Regulation · 2013
Treas. Reg. 1.263(a)-3(k) — Restoration Test
Treas. Reg. 1.263(a)-3(k)
Treasury Regulation (T.D. 9636)
Audio summary
A short audio walkthrough of this rule: what it says and why it matters for your study.
What it holds
A building expenditure is a restoration, and must be capitalized, if it: (1) replaces a component on which you already claimed a Section 165 casualty loss or a retirement loss; (2) restores the property to its condition after a casualty when you already claimed a casualty loss; or (3) rebuilds the unit of property to like-new condition after its class life. Replacement of a major component or substantial structural part also triggers restoration treatment.
Why it matters for your study: The major component standard inside this test is one of the most-audited areas in cost segregation. A study documents original component costs so you can measure whether a replacement crosses the major-component threshold, and it sets up the partial-disposition loss when the old component is retired.
Where this comes from
The restoration test is the second of three tests in the B/R/A framework created by the 2013 tangible property regulations (Treasury Decision 9636). Where the betterment test asks whether you made the property better, the restoration test asks whether you brought it back to a prior condition or replaced a major part of it.
What it established
Three core situations trigger capitalization under the restoration test.
First: you replace a component and already took a tax loss when you retired the old one. The replacement cost is capitalized.
Second: you repair the property after a casualty event and already claimed a casualty loss under Section 165.
Third: you rebuild the unit of property to a like-new condition after it reaches the end of its class life.
Inside those three triggers sits the standard that gets litigated most often: replacing a major component or substantial structural part. The unit of property for this comparison is the building system, not the entire building. A new chiller is measured against the HVAC system unit.
How it shows up in a study
A cost segregation study records the original cost of each building system and each major component at the time the property is placed in service. When you replace a component years later, that record is the anchor for the major-component analysis.
If the replacement cost is large relative to the original component cost, it may be a major component and must be capitalized. If it is a small share, it may not cross the threshold.
The study also connects to the partial-disposition rules in Treasury Decision 9689. When a component identified in the study is replaced, you can elect to write off its remaining tax basis at the time of replacement, instead of continuing to depreciate a part that no longer exists.
What it does not mean
The restoration test does not apply to every component replacement. Replacements that are routine maintenance expected to recur more than once in ten years may be deductible immediately under the routine maintenance safe harbor.
A cost does not become a restoration simply because it is large. The comparison is against the unit of property, the building system. A large cost may be a small share of a large system and still fail the major-component standard.
As with the betterment test, you run all three B/R/A tests before concluding a cost is a deductible repair.
Primary source
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- Category
- Tangible property regs
- Applies to
- All property types
- Status
- Vetted
This page explains a tax authority in plain words. It is not tax advice for your situation. The way this authority applies to your property is reviewed by a licensed tax professional. Citation is provided so you or your advisor can read the primary source.