Introduction  

The Tangible Property Regulations brought welcome clarity to an important real-estate decision making process – can the cost of an improvement be expensed? Or must it be capitalized?  

When applied correctly, the TPR guidelines determine precisely which real estate costs require capitalization, and which may be expensed. The Capstan TPR Flowchart is helpful in walking through the process – please feel free to print and share.  

Regular readers might recall a blog on the three safe harbor elections established by the TPRs. When evaluating a real estate expenditure, the first order of business is to explore these expensing options – perhaps the spend in question meets one of these exceptions to capitalization.  

If that isn’t the case, the spend must be evaluated against the BAR Test: 

The purpose of the BAR Test is to determine whether the cost represents an improvement in the form of a Betterment, Adaptation, or Restoration. If the improvement is determined to be a Betterment, Adaptation, or Restoration, the cost of the improvement must be capitalized.  

This rule seems straightforward, but there are numerous subtleties in application. Let’s examine Betterments, Adaptations, and Restorations, and put some real estate expenditures to the test.   

B is for Betterment

The first type of betterment is one that corrects a pre-existing material condition or defect. If a taxpayer purchased land and then discovered the soil was tainted, remediation costs would be a betterment and must be capitalized.  

The other types of betterment are improvements that, well, make a property better: 

Assets that will increase the physical space or capacity of a property, or will increase the efficiency, strength, productivity, or quality of the property are all considered betterments. 

• Expanding the seating area at a successful family restaurant? That’s a material addition to increase size, and is therefore a betterment that must be capitalized.
  

• Sprayed insulation throughout a property, resulting in a tremendous decrease in energy costs? That’s a material increase to the property’s efficiency, and is therefore a betterment that must be capitalized.
  

• A property was purchased with a roof membrane in good condition. Over time, due to normal wear and tear, the membrane began to wear out.  Is replacing the membrane a betterment?  
  

It depends.  

• If the old membrane is replaced with a new comparable membrane, returning it to its initial condition but not making it any better, this is not considered a betterment. According to the Regulations, in this situation the new membrane could be expensed.
  
• If the old membrane is replaced with a more energy-efficient one, the new membrane would be considered a betterment. In this case the new membrane would have to be capitalized and depreciated. 

A is for Adaptation

An improvement is considered an adaptation if it adapts the Unit of Property (UoP) to a use other than the original use of the UoP at the time the building was placed-in-service.  

The classic example noted in the Regulations considers a taxpayer who opens a manufacturing facility, which functions for several years manufacturing some type of item. The taxpayer then decides to take a portion of the manufacturing space and convert it into to sales showroom space. The costs required to modify the building would be considered adaptations, since they are adapting a portion of the property to a different use. 

R is for Restoration 

The following improvements qualify as restorations:  

• Replacement of a major property component 
  

   

  • After the component was sold 
  • After the taxpayer deducted a loss for the component 
  • After the taxpayer claimed casualty loss 

• Restoration of a UoP to like-new condition after the end of its class life 
• Restoration of a UoP to its original operating condition 

That last bullet might seem confusing. Above, we said that replacing the old roof membrane with a new, comparable one – restoring it to its original operating condition – is not a betterment and doesn’t have to be capitalized.   

Now we’re saying that restoring a UoP to its original operating condition would be a restoration and would have to be capitalized.  

What’s the difference?    

The deciding factor is what caused the deterioration of the component in the first place – was it just normal wear and tear, or had the component been actively neglected?   

• If it was just normal wear and tear, like in the roof example, restoring the roof to its original operating condition is not considered a betterment and might not have to be capitalized.  

• If the deterioration was caused by major neglect on the part of the owner, then restoring the component to its original operating condition is considered a restoration and must be capitalized.  
  

For example, imagine that a farmer has three outbuildings on his land for storing equipment and materials, but decided he only needs two. He completely neglects upkeep on the third, so that it falls into a state of disrepair and is not fit to store expensive equipment. If he eventually realizes he does need three outbuildings, costs incurred for restoring the third outbuilding to its original operating condition would be considered restorations, and would require capitalization.  

So, if an improvement is determined to be a Betterment, Adaptation, or Restoration, it must be capitalized. But what if the improvement is determined to be none of the above?   

In Part III of this TPR Series, we’ll answer that question by posing the Materiality Test. (If you’re not getting our monthly newsletter, just let us know – you don’t want to miss out on Part III.)    

And if you have an immediate question that can’t wait for the sequel, please reach out. As always, we’re here to help.