CYCLICAL EXPENDITURES FOR RECONDITIONING RAILROAD FREIGHT-TRAIN CARS MUST BE CAPITALIZED.

Rev. Rul. 88-57

ISSUE

If a railroad incurs cyclical expenditures for rehabilitations of railroad freight-train cars, are such expenditures repair and maintenance expenses that are deductible when incurred or expenditures that must be capitalized?

FACTS

Taxpayer, a corporation in the railroad business, established a program for major cyclical rehabilitation of freight train cars. Under this program, Taxpayer transfers its freight-train cars to its shops after a predetermined amount of service and restores them to an efficient operating condition. This rehabilitation usually occurs after approximately 8 to 10 years of continuous use. At this time the freight-train car typically has a value of $8,000. Following rehabilitation, the car's value increases to approximately $30,000. The rehabilitation includes a complete disassembly, inspection, and reconditioning and/or replacement of components of the suspension and draft systems, trailer hitches, and other special equipment. Modifications are made to the car in order to upgrade various components to the latest engineering standards. The freight-train car essentially is stripped to the frame, with all of its structural components either reconditioned or replaced. The frame itself is the longest-lasting part of the car and is reconditioned. The walls of the freight-train car are replaced or are sandblasted and repainted. New wheels typically are installed on the car. All the remaining components of the car are restored before they are reassembled. After this procedure, cars fulfill the requirements for "Reconditioned" status under the terms of the FRA Railroad Freight Car Safety Standards. Reconditioning each car requires from $8,000 to $15,000 for materials and from 80 to 150 hours of labor. The current cost of a new freight-train car is approximately $45,000.

Absent these rehabilitations, the freight-train cars would have a service life of 12 to 14 years. At the end of the rehabilitation, the freight-train cars have been restored to "like new" condition, and the cars have a new service life of 12 to 14 years. With repeated cyclical rehabilitations, the cars usually have an aggregate service life in excess of 30 years.

LAW AND ANALYSIS

Section 168(a) of the Internal Revenue Code provides generally that the depreciation deduction permitted by section 167(a) for any tangible property shall be determined by using (1) the applicable depreciation method, (2) the applicable recovery period, and (3) the applicable convention. Under the classifications of property set forth in section 168(e)(1), the recovery period of freight-train cars is 7 years.

Section 162 of the Code provides for the deduction of all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business.

Section 1.162-4 of the Income Tax Regulations provides that the cost of incidental repairs that neither materially add to the value of the property nor appreciably prolong its life, but keep it in ordinary efficient operating condition, may be deducted as an expense. In general, repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, shall either be capitalized and depreciated in accordance with section 167 of the Code or charged against the depreciation reserve.

Section 263(a)(1) of the Code provides that no deduction shall be allowed for any amount paid out for new buildings or for permanent improvement or betterments made to increase the value of any property or estate.

Section 263(a)(2) of the Code provides that no deduction shall be allowed for any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.

Section 263(d) of the Code provides that a domestic common carrier may make an election to expense amounts for rehabilitation of a unit of rolling stock that would, but for section 263(d), be properly chargeable to capital account, if during any 12-month period they do not exceed an amount equal to 20 percent of the basis of such unit in the hands of the taxpayer. In the present situation, Taxpayer could not make the section 263(d) election because the rehabilitation expenses exceeded 20 percent of its basis of the freight-train cars.

Section 1.263(A)-1(a) and (b) of the regulations provides that no deductions shall be allowed for amounts expended in restoring property or in making good the exhaustion thereof including amounts paid or incurred to add to the value or substantially prolong the useful life of property owned by the taxpayer, such as plant or equipment. Amounts paid or incurred for incidental repairs and maintenance of property are not capital expenditures.

Rev. Rul. 69-116, 1969-1 C.B. 85, involves programmed rehabilitation of freight-train cars with a presumed useful life of 17 years depreciated under the provisions of Rev. Proc. 62-21, 1962-2 C.B. 418. That ruling concludes that the cost of the first rehabilitation, after 8 to 10 years of service, is deductible as a current expense because it does not appreciably extend the 17-year life used for depreciation. Thus, in Rev. Rul. 69-116, the useful life of the asset in the hands of the taxpayer was presumed to be equal to the depreciable life.

In 1971 and 1973, respectively, section 1.167(a)-11(g)(1)(ii)(b) of the regulations (dealing with the asset depreciation range) and section 1.167(a)-12(d)(3)(ii) (dealing with the class life system) were issued. They provide that, for purposes of sections 162 and 263 of the Code and the regulations thereunder, whether an expenditure prolongs the life of an asset shall be determined on the basis of the anticipated period of use of the asset (estimated at the close of the tax year in which the asset is first placed in service) without regard to the asset depreciation period for such asset. The regulations indicate that the shortened lives used under the class life and CLADR systems are not the useful life criteria to be used in determining whether the expenditure substantially prolongs the useful life of the property.

Under the case law, an expenditure made for an item that is part of a general plan of rehabilitation, modernization, and improvement of the property must be capitalized, even though, standing alone, the item may appropriately be classified as one of repair. United States v. Wehrli, 400 F.2d 686 (10th Cir. 1968); Home News Publishing Co. v. Commissioner, 18 B.T.A. 1008 (1930).

Thus, under applicable law, an expenditure to rehabilitate property must be capitalized rather than deducted as an expense if any of the following tests is satisfied: (1) the expenditure appreciably prolongs the useful life of the property; (2) the expenditure materially adds to the value of the property; or (3) the expenditure is part of a general plan of rehabilitation, modernization, and improvement of the property. A taxpayer must apply each of these tests before determining that an expenditure can be deducted as an expense.

Section 1.167(a)-11(g)(1)(ii)(b) and section 1.167(a)- 12(d)(3)(ii) of the regulations provide that, under the asset depreciation range or class life system, whether an expenditure prolongs the life of an asset is to be determined on the basis of the anticipated period of use of the asset estimated at the close of the tax year in which the asset is first placed in service. In the instant case, the taxpayer's freight-train cars would have a service life of 12 to 14 years, absent rehabilitation. Following rehabilitation the cars have a new service life of 12 to 14 years and, with repeated cyclical rehabilitations, can have an aggregate service life in excess of 30 years. Therefore, the first test requires the cyclical rehabilitation expenditures to be capitalized because the useful life of the property has been appreciably prolonged.

Whether or not the expenditure appreciably prolongs the useful life of the property, the expenditure must be capitalized if it materially adds to the value of the property. In the absence of sudden and anticipated damage to the asset, the appropriate standard for this second test involves comparing the value of the asset immediately prior to the expenditure with the value of the asset immediately after the expenditure. Immediately before rehabilitation, a freight-train car typically has a value of $8,000. After rehabilitation, its value increases to approximately $30,000. Thus, the rehabilitation materially adds to the value of the property. This addition to value demonstrates that the expenditure is not an incidental repair to be deducted as an expense.

Case law has supplied another test as to whether an expenditure has been made for an incidental repair. Under this well-established body of case law, expenditures made pursuant to a general plan of rehabilitation, modernization, and improvement of the property must be capitalized, even if certain portions of the work done, standing alone rather than as part of a general scheme, would properly be classified as repairs. See Wehrli and Home News Publishing. The taxpayer's program for major rehabilitation of its freight-train cars to restore them to efficient operating condition is such a plan. Thus, under this test none of the expenditures are for incidental repairs and all the expenditures must be capitalized.

HOLDING

Cyclical expenditures for major rehabilitations of railroad freight-train cars are capital expenditures under section 263(a) of the Code.

A change from treating cyclical expenditures for rehabilitations of railroad freight-train cars as repair and maintenance expenses to treating them as capital expenditures is a change in method of accounting to which sections 446 and 481 of the Code and the related regulations apply. This revenue ruling is identified as a designated ruling pursuant to section 5.12(2) of Rev. Proc. 84-74, 1984-2 C.B. 736.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 69-116, 1969-1 C.B. 85, is revoked.

PROSPECTIVE APPLICATION

Pursuant to the authority contained in section 7805(b) of the Code, this revenue ruling does not apply to tax years beginning before July 11, 1988, the date of publication of this revenue ruling.

DRAFTING INFORMATION

The principal author of this revenue ruling is Mark Pitzer of the Corporation Tax Division. For further information regarding this revenue ruling contact Mr. Mark Pitzer on (202) 566-4440 (not a toll- free call).