This may sound like esoteric tax code nit-picking applicable only to a small subset of businesses, but UofP plays a large role in determining your repair or improvement tax treatment. It all relates to the test of the significance (material impact) of the expenditure on the property. You’ll want the UoP to be as large as possible because it’s harder for expenditures to have a material impact on the property. Thus, it’s more likely an expenditure will be considered a repair rather than an improvement.
Here’s an example: Karl’s Self Storage has three large, illuminated signs on the property. Karl upgrades the lighting system on one sign to be more visible and energy efficient. If all the signs are considered a single UoP, it’s easier to claim this wasn’t a material increase in efficiency and quality. In contrast, if each sign is a separate UoP, it’s far more likely the upgrade to the one sign will materially increase its efficiency and quality. Unfortunately, the latter is most likely to be the case.
Beware: Buildings Constitute Multiple Units of Property
For purposes of determining whether an expense is a repair or an improvement, each of the numerous systems within your building is considered a separate UoP. Therefore, a building is composed of the following UoPs:
- Building structure (walls, roof, windows, etc.)
- Heating, ventilation and air-conditioning (HVAC) systems
- Plumbing systems
- Electrical systems
- Gas-distribution systems
- Elevators or escalators
- Fire-protection and alarm systems
- Security systems
This division becomes critically important when money is spent on building upkeep. Here are two examples to consider. Deborah owns a three-story, climate-controlled storage facility. The facility’s HVAC system contains three separate cooling units. She replaced the compressor and pump on one of the units. Deborah considered her entire facility as a single unit of property and her costs a repair.
However, after checking the repair regulations, she’s not so certain. According to the IRS, the HVAC system is a separate UoP. Now, Deborah thinks the expenditure looks much more like a capital improvement. The determination will rest on whether the action was taken to cure a material defect or it resulted in a material improvement to the capacity, productivity, output, efficiency, strength or quality of the system. In many cases, the material-improvement test can work in your favor by allowing you to deduct expenses that previously would have been capitalized.
Now consider this example: Carlos replaced all the shingles on his self-storage facility roof with shingles of the same quality as the old ones. According to the IRS, even though all the shingles were replaced, the cost is a repair, not a capital improvement, because there wasn’t a material increase in quality. Carlos can deduct the full amount in 2012.
If Carlos had upgraded the quality of his roof, even by using significantly better shingles, the expense would have been classified as an improvement, meaning he would have to depreciate the cost over a 39-year period.