Capitalize or Expense Building Improvements?
Recently a client came to us with a question about whether she should capitalize or expense a new interior door that replaced an old door within their building. The new door was heavy duty, fire resistant, and contained a window to facilitate monitoring of vulnerable clients. It was much more expensive than the standard door without a window that it replaced. In fact the $550 cost of the door, including installation, exceeded the organization’s capitalization threshold of $500.
IRS Rules on Tangible Property
Nonprofit organizations are not bound by IRS rules regarding tangible property (except for property used to generate unrelated business taxable income). However, the IRS framework for evaluating property purchases for capitalization is still a useful guide, especially when it comes to building improvements. If your organization owns or leases a building, you are probably familiar with how much money goes into repairing and maintaining a physical structure! Which building costs should you capitalize?
The IRS allows businesses to expense property purchases and improvements using a “de minimis safe harbor election” for property costing up to $2,500. This safe harbor is analogous to the capitalization threshold for nonprofits we have talked about in prior posts. Nonprofits should establish a capitalization threshold for assets with a useful life of more than one year that makes sense in light of the organization’s size and nature of its fixed assets.
- Property purchases at or above the capitalization threshold should be capitalized (recorded as an asset on the balance sheet).
- Property purchases below the capitalization threshold should be expensed, even if they have a useful life of more than a year.
See our post Fixed Asset or Expense? for more information on setting an appropriate capitalization threshold.
IRS Framework for Capitalization
In 2013 the IRS issued final regulations over costs to “acquire, produce or improve tangible real or personal property.” The regulations include a framework to explain more clearly which property costs should be capitalized vs. expensed.
In this post we are focused on building improvements, so we will describe the IRS framework in these terms. Costs to improve a building should be capitalized if the cost meets the organization’s capitalization threshold and is a(n):
- Fixing a defect or problem in construction or that existed before purchase
- Enlarging a building or significantly increasing capacity
- Materially improving a building, such as making it stronger or more energy efficient
- Adaptation of a property to a new or different use
- Replacing a major component or structural part of the building
- Restoring a property to good operating condition
- Restoring a property to like-new condition after the end of its useful life
You can use the acronym BAR to remember these three criteria.
IRS Framework for Maintenance
In contrast to capitalization, building improvements that qualify as maintenance should be expensed. The IRS describes routine maintenance costs as:
- Recurring activities that you expect to perform;
- As a result of your use of the property in your trade or business;
- To keep the property in its ordinarily efficient operating condition; and
- You reasonably expect, at the time the property is placed in service, to perform the activities more than once during the 10-year period beginning when placed in service.
Therefore even infrequent, major maintenance, such as painting, should be expensed.
The Question About the Door
Given the above information, we can now go back to our client’s question about the new door. Determining if the cost of the door should be capitalized or expensed follows a two-step process:
- Determine if the cost of the property improvement meets the client’s capitalization threshold.
- If the answer to #1 above is
- No, then expense the cost. It does not cost enough money to capitalize.
- Yes, then determine if the property improvement fits the IRS framework for capitalization or for maintenance.
The new door cost $750, which is more than the client’s $500 capitalization threshold. Therefore we proceed to step 2 and consider the IRS framework for capitalization vs. maintenance.
The new door did in fact replace a worn out door, so in that sense it was needed maintenance to keep the property in ordinary operating condition. However, the door that was installed was a much better quality door and more functional than the one it replaced, so in that sense we could say it was a major improvement. One aspect of maintenance is that it is recurring. The client does not expect to replace the door again within 10 years, perhaps not even within 30 or more years. Therefore this particular property improvement meets the definition of capital improvement:
- The door cost more than the client’s capitalization threshold of $500.
- It’s a “betterment” to the building, making the building safer (more fire resistant) and more functional (adding a window for observation).
Therefore we recommend capitalizing the new door.
We also recommend the IRS framework as described above for helping you make decisions about property improvements, especially those that fall into “borderline” territory between maintenance and capital improvement. As you can see, professional judgment is still required. Differences in opinion, even between two financial professionals, can occur. We suggest documenting why a decision was made to capitalize or expense a property improvement that exceeds the organization’s capitalization threshold, especially if an argument can be made either way. Also remember if the property is used for the production of unrelated business taxable income, then you must follow the IRS guidance for tax purposes.
Is that property or leasehold improvement “over the BAR?”
Next time you are wondering whether to capitalize a property or leasehold improvement, ask yourself if the cost is “over the BAR?” If a property improvement meets your organization’s capitalization threshold and the BAR criteria above, then it’s a candidate for capitalization!