By Marcia Richards Suelzer
Savvy self-storage operators know curb appeal is essential for helping attract new customers and retaining existing ones. Of course, maintaining curb appeal means keeping up with repairs and undertaking renovations. As they say, you’ve got to spend money to make money. Unfortunately, many operators overlook the tax impact of facility repairs and improvements—and pay a price no general contractor’s estimate will ever include. Avoid that mistake by familiarizing yourself with the major tax issues involved when you spruce up your facility.
The Overwhelming Question: Is It a Repair or an Improvement?
Last year, the IRS attempted to clarify the characterization of a repair vs. an improvement by releasing the “repair regulations.” These regulations apply to tax years after 2011 and affect virtually every business taxpayer—with no exceptions for self-storage operators.
Historically, a simple repair to a capital asset, such as a building or a climate-control system, was considered a business expense. This meant the cost was fully deductible in the year it was incurred.
In contrast, an improvement to such an asset was deemed a capital expenditure. The entire cost of an improvement could not be deducted in the year it was incurred. Instead, the property was depreciated over a specified number of years, and your business was able to deduct only a portion of the cost each year.
Distinguishing between a repair and an improvement has always been tricky. As is often the case in tax law, the interests of the taxpayer and the IRS stand in direct conflict. You want to reduce taxes owed by as much as legally possible; the IRS wants to collect as much tax as possible from each and every taxpayer. In matters of physical repairs or improvement, classification determines whether the IRS or the taxpayer has the upper hand.
It’s to your advantage to classify physical work as a business expense to generate large deductions that, in turn, reduce taxable income. However, the IRS wants to characterize the work on your facility as a capital expense, with deductions for depreciation spread out over a large number of years.
Put simply, the new regulations confirm that everything that’s not a repair is an improvement, and the cost of improvements must be capitalized. Improvements comprise three distinct categories: betterments, restorations and adaptations. Just as the names imply:
- Betterments change the existing condition of a unit of property for the better.
- Restorations bring the property’s condition back to what it once was.
- Adaptations convert property to a new or different use.
For existing facilities in reasonably good condition, the tax treatment is a matter of distinguishing repairs from betterments. A “yes” answer to any of the following questions points to a betterment, not a repair.
- Does the action cure a material defect?
- Does the action enlarge or expand the property?
- Does the action materially increase the property’s capacity, productivity, output, efficiency, strength or quality?
You must answer these questions based on all the facts and circumstances, including why the expenditure was made, what actual work was done, how the work affected the property and how the expense is treated on financial statements.
What Is a Unit of Property and Why Should You Care?
IRS regulations require you to evaluate whether an expense is a repair or improvement with respect to a specific “unit of property” (UoP). As you might expect, the IRS’s notion of a UoP differs drastically from the average self-storage operator’s.
The IRS specifies that a UoP consists of all the functionally interdependent components necessary to use the property. If you cannot use one component without using other components, those components are functionally interdependent. (Special rules apply to buildings.) For example, a car is a UoP because it’s composed of functionally interdependent components. In contrast, a computer and a printer are two separate UoPs because one can be used without the other.