REG-168745-03 |
September 25, 2006 |
Notice of Proposed Rulemaking and Notice of Public Hearing
Guidance Regarding Deduction and Capitalization
of Expenditures Related to Tangible Property
Internal Revenue Service (IRS), Treasury.
Notice of proposed rulemaking and notice of public hearing.
This document contains proposed regulations that explain how section
263(a) of the Internal Revenue Code (Code) applies to amounts paid to acquire,
produce, or improve tangible property. The proposed regulations clarify and
expand the standards in the current regulations under section 263(a), as well
as provide some bright-line tests (for example, a 12-month rule for acquisitions
and a repair allowance for improvements). The proposed regulations will affect
all taxpayers that acquire, produce, or improve tangible property. This document
also provides a notice of public hearing on the proposed regulations.
Written or electronic comments must be received by November 20, 2006.
Requests to speak and outlines of topics to be discussed at the public hearing
scheduled for Tuesday, December 19, 2006, at 10:00 a.m., must be received
by November 28, 2006.
Send submissions to: CC:PA:LPD:PR (REG-168745-03), room 5203, Internal
Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Alternatively,
comments may be sent electronically, via the IRS Internet site at www.irs.gov/regs or
via the Federal eRulemaking Portal at www.regulations.gov (IRS-REG-168745-03).
The public hearing will be held in the auditorium of the New Carrollton Federal
Building, 5000 Ellin Road, Lanham, MD 20706 at 10:00 a.m.
FOR FURTHER INFORMATION CONTACT:
Concerning the proposed regulations, Kimberly L. Koch, (202) 622-7739;
concerning submission of comments, the hearing, and/or to be placed on the
building access list to attend the hearing, Richard A. Hurst at Richard.A.Hurst@irscounsel.treas.gov or
at (202) 622-7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
In recent years, much debate has focused on the extent to which section
263(a) of the Code requires taxpayers to capitalize as an improvement amounts
paid to restore property to its former working condition; that is, whether,
or the extent to which, the amounts paid to restore or improve the property
are capital expenditures or deductible ordinary and necessary repair and maintenance
expenses. There has been controversy, for example, regarding what tests to
apply for determining capitalization or expensing, how to apply the tests,
and the appropriate unit of property with respect to which to apply the tests.
On January 20, 2004, the IRS and Treasury Department published Notice 2004-6,
2004-1 C.B. 308, announcing an intention to propose regulations providing
guidance in this area. The notice identified issues under consideration by
the IRS and Treasury Department and invited public comment on whether these
or other issues should be addressed in the regulations and, if so, what specific
rules and principles should be provided. To respond to various comments and
provide a more comprehensive set of rules regarding tangible property, the
proposed regulations include the treatment of amounts paid to acquire or produce
tangible property.
Explanation of Provisions
The proposed regulations under section 263(a) of the Code set forth
the general statutory principles of capitalization and provide that capital
expenditures generally include amounts paid to sell, acquire, produce, or
improve tangible property. The proposed regulations, if promulgated as final
regulations, would replace current §§1.263(a)-1, 1.263(a)-2, and
1.263(a)-3 of the Income Tax Regulations. The treatment of amounts paid to
acquire or create intangibles was addressed with the publication of §§1.263(a)-4
and 1.263(a)-5 in the Federal Register on
January 5, 2004 (T.D. 9107, 2004-1 C.B. 447 [69 FR 436]).
Certain sections of the current regulations under section 263(a) are
proposed to be removed entirely and are not restated in the proposed regulations.
Section 1.263(a)-1(c) of the current regulations lists several Code and regulation
sections to which the capitalization provisions do not apply. Section 1.263(a)-3
(election to deduct or capitalize certain expenditures) lists several Code
sections under which a taxpayer may elect to treat certain capital expenditures
as either deductible or deferred expenses, or to treat deductible expenses
as capital expenditures. These two sections have not been carried over to
the proposed regulations because the lists of items in these sections are
outdated. This language is intended to have the same general effect as current
§§1.263(a)-1(c) and 1.263(a)-3, without citing to specific Code
and regulation sections that may have been repealed and without omitting specific
Code and regulation sections that may have been added.
Certain portions of §1.263(a)-2 of the current regulations (examples
of capital expenditures) also are not restated in the proposed regulations,
or are incorporated into other sections of the proposed regulations. Section
1.263(a)-2(a) of the current regulations (the cost of acquisition of property
with a useful life substantially beyond the taxable year) is incorporated
into and expanded upon in §1.263(a)-2 of the proposed regulations (amounts
paid to acquire or produce tangible property). Section 1.263(a)-2(b) of the
current regulations (amounts expended for securing a copyright and plates)
is proposed to be removed because these amounts are now addressed by §1.263(a)-4(d)(5)
and section 263A. The rules in §1.263(a)-2(c) of the current regulations
(the cost of defending or perfecting title to property) are addressed in §1.263(a)-4(d)(9)
of the current regulations with regard to intangibles and in §1.263(a)-2(d)(2)
of the proposed regulations with regard to tangible property. Section 1.263(a)-2(d)
of the current regulations (amounts expended for architect’s services)
is proposed to be removed because those amounts are now included in section
263A. The rules in §1.263(a)-2(f) and (g) of the current regulations
(relating to certain capital contributions) essentially are restated in §1.263(a)-1(b)
of the proposed regulations. Finally, §1.263(a)-2(h) of the current
regulations (the cost of goodwill in connection with the acquisition of the
assets of a going concern) is proposed to be removed because this cost is
now addressed by §1.263(a)-4(c)(1)(x).
Taking into account the provisions that are proposed to be removed and
other modifications to the current regulations noted above, the remaining
guidance in the current regulations is contained in §1.263(a)-1(a) and
(b) of the proposed regulations. Section 1.263(a)-1(a) of the current regulations
restates the statutory rules from section 263(a), which are carried over in
§1.263(a)-1(a) of the proposed regulations. The rules in §1.263(a)-1(b)
of the current regulations address amounts paid to add to the value, or substantially
prolong the useful life, of property owned by the taxpayer, and amounts paid
to adapt property to a new or different use. They also address the treatment
of those capitalized expenditures, for example, as a charge to capital account
or basis. These rules are incorporated into and expanded upon in §1.263(a)-3
of the proposed regulations. The proposed regulations also revise §1.162-4
of the current regulations (allowing a deduction for the cost of incidental
repairs) to provide rules consistent with §1.263(a)-3 of the proposed
regulations (requiring capitalization of amounts paid to improve property).
The proposed regulations do not address amounts paid to acquire or create
intangible interests in land, such as easements, life estates, mineral interests,
timber rights, zoning variances, or other intangible interests in land. The
IRS and Treasury Department request comments on whether these and similar
amounts, or certain of these amounts, should be addressed in the final regulations
and, if so, what rules should be provided. The proposed regulations also
do not address the treatment of software development costs.
II. General Principle of Capitalization
The proposed regulations require capitalization of amounts paid to acquire,
produce, or improve tangible real and personal property, including amounts
paid to facilitate the acquisition of tangible property. The proposed regulations
do not address amounts paid to facilitate an acquisition of a trade or business
because those amounts are addressed in §1.263(a)-5 of the current regulations.
The proposed regulations clarify that they do not change the treatment
of any amount that is specifically provided for under any provision of the
Code or regulations other than section 162(a) or section 212 and the regulations
under those sections. This rule applies regardless of whether that specific
provision is more or less favorable to the taxpayer than the treatment in
the proposed regulations. Thus, where another section of the Code or regulations
prescribes a specific treatment of an amount, the provisions of that section
apply and not the rules contained in the proposed regulations. This rule
is the same as that contained in §§1.263(a)-4(b)(4) and 1.263(a)-5(j)
of the current regulations. The proposed regulations, for example, do not
preclude taxpayers from deducting the cost of certain depreciable business
assets under section 179. On the other hand, the proposed regulations do
not exempt taxpayers from applying the uniform capitalization rules under
section 263A when applicable, nor do they exempt taxpayers from complying
with the timing rules regarding incurring a liability under section 461 (including
economic performance).
The rule clarifying that the proposed regulations do not change the
treatment of any other amount that is specifically provided for under any
other provision of the Code or regulations provides an exception for the treatment
of any amount that is specifically provided for under section 162(a) or section
212 or the regulations under those sections. Thus, the proposed regulations
override any conflicting provisions in the regulations under sections 162(a)
and 212. For this reason, the proposed regulations amend the current rule
for deductible repairs under §1.162-4 to provide that amounts paid for
repairs and maintenance to tangible property are deductible if the amounts
paid are not required to be capitalized under §1.263(a)-3 of the proposed
regulations. The proposed regulations, however, do not amend or remove any
other provisions of the current regulations under section 162(a), including
§§1.162-6 (regarding professional expenses) and 1.162-12 (regarding
certain expenses of farmers). Section 1.162-6 permits a deduction for amounts
paid for books, furniture, and professional instruments and equipment, the
useful life of which is short, while §1.162-12 permits a deduction for
the cost of ordinary tools of short life or small cost. The rules in current
§§1.162-6 and 1.162-12 are consistent with the rules in the proposed
regulations and are not revised.
B. Amounts paid to sell property
The proposed regulations provide that, except in the case of dealers
in property, commissions and other transaction costs paid to facilitate the
sale of property generally must be capitalized and treated as a reduction
in the amount realized. Dealers in property include taxpayers that maintain
and sell inventories and taxpayers that produce property for sale in the ordinary
course of business, for example, the home construction business. The language
in this section is slightly broader than the current language of §1.263(a)-2(e),
which refers only to commissions paid in selling securities. However, the
language in the proposed regulations is consistent with case law that generally
treats all transaction costs paid in connection with the sale of any property
as capitalized and offset against the amount realized. See, Wilson
v. Commissioner, 49 T.C. 406, 414 (1968); rev’d on other
grounds, 412 F.2d 314 (6th Cir. 1969) (“The
rule is thoroughly engrained that commissions and similar charges must be
treated as capital expenditures which reduce the selling price when gain or
loss is computed on the transaction”); Frick v. Commissioner,
T.C. Memo 1983-733, aff’d without opinion, 774 F.2d 1168 (7th Cir.
1985) (“Fees paid in connection with the disposition of real property
are capital expenditures and are deductible from the selling price in determining
gain or loss on the ultimate disposition”); Hindes v. United
States, 246 F. Supp. 147, 150 (W.D. Tex. 1965); affd. in part,
revd. in part on other grounds, 371 F.2d 650 (5th Cir.
1967) (“Fees and expenses paid in connection with the acquisition or
disposition of property, real or personal, are capital expenditures, and,
in the case of a taxpayer not engaged in the business of buying and selling
real estate, are deductible from the selling price in determining gain or
loss on the ultimate disposition”). The sales cost rule in the proposed
regulations, however, applies only to transaction costs and does not include
other amounts that might be paid for the purpose of selling property, such
as amounts paid to repair or improve the property in preparation for a sale.
The treatment of those amounts is governed by the general rules under §1.263(a)-3
of the proposed regulations relating to improvements.
III. Amounts Paid to Acquire or Produce Tangible Property
The current regulations under section 263(a) require capitalization
of amounts paid for the acquisition, construction, or erection of buildings,
machinery and equipment, furniture and fixtures, and similar property having
a useful life substantially beyond the taxable year. See §1.263(a)-2(a)
of the current regulations. The proposed regulations are consistent with
this rule, but treat amounts paid to construct or erect property as production
costs. Specifically, the proposed regulations require capitalization of amounts
paid for property having a useful life substantially beyond the taxable year,
including land and land improvements, buildings, machinery and equipment,
and furniture and fixtures, and a unit of property (as determined under §1.263(a)-3(d)(2)),
having a useful life substantially beyond the taxable year. See §1.263(a)-2(d)
of the proposed regulations. Thus, §1.263(a)-2 of the proposed regulations
requires capitalization of amounts paid for property that is not itself a
unit of property, such as property (not treated as a material or supply under
§1.162-3) that is intended to be used as a component in the repair or
improvement of a unit of property. Additionally, the current regulations
at §1.263(a)-1(b) list inventory costs as capital expenditures under
§1.263(a)-1(a). Therefore, §1.263(a)-2 of the proposed regulations
also requires capitalization of amounts paid to acquire real or personal property
for resale and to produce real or personal property for sale.
The proposed regulations provide that the terms amounts paid and payment mean,
in the case of a taxpayer using an accrual method of accounting, a liability
incurred (within the meaning of §1.446-1(c)(1)(ii)). The definitions
of real and tangible personal property are intended to be the same as the
definitions used for depreciation purposes as derived from the language in
the regulations at §1.48-1. Thus, for purposes of the proposed regulations,
tangible personal property means any tangible property except land and improvements
thereto, such as buildings or other inherently permanent structures (including
items that are structural components of buildings or structures). See, Whiteco
Indus., Inc. v. Commissioner, 65 T.C. 664 (1975) (applying six
factors in determining whether property is an inherently permanent structure).
Under the proposed regulations, the definitions of building and structural
components are the definitions provided in §1.48-1(e). The IRS and Treasury
Department considered other definitions of real and tangible personal property,
including the definitions in the regulations under section 263A(f), but believe
that the definitions used for depreciation purposes are the definitions most
consistent with the purposes of the proposed regulations.
The definition of produce in §1.263(a)-2(b)(4) of the proposed
regulations is intended to be the same as the definition used for purposes
of section 263A(g)(1) and §1.263A-2(a)(1)(i), except that improvements
are separately defined in §1.263(a)-3 of the proposed regulations. The
costs that are required to be capitalized to property produced or to any improvement
are the costs that must be capitalized under section 263A. Thus, for example,
all direct materials and direct labor, and all indirect costs that directly
benefit or are incurred by reason of production/improvement activities are
required to be capitalized to the property being produced or improved.
The proposed regulations require taxpayers to capitalize an amount paid
to defend or perfect title to tangible property. This rule is consistent
with the current regulations at §1.263(a)-2(c) and parallels the rule
in §1.263(a)-4(d)(9) with regard to intangible property. The proposed
regulations also require capitalization of amounts paid to facilitate the
acquisition of real or personal property. The IRS and Treasury Department
request comments on whether any specific guidance is needed with regard to
employee compensation and overhead costs that facilitate the acquisition of
tangible property and, if so, what that guidance should provide. The proposed
regulations do not address transaction costs related to the production or
improvement of tangible property because those costs are subject to capitalization
under section 263A.
B. Materials and supplies
As noted in section II.A. above, the proposed regulations generally
do not change the treatment of any amount that is specifically provided for
under any provision of the Code or regulations other than section 162(a) or
section 212 and the regulations under those sections. However, with regard
to section 162(a), the proposed regulations provide an exception for amounts
paid for materials and supplies that are properly treated as deductions or
deferred expenses, as appropriate, under §1.162-3. Thus, the proposed
regulations do not change the treatment of materials and supplies under §1.162-3,
including property that is treated as a material and supply that is not incidental
under Rev. Proc. 2002-28, 2002-1 C.B. 815 (regarding the use of the cash method
by certain qualifying small business taxpayers), Rev. Proc. 2002-12, 2002-1
C.B. 374 (regarding smallwares), and Rev. Proc. 2001-10, 2001-1 C.B 272 (regarding
inventory of certain qualifying taxpayers).
The current regulations under sections 263(a), 446, and 461 require
taxpayers to capitalize amounts paid to acquire property having a useful life
substantially beyond the taxable year. See §§1.263(a)-2(a), 1.446-1(c)(1)(ii),
and 1.461-1(a)(2)(i) of the current regulations. Section 1.263(a)-2(d) of
the proposed regulations retains this general rule. Some courts have adopted
a 12-month rule for determining whether property has a useful life substantially
beyond the taxable year. See Mennuto v. Commissioner,
56 T.C. 910 (1971), acq. (1973-2 C.B. 2); Zelco, Inc. v. Commissioner,
331 F.2d 418 (1st Cir. 1964); International
Shoe Co. v. Commissioner, 38 B.T.A. 81 (1938). Under the 12-month
rule adopted by some courts, a taxpayer may deduct currently an amount paid
for a benefit or paid for property having a useful life that does not extend
beyond one year. This rule was adopted in the regulations relating to intangibles.
See §1.263(a)-4(f). The proposed regulations provide a similar 12-month
rule for amounts paid to acquire or produce certain tangible property.
The proposed regulations generally provide that an amount (including
transaction costs) paid for the acquisition or production of a unit of property
with an economic useful life of 12 months or less is not a capital expenditure.
The unit of property and economic useful life determinations are made under
the rules described in §1.263(a)-3 for improved property. The 12-month
rule generally applies unless the taxpayer elects not to apply the 12-month
rule, which election may be made with regard to each unit of property that
the taxpayer acquires or produces. An election not to apply the 12-month
rule may not be revoked. Taxpayers that have elected to use the original
tire capitalization method of accounting for the cost of certain tires under
Rev. Proc. 2002-27, 2002-1 C.B. 802, must use that method for the original
and replacement tires of all their qualifying vehicles. See section 5.01
of Rev. Proc. 2002-27. Therefore, taxpayers that use that method cannot use
the 12-month rule provided under the proposed regulations to deduct amounts
paid to acquire original or replacement tires.
The proposed regulations clarify the interaction of the 12-month rule
with the timing rules contained in section 461 of the Code. Nothing in the
proposed regulations is intended to change the application of section 461,
including the application of the economic performance rules in section 461(h).
This coordination rule is the same as that provided in the regulations under
section 263(a) relating to intangibles. See §1.263(a)-4(f). In the
case of a taxpayer using an accrual method of accounting, section 461 requires
that an item be incurred before it is taken into account through capitalization
or deduction. For example, under §1.461-1(a)(2), a liability generally
is not incurred until the taxable year in which all the events have occurred
that establish the fact of the liability, the amount of the liability can
be determined with reasonable accuracy, and economic performance has occurred
with respect to the liability. Thus, the 12-month rule provided by the proposed
regulations does not permit an accrual method taxpayer to deduct an amount
paid for tangible property if the amount has not been incurred under section
461 (for example, if the taxpayer does not have a fixed liability to acquire
the property). The proposed regulations contain examples illustrating the
interaction of the 12-month rule with section 461.
The proposed regulations provide that, upon a sale or other disposition,
property to which a taxpayer applies the 12-month rule is not treated as a
capital asset under section 1221 or as property used in the trade or business
under section 1231. Thus, 12-month property is not of a character subject
to depreciation and any amount realized upon disposition of 12-month property
is ordinary income to the taxpayer.
The IRS and Treasury Department do not believe that it is appropriate
to apply the 12-month rule to certain types of property. Thus, the proposed
regulations provide that the 12-month rule does not apply to property that
is or will be included in property produced for sale or property acquired
for resale, improvements to a unit of property, land, or a component of a
unit of property.
In Notice 2004-6, the IRS and Treasury Department requested comments
on whether the regulations should provide a de minimis rule.
Because the notice refers to the application of section 263(a) to amounts
paid to repair, improve, or rehabilitate tangible property, most commentators
focused on a de minimis rule for the cost of repairs
rather than the cost to acquire property. However, one commentator requested
that the regulations specifically provide a de minimis rule
for acquisition costs, but allow taxpayers to continue to use their current
method if they have reached a working agreement with their IRS examining agent
regarding a de minimis rule.
The IRS and Treasury Department recognize that for regulatory or financial
accounting purposes, taxpayers often have a policy for deducting an amount
paid below a certain dollar threshold for the acquisition of tangible property
(de minimis rule). For Federal income tax purposes,
the taxpayer generally would be required to capitalize the amount paid if
the property has a useful life substantially beyond the taxable year. However,
in this context some courts have permitted the use of a de minimis rule
for Federal income tax purposes. See Union Pacific R.R. Co. v.
United States, 524 F.2d 1343 (Ct. Cl. 1975) (permitting the use
of the taxpayer’s $500 de minimis rule, which was
in accordance with the Interstate Commerce Commission (ICC) minimum rule and
generally accepted accounting principles); Cincinnati, N.O. &
Tex. Pac. Ry. v. United States, 424 F.2d 563 (Ct. Cl. 1970) (same).
But see Alacare Home Health Services, Inc. v. Commissioner,
T.C. Memo 2001-149 (disallowing the taxpayer’s use of a $500 de
minimis rule because it distorted income).
The proposed regulations do not include a de minimis rule
for acquisition costs. However, the IRS and Treasury Department recognize
that taxpayers often reach an agreement with IRS examining agents that, as
an administrative matter, based on risk analysis and/or materiality, the IRS
examining agents do not select certain items for review such as the acquisition
of tangible assets with a small cost. This often is referred to by taxpayers
and IRS examining agents as a de minimis rule. The absence
of a de minimis rule in the proposed regulations is not
intended to change this practice.
The IRS and Treasury Department considered including a de
minimis rule in the proposed regulations. The de minimis rule
considered would have provided that taxpayers are not required to capitalize
certain de minimis amounts paid for the acquisition or
production of a unit of property. Under the rule considered, if a taxpayer
had written accounting procedures in place treating as an expense on its applicable
financial statement (AFS) amounts paid for property costing less than a certain
dollar amount, and treated the amounts paid during the taxable year as an
expense on its AFS in accordance with those written accounting procedures,
the taxpayer would not have been required to capitalize those amounts if they
did not exceed a certain dollar threshold. A taxpayer that did not meet these
criteria (for example, a taxpayer that did not have an AFS) would not have
been required to capitalize amounts paid for a unit of property that did not
exceed the established dollar threshold. Because taxpayers without an AFS
generally are smaller than taxpayers with an AFS, the dollar threshold for
the de minimis rule that would have applied to them would
have been lower than the threshold for taxpayers with an AFS (although the de
minimis rule for taxpayers with an AFS also would have been limited
to the amount treated as an expense on their AFS). The de minimis rule
considered by the IRS and Treasury Department would not have applied to inventory
property, improvements, land, or a component of a unit of property.
The de minimis rule considered also would have
provided that property to which a taxpayer applies the de minimis rule
is treated upon sale or disposition similar to section 179 property. Thus, de
minimis property would have been property of a character subject
to depreciation and amounts paid that were not capitalized under the de
minimis rule would have been treated as amortization subject to
recapture under section 1245. Thus, gain on disposition of the property would
have been ordinary income to the taxpayer to the extent of the amount treated
as amortization for purposes of section 1245.
The IRS and Treasury Department decided to not include a de
minimis rule in the proposed regulations but instead to request
comments on whether such a rule should be included in the final regulations
or whether to continue to rely on the current administrative practice of IRS
examining agents. Therefore, the IRS and Treasury Department request comments
on whether a de minimis rule for acquisition costs should
be included in the final regulations, and, if so, whether the de
minimis rule should be the rule described above and what dollar
thresholds are appropriate.
The IRS and Treasury Department also request comments on the scope of
costs that should be included in a de minimis rule if
one is provided in the final regulations and on the character of de
minimis rule property. For example, the de minimis rule
considered by the IRS and Treasury Department would have applied to the aggregate
of amounts paid for the acquisition or production (including any amounts paid
to facilitate the acquisition or production) of a unit of property and including
amounts paid for improvements prior to the unit of property being placed in
service. If a de minimis rule should be provided in
the final regulations, the IRS and Treasury Department request comments on
what, if any, type of rule should be provided to prevent a distortion of income
when taxpayers acquire a large number of assets, each of which individually
is within the de minimis rule (for example, the purchase
by a taxpayer of 2,000 personal computers).
If a de minimis rule for acquisition costs should
be provided in the final regulations, the IRS and Treasury Department request
comments on whether the rule should permit IRS examining agents and taxpayers
to agree to the use of higher de minimis thresholds on
the basis of materiality and risk analysis and, if so, under what circumstances
a higher threshold should be allowed. The IRS and Treasury Department also
request comments on whether, if a de minimis rule should
be provided in the final regulations, changes to begin using a de
minimis rule or changes to a higher dollar amount within a de
minimis rule should be treated as changes in a method of accounting.
E. Recovery of costs when property is used in a repair
As noted in section III.A. of this preamble, §1.263(a)-2 of the
proposed regulations generally requires capitalization of amounts paid for
the acquisition or production of property having a useful life substantially
beyond the taxable year. Thus, §1.263(a)-2(d) of the proposed regulations
applies to property that is not itself a unit of property, such as property
(not treated as a material or supply under §1.162-3) that is intended
to be used as a component in the repair or improvement of a unit of property.
It must be determined whether the subsequent use of the component property
results in an improvement to the unit of property under §1.263(a)-3 or
an otherwise deductible repair or maintenance cost under §1.162-4. Even
if the subsequent use of the component is an otherwise deductible expense
under §1.162-4, the amount paid nonetheless may be required to be capitalized.
For example, it must be determined whether the amount paid for the component
property is required to be capitalized under section 263A as an indirect cost
that directly benefits or is incurred by reason of property produced or acquired
for resale. The proposed regulations illustrate this concept in an example
of a manufacturer that replaces one window in a building. The taxpayer initially
must capitalize under §1.263(a)-2(d) amounts paid to acquire the window.
The replacement of the window subsequently is determined to be a repair to
the building rather than an improvement. Amounts paid for the repair (or
an allocable portion thereof) must then be capitalized under section 263A
to the inventory that the taxpayer produces to the extent that the repair
directly benefits or is incurred by reason of the taxpayer’s production
activities.
IV. Amounts Paid to Improve Tangible Property
In response to Notice 2004-6, the IRS and Treasury Department received
several comments on the issues that should be addressed in the proposed regulations
to provide guidance on amounts paid to repair, improve, and rehabilitate tangible
property. These comments have been taken into account in drafting §1.263(a)-3
of the proposed regulations. That section addresses amounts paid to improve
tangible property and includes the following provisions: (1) rules for determining
the appropriate unit of property to which the improvement provisions apply;
(2) general rules for improvements; (3) rules for determining whether an amount
paid materially increases the value of the unit of property; (4) rules for
determining whether an amount paid restores the unit of property; and (5)
an optional repair allowance method.
B. Unit of property rules
A threshold issue in applying the improvement rules under §1.263(a)-3
of the proposed regulations is determining the appropriate unit of property
to which the rules should be applied. For example, to determine whether an
amount paid materially increases the value of property, it is necessary to
know what property is at issue. The smaller the unit of property, the more
likely it is that amounts paid in connection with that unit of property will
materially increase the value of, or restore, the property. Taxpayers and
the IRS frequently disagree on the unit of property to which the capitalization
rules should be applied. Thus, the unit of property rules in the proposed
regulations are intended to provide guidance in determining whether an amount
paid improves the unit of property under §1.263(a)-3. The unit of property
rules also apply for purposes of §1.263(a)-1 of the proposed regulations
(which references the rules in §§1.263(a)-2 and 1.263(a)-3 of the
proposed regulations) and §1.263(a)-2 of the proposed regulations (for
example, with regard to the 12-month rule). The unit of property rules in
the proposed regulations apply only for purposes of section 263(a) and §§1.263(a)-1,
1.263(a)-2, and 1.263(a)-3 of the proposed regulations, and not any other
Code or regulation section. For example, no inference is intended that these
unit of property rules have any application for section 263A(f) interest capitalization
purposes.
The current regulations under section 263(a) do not provide any guidance
on determining the appropriate unit of property. Some courts have addressed
the unit of property issue under section 263(a), but their holdings are based
on the particular facts of each case and do not contain rules that are generally
applicable for purposes of section 263(a). See, FedEx Corp. v.
United States, 291 F. Supp. 2d 699 (W.D. Tenn. 2003), aff’d,
412 F.3d 617 (6th Cir. 2005) (concluding that an
aircraft, and not the aircraft engine, was the appropriate unit of property); Smith
v. Commissioner, 300 F.3d 1023 (9th Cir.
2002) (concluding that an aluminum reduction cell, rather than entire cell
line, was the appropriate unit of property); Ingram Industries,
Inc. v. Commissioner, T.C. Memo 2000-323 (concluding that a towboat,
and not the towboat engine, was the appropriate unit of property); LaSalle
Trucking Co. v. Commissioner, T.C. Memo 1963-274 (concluding that
truck engines, tanks, and cabs were each separate units of property).
In FedEx, the court ruled on whether an aircraft
engine or the entire aircraft was the appropriate unit of property for determining
whether the costs of engine shop visits (ESVs) must be treated as capital
expenditures. Relying on the opinions in Ingram and Smith,
the court concluded that the following four factors were relevant in determining
the appropriate unit of property: (1) whether the taxpayer and the industry
treat the component part as a part of a larger unit of property for regulatory,
market, management, or accounting purposes; (2) whether the economic useful
life of the component part is coextensive with the economic useful life of
the larger unit of property; (3) whether the larger unit of property and the
smaller unit of property can function without each other; and (4) whether
the component part can be and is maintained while affixed to the larger unit
of property. Applying these factors to aircraft engines, the court concluded
that the engines should not be considered a unit of property separate and
apart from the airplane.
In Notice 2004-6, the IRS and Treasury Department requested comments
on the relevance of various unit of property factors derived from FedEx and
other cases that addressed the unit of property issue. The factors listed
in Notice 2004-6 included: (1) whether the property is manufactured, marketed,
or purchased separately; (2) whether the property is treated as a separate
unit by a regulatory agency, in industry practice, or by the taxpayer in its
books and records; (3) whether the property is designed to be easily removed
from a larger assembly, is regularly or periodically replaced, or is one of
a fungible set of interchangeable or rotable assets; (4) whether the property
must be removed from a larger assembly to be fixed or improved; (5) whether
the property has a different economic life than the larger assembly; (6) whether
the property is subject to a separate warranty; (7) whether the property serves
a discrete purpose or functions independently from a larger assembly; or (8)
whether the property serves a dual purpose function.
The IRS and Treasury Department received nine comments on the unit of
property issue, four of which specifically recommended that the proposed regulations
adopt the factors used by the court in FedEx. These
factors essentially are contained in factors 1, 2, 4, 5, and 7 of Notice 2004-6.
Several of the factors listed in Notice 2004-6 have been incorporated into
the proposed regulations. However, the IRS and Treasury Department determined
that some factors were not relevant for certain types of property. For example,
the factors listed in Notice 2004-6 primarily derive from case law that addresses
tangible personal property; therefore, the factors were not as helpful in
determining the appropriate unit of property for real property, such as land.
Further, some types of property lend themselves to specific unit of property
rules, such as buildings and property owned by taxpayers in a regulated industry.
The IRS and Treasury Department believe that the administrative burden associated
with determining the appropriate unit of property can be reduced for both
the IRS and taxpayers by identifying specific rules reflecting an approach
appropriate for the taxpayer’s industry and the type of property at
issue. Therefore, the proposed regulations provide different unit of property
rules for four categories of property, rather than prescribing one rule for
all types of property.
The unit of property rules in the proposed regulations apply to all
real and personal property other than network assets. For purposes of the
unit of property rules, network assets means railroad
track, oil and gas pipelines, water and sewage pipelines, power transmission
and distribution lines, and telephone and cable lines that are owned or leased
by taxpayers in each of those respective industries. Network assets include,
for example, trunk and feeder lines, pole lines, and buried conduit. They
do not include property that would be included as a structural component of
a building under §1.263(a)-3(d)(2)(iv) of the proposed regulations, nor
do they include separate property that is adjacent to, but not part of a network
asset, such as bridges, culverts, or tunnels. The proposed regulations do
not affect current guidance that addresses the unit of property or capitalization
rules for network assets, such as Rev. Proc. 2001-46, 2001-2 C.B. 263 (track
maintenance allowance method for Class I railroads); Rev. Proc. 2002-65, 2002-2
C.B. 700 (track maintenance allowance method for Class II and III railroads);
and Rev. Proc. 2003-63, 2003-2 C.B. 304 (safe harbor unit of property rule
for cable television distribution systems). The IRS and Treasury Department
request comments on the relevant rules for determining the appropriate unit
of property for network assets. Additionally, the IRS and Treasury Department
request comments on whether to include rules for network assets in final regulations,
or whether to develop for network assets industry-specific guidance that is
similar to the above referenced revenue procedures.
With the exception of network assets, the four categories of property
in the proposed regulations are intended to cover all real and personal property.
In addition to the four categories of property, the unit of property rules
provide for an initial unit of property determination, which, except with
regard to buildings and structural components, is made prior to categorizing
the property. The initial unit of property determination is based on the
functional interdependence test in §1.263A-10(a)(2), relating to the
capitalization of interest. The initial unit of property determination is
intended to be a common-sense approach to defining the largest possible unit
of property as a starting point for analyzing the rules under one of the four
relevant unit of property categories. After the initial unit of property
is determined, the additional unit of property rules are intended to result
in a determination that either confirms the initial unit of property as the
unit of property, or that separates one or more components of the initial
unit of property into separate units of property.
Some commentators suggested that the functional interdependence test
under §1.263A-10(a)(2) regarding interest capitalization should be the
sole test for determining the appropriate unit of property. The IRS and Treasury
Department believe that the functional interdependence test is a relevant,
but not dispositive factor. The purpose of that test under §1.263A-10(a)(2)
is to calculate the appropriate unit of property for determining the accumulated
production expenditures at the beginning and end of the production period.
The preamble that accompanied the promulgation of §1.263A-10 discusses
the reasoning for adopting a broad formulation of the unit of property definition
and states that “this concept of single property may differ from the
concept of single or separate property that taxpayers use for other purposes
(e.g., for computing amounts of depreciation deductions
or separately tracking the bases of assets).” T.D. 8584, 1995-1 C.B.
20, 25; [59 FR 67, 187] Dec. 29, 1994).
In contrast to the unit of property rules in §1.263A-10(a)(2),
the purpose of the unit of property rules under section 263(a) is to provide
a starting point for determining whether an amount paid materially increases
the value of, or restores, the unit of property. Thus, §1.263A-10(a)(2)
has a different purpose than the proposed regulations under section 263(a).
Further, in determining the appropriate unit of property for purposes of
section 263(a), the functional interdependence test does not always produce
appropriate results. For example, a taxpayer might argue that application
of that test results in an entire complex of structures and machinery, such
as an entire power plant, being treated as a single unit of property. The
IRS and Treasury Department do not believe that result is correct for purposes
of section 263(a).
After the initial unit of property determination is made, the unit of
property analysis continues with determining the appropriate category of property
and applying the rules in that category. The proposed regulations provide
specific rules for four categories of property: (1) property owned by taxpayers
in a regulated industry; (2) buildings and structural components; (3) other
personal property; and (4) other real property. The unit of property determination
made under the applicable category is then subject to an additional rule in
§1.263(a)-3(d)(2)(vii) regarding treatment for other Federal income tax
purposes. The rules for each of the four categories are explained below.
2. Category I: Taxpayers in regulated industries
The first unit of property category in the proposed regulations is property
owned by taxpayers in a regulated industry. The proposed regulations provide
that if the taxpayer is in an industry for which a Federal regulator has
a uniform system of accounts (USOA) identifying a particular unit of property,
the taxpayer must use the same unit of property for Federal income tax purposes,
regardless of whether the taxpayer is subject to the regulatory accounting
rules of the Federal regulator and regardless of whether the property is particular
to that industry. This rule derives from one of the factors cited by the
court in FedEx for determining the appropriate unit of
property — whether the taxpayer and the industry treat the component
part as part of the larger unit of property for regulatory, market, management,
or accounting purposes. Thus, this rule ties into the regulatory accounting
element of the FedEx factor, as well as the general concept
of industry practice. The IRS and Treasury Department are aware of three
Federal regulators that provide a USOA: (1) the Federal Energy Regulatory
Commission (FERC); (2) the Federal Communications Commission (FCC); and (3)
the Surface Transportation Board (STB). Accordingly, this unit of property
category applies to taxpayers such as power companies, telecommunications
companies, and railroads.
The IRS and Treasury Department determined that the regulatory accounting
rule should be applied similarly to all taxpayers in industries for which
a Federal regulator provides a USOA, regardless of whether the taxpayer is
subject to the regulatory accounting rules of the Federal regulator. This
rule is consistent with the general standard of using industry practice to
determine the appropriate unit of property. Further, it results in all taxpayers
within a specific industry being treated the same for Federal income tax purposes,
without regard to whether a particular taxpayer is subject to the accounting
rules of the Federal regulator. The rule is limited to the regulator’s
USOA and does not apply to other Federal regulatory rules, such as rules concerning
safety or health. The proposed regulations apply only to USOA provided by
Federal regulators and do not apply to USOA issued by any state or local agencies.
Rules of state and local agencies may be different than Federal regulatory
rules and can vary widely within an industry depending on the taxpayer’s
location.
Four of the commentators on this aspect of Notice 2004-6 recommended
adopting the four factors cited in FedEx, from which
the regulated industry rule was derived. None of the commentators specifically
objected to a regulatory accounting rule, although one commentator suggested
that where cost recovery is determined for non-tax purposes by a Federal or
state agency, the regulations should provide a special election that may be
made on an annual basis under which the taxpayer may use the same unit of
property for tax purposes as it must use for regulatory purposes. The IRS
and Treasury Department believe the unit of property inquiry should result
in one clear determination that will be used consistently by the taxpayer
unless the underlying facts change and, therefore, do not believe an annual
election is appropriate.
3. Category II: Buildings and structural components
In general, a building and its structural components must be treated
as one unit of property. This rule is based on the definitions of building and structural
component in the regulations under section 48. The repair allowance
regulations under the Class Life Asset Depreciation Range (CLADR) system also
provide that a building and its structural components generally are a single
unit of property. See §1.167(a)-11(d)(2)(vi). The IRS and Treasury
Department believe that these definitions are useful in determining the appropriate
unit of property for buildings and structural components. One commentator
specifically requested that the proposed regulations use the definition of
building under §1.48-1(e) to determine a unit of property. The proposed
regulations rely on the definition of building under §1.48-1(e). Property
located inside a building that is not a structural component of the building
must be analyzed under one of the other three unit of property categories;
for example, machinery and equipment inside a factory must be analyzed under
Category III (the other personal property category).
This Category II is the only category to which the initial unit of property
determination does not apply. Applying the functional interdependence test
to a building would raise issues in cases where certain floors or portions
of a building are placed in service independently of another. The IRS and
Treasury Department believe that, unless the additional rule in §1.263(a)-3(d)(2)(vii)
of the proposed regulations (regarding treatment for other Federal income
tax purposes) applies to require a component of a building to be treated as
a separate unit of property, the building and its structural components should
be the unit of property. The IRS and Treasury Department recognize, however,
that it is not always appropriate to treat the entire building as the unit
of property. For example, a taxpayer who owns a unit in a condominium building,
whether the unit is used for personal or investment purposes, should not treat
the entire building as the unit of property. Therefore, the IRS and Treasury
request comments on how the unit of property rules should apply to condominiums,
cooperatives, and similar types of property.
4. Category III: Other personal property
The unit of property determination for personal property not included
in Category I (taxpayers in a regulated industry) is a facts and circumstances
test, based on four exclusive factors, none of which is dispositive or weighs
more heavily than the others.
a. Factor 1: Marketplace treatment factor
The first exclusive factor is whether the component is (1) marketed
separately to or acquired or leased separately by the taxpayer (from a party
other than the seller/lessor of the property of which the component is a part)
at the time it is initially acquired or leased; (2) subject to a separate
warranty contract (from a party other than the seller/lessor of the property
of which the component is a part); (3) subject to a separate maintenance manual
or written maintenance policy; (4) appraised separately; or (5) sold or leased
separately by the taxpayer to another party. This factor contains a number
of items intended to determine the treatment in the marketplace of the component
as a separate unit of property.
Whether the component is acquired separately was a factor addressed
by the courts in FedEx and Ingram,
and is also part of the CLADR repair allowance regulations under section 167
and the unit of property determination for interest capitalization in §1.263A-10.
In FedEx, the court discussed this issue in the context
of whether the taxpayer and the industry treat the component part as part
of the larger unit of property for regulatory, market, management, or accounting
purposes. In finding that the aircraft engines were not purchased separately,
the court relied on the fact that the engines and aircraft were designed to
be compatible and were generally acquired by the taxpayer at the same time.
The court disregarded the fact that the taxpayer purchased the engines and
airframes from different sellers when the aircraft were initially acquired.
The IRS and Treasury Department believe that the acquisition of a component
from a different seller at the time the larger property is acquired should
be a relevant factor, and that the same rule should apply if the taxpayer
leases the component from a different party than the seller of the larger
property.
The IRS and Treasury Department recognize that this factor may produce
different results depending on whether the property is new or used. When
a taxpayer acquires or leases used property, it is possible that items that
were separate units of property when purchased new will be treated as one
unit of property because the initial purchaser has assembled the units into
one functional item that it sells or leases. The IRS and Treasury Department
considered whether it was appropriate to have a factor that could treat new
and used property differently, and decided that the difference reasonably
reflects the substance of the transactions — where the taxpayer acquires
or leases a component from a different party from whom it acquires or leases
the larger property, the taxpayer typically is conducting different, but related,
transactions with separately negotiated terms.
Whether the component is subject to a separate warranty contract, maintenance
manual, or written maintenance policy was cited as a factor in FedEx and
is adopted as part of the marketplace treatment factor in the proposed regulations.
The warranty contract factor applies only to a warranty that is provided
by a party other than the seller/lessor of the larger property. It is not
intended to apply to a warranty provided by the sellor/lessor that may contain
separate warranties (for example, for different time periods) on various components
of the larger property. Whether the property is manufactured separately was
a possible factor cited in Notice 2004-6. The proposed regulations do not
specifically adopt this factor because components that are subject to a separate
warranty or maintenance procedures also are likely to be manufactured separately.
The FedEx case used as a factor whether the component
was appraised or valued separately and the CLADR repair allowance regulations
under section 167 addressed whether the component was sold separately to another
party. The proposed regulations adopt these tests as part of the marketplace
factor.
The IRS and Treasury Department believe that it is important that all
the criteria in this factor be taken into account together when weighing this
factor with the other three factors. Some criteria may be stronger indicators
warranting treatment of the component as a separate unit of property than
others. The IRS and Treasury Department acknowledge that several of the criteria
within this factor do not work well for property produced by the taxpayer,
and request comments regarding how and whether a marketplace factor should
apply to self-constructed property.
b. Factor 2: Industry practice and financial accounting factor
The second exclusive factor in this Category III is whether the component
is treated as a separate unit of property in industry practice or by the taxpayer
in its books and records. This factor was cited by the court in FedEx.
The IRS and Treasury Department believe that the taxpayer’s treatment
of the component as separate in its books and records is a relevant factor
in determining whether the component should be treated as a separate unit
of property in the proposed regulations. In particular, if the taxpayer’s
books and records assign different economic useful lives to the component
and the larger property, this factor would weigh heavily toward treating the
component as a separate unit of property.
The IRS and Treasury Department considered whether to use as a factor
whether the component has a different economic useful life than the property
of which it is a part. This factor was cited by the courts in Smith, Ingram,
and FedEx. However, for this factor to be useful, the
regulations would need to define economic useful life. The proposed regulations
at §1.263(a)-3(f) (with regard to restoration of a unit of property)
provide a definition of economic useful life, which has different meanings
depending on whether a taxpayer has an AFS. If the unit of property rules
adopted this definition, the economic useful life test under this factor would
produce different results depending on whether the taxpayer has an AFS. These
different results are not justified in this context. Further, a taxpayer’s
treatment of the component in its books and records under this Factor 2 includes
any useful life determinations of the component and the property of which
the component is a part in the books and records. Therefore, the economic
useful life factor was not specifically adopted as a separate factor.
c. Factor 3: Rotable part factor
The third exclusive factor in the other personal property category is
whether the taxpayer treats the component as a rotable part. A rotable part
is defined as a part that is removeable from property, repaired or improved,
and either immediately reinstalled on other property or stored for later installation.
This factor was cited by the courts in Smith and LaSalle.
The court in FedEx ignored this factor, but considered
as a separate concept whether the component can be and is maintained while
affixed to the larger unit. The IRS and Treasury Department considered this
separate concept as well, but believe that the rotable part factor incorporates
this concept from FedEx. As the examples in the proposed
regulations illustrate, this factor focuses on the particular taxpayer’s
treatment of the property as a rotable part in determining whether the rotable
is a separate unit of property. Therefore, for example, if the rotable part
is a separate unit of property to the taxpayer and the taxpayer incorporates
the rotable into other property for resale, the rotable part will not necessarily
be a separate unit of property to the purchaser.
Two commentators stated that the treatment of a component as a rotable
part is of limited or no relevance. While treatment of minor parts as rotable
would not weigh heavily toward separate unit of property treatment, the IRS
and Treasury Department believe that the treatment of major components as
rotable is a relevant factor in determining whether a component is a separate
unit of property, particularly when the economic useful life of the larger
property is limited by the expected useful life of the rotable part. Many
taxpayers do not maintain an inventory of rotable spares for their major components.
Although it is understood that the purpose for maintaining an inventory of
rotables is to minimize the time that the larger property is out of service,
treatment of a major component as a rotable has consequences that tend to
be indicative of a separate unit of property. For example, in the case of
a taxpayer that does not maintain an inventory of rotable spare parts, if
a major component of the larger property breaks down, then the entire larger
property must be taken out of service while the major component is being repaired.
This is indicative of the larger property and the component collectively
being treated as one unit of property. Conversely, a taxpayer that does maintain
an inventory of rotable spare parts for a major component is able to continue
to use the larger property without regard to the time required to repair the
broken down component. In this instance, the IRS and Treasury Department
believe that continued use of the larger property is indicative of separate
unit of property treatment for the rotable part. In addition, rotables being
depreciated as rotable spare parts is indicative of separate treatment because
the components are depreciated separately from the larger property.
In the request for comments, Notice 2004-6 combined several other factors
with the rotables factor, including whether a component is designed to be
easily removed from a larger assembly, is regularly or periodically replaced,
or is one of a fungible set of interchangeable assets. These factors are
broader than the rotables factor in the proposed regulations and would sweep
in many minor components that rarely, if ever, would be appropriately considered
a separate unit of property. Further, these factors are duplicative of the
rotables part factor, because a rotable generally meets all of these factors.
The IRS and Treasury Department believe that these factors are not more helpful
in determining whether a component is a separate unit of property than the
rotables factor described in the proposed regulations. Therefore, the proposed
regulations do not include these other factors.
d. Factor 4: Function factor
The fourth and final factor in Category III is whether the property
of which the component is a part generally functions for its intended use
without the component property. This factor was cited by the court in FedEx and
is similar to the discrete purpose test under the CLADR repair allowance regulations.
It is also similar to the functional interdependence test under §1.263A-10(a)(2)
and the rules in these proposed regulations regarding the initial unit of
property determination. As noted in the discussion of the initial unit of
property determination, the IRS and Treasury Department agree with commentators
that the functional interdependence test is a relevant, although not dispositive,
factor in the unit of property analysis. Although the proposed regulations
use the functional interdependence test to determine the initial unit of property,
the functional interdependence test in that context is merely a starting point
in determining the appropriate unit of property, rather than a specific factor
to be considered. Providing this version of the functional interdependence
test as a specific factor gives appropriate weight to that test in the unit
of property analysis for other personal property.
5. Category IV: Other real property
The unit of property determination for real property not included in
Category I or II is based on a facts and circumstances test. The property
subject to this category is primarily land and land improvements owned or
leased by taxpayers not in a regulated industry. This category does not list
specific factors because land and land improvements are such unique assets
that specific factors cannot uniformly provide appropriate results. Thus,
the unit of property determination for property in this category may be based
on some, all, or none of the factors listed in Category III for personal property,
or may be based on other factors. The IRS and Treasury Department request
comments on whether additional guidance is needed for this category of property
and, if so, what unit of property guidance would be appropriate.
6. Additional rule for unit of property
After determining the initial unit of property and applying the unit
of property rules under the appropriate category, the additional rule in §1.263(a)-3(d)(2)(vii)
must be applied. Under this rule, if a taxpayer properly treats a component
as a separate unit of property for any Federal income tax purpose, the taxpayer
must treat the component as a separate unit of property for purposes of §1.263(a)-3.
The purpose of this rule is to prevent taxpayers from taking inconsistent
positions by arguing that a component of property is a unit of property for
one tax purpose and that it is not a separate unit of property for capitalization
purposes. For example, if a taxpayer does a cost segregation study on a building
and properly identifies separate section 1245 property, the taxpayer must
treat that separate property as the unit of property for capitalization purposes.
As a further example, if a taxpayer properly recognizes a loss under
section 165, or under another applicable provision, from a retirement of a
component of property or from the worthlessness or abandonment of a component
of property, the taxpayer must treat the component as a separate unit of property.
A loss arising under another applicable provision in this context includes
a loss arising under (1) §1.167(a)-8 or 1.167(a)-11, as applicable, from
a retirement of a component of property if the component is not subject to
section 168 (MACRS property) or former section 168 (ACRS property); (2) §1.167(a)-8(a)
from a retirement of a component of property if the component is MACRS or
ACRS property (applying §1.167(a)-8(a) as though the retirement is a
normal retirement from a single asset account) unless the component is a structural
component or the component is in a mass asset account (ACRS property) or a
general asset account (MACRS property); or (3) §1.168(i)-1(e) from the
disposition of a component of property if the component is MACRS property
and in a general asset account. No inference is intended that this rule in
the proposed regulations requires or allows taxpayers that are using a unit
of property for purposes of the proposed regulations to use the same unit
of property for purposes of any Code or regulation section other than section
263(a) and §§1.263(a)-1, 1.263(a)-2, and 1.263(a)-3 of the proposed
regulations.
This rule is intended to prevent taxpayers from taking a loss deduction
on a component of a unit of property, and then deducting the cost of the replaced
component as a repair. The application of this rule results in the replacement
component being treated as a separate unit of property, thus requiring capitalization
under §1.263(a)-2 of amounts paid to acquire or produce the replacement
component. The IRS and Treasury Department believe that taxpayers must be
consistent in the treatment of a unit of property for capitalization (other
than interest capitalization), depreciation, and loss deduction purposes.
The IRS and Treasury Department recognize that the language of this consistency
rule is very broad, and request comments regarding circumstances in which
this rule should not apply.
V. Improvements in General
Section 1.263(a)-1(b) of the current regulations provides that an amount
must be capitalized if it (1) adds to the value, or substantially prolongs
the useful life, of property owned by the taxpayer, or (2) adapts the property
to a new or different use. Notice 2004-6 requested comments on what general
principles of capitalization should apply to amounts paid to repair or improve
tangible property. Commentators were almost unanimous in their suggestion
that the current principles of value, useful life, and new or different use
be retained. The IRS and Treasury Department agree with the commentators
that the current guidelines generally are appropriate. However, the current
regulations require a subjective inquiry into the application of the particular
facts at issue, which often results in disagreements between taxpayers and
the IRS. Accordingly, the proposed regulations attempt to clarify and expand
the standards in the current regulations by setting forth rules to determine
whether there has been a material increase in value (including adapting property
to a new or different use) and to determine whether there has been a restoration
of property (the useful life rules). In addition, the proposed regulations
provide objective rules for improvements in an optional repair allowance method.
The proposed regulations generally provide that a taxpayer must capitalize
the aggregate of related amounts paid that improve a unit of property, whether
the improvements are made by the taxpayer or a third party. The aggregate
of related amounts does not encompass otherwise deductible repair costs unless
those costs directly benefit or are incurred by reason of a capital improvement.
Instead, the aggregation language is intended to include amounts paid for
an entire project, including removal costs and other project costs, regardless
of whether amounts are paid to more than one party or whether the work spans
more than one taxable year. The proposed regulations do not affect the treatment
of amounts paid to retire and remove a unit of property in connection with
the installation or production of a replacement asset. See Rev. Rul. 2000-7,
2000-1 C.B. 712.
Several commentators suggested that the proposed regulations provide
that the relevant distinction between capital improvements and deductible
repairs is whether the amounts were paid to put the property in ordinarily
efficient operating condition or to keep the property in ordinarily efficient
operating condition. See Estate of Walling v. Commissioner,
373 F.2d 190 (3d Cir. 1967); Illinois Merchants Trust Co. v. Commissioner,
4 B.T.A. 103 (1926), acq. (V-2 C.B. 2); Rev. Rul. 2001-4, 2001-1 C.B. 295.
The improvement rules in the proposed regulations are consistent with the
put versus keep standard, to the extent that standard is relevant. An amount
paid may be a capital expenditure even if it does not put the property in
ordinarily efficient operating condition because not all repair or improvement
costs affect the functionality of the property. Thus, amounts paid that keep
property in ordinarily efficient operating condition are not necessarily deductible
repair costs, particularly if the useful life is extended. On the other hand,
amounts that put property in ordinarily efficient operating condition are
likely to be amounts paid prior to the property’s being placed in service
or to ameliorate a pre-existing condition or defect. Amounts paid in these
later situations would be capital expenditures under either the value rule
or the restoration rule in the proposed regulations.
Some commentators suggested that the frequency of the expenditure should
be considered, noting that an expenditure being regularly incurred on a cyclical
basis should be a strong indication of deductible maintenance. The IRS and
Treasury Department considered this comment but concluded that the frequency
of the expenditure was too vague a standard to be administrable. Further,
the IRS and Treasury Department believe that the proposed regulations provide
appropriate guidance on cyclical maintenance by clarifying other rules, such
as the appropriate comparison rule for adding value and the rules relating
to prolonging economic useful life.
In accordance with several comments received in response to Notice 2004-6,
the proposed regulations provide that a Federal, state, or local regulator’s
requirement that a taxpayer perform certain repairs or maintenance is not
relevant in determining whether the amount paid improves the unit of property.
Several courts have held that amounts paid to bring property into compliance
with government regulations were capital expenditures, in part because they
made the taxpayer’s property more valuable for use in its trade or business.
See, Swig Investment Co. v. United States, 98 F.3d 1359
(Fed. Cir. 1996) (replacing cornices and parapets on hotel to comply with
city earthquake ordinance); Teitelbaum v. Commissioner,
294 F.2d 541 (7th Cir. 1961) (converting electrical
system from direct current to alternating current to comply with city ordinance); RKO
Theatres, Inc. v. United States, 163 F. Supp. 598 (Ct. Cl. 1958)
(installing fire-proof doors and fire escapes to comply with city code); Hotel
Sulgrave, Inc. v. Commissioner, 21 T.C. 619 (1954) (installing
sprinkler system to comply with city code). In each case, however, the court
did not rely entirely on regulatory compliance as a basis for requiring capitalization.
For example, in Hotel Sulgrave and RKO Theatres,
both involving the installation of certain equipment to comply with city fire
codes, the courts emphasized that the work involved the addition of property
with a useful life extending beyond the taxable year. Moreover, both Swig and Teitelbaum involved
expenditures for the replacement of major structural components of a building
(parapets and cornices in Swig and an electrical system
in Teitelbaum) with upgraded components. Thus, in all
these cases, even without the legal compulsion to make these changes, the
taxpayers’ amounts paid would have constituted capital expenditures.
In contrast to the cases discussed above, both the courts and the IRS
have permitted a current deduction for some government mandated expenditures.
For example, in Midland Empire Packing Co. v. Commissioner,
14 T.C. 635 (1950), acq. (1950-2 C.B. 3), the court allowed the taxpayer to
deduct the costs of applying a concrete liner to its basement walls to satisfy
Federal meat inspectors. Similarly, the IRS has permitted taxpayers to treat
as otherwise deductible repairs amounts paid to remediate certain environmental
contamination and to replace certain waste storage tanks to comply with applicable
state and Federal regulations. See Rev. Rul. 94-38, 1994-1 C.B. 35; Rev.
Rul. 98-25, 1998-1 C.B. 998. The IRS specifically recognized in Rev. Rul.
2001-4, 2001-1 C.B. 295 that the requirement of a regulatory authority to
make certain repairs or to perform certain maintenance on an asset to continue
operating the asset does not mean that the work performed must be capitalized.
Thus, the proposed regulations reiterate that statement in Rev. Rul. 2001-4
and provide that a legal compulsion to repair or maintain tangible property
is not a relevant factor in the repair versus improvement analysis. The IRS
and Treasury Department further believe that a new government requirement
for existing property that mandates certain expenditures with respect to the
property does not create an inherent defect in the property.
In response to several comments, the proposed regulations provide that
if a taxpayer needs to replace part of a unit of property that cannot practicably
be replaced with the same type of part, the replacement of the part with an
improved but comparable part does not, by itself, result in an improvement
to the unit of property. This rule is intended to apply in cases where the
same replacement part is no longer available, generally because of technological
advancements or product enhancements. This rule, however, is not intended
to apply if, instead of replacing an obsolete part with the most similar comparable
part available, the taxpayer replaces the part with one of a better quality
than what would have sufficed.
The proposed regulations do not prescribe a plan of rehabilitation doctrine
as traditionally described in the case law. That judicially-created doctrine
provides that a taxpayer must capitalize otherwise deductible repair costs
if they are incurred as part of a general plan of rehabilitation to the property.
See, Norwest Corp. v. Commissioner, 108 T.C. 265 (1997); Moss
v. Commissioner, 831 F.2d 833 (9th Cir.
1987); United States v. Wehrli, 400 F.2d 686 (10th Cir.
1968). Specifically, if an expenditure is made as part of a general plan
of rehabilitation, modernization, and improvement of the property, the expenditure
must be capitalized, even though, standing alone, the item may be classified
as one of repair or maintenance. Wehrli, 400 F.2d at
689. Whether a general plan of rehabilitation exists, and whether a particular
repair or maintenance item is part of it, are questions of fact to be determined
based upon all the surrounding facts and circumstances, including, but not
limited to, the purpose, nature, extent, and value of the work done. Id. at
690.
The issue of whether an amount paid must be capitalized under the plan
of rehabilitation doctrine has been the subject of much litigation, with varying
results. For example, some cases have limited application of the plan of
rehabilitation doctrine to buildings that are not suitable for their intended
use in the taxpayer’s trade or business. See Schroeder v.
Commissioner, T.C. Memo 1996-336; Koanis v. Commissioner,
T.C. Memo 1978-184, aff’d mem., 639 F.2d 788 (9th Cir.
1981); Keller Street Dev. Co. v. Commissioner, 37 T.C.
559 (1961); acq., 1962-2 C.B. 5, aff’d in part, rev’d in part
on other grounds, 323 F.2d 166 (9th Cir. 1963).
Other courts, as well as the IRS, have viewed the plan of rehabilitation
doctrine more broadly, emphasizing the planned aspect of the work done by
the taxpayer, rather than the condition of the property. See Mountain
Fuel Supply Co. v. United States, 449 F.2d 816 (10th Cir.
1971); Wolfsen Land & Cattle Co. v. Commissioner,
72 T.C. 1 (1979); Rev. Rul. 88-57, 1988-2 C.B. 36.
In Rev. Rul. 2001-4, 2001-1 C.B. 295, the IRS clarified its view of
the plan of rehabilitation doctrine. In applying the plan of rehabilitation
doctrine to the facts in Situation 3 of that ruling, the IRS noted that (1)
the taxpayer planned to perform substantial capital improvements to upgrade
the unit of property; (2) the repairs were incidental to the taxpayer’s
plan to upgrade the unit of property; and (3) the effect of all the work performed
on the unit of property, including the repairs and maintenance work, was to
materially increase the value or prolong the useful life of the unit of property.
The ruling also notes that the existence of a written plan, by itself, is
not sufficient to trigger the plan of rehabilitation doctrine. The ruling’s
interpretation of the plan of rehabilitation doctrine is consistent with the
majority of cases applying that doctrine. See California Casket
Co. v. Commissioner, 19 T.C. 32 (1952), acq., 1953-1 C.B. 3; Stoeltzing
v. Commissioner, 266 F.2d 374 (3d Cir. 1959); Bank of
Houston v. Commissioner, T.C.M. 1960-110.
The IRS and Treasury Department do not believe it is appropriate to
capitalize as an improvement otherwise deductible repair costs solely because
the taxpayer has a plan (written or otherwise) to perform periodic repairs
or maintenance or solely because the taxpayer performs several repairs to
the same property at one time. The IRS and Treasury Department believe that
it is appropriate to capitalize otherwise deductible repair costs as part
of an improvement only if the taxpayer improves a unit of property and the
otherwise deductible repair costs directly benefit or are incurred by reason
of the improvement to the property. Section 263A applies to these expenditures.
Section 263A requires that all direct costs of an improvement and all indirect
costs that directly benefit or are incurred by reason of the improvement must
be capitalized. This application of section 263A to otherwise deductible
repair costs in this context is consistent with the application of the plan
of rehabilitation doctrine described in Rev. Rul. 2001-4. The proposed regulations
provide that repairs that are made at the same time as an improvement, but
that do not directly benefit or are not incurred by reason of the improvement,
are not required to be capitalized under section 263(a).
The proposed regulations provide that a taxpayer must capitalize amounts
paid that materially increase the value of a unit of property and provide
an exclusive list of five tests for determining whether an amount paid materially
increases value. An amount paid must be capitalized if it meets any of the
five tests. The first test is whether the amount paid ameliorates a condition
or defect that either existed prior to the taxpayer’s acquisition of
the unit of property or arose during the production of the unit of property.
See United Dairy Farmers, Inc. v. United States, 267
F.3d 510 (6th Cir. 2001); Dominion Resources,
Inc. v. United States, 219 F.3d 359 (4th Cir.
2000); Jones v. Commissioner, 242 F.2d 616 (5th Cir.
1957). This rule is consistent with the concept that amounts paid to put
property into ordinarily efficient operating condition must be capitalized.
This pre-existing defect rule applies regardless of whether the taxpayer
was aware of the condition or defect at the time of acquisition or production.
The IRS and Treasury Department considered but rejected as too subjective
the idea of providing different treatment based on the taxpayer’s prior
knowledge of the condition or defect. The IRS and Treasury Department request
comments on whether, and in what circumstances, the pre-existing defect rule
should take into account the condition of the property in the hands of a transferor.
For example, if an individual transfers property to a corporation in exchange
for stock in a transaction under section 351, should the pre-existing defect
rule take into account the condition of the property when acquired by the
individual, rather than the condition of the property when received by the
corporation?
The second test for materially increasing value is whether the work
was performed prior to the date the property is placed in service by the taxpayer.
This test essentially restates the concept that amounts paid to put property
into ordinarily efficient operating condition must be capitalized. The IRS
and Treasury Department believe that if the property cannot be placed in service
prior to work being performed, that work necessarily increases the value of
the property.
The third value test is whether the amounts paid adapt the property
to a new or different use. The commentators agreed that this factor should
remain a standard for capitalization. The new or different use standard is
unchanged from the current regulations, but it is included in the value section
of the proposed regulations, rather than as its own standard. The new or
different use test is not intended to apply to amounts paid to prepare a unit
of property for sale (for example, painting a house).
The fourth value test is whether the amount paid results in a betterment
or material addition to the unit of property. The betterment language is
consistent with the statutory language of section 263(a)(1) as well as the
current regulations at §1.263(a)-1(a)(1). A betterment is an improvement
that does more than restore to a former good condition. The betterment test
is intended to capture amounts paid that are qualitative improvements to the
property that make the property better and more valuable than mere repairs
would do, such as using upgraded materials when materials comparable to the
original were available and would have sufficed. However, the betterment
test is not intended to be a fair market value test.
The fifth test in the value section of the proposed regulations is whether
the amount paid results in a material increase in capacity, productivity,
efficiency, or quality of output of the unit of property. These standards
are consistent with case law under the current regulations.
The proposed regulations provide an exception to the value tests if
the original economic useful life of the unit of property is 12 months or
less and the taxpayer does not elect to capitalize amounts paid for the property.
The purpose of this rule is to not require capitalization under the value
rules for improvements made to 12-month property. This exception, however,
does not apply to the restoration rule for determining whether an amount paid
improves property. Thus, for example, if a taxpayer performs work on 12-month
property that prolongs the economic useful life of the property, the amount
paid must be capitalized.
The proposed regulations do not adopt an increase in fair market value
as a standard for capitalization. In response to Notice 2004-6, most commentators
stated that value means fair market value. However, in practice, taxpayers
generally do not measure, and would have no reason to measure, the fair market
value of a unit of property prior to some condition necessitating the expenditure.
Further, taxpayers generally have no reason to measure the fair market value
of a unit of property after the work is performed. The IRS and Treasury Department
did not want to propose regulations with a standard that required taxpayers
to have property appraised solely for the purpose of applying a capitalization
standard. In fact, the courts rarely have applied a strict increase in fair
market value standard. Usually, the courts rely on some surrogate for fair
market value to determine whether value is increased. For example, courts
have looked to the amount of the expenditure versus (1) the cost of the property
(see Stoeltzing v. Commissioner, 266 F.2d 374 (3d Cir.
1959)); (2) the cost of comparable new property (see LaSalle Trucking
Co. v. Commissioner, T.C. Memo 1963-274); and (3) the cost of comparable
used property (see Ingram Industries, Inc. v. Commissioner,
T.C. Memo 2000-323). Courts have considered fair market value only in a few
cases when property has been appraised for some other purpose (see Jones
v. United States, 279 F. Supp. 772, 774 (D. Del. 1968)), or when
property has been appraised in the course of the litigation (see FedEx,
291 F. Supp. 2d at 706-707).
Additionally, the fair market value of property may change over time
without regard to the use, upkeep, or improvements made by the taxpayer, due
to other factors such as supply and demand or changes in style, trends, technologies,
etc. For example, land may increase in fair market value over time without
the taxpayer performing any activities to improve it. Conversely, amounts
paid to make substantial improvements to a unit of property may not always
increase fair market value, or may not increase the fair market value by the
full amount paid for the improvements. See, Harrah’s Club
v. United States, 661 F.2d 203 (Ct. Cl. 1981) (amount paid to restore
antique automobiles must be capitalized even though restoration did not increase
fair market value by the amount paid for the restoration). Attempting to
adjust fair market value for factors like these further complicates any possible
comparison. The IRS and Treasury Department believe that the fair market
value standard is too subjective and impractical, particularly because most
repairs also increase the fair market value of property if the value is compared
immediately before and after the work is performed. Therefore, the IRS and
Treasury Department do not believe that fair market value is an appropriate
standard. The value factors in the proposed regulations are intended to be
objective indications of work performed that generally would increase the
fair market value of the unit of property. Whether amounts paid materially
increase the value of a unit of property requires an analysis of the purpose,
the physical nature, and the effect of the work for which the amounts were
paid, and not an analysis of the fair market value of the property or the
level of monetary expenditures.
Some commentators requested that the regulations provide a bright line
rule defining a material increase in value with respect to a specified percentage
increase, for example a twenty-five percent increase in capacity. The IRS
and Treasury Department do not believe that providing a fixed percentage as
a presumption of what is a material increase would be an appropriate safe
harbor. Although perhaps measurable, the same fixed percentage increase in
capacity would not work well as a rule applicable to all types of property.
A twenty-five percent increase in capacity may be a reasonable litmus test
for determining whether there has been a material increase in value for certain
types of property. However, for many types of property, a much smaller increase
in capacity may be an extraordinary, or in some cases impossible, improvement.
For example, an increase in the square footage of a 50,000 square foot building
by 5 percent would be a rather large improvement that should be capitalized.
Therefore, the determination of whether an increase in capacity, productivity,
efficiency, or quality is a material increase in value should be based on
all the facts and circumstances.
B. Appropriate comparison
Notice 2004-6 requested comments on the proper starting point for comparing
whether an expenditure materially increases the value of property. Almost
all the commentators suggested that the proposed regulations adopt the test
set forth in Plainfield-Union Water Co. v. Commissioner,
39 T.C. 333 (1962), nonacq. on other grounds (1964-2 C.B. 8) (the Plainfield-Union
test). In that case, the court noted that almost any properly performed repair
adds value as compared with the situation existing immediately prior to that
repair. The proper test, the court said, is whether the expenditure materially
enhances the value of the property as compared with the status of the property
prior to the condition necessitating the expenditure. The court also noted
that the test is appropriate even when the expenditure does not arise from
a sudden, unexpected, or unusual external circumstance.
The IRS and Treasury Department agree with this application of the Plainfield-Union
test and believe that the test is appropriately applied to cases of normal
wear and tear as well as cases when the expenditure arises from a sudden,
unexpected, or unusual external circumstance. The proposed regulations adopt
the Plainfield-Union test for cases in which a particular event necessitates
the expenditure and clarify that when the event necessitating the expenditure
is normal wear and tear, the condition of the property immediately prior to
the event necessitating the expenditure is the condition of the property after
the last time the taxpayer corrected the effects of normal wear and tear or,
if the taxpayer has not previously corrected the effects of normal wear and
tear, the condition of the property when placed in service by the taxpayer.
This comparison rule for wear and tear is intended to apply when a taxpayer
engages in regular, cyclical maintenance of a unit of property to correct
the effects of normal wear and tear. Although wear and tear begins affecting
the condition of property as soon as it is placed in service, the proposed
regulations do not adopt the placed-in-service date as the appropriate comparison
point. Although the placed-in-service date would be the appropriate comparison
point when the taxpayer first corrects the effects of normal wear and tear,
the IRS and Treasury Department believe that the condition of the property
after the previous maintenance cycle is the appropriate comparison point for
each subsequent maintenance cycle.
The Plainfield-Union test works well when the amount paid is necessitated
by a specific event (like amounts paid to repair damage or amounts paid to
maintain property by correcting the effects of wear and tear). However, the
test does not work in a pure improvement setting; that is, when a taxpayer
decides to improve property without any event causing the taxpayer to perform
the work to restore the property to a former good condition. Therefore, the
proposed regulations do not apply the Plainfield-Union test to the first three
value factors (pre-existing defects, work performed prior to the property
being placed in service, and adapting the property to a new or different use).
These factors are more appropriately analyzed on an absolute, rather than
relative basis. Similarly, the test does not work well for betterments, which
by definition are improvements that do more than restore property to a former
good condition.
The proposed regulations provide that a taxpayer must capitalize amounts
paid to restore property. The restoration language is from section 263(a)(2)
and §1.263(a)-1(a)(2) of the current regulations and generally has been
viewed as a rule requiring the capitalization of amounts paid that substantially
prolong the useful life of the property. See §1.263(a)-1(b). This section
of the proposed regulations defines economic useful life and what it means
to substantially prolong economic useful life.
The comments received in response to Notice 2004-6 varied greatly with
regard to useful life, with two commentators specifically suggesting that
the concept of useful life be eliminated from the regulations. The other
commentators suggested that economic useful life be defined as the period
of time over which the property is expected to be useful to the taxpayer,
taking into account the various factors listed in §1.167(a)-1(b). The
proposed regulations adopt this definition of economic useful life for taxpayers
that do not have an AFS. Economic useful life is not determined by reference
to the recovery period under section 168 for the property.
For a taxpayer that has an AFS, the economic useful life of the property
is presumed to be the same as the useful life used by the taxpayer for purposes
of determining depreciation in its AFS. The IRS and Treasury Department believe
that the economic useful life definition is subjective and difficult to apply;
therefore, this rule provides certainty for taxpayers with an AFS. The regulations
provide an exception to this rule for situations in which a taxpayer does
not assign a useful life to certain property in its AFS, even though the property
has a useful life of more than one year. For example, a taxpayer may treat
amounts paid for a unit of property as an expense in its AFS if the property
is used in a specific research project and has no alternative future uses.
Additionally, many taxpayers have a policy of treating as an expense in their
AFS an amount paid for tangible property below a certain dollar threshold,
despite the fact that the property has a useful life of more than one year.
This type of property does not have a useful life for purposes of determining
depreciation in the taxpayer’s AFS, even though it may have a useful
life of more than one year. Therefore, the IRS and Treasury Department believe
that in these situations it is appropriate for taxpayers to use the economic
useful life definition that applies to taxpayers without an AFS.
One commentator stated that the useful life used for book depreciation
purposes is not appropriate for tax purposes because the book useful life
takes into account factors that do not measure the inherent useful life, but
rather the period over which the property is expected to be useful (on average)
to the taxpayer. The IRS and Treasury Department believe it is appropriate
to take into account the period over which the property may reasonably be
expected to be useful to the taxpayer, as required by taxpayers without an
AFS, rather than the inherent useful life of the property.
The proposed regulations also provide four rules for determining when
an amount paid substantially prolongs economic useful life. The first rule
requires capitalization when the amount paid extends the period over which
the property may reasonably be expected to be useful to the taxpayer beyond
the end of the taxable year immediately succeeding the taxable year in which
the economic useful life of the property was originally expected to cease.
One commentator suggested that the regulations provide a safe harbor bright
line rule to define whether an amount substantially prolongs the useful life.
The IRS and Treasury Department believe that a one year rule is an appropriate
bright line. Therefore, the regulations require capitalization when the amount
paid extends the original useful life of the property by more than one taxable
year. The IRS and Treasury Department believe that a one year rule is a more
appropriate bright line than a rule based on a percentage of the useful life,
because the one-year rule corresponds with the 12-month safe harbor rule for
the acquisition or production of property.
The second rule requires capitalization if a major component or a substantial
structural part of the unit of property is replaced and notes that the replacement
of a relatively minor portion of the physical structure of the unit of property
or a relatively minor portion of any of its major parts does not constitute
the replacement of a major component or substantial structural part of the
unit of property. It is possible, however, for amounts paid to replace a
relatively minor portion of the physical structure of the unit of property
or a relatively minor portion of any of its major parts to substantially prolong
the economic useful life of the property if the property is near the end of
its economic useful life, in which case the amounts paid nevertheless must
be capitalized. The rule is not intended to require capitalization if a major
component is replaced with a similar, used component that has not been rebuilt,
for example, if the engine in a car is replaced with a used engine with similar
mileage obtained from a junkyard, or a component of property subject to a
warranty or maintenance agreement is replaced with a used part that has been
repaired.
Although the replacement of minor parts does not usually prolong the
economic useful life of most property, the replacement of most or all minor
parts for some types of property may be the equivalent of rebuilding the property,
particularly in cases in which the property consists almost entirely of minor
parts. Therefore, the third rule provides that amounts paid that restore
a unit of property (or a major component or substantial structural part of
the unit of property) to a like-new condition substantially prolong the useful
life. The IRS and Treasury Department intend that this test be applied to
situations in which the property undergoes the equivalent of being rebuilt.
Merely reconditioning a property by dismantling the property, and cleaning
and inspecting components, is not the equivalent of rebuilding. All or almost
all major and minor parts of the unit of property (or the major component
or substantial structural part of the unit of property) must be returned to
the original manufacturers’ specifications.
The fourth rule relates to the restoration of a unit of property after
the taxpayer has properly deducted a casualty loss under section 165 with
respect to the property. Section 165(a) allows a taxpayer to deduct any loss
sustained during the taxable year and not compensated for by insurance or
otherwise. Generally, any loss arising from a fire, storm, shipwreck, or
other casualty is allowable as a deduction under section 165(a). Section
1.165-7(a)(1). The amount of the deduction is the difference between the
fair market value of the property before and after the casualty, to the extent
the amount does not exceed the property’s adjusted basis. Section 1.165-7(b)(1).
A casualty loss deduction under section 165(a) results in a decrease in the
taxpayer’s basis in the property.
The courts have distinguished between losses that are deductible as
casualties under section 165(a) and incidental repair costs that are deductible
under section 162(a) as ordinary and necessary business expenses. In general,
if property is lost, destroyed, or abandoned as a result of a casualty, a
loss deduction under section 165(a) is appropriate; however, if property is
simply damaged in a casualty and expenditures are made to repair the property
in a manner that does not permanently improve or better it or prolong its
useful life, those expenditures are business expenses deductible under section
162(a). Hensler v. Commissioner, 73 T.C. 168, 179 (1979);
see also Hubinger v. Commissioner, 36 F.2d 724, 726 (2d
Cir. 1929) (expenses resulting from “trifling accidental causes”
are deductible only under section 162(a) and not under section 165(a)); Atlantic
Greyhound Corp. v. United States, 111 F. Supp. 953 (1953) (“the
provisions for deductions of ‘ordinary and necessary expenses’
and ‘casualty losses’ would seem to be mutually exclusive, for
the normal connotation of one negates, at least by implication, the idea of
the other”). Thus, the mere fact that the damage results from a casualty
is not controlling; instead, the nature of the damage resulting from the casualty
is relevant in determining whether the expenditure should be treated as a
loss or deduction.
The IRS and Treasury Department believe that when a taxpayer properly
deducts a casualty loss, the nature of the damage resulting from the casualty
is such that any repairs done to restore the property after the casualty should
not be treated as ordinary and necessary repair costs. Thus, the proposed
regulations provide that any amounts paid to repair property after a casualty
loss must be capitalized.
Commentators stated that amounts paid at any point during the property’s
economic useful life that do not change the function, design, etc., but enable
property to be used for its expected useful life should not be determined
to extend the useful life. The IRS and Treasury Department believe that there
are circumstances in which amounts paid that merely restore property to a
former good condition may properly be capitalized as substantially prolonging
useful life, for example, when repairs are made to property after a casualty
loss. As another example, work performed at the end of the economic useful
life of the unit of property may extend the property’s useful life.
Additionally, replacement of a major component or a substantial structural
part of a unit of property extends the useful life, particularly when the
expected life of the component is coterminous with the economic useful life
of the unit of property, and the economic useful life of the unit of property
is in fact limited by the period over which the component is expected to be
useful. Thus, the proposed regulations do not adopt the commentators’
suggestion.
VIII. Repair Allowance Method
The primary focus of the proposed regulations is to provide guidance
that distinguishes deductible repair expenses from capital expenditures.
However, because this remains inherently a facts-and-circumstances based determination,
the IRS and Treasury Department requested comments in Notice 2004-6 on whether
the regulations should provide a repair allowance. Six commentators suggested
the regulations should provide a repair allowance or other de minimis rules
for repair expenditures. Two commentators specifically proposed a repair
allowance system modeled on the former CLADR repair allowance system. The
proposed regulations adopt these suggestions and provide an optional repair
allowance method, similar to the CLADR repair allowance, to create objective
rules in this area. Although some commentators additionally requested other de
minimis rules for repair expenditures as well, the IRS and Treasury
Department believe that a repair allowance is an appropriate safe harbor for
repair expenditures. Therefore, the proposed regulations do not provide a
safe harbor other than the repair allowance.
Under the repair allowance in the proposed regulations, the taxpayer
compares the amounts paid for materials and labor during the taxable year
to repair, maintain, or improve repair allowance property to the repair allowance
amount. The amounts paid are deductible under section 162 to the extent of
the repair allowance amount, and any excess amounts paid are capitalized.
Under the proposed repair allowance method, a repair allowance amount is
determined separately for each MACRS class. The repair allowance amount for
a particular class is determined by multiplying the repair allowance percentage
in effect for that class by the average unadjusted basis of repair allowance
property in that class. For buildings that are repair allowance property,
the repair allowance method is applied separately to each building. This
rule is consistent with the rule for buildings under the CLADR repair allowance
system.
The excess of amounts paid to repair, maintain, or improve all the repair
allowance property in a MACRS class over the repair allowance amount for the
class must be capitalized (the capitalized amount). The capitalized amount
includes the taxpayer’s direct costs of repairing, maintaining, or improving
repair allowance property in a particular MACRS class. In addition, the taxpayer
must add to the capitalized amount any allocable indirect costs of producing
the repair allowance property in the MACRS class, which must be capitalized
in accordance with the taxpayer’s method of accounting for section 263A
costs. Except with regard to repair allowance property that is depreciated
under section 168(g) or repair allowance property that is public utility property
(for which separate rules are provided), the proposed regulations permit taxpayers
to choose one of two methods of treating the capitalized amount. The first
method is to treat the capitalized amount as a separate single asset and to
depreciate the asset in accordance with that MACRS class. The second method
is to allocate the capitalized amount for a particular MACRS class to all
repair allowance property in the particular MACRS class in proportion to the
unadjusted basis of the property in that MACRS class as of the beginning of
the taxable year. Under either the single asset method or the allocation
method, the capitalized amount is treated as a section 168(i)(6) improvement
and is treated as placed in service by the taxpayer on the last day of the
first half of the taxable year in which the amount is paid, before application
of the convention under section 168(d). For example, the capitalized amount
for a calendar year taxpayer would be treated as placed in service on June
30 of the taxable year.
Because the single asset treatment does not permit taxpayers to recognize
a gain or loss on the disposition of repair allowance property, the IRS and
Treasury Department request comments on whether, in the final regulations,
taxpayers should be permitted to change to the allocation treatment for the
taxable year of disposition and if so, what record keeping rules or other
rules should be required for taxpayers to make that change. With regard to
the allocation treatment, the IRS and Treasury Department request comments
on whether the allocation should be based on an amount other than the unadjusted
basis as of the beginning of the taxable year, such as the unadjusted basis
at the end of the taxable year or the average unadjusted basis.
C. Repair allowance property
Repair allowance property is defined in the proposed regulations as
real or personal property subject to MACRS that is used in the taxpayer’s
trade or business or for the production of income. It also includes certain
tangible property not otherwise subject to MACRS if the taxpayer, solely for
purposes of the repair allowance method, classifies the property in the appropriate
MACRS class in which the property would be included if the property were subject
to MACRS. Taxpayers are not required to classify non-MACRS property (property
placed in service before the effective date of section 168 and property for
which the taxpayer properly elected out of section 168). Non-classified property
will not be repair allowance property eligible for the repair allowance method.
Certain types of property are not included in repair allowance property,
including any property for which the taxpayer has elected to use the CLADR
repair allowance method and property for which the taxpayer uses the method
of accounting provided in Rev. Proc. 2001-46, 2001-2 C.B. 263, or Rev. Proc.
2002-65, 2002-2 C.B. 700 (both with regard to railroad track). Thus, the
repair allowance in the proposed regulations does not repeal the CLADR repair
allowance, nor does it prohibit taxpayers from using the repair allowance
method in these regulations for repair allowance property, while continuing
to use the CLADR repair allowance for other property.
Repair allowance property also does not include excluded additions,
the cost of which must be capitalized. The CLADR repair allowance system
has a similar rule. Under the CLADR repair allowance system, excluded additions
are defined as any expenditures (1) that increase by 25% or more the productivity
or capacity of an existing identifiable unit of property over its productivity
or capacity when first acquired; (2) that modify an existing identifiable
unit of property for a substantially different use; (3) for an additional
identifiable unit of property or a replacement of an identifiable unit of
property that was retired; (4) for a replacement of a part in or a component
or portion of an existing identifiable unit of property if such part, component,
or portion is for replacement of a part, component or portion which was retired
in a retirement upon which gain or loss was recognized; (5) in the case of
a building or other structure, for additional cubic or linear space; and (6)
in the case of those units of property of pipelines, electric utilities, telephone
companies, and telegraph companies consisting of lines, cables, and poles,
for replacement of 5% or more of the unit of property with respect to which
the replacement is made.
One commentator suggested that the proposed regulations should not have
excluded additions similar to those in the CLADR repair allowance because
they are too qualitative and difficult to administer. The IRS and Treasury
Department agree that some of the items listed as excluded additions under
the CLADR system are too subjective and do not provide the kind of objective
determination the proposed repair allowance is intended to provide. For this
reason, the proposed regulations limit the excluded additions to amounts paid
(1) for the acquisition or production of a specific unit of property; (2)
for work that ameliorates a condition or defect that either existed prior
to the taxpayer’s acquisition of the unit of property or arose during
the production of the unit of property, whether or not the taxpayer was aware
of the condition or defect at the time of acquisition or production; (3) for
work performed prior to the date the unit of property is placed in service
by the taxpayer (without regard to any applicable convention under section
168(d)); (4) that adapts the unit of property to a new or different use; or
(5) that increases the cubic or square space of a building.
Thus, the proposed regulations adopt excluded additions 2, 3, and 5
in the CLADR repair allowance. These excluded additions are also listed in
§1.263(a)-3(e)(1) of the proposed regulations as factors that indicate
a material increase in value. The regulations do not adopt excluded addition
1 in the CLADR repair allowance because an increase in productivity or capacity
of 25% or more may be too difficult to measure. The regulations do not specifically
cite excluded addition 4 from the CLADR repair allowance; however, if a part,
component, or portion of a unit of property is retired in a retirement upon
which gain or loss properly was recognized, the replacement of that component
is a separate unit of property under §1.263(a)-3(d)(2) of the proposed
regulations and thus is addressed by excluded addition 1 of the proposed regulations.
Excluded addition 6 in the CLADR repair allowance addresses network assets
and was not adopted in the proposed regulations pending comments on how the
final regulations should address the unit of property rules relating to network
assets.
In addition to the three excluded additions that the proposed regulations
carry over from the CLADR repair allowance, the excluded additions in the
proposed regulations include amounts paid for work that ameliorates a pre-existing
condition or defect and for work performed prior to the date the unit of property
is placed in service by the taxpayer. These two excluded additions also are
listed as factors in §1.263(a)-3(e)(1) of the proposed regulations that
indicate a material increase value. The IRS and Treasury Department believe
that the excluded additions provided in the repair allowance in the proposed
regulations are more objective than those in the CLADR regulations and are
easier to verify.
Like the repair allowance under CLADR, repair allowance property does
not include property leased by the taxpayer from another party. One commentator
suggested that the repair allowance apply to leased property. The IRS and
Treasury Department recognize that taxpayers that lease property confront
the same issues as owners in distinguishing deductible repairs from capital
improvements. However, the application of the repair allowance method to
leased property raises several difficult issues. The IRS and Treasury Department
request comments on whether the repair allowance method should be extended
to leased property and, if so, how the following issues should be resolved:
(1) How should the unadjusted basis of leased property be determined? Should
fair market value be used instead of unadjusted basis and, if so, how and
when should fair market value be determined? (2) How should the regulations
be drafted to prevent abuse between related lessors and lessees? (3) How
should the regulations be drafted to prevent both the lessor and lessee from
using the repair allowance method for the same property? (4) How should the
regulations address qualified lessee construction allowances for short-term
leases under section 110? (5) What is the proper treatment of the capitalized
amount for leased property under the repair allowance? (6) Should lessees
be permitted to classify the leased property to a MACRS class and use one
of the treatments of the capitalized amount in the proposed regulations?
(7) Should the capitalized amount be allocated to individual leases and amortized
over the remaining term of each lease and, if so, how should that allocation
be made? (8) If the taxpayer has a number of leases with varying lease terms,
should the capitalized amount be allocated to certain groups of leases and
amortized over the average remaining term of the leases and if so, how should
the leases be grouped? (9) Are there any other issues with regard to the
application of a repair allowance to leased property that need to be addressed?
The definition of repair allowance property in the proposed regulations
does not specifically exclude network assets. However, application of the
repair allowance requires a determination of the appropriate unit of property,
in particular with regard to identifying excluded additions. The unit of
property determination with regard to network assets is not addressed in the
proposed regulations and is an issue on which the IRS and Treasury Department
have requested comments. Therefore, the IRS and Treasury Department anticipate
that final regulations specifically will include network assets as repair
allowance property if appropriate unit of property rules can be determined.
If appropriate unit of property rules cannot be determined for network assets,
the IRS and Treasury Department request comments on whether to develop industry-specific
guidance on how the repair allowance method should apply (in particular, how
excluded additions should be determined) with regard to network assets in
a particular industry.
G. Repair allowance percentages
The repair allowance percentages under the CLADR repair allowance were
determined by the Treasury Department’s Office of Industrial Economics,
which is no longer in existence. The percentages were published in various
revenue procedures (most recently in Rev. Proc. 83-35, 1983-1 C.B. 745), made
obsolete by Rev. Proc. 87-56, 1987-2 C.B. 674, with regard to property subject
to section 168, and were revised and supplemented periodically. The proposed
regulations create a new repair allowance percentage for each MACRS class.
These rates are based on the principle that a taxpayer will spend 50% of
the property’s unadjusted basis on repairs over the property’s
MACRS recovery period. Thus, the repair allowance percentages for a particular
MACRS class in the proposed regulations were computed by: (1) dividing 100%
by the number of years in the recovery period for the MACRS class, which represents
the portion of the property’s unadjusted basis that is allocable to
each year of the recovery period, and; (2) multiplying the result by 50%.
For example, if a taxpayer has repair allowance property in a MACRS class
with a 5 year recovery period, 100% divided by 5 is 20%, which represents
the portion of the property’s unadjusted basis that is allocable to
each year of the recovery period. Multiplying the 20% amount by 50% results
in a repair allowance percentage of 10% for that MACRS class.
The IRS and Treasury Department request comments on whether the repair
allowance percentages should be different than those provided in the proposed
regulations, whether the rates in Rev. Proc. 83-35 should be used, and whether
the final regulations should permit taxpayers to choose between repair allowance
percentages in Rev. Proc. 83-35 and the final regulations. The IRS and Treasury
Department also request comments on whether a separate repair allowance percentage
should be provided for certain types of property, such as repair allowance
property subject to section 168(g) (for example, a percentage that reflects
the recovery period under the alternative depreciation system in section 168(g)
rather than the MACRS recovery period under section 168). Finally, the IRS
and Treasury Department request comments on whether industries should be permitted
to request guidance through the Industry Issue Resolution program to establish
different repair allowance percentages for their particular industry.
H. Manner of electing and manner of revoking election
The proposed regulations reserve the issue of how a taxpayer will elect
the repair allowance method. Two commentators suggested that taxpayers be
permitted to elect the repair allowance on a year by year basis. The IRS
and Treasury Department disagree with this suggestion. The repair allowance
method is a method of accounting under section 446(e) and should be used consistently
by taxpayers. Allowing a year by year election would complicate a taxpayer’s
record keeping and would create a burden on IRS examining agents when auditing
a taxpayer’s compliance with the repair allowance method. Therefore,
the IRS and Treasury Department do not expect to permit a year by year election.
However, even though the repair allowance method is a method of accounting
under section 446(e), the IRS and Treasury Department expect to provide that
taxpayers may elect the repair allowance method prospectively without having
to file an application for change in accounting method and that the election
be done on a cutoff basis. Procedures for electing the repair allowance method
will be provided either in the final regulations or in published guidance
in the Internal Revenue Bulletin.
The proposed regulations provide that the repair allowance method, if
elected, must be elected for all repair allowance property. A taxpayer may
revoke an election made under the repair allowance method only by obtaining
the Commissioner’s consent. Procedures for obtaining the Commissioner’s
consent to revoke an election will be provided either in the final regulations
or in published guidance in the Internal Revenue Bulletin. The IRS and Treasury
Department expect to provide that a taxpayer that revokes an election may
not re-elect the repair allowance method for a period of at least five taxable
years, beginning with the year of the revocation unless, based on a showing
of unusual and compelling circumstances, consent is specifically granted by
the Commissioner to re-elect the repair allowance at an earlier time. The
IRS and Treasury Department request comments on the appropriateness of the
five year waiting period, as well as on the circumstances that should be considered
unusual and compelling so that the Commissioner would grant consent to re-elect
the repair allowance prior to expiration of the five year waiting period.
The proposed regulations do not impose any specific record keeping requirements.
However, under section 6001, taxpayers are required to keep books and records
sufficient to establish the amounts used to compute a deduction under the
repair allowance method. For example, taxpayers must maintain books and records
reasonably sufficient to determine (1) the total amounts paid (other than
amounts paid for excluded additions) during the taxpayer year for the repair,
maintenance, or improvement of repair allowance property in the specific MACRS
class; (2) the unadjusted basis of all repair allowance property in the specific
MACRS class at the beginning and the end of the taxable year; (3) the repair
allowance percentages used for the specific MACRS class for the taxable year;
and (4) the treatment of the capitalized amounts (whether capitalized as a
single asset or allocated to all repair allowance property in the specific
MACRS class).
These regulations are proposed to apply to taxable years beginning on
or after the date the final regulations are published in the Federal
Register. The final regulations will provide rules applicable
to taxpayers that seek to change a method of accounting to comply with the
rules contained in the final regulations. Taxpayers may not change a method
of accounting in reliance upon the rules contained in the proposed regulations
until the rules are published as final regulations in the Federal
Register.
The IRS and Treasury Department anticipate that, except as otherwise
provided (for example, in the repair allowance section), the final regulations
will provide that a taxpayer seeking to change to a method of accounting provided
in the final regulations must follow the applicable procedures for obtaining
the Commissioner’s automatic consent to a change in accounting method.
Generally, a change in method of accounting is made using an adjustment under
section 481(a). However, the IRS and Treasury Department are concerned about
the potential administrative burden on taxpayers and the IRS that may result
from section 481(a) adjustments that originate many years prior to the effective
date of the final regulations. The IRS and Treasury Department request comments
on whether there are circumstances in which it is appropriate to permit a
change in method of accounting to be made using a cut-off basis instead of
a section 481(a) adjustment. Finally, the IRS and Treasury Department request
comments on any additional terms and conditions for changes in methods of
accounting that would be helpful to taxpayers in adopting the rules contained
in these proposed regulations.
It has been determined that this notice of proposed rulemaking is not
a significant regulatory action as defined in Executive Order 12866. Therefore,
a regulatory assessment is not required. It also has been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does
not apply to these regulations, and, because the regulation does not impose
a collection of information on small entities, the Regulatory Flexibility
Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the
Code, this notice of proposed rulemaking will be submitted to the Chief Counsel
for Advocacy of the Small Business Administration for comment on its impact
on small business.
Comments and Public Hearing
Before the proposed regulations are adopted as final regulations, consideration
will be given to any written comments (a signed original and eight (8) copies)
or electronic comments that are submitted timely to the IRS. Comments are
requested on all aspects of the proposed regulations. In addition, the IRS
and Treasury Department specifically request comments on the clarity of the
proposed rules and how they may be made easier to understand. All comments
will be available for public inspection and copying.
A public hearing has been scheduled for Tuesday, December 19, 2006,
at 10:00 a.m., in the auditorium of the New Carrollton Federal Building, 5000
Ellin Road, Lanham, MD 20706. Due to building security procedures, visitors
must enter at the main front entrance. In addition, all visitors must present
photo identification to enter the building. Because of access restrictions,
visitors will not be admitted beyond the immediate entrance area more than
30 minutes before the hearing starts. For information about having your name
placed on the building access list to attend the hearing, see the “FOR
FURTHER INFORMATION CONTACT” section of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit electronic or written
comments and an outline of the topics to be discussed and the time to be devoted
to each topic (signed original and eight (8) copies) by November 28, 2006.
A period of 10 minutes will be allotted to each person for making comments.
An agenda showing the scheduling of the speakers will be prepared after the
deadline for receiving outlines has passed. Copies of the agenda will be
available free of charge at the hearing.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.162-4 is revised to read as follows:
Amounts paid for repairs and maintenance to tangible property are deductible
if the amounts paid are not required to be capitalized under §1.263(a)-3.
Par. 3. Section 1.263(a)-0 is amended by revising the entries for §1.263(a)-1
through §1.263(a)-3 to read as follows:
§1.263(a)-0 Table of contents. * * *
§1.263(a)-1 Capital expenditures; in general.
(a) General rule for capital expenditures.
(b) Examples of capital expenditures.
(c) Amounts paid to sell property.
(1) In general.
(2) Treatment of capitalized amount.
(3) Examples.
(d) Amount paid.
(e) Effective date.
(f) Accounting method changes.
§1.263(a)-2 Amounts paid to acquire or produce tangible
property.
(a) Overview.
(b) Definitions.
(1) Amount paid.
(2) Personal property.
(3) Real property.
(4) Produce.
(c) Coordination with other provisions of the Internal Revenue Code.
(1) In general.
(2) Materials and supplies.
(d) Acquired or produced tangible property.
(1) In general.
(i) Requirement of capitalization.
(ii) Examples.
(2) Defense or perfection of title to tangible property.
(i) In general.
(ii) Examples.
(3) Transaction costs.
(i) In general.
(ii) Examples.
(4) 12-month rule.
(i) In general.
(ii) Coordination with section 461.
(iii) Exceptions to 12-month rule.
(iv) Character of property subject to 12-month rule.
(v) Election to capitalize.
(vi) Examples.
(e) Treatment of capital expenditures.
(f) Recovery of capitalized amounts.
(1) In general.
(2) Examples.
(g) Effective date.
(h) Accounting method changes.
§1.263(a)-3 Amounts paid to improve tangible property.
(a) Overview.
(b) Definitions.
(1) Amount paid.
(2) Personal property.
(3) Real property.
(c) Coordination with other provisions of the Internal Revenue Code.
(1) In general.
(2) Example.
(d) Improved property.
(1) Capitalization rule.
(2) Determining the appropriate unit of property.
(i) In general.
(ii) Initial unit of property determination.
(iii) Category I: Taxpayers in regulated industries.
(iv) Category II: Buildings and structural components.
(v) Category III: Other personal property.
(vi) Category IV: Other real property.
(vii) Additional rule.
(viii) Examples.
(3) Compliance with regulatory requirements.
(4) Unavailability of replacement parts.
(5) Repairs performed during an improvement.
(i) In general.
(ii) Exception for individuals.
(e) Value.
(1) In general.
(2) Exception.
(3) Appropriate comparison.
(4) Examples.
(f) Restoration.
(1) In general.
(2) Economic useful life.
(i) Taxpayers with an applicable financial statement.
(ii) Taxpayers without an applicable financial statement.
(iii) Definition of “applicable financial statement.”
(3) Substantially prolonging economic useful life.
(i) In general.
(ii) Replacements.
(iii) Restoration to like-new condition.
(iv) Restoration after a casualty loss.
(4) Examples.
(g) Repair allowance method.
(1) In general.
(2) Election of repair allowance method.
(3) Application of repair allowance method.
(4) Repair allowance amount.
(i) In general.
(ii) Average unadjusted basis.
(iii) Unadjusted basis.
(iv) Buildings.
(5) Capitalized amount.
(i) In general.
(ii) Single asset treatment of capitalized amount.
(iii) Allocation treatment of capitalized amount.
(iv) Section 168(g) repair allowance property.
(v) Section 168(g) election.
(vi) Public utility property.
(6) Repair allowance property.
(i) In general.
(ii) Certain property not subject to section 168.
(iii) Exclusions from repair allowance property.
(7) Excluded additions.
(i) In general.
(ii) Treatment of excluded additions.
(8) Repair allowance percentage.
(9) Manner of election.
(10) Manner of revoking election.
(11) Examples.
(h) Treatment of capital expenditures.
(i) Recovery of capitalized amounts.
(j) Effective date.
(k) Accounting method changes.
* * * * *
Par. 4. Sections 1.263(a)-1 through 1.263(a)-3 are revised to read
as follows:
§1.263(a)-1 Capital expenditures; in general.
(a) General rule for capital expenditures. Except
as provided in chapter 1 of the Internal Revenue Code, no deduction is allowed
for—
(1) Any amount paid for new buildings or for permanent improvements
or betterments made to increase the value of any property or estate, or
(2) Any amount paid in restoring property or in making good the exhaustion
thereof for which an allowance is or has been made in the form of a deduction
for depreciation, amortization, or depletion.
(b) Examples of capital expenditures. The following
amounts paid are examples of capital expenditures:
(1) An amount paid to acquire or produce real or personal property.
See §1.263(a)-2.
(2) An amount paid to improve real or personal property. See §1.263(a)-3.
(3) An amount paid to acquire or create intangibles. See §1.263(a)-4.
(4) An amount paid or incurred to facilitate an acquisition of a trade
or business, a change in capital structure of a business entity, and certain
other transactions. See §1.263(a)-5.
(5) An amount assessed and paid under an agreement between bondholders
or shareholders of a corporation to be used in a reorganization of the corporation
or voluntary contributions by shareholders to the capital of the corporation
for any corporate purpose. See section 118 and §1.118-1.
(6) An amount paid by a holding company to carry out a guaranty of dividends
at a specified rate on the stock of a subsidiary corporation for the purpose
of securing new capital for the subsidiary and increasing the value of its
stockholdings in the subsidiary. This amount must be added to the cost of
the stock in the subsidiary.
(c) Amounts paid to sell property—(1) In
general. Commissions and other transaction costs paid to facilitate
the sale of property generally must be capitalized. However, in the case
of dealers in property, amounts paid to facilitate the sale of property are
treated as ordinary and necessary business expenses. See §1.263(a)-5(g)
for the treatment of amounts paid to facilitate the disposition of assets
that constitute a trade or business.
(2) Treatment of capitalized amount. Amounts capitalized
under paragraph (c)(1) of this section are treated as a reduction in the amount
realized and generally are taken into account either in the taxable year in
which the sale occurs or in the taxable year in which the sale is abandoned
if a loss deduction is permissible. The capitalized amount is not added to
the basis of the property and is not treated as an intangible under §1.263(a)-4.
(3) Examples. The following examples, which assume
the sale is not an installment sale under section 453, illustrate the rules
of this paragraph (c):
Example 1. Sales costs of real property.
X owns a parcel of real estate. X sells the real estate and pays legal
fees, recording fees, and sales commissions to facilitate the sale. X must
capitalize the fees and commissions and, in the taxable year of the sale,
offset the fees and commissions against the amount realized from the sale
of the real estate.
Example 2. Sales costs of dealers.
Assume the same facts as in Example 1, except that X
is a dealer in real estate. The commissions and fees paid to facilitate the
sale of the real estate are treated as ordinary and necessary business expenses
under section 162.
Example 3. Sales costs of personal property
used in the trade or business. X is a farmer and owns a truck
for use in X’s trade or business. X decides to sell the truck and on
November 15, 2008, X pays to advertise the sale of the truck in the local
news media. On February 15, 2009, X sells the truck to Y. X is required
to capitalize in 2008 the amount paid to advertise the sale of the truck and,
in 2009, is required to offset the amount paid against the amount realized
from the sale of the truck.
Example 4. Costs of abandoned sale of
personal property used in a trade or business. Assume the same
facts as in Example 3, except that, instead of selling
the truck on February 15, 2009, X decides on that date not to sell the truck
and takes the truck off the market. X is required to capitalize in 2008 the
amount paid to advertise the sale of the truck. However, X may treat the
amount paid as a loss under section 165 in 2009 when the sale is abandoned.
Example 5. Sales costs of personal property
not used in a trade or business. Assume the same facts as in Example
3, except that X does not use the truck in X’s trade or business,
but instead uses it for personal purposes. X decides to sell the truck and
on November 15, 2008, X pays to advertise the sale of the truck in the local
news media. On February 15, 2009, X sells the truck to Y. X is required
to capitalize in 2008 the amount paid to advertise the sale of the truck and,
in 2009, is required to offset the amount paid against the amount realized
from the sale of the truck.
Example 6. Costs of abandoned sale of
personal property not used in a trade or business. Assume the
same facts as in Example 5, except that, instead of selling
the truck on February 15, 2009, X decides on that date not to sell the truck
and takes the truck off the market. X is required to capitalize in 2008 the
amount paid to advertise the sale of the truck. Although the sale is abandoned
in 2009, X may not treat the amount paid as a loss under section 165 because
the truck was not used in X’s trade or business or in a transaction
entered into for profit.
(d) Amount paid. For purposes of this section,
the terms amounts paid and payment mean,
in the case of a taxpayer using an accrual method of accounting, a liability
incurred (within the meaning of §1.446-1(c)(1)(ii)). A liability may
not be taken into account under this section prior to the taxable year during
which the liability is incurred.
(e) Effective date. The rules in this section
apply to taxable years beginning on or after the date of publication of the
Treasury decision adopting these rules as final regulations in the Federal Register.
(f) Accounting method changes. [Reserved]
§1.263(a)-2 Amounts paid to acquire or produce tangible
property.
(a) Overview. This section provides rules for
applying section 263(a) to amounts paid to acquire or produce real or personal
property. See §1.263(a)-3 for the treatment of amounts paid to improve
tangible property, §1.263(a)-4 for the treatment of amounts paid to acquire
or create intangibles, and §1.263(a)-5 for the treatment of amounts paid
to facilitate an acquisition of a trade or business, a change in capital structure
of a business entity, and certain other transactions.
(b) Definitions. For purposes of this section,
the following definitions apply:
(1) Amount paid. In the case of a taxpayer using
an accrual method of accounting, the terms amounts paid and payment mean
a liability incurred (within the meaning of §1.446-1(c)(1)(ii)). A liability
may not be taken into account under this section prior to the taxable year
during which the liability is incurred.
(2) Personal property. Personal property means
tangible personal property as defined in §1.48-1(c).
(3) Real property. Real property means
land and improvements thereto, such as buildings or other inherently permanent
structures (including items that are structural components of such buildings
or structures) that are not personal property as defined in paragraph (b)(2)
of this section. Local law is not controlling in determining whether property
is real property for purposes of this section.
(4) Produce. Produce means
construct, build, install, manufacture, develop, create, raise, or grow.
See §1.263(a)-3 for capitalization rules applicable to amounts paid to
improve property.
(c) Coordination with other provisions of the Internal Revenue
Code—(1) In general. Nothing in this
section changes the treatment of any amount that is specifically provided
for under any provision of the Internal Revenue Code or regulations other
than section 162(a) or section 212 and the regulations under those sections.
(2) Materials and supplies. Nothing in this section
changes the treatment of amounts paid for materials and supplies that are
properly treated as deductions or deferred expenses, as appropriate, under
§1.162-3.
(d) Acquired or produced tangible property—(1) In
general—(i) Requirement of capitalization.
A taxpayer must capitalize amounts paid to acquire or produce real or personal
property having a useful life substantially beyond the taxable year, including
land and land improvements, buildings, machinery and equipment, and furniture
and fixtures, and a unit of property (as determined under §1.263(a)-3(d)(2)),
having a useful life substantially beyond the taxable year. A taxpayer also
must capitalize amounts paid to acquire real or personal property for resale
and to produce real or personal property for sale. See section 263A for the
scope of costs required to be capitalized to property produced by the taxpayer
or to property acquired for resale.
(ii) Examples. The following examples illustrate
the rule of this paragraph (d)(1):
Example 1. Acquisition of personal property
— coordination with §1.162-3. X, an airline, operates
a fleet of aircraft. X purchases and maintains in stock for repairs to its
aircraft a great number of different expendable flight equipment spare parts
(including cartridges, canisters, cylinders, and disks), based in part on
the manufacturer’s recommendations and in part on the airline’s
experience. The expendable flight equipment spare parts are carried on hand
by X until they are installed in the particular type of aircraft for which
purchased. The expendable flight equipment spare parts are of a type normally
not repaired and reused. As these parts are taken from stock and used to
repair aircraft, the stock supply is replenished by X purchasing new parts.
In 2008, X purchases expendable flight equipment spare parts. X properly
treats the amount paid for the expendable flight equipment spare parts as
a deferred expense under §1.162-3. Nothing in this section changes the
treatment of the original acquisition cost as a deferred expense.
Example 2. Acquisition of personal property
— coordination with §1.162-3. X, an industrial laundry
business, leases many products, including garments, linens, shop towels, continuous
roll towels, and mops (rental items). X maintains a supply of rental items
on hand to replace worn or damaged items. The rental items have useful lives
of 12 months or less. In 2008, X purchases a large quantity of rental items.
The amount paid for the rental items is properly treated by X as a deferred
expense under §1.162-3. Nothing in this section changes the treatment
of the original acquisition cost as a deferred expense.
Example 3. Acquisition of personal property.
In 2008, X purchases new cash registers, which have a useful life substantially
beyond the taxable year, for use in its retail store located in a leased space
in a shopping mall. X must capitalize under this paragraph (d)(1) the amount
paid to purchase each cash register.
Example 4. Relocation and installation
of personal property. Assume the same facts as in Example
3, except that X’s lease expires in 2009 and X decides to
relocate its retail store to a different building. In addition to various
other costs, X pays $5,000 to move the cash registers and $1,000 to reinstall
them in the other store. X is not required to capitalize under this paragraph
(d)(1) the $5,000 amount paid for moving the cash registers; however, X must
capitalize under this paragraph (d)(1) the $1,000 amount paid to reinstall
the cash registers in its other store because, under paragraph (b)(4) of this
section, installation costs are production costs.
Example 5. Acquisition of land.
X purchases a parcel of undeveloped real estate. X must capitalize under
this paragraph (d)(1) the amount paid to acquire the real estate. See §1.263(a)-2(d)(3)
for the treatment of amounts paid to facilitate the acquisition of real property.
Example 6. Acquisition of building.
X purchases a building. X must capitalize under this paragraph (d)(1) the
amount paid to acquire the building. See §1.263(a)-2(d)(3) for the treatment
of amounts paid to facilitate the acquisition of real property.
Example 7. Acquisition of property for
resale. X purchases goods for resale. X must capitalize under
this paragraph (d)(1) the amounts paid to acquire the goods. See section
263A for the treatment of amounts paid to acquire property for resale.
Example 8. Production of property for
sale. X produces goods for sale. X must capitalize under this
paragraph (d)(1) the amount paid to produce the goods. See section 263A for
the treatment of amounts paid to produce property.
Example 9. Production of building.
X constructs a building. X must capitalize under this paragraph (d)(1) the
amount paid to construct the building. See section 263A for the treatment
of amounts paid to produce real property.
Example 10. Acquisition of assets constituting
a trade or business. Y owns tangible and intangible assets that
constitute a trade or business. X purchases all the assets of Y in a taxable
transaction. X must capitalize under this paragraph (d)(1) the amount paid
for the tangible assets of Y. See §1.263(a)-4 for the treatment of amounts
paid to acquire intangibles and §1.263(a)-5 for the treatment of amounts
paid to facilitate the acquisition of assets that constitute a trade or business.
See section 1060 for special allocation rules for certain asset acquisitions.
(2) Defense or perfection of title to property—(i) In
general. Amounts paid to defend or perfect title to real or personal
property constitute amounts paid to acquire or produce property within the
meaning of this section and must be capitalized. See section 263A for the
scope of costs required to be capitalized to property produced by the taxpayer
or to property acquired for resale.
(ii) Examples. The following examples illustrate
the rule of this paragraph (d)(2):
Example 1. Amounts paid to contest condemnation.
X owns real property located in County. County filed an eminent domain complaint
condemning a portion of X’s property to use as a roadway. X hired an
attorney to contest the condemnation. Amounts paid by X to the attorney must
be capitalized because they were to defend X’s title to the property.
Example 2. Amounts paid to invalidate
ordinance. X is in the business of quarrying and supplying sand
and stone in a certain municipality. Several years after X established its
business, the municipality in which it was located passed an ordinance that
prohibited the operation of X’s business. X incurred attorney’s
fees in a successful prosecution of a suit to invalidate the municipal ordinance.
X prosecuted the suit to preserve its business activities and not to defend
X’s title in the property. Therefore, attorney’s fees paid by
X are not required to be capitalized under this paragraph (d)(2). However,
under section 263A, all indirect costs, including otherwise deductible costs,
that directly benefit or are incurred by reason of the taxpayer’s production
activities must be capitalized to the property produced for sale. Therefore,
because the amounts paid to invalidate the ordinance are incurred by reason
of X’s production activities, the amounts paid must be capitalized under
section 263A to the property produced for sale by X.
Example 3. Amounts paid to challenge
building line. The board of public works of a municipality established
a building line across X’s business property, adversely affecting the
value of the property. X incurred legal fees in unsuccessfully litigating
the establishment of the building line. Amounts paid by X to the attorney
must be capitalized because they were to defend X’s title to the property.
(3) Transaction costs—(i) In general.
A taxpayer must capitalize amounts paid to facilitate the acquisition of
real or personal property, including shipping costs, bidding costs, sales
and transfer taxes, legal and accounting fees, title fees, engineering fees,
survey costs, inspection costs, appraisal fees, recording fees, application
fees, commissions, and compensation for the services of a qualified intermediary
or other facilitator of an exchange under section 1031. See §1.263(a)-5
for the treatment of amounts paid to facilitate the acquisition of assets
that constitute a trade or business. See section 263A for the scope of costs
required to be capitalized to property produced by the taxpayer or to property
acquired for resale.
(ii) Examples. The following examples illustrate
the rule of this paragraph (d)(3):
Example 1. Legal fees, taxes, and commissions
to facilitate an acquisition. X purchases a building and pays
legal fees, sales taxes, and sales commissions to facilitate the acquisition.
X must capitalize the amounts paid for legal fees, sales taxes, and sales
commissions.
Example 2. Moving costs to facilitate
an acquisition. X purchases all the assets of Y and, in connection
with the purchase, hires a transportation company to move storage tanks from
Y’s plant to X’s plant. X must capitalize the amount paid to
move the tanks from Y’s plant to X’s plant because the amount
paid facilitates the acquisition of the storage tanks.
(4) 12-month rule—(i) In general.
Except as otherwise provided in this paragraph (d)(4), an amount paid for
the acquisition or production (including any amount paid to facilitate the
acquisition or production) of a unit of property (as determined under §1.263(a)-3(d)(2))
with an economic useful life (as defined in §1.263(a)-3(f)(2)) of 12
months or less is not a capital expenditure under paragraph (d) of this section.
(ii) Coordination with section 461. In the case
of a taxpayer using an accrual method of accounting, the rules of this paragraph
(d)(4) do not affect the determination of whether a liability is incurred
during the taxable year, including the determination of whether economic performance
has occurred with respect to the liability. See §1.461-4 for rules relating
to economic performance.
(iii) Exceptions to 12-month rule. The 12-month
rule in paragraph (d)(4)(i) of this section does not apply to the following:
(A) Amounts paid for property that is or will be included in property
produced for sale or property acquired for resale;
(B) Amounts paid to improve property under §1.263(a)-3;
(C) Amounts paid for land; and
(D) Amounts paid for any component of a unit of property.
(iv) Character of property subject to 12-month rule.
Property to which a taxpayer applies the 12-month rule contained in paragraph
(d)(4)(i) of this section is not treated upon sale or disposition as a capital
asset under section 1221 or as property used in the trade or business under
section 1231.
(v) Election to capitalize. A taxpayer may elect
not to apply the 12-month rule contained in paragraph (d)(4)(i) of this section
with regard to a unit of property. An election made under this paragraph
(d)(4)(v) applies to any unit of property during the taxable year to which
paragraph (d)(4)(i) of this section would apply (but for the election under
this paragraph (d)(4)(v)). A taxpayer makes the election by treating the
amount paid as a capital expenditure in its timely filed original Federal
income tax return (including extensions) for the taxable year in which the
amount is paid. In the case of a pass-through entity, the election is made
by the pass-through entity, and not by the shareholders, partners, etc. An
election may not be made through the filing of an application for change in
accounting method or by an amended Federal income tax return and an election
may not be revoked.
(vi) Examples. The rules of this paragraph (d)(4)
are illustrated by the following examples, in which it is assumed (unless
otherwise stated) that the taxpayer is a calendar year, accrual method taxpayer
that has not elected out of the 12-month rule under paragraph (d)(4)(v) of
this section with regard to the unit of property, and that none of the property
is materials and supplies under §1.162-3:
Example 1. Production cost.
X corporation manufactures and sells aluminum storm windows and doors. To
conduct its business, X purchases strips of aluminum called extrusions and
applies paint electrostatically to the extrusions through a complex process.
In 2008, X installs a leaching pit to provide a draining area for liquid
waste produced in the process of painting the extrusions. X previously had
dumped this waste into a creek bed, but the local water department ordered
it to cease this practice. The economic useful life of the leaching pit is
12 months, after which time the factory will be connected to the local sewer
system. Assume that the leaching pit is the unit of property, as determined
under §1.263(a)-3(d)(2). X is not required to capitalize under paragraph
(d) of this section the amount paid to produce the leaching pit because the
useful life of the leaching pit is 12 months or less. However, under section
263A, all indirect costs, including otherwise deductible costs, that directly
benefit or are incurred by reason of the taxpayer’s manufacturing activities
must be capitalized to the property produced for sale. Therefore, because
the amounts paid for the leaching pit are incurred by reason of X’s
manufacturing operations, the amounts paid must be capitalized under section
263A to the property produced for sale by X.
Example 2. Acquisition or production
cost. X purchases or produces jigs, dies, molds, and patterns
for use in the manufacture of motor vehicles and motor vehicle parts. The
economic useful life of the jigs, dies, molds, and patterns is 12 months.
Assume each jig, die, mold, and pattern is a separate unit of property, as
determined under §1.263(a)-3(d)(2). X is not required to capitalize
under paragraph (d) of this section the amounts paid to produce or purchase
the jigs, dies, molds, and patterns because the economic useful life is 12
months or less. However, under section 263A, all indirect costs, including
otherwise deductible costs, that directly benefit or are incurred by reason
of the taxpayer’s manufacturing activities must be capitalized to the
property produced for sale. Therefore, because the amounts paid for the jigs,
dies, molds, and patterns are incurred by reason of X’s manufacturing
operations, the amounts paid must be capitalized under section 263A to the
property produced for sale by X.
Example 3. Acquisition or production
cost. Assume the same facts as in Example 2,
but the economic useful life of the jigs, dies, molds, and patterns is 3 years.
X is required to capitalize under paragraph (d) of this section the amounts
paid to produce or purchase the jigs, dies, molds, and patterns because the
economic useful life is more than 12 months.
Example 4. Acquisition cost.
X corporation is an interstate motor carrier. On December 1, 2008, X purchases,
pays for, and takes delivery of truck tires with an economic useful life of
12 months. Assume X does not use the original tire capitalization method
described in Rev. Proc. 2002-27, 2002-1 C.B. 802 (see §601.601(d)(2)
of this chapter). Also assume that each tire is a separate unit of property,
as determined under §1.263(a)-3(d)(2). X is not required under paragraph
(d) of this section to capitalize the amount paid for the tires because the
economic useful life of the tires is 12 months or less.
Example 5. Transaction costs.
Assume the same facts as in Example 4, but in addition
to the amount paid for the tires, X also pays sales tax and delivery charges
for the tires. X is not required to capitalize under paragraph (d) of this
section the sales tax and delivery charges because they were paid to facilitate
the acquisition of property with an economic useful life of 12 months or less.
Example 6. Coordination with section
461 fixed liability rule. Assume the same facts as in Example
4, except that instead of purchasing the tires on December 1, 2008,
X enters into a contract with the tire manufacturer on that date to purchase
tires from the manufacturer in 2009. X purchases, pays for, and takes delivery
of the tires on March 31, 2009. X does not incur a liability under section
461 for the tires in 2008 because X does not have a fixed liability with respect
to the tires until 2009. When X incurs the amount in 2009, X is not required
under paragraph (d) of this section to capitalize that amount.
Example 7. Coordination with section
461 economic performance rule. Assume the same facts as in Example
4, except that the tires are not delivered to X until March 31,
2009. X does not incur a liability under section 461 for the tires in 2008
because economic performance does not occur with respect to the liability
until the property is provided to X in 2009. See §1.461-4(d)(2). When
X incurs the amount in 2009, X is not required under paragraph (d) of this
section to capitalize that amount.
Example 8. Election not to capitalize.
Assume the same facts as in Example 4, except that X
elects under paragraph (d)(4)(v) of this section not to apply the 12-month
rule contained in paragraph (d)(4)(i) of this section to the tires purchased
on December 1, 2008. X must capitalize under paragraph (d) of this section
the amount paid for the tires.
Example 9. Exception to 12-month rule
— property acquired for resale. Assume the same facts as
in Example 4, except that X purchases the tires for resale.
The 12-month rule in paragraph (d)(4)(i) of this section does not apply because
the tires are property acquired for resale. Thus, X is required under paragraph
(d) of this section to capitalize the amount paid for the tires.
Example 10. Exception to 12-month rule
— component of property. Assume the same facts as in Example
4, except that the tires are the first set of tires to be installed
on a truck tractor acquired by X and X uses the original tire capitalization
method described in Rev. Proc. 2002-27 (see §601.601(d)(2) of this chapter)
so that the truck tractor (including the tires) is the unit of property, as
determined under §1.263(a)-3(d)(2). Also assume that the truck tractor
has an economic useful life of more than 12 months and that the invoice for
the acquisition of the truck tractor separately states the cost of tires and
various other components of the truck tractor. X is required under paragraph
(d) of this section to capitalize the amount paid for the truck tractor because
the economic useful life of the truck tractor is more than 12 months. Further,
X may not use the 12-month rule to currently deduct the amount paid for the
tires or any other component of the truck tractor, regardless that some components
may have an economic useful life of 12 months or less and regardless that
the cost of individual components is separately stated in the invoice.
(e) Treatment of capital expenditures. Amounts
required to be capitalized under this section are capital expenditures and
must be taken into account through a charge to capital account or basis, or
in the case of property that is inventory in the hands of a taxpayer, through
inclusion in inventory costs. See section 263A for the treatment of amounts
referred to in this section as well as other amounts paid in connection with
the production of real property and personal property, including films, sound
recordings, video tapes, books, or similar properties.
(f) Recovery of capitalized amounts—(1) In
general. Amounts that are capitalized under this section are recovered
through depreciation, cost of goods sold, or by an adjustment to basis at
the time the property is placed in service, sold, used, or otherwise disposed
of by the taxpayer. Cost recovery is determined by the applicable Internal
Revenue Code and regulation provisions relating to the use, sale, or disposition
of property. For example, §§1.162-4 and 1.263(a)-3 determine whether
amounts capitalized under this section §1.263(a)-2 for property that
is used to replace a component of a unit of property are repair or maintenance
expenses or capitalized as an improvement to the unit of property.
(2) Examples. The following examples illustrate
the rule of this paragraph (f)(1) and assume that the taxpayer does not treat
the acquired property as materials and supplies under §1.162-3:
Example 1. Recovery when property placed
in service. X owns a 10-unit apartment building. The refrigerator
in one of the apartments stops functioning and X purchases a new refrigerator
to replace the old one. X pays for the acquisition, delivery, and installation
of the new refrigerator. Assume the refrigerator is the unit of property,
as determined under §1.263(a)-3(d)(2). Section 1.263(a)-2(d) requires
capitalization of amounts paid for the acquisition, delivery, and installation
of the refrigerator. Under this paragraph (f), the capitalized amounts are
recovered through depreciation when the refrigerator is placed in service
by X.
Example 2. Recovery when property used
in a repair. Assume the same facts as in Example 1,
except that a window in one of the apartments needs to be replaced. X pays
for the acquisition, delivery, and installation of a new window. Assume the
window is a structural component of the apartment building and that the apartment
building is the unit of property, as determined under §1.263(a)-3(d)(2).
Section 1.263(a)-2(d) requires capitalization of amounts paid for the acquisition
and delivery of the window because the window is property with a useful life
substantially beyond the end of the taxable year. Assume the replacement
of the old window with the new one does not improve the apartment building
under §1.263(a)-3. Under this paragraph (f), the capitalized amounts
paid to acquire the window are recovered as ordinary and necessary repair
expenses under §1.162-4 when the window is used in the repair by its
installation in the apartment building.
Example 3. Recovery when property used
in a repair; coordination with section 263A. Assume the same facts
as in Example 2, except that the window that is replaced
is in an office in a plant where X manufactures widgets for sale. Section
1.263(a)-2(d) requires capitalization of amounts paid to produce inventory.
Under section 263A, all indirect costs, including otherwise deductible repair
costs that directly benefit or are incurred by reason of the production of
inventory must be capitalized to the inventory produced. Although the repair
cost otherwise would be deductible as an expense under §1.162-4, X must
determine whether the cost of the repair, or an allocable portion thereof,
is required to be capitalized to the inventory produced as an indirect expense
that directly benefits or is incurred by reason of the production activities.
Any portion of the repair capitalized to inventory is recovered through cost
of goods at the time the property is sold or otherwise disposed of in accordance
with the taxpayer’s method of accounting for inventories.
(g) Effective date. The rules in this section
apply to taxable years beginning on or after the date of publication of the
Treasury decision adopting these rules as final regulations in the Federal Register.
(h) Accounting method changes. [Reserved]
§1.263(a)-3 Amounts paid to improve tangible property.
(a) Overview. This section provides rules for
applying section 263(a) to amounts paid to improve tangible property. Paragraph
(b) of this section contains definitions. Paragraph (c) of this section contains
rules for coordinating this section with other provisions of the Internal
Revenue Code. Paragraph (d) of this section provides rules for determining
the treatment of amounts paid to improve tangible property, including rules
for determining the appropriate unit of property. Paragraph (e) of this section
contains rules for determining whether amounts paid materially increase the
value of the unit of property. Paragraph (f) of this section contains rules
for determining whether amounts paid restore the unit of property. Paragraph
(g) of this section describes an optional repair allowance method.
(b) Definitions. For purposes this section, the
following definitions apply:
(1) Amount paid. In the case of a taxpayer using
an accrual method of accounting, the terms amounts paid and payment mean
a liability incurred (within the meaning of §1.446-1(c)(1)(ii)). A liability
may not be taken into account under this section prior to the taxable year
during which the liability is incurred.
(2) Personal property. Personal property means
tangible personal property as defined in §1.48-1(c).
(3) Real property. Real property means
land and improvements thereto, such as buildings or other inherently permanent
structures (including items that are structural components of such buildings
or structures) that are not personal property as defined in paragraph (b)(2)
of this section. Local law is not controlling in determining whether property
is real property for purposes of this section.
(c) Coordination with other provisions of the Internal Revenue
Code—(1) In general. Nothing in this
section changes the treatment of any amount that is specifically provided
for under any provision of the Internal Revenue Code or regulations (other
than section 162(a) or section 212 and the regulations under those sections).
(2) Example. The following example illustrates
the rules of this paragraph (c):
Example. Railroad rolling stock.
X is a railroad that properly treats amounts paid for the rehabilitation
of railroad rolling stock as deductible expenses under section 263(d). X
is not required to capitalize the amounts paid because nothing in this section
changes the treatment of amounts specifically provided for under section 263(d).
(d) Improved property—(1) Capitalization
rule. Except as provided in the repair allowance method in paragraph
(g) of this section, a taxpayer must capitalize the aggregate of related amounts
paid to improve a unit of property (including a unit of property for which
the acquisition or production costs were deducted under the 12-month rule
in §1.263(a)-2(d)(4)), whether the improvements are made by the taxpayer
or by a third party. See section 263A for the scope of costs required to
be capitalized to property produced by the taxpayer or to property acquired
for resale; section 1016 for adding capitalized amounts to the basis of the
unit of property; and section 168(i)(6) for the treatment of additions or
improvements to a unit of property. For purposes of this paragraph (d), a
unit of property is improved if the amounts paid—
(i) Materially increase the value of the unit of property (see paragraph
(e) of this section); or
(ii) Restore the unit of property (see paragraph (f) of this section).
(2) Determining the appropriate unit of property—(i) In
general. The unit of property rules in this paragraph (d)(2) apply
only for purposes of section 263(a) and §§1.263(a)-1, 1.263(a)-2,
and 1.263(a)-3, and not any other Internal Revenue Code or regulation section.
Under this paragraph (d)(2), the appropriate unit of property is initially
determined by applying the rules in paragraph (d)(2)(ii) of this section,
except as provided in paragraph (d)(2)(iv) of this section (relating to buildings
and structural components). The initial unit of property determination is
further analyzed in accordance with the appropriate hierarchical category
described in one of paragraphs (d)(2)(iii) through (d)(2)(vi) of this section
and by applying the additional rule in paragraph (d)(2)(vii) of this section.
The specific rules contained in paragraphs (d)(2)(iii) through (d)(2)(vii)
of this section dictate whether one or more components of the initial unit
of property determination must be treated as separate units of property.
This paragraph (d)(2) applies to all real and personal property, other
than network assets. For purposes of this paragraph (d)(2), network assets
means railroad track, oil and gas pipelines, water and sewage pipelines, power
transmission and distribution lines, and telephone and cable lines that are
owned or leased by taxpayers in each of those respective industries. The
term includes, for example, trunk and feeder lines, pole lines, and buried
conduit. It does not include property that would be included as a structural
component of a building under paragraph (d)(2)(iv), nor does it include separate
property that is adjacent to, but not part of a network asset, such as bridges,
culverts, or tunnels.
(ii) Initial unit of property determination. Except
for property described in paragraph (d)(2)(iv) of this section (regarding
buildings and structural components), the unit of property determination under
this paragraph (d)(2) begins by identifying property that consists entirely
of components that are functionally interdependent. Components of property
are functionally interdependent if the placing in service of one component
by the taxpayer is dependent on the placing in service of the other component
by the taxpayer. For purposes of this section, property that is aggregated
and subject to a general asset account election may not be treated as a single
unit of property.
(iii) Category I: Taxpayers in regulated industries.
In the case of a taxpayer engaged in a trade or business in a regulated industry,
the unit of property is the USOA (uniform system of accounts) unit of property.
For purposes of this section, a regulated industry is an industry for which
a Federal regulator (including any Federal department, agency, commission,
board, or similar entity) has a USOA identifying a particular unit of property
(USOA unit of property). This rule applies to any taxpayer engaged in a trade
or business in the regulated industry, regardless of whether the taxpayer
is subject to the regulatory accounting rules of the Federal regulator. The
unit of property determination made under this paragraph (d)(2)(iii) is subject
to paragraph (d)(2)(vii) of this section, which may require one or more components
to be treated as separate units of property.
(iv) Category II: Buildings and structural components.
In the case of a building (as defined in §1.48-1(e)(1)) other than that
described in paragraph (d)(2)(iii) of this section, the building and its structural
components (as defined in §1.48-1(e)(2)) are a single unit of property.
The unit of property determination made under this paragraph (d)(2)(iv) is
subject to paragraph (d)(2)(vii) of this section, which may require one or
more components to be treated as separate units of property.
(v) Category III: Other personal property. In
the case of personal property other than that described in paragraph (d)(2)(iii)
of this section, the unit of property determination must be made on the basis
of the four factors listed in this paragraph (d)(2)(v). These four factors
are the exclusive factors under this paragraph (d)(2)(v). No one factor is
determinative and it is not intended that a determination be made on the basis
of the number of factors indicating that a component is, or is not, a separate
unit of property. The unit of property determination made under this paragraph
(d)(2)(v) is subject to paragraph (d)(2)(vii) of this section, which may require
one or more components to be treated as separate units of property. The following
factors must be taken into account:
(A) Whether the component is—
(1) Marketed separately to the taxpayer by a party
other than the seller/lessor of the property of which the component is a part
at the time the property is initially acquired or leased;
(2) Acquired or leased separately by the taxpayer
from a party other than the seller/lessor of the property of which the component
is a part at the time the property is initially acquired or leased;
(3) Subject to a separate warranty contract (from
a party other than the seller/lessor of the property of which the component
is a part);
(4) Subject to a separate maintenance manual or
written maintenance policy;
(5) Appraised separately; or
(6) Sold or leased separately by the taxpayer to
another party;
(B) Whether the component is treated as a separate unit of property
in industry practice or by the taxpayer in its books and records;
(C) Whether the taxpayer treats the component as a rotable part (a part
that is removable from property, repaired or improved, and either immediately
reinstalled on other property or stored for later installation); and
(D) Whether the property of which the component is a part generally
functions for its intended use without the component property.
(vi) Category IV: Other real property. In the
case of real property other than that described in paragraphs (d)(2)(iii)
and (d)(2)(iv) of this section, the unit of property determination must be
made on the basis of all the facts and circumstances. The unit of property
determination made under this paragraph (d)(2)(vi) is subject to paragraph
(d)(2)(vii) of this section, which may require one or more components to be
treated as separate units of property.
(vii) Additional rule. If the taxpayer properly
treats a component as a separate unit of property for any Federal income tax
purpose, the taxpayer must treat the component as a separate unit of property
for purposes of this paragraph (d)(2). For purposes of paragraph (d)(2),
the term any Federal income tax purpose includes, but
is not limited to, the use of different placed-in-service dates (other than
the use of a new placed-in-service date for an improvement (as determined
under this section) to the unit of property or a different placed-in-service
date for a particular floor of a building) or different classes of property
as set forth in section 168(e) (MACRS classes), for the component and the
property of which the component is a part. If the taxpayer properly recognizes
a loss under section 165, or under another applicable provision, from a retirement
of a component of property or from the worthlessness or abandonment of a component
of property, the taxpayer must treat the component as a separate unit of property
for purposes of this paragraph (d)(2). Therefore, any property that replaces
the component also will be treated as a separate unit of property. See §1.263(a)-2(d)(1).
For purposes of this paragraph (d)(2), merely claiming a tax credit related
to tangible property does not constitute treatment of that property as a separate
unit of property for a Federal income tax purpose.
(viii) Examples. The rules of this paragraph (d)(2)
are illustrated by the following examples, in which it is assumed (unless
otherwise stated) that the taxpayer has not made a general asset account election
with regard to the property and that paragraph (d)(2)(vii) of this section
does not require the use of a different unit of property:
Example 1. Category I. X
is an electric utility company that operates a power plant to generate electricity.
X’s operation previously was regulated by the Federal Energy Regulatory
Commission (FERC) but, for various reasons, is no longer subject to regulation
by FERC. Under FERC’s USOA, each turbine, economizer, generator, and
pulverizer is treated as a separate unit of property for regulatory accounting
purposes. The initial unit of property determined under paragraph (d)(2)(ii)
of this section is the entire power plant, which consists entirely of components
that are functionally interdependent. The power plant must next be analyzed
under paragraph (d)(2)(iii) of this section because X is engaged in a trade
or business in an industry for which a Federal regulator has a USOA. Under
the rules in that paragraph, X must treat each turbine, economizer, generator,
and pulverizer as a separate unit of property for determining whether an amount
paid improves the unit of property for Federal income tax purposes.
Example 2. Category I. X
is a Class I railroad. All Class I railroads are regulated by the Surface
Transportation Board (STB). Under STB’s USOA, each locomotive and each
freight car is treated as a separate unit of property for regulatory accounting
purposes. Although each locomotive consists of various components, such as
an engine, generators, batteries, trucks, etc., those components are functionally
interdependent. Thus, the locomotive is an initial unit of property as determined
under paragraph (d)(2)(ii) of this section. Similarly, each freight car consists
entirely of functionally interdependent components and, thus, each freight
car is an initial unit of property under paragraph (d)(2)(ii) of this section.
Each locomotive and freight car must next be analyzed under paragraph (d)(2)(iii)
of this section because X is engaged in a trade or business in an industry
for which a Federal regulator has a USOA. Under the rules in that paragraph,
X must treat each locomotive and each freight car as a separate unit of property
for determining whether an amount paid improves the unit of property for Federal
income tax purposes.
Example 3. Category I. Assume
the same facts as in Example 2, except that X is a Class
II railroad. The STB does not regulate Class II railroads. However, because
X is engaged in a trade or business in an industry (the railroad industry)
for which a Federal regulator has a USOA, the rules in paragraph (d)(2)(iii)
of this section apply, regardless of whether X is subject to those rules.
Based on these facts, X must treat each locomotive and each freight car as
a separate unit of property for determining whether an amount paid improves
the unit of property for Federal income tax purposes.
Example 4. Category I. X
is a telecommunications company regulated by the Federal Communications Commission
(FCC) and subject to a USOA for telephone companies. The assets of X include
a telephone central office switching center, which contains numerous switches
and various other switching equipment that all work together to provide telephone
service to customers. The initial unit of property determined under paragraph
(d)(2)(ii) of this section is the central office switching center, which consists
entirely of components that are functionally interdependent. The telecommunications
system must next be analyzed under paragraph (d)(2)(iii) of this section because
X is engaged in a trade or business in an industry for which a Federal regulator
has a USOA. Under the rules in that paragraph, X must treat each switch and/or
piece of equipment as defined in the USOA of the FCC and used in the central
office operation as a separate unit of property for determining whether an
amount paid improves the unit of property for Federal income tax purposes.
Example 5. Category II. X
owns a manufacturing building containing various types of manufacturing equipment
that are not structural components of the manufacturing building. Because
the property is a building, as defined in §1.48-1(e)(1), paragraph (d)(2)(ii)
of this section does not apply and the property must be analyzed under paragraph
(d)(2)(iv) of this section. Under the rules in that paragraph, X must treat
the manufacturing building and its structural components as a single unit
of property for determining whether an amount paid improves the unit of property
for Federal income tax purposes. The appropriate unit of property determination
for the manufacturing equipment must be made separately under paragraph (d)(2)(v)
of this section.
Example 6. Category III; additional
rule. Assume the same facts as in Example 5,
except that X does a cost segregation study of the manufacturing building
and properly determines that refrigeration equipment used to create a walk-in
freezer in the manufacturing building is section 1245 property as defined
in section 1245(a)(3). The refrigeration equipment is not part of the HVAC
system that relates to the general operation or maintenance of the building.
For Federal income tax purposes, X properly treats the refrigeration equipment
as a separate unit of property for depreciation purposes. The rules of paragraph
(d)(2)(v) of this section apply to determine whether the refrigeration equipment,
or some smaller component, is the appropriate unit of property. In this example,
assume that no components of the refrigeration equipment meet any of the facts
and circumstances listed in paragraph (d)(2)(v) of this section. Based on
these facts, X must treat the refrigeration equipment as the unit of property
for determining whether an amount paid improves the unit of property for Federal
income tax purposes.
Example 7. Category III; additional rule.
Assume the same facts as in Example 6, except that the
refrigeration equipment for the walk-in freezer ceases to function. X decides
not to repair the refrigeration equipment, but to replace it altogether.
X abandons the refrigeration equipment for the walk-in freezer and properly
recognizes a loss under section 165 from the abandonment of the refrigeration
equipment. Therefore, X must treat the refrigeration equipment for the walk-in
freezer as a separate unit of property for determining whether amounts paid
to replace the equipment must be capitalized for Federal income tax purposes.
See §1.263(a)-2(d)(1).
Example 8. Category III. (i)
X is a commercial airline engaged in the business of transporting passengers
and freight throughout the United States and abroad. To conduct its business,
X owns or leases various types of aircraft. X purchases the aircraft engine
separately at the time the aircraft is acquired. The engine is subject to
a separate warranty and written maintenance policy provided by the engine
manufacturer. For financial accounting purposes, X accounts for each type
of aircraft by maintaining separate accounts on its books for each type of
airframe and engine in its fleet. To perform maintenance on an engine, X
removes the engine from the aircraft and replaces it with another used engine
that has returned from a maintenance visit.
(ii) The initial unit of property determined under paragraph (d)(2)(ii)
of this section is the aircraft (and not the entire fleet of aircraft), which
consists entirely of components that are functionally interdependent. The
aircraft must next be analyzed under one of paragraphs (d)(2)(iii) through
(d)(2)(vi) of this section. Although X is engaged in a trade or business
in an industry regulated by the Federal Aviation Administration (FAA), the
FAA does not have a USOA. Therefore, the rules of paragraph (d)(2)(iii) of
this section do not apply to X; instead, the rules of paragraph (d)(2)(v)
of this section apply to determine whether the entire aircraft, or the engine,
is the appropriate unit of property. In this Example 8,
the aircraft engine is acquired separately, is subject to a separate warranty
and maintenance policy, is treated separately for financial accounting purposes,
and is rotable. Based on these facts, X must treat the engine as the unit
of property for determining whether an amount paid improves the engine for
Federal income tax purposes. X must treat the aircraft without the engine
as a unit of property for determining whether an amount paid improves the
aircraft for Federal income tax purposes.
Example 9. Category III.
X is a corporation that owns a small aircraft for use in its trade or business.
X performs required maintenance on its aircraft engines. The aircraft engine
is not marketed, purchased, leased, appraised, or sold separately, but it
is subject to a separate warranty and written maintenance policy provided
by the engine manufacturer. For financial accounting purposes, X does not
maintain separate accounts on its books for individual engines. X does not
treat the engine as a rotable part. The initial unit of property determined
under paragraph (d)(2)(ii) of this section is the aircraft, which consists
entirely of components that are functionally interdependent. The aircraft
must next be analyzed under paragraph (d)(2)(v) of this section to determine
whether the entire aircraft, or the engine, is the appropriate unit of property.
Based on these facts, the engine is not a separate unit of property. Therefore,
X must treat the aircraft, including the aircraft engine, as the unit of property
for determining whether an amount paid improves the unit of property for Federal
income tax purposes.
Example 10. Category III.
X is a towboat operator that owns and leases a fleet of towboats. X performs
maintenance on its towboat engines every 3 to 4 years, in accordance with
the engine manufacturer’s maintenance manuals. Towboat engines are
not marketed, purchased, leased, appraised, or sold separately; however, the
engines are subject to a separate warranty and written maintenance policy
provided by the engine manufacturer. For financial accounting purposes, X
does not maintain separate accounts on its books for individual engines.
X does not treat the engine as a rotable part. The initial unit of property
determined under paragraph (d)(2)(ii) of this section is the towboat (and
not the entire fleet of towboats), which consists entirely of components that
are functionally interdependent. The towboat must next be analyzed under
paragraph (d)(2)(v) of this section. Based on these facts, the engine is
not a separate unit of property. Therefore, X must treat the towboat, including
the towboat engine, as the unit of property for determining whether an amount
paid improves the unit of property for Federal income tax purposes.
Example 11. Category III.
X purchases a car to use in X’s taxi service. The invoice received
by X for the purchase of the car separately lists several options, including
air conditioning, automatic transmission, antilock braking system, side impact
air bags, power group, and special alloy wheels. Under paragraph (d)(2)(ii)
of this section, the initial unit of property is the car because the options
are functionally interdependent with the car. The options are not subject
to separate warranties. X is an individual and does not keep books and records
other than for tax purposes. For depreciation purposes, X properly treats
the car and options as one unit of property. X does not treat any of the
options as rotable parts. Based on these facts, the options are not separate
units of property. X must treat the car, including the options, as the unit
of property for determining whether an amount paid improves the unit of property
for Federal income tax purposes.
Example 12. Category III.
X is a common carrier that owns a fleet of fuel hauling trucks and periodically
performs maintenance on its truck engines. The entire fleet of trucks is
subject to a general asset account election, one for the truck trailers and
one for the truck tractors. Under paragraph (d)(2)(ii) of this section, X
may not treat the entire fleet as the unit of property. Instead, the initial
units of property determined under paragraph (d)(2)(ii) of this section are
each truck tractor and each truck trailer. Each tractor consists entirely
of functionally interdependent components and each trailer consists entirely
of functionally interdependent components. To determine whether the engine
is a separate unit of property from the tractor, the factors in paragraph
(d)(2)(v) of this section apply. The engines are marketed separately from
the tractor and are subject to a separate warranty and written maintenance
policy provided by the engine manufacturer. The engines are not treated as
a separate unit of property in industry practice or by X in its books and
records. The engine is removed from the tractor, repaired or improved, and
stored for later installation on another tractor. Based on these facts, the
engine is a separate unit of property. Therefore, X must treat the engine
as the unit of property for determining whether an amount paid improves the
unit of property for Federal income tax purposes.
Example 13. Category III.
Assume the same facts as in Example 12, except that
the inquiry is whether the oil filter in the tractor engine is a separate
unit of property. The oil filter is not marketed, acquired, leased, appraised,
or sold separately, nor is it subject to a separate warranty or maintenance
manual. The filter is not treated as a separate unit of property in industry
practice or by X in its books and records, nor is it treated as a rotable
part. Based on these facts, the oil filter is not a separate unit of property.
Therefore, X must treat the engine, including the oil filter, as the unit
of property for determining whether an amount paid improves the unit of property
for Federal income tax purposes.
Example 14. Category III.
(i) X manufactures and sells computers and computer equipment. It also operates
a separate computer maintenance business, for which X maintains pools of rotable
spare parts that are primarily used to repair computer equipment purchased
or leased by its customers. Most of X’s computer maintenance business
is conducted pursuant to standardized maintenance agreements that obligate
X to provide all parts and labor, product upgrades, preventive maintenance,
and telephone assistance necessary to keep a customer’s computer operational
for the duration of the contract (usually one year) in exchange for a predetermined
fee. In its computer maintenance business, X sends technicians to its customer’s
location, who use the supply of rotable spare parts to diagnose problems in
the customer’s equipment, and then exchange the working parts for any
malfunctioning parts. A customer’s part that is identified as the cause
of the malfunction is replaced with the identical functioning part from X’s
rotable spare parts pool. The malfunctioning part removed from the customer’s
equipment is then repaired and placed in X’s rotable spare parts pool
for continued use in the computer maintenance business.
(ii) Under paragraph (d)(2)(ii) of this section, X may not treat the
entire pool of rotable spare parts as the unit of property. Instead, the
initial unit of property determined under paragraph (d)(2)(ii) of this section
is each rotable spare part because each part consists entirely of functionally
interdependent components. Assume for purposes of this Example
14 that paragraph (d)(2)(v) of this section does not require any
components of the rotable spare parts to be treated as separate units of property.
Based on these facts, the entire pool of spare parts is not the unit of property.
Therefore, X must treat each rotable spare part as a unit of property for
determining whether an amount paid improves the unit of property for Federal
income tax purposes.
Example 15. Category III.
(i) X is a dentist and operates a small dental clinic. On March 1, 2008,
X purchases a new laptop computer, with a one-year warranty, for use in the
dental business. On May 1, 2009, after the warranty has expired, the computer
malfunctions and X contacts the manufacturer’s computer maintenance
shop for assistance. The maintenance shop sends a technician to X’s
dental clinic, who uses a supply of rotable spare parts to diagnose problems
in X’s computer. The technician determines that the circuit board must
be replaced and exchanges X’s malfunctioning circuit board with the
identical functioning circuit board from the computer maintenance operation’s
rotable spare parts pool. The malfunctioning circuit board removed from X’s
computer is then repaired and placed in the manufacturer’s rotable spare
parts pool for continued use in the computer maintenance business.
(ii) The initial unit of property determined under paragraph (d)(2)(ii)
of this section is the computer, which consists entirely of components (circuit
board or motherboard, central processing unit or CPU, hard drive, RAM, keyboard,
monitor, case, etc.) that are functionally interdependent. To determine whether
the circuit board is a separate unit of property from the computer, the factors
in paragraph (d)(2)(v) of this section apply. The circuit board was not marketed
separately to X or acquired separately by X, nor is it subject to a separate
warranty. The CPU, however, was marketed separately to the taxpayer, but
not acquired separately. No component, including the circuit board and CPU
of the laptop computer, is treated as a separate unit of property by X in
its books and records, nor does X treat any component as a rotable part.
The computer does not function for its intended use without the circuit board
and the CPU. Based on these facts, neither the circuit board nor the CPU
is a separate unit of property. X must treat the entire laptop computer,
including the circuit board and CPU, as the unit of property for determining
whether an amount paid improves the unit of property for Federal income tax
purposes.
(3) Compliance with regulatory requirements. For
purposes of this section, a Federal, state, or local regulator’s requirement
that a taxpayer perform certain repairs or maintenance on a unit of property
to continue operating the property is not relevant in determining whether
the amount paid improves the unit of property.
(4) Unavailability of replacement parts. For purposes
of this section, if a taxpayer needs to replace part of a unit of property
that cannot practicably be replaced with the same type of part (for example,
because of technological advancements or product enhancements), the replacement
of the part with an improved but comparable part does not, by itself, result
in an improvement to the unit of property.
(5) Repairs performed during an improvement—(i) In
general. Repairs that do not directly benefit or are not incurred
by reason of an improvement are not required to be capitalized under section
263(a), regardless of whether they are made at the same time as an improvement.
See section 263A for rules requiring capitalization of all direct costs of
an improvement and all indirect costs that directly benefit or are incurred
by reason of the improvement.
(ii) Exception for individuals. A taxpayer who
is an individual may capitalize amounts paid for repairs that are made at
the same time as substantial capital improvements to property not used in
the taxpayer’s trade or business or for the production of income if
the repairs are done as part of a remodeling or restoration of the taxpayer’s
residence.
(e) Value—(1) In general.
A taxpayer must capitalize amounts paid that materially increase the value
of a unit of property. An amount paid materially increases the value of a
unit of property only if it—
(i) Ameliorates a condition or defect that either existed prior to the
taxpayer’s acquisition of the unit of property or arose during the production
of the unit of property, whether or not the taxpayer was aware of the condition
or defect at the time of acquisition or production;
(ii) Is for work performed prior to the date the property is placed
in service by the taxpayer (without regard to any applicable convention under
section 168(d));
(iii) Adapts the unit of property to a new or different use (including
a permanent structural alteration to the unit of property);
(iv) Results in a betterment (including a material increase in quality
or strength) or a material addition (including an enlargement, expansion,
or extension) to the unit of property; or
(v) Results in a material increase in capacity (including additional
cubic or square space), productivity, efficiency, or quality of output of
the unit of property.
(2) Exception. Notwithstanding the rules in paragraph
(e)(1)(i) through (e)(1)(v) of this section, an amount paid does not result
in a material increase in value to a unit of property if the economic useful
life (as defined in §1.263(a)-3(f)(2)) of the unit of property is 12
months or less and the taxpayer did not elect to capitalize the amounts paid
originally for the unit of property.
(3) Appropriate comparison. For purposes of paragraphs
(e)(1)(iv) and (e)(1)(v) of this section, in cases in which a particular event
necessitates an expenditure, the determination of whether the amount paid
materially increases the value of the unit of property is made by comparing
the condition of the property immediately after the expenditure with the condition
of the property immediately prior to the event necessitating the expenditure.
When the event necessitating the expenditure is normal wear and tear to the
unit of property, the condition of the property immediately prior to the event
necessitating the expenditure is the condition of the property after the last
time the taxpayer corrected the effects of normal wear and tear (whether the
amounts paid were for maintenance or improvements) or, if the taxpayer has
not previously corrected the effects of normal wear and tear, the condition
of the property when placed in service by the taxpayer.
(4) Examples. The following examples illustrate
the rules of this paragraph (e) and assume that the amounts paid are not required
to be capitalized under any other provision of this section (paragraph (f),
for example):
Example 1. Pre-existing condition.
In 2008, X purchased a store located on 10 acres of land that contained underground
gasoline storage tanks left by prior occupants. The tanks had leaked, causing
soil contamination. X was not aware of the contamination at the time of purchase.
When X discovered the contamination, it incurred costs to remediate the soil.
For purposes of this Example 1, assume the 10 acres
of land is the appropriate unit of property. The amounts paid for soil remediation
must be capitalized as an improvement to the land because they ameliorated
a condition or defect that existed prior to the taxpayer’s acquisition
of the land. The comparison rule in paragraph (e)(3) of this section does
not apply to these amounts paid.
Example 2. Not a pre-existing condition;
repair performed during an improvement. (i) X owned land on which
it constructed a building in 1969 for use as a bank. The building was constructed
with asbestos-containing materials. The health dangers of asbestos were not
widely known when the building was constructed. The presence of asbestos
did not necessarily endanger the health of building occupants. The danger
arises when asbestos-containing materials are damaged or disturbed, thereby
releasing asbestos fibers into the air (where they can be inhaled). In 1971,
Federal regulatory agencies designated asbestos a hazardous substance. In
2008, X determined it needed additional space in its building to accommodate
additional operations at its branch and decided to remodel the building.
However, any remodeling work could not be undertaken without disturbing the
asbestos-containing materials. The governmental regulations required that
asbestos be removed if any remodeling was undertaking that would disturb asbestos-containing
materials. Therefore, X decided to remove the asbestos-containing materials
from the building in coordination with the overall remodeling project.
(ii) For purposes of this Example 2, assume that
the building is the appropriate unit of property and that the amounts paid
to remodel are required to be capitalized under §1.263(a)-3. The amounts
paid to remove the asbestos are not required to be capitalized as a separate
improvement under paragraph (e)(1)(i) of this section because the asbestos,
although later determined to be unsafe under certain circumstances, was not
an inherent defect to the property. The removal of the asbestos, by itself,
also did not result in a material increase in value under paragraphs (e)(1)(ii)
through (e)(1)(v) of this section. Under paragraph (d)(5)(i) of this section,
repairs that do not directly benefit or are not incurred by reason of an improvement
are not required to be capitalized under section 263(a). Under section 263A,
all indirect costs, including otherwise deductible repair costs, that directly
benefit or are incurred by reason of the improvement must be capitalized as
part of the improvement. The amounts paid to remove the asbestos were incurred
by reason of the remodeling project, which was an improvement. Therefore,
X must capitalize under section 263A to the remodeling improvement amounts
paid to remove the asbestos.
Example 3. Work performed prior to placing
the property in service. In 2008, X purchased a building for use
as a business office. The building was in a state of disrepair. In 2009,
X incurred costs to repair cement steps; shore up parts of the first and second
floors; replace electrical wiring; remove and replace old plumbing; and paint
the outside and inside of the building. Assume all the work was performed
on the building or its structural components. In 2010, X placed the building
in service and began using the building as its business office. For purposes
of this Example 3, assume the building and its structural
components are the appropriate unit of property. The amounts paid must be
capitalized as an improvement to the building because they were for work performed
prior to X’s placing the building in service. The comparison rule in
paragraph (e)(3) of this section does not apply to these amounts paid.
Example 4. Work performed prior to placing
the property in service. In January 2008, X purchased new machinery
for use in an existing production line of its manufacturing business. After
the machinery was installed, X performed critical testing on the machinery
to ensure that it was operational. On November 1, 2008, the new machinery
became operational and, thus, the machinery was placed in service on November
1, 2008 (although X continued to perform testing for quality control). The
amounts paid must be capitalized as an improvement to the machinery because
they were for work performed prior to X’s placing the machinery in service.
The comparison rule in paragraph (e)(3) of this section does not apply to
these amounts paid.
Example 5. New or different use.
X is an interior decorating company and manufactures its own designs. In
2008, X decides to stop manufacturing and converts the manufacturing facility
into a showroom for X’s business. To convert the facility, X removes
certain load-bearing walls and builds new load-bearing walls to provide a
better layout for the showroom and its offices. As part of building the new
walls, X moves or replaces electrical, cable, and telephone wiring and paints
the walls. X also repairs the floors, builds a fire escape, and performs
small carpentry jobs related to making the showroom accessible, including
installing ramps and widening doorways. For purposes of this Example
5, assume the building and its structural components are the unit
of property and that the work is performed on the structural components.
The amounts paid by X to convert the manufacturing facility into a showroom
must be capitalized as an improvement to the building because they adapted
the building to a new or different use. The comparison rule in paragraph
(e)(3) of this section does not apply to these amounts paid.
Example 6. New or different use.
X owned a building consisting of five separate retail stores, each of which
it rented to different tenants. In 2008, two of the stores rented became
vacant and remained vacant for several months. One of the remaining tenants
agreed to expand its occupancy to the two vacant stores, which adjoined its
own retail store. X incurred costs to break down walls between the existing
stores and construct an additional rear entrance. For purposes of this Example
6, assume the building and its structural components are the appropriate
unit of property. The amounts paid by X to convert three retail stores into
one larger store must be capitalized because they resulted in a permanent
structural alteration, and thus a new or different use, to the building.
The comparison rule in paragraph (e)(3) of this section does not apply to
these amounts paid.
Example 7. Not a new or different use.
X owns a building for rental purposes and decides to sell it. In preparation
of selling, X paints the interior walls, cleans the gutters, repairs cracks
in the porch, and refinishes the hardwood floors. For purposes of this Example
7, assume the building and its structural components are the unit
of property. Amounts paid for work done in anticipation of selling the building
are not required to be capitalized unless the amounts paid materially increase
the value as defined in paragraph (e)(3) of this section or prolong the economic
useful life as defined in paragraph (f)(3). The amounts paid by X are not
transaction costs paid to facilitate the sale of property under §1.263(a)-1(c),
nor do they materially increase the value of the building. Although the amounts
were paid for the purpose of selling the building, the sale does not constitute
a new or different use. Therefore, X is not required to capitalize as an
improvement under paragraph (e) of this section the amounts paid for work
performed on the building. The comparison rule in paragraph (e)(3) of this
section does not apply to these amounts paid.
Example 8. Not a material increase in
value. (i) X is a commercial airline engaged in the business of
transporting passengers and freight throughout the United States and abroad.
To conduct its business, X owns or leases various types of aircraft. As
a condition of maintaining its airworthiness certification for these aircraft,
X is required by the Federal Aviation Administration (FAA) to establish and
adhere to a continuous maintenance program for each aircraft within its fleet.
These programs, which are designed by X and the aircraft’s manufacturer
and approved by the FAA are incorporated into each aircraft’s maintenance
manual. The maintenance manuals require a variety of periodic maintenance
visits at various intervals during the operating lives of each aircraft.
One type of maintenance visit is an engine shop visit (ESV), which is performed
on X’s aircraft engines approximately every 4 years.
(ii) In 2004, X purchased a new aircraft and engine. In 2008, X performs
its first ESV on the aircraft engine. The ESV includes some or all of the
following activities: disassembly, cleaning, inspection, repair, replacement,
reassembly, and testing. During the ESV, the engine is removed from the aircraft
and shipped to an outside vendor who performs the ESV. When the engine arrives
at the vendor, the engine is cleaned and externally inspected. Regardless
of condition, it is thoroughly inspected visually and, as appropriate, further
inspected using a number of non-destructive testing procedures. The engine
is then disassembled into major parts and, if necessary, into smaller parts.
If inspection or testing discloses a discrepancy in a part’s conformity
to the specifications in X’s maintenance program, the part is repaired,
or if necessary, replaced with a new or used serviceable part conforming to
the specifications. If a part can be repaired, but not in time to be returned
to the engine with which the part had arrived, the vendor first attempts to
replace the part with a similar part from customer stock (used parts from
X’s aircraft that were replaced or exchanged and repaired during an
earlier ESV and then stored for future use on X’s aircraft). If a part
is not available from customer stock, the part is exchanged with a used, serviceable
part in the vendor’s inventory. A part is replaced (generally with
a used serviceable part) only if the part removed from X’s engine cannot
be repaired timely.
(iii) For purposes of this Example 8, assume the
aircraft engine is the appropriate unit of property. To determine whether
the ESV results in a material increase in value under paragraph (e)(1)(iv)
or (e)(1)(v) of this section, the comparison rule in paragraph (e)(3) of this
section applies. Because the event necessitating the ESV was normal wear
and tear, and X had not previously performed an ESV on the engine, the relevant
comparison is the condition of the property immediately after the ESV with
the condition of the property when placed in service by X. Using this comparison,
the ESV did not result in a material addition, betterment, or material increase
in capacity, productivity, efficiency, or quality of output of the engine
compared to the condition of the engine when placed in service, nor did it
adapt the engine to a new or different use. Therefore, the amounts paid by
X for the ESV did not result in a material increase in value to the engine.
X is not required to capitalize as an improvement under paragraph (e) of
this section amounts paid for the ESV.
Example 9. Betterment; regulatory requirement.
X owned a hotel in City that included five foot high unreinforced terra cotta
and concrete parapets with overhanging cornices around the entire roof perimeter.
The parapets and cornices were in good condition. In 2008, City passed an
ordinance setting higher safety standards for parapets and cornices because
of the hazardous conditions caused by earthquakes. To comply with the ordinance,
X replaced the old parapets and cornices with new ones made of glass fiber
reinforced concrete, which made them lighter and stronger than the original
ones. They were attached to the hotel using welded connections instead of
wire supports, making them more resistant to damage from lateral movement.
For purposes of this Example 9, assume the hotel building
and its structural components are the appropriate unit of property. The event
necessitating the expenditure was the 2008 City ordinance. Prior to the ordinance,
the old parapets and cornices were in good condition, but were determined
by City to create a potential hazard. After the expenditure, the new parapets
and cornices significantly improved the structural soundness of the hotel.
Therefore, the amounts paid by X to replace the parapets and cornices must
be capitalized because they resulted in a betterment to the hotel. City’s
requirement that X correct the potential hazard to continue operating the
hotel is not relevant in determining whether the amount paid improved the
hotel. See paragraph (d)(3) of this section.
Example 10. Not a material increase
in value; regulatory requirement. X owned a meat processing plant.
In 2008, X discovered that oil was seeping through the concrete walls of
the plant, creating a fire hazard. Federal meat inspectors advised X that
it must correct the seepage problem or shut down its plant. To correct the
problem, X incurred costs to add a concrete lining to the walls from the floor
to a height of about four feet and also to add concrete to the floor of the
plant. For purposes of this Example 10, assume the plant
building and its structural components are the appropriate unit of property.
The event necessitating the expenditure was the seepage of the oil. Prior
to the seepage, the plant did not leak and was functioning for its intended
use. The expenditure did not result in a material addition, betterment, or
material increase in capacity, productivity, efficiency, or quality of output
of the plant compared to the condition of the plant prior to the seepage of
the oil, nor did it adapt the plant to a new or different use. Therefore,
the amounts paid by X to correct the seepage do not materially increase the
value of the plant. X is not required to capitalize as an improvement under
paragraph (e) of this section amounts paid to correct the seepage problem.
The Federal meat inspectors’ requirement that X correct the seepage
to continue operating the plant is not relevant in determining whether the
amount paid improved the plant. See paragraph (d)(3) of this section.
Example 11. Not a material increase
in value; replacement with same part. X owns a small retail shop.
In 2008, a storm damaged the roof of X’s shop by displacing numerous
wooden shingles. X decides to replace all the wooden shingles on the roof
and hired a contractor to replace all the shingles on the roof with new wooden
shingles. No part of the sheathing, rafters, or joists was replaced. For
purposes of this Example 11, assume the shop and its
structural components are the appropriate unit of property. The event necessitating
the expenditure was the storm. Prior to the storm, the retail shop was functioning
for its intended use. The expenditure did not result in a material addition,
betterment, or material increase in capacity, productivity, efficiency, or
quality of output of the shop compared to the condition of the shop prior
to the storm, nor did it adapt the shop to a new or different use. Therefore,
the amounts paid by X to reshingle the roof with wooden shingles do not materially
increase the value of the shop. X is not required to capitalize as an improvement
under paragraph (e) of this section amounts paid to replace the shingles.
Example 12. Not a material increase
in value; replacement with comparable part. Assume the same facts
as in Example 11, except that wooden shingles are not
available on the market. X decides to replace all the wooden shingles with
comparable asphalt shingles. The amounts paid by X to reshingle the roof
with asphalt shingles do not materially increase the value of the shop, even
though the asphalt shingles may be an improvement over the wooden shingles.
Because the wooden shingles could not practicably be replaced with new wooden
shingles, the replacement of the old shingles with comparable asphalt shingles
does not, by itself, result in an improvement to the shop. X is not required
to capitalize as an improvement under paragraph (e) of this section amounts
paid to replace the shingles.
Example 13. Betterment; replacement
with improved parts. Assume the same facts as in Example
11, except that, instead of replacing the wooden shingles with
asphalt shingles, X decides to replace all the wooden shingles with shingles
made of lightweight composite materials that are maintenance-free and do not
absorb moisture. The new shingles have a 50-year warranty and a Class A fire
rating. X must capitalize as an improvement amounts paid to reshingle the
roof because they result in a betterment to the shop.
Example 14. Material increase in capacity.
X owns a factory building with a storage area on the second floor. In 2008,
X replaces the columns and girders supporting the second floor to permit storage
of supplies with a gross weight 50 percent greater than the previous load-carrying
capacity of the storage area. For purposes of this Example 14,
assume the factory building and its structural components are the appropriate
unit of property. X must capitalize as an improvement amounts paid for the
columns and girders because they result in a material increase in the load-carrying
capacity of the building. The comparison rule in paragraph (e)(3) of this
section does not apply to these amounts paid because the expenditure was not
necessitated by a particular event.
Example 15. Material increase in capacity.
In 2008, X purchased harbor facilities consisting of a slip for the loading
and unloading of barges and a channel leading from the slip to the river.
At the time of purchase, the channel was 150 feet wide, 1,000 feet long,
and 10 feet deep. To allow for ingress and egress and for the unloading of
its barges, X needed to deepen the channel to a depth of 20 feet. X hired
a contractor to dredge the channel to the required depth. For purposes of
this Example 15, assume the channel is the appropriate
unit of property. X must capitalize as an improvement amounts paid for the
dredging because it resulted in a material increase in the capacity of the
channel. The comparison rule in paragraph (e)(3) of this section does not
apply to these amounts paid because the expenditure was not necessitated by
a particular event.
Example 16. Not a material increase
in capacity. Assume the same facts as in Example 15,
except that the channel was susceptible to siltation and, by 2009, the channel
depth had been reduced to 18 feet. X hired a contractor to redredge the channel
to a depth of 20 feet. The event necessitating the expenditure was the siltation
of the channel. Both prior to the siltation and after the redredging, the
depth of the channel was 20 feet. Therefore, the amounts paid by X for redredging
the channel did not materially increase the capacity of the unit of property.
X is not required to capitalize as an improvement under paragraph (e) of
this section amounts paid to redredge.
Example 17. Not a material increase in
capacity. X owns a building used in its trade or business. The
first floor has a drop-ceiling. X decides to remove the drop-ceiling and
repaint the original ceiling. For purposes of this Example 17,
assume the building and its structural components are the appropriate unit
of property. The removal of the drop-ceiling does not create additional capacity
in the building that was not there prior to the removal. Therefore, the amounts
paid by X to remove the drop-ceiling and repaint the original ceiling did
not materially increase the capacity of the unit of property. X is not required
to capitalize as an improvement under paragraph (e) of this section amounts
paid related to removing the drop-ceiling. The comparison rule in paragraph
(e)(3) of this section does not apply to these amounts paid because the expenditure
was not necessitated by a particular event.
(f) Restoration—(1) In general.
A taxpayer must capitalize amounts paid that restore a unit of property.
Amounts paid restore property if the amounts paid substantially (as defined
in paragraph (f)(3) of this section) prolong the economic useful life of the
unit of property.
(2) Economic useful life—(i) Taxpayers
with an applicable financial statement. For taxpayers with an
applicable financial statement (as defined in paragraph (f)(2)(iii) of this
section), the economic useful life of a unit of property generally is presumed
to be the same as the useful life used by the taxpayer for purposes of determining
(at the time the property is originally acquired or produced by the taxpayer)
depreciation in its applicable financial statement, regardless of any salvage
value of the property. A taxpayer may rebut this presumption only if there
is a clear and convincing basis that the economic useful life (as defined
in paragraph (f)(2)(ii) of this section for taxpayers without an applicable
financial statement) of the unit of property is significantly different than
the useful life used by the taxpayer for purposes of determining depreciation
in its applicable financial statement. If a taxpayer does not have an applicable
financial statement at the time the property was originally acquired or produced,
but does have an applicable financial statement at some later date, the economic
useful life of the unit of property must be determined under paragraph (f)(2)(ii)
of this section. Further, if a taxpayer treats amounts paid for a unit of
property as an expense in its applicable financial statement on a basis other
than the property having a useful life of one year or less, the economic useful
life of the unit of property must be determined under paragraph (f)(2)(ii)
of this section. For example, if a taxpayer has a policy of treating as an
expense on its applicable financial statement amounts paid for property costing
less than a certain dollar amount, notwithstanding that the property has a
useful life of more than one year, the economic useful life of the property
must be determined under paragraph (f)(2)(ii) of this section.
(ii) Taxpayers without an applicable financial statement.
For taxpayers that do not have an applicable financial statement (as defined
in paragraph (f)(2)(iii) of this section), the economic useful life of a unit
of property is not necessarily the useful life inherent in the property but
is the period over which the property may reasonably be expected to be useful
to the taxpayer or, if the taxpayer is engaged in a trade or business or an
activity for the production of income, the period over which the property
may reasonably be expected to be useful to the taxpayer in its trade or business
or for the production of income, as applicable. This period is determined
by reference to the taxpayer’s experience with similar property, taking
into account present conditions and probable future developments. Factors
to be considered in determining this period include, but are not limited to—
(A) Wear and tear and decay or decline from natural causes;
(B) The normal progress of the art, economic changes, inventions, and
current developments within the industry and the taxpayer’s trade or
business;
(C) The climatic and other local conditions peculiar to the taxpayer’s
trade or business; and
(D) The taxpayer’s policy as to repairs, renewals, and replacements.
(iii) Definition of “applicable financial statement”.
The taxpayer’s applicable financial statement is the taxpayer’s
financial statement listed in paragraphs (f)(2)(ii)(A) through (C) of this
section that has the highest priority (including within paragraph (f)(2)(ii)(B)
of this section). The financial statements are, in descending priority —
(A) A financial statement required to be filed with the Securities and
Exchange Commission (SEC) (the 10-K or the Annual Statement to Shareholders);
(B) A certified audited financial statement that is accompanied by the
report of an independent CPA (or in the case of a foreign entity, by the report
of a similarly qualified independent professional), that is used for—
(1) Credit purposes,
(2) Reporting to shareholders, partners, or similar
persons; or
(3) Any other substantial non-tax purpose; or
(C) A financial statement (other than a tax return) required to be provided
to the Federal or a state government or any Federal or state agencies (other
than the SEC or the Internal Revenue Service).
(3) Substantially prolonging economic useful life—(i) In
general. An amount paid substantially prolongs the economic useful
life of the unit of property if it extends the period over which the property
may reasonably be expected to be useful to the taxpayer in its trade or business
or for the production of income, as applicable (or, if the taxpayer is not
engaged in a trade or business or an activity for the production of income,
the period over which the property may reasonably be expected to be useful
to the taxpayer) beyond the end of the taxable year immediately succeeding
the taxable year in which the economic useful life of the unit of property
was originally expected to cease, or if the property’s economic useful
life was previously prolonged (as determined under this paragraph (e)(3)(i)),
the end of the taxable year immediately succeeding the taxable year in which
the prolonged economic useful life was expected to cease.
(ii) Replacements. Amounts paid will be deemed
to substantially prolong the economic useful life of the unit of property
if a major component or a substantial structural part of the unit of property
is replaced with either a new part or a part that has been restored to like-new
condition as described in paragraph (f)(3)(iii) of this section. Thus, the
replacement of a part with another part that is not new or is not in like-new
condition (for example, a used or reconditioned part) does not constitute
the replacement of a major component or substantial structural part of the
unit of property under this paragraph (f)(3)(ii). Further, replacement of
a relatively minor portion of the physical structure of the unit of property
or a relatively minor portion of any of its major parts, even if those parts
are new, does not constitute the replacement of a major component or substantial
structural part of the unit of property.
(iii) Restoration to like-new condition. Amounts
paid will be deemed to substantially prolong the economic useful life of the
unit of property if they result in the unit of property or a major component
or substantial structural part of the unit of property being restored to a
like-new condition (including bringing the unit of property or a major component
or substantial structural part of the property to the status of new, rebuilt,
remanufactured, or similar status under the terms of any Federal regulatory
guideline or the manufacturer’s original specifications).
(iv) Restoration after a casualty loss. Amounts
paid will be deemed to substantially prolong the useful life of the unit of
property if the taxpayer properly deducts a casualty loss under section 165
with respect to the unit of property and the amounts paid restore the unit
of property to a condition that is the same or better than before the casualty.
(4) Examples. The following examples illustrate
the rules of this paragraph (f) and, except as otherwise provided, assume
that the amounts paid would not be required to be capitalized under any other
provision of this section (paragraph (e), for example):
Example 1. Prolonged economic useful
life. X is a Class I railroad that owns a fleet of locomotives.
In 1989, X purchased a new locomotive with an economic useful life (as defined
in paragraph (f)(2) of this section) of 22 years (from 1989 - 2011). X performs
substantially the same cyclical maintenance on its locomotives approximately
every 6 years. X performed cyclical maintenance on the locomotive in 1995,
in 2001, and in 2007. Assume that the locomotive (which includes the engine)
is the appropriate unit of property and that none of the cyclical maintenance
projects resulted in a restoration under paragraph (f)(3)(ii) or (f)(3)(iii)
of this section. Amounts paid for cyclical maintenance in 1995 and 2001 do
not substantially prolong the economic useful life of the locomotive. However,
the cyclical maintenance performed in 2007 will prolong the economic useful
life of the locomotive to 2013, which is beyond the end of the next succeeding
taxable year after the economic useful life of the locomotive ceases (2011).
Therefore, under paragraphs (f)(1) and (f)(3)(i) of this section, X must
capitalize as an improvement to the locomotive amounts paid for the cyclical
maintenance performed in 2007, regardless of whether X was required to capitalize
the amounts paid in previous years for cyclical maintenance.
Example 2. Economic useful life not
prolonged. Assume the same facts as in Example 1,
except that in 2009, X replaces a filter in the locomotive engine. X generally
replaces this type of filter every 4 years. Although the filter itself would
last beyond the end of the locomotive’s economic useful life in 2011,
the amount paid for the filter does not substantially prolong the economic
useful life of the locomotive because the filter will not extend beyond 2009
the period over which the locomotive may reasonably be expected to be useful
to X in its trade or business. Additionally, although the filter is a necessary
component of the locomotive, the filter is not a substantial structural part
or major component of the locomotive. Therefore, the amount paid to replace
the filter does not substantially prolong the economic useful life of the
locomotive.
Example 3. Minor part replacement.
X owns a small retail shop. In 2008, a storm damaged the roof of X’s
shop by displacing numerous wooden shingles. X decides to replace all the
wooden shingles on the roof and hires a contractor to replace all the shingles
on the roof with new wooden shingles. No part of the sheathing, rafters,
or joists was replaced. For purposes of this Example 3,
assume the shop and its structural components are the appropriate unit of
property. The replacement of the shingles did not extend the useful life
of the shop under paragraph (f)(3)(i) of this section. The portion of the
roof replaced is not a substantial structural part of the shop, nor does the
replacement of the shingles restore to a like-new condition a major component
or substantial structural part of the shop. Therefore, the amounts paid by
X to reshingle the roof with wooden shingles do not substantially prolong
the economic useful life of the shop.
Example 4. Major component or substantial
structural part. Assume the same facts as in Example
3, except that when the contractor began work on the shingles,
the contractor discovered that a major portion of the sheathing had rotted,
and the rafters were weakened as well. The contractor replaced all the sheathing
and a significant portion of the rafters. The roof (including the shingles,
sheathing, rafters, and joists) is a substantial structural part of a building.
The replacement of the shingles, sheathing, and rafters restored to a like-new
condition a substantial structural part of the shop. Therefore, under paragraphs
(f)(1) and (f)(3)(iii) of this section, X must capitalize as an improvement
to the shop amounts paid to replace the roof of the shop.
Example 5. Not a major component or structural
part. X uses a car in providing a taxi service. X purchased the
car in 2008. Assume that the unit of property is the car. The car has an
economic useful life of 5 years. In 2011, the battery dies and X takes the
car to a repair shop, which replaces the battery. Although the battery itself
may last beyond the end of the car’s economic useful life, the amount
paid for the battery does not substantially prolong the economic useful life
of the car because the battery will not extend beyond 2013 the period over
which the car may reasonably be expected to be useful to X in its trade or
business. Although the battery is a necessary component of the car, the battery
is not a substantial structural part or major component of the car. Therefore,
the amount paid to replace the battery does not substantially prolong the
economic useful life of the car.
Example 6. Major component or structural
part. Assume the same facts as Example 5,
except rather than the battery dying, the car overheats and causes so much
damage that the engine has to be rebuilt. The engine is a major component
of the car. Therefore, X is required to capitalize as an improvement to the
car under paragraphs (f)(1) and (f)(3)(iii) of this section the amounts paid
to rebuild the engine.
Example 7. Repair performed during an
improvement; coordination with section 263A. Assume the same facts
as Example 6, except that X has a broken taillight fixed
at the same time that the engine was rebuilt. The repair to the taillight
was not incurred because the engine was rebuilt, nor did it benefit the rebuild
of the engine. The repair of the broken taillight is a deductible expense
under §1.162-4. Under section 263A, all indirect costs, including otherwise
deductible repair and maintenance costs that directly benefit or are incurred
by reason of the improvement must be capitalized as part of the improvement.
Therefore, all amounts paid that are incurred by reason of the engine being
rebuilt must be capitalized, including, for example, amounts paid for activities
that would usually be deductible maintenance expenses, such as refilling the
engine with oil and radiator fluid. Amounts paid to repair the broken taillight,
however, are not incurred by reason of the engine being rebuilt, nor do the
amounts paid directly benefit the engine rebuild, despite being repaired at
the same time. Thus, X is not required to capitalize to the improvement of
the car (the rebuild of the engine) the amounts paid to repair the broken
taillight.
Example 8. Related amounts to replace
major component or structural part. (i) X owns a retail gasoline
station, consisting of a paved area used for automobile access to the pumps
and parking areas, a building used to market gasoline, and a canopy covering
the gasoline pumps. The premises also consists of underground storage tanks
(USTs) that are connected by piping to the pumps and are part of the machinery
used in the immediate retail sale of gas. The pumps also are connected to
a monitoring unit in the building that allows the sales clerk to monitor the
gasoline sales. To comply with regulations issued by the Environmental Protection
Agency, X is required to remove and replace leaking USTs. In 2008, X hires
a contractor to perform the removal and replacement, which consists of removing
the old tanks and installing new tanks with leak detection systems. The removal
of the old tanks includes removing the paving material covering the tanks,
excavating a hole large enough to gain access to the old tanks, disconnecting
any strapping and pipe connections to the old tanks, and lifting the old tanks
out of the hole. Installation of the new tanks includes placement of a liner
in the excavated hole, placement of the new tanks, installation of a leak
detection system, installation of an overfill system, connection of the tank
to the pipes leading to the pumps, backfilling of the hole, and replacement
of the paving. X is also required to pay a permit fee to the county to undertake
the installation of the new tanks.
(ii) X pays the permit fee to the county on October 15, 2008. The contractor
performs all of the required work and, on November 1, 2008, bills X for the
costs of removing the old USTs. On November 15, 2008, the contractor bills
X for the remainder of the work. Assume the fuel distribution system is the
appropriate unit of property. The USTs are major components of the fuel distribution
system. Therefore, under paragraphs (f)(1) and (f)(3)(ii) of this section,
X must capitalize as an improvement to the fuel distribution system the aggregate
of related amounts paid to replace the USTs, which related amounts include
the amount paid to the county, the amount paid to remove the old USTs, and
the amount paid to install the new USTs (regardless that the amounts were
separately invoiced and paid to two different parties).
Example 9. Major component or substantial
structural part. X is a common carrier that owns a fleet of petroleum
hauling trucks. In 2008, X replaces the existing engine, cab, and petroleum
tank of a truck with a new engine, cab, and tank. Assume the tractor of the
truck (which includes the cab and the engine) is a separate unit of property
from the rest of the truck. Also assume that the trailer (which contains
the petroleum tank) is a separate unit of property from the truck. The engine
and the cab are major components of the truck tractor, and the petroleum tank
is a major component of the trailer. Therefore, under paragraphs (f)(1) and
(f)(3)(ii) of this section, X must capitalize as an improvement to the tractor
amounts paid to replace the engine and cab, and must capitalize as an improvement
to the trailer amounts paid to replace the petroleum tank.
Example 10. Restoration of major component
to like-new condition. (i) X is a towboat operator that owns and
leases a fleet of towboats. In 2008, X replaces an existing towboat engine
with a rebuilt engine. A towboat engine is rebuilt through a series of steps
designed to put the engine in like-new operating condition to the maximum
extent possible. Engines in a towboat nearing the end of its useful life
or engines that have been removed from towboats due to a catastrophic malfunction
are likely candidates for the rebuilding process. The goal of the rebuilding
process is to bring each of an engine’s component parts to the manufacturer’s
original dimensional specifications for new parts.
(ii) Replacement of the existing towboat engine with a rebuilt engine
involves dry-docking the towboat. The rebuilding and replacement process
takes approximately 3 to 5 months. The process requires the removal of the
engine from the towboat and the removal of all of the moving and nonmoving
components from the engine as well. The engine’s crankcase and oil
pan are separated, and every part of the engine is cleaned, inspected using
intense illumination, machined, and treated with special materials to restore
the engine to like-new operating condition. The engine crankcase and oil
pan are extensively machined and welded, and numerous dimensional tests and
checks are performed to ensure that the engine is returned to a like-new condition
through the rebuilding process. In addition, a reconditioned crankshaft and
camshaft normally are installed in the engine during the rebuilding process.
The power packs are completely rebuilt with a large number of new parts during
the rebuilding process. The oil pumps, water pumps, engine turbochargers,
and governors are normally removed and exchanged for rebuilt parts during
the rebuilding process. The accessory drive gears, all of the piping on the
front and aft ends of the engine, the governor drive gear, and the turbocharger
drive gears are removed and normally exchanged for rebuilt parts during the
rebuilding process. The goal of the rebuilding process is to bring each of
an engine’s component parts to the engine manufacturer’s original
dimensional specifications for new parts. Assume the towboat (which includes
the engine) is the appropriate unit of property. The work done on the towboat
engine constitutes a remanufacture or rebuild of the engine, which is a major
component of the towboat. Therefore, under paragraphs (f)(1) and (f)(3)(iii)
of this section, X must capitalize as an improvement to the towboat amounts
paid to rebuild the towboat engine.
Example 11. Repairs performed during
an improvement; coordination with section 263A. Assume the same
facts as in Example 10, except that while the towboat
is in dry-dock to have the engine rebuilt, X also makes repairs to the hull
and rudders that are not by themselves an improvement under this section.
The amounts paid to repair the hull and rudders do not directly benefit nor
are incurred by reason of the engine rebuild. Under section 263A, all indirect
costs, including otherwise deductible repair costs that directly benefit or
are incurred by reason of the improvement must be capitalized as part of the
improvement. Therefore, all amounts paid that are incurred by reason of the
engine being rebuilt must be capitalized to the improvement, including, for
example, amounts paid for activities such as cleaning and inspecting the engine,
which usually would be deductible maintenance costs. Amounts paid to repair
the hull and rudders, however, are not incurred by reason of the engine being
rebuilt, nor do the amounts paid directly benefit the engine rebuild, despite
being incurred at the same time. Thus, in accordance with paragraph (d)(5)(i)
of this section, X is not required to capitalize to the towboat amounts paid
to repair the hull and rudders to the improvement.
Example 12. Restoration to like-new
condition; coordination with section 263A. Assume the same facts
as Example 10, except that while the towboat is in dry-dock,
X also makes substantial improvements to the propulsion systems and the mechanical
systems, including rebuilding large sections of the hull, and rebuilding,
replacing, or upgrading the steering systems, shafting systems, and electrical
systems, such that almost the entire towboat is restored to like-new condition.
This process constitutes a remanufacture or rebuild of the towboat. Under
section 263A, all indirect costs, including otherwise deductible repair costs
that directly benefit or are incurred by reason of the improvement must be
capitalized as part of the improvement. Therefore, under paragraph (d)(5)(i)
of this section, X must capitalize to the improvement of the towboat (the
rebuild) amounts paid that otherwise would be deductible repair costs that
directly benefit or are incurred by reason of the improvement.
Example 13. Restoration to like-new condition.
X is a Class I railroad that owns a fleet of freight cars. Approximately
every 10 years, X rebuilds its freight cars. The rebuild 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 to upgrade various components to the latest
engineering standards. The freight car essentially is stripped to the frame,
with all of its substantial 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. At the end of the rebuild,
the freight cars have been restored to like-new condition. Assume the freight
car is the appropriate unit of property. The work done to the freight car
constitutes a remanufacture or rebuild of the freight car. Therefore, under
paragraphs (f)(1) and (f)(3)(iii) of this section, X must capitalize as an
improvement to the freight car amounts paid to rebuild the freight car.
Example 14. Restoration of major component
to like-new condition. X owned a factory that it acquired in 1997.
In 2008, the factory roof began to leak. These leaks on occasion resulted
in damage to X’s products and prevented the use of certain portions
of the factory. X decided to reroof the entire factory and hired a contractor
to perform the reroofing. The structure of the roof, including substantial
portions of the rafters and joists, was restored to a like-new condition.
Assume the factory building and its structural components are the appropriate
unit of property. The roofing process constitutes a remanufacture or rebuild
of the roof, which is a substantial structural part of the factory. Therefore,
under paragraphs (f)(1) and (f)(3)(iii) of this section, X must capitalize
as an improvement to the factory amounts paid to reroof the factory.
Example 15. Minor part replacement; coordination
with section 263A. X is in the business of smelting aluminum.
X’s aluminum smelting facility includes a plant where molten aluminum
is poured into molds and allowed to solidify. Because of the potential of
fire from a molten metal explosion, the plant’s roof must be made of
fire-resistant material. The roof must also be without leaks because rain
water hitting the molten aluminum could cause an explosion. The roof of the
plant was made of roofing material and corrugated sheet metal decking, which
supports the roofing material. During 2008, X removed and replaced a minor
portion of the plant’s roof decking and roofing material. At the time
of the replacement, the pattern of the original metal support decking was
not available. Therefore, X used comparable fire resistant wood decking to
replace the corrugated metal decking. For purposes of this Example
15, assume the plant building and its structural components are
the appropriate unit of property and that the amount paid does not prolong
the economic useful life of the plant under paragraph (f)(3)(i) of this section.
The portion of the roof structure being replaced is not a substantial structural
part of the plant, nor does the work performed return to like-new condition
a major component or substantial structural part of the plant. Further, because
X could not practicably replace the roof material with the same type of material,
the replacement of the original roof material with an improved, but comparable,
material does not, by itself, result in an improvement. Therefore, the amount
paid to remove and replace a minor part of the plant’s roof decking
and roofing materially does not substantially prolong the economic useful
life of the plant. However, under section 263A, all indirect costs, including
otherwise deductible costs, that directly benefit or are incurred by reason
of the taxpayer’s manufacturing activities must be capitalized to the
property produced for sale. Therefore, because the amounts paid for the roof
decking and materials are incurred by reason of X’s manufacturing operations,
the amounts paid must be capitalized under section 263A to the property produced
for sale by X.
Example 16. Minor part replacement.
(i) X is a commercial airline engaged in the business of transporting passengers
and freight throughout the United States and abroad. To conduct its business,
X owns or leases various types of aircraft. As a condition of maintaining
its airworthiness certification for these aircraft, X is required by the Federal
Aviation Administration (FAA) to establish and adhere to a continuous maintenance
program for each aircraft within its fleet. These programs, which are designed
by X and the aircraft’s manufacturer and approved by the FAA are incorporated
into each aircraft’s maintenance manual. The maintenance manuals require
a variety of periodic maintenance visits at various intervals during the operating
lives of each aircraft. One type of maintenance visit is an engine shop visit
(ESV), which is performed on X’s aircraft engines approximately every
4 years.
(ii) In 2004, X purchased a new aircraft and engine. In 2008, X performs
its first ESV on the aircraft engine. The ESV includes some or all of the
following activities: disassembly, cleaning, inspection, repair, replacement,
reassembly, and testing. During the ESV, the engine is removed from the aircraft
and shipped to an outside vendor who performs the ESV. When the engine arrives
at the vendor, the engine is cleaned and externally inspected. Regardless
of condition, it is thoroughly inspected visually and, as appropriate, further
inspected using a number of non-destructive testing procedures. The engine
is then disassembled into major parts and, if necessary, into smaller parts.
If inspection or testing discloses a discrepancy in a part’s conformity
to the specifications in X’s maintenance program, the part is repaired,
or if necessary, replaced with a new or used serviceable part conforming to
the specifications. If a part can be repaired, but not in time to be returned
to the engine with which the part had arrived, the vendor first attempts to
replace the part with a similar part from customer stock (used parts from
X’s aircraft that were replaced or exchanged and repaired during an
earlier ESV and then stored for future use on X’s aircraft). If a part
is not available from customer stock, the part is exchanged with a used, serviceable
part in the vendor’s inventory. A part is replaced (generally with
a used serviceable part) only if the part removed from X’s engine cannot
be repaired timely. Although many minor parts may be replaced during the
ESV, the ESV does not return the engine to a like-new condition.
(iii) For purposes of this Example 16, assume the
aircraft engine is the appropriate unit of property. The ESV does not result
in the replacement of the engine nor does it restore the engine to a like-new
condition. Therefore, the amount paid for the ESV does not substantially
prolong the economic useful life of the engine.
Example 17. Repairs performed during
an improvement; coordination with section 263A. (i) Assume the
same facts as in Example 16, except that X purchased
the aircraft in 1986 and, in addition to the continuous maintenance program
for engines, X adheres to a continuous maintenance program for its aircraft
airframes. One type of maintenance visit is a heavy maintenance visit (HMV),
which is performed on X’s aircraft airframes approximately every 8 years.
In 2008, X decided to make substantial modifications to the airframe, which
resulted in the restoration of the airframe to like-new condition. The modifications
included removing all the belly skin panels on the aircraft’s fuselage
and replacing them with new skin panels; replacing the metal supports under
the lavatories and galleys; removing the wiring in the leading edges of both
wings and replacing it with new wiring; removing the fuel tank bladders, harnesses,
wiring systems, and connectors and replacing them with new components; opening
every lap joint on the airframe and replacing the epoxy and rivets used to
seal the lap joints with a non-corrosive sealant and larger rivets; reconfiguring
and upgrading the avionics and the equipment in the cockpit; replacing all
the seats, overhead bins, sidewall panels, partitions, carpeting, windows,
galleys, lavatories, and ceiling panels with new items; installing a cabin
smoke and fire detection system, and a ground proximity warning system; and
painting the exterior of the aircraft. In addition, X performed much of the
same work that would be performed during an HMV.
(ii) For purposes of this Example 17, assume the
aircraft airframe is the appropriate unit of property. The amounts paid to
modify the airframe are required to be capitalized as an improvement to the
airframe under paragraph (f) of this section because the modifications restored
the airframe to a like-new condition. Assume the amounts paid for the HMV
are not required to be capitalized as a separate improvement to the airframe.
Under section 263A, all indirect costs, including otherwise deductible repair
costs that directly benefit or are incurred by reason of the improvement must
be capitalized as part of the improvement. Therefore, X must capitalize to
the improvement of the airframe (the restoration) amounts paid that usually
would be ordinary and necessary repair costs, including any amounts paid for
the HMV that directly benefit or are incurred by reason of the improvement
to the airframe. X is not required, however, to capitalize to the improvement
of the airframe any amounts paid for the HMV that do not directly benefit
or are not incurred by reason of the improvement to the airframe.
Example 18. Restoration of major component
to like-new condition; coordination with section 263A. (i) X is
a Class I railroad that owns a fleet of locomotives. In 1994, X purchased
a new locomotive (Locomotive A) with an economic useful life (as defined in
paragraph (f)(2) of this section) of 20 years (from 1994 - 2014). X performed
cyclical maintenance on Locomotive A in 2000, and again in 2008. In 2000,
X replaced the power cylinders on Locomotive A’s engine, and performed
work on other components of Locomotive A. In 2008, X removed the engine and
replaced it with one it had previously remanufactured to the manufacturer’s
original specifications, and again performed work on other components of Locomotive
A. The engine that X removed from Locomotive A in 2008 was remanufactured
to the manufacturer’s original specifications and installed on Locomotive
B later in 2008.
(ii) Assume the locomotive (which includes the engine) is the appropriate
unit of property. The replacement of the power cylinders and the other work
performed on Locomotive A in 2000 did not prolong the economic useful life
of Locomotive A under paragraph (f)(3) of this section. However, the amounts
paid in 2008 to remove the engine and replace it with a previously manufactured
engine must be capitalized under paragraph (f)(3)(ii) of this section. Assume
the amounts paid in 2008 to perform work on other components of Locomotive
A are not required to be capitalized as a separate improvement to Locomotive
A. Under section 263A, all indirect costs, including otherwise deductible
repair costs that directly benefit or are incurred by reason of the improvement
must be capitalized as part of the improvement. Therefore, X must capitalize
to the improvement of Locomotive A (the installation of the remanufactured
engine) amounts paid that usually would be ordinary and necessary repair costs,
including any amounts paid for work on other components that directly benefit
or are incurred by reason of the improvement to Locomotive A. X is not required,
however, to capitalize to the improvement of Locomotive A any amounts paid
for work performed on other components that do not directly benefit or are
not incurred by reason of the improvement to Locomotive A. Further, X must
capitalize to the improvement of Locomotive B (the installation of remanufactured
engine) the amounts paid to remanufacture the engine removed from Locomotive
A and amounts paid to install the remanufactured engine on Locomotive B.
(g) Repair allowance method—(1) In
general. This paragraph (g) provides an optional simplified method
(the repair allowance method) for determining whether amounts paid to repair,
maintain, or improve certain tangible property are to be treated as deductible
expenses or capital expenditures. A taxpayer that elects to use the repair
allowance method described in paragraph (g)(3) of this section may use that
method instead of determining whether amounts paid to repair, maintain, or
improve property are capital expenditures or deductible expenses under the
general principles of sections 162(a), 212, and 263(a). Thus, except for
the rules in paragraph (d)(2) of this section for determining the appropriate
unit of property, the capitalization rules in §1.263(a)-3(d) do not apply
to property for which the taxpayer uses the repair allowance method under
this paragraph (g). See section 263A for the scope of costs required to be
capitalized to property produced by the taxpayer or to property acquired for
resale.
(2) Election of repair allowance method. In the
case of repair allowance property (as defined in paragraph (g)(6) of this
section), a taxpayer may elect to use the repair allowance method described
in paragraph (g)(3) of this section. See paragraph (g)(9) of this section
for the manner of electing the repair allowance. A taxpayer that elects to
use the repair allowance method must use that method for all of its repair
allowance property in all MACRS classes (including property classified into
a MACRS class for purposes of the repair allowance method under paragraph
(g)(6)(ii) of this section). A taxpayer electing the repair allowance method
must use that method consistently for all future years unless the taxpayer
revokes the election in accordance with paragraph (g)(10) of this section.
(3) Application of repair allowance method. Under
the repair allowance method, a taxpayer must treat all amounts paid (other
than amounts paid for excluded additions, as defined in paragraph (g)(7) of
this section) for materials and labor to repair, maintain, or improve all
the repair allowance property in a particular MACRS class as deductible expenses
under section 162 for the taxable year, up to the repair allowance amount
(as determined in paragraph (g)(4) of this section) for that MACRS class,
and treat the excess of all amounts paid to repair, maintain, or improve all
the repair allowance property in that MACRS class (the capitalized amount)
in accordance with paragraph (g)(5) of this section.
(4) Repair allowance amount—(i) In
general. Except as provided in paragraph (g)(4)(iv) of this section
(with regard to buildings), under the repair allowance method for a particular
taxable year, the repair allowance amount for a particular MACRS class consisting
of repair allowance property is an amount equal to the average unadjusted
basis (as defined in paragraph (g)(4)(ii) of this section) of repair allowance
property in the MACRS class multiplied by the repair allowance percentage
in effect for the MACRS class for the taxable year.
(ii) Average unadjusted basis. For purposes of
this section, average unadjusted basis is the average of the unadjusted basis
(as defined in paragraph (g)(4)(iii) of this section) of all repair allowance
property in the MACRS class at the beginning of the taxable year and the unadjusted
basis of all repair allowance property in the MACRS class at the end of the
taxable year.
(iii) Unadjusted basis. For purposes of this section,
unadjusted basis is the basis as determined under section 1012, or other applicable
sections of subchapter O, and subchapters C (relating to corporate distributions
and adjustments), K (relating to partners and partnerships), and P (relating
to capital gains and losses). Unadjusted basis is determined without regard
to any adjustments described in section 1016(a)(2) or (3) or to amounts for
which the taxpayer has elected to treat as an expense (for example, under
section 179, 179B, or 179C), but with regard to basis reductions which are
required because of credits taken on the property (for example, under section
44, 45G, 45H, or 50(c)). Unadjusted basis also must reflect the reduction
in basis for the percentage of the taxpayer’s use of property for the
taxable year other than for use in the taxpayer’s trade or business
(or for the production of income).
(iv) Buildings. In the case of buildings and structural
components that are repair allowance property, the repair allowance method
is applied separately with respect to each unit of property.
(5) Capitalized amount—(i) In general.
Under the repair allowance method for a particular taxable year, the capitalized
amount is the excess of all amounts paid to repair, maintain, or improve all
the repair allowance property in a MACRS class over the repair allowance amount
for that MACRS class. In addition, the capitalized amount includes all of
the indirect costs of producing the repair allowance property in the MACRS
class, which must be capitalized in accordance with the taxpayer’s method
of accounting for section 263A costs. Except as provided in paragraphs (g)(5)(iv),
(g)(5)(v), and (g)(5)(vi) of this section, a taxpayer may choose to treat
the capitalized amount as a single asset under paragraph (g)(5)(ii) of this
section or, alternatively, may choose to allocate the capitalized amount to
specific repair allowance property in the MACRS class in accordance with paragraph
(g)(5)(iii) of this section.
(ii) Single asset treatment of capitalized amount.
In general, the capitalized amount for a particular MACRS class may be treated
by the taxpayer as a separate single asset and depreciated in accordance with
that MACRS class. The single asset is treated as a section 168(i)(6) improvement
and is treated as placed in service by the taxpayer on the last day of the
first half of the taxable year in which the amount is paid, before application
of the convention under section 168(d). Except for a sale of assets constituting
a trade or business, no gain or loss is recognized on capitalized amounts
treated as a single asset under this paragraph (g)(5)(ii) upon disposition
of any repair allowance property to which the capitalized amounts are related.
A disposition includes the sale, exchange, retirement, physical abandonment,
or destruction of property. Taxpayers must continue to depreciate the single
asset over the remainder of the MACRS applicable recovery period.
(iii) Allocation treatment of capitalized amount.
Instead of treating the capitalized amount as a single asset under paragraph
(g)(5)(ii) of this section, a taxpayer may allocate the capitalized amount
for a particular MACRS class to all repair allowance property in the particular
MACRS class in proportion to the unadjusted basis of the property in that
MACRS class as of the beginning of the taxable year. The capitalized amount
allocated to repair allowance property is treated as a section 168(i)(6) improvement
to the underlying repair allowance property and is treated as placed in service
by the taxpayer on the last day of the first half of the taxable year in which
the amount is paid, before application of the convention under section 168(d).
(iv) Section 168(g) repair allowance property.
If any repair allowance property in a particular MACRS class as of the beginning
of the taxable year is depreciated under section 168(g) pursuant to section
168(g)(1)(A) through (D) or other provisions of the Internal Revenue Code,
the portion of the capitalized amount for that MACRS class that is attributable
to all section 168(g) repair allowance property in that MACRS class (section
168(g) total capitalized amount) is determined by multiplying the capitalized
amount for that MACRS class (as determined under paragraph (g)(5)(i) of this
section) by a percentage that is equal to the unadjusted basis of all section
168(g) repair allowance property in that MACRS class as of the beginning of
the taxable year divided by the unadjusted basis of all repair allowance property
in that MACRS class as of the beginning of the taxable year. The section
168(g) total capitalized amount for a particular MACRS class then is allocated
to each section 168(g) repair allowance property in that MACRS class by multiplying
the section 168(g) total capitalized amount for that MACRS class by a percentage
that is equal to the unadjusted basis of the particular section 168(g) repair
allowance property in that MACRS class as of the beginning of the taxable
year divided by the unadjusted basis of all section 168(g) repair allowance
property in that MACRS class as of the beginning of the taxable year. The
capitalized amount allocated to each section 168(g) repair allowance property
is depreciated in accordance with section 168(g), is treated as a section
168(i)(6) improvement to the underlying repair allowance property, and is
treated as placed in service by the taxpayer on the last day of the first
half of the taxable year in which the amount is paid, before application of
the convention under section 168(d).
(v) Section 168(g) election. If a taxpayer makes
an election under section 168(g)(7) for a particular MACRS class with respect
to property placed in service in the current taxable year, the election applies
to the capitalized amount for that MACRS class. If such an election is made,
the taxpayer must allocate the capitalized amount for that MACRS class to
all repair allowance property in the MACRS class in proportion to the unadjusted
basis of the property in that MACRS class as of the beginning of the taxable
year. The capitalized amount is treated as a section 168(i)(6) improvement
to the underlying repair allowance property and is treated as placed in service
by the taxpayer on the last day of the first half of the taxable year in which
the amount is paid, before application of the convention under section 168(d).
The depreciation of the capitalized amount allocated to repair allowance
property must be determined under section 168(g) whether or not the repair
allowance property in the MACRS class as of the beginning of the taxable year
is depreciated under section 168(g).
(vi) Public utility property. If any repair allowance
property in a particular MACRS class is public utility property (as defined
in section 168(i)(10) or former section 167(l)(3)(A)), the portion of the
capitalized amount for that MACRS class that is attributable to all public
utility property in that MACRS class (public utility property total capitalized
amount) is determined by multiplying the capitalized amount for that MACRS
class (as determined under paragraph (g)(5)(i) of this section) by a percentage
that is equal to the unadjusted basis of all public utility property in that
MACRS class as of the beginning of the taxable year divided by the unadjusted
basis of all repair allowance property in that MACRS class as of the beginning
of the taxable year. The public utility property total capitalized amount
for a particular MACRS class then is subtracted from the unadjusted basis
of all repair allowance property in that MACRS class as of beginning of the
taxable year to determine the non-public utility property total capitalized
amount. A taxpayer may choose to treat the public utility property total
capitalized amount for a particular MACRS class as a single asset in accordance
with paragraph (g)(5)(ii) of this section, and the non-public utility property
total capitalized amount for that MACRS class as another single asset in accordance
with paragraph (g)(5)(ii) of this section. Alternatively, the taxpayer may
choose to allocate the public utility property total capitalized amount for
a particular MACRS class in proportion to the unadjusted basis of the public
utility property in that MACRS class as of the beginning of the taxable year
in accordance with paragraph (g)(5)(iii) of this section, and allocate the
non-public utility property total capitalized amount for a particular MACRS
class in proportion to the unadjusted basis of the non-public utility property
in that MACRS class as of the beginning of the taxable year in accordance
with paragraph (g)(5)(iii) of this section. In either case, the public utility
property total capitalized amount for a particular MACRS class is subject
to the normalization requirements of section 168(i)(9).
(6) Repair allowance property—(i) In
general. Except as provided in paragraph (g)(6)(iii) of this section,
repair allowance property means real or personal property subject to section
168 of the Internal Revenue Code of 1986, or treated as subject to section
168 under paragraph (g)(6)(ii) of this section, that is used in the taxpayer’s
trade or business or for the production of income.
(ii) Certain property not subject to section 168.
Repair allowance property includes tangible depreciable property not otherwise
in a MACRS class if the taxpayer classifies the property, only for purposes
of the repair allowance method in paragraph (g)(4) of this section, to determine
the appropriate MACRS class and either the taxpayer placed the property in
service before the effective date of section 168 of the Internal Revenue Code
of 1986 or the taxpayer properly elected out of section 168 with regard to
the property.
(iii) Exclusions from repair allowance property.
Repair allowance property does not include any property for which the taxpayer
has elected to use the asset guideline class repair allowance in §1.167(a)-11(d)(2);
the method of accounting provided in section 263(d) (with regard to certain
railroad rolling stock); the method of accounting provided in Rev. Proc. 2001-46,
2001-2 C.B. 263, or Rev. Proc. 2002-65, 2002-2 C.B. 700 (with regard to railroad
track) (see §601.601(d)(2) of this chapter); or any other property or
method of accounting that is designated in guidance published in the Federal Register or the Internal Revenue Bulletin (see
§601.601(d)(2) of this chapter).
(7) Excluded additions—(i) In general.
Excluded addition means any amount paid—
(A) For the acquisition or production of a specific unit of property;
(B) For work that ameliorates a condition or defect that either existed
prior to the taxpayer’s acquisition of the unit of property or arose
during the production of the unit of property, whether or not the taxpayer
was aware of the condition or defect at the time of acquisition or production;
(C) For work performed prior to the date the unit of property is placed
in service by the taxpayer (without regard to any applicable convention under
section 168(d));
(D) That adapts the unit of property to a new or different use; or
(E) That increases the cubic or square space of a building.
(ii) Treatment of excluded additions. Any amount
paid for an excluded addition is treated as a capital expenditure under sections
263(a) and 263A.
(8) Repair allowance percentage. Except as provided
in any future guidance published in the Federal Register or
the Internal Revenue Bulletin, the repair allowance percentage in effect for
each MACRS class for a particular taxable year is as follows:
(9) Manner of election. [Reserved]
(10) Manner of revoking election. A taxpayer may
revoke an election made under the repair allowance method only by obtaining
the Commissioner’s consent to revoke the election. An election must
be revoked prospectively and may not be revoked through the filing of an amended
Federal income tax return. A taxpayer that revokes an election may not re-elect
the repair allowance method for a period of at least five taxable years, beginning
with the year of the revocation unless, based on a showing of unusual and
compelling circumstances, consent is specifically granted by the Commissioner
to re-elect the repair allowance at an earlier time.
(11) Examples. The following examples illustrate
the rules of this paragraph (g) and assume that none of the rules in paragraph
(g)(5)(iv) or (g)(5)(v) of this section applies:
Example 1. X elects the repair allowance method
described in this paragraph (g). X’s total unadjusted basis of all
of its MACRS 10-year property as of January 1, 2008 is $10 million. X’s
total unadjusted basis of all MACRS 10-year property as of December 31, 2008
is $15 million (computed without regard to amounts capitalized under this
repair allowance provision). During 2008, X pays $1,000,000 to repair, maintain,
or improve MACRS 10-year property. Assume that none of X’s property
is an excluded addition as defined in paragraph (g)(7) of this section. The
repair allowance percentage for MACRS 10-year property is 5 percent. X’s
repair allowance amount and capitalized amount are computed as follows:
(i) X determines its average unadjusted basis of MACRS 10-year property:
($10,000,000 + $15,000,000)/2 = $12,500,000.
(ii) X multiplies its average unadjusted basis of MACRS 10-year property
by the prescribed repair allowance percentage for MACRS 10-year property to
arrive at the repair allowance amount: $12,500,000 x 5% = $625,000.
(iii) Because X’s amounts paid to repair, maintain, or improve
MACRS 10-year property ($1,000,000) exceed the repair allowance amount for
MACRS 10-year property ($625,000), X deducts under section 162(a) amounts
paid to the extent of the repair allowance amount ($625,000) and capitalizes
the amounts paid in excess of the repair allowance amount ($1,000,000 - $625,000
= $375,000).
(iv) The capitalized amount ($375,000) is treated as an improvement
under section 168(i)(6). The improvement is depreciated as 10-year property
under section 168 and is considered placed in service on the last day of the
first half of 2008.
Example 2. X elects the repair allowance method
described in this paragraph (g). X uses a car in providing a taxi service.
X’s unadjusted basis in the car is $25,000. Assume that the unit of
property (as determined under paragraph (d)(2) of this section) is the car.
In 2008, X incurs various costs to maintain, repair, and improve the car,
including: $4,500 for gasoline; $550 for car washes and detailing, $2,200
for scheduled maintenance such as oil changes, tire rotation, new brakes,
minor parts, and fluid replacements, etc.; $80 for new headlights; $250 for
new tires; and $4,800 to rebuild the engine after the car overheated. Assume
that none of X’s expenditures are an excluded addition as defined in
paragraph (g)(7) of this section. The car is classified as MACRS 5-year property.
Assume that X has no other MACRS 5-year property. The repair allowance percentage
for MACRS 5-year property is 10 percent. X’s repair allowance amount
and capitalized amount are computed as follows:
(i) X determines its average unadjusted basis of MACRS 5-year property
is $25,000.
(ii) X multiplies its average unadjusted basis of MACRS 5-year property
by the prescribed repair allowance percentage for MACRS 5-year property to
arrive at the repair allowance amount: $25,000 x 10% = $2,500.
(iii) Because X’s amounts to repair, maintain, or improve MACRS
5-year property ($2,200 + $80 + $250 + $4,800 = $7,330) exceed the repair
allowance amount for MACRS 5-year property ($2,500), X treats $2,500 as an
otherwise deductible ordinary and necessary expenditure under section 162(a)
and capitalizes $4,830 as the amounts paid in excess of the repair allowance
amount.
(iv) The capitalized amount ($4,830) is treated as an improvement under
section 168(i)(6). The improvement is depreciated as 5-year property under
section 168 and is considered placed in service on the last day of the first
half of 2008.
(h) Treatment of capital expenditures. Amounts
required to be capitalized under this section are capital expenditures and
must be taken into account through a charge to capital account or basis, or
in the case of property that is inventory in the hands of a taxpayer, through
inclusion in inventory costs. See section 263A for the treatment of amounts
referred to in this section as well as other amounts paid in connection with
the production of real property and personal property, including films, sound
recordings, video tapes, books, or similar properties.
(i) Recovery of capitalized amounts. Amounts that
are capitalized under this section are recovered through depreciation, cost
of goods sold, or by an adjustment to basis at the time the property is placed
in service, sold, used, or otherwise disposed of by the taxpayer. Cost recovery
is determined by the applicable Internal Revenue Code and regulation provisions
relating to the use, sale, or disposition of property.
(j) Effective date. The rules in this section
apply to taxable years beginning on or after the date of publication of the
Treasury decision adopting these rules as final regulations in the Federal Register.
(k) Accounting method changes. [Reserved]
Mark E. Matthews, Deputy
Commissioner for Services and Enforcement.
Note
(Filed by the Office of the Federal Register on August 18, 2006, 8:45
a.m., and published in the issue of the Federal Register for August 21, 2006,
71 F.R. 48590)
The principal author of these regulations is Kimberly L. Koch, Office
of the Associate Chief Counsel (Income Tax and Accounting), IRS. However,
other personnel from the IRS and Treasury Department participated in their
development.
* * * * *
Internal Revenue Bulletin 2006-39
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