Depreciation question

[NotEasy]

A stairway of a rental property is broken and hazardous. So a new stairway is installed to replace it.

Does the taxpayer have to depreciate it?

Thanks.

[Koss]

Fully deductible in the current year?

An accountant I know recently made me rethink this particular question, i.e., whether something is a capital expenditure that must be depreciated or whether it is actually an ordinary business expense.

The underlying purpose of the expense, as well as the question of whether the expense was necessary to properly operate and maintain the business activity are the key factors.

On your fact pattern, my colleague would probably take the position that the replacement of the stairwell was an ordinary and necessary business expense, and classify it as repair or maintenance.

The text of the Internal Revenue Code that requires depreciation, and disallows a full current-year deduction, reads as follows:

§ 263. Capital expenditures

(a) General rule

No deduction shall be allowed for—

(1) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.

In contrast, the section that authorizes ordinary deductions reads as follows:

§ 212. Expenses for production of income

In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year—

(1) for the production or collection of income;
(2) for the management, conservation, or maintenance of property held for the production of income; or
(3) in connection with the determination, collection, or refund of any tax.

So the issue here is whether the stairway had to be replaced. If replacing it was the only reasonable way to eliminate the hazard, or if replacing it was effectively cheaper than repairing it, then the building owner did not pay for the work to increase the value of the property; rather, he paid for the work to maintain the property.

It may be the case that the value of the building increased a bit when the work was completed. But the text of the law can be read in a way that hinges heavily on the intent of the taxpayer.

When you add a deck or a swimming pool, you are not maintaining something that was already there, and I think it's a bit more cut-and-dried.

But my colleague argues that something like replacing a garage door or a kitchen sink, if that particular fixture has reached the end of its useful life, is not a capital improvement. It is simply maintaining the property. If you don't replace it, the property becomes uninhabitable, and may even violate building or housing codes. Correcting that kind of problem is remedial. You are not adding value to the property in a meaningful way. To the extent that the value may increase a little, that is incidental to the real underlying purpose of the work.

I'll concede that this is a gray area, that is highly dependent on individual facts and circumstances. If you tear up an old linoleum floor and put down expensive marble tile that is worth five times what the linoleum was worth when it was new, then perhaps you've made a capital improvement. But if you replace the floor with something comparable, and it had to be replaced, then you're just maintaining the property.

I think maybe some of us have a knee-jerk reaction that anything with a useful life of more than one year must be depreciated. I certainly thought that was how it worked most of the time. But now I've started looking at this from a different perspective. The useful life does not appear to be the only factor...

By the way: there are many areas of the tax law in which the IRS recognizes that the taxpayer's intent can have a significant impact on the tax treatment of an item. See, for example, the IRS discussion of the bona fide residence test for purposes of qualifying for the Foreign Earned Income Exclusion. You'll find this in the instructions for Form 2555, or in Publication 54.

[Black Bart]

Well-done, Burton.

...recently made me rethink this particular question, i.e., whether something is a capital expenditure that must be depreciated or whether it is actually an ordinary business expense.

...the issue here is whether the...had to be replaced..my colleague argues...if that particular fixture has reached the end of its useful life, is not a capital improvement. It is simply maintaining the property...Correcting that kind of problem is remedial. You are not adding value to the property in a meaningful way. To the extent that the value may increase a little, that is incidental to the real underlying purpose of the work.

I'll concede that this is a gray area...highly dependent on individual...circumstances...If you...put down expensive...tile...worth five times...new, then perhaps you've made a capital improvement. But if you replace the floor with something comparable, and it had to be replaced, then you're just maintaining the property.

This is a very timely and wonderfully insightful discussion of a problem that I'm sure many of us confront quite often (I do), especially if you have older clients who won't be around 27 1/2 years later. Clients naturally feel they should get some sort of immediate substantial benefit in these cases and it's very tough to break the news that they're getting maybe $250 depreciation and a token 50 bucks or so tax savings on an expensive and major cash outlay. Naturally they're disappointed and upset about it.

...some of us have a knee-jerk reaction...anything with a useful life of more than one year must be depreciated. I certainly thought that was how it worked...But now I've started looking at this from a different perspective...

That is also how I thought it worked too and I always felt there was something there that I couldn't quite put my finger on (on the tip of the tongue you might say), but this post crystallized my thinking on it and clarified it in a way I had not previously been able to grasp. I'm going to be doing more of this kind of inquiry and maybe getting some good and well-deserved deductions for some of my clients.

Thanks for a great post!

[fliszt]

Yes, thank you Koss,

I just printed this and put it with my other items of knowledge form Burton Koss.

[Black Bart]

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for Donanita.