Basics of Repairs versus Improvements

In an earlier post, I reviewed some of the basics around fixed assets, focusing primarily on purchased tangible property.  This is a deeper dive into repairs and maintenance expenses versus capital improvements for businesses that own real property.  Businesses that have build-outs in leased space or equipment may also need to consider if an expenditure is a repair or improvement. Determining whether to expense or capitalize specific transactions requires some judgement. 

Repairs and Maintenance

Routine maintenance costs should always be expensed regardless of the dollar amount of expense.  Annual inspections and cleanings of any systems are maintenance.  Examples of maintenance include the following:

•  HVAC annual inspection and maintenance

• Annual elevator inspections

• Annual fire sprinkler and extinguisher inspections

• Painting of existing structures

• Refinishing wood floors

• Sealcoating and striping of asphalt

Repairs generally restore a broken or worn item to its previous condition.  Repairs do not improve the fixed asset; repairs simply return the asset to its prior state.  Examples of repairs include the following:

• Replacing broken floorboards or tiles

• Replacing a broken window

• Repairing a furnace

• Repairing leaking plumbing

• Filling cracks in asphalt

• Replacing flashing around roof penetrations

So how do you treat more extensive repairs or replacements?  Naturally, the answer is that it depends.  Generally, repairs replace a minor portion of a fixed asset component (“Unit of Property” in IRS regulations), typically less than one-third.  For example, if repairing part of a roof damaged in a storm, if one-fourth of the roof is replaced, it is a repair.  If half of the roof is replaced, it is a replacement.  If windows on one side of a building require replacement, if less than one-third of all windows are replaced, it is a repair If you have a wooden fence with some rotted posts and panels, if you replace less than one-third of the fence it is a repair

Improvements

Improvements are changes to a fixed asset that must be capitalized on the balance sheet and depreciated over time.  Again, fixed asset components (“Unit of Property” in IRS regulations) should be considered when determining if expenditures are an improvement.  The IRS classifies three types of improvements: betterment, adaptation, or restoration.

Betterments include additions or other modifications that increase quality.  Examples of betterments include the following:

• Installing a hardwood floor

• Installing a sprinkler system

• Building a structural addition

Adaptations occur when a space is converted from its original use.  Examples of adaptations include the following:

• Converting a residential house into office spaces

• Converting an attic into a bedroom

• Converting a garage into a beauty salon

Restorations return property that is damaged or in disrepair to ordinary operating conditions.  Restorations include replacement of substantial portions of a property.  Examples include the following:

• Replacing all old single-pane windows with new energy-efficient triple pane windows

• Replacing a roof

• Replacing a septic system

Many of these examples will obviously overlap other types of improvements; converting an attic into a bedroom is likely to include betterments such as new windows, wiring, heating, insulation and finished surfaces.  The actual classification of an improvement as a betterment, adaptation or restoration isn’t important for most users; the importance is in recognizing that the project is an improvement to be capitalized. 

Any fees to architects or engineers as well as permitting fees are included as part of the capitalized costs of improvements.

For those who like decision trees, KBKG has an excellent one here .

Recordkeeping and Bookkeeping

For all of these expenditures, owners should keep actual or electronic copies of receipts.  For major projects with any architects or general contractors, do keep all the budget and proposal elements of contracts.  Breakdowns of a total project into component costs will help determine the basis and useful life of various parts.  For example, an addition to a residential rental may cost $100,000.   If the costs are not segregated into components, the entire addition may be depreciated over 27.5 years.  If the costs are broken into component parts, there will be some components with 15-, 7- and 5-year lives.  This allows an owner to recover depreciation expenses more quickly.  The crucial part for an owner and a bookkeeper are to keep good records to help classify repairs versus improvements, and within improvements to identify components and their costs when possible.

Conclusion

I’ve reviewed some of the criteria used to discriminate between repairs and improvements.  Even if an expenditure is a relatively high dollar amount, it may still be maintenance or a repair.  When a bookkeeper or business owner still isn’t sure about the proper classification, keeping detailed records and documenting them in the general ledger is a good practice until you can review things with your tax accountant.