Repairs or replacements: Current deductibility of reconstruction costs

by Ronald A. Morris, Elliot Pisem
Published: January 01, 1997
Source: National Real Estate Investor

Capital expenditures are not currently deductible for tax purposes. By contrast, the cost of "incidental repairs" to business or rental property may be currently deducted as an "ordinary and necessary" business expense. Although the deductibility of business expenses in general, and of repair expenses in particular, is well established, the rule of capitalization is, as a theoretical matter, the primary one -- expenditures may be deducted only if they qualify for the trade or business expense "exception" to the requirement of capitalization.

The line between deductible repair costs and nondeductible capital outlays is a fine one and rests upon whether a given expenditure prolongs extend the life or adds to the value of an asset or merely keeps it "in an ordinarily efficient operating condition." Of course, many repairs, even if undertaken solely in order to maintain an asset in efficient operating condition, will also extend the asset's life to some extent and thereby add to its value. It is for this reason that applying these standards to actual cases has been described by the courts as "none too easy." The Court of Appeals for the Federal Circuit recently had occasion to try to clarify matters in a case involving the deductibility of construction costs undertaken in order to "earthquake-proof" a hotel structure. Swig Investment Co. v. United States (October 10, 1996).

The case involved the historic Fairmont Hotel, located atop Nob Hill in San Francisco. As built in 1907, the landmarked structure was distinguished by an unreinforced terra cotta and concrete entablature around the entire perimeter of the hotel roof which supported ornamental overhanging parapets and cornices. In 1969, the City of San Francisco, in order to mitigate hazards attendant to living in an earthquake zone, enacted an ordinance setting forth stricter lateral support standards. Pursuant to that ordinance, the San Francisco Department of Public Works issued a notice to the hotel that the wire-supported cornices and parapets, as well as the entablature supporting them, were in violation of the ordinance. The notice required the hotel to remove, reinforce, or reconstruct the entire entablature. The hotel's management viewed the hazardous architectural elements to be essential to the hotel's unique identity and, therefore, rejected the option of entirely removing the entablature. Instead the taxpayer opted for reconstruction. New glass reinforced concrete parapets and cornices, welded to the existing structure, were stronger and lighter than their terra cotta predecessors. The cost of the reconstruction was over $3,000,000, which the taxpayer claimed as an allowable deduction for an ordinary and necessary repair expense, on the theory that it was aiming only to cure a defect in order to bring the building into compliance with the ordinance and that the costs in question were incurred solely with an eye to the "repair and maintenance" of the hotel. Any long-term benefits inuring to it, the taxpayer maintained, were merely incidental to that purpose.

The Internal Revenue Service disallowed the deduction on the grounds that the cost of reconstruction was properly to be capitalized. The Service argued that the reconstruction, although undertaken in order to keep the building in safe operating condition, in fact extended the useful life of the entire building and thereby increased its value.

The Court of Appeals supported the Service's view. Viewing the current deductibility of certain business expenses as a "matter of legislative grace" excepted from the default rule of capitalization, the Court of Appeals rejected the taxpayer's contention that the long-term advantages of replacing the parapets and cornices were "incidental" to compliance with the mandate of San Francisco's ordinance. The court noted that the taxpayer could have instead opted for the far less expensive option of removing the entablature; that course, the court suggested, might have been classified as an "incidental repair." The taxpayer was motivated to rebuild the entablature by aesthetic, rather than safety, considerations. Furthermore, as the reconstruction buttressed existing lateral support mechanisms, it was found to extend the useful life of the entire structure, rather than of only a small part of it. The court rejected the taxpayer's contention that its costs of complying with the ordinance were in the nature of short-term repairs incurred solely to keep the hotel in proper operating condition.

While the taxpayer lost this case, the court did concede that the fact-intensive inquiry necessitated by the distinction between capital expenditures and deductible repair expenses "present[s] close questions." Property owners and their tax advisors should be alert to the varying factual circumstances and legal theories that may lead to undesired results in some cases, but possibly to material tax benefits in others.