[Federal Register Volume 71, Number 161 (Monday, August 21, 2006)]
[Proposed Rules]
[Pages 48590-48623]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 06-6969]



[[Page 48589]]

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Part II





Department of the Treasury





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Internal Revenue Service



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26 CFR Part 1



 Guidance Regarding Deduction and Capitalization of Expenditures 
Related to Tangible Property; Proposed Rule

  Federal Register / Vol. 71, No. 161 / Monday, August 21, 2006 / 
Proposed Rules  

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-168745-03]
RIN 1545-BE18


Guidance Regarding Deduction and Capitalization of Expenditures 
Related to Tangible Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: 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.

DATES: 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 a.m., 
must be received by November 28, 2006.

ADDRESSES: 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 http://www.irs.gov/regs or 
via the Federal eRulemaking Portal at http://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 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 [email protected] 
or at (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    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 (2004-3 I.R.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

I. Introduction

    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 Sec. Sec.  
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 Sec. Sec.  1.263(a)-4 and 1.263(a)-5 
in the Federal Register on January 5, 2004 (TD 9107; 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 Sec. Sec.  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 Sec.  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 
Sec.  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 Sec.  
1.263(a)-4(d)(5) and section 263A. The rules in Sec.  1.263(a)-2(c) of 
the current regulations (the cost of defending or perfecting title to 
property) are addressed in Sec.  1.263(a)-4(d)(9) of the current 
regulations with regard to intangibles and in Sec.  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 Sec.  1.263(a)-2(f) and 
(g) of the current regulations (relating to certain capital 
contributions) essentially are restated in Sec.  1.263(a)-1(b) of the 
proposed regulations. Finally, Sec.  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 Sec.  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 Sec.  
1.263(a)-1(a) and (b) of the proposed regulations. Section 1.263(a)-
01(a) of the current regulations restates the statutory rules from 
section 263(a), which are carried over in Sec.  1.263(a)-1(a) of the 
proposed regulations. The rules in Sec.  1.263(a)-1(b) of the current 
regulations address

[[Page 48591]]

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 Sec.  1.263(a)-3 of the proposed regulations. The proposed 
regulations also revise Sec.  1.162-4 of the current regulations 
(allowing a deduction for the cost of incidental repairs) to provide 
rules consistent with Sec.  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

A. Overview
    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 Sec.  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 Sec. Sec.  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 Sec.  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 Sec.  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 Sec. Sec.  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 Sec.  1.162-12 permits a deduction for the cost of 
ordinary tools of short life or small cost. The rules in current 
Sec. Sec.  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 Sec.  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 Sec.  1.263(a)-3 of the proposed 
regulations relating to improvements.

III. Amounts Paid To Acquire or Produce Tangible Property

A. In General
    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 Sec.  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 Sec.  1.263(a)-3(d)(2)), having a useful life 
substantially beyond the taxable year. See Sec.  1.263(a)-2(d) of the 
proposed

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regulations. Thus, Sec.  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 Sec.  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 Sec.  1.263(a)-1(b) list inventory costs as 
capital expenditures under Sec.  1.263(a)-1(a). Therefore, Sec.  
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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  1.263A-2(a)(1)(i), except that 
improvements are separately defined in Sec.  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 Sec.  1.263(a)-2(c) and 
parallels the rule in Sec.  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 Sec.  1.162-3. Thus, the proposed regulations do not 
change the treatment of materials and supplies under Sec.  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).
C. 12-Month Rule
    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 Sec. Sec.  
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 Sec.  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 Sec.  
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 Sec.  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 Sec.  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

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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.
D. De Minimis Rule
    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

[[Page 48594]]

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, Sec.  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, Sec.  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 
Sec.  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 Sec.  1.263(a)-3 or an otherwise deductible 
repair or maintenance cost under Sec.  1.162-4. Even if the subsequent 
use of the component is an otherwise deductible expense under Sec.  
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 
Sec.  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

A. In General
    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 Sec.  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
1. In General
    A threshold issue in applying the improvement rules under Sec.  
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 Sec.  1.263(a)-3. The 
unit of property rules also apply for purposes of Sec.  1.263(a)-1 of 
the proposed regulations (which references the rules in Sec. Sec.  
1.263(a)-2 and 1.263(a)-3 of the proposed regulations) and Sec.  
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 Sec. Sec.  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)

[[Page 48595]]

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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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).'' TD 8584 (59 FR 67,187; 
1995-1 C.B. 20, 25; Dec. 29, 1994).
    In contrast to the unit of property rules in Sec.  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, Sec.  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 Sec.  
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

[[Page 48596]]

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 
Sec.  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 Sec.  1.48-1(e) to determine a unit of property. The 
proposed regulations rely on the definition of building under Sec.  
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 Sec.  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 Sec.  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

[[Page 48597]]

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 Sec.  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,

[[Page 48598]]

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 Sec.  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 Sec.  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 Sec.  
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) 
Sec.  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) Sec.  
1.167(a)-8(a) from a retirement of a component of property if the 
component is MACRS or ACRS property (applying Sec.  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) Sec.  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 Sec. Sec.  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 Sec.  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

[[Page 48599]]

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

[[Page 48600]]

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).

VI. Value

A. In General
    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 Sec.  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

[[Page 48601]]

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

[[Page 48602]]

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.

VII. Restoration

    The proposed regulations provide that a taxpayer must capitalize 
amounts paid to restore property. The restoration language is from 
section 263(a)(2) and Sec.  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 Sec.  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 Sec.  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

[[Page 48603]]

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

A. In General
    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.
B. Capitalized Amount
    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

[[Page 48604]]

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.
D. Excluded Additions
    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 Sec.  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 Sec.  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 Sec.  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.
E. Leased Property
    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

[[Page 48605]]

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?
F. Network Assets
    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 recordkeeping 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.
I. Recordkeeping
    The proposed regulations do not impose any specific recordkeeping 
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

[[Page 48606]]

capitalized as a single asset or allocated to all repair allowance 
property in the specific MACRS class).

Proposed Effective Date

    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.

Special Analyses

    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 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.

Drafting Information

    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.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    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:


Sec.  1.162-4  Repairs.

    Amounts paid for repairs and maintenance to tangible property are 
deductible if the amounts paid are not required to be capitalized under 
Sec.  1.263(a)-3.
    Par. 3. Section 1.263(a)-0 is amended by revising the entries for 
Sec.  1.263(a)-1 through Sec.  1.263(a)-3 to read as follows:


Sec.  1.263(a)-0  Table of contents. * * *


Sec.  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.

Sec.  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.

[[Page 48607]]

    (1) In general.
    (2) Examples.
    (g) Effective date.
    (h) Accounting method changes.

Sec.  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:


Sec.  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 Sec.  1.263(a)-2.
    (2) An amount paid to improve real or personal property. See Sec.  
1.263(a)-3.
    (3) An amount paid to acquire or create intangibles. See Sec.  
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 Sec.  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 Sec.  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 Sec.  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 Sec.  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

[[Page 48608]]

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 Sec.  
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]


Sec.  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 Sec.  1.263(a)-3 for the treatment of amounts paid to improve 
tangible property, Sec.  1.263(a)-4 for the treatment of amounts paid 
to acquire or create intangibles, and Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  
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 Sec.  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 
Sec.  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 Sec.  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 
Sec.  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 Sec.  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 Sec.  
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 Sec.  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

[[Page 48609]]

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 Sec.  1.263(a)-4 for 
the treatment of amounts paid to acquire intangibles and Sec.  
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 Sec.  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 Sec.  1.263(a)-3(d)(2)) with 
an economic useful life (as defined in Sec.  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 Sec.  
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 Sec.  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 Sec.  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 Sec.  
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,

[[Page 48610]]

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 Sec.  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 Sec.  
601.601(d)(2) of this chapter). Also assume that each tire is a 
separate unit of property, as determined under Sec.  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 Sec.  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 Sec.  601.601(d)(2) of this chapter) so that the 
truck tractor (including the tires) is the unit of property, as 
determined under Sec.  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, Sec. Sec.  1.162-4 and 1.263(a)-3 
determine whether amounts capitalized under this section Sec.  
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 Sec.  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 Sec.  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 
Sec.  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 Sec.  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 Sec.  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

[[Page 48611]]

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 Sec.  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]


Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec. Sec.  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

[[Page 48612]]

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 Sec.  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 Sec.  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 Sec.  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

[[Page 48613]]

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 Sec.  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 Sec.  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.

[[Page 48614]]

    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 Sec.  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

[[Page 48615]]

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 Sec.  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 
Sec.  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

[[Page 48616]]

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

[[Page 48617]]

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

[[Page 48618]]

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 
Sec.  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

[[Page 48619]]

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

[[Page 48620]]

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

[[Page 48621]]

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 Sec.  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

[[Page 48622]]

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 Sec.  
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 
Sec.  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 Sec.  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:

[[Page 48623]]



------------------------------------------------------------------------
                                                              Repair
              MACRS class                 MACRS recovery     allowance
                                          period (years)    percentage
------------------------------------------------------------------------
3-year property........................              3             16.5
5-year property........................              5             10
7-year property........................              7              7.14
10-year property.......................             10              5
15-year property.......................             15              3.33
20-year property.......................             20              2.5
Water utility property.................             25              2
Residential rental property............             27.5            1.82
Nonresidental rental property..........             39              1.28
Railroad grading or tunnel bore........             50              1
------------------------------------------------------------------------

    (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.
[FR Doc. 06-6969 Filed 8-18-06; 8:45 am]
BILLING CODE 4830-01-P