Pauly v. Dept. of Rev. ( 2020 )

IN THE OREGON TAX COURT
MAGISTRATE DIVISION
Income Tax
RALPH W. PAULY )
and CYNTHIA R. PAULY, )
)
Plaintiffs, ) TC-MD 190264N
v. )
)
DEPARTMENT OF REVENUE, )
State of Oregon, )
) ORDER ON CROSS-MOTIONS
Defendant. ) FOR SUMMARY JUDGMENT
Plaintiffs appealed Defendant’s Notice of Deficiency, dated April 19, 2019, for the 2016
tax year. The parties agreed to proceed with written briefing based on a stipulated factual record.
The parties’ Joint Stipulated Facts and Exhibits were filed on October 15, 2019. Defendant’s
Written Argument was filed on November 8, 2019. Plaintiffs’ Argument was filed on
November 18, 2019.
I. STATEMENT OF FACTS
Plaintiffs claimed $9,814 in repairs expense on their schedule E in connection with a
rental property they owned located at 56503 Crest Drive, Warren, Oregon (Crest Drive property).
(Stip Facts ¶ II; Ex 1.) At audit, Defendant allowed a repair expense of $838 but denied the
remaining $8,976 because it represented a roof replacement which, in Defendant’s view, is
required to be capitalized rather than expensed. (Compl at 4-5.)1
Plaintiffs purchased the Crest Drive property on June 8, 1977, for $43,000. (Stip Facts ¶
III.) The Crest Drive property has a “steep roof” or a “steep pitch roof.” (Id. ¶V.) The roofing
work done on the Crest Drive property was estimated to cost $8,976 in a bid dated October 18,
1
It appears that Defendant may have disallowed a corresponding depreciation deduction, although it is
unclear because pages 5-6 of the Notice of Deficiency are missing. (See Compl at 5-6.)
ORDER ON CROSS-MOTIONS FOR SUMMARY JUDGMENT TC-MD 190264N 1
2016. (Stip Facts ¶IV, Ex 2.) The estimate was for a “Roof Replacement” and specified that the
price included “[c]omplete[] remov[al] and recycle [of] all existing roofing materials from all
roof deck elevations of the home.” (Stip Facts, Ex 2 at 2.) The estimate specified that the scope
of the work included installing new underlayment, flashing, coatings, and roofing shingles to all
roof deck areas. (Id.) “Any plywood roof deck sheeting that must be replaced due to water
damage will be at an additional charge” and was not included in the estimate. (Id.) The shingles
included a 50-year factory warranty. (Id.) The final receipt, dated December 22, 2016, showed
that $8,976 was paid for “Roof Replacement” and an additional $838 was paid for “additional
repairs” for a total of $9,814. (Stip Facts, Ex 2 at 3.)
The parties provided an article from AICPA’s The Tax Adviser regarding the
deductibility of roofing expenses that contained Plaintiffs’ handwritten notes regarding the
roofing work done. (Stip Facts, Ex 5.) The parties stipulated that the handwritten notes were “a
true and accurate reflection of events.” (Stip Facts ¶IX.) In response to question 1 of the article,
“Why was the roof replaced?”, Plaintiffs wrote “worn out.” (Stip Facts, Ex 5 at 4.) In response
to question 2, “How much time elapsed between the building acquisition and the roof work?”,
Plaintiffs wrote “28 years.” (Id.) The handwritten notes also stated that both the prior roofing
type and the new roofing type were “asphalt shingles.” (Id.) Finally, the notes indicated that the
roof work did not relate to an enlargement of the existing building. (Id.)
Plaintiffs’ Schedule E shows that they received $0 in rental income from the Crest Drive
property in 2016 but claimed losses of $17,590. (Stip Facts, Ex 1.) Plaintiffs attached and timely
filed their Section 1.263(a)-1(f) De Minimis Safe Harbor Election and Section 1.263(a)-3(h) Safe
Harbor Election for Small Taxpayers with their 2016 tax return. (Stip Facts ¶VII; Ex 4.)
///
ORDER ON CROSS-MOTIONS FOR SUMMARY JUDGMENT TC-MD 190264N 2
II. ANALYSIS
The issue presented is whether work performed by Plaintiffs on the roof of their
residential rental property in 2016 may be deducted as a current year repair expense under IRC
section 162(a) or rather must be capitalized under IRC section 263(a). Plaintiffs characterize the
work done in 2016 as “shingle replacement.” (Ptfs’ Arg at 2.) Defendant characterizes it as a
“roof replacement.” (Def’s Resp at 8.)
The legislature intended that Oregon personal income tax law be “identical in effect to the
provisions of the Internal Revenue Code [IRC] relating to the measurement of taxable income of
individuals, * * * modified as necessary by the state’s jurisdiction to tax and the revenue needs of the
state.” ORS 316.007(1).2 This includes both personal and business deductions. ORS 316.007(2).
The court follows “the administrative and judicial interpretations of the federal income tax law” to
the extent practicable. See ORS 314.011(3). Plaintiffs bear the burden of proof and must prove their
case by a preponderance of the evidence. ORS 305.427. “Preponderance of the evidence means the
greater weight of evidence, the more convincing evidence.” Feves v. Dept. of Revenue, 4 OTR 302,
312 (1971). “[I]f the evidence is inconclusive or unpersuasive, the taxpayer will have failed to meet
his burden of proof * * *.” Reed v. Dept. of Rev., 310 Or 260, 265, 798 P2d 235 (1990). The court
has jurisdiction to determine the correct amount of the deficiency, even if on “grounds other or
different from those asserted by” Defendant. ORS 305.575.
A. Whether Roof-Related Expenditures Were a Capital Expense
Taxpayers shall be allowed a deduction of “all the ordinary and necessary expenses paid
or incurred during the taxable year in carrying on any trade or business * * *.” IRC § 162(a).
However, no deduction shall be allowed for “permanent improvements or betterments made to
2
The court’s references to the Oregon Revised Statutes (ORS) are to 2015.
ORDER ON CROSS-MOTIONS FOR SUMMARY JUDGMENT TC-MD 190264N 3
increase the value of any property * * *.” IRC § 263(a)(1). Such improvements represent capital
expenditures. See Treas Reg § 1.263(a)-3. Capital expenditures “are added to the basis of the
capital asset with respect to which they are incurred and are taken into account for tax purposes
either through depreciation or by reducing the capital gain (or increasing the loss) when the asset is
sold.” Woodward v. Comm’r, 397 US 572, 574-75, 90 S Ct 1302, 25 L Ed 2d 577 (1970); see also
IRC § 167. “[D]eductions are the exceptions to the norm of capitalization * * *.” INDOPCO, Inc.
v. Comm’r, 503 US 79, 84, 112 S Ct 1039, 117 L Ed2d 226 (1992).
Whether an expenditure is deductible as a business expense or must be depreciated as a
business asset (capitalized) depends on “the purpose for which the expenditure was made.” Oberman
Mfg. Co. v. Comm’r, 47 TC 471, 482 (1967). “A repair is an expenditure for the purpose of keeping
the property in an ordinarily efficient operating condition. It does not add to the value of the property,
nor does it appreciably prolong its life.” Id. In Oberman, the court allowed taxpayer to deduct the cost
of repairing the leaking roof of a leased commercial building, finding the repairs did not “prolong the
life of [the] property” or constitute a “replacement or substitution of the roof.” Id. at 482. By contrast,
courts have held that an owner’s roof replacement is a capital expense and must be capitalized. See e.g.
Stark v. Comm’r, 77 TCM (CCH) 1181 (1999), 1999 WL 30943 at *13 (US Tax Ct) (holding that
owner’s roofing expense must be capitalized where roof removed “right down to the wood” and
replacement expected to last 20 years); Tsakopoulos v. Comm’r, 83 TCM (CCH) 1064 (2002) (cost of
work performed on roof was capital expenditure because of the substantial nature of work and because
it was intended to last 10 years appreciably prolonging life of roof); see also Treas Reg § 1.263(a)-
3(k).3
3
The examples provided in the applicable Treasury Regulation suggest that merely replacing a roofing
component, such as a membrane or shingles constitutes a repair, but replacement of all major components constitutes a
capital improvement. Compare Treas Reg § 1.263(a)-3(g) Ex 3, (k) Ex 15 with Treas Reg § 1.263(a)-3 (k) Ex 14.
ORDER ON CROSS-MOTIONS FOR SUMMARY JUDGMENT TC-MD 190264N 4
Here, Plaintiffs own the property. There is nothing in the record suggesting that the roof
was leaking or was otherwise failing to function as intended thereby necessitating a repair; the
reason for the replacement was ordinary wear. A worn roof may affect the value of the property
as whole but does not interfere with its function. Despite Plaintiffs’ characterization of the
expense as “replace[ment of] asphalt shingles,” the evidence indicates that the scope of the
project was more substantial. The contractor characterized it as “roof replacement.” (Compare
Ptfs’ Arg at 1 with Stip Facts, Ex 2.) The replacement shingles were subject to a long warranty
period (50-year factory warranty) and appreciably prolonged the life of the property.4 The court
concludes that the roof-related expenditures must be capitalized under IRC section 263(a)(1)
unless some exception applies.
B. Whether an Exception to IRC Section 263(a)(1) Applies
Plaintiffs rely on two safe harbor provisions under federal Treasury Regulations in
support of their repair expense deduction. For purposes of the relevant deduction, “rules or
regulations [under the IRC relating to taxable income] shall be regarded as rules adopted by the
department * * *.” ORS 316.032(3). The court will examine each in turn.
1. De Minimis Safe Harbor Election Under Treasury Regulation 1.263(a)-1(f)
The de minimis safe harbor election under Treasury Regulation 1.263(a)-1(f) provides
that a taxpayer may elect not to capitalize an expenditure where the taxpayer meets certain
accounting requirements and where the cost does not exceed certain dollar limitations. For
taxpayers without the applicable financial statement, the amount allowed was originally limited
to “$500 per invoice (or per item substantiated by the invoice) or other amount as identified in
4
The long warranty period suggests that Plaintiffs may have replaced the existing shingles with better
quality asphalt shingles.
ORDER ON CROSS-MOTIONS FOR SUMMARY JUDGMENT TC-MD 190264N 5
published guidance in the Federal Register or the Internal Revenue Bulletin * * *.” Treas Reg §
1.263(a)-1(f)(1)(ii). In 2015, the IRS issued a notice raising the minimum under Treasury
Regulation section 1.263(a)-1(f)(1)(ii) to $2,500 per invoice for the 2016 tax year. IRS Notice
2015-82, Dec 14, 2015. Even under the increased de minimis limit Plaintiffs’ expenditure in the
amount of $8,976 does not meet that requirement.
2. Safe Harbor Election for Small Taxpayers Under Treasury Regulation 1.263(a)-3(h)
Under the Safe Harbor Election for Small Taxpayers (Small Taxpayer election), landlords
may deduct the cost of building repairs and improvements provided they meet certain
requirements. The Small Taxpayer election is only available 1) if the building “has an
unadjusted basis of $1,000,000 or less”; 2) the taxpayer’s “average annual gross receipts * * *
for the preceding three taxable years is less than or equal to $10,000,000”; and 3) “the total
amount paid during the taxable year for repairs, maintenance, improvements * * * does not
exceed the lesser of—(i) 2 percent of the unadjusted basis * * * of the eligible building property;
or (ii) $10,000.” Treas Reg § 1.263(a)-3(h)(1), (3), (4). The unadjusted basis for property is “the
cost of such property * * *.” Treas Reg § 1.263(a)-3(h)(5); IRC § 1012(1). The election is made
per eligible building property. See Treas Reg § 1.263(a)-3(h)(6), Ex 3. “If total amounts paid by
a qualifying taxpayer during the taxable year for repairs, maintenance, improvements, and
similar activities performed on an eligible building exceed the safe harbor limitations * * * then
the safe harbor election is not available for that eligible building property and the taxpayer must
apply the general improvement rules * * *.” Treas Reg § 1.263(a)-3(h)(8).
Defendant argues that the amount paid for the roofing work exceeds the limit for
improvements under the Small Taxpayer election. (Def’s Recommendations at 6.) Plaintiffs
purchased the Crest Drive property for $43,000. (Stip Facts ¶III.) That amount represents
ORDER ON CROSS-MOTIONS FOR SUMMARY JUDGMENT TC-MD 190264N 6
Plaintiffs’ unadjusted basis in the property. Two percent of $43,000 is $860. The election
requires that the amount allowed not exceed the lesser of $860 or $10,000. The amount
Plaintiffs paid for the roofing work exceeds $860. This election is unavailable to Plaintiffs.
III. CONCLUSION
After careful consideration, the court concludes that Plaintiffs’ roof-related expenditures
are not deductible for the 2016 tax year because they represent an “improvement or betterment”
to the property under IRC section 263(a)(1). The court further concludes that no exception
applies, and that Plaintiffs are not eligible for either the Treasury Regulation 1.263(a)-1(f) or the
Treasury Regulation 1.263(a)-3(h) safe harbor elections. Accordingly, Plaintiffs’ appeal must be
denied. Now, therefore,
IT IS ORDERED that Plaintiffs’ appeal is denied.
This is a dispositive order pursuant to Tax Court Rule – Magistrate Division 16
C(1). The court will issue a decision after waiting 14 days to determine whether
there is a dispute about costs and disbursements. Any claim of error in regard to
this order should be raised in an appeal of the Magistrate’s decision when all
issues have been resolved. See TCR-MD 19.
This document was signed by Magistrate Allison R. Boomer and entered on
March 26, 2020.
ORDER ON CROSS-MOTIONS FOR SUMMARY JUDGMENT TC-MD 190264N 7