Under §263(a), expenditures that keep an asset that has been placed in service for more than two years in its current operating condition, generally, must be expensed. In other words, if an expenditure is deemed to be a repair, it must be expensed.
If the expenditure restores the asset from a non-working condition to working condition, adapts the asset to a different use, materially improves the asset, or effects a major portion of the like components within an asset, it generally must be capitalized. §263(a) applies to all present and future expenditures
However, under §481a capitalized past expenditures that are not restorations, adaptations, betterments, or major improvements (RABI) can be expensed in the current tax year. This can create a large -481a adjustment. However, the eligibility requirements are very clear. The owner must not have ever used 263a (safe harbors notwithstanding) to determine expense versus capitalization of an expenditure. Also, a form 3115 with a DCN 184 must be submitted with a timely filed tax return.
The unit of property is the entire asset used for comparison. Buildings are usually a single unit of property, and the land improvements should be separated into a separate unit of property. Buildings are also broken down into building systems (HVAC, elevators and escalators, electrical, structure, etc.) and further broken down into components within the building systems which serve a major and critical function.
The following is a brief description of each of the RABI criteria. If an expenditure meets any of these definitions, it must be capitalized.
- Restorations. If the expenditure was performed anytime during the first two years after the asset was put in service, it is a restoration. In addition, if the asset was in a non-working condition and the expenditure put the asset back to a working condition, it is a restoration.
- Adaptation. If the expenditure changed the original intended use of an asset or building, it is an adaptation, and the entire amount must be capitalized.
- Betterment. If the expenditure materially increases the capacity, productivity, efficiency, strength, quality, or output of the component(s), it is a betterment and must be capitalized. The examples in the regulations leave room for interpretation of the word “materially”.
- Major Improvement. If the expenditure effects greater than 33% of all the like components which serve a discrete and critical function within the unit of property, it generally must be expensed. Again, the examples in the regulations leave interpretation of the 33% rule.
The following are actual examples of -481 adjustments utilizing the RABI rules.
- Purchased and put into occupancy in 1993
- Improvements over the years (after 1995) totaled $7,801,130
- $1,387,016 qualify as repairs
- The reclassification created a -481(a) adjustment of $1,387,016.
- The taxpayers combined tax rate was 37%. The -481a adjustment created a one-time tax savings of $513,195.
- Retail Strip Center
- Purchased and put into occupancy in 2000
- The building had four HVACS units.
- One of four HVAC’s was replaced in 2003.
- The replacement was 25% of the total HVAC units. Therefore, this was not a Restoration, Adaptation, Betterment, or Major Improvement.
- This created a -481 (a) adjustment of $10,000
- The clients combined tax rate was 24%. This created a one-time tax savings of $2,400.
CPAs should consider “scrubbing” their building owner clients’ depreciation schedules to look for possible depreciated expenditures that do not rise to the RABI criteria.