[Federal Register Volume 73, Number 47 (Monday, March 10, 2008)]
[Proposed Rules]
[Pages 12838-12867]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-4466]



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Part III





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. 73, No. 47 / Monday, March 10, 2008 / 
Proposed Rules  

[[Page 12838]]


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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, a notice of public hearing, and 
withdrawal of previously proposed regulations.

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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 de minimis rule for acquisitions). 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 and withdraws the proposed regulations published 
in the Federal Register on August 21, 2006 (71 FR 161).

DATES: Written or electronic comments must be received by June 9, 2008. 
Outlines of topics to be discussed at the public hearing scheduled for 
June 24, 2008, at 10 a.m., must be received by June 3, 2008.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-168745-03), room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
168745-03), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC 20224, or sent electronically, via the 
Federal eRulemaking Portal at www.regulations.gov (IRS REG-168745-03). 
The public hearing will be held in the auditorium of the Internal 
Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Merrill D. Feldstein or Mon L. Lam, (202) 622-4950; concerning 
submission of comments, the hearing, and/or to be placed on the 
building access list to attend the hearing, 
[email protected].

SUPPLEMENTARY INFORMATION:

Background

    On August 21, 2006, the IRS and Treasury Department published in 
the Federal Register (71 FR 161) proposed amendments to the regulations 
under section 263(a) (2006 proposed regulations) relating to amounts 
paid to acquire, produce, or improve tangible property. The IRS and 
Treasury Department received numerous written comments. A public 
hearing was held on December 19, 2006. After considering the comment 
letters and the statements at the public hearing, the IRS and Treasury 
Department are withdrawing the 2006 proposed regulations and are 
proposing new regulations.

Summary of Comments and Explanation of Provisions

I. Overview

    These new proposed regulations include many of the provisions 
contained in the 2006 proposed regulations, including the proposed 
format changes in which Sec.  1.263(a)-1 provides general rules for 
capital expenditures, Sec.  1.263(a)-2 provides rules for amounts paid 
for the acquisition or production of tangible property, and Sec.  
1.263(a)-3 provides rules for amounts paid for the improvement of 
tangible property. However, these new proposed regulations provide many 
additional rules that were not included in the 2006 proposed 
regulations. For example, these new proposed regulations provide a 
definition of materials and supplies under Sec.  1.162-3 (including a 
special 12-month rule and a $100 de minimis rule), a book conformity de 
minimis rule for acquisitions of units of property under Sec.  
1.263(a)-2, a safe harbor for routine maintenance under Sec.  1.263(a)-
3, and an optional simplified method for regulated taxpayers under 
Sec.  1.263(a)-3. Additionally, these new proposed regulations provide 
significant changes to the rules relating to unit of property, 
restorations, and allow for industry-specific repair allowance methods 
in future Internal Revenue Bulletin guidance. These new proposed 
regulations generally will apply to taxable years beginning on or after 
the date that final regulations are published in the Federal Register.

II. Withdrawal and Re-Proposal of Regulations

    In addition to providing specific comments, many commentators 
suggested that, given the broad scope and effect of the regulations and 
the numerous comments received on the 2006 proposed regulations, 
consideration should be given to re-proposing the regulations in their 
entirety. This suggestion has been adopted and the 2006 proposed 
regulations are withdrawn and replaced with these new proposed 
regulations.

III. Materials and Supplies Under Sec.  1.162-3

    Various commentators thought that the 2006 proposed regulations 
failed to fully address the relationship between the rules for 
capitalization of tangible property under section 263(a) and the 
materials and supplies rules provided in Sec.  1.162-3 of the current 
regulations because the 2006 proposed regulations did not provide 
special rules for the interaction between the two provisions. 
Specifically, commentators noted that under the 2006 proposed 
regulations, tangible property with a useful life of 12 months or less 
was not treated as a material and supply, which treatment was 
inconsistent with existing authorities, particularly with regard to the 
timing of when to deduct amounts paid to acquire the property with a 
useful life of 12 months or less. Commentators pointed out that the 
2006 proposed regulations were inconsistent with Sec.  1.162-3 and 
would create uncertainty with regard to which provision should be 
applied to which property. In response, the IRS and Treasury Department 
decided to revise Sec. Sec.  1.162-3 and 1.263(a)-2 to provide clear 
and consistent treatment for those items that traditionally have been 
considered to be materials and supplies and to provide distinct, but 
coordinated, treatment for those items that should be addressed under 
section 263(a).
    The new proposed regulations provide additional guidance under 
Sec.  1.162-3 with respect to the definition of materials and supplies. 
Specifically, the proposed rules define a material and supply as 
tangible property that (a) is not a unit of property, (b) is a unit of 
property with an economic useful life of 12 months or less, (c) is a 
unit of property that costs $100 or less, or (d) is identified as a 
material and supply in future guidance.
    Under the existing regulations, the costs of non-incidental 
materials and supplies are deducted as the materials and supplies are 
used or consumed, and the costs of incidental materials and

[[Page 12839]]

supplies are deducted as the costs are incurred. These new proposed 
regulations retain this treatment of materials and supplies, except 
with respect to rotable and temporary spare parts. These new proposed 
regulations provide that rotable or temporary spare parts treated as 
materials and supplies will be considered used or consumed in the 
taxable year in which the taxpayer disposes of the parts. This rule 
prevents taxpayers from prematurely deducting the cost of a unit of 
property by systematically replacing components with rotable spare 
parts. The IRS and Treasury Department anticipate that taxpayers with 
rotable or temporary spare parts that are not discarded after their 
original use generally will prefer to capitalize their costs and treat 
those parts as depreciable assets. These new proposed regulations 
provide for an election to capitalize these costs.
    Taxpayers should recognize that the used or consumed standard for 
non-incidental materials and supplies generally is met later than the 
placed in service standard used for depreciation. In addition, 
taxpayers are reminded that after a material or supply is used or 
consumed, capitalization of the material or supply cost to another 
property may be required. For example, amounts paid for materials and 
supplies used in the production of inventory or a self-constructed 
asset generally are required to be capitalized under section 263A. 
Similarly, amounts paid to produce materials and supplies generally are 
required to be capitalized as part of the production costs of the 
materials and supplies. Nothing in these new proposed regulations is 
intended to change this treatment.
    First, these new proposed regulations provide that property that is 
not a unit of property as defined in Sec.  1.263(a)-3 will be 
considered a material and supply. In general, this definition is 
intended to describe spare and replacement parts and is consistent with 
the current characterization of these items.
    Second, these new proposed regulations provide that property that 
has an economic useful life of 12 months or less will be considered a 
material and supply. Commentators requested clarification concerning 
the application of the 12-month rule provided in the 2006 proposed 
regulations. For purposes of applying the 12-month rule, these new 
proposed regulations generally adopt the economic useful life 
definition in Sec.  1.167(a)-1(b) and provide that, for purposes of 
these new proposed material and supplies regulations, the measurement 
period for economic useful life begins when the item is first used or 
consumed in the taxpayer's trade or business. Therefore, the time prior 
to when an item is used or consumed is not taken into consideration in 
determining the economic useful life of the asset for these new 
proposed regulations, notwithstanding the fact that the item may have 
been placed in service (ready and available for its intended use) for 
depreciation.
    In addition, these new proposed regulations provide a special 
economic useful life test under the 12-month rule for taxpayers with 
applicable financial statements (AFS). Under this rule, taxpayers with 
AFS are required to determine the economic useful life in a manner 
consistent with the economic useful life used for purposes of 
determining depreciation in the books and records supporting their AFS. 
An exception is provided if a taxpayer does not assign a useful life to 
certain property in its AFS (for example, the item is currently 
expensed in the taxpayer's AFS because it is considered de minimis).
    The 2006 proposed regulations did not provide a de minimis rule for 
the acquisition or production of property but requested comments on 
whether a de minimis rule should be adopted. Commentators generally 
agreed that the regulations should include a de minimis rule but varied 
on how that rule should be structured.
    Third, these new proposed regulations provide a $100 de minimis 
rule within the definition of materials and supplies. Materials and 
supplies include a unit of property that has a production or 
acquisition cost of $100 or less, without regard to the treatment of 
the item in the taxpayer's financial statements. Allowing small items 
to be treated as materials and supplies resolves uncertainty with 
respect to whether those items represent a depreciable asset or a 
material and supply, and $100 is a low enough threshold to alleviate 
concerns about the potential distortion of income. However, treating a 
small unit of property as a material and supply may affect the timing 
of the deduction for the material and supply cost because expensing an 
amount paid for a non-incidental material and supply will only occur in 
the period in which the item is used or consumed.
    Various commentators pointed out that taxpayer burden may be 
reduced by allowing taxpayers to capitalize amounts paid for items that 
otherwise would qualify as materials and supplies and treat the items 
as depreciable assets. For example, many taxpayers currently treat 
rotable spare parts as capital expenditures depreciable over the life 
of the unit of property in which the rotables are used. See Rev. Rul. 
69-200 (1969-1 CB 60). See Sec.  601.601(d)(2)(ii)(b).
    Under these new proposed regulations, taxpayers may elect to treat 
an amount paid for a material and supply as a capital expenditure. In 
general, the election is made separately for each material and supply 
and is revocable only with the consent of the Commissioner. The 
election is made by capitalizing the cost of the material and supply in 
the year the cost is incurred and beginning depreciation of the item in 
the year it is placed in service.

IV. Repairs under Sec.  1.162-4

    The 2006 proposed regulations revised Sec.  1.162-4 (the repair 
rules), to provide rules consistent with the improvement rules under 
Sec.  1.263(a)-3 of the 2006 proposed regulations. Commentators 
expressed concern that the proposed changes would result in challenges 
to the deductibility of costs that the IRS has long agreed with 
taxpayers are deductible. The IRS and Treasury Department do not think 
that the proposed change to Sec.  1.162-4 creates a burden of proof 
higher than that which exists under current law or requires 
capitalization of costs that are not required to be capitalized under 
current law. Therefore, these new proposed regulations do not propose 
any specific changes to the rules proposed in the 2006 proposed 
regulations. However, a routine maintenance safe harbor is provided in 
these new proposed regulations in Sec.  1.263(a)-3.

V. Professional Expenses Under Sec.  1.162-6

    The existing regulations under Sec.  1.162-6 provide rules for 
professional expenses. These new proposed regulations propose to remove 
Sec.  1.162-6. In general, the treatment of the items listed in Sec.  
1.162-6 is adequately addressed in these new proposed regulations and 
other existing regulations. The proposed removal of Sec.  1.162-6 is 
not intended to result in any substantive changes in the treatment of 
professional expenses.

VI. Capital Expenditures

A. Amounts Paid To Sell Property

    The 2006 proposed regulations provided rules for the capitalization 
of selling expenses, except in the case of dealers, under Sec.  
1.263(a)-1. The 2006 proposed regulations included an example that 
required the capitalization

[[Page 12840]]

of advertising costs as a selling expense that must be offset against 
the sale proceeds. Various commentators questioned this treatment of 
advertising costs. In general, advertising costs are not capital 
expenditures. Therefore, these new proposed regulations retain the 
general rule but remove the references to advertising costs provided in 
the 2006 proposed regulations and update the examples accordingly.

B. Interests in Land

    The 2006 proposed regulations did not provide a specific 
capitalization rule for amounts paid to acquire or create intangible 
interests in land. The 2006 proposed regulations specifically requested 
comments on this issue, but no comments were received. These new 
proposed regulations provide that amounts paid to acquire or create 
interests in land, such as easements, life estates, mineral interests, 
timber rights, zoning variances, or other interests in land, are 
examples of capital expenditures. Comments are specifically requested 
on this proposed rule.

VII. Amounts Paid To Acquire or Produce Tangible Property

    The 2006 proposed regulations provided rules for the capitalization 
of amounts paid to acquire or produce tangible property under Sec.  
1.263(a)-2. These new proposed regulations generally retain the same 
format, but make some modifications to the 2006 proposed regulations. 
For example, modifications have been made to clarify the interaction of 
Sec.  1.263(a)-2 of these new proposed regulations with the materials 
and supplies rules under Sec.  1.162-3. Significant modifications and 
clarifications are discussed further in this preamble.

A. Definition of Produce

    Commentators asked whether the term ``produce'' as used in the 2006 
proposed regulations had the same meaning as the term ``produce'' under 
section 263A. These new proposed regulations clarify that the 
definition of the term produce for purposes of Sec.  1.162-3 and Sec.  
1.263(a)-2 generally is the same as the definition of the term produce 
for section 263A purposes. The sole difference is that the term 
``improve'' is not included in Sec.  1.162-3 and Sec.  1.263(a)-2 
because ``improve'' under section 263A is specifically defined in Sec.  
1.263(a)-3 of these new proposed regulations, relating to the 
improvement of tangible property.

B. Transaction Costs

    The 2006 proposed regulations generally required a taxpayer to 
capitalize amounts paid to facilitate the acquisition of real or 
personal property, and included a list of typical transaction costs. 
Commentators suggested that with respect to the rules requiring the 
capitalization of facilitative transaction costs, an exception should 
be provided for transaction costs for pre-decisional investigatory 
costs, similar to the exception provided with respect to certain 
intangibles in Sec.  1.263(a)-4(e)(1)(iii) (creation of certain 
contract rights) and Sec.  1.263(a)-5(e) (acquisition of a trade or 
business). These new proposed regulations provide a general rule 
similar to the rules in the intangibles regulations requiring that 
taxpayers capitalize all costs that facilitate an acquisition of 
tangible property, including the costs of investigating the 
acquisition, but adopt the commentators' suggestion in part by 
providing an exception for certain costs incurred in the investigation 
of real property acquisitions. The IRS and Treasury Department think it 
is appropriate to provide an exception for real property acquisitions 
because these types of transactions most often raise the issue of 
whether the investigatory costs are deductible business expansion costs 
rather than capital expenditures to acquire a specific asset. The 
exception provides that costs relating to activities performed in the 
process of determining whether to acquire real property and which real 
property to acquire generally are deductible pre-decisional costs. 
Under this exception, capitalization will not be required for certain 
pre-decisional investigative activities, such as marketing studies, 
that are not specifically identified in these regulations as being 
inherently facilitative. These new proposed regulations provide that 
inherently facilitative costs must be capitalized and list the costs, 
such as transportation and shipping costs, that are inherently 
facilitative.
    A commentator pointed out that section 263A does not apply to 
acquisitions of property that are not intended for resale, and thus, 
taxpayers should not be required to capitalize overhead costs to this 
type of property. These new proposed regulations address this comment 
by providing a simplifying convention for employee compensation and 
overhead costs similar to the rules provided for intangible property. 
However, the new proposed regulations reiterate that section 263A does 
apply to the production of real or personal property. Section 263A 
contains rules for certain costs incurred prior to production.
    Under current law, if a taxpayer engages in multiple separate and 
distinct transactions, the taxpayer may allocate transaction costs to 
the separate transactions and recover the allocable transaction costs 
as each distinct transaction is abandoned. Sibley, Lindsay & Curr Co. 
v. Commissioner, 15 T.C. 106, 110 (1950), acq., 1951-1 CB 3. See Sec.  
601.601(d)(2)(ii)(b). However, if the transactions are viewed as 
alternatives, only one of which the taxpayer can complete, the courts 
have held that the taxpayer must capitalize all the transaction costs 
to the one transaction ultimately completed. United Dairy Farmers, Inc. 
v. United States, 267 F.3d 510 (6th Cir. 2001); Nicolazzi v. 
Commissioner, 79 T.C. 109 (1982), aff'd, 722 F.2d 324 (6th Cir. 1983). 
To avoid the difficulty inherent in administering this rule, including 
ascertaining the intent of the taxpayer, the new proposed regulations 
provide a more objective rule. This rule allows taxpayers to allocate 
inherently facilitative costs among the separate and distinct 
properties considered, regardless of the taxpayer's ultimate intent or 
plan. The taxpayer capitalizes the allocable transaction costs to each 
property, including properties not acquired, and recovers the costs as 
appropriate under the applicable provision of the Code (for example, 
section 165, 167, or 168). Examples are provided to demonstrate the 
application of these rules.
    In addition, a commentator noted that the rule contained in the 
2006 proposed regulations with respect to costs incurred prior to 
placing property in service is really a rule for acquisition costs, not 
improvement costs. The IRS and Treasury Department agree that 
activities occurring prior to placing the property in service are 
conceptually more related to the acquisition of the property than to 
the improvement of property. Therefore, these new proposed regulations 
move to the acquisition cost section of these regulations the 
requirement to capitalize amounts paid for work performed prior to 
placing property in service.

 C. De minimis rule

    The 2006 proposed regulations did not provide a specific de minimis 
rule for the acquisition or production of property, but the preamble 
provided a detailed proposal of what might be an appropriate de minimis 
rule and requested comments from taxpayers on this issue. Numerous 
comments supported the adoption of a de minimis rule to the extent such 
a proposal would not alter the current understandings between taxpayers 
and examining agents with respect to what type of transactions are 
considered de minimis

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on examination for purposes of evaluating risk. Therefore, to reduce 
burden and provide simplification, these new proposed regulations 
provide a de minimis rule. With respect to the concerns raised by 
commentators as to the adoption of a de minimis rule, the IRS and 
Treasury Department want to make clear that the adoption of such a rule 
is not intended to alter the general risk analysis currently employed 
by examining agents. Therefore, the de minimis rule proposed in these 
regulations should not affect any current understandings between 
examining agents and taxpayers with respect to the size and character 
of transactions that will be the focus of examinations.
    The proposed de minimis rule is based primarily on a qualifying 
taxpayer's financial statement standards. A qualifying taxpayer is a 
taxpayer that: (a) Has an AFS, (b) has written accounting procedures 
for the expensing of de minimis items, and (c) recognizes de minimis 
costs as expenses on its AFS. Under the rule provided in these new 
proposed regulations, a qualifying taxpayer can use the de minimis 
standard adopted in its AFS to the extent the AFS de minimis standard 
does not result in a distortion of income. Although commentators varied 
regarding whether it is appropriate to require conformity with AFS to 
qualify for a de minimis rule, the IRS and Treasury Department think 
that it provides simplification and reduces burden only to allow 
deductions for de minimis amounts paid for property (other than the 
$100 rule for materials and supplies) that are already being deducted 
for AFS purposes.
    The primary concern with the adoption of a de minimis rule is that 
expensing items under a de minimis rule may not clearly reflect income 
under section 446, particularly for aggregate or bulk purchases of de 
minimis items. In general, the IRS and Treasury Department recognize 
that accounting for an item using generally accepted accounting 
principles will not result in a distortion of income. Nonetheless, a 
distortion of income standard has been adopted in an effort to avoid 
intentional manipulations of the de minimis rule. These new proposed 
regulations provide a safe harbor in which the use of an AFS de minimis 
standard will be deemed not to distort income. Specifically, the safe 
harbor provides that an amount deducted under the AFS de minimis rule 
for the taxable year will be deemed not to distort income if that 
amount, added to the amounts deducted in the taxable year as materials 
and supplies for units of property costing $100 or less, is less than 
or equal to the lesser of (i) 0.1 percent of the taxpayer's gross 
receipts for the taxable year, or (ii) 2 percent of the taxpayer's 
total depreciation and amortization for the taxable year as determined 
in its AFS. The safe harbor provided in these new proposed regulations 
is based upon percentages and comparisons provided in case law. See 
Alacare Home Health Services, Inc. v. Commissioner, T.C. Memo. 2001-
149; Cincinnati, New Orleans & Tex. Pac. Ry. Co. v. United States, 424 
F.2d 563 (Ct. Cl. 1970). This safe harbor is not intended to be used in 
other contexts as a bright-line rule of an amount that distorts income. 
Whether amounts above the safe harbor result in a distortion of income 
depends upon the taxpayer's facts and circumstances.
    These new proposed regulations also provide that gain on the sale 
or disposition of property accounted for under the de minimis rule is 
not treated as gain resulting from the sale or disposition of a capital 
asset under section 1221 or as property used in the trade or business 
under section 1231. These new proposed regulations also clarify that 
property accounted for under the de minimis rule is not a material or 
supply under Sec.  1.162-3.
    Moreover, these new proposed regulations provide that taxpayers may 
elect to capitalize items that might otherwise be within the scope of 
the de minimis rule. In general, this election to capitalize is made 
separately for each asset by treating the amount paid as a capital 
expenditure on the tax return.
    These new proposed regulations also make a conforming change to the 
regulations under section 263A to ensure that amounts paid for property 
produced by the taxpayer also qualify under the de minimis rule, 
because there is no basis for distinguishing between acquired and 
produced property for this purpose. This change is provided in Sec.  
1.263A-1(b)(14) of the these new proposed regulations. The rule 
provides that the cost of property to which a taxpayer properly applies 
the de minimis rule contained in Sec.  1.263(a)-2(d)(4) of these new 
proposed regulations (including the requirement that it not distort 
income) is not required to be capitalized under section 263A as a 
separate unit of property, but may be required to be capitalized as a 
cost incurred by reason of the production of other property. This 
change is necessary because without a conforming change to section 
263A, property produced by the taxpayer that qualified under the de 
minimis rule would be capitalized under section 263A despite the de 
minimis rule under section 263(a).
    These new proposed regulations do not impose any specific record 
keeping requirements for the use of the de minimis rule. However, under 
section 6001, taxpayers are required to keep books and records 
sufficient to establish their eligibility to use the de minimis rule. 
Specifically, taxpayers must maintain books and records reasonably 
sufficient to determine (1) the total amounts paid and deducted as 
materials and supplies pursuant to Sec.  1.162-3(d)(1)(iii) of these 
new proposed regulations; (2) the total amounts paid and not 
capitalized pursuant to Sec.  1.263(a)-2(d)(4)(i) of these new proposed 
regulations; (3) the computation of the safe harbor amount provided by 
Sec.  1.263(a)-2(d)(4)(iii) of these new proposed regulations; (4) that 
income has not been distorted by the aggregate of the deductions under 
Sec. Sec.  1.162-3(d)(1)(iii) and 1.263(a)-2(d)(4)(i) of these new 
proposed regulations if the aggregate amount exceeds the safe harbor 
amount determined pursuant to Sec.  1.263(a)-2(d)(4)(iii) of these new 
proposed regulations; and (5) that the requirements of Sec.  1.263(a)-
2(d)(4)(i)(A)-(C) of these new proposed regulations have been met.

VIII. Improvements

    In general, these proposed regulations are intended to reduce 
controversy and provide clarity on how to determine whether an amount 
paid must be capitalized under section 263(a) as an improvement cost. 
Consistent with that intent, the 2006 proposed regulations contained 
rules with respect to improvements, including rules to determine 
whether an amount paid results in a material increase in value or 
prolonged useful life. As described below, these regulations modify the 
rules set forth in the 2006 proposed regulations to reflect comments 
received. While these proposed regulations attempt to provide more 
certainty in an area of law that currently requires a subjective 
analysis, the IRS and Treasury Department request comments on whether 
the improvement rules in these regulations are consistent with the 
overriding goal of providing clarity and certainty in this area.
    The IRS and Treasury Department received numerous comments 
regarding the improvement rules provided in the 2006 proposed 
regulations. Many of the comments received included a general request 
that consideration be given to providing more bright-line rules and 
clarifying definitions as well as providing greater consistency with 
other

[[Page 12842]]

provisions of the Code. The rules contained in these new proposed 
regulations attempt to address these concerns.
    Section 1.263(a)-3 of the 2006 proposed regulations provided that 
taxpayers are required to capitalize amounts paid to improve a unit of 
property. Under the general rule in the 2006 proposed regulations, a 
unit of property is improved if the amounts paid (i) materially 
increase the value of the unit of property; or (ii) restore the unit of 
property. Under the 2006 proposed regulations, amounts paid to adapt a 
unit of property to a new or different use were considered to 
materially increase the value of a unit of property. The 2006 proposed 
regulations also contained rules for determining the appropriate unit 
of property.
    These new proposed regulations remove the new or different use 
standard from the material increase in value rules and provide a 
separate category for new or different use. Additionally, the material 
increase in value standard has been renamed the ``betterment'' standard 
because the betterment standard more closely reflects the manner in 
which section 263(a) has been interpreted and applied under current 
law. Therefore, these new proposed regulations identify three 
categories of costs that result in an improvement to property. 
Taxpayers under the new proposed regulations must capitalize amounts 
paid that:
    (i) Result in a betterment to a unit of property;
    (ii) Restore a unit of property; or
    (ii) Adapt a unit of property to a new or different use.
    These new proposed regulations continue to include rules for 
defining the unit of property to be used in making these 
determinations.
    The 2006 proposed regulations did 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). Commentators requested that the regulations specifically 
state that the plan of rehabilitation doctrine either is eradicated or 
is limited to clearly defined circumstances.
    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. See section 263A(b), which states 
that section 263A applies to real or tangible property produced by the 
taxpayer, and section 263A(g)(1), which states that the definition of 
``produce'' includes improve. See also Sec.  1.263A-1(e), which 
requires the capitalization of direct costs and of all indirect costs 
that directly benefit or are incurred by reason of the performance of 
production activities. Section 263A, therefore, requires a taxpayer to 
capitalize otherwise deductible repair costs as part of an improvement 
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. Thus, section 263A has eliminated the 
need for a plan of rehabilitation doctrine to determine the allocable 
costs that must be capitalized as part of an improvement. Although some 
commentators requested that the circumstances in which otherwise 
deductible repair costs must be capitalized as part of an improvement 
be limited, for example, to property that is totally dysfunctional and 
unsuitable for its intended purpose, there is no authority for doing so 
because section 263A specifically applies to improvements. The 
legislative history to the Tax Reform Act of 1986, Public Law 99-514 
(100 Stat. 2085) also indicates that Congress intended section 263A to 
apply to improvements to property. See, for example, S. Rep. No. 99-
313, 99th Cong., 2d Sess. 133-152 (1986), which states that the uniform 
capitalization rules will apply to assets or improvements to assets 
constructed by a taxpayer for its own use in a trade or business or in 
an activity engaged in for profit, and that the rules are not intended 
to apply to expenditures properly treated as repair costs under present 
law that do not relate to the manufacture, remanufacture, or production 
of property.
    Section 263A does not require otherwise deductible repair costs to 
be capitalized if the repairs do not directly benefit or are not 
incurred by reason of a production activity (for example, an 
improvement). The judicially-created plan of rehabilitation doctrine, 
however, has been cited to require capitalization of 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 even though the property is not improved. As stated in the 
preamble to the 2006 proposed regulations, the IRS and Treasury 
Department do not think this characterization is appropriate. These new 
proposed regulations specifically 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). These new proposed regulations do not 
prescribe a plan of rehabilitation doctrine. Therefore, when these new 
proposed regulations are finalized, the judicially-created plan of 
rehabilitation doctrine will be obsolete, particularly with regard to 
the assertion that the doctrine transforms otherwise deductible repair 
costs into capital improvement costs solely because the repairs are 
performed at the same time as an improvement, or are pursuant to a 
maintenance plan, even though the repairs do not improve the property 
under Sec.  1.263(a)-3. However, section 263A continues to require a 
taxpayer to capitalize otherwise deductible repair costs 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.

A. Unit of Property

    The 2006 proposed regulations began with an initial unit of 
property determination of all components that are functionally 
interdependent to define the largest unit of property as a starting 
point for the analysis. Special rules applied to buildings and their 
structural components and to property used in certain regulated 
industries; network assets were excluded from the definition of unit of 
property. The unit of property determination for other personal 
property employed a facts and circumstances test based on the 
application of four exclusive factors--(1) marketplace treatment; (2) 
industry practice and financial accounting; (3) treatment as a rotable 
spare part; and (4) functional use. An overriding rule required 
taxpayers to treat property as a unit of property for purposes of 
section 263 if the taxpayer did so for any other Federal income tax 
purpose.
    The IRS and Treasury Department received multiple comments on the 
definition of a unit of property provided in the 2006 proposed 
regulations. The commentators generally expressed dissatisfaction with 
the unit of property rules provided in the 2006 proposed regulations, 
particularly with respect to the regulated industry rules and the rule 
for rotable spare parts. Commentators generally agreed with the unit of 
property rules for a building, but raised

[[Page 12843]]

objections that the remaining rules provided in the 2006 proposed 
regulations were overly complex and ambiguous. Many commentators 
recommended that the determination of a unit of property be based 
primarily on the functional interdependence test, similar to that used 
for depreciation and section 263A purposes, with no further factors, 
while other commentators recommended that the determination be based on 
the factors used in FedEx Corp. v. United States, 291 F. Supp. 2d 699 
(W.D. Tenn. 2003), aff'd, 412 F.3d 617 (6th Cir. 2005).
    The IRS and Treasury Department think that most of the factors 
listed in the 2006 proposed regulations were the same as the factors 
used in FedEx. However, commentators generally criticized the manner in 
which the 2006 proposed regulations applied these factors. Nonetheless, 
the IRS and Treasury Department agree that some factors, such as the 
rotable spare parts factor, may be overly burdensome, particularly for 
taxpayers that use small components in their businesses. Additionally, 
although some taxpayers in regulated industries favored the ability to 
conform to regulatory reporting, many that are not subject to 
regulatory accounting for all assets objected to the conformity rule as 
inappropriate and a potential source for uncertainty and controversy. 
Therefore, these new proposed regulations substantially modify the unit 
of property definition contained in the 2006 proposed regulations.
    These new proposed regulations provide unit of property rules that 
generally are based on the functional interdependence standard, and 
include special rules for buildings, plant property, and network 
assets. Additional rules are provided that may require a smaller unit 
of property characterization in certain circumstances. Generally, 
improvements to a unit of property are not considered separate units of 
property even though the improvements are treated as separate assets 
for depreciation purposes.
    These new proposed regulations generally provide the same rule for 
buildings as the 2006 proposed regulations. A building and its 
structural components are treated as a single unit of property. 
However, a special rule for condominiums and cooperatives is provided. 
Additionally, a leasehold improvement that is section 1250 property and 
is made by a lessee is a separate unit of property.
    For property other than a building, these new proposed regulations 
provide that, in general, a single unit of property includes all 
components that are functionally interdependent. However, a number of 
special rules are provided that may require a smaller unit of property 
to be considered. The IRS and Treasury Department do not think that 
applying solely a functional interdependence test results in the 
appropriate unit for all types of property. For some types of property, 
such as machinery and equipment in a manufacturing plant, the 
functional interdependence test often results in a very expansive unit 
of property. The IRS and Treasury Department think it is inappropriate 
to use such a large unit of property for making a determination 
regarding improvements.
    These new proposed regulations provide a special rule for plant 
property, which is defined as ``functionally interdependent machinery 
or equipment * * * used to perform an industrial process * * *.'' This 
definition is not intended to include all types of property used in a 
taxpayer's trade or business, but is intended only to capture the 
functionally interdependent machinery and equipment used in industrial 
processes like manufacturing, electric generation, distribution, 
warehousing, as well as equipment used in providing industrial services 
such as automated materials handling equipment. This special rule 
requires that the functionally interdependent machinery and equipment 
be separated into a component or a group of components that performs a 
discrete and major function or operation. These new proposed 
regulations provide various examples to illustrate activities that will 
constitute a discrete and major function.
    These new proposed regulations provide the same definition of 
network assets as the 2006 proposed regulations and continue to reserve 
on providing a special rule for network assets. The IRS and Treasury 
Department think that in many situations, the unit of property for 
network assets should be smaller than the unit of property determined 
under the functional interdependence test. The IRS and Treasury 
Department generally think that the unit of property rules for network 
assets should be addressed on an industry by industry basis in Internal 
Revenue Bulletin guidance. Industries are invited to submit requests 
for guidance under the Industry Issue Resolution (IIR) program after 
these regulations are finalized.
    These new proposed regulations also provide two additional rules 
that may require a smaller unit of property determination than that 
provided under the general rule. The first rule is triggered if the 
taxpayer has assigned different economic useful lives for financial 
statement or regulatory purposes to components of a single unit of 
property at the time the unit of property is placed in service by the 
taxpayer. Simply accounting for components separately (for example, 
recording the property separately in depreciation or other asset-
tracking books and records) does not trigger this rule. However, 
assigning a different economic useful life to components will require 
that the unit of property determination be limited to those components 
that have been assigned the same useful life for financial statement 
purposes. The second rule applies when components of a single unit of 
property are depreciated by the taxpayer under different MACRS classes 
(including a different MACRS class that results from a change in method 
of accounting). This second rule also applies if components of a single 
unit of property are depreciated by the taxpayer using different 
recovery methods (for example, double-declining balance versus unit-of-
production). Again, simply recording various components separately in 
the taxpayer's depreciation books and records will not trigger the 
rule.
    These rules are intended to prevent overly broad unit of property 
determinations that are inconsistent with the taxpayer's 
characterization of the unit of property for depreciation purposes. In 
general, the IRS and Treasury Department anticipate that these limiting 
rules will apply only in unique circumstances. The IRS and Treasury 
Department encourage taxpayers to provide comments on the application 
of these limiting rules and to identify situations (if any) in which 
the limiting rules may not operate as intended.

B. Routine Maintenance Safe Harbor

    The 2006 proposed regulations did not contain a routine maintenance 
safe harbor. Various commentators requested that the regulations 
provide guidance to clarify when the cost of a routine maintenance 
activity will be considered a deductible expense. In addition, 
commentators expressed concern that under the rules provided in the 
2006 proposed regulations, routine maintenance activities are required 
to be capitalized if performed near the end of the economic useful life 
of the property, regardless that identical activities were considered 
deductible if performed earlier in the useful life.
    To address this concern, these new proposed regulations provide a 
routine maintenance safe harbor under which qualifying activities will 
be deemed to not improve the unit of property. Under

[[Page 12844]]

this safe harbor, routine maintenance activities include recurring 
activities that a taxpayer expects to perform more than once over the 
class life of the unit of property as a result of the taxpayer's use of 
the unit of property to keep the unit of property in its ordinarily 
efficient operating condition. Amounts paid for betterments do not keep 
the unit of property in an ordinarily efficient operating condition; 
however, the replacement of minor parts with improved but comparable 
parts generally does not result in a betterment. Thus, for example, the 
safe harbor includes amounts paid for replacement parts that the 
taxpayer expects to replace more than once during the class life of the 
unit of property, even if the replacement part is an improved but 
comparable part. As part of the safe harbor provisions, these new 
proposed regulations provide a list of relevant considerations to be 
taken into account in determining whether an amount is paid for routine 
maintenance. These considerations include the recurring nature of the 
activity, industry practice, manufacturer recommendations, taxpayer 
experience and the treatment of the activity on the taxpayer's AFS. The 
safe harbor maintenance rule specifically applies to maintenance 
activities performed on rotable or temporary spare parts, but reminds 
taxpayers that under the rules proposed in Sec.  1.162-3(b) of these 
new proposed regulations, the capitalized costs associated with rotable 
and temporary spare parts (that is, acquisition costs) may be deducted 
only in the taxable year in which the rotable or temporary spare part 
is discarded.
    One concern with establishing a maintenance safe harbor that 
includes the costs of replacement parts is creating an incentive for 
taxpayers to componentize assets in an effort to recover basis upon the 
removal of a component while deducting the replacement cost as a repair 
or maintenance expense. Therefore, the safe harbor does not apply to 
the cost of replacement components in situations in which the taxpayer 
has taken into account the basis of the component being replaced in 
determining gain or loss resulting from a sale or exchange of the 
replacement component, has taken a loss related to the retirement of 
the component, or has taken a basis adjustment related to a casualty 
event under section 165.
    The safe harbor is intended to operate only as a safe harbor in 
which qualifying costs will be deemed not to constitute an improvement. 
The IRS and Treasury Department recognize that many activities that do 
not qualify for the safe harbor nonetheless may be activities that do 
not give rise to capitalization of costs under section 263(a). 
Additionally, costs deductible under the maintenance safe harbor may be 
required to be capitalized under section 263A to other property 
produced or acquired for resale.

C. Betterments

1. Overview
    The 2006 proposed regulations used the term ``material increase in 
value'' to generally describe the concept of a betterment. In general, 
commentators agreed with the standards outlined in the 2006 proposed 
regulations to determine whether an amount paid materially increases 
the value of property. However, commentators differed on whether 
taxpayers should be allowed to override the material increase in value 
test by proving that the activity did not actually increase fair market 
value. Consistent with the preamble to the 2006 proposed regulations, 
the IRS and Treasury Department continue to think that whether an 
amount paid should be capitalized as a betterment to a unit of property 
depends upon the purpose, the physical nature, and the effect of the 
work for which the amounts were paid, and not upon an analysis of the 
fair market value of the property before and after the work. Therefore, 
to clarify this distinction, these new proposed regulations change the 
name of the material increase in value test to the betterment test. The 
general rule focuses on betterments to the condition of the property, 
the costs of which should be capitalized as an improvement if the 
betterment is material, regardless of whether the betterment increases 
the fair market value.
    Commentators noted that the general concept of a betterment is 
difficult to apply and suggested that the language in the regulations 
better define what types of events would give rise to a betterment. 
Additionally, commentators pointed out that some of the betterment 
tests were redundant. The IRS and Treasury Department agree that the 
general concept of a betterment or improvement can be difficult to 
apply. In developing these new proposed regulations, consideration was 
given to retaining the rules provided in the current regulations 
without providing clarification of material increase in value, prolong 
useful life, and new or different use. The principal concern in 
providing detailed rules on the concept of an improvement is the 
potential to create controversy in areas where none currently exists, 
which would undermine one of the primary purposes of the project.
    Nonetheless, because commentators generally did not oppose the 
tests provided for material increase in value under the 2006 proposed 
regulations, these new proposed regulations continue to provide an 
exclusive list of tests that determine whether an amount paid results 
in a betterment in an attempt to further solicit comments in this area. 
The IRS and Treasury Department specifically request comments as to 
whether the exclusive list of tests with respect to improvements 
provides additional certainty in this area and if not, why. Given the 
continuing evaluation of this area, taxpayers should be particularly 
aware that no reliance should be placed on the rules provided in these 
new proposed regulations until such rules are finalized.
    The tests included in the original proposed regulations have been 
reorganized in these new proposed regulations in an attempt to provide 
additional clarification. Under these new proposed regulations, an 
amount paid results in a betterment if it:
    (i) Ameliorates a material condition or material defect that 
existed prior to the acquisition or arose during the production of the 
property,
    (ii) Results in a material addition to the unit of property 
(including a physical enlargement, expansion, or extension), or
    (iii) Results in a material increase in the capacity, productivity, 
efficiency, strength, or quality of the unit of property or its output.
2. Ameliorates a Material Condition or Defect
    This rule generally follows the rule contained in the 2006 proposed 
regulations but clarifies, in response to comments received, that 
capitalization is only required to the extent the condition or defect 
is considered material. Commentators noted that a taxpayer may not know 
of a condition or defect that exists at the time property is acquired 
and that requiring capitalization of costs in this situation would 
create a hardship for those taxpayers. Although taxpayers may not be 
aware of defects that exist at the time of acquisition, the remedial 
activity being performed necessarily results in a betterment, 
regardless of whether the activity actually increases the fair market 
value of the property. The rule provided in these proposed regulations 
is consistent with established case law. See United Dairy Farmers, Inc. 
v. United States, 267 F.3d 510 (6th Cir. 2001);

[[Page 12845]]

Dominion Resources, Inc. v. United States, 219 F.3d 359 (4th Cir. 
2000).
    Moreover, adopting a rule based on a taxpayer's knowledge at the 
time of acquisition or production would be difficult to administer. The 
IRS and Treasury Department recognize that application of this rule to 
used property acquired by a taxpayer will result in some costs that 
would otherwise be deductible as repair costs being capitalized the 
first time the repairs are performed (if the condition or defect is 
material) if the nature of the activities is to correct the effects of 
wear and tear that was not caused by the taxpayer's use of the 
property. This result is consistent with the routine maintenance safe 
harbor, which requires the activities under that safe harbor to be 
performed as a result of the taxpayer's own use of the property.
    The IRS and Treasury Department understand that certain cases exist 
in which a taxpayer contaminates property during its operations, the 
taxpayer disposes of the property, and the taxpayer reacquires the 
property to clean up the contamination. Under the proposed rule, a 
taxpayer would be required to capitalize the costs incurred to clean up 
the property even though it was the taxpayer's own activities that 
contaminated the property. The IRS and Treasury Department request 
comments regarding the appropriate treatment of environmental 
remediation costs in these circumstances, considering that the 
remediation is performed as a result of the taxpayer's own use of the 
property. The IRS and Treasury Department also request comments 
regarding how to determine whether the contamination was due solely to 
the taxpayer's prior operations or, if an interim owner may have added 
to the contamination, how to determine the appropriate treatment of 
remediation costs in that circumstance.
3. Results in a Material Increase in the Capacity, etc.
    This rule applies both to material increases in the capacity, 
efficiency, strength, or quality of the unit of property itself as well 
as to material increases in the capacity, efficiency, strength, or 
quality of the output of the unit of property.
4. Application of Betterments Rule
    Commentators requested that, to the extent possible, additional 
guidance be provided with respect to how the betterments rules, 
including materiality, should be applied. The IRS and Treasury 
Department considered various possible bright-line rules with respect 
to materiality, but determined that each rule was inappropriate under 
certain circumstances. For example, the IRS and Treasury Department 
considered a rule that presumed materiality if the amounts paid are 
capitalized in the taxpayer's financial statements as a permanent 
improvement, that is, the betterment is capitalized in the taxpayer's 
financial statements over the remaining economic useful life of the 
unit of property or longer. The IRS and Treasury Department think that 
financial statement treatment is an important factor in determining 
materiality, because if the activity is material enough to treat as an 
improvement for financial statements, then generally it should be a 
material improvement for tax purposes. However, this bright-line rule 
was not adopted because the IRS and Treasury Department recognize that 
the standards used for financial statement purposes for capitalization 
of improvements do not coincide with the rules for capitalization of 
improvements in these proposed regulations. For example, some taxpayers 
may defer major maintenance expenses and amortize the expenses over the 
period until the next maintenance cycle rather than immediately 
expensing the costs for financial statement purposes. The taxpayer's 
reason for not immediately expensing the cost for financial statement 
purposes (that is, treating the cost as a deferred expense or as a 
material capital expenditure) may not be readily apparent to the IRS, 
creating administrative burden and a potential source of controversy. 
Therefore, under these new proposed regulations, materiality will be 
based upon the facts and circumstances in each case. Examples are 
provided to illustrate to the application of materiality.
5. Appropriate Comparison for Betterments
    The 2006 proposed regulations specifically provided that the 
appropriate comparison for determining whether an amount paid results 
in a betterment is made by comparing the condition of the unit of 
property immediately after the expenditure with the condition of the 
property prior to the circumstances necessitating the expenditure. 
These new proposed regulations retain the same comparison test.

D. Restorations

1. Overview
    The 2006 proposed regulations provided that, consistent with 
section 263(a)(2), a taxpayer must capitalize amounts paid that restore 
a unit of property. The 2006 proposed regulations provided that amounts 
paid restore a unit of property only if they substantially prolong the 
economic useful life of the unit of property, and provided four rules 
for making that determination. The restoration of property rules 
contained in the 2006 proposed regulations were criticized by 
commentators as being overbroad and difficult to apply. In particular, 
the AFS definition of economic useful life and the bright-line one-year 
rule were denounced as providing inappropriate results. In response, 
these new proposed regulations make numerous modifications to the 2006 
proposed regulations.
    These new proposed regulations continue to require a taxpayer to 
capitalize amounts paid to restore a unit of property. However, the 
one-year rule and the AFS conformity requirement for economic useful 
life have been removed. These new proposed regulations provide a series 
of bright-line rules to determine when an amount paid is deemed to 
restore property. Although some commentators criticized rules that deem 
the cost of certain activities to be capitalized as restorations, the 
IRS and Treasury Department think that bright lines under this test 
will reduce controversy and help ease administration. These rules also 
expand on the rules provided in the 2006 proposed regulations with 
regard to the restoration of property after a casualty loss.
    Section 263(a)(2) states that no deduction is allowed for any 
amount paid in restoring property or in making good the exhaustion 
thereof for which an allowance is or has been made. The IRS and 
Treasury Department think that this language requires capitalization of 
a replacement component if the taxpayer removes the basis of the 
replaced component from its books and records and takes the basis of 
the replaced component into account in its tax return. If a taxpayer 
takes into account the basis of a replaced component in its tax return, 
then the replacement of that component ``makes good the exhaustion 
thereof for which an allowance has been made.'' Therefore, these new 
proposed regulations provide that if the taxpayer has properly taken a 
portion of the existing adjusted basis of the restored asset into 
account in the computation of gain or loss on a sale or exchange, or as 
a retirement loss or other loss under the Code, the replacement of that 
component will be deemed to restore the unit of property.

[[Page 12846]]

2. Restoration of Property Destroyed In a Casualty
    The 2006 proposed regulations required a taxpayer to capitalize 
amounts paid to repair property if the taxpayer properly deducted a 
casualty loss under section 165 with respect to a 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. The casualty loss rule 
provided in the 2006 proposed regulations was criticized. In general, 
commentators thought there should be no link between the recognition of 
a casualty loss under section 165 and the determination of whether the 
cost to replace the property destroyed (in part or in whole) after a 
casualty event constitutes a capital expenditure. However, significant 
authority implies that a casualty-type event generally may only be 
characterized either as an extraordinary event (thus giving rise to a 
``loss'' under section 165), or as an ordinary and necessary event in 
the operation of a trade or business (thus giving rise to an ordinary 
and necessary deduction under section 162). See, e.g., R. R. Hensler, 
Inc. v. Commissioner, 73 T.C. 168, 179 (1979), acq., (1980-2 CB 1); 
Hubinger v. Commissioner, 36 F.2d 724, 726 (2d Cir. 1929), cert. 
denied, 281 U.S. 741 (1930). Thus, a casualty is not an ordinary event, 
and the cost to repair property damaged by a casualty is not an 
ordinary expense. Stated differently, a loss under section 165 
represents a destruction of property necessitating a replacement, which 
is capital, while an ordinary event generally represents damage to 
property necessitating a repair, which may or may not be capital. 
Because the restoration cost resulting from a loss is not ordinary, it 
is not allowed as an ordinary and necessary expense under section 162, 
but is treated as a capital expenditure under section 263(a). Although 
it is clear that a casualty event generally results in two economic 
costs to the taxpayer (the destruction of the previously invested 
capital and the costs to replace the destruction), the event giving 
rise to both of these costs is the same.
    These new proposed regulations generally require consistent 
characterization of all costs arising from a single event. Therefore, 
under the rules provided in these new proposed regulations, a taxpayer 
that experiences an extraordinary loss event sufficiently destructive 
to invoke the provisions of section 165 will be required to treat the 
resulting restoration costs as a capitalized replacement of the 
destroyed property. This rule is required to ensure consistency in tax 
treatment among similarly situated taxpayers. For example, a taxpayer 
whose property is completely destroyed by a casualty event is required 
to capitalize the restoration of the loss because the restoration 
results in the replacement of the destroyed property with an entirely 
new unit of property. However, without a consistency rule, a taxpayer 
who experiences the same casualty event but only has part of a unit of 
property destroyed might argue that the cost to replace the destroyed 
portion of the unit of property is deductible because it simply returns 
the unit of property as a whole to its pre-casualty state. Allowing 
this type of disparity in tax treatment would provide an incentive to 
characterize destructions of property as partial destructions in order 
to leave open the position that a deduction may be taken for both the 
destruction of property resulting from the casualty event, as well as 
the ordinary and necessary expense of replacing the destroyed property. 
This rule also eliminates the dual characterization of minor costs 
incurred for items such as broken windows or blown-off shingles as both 
a casualty loss under section 165 and an ordinary and necessary expense 
under section 162.
    Commentators noted that a rule requiring the capitalization of 
restoration costs following the recognition of a casualty loss would 
unfairly burden taxpayers that routinely experience extraordinary loss 
events in their trade or business. However, it should be noted that 
under these new proposed regulations, capitalization is required only 
if a loss or basis adjustment to the property is recognized by the 
taxpayer with respect to the event.
    Various judicial authorities have held that events that generally 
are viewed as extraordinary loss events may nonetheless be considered 
ordinary occurrences in a particular industry. See Atlantic Greyhound 
Corp. v. United States, 111 F. Supp. 953 (Ct. Cl. 1953). In this 
situation, the costs to replace property destroyed in what would 
normally be characterized as a casualty event may result in an ordinary 
and necessary expenditure under section 162 rather than a loss under 
section 165. In this regard, the IRS and Treasury Department will 
consider providing guidance on what types of events may be considered 
ordinary in a particular industry. Taxpayers are encouraged to provide 
comments on this issue.
    Commentators also noted that the rule provided in the 2006 proposed 
regulations created a disparity between taxpayers that recognized a 
loss under section 165 and taxpayers that received untaxed insurance 
proceeds as a result of a casualty event and adjusted the basis of the 
damaged asset accordingly. These new proposed regulations eliminate 
this disparity.
3. Other Restorations
    Similar to the 2006 proposed regulations, these new proposed 
regulations provide additional circumstances in which a restoration is 
deemed to occur. Capitalization is required for amounts paid to return 
a unit of property to its ordinarily efficient operating condition if 
the property has deteriorated to a state of disrepair and can no longer 
function for its intended purpose. The IRS and Treasury Department 
anticipate that these types of restorations will occur either as a 
result of lack of maintenance by the taxpayer or after the end of the 
property's useful life. A unit of property that is damaged by a 
casualty is not considered to be deteriorated to a state of disrepair.
    These new proposed regulations also require capitalization of 
amounts paid to rebuild a unit of property to a like-new condition 
after the end of its economic useful life. The IRS and Treasury 
Department anticipate that this standard will apply to the traditional 
rebuilding of a unit of property to return it to a like-new condition. 
In general, a restoration under this rule will not result from routine 
maintenance activities, even if performed near the end of the useful 
life of the property, but instead represents a fundamental renewal of 
the economic useful life of the asset.
    Similar to the 2006 proposed regulations, the new proposed 
regulations require capitalization of amounts paid to replace a major 
component or substantial structural part of a unit of property. In 
response to comments regarding the uncertainty in applying this 
standard, these new proposed regulations define the term ``major 
component or substantial structural part.'' Specifically, these new 
proposed regulations provide that the replacement of a major component 
or substantial structural part will be deemed to occur only if (a) the 
replacement costs constitute 50 percent or more of the replacement cost 
of the unit of property or (b) the replacement part or parts constitute 
50 percent or more of the physical structure of the unit of property. 
These 50 percent thresholds apply solely for purposes of the 
restoration rules and are not intended to be applied to the betterment 
or new or different use rules.

[[Page 12847]]

E. New or Different Use

    In general, these new proposed regulations contain the rules set 
forth in the 2006 proposed regulations with respect to the 
capitalization of amounts paid to adapt property to a new or different 
use. However, these new proposed regulations remove the parenthetical 
contained in the 2006 proposed regulations relating to ``structural 
alterations to the unit of property.'' Commentators noted that, 
although permanent structural alterations may result in adapting 
property to a new or different use, those alterations also could result 
in betterments to the unit of property and, in certain circumstances, 
could constitute routine maintenance. Commentators also noted that 
adapting property to a new or different use does not necessarily make 
the property better or increase its value, but nevertheless is a 
capital expenditure. Therefore, the new or different use rules are 
provided separately from the betterment rules in these new proposed 
regulations.
    These new proposed regulations also clarify that amounts paid will 
be deemed to adapt property to a new or different use only if the new 
use is not consistent with the taxpayer's intended use of the property 
at the time the property is placed in service by the taxpayer. 
Additional examples have been added to clarify the application of this 
rule.

F. Repair Allowance

    The 2006 proposed regulations provided a repair allowance similar 
to the CLADR repair allowance, but did not specify different repair 
allowance percentages for different industries. Commentators generally 
favored the idea of a repair allowance; however, they widely criticized 
the lack of percentages tailored to specific industries. Some 
commentators in regulated industries requested that they be allowed to 
determine their deductible repair costs and their capital improvement 
costs for tax purposes based on conformity with regulatory accounting 
reporting.
    These new proposed regulations adopt the request by certain 
regulated industries to conform the tax treatment of amounts paid to 
maintain, repair, or improve tangible property to their regulatory 
accounting treatment. An optional regulatory accounting method is 
proposed for amounts paid to maintain, repair, or improve tangible 
property subject to regulatory accounting. For purposes of this method, 
regulated accounting industries include industries regulated by the 
Federal Energy Regulatory Commission (FERC), the Federal Communications 
Commission (FCC), and the Surface Transportation Board (STB). The IRS 
and Treasury Department recognize that conformity with the regulatory 
accounting rules in these industries frequently may result in the 
overcapitalization of costs, and sometimes the undercapitalization of 
costs, as compared to the general rules for improvements under these 
new proposed regulations. The regulatory accounting method is not 
intended to be used as a definitive test of what should be capitalized 
for taxpayers that do not elect to use the method.
    These new proposed regulations do not propose a detailed repair 
allowance like the one that was provided in the 2006 proposed 
regulations. Some commentators stated that very large taxpayers will 
want to have a repair allowance, because applying the general rules 
asset-by-asset is too burdensome because of their numerous assets. The 
commentators made clear, however, that taxpayers would not widely use a 
one-size-fits-all approach and that any repair allowance must be 
tailored to individual industries. Therefore, these new proposed 
regulations provide authority for issuing industry-specific repair 
allowance guidance in the future.

IX. Accounting Method Changes

    These new proposed regulations do not provide any specific rules 
for changes in method of accounting. Because these proposed regulations 
are not effective until they are published as final regulations, 
taxpayers may not change their accounting method to conform to a method 
of accounting provided in these proposed regulations. Generally, a 
taxpayer's treatment of an amount paid to conform with these proposed 
regulations will be a change in method of accounting under section 
446(e). For example, a change to the routine maintenance safe harbor in 
Sec.  1.263(a)-3(e) of these proposed regulations or to the optional 
regulatory accounting method in Sec.  1.263(a)-3(i) of these proposed 
regulations is a change in method of accounting. The IRS and Treasury 
Department request comments on whether a change to or from the use of 
the de minimis rule in Sec.  1.263(a)-2(d)(4) of these proposed 
regulations is a change in method of accounting under section 446(e).

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 these new 
proposed regulations until the rules are published as final regulations 
in the Federal Register.

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), 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 June 24, 2008, at 10 a.m. 
in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue, 
NW., Washington, DC. Due to building security procedures, visitors must 
enter at the Constitution Avenue 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 by June 9, 2008 and an outline of the topics to be 
discussed and

[[Page 12848]]

the time to be devoted to each topic (signed original and eight (8) 
copies) by June 3, 2008. 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 Merrill D. Feldstein, 
Office of the Associate Chief Counsel (Income Tax and Accounting). 
However, other personnel from the IRS and Treasury Department 
participated in their development.

Withdrawal of Proposed Amendments to the Regulations

    Accordingly, under the authority of 26 U.S.C. 7805, the notice of 
proposed rulemaking (REG-168745-03) published in the Federal Register 
on August 21, 2006, (71 FR 161) is withdrawn.

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 1.162-3 is revised to read as follows:


Sec.  1.162-3  Materials and supplies.

    (a) In general--(1) Non-incidental materials and supplies. Amounts 
paid to acquire or produce materials and supplies are deductible in the 
taxable year in which the materials and supplies are used or consumed 
in the taxpayer's operations.
    (2) Incidental materials and supplies. Amounts paid to acquire or 
produce incidental materials and supplies that are carried on hand and 
for which no record of consumption is kept or physical inventories at 
the beginning and end of the year are not taken, are deductible in the 
taxable year in which these amounts are paid, provided taxable income 
is clearly reflected.
    (b) Rotable and temporary spare parts. For purposes of this 
section, rotable spare parts are parts that are removable from the unit 
of property, generally repaired or improved, and either reinstalled on 
other property, or stored for later installation. Temporary spare parts 
are parts that are used temporarily until a new or repaired part can be 
installed, and then removed and stored for later (emergency or 
temporary) installation. For purposes of paragraph (a)(1) of this 
section, rotable and temporary spare parts are used or consumed in the 
taxpayer's business in the taxable year in which the taxpayer disposes 
of the parts.
    (c) Coordination with other provisions of the Internal Revenue 
Code. Nothing in this section changes the treatment of any amount that 
is specifically provided for under any provision of the Internal 
Revenue Code (Code) or regulations other than section 162(a) or section 
212 and the regulations under those sections. For example, see section 
Sec.  1.263(a)-3, which requires taxpayers to capitalize amounts paid 
to improve units of property and section 263A and the regulations under 
section 263A, which require taxpayers to capitalize the direct and 
allocable indirect costs, including the cost of materials and supplies, 
to property produced or to property acquired for resale.
    (d) Definitions--(1) Materials and supplies. For purposes of this 
section, materials and supplies means tangible property that is used or 
consumed in the taxpayer's operations and that--
    (i) Is not a unit of property (as determined under Sec.  1.263(a)-
3(d)(2)) and is not acquired as part of a single unit of property; or
    (ii) Is a unit of property (as determined under Sec.  1.263(a)-
3(d)(2)) that has an economic useful life of 12 months or less, 
beginning when the property is used or consumed in the taxpayer's 
operations; or
    (iii) Is a unit of property (as determined under Sec.  1.263(a)-
3(d)(2)) that has an acquisition cost or production cost (as determined 
under section 263A) of $100 or less; or
    (iv) Is identified in published guidance in the Federal Register or 
in the Internal Revenue Bulletin (see Sec.  601.601(d)(2)(ii)(b) of 
this chapter) as materials and supplies for which treatment is 
permitted under this section.
    (2) Economic useful life--(i) General rule. 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. See Sec.  1.167(a)-1(b) for the 
factors to be considered in determining this period.
    (ii) Taxpayers with an applicable financial statement. For 
taxpayers with an applicable financial statement (as defined in 
paragraph (d)(2)(iii) of this section), the economic useful life of a 
unit of property, solely for the purposes of applying the provisions of 
paragraph (d)(1)(ii) of this section, is the useful life initially used 
by the taxpayer for purposes of determining depreciation in its 
applicable financial statement, regardless of any salvage value of the 
property. If a taxpayer does not have an applicable financial statement 
for the taxable year in which the property was originally acquired or 
produced, the economic useful life of the unit of property must be 
determined under paragraph (d)(2)(i) 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 useful 
life of the property or if a taxpayer does not depreciate the unit of 
property on its applicable financial statement, the economic useful 
life of the unit of property must be determined under paragraph 
(d)(2)(i) 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 (d)(2)(i) of this section.
    (iii) Definition of applicable financial statement. The taxpayer's 
applicable financial statement is the taxpayer's financial statement 
listed in paragraphs (d)(2)(iii)(A) through (C) of this section that 
has the highest priority (including within paragraph (d)(2)(iii)(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

[[Page 12849]]

the Federal or a state government or any Federal or state agencies 
(other than the SEC or the Internal Revenue Service).
    (3) Amount paid. For purposes of this section, in the case of a 
taxpayer using an accrual method of accounting, the terms amount 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.
    (4) Produce. For purposes of this section, produce means construct, 
build, install, manufacture, develop, create, raise or grow. See also 
Sec.  1.263(a)-2(b)(4). This definition is intended to have the same 
meaning as the definition used for purposes of section 263A(g)(1) and 
Sec.  1.263A-2(a)(1)(i), except that improvements are excluded from the 
definition in this paragraph (d)(4) and are separately defined and 
addressed in Sec.  1.263(a)-3. Amounts paid to produce materials and 
supplies must be capitalized under section 263A.
    (e) Election to capitalize. A taxpayer may elect to treat as a 
capital expenditure the cost of any material or supply as defined in 
paragraph (d)(1) of this section, unless the material or supply is a 
component of a unit of property as described in paragraph (d)(1)(i) of 
this section, and the unit of property is a material or supply under 
paragraph (d)(1)(ii)-(iv) of this section, rather than a capital 
expenditure. An election made under this paragraph (e) applies to 
amounts paid during the taxable year to acquire or produce any material 
or supply to which paragraph (a) of this section would apply (but for 
the election under this paragraph (e)). A taxpayer makes the election 
by capitalizing the amounts paid to acquire or produce a material or 
supply in the taxable year the amounts are paid and by recovering the 
costs when the material or supply is placed in service by the taxpayer 
for the purposes of determining depreciation under the applicable Code 
and regulation provisions. A taxpayer must make this election in its 
timely filed original Federal income tax return (including extensions) 
for the taxable year the material or supply is placed in service by the 
taxpayer for purposes of determining depreciation. See Sec.  1.263(a)-2 
for the treatment of amounts paid to acquire or produce real or 
personal tangible property. 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 must be made for each material 
and/or supply. A taxpayer may revoke an election made under this 
paragraph (e) with respect to a material or supply only by filing a 
request for a private letter ruling and obtaining the Commissioner's 
consent to revoke the election. An election may not be made or revoked 
through the filing of an application for change in accounting method or 
by an amended Federal income tax return. A taxpayer that revokes an 
election may not re-elect to capitalize the material or supply for a 
period of at least 60 months, beginning with the taxable year of 
revocation.
    (f) Examples. The rules of this section are illustrated by the 
following examples, in which it is assumed (unless otherwise stated) 
that the property is not an incidental material or supply, that the 
taxpayer is a calendar year, accrual method taxpayer, and that the 
taxpayer has not elected to capitalize under paragraph (e) of this 
section.

    Example 1. Not a unit of property; component of personal 
property. X operates a fleet of aircraft. In 2008, X purchases a 
stock of spare parts, which it uses to maintain and repair its 
aircraft. The spare parts are not units of property as determined 
under Sec.  1.263(a)-3(d)(2) and are not rotable or temporary spare 
parts. In 2009, X uses the spare parts in a repair and maintenance 
activity that does not improve the property under Sec.  1.263(a)-3. 
Under paragraph (a)(1) of this section, the amounts paid for the 
spare parts are deductible as materials and supplies in 2009, the 
taxable year in which the spare parts are used to repair and 
maintain the aircraft.
    Example 2. Not a unit of property; rotable spare parts. X 
operates a fleet of specialized vehicles that it uses in its service 
business. At the time that it acquires a new type of vehicle, X also 
acquires a substantial number of rotable spare parts that will be 
kept on hand to quickly replace similar parts in X's vehicles as 
those parts break down or wear out. These rotable replacement parts 
are not units of property as determined under Sec.  1.263(a)-
3(d)(2), are removable from the vehicles, and are repaired or 
reconditioned, so that they can be reinstalled on the same or 
similar vehicles. In 2008, X acquires several vehicles and 
associated rotable spare parts. In 2009, X makes repairs to several 
vehicles by using these rotable spare parts to replace worn or 
damaged parts. In 2010, X removes these rotable spare parts from its 
vehicles, repairs them and reinstalls them on other similar 
vehicles. In 2012, X can no longer use the rotable parts it acquired 
in 2008 and disposes of them as scrap. Under paragraph (d)(1) of 
this section, the rotable spare parts acquired in 2008 are materials 
and supplies. However, under paragraph (b) of this section, these 
parts are not used or consumed until the taxable year in which X 
disposes of the parts. Therefore, under paragraph (a)(1) of this 
section, X may deduct the amounts paid for the rotable spare parts 
in 2012, the taxable year in which X disposes of the parts.
    Example 3. Not a unit of property; part of a single unit of real 
property. X owns an apartment building and discovers that a window 
in one of the apartments is broken. In 2008, X pays for the 
acquisition, delivery, and installation of a new window to replace 
the broken window. In the same year, the new window is installed. 
The window is not a unit of property as determined under Sec.  
1.263(a)-3(d)(2), and the replacement of the window does not improve 
the property under Sec.  1.263(a)-3. Under paragraph (a)(1) of this 
section, the amounts paid for the acquisition, delivery, and 
installation of the window are deductible as materials and supplies 
in 2008, the taxable year in which the window is installed in the 
apartment building.
    Example 4. Economic useful life of 12 months or less. X operates 
a fleet of aircraft that carries freight for its customers. X owns a 
storage tank on its premises, which can hold a one-month supply of 
jet fuel for its aircraft. On December 31, 2008, X purchases a one-
month supply of jet fuel. In 2009, X uses the jet fuel purchased on 
December 31, 2008, to fuel the aircraft used in its business. Under 
paragraph (a)(1) of this section, the amounts paid for the jet fuel 
are deductible as materials and supplies in 2009, the taxable year 
in which the jet fuel is used or consumed in the operation of X's 
aircraft.
    Example 5. Unit of property that costs $100 or less. X operates 
a rental business that rents out a variety of small individual items 
to customers (rental items). X maintains a supply of rental items on 
hand to replace worn or damaged items. In 2008, X purchases a large 
quantity of rental items to use in its rental business. Each of 
these rental items is a unit of property that costs $100 or less. In 
2009, X begins using all of the rental items purchased in 2008 by 
providing them to customers of its rental business. X does not sell 
or exchange these items on established retail markets at any time 
after the items are used in the rental business. Under paragraph 
(a)(1) of this section, the amounts paid for the rental items are 
deductible as materials and supplies in 2009, the taxable year in 
which the rental items are used in X's business.
    Example 6. Unit of property that costs $100 or less. X provides 
billing services to its customers. In 2008, X incurs costs to 
purchase 50 facsimile machines to be used by its employees. Each 
facsimile machine is a unit of property that costs less than $100. 
In 2008, X's employees begin using 35 of the facsimile machines, and 
X stores the remaining 15 machines for use in a later taxable year. 
Under paragraph (a)(1) of this section, the amounts paid for 35 of 
the facsimile machines are deductible as materials and supplies in 
2008, the taxable year in which X uses those machines. The amounts 
paid for each of the remaining 15 machines are deductible in the 
taxable year in which each machine is used.
    Example 7. Materials and supplies used in improvements; 
coordination with Sec.  1.263(a)-3. X owns various machines that are 
used in its business. In 2008, X purchases a supply of spare parts 
for its machines. The spare parts are not units of property as 
determined under Sec.  1.263(a)-3(d)(2) and are not rotable or 
temporary spare parts. The spare parts may be used by X in the 
repair or maintenance of a machine under Sec.  1.162-4 or in the 
improvement of a machine under

[[Page 12850]]

Sec.  1.263(a)-3. In 2009, X uses all of these spare parts in an 
activity that improves the unit of property under Sec.  1.263(a)-3. 
Under paragraph (d)(1)(i) of this section, the spare parts purchased 
by X in 2008 are materials and supplies. Under paragraph (a)(1) of 
this section, the amounts paid for the spare parts are otherwise 
deductible as materials and supplies in 2009, the taxable year in 
which X uses those parts. However, because these materials and 
supplies are used to improve X's property, X is required to 
capitalize the amounts paid for those spare parts under Sec.  
1.263(a)-3. See also section 263A requiring taxpayers to capitalize 
the direct and allocable indirect costs of property produced or 
acquired for resale.
    Example 8. Cost of producing materials and supplies; 
coordination with section 263A. X is a manufacturer that produces 
liquid waste as part of its operations. X determines that its 
current liquid waste disposal process is inadequate. To remedy the 
problem, in 2008, X constructs a leaching pit to provide a draining 
area for the liquid waste. The leaching pit has an economic useful 
life of less than 12 months, starting on the date that X begins to 
use the leaching pit as a draining area. At the end of this period, 
X's factory will be connected to the local sewer system. In 2009, X 
starts using the leaching pit in its operations. The amounts paid to 
construct the leaching pit (including the direct and allocable 
indirect costs of property produced under section 263A) are amounts 
paid for a material or supply under paragraph (d)(1)(ii) of this 
section. Under paragraph (a)(1) of this section, the amounts paid 
for the leaching pit are otherwise deductible as materials and 
supplies in 2009, the taxable year in which X uses the leaching pit. 
However, because the amounts paid to construct the leaching pit are 
incurred by reason of X's manufacturing operations, X is required to 
capitalize the amounts paid to construct the leaching pit to X's 
property produced. See Sec.  1.263A-1(e)(3)(ii)(E).
    Example 9. Costs of acquiring materials and supplies for 
production of property; coordination with section 263A. In 2008, X 
purchases jigs, dies, molds, and patterns for use in the manufacture 
of X's products. The economic useful life of each jig, die, mold, 
and pattern is 12 months or less, beginning when each item is used 
in the manufacturing process. X begins using the purchased items in 
2009 to manufacture its products. These items are materials and 
supplies under paragraph (d)(1)(ii) of this section. Under paragraph 
(a)(1) of this section, the amounts paid for the items are otherwise 
deductible as materials and supplies in 2009, the taxable year in 
which X uses those items. However, because the amounts paid for 
these materials and supplies directly benefit or are incurred by 
reason of the taxpayer's production activities, X is required to 
capitalize the amounts paid for these items to X's property 
produced. See Sec.  1.263A-1(e)(3)(ii)(E).
    Example 10. Election to capitalize. X operates a rental business 
that rents out a variety of items (rental items) to its customers, 
each of which is a separate unit of property as determined under 
Sec.  1.263(a)-3(d)(2). X does not sell or exchange these items on 
established retail markets at any time after the items are used in 
the rental business. In 2008, X incurs costs to purchase various 
rental items, all of which cost less than $100 or have an economic 
useful life of less than 12 months, beginning when used or consumed. 
X begins using the rental items in its business in 2008. Under 
paragraph (a)(1) of this section, the amounts paid for each rental 
item purchased in 2008 are deductible as a material or supply in the 
taxable year in which the item is used. However, for administrative 
reasons, X would prefer to treat all of its rental items as capital 
expenditures subject to depreciation. Under paragraph (e) of this 
section, X may elect not to apply the rule contained in paragraph 
(a)(1) of this section to the rental items. X makes this election by 
capitalizing the amounts paid for each rental item in the taxable 
year the costs are incurred and by beginning to recover the costs of 
each item on its timely filed Federal income tax return for the 
taxable year that the item is placed in service by X for purposes of 
determining depreciation under the applicable Code and regulation 
provisions. See Sec.  1.263(a)-2(e) for the treatment of capital 
expenditures.
    Example 11. Election to capitalize. X is an electric utility. In 
2008, X acquires certain temporary spare parts, which it keeps on 
hand to avoid operational time loss in the event it must make 
emergency repairs to a unit of property that is subject to 
depreciation. These parts are not units of property as determined 
under Sec.  1.263(a)-3(d)(2) and are not used to improve property 
under Sec.  1.263(a)-3(d)(1). These temporary spare parts are used 
until a new or repaired part can be installed, and then removed and 
stored for later emergency installation. Under paragraphs (a)(1) and 
(b) of this section, the amounts paid for the temporary spare parts 
are deductible as materials and supplies in the taxable year in 
which they are disposed of by the taxpayer. However, because it is 
unlikely that the temporary spare parts will be disposed of in the 
near future, X would prefer to treat the spare parts as capital 
expenditures subject to depreciation. Accordingly, X may elect under 
paragraph (e) of this section not to apply the rule contained in 
paragraph (a)(1) of this section to each of its temporary spare 
parts. X makes this election by capitalizing the amounts paid for 
each spare part in the taxable year the costs are incurred and by 
beginning to recover the costs of each part on its timely filed 
Federal income tax return for the taxable year that the part is 
placed in service by X for purposes of determining depreciation 
under the applicable Code and regulation provisions. See Sec.  
1.263(a)-2(e) for the treatment of capital expenditures and section 
263A requiring taxpayers to capitalize the direct and allocable 
indirect costs of property produced or acquired for resale.

    Par. 3. 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.


Sec.  1.162-6  [Removed]

    Par. 4. Section 1.162-6 is removed.
    Par. 5. Section 1.263(a)-0 is amended by revising the entries for 
Sec. Sec.  1.263(a)-1, 1.263(a)-2 and 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) Coordination with section 263A.
    (c) Examples of capital expenditures.
    (d) Amounts paid to sell property.
    (1) In general.
    (2) Treatment of capitalized amount.
    (3) Examples.
    (e) Amount paid.
    (f) [Reserved]
    (g) Effective/applicability date.


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 property.
    (i) In general.
    (ii) Examples.
    (3) Transaction costs.
    (i) In general.
    (ii) Scope of facilitate.
    (A) In general.
    (B) Inherently facilitative amounts.
    (C) Special rule for acquisitions of real property.
    (D) Employee compensation and overhead costs.
    (1) In general.
    (2) Election to capitalize.
    (iii) Treatment of transaction costs.
    (iv) Examples.
    (4) De minimis rule.
    (i) In general.
    (ii) Exceptions to de minimis rule.
    (iii) Safe harbor.
    (iv) Additional rules.
    (v) Election to capitalize.
    (vi) Definition of applicable financial statement.
    (vii) Examples.
    (e) Treatment of capital expenditures.
    (f) Recovery of capitalized amounts.
    (1) In general.
    (2) Examples.
    (g) [Reserved]
    (h) Effective/applicability date.


Sec.  1.263(a)-3  Amounts paid to improve tangible property.

    (a) Overview.

[[Page 12851]]

    (b) Definitions.
    (1) Amount paid.
    (2) Personal property.
    (3) Real property.
    (4) Applicable financial statement.
    (c) Coordination with other provisions of the Internal Revenue 
Code.
    (1) In general.
    (2) Example.
    (d) Improved property.
    (1) Capitalization rule.
    (2) Determining the unit of property.
    (i) In general.
    (ii) Building and structural components.
    (iii) Property other than buildings.
    (A) In general.
    (B) Plant property.
    (1) Definition.
    (2) Unit of property for plant property.
    (C) Network assets.
    (1) Definition.
    (2) [Reserved]
    (D) Additional rules.
    (iv) Examples.
    (3) Compliance with regulatory requirements.
    (4) Repairs and maintenance performed during an improvement.
    (i) In general.
    (ii) Exception for individuals.
    (5) Aggregate of related amounts.
    (e) Safe harbor for routine maintenance.
    (1) In general.
    (2) Exceptions.
    (3) Rotable or temporary spare parts.
    (4) Class life.
    (5) Examples.
    (f) Capitalization of betterments.
    (1) In general.
    (2) Application of general rule.
    (i) Facts and circumstances.
    (ii) Unavailability of replacement parts.
    (iii) Appropriate comparison.
    (A) In general.
    (B) Normal wear and tear.
    (C) Particular event.
    (3) Examples.
    (g) Capitalization of restorations.
    (1) In general.
    (2) Rebuild to like-new condition.
    (i) In general.
    (1) Like-new condition.
    (2) Economic useful life.
    (ii) Exception.
    (3) Replacement of a major component or substantial structural 
part.
    (i) In general.
    (ii) Exception.
    (4) Examples.
    (h) Capitalization of amounts to adapt property to a new or 
different use.
    (1) In general.
    (2) Examples.
    (i) Optional regulatory accounting method.
    (1) In general.
    (2) Eligibility for regulatory accounting method.
    (3) Description of regulatory accounting method.
    (4) [Reserved]
    (5) Examples.
    (j) Repair allowance.
    (k) Treatment of capital expenditures.
    (l) Recovery of capitalized amounts.
    (m) [Reserved]
    (n) Effective/applicability date.

    Par. 6. Section 1.263(a)-1 is 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 (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.
    (b) Coordination with section 263A. Section 263(a) generally 
requires taxpayers to capitalize an amount paid to acquire, produce, or 
improve real or personal tangible property. Section 263A generally 
prescribes the direct and indirect costs that must be capitalized to 
property produced or improved by the taxpayer and property acquired for 
resale.
    (c) Examples of capital expenditures. The following amounts paid 
are examples of capital expenditures:
    (1) An amount paid to acquire or produce real or personal tangible 
property. See Sec.  1.263(a)-2.
    (2) An amount paid to improve real or personal tangible 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 paid to acquire or create interests in land, such as 
easements, life estates, mineral interests, timber rights, zoning 
variances, or other interests in land.
    (6) 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.
    (7) 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.
    (d) Amounts paid to sell property--(1) In general. Except in the 
case of dealers in property, 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 (d)(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 (d):

    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 a trade or 
business. X owns a truck for use in X's trade or business. X decides 
to sell the truck and on November 15, 2008, X pays for an appraisal 
to determine a reasonable asking price. On February 15, 2009, X 
sells the truck to Y. X is required to capitalize in 2008 the amount 
paid to appraise 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 
appraise the truck. However, X may treat the amount paid to appraise 
the truck as a loss under section 165 in 2009 when the sale is 
abandoned.
    Example 5. Sales costs of personal property not used in a trade 
or business. Assume the same facts as in Example 3, except that X 
does not use the truck in X's trade or business, but instead uses it 
for personal purposes. X decides to sell the truck and on November 
15, 2008, X pays for an appraisal to determine a reasonable asking 
price. On February 15, 2009, X sells the truck to Y. X is required 
to capitalize in 2008 the amount

[[Page 12852]]

paid to appraise 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 
appraise the truck. Although the sale is abandoned in 2009, X may 
not treat the amount paid to appraise the truck 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.

    (e) Amount paid. In the case of a taxpayer using an accrual method 
of accounting, the terms amount 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.
    (f) [Reserved]
    (g) Effective/applicability 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.
    Par. 7. Section 1.263(a)-2 is revised to read as follows:


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 a unit of real or personal 
property. Paragraph (b) of this section contains definitions. Paragraph 
(c) of this section contains the rules for coordinating this section 
with other provisions of the Internal Revenue Code (Code). Paragraph 
(d) of this section provides the rules for determining the treatment of 
amounts paid to acquire or produce a unit of real or personal property, 
including amounts paid to defend or perfect title to real or personal 
property and amounts paid to facilitate the acquisition of property. 
Paragraph (d) also provides a de minimis rule.
    (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 amount 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 means tangible personal property as defined 
in Sec.  1.48-1(c).
    (3) Real property means land and improvements thereto, such as 
buildings or other inherently permanent structures (including items 
that are structural components of the buildings or structures) that are 
not personal property as defined in paragraph (b)(2) of this section. 
Any property that constitutes other tangible property under Sec.  1.48-
1(d) is treated as real property for purposes of this section. Local 
law is not controlling in determining whether property is real property 
for purposes of this section.
    (4) Produce means construct, build, install, manufacture, develop, 
create, raise, or grow. This definition is intended to have the same 
meaning as the definition used for purposes of section 263A(g)(1) and 
Sec.  1.263A-2(a)(1)(i), except that improvements are excluded from the 
definition in this paragraph (b)(4) and are separately defined and 
addressed in Sec.  1.263(a)-3.
    (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 
Code or regulations other than section 162(a) or section 212 and the 
regulations under those sections. For example, see section 263A 
requiring taxpayers to capitalize the direct and certain indirect costs 
of producing property or acquiring property for resale.
    (2) Materials and supplies. Nothing in this section changes the 
treatment of amounts paid to acquire or produce property that is 
properly treated as materials and supplies under Sec.  1.162-3.
    (d) Acquired or produced tangible property--(1) In general--(i) 
Requirement of capitalization. Except as provided in paragraph (d)(4) 
of this section (relating to the de minimis rule) and in Sec.  1.162-
3(d)(1)(ii), (iii), and (iv) (relating to certain materials and 
supplies), a taxpayer must capitalize amounts paid to acquire or 
produce a unit of real or personal property (as determined under Sec.  
1.263(a)-3(d)(2)), including leasehold improvement property, land and 
land improvements, buildings, machinery and equipment, and furniture 
and fixtures. Amounts paid to acquire or produce a unit of real or 
personal property include the invoice price, transaction costs as 
determined under paragraph (d)(3) of this section, and costs for work 
performed prior to the date that the unit of property is placed in 
service by the taxpayer (without regard to any applicable convention 
under section 168(d)). A taxpayer also must capitalize amounts paid to 
acquire real or personal property for resale and to produce real or 
personal property. See section 263A for the costs required to be 
capitalized to property produced by the taxpayer or to property 
acquired for resale.
    (ii) Examples. The rules of this section are illustrated by the 
following examples, in which it is assumed that the taxpayer does not 
apply the de minimis rule under paragraph (d)(4) of this section:

    Example 1. Acquisition of personal property. In 2008, X 
purchases new cash registers for use in its retail store located in 
leased space in a shopping mall. Assume each cash register is a unit 
of property as determined under Sec.  1.263(a)-3(d)(2), and is not a 
material or supply under Sec.  1.162-3. X must capitalize under this 
paragraph (d)(1) the amount paid to purchase each cash register.
    Example 2. Relocation of personal property. Assume the same 
facts as in Example 1, 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. X is not required to capitalize under this paragraph 
(d)(1) the $5,000 amount paid for moving the cash registers.
    Example 3. Acquisition of personal property that is not a unit 
of property; coordination with Sec.  1.162-3. X operates a fleet of 
aircraft. In 2008, X purchases a stock of spare parts, which it uses 
to maintain and repair its aircraft. Assume that the spare parts are 
not units of property as determined under Sec.  1.263(a)-3(d)(2). X 
does not make elections under Sec.  1.162-3(e) to treat the 
materials and supplies as capital expenditures. In 2009, X uses the 
spare parts in a repair and maintenance activity that does not 
improve the property under Sec.  1.263(a)-3. Because the parts are 
not units of property, X is not required to capitalize the amounts 
paid for the parts under this paragraph (d)(1). Rather, X must apply 
the rules in Sec.  1.162-3, governing the treatment of materials and 
supplies, to determine the treatment of these amounts.
    Example 4. Acquisition of unit of personal property; 
coordination with Sec.  1.162-3. X operates a rental business that 
rents out a variety of small individual items to customers (rental 
items). X maintains a supply of rental items on hand to replace worn 
or damaged items. In 2008, X purchases a large quantity of rental 
items to be used in its business. Assume that each of these items is 
a unit of property under Sec.  1.263(a)-3(d)(2) and that several of 
these rental items are materials and supplies under the definition 
provided in Sec.  1.162-3(d). Therefore, X must apply the rules in 
Sec.  1.162-3 to determine the treatment of the amounts paid to 
acquire rental items that are materials and supplies. Under this 
paragraph (d)(1), X must capitalize the amounts paid for the rental 
items that are units of property and do not otherwise qualify as 
materials and supplies under Sec.  1.162-3(d).
    Example 5. Acquisition or production cost. X purchases or 
produces jigs, dies, molds, and patterns for use in the manufacture 
of X's products. Assume that each of these items is a unit of 
property as determined under Sec.  1.263(a)-3(d)(2), and is not a 
material and supply under Sec.  1.162-3(d). X is required to

[[Page 12853]]

capitalize under this paragraph (d)(1) the amounts paid to produce 
or purchase the jigs, dies, molds, and patterns. See section 263A 
for the costs to be capitalized to property produced by X.
    Example 6. 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 7. 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 8. 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 costs to 
be capitalized to property acquired for resale.
    Example 9. 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 costs to be 
capitalized to property produced by X.
    Example 10. Production of building. X constructs a building. X 
must capitalize under this paragraph (d)(1) the amount paid to 
construct the building. See section 263A for the costs to be 
capitalized to real property produced by X.
    Example 11. 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.
    Example 12. Work performed prior to placing the property in 
service. In 2008, X purchases a building for use as a business 
office. The building is in a state of disrepair. Prior to placing 
the building in service, X incurs 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. All the work was performed on the building 
or its structural components. In 2010, X places the building in 
service and begins using the building as its business office. Assume 
the building and its structural components is the unit of property. 
The amounts paid must be capitalized as costs of acquiring the 
building because they were for work performed prior to X's placing 
the building in service.
    Example 13. Work performed prior to placing the property in 
service. In January 2008, X purchases a new machine for use in an 
existing production line of its manufacturing business. Assume that 
the machine is a unit of property under Sec.  1.263(a)-3(d)(2). 
After the machine is installed, X performs critical testing on the 
machine to ensure that it is operational. On November 1, 2008, the 
critical testing is complete and X places the machine in service on 
the production line. X continues to perform testing for quality 
control. The amounts paid for the installation and critical testing 
must be capitalized as costs of acquiring the machine because they 
were for work performed prior to X's placing the machine in service. 
However, amounts paid for quality control testing after the machine 
is placed in service by X are not required to be capitalized as a 
cost of acquiring the machine.

    (2) Defense or perfection of title to property--(i) In general. 
Amounts paid to defend or perfect title to real or personal property 
are amounts paid to acquire or produce property within the meaning of 
this section and must be capitalized. See section 263A for the 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 files an eminent domain complaint 
condemning a portion of X's property to use as a roadway. X hires 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 for sale sand and stone in a 
certain municipality. Several years after X establishes its 
business, the municipality in which it is located passes an 
ordinance that prohibits the operation of X's business. X incurs 
attorney's fees in a successful prosecution of a suit to invalidate 
the municipal ordinance. X prosecutes 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. See Sec.  1.263A-1(e)(3)(i). 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 establishes a building line across 
X's business property, adversely affecting the value of the 
property. X incurs 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 or production of real or 
personal property. See section 263A for the costs required to be 
capitalized to property produced by the taxpayer or to property 
acquired for resale. See Sec.  1.263(a)-5 for the treatment of amounts 
paid to facilitate the acquisition of assets that constitute a trade or 
business.
    (ii) Scope of facilitate--(A) In general. Except as otherwise 
provided in this section, an amount is paid to facilitate the 
acquisition of real or personal property if the amount is paid in the 
process of investigating or otherwise pursuing the acquisition. Whether 
an amount is paid in the process of investigating or otherwise pursuing 
the acquisition is determined based on all of the facts and 
circumstances. In determining whether an amount is paid to facilitate 
an acquisition, the fact that the amount would (or would not) have been 
paid but for the acquisition is relevant, but is not determinative. 
These amounts include, but are not limited to, inherently facilitative 
amounts specified in paragraph (d)(3)(ii)(B) of this section.
    (B) Inherently facilitative amounts. An amount paid in the process 
of investigating or otherwise pursuing the acquisition of real or 
personal property facilitates the acquisition if the amount is 
inherently facilitative. An amount is inherently facilitative if the 
amount is paid for--
    (1) Transporting the property (for example, shipping fees and 
moving costs);
    (2) Securing an appraisal or determining the value or price of 
property;
    (3) Negotiating the terms or structure of the acquisition and 
obtaining tax advice on the acquisition;
    (4) Application fees, bidding costs, or similar expenses;
    (5) Preparing and reviewing the documents that effectuate the 
acquisition of the property (for example, preparing the bid, offer, 
sales contract, or purchase agreement);
    (6) Examining and evaluating the title of property;
    (7) Obtaining regulatory approval of the acquisition or securing 
permits related to the acquisition, including application fees;
    (8) Conveying property between the parties, including sales and 
transfer taxes, and title registration costs;
    (9) Finders' fees or brokers' commissions, including amounts paid 
that are contingent on the successful closing of the acquisition;
    (10) Architectural, geological, engineering, environmental or 
inspection services pertaining to particular properties; and

[[Page 12854]]

    (11) Services provided by a qualified intermediary or other 
facilitator of an exchange under section 1031.
    (C) Special rule for acquisitions of real property. Except as 
provided in paragraph (d)(3)(ii)(B) of this section (relating to 
inherently facilitative amounts), an amount paid by the taxpayer in the 
process of investigating or otherwise pursuing the acquisition of real 
property does not facilitate the acquisition if it relates to 
activities performed in the process of determining whether to acquire 
real property and which real property to acquire.
    (D) Employee compensation and overhead costs--(1) In general. For 
purposes of this paragraph (d)(3), amounts paid for employee 
compensation (within the meaning of Sec.  1.263(a)-4(e)(4)(ii)) and 
overhead are treated as amounts that do not facilitate the acquisition 
of real or personal property. See section 263A for the treatment of 
employee compensation and overhead costs required to be capitalized to 
property produced by the taxpayer or to property acquired for resale.
    (2) Election to capitalize. A taxpayer may elect to treat amounts 
paid for employee compensation or overhead as amounts that facilitate 
the acquisition of property. The election is made separately for each 
acquisition and applies to employee compensation or overhead, or both. 
For example, a taxpayer may elect to treat overhead, but not employee 
compensation, as amounts that facilitate the acquisition of property. A 
taxpayer makes the election by treating the amounts to which the 
election applies as amounts that facilitate the acquisition in the 
taxpayer's timely filed original Federal income tax return (including 
extensions) for the taxable year during which the amounts are paid. In 
the case of an S corporation or partnership, the election is made by 
the S corporation or by the partnership, and not by the shareholders or 
partners. A taxpayer may revoke an election made under this paragraph 
(d)(3)(ii)(D)(2) with respect to each acquisition only by filing a 
request for a private letter ruling and obtaining the Commissioner's 
consent to revoke the election. An election may not be made or revoked 
through the filing of an application for change in accounting method or 
by an amended Federal income tax return.
    (iii) Treatment of transaction costs. All amounts paid to 
facilitate the acquisition or production of real or personal property 
are capital expenditures. Inherently facilitative amounts allocable to 
real or personal property are capital expenditures related to such 
property even if the property is not eventually acquired or produced. 
Facilitative amounts allocable to real or personal property actually 
acquired or produced must be included in the basis of the property 
acquired or produced. See paragraph (f) of this section for the 
recovery of capitalized amounts.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (d)(3):

    Example 1. Broker's fees to facilitate an acquisition. X decides 
to purchase a building in which to relocate its offices and hires a 
real estate broker to find a suitable building. X pays fees to the 
broker to find property for X to acquire. Under paragraph (d)(3)(i) 
of this section, X must capitalize the amounts paid to the broker 
because these costs are inherently facilitative of the acquisition 
of real property.
    Example 2. Inspection and survey costs to facilitate an 
acquisition. X decides to purchase building A and pays amounts to 
third-party contractors for a termite inspection and an 
environmental survey of building A. Under paragraph (d)(3)(i) of 
this section, X must capitalize the amounts paid for the inspection 
and the survey of the building because these costs are inherently 
facilitative of the acquisition of real property.
    Example 3. 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. Under paragraph (d)(3)(i) of this section, X must 
capitalize the amount paid to move the storage tanks from Y's plant 
to X's plant because this cost is inherently facilitative to the 
acquisition of personal property.
    Example 4. Scope of facilitate. X is in the business of 
providing legal services to clients. X is interested in acquiring a 
new conference table for its office. X hires and incurs fees for an 
interior designer to shop for, evaluate, and make recommendations to 
X regarding which new table to acquire. Under paragraph (d)(3)(i) of 
this section, X must capitalize the amounts paid to the interior 
designer to provide these services because they are paid in the 
process of investigating or otherwise pursuing the acquisition of 
personal property.
    Example 5. Transaction costs allocable to other property. X, a 
retailer, wants to acquire land for the purpose of building a new 
distribution facility for its products. X considers various 
properties on highway A in state B. In evaluating the feasibility of 
several sites, X incurs fees for the services of an architect to 
advise and prepare preliminary plans for a facility that X is 
reasonably likely to construct at one of the sites. The architect's 
fees are not inherently facilitative to the acquisition of land, but 
are inherently facilitative to the acquisition of a building under 
paragraph (d)(3)(ii)(B)(10) of this section. In addition, these 
costs are allocable as construction costs of the building under 
section 263A. Therefore, X does not capitalize these fees as amounts 
to acquire the building under paragraph (d)(3)(ii)(B) of this 
section, but instead must capitalize these costs as indirect costs 
allocable to the production of property under section 263A.
    Example 6. Special rule for acquisitions of real property. X 
owns several retail stores. X decides to examine the feasibility of 
opening a new store in City A. In October 2008, X hires and incurs 
costs for a development consulting firm to study City A and perform 
market surveys, evaluate zoning and environmental requirements, and 
make preliminary reports and recommendations as to areas that X 
should consider for purposes of locating a new store. In December 
2008, X continues to consider whether to purchase real property in 
City A and which property to acquire. X hires, and incurs fees for, 
an appraiser to perform appraisals on two different sites to 
determine a fair offering price for each site. In March 2009, X 
decides to acquire one of these two sites for the location of its 
new store. At the same time, X determines not to acquire the other 
site. Under paragraph (d)(3)(ii)(C) of this section, X is not 
required to capitalize amounts paid to the development consultant in 
2008 because the amounts relate to activities performed in the 
process of determining whether to acquire real property and which 
real property to acquire and the amounts are not inherently 
facilitative costs under paragraph (d)(3)(ii)(B) of this section. 
However, X must capitalize amounts paid to the appraiser in 2008 
because the appraisal costs are inherently facilitative costs under 
paragraph (d)(3)(ii)(B)(2) of this section. In 2009, X must include 
the appraisal costs allocable to property acquired in the basis of 
the property acquired and may recover the appraisal costs allocable 
to the property not acquired in accordance with paragraph (f) of 
this section.
    Example 7. Employee compensation and overhead. X, a freight 
carrier, maintains an acquisition department whose sole function is 
to arrange for the purchase of vehicles and aircraft from 
manufacturers or other parties to be used in its freight carrying 
business. As provided in paragraph (d)(3)(ii)(D)(1) of this section, 
X is not required to capitalize any portion of the compensation paid 
to employees in its acquisition department or any portion of its 
overhead allocable to its acquisition department. However, under 
paragraph (d)(3)(ii)(D)(2) of this section, X may elect to 
capitalize the compensation and overhead costs allocable to the 
acquisition of a vehicle or aircraft by treating these amounts as 
costs that facilitate the acquisition of that property in its timely 
filed original Federal income tax return for the year the amounts 
are paid.

    (4) De minimis rule--(i) In general. Except as otherwise provided 
in this paragraph (d)(4), a taxpayer is not required to capitalize 
under paragraph (d) of this section amounts paid for the acquisition or 
production (including any amounts paid to facilitate the acquisition or 
production) of a unit of property (as determined under Sec.  1.263(a)-
3(d)(2)) if--
    (A) The taxpayer has an applicable financial statement (as defined 
in Sec.  1.263(a)-2(d)(4)(vi));

[[Page 12855]]

    (B) The taxpayer has at the beginning of the taxable year, written 
accounting procedures treating as an expense for non-tax purposes the 
amounts paid for property costing less than a certain dollar amount;
    (C) The taxpayer treats the amounts paid during the taxable year as 
an expense on its applicable financial statement in accordance with its 
written accounting procedures; and
    (D) The total aggregate of amounts paid and not capitalized under 
paragraphs (d)(4)(i)(A), (B), and (C) of this section for the taxable 
year do not distort the taxpayer's income for the taxable year.
    (ii) Exceptions to de minimis rule. The de minimis rule in 
paragraph (d)(4)(i) of this section does not apply to the following:
    (A) Amounts paid to improve property under Sec.  1.263(a)-3.
    (B) Amounts paid for property that is or is intended to be included 
in property produced or acquired for resale.
    (C) Amounts paid for land.
    (iii) Safe harbor. The total aggregate amount that is not required 
to be capitalized under the de minimis rule of paragraphs (d)(4)(i)(A), 
(B) and (C) of this section for the taxable year is deemed to not 
distort the taxpayer's income under paragraph (d)(4)(i)(D) of this 
section if this amount, added to the amount the taxpayer deducts in the 
taxable year as materials and supplies under the definition provided 
under Sec.  1.162-3(d)(1)(iii) (relating to certain property costing 
$100 or less), is less than or equal to the lesser of--
    (A) 0.1 percent of the taxpayer's gross receipts for the taxable 
year; or
    (B) 2 percent of the taxpayer's total depreciation and amortization 
expense for the taxable year as determined in its applicable financial 
statement.
    (iv) Additional rules. Property to which a taxpayer applies the de 
minimis rule contained in paragraph (d)(4) 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. 
Property to which a taxpayer applies the de minimis rule contained in 
paragraph (d)(4) of this section is not a material or supply under 
Sec.  1.162-3. The cost of property to which a taxpayer properly 
applies the de minimis rule contained in paragraph (d)(4) of this 
section is not required to be capitalized under section 263A to a 
separate unit of property, but may be required to be capitalized as a 
cost of other property if incurred by reason of the production of the 
other property. See, for example, Sec.  1.263A-1(e)(3)(ii)(O) requiring 
taxpayers to capitalize repair and maintenance costs allocable to 
property produced or acquired for resale.
    (v) Election to capitalize. A taxpayer may elect not to apply the 
de minimis rule contained in paragraph (d)(4)(i) of this section. An 
election made under this paragraph (d)(4)(v) applies to any unit of 
property during the taxable year to which paragraphs (d)(4)(i)(A), (B), 
and (C) 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 an S corporation or 
partnership, the election is made by the S corporation or by the 
partnership, and not by the shareholders or partners. A taxpayer may 
revoke an election made under this paragraph (d)(4)(v) with respect to 
a unit of property only by filing a request for a private letter ruling 
and obtaining the Commissioner's consent to revoke the election. An 
election may not be made or revoked through the filing of an 
application for change in accounting method or by an amended Federal 
income tax return.
    (vi) Definition of applicable financial statement. For purposes of 
this paragraph (d)(4), the taxpayer's applicable financial statement is 
the taxpayer's financial statement listed in paragraphs (d)(4)(vi)(A) 
through (C) of this section that has the highest priority (including 
within paragraph (d)(4)(iv)(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).
    (vii) Examples. The following examples illustrate the rule of this 
paragraph (d)(4):

    Example 1. De minimis rule. X purchases 10 printers at $200 each 
for a total cost of $2000. Assume that each printer is a unit of 
property under Sec.  1.263(a)-3(d)(2). X has an applicable financial 
statement. X has a written policy at the beginning of the taxable 
year to expense amounts paid for property costing less than $500. X 
treats the amounts paid for the printers as an expense on its 
applicable financial statement. Assuming the total aggregate amounts 
not capitalized under the de minimis rule for the taxable year do 
not distort the taxpayer's income, X is not required to capitalize 
the amounts paid for the printers.
    Example 2. De minimis rule safe harbor not met. X is a member of 
an affiliated group that files a consolidated return. In 2008, X 
purchases 300 computers at $400 each for a total cost of $120,000. 
Assume that each computer is a unit of property under Sec.  
1.263(a)-3(d)(2). X has a written policy at the beginning of the 
taxable year to expense amounts paid for property costing less than 
$500. X treats the amounts paid for the computers as an expense on 
its applicable financial statement. In addition, in 2008 X purchases 
300 desk chairs for $50 each for a total cost of $15,000. X intends 
to deduct the amounts paid for the desk chairs when used or consumed 
as non-incidental materials and supplies under Sec.  1.162-3(a)(1) 
and Sec.  1.162-3(d)(1)(iii) because they are units of property 
costing less than $100. For its 2008 taxable year, X has gross 
receipts of $125,000,000 and reports $7,000,000 of depreciation and 
amortization on its applicable financial statement. Thus, in order 
to meet the de minimis rule safe harbor for 2008, the sum of the 
amounts not required to be capitalized under the de minimis rule for 
2008 ($120,000) plus the amounts X intends to deduct as materials 
and supplies under Sec.  1.162-3(a)(1) and Sec.  1.162-3(d)(1)(iii) 
for 2008 ($15,000), must be less than or equal to $125,000 (0.1% of 
X's total gross receipts of $125,000,000), which is less than 
$140,000 (2% of X's total depreciation and amortization of 
$7,000,000). Because $135,000 ($120,000 + $15,000) exceeds $125,000, 
X will not meet the de minimis rule safe harbor for its 2008 taxable 
year. As a result, to apply the de minimis rule to the $120,000 paid 
to acquire the computers, X will have to otherwise establish that 
this amount does not distort the taxpayer's income in 2008.
    Example 3. De minimis rule safe harbor met. Assume the same 
facts as in Example 2, except X makes an election under paragraph 
(d)(4)(v) of this section to capitalize the $10,000 paid to acquire 
25 of the 300 computers at $400 each. In this case, X is not 
required to capitalize the $110,000 paid to acquire the remaining 
275 computers under paragraph (d)(4)(i) because this amount, when 
added to the $15,000 that X intends to deduct in 2008 as materials 
and supplies under Sec.  1.162-3(a)(1) and Sec.  1.163-3(d)(1)(iii), 
does not exceed the de minimis rule safe harbor of $125,000 for 
2008.
    Example 4. De minimis rule safe harbor; election to capitalize. 
Assume the same facts as in Example 2, except X does not otherwise 
establish that the deduction of amounts in excess of the $125,000 
safe harbor do not distort X's income in 2008. Rather, X makes an 
election under Sec.  1.162-3(d) to capitalize

[[Page 12856]]

$10,000 paid to acquire 200 of the 300 desk chairs at $50 each. In 
this case, X is not required to capitalize the $120,000 paid to 
acquire the 300 computers under paragraph (d)(4)(i) of this section 
because this amount, when added to the $5000 (the remaining 100 desk 
chairs at $50 each) that X intends to deduct in 2008 as materials 
and supplies under Sec.  1.162-3(a)(1) and Sec.  1.162-3(d)(1)(iii), 
does not exceed the de minimis rule safe harbor of $125,000 for 
2008.

    (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 Code and 
regulation provisions relating to the use, sale, or disposition of 
property.
    (2) Examples. The following examples illustrate the rule of this 
paragraph (f)(1). Assume that X does not apply the de minimis rule 
under paragraph (d)(4) of this section.

    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 to replace the old 
refrigerator. Assume that the refrigerator is the unit of property, 
as determined under Sec.  1.263(a)-3(d)(2), and is not a material or 
supply under Sec.  1.162-3. Under paragraph (d) of this section, X 
is required to capitalize the 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 the production of 
property. X operates a plant where it manufactures widgets. X 
purchases a tractor/loader to move raw materials into and around the 
plant for use in the manufacturing process. Assume that the tractor/
loader is a unit of property, as determined under Sec.  1.263(a)-
3(d)(2), and is not a material or supply under Sec.  1.162-3. Under 
paragraph (d) of this section, X is required to capitalize the 
amounts paid to acquire the tractor/loader. Under this paragraph 
(f), the capitalized amounts are recovered through depreciation when 
the tractor/loader is placed in service by X. However, because the 
tractor/loader is used in the production of property, under section 
263A the cost recovery (that is, the depreciation) on the 
capitalized amounts must be capitalized to X's property produced, 
and consequently, recovered through cost of goods sold. See Sec.  
1.263A-1(e)(3)(ii)(I).
    (g) [Reserved]
    (h) Effective/applicability 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.
    Par. 8. Section 1.263(a)-3 is revised to read as follows:


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 provides definitions. Paragraph (c) of this section 
provides rules for coordinating this section with other provisions of 
the Internal Revenue Code (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 provides a safe harbor for 
routine maintenance costs. Paragraph (f) of this section provides rules 
for determining whether amounts paid result in betterments to the unit 
of property. Paragraph (g) of this section provides rules for 
determining whether amounts paid restore the unit of property. 
Paragraph (h) of this section provides rules for amounts paid to adapt 
the unit of property to a new or different use. Paragraph (i) of this 
section provides an optional regulatory accounting method safe harbor. 
Paragraph (j) of this section provides an optional repair allowance. 
Paragraphs (k) through (m) of this section provide additional rules 
related to these provisions. Paragraph (n) of this section provides the 
applicability date of the rules in this section.
    (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 means tangible personal property as defined 
in Sec.  1.48-1(c).
    (3) Real property means land and improvements thereto, such as 
buildings or other inherently permanent structures (including items 
that are structural components of the buildings or structures) that are 
not personal property as defined in paragraph (b)(2) of this section. 
Any property that constitutes other tangible property under Sec.  1.48-
1(d) is also treated as real property for purposes of this section. 
Local law is not controlling in determining whether property is real 
property for purposes of this section.
    (4) Applicable financial statement. The applicable financial 
statement is the taxpayer's financial statement listed in paragraphs 
(b)(4)(i) through (iii) of this section that has the highest priority 
(including within paragraph (b)(4)(ii) of this section). The financial 
statements are, in descending priority--
    (i) A financial statement required to be filed with the Securities 
and Exchange Commission (SEC) (the 10-K or the Annual Statement to 
Shareholders);
    (ii) 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--
    (A) Credit purposes,
    (B) Reporting to shareholders, partners, or similar persons; or
    (C) Any other substantial non-tax purpose; or
    (iii) 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).
    (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 
Code or regulations (other than section 162(a) or section 212 and the 
regulations under those sections). See, for example, Sec.  1.263A-
1(e)(3), requiring taxpayers to capitalize costs that directly benefit 
or are incurred by reason of the performance of the production or 
resale activities, including repair and maintenance costs allocable to 
property produced or acquired for resale.
    (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

[[Page 12857]]

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 optional regulatory accounting method in paragraph (i) of this 
section or under any repair allowance method published in accordance 
with paragraph (j) of this section, a taxpayer must capitalize the 
aggregate of related amounts paid to improve a unit of property, 
whether the improvements are made by the taxpayer or by a third party, 
and whether the taxpayer is an owner or lessee of the property. For 
purposes of this section, a unit of property includes units of property 
for which the acquisition or production costs were deducted as 
materials and supplies under Sec.  1.162-3(a)(1) or under the de 
minimis rule in Sec.  1.263(a)-2(d)(4). See section 263A for the 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 for the 
treatment of additions or improvements for depreciation purposes. For 
purposes of this section, a unit of property is improved if the amounts 
paid for activities performed after the property is placed in service 
by the taxpayer--
    (i) Result in a betterment to the unit of property (see paragraph 
(f) of this section); or
    (ii) Restore the unit of property (see paragraph (g) of this 
section); or
    (iii) Adapt the unit of property to a new or different use (see 
paragraph (h) 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, 
1.263(a)-3, and 1.162-3(d). In general, the unit of property 
determination is based upon the functional interdependence standard 
provided in paragraph (d)(2)(iii)(A) of this section. However, special 
rules are provided for buildings (see paragraph (d)(2)(ii) of this 
section), plant property (see paragraph (d)(2)(iii)(B) of this 
section), and network assets (see paragraph (d)(2)(iii)(C) of this 
section). Additional rules are provided if a taxpayer has assigned 
different financial statement economic useful lives or MACRS classes or 
depreciation methods to components of property (see paragraph 
(d)(2)(iii)(D) of this section). Property that is aggregated and 
subject to a general asset account election or accounted for in a 
multiple asset account (that is, pooled) may not be treated as a single 
unit of property. In addition, an improvement to a unit of property as 
determined under this section, other than a leasehold improvement, is 
not a unit of property separate from the unit of property improved.
    (ii) Buildings and structural components. In the case of a building 
(as defined in Sec.  1.48-1(e)(1)), the building and its structural 
components (as defined in Sec.  1.48-1(e)(2)) are a single unit of 
property. In the case of a leasehold improvement made by a lessee and 
that is section 1250 property, the leasehold improvement is a separate 
unit of property. In the case of a taxpayer that owns or occupies an 
individual unit in a building with multiple units (such as a 
condominium or cooperative), the unit of property is the individual 
unit owned and/or occupied by the taxpayer.
    (iii) Property other than buildings--(A) In general. Except as 
provided in paragraph (d)(2)(iii)(B), (C) and (D) of this section, in 
the case of real or personal property other than property described in 
paragraph (d)(2)(ii) of this section, all the components that are 
functionally interdependent comprise a single unit of property. 
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.
    (B) Plant property--(1) Definition. For purposes of this paragraph 
(d)(2) of this section, the term plant property means functionally 
interdependent machinery or equipment, other than network assets, used 
to perform an industrial process, such as manufacturing, generation, 
warehousing, distribution, automated materials handling in service 
industries, or other similar activities.
    (2) Unit of property for plant property. In the case of plant 
property, a unit of property is comprised of each component (or group 
of components) within the unit of property determined under the general 
rule of paragraph (d)(2)(iii)(A) of this section that performs a 
discrete and major function or operation within the functionally 
interdependent machinery or equipment.
    (C) Network assets--(1) Definition. For purposes of this paragraph 
(d)(2), the term 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)(ii) of this 
section, nor does it include separate property that is adjacent to, but 
not part of a network asset, such as bridges, culverts, or tunnels.
    (2) [Reserved]
    (D) Additional rules. Notwithstanding the unit of property 
determination under paragraphs (d)(2)(iii)(A), (B), and (C) of this 
section, a component (or a group of components) of a unit property must 
be treated as a separate unit of property if--
    (1) At the time the unit of property (as determined under paragraph 
(d)(2)(iii)(A), (B), and (C) of this section) is placed in service by 
the taxpayer (without regard to subsequent improvements), the taxpayer 
has recorded on its books and records for financial or regulatory 
accounting purposes an economic useful life for the component that is 
different from the economic useful life of the unit of property of 
which the component is a part; or
    (2) The taxpayer has properly treated the component as being within 
a different class of property under section 168(e) (MACRS classes) than 
the class of the unit of property of which the component is a part or, 
the taxpayer, at the time the component was placed in service by the 
taxpayer, has properly depreciated the component using a different 
depreciation method under section 167 or section 168 than the 
depreciation method of the unit of property of which the component is a 
part.
    (iv) Examples. The rules of this paragraph (d)(2) are illustrated 
by the following examples, in which it is assumed that the taxpayer has 
not made a general asset account election with regard to property or 
accounted for property in a multiple asset account.

    Example 1. Buildings and structural components; plant property. 
X owns a building containing various types of manufacturing 
equipment that are not structural components of the building. 
Because the property is a building, as defined in Sec.  1.48-
1(e)(1), the unit of property for the building must be determined 
under paragraph (d)(2)(ii) of this section. Under the rules of that 
paragraph, X must treat the building and all its structural 
components as a single unit of property. In addition, because the 
manufacturing equipment contained within the building constitutes 
property other than a building, the units of property for the 
manufacturing equipment are initially determined under the general 
rule in paragraph (d)(2)(iii)(A) of this section and are therefore 
comprised of all the components that are functionally 
interdependent. Moreover, because the manufacturing equipment is 
plant property, under

[[Page 12858]]

paragraph (d)(2)(iii)(B) of this section, the units of property 
under the general rule are further divided into smaller units of 
property by determining the components (or groups of components) 
that perform discrete and major functions within the plant. Finally, 
X must apply the additional rules in paragraph (d)(2)(iii)(D) of 
this section to determine whether any of the units of property 
determined under paragraphs (d)(2)(iii)(A) and (B) of this section 
contain components that must be treated as separate units of 
property.
    Example 2. Buildings and structural components; property other 
than plants. X, a manufacturer, owns a building adjacent to its 
manufacturing facility that contains office space and related 
facilities for X's employees that manage and administer X's 
manufacturing operations. The office building contains equipment, 
such as desks, chairs, computers, telephones, and bookshelves, that 
are not structural components of the building. Because the office 
building is a building, as defined in Sec.  1.48-1(e)(1), the unit 
of property for the building must be determined under paragraph 
(d)(2)(ii) of this section. Under the rules of that paragraph, X 
must treat the office building and all its structural components as 
a single unit of property. In addition, because the equipment 
contained within the office building constitutes property other than 
a building, the units of property for the office equipment are 
initially determined under the general rule in paragraph 
(d)(2)(iii)(A) of this section and are comprised of the groups of 
components that are functionally interdependent. X then must apply 
the additional rules in paragraph (d)(2)(iii)(D) of this section to 
determine whether any of the units of property determined under 
paragraph (d)(2)(iii)(A) of this section contain components that 
must be treated as separate units of property.
    Example 3. Plant property; discrete and major function. X is an 
electric utility company that operates a power plant to generate 
electricity. The power plant includes a structure that is not a 
building under Sec.  1.48-1(e)(1), four pulverizers that grind coal, 
one boiler that produces steam, one turbine that converts the steam 
into mechanical energy, and one generator that converts mechanical 
energy into electrical energy. In addition, the turbine contains a 
series of blades that cause the turbine to rotate when affected by 
the steam. When X placed the plant into service, X recorded all the 
components of the plant as having the same economic useful life on 
its books and records for financial and regulatory accounting 
purposes. X also treated all the components of the plant as being 
within the same class of property under section 168(e) and has 
depreciated all the components using the same depreciation methods. 
Because the plant is composed of real and personal tangible property 
other than a building, the unit of property for the generating 
equipment is initially determined under the general rule in 
paragraph (d)(2)(iii)(A) of this section and is comprised of all the 
components that are functionally interdependent. Under this rule, 
the initial unit of property is the entire plant because the 
components of the plant are functionally interdependent. However, 
because the power plant is plant property under paragraph 
(d)(2)(iii)(B) of this section, the initial unit of property is 
further divided into smaller units of property by determining the 
components (or groups of components) that perform discrete and major 
functions within the plant. Under this paragraph, X must treat the 
structure, the boiler, the turbine, and the generator each as a 
separate unit of property, and each of the four pulverizers as a 
separate unit of property because each of these components performs 
a discrete and major function within the power plant. X is not 
required to treat components, such as the turbine blades, as 
separate units of property because each of these components does not 
perform a discrete and major function within the plant.
    Example 4. Plant property; discrete and major function. X is 
engaged in a uniform and linen rental business that operates a plant 
to treat and launder items used in its business. Within the plant X 
utilizes an assembly line-like process that incorporates many 
different machines and equipment to launder and prepare the items to 
be returned to customers. X utilizes two laundering lines in its 
plant, each of which can operate independently. One line is used for 
uniforms and another line is used for linens. Both lines incorporate 
several sorters, boilers, washers, dryers, ironers, folders, and 
waste water treatment systems. Because the laundering equipment 
contained within the plant is personal property, the unit of 
property for the laundering equipment is initially determined under 
the general rule in paragraph (d)(2)(iii)(A) of this section and is 
comprised of all the components that are functionally 
interdependent. Under this rule, the initial units of property are 
each laundering line because each line is functionally independent 
and is comprised of components that are functionally interdependent. 
However, because each line is comprised of plant property under 
paragraph (d)(2)(iii)(B) of this section, the initial units of 
property are further divided into smaller units of property by 
determining the components (or groups of components) that perform 
discrete and major functions within the line. Under paragraph 
(d)(2)(iii)(B) of this section, X must treat each sorter, boiler, 
washer, dryer, ironer, folder, and waste water treatment system in 
each line as a separate unit of property because each of these 
components performs a discrete and major function within the line. 
Finally, X must apply the additional rules in paragraph 
(d)(2)(iii)(D) of this section to determine whether any of the units 
of property determined under paragraph (d)(2)(iii)(B) of this 
section contain components that must be treated as separate units of 
property.
    Example 5. Plant property; industrial process. X operates a 
restaurant that prepares and serves food to retail customers. Within 
its restaurant, X has a large piece of equipment that uses an 
assembly line-like process to prepare and cook tortillas that X 
serves to its customers. Because the tortilla-making equipment is 
personal property, the unit of property for the equipment is 
initially determined under the general rule in paragraph 
(d)(2)(iii)(A) of this section and is comprised of all the 
components that are functionally interdependent. Under this rule, 
the initial unit of property is the entire tortilla-making equipment 
because the various components of the equipment are functionally 
interdependent. Although the equipment is used to perform a 
manufacturing process, the equipment is not being used in an 
industrial process, as it performs a small-scale function as part of 
X's retail restaurant operations. Therefore, the equipment is not 
plant property under paragraph (d)(2)(iii)(B) of this section. 
Finally, X must apply the additional rules in paragraph 
(d)(2)(iii)(D) of this section to determine whether the equipment 
contains components that must be treated as separate units of 
property.
    Example 6. Personal property. X owns locomotives that it uses in 
its railroad business. Each locomotive consists of various 
components, such as an engine, generators, batteries and trucks. X 
acquired a locomotive with all its components and recorded all the 
components as having the same economic useful life on its books and 
records for financial and regulatory accounting. X also treated all 
the components of the locomotive as being within the same class of 
property under section 168(e) and has depreciated all the components 
using the same depreciation methods. Because X's locomotive is 
property other than a building, the initial unit of property is 
determined under paragraph (d)(2)(iii)(A) of this section. Under 
this paragraph, the locomotive is a single unit of property because 
it consists entirely of components that are functionally 
interdependent. Because the additional rules under paragraph 
(d)(2)(iii)(D) of this section do not apply under these facts, the 
locomotive is a single unit of property.
    Example 7. Personal property. X is engaged in the business of 
transporting freight throughout the United States. To conduct its 
business, X owns a fleet of tractors and trailers. Each tractor and 
trailer is comprised of various components, including tires. X 
purchases a truck trailer with all of its components, including 16 
tires. At the time the trailer was placed in service by X, X treated 
the trailer and the tires as being within the same class of property 
under section 168(e) and has depreciated all the components using 
the same depreciation methods. However, on its books and records for 
financial accounting purposes, X recorded economic useful lives for 
the tires that were different from the economic useful life that it 
recorded for the trailer. Because X's trailer is property other than 
a building, the initial units of property for the trailer are 
determined under the general rule in paragraph (d)(2)(iii)(A) of 
this section and are comprised of all the components that are 
functionally interdependent. Under this rule, the truck trailer, 
including its 16 tires, is a single unit of property because the 
trailer and the tires are functionally interdependent (that is, the 
placing in service of the tires is dependent upon the placing in 
service of the trailer). X then must apply the additional rules in 
paragraph (d)(2)(iii)(D) of this section to determine whether the 
initial unit of property determined under paragraph

[[Page 12859]]

(d)(2)(iii)(A) of this section contains components that must be 
treated as separate units of property. Under paragraph 
(d)(2)(iii)(D)(1) of this section, because X recorded on its books 
and records economic useful lives for the tires that are different 
from the economic useful lives that it recorded for the trailer, the 
tires must be treated as separate units of property.
    Example 8. Personal property. X provides legal services to 
customers. X purchased a laptop computer and a printer to be used by 
its employees in providing services. When X placed the computer and 
printer into service, X recorded both items and all their components 
as having the same economic useful life on its books and records for 
financial accounting purposes. X also treated the computer and 
printer and all their components as being within the same class of 
property under section 168(e) and has depreciated all the components 
using the same depreciation methods. Because the computer and 
printer are property other than a building, the initial units of 
property are determined under the general rule in paragraph 
(d)(2)(iii)(A) of this section and are comprised of the components 
that are functionally interdependent. Under this paragraph 
(d)(2)(iii)(A), the computer and the printer are separate units of 
property because the computer and the printer are not components 
that are functionally interdependent (that is, the placing in 
service of the computer is not dependent on the placing in service 
of the printer). The additional rules in paragraph (d)(2)(iii)(D) of 
this section do not apply under these facts. Accordingly, the 
computer and the printer each constitute separate units of property.

    (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) Repairs and maintenance performed during an improvement--(i) In 
general. A taxpayer must capitalize all the direct costs of an 
improvement and all the indirect costs (including otherwise deductible 
repair costs) that directly benefit or are incurred by reason of an 
improvement in accordance with the rules under section 263A. Repairs 
and maintenance 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.
    (ii) Exception for individuals' residences. A taxpayer who is an 
individual may capitalize amounts paid for repairs and maintenance 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 of 
the taxpayer's residence.
    (5) Aggregate of related amounts. For purposes of paragraph (d)(1) 
of this section, the aggregate of related amounts paid to improve a 
unit of property may be incurred over a period of more than one taxable 
year. Whether amounts are related to the same improvement depends on 
the facts and circumstances of the activities being performed and 
whether the costs are incurred by reason of a single improvement or 
directly benefit a single improvement.
    (e) Safe harbor for routine maintenance--(1) In general. An amount 
paid for routine maintenance performed on a unit of property is deemed 
to not improve that unit of property. Routine maintenance is the 
recurring activities that a taxpayer expects to perform as a result of 
the taxpayer's use of the unit of property to keep the unit of property 
in its ordinarily efficient operating condition. Routine maintenance 
activities include, for example, the inspection, cleaning, and testing 
of the unit of property, and the replacement of parts of the unit of 
property with comparable and commercially available and reasonable 
replacement parts. The activities are routine only if, at the time the 
unit of property is placed in service by the taxpayer, the taxpayer 
reasonably expects to perform the activities more than once during the 
class life (as defined in paragraph (e)(4) of this section) of the unit 
of property. Among the factors to be considered in determining whether 
a taxpayer is performing routine maintenance are the recurring nature 
of the activity, industry practice, manufacturers' recommendations, the 
taxpayer's experience, and the taxpayer's treatment of the activity on 
its applicable financial statement (as defined in paragraph (b)(4) of 
this section). With respect to a taxpayer that is a lessor of a unit of 
property, the taxpayer's use of the unit of property includes the 
lessee's use of the unit of property.
    (2) Exceptions. Routine maintenance does not include the 
following--
    (i) Amounts paid for the replacement of a component of a unit of 
property if the taxpayer has properly deducted a loss for that 
component (other than a casualty loss under Sec.  1.165-7);
    (ii) Amounts paid for the replacement of a component of a unit of 
property if the taxpayer has properly taken into account the adjusted 
basis of the component in realizing gain or loss resulting from the 
sale or exchange of the component;
    (iii) Amounts paid for the repair of damage to a unit of property 
for which the taxpayer has taken a basis adjustment as a result of a 
casualty loss under section 165 or relating to a casualty event 
described in section 165; and
    (iv) Amounts paid to return a unit of property to its former 
ordinarily efficient operating condition, if the property has 
deteriorated to a state of disrepair and is no longer functional for 
its intended use.
    (3) Rotable or temporary spare parts. For purposes of paragraph 
(e)(1) of this section, amounts paid for routine maintenance include 
routine maintenance performed on (and with regard to) rotable and 
temporary spare parts. But see Sec.  1.162-3(b), which provides that 
rotable and temporary spare parts are used or consumed by the taxpayer 
in the taxable year in which the taxpayer disposes of the part.
    (4) Class life. The class life of a unit of property is the 
recovery period prescribed for the property under section 168(g)(2) and 
(3) for purposes of the alternative depreciation system, regardless of 
whether the property is depreciated under section 168(g). For purposes 
of determining class life under this paragraph (e), section 
168(g)(3)(A) (relating to tax-exempt use property subject to lease) 
does not apply.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (e).

    Example 1. Routine maintenance on rotable component. (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. One type of maintenance visit is an engine 
shop visit (ESV), which X expects to perform on its aircraft engines 
approximately every 4 years in order to keep its aircraft in its 
ordinarily efficient operating condition. In 2004, X purchased a new 
aircraft and four new engines to use in that aircraft and later, in 
other aircraft in its fleet. The aircraft engines are rotable spare 
parts because they are removable from the aircraft, and repaired and 
reinstalled on other aircraft or stored for later installation on 
other aircraft. See Sec.  1.162-3(b) (treatment of materials and 
supplies). In 2008, X performs its first ESV on the aircraft 
engines. The ESV includes disassembly, cleaning, inspection, repair, 
replacement, reassembly, and testing of the

[[Page 12860]]

engine and its component parts. During the ESV, the engine is 
removed from the aircraft and shipped to an outside vendor who 
performs the ESV. 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 
comparable and commercially available and reasonable replacement 
part. After the ESVs the engines are returned to X to be reinstalled 
on another aircraft or stored for later installation. Assume the 
unit of property for X's aircraft is the entire aircraft, including 
the aircraft engines, and that the class life for X's aircraft is 12 
years. Assume that none of the exceptions set out in paragraph 
(e)(2) of this section applies to the costs of performing the ESVs.
    (ii) Because the ESVs involve the recurring activities that X 
expects to perform as a result of its use of the aircraft to keep 
the aircraft in ordinarily efficient operating condition, and 
consist of maintenance activities that X expects to perform more 
than once during the 12 year class life of the aircraft, X's ESVs 
are within the routine maintenance safe harbor under paragraph (e) 
of this section. Accordingly, the amounts paid by X for the ESVs are 
deemed not to improve the aircraft and are not required to be 
capitalized under paragraph (d)(1) of this section. For the 
treatment of costs to acquire the engines, see Sec.  1.162-3.
    Example 2. Routine maintenance after economic useful life. 
Assume the same facts as in Example 1, except that X incurs costs to 
perform an ESV on one of its aircraft engines in 2024, after the end 
of the economic useful life that X anticipated for the aircraft. 
Because this ESV involves the same routine maintenance activities 
that were performed on aircraft engines in Example 1, this ESV also 
is within the routine maintenance safe harbor under paragraph (e) of 
this section. Accordingly, the amounts paid by X for this ESV, even 
though performed after the economic useful life of the aircraft, are 
deemed not to improve the aircraft and are not required to be 
capitalized under paragraph (d)(1) of this section.
    Example 3. Routine maintenance resulting from prior owner's use. 
(i) In January 2008, X purchases a used machine for use its 
manufacturing operations. Assume that the machine is the unit of 
property and has a class life of 10 years. The machine is fully 
operational at the time it is purchased by X and is immediately 
placed in service in X's business. At the time it is placed in 
service by X, X expects to perform manufacturer recommended 
scheduled maintenance on the machine approximately every three 
years. The scheduled maintenance includes the cleaning and oiling of 
the machine, the inspection of parts for defects, and the 
replacement of minor items such as springs, bearings, and seals with 
comparable and commercially available and reasonable replacement 
parts. At the time the machine is purchased, it is approaching the 
end of a three-year scheduled maintenance period. As a result, in 
February 2008, X incurs costs to perform the manufacturer 
recommended scheduled maintenance. Assume that none of the 
exceptions set out in paragraph (e)(2) of this section apply to the 
amounts paid for the scheduled maintenance.
    (ii) The majority of the costs incurred by X do not qualify 
under the routine maintenance safe harbor in paragraph (e) of this 
section because the costs were primarily incurred as a result of the 
prior owner's use of the property and not X's use. The condition of 
the machine at the time that it was placed in service by X was that 
of a machine nearing the end of a scheduled maintenance period. 
Accordingly, the amounts paid by X for the scheduled maintenance 
resulting from the prior owner's use of the property must be 
capitalized if those amounts result in a betterment under paragraph 
(f) of this section, including the amelioration of a material 
condition or defect, or otherwise result in an improvement under 
paragraph (d)(1) of this section. See also section 263A requiring 
taxpayers to capitalize the direct and allocable share of indirect 
costs of property produced or acquired for resale.
    Example 4. Routine maintenance resulting from new owner's use. 
Assume the same facts as in Example 3, except that after X incurs 
costs for the maintenance in 2008, X continues to operate the 
machine in its manufacturing business. In 2011, X incurs costs to 
perform the next scheduled manufacturer recommended maintenance on 
the machine. Assume that the scheduled maintenance activities 
performed are the same as those performed in Example 3 and that none 
of the exceptions set out in paragraph (e)(2) of this section apply 
to the amounts paid for the scheduled maintenance. Because the 
scheduled maintenance performed in 2011 involves the recurring 
activities that X performs as a result of its use of the machine, 
keeps the machine in an ordinarily efficient operating condition, 
and consists of maintenance activities that X expects to perform 
more than once during the 10 year class life of the machine, X's 
scheduled maintenance costs are within the routine maintenance safe 
harbor under paragraph (e) of this section. Accordingly, the amounts 
paid by X for the scheduled maintenance in 2011 are deemed not to 
improve the machine and are not required to be capitalized under 
paragraph (d)(1) of this section. However, because the amounts paid 
for the scheduled maintenance are incurred by reason of X's 
manufacturing operations, X is required to capitalize the amounts 
paid for the maintenance to products produced by X. See Sec.  
1.263A-1(e)(3)(ii).
    Example 5. Routine maintenance; replacement of substantial 
structural part. X is in the business of producing commercial 
products for sale. As part of the production process, X places raw 
materials into lined containers in which a chemical reaction is used 
to convert raw materials into the finished product. The lining is a 
substantial structural part of the container, and comprises 60% of 
the total physical structure of the container. Assume that each 
container, including its lining, is the unit of property and that a 
container has a class life of 12 years. At the time that X placed 
the container into service, X was aware that approximately every 
three years, X would be required to replace the lining in the 
container with comparable and commercially available and reasonable 
replacement materials. At the end of that period, the container will 
continue to function, but will become less efficient and the 
replacement of the lining will be necessary to keep the container in 
an ordinarily efficient operating condition. In 2003, X acquired 10 
new containers and placed them into service. In 2006, 2009, 2011, 
and 2014, X pays amounts to replace the containers' linings with 
comparable and commercially available and reasonable replacement 
parts. Assume that none of the exceptions set out in paragraph 
(e)(2) of this section apply to the amounts paid for the replacement 
linings. Because the replacement of the linings involves recurring 
activities that X expects to perform as a result of its use of the 
containers to keep the containers in their ordinarily efficient 
operating condition, and consists of maintenance activities that X 
expects to perform more than once during the 12 year class lives of 
the containers, X's lining replacement costs are within the routine 
maintenance safe harbor under paragraph (e) of this section. 
Accordingly, the amounts paid by X for the replacement of the 
container linings are deemed not to improve the containers and are 
not required to be capitalized under paragraph (d)(1) of this 
section. However, because the amounts paid to replace the container 
linings are incurred by reason of X's manufacturing operations, X is 
required to capitalize the amounts paid for the replacements to 
products produced by X. See Sec.  1.263A-1(e)(3)(ii).
    Example 6. Routine maintenance once during class life. X is a 
Class I railroad that owns a fleet of freight cars. Assume that a 
freight car, including all its components, is a unit of property and 
has a class life of 14 years. At the time that X places a freight 
car into service, X expects to perform cyclical reconditioning to 
the car every 8 to 10 years in order to keep the freight car in 
ordinarily efficient operating condition. During this 
reconditioning, X incurs costs to disassemble, inspect, and 
recondition and/or replace components of the freight car with 
comparable and commercially available and reasonable replacement 
parts. Ten years after the freight car is placed in service by X, X 
incurs costs to perform a cyclical reconditioning on the car. 
Because X expects to perform the reconditioning only once during the 
14 year class life of the freight car, the costs incurred for 
reconditioning do not qualify for the routine maintenance safe 
harbor under paragraph (e) of this section. Accordingly, X must 
capitalize the amounts paid for the reconditioning of the freight 
car if these amounts result in an improvement under paragraph (d)(1) 
of this section.
    Example 7. Routine maintenance on non-rotable part. X is a 
towboat operator that owns and leases a fleet of towboats. Each 
towboat is equipped with two diesel-powered engines. Assume that 
each towboat, including its engines, is the unit of property and 
that a towboat has a class life of 18 years. At the time that X 
places its towboats into service, X is aware that approximately 
every three to four years, X will need to perform scheduled 
maintenance on the two towboat engines to keep the engines in their

[[Page 12861]]

ordinarily efficient operating condition. This maintenance is 
completed while the engines are attached to the towboat and involves 
the cleaning and inspecting of the engines to determine which parts 
are within acceptable operating tolerances and can continue to be 
used, which parts must be reconditioned to be brought back to 
acceptable tolerances, and which parts must be replaced. Engine 
parts replaced during these procedures are replaced with comparable 
and commercially available and reasonable replacement parts. Assume 
the towboat engines are not rotable spare parts under Sec.  1.162-
3(b). In 2005, X acquired a new towboat, including its two engines, 
and placed the towboat into service. In 2009, X incurs amounts to 
perform scheduled maintenance on both engines in the towboat. Assume 
that none of the exceptions set out in paragraph (e)(2) of this 
section apply to the scheduled maintenance costs. Because the 
scheduled maintenance involves recurring activities that X expects 
to perform more than once during the 18 year class life of the 
towboat. This maintenance results from X's use of the towboat, and 
is performed to keep the towboat in an ordinarily efficient 
operating condition, the scheduled maintenance on X's towboat is 
within the routine maintenance safe harbor under paragraph (e) of 
this section. Accordingly, the amounts paid by X for the scheduled 
maintenance to its towboat engines in 2009 are deemed not to improve 
the towboat and are not required to be capitalized under paragraph 
(d)(1) of this section.
    Example 8. Routine maintenance with betterments. Assume the same 
facts as Example 7, except that in 2013, X's towboat engines are due 
for another scheduled maintenance visit. At this time X decides to 
upgrade the engines to increase their horsepower and propulsion, 
which would permit the towboats to tow heavier loads. Accordingly, 
in 2013 X incurs costs to perform many of the same activities that 
it would perform during the typical scheduled maintenance activities 
such as cleaning, inspecting, reconditioning, and replacing minor 
parts, but at the same time, X incurs costs to upgrade certain 
engine parts to increase the towing capacity of the boats in excess 
of the capacity when the boats were placed in service by X. Both the 
scheduled maintenance procedures and the replacement of parts with 
new and upgraded parts are necessary to increase the horsepower of 
the engines and the towing capacity of the boat. Thus, the work done 
on the engines encompasses more than the recurring activities that X 
expected to perform as a result of its use of the towboats and did 
more than keep the towboat in its ordinarily efficient operating 
condition. In addition, the scheduled maintenance procedures 
directly benefit and are incurred by reason of the upgrades. 
Therefore, the amounts paid by X in 2013 for the maintenance and 
upgrade of the engines do not qualify for the routine maintenance 
safe harbor described under paragraph (e) of this section. These 
amounts must be capitalized if they result in a betterment under 
paragraph (f) of this section, including a material increase in the 
capacity of the towboat, or otherwise result in an improvement under 
paragraph (d)(1) of this section. See also section 263A requiring 
taxpayers to capitalize all the direct costs of an improvement to 
property and all the indirect costs that directly benefit or are 
incurred by reason of an improvement to property.
    Example 9. Exceptions to routine maintenance. X owns and 
operates a farming and cattle ranch with an irrigation system that 
provides water for crops. Assume that each canal in the irrigation 
system is a single unit of property and has a class life of 20 
years. When X placed the canals into service, X expected to have to 
perform major maintenance on the canals every 3 years to keep the 
canals in their ordinarily efficient operating condition. This 
maintenance included draining the canals, and then cleaning, 
inspecting, repairing, reconditioning or replacing parts of the 
canal with comparable and commercially available and reasonable 
replacement parts. X placed the canals into service in 2005 and did 
not perform any maintenance on the canals until 2010. At that time, 
the canals had fallen into a state of disrepair and no longer 
functioned for irrigation. In 2010, X paid amounts to drain the 
canals, and do extensive cleaning, repairing, reconditioning and 
replacing parts of the canals with comparable and commercially 
available and reasonable replacement parts. Although the work 
performed on X's canals was similar to the activities that X 
expected to perform, but did not perform, every three years, the 
costs of these activities do not fall within the routine maintenance 
safe harbor. Specifically, under paragraph (e)(2)(iv) of this 
section, routine maintenance does not include amounts paid to return 
a unit of property to its former ordinary efficient operating 
condition if the property has deteriorated to a state of disrepair 
and is no longer functional for its intended use. Accordingly, 
amounts paid by X for work performed on the canals in 2010 must be 
capitalized if they result in improvements under paragraph (d)(1) of 
this section (for example, restorations under paragraph (g) of this 
section).

    (f) Capitalization of betterments--(1) In general. A taxpayer must 
capitalize amounts paid that result in the betterment of a unit of 
property. An amount paid results in the betterment of a unit of 
property only if it--
    (i) Ameliorates a material 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) Results in a material addition (including a physical 
enlargement, expansion, or extension) to the unit of property; or
    (iii) Results in a material increase in capacity (including 
additional cubic or square space), productivity, efficiency, strength, 
or quality of the unit of property or the output of the unit of 
property.
    (2) Application of general rule--(i) Facts and circumstances. To 
determine whether an amount paid results in a betterment described in 
paragraph (f)(1) of this section, it is appropriate to consider all the 
facts and circumstances including, but not limited to, the purpose of 
the expenditure, the physical nature of the work performed, the effect 
of the expenditure on the unit of property, and the taxpayer's 
treatment of the expenditure on its applicable financial statement (as 
described in paragraph (b)(4) of this section).
    (ii) Unavailability of replacement parts. 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 a 
betterment to the unit of property.
    (iii) Appropriate comparison--(A) In general. In cases in which a 
particular event necessitates an expenditure, the determination of 
whether an expenditure results in a betterment 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 circumstances necessitating the expenditure.
    (B) Normal wear and tear. If the expenditure is made to correct the 
effects of normal wear and tear to the unit of property (including the 
amelioration of a condition or defect that existed prior to the 
taxpayer's acquisition of the unit of property resulting from normal 
wear and tear), the condition of the property immediately prior to the 
circumstances necessitating the expenditure is the condition of the 
property after the last time the taxpayer corrected the effects of 
normal wear and tear (whether the amounts paid were for maintenance or 
improvements) or, if the taxpayer has not previously corrected the 
effects of normal wear and tear, the condition of the property when 
placed in service by the taxpayer.
    (C) Particular event. If the expenditure is made as a result of a 
particular event, the condition of the property immediately prior to 
the circumstances necessitating the expenditure is the condition of the 
property immediately prior to the particular event.
    (3) Examples. The following examples illustrate solely the rules of 
this paragraph (f). Even if capitalization is not required in an 
example under this paragraph (f), the amounts paid in the example may 
be subject to capitalization

[[Page 12862]]

under a different provision of this section.

    Example 1. Amelioration of pre-existing material condition or 
defect. In 2008, X purchases a store located on a parcel of land 
that contained underground gasoline storage tanks left by prior 
occupants. Assume that the parcel of land is the unit of property. 
The tanks had leaked, causing soil contamination. X is not aware of 
the contamination at the time of purchase. In 2009, X discovers the 
contamination and incurs costs to remediate the soil. The 
remediation costs incurred by X result in a betterment to the land 
under paragraph (f)(1)(i) of this section because the costs were 
incurred to ameliorate a material condition or defect that existed 
prior to the taxpayer's acquisition of the land.
    Example 2. Not amelioration of pre-existing condition or defect. 
X owned a building that was constructed with insulation that 
contained asbestos. The health dangers of asbestos were not widely 
known when the building was constructed. In 2008, X determined that 
certain areas of asbestos-containing insulation had begun to 
deteriorate and could eventually pose a health risk to employees. 
Therefore, X decided to remove the asbestos-containing insulation 
from the building and replace it with new insulation that was safer 
to employees, but no more efficient or effective than the asbestos 
insulation. Assume the building and its structural components 
(including the asbestos insulation) is the unit of property. The 
amounts paid to remove and replace the asbestos insulation are not 
required to be capitalized as a betterment under paragraphs 
(f)(1)(i) and (f)(2)(i) of this section because the asbestos, 
although later determined to be unsafe under certain circumstances, 
was not an inherent and material defect to the property. In 
addition, the removal and replacement of the asbestos did not result 
in any material additions to the building or material increases in 
capacity, productivity, efficiency, strength or quality of the 
building or the output of the building under paragraphs (f)(1)(ii) 
and (f)(1)(iii) of this section.
    Example 3. Not amelioration of pre-existing material condition 
or defect. (i) In January 2008, X purchases a used machine for use 
its manufacturing operations. Assume that the machine is a unit of 
property and it has a class life of 10 years. The machine is fully 
operational at the time it is purchased by X and is immediately 
placed in service in X's business. At the time it is placed in 
service by X, X expects to perform manufacturer recommended 
scheduled maintenance on the machine every three years. The 
scheduled maintenance includes the cleaning and oiling of the 
machine, the inspection of parts for defects, and the replacement of 
minor items such as springs, bearings, and seals with comparable and 
commercially available and reasonable replacement parts. The 
scheduled maintenance does not result in any material additions or 
material increases in capacity, productivity, efficiency, strength 
or quality of the machine or the output of the machine. At the time 
the machine is purchased, it is approaching the end of a three-year 
scheduled maintenance period. As a result, in February 2008, X 
incurs costs to perform the manufacturer recommended scheduled 
maintenance to keep the machine in its ordinarily efficient 
operating condition.
    (ii) The majority of the costs incurred by X do not qualify 
under the routine maintenance safe harbor in paragraph (e) of this 
section because the costs were primarily incurred as a result of the 
prior owner's use of the property and not the taxpayer's use. The 
condition of the machine at the time that it was placed in service 
by X was that of a machine nearing the end of a scheduled 
maintenance period. Accordingly, the amounts paid by X for the 
scheduled maintenance resulting from the prior owner's use of the 
property ameliorate conditions or defects that existed prior to X's 
ownership of the machine. Nevertheless, considering the facts and 
circumstances under paragraph (f)(2)(i) of this section, including 
the purpose and minor nature of the work performed, those amounts do 
not ameliorate a material condition or defect under paragraph 
(f)(1)(i) of this section and accordingly do not result in a 
betterment that must be capitalized under this paragraph (f).
    Example 4. Not amelioration of pre-existing material condition 
or defect. In 2008, X purchases a used ice resurfacing machine for 
use in the operation of its ice skating rink. To comply with local 
regulations, X is required to routinely monitor the air quality in 
the ice skating rink. One week after X places the machine into 
service, during a routine air quality check, X discovers that the 
operation of the machine is adversely affecting the air quality in 
the skating rink. As a result, X incurs costs to inspect and retune 
the machine, which includes replacing minor components of the 
engine, which had worn out prior to X's acquisition of the machine. 
Assume the resurfacing machine, including the engine, is the unit of 
property. The routine maintenance safe harbor in paragraph (e) of 
this section does not apply to the amounts paid because the 
activities performed do more than return the machine to the 
condition that existed at the time it was placed in service by X. 
The amounts paid by X to inspect, retune, and replace minor 
components of the ice resurfacing machine ameliorated a condition or 
defect that existed prior to X's acquisition of the equipment. 
Nevertheless, considering the facts and circumstances under 
paragraph (f)(2)(i) of this section, including the purpose and minor 
nature of the work performed, these amounts do not ameliorate a 
material condition or defect under paragraph (f)(1)(i) of this 
section, result in a material addition to the machine under 
paragraph (f)(1)(ii) of this section, or result in a material 
increase in the capacity, productivity, efficiency, strength or 
quality of the machine or the output of the machine. Accordingly, 
the amounts paid by X to inspect, retune, and replace minor 
components of the machine do not result in a betterment that must be 
capitalized under this paragraph (f).
    Example 5. Amelioration of material condition or defect; 
increase in quality. (i) In January 2009, X acquires a building for 
use in its business of providing assisted living services. Before 
and after the purchase, the building functions as an assisted living 
facility. However, at the time of the purchase, X is aware that the 
building is in a condition that is below the standards that X 
requires for facilities used in its business. Beginning in 2009 and 
over the next two years, while X continues to use the building as an 
assisted living facility, X incurs costs for repairs, maintenance, 
and the acquisition of new property to bring the facility into the 
high-quality condition for which X's facilities are known. The work 
includes repainting; replacing flooring materials, windows, and 
tiling and fixtures in bathrooms; replacing window treatments, 
furniture, and cabinets; and repairing or replacing roofing 
materials, heating and cooling systems. On its applicable financial 
statements, X capitalizes the costs of the repairs, maintenance, and 
acquisitions over the remaining economic useful life recorded for 
the building. Assume that the building, including its structural 
components, is a single unit of property and that each section 1245 
property is a separate unit of property.
    (ii) Considering the facts and circumstances under paragraph 
(f)(2)(i) of this section, including the purpose of the 
expenditures, the effect of the expenditures on the building, and 
the treatment of the expenditures in X's applicable financial 
statements, the amounts paid by X for repairs and maintenance to the 
building and its structural components ameliorated material 
conditions and defects that existed prior to X's acquisition of the 
building. In addition, these amounts materially increased the 
quality of the building as compared to the condition of the building 
when it was placed in service by X. Accordingly, the amounts paid by 
X for repairs and maintenance to the building and its structural 
components (that is, repainting, replacing windows, replacing 
bathroom fixtures, repairing and replacing roofing materials and 
heating and cooling systems) result in betterments that must be 
capitalized under this paragraph (f). Moreover, X is required to 
capitalize the amounts paid to acquire and install each section 1245 
property, including the flooring materials, tiling, each window 
treatment, each item of furniture, and each cabinet, in accordance 
with Sec.  1.263(a)-2(d).
    Example 6. Not a betterment. X owns a nationwide chain of retail 
stores that sell a wide variety of items. To remain competitive in 
the industry, X periodically changes the layout and appearance of 
its stores. These changes include the reconfiguration of the stores 
to provide better exposure of the merchandise and cosmetic 
alterations to keep the store modern and attractive to customers. 
The work is not undertaken for the purpose of repairing damaged 
property but rather to renew the appearance of the property. X 
incurs costs to update 50 stores during the taxable year. In its 
applicable financial statement, X capitalizes all the costs of the 
updates over a 5-year period until which X anticipates it would have 
to update again. Assume that each store building, including its 
structural components, is a unit of property and that each section 
1245 property within the store is a separate unit of property. Also 
assume that the work performed did not ameliorate any material 
conditions or defects that existed when X acquired the store

[[Page 12863]]

buildings or result in any material additions to the store 
buildings.
    (ii) Considering the facts and circumstances under paragraph 
(f)(2)(i) of this section, including the purpose of the expenditure, 
the nature of the work performed, and the treatment of the work on 
X's applicable financial statements, the amounts paid by X for 
updates to its store buildings (including their structural 
components) do not result in material increases in capacity, 
productivity, efficiency, strength or quality of the store 
buildings. Accordingly, the amounts paid by X for the updates on the 
store buildings (including their structural components) do not 
result in betterments that must be capitalized under this paragraph 
(f). However, X is required to capitalize the amounts paid to 
acquire and install each section 1245 property in accordance with 
Sec.  1.263(a)-2(d).
    Example 7. Betterment; regulatory requirement. X owns a hotel in 
City that includes five foot high unreinforced terra cotta and 
concrete parapets with overhanging cornices around the entire roof 
perimeter. The parapets and cornices are in good condition. In 2008, 
City passes an ordinance setting higher safety standards for 
parapets and cornices because of the hazardous conditions caused by 
earthquakes. To comply with the ordinance, X replaces the old 
parapets and cornices with new ones made of glass fiber reinforced 
concrete, which makes them lighter and stronger than the original 
ones. They are attached to the hotel using welded connections 
instead of wire supports, making them more resistant to damage from 
lateral movement. Assume the hotel building and its structural 
components are the 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 materially increased the 
structural soundness (that is, the strength) of the hotel building. 
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 8. Not a betterment; regulatory requirement. X owns a 
meat processing plant. In 2008, X discovers that oil was seeping 
through the concrete walls of the plant, creating a fire hazard. 
Federal meat inspectors advise X that it must correct the seepage 
problem or shut down its plant. To correct the problem, X incurs 
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. Assume the plant building and its structural components 
are the 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 or material increase in capacity, 
productivity, efficiency, strength or quality of the plant or its 
output of compared to the condition of the plant prior to the 
seepage of the oil. Therefore, the amounts paid by X to correct the 
seepage do not result in a betterment to the plant. X is not 
required to capitalize as an improvement under this paragraph (f) 
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 9. Not a betterment; replacement with same part. X owns 
a small retail shop. In 2008, a storm damages 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. Assume the shop 
building and its structural components are the 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, or material 
increase in the capacity, productivity, efficiency, strength or 
quality of the shop or the output of the shop compared to the 
condition of the shop prior to the storm. Therefore, the amounts 
paid by X to reshingle the roof with wooden shingles do not result 
in betterment to the shop building. X is not required to capitalize 
as an improvement under this paragraph (f) amounts paid to replace 
the shingles.
    Example 10. Not a betterment; replacement with comparable part. 
Assume the same facts as in Example 9, 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 result in a 
betterment to the shop, even though the asphalt shingles may be 
stronger than 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 this paragraph (f) 
amounts paid to replace the shingles.
    Example 11. Betterment; replacement with improved parts. Assume 
the same facts as in Example 9, 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. The 
expenditure for these shingles resulted in a material increase in 
the quality of the shop building as compared to the condition of the 
shop building prior to the storm. X must capitalize amounts paid to 
reshingle the roof as an improvement under this paragraph (f) 
because they result in a betterment to the shop.
    Example 12. 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. Assume 
the factory building and its structural components are the 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 (f)(2)(iii) of this section does not apply to these 
amounts paid because the expenditure was not necessitated by a 
particular event.
    Example 13. Material increase in capacity. In 2008, X purchases 
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 is 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 needs to deepen the channel to a depth of 20 feet. 
X hires a contractor to dredge the channel to the required depth. 
Assume the channel is the unit of property. X must capitalize as an 
improvement amounts paid for the dredging because it resulted in a 
material increase in the capacity of the channel. The comparison 
rule in paragraph (f)(2)(iii) of this section does not apply to 
these amounts paid because the expenditure was not necessitated by a 
particular event.
    Example 14. Not a material increase in capacity. Assume the same 
facts as in Example 13, 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 result in a material addition 
to the unit of property or a material increase in the capacity, 
productivity, efficiency, strength or quality of the unit of 
property or the output of the unit of property. X is not required to 
capitalize as a betterment under paragraph (f) of this section 
amounts paid to redredge the channel.
    Example 15. 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. Assume the building and its structural components 
are the 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 result in a 
material addition or a material increase to the capacity, 
productivity, efficiency, strength or quality of the unit of 
property or output of the unit of property. X is not required to 
capitalize as a betterment under this paragraph (f) amounts paid 
related to removing the drop-ceiling. The comparison rule in 
paragraph (f)(2)(iii) of this section does not apply to these 
amounts paid because the expenditure was not necessitated by a 
particular event.


[[Page 12864]]


    (g) Capitalization of restorations--(1) In general. A taxpayer must 
capitalize amounts paid to restore a unit of property, including 
amounts paid in making good the exhaustion for which an allowance is or 
has been made. An amount is paid to restore a unit of property if it--
    (i) Is for the replacement of a component of a unit of property and 
the taxpayer has properly deducted a loss for that component (other 
than a casualty loss under Sec.  1.165-7);
    (ii) Is for the replacement of a component of a unit of property 
and the taxpayer has properly taken into account the adjusted basis of 
the component in realizing gain or loss resulting from the sale or 
exchange of the component;
    (iii) Is for the repair of damage to a unit of property for which 
the taxpayer has properly taken a basis adjustment as a result of a 
casualty loss under section 165, or relating to a casualty event 
described in section 165;
    (iv) Returns the unit of property to its ordinarily efficient 
operating condition if the property has deteriorated to a state of 
disrepair and is no longer functional for its intended use;
    (v) Results in the rebuilding of the unit of property to a like-new 
condition after the end of its economic useful life (see paragraph 
(g)(2) of this section); or
    (vi) Is for the replacement of a major component or a substantial 
structural part of the unit of property (see paragraph (g)(3) of this 
section).
    (2) Rebuild to like-new condition--(i) In general. For purposes of 
paragraph (g)(1)(v) of this section, the following definitions apply:
    (1) Like-new condition. A unit of property is rebuilt to a like-new 
condition if it is brought to the status of new, rebuilt, 
remanufactured, or similar status under the terms of any Federal 
regulatory guideline or the manufacturer's original specifications.
    (2) Economic useful life. 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. See Sec.  1.167(a)-1(b) for the factors to be considered in 
determining this period.
    (ii) Exception. An amount paid is not required to be capitalized 
under paragraph (g)(1)(v) of this section if it is paid during the 
recovery period prescribed in section 168(c) (taking into account the 
applicable convention) for the property, regardless of whether the 
property is depreciated under section 168(a).
    (3) Replacement of a major component or a substantial structural 
part--(i) In general. For purposes of paragraph (g)(1)(vi) of this 
section, the replacement of a major component or a substantial 
structural part means the replacement of--
    (1) A part or a combination of parts of the unit of property, the 
cost of which comprises 50 percent or more of the replacement cost of 
the unit of property; or
    (2) A part or a combination of parts of the unit of property that 
comprise 50 percent or more of the physical structure of the unit of 
property.
    (ii) Exception. An amount paid is not required to be capitalized 
under paragraph (g)(1)(vi) of this section if it is paid during the 
recovery period prescribed in section 168(c) (taking into account the 
applicable convention) for the property, regardless of whether the 
property is depreciated under section 168(a).
    (4) Examples. The following examples illustrate solely the rules of 
this paragraph (g). Even if capitalization is not required in an 
example under the cited subparagraph under this paragraph (g), the 
amounts paid in the example may be subject to capitalization under a 
different provision of this section, or under a different subparagraph 
in this paragraph (g).

    Example 1. Replacement of loss component. X owns a manufacturing 
building containing various types of manufacturing equipment. X does 
a cost segregation study of the manufacturing building and properly 
determines that a walk-in freezer in the manufacturing equipment is 
section 1245 property as defined in section 1245(a)(3). The freezer 
is not part of the HVAC system that relates to the general operation 
or maintenance of the building. The components of the walk-in 
freezer cease to function and X decides to replace them. X abandons 
the freezer components and properly recognizes a loss from the 
abandonment of the components. X replaces the abandoned freezer 
components with new components and incurs costs to acquire and 
install the new components. Under paragraph (g)(1)(i) of this 
section, X must capitalize the amounts paid to acquire and install 
the new freezer components because X replaced components for which 
it had properly deducted a loss.
    Example 2. Replacement of sold component. Assume the same facts 
as in Example 1 except that X did not abandon the components, but 
instead sold them to another party and properly recognized a loss on 
the sale. Under paragraph (g)(1)(ii) of this section, X must 
capitalize the amounts paid to acquire and install the new freezer 
components because X replaced components for which it had property 
taken into account the adjusted basis of the components in realizing 
a loss from the sale of the components.
    Example 3. Restoration after casualty loss. X owns an office 
building that it uses in its trade or business. A storm damages the 
office building at a time when the building has an adjusted basis of 
$500,000. X deducts under section 165 a casualty loss in the amount 
of $50,000 and properly reduces its basis in the office building to 
$450,000. X hires a contractor to repair the damage to the building 
and pays the contractor $50,000 for the work. Under paragraph 
(g)(1)(iii) of this section, X must capitalize the $50,000 amount 
paid to the contractor because X properly adjusted its basis as a 
result of a casualty loss under section 165.
    Example 4. Restoration after casualty event. Assume the same 
facts as in Example 3, except that X receives insurance proceeds of 
$50,000 after the casualty to compensate for its loss. X cannot 
deduct a casualty loss under section 165 because its loss was 
compensated by insurance. However, X properly reduces its basis in 
the property by the amount of the insurance proceeds. Under 
paragraph (g)(1)(iii) of this section, X must capitalize the $50,000 
amount paid to the contractor because X has properly taken a basis 
adjustment relating to a casualty event described in section 165.
    Example 5. Restoration of property in a state of disrepair. X 
owns and operates a farm with several barns and outbuildings. One of 
the outbuildings is not used or maintained by X on a regular basis 
and falls into a state of disrepair. The outbuilding previously was 
used for storage but can no longer be used for that purpose because 
the building is not structurally sound. X decides to restore the 
outbuilding and incurs costs to shore up the walls and replace the 
siding. Under paragraph (g)(1)(iv) of this section, X must 
capitalize the amounts paid to restore the outbuilding because they 
return the outbuilding to its ordinarily efficient operating 
condition after it had deteriorated to a state of disrepair and was 
no longer functional for its intended use.
    Example 6. Rebuild of property to like-new condition before end 
of economic useful life. X is a Class I railroad that owns a fleet 
of freight cars. Freight cars have a recovery period of 7 years 
under section 168(c) and an economic useful life of 30 years. Every 
8 to 10 years, X rebuilds its freight cars. Ten years after the 
freight car is placed in service by X, X performs a rebuild, which 
includes a complete disassembly, inspection, and reconditioning and/
or replacement of components of the suspension and draft systems, 
trailer hitches, and other special equipment. X modifies 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 car are replaced or are sandblasted and 
repainted. New wheels

[[Page 12865]]

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 car has been restored to rebuilt condition under the 
manufacturer's specifications. Assume the freight car is the unit of 
property. X is not required to capitalize under paragraph (g)(1)(v) 
of this section the amounts paid to rebuild the freight car because, 
although the amounts paid restore the freight car to like-new 
condition, the amounts were not paid after the end of the economic 
useful life of the freight car.
    Example 7. Rebuild of property to like-new condition after end 
of economic useful life. Assume the same facts as in Example 6, 
except that X rebuilds the freight car 40 years after it is placed 
in service by X. Under paragraph (g)(1)(v) of this section, X must 
capitalize the amounts paid to rebuild the freight car because the 
amounts paid restore the freight car to like-new condition after the 
end of the economic useful life of the freight car.
    Example 8. Replacement of major component. X is a common carrier 
that owns a fleet of petroleum hauling trucks. X replaces the 
existing engine, cab, and petroleum tank with a new engine, cab, and 
tank. The new engine and cab cost $25,000; the new tank costs 
$10,000. The cost of a new tractor is $50,000 and the cost of a new 
trailer is $30,000. 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, and that the trailer (which contains the petroleum 
tank) is a separate unit of property from the rest of the truck. 
Also assume that X replaced the components after the end of the 
recovery periods under section 168(c) for the tractor and the 
trailer. The amounts paid for the new engine and cab comprise 50% of 
the cost of a new tractor and must be capitalized under paragraph 
(g)(1)(vi) of this section. The amounts paid for the new petroleum 
tank do not comprise 50% or more of the cost of a new trailer; 
however, the tank comprises more than 50% of the physical structure 
of the trailer. Therefore, the amounts paid for the new tank also 
must be capitalized under paragraph (g)(1)(vi) of this section.
    Example 9. Repair performed during a restoration. Assume the 
same facts as in Example 8, except that, at the same time the engine 
and cab of the tractor are replaced, X paints the cab of the tractor 
with its company logo and fixes a broken taillight on the tractor. 
The repair of the broken taillight and the painting of the cab 
generally are deductible expenses under Sec.  1.162-4. However, 
under paragraph (d)(4)(i) of this section, a taxpayer must 
capitalize all the direct costs of an improvement and all the 
indirect costs that directly benefit or are incurred by reason of an 
improvement in accordance with the rules under section 263A. Repairs 
and maintenance 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. Therefore, all amounts paid that directly benefit 
or are incurred by reason of the tractor restoration must be 
capitalized, including amounts paid for activities that usually 
would be deductible maintenance expenses, such as the painting of 
the cab. Amounts paid to repair the broken taillight, however, are 
not incurred by reason of the restoration of the tractor, nor do the 
amounts paid directly benefit the tractor restoration, despite that 
the repair was performed at the same time as the restoration. Thus, 
X must capitalize to the restoration of the tractor the amounts paid 
to paint the cab, but X is not required to capitalize to the 
restoration of the tractor the amounts paid to repair the broken 
taillight.
    Example 10. Not a replacement of substantial structural part. X 
owns a large retail store. X discovers a leak in the roof of the 
store and hires a contractor to inspect and fix the roof. The 
contractor discovers that a major portion of the sheathing and 
rafters has rotted, and recommends the replacement of the entire 
roof. X pays the contractor to replace the roof. Assume the store 
and its structural components are the unit of property and that the 
roof does not comprise 50% or more of the physical structure of the 
store. Also assume the cost of the roof does not comprise 50% or 
more of the cost to acquire a new store. Consequently, the new roof 
is not a major component or substantial structural part of the 
store. Therefore, X is not required to capitalize under paragraph 
(g)(1)(vi) of this section the amounts paid to replace the roof.
    Example 11. Related amounts to replace major component. (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 consist 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. 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 tanks to the pipes leading to the pumps, backfilling of the 
hole, and replacement of the paving. Assume the new tanks comprise 
50% or more of the physical structure of the gasoline distribution 
system. X also is required to pay a permit fee to the county to 
undertake the installation of the new tanks.
    (ii) X pays the permit fee to the county on October 15, 2008. 
The contractor performs all of the required work and, on November 1, 
2008, bills X for the costs of removing the old USTs. On November 
15, 2008, the contractor bills X for the remainder of the work. 
Assume the gasoline distribution system is the unit of property. The 
USTs are major components of the gasoline distribution system. 
Therefore, under paragraphs (d)(5) and (g)(1)(vi) of this section, X 
must capitalize as an improvement to the 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 12. 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. 
During 2008, X removed and replaced a major portion of the plant's 
roof decking and roofing material. Assume the plant building and its 
structural components are the unit of property and that the portion 
of the roof that is replaced is not a major component or substantial 
structural part of the building. X is not required to capitalize 
under paragraph (g)(1)(vi) of this section the amounts paid to 
remove and replace the roof decking and materials. However, under 
section 263A, all direct and indirect costs, including otherwise 
deductible costs, that directly benefit or are incurred by reason of 
X's manufacturing activities must be capitalized to the property 
produced by X. 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 by X.

    (h) Capitalization of amounts to adapt property to a new or 
different use--(1) In general. Taxpayers must capitalize amounts paid 
to adapt a unit of property to a new or different use. In general, an 
amount is paid to adapt a unit of property to a new or different use if 
the adaptation is not consistent with the taxpayer's intended ordinary 
use of the unit of property at the time originally placed in service by 
the taxpayer.
    (2) Examples. The following examples illustrate solely the rules of 
this paragraph (h). Even if capitalization is not required in an 
example under this paragraph (h), the amounts paid in the example may 
be subject to capitalization under a different provision of this 
section.

    Example 1. New or different use. X is a manufacturer and owns a 
manufacturing facility that it has used for manufacturing since 
1970, when it was placed in service by X. Assume the manufacturing 
facility is a unit of property. In 2008, X incurred costs to convert 
its manufacturing facility into a showroom for its business. To 
convert the facility, X replaces various structural components to 
provide a better layout for the

[[Page 12866]]

showroom and its offices. X also rewires and repaints the building 
as part of the conversion. None of the materials used, such as the 
wiring, are better than existing materials in the building. Under 
this paragraph (h), the amounts paid by X to convert the 
manufacturing facility into a showroom are paid to adapt the 
building to a new or different use because the conversion is not 
consistent with X's intended ordinary use of the property at the 
time it was placed in service. Therefore, X is required to 
capitalize these amounts under paragraph (h)(1) of this section.
    Example 2. Not a new or different use. X owns a building, which 
is a unit of property, consisting of twenty retail spaces. The space 
was designed to be reconfigured; that is, adjoining spaces could be 
combined into one space. In 2008, one of the tenants expanded its 
occupancy to include two adjoining retail spaces. To facilitate the 
new lease, X incurred costs to remove the walls between the three 
retail spaces. Under this paragraph (h), the amounts paid by X to 
convert three retail spaces into one larger space for an existing 
tenant do not adapt X's building to a new or different use because 
the combination of retail spaces is consistent with X's intended, 
ordinary use of the building. Therefore, the costs are not required 
by this paragraph (h) to be capitalized.
    Example 3. Not a new or different use. X owns a building, which 
is a unit of property, consisting of twenty retail spaces. X decides 
to sell the building. In anticipation of selling the building, X 
repaints the interior walls and refinishes the hardwood floors. 
Preparing the building for sale does not constitute a new or 
different use for the building. Therefore, amounts paid in preparing 
the building for sale are not required by this paragraph (h) to be 
capitalized.
    Example 4. New or different use. Since 1930, X has owned a 
parcel of land on which it previously operated a manufacturing 
facility. Assume that the land is the unit of property. During the 
course of X's operation of the manufacturing facility, the land 
became contaminated with wastes from its manufacturing processes. In 
1995, X discontinued manufacturing operations at the site. In 2008, 
X decides to sell the property to a developer that intends to use 
the property for residential housing. In anticipation of selling the 
land, X pays amounts to cleanup the land to a standard that is 
required for the land to be used for residential purposes. In 
addition, X pays amounts to regrade the land so that it can be used 
for residential purposes. Amounts paid by X to cleanup wastes that 
were discharged in the course of X's manufacturing operations do not 
adapt the land to a new or different use, regardless of the extent 
to which the land was cleaned. However, amounts to regrade the land 
so that it can be used for residential purposes adapts the land to a 
new or different use that is inconsistent with X's intended ordinary 
use of the property at the time it was placed in service. 
Accordingly, the amounts paid by X to regrade the land must be 
capitalized under paragraph (h)(1) of this section.

    (i) Optional regulatory accounting method--(1) In general. This 
paragraph (i) provides an optional simplified method (the regulatory 
accounting method) for regulated taxpayers to determine whether amounts 
paid to repair, maintain, or improve tangible property are to be 
treated as deductible expenses or capital expenditures. A taxpayer that 
elects to use the regulatory accounting method described in paragraph 
(i)(3) of this section must use that method for property subject to 
regulatory accounting 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, the capitalization rules in Sec.  1.263(a)-3(d) 
(and the routine maintenance safe harbor described in paragraph (e) of 
this section) do not apply to amounts paid to repair, maintain, or 
improve property subject to regulatory accounting by taxpayers that 
elect to use the regulatory accounting method under this paragraph (i). 
However, section 263A continues to apply to costs required to be 
capitalized to property produced by the taxpayer or to property 
acquired for resale.
    (2) Eligibility for regulatory accounting method. A taxpayer that 
is engaged in a trade or business in a regulated industry may use the 
regulatory accounting method under this paragraph (i). For purposes of 
this paragraph (i), a taxpayer in a regulated industry is a taxpayer 
that is subject to the regulatory accounting rules of the Federal 
Energy Regulatory Commission (FERC), the Federal Communications 
Commission (FCC), or the Surface Transportation Board (STB).
    (3) Description of regulatory accounting method. Under the 
regulatory accounting method, a taxpayer must follow its method of 
accounting for regulatory accounting purposes in determining whether an 
amount paid improves property under this section. Therefore, a taxpayer 
must capitalize for Federal income tax purposes an amount paid that is 
capitalized as an improvement for regulatory accounting purposes. A 
taxpayer must not capitalize for Federal income tax purposes under this 
section an amount paid that is not capitalized as an improvement for 
regulatory accounting purposes. A taxpayer that uses the regulatory 
accounting method must use that method for all of its tangible property 
that is subject to regulatory accounting rules. The method does not 
apply to tangible property that is not subject to regulatory accounting 
rules.
    (4) [Reserved]
    (5) Examples. The rules of this paragraph (i) are illustrated by 
the following examples.

    Example 1. Taxpayer subject to regulatory accounting rules of 
FERC. X is an electric utility company that operates a power plant 
to generate electricity. X is subject to the regulatory accounting 
rules of FERC and X chooses to use the regulatory accounting method 
under this paragraph (i). X does not capitalize on its books and 
records for regulatory accounting purposes the cost of repairs made 
to its turbines. Under the regulatory accounting method, X must not 
capitalize for Federal income tax purposes amounts paid for repairs 
made to its turbines.
    Example 2. Taxpayer not subject to regulatory accounting rules 
of FERC. X is an electric utility company that operates a power 
plant to generate electricity. X previously was subject to the 
regulatory accounting rules of FERC but, for various reasons, X is 
no longer required to use FERC's regulatory accounting rules. X 
cannot use the regulatory accounting method provided in this 
paragraph (i).
    Example 3. Taxpayer subject to regulatory accounting rules of 
FCC. X is a telecommunications company that is subject to the 
regulatory accounting rules of the FCC. X chooses to use the 
regulatory accounting method under this paragraph (i). The assets of 
X include a telephone central office switching center, which 
contains numerous switches and various switching equipment. X 
capitalizes on its books and records for regulatory accounting 
purposes the cost of replacing each switch. Under the regulatory 
accounting method, X is required to capitalize for Federal income 
tax purposes amounts paid to replace each switch.
    Example 4. Taxpayer subject to regulatory accounting rules of 
STB. X is a Class I railroad that is subject to the regulatory 
accounting rules of the STB. X chooses to use the regulatory 
accounting method under this paragraph (i). X capitalizes on its 
books and records for regulatory accounting purposes the cost of 
locomotive rebuilds. Under the regulatory accounting method, X is 
required to capitalize for Federal income tax purposes amounts paid 
to rebuild its locomotives.

    (j) Repair allowance. A taxpayer may use a repair allowance method 
of accounting that is identified in published guidance in the Federal 
Register or in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter).
    (k) 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,

[[Page 12867]]

including films, sound recordings, video tapes, books, or similar 
properties.
    (l) 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 Code and regulation provisions 
relating to the use, sale, or disposition of property.
    (m) [Reserved]
    (n) Effective/applicability 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.
    Par. 9. Section 1.263A-1 is amended by adding paragraph (b)(14) as 
follows:


Sec.  1.263A-1  Uniform capitalization of costs.

* * * * *
    (b) * * *
    (14) Property subject to de minimis rule. Section 263A does not 
apply to the costs of property produced by a taxpayer to which the 
taxpayer properly applies the de minimis rule under Sec.  1.263(a)-
2(d)(4). However, the cost of property to which a taxpayer properly 
applies the de minimis rule under Sec.  1.263(a)-2(d)(4) may be 
required to be capitalized to other property as a cost incurred by 
reason of the production of the other property that is subject to 
section 263A.
* * * * *

 Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
 [FR Doc. E8-4466 Filed 3-7-08; 8:45 am]
BILLING CODE 4830-01-P