Deductions for Repairs, Maintenance, and Capital Improvements for Businesses
Repair and maintenance costs are generally deductible. Capital expenses can only be deducted through depreciation, by adding the cost to the tax basis of the property. A capital expense materially adds to the value of the property, prolongs its life, or adopts the property for a different use. Some activity can be classified as either repairs or capital improvements — there is not always a bright line distinguishing repairs from capital improvements. Repairs keep property in good working condition, but they also extend the life of the property. In borderline cases, distinguishing between repairs and capital improvements depends on the facts and circumstances.
Repairing equipment is generally considered a repair, while repairing realty, such as replacing a roof, is usually considered a capitalized expense. Repairs can also include replacing inexpensive items. Repairing damage to property that is reimbursed by insurance is not deductible, but is considered a casualty loss. The taxpayer can elect to capitalize repair or maintenance costs if the costs are listed as such in the accounting system. Once the election is made, then the cost becomes depreciable. For business entities, partnerships, limited liability companies, and S corporations must make the election, not the individual owners.
Routine maintenance is deductible. Moreover, there is a safe harbor for treating routine maintenance costs as current deductions if the activities recur at least once a year over a 10-year period. Another safe harbor for small taxpayers — those with average annual gross receipts in the prior 3 years not exceeding $10 million — repairs, maintenance, and improvements do not have to be capitalized if they do not exceed the lesser of $10,000 or 2% of the unadjusted basis of the building, and the unadjusted basis of the building itself cannot exceed $1 million. The safe harbor applies to each separate building owned by the taxpayer. Again, in the case of business entities, only the entity can make the election.
Directives from a governmental agency or changes necessitated by law, such as changes that may be required by the fire department or by sanitary or health laws, do not reclassify such changes as repairs if they would otherwise be classified as capital improvements. Generally, environmental cleanup costs are deductible, such as those requirements set by the Environmental Protection Agency, such as encapsulating or removing asbestos, or replacing mold or contaminated drywall. Nonetheless, if the change is considered an improvement to the property, then the cost must be capitalized.
If the business claims a casualty loss for damage inflicted by natural forces, then any repairs must be capitalized.
Under the rehabilitation doctrine, any repairs that are made as part of a general plan to improve the property must be capitalized. For instance, if a new addition is added, then painted, then the cost of painting must be capitalized, even though it would have been deductible as a current expense if it had been done separately. However, a business owner may separate the repair cost from the improvement costs by scheduling them at different times and by receiving separate bills for the 2 activities.
Demolition and Removal Expenses
The cost of demolishing a building is added to the adjusted basis of the new building. However, partial demolition, defined as leaving at least 75% of existing external walls and of internal framework, then the cost can be currently deducted. Removal costs for tangible personal property are generally currently deductible.
Rehabilitation Tax Credits
There are 2 tax credits for rehabilitating certain types of property. A 10% tax credit can be claimed for rehabilitating a nonresidential building placed in service before 1936. A tax credit equal to 20% of the cost can be applied for rehabilitating a certified historic structure, which is one listed in the National Register or located in a registered historic district. The credit is claimed in the year in which the rehabilitation is finished and the property is placed back in service. The credit may be limited by passive loss rules if the owners do not actively participate in the business.
The rehabilitation must have been substantial, defined as rehabilitation expenditures that exceeded the greater of either the adjusted basis of the building or $5000 within any 2-year period during the rehabilitation. For pre-1936 buildings, at least 75% of the external walls must be left intact, with at least 50% of those external walls remaining as external walls.
Additionally, the Secretary of the Interior must certify that the rehabilitation of certified historic structures will maintain the building's historic status. The credit is claimed on the Form 3468, Investment Credit.
Special Tax Credits for Improvements Accommodating the Elderly or the Handicapped
The Americans with Disability Act (ADA) requires businesses to modify their property to better accommodate the handicapped and elderly, such as widening doorways, providing ramps for people in wheelchairs, and modifying bathrooms for the physically impaired.
Although most of these improvements would ordinarily be considered capital expenditures, the tax law provides incentives to businesses to make these changes, making them currently deductible or by providing a tax credit to offset their cost.
Small businesses with gross receipts not exceeding $1 million and with no more than 30 full-time employees for the tax year before the credit is claimed can claim the tax credit for expenditures to remove barriers on business property that impedes handicap access or to accommodate the visually- or hearing-impaired.
The maximum credit is $5000, but cannot exceed 50% of the expenditures between $250 and $10,250. In the case of business entities, the dollar limit applies to both the entity and the owners, such as partnerships and partners, and S corporations and shareholders.
Tax Credit = (Qualifying Costs – $250) × 50%
The maximum applicable expenditure is $10,250, so the maximum credit is $5000. To receive any credit, the expenditure must exceed $250.
Qualifying costs are for those improvements that were made to comply with ADA requirements. However, the tax credit cannot be claimed if the business is already in compliance with the ADA or if the expenditures were for new construction.
Removing Architectural or Transportation Barriers
The cost of removing architectural or transportation barriers to aid the handicapped or the elderly are currently deductible, with a maximum deduction of $15,000 for each year. Any costs exceeding $15,000 must be depreciated. For business entities, the dollar limit applies to both the entity and the business owners. For instance, the limit for the partnership as a whole is $15,000, which can be distributed to the partners according their share of the partnership costs. However, if the partners have other businesses or business entities, then their own expenditures cannot exceed the $15,000 limit from all businesses. If the business owner fails to use the total allocated share from a business entity, then the entity can use the unused portion, provided the business entity has received written confirmation from the business owner. So if a partnership allocates $10,000 worth of the capital expenditures to a partner, but the partner uses only $5000, then the partnership can allocate that $5000 to other partners. Records, such as contracts, architectural plans and blueprints, building permits, and other relevant documents, should be maintained to support the claim.
There also special tax rules and credits for energy improvements: Residential Energy Credits.