Deductible Repairs Versus Capitalization

Overview

The rules as to what is a “repair” and, therefore, is deductible, and what must be capitalized and depreciated have never provided a bright line for determining how an expense should be handled.  The basic issue is finding the line between I.R.C. §162(a) and I.R.C. §263(a).  I.R.C. §162(a) allows a deduction for ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business, including amounts paid for incidental repairs.  Conversely, I.R.C. §263(a) denies a current deduction for any amount paid for new property or for permanent improvements or betterments that increase the value of any property, or amounts spent to restore property.

The line between a currently deductible repair and an expense that must be capitalized is one that farmers and ranchers often deal with.  A recent court decision involving a Colorado grape-growing operation illustrates the difficulty in determining the correct tax classification of expenses.

Basic Principles

In general, any expense of a farmer associated with the business with a useful life of less than one year is deductible against gross income.  Depreciation is required if an asset has a useful life of more than one year.  Expenses are current costs, and any cost that produces a benefit lasting for more than one year (such as expenses for improvements that increase the property’s value) is generally not currently deductible.  Instead, those items must be depreciated or amortized over the period of benefit or use.  Indeed, Treas. Reg. §§1.263(a)-1, (b)-2, 1.461-1(a)(2), an expense must be capitalized if the item has a benefit to the taxpayer extending substantially over one year or adapts the property to a new or different use.

A big issue for farmers and ranchers is whether major engine or transmission overhauls are currently deductible as repairs.  Fortunately, there are cases that provide useful authority for the position that major engine or transmission overhauls should be currently deductible as repairs. See, e.g., Ingram Industries, Inc. & Subs. v. Comm’r, T.C. Memo. 2000-323; FedEx Corp. & Subs. v. United States, 121 Fed. Appx. 125 (6th Cir. 2005), aff’g, 291 F. Supp. 2d 699 (W.D. Tenn. 2003).  Under these court opinions, engines and transmissions are generally treated as part of the larger machine.  This means that the economic life of the engine or transmission is to be treated as co-extensive with the economic life of the larger machine (e.g., a tractor or combine).  Because the larger machine cannot function without an engine or transmission, overhaul of the engine or transmission while affixed to the machine can give rise to a current deduction.

Recent Case

In Wells v. Comr., T.C. Memo. 2018-11, the petitioner owned and lived on a 265-acre farm.  She had lived there off-and-on since 1965, but continuously from 1983 forward.  Before the petitioner came into ownership of the property, her father owned it.  She cultivated about 700 white French hybrid rind grapevines on a part of the property.  In the good years, the vines produced up to four tons of grapes, but in the lean years production could be as low as one-half ton.  The petitioner normally sold the grapes, but when production declined, she began crushing the grapes and selling the juice to local buyers.  She grazed animals on other parts of the farm.  Her gross farm income for 2010 and 2011 was $305 and $255 in 2010 and 2011 respectively, and her total farming expenses were $208,265 in 2010 and $54,734 in 2011.  Many of those claimed deductible expenses were associated with her grape growing activity.  Upon audit, the IRS denied a large portion of the petitioner’s claimed expenses, asserting that the they were improvements that should be capitalized. 

Underground water line.  In 1965, the petitioner’s father installed an underground pipe to convey water from a spring on one part of the farm to supply water to a pasture where animals were grazed as well as to irrigate the grapes.  Over time, portions of the two-inch pipe were replaced with new two-inch pipe that was of higher quality and could withstand higher water pressure.  The pipeline was completely replaced in 2009 with new pipe, but then started leaking and a section of it was replaced later in 2009.  More leaks occurred in 2010 and additional sections of the pipe were replaced and joints repaired.  The court determined that the entire water line was replaced at least one time during 2009 and 2010. 

The petitioner claimed that neither the pipeline’s useful life was extended nor the value increased.  Instead, the petitioner asserted that the pipeline replacement cost was deductible because floods destroyed parts of the pipeline in 2009 and 2010 and she had no other option but to replace the pipeline, and that doing so was simply an accumulation of repairs into 2009 and 2010.  She claimed to not have the funds in prior years to make repairs in those earlier years. 

The IRS maintained that the pipeline “repair” expense was properly capitalized as an improvement, and the court agreed.  The court determined that the pipeline work was part of a “general plan of rehabilitation, modernization, and improvement” to completely repair the pipeline.  The court noted that the pipeline was completely replaced, its life was extended and its value was increased (because of the use of higher quality pipe).  It was immaterial, the court held, that flooding might have destroyed part of the pipeline leaving replacement as the petitioner’s only option.  The court noted that an analogous situation was present in Hunter v. Comr., 46 T.C. 477 (1966), where the cost of a replacement dam had to be capitalized when the old dam had been washed out by flooding.   

The court also held that costs associated with work on “road maintenance” and around a barn were also not currently deductible expenses.  However, the IRS conceded that $9,000 allocated to repair a culvert, cut trees and spread manure were currently deductible.

Storage yard.  The petitioner also deducted over $16,000 for the construction of a storage yard, including funds for fencing work related to the storage yard.  The storage yard did not previously exist.  The IRS claimed that the amounts expended to create the storage yard was a capital improvement which had to be capitalized.  The court agreed.  It was new construction on top of previously unimproved land and, as such, was an improvement.  The associated costs were not currently deductible. 

Burn area.  In 2010, a wildfire burned about 26 acres of the petitioner’s property that the petitioner had used, at least in part, for grazing animals.  After the fire, it was determined that the fire had made the burned area unable to absorb water.  As a result, the petitioner, paid to have burned tree stumps removed along with boulders.  The soil of the burned area was cultivated so that the tract could be used for forage.  The cost of this work was slightly less than $50,000, which the petitioner deducted on her 2011 return.  The IRS denied the deduction claiming instead that the amount was an expense that had to be capitalized as a “plan of rehabilitation.” 

The court agreed with the IRS.  The evidence, the court determined, showed that the petitioner had a plan to rehabilitate the burn area, and believed that the expenses would improve the land and its value.  In addition, the court noted that the work on the burn area was extensive and that a large portion of the burn area, before the fire, had no relation to the petitioner’s business.  After the fire, the court noted that the petitioner testified that the entire area would be used as forage.  Thus, the burn area was adapted for a new use which meant that the expenses associated with it had to be capitalized. 

Conclusion

The case points out how expenses that a taxpayer thinks might be currently deductible may actually be expenses that must be capitalized.  The Wells case is a good illustration of how these issues can play out with respect to an agricultural set of facts.