed amount.
• De Minimis Safe Harbor: If the cost of the improvement is below the de minimis threshold and is expensed, depreciation does not apply.

8. The Improvement is to Property Not Owned by the Taxpayer

• Ownership Requirement: To claim depreciation, the taxpayer must own the property (or be treated as the owner for tax purposes, such as under a capital lease). If the taxpayer does not own the improvement, depreciation does not apply.

9. The Improvement is to Property Used for Tax-Exempt or Governmental Purposes

• Tax-Exempt Use Property: Improvements to property used by tax-exempt organizations or governmental units may not be depreciable by the taxpayer, or may be subject to special rules under ADS.

10. The Improvement is to Property Used Predominantly Outside the United States

• Foreign Use: Improvements to property used predominantly outside the U.S. are subject to ADS and may not be eligible for bonus depreciation or accelerated methods.

11. The Improvement is to Property Held for Sale (Inventory)

• Inventory Property: If the building is held primarily for sale to customers (inventory), improvements are not depreciable.

12. The Improvement is to Property Used Less Than 50% for Business

• Business Use Requirement: If the improvement is to property used 50% or less for business, depreciation may not be allowed, or may be limited.

13. Summary Table of Key Situations Where Depreciation Does Not Apply

In summary: Depreciation for property improvements does not apply to building upgrades when the expenditure is not a capital improvement, the property is not depreciable, the improvement is not to depreciable property, the improvement is not capitalized by the taxpayer, the improvement is not eligible for the chosen depreciation system, the improvement is not QIP or is otherwise excluded, the improvement is expensed instead of capitalized, the improvement is to property not owned by the taxpayer, the improvement is to property used for tax-exempt or governmental purposes, the improvement is to property used predominantly outside the U.S., the improvement is to property held for sale, or the improvement is to property used less than 50% for business.