[Federal Register Volume 76, Number 248 (Tuesday, December 27, 2011)]
[Rules and Regulations]
[Pages 81060-81127]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-32024]



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Vol. 76

Tuesday,

No. 248

December 27, 2011

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; Temporary Regulation and Proposed Rule

  Federal Register / Vol. 76, No. 248 / Tuesday, December 27, 2011 / 
Rules and Regulations  

[[Page 81060]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9564]
RIN 1545-BJ93


Guidance Regarding Deduction and Capitalization of Expenditures 
Related to Tangible Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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SUMMARY: This document contains temporary regulations that provide 
guidance on the application of sections 162(a) and 263(a) of the 
Internal Revenue Code to amounts paid to acquire, produce, or improve 
tangible property. The temporary regulations clarify and expand the 
standards in the current regulations under sections 162(a) and 263(a) 
and provide certain bright-line tests (for example, a de minimis rule 
for certain acquisitions) for applying these standards. The temporary 
regulations also provide guidance under section 168 regarding the 
accounting for, and dispositions of, property subject to section 168. 
The temporary regulations also amend the general asset account 
regulations. The temporary regulations will affect all taxpayers that 
acquire, produce, or improve tangible property. The text of the 
temporary regulations also serves as the text of proposed regulations 
set forth in the notice of proposed rulemaking on this subject 
appearing elsewhere in this issue of the Federal Register.

DATES: Effective Date: These regulations are effective on January 1, 
2012.
    Applicability Dates: For dates of applicability of the temporary 
regulations, see Sec. Sec.  1.162-3T, 1.162-4T, 1.162-11T, 1.165-2T, 
1.167(a)-4T, 1.167(a)-7T, 1.167(a)-8T, 1.168(i)-1T, 1.168(i)-7T, 
1.168(i)-8T, 1.263(a)-1T, 1.263(a)-2T, 1.263(a)-3T, 1.263(a)-6T, 
1.263A-1T, and 1.1016-3T.

FOR FURTHER INFORMATION CONTACT: Concerning Sec. Sec.  1.162-3T, 1.162-
4T, 1.162-11T, 1.263(a)-1T, 1.263(a)-2T, 1.263(a)-3T, 1.263(a)-6T, 
Merrill D. Feldstein or Alan S. Williams, Office of Associate Chief 
Counsel (Income Tax & Accounting), (202) 622-4950 (not a toll-free 
call); Concerning Sec. Sec.  1.165-2T, 1.167(a)-4T, 1.167(a)-7T, 
1.167(a)-8T, 1.168(i)-1T, 1.168(i)-7T, 1.168(i)-8T, 1.263A-1T, and 
1.1016-3T, Kathleen Reed or Patrick Clinton, Office Associate Chief 
Counsel (Income Tax & Accounting), (202) 622-4930 (not a toll-free 
call).

SUPPLEMENTARY INFORMATION: 

Background

    Section 263(a) provides that no deduction is allowed for (1) any 
amount paid out for new buildings or permanent improvements or 
betterments made to increase the value of any property or estate, or 
(2) any amount expended in restoring property or in making good the 
exhaustion thereof for which an allowance has been made. Regulations 
issued under section 263(a) provided that capital expenditures included 
amounts paid or incurred to (1) add to the value, or substantially 
prolong the useful life, of property owned by the taxpayer, or (2) 
adapt the property to a new or different use. However, those 
regulations also provided that amounts paid or incurred for incidental 
repairs and maintenance of property within the meaning of section 162 
and Sec.  1.162-4 of the Income Tax Regulations are not capital 
expenditures under Sec.  1.263(a)-1.
    The United States Supreme Court has recognized the highly factual 
nature of determining whether expenditures are for capital improvements 
or for ordinary repairs. See Welch v. Helvering, 290 U.S. 111, 114 
(1933) (``decisive distinctions [between capital and ordinary 
expenditures] are those of degree and not of kind''); Deputy v. du 
Pont, 308 U.S. 488, 496 (1940) (each case ``turns on its special 
facts''). Because of the factual nature of the issue, the courts have 
articulated a number of ways to distinguish between deductible repairs 
and non-deductible capital improvements. For example, in Illinois 
Merchants Trust Co. v. Commissioner, 4 B.T.A. 103, 106 (1926), acq. (V-
2 CB 2), the court explained that repair and maintenance expenses are 
incurred for the purpose of keeping property in an ordinarily efficient 
operating condition over its probable useful life for the uses for 
which the property was acquired. Capital expenditures, in contrast, are 
for replacements, alterations, improvements, or additions that 
appreciably prolong the life of the property, materially increase its 
value, or make it adaptable to a different use. In Estate of Walling v. 
Commissioner, 373 F.2d 190, 192-193 (3rd Cir. 1966), the court 
explained that the relevant distinction between capital improvements 
and repairs is whether the expenditures were made to ``put'' or 
``keep'' property in efficient operating condition. In Plainfield-Union 
Water Co. v. Commissioner, 39 T.C. 333, 338 (1962), nonacq. on other 
grounds (1964-2 CB 8), the court stated that if the expenditure merely 
restores the property to the state it was in before the situation 
prompting the expenditure arose and does not make the property more 
valuable, more useful, or longer-lived, then such an expenditure is 
usually considered a deductible repair. In contrast, a capital 
expenditure is generally considered to be a more permanent increment in 
the longevity, utility, or worth of the property.
    The standards for applying section 263(a), as set forth in the 
regulations, case law, and administrative guidance, are difficult to 
discern and apply in practice and have led to considerable uncertainty 
and controversy for taxpayers. On January 20, 2004, the IRS and the 
Treasury Department published Notice 2004-6 (2004-3 IRB 308) announcing 
an intention to propose regulations providing guidance in this area. 
The notice identified issues under consideration by the IRS and the 
Treasury Department and invited public comment on whether these or 
other issues should be addressed in the regulations and, if so, what 
specific rules and principles should be provided.
    On August 21, 2006, the IRS and the Treasury Department published 
in the Federal Register (71 FR 48590-01) 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 the Treasury Department received numerous written comments on 
the 2006 proposed regulations and held a public hearing on December 19, 
2006. On March 10, 2008, after consideration of the comment letters and 
the statements at the public hearing, the IRS and the Treasury 
Department withdrew the 2006 proposed regulations and proposed new 
regulations (2008 proposed regulations) in the Federal Register (73 FR 
47 12838-01) under sections 162(a) (relating to the deduction for 
ordinary and necessary trade or business expenses) and section 263(a) 
(relating to the capitalization requirement). The IRS and the Treasury 
Department received several comment letters on the 2008 proposed 
regulations and held a public hearing on the 2008 proposed regulations 
on June 24, 2008. After considering the comment letters and the 
statements at the public hearing, the IRS and the Treasury Department 
are issuing temporary regulations amending 26 CFR part 1. The IRS and 
the Treasury Department are also withdrawing the 2008 proposed 
regulations and are proposing new regulations that incorporate the text 
of these temporary regulations.

[[Page 81061]]

Explanation of Provisions

I. Overview

    Section 263(a) generally requires the capitalization of amounts 
paid to acquire, produce, or improve tangible property. These temporary 
regulations provide a general framework for capitalization and retain 
many of the provisions of the 2008 proposed regulations, which in many 
instances incorporated standards from existing authorities under 
section 263(a). The temporary regulations also modify several sections 
of the 2008 proposed regulations in response to comments received and 
to achieve results that are more consistent with the established 
authorities. The temporary regulations adopt the same general format as 
the 2006 and 2008 proposed regulations, whereby Sec.  1.263(a)-1T 
provides general rules for capital expenditures, Sec.  1.263(a)-2T 
provides rules for amounts paid for the acquisition or production of 
tangible property, and Sec.  1.263(a)-3T provides rules for amounts 
paid for the improvement of tangible property. The temporary 
regulations also adopt and refine many of the rules contained in the 
2008 proposed regulations. For example, the temporary regulations adopt 
and refine the definition and treatment of materials and supplies under 
Sec.  1.162-3T, the de minimis rule for the acquisition and production 
of property under Sec.  1.263(a)-2T, and the safe harbor for routine 
maintenance under Sec.  1.263(a)-3T.
    The temporary regulations also modify some of the rules set out in 
the 2008 proposed regulations. For example, the temporary regulations 
revise certain rules for determining whether there has been an 
improvement to a unit of property under Sec.  1.263(a)-3T. Notably, the 
temporary regulations revise the rules for determining whether an 
amount is paid for an improvement to a building. The temporary 
regulations also revise the rule for determining whether an amount is 
paid for the replacement of a major component or substantial structural 
part of a unit of property. In addition, the temporary regulations 
include numerous new and revised examples to illustrate the application 
of the improvement rules. Finally, the temporary regulations provide 
several additional rules that were not included in the 2008 proposed 
regulations. For example, the temporary regulations provide rules under 
Sec.  1.263(a)-3T(f) for the treatment of amounts paid to improve 
leased property and provide rules under Sec.  1.168(i)-8T that revise 
the definition of disposition for property subject to section 168 to 
include the retirement of a structural component of a building.

II. Materials and Supplies Under Sec.  1.162-3

    Section 1.162-3 provides, in part, that a taxpayer carrying 
materials and supplies on hand should include in expenses the charges 
for materials and supplies only in the amount that are actually 
consumed and used in operation during the taxable year for which the 
return is made. Section 1.162-3 does not define materials and supplies; 
however various judicial and administrative authorities have ruled on 
whether property constitutes a material or supply (rather than 
inventory or depreciable property). See, for example, Rev. Rul. 81-185 
(1981-2 CB 59); Rev. Rul. 78-382 (1978-2 CB 111).
    In response to practitioner comments that the 2006 proposed 
regulations failed to address the relationship between the treatment of 
acquisition costs and the treatment of materials and supplies, the 2008 
proposed regulations proposed substantial modifications to Sec.  1.162-
3. The 2008 proposed regulations defined materials and supplies as 
tangible property that is used or consumed in the taxpayer's operations 
that (1) is not a unit of property or acquired as part of a single unit 
of property; (2) is a unit of property that had an economic useful life 
of 12 months or less, beginning when the property was used or consumed; 
(3) is a unit of property that had an acquisition or production cost 
(as determined under section 263A) of $100 or less; or (4) is 
identified as a material and supply in future published guidance. In 
addition, the 2008 proposed regulations adopted the general rule that 
incidental materials and supplies (for which no inventories or records 
of consumption are maintained) are deductible in the year purchased and 
that non-incidental materials and supplies are not deductible until the 
year in which they are used or consumed in the taxpayer's operations.
    The 2008 proposed regulations included a specific rule for the 
treatment of rotable or temporary spare parts that otherwise met the 
definition of materials and supplies. Because rotable and temporary 
spare parts are typically removed, repaired, and reused over a period 
of years, the 2008 proposed regulations treated rotable and temporary 
spare parts as used or consumed in the taxable year in which a taxpayer 
disposed of the rotable or temporary part.
    The temporary regulations generally retain the framework set forth 
in the 2008 proposed regulations for materials and supplies. In 
response to practitioner and industry comments, however, the temporary 
regulations modify and expand the definition of materials and supplies, 
provide an alternative optional method of accounting for rotable and 
temporary spare parts, and provide an election to treat certain 
materials and supplies under the de minimis rule of Sec.  1.263(a)-2T. 
In addition, consistent with the 2008 proposed regulations, the 
temporary regulations allow a taxpayer to elect to capitalize certain 
materials and supplies.

A. Definition of Materials and Supplies

    The 2008 proposed regulations defined the first category of 
materials and supplies as tangible property used and consumed in the 
taxpayers operations, not constituting a unit of property under Sec.  
1.263(a)-3(d)(2), and not acquired as part of a single unit of 
property. Under this definition, many component parts acquired 
separately from an existing unit of property would not be treated as 
materials and supplies if they were treated as separate units of 
property under Sec.  1.263(a)-3(d)(2). The IRS and the Treasury 
Department intended that these components generally qualify as 
materials and supplies. Therefore, the temporary regulations redefine 
the first category of materials and supplies by further describing the 
types of components that qualify and by eliminating the requirement 
that such property not be a unit of property under section Sec.  
1.263(a)-3T(d)(2). Under the temporary regulations, the first category 
of materials and supplies includes components that are acquired to 
maintain, repair, or improve a unit of tangible property owned, leased, 
or serviced by the taxpayer and that are not acquired as part of any 
single unit of property.
    In addition, the temporary regulations provide a new category of 
materials and supplies. One commentator suggested that the IRS and the 
Treasury Department consider the treatment of certain property that 
does not fit clearly into any of the categories set out in the 2008 
proposed regulations but that generally is not considered depreciable 
property or inventory property, such as fuel, water, or lubricants. The 
temporary regulations add a category of materials and supplies for 
fuel, lubricants, water, and similar items that are reasonably expected 
to be consumed in 12 months or less, beginning when used in the 
taxpayer's operations.
    In addition, the IRS and the Treasury Department received several 
comments requesting that the definition of

[[Page 81062]]

materials and supplies raise the specified acquisition or production 
cost threshold from $100 or less to $500 or less and that this 
specified amount be indexed for inflation. The temporary regulations 
retain the $100 limitation to avoid possible inappropriate distortions 
of a taxpayer's income. The temporary regulations add language, 
however, that gives the IRS and the Treasury Department the flexibility 
to change the amount of the limitation by future published guidance. 
Moreover, a taxpayer with applicable financial statements will be 
permitted to deduct amounts paid for property up to higher thresholds 
if it complies with the requirements set out in the de minimis rule 
provided in Sec.  1.263(a)-2T.
    Finally, several commentators questioned the effect of proposed 
Sec.  1.162-3 on certain safe harbor revenue procedures that permit 
taxpayers to treat certain property as materials and supplies. For 
example, Rev. Proc. 2002-12 (2002-1 CB 374) allows a taxpayer to treat 
smallwares as materials and supplies that are not incidental under 
Sec.  1.162-3. Similarly, Rev. Proc. 2002-28 (2002-1 CB 815) allows a 
qualifying small business taxpayer to treat certain inventoriable items 
in the same manner as materials and supplies that are not incidental 
under Sec.  1.162-3. The temporary regulations do not supersede, 
obsolete, or replace these revenue procedures to the extent they deem 
certain property to constitute materials and supplies under Sec.  
1.162-3. This designated property continues to qualify as materials and 
supplies under the temporary regulations because the property is 
identified in published guidance as materials and supplies.

B. Optional Method for Rotable or Temporary Spare Parts

    The 2008 proposed regulations proposed to allow a deduction for 
amounts paid for rotable or temporary spare parts when the parts were 
discarded from the taxpayer's operations. Alternatively, a taxpayer 
could elect to capitalize and depreciate rotable spare parts over the 
parts' applicable recovery period.
    The IRS and the Treasury Department received comments stating that 
the requirement to defer the deduction of rotable spare parts until the 
year of disposition is inconsistent with the method that many taxpayers 
currently use for rotable spare parts and would result in an 
administrative burden for those taxpayers. One commentator explained 
that, under this method, a taxpayer deducts an amount paid for a new 
rotable spare part in the taxable year in which it installs the rotable 
part in its equipment. The taxpayer includes in income and assigns a 
cost basis equal to the fair market value of the used, non-functioning 
part, and capitalizes the costs of repairing the part. If the repaired 
part is later used as a replacement part in the taxpayer's equipment, 
the taxpayer deducts the basis of the part in the taxable year it is 
re-installed. This cycle continues until disposition of the part.
    The temporary regulations generally adopt the recommendations of 
the commentator and include the proposed method of accounting for 
rotable parts as an optional method. This optional method may be used 
as an alternative to treating the parts as used or consumed in the year 
of disposition or electing to treat the parts as depreciable assets. If 
a taxpayer chooses to use the optional method, the method must be used 
for all of the taxpayer's rotable and temporary spare parts in the same 
trade or business.

C. Election To Deduct Materials and Supplies Under the De Minimis Rule

    The IRS and the Treasury Department received several comments 
requesting that the regulations clarify whether a taxpayer may apply 
the de minimis rule contained in Sec.  1.263(a)-2 of the 2008 proposed 
regulations to units of property that were also treated as materials 
and supplies under Sec.  1.162-3 of the proposed regulation. Under the 
proposed de minimis rule, a taxpayer was not required to capitalize 
amounts paid for the acquisition or production of a unit of property if 
the taxpayer met certain requirements set out in that regulation. The 
proposed de minimis rule provided a taxpayer with more favorable 
treatment (that is, deduction when an amount is paid or incurred) than 
the treatment of materials and supplies under the general rule of Sec.  
1.162-3 (that is, deduction when property is used or consumed). 
Commentators indicated that the requirement to differentiate and 
separately account for certain materials and supplies is impractical 
and presents an administrative burden that is inconsistent with the 
purpose of the de minimis rule. Thus, commentators requested that a 
taxpayer be permitted to apply the de minimis rule of Sec.  1.263(a)-2, 
rather than the materials and supplies rules, to the costs of any unit 
of property that meets the definition of materials and supplies.
    The temporary regulations adopt this recommendation and allow a 
taxpayer to elect to apply the de minimis rule of Sec.  1.263(a)-2T(g) 
to the costs of acquiring or producing any type of material or supply 
defined in Sec.  1.162-3T if such costs meet the requirements of the de 
minimis rule. Thus, a taxpayer may apply a single timing rule (that is, 
deduction when paid or incurred) to any unit of property, including 
materials and supplies, to the extent the aggregate amount paid for 
such property does not exceed the limit described in Sec.  1.263(a)-
2T(g)(1)(iv).

D. Election To Capitalize Materials and Supplies

    The temporary regulations retain the rule from the 2008 proposed 
regulations that permits a taxpayer to elect to capitalize and 
depreciate amounts paid for certain materials and supplies. Several 
commentators questioned the effect of this provision and the other new 
rules under proposed Sec.  1.162-3 on previous IRS pronouncements that 
distinguished certain depreciable property from materials and supplies. 
See, for example, Rev. Rul. 2003-37 (2003-1 CB 717) (permitting 
taxpayers to treat certain rotable spare parts used in a service 
business as depreciable assets); Rev. Rul. 81-185 (1981-2 CB 59) 
(concluding that major standby emergency spare parts are depreciable 
property); Rev. Rul. 69-201 (1969-1 CB 60) (holding that standby 
replacement parts used in pit mining business are items for which 
depreciation is allowable); Rev. Rul. 69-200 (1969-1 CB 60) (holding 
that flight equipment rotatable spare parts and assemblies are tangible 
property for which depreciation is allowable while expendable flight 
equipment spare parts are materials and supplies); Rev. Proc. 2007-48 
(2007-2 CB 110) (providing a safe harbor method of accounting to treat 
certain rotable spare parts as depreciable assets).
    Section 1.162-3T is applicable to all materials and supplies as 
defined under that provision, including certain types of property that 
were treated as depreciable property under previously published 
guidance. Thus, for example, the temporary regulations modify Rev. Rul. 
2003-37, Rev. Rul. 81-185, Rev. Rul. 69-200, and Rev. Rul. 69-201 to 
the extent that the temporary regulations characterize certain tangible 
properties addressed in these rulings as materials and supplies. 
However, the temporary regulations permit taxpayers to elect to treat 
these properties as assets subject to the allowance for depreciation 
consistent with the holdings in these revenue rulings. In addition, the 
IRS and the Treasury Department recognize that Rev. Proc. 2007-48 may 
need to be revised to address the treatment of certain rotable spare 
parts defined as materials and supplies under the temporary 
regulations. Thus, comments

[[Page 81063]]

are requested on the application of the safe harbor method in this 
context.

III. Repairs Under Sec.  1.162-4

    The 2008 proposed regulations proposed to revise Sec.  1.162-4 (the 
repairs regulation) to provide rules consistent with the improvement 
rules under Sec.  1.263(a)-3 of the proposed regulations. The 2008 
proposed regulations provided that amounts paid for repairs and 
maintenance to tangible property are deductible if the amounts paid are 
not required to be capitalized under Sec.  1.263(a)-3. The IRS and 
Treasury Department received no comments on this proposed regulation. 
The temporary regulations retain the rule from the 2008 proposed 
regulations and clarify that a taxpayer is permitted to deduct amounts 
paid to repair and maintain tangible property provided such amounts are 
not required to be capitalized under section 263(a) or any other 
provision of the Code or regulations. See, for example, section 263A 
and the regulations thereunder.

IV. Rentals Under Sec.  1.162-11 and Leased Property Under Sec.  
1.167(a)-4

    The existing regulations under Sec.  1.162-11 provide rules for the 
treatment of amounts paid (1) to acquire a leasehold and (2) for 
leasehold improvements by a lessee on a lessor's property. The 
temporary regulations do not amend the rule in Sec.  1.162-11(a) that 
provides that a taxpayer may amortize the cost of acquiring a leasehold 
over the term of the lease. The temporary regulations make only minor 
revisions to the rule in Sec.  1.162-11(b) that provides that the cost 
of erecting a building or making a permanent improvement to property 
leased by the taxpayer is a capital expenditure and is not deductible 
as a business expense.
    Section 1.162-11(b) of the existing regulations also provides that 
a taxpayer lessee may amortize a leasehold improvement over the shorter 
of the estimated useful life of the improvement or the remaining period 
of the lease. A similar rule exists in Sec.  1.167(a)-4. In that 
respect, the existing regulations do not reflect the amendments made to 
sections 168 and 178 by sections 201(a) and 201(d)(2)(A), respectively, 
of the Tax Reform Act of 1986, Public Law 99-514. See sections 
168(i)(6) and (8), which require a lessee or lessor to depreciate or 
amortize leasehold improvements under the cost recovery provisions of 
the Code applicable to the improvements, without regard to the term of 
the lease. Accordingly, the temporary regulations both amend the rules 
in Sec. Sec.  1.162-11(b) and 1.167(a)-4 to provide that a lessee or 
lessor must depreciate or amortize its leasehold improvements under the 
cost recovery provisions of the Internal Revenue Code applicable to the 
improvements, without regard to the term of the lease, and also remove 
the rules permitting amortization over the shorter of the estimated 
useful life or the term of the lease. For example, if the leasehold 
improvement is property to which section 168 applies, the leasehold 
improvement is depreciated under section 168. Section 1.162-11 of the 
temporary regulations also includes cross references to Sec.  1.263(a)-
3T(f)(1) (regarding improvements to leased property) and to Sec.  
1.167(a)-4T (regarding depreciation or amortization deductions for 
leasehold improvements).

V. Amounts Paid To Acquire or Produce Tangible Property Under Sec.  
1.263(a)-2T

    The 2008 proposed regulations provided rules for the capitalization 
of amounts paid to acquire or produce units of tangible property. The 
temporary regulations retain most of these rules, including the general 
requirement to capitalize acquisition and production costs, and the 
requirement to capitalize amounts paid to defend and perfect title to 
property. In response to comments received, the temporary regulations 
clarify the application of the rules to moving and reinstallation 
costs; retain the rule for costs incurred prior to placing property 
into service; add and clarify certain rules with respect to transaction 
costs; and modify and refine the de minimis rule.

A. Moving and Reinstallation Costs

    An example in the 2008 proposed regulations illustrated that a 
taxpayer generally is not required to capitalize the costs of moving 
tangible personal property already placed in service from one facility 
to another similar facility. Several commentators expressed concern, 
however, that the example in the 2008 proposed regulations omitted any 
discussion of the treatment of amounts paid to reinstall the unit of 
property in the new location. Amounts paid to move and reinstall a unit 
of property that has already been placed in service by the taxpayer 
generally are not amounts paid to acquire or produce a unit of 
property. Thus, these costs are not required to be capitalized under 
the rules for acquisition or production of property. But, if the costs 
of moving and reinstalling a unit of property directly benefit, or are 
incurred by reason of, an improvement to the unit of property that is 
moved and reinstalled, such costs are required to be capitalized. The 
temporary regulations address these types of moving and reinstallation 
costs in examples provided in Sec.  1.263(a)-3T(h)(4), governing 
improvements to property.

B. Work Performed Prior To Placing Property Into Service

    The 2008 proposed regulations provided that acquisition costs 
include costs for work performed on a unit of property prior to the 
date the unit of property is placed in service. Several commentators 
expressed concern that this rule would require a taxpayer to capitalize 
generally deductible costs, such as repair costs, if they were incurred 
prior to placing the unit of property in service. One commentator 
suggested that the regulations allow a taxpayer to rebut the 
presumption that these costs are acquisition costs.
    Amounts paid for work performed on a unit of property prior to 
placing the property in service are related to the acquisition of the 
unit of property and, therefore, must be treated as an acquisition 
cost. The temporary regulations do not incorporate a rebuttable 
presumption in this rule because there are very few, if any, costs to 
which the presumption would apply. Moreover, a rebuttable presumption 
is more subjective and difficult to administer. Thus, the temporary 
regulations retain the bright-line rule that requires a taxpayer to 
capitalize costs that are incurred prior to the date a unit of property 
is placed in service.

C. Transaction Costs

    The 2008 proposed regulations provided that a taxpayer must, in 
general, capitalize amounts paid to facilitate the acquisition or 
production of real or personal property. They included a rule that 
provided 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 unless they are 
described in the regulations as inherently facilitative costs. The 
temporary regulations retain the general rule in the 2008 proposed 
regulations and the rules defining the costs that facilitate the 
acquisition or production of real or tangible property. The temporary 
regulations also clarify that a taxpayer may be required to allocate 
certain facilitative costs between personal property and real property 
acquired in a single transaction. Accordingly, the temporary 
regulations add a ``reasonable allocation'' rule to assist a taxpayer 
in making allocations of facilitative costs between personal

[[Page 81064]]

property and real property. In addition, the temporary regulations 
provide that a taxpayer may allocate inherently facilitative amounts to 
separate units of property that are considered, but not acquired, and 
recover such costs in accordance with applicable sections of the Code 
and regulations. The temporary regulations do not accommodate 
commentators' requests to extend the rule permitting deduction of 
certain pre-decisional costs of acquiring real property to personal 
property because such a rule could generate controversy over unduly 
small amounts.

D. De Minimis Rule

    The 2008 proposed regulations provided that a taxpayer must 
capitalize amounts paid to acquire or produce a unit of real or 
personal property, including the related transaction costs. Under the 
proposed de minimis rule, however, a taxpayer was not required to 
capitalize amounts paid for the acquisition or production (including 
any amounts paid to facilitate the acquisition or production) of a unit 
of property if (1) the taxpayer had an applicable financial statement 
(AFS) as defined in the regulation; (2) the taxpayer had, 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; (3) the taxpayer treated the 
amounts paid during the taxable year as an expense on its AFS in 
accordance with its written accounting procedures; and (4) the total 
aggregate of amounts paid and not capitalized for the taxable year 
under this provision did not distort the taxpayer's income for the 
taxable year (the ``no distortion requirement'').
    The IRS and the Treasury Department included the no distortion 
requirement in the 2008 de minimis rule in an effort to limit the 
deduction to amounts that clearly reflected income under section 446. 
To ease the administrative burden of determining whether amounts 
expensed under the de minimis rule distorted taxable income, the 2008 
proposed regulations included a safe harbor. Under this safe harbor, an 
amount deducted under the AFS-based de minimis rule for the taxable 
year would be deemed not to distort income if that amount (when added 
to the amounts deducted in the taxable year as materials and supplies 
for units of property costing $100 or less) was less than or equal to 
the lesser of 0.1 percent of the taxpayer's gross receipts for the 
taxable year or 2 percent of the taxpayer's total AFS depreciation and 
amortization for the taxable year. The preamble to the 2008 proposed 
regulations clarified that, depending on a taxpayer's particular facts 
and circumstances, an amount in excess of the safe harbor would not 
necessarily result in a distortion of income.
    A number of commentators approved of the concept of an AFS-based de 
minimis rule but were critical of the inclusion of the no distortion 
requirement. The commentators expressed concern that the no distortion 
requirement would increase controversy, was burdensome, and was 
contrary to the regulation's goal of clarity and certainty. Some 
commentators asserted that the imposition of a financial conformity 
requirement on the use of a de minimis rule established its own 
safeguards with respect to the materiality of the deductions under the 
de minimis rule.
    In addition, some commentators suggested that if the no distortion 
requirement were retained in the final regulations, the safe harbor 
limits should be set at a higher level. The IRS and the Treasury 
Department also received comment letters requesting that the de minimis 
rule be expanded to a taxpayer without an AFS by setting specific de 
minimis threshold amounts.
    The de minimis rule under the temporary regulations retains the 
requirement that a taxpayer may deduct certain amounts paid for 
tangible property if the taxpayer has an AFS, has written accounting 
procedures for expensing amounts paid for such property under certain 
dollar amounts, and treats such amounts as expenses on its AFS in 
accordance with such written accounting procedures. However, the 
temporary regulations replace the no distortion requirement with an 
overall ceiling that generally limits the total expenses that a 
taxpayer may deduct under the de minimis rule. The new criteria 
mandates that the aggregate of amounts paid and not capitalized under 
the de minimis rule for the taxable year must be less than or equal to 
the greater of (1) 0.1 percent of the taxpayer's gross receipts for the 
taxable year as determined for Federal income tax purposes; or (2) 2.0 
percent of the taxpayer's total depreciation and amortization expense 
for the taxable year as determined in its AFS.
    The use of a ceiling provides an objective and administrable limit 
on a taxpayer's total de minimis expense deduction and does not require 
an independent analysis to determine whether the amount clearly 
reflects the taxpayer's income. While a taxpayer's treatment on its 
financial statements provides a reasonable foundation for determining a 
taxpayer's de minimis expenses, the application of certain limits, 
based on a percentage of gross receipts or percentage of depreciation 
expense, is supported by the case law and the clear reflection of 
income principle under section 446. See, for example, Cincinnati, New 
Orleans & Tex. Pac. Ry. Co. v. United States, 424 F.2d 563 (Ct. Cl. 
1970); Alacare Home Health Services, Inc. v. Commissioner, T.C. Memo. 
2001-149.
    In response to several comment letters, the temporary regulations 
also add and modify several provisions governing the application of the 
de minimis rule. For example, temporary regulations eliminate the 
requirement in the 2008 proposed regulations that, in calculating 
whether a taxpayer's de minimis amount exceeds the ceiling, the 
taxpayer must also include the amounts deducted under proposed Sec.  
1.162-3 as materials and supplies costing $100 or less. Under the 
temporary regulations, amounts paid for materials and supplies are 
subject to the de minimis ceiling only if the taxpayer elects under 
Sec.  1.162-3T to treat those materials or supplies under the de 
minimis rule of Sec.  1.263(a)-2T. In addition, the temporary 
regulations eliminate the exceptions from the proposed de minimis rule 
for property acquired for repairs and property acquired for 
improvements. Thus, the de minimis rule may be applied to these 
amounts. However, the de minimis rule does not apply to amounts paid 
for labor and overhead incurred in repairing or improving property.
    The IRS and the Treasury Department received one comment letter 
suggesting that that the temporary regulations clarify the application 
of the de minimis rule to a member of a consolidated group. In 
response, the temporary regulations add a provision that permits a 
member to utilize the written accounting procedures provided on the 
applicable financials statements of its affiliated group. The IRS and 
the Treasury Department intend to give further consideration to the 
application of the de minimis rule in a consolidated group setting. In 
this regard, the IRS and the Treasury Department request additional 
comments on the manner in which the de minimis rule, including the de 
minimis rule limitations, may be applied to, and based on, the tax and 
financial results of a consolidated group.
    The de minimis rule in the temporary regulations is not intended to 
prevent a taxpayer from reaching an agreement with its IRS examining 
agents that, as an administrative matter, based on risk analysis or 
materiality, the IRS examining agents will not review

[[Page 81065]]

certain items. It is not intended that examining agents must now revise 
their materiality thresholds in accordance with the de minimis rule 
ceiling. Thus, if examining agents and a taxpayer agree that certain 
amounts in excess of the de minimis rule ceiling are immaterial and 
should not be subject to review, that agreement should be respected, 
notwithstanding the requirements of the de minimis rule in the 
temporary regulations. However, a taxpayer that seeks a deduction for 
amounts in excess of the amount allowed by this rule or by agreement 
with IRS examining agents will have the burden of showing that such 
treatment clearly reflects income.
    Finally, the temporary regulations do not expand the de minimis 
rule to a taxpayer without an AFS or provide specific de minimis 
amounts deductible by a taxpayer in this context. A taxpayer without an 
AFS does not have a consistent, audited methodology for determining de 
minimis expenses, and as a result, the IRS would have little or no 
assurance that a taxpayer without an AFS was using a reasonable, 
consistent methodology that clearly reflects income. However, the 
temporary regulations provide some relief for a taxpayer without an AFS 
by providing a deduction under Sec.  1.162-3T for materials and 
supplies that cost $100 or less. The IRS and the Treasury Department 
request comments addressing de minimis rule alternatives that would 
substantiate the use of a reasonable and consistent methodology and 
ensure clear reflection of income for determining de minimis expenses 
for a taxpayer without an AFS.

VI. Amounts To Improve Property Under Sec.  1.263(a)-3T

A. Overview

    The temporary regulations retain the basic framework of the 2008 
proposed regulations for determining the unit of property and for 
determining whether there is an improvement to the unit of property. 
The temporary regulations also retain many of the simplifying 
conventions set out in the 2008 proposed regulations, including the 
routine maintenance safe harbor and the optional regulatory accounting 
method. As explained below, the temporary regulations also modify the 
2008 proposed regulations in several areas.
    A goal of both the 2006 and 2008 proposed regulations was to reduce 
controversy and provide clarity in determining whether an amount is 
paid for an improvement that must be capitalized under section 263(a). 
In several respects, however, the more objective rules provided in the 
2008 proposed regulations limited the circumstances in which an amount 
paid would be capitalized as an improvement. First, the 2008 proposed 
regulations defined the unit of property for a building as the building 
and its structural components. Thus, work performed on a building would 
rise to the level of an improvement only if it resulted in a betterment 
or restoration (or a new or different use) when applied to the building 
and its structural components as a whole. Second, the restoration rules 
under the 2008 proposed regulations provided that a taxpayer did not 
have to capitalize, or treat as an improvement, amounts paid to replace 
a major component or substantial structural part of a unit of property 
unless those amounts were paid after the recovery period for the 
property, and either (1) the replacement cost comprised 50 percent or 
more of the replacement cost of the entire unit of property, or (2) the 
replacement parts comprised 50 percent or more of the physical 
structure of the unit of property (``the 50 percent thresholds''). 
Thus, capitalization under the major component rule applied only if the 
property was fully depreciated and either of the 50 percent thresholds 
were triggered.
    These sections of the 2008 proposed regulations would have led to 
results that were contrary to long-standing case law (discussed below) 
and inconsistent with the way most taxpayers had treated these items 
for tax purposes. Although the preamble to the 2008 proposed 
regulations provided that a taxpayer should not rely on the proposed 
rules, many taxpayers applied to change their methods of accounting 
from capitalizing certain expenditures to deducting these expenditures 
as repairs based on the standards in the 2008 proposed regulations.
    The 2008 proposed regulations limited capitalization and allowed 
more frequent deductions for work performed on tangible property, in 
part, to lessen the effects of depreciation and disposition rules under 
section 168 (MACRS). Under section 168(i)(6), a taxpayer is required to 
depreciate an amount paid for an improvement using the same recovery 
period and the same depreciation method as the underlying property, 
with the recovery period beginning when the improvement is placed in 
service. In addition, Sec.  1.168-2(l)(1) of the proposed ACRS 
regulations (which have been generally applied to MACRS property) 
provides that a disposition does not include the retirement of a 
structural component of a building. Accordingly, Sec.  1.168-6(b) of 
the proposed ACRS regulations provides that no loss shall be recognized 
upon the retirement of a structural component of a building. Thus, if a 
taxpayer replaced a structural component of a building during the 
recovery period of the building, the taxpayer could not immediately 
recover the basis allocable to the removed component, but rather had to 
continue to depreciate it as part of the building. If the taxpayer were 
required to capitalize the costs of the replacement component under 
section 263(a), then the taxpayer would be required to depreciate 
contemporaneously both the retired component and the replacement 
component.
    To achieve results more consistent with existing law and to provide 
relief from the potential inequities that can result from the 
application of the depreciation and disposition rules, the temporary 
regulations revise and amend the 2008 proposed regulations in several 
respects. First, the temporary regulations retain the rule from the 
2008 proposed regulations that the unit of property for a building 
consists of the building and its structural components. However, the 
temporary regulations revise the manner in which the improvement 
standards must be applied to the building and its structural 
components. In determining whether an amount paid is for an improvement 
to the building, the temporary regulations require a taxpayer to 
consider the effect of the expenditure on certain significant and 
specifically defined components of the building, rather than the 
building and its structural components as a whole. Second, the 
temporary regulations do not include the 50 percent thresholds and 
recovery period limitation for determining whether a replacement rises 
to the level of a major component or substantial structural part of a 
unit of property. Finally, the temporary regulations include new 
provisions under section 168 that expand the definition of dispositions 
to include the retirement of a structural component of a building. This 
change allows a taxpayer to recognize a loss on the disposition of a 
structural component of a building before the disposition of the entire 
building, so that a taxpayer will not have to continue to depreciate 
amounts allocable to structural components that are no longer in 
service. Thus, under the temporary regulations, a taxpayer is not 
required to capitalize and depreciate simultaneously amounts paid for 
both the removed and the replacement properties.
    The IRS and the Treasury Department recognize that it may be 
difficult for taxpayers to determine specifically the

[[Page 81066]]

amount of the adjusted basis of the property that is allocable to the 
retired component. This difficulty may be particularly acute in 
industries where a taxpayer has capitalized a number of improvements as 
part of cyclical remodels or renovations. Comments are requested on 
computational methodologies or safe harbors that a taxpayer may use to 
simplify this determination.
    In addition to these changes, the temporary regulations incorporate 
more detailed rules for determining the units of property for 
condominium, cooperatives, and leased property, for the treatment of 
leasehold improvements, and for additional costs incurred during an 
improvement, such as related repair and maintenance costs. The 
temporary regulations also clarify various examples and add new 
examples illustrating the treatment of items such as moving and 
reinstallation costs, retail remodeling costs, and the costs of 
replacing major components.

B. Determining the Unit of Property

1. Overview
    The 2008 proposed regulations generally defined a unit of property 
as consisting of all the components of the unit of property that are 
functionally interdependent. The proposed regulations, however, 
provided special rules for determining the unit of property for 
buildings, plant property, and network assets. For property other than 
buildings, the 2008 proposed regulations further refined the units of 
property by treating a functionally interdependent component as a 
separate unit of property if the taxpayer initially assigned a 
different economic useful life to the component for financial statement 
or regulatory purposes or if the taxpayer assigned a different MACRS 
class or recovery method to the component. The temporary regulations 
retain most of these rules for determining units of property, with 
minor exceptions. In addition, the temporary regulations clarify the 
application of the improvement rules to the unit of property for 
buildings and set out more detailed rules for applying these rules to 
condominiums, cooperatives, and leased property. The temporary 
regulations also contain new and revised provisions addressing the 
treatment of, and the unit of property determination for, leasehold 
improvements.
2. Buildings and Structural Components
    The 2008 proposed regulations retained the rule from the 2006 
proposed regulations that the building (as defined in Sec.  1.48-
1(e)(1)) and its structural components (as defined in Sec.  1.48-
1(e)(2)) are a single unit of property. In response to the 2008 
proposed regulations, the IRS and the Treasury Department did not 
receive any comments addressing the unit of property for buildings. 
After issuance of the 2008 proposed regulations, however, many 
taxpayers claimed that major work performed on buildings did not result 
in an improvement because the work affected only a small portion of the 
unit of property, that is, the entire building. Under this analysis, 
for example, taxpayers claimed that the costs of new roofs, 
replacements of entire heating and air conditioning systems, and major 
structural changes to building interiors were all deductible as repairs 
or maintenance. Moreover, taxpayers may have viewed the 50 percent 
thresholds and recovery period limitation exceptions to the major 
component and substantial structural part rule as consistent with the 
conclusion that these types of expenses should generally be treated as 
deductible repair or maintenance costs. Although the preamble to the 
2008 proposed regulations explicitly stated that a taxpayer should not 
rely on the proposed rules, many taxpayers regarded these rules as the 
IRS's and the Treasury Department's interpretation of current law.
    The temporary regulations revise the 2008 standards in several 
respects to achieve results that are more consistent with current law. 
The temporary regulations retain the general rule that the unit of 
property for a building is comprised of the building and its structural 
components. The temporary regulations, however, require that a taxpayer 
apply the improvement standards separately to the primary components of 
the building, that is, the building structure or any of the 
specifically defined building systems. Thus, a cost is treated as a 
capital expenditure if it results in an improvement to the building 
structure or to any of the specifically enumerated building systems. 
The temporary regulations define the building structure as the building 
(as defined in Sec.  1.48-1(e)(1)) and its structural components (as 
defined in Sec.  1.48-1(e)(2)) other than the components specifically 
enumerated as building systems. The temporary regulations define 
building systems to include (1) the heating, ventilation, and air 
conditioning systems (``HVAC''); (2) the plumbing systems; (3) the 
electrical systems; (4) all escalators; (5) all elevators; (6) the fire 
protection and alarm systems; (7) the security systems; (8) the gas 
distribution systems; and (9) any other systems identified in published 
guidance.
    Accordingly, if an amount paid results in a restoration of a 
building structure, such as the replacement of an entire roof, then 
under the temporary regulations the expenditure constitutes an 
improvement to the building unit of property. Similarly, if an amount 
paid results in a betterment to a building system, such as an 
improvement to the HVAC system, then the expenditure also constitutes 
an improvement to the building unit of property. Compared to the 
approach provided in the 2008 proposed regulations, the approach 
contained in these temporary regulations produces results that are more 
consistent with current law. See, for example, Smith v. Commissioner, 
300 F.3d 1023 (9th Cir. 2002) (holding that costs to replace a 
substantial portion of floor were capital expenditures); Tsakopoulous 
v. Commissioner, T.C. Memo. 2002-8 (holding that costs to replace the 
roof on a portion of the suites of a shopping center were capital 
expenditures); Hill v. Commissioner, T.C. Memo. 1983-112 (holding that 
costs to replace the water heater and furnace in rental property were 
capital expenditures); Stewart Supply Co. v. Commissioner, T.C. Memo. 
1963-62 (holding that costs to replace the front wall of a building and 
make electrical connections to that wall were capital expenditures); 
First Nat'l Bank v. Commissioner, 30 B.T.A. 632 (1934) (holding that 
costs of replacing the electrical system in a bank building were 
capital expenditures); Georgia Car and Locomotive Co., 2 B.T.A. 986 
(1925) (holding that costs of a new roof on a building were capital 
expenditures). The approach for buildings is conceptually similar to 
the plant property rule discussed below, which segregates plant 
property into units of property that perform discrete and major 
functions within the plant.
a. Condominiums and Cooperatives
    The 2008 proposed regulations provided that the unit of property 
for a condominium was the individual unit owned by the taxpayer and 
that the unit of property for a cooperative was the individual unit 
possessed by the taxpayer. The temporary regulations provide additional 
detail defining the unit of property for condominiums and cooperatives 
and provide additional guidance for applying the improvement rules to 
these units of property. The temporary regulations provide that for the 
owner of a condominium, the unit of property is the individual unit 
owned by the taxpayer and the structural

[[Page 81067]]

components that are part of the condominium unit. Similarly, for a 
taxpayer that has an ownership interest in a cooperative housing 
corporation, the unit of property is the portion of the building in 
which the taxpayer has possessory rights and the structural components 
that are part of the portion of the building subject to the taxpayer's 
possessory rights. For both condominiums and cooperatives, however, the 
temporary regulations provide that an amount is paid for an improvement 
to these units of property if the amount results in an improvement to 
the building structure that is part of the condominium or cooperative 
unit or to the portion of any building system that is part of the 
condominium or cooperative unit.
b. Leased Buildings (Taxpayer as Lessee)
    The 2008 proposed regulations did not address the unit of property 
for leased property. The IRS and the Treasury Department received 
several comments requesting that the regulations include more detailed 
rules regarding the unit of property for leased property and the unit 
of property for leasehold improvements. The temporary regulations 
define the unit of property for leased buildings and provide that if a 
taxpayer is a lessee of all or a portion of one or more buildings (such 
as an office, floor, or certain square footage), the unit of property 
is each building and its structural components or the portion of each 
building subject to the lease and the structural components associated 
with the leased portion. The temporary regulations also provide that an 
amount is paid for an improvement to a leased building or a leased 
portion of a building if the amount paid results in an improvement to 
the leased building structure (or the portion thereof subject to the 
lease) or any of the leased building systems (or the portion thereof 
subject to the lease).
3. Property Other Than Buildings
    The 2008 proposed regulations generally defined the unit of 
property for real and personal property other than buildings to include 
all functionally interdependent components. Components were defined as 
functionally interdependent if placing one component in service depends 
on placing the other component in service. Special rules were provided 
for plant property and network assets.
    The temporary regulations retain the functional interdependence 
test as the general rule for determining the unit of property for real 
and personal property other than buildings. The temporary regulations 
also continue to provide special rules for plant property and network 
assets. However, the temporary regulations remove the rule requiring 
taxpayers to treat a functionally interdependent component as a 
separate unit of property if the taxpayer initially assigned a 
different economic useful life to the component for financial statement 
or regulatory purposes. In addition, the temporary regulations include 
a rule for determining the unit of property for leased property other 
than buildings.
a. Plant Property
    Under the 2008 proposed regulations, a unit of property for plant 
property generally was comprised of each component (or group of 
components) within the plant that performs a discrete and major 
function or operation within functionally interdependent machinery or 
equipment. The discrete and major function rule provides a reasonable 
and administrable limitation on the functional interdependence 
standard, which otherwise could be overly broad in its application to 
industrial equipment. Accordingly, the temporary regulations retain the 
plant property rule as it was proposed in the 2008 proposed 
regulations.
b. Network Assets
    The 2008 proposed regulations generally defined network assets as 
railroad track, oil and gas pipelines, water and sewage pipelines, 
power transmission and distribution lines, and telephone and cable 
lines but reserved defining the unit of property for network assets in 
specific industries. The preamble to the 2008 proposed regulations 
invited industries with network assets to request guidance under the 
Industry Issue Resolution (``IIR'') program. Although several 
commentators requested that the regulations provide guidance on the 
units of property for network assets, given the detailed factual issues 
underpinning the proper treatment of such assets, the units of property 
for network assets are more appropriately determined through guidance 
tailored to individual industries under the IIR program. The IRS and 
the Treasury Department have accepted IIR requests from several 
industries to develop industry specific guidance in this area and 
encourage other industries with network assets to request guidance 
under the IIR procedures.
    The temporary regulations retain the definition of network assets 
provided in the 2008 proposed regulations and add an operative rule 
providing that in the case of network assets, the unit of property is 
determined by the taxpayer's particular facts and circumstances except 
as otherwise provided in guidance published in the Federal Register or 
the Internal Revenue Bulletin. The functional interdependence standard, 
by itself, could lead to unit of property definitions for network 
assets that are overly broad. Thus, functional interdependence is not 
determinative for network assets. Finally, the temporary regulations do 
not alter or invalidate previously published guidance addressing the 
treatment of network assets for particular industries, such as Rev. 
Proc. 2011-43 (2011-37 IRB 326) (safe harbor method for electric 
utility transmission and distribution property); Rev. Proc. 2011-28 
(2011-18 IRB 743) (network asset maintenance allowance or units of 
property method for wireless telecommunication network assets); Rev. 
Proc. 2011-27 (2011-18 IRB 740) (network asset maintenance allowance or 
units of property method for wireline telecommunication network 
assets); Rev. Proc. 2002-65 (2002-2 CB 700) (track maintenance 
allowance method for Class II and III railroads); or Rev. Proc. 2001-46 
(2001-2 CB 263) (track maintenance allowance method for Class I 
railroads).
c. Leased Property Other Than Leased Buildings
    The IRS and the Treasury Department received several comments 
requesting that the proposed regulations include more detailed rules 
regarding the unit of property for leased personal property. The 
temporary regulations provide that a lessee's unit of property for 
leased real or personal property other than building property is 
determined under the general rules for property other than buildings, 
including the functional interdependence test and the plant property 
rule (as applicable), except that, after applying those applicable 
rules, the unit of property may not be larger than the unit of leased 
property.
4. Unit of Property for Improvements
    The 2008 proposed regulations provided that an improvement to a 
unit of property, other than a leasehold improvement, is not a unit of 
property separate from the unit of property improved. The 2008 proposed 
regulations provided that a leasehold improvement made by a lessee that 
is section 1250 property is treated as a separate unit of property. The 
temporary regulations retain the general rule that an improvement is 
generally not a unit of property separate from the unit of property 
improved but clarify the rule for leasehold improvements. As

[[Page 81068]]

explained below, the temporary regulations provide that only a ``lessee 
improvement,'' rather than a ``leasehold improvement,'' is a unit of 
property separate from the unit of property improved. Moreover, this 
rule has been moved to a separate subsection governing the unit of 
property for improvements.
5. Unit of Property for Leasehold Improvements
    Current law provides that if a lessee makes a leasehold improvement 
that is not a substitute for rent, the lessee is generally required to 
capitalize the cost of the improvement under section 263(a) and 
Sec. Sec.  1.162-11(b) and 1.167(a)-4 and, if the leasehold improvement 
is property to which section 168 applies, depreciate the improvement 
under section 168. See section 168(i)(8)(A). Current law, however, does 
not clearly address the unit of property for leasehold improvements.
    The 2008 proposed regulations provided that, in the case of a 
leasehold improvement made by a lessee that is section 1250 property, 
the leasehold improvement is a separate unit of property. The 2008 
proposed regulations did not address leased section 1245 property or 
discuss the unit of property for improvements made by a lessor. The IRS 
and the Treasury Department received several comments requesting that 
the regulations provide additional guidance on the unit of property for 
improvements to leased section 1250 property and address the unit of 
property for improvements to leased section 1245 property. In addition, 
commentators suggested that revised regulations provide operative rules 
for determining when there has been an improvement to leased property. 
In response to the comments, the temporary regulations address whether 
amounts paid by a lessee or lessor are for the improvement of a unit of 
leased property, requiring capital treatment. The temporary regulations 
also define the unit of property for purposes of determining whether 
amounts paid subsequent to an initial leasehold improvement must be 
capitalized.
    The temporary regulations for lessee improvements are consistent 
with the rule in the 2008 proposed regulations but provide further 
elaboration and are extended to section 1245 property. The temporary 
regulations provide that an amount initially capitalized as a lessee 
improvement is treated as a cost of acquiring or producing a unit of 
property, and constitutes a unit of property separate from the leased 
property being improved. However, the cost of improving a lessee 
improvement is not a unit of property separate from the lessee 
improvement being improved.
    Treating the lessee's initial improvement as a separate unit of 
property is based on the premise that, when making a leasehold 
improvement, the lessee should be treated as if it has acquired or 
produced new property. This new property interest is separate and 
distinguishable from the lessee's interest in the underlying property. 
Also, this approach is consistent with the depreciation rules under 
sections 168(i)(6) and (i)(8)(A), which treat the leasehold improvement 
as a separate asset for purposes of section 168. Finally, treatment of 
a lessee's subsequent improvement as part of the lessee's initial 
leasehold improvement is consistent with the rule governing the unit of 
property determination for improvements to owned property, which 
generally treats the improvement and the property improved as a single 
unit of property.
    The temporary regulations also provide a rule for determining the 
unit of property for a lessor improvement. The temporary regulations 
provide that an amount capitalized as a lessor improvement is not a 
unit of property separate from the unit of property improved. This rule 
is based on the premise that the lessor of property generally should be 
treated in the same manner as any other owner of property when it makes 
an improvement to its property. Thus, in accordance with the general 
rule for property owners, a lessor improvement to a unit of property is 
not a unit of property separate from the property being improved.
6. Additional Rules for Determining Units of Property
    The 2008 proposed regulations included two additional rules that, 
if applicable, would more narrowly define the unit of property for 
property other than buildings. The 2008 proposed regulations provided 
that a component must be treated as a separate unit of property if, at 
the time the unit of property is placed in service by the taxpayer, 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 (the ``book life 
consistency rule''). The 2008 proposed regulations also provided that a 
component must be treated as a separate unit of property if the 
taxpayer has properly treated the component as being within a different 
MACRS class than the class of the unit of property of which the 
component is a part, or depreciated the component using a section 167 
or section 168 depreciation method different from the depreciation 
method for the unit property of which the component is a part (the 
``depreciation consistency rule'').
    The IRS and the Treasury Department received several comments 
requesting that the book life consistency rule be removed from the 
final regulation. Commentators noted that tax and financial accounting 
have different goals and that a taxpayer generally has non-tax reasons 
for classifying property differently for financial accounting purposes. 
For these reasons, the temporary regulations do not adopt the book life 
consistency rule contained in the 2008 proposed regulations.
    The temporary regulations retain the depreciation consistency rule 
that applies to property, other than buildings, in the taxable year the 
property is initially placed in service. The temporary regulations add 
a second depreciation consistency rule that applies if a taxpayer or 
the IRS properly changes the MACRS class or depreciation method for any 
type of property (for example, as a result of a cost segregation study 
or a change in the use of the property) in a taxable year after the 
year the property was initially placed in service. Under this rule, the 
taxpayer must change the unit of property determination for the 
effected property to be consistent with the change in treatment for 
depreciation purposes. Thus, for example, if a taxpayer performs a cost 
segregation study and changes the classification of components in a 
building from section 1250 property to section 1245 property, the 
taxpayer must use the same classifications to define the unit of 
property for capitalization purposes.

C. Special Rules for Improvements

1. Improvements to Leased Property
    The 2008 proposed regulations provided that a taxpayer must 
capitalize amounts paid to acquire or produce a unit of real or 
personal property, including leasehold improvement property. The 2008 
proposed regulations also noted that a taxpayer must capitalize amounts 
paid to improve a unit of property whether the taxpayer is the owner or 
lessee of the unit of property. However, the 2008 proposed regulations 
did not provide operative rules for determining whether there was an 
improvement to leased property (``leasehold improvement'') and did not 
clarify how a leasehold improvement must be treated under the 
regulations.

[[Page 81069]]

a. Application of Intangible Regulation Under Sec.  1.263(a)-4 to 
Leasehold Improvements
    The IRS and the Treasury Department received several informal 
questions and comments regarding whether lessee improvements should be 
capitalized under the 2008 proposed regulations or under Sec.  
1.263(a)-4 (``intangibles regulations''), which governs the 
capitalization of costs related to intangible property. Section 
1.263(a)-4(d)(8), which is titled ``Certain benefits arising from the 
provision, production, or improvement of real property,'' provides, in 
part, that a taxpayer must capitalize amounts paid to produce or 
improve real property owned by another if the real property can 
reasonably be expected to produce significant economic benefits for the 
taxpayer. Examples of amounts capitalized under this section include 
amounts contributed by a taxpayer to a city to defray the cost of 
constructing a publicly owned bridge capable of accommodating the 
taxpayer's trucks and amounts contributed by a taxpayer to a port 
authority to build a breakwater that will make it easier for the 
taxpayer to unload its vessels.
    Section 1.263(a)-4(d)(8) of the regulations was not intended to 
apply to leasehold improvements or to situations in which the taxpayer 
pays to acquire or produce tangible property that clearly benefits the 
taxpayer and not other parties. The examples provided under the 
intangibles regulations involve improvements to public assets where 
there is an intangible economic benefit to the taxpayer, not a direct 
tangible interest in property, such as a leasehold interest. In 
contrast to the examples under the intangibles regulations, a leasehold 
improvement involves an interest in tangible property for which basis 
recovery is permitted through depreciation. See, for example, section 
168(i)(8)(A) (treatment of leasehold improvements that are subject to 
section 168).
    The temporary regulations provide that Sec.  1.263(a)-4 does not 
apply to amounts paid for improvements to units of leased property or 
to amounts paid for the acquisition or production of leasehold 
improvement property. In addition, the temporary regulations provide 
operative rules for the definition and treatment of leasehold 
improvements by lessees and lessors and clarify that these rules are 
the exclusive guidance for determining whether amounts paid by a 
taxpayer are for an improvement to a unit of leased property.
b. Operative Rules for Leasehold Improvements
    The IRS and the Treasury Department received several comments 
requesting that the regulations provide guidance regarding the 
application of the improvement rules to leased section 1250 property 
(generally real property) and leased section 1245 property (generally 
personal property). The temporary regulations apply to both leased real 
property and leased personal property and provide operative rules for 
both lessees and lessors that make improvements to a leased unit of 
property.
i. Lessee Improvements
    Under the temporary regulations, a taxpayer lessee must capitalize 
the aggregate of related amounts that it pays to improve a unit of 
leased property, except to the extent that section 110 applies to a 
construction allowance received by the lessee for the purpose of such 
improvement or where the improvement constitutes a substitute for rent. 
A taxpayer lessee must also capitalize the aggregate of related amounts 
paid by the lessor to improve a unit of leased property if the lessee 
owns the improvement for federal income tax purposes, except to the 
extent that section 110 applies to a construction allowance received by 
the lessee for the purpose of such improvement. An amount paid for a 
lessee improvement under the temporary regulations is treated as an 
amount paid to acquire or produce a unit of real or personal property 
under Sec.  1.263(a)-2T(d)(1)(i).
    Because a lessee improvement involves the acquisition or production 
of a new and distinct interest in property and this property interest 
is often different from the underlying leased property, amounts paid 
for a lessee improvement are treated as the acquisition or production 
of a new unit of property (that is, a unit of property separate from 
the leased unit of property), rather than an improvement to the 
underlying property. This treatment is consistent with the depreciation 
requirements under section 168(i)(8)(A), which do not allow a taxpayer 
to depreciate leasehold improvements over the term of the underlying 
lease, but rather require that a taxpayer depreciate the leasehold 
improvement over the applicable recovery period under MACRS for the 
type of property acquired or produced.
ii. Lessor Improvements
    The temporary regulations provide that a taxpayer lessor must 
capitalize the aggregate of related amounts that it pays directly, or 
indirectly through a construction allowance to the lessee, to improve a 
unit of leased property where the lessor is the owner of the 
improvement or to the extent that section 110 applies to the 
construction allowance. In addition, a lessor must also capitalize the 
aggregate of related amounts paid by the lessee to improve a unit of 
leased property where the lessee's improvement constitutes a substitute 
for rent. Finally, amounts capitalized by the lessor under this 
paragraph may not be capitalized by the lessee.
    The rules provided in the temporary regulations for lessor 
improvements are corollaries to the rules provided for lessee 
improvements. In general, a lessor must capitalize amounts paid for 
leasehold improvements where the lessor is the owner of the leasehold 
improvement, where section 110 applies, or where the lessee's 
improvement is a substitute for rent. However, in contrast with a 
lessee, the lessor is the owner of the underlying property. As such, a 
lessor improvement is treated in the same manner as any other owner 
improvement to a unit of property. Therefore, a lessor improvement is 
treated as an improvement to the underlying property under Sec.  
1.263(a)-3T and is not treated as the acquisition or production of a 
new unit of property.
2. Certain Costs Incurred During an Improvement
    The 2008 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 or maintenance costs if they are 
incurred as part of a general plan of rehabilitation, modernization, 
and improvement to the property. See Moss v. Commissioner, 831 F.2d 833 
(9th Cir. 1987); United States v. Wehrli, 400 F.2d 686 (10th Cir. 
1968); Norwest Corp. v. Commissioner, 108 T.C. 265 (1997). Instead, the 
2008 proposed regulations incorporated the section 263A rules for the 
treatment of repairs and maintenance performed during an improvement. 
Specifically, the 2008 proposed regulations provided that 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. See Sec.  1.263A-1(e). 
Thus, the 2008 proposed regulations concluded that repairs and

[[Page 81070]]

maintenance that do not directly benefit and that are not incurred by 
reason of an improvement are not required to be capitalized under 
section 263(a), regardless of whether the repairs and maintenance are 
performed at the same time as an improvement. The 2008 proposed 
regulations also included an exception for an individual residence, 
which permitted an individual taxpayer to capitalize repair and 
maintenance costs incurred at the time of a substantial remodel of its 
residence.
    The temporary regulations retain the general rule from the 2008 
proposed regulations for otherwise deductible indirect costs incurred 
during an improvement but clarify that all indirect costs, including 
repair and removal costs, are subject to the section 263A standard. The 
temporary regulations also retain the exception for substantial 
improvements to individual residences.
    The rules provided in section 263A and Sec.  1.263A-1(e) regarding 
the capitalization of indirect costs require the capitalization of 
indirect costs that directly benefit or are incurred by reason of an 
improvement to property. By adopting the Sec.  1.263A-1(e) standard for 
purposes of section 263(a), the temporary regulations set out a clearly 
articulated standard that provides appropriate parameters for 
determining when otherwise deductible indirect costs must be 
capitalized as part of an improvement to property. Accordingly, the 
temporary regulations obsolete the plan of rehabilitation doctrine to 
the extent the court created doctrine provided different standards for 
determining whether an otherwise deductible indirect cost must be 
capitalized as part of an improvement.
3. Removal Costs
    The 2008 proposed regulations did not address the treatment of 
amounts paid to remove a unit of property, asset, or a component of a 
unit of property. Examples in the 2008 proposed regulations, however, 
suggested that if a taxpayer removes a component in order to facilitate 
a replacement and the costs of the replacement component constitute an 
improvement to the unit of property, then the costs of removing the old 
component must be treated a part of the improvement.
    No comments were received addressing the treatment of removal 
costs, and the temporary regulations do not include a specific rule for 
such costs. But the costs of removing a component of a unit of property 
should be analyzed in the same manner as any other indirect cost 
incurred during an improvement to property. Thus, similar to the 
treatment of otherwise deductible repair and maintenance costs incurred 
during an improvement, the costs of removing a component of a unit of 
property must be capitalized if they directly benefit or are incurred 
by reason of an improvement to a unit of property. See, for example, 
Towanda Coke Corp. v. Commissioner, 95 T.C. 124 (1990) (holding that 
costs of removing piping damaged in a fire and installing new pipe were 
capital expenditures); Phillips Easton Supply Co. v. Commissioner, 20 
T.C. 455 (1953) (holding that costs of removing a cement floor in a 
building and replacing it with a concrete floor were capital 
expenditures to improve the property); Rev. Rul. 2000-7 (2000-1 CB 712) 
(providing that the costs of removing a component of a depreciable 
asset are either capitalized or deducted based on whether the 
replacement of the component constitutes an improvement or a repair). 
As with other costs incurred during an improvement, a taxpayer may 
deduct the costs of removing a component if the taxpayer can 
demonstrate that such costs relate only to the disposition of the 
removed property and that the costs do not have the requisite 
relationship to any improvement.
    In addition, the temporary regulations do not affect the holding of 
Rev. Rul. 2000-7 as it applies to the costs of removing an entire unit 
of property. Under Rev. Rul. 2000-7, a taxpayer is not required to 
capitalize the cost of removing a retired depreciable asset under 
section 263(a) or section 263A, even where the retirement and removal 
occurred in connection with the installation of a replacement asset. 
Historically, the costs of removing a depreciable asset generally have 
been allocable to the removed asset and, thus, generally have been 
deductible when the asset is retired. See Sec.  1.165-3(b); Sec.  
1.167(a)-1(c); Sec.  1.167(a)-11(d)(3)(x); Rev. Rul. 74-455 (1974-2 CB 
63); Rev. Rul. 75-150 (1975-1 CB 73). Because the costs of removing a 
retired asset typically relate to the depreciable asset being removed 
and are not allocable to the improvements, Sec.  1.263(a)-3T generally 
is not applicable to such removal costs. Moreover, the temporary 
regulations do not change the treatment of any amounts addressed under 
section 280B, which governs amounts expended and losses sustained for 
the demolition of structures.

D. Safe Harbor for Routine Maintenance

    The 2008 proposed regulations provided a safe harbor from 
capitalization for the costs of performing certain routine maintenance 
activities. Under the safe harbor, an amount paid was deemed not to 
improve the unit of property if it was for the ongoing activities that 
a taxpayer (or a lessor) expected to perform as a result of the 
taxpayer's (or the lessee's) use of the unit of property to keep the 
unit of property in its ordinarily efficient operating condition. The 
activities were routine only if, at the time the unit of property was 
placed in service, the taxpayer reasonably expected to perform the 
activities more than once during the class life of the unit of property 
(that is, the recovery period prescribed under sections 168(g)(2) and 
168(g)(3), regardless of whether the property was depreciated under 
section 168(g)).
    The IRS and the Treasury Department received comments criticizing 
the safe harbor's use of defined class life as the testing period. 
Instead, the comments suggested that the safe harbor should utilize the 
economic useful life of the unit of property as the appropriate testing 
period. The temporary regulations retain the requirement that a 
taxpayer must expect to perform routine maintenance more than once 
during the defined class life of the unit of property. The class life 
based standard is more objective, is more consistent among taxpayers, 
and is more administrable than a standard based on the economic useful 
life of the property. Notably, during the consideration of the 2006 
proposed regulations, many commentators expressed concern that the 
economic useful life of property is not an accurate determinant of its 
actual useful life and that reliance on this standard would create 
disparate treatment among taxpayers in characterizing similar costs.
    The IRS and the Treasury Department also received comments 
regarding the application of the routine maintenance safe harbor to 
buildings. Because buildings typically have a long class life (for 
example, 39.5 years for nonresidential real property), many remodeling 
projects arguably could be deducted under the safe harbor, regardless 
of the nature or extent of the work involved. For example, if a 
taxpayer expected to replace a major component, such as a roof, an HVAC 
system, or an electrical system, more than once during the long class 
life of the building, then the costs of such replacements generally 
would have been deductible under the safe harbor. Allowing a deduction 
for costs attributable to these types of projects is inconsistent with 
much of the case law addressing building improvements. Generally, the 
courts have held that amounts paid for replacements of major components 
or substantial structural parts of buildings and their structural

[[Page 81071]]

components are capital expenditures. See, for example, Tsakopoulous v. 
Commissioner, T.C. Memo 2002-8 (holding that costs to replace the roof 
on a portion of the suites of a shopping center were capital 
expenditures); Hill v. Commissioner, T.C. Memo 1983-112 (holding that 
costs to replace the water heater and the furnace in rental property 
were capital expenditures); Stewart Supply Co. v. Commissioner, T.C. 
Memo 1963-62 (holding that costs to replace the front wall of a 
building and make electrical connections to that wall were capital 
expenditures); First Nat'l Bank v. Commissioner, 30 B.T.A. 632 (1934) 
(holding that costs of replacing the electrical system in a bank 
building were capital expenditures); Georgia Car and Locomotive Co., 2 
B.T.A. 986 (1925) (holding that costs of a new roof on a building were 
capital expenditures).
    Accordingly, the routine maintenance safe harbor is not appropriate 
for work performed on buildings. Rather, the proper analysis requires 
the application of the general rules for improvements, including the 
rules for determining whether the costs are incurred for a betterment 
or restoration to the building or the building systems, or to adapt the 
building or any of its systems to a new or different use. The temporary 
regulations revise the routine maintenance safe harbor to apply only to 
property other than buildings. In addition, the temporary regulations 
include new rules clarifying the application of the improvement 
standards to a building and provide new examples illustrating the 
application of these rules.

E. Betterments

    The 2008 proposed regulations provided that an amount paid results 
in a betterment, and accordingly, an improvement, if it ameliorates a 
material condition or material defect that existed prior to the 
acquisition of the property or arose during the production of the 
property; results in a material addition to the unit of property 
(including a physical enlargement, expansion, or extension); or results 
in a material increase in the capacity, productivity, efficiency, 
strength, or quality of the unit of property or its output. The 
temporary regulations retain all of these criteria, as well as the 2008 
proposed rules that detail how the betterment standards are applied.
    The IRS and the Treasury Department received several comment 
letters recommending that the drafters modify the betterment rules in 
several areas, create exceptions for particular situations, and clarify 
or modify some of the examples. One commentator expressed concern that 
the 2008 proposed regulations' definition of betterments would require 
a taxpayer to capitalize costs that do not extend the useful life of 
the unit of property as a whole and suggested that the MACRS rules be 
modified so that betterments would be assigned a recovery period based 
on the remaining recovery period of the unit of property. Such a 
revision to the MACRS regulations would be contrary to section 
168(i)(6), which generally requires that the depreciation deduction for 
an addition or improvement be computed in the same manner as the 
depreciation deduction for the underlying property would be computed if 
the underlying property had been placed in service at the same time as 
the addition or improvement.
1. Amounts Paid to Ameliorate Material Conditions and Defects
a. Knowledge of Defect
    Several commentators suggested changes to the 2008 proposed rule 
that defined a betterment as an amount paid to ameliorate a material 
condition or defect that existed prior to acquisition or arose during 
the production of the unit of property, whether or not the taxpayer was 
aware of the defect at the time of acquisition or production. One 
commentator suggested that a taxpayer should be required to capitalize 
the costs of ameliorating a defect only if the taxpayer was aware of or 
should have been aware of the defect at the time of acquisition. 
Another commentator suggested that a taxpayer should be required to 
capitalize these costs only if they were incurred within two years of 
the acquisition of the property.
    The temporary regulations do not revise the rule to require that a 
taxpayer's knowledge be taken into account in determining whether 
expenditures to ameliorate a preexisting condition or defect must be 
capitalized. The rule provided in the 2008 proposed regulations is 
consistent with established case law, which requires a taxpayer to 
capitalize these costs whether or not the taxpayer was aware of the 
defect at the time of acquisition. See United Dairy Farmers, Inc. v. 
United States, 267 F.3d 510 (6th Cir. 2001); Dominion Resources, Inc. 
v. United States, 219 F.3d 359 (4th Cir. 2000); La France Wine Co. v. 
Commissioner, T.C. Memo 1974-254. In addition, a rule that would 
require a subjective inquiry as to the taxpayer's knowledge at the time 
of acquisition or production would be difficult for the IRS to 
administer and to enforce.
    Finally, the IRS and the Treasury Department did not adopt the 
suggestion to add a two-year limitation on the application of the rule 
because such a limitation might encourage a taxpayer simply to postpone 
its expenditures to avoid treatment as an improvement.
b. Environmental Cleanup of Reacquired Property
    As mentioned above, the 2008 proposed regulations required a 
taxpayer to capitalize an amount paid to ameliorate a material 
condition or defect that existed at the time the taxpayer acquired or 
produced the property. The rule follows the general principle that a 
taxpayer must capitalize costs incurred to correct a pre-existing 
defect in acquired property regardless of whether the taxpayer was 
aware of the defect at the time of acquisition. See United Dairy 
Farmers, Inc. v. United States, 267 F.3d 510 (6th Cir. 2001). The 
preamble to the 2008 proposed regulations stated that under this rule a 
taxpayer would be required to capitalize environmental remediation 
costs in the situation in which the taxpayer contaminated property in 
the course of its business operations, disposed of the property (for 
example, by sale), and later reacquired property to clean up the 
contamination. The preamble requested comments regarding the 
appropriate treatment of environmental remediation costs in these 
situations, including how to determine whether the taxpayer's own use, 
or a prior owner's use, caused the contamination.
    Several commentators recommended that the regulations allow a 
deduction for clean-up costs under certain circumstances after a 
taxpayer acquires, or reacquires, property that the taxpayer had 
previously contaminated. The commentators generally asserted that a 
taxpayer that acquires or reacquires property that it had previously 
contaminated should be treated no differently than a taxpayer that 
continuously owns the property and contaminated the property through 
the course of its operations. See Rev. Rul. 94-38 (1994-1 CB 35), in 
which a taxpayer was permitted to deduct the costs of remediating 
property that it continuously owned and contaminated in the course of 
its operations because the taxpayer restored the property to the 
condition it was in prior to the circumstances necessitating the 
expenditure. One commentator addressed the situation in which a 
taxpayer contaminates property as a lessee of property and later 
acquires the property in an effort to minimize disputes with the lessor 
over clean-up obligations. The commentator recommended an exception to

[[Page 81072]]

capitalization for amounts incurred to clean up contamination that 
existed at the time a taxpayer acquires property provided (1) the 
taxpayer is legally liable for the cost of cleaning up the property 
prior to its acquisition by the taxpayer, and (2) the taxpayer's sole 
purpose for acquiring the property is to minimize the cost of clean-up. 
The commentator also indicated that a taxpayer that acquires 
contaminated property for an amount that is at least equal to the 
remediated fair market value of the property should be treated no 
differently than a taxpayer that continuously owned the property.
    The IRS and the Treasury Department recognize that a taxpayer that 
acquires, or reacquires, contaminated property for an amount at least 
equal to the remediated fair market value of the property may be in a 
position similar to that of a taxpayer that had continuously owned the 
property. However, the IRS and the Treasury Department are reluctant to 
create a rule that would hinge on the taxpayer's purpose for acquiring 
the property and a subjective determination of the remediated fair 
market value of the property. Moreover, Congress specifically provides 
a deduction under section 198 for taxpayers that incur certain 
environmental remediation expenditures that are otherwise required to 
be capitalized under section 263(a), including costs incurred by 
taxpayers conducting remediation on reacquired property. Taxpayers that 
elect to deduct these remediation costs under section 198 must comply 
with the requirements of that provision.
    The IRS and the Treasury Department recognize, however, that a 
taxpayer may encounter an unusual situation for which section 198 does 
not provide relief or to which the rationale underlying the temporary 
regulations does not apply. The IRS and the Treasury Department believe 
that these situations are better addressed through subject-specific 
guidance outside the regulations. Any taxpayer with a specific concern 
regarding the treatment of these types of costs should consider 
submitting a request for a private letter ruling under Rev. Proc. 2011-
1 (2011-1 IRB 1) (or its successor).
2. Material Increase in Capacity, Productivity, Efficiency, Strength, 
or Quality
    The 2008 proposed regulations defined betterments to include 
expenditures that result in a material increase in the capacity, 
productivity, efficiency, strength, or quality of the unit of property 
or its output. One commentator expressed concern about the subjective 
nature of determining any increase in ``quality'' of a unit of 
property. The temporary regulations do not change this standard but 
revise the examples from the 2008 proposed regulations and add a number 
of new examples to help illustrate and clarify the application of the 
increase in quality standard to particular facts and circumstances.
    Another commentator requested an example that permitted a deduction 
for the costs of earthquake retrofitting. The temporary regulations do 
not include an example allowing a deduction for earthquake 
retrofitting. Earthquake retrofitting encompasses various factual 
scenarios and could involve substantial structural additions that 
strengthen the unit of property and that may constitute betterments 
under the temporary regulations. Also, the temporary regulations retain 
an example from the 2008 proposed regulations that illustrates that 
certain amounts paid to strengthen a building to make it safer in the 
event of an earthquake may constitute a betterment to the unit of 
property. The temporary regulations illustrate that a taxpayer's 
treatment of amounts paid for earthquake retrofitting depends on the 
taxpayer's particular facts and circumstances.
3. Refreshing and Remodeling Buildings
    The 2008 proposed regulations provided an example that addressed 
whether amounts paid to update or remodel a building resulted in a 
betterment because they materially increased the capacity, 
productivity, efficiency, strength, or quality of the unit of property. 
In Example 6 of Sec.  1.263(a)-3(f)(3) of the 2008 proposed 
regulations, a taxpayer was not required to capitalize as betterments 
the amounts paid to change periodically the layout and appearance of 
its retail stores. The IRS and the Treasury Department received several 
comments suggesting that additional examples be added to the 
regulations to clarify the types of refresh or remodel expenses that 
would not result in a betterment. One commentator suggested the 
addition of an example illustrating that a remodel expense intended to 
increase sales should not, by itself, be evidence of a material 
increase in the quality of the unit of property under the betterment 
standards. Another commentator recommended revising the betterment 
standards to clarify that minor costs incurred as part of regularly 
recurring store updates are treated as currently deductible selling or 
marketing expenses.
    The betterment standards in the temporary regulations have not been 
revised to create an exception for minor and recurring store refresh or 
remodel costs. The analysis of whether store refresh or remodel costs 
result in a betterment requires an examination of all the facts and 
circumstances. The application of a per se exception to capitalization 
for all costs incurred as part of a recurring store refresh or remodel 
would be inappropriate, for example, in situations where a taxpayer 
performs major structural work on the building during a refresh or 
remodel.
    To provide additional guidance in this area, however, the temporary 
regulations expand upon the facts and analysis provided in Example 6 
and set out additional examples addressing the refreshing and 
remodeling of retail buildings. The additional examples demonstrate a 
range of outcomes based on the amount and type of work performed on the 
building and its structural components. The examples in the temporary 
regulations illustrate a refresh of retail buildings that merely keeps 
the buildings in ordinarily efficient operating condition; a refresh of 
retail buildings that also includes an improvement to a building 
system; and finally, a large scale refresh and remodel of retail 
buildings that involve an improvement to the buildings. These examples 
also illustrate the application of the rule governing the treatment of 
indirect costs incurred during an improvement of property.

F. Restorations

    The 2008 proposed regulations provided that an amount is paid to 
restore, and therefore improve, a unit of property if it (1) 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); (2) is for the replacement of a component of a 
unit of property and the taxpayer had properly taken into account the 
adjusted basis of the component in realizing gain or loss resulting 
from the sale or exchange of the component; (3) 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; (4) returns the 
unit of property to its ordinarily efficient operating condition if the 
property has deteriorated to a state of disrepair and was no longer 
functional for its intended use; (5) results in the rebuilding of the 
unit of property to a like-new condition after the end of its economic 
useful life; or (6) is for the replacement of a major component or a

[[Page 81073]]

substantial structural part of the unit of property.
    The IRS and the Treasury Department received many comments 
regarding the 2008 proposed restoration rules. The temporary 
regulations generally retain the restoration standards set forth in the 
2008 proposed regulations but have revised certain definitions as well 
as the operation and the application of some of the rules. The 
comments, the revisions, and the reasons for these changes are 
discussed below.
1. Casualty Loss
    The 2008 proposed regulations provided that an amount is paid to 
restore a unit of property if it is for the repair of damage to the 
unit of property for which the taxpayer had 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 (``casualty loss 
rule''). The IRS and the Treasury Department received comments from 
several practitioners and industry groups requesting that the drafters 
remove the proposed casualty loss rule from the regulation. These 
commentators requested that the regulations confirm and acknowledge 
that a taxpayer that is engaged in a trade or business is entitled to 
claim a casualty loss deduction, adjust basis in the property, and 
claim an ordinary and necessary business expense deduction to repair 
the property damaged in the casualty event.
    The temporary regulations retain the casualty loss rule because the 
rule is consistent with the fundamental principle that a taxpayer must 
capitalize the cost of acquiring new property. The casualty loss rule 
is also consistent with the restoration rules in the temporary 
regulations that require a taxpayer to capitalize the cost of a 
replacement component where it has properly deducted a loss for the 
component or taken into account the adjusted basis of the component in 
realizing gain or loss. In these situations, a taxpayer deducts the 
amount of the loss, reduces basis in the unit of property by the amount 
of loss, and then incurs costs to acquire a replacement component. 
Thus, the replacement is treated like the acquisition of new property 
(that is, the replacement of the reduced or eliminated basis), and the 
amounts paid for the replacement is treated as a capital expenditure. 
The replacement of property damaged in a casualty may involve the 
replacement or restoration of the entire property or components of that 
property. In either event, the damaged part of the property is treated 
as retired, the basis attributable to the damaged part is removed, and 
the damaged part is restored or replaced. Thus, costs to restore or 
replace the portion of property for which basis has been recovered are 
analogous to the costs of acquiring new property and must be treated as 
capital expenditures.
    In response to the casualty loss rule in the 2008 proposed 
regulations, commentators contended that the casualty loss and the 
repair expense do not create a double deduction for the same item 
because they arise out of separate tax events. Specifically, the 
commentators argued that the casualty loss permitted under section 
165(c) compensates the taxpayer for the unanticipated diminution in 
value of the taxpayer's property, while the repair expense deduction 
permitted under section 162 compensates the taxpayer for its out-of-
pocket expenditures necessary to restore its property to working 
condition. The commentators emphasized that sections 165 and 162 confer 
separate benefits with separate regulatory requirements.
    The IRS and the Treasury Department recognize that the section 165 
loss and the section 162 business expense deduction do not create a 
double deduction for the same item and do confer different benefits to 
a taxpayer engaged in a trade or business. The section 165 loss permits 
recognition for a property loss suffered (in this case due to a 
casualty), and the section 162 deduction allows a taxpayer to take 
current deductions for the ordinary and necessary expenses of carrying 
on a trade or business, unless such deductions are prohibited under 
section 263(a). Where a casualty event occurs, however, the application 
of the section 165 loss provisions to a unit of property, specifically 
the reduction of basis that is required, creates a situation where the 
principles of section 263(a) should apply to the restoration event to 
prohibit a section 162 deduction. As discussed, in this situation, the 
amounts paid to restore property are analogous to the costs of 
acquiring new property and are properly capitalized, in this case 
through the addition of basis to the restored underlying property.
    Commentators also asserted that the casualty loss rule in the 2008 
proposed regulations negated the benefit of the casualty loss deduction 
specifically permitted under section 165(c) and Sec.  1.165-7(a)(1) to 
a taxpayer engaged in a trade or business where there is partial damage 
to property, rather than full destruction. The commentators claimed 
that the casualty loss rule results in especially harsh treatment to a 
business taxpayer because this taxpayer must capitalize its restoration 
costs and recover them over the full recovery period assigned to the 
underlying property starting in the year the improvement is placed in 
service.
    By retaining the casualty loss rule, however, the temporary 
regulations are not eliminating the benefit provided to trade and 
businesses by the allowance of a casualty loss. Rather, the temporary 
regulations are disallowing the acceleration of deductions for both the 
casualty loss and the costs of restoring the property. The casualty 
loss rule does not limit a taxpayer's ability to accelerate the 
recovery of the basis attributable to such property through the section 
165 loss provisions. Rather, it requires a taxpayer to capitalize the 
costs of restoring the property, with recovery of such costs permitted 
through depreciation over the proper recovery period.
    One commentator asserted that it was Congress' intent in enacting 
section 165(c) and the Treasury Department's intent in applying section 
165(c) to business taxpayers (which, the commentator contends, is 
imputed to Congress through legislative enactment) to confer a benefit 
on all taxpayers by allowing them a casualty loss in situations where 
such loss would not otherwise be deductible (that is, where there is 
only partial damage to the property). The commentator further explains 
that a requirement to capitalize otherwise deductible section 162 
expenses following a casualty undercuts Congress' intent in allowing a 
current deduction for the loss in value of the property. The problem 
with this analysis, however, is that an individual not engaged in a 
trade or business or in a for-profit transaction (an individual) is not 
entitled to an additional deduction under section 162 or any other 
provision for amounts paid to repair the damaged property. Thus, 
Congress could not have intended to provide an additional benefit to 
all taxpayers (in the form of a section 162 deduction) through 
legislative reenactment, where that benefit was not available to an 
individual who had suffered partial damage from a casualty. In general, 
an individual takes the loss deduction, reduces its basis in the 
damaged property, and capitalizes the costs of restoring the damaged 
property. In contrast, under the commentator's preferred approach, a 
business taxpayer would take the loss deduction, reduce the basis of 
the damaged property, and then claim an immediate deduction for the 
restoration costs. Thus, the commentator's approach would result in 
disparate results between individual and business taxpayers.
    The casualty loss rule is consistent with current law. Although

[[Page 81074]]

commentators pointed to cases that specifically permit taxpayers to 
take business expense deductions for the costs of restoring property 
damaged in a casualty event, those same cases often imply that a repair 
expense and a loss deduction are of opposite character and may be 
mutually exclusive. See, for example, Trinity Meadows Raceway v. 
Commissioner, 187 F.3d 638 (6th Cir. 1999) (unpublished decision) 
(disallowing both a casualty loss and a related section 162 deduction 
for property damaged by a flood because the taxpayer did not maintain 
adequate records but stating that a taxpayer may deduct the repairs 
under section 162 or take the loss in value under section 165); 
Hubinger v. Commissioner, 36 F.2d 724 (2nd Cir. 1929) (holding taxpayer 
could not deduct the costs of reconditioning property after a fire as 
ordinary and necessary expenses because such items were more in the 
nature of casualty losses, but taxpayer was not entitled to casualty 
loss because there was no proof of loss); R. R. Hensler, Inc. v. 
Commissioner, 73 T.C. 168 (1979), acq., (1980-2 CB 1) (allowing a 
business expense deduction for taxpayer's cost of recovering, 
repairing, and replacing equipment ``displaced and damaged'' by flood 
and distinguishing such property from property that is ``lost, 
destroyed, or abandoned'' and which ``gives rise to a loss under 
section 165''); Atlantic Greyhound Corp. v. United States, 111 F. Supp. 
953 (Ct. Cl. 1953) (disallowing casualty losses for the expenses of 
repairing buses occasioned by accidents because such damage was 
``expected, normal, and inevitable'' and the costs of repairing such 
damage was ordinary and necessary). In addition, where this question 
has been raised, the courts have not opined on whether the taxpayer may 
take a casualty loss and a business expense deduction with regard to a 
single casualty. See R.R. Hensler, 73 T.C. at 176 n. 9; Louisville & 
Nashville R.R. Co. v. Commissioner, T.C. Memo 1987-616, n. 24.
    The IRS and the Treasury Department are aware that the property 
damaged in a casualty event might have remaining basis that is 
insignificant compared to the costs necessary to restore the property. 
Focusing on this possibility, commentators requested that if the 
casualty loss rule contained in the 2008 proposed regulations were 
retained, consideration should be given to allowing taxpayers to forgo 
claiming a section 165 loss in order to qualify for a section 162 
deduction. The temporary regulations address this concern and provide 
for such a result. Specifically, the temporary regulations revise the 
rules of accounting for property to which section 168 applies (MACRS 
property) and also for determining gain or loss upon the disposition of 
MACRS property. These rules, discussed in more detail in section VII of 
this preamble, provide that a taxpayer electing to use a general asset 
account under temporary regulation Sec.  1.168(i)-1T may forgo 
recognizing a casualty loss (without reducing basis) and may claim a 
repair deduction under section 162 for the replacement property, 
provided the replacement cost is not treated as a capital expenditure 
under a different provision of the temporary regulations.
2. Rebuilding to Like-New Condition
    The 2008 proposed regulations provided that if an amount paid 
results in the rebuilding of a unit of property to a like-new condition 
after the end of its economic useful life, the amount must be 
capitalized as a restoration of the unit of property. However, an 
exception provided that if the amount is paid after the economic useful 
life of the property but during the recovery period (as prescribed in 
section 168(c)), the amount is not required to be capitalized. The 
temporary regulations revise the rule to apply only to amounts paid to 
rebuild the unit of property after the end of the class life of the 
unit of property as defined under sections 168(g)(2) and (3). The 
temporary regulations also remove the recovery period exception so that 
a taxpayer must look only to the class life of the property in 
determining the application of this rule. The use of defined class life 
rather than economic useful life provides a more objective standard for 
determining whether the rebuilding rule applies and is consistent with 
the standard that applies in determining whether amounts qualify for 
the routine maintenance safe harbor. This more objective standard is 
designed to avoid disputes that might otherwise arise in determining 
the economic useful life of property and to provide for consistent 
application among taxpayers that hold the same type of property.
3. Replacement of Major Component or Substantial Structural Part
    The 2008 proposed regulations provided that an amount paid for the 
replacement of a major component or a substantial structural part of a 
unit of property is an amount paid to restore (and therefore improve) 
the unit of property. The 2008 proposed regulations defined ``major 
component or substantial structural part'' as 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 the 
replacement of which comprises 50 percent or more of the physical 
structure of the unit of property (``the 50 percent thresholds''). 
Furthermore, the 2008 proposed regulations provided that an amount was 
not required to be capitalized as a replacement of a major component or 
substantial structural part if it was paid during the recovery period 
prescribed in section 168(c) (``recovery period limitation'').
    The IRS and the Treasury Department received two comments on this 
provision. One commentator suggested that the regulation should provide 
guidance establishing reasonable methods for substantiating replacement 
costs. This commentator also recommended that the drafters eliminate 
the 50 percent thresholds because physical structure is too difficult 
to measure. Another commentator suggested that the 50 percent 
thresholds should be abandoned arguing that they have no basis in law 
and will lead to unexpected complications in application.
    The 50 percent thresholds and the recovery period limitation were 
first introduced in the 2008 proposed regulations. The exceptions were 
intended to provide a more objective standard for capitalization in 
this area and to counter the effect of the disposition and depreciation 
rules for buildings that generally require a taxpayer to capitalize and 
depreciate multiple replacements of the same structural component while 
continuing to recover the cost of the original structural component as 
part of the asset (for example, a taxpayer could not take a retirement 
loss on the disposition of a structural component of a building).
    The 50 percent thresholds and the recovery period limitation in the 
2008 proposed regulations provided an objective, bright-line 
alternative to the highly factual analysis applied by the courts and 
the IRS in determining whether a replacement part is a major component 
or substantial structural part of property and must therefore be 
capitalized, or is a relatively minor portion of the physical structure 
of the property or of any of its major parts and may therefore be 
deducted as a repair. Neither the courts nor the IRS, however, have 
previously adopted or applied the 50 percent thresholds or the recovery 
period limitation in determining whether a taxpayer must capitalize the 
cost of replacement parts or components. See, for example, Buckland v. 
United States, 66 F. Supp. 681 (D. Conn. 1946) (holding that costs to 
replace window sills in a factory

[[Page 81075]]

building were deductible); Rev. Rul. 2001-4, 2001-1 CB 295 (holding, in 
part, that costs of certain heavy maintenance on aircraft airframe were 
deductible); Smith v. Commissioner, 300 F.3d 1023, 1032 (9th Cir. 2002) 
(holding that costs of relining aluminum smelting cells were capital 
expenditures even though they amounted to only 22.21 percent of the 
costs of replacing an entire cell); Denver & Rio Grande Western R.R. 
Co. v. Commissioner, 279 F.2d 368 (10th Cir. 1960) (holding that costs 
to replace the floor planks and stringers of a viaduct were capital 
expenditures); P. Dougherty Co. v. Commissioner, 159 F.2d 272 (4th Cir. 
1946) (holding that costs of replacing the stern section of a barge 
were capital expenditures); Tsakopoulous v. Commissioner, T.C. Memo 
2002-8 (holding that costs to replace the roof on a portion of the 
suites of a shopping center were capital expenditures); Stewart Supply 
Co. v. Commissioner, T.C. Memo 1963-62 (holding that costs to replace a 
front wall of a building and make electrical connections to that wall 
were capital expenditures).
    The IRS and the Treasury Department are concerned that the 50 
percent thresholds and the recovery period limitation, although 
objective, will lead to results that are drastically different from the 
results reached in the case law and rulings in this area. The 50 
percent thresholds and the recovery period limitation would, in many 
cases, allow the replacement of a major component or substantial 
structural part to be treated as deductible repair rather than a 
capital expenditure, in effect reversing most of the existing 
authorities.
    The temporary regulations therefore retain the standard that 
requires capitalization of an amount paid for the replacement of a 
major component or substantial structural part of the unit of property 
but revise the standard to more closely follow the facts and 
circumstances approach used by the courts. Under the temporary 
regulations, in determining whether an amount is paid for the 
replacement of a part or a combination of parts that comprise a major 
component or a substantial structural part of the unit of property, the 
taxpayer must consider all the facts and circumstances, including the 
quantitative or qualitative significance of the part or combination of 
parts in relation to the unit of property or, in the case of a 
building, in relation to the building structure or the relevant 
building system. The temporary regulations also define a major 
component or substantial structural part to include a part or 
combination of parts that comprise a large portion of the physical 
structure of the unit of property or that perform a discrete and 
critical function in the operation of the unit of property. The 
replacement of a minor component of the unit of property, even though 
such component may affect the function of the unit of property, will 
not generally by itself constitute a major component or substantial 
structural part under the temporary regulations. The temporary 
regulations add a number of examples to illustrate the application of 
the revised standards in a variety of situations, including its 
application to a building structure and building systems.
    In addition, the temporary regulations revise the disposition and 
depreciation rules to minimize the harsh result that occurs when an 
original part and any subsequent replacements of the same part are 
required to be capitalized and recovered simultaneously. As mentioned, 
in the case of buildings, taxpayers are currently required to 
capitalize and depreciate the costs to replace a structural component 
and to continue to recover the cost of the original structural 
component (for example, a taxpayer could not take a retirement loss on 
the disposition of a structural component of a building). For example, 
if a taxpayer were required to capitalize the costs of replacing an 
entire roof, it could not recover its basis in the original roof that 
was removed. Rather, the taxpayer would have to continue depreciating 
the removed roof, and at the same time, capitalize and depreciate the 
replacement roof over the same recovery period as the building. The 
temporary regulations revise the definition of disposition so that a 
taxpayer may treat the retirement of a structural component of a 
building as a disposition of property. Furthermore, the temporary 
regulations clarify that a taxpayer may recognize a loss on a component 
of a unit of property that is section 1245 property if the taxpayer 
consistently treats the component as a separate asset for disposition 
purposes. As a result, the 50 percent thresholds and the recovery 
period limitation are not necessary to prevent contemporaneous 
depreciation of both the retired component and the replacement 
component and, therefore, are not included in the temporary regulations 
as exceptions to the major component and substantial structural part 
rule.

VII. Accounting and Disposition Rules for MACRS Property

    The temporary regulations revise the rules for accounting for 
assets to which section 168 applies (MACRS property) and the rules for 
determining gain or loss upon the disposition of MACRS property.
    Currently, a taxpayer may account for its MACRS property by 
accounting for an asset individually in a single asset account, by 
combining two or more assets in a multiple asset account (or pool), or 
by electing to include the asset in a general asset account. The 
temporary regulations continue to allow these types of accounts. 
However, the rules under Sec.  1.167(a)-7 for the different types of 
multiple asset accounts (specifically group account, classified 
account, and composite account) are based on a taxpayer being permitted 
to depreciate assets in the account over their useful lives or average 
useful lives (less salvage value). Since the enactment of the 
Accelerated Cost Recovery System (ACRS) in 1981, a taxpayer is required 
to depreciate assets over their recovery periods instead of their 
useful lives. Consequently, the temporary regulations eliminate group 
accounts, classified accounts, and composite accounts. Instead, the 
temporary regulations provide that each multiple asset account must 
include, in most cases, assets that have the same depreciation method, 
recovery period, and convention, and that are placed in service in the 
same taxable year.
    Section 1.168-6 of the proposed ACRS regulations provides the rules 
for determining gain or loss upon the disposition of ACRS property. 
These rules generally have been applied to MACRS property. The 
temporary regulations provide rules for determining gain or loss upon 
the disposition of MACRS property that are consistent with the 
disposition rules under Sec.  1.168-6 of the proposed ACRS regulations. 
However, as previously mentioned, the temporary regulations expand the 
definition of disposition for MACRS property to include the retirement 
of a structural component of a building and, accordingly, the temporary 
regulations allow the recognition of a loss upon such retirement. The 
temporary regulations also clarify that, if an asset is disposed of by 
physical abandonment and that asset is subject to nonrecourse 
indebtedness, the asset is treated in the same manner as an asset 
disposed of by sale. In addition, the temporary regulations provide 
rules for determining the asset disposed of and identifying which 
multiple asset account includes the asset disposed of.
    The temporary regulations also amend the rules for general asset 
accounts under Sec.  1.168(i)-1. Section 1.168(i)-1(e)(2) provides 
that, in general, no loss is recognized upon the disposition of an 
asset from a general asset account.

[[Page 81076]]

However, Sec.  1.168-1(e)(3)(iii) provides that a taxpayer may elect to 
recognize gain or loss upon the disposition of an asset in a general 
asset account if there is a qualifying disposition. A qualifying 
disposition is defined to include a casualty loss, a charitable 
contribution, termination of a business or income producing activity, 
and certain types of transactions. The temporary regulations amend the 
general asset account rules by expanding the definition of disposition 
to include the retirement of a structural component of a building and 
by expanding the definition of a qualifying disposition to allow the 
recognition of gain or loss upon most dispositions of assets in general 
asset accounts. Thus, by electing general asset account treatment, a 
taxpayer will have the option of recognizing gain or loss on an 
expanded list of qualifying dispositions, which are not all treated as 
qualifying dispositions under the current general asset account rules. 
In addition, the temporary regulations modify the rules for 
establishing general asset accounts and clarify the computation of 
depreciation for a general asset account when the assets in the account 
are eligible for the additional first year depreciation deduction.

A. Accounting for MACRS property

    The existing regulations under Sec.  1.167(a)-7 allow a taxpayer to 
account for its depreciable assets by treating each asset as a single 
asset account or by combining two or more assets in a multiple asset 
account (or pool). A taxpayer may establish as many accounts for 
depreciable assets as the taxpayer wants and may group the assets in 
multiple asset accounts in different ways. When depreciation was 
determined using the useful lives of assets and average useful lives 
were permitted for an account, the common multiple asset accounts were 
a group account (assets similar in kind with approximately the same 
useful lives), a classified account (assets based on use without regard 
to useful life), and a composite account (assets in the same account 
without regard to their character or useful lives). The temporary 
regulations amend Sec.  1.167(a)-7 to provide generally that those 
rules (which were originally issued in 1956) apply only to property 
subject to section 167 and not to MACRS property (generally property 
placed in service after 1986) or ACRS property (generally property 
placed in service after 1980 and before 1987).
    The temporary regulations will, consistent with the rules under 
Sec.  1.167(a)-7, continue to provide flexibility to a taxpayer in 
establishing its depreciable accounts for MACRS property. The temporary 
regulations under Sec.  1.168(i)-7T allow a taxpayer to account for its 
MACRS property by treating each asset as a single asset account or by 
combining two or more assets in a multiple asset account. A taxpayer 
also may establish as many accounts for assets as the taxpayer wants. 
If a taxpayer chooses to account for its assets in multiple asset 
accounts, the temporary regulations provide that each multiple asset 
account must include assets that have the same depreciation method, 
recovery period, and convention, and are placed in service in the same 
taxable year. For example, in one multiple asset account, a taxpayer in 
the wholesale distribution business may account for most of its items 
of 5-year property that are placed in service in 2012 and have the same 
depreciation method, recovery period, and convention even though the 
assets may have different uses (for example, copiers, forklifts, and 
equipment in the distribution warehouse). Alternatively, the taxpayer 
may choose to account for the items of 5-year property in more than one 
multiple asset account, each as a single asset account, or in a 
combination of single and multiple asset accounts.
    Even if assets have the same depreciation method, recovery period, 
and convention, depreciation for the assets may be computed 
differently. For example, depreciation may be limited for passenger 
automobiles subject to section 280F(a), or some assets may be eligible 
for the additional first year depreciation while others are not. As a 
result, the temporary regulations provide additional rules for 
establishing multiple asset accounts. For example, assets subject to 
the mid-month convention may be grouped in a multiple asset account 
only with assets placed in service in the same month. Similarly, assets 
eligible for the additional first year depreciation deduction cannot be 
grouped with assets ineligible for the additional first year 
depreciation deduction. Also, assets eligible for the additional first 
year depreciation deduction may be grouped only with assets eligible 
for the same percentage of the additional first year depreciation.
    In limited circumstances, the temporary regulations require the use 
of a single asset account. A taxpayer must account for an asset in a 
single asset account if the taxpayer uses the asset both for business 
use and personal use, or the taxpayer places the asset in service and 
disposes of it in the same taxable year. A single asset account is also 
required for an asset that was included in a general asset account but 
general asset account treatment for the asset was terminated under the 
rules in Sec.  1.168(i)-1T. Section 1.168(i)-7T does not apply to 
assets while they are included in general asset accounts subject to 
Sec.  1.168(i)-1T.

B. Dispositions of MACRS Property

    Section 168(i)(6) provides that an improvement or addition to 
property is depreciated under section 168 by using the depreciation 
method, recovery period, and convention that would be applicable to the 
underlying property if the underlying property is placed in service at 
the same time as the improvement or addition. If an improvement or 
addition to the underlying property is placed in service after the 
taxpayer placed the underlying property in service, the recovery period 
for the improvement or addition begins on the placed-in-service date of 
the improvement or addition. In effect, that improvement or addition is 
treated as a separate asset for purposes of section 168.
    If a lessor made an improvement for a lessee and that improvement 
is irrevocably disposed of or abandoned by the lessor at the 
termination of the lease, section 168(i)(8)(B) allows the lessor to 
recognize gain or loss upon the disposition of that improvement. This 
rule applies to improvements that are structural components of a 
building. Similarly, if a lessee of a leased building makes an 
improvement that is a structural component of that building, the lessee 
may recognize gain or loss upon its disposition of that improvement.
    However, Sec.  1.168-2(l)(1) of the proposed ACRS regulations 
(which have been generally applied to MACRS property) provides that a 
disposition does not include the retirement of a structural component 
of a building. Consequently, Sec.  1.168-6(b) of the proposed ACRS 
regulations provides that no loss is recognized upon the retirement of 
a structural component of a building.
    As previously mentioned, the temporary regulations for determining 
whether there is an improvement to the unit of property take an 
approach different from the 2008 proposed regulations in order to 
achieve results more consistent with existing case law and to avoid the 
potential inequities resulting from the depreciation and disposition 
rules. As explained below, the temporary regulations expand the 
definition of disposition to include retirements of structural 
components of buildings and clarify that, in some

[[Page 81077]]

cases, components of section 1245 property may be treated as the asset 
disposed of. These changes will allow taxpayers, for example, to claim 
a retirement loss for worn or damaged components that are discarded 
from the taxpayer's operations. On the other hand, a taxpayer that has 
elected general asset account treatment may choose not to claim a 
retirement loss for property that has been disposed of, and would 
accordingly continue to depreciate the basis in the property.
1. Definition of Disposition
    Under the temporary regulations under Sec.  1.168(i)-8T, a 
disposition occurs when ownership of the asset is transferred or when 
the asset is permanently withdrawn from use either in the taxpayer's 
trade or business or in the production of income. A disposition 
includes the sale, exchange, retirement, physical abandonment, or 
destruction of an asset. A disposition also includes the retirement of 
a structural component of a building. Finally, a disposition also 
occurs when an asset is transferred to a supplies, scrap, or similar 
account.
    Prior to the enactment of ACRS in 1981, a taxpayer was permitted to 
depreciate the cost of property over its useful life (less salvage 
value), which was based on the taxpayer's subjective determination of 
the period over which the asset would be useful to the taxpayer in its 
trade or business or in the production of its income. Some taxpayers 
utilized component depreciation under this system in determining the 
useful life of buildings. Under component depreciation, a taxpayer 
allocates the cost of a building to its component parts and then 
assigns a separate useful life to each of these components. Each of the 
component parts is then depreciated as a separate asset. The ACRS rules 
prohibited the use of component depreciation and required composite 
depreciation for buildings. Composite depreciation was also required 
when the ACRS rules were modified in 1986 (generally referred to as 
``MACRS,'' the modified rules generally applied to property placed in 
service after 1986). Under composite depreciation, a taxpayer 
depreciates a building and its structural components using the same 
recovery period and depreciation method. The temporary regulations do 
not change the requirement to use composite depreciation. Under section 
168, a taxpayer must depreciate a building and all of its structural 
components using the same recovery period, depreciation method, and 
convention, even though under the temporary regulations each of the 
structural components is a separate asset.
2. Gain or Loss
    The temporary regulations provide rules for determining gain or 
loss upon the disposition of MACRS property that are consistent with 
the disposition rules under Sec.  1.167(a)-8 and Sec.  1.168-6 of the 
proposed ACRS regulations. If an asset is disposed of by sale, 
exchange, or involuntary conversion, gain or loss is recognized under 
the applicable provisions of the Internal Revenue Code. If an asset is 
disposed of by physical abandonment, loss is recognized in the amount 
of the asset's adjusted depreciable basis at the time of the 
abandonment. However, if the abandoned asset is subject to nonrecourse 
indebtedness, the temporary regulations clarify that the asset is 
treated in the same manner as an asset disposed of by sale. If an asset 
is disposed of by conversion to personal use, no gain or loss is 
recognized. See Sec.  1.168(i)-4(c). If an asset is disposed of other 
than by sale, exchange, involuntary conversion, physical abandonment, 
or conversion to personal use (for example, when the asset is 
transferred to a supplies or scrap account), gain is not recognized but 
loss is recognized in the amount of the excess of the asset's adjusted 
depreciable basis over its fair market value at the time of 
disposition. The temporary regulations also provide that the manner of 
disposition (for example, abnormal retirement or normal retirement) is 
not taken into consideration in determining whether a disposition 
occurs or gain or loss is recognized.
3. Determining the Appropriate Asset Disposed of
    The temporary regulations provide that the facts and circumstances 
of each disposition are considered in determining the appropriate asset 
disposed of. In general, the asset for disposition purposes cannot be 
larger than the unit of property as determined under Sec.  1.263(a)-
3T(e)(2), (e)(3), and (e)(5) or as otherwise provided in published 
guidance in the Federal Register or in the Internal Revenue Bulletin 
(see, for example, Rev. Proc. 2011-28 (2011-18 IRB 743) providing units 
of property for wireless network assets). However, each disposed of 
building is the asset except if more than one building is treated as 
the asset under Sec.  1.1250-1(a)(2)(ii). If the building includes two 
or more condominium or cooperative units, then each condominium or 
cooperative unit (instead of the building) is the asset. Consistent 
with the expansion of the definition of a disposition to include a 
retirement of a structural component of a building, the temporary 
regulations provide that each structural component of a building, 
condominium unit, or cooperative unit is the asset for disposition 
purposes. Further, if a taxpayer properly includes an item in one of 
the asset classes 00.11 through 00.4 of Rev. Proc. 87-56 (1987-2 CB 
674) or classifies an item in one of the categories under section 
168(e)(3) (other than a category that includes buildings or structural 
components; for example, retail motor fuels outlet and qualified 
leasehold improvement property), each item is the asset provided it is 
not larger than the unit of property as determined under Sec.  
1.263(a)-3T(e)(3) or (e)(5). For example, each desk is the asset, each 
computer is the asset, and each qualified smart electric meter is the 
asset (assuming these assets are not larger than the unit of property 
as determined under Sec.  1.263(a)-3T(e)(3) or (e)(5)). Consistent with 
section 168(i)(6), the temporary regulations also provide that if the 
taxpayer places in service an improvement or addition to an asset after 
the taxpayer placed the asset in service, the improvement or addition 
is a separate asset for depreciation purposes. The temporary 
regulations also provide that a taxpayer generally may use any 
reasonable, consistent method to treat each of an asset's components as 
the asset for disposition purposes.
    The temporary regulations provide rules for determining the placed-
in-service year of the asset disposed of. In general, a taxpayer must 
use the specific identification method. Under this method, the taxpayer 
can determine when the asset disposed of was placed in service. If a 
taxpayer accounts for assets in multiple asset accounts, the IRS and 
the Treasury Department recognize that it may be impracticable to 
determine from the taxpayer's records when the asset disposed of was 
placed in service. Accordingly, the temporary regulations allow the 
taxpayer to use a first-in, first-out (FIFO) method under which the 
taxpayer treats the asset disposed of as being from the multiple asset 
account with the earliest placed-in-service year that has assets with 
the same recovery period as the asset disposed of. However, if the 
taxpayer can readily determine from its records the unadjusted 
depreciable basis of the asset disposed of, the temporary regulations 
allow the taxpayer to use a modified FIFO method under which the 
taxpayer treats the asset disposed of as being from the multiple asset 
account

[[Page 81078]]

with the earliest placed-in-service year that has assets with the same 
recovery period as the asset disposed of and with the same unadjusted 
depreciable basis of the asset disposed of. If the asset disposed of is 
a mass asset in a multiple asset account, the temporary regulations 
also allow the taxpayer to use a mortality dispersion table to identify 
when the asset was placed in service. Finally, the temporary 
regulations allow a taxpayer to use any other method designated by the 
Secretary. The IRS and the Treasury Department invite taxpayers to 
submit comments on reasonable methods to be considered for this 
purpose. However, the IRS and the Treasury Department do not consider a 
last-in, last-out (LIFO) method to be a reasonable method. Under the 
LIFO method, the taxpayer treats the asset disposed of as being from 
the multiple asset account with the most recent placed-in-service year 
that has assets with the same recovery period as the asset disposed of.
4. Accounting for Assets Disposed of
    The IRS and the Treasury Department recognize that it may be 
impracticable for a taxpayer that accounts for assets in multiple asset 
accounts to determine from the taxpayer's records the unadjusted 
depreciable basis of the asset disposed of. Accordingly, the temporary 
regulations provide that the taxpayer may use any reasonable, 
consistent method to make that determination. Similar rules are 
provided if the asset disposed of is a component of a larger asset.
    When an asset is disposed of, the temporary regulations provide 
that depreciation ends for that asset. See Sec.  1.167(a)-10(b). 
Accordingly, if the asset disposed of is in a single asset account, the 
temporary regulations provide that the single asset account terminates 
as of the date of disposition (taking into account the applicable 
convention of the asset disposed of). Also, if the asset disposed of is 
in a multiple asset account, the temporary regulations provide that the 
asset is removed from that account and the unadjusted depreciable basis 
and depreciation reserve of the account are adjusted. Similar rules are 
provided if the asset disposed of is a component of a larger asset.
    The temporary regulations also provide that the Sec.  1.167(a)-8 
rules apply to property subject to section 167 and not to MACRS 
property (generally property placed in service after 1986) or ACRS 
property (generally property placed in service after 1980 and before 
1987).

C. General Asset Accounts

    Section 168(i)(4) provides that under regulations, a taxpayer may 
maintain one or more general asset accounts for any MACRS property. 
Except as provided in regulations, all proceeds realized on any 
disposition of property in a general asset account shall be included in 
income as ordinary income.
    The existing rules for general asset accounts are provided under 
Sec.  1.168(i)-1. The provisions of Sec.  1.168(i)-1 apply only to 
assets for which the taxpayer has made an election to account for the 
assets in general asset accounts. The temporary regulations for general 
asset accounts under Sec.  1.168(i)-1T retain this rule. Under the 
existing rules and temporary regulations, each general asset account is 
effectively treated as the asset.
1. Establishing General Asset Accounts
    Consistent with the existing general asset account rules under 
Sec.  1.168(i)-1(c), the temporary regulations provide that assets may 
be grouped into one or more general asset accounts. The temporary 
regulations, however, expand the assets that may be included in each 
general asset account. The temporary regulations eliminate the existing 
rule that each general asset account must include only assets that have 
the same asset class. Thus, under the temporary regulations, each 
general asset account must include only assets that have the same 
depreciation method, recovery period, and convention, and are placed in 
service in the same taxable year.
    The existing general asset account rules also provide special rules 
for establishing general asset accounts. These rules are necessary 
because even though assets have the same depreciation method, recovery 
period, and convention, depreciation for the assets may be computed 
differently. As a result, the temporary regulations do not change the 
existing rules, but they add new rules to be consistent with the 
temporary regulations for establishing multiple asset accounts for 
MACRS property. For example, assets eligible for the additional first 
year depreciation deduction cannot be grouped with assets ineligible 
for the additional first year depreciation deduction. Also, assets 
eligible for the additional first year depreciation deduction may be 
grouped only with assets eligible for the same percentage of the 
additional first year depreciation.
2. Depreciation of General Asset Account
    Section 1.168(i)-1(d) provides the rules for determining the 
depreciation for each general asset account. However, these rules do 
not reflect the additional first year depreciation provisions added to 
section 168 since the promulgation of Sec.  1.168(i)-1 in 1994. 
Accordingly, the temporary regulations provide rules for determining 
the depreciation for a general asset account where all the assets in 
the account are eligible for the additional first year depreciation 
deduction and where all the assets in the account are not eligible for 
that deduction.
3. Disposition of an Asset From a General Asset Account
    Consistent with the expansion of the definition of disposition of 
MACRS property, the temporary regulations expand the definition of 
disposition under Sec.  1.168(i)-1(e)(1) to include a retirement of a 
structural component of a building.
    Immediately before any disposition of an asset in a general asset 
account, the existing rules treat the asset as having an adjusted 
depreciable basis of zero for purposes of section 1011. Therefore, no 
loss is realized upon the disposition of the asset. The existing rules 
also provide that any amount realized on a disposition generally is 
recognized as ordinary income. Further, the existing rules provide that 
the unadjusted depreciable basis and depreciation reserve of the 
general asset account are not affected by the disposition. Accordingly, 
a taxpayer continues to depreciate the general asset account, including 
the asset disposed of, as though no disposition occurred. The temporary 
regulations do not change any of these rules.
    The existing rules also allow a taxpayer to terminate general asset 
account treatment upon certain dispositions. Under the existing rules, 
the taxpayer may elect to recognize gain or loss for a general asset 
account when the taxpayer disposes of all of the assets, or the last 
asset, in the account. The temporary regulations retain this rule.
    The existing rules further allow a taxpayer to elect to terminate 
general asset account treatment for an asset in a general asset account 
when the taxpayer disposes of the asset in a qualifying disposition. 
Under the existing rules, a qualifying disposition generally is a 
casualty or extraordinary event. The temporary regulations expand a 
qualifying disposition to include generally any disposition. If a 
taxpayer elects to terminate general asset account treatment for an 
asset disposed of in a qualifying disposition, the temporary 
regulations do not change the existing rules that require the taxpayer 
to remove the asset disposed of

[[Page 81079]]

from the general asset account and adjust the unadjusted depreciable 
basis and depreciation reserve of the account.
    The temporary regulations also do not change the existing rules 
that require a taxpayer to terminate general asset account treatment 
for assets in a general asset account that are disposed of in 
transactions subject to section 167(i)(7)(B), section 1031, or section 
1033, or in an abusive transaction described under the existing rules. 
In addition, the temporary regulations require a partnership to 
terminate its general asset accounts upon the technical termination of 
the partnership under section 708(b)(1)(B).
4. Other Transactions
    The temporary regulations require a taxpayer to terminate general 
asset account treatment for an asset that the taxpayer uses for both 
business use and personal use. If there is a redetermination of basis 
of an asset in a general asset account (for example, due to contingent 
purchase price or discharge of indebtedness), the temporary regulations 
provide that the election for the asset also applies to the increase or 
decrease in basis and require the taxpayer to establish a new general 
asset account for that increase or decrease in basis.
5. Identification of Disposed of or Converted Asset
    Because the general asset account is the asset, the existing rules 
provide that a taxpayer may use any reasonable method that is 
consistently applied to all of its general asset accounts for 
determining the unadjusted depreciable basis of an asset for which 
general asset account treatment is terminated. The temporary 
regulations retain this rule but provide what methods are reasonable 
for identifying the placed-in-service year of the asset disposed of. 
These methods are the same as those discussed above for identifying the 
placed-in-service year of an asset disposed of in a multiple asset 
account: the specific identification method, the FIFO method, the 
modified FIFO method, a mortality dispersion table if the asset 
disposed of is a mass asset grouped in a general asset account with 
other mass assets, or any method designated by the Secretary. The LIFO 
method is not permitted.
    The temporary regulations also amend Sec. Sec.  1.165-2 and 1.1016-
3 to include cross-references to Sec. Sec.  1.168(i)-1T and 1.168(i)-
8T.

VIII. Effective Dates and Changes in Methods of Accounting

    The preamble to the 2008 proposed regulations provided that a 
change to conform to the proposed regulations upon finalization will be 
considered a change in method of accounting under section 446(e). The 
2008 proposed regulations, however, were not effective until issued as 
final regulations and thus did not provide specific procedures for 
changes in method of accounting.
    The IRS and the Treasury Department received several comments 
regarding the procedures that a taxpayer should utilize to change its 
method of accounting to comply with the regulations. Several 
commentators favored the use of a cut-off method, primarily for reasons 
of administrative convenience. However, other commentators asserted 
that any change in method of accounting must include a section 481(a) 
adjustment.
    The temporary regulations under Sec.  1.162-3T are generally 
effective for amounts paid or incurred (to acquire or produce property) 
in taxable years beginning on or after January 1, 2012, except for 
Sec.  1.162-3T(e), which is effective for taxable years beginning on or 
after January 1, 2012. The temporary regulations under Sec. Sec.  
1.167(a)-4, 1.167(a)-7T, 1.167(a)-8T, 1.168(i)-1T, 1.168(i)-7T, 
1.168(i)-8T, 1.263(a)-1T, 1.263(a)-2T, 1.263(a)-3T, 1.263(a)-6T, and 
1.1016-3T are generally effective for taxable years beginning on or 
after January 1, 2012, except for Sec. Sec.  1.263(a)-2T(f)(2)(iii), 
(f)(2)(iv), (f)(3)(ii), and (g), which are effective for amounts paid 
or incurred (to acquire or produce property) in taxable years beginning 
on or after January 1, 2012. In addition, the temporary regulations 
under Sec.  1.263A-1T are effective for amounts paid or incurred (to 
acquire or produce property) in taxable years beginning on or after 
January 1, 2012.
    As stated in the preamble to the 2008 proposed regulations, a 
change to conform to these regulations will be a change in method of 
accounting under section 446(e). In general, a taxpayer seeking a 
change in method of accounting to comply with these temporary 
regulations must take into account an adjustment under section 481(a). 
Procedures will be provided under which taxpayers may obtain automatic 
consent for a taxable year beginning on or after Jan 1, 2012 to change 
to a method of accounting provided in the temporary regulations.
    The imposition of a section 481(a) adjustment for a change in 
method of accounting to conform to the temporary regulations provides 
for a uniform and consistent rule for all taxpayers and ultimately 
reduces the administrative burdens on taxpayers and the IRS in 
enforcing the requirements of section 263(a). Although the IRS and the 
Treasury Department recognize that requiring a section 481(a) 
adjustment may place a burden on taxpayers to calculate reasonable 
adjustments, taxpayers have shown a willingness and ability to make 
these calculations in requesting method changes after the publication 
of the 2008 proposed regulations. In addition, taxpayers and the IRS 
routinely reach agreements on calculation methodologies and amounts. 
Moreover, by utilizing a section 481(a) adjustment to make the change, 
a taxpayer is put on the same method of accounting for all amounts or 
costs incurred both prior to and after the effective date of these 
regulations. Furthermore, a section 481(a) adjustment results in 
similar treatment for all taxpayers, including those that changed their 
method of accounting in response to the 2008 proposed regulations. 
Finally, requiring a section 481(a) adjustment reduces the burden for 
taxpayers and the IRS during examinations that include years both 
before and after the effective date of these regulations because the 
parties will need to apply only the temporary regulations, and will not 
need to apply the rules in effect prior to the effective date of the 
temporary regulation.

Comments and Public Hearing

    The text of these temporary regulations also serves as the text of 
the proposed regulations set forth in a notice of proposed rulemaking 
on this subject appearing elsewhere in this issue of the Federal 
Register. Please see the ``Comments and Public Hearing'' section of the 
notice of proposed rulemaking for the procedures to follow for 
submitting comments and requesting to speak at the public hearing on 
the proposed regulations on this subject.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866, as 
supplemented by Executive Order 13563. 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), these temporary

[[Page 81080]]

regulations will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on their impact on small 
business.

Drafting Information

    The principal authors of these regulations are Merrill D. Feldstein 
and Kathleen Reed, Office of the Associate Chief Counsel (Income Tax 
and Accounting). Other personnel from the IRS and the Treasury 
Department have participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding an 
entry in numerical order to read as follows:

    Authority:  26 U.S.C. 7805 * * *
    Section 1.168(i)-1T also issued under 26 U.S.C. 168(i)(4). * * *


0
Par. 2. Section 1.162-3 is revised to read as follows:


Sec.  1.162-3  Materials and Supplies.

    (a) through (j) [Reserved]. For further guidance, see Sec.  1.162-
3T(a) through (j).
0
Par. 3. Section 1.162-3T is added to read as follows:


Sec.  1.162-3T  Materials and supplies (temporary).

    (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 of which physical 
inventories at the beginning and end of the taxable year are not taken, 
are deductible in the taxable year in which these amounts are paid, 
provided taxable income is clearly reflected.
    (3) Use or consumption of rotable and temporary spare parts. Except 
as provided in paragraphs (d), (e), and (f) of this section, for 
purposes of paragraph (a)(1) of this section, rotable and temporary 
spare parts (defined under paragraph (c)(2) of this section) are used 
or consumed in the taxpayer's operations in the taxable year in which 
the taxpayer disposes of the parts.
    (b) 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 or regulations other than section 162(a) or section 212 
and the regulations under those sections. For example, see section 
Sec.  1.263(a)-3T, which requires taxpayers to capitalize amounts paid 
to improve tangible 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. See also Sec.  
1.471-1, which requires taxpayers to include in inventory certain 
materials and supplies.
    (c) 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 that is not inventory and that--
    (i) Is a component acquired to maintain, repair, or improve a unit 
of tangible property (as determined under Sec.  1.263(a)-3T(e)) owned, 
leased, or serviced by the taxpayer and that is not acquired as part of 
any single unit of tangible property;
    (ii) Consists of fuel, lubricants, water, and similar items, that 
are reasonably expected to be consumed in 12 months or less, beginning 
when used in taxpayer's operations;
    (iii) Is a unit of property as determined under Sec.  1.263(a)-
3T(e) that has an economic useful life of 12 months or less, beginning 
when the property is used or consumed in the taxpayer's operations;
    (iv) Is a unit of property as determined under Sec.  1.263(a)-3T(e) 
that has an acquisition cost or production cost (as determined under 
section 263A) of $100 or less (or other amount as 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)); or
    (v) 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) Rotable and temporary spare parts. For purposes of this 
section, rotable spare parts are materials and supplies under paragraph 
(c)(1)(i) of this section that are acquired for installation on a unit 
of property, removable from that unit of property, generally repaired 
or improved, and either reinstalled on the same or other property or 
stored for later installation. Temporary spare parts are materials and 
supplies under paragraph (c)(1)(i) of this section that are used 
temporarily until a new or repaired part can be installed and then are 
removed and stored for later (emergency or temporary) installation.
    (3) 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 (c)(3)(iii) of this section), the economic useful life of a 
unit of property, solely for the purposes of applying the provisions of 
paragraph (c)(1)(iii) 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 a unit of property was originally 
acquired or produced, the economic useful life of the unit of property 
must be determined under paragraph (c)(3)(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 
(c)(3)(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 a unit of property costing less than a certain dollar amount, 
notwithstanding that the unit of property has a useful life of more 
than one year, the economic useful life of the unit of property must be 
determined under paragraph (c)(3)(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 (c)(3)(iii)(A) through (C) of this section that 
has the highest priority (including

[[Page 81081]]

within paragraph (c)(3)(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 the Federal or a state government or any Federal or state 
agencies (other than the SEC or the Internal Revenue Service).
    (4) 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.
    (5) Produce. For purposes of this section, 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 
(c)(5) and are separately defined and addressed in Sec.  1.263(a)-3T. 
Amounts paid to produce materials and supplies are subject to section 
263A.
    (d) Election to capitalize and depreciate--(1) In general. A 
taxpayer may elect to treat as a capital expenditure and to treat as an 
asset subject to the allowance for depreciation the cost of any 
material or supply as defined in paragraph (c)(1) of this section. 
Except as specified in paragraph (d)(2) of this section, an election 
made under this paragraph (d) 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 (d)). Any asset for which this election is made shall 
not be treated as a material or a supply.
    (2) Exceptions. A taxpayer may not elect to capitalize and 
depreciate under paragraph (d) of this section--
    (i) Any amount paid to acquire or produce a material or supply 
described in paragraph (c)(1)(i) of this section if--
    (A) The material or supply is intended to be used as a component of 
a unit of property that is a material or supply under paragraph 
(c)(1)(iii), (iv), or (v) of this section; and
    (B) The taxpayer has not elected to capitalize and depreciate that 
unit of property under this paragraph (d); or
    (ii) Any amount paid to acquire or produce a rotable or temporary 
spare part if the taxpayer has applied the optional method of 
accounting for rotable and temporary spare parts under paragraph (e) of 
this section.
    (3) Manner of electing. A taxpayer makes the election under 
paragraph (d) of this section by capitalizing the amounts paid to 
acquire or produce a material or supply in the taxable year the amounts 
are paid and by beginning to recover the costs when the asset is placed 
in service by the taxpayer for the purposes of determining depreciation 
under the applicable provisions of Internal Revenue Code and 
regulations thereunder. A taxpayer must make this election in its 
timely filed original Federal income tax return (including extensions) 
for the taxable year the asset 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 or 
partners. A taxpayer may make an election for each material or supply 
that qualifies for the election under this paragraph (d). A taxpayer 
may revoke an election made under this paragraph (d) 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. The 
Commissioner may grant a request to revoke this election if the 
taxpayer can demonstrate good cause for the revocation. An election may 
not be made or revoked through the filing of an application for change 
in accounting method or, before obtaining the Commissioner's consent to 
make the late election or to revoke the election, by filing an amended 
Federal income tax return.
    (e) Optional method of accounting for rotable and temporary spare 
parts--(1) In general. This paragraph (e) provides an optional method 
of accounting for rotable and temporary spare parts (the optional 
method for rotables). A taxpayer may use the optional method for 
rotables, instead of the general rule under paragraph (a)(3) of this 
section, to account for its rotable and temporary spare parts as 
defined in paragraph (c)(2) of this section. A taxpayer that uses the 
optional method for rotables must use this method for all of its 
rotable and temporary spare parts in the same trade or business. The 
optional method for rotables is a method of accounting under section 
446(a). Under the optional method for rotables, the taxpayer must apply 
the rules in this paragraph (e) to each rotable or temporary spare part 
(part) upon the taxpayer's initial installation, removal, repair, 
maintenance or improvement, reinstallation, and disposal of each part.
    (2) Description of optional method for rotables--(i) Initial 
installation. The taxpayer must deduct the amount paid to acquire or 
produce the part in the taxable year that the part is first installed 
on a unit of property for use in the taxpayer's operations.
    (ii) Removal from unit of property. In each taxable year in which 
the part is removed from a unit of property to which it was initially 
or subsequently installed, the taxpayer must--
    (A) Include in gross income the fair market value of the part; and
    (B) Include in the basis of the part the fair market value of the 
part included in income under paragraph (e)(2)(ii)(A) of this section 
and the amount paid to remove the part from the unit of property.
    (iii) Repair, maintenance, or improvement of part. The taxpayer may 
not currently deduct and must include in the basis of the part any 
amounts paid to maintain, repair, or improve the part in the taxable 
year these amounts are paid.
    (iv) Reinstallation of part. The taxpayer must deduct the amounts 
paid to reinstall the part and those amounts included in the basis of 
the part under paragraphs (e)(2)(ii)(B) and (e)(2)(iii) of this 
section, to the extent that those amounts have not been previously 
deducted under this paragraph (e)(2)(iv), in the taxable year that the 
part is reinstalled on a unit of property.
    (v) Disposal of the part. The taxpayer must deduct the amounts 
included in the basis of the part under paragraphs (e)(2)(ii)(B) and 
(e)(2)(iii) of this section, to the extent that those amounts have not 
been previously deducted under paragraph (e)(2)(iv) of this section, in 
the taxable year in which the part is disposed of by the taxpayer.
    (f) Election to apply de minimis rule--(1) In general. A taxpayer 
may elect to apply the de minimis rule under Sec.  1.263(a)-2T(g) to 
any material or supply defined in paragraph (c)(1) this section. Any 
material or supply to which the taxpayer elects to apply the

[[Page 81082]]

de minimis rule under Sec.  1.263(a)-2T(g) is not treated as a material 
or supply under this section. See Sec.  1.263(a)-2T(g)(5).
    (2) Manner of electing. A taxpayer makes the election by deducting 
the amounts paid to acquire or produce a material or supply in the 
taxable year that the amounts are paid and by complying with the 
requirements set out in Sec.  1.263(a)-2T(g). A taxpayer must make this 
election in its timely filed original Federal income tax return 
(including extensions) for the taxable year that amounts are paid for 
the material or supply. In the case of a pass-through entity, the 
election is made by the pass-through entity and not by the shareholders 
or partners. A taxpayer may make an election for each material or 
supply that qualifies for the election under paragraph (f) of this 
section. A taxpayer may revoke an election made under paragraph (f) of 
this section 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. The Commissioner may grant a request to 
revoke this election if the taxpayer can demonstrate good cause for the 
revocation. An election may not be made or revoked through the filing 
of an application for change in accounting method or, before obtaining 
the Commissioner's consent to make the late election or to revoke the 
election, by filing an amended Federal income tax return.
    (g) Sale or disposition of materials and supplies. Upon sale or 
other disposition, materials and supplies as defined in this section 
are not treated as a capital asset under section 1221 or as property 
used in the trade or business under section 1231. Any asset for which 
the taxpayer makes the election to capitalize and depreciate under 
paragraph (d) of this section shall not be treated as a material or 
supply.
    (h) 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 (d) of this 
section or to apply the de minimis rule under paragraph (f) of this 
section.

    Example 1. Non-rotable components. X owns a fleet of aircraft 
that it operates in its business. In Year 1, X purchases a stock of 
spare parts, which it uses to maintain and repair its aircraft. X 
keeps a record of consumption of these spare parts. In Year 2, X 
uses the spare parts for the repair and maintenance of one of its 
aircraft. Assume each aircraft is a unit of property under Sec.  
1.263(a)-3T(e) and that spare parts are not rotable or temporary 
spare parts under paragraph (c)(2) of this section. Assume these 
repair and maintenance activities do not improve the aircraft under 
Sec.  1.263(a)-3T. These parts are materials and supplies under 
paragraph (c)(1)(i) of this section because they are components 
acquired and used to maintain and repair X's aircraft. Under 
paragraph (a)(1) of this section, the amounts that X paid for the 
spare parts in Year 1 are deductible in Year 2, the taxable year in 
which the spare parts are used to repair and maintain the aircraft.
    Example 2. Rotable spare parts. X operates a fleet of 
specialized vehicles that it uses in its service business. Assume 
that each vehicle is a unit of property under Sec.  1.263(a)-3T(e). 
At the time that it acquires a new type of vehicle, X also acquires 
a substantial number of rotable spare parts that it will keep on 
hand to quickly replace similar parts in X's vehicles as those parts 
break down or wear out. These rotable parts are removable from the 
vehicles and are repaired so that they can be reinstalled on the 
same or similar vehicles. X does not use the optional method of 
accounting for rotable and temporary spare parts provided in 
paragraph (e) of this section. In Year 1, X acquires several 
vehicles and a number of rotable spare parts to be used as 
replacement parts in these vehicles. In Year 2, X repairs several 
vehicles by using these rotable spare parts to replace worn or 
damaged parts. In Year 3, X removes these rotable spare parts from 
its vehicles, repairs the parts, and reinstalls them on other 
similar vehicles. In Year 5, X can no longer use the rotable parts 
it acquired in Year 1 and disposes of them as scrap. Under paragraph 
(c)(1)(i) of this section, the rotable spare parts acquired in Year 
1 are materials and supplies. Under paragraph (a)(3) of this 
section, rotable spare parts are generally used or consumed in the 
taxable year in which the taxpayer disposes of the parts. Therefore, 
under paragraph (a)(1) of this section, the amounts that X paid for 
the rotable spare parts in Year 1 are deductible in Year 5, the 
taxable year in which X disposes of the parts.
    Example 3. Rotable spare parts; application of optional method 
of accounting. Assume the same facts as in Example 2, except X uses 
the optional method of accounting for all its rotable and temporary 
spare parts under paragraph (e) of this section. In Year 1, X 
acquires several vehicles and a number of rotable spare parts (the 
``Year 1 rotables'') to be used as replacement parts in these 
vehicles. In Year 2, X repairs several vehicles and uses the Year 1 
rotables to replace worn or damaged parts. In Year 3, X pays amounts 
to remove these Year 1 rotables from its vehicles. In Year 4, X pays 
amounts to maintain, repair, or improve the Year 1 rotables. In Year 
5, X pays amounts to reinstall the Year 1 rotables on other similar 
vehicles. In Year 8, X removes the Year 1 rotables from these 
vehicles and stores these parts for possible later use. In Year 9, X 
disposes of the Year 1 rotables. Under paragraph (e) of this 
section, X must deduct the amounts paid to acquire and install the 
Year 1 rotables in Year 2, the taxable year in which the rotable 
spare parts are first installed by X in X's vehicles. In Year 3, 
when X removes the Year 1 rotables from its vehicles, X must include 
in its gross income the fair market value of each part. Also, in 
Year 3, X must include in the basis of each Year 1 rotable the fair 
market value of the rotable and the amount paid to remove the 
rotable from the vehicle. In Year 4, X must include in the basis of 
each Year 1 rotable the amounts paid to maintain, repair, or improve 
each rotable. In Year 5, the year that X reinstalls the Year 1 
rotables (as repaired or improved) in other vehicles, X must deduct 
the reinstallation costs and the amounts previously included in the 
basis of each part. In Year 8, the year that X removes the Year 1 
rotables from the vehicles, X must include in income the fair market 
value of each rotable part removed. In addition, in Year 8, X must 
include in the basis of each part the fair market value of that part 
and the amount paid to remove the each rotable from the vehicle. In 
Year 9, the year that X disposes of the Year 1 rotables, X may 
deduct the amounts remaining in the basis of each rotable.
    Example 4. Rotable part acquired as part of a single unit of 
property; not material or supply. X operates a fleet of aircraft. In 
Year 1, X acquires a new aircraft, which includes two new aircraft 
engines. The aircraft costs $500,000 and has an economic useful life 
of more than 12 months, beginning when it is placed in service. In 
Year 5, after the aircraft is operated for several years in X's 
business, X removes the engines from the aircraft, repairs or 
improves the engines, and either reinstalls the engines on a similar 
aircraft or stores the engines for later reinstallation. Assume the 
aircraft purchased in Year 1, including its two engines, is a unit 
of property under Sec.  1.263(a)-3T(e). Because the engines were 
acquired as part of the aircraft, a single unit of property, the 
engines are not materials or supplies under paragraph (c)(1)(i) of 
this section nor rotable or temporary spare parts under paragraph 
(c)(2) of this section. Accordingly, X may not apply the rules of 
this section to the aircraft engines upon the original acquisition 
of the aircraft nor after the removal of the engines from the 
aircraft for use in the same or similar aircraft. Rather, X must 
apply the rules under Sec. Sec.  1.263(a)-2T and 1.263(a)-3T to the 
aircraft, including its engines, to determine the treatment of 
amounts paid to acquire, produce, or improve the unit of property.
    Example 5. Components of real property. X owns an apartment 
building that it leases in its business operation and discovers that 
a window in one of the apartments is broken. Assume that the 
building, including its windows, is a unit of property under Sec.  
1.263(a)-3T(e) and the window is not a rotable or temporary spare 
part under paragraph (c)(2) of this section. X pays for the 
acquisition and delivery of a new window to replace the broken 
window. In the same taxable year, the new window is installed. 
Assume that the replacement of the window does not improve the 
property under Sec.  1.263(a)-3T and that X does not recognize gain 
or loss on the disposition of the broken window. The new window is a 
material or supply under paragraph (c)(1)(i) of this section because 
it is a component acquired

[[Page 81083]]

and used to repair a unit of property owned by X and used in X's 
operations. Under paragraph (a)(1) of this section, the amounts X 
paid for the acquisition and delivery of the window are deductible 
in the taxable year in which the window is installed in the 
apartment building. See Sec.  1.168(i)-8T for the treatment of the 
disposition of the broken window.
    Example 6. Consumable property. X operates a fleet of aircraft 
that carries freight for its customers. X has several storage tanks 
on its premises, which hold jet fuel for its aircraft. Assume that 
once the jet fuel is placed in X's aircraft, the jet fuel is 
reasonably expected to be consumed within 12 months or less. On 
December 31, Year 1, X purchases a two-year supply of jet fuel. In 
Year 2, X uses a portion of the jet fuel purchased on December 31, 
Year 1, to fuel the aircraft used in its business. The jet fuel that 
X purchased in Year 1 is a material or supply under paragraph 
(c)(1)(ii) of this section because it is reasonably expected to be 
consumed within 12 months or less from the time it is placed in X's 
aircraft. Under paragraph (a)(1) of this section, X may deduct in 
Year 2 the amounts paid for the portion of jet fuel used in the 
operation of X's aircraft in Year 2.
    Example 7. Unit of property that costs $100 or less. X operates 
a business that rents out a variety of small individual items to 
customers (rental items). X maintains a supply of rental items on 
hand. In Year 1, X purchases a large quantity of rental items to use 
in its rental business. Assume that each rental item is a unit of 
property under Sec.  1.263(a)-3T(e) and costs $100 or less. In Year 
2, X begins using all the rental items purchased in Year 1 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. The rental items 
are materials and supplies under paragraph (c)(1)(iv) of this 
section. Under paragraph (a)(1) of this section, the amounts that X 
paid for the rental items in Year 1 are deductible in Year 2, the 
taxable year in which the rental items are used in X's business.
    Example 8. Unit of property that costs $100 or less. X provides 
billing services to its customers. In Year 1, X pays amounts to 
purchase 50 facsimile machines to be used by its employees. Assume 
each facsimile machine is a unit of property under Sec.  1.263(a)-
3T(e) and costs less than $100. In Year 1, X's employees begin using 
35 of the facsimile machines, and X stores the remaining 15 machines 
for use in a later taxable year. The facsimile machines are 
materials and supplies under paragraph (c)(1)(iv) of this section. 
Under paragraph (a)(1) of this section, the amounts X paid for 35 of 
the facsimile machines are deductible in Year 1, the taxable year in 
which X uses those machines. The amounts that X paid for each of the 
remaining 15 machines are deductible in the taxable year in which 
each machine is used.
    Example 9. Materials and supplies used in improvements; 
coordination with Sec.  1.263(a)-3T. X owns various machines that 
are used in its business. Assume that each machine is a unit of 
property under Sec.  1.263(a)-3T(e). In Year 1, X purchases a supply 
of spare parts for its machines. X acquired the parts to use in the 
repair or maintenance of the machines under Sec.  1.162-4T or in the 
improvement of the machines under Sec.  1.263(a)-3T. The spare parts 
are not rotable or temporary spare parts under paragraph (c)(2) of 
this section. In Year 2, X uses all of these spare parts in an 
activity that improves a machine under Sec.  1.263(a)-3T. Under 
paragraph (c)(1)(i) of this section, the spare parts purchased by X 
in Year 1 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 Year 2, the taxable year in 
which X uses those parts. However, because these materials and 
supplies are used to improve X's machine, X is required to 
capitalize the amounts paid for those spare parts under Sec.  
1.263(a)-3T. See also section 263A for the requirement to capitalize 
the direct and allocable indirect costs of property produced or 
property acquired for resale.
    Example 10. 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 Year 1, X constructs a leaching pit to provide a 
draining area for the liquid waste. Assume the leaching pit is a 
unit of property under Sec.  1.263(a)-3T(e) and has an economic 
useful life 12 months or less, 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 Year 2, 
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 (c)(1)(iii) 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 Year 2, the taxable year in which X uses the leaching 
pit. However, because the amounts paid to construct the leaching pit 
directly benefit or are incurred by reason of X's manufacturing 
operations, X must capitalize those costs under section 263A to the 
property produced. See Sec.  1.263A-1(e)(3)(ii)(E).
    Example 11. Costs of acquiring materials and supplies for 
production of property; coordination with section 263A. In Year 1, X 
purchases jigs, dies, molds, and patterns for use in the manufacture 
of X's products. Assume each jig, die, mold, and pattern is a unit 
of property under Sec.  1.263(a)-3T(e). 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. The jigs, dies, 
molds, and patterns are not components acquired to maintain, repair, 
or improve any of X's equipment under paragraph (c)(1)(i) of this 
section. X begins using the jigs, dies, molds and patterns in Year 2 
to manufacture its products. These items are materials and supplies 
under paragraph (c)(1)(iii) of this section. Under paragraph (a)(1) 
of this section, the amounts paid for the items are otherwise 
deductible in Year 2, 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 X's manufacturing 
operations, X must capitalize the costs under section 263A to the 
property produced. See Sec.  1.263A-1(e)(3)(ii)(E).
    Example 12. Election to capitalize and depreciate. X operates a 
rental business that rents out a variety of items (rental items) to 
its customers. Assume each rental item is a separate unit of 
property as determined under Sec.  1.263(a)-3T(e). X does not sell 
or exchange these items on established retail markets at any time 
after the items are used in the rental business. X purchases various 
rental items, each of which costs less than $100 or has an economic 
useful life of 12 months or less, beginning when the items are used 
or consumed. The rental items are materials and supplies under 
paragraph (c)(1)(iii) or (c)(1)(iv) of this section. Under paragraph 
(a)(1) of this section, the amount paid for each rental item is 
deductible in the taxable year in which the item is used in the 
rental business. However, X would prefer to treat the cost of each 
rental item as a capital expenditure subject to depreciation. Under 
paragraph (d) 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 that X purchases the item and by beginning 
to recover the costs of each item on its timely filed Federal income 
tax return for the taxable year that X places the item in service 
for purposes of determining depreciation under the applicable 
provisions of the Internal Revenue Code and the regulations 
thereunder. See Sec.  1.263(a)-2T(h) for the treatment of capital 
expenditures.
    Example 13. Election to capitalize and depreciate. X is an 
electric utility. 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 used to improve property under 
Sec.  1.263(a)-3T(d). These temporary spare parts are used until a 
new or repaired part can be installed and then are removed and 
stored for later emergency installation. X does not use the optional 
method of accounting for rotable and temporary spare parts in 
paragraph (e) of this section for any of its rotable or temporary 
spare parts. The temporary spare parts are materials and supplies 
under paragraph (c)(1)(i) of this section. Under paragraphs (a)(1) 
and (a)(3) of this section, the amounts paid for the temporary spare 
parts are deductible 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 amounts paid for the spare parts as 
capital expenditures subject to depreciation. X may elect under 
paragraph (d) 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 that X acquires the spare parts 
and by beginning to recover the

[[Page 81084]]

costs of each part on its timely filed Federal income tax return for 
the taxable year in which the part is placed in service for purposes 
of determining depreciation under the applicable provisions of the 
Internal Revenue Code and the regulations thereunder. See Sec.  
1.263(a)-2T(h) for the treatment of capital expenditures and section 
263A for the requirement to capitalize the direct and allocable 
indirect costs of property produced or property acquired for resale.
    Example 14. Election to apply de minimis rule. X provides 
consulting services to its customers. X purchases 50 office chairs 
to be used by its employees. Each office chair is a unit of property 
that costs $80. Also in the same taxable year, X pays amounts to 
purchase 50 customized briefcases. Assume each briefcase is a unit 
of property under Sec.  1.263(a)-3T(e), costs $120, and has an 
economic useful life of 12 months or less, beginning when used and 
consumed. X has an applicable financial statement (as defined in 
Sec.  1.263(a)-2T(g)(6)), and X has a written policy at the 
beginning of the taxable year to expense amounts paid for units of 
property costing less than $300. The briefcases and the office 
chairs are materials and supplies under paragraph (c)(1)(iii) and 
(c)(1)(iv), respectively, of this section. Under paragraph (a)(1) of 
this section, the amounts paid for the office chairs and briefcases 
are deductible in the taxable year in which they are used or 
consumed. However, assuming X meets all the requirements of Sec.  
1.263(a)-2T(g), X may elect under paragraph (f) of this section to 
apply the de minimis rule under Sec.  1.263(a)-2T(g) to amounts paid 
for the office chairs and briefcases, rather than treat these 
amounts as the costs of materials and supplies under Sec.  1.162-3T.

    (h) Accounting method changes. Except as otherwise provided in this 
section, a change to comply with this section is a change in method of 
accounting to which the provisions of sections 446 and 481, and the 
regulations thereunder, apply. A taxpayer seeking to change to a method 
of accounting permitted in this section must secure the consent of the 
Commissioner in accordance with Sec.  1.446-1(e) and follow the 
administrative procedures issued under Sec.  1.446-1(e)(3)(ii) for 
obtaining the Commissioner's consent to change its accounting method.
    (i) Effective/applicability date. This section generally applies to 
amounts paid or incurred (to acquire or produce property) in taxable 
years beginning on or after January 1, 2012. However, a taxpayer may 
apply Sec.  1.162-3(e) (the optional method of accounting for rotable 
and temporary spare parts) to taxable years beginning on or after 
January 1, 2012. For the applicability of regulations to taxable years 
beginning before January 1, 2012, see Sec.  1.162-3 in effect prior to 
January 1, 2012 (Sec.  1.162-3 as contained in 26 CFR part 1 edition 
revised as of April 1, 2011).
    (j) Expiration date. The applicability of this section expires on 
December 23, 2014.

0
Par. 4. Section 1.162-4 is revised to read as follows:


Sec.  1.162-4  Repairs.

    (a) through (d) [Reserved]. For further guidance, see Sec.  1.162-
4T(a) through (d).

0
Par. 5. Section 1.162-4T is added to read as follows:


Sec.  1.162-4T  Repairs (temporary).

    (a) In general. A taxpayer may deduct amounts paid for repairs and 
maintenance to tangible property if the amounts paid are not otherwise 
required to be capitalized.
    (b) Accounting method changes. Except as otherwise provided in this 
section, a change to comply with this section is a change in method of 
accounting to which the provisions of sections 446 and 481, and the 
regulations thereunder, apply. A taxpayer seeking to change to a method 
of accounting permitted in this section must secure the consent of the 
Commissioner in accordance with Sec.  1.446-1(e) and follow the 
administrative procedures issued under Sec.  1.446-1(e)(3)(ii) for 
obtaining the Commissioner's consent to change its accounting method.
    (c) Effective/applicability date. This section applies to taxable 
years beginning on or after January 1, 2012. For the applicability of 
regulations to taxable years beginning before January 1, 2012, see 
Sec.  1.162-4 in effect prior to January 1, 2012 (Sec.  1.162-4 as 
contained in 26 CFR part 1 edition revised as of April 1, 2011).
    (d) Expiration date. The applicability of this section expires on 
December 23, 2014


Sec.  1.162-6  [Removed]

0
Par. 6. Section 1.162-6 is removed.
0
Par. 7. Section 1.162-11 is amended by revising paragraph (b), and 
adding paragraphs (c) and (d) to read as follows:


Sec.  1.162-11  Rentals.

* * * * *
    (b) [Reserved]. For further guidance, see Sec.  1.162-11T(b).
    (c) [Reserved]. For further guidance, see Sec.  1.162-11T(c).
    (d) [Reserved]. For further guidance, see Sec.  1.162-11T(d).


0
Par. 8. Section 1.162-11T is added to read as follows:


Sec.  1.162-11T  Rentals (temporary).

    (a) [Reserved]. For further guidance, see Sec.  1.162-11(a).
    (b) Improvements by lessee on lessor's property. The cost to a 
taxpayer of erecting buildings or making permanent improvements on 
property of which the taxpayer is a lessee is a capital expenditure and 
is not deductible as a business expense. For the rules regarding 
improvements to leased property where the improvements are tangible 
property, see Sec.  1.263(a)-3T(f)(1). For the rules regarding 
depreciation or amortization deductions for leasehold improvements, see 
Sec.  1.167(a)-4T.
    (c) Effective/applicability date. This section applies to taxable 
years beginning on or after January 1, 2012. For the applicability of 
regulations to taxable years beginning before January 1, 2012, see 
Sec.  1.162-11 in effect prior to January 1, 2012 (Sec.  1.162-11 as 
contained in 26 CFR part 1 edition revised as of April 1, 2011).
    (d) Expiration date. The applicability of this section expires on 
December 23, 2014.


0
Par. 9. Section 1.165-2 is amended by revising paragraph (c) and adding 
paragraphs (d) and (e) to read as follows:


Sec.  1.165-2  Obsolescence of nondepreciable property.

* * * * *
    (c) Cross references. [Reserved]. For further guidance, see Sec.  
1.165-2T(c).
    (d) Effective/applicability date. [Reserved]. For further guidance, 
see Sec.  1.165-2T(d).
    (e) Expiration date. [Reserved]. For further guidance, see Sec.  
1.165-2T(e).


0
Par. 10. Section 1.165-2T is added to read as follows:


Sec.  1.165-2T  Obsolescence of nondepreciable property (temporary).

    (a) and (b) [Reserved]. For further guidance, see Sec.  1.165-2(a) 
and (b).
    (c) Cross references. For the allowance under section 165(a) of 
losses arising from the permanent withdrawal of depreciable property 
from use in the trade or business or in the production of income, see 
Sec.  1.167(a)-8T, Sec.  1.168(i)-1T, or Sec.  1.168(i)-8T, as 
applicable. For provisions respecting the obsolescence of depreciable 
property for which depreciation is determined under section 167 (but 
not under section 168, section 1400I, section 1400L(c), section 168 
prior to its amendment by the Tax Reform Act of 1986 (100 Stat. 2121), 
or under an additional first year depreciation deduction provision of 
the Internal Revenue Code (for example, section 168(k) through (n), 
1400L(b), or 1400N(d))), see Sec.  1.167(a)-9. For the allowance of 
casualty losses, see Sec.  1.165-7.
    (d) Effective/applicability date. This section applies to taxable 
years

[[Page 81085]]

beginning on or after January 1, 2012. For the applicability of 
regulations to taxable years beginning before January 1, 2012, see 
Sec.  1.165-2 in effect prior to January 1, 2012 (Sec.  1.165-2 as 
contained in 26 CFR part 1 edition revised as of April 1, 2011).
    (e) Expiration date. The applicability of this section expires on 
December 23, 2014.

0
Par. 11. Section 1.167(a)-4 is revised to read as follows:


Sec.  1.167(a)-4  Leased property.

    (a) In general. [Reserved]. For further guidance, see Sec.  
1.167(a)-4T(a).
    (b) Effective/applicability date. [Reserved]. For further guidance, 
see Sec.  1.167(a)-4T(b).


0
Par. 12. Section 1.167(a)-4T is added to read as follows:


Sec.  1.167(a)-4T  Leased property (temporary).

    (a) In general. Capital expenditures made by either a lessee or 
lessor for the erection of a building or for other permanent 
improvements on leased property are recovered by the lessee or lessor 
under the provisions of the Internal Revenue Code applicable to the 
cost recovery of the building or improvements, if subject to 
depreciation or amortization, without regard to the period of the 
lease. For example, if the building or improvement is property to which 
section 168 applies, the lessee or lessor determines the depreciation 
deduction for the building or improvement under section 168. See 
section 168(i)(8)(A). If the improvement is property to which section 
167 or section 197 applies, the lessee or lessor determines the 
depreciation or amortization deduction for the improvement under 
section 167 or section 197, as applicable.
    (b) Effective/applicability date--(1) In general. Except as 
provided in paragraphs (b)(2) and (b)(3) of this section, this section 
applies to taxable years beginning on or after January 1, 2012.
    (2) Application of this section to leasehold improvements placed in 
service after December 31, 1986, in taxable years beginning before 
January 1, 2012. For leasehold improvements placed in service after 
December 31, 1986, in taxable years beginning before January 1, 2012, a 
taxpayer may--
    (i) Apply the provisions of this section; or
    (ii) Depreciate any leasehold improvement to which section 168 
applies under the provisions of section 168 and depreciate or amortize 
any leasehold improvement to which section 168 does not apply under the 
provisions of the Internal Revenue Code that are applicable to the cost 
recovery of that leasehold improvement, without regard to the period of 
the lease.
    (3) Application of this section to leasehold improvements placed in 
service before January 1, 1987. For leasehold improvements placed in 
service before January 1, 1987, see Sec.  1.167(a)-4 in effect prior to 
January 1, 2012 (Sec.  1.167(a)-4 as contained in 26 CFR part 1 edition 
revised as of April 1, 2011).
    (4) Change in method of accounting. Except as provided in Sec.  
1.446-1(e)(2)(ii)(d)(3)(i), a change to comply with this section for 
depreciable assets placed in service in a taxable year ending on or 
after December 30, 2003, is a change in method of accounting to which 
the provisions of section 446(e) and the regulations under section 
446(e) apply. Except as provided in Sec.  1.446-1(e)(2)(ii)(d)(3)(i), a 
taxpayer also may treat a change to comply with this section for 
depreciable assets placed in service in a taxable year ending before 
December 30, 2003, as a change in method of accounting to which the 
provisions of section 446(e) and the regulations under section 446(e) 
apply.
    (5) Expiration date. The applicability of this section expires on 
December 23, 2014.

0
Par. 13. Section 1.167(a)-7 is amended by adding paragraphs (e), (f), 
and (g) to read as follows:


Sec.  1.167(a)-7  Accounting for depreciable property.

* * * * *
    (e) Applicability. [Reserved]. For further guidance, see Sec.  
1.167(a)-7T(e).
    (f) Effective/applicability date. [Reserved]. For further guidance, 
see Sec.  1.167(a)-7T(f).
    (g) Expiration date. [Reserved]. For further guidance, see Sec.  
1.167(a)-7T(g).


0
Par. 14. Section 1.167(a)-7T is added to read as follows:


Sec.  1.167(a)-7T  Accounting for depreciable property (temporary).

    (a) through (d) [Reserved]. For further guidance, see Sec.  
1.167(a)-7(a) through (d).
    (e) Applicability. Paragraphs (a), (b), and (d) of this section 
apply to property for which depreciation is determined under section 
167 (but not under section 168, section 1400I, section 1400L(c), 
section 168 prior to its amendment by the Tax Reform Act of 1986 (100 
Stat. 2121), or under an additional first year depreciation deduction 
provision of the Internal Revenue Code (for example, section 168(k) 
through (n), 1400L(b), or 1400N(d))). Paragraph (c) of this section 
does not apply to general asset accounts as provided by section 
168(i)(4) and Sec.  1.168(i)-1T.
    (f) Effective/applicability date. This section applies to taxable 
years beginning on or after January 1, 2012. For the applicability of 
regulations to taxable years beginning before January 1, 2012, see 
Sec.  1.167(a)-7 in effect prior to January 1, 2012 (Sec.  1.167(a)-7 
as contained in 26 CFR part 1 edition revised as of April 1, 2011).
    (g) Expiration date. The applicability of this section expires on 
December 23, 2014.


0
Par. 15. Section 1.167(a)-8 is amended by adding paragraphs (g), (h), 
and (i) to read as follows:


Sec.  1.167(a)-8  Retirements.

* * * * *
    (g) Applicability. [Reserved]. For further guidance, see Sec.  
1.167(a)-8T(g).
    (h) Effective/applicability date. [Reserved]. For further guidance, 
see Sec.  1.167(a)-8T(h).
    (i) [Reserved]. For further guidance, see Sec.  1.167(a)-8T(i).
0
Par. 16. Section 1.167(a)-8T is added to read as follows:


Sec.  1.167(a)-8T  Retirements (temporary).

    (a) through (f) [Reserved]. For further guidance, see Sec.  
1.167(a)-8(a) through (f).
    (g) Applicability. This section applies to property for which 
depreciation is determined under section 167 (but not under section 
168, section 1400I, section 1400L(c), section 168 prior to its 
amendment by the Tax Reform Act of 1986 (100 Stat. 2121), or under an 
additional first year depreciation deduction provision of the Internal 
Revenue Code (for example, section 168(k) through (n), 1400L(b), or 
1400N(d))).
    (h) Effective/applicability date. This section applies to taxable 
years beginning on or after January 1, 2012. For the applicability of 
regulations to taxable years beginning before January 1, 2012, see 
Sec.  1.167(a)-8 in effect prior to January 1, 2012 (Sec.  1.167(a)-8 
as contained in 26 CFR part 1 edition revised as of April 1, 2011).
    (i) Expiration date. The applicability of this section expires on 
December 23, 2014.
0
Par. 17. Section 1.168(i)-0 is amended by:
0
1. Adding entries for paragraphs (b)(5) and (b)(6).
0
2. Adding entry for paragraph (c)(3).
0
3. Redesignating the entry for paragraph (d)(2) as (d)(4) and adding 
new entries for paragraphs (d)(2) and (d)(3).

[[Page 81086]]

0
4. Redesignating the entry for paragraph (e)(2)(v) as the entry for 
paragraph (e)(2)(ix).
0
5. Adding entries for paragraphs (e)(2)(v), (vi), (vii), (viii).
0
6. Redesignating paragraph (e)(3)(vi) as (e)(3)(vii) and adding a new 
paragraph (e)(3)(vi).
0
7. Redesignating the entry for paragraph (h)(2) as (h)(3), and adding a 
new paragraph (h)(2).
0
8. Redesignating the entry for paragraph (i) as (j) and adding a new 
paragraph (i).
0
9. Redesignating the entry for paragraph (j) as (k).

0
10. Redesignating the entries for paragraphs (k), (k)(1), (k)(2), and 
(k)(3) as (l), (l)(1), (l)(2), and (l)(3) respectively and
0
11. Redesignating paragraph (l) as paragraph (m).


Sec.  1.168(i)-0  Table of contents for the general asset account 
rules.

* * * * *


Sec.  1.168(i)-1  General asset accounts.

* * * * *
    (b) * * *
    (5) and (6) [Reserved]. For further guidance, see the entries for 
Sec.  1.168(i)-1T(b)(5) and (6).
    (c) * * *
    (3) [Reserved]. For further guidance, see the entry for Sec.  
1.168(i)-1T(c)(3).
* * * * *
    (d)(2) and (3) [Reserved]. For further guidance, see the entries 
for Sec.  1.168(i)-1T(d)(2) and (3).
* * * * *
    (e)(2) * * *
    (v) through (viii) [Reserved]. For further guidance, see the 
entries for Sec.  1.168(i)-1T(e)(2)(v) through (viii).
* * * * *
    (e)(3) * * *
    (vi) [Reserved]. For further guidance, see the entry for Sec.  
1.168(i)-1T(e)(3)(vi).
* * * * *
    (h) * * *
    (2) [Reserved]. For further guidance, see the entry for Sec.  
1.168(i)-1T(h)(2).
* * * * *
    (i) [Reserved]. For further guidance, see the entry for Sec.  
1.168(i)-1T(i).
* * * * *
    (m) [Reserved]. For further guidance, see the entry for Sec.  
1.168(i)-1T(m).

0
Par. 18. Section 1.168(i)-0T is added to read as follows:


Sec.  1.168(i)-0T  Table of contents for the general asset account 
rules (temporary).

    This section lists the major paragraphs contained in Sec.  
1.168(i)-1T.


Sec.  1.168(i)-1T  General asset accounts (temporary).

    (a) through (b)(4) [Reserved]. For further guidance, see the 
entries for Sec.  1.168(i)-1(a) through (b)(4).
    (5) Mass assets.
    (6) Remaining adjusted depreciable basis of the general asset 
account.
    (c)(1) through (c)(2) [Reserved]. For further guidance, see the 
entries for Sec.  1.168(i)-1(c)(1) through (c)(2).
    (3) Examples.
    (d)(1) [Reserved]. For further guidance, see the entry for Sec.  
1.168(i)-1(d)(1).
    (d)(2) Assets in general asset account are eligible for additional 
first year depreciation deduction.
    (d)(3) No assets in general asset account are eligible for 
additional first year depreciation deduction.
    (d)(4) through (e)(2)(iv) [Reserved]. For further guidance, see the 
entries for Sec.  1.168(i)-1(d)(4) through (e)(2)(iv).
    (v) Manner of disposition.
    (vi) Disposition by transfer to a supplies account.
    (vii) Leasehold improvements.
    (viii) Determination of asset disposed of.
    (e)(2)(ix) through (e)(3)(v) [Reserved]. For further guidance, see 
the entries for Sec.  1.168(i)-1(e)(2)(ix) through (e)(3)(v).
    (vi) Technical termination of a partnership.
    (e)(3)(vii) through (h)(1) [Reserved]. For further guidance, see 
the entries for Sec.  1.168(i)-1(e)(3)(vii) through (h)(1).
    (h)(2) Business or income-producing use percentage changes.
    (h)(3) [Reserved]. For further guidance, see the entry for Sec.  
1.168(i)-1(h)(3).
    (i) Redetermination of basis.
    (j) through (l) [Reserved]. For further guidance, see the entries 
for Sec.  1.168(i)-1(j) through (l).
    (m) Effective/applicability date.

0
Par. 19. Section 1.168(i)-1 is amended by:
0
1. Revising paragraphs (a) through (l)(1); and
0
2. Adding paragraph (m).
    The revisions and additions read as follows:


Sec.  1.168(i)-1  General asset accounts.

    (a) through (l)(1) [Reserved]. For further guidance, see Sec.  
1.168(i)-1T(a) through (l)(1).
* * * * *
    (m) [Reserved]. For further guidance, see Sec.  1.168(i)-1T(m).

0
Par. 20. Section 1.168(i)-1T is added to read as follows:


Sec.  1.168(i)-1T  General asset accounts (temporary).

    (a) Scope. This section provides rules for general asset accounts 
under section 168(i)(4). The provisions of this section apply only to 
assets for which an election has been made under paragraph (l) of this 
section.
    (b) Definitions. For purposes of this section, the following 
definitions apply:
    (1) Unadjusted depreciable basis has the same meaning given such 
term in Sec.  1.168(b)-1(a)(3).
    (2) Unadjusted depreciable basis of the general asset account is 
the sum of the unadjusted depreciable bases of all assets included in 
the general asset account.
    (3) Adjusted depreciable basis of the general asset account is the 
unadjusted depreciable basis of the general asset account less the 
adjustments to basis described in section 1016(a)(2) and (3).
    (4) Expensed cost is the amount of any allowable credit or 
deduction treated as a deduction allowable for depreciation or 
amortization for purposes of section 1245 (for example, a credit 
allowable under section 30 or a deduction allowable under section 179, 
179A, or 190). Expensed cost does not include any additional first year 
depreciation deduction.
    (5) Mass assets is a mass or group of individual items of 
depreciable assets--
    (i) That are not necessarily homogenous;
    (ii) Each of which is minor in value relative to the total value of 
the mass or group;
    (iii) Numerous in quantity;
    (iv) Usually accounted for only on a total dollar or quantity 
basis;
    (v) With respect to which separate identification is impracticable; 
and
    (vi) Placed in service in the same taxable year.
    (6) Remaining adjusted depreciable basis of the general asset 
account is the unadjusted depreciable basis of the general asset 
account less the amount of the additional first year depreciation 
deduction allowed or allowable, whichever is greater, for the general 
asset account.
    (c) Establishment of general asset accounts--(1) Assets eligible 
for general asset accounts--(i) General rules. Assets that are subject 
to either the general depreciation system of section 168(a) or the 
alternative depreciation system of section 168(g) may be accounted for 
in one or more general asset accounts. An asset is included in a 
general asset account only to the extent of the asset's unadjusted 
depreciable basis. However, an asset is not to be included in a general 
asset account if the asset is used both in a trade or business (or for 
the production of income) and in a personal activity at any time during 
the taxable year in which the asset is placed in service by the 
taxpayer or if the asset is

[[Page 81087]]

placed in service and disposed of during the same taxable year.
    (ii) Special rules for assets generating foreign source income. (A) 
Assets that generate foreign source income, both United States and 
foreign source income, or combined gross income of a FSC (as defined in 
former section 922), DISC (as defined in section 992(a)), or 
possessions corporation (as defined in section 936) and its related 
supplier, may be included in a general asset account if the 
requirements of paragraph (c)(2)(i) of this section are satisfied. If, 
however, the inclusion of these assets in a general asset account 
results in a substantial distortion of income, the Commissioner may 
disregard the general asset account election and make any reallocations 
of income or expense necessary to clearly reflect income.
    (B) A general asset account shall be treated as a single asset for 
purposes of applying the rules in Sec.  1.861-9T(g)(3) (relating to 
allocation and apportionment of interest expense under the asset 
method). A general asset account that generates income in more than one 
grouping of income (statutory and residual) is a multiple category 
asset (as defined in Sec.  1.861-9T(g)(3)(ii)), and the income yield 
from the general asset account must be determined by applying the rules 
for multiple category assets as if the general asset account were a 
single asset.
    (2) Grouping assets in general asset accounts--(i) General rules. 
If a taxpayer makes the election under paragraph (l) of this section, 
assets that are subject to the election are grouped into one or more 
general asset accounts. Assets that are eligible to be grouped into a 
single general asset account may be divided into more than one general 
asset account. Each general asset account must include only assets 
that--
    (A) Have the same applicable depreciation method;
    (B) Have the same applicable recovery period;
    (C) Have the same applicable convention; and
    (D) Are placed in service by the taxpayer in the same taxable year.
    (ii) Special rules. In addition to the general rules in paragraph 
(c)(2)(i) of this section, the following rules apply when establishing 
general asset accounts--
    (A) Assets subject to the mid-quarter convention may only be 
grouped into a general asset account with assets that are placed in 
service in the same quarter of the taxable year;
    (B) Assets subject to the mid-month convention may only be grouped 
into a general asset account with assets that are placed in service in 
the same month of the taxable year;
    (C) Passenger automobiles for which the depreciation allowance is 
limited under section 280F(a) must be grouped into a separate general 
asset account;
    (D) Assets not eligible for any additional first year depreciation 
deduction (including assets for which the taxpayer elected not to 
deduct the additional first year depreciation) provided by, for 
example, section 168(k) through (n), 1400L(b), or 1400N(d), must be 
grouped into a separate general asset account;
    (E) Assets eligible for the additional first year depreciation 
deduction may only be grouped into a general asset account with assets 
for which the taxpayer claimed the same percentage of the additional 
first year depreciation (for example, 30 percent, 50 percent, or 100 
percent);
    (F) Except for passenger automobiles described in paragraph 
(c)(2)(ii)(C) of this section, listed property (as defined in section 
280F(d)(4)) must be grouped into a separate general asset account;
    (G) Assets for which the depreciation allowance for the placed-in-
service year is not determined by using an optional depreciation table 
(for further guidance, see section 8 of Rev. Proc. 87-57, 1987-2 CB 
687, 693 (see Sec.  601.601(d)(2) of this chapter)) must be grouped 
into a separate general asset account;
    (H) Mass assets that are or will be subject to paragraph 
(j)(2)(iii) of this section (disposed of or converted mass asset is 
identified by a mortality dispersion table) must be grouped into a 
separate general asset account; and
    (I) Assets subject to paragraph (h)(3)(iii)(A) of this section 
(change in use results in a shorter recovery period or a more 
accelerated depreciation method) for which the depreciation allowance 
for the year of change (as defined in Sec.  1.168(i)-4(a)) is not 
determined by using an optional depreciation table must be grouped into 
a separate general asset account.
    (3) Examples. The following examples illustrate the application of 
this paragraph (c):

    Example 1. In 2012, J, a proprietorship with a calendar year-
end, purchases and places in service one item of equipment that 
costs $550,000. This equipment is section 179 property and also is 
5-year property under section 168(e). On its Federal income tax 
return for 2012, J makes an election under section 179 to expense 
$500,000 of the equipment's cost and makes an election under 
paragraph (l) of this section to include the equipment in a general 
asset account. As a result, the unadjusted depreciable basis of the 
equipment is $50,000. In accordance with paragraph (c)(1) of this 
section, J must include only $50,000 of the equipment's cost in the 
general asset account.
    Example 2. The facts are the same as in Example 1, except that J 
also places in service 99 other items of equipment in 2012. On its 
Federal income tax return for 2012, J does not make an election 
under section 179 to expense the cost of any of the 100 items of 
equipment and does make an election under paragraph (l) of this 
section to include the 100 items of equipment in a general asset 
account. All of the 100 items of equipment placed in service in 2012 
are 5-year property under section 168(e), are not listed property, 
and are not eligible for any additional first year depreciation 
deduction. J depreciates its 5-year property placed in service in 
2012 using the optional depreciation table that corresponds with the 
general depreciation system, the 200-percent declining balance 
method, a 5-year recovery period, and the half-year convention. In 
accordance with paragraph (c)(2) of this section, J includes all of 
the 100 items of equipment in one general asset account.
    Example 3. The facts are the same as in Example 2, except that J 
decides not to include all of the 100 items of equipment in one 
general asset account. Instead and in accordance with paragraph 
(c)(2) of this section, J establishes 100 general asset accounts and 
includes one item of equipment in each general asset account.
    Example 4. K, a calendar-year corporation, is a wholesale 
distributer. In 2012, K places in service the following properties 
for use in its wholesale distribution business: computers, 
automobiles, and forklifts. On its federal income tax return for 
2012, K does not make an election under section 179 to expense the 
cost of any of these items of equipment and does make an election 
under paragraph (l) of this section to include all of these items of 
equipment in a general asset account. All of these items are 5-year 
property under section 168(e) and are not eligible for any 
additional first year depreciation deduction. The computers are 
listed property, and the automobiles are listed property and are 
subject to section 280F(a). K depreciates its 5-year property placed 
in service in 2012 using the optional depreciation table that 
corresponds with the general depreciation system, the 200-percent 
declining balance method, a 5-year recovery period, and the half-
year convention. Although the computers, automobiles, and forklifts 
are 5-year property, K cannot include all of them in one general 
asset account because the computers and automobiles are listed 
property. Further, even though the computers and automobiles are 
listed property, K cannot include them in one general asset account 
because the automobiles also are subject to section 280F(a). In 
accordance with paragraph (c)(2) of this section, K establishes 
three general asset accounts: One for the computers, one for the 
automobiles, and one for the forklifts.
    Example 5. L, a fiscal-year corporation with a taxable year 
ending June 30, purchases and places in service ten items of new 
equipment in October 2011, and purchases and places in service five 
other items of new equipment in February 2012. On its federal income 
tax return for the taxable year ending

[[Page 81088]]

June 30, 2012, L does not make an election under section 179 to 
expense the cost of any of these items of equipment and does make an 
election under paragraph (l) of this section to include all of these 
items of equipment in a general asset account. All of these items of 
equipment are 7-year property under section 168(e), are not listed 
property, and are not property described in section 168(k)(2)(B) or 
(C). All of the ten items of equipment placed in service in October 
2011 are eligible for the 100-percent additional first year 
depreciation deduction provided by section 168(k)(5). All of the 
five items of equipment placed in service in February 2012 are 
eligible for the 50-percent additional first year depreciation 
deduction provided by section 168(k)(1). L depreciates its 7-year 
property placed in service for the taxable year ending June 30, 
2012, using the optional depreciation table that corresponds with 
the general depreciation system, the 200-percent declining balance 
method, a 7-year recovery period, and the half-year convention. 
Although the 15 items of equipment are depreciated using the same 
depreciation method, recovery period, and convention, L cannot 
include all of them in one general asset account because they are 
eligible for different percentages of the additional first year 
depreciation deduction. In accordance with paragraph (c)(2) of this 
section, L establishes two general asset accounts: one for the ten 
items of equipment eligible for the 100-percent additional first 
year depreciation deduction, and one for the five items of equipment 
eligible for the 50-percent additional first year depreciation 
deduction.

    (d) Determination of depreciation allowance--(1) In general. 
Depreciation allowances are determined for each general asset account. 
The depreciation allowances must be recorded in a depreciation reserve 
account for each general asset account. The allowance for depreciation 
under this section constitutes the amount of depreciation allowable 
under section 167(a).
    (2) Assets in general asset account are eligible for additional 
first year depreciation deduction. If all the assets in a general asset 
account are eligible for the additional first year depreciation 
deduction, the taxpayer first must determine the allowable additional 
first year depreciation deduction for the general asset account for the 
placed-in-service year and then must determine the amount otherwise 
allowable as a depreciation deduction for the general asset account for 
the placed-in-service year and any subsequent taxable year. The 
allowable additional first year depreciation deduction for the general 
asset account for the placed-in-service year is determined by 
multiplying the unadjusted depreciable basis of the general asset 
account by the additional first year depreciation deduction percentage 
applicable to the assets in the account (for example, 30 percent, 50 
percent, or 100 percent). The remaining adjusted depreciable basis of 
the general asset account then is depreciated using the applicable 
depreciation method, recovery period, and convention for the assets in 
the account.
    (3) No assets in general asset account are eligible for additional 
first year depreciation deduction. If none of the assets in a general 
asset account are eligible for the additional first year depreciation 
deduction, the taxpayer must determine the allowable depreciation 
deduction for the general asset account for the placed-in-service year 
and any subsequent taxable year by using the applicable depreciation 
method, recovery period, and convention for the assets in the account.
    (4) Special rule for passenger automobiles. For purposes of 
applying section 280F(a), the depreciation allowance for a general 
asset account established for passenger automobiles is limited for each 
taxable year to the amount prescribed in section 280F(a) multiplied by 
the excess of the number of automobiles originally included in the 
account over the number of automobiles disposed of during the taxable 
year or in any prior taxable year in a transaction described in 
paragraphs (e)(3)(iii) (disposition of an asset in a qualifying 
disposition), (e)(3)(iv) (transactions subject to section 168(i)(7)), 
(e)(3)(v) (transactions subject to section 1031 or 1033), (e)(3)(vi) 
(technical termination of a partnership), (e)(3)(vii) (anti-abuse 
rule), (g) (assets subject to recapture), (h)(1) (conversion to 
personal use), or (h)(2) (business or income-producing use percentage 
changes) of this section.
    (e) Disposition of an asset from a general asset account--(1) 
Scope. This paragraph (e) provides rules applicable to dispositions of 
assets included in a general asset account. For purposes of this 
paragraph (e), an asset in a general asset account is disposed of when 
ownership of the asset is transferred or when the asset is permanently 
withdrawn from use either in the taxpayer's trade or business or in the 
production of income. A disposition includes the sale, exchange, 
retirement, physical abandonment, or destruction of an asset. A 
disposition also occurs when an asset is transferred to a supplies, 
scrap, or similar account. A disposition also includes the retirement 
of a structural component (as defined in Sec.  1.48-1(e)(2)) of a 
building (as defined in Sec.  1.48-1(e)(1)).
    (2) General rules for a disposition--(i) No immediate recovery of 
basis. Except as provided in paragraph (e)(3) of this section, 
immediately before a disposition of any asset in a general asset 
account, the asset is treated as having an adjusted depreciable basis 
(as defined in Sec.  1.168(b)-1(a)(4)) of zero for purposes of section 
1011. Therefore, no loss is realized upon the disposition of an asset 
from the general asset account. Similarly, where an asset is disposed 
of by transfer to a supplies, scrap, or similar account, the basis of 
the asset in the supplies, scrap, or similar account will be zero.
    (ii) Treatment of amount realized. Any amount realized on a 
disposition is recognized as ordinary income (notwithstanding any other 
provision of subtitle A of the Internal Revenue Code) to the extent the 
sum of the unadjusted depreciable basis of the general asset account 
and any expensed cost (as defined in paragraph (b)(4) of this section) 
for assets in the account exceeds any amounts previously recognized as 
ordinary income upon the disposition of other assets in the account. 
The recognition and character of any excess amount realized are 
determined under other applicable provisions of the Internal Revenue 
Code (other than sections 1245 and 1250 or provisions of the Internal 
Revenue Code that treat gain on a disposition as subject to section 
1245 or 1250).
    (iii) Effect of disposition on a general asset account. The 
unadjusted depreciable basis and the depreciation reserve of the 
general asset account are not affected as a result of a disposition of 
an asset from the general asset account.
    (iv) Coordination with nonrecognition provisions. For purposes of 
determining the basis of an asset acquired in a transaction, other than 
a transaction described in paragraphs (e)(3)(iv) (pertaining to 
transactions subject to section 168(i)(7)), (e)(3)(v) (pertaining to 
transactions subject to section 1031 or 1033), and (e)(3)(vi) 
(pertaining to technical terminations of partnerships) of this section, 
to which a nonrecognition section of the Internal Revenue Code applies 
(determined without regard to this section), the amount of ordinary 
income recognized under this paragraph (e)(2) is treated as the amount 
of gain recognized on the disposition.
    (v) Manner of disposition. The manner of disposition of an asset in 
a general asset account (for example, normal retirement, abnormal 
retirement, ordinary retirement, or extraordinary retirement) is not 
taken into account in determining whether a disposition occurs or gain 
or loss is recognized.
    (vi) Disposition by transfer to a supplies account. If a taxpayer 
made an election under Sec.  1.162-3T(d) to treat the cost of any 
material and supply as a capital expenditure subject to the

[[Page 81089]]

allowance for depreciation and also made an election under paragraph 
(l) of this section to include that material and supply in a general 
asset account, the taxpayer can dispose of the material and supply by 
transferring it to a supplies account only if the taxpayer has obtained 
the consent of the Commissioner to revoke the Sec.  1.162-3T(d) 
election. See Sec.  1.162-3T(d)(3) for the procedures for revoking a 
Sec.  1.162-3T(d) election.
    (vii) Leasehold improvements. The rules of paragraph (e) of this 
section also apply to--
    (A) A lessor of leased property that made an improvement to that 
property for the lessee of the property, has a depreciable basis in the 
improvement, made an election under paragraph (l) of this section to 
include the improvement in a general asset account, and disposes of the 
improvement before or upon the termination of the lease with the 
lessee. See section 168(i)(8)(B); and
    (B) A lessee of leased property that made an improvement to that 
property, has a depreciable basis in the improvement, made an election 
under paragraph (l) of this section to include the improvement in a 
general asset account, and disposes of the improvement before or upon 
the termination of the lease.
    (viii) Determination of asset disposed of--(A) In general. For 
purposes of applying paragraph (e) of this section to the disposition 
of an asset in a general asset account (instead of the disposition of 
the general asset account), the facts and circumstances of each 
disposition are considered in determining what is the appropriate asset 
disposed of. Except as provided in paragraph (e)(2)(viii)(B) of this 
section, the asset cannot be larger than the unit of property as 
determined under Sec.  1.263(a)-3T(e)(2), (e)(3), and (e)(5) or as 
otherwise determined in published guidance in the Federal Register or 
in the Internal Revenue Bulletin (see, for example, Rev. Proc. 2011-38, 
2011-18 IRB 743, for units of property for wireless network assets (see 
Sec.  601.601(d)(2)(ii)(b) of this chapter)).
    (B) Exceptions. For purposes of applying paragraph (e) of this 
section to the disposition of an asset in a general asset account 
(instead of the disposition of the general asset account):
    (1) Each building (not including its structural components) is the 
asset except as provided in Sec.  1.1250-1(a)(2)(ii) or in paragraph 
(e)(2)(viii)(B)(2) or (5) of this section.
    (2) If a building has two or more condominium or cooperative units, 
each condominium or cooperative unit (not including its structural 
components) is the asset except as provided in Sec.  1.1250-1(a)(2)(ii) 
or in paragraph (e)(2)(viii)(B)(5) of this section.
    (3) Each structural component (including all components thereof) of 
a building, condominium unit, or cooperative unit is the asset.
    (4) If a taxpayer properly includes an item in one of the asset 
classes 00.11 through 00.4 of Rev. Proc. 87-56 (1987-2 CB 674) (see 
Sec.  601.601(d)(2)(ii)(b) of this chapter) or properly classifies an 
item in one of the categories under section 168(e)(3) (except for a 
category that includes buildings or structural components; for example, 
retail motor fuels outlet, qualified leasehold improvement property, 
qualified restaurant property, and qualified retail improvement 
property), each item is the asset provided it is not larger than the 
unit of property as determined under Sec.  1.263(a)-3T(e)(3) or (e)(5) 
or as otherwise determined in published guidance in the Federal 
Register or in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), or provided paragraph 
(e)(2)(viii)(B)(5) of this section does not apply to the item. For 
example, each desk is the asset, each computer is the asset, and each 
qualified smart electric meter is the asset (assuming these assets are 
not larger than the unit of property as determined under Sec.  
1.263(a)-3T(e)(3) or (e)(5) or as otherwise determined in published 
guidance in the Federal Register or in the Internal Revenue Bulletin 
(see Sec.  601.601(d)(2)(ii)(b) of this chapter)).
    (5) If the taxpayer places in service an improvement or addition to 
an asset after the taxpayer placed the asset in service, the 
improvement or addition is a separate asset provided it is not larger 
than the unit of property as determined under Sec.  1.263(a)-3T(e)(3) 
or (e)(5) or as otherwise determined in published guidance in the 
Federal Register or in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter).
    (6) If an asset is not described in one of the asset classes 00.11 
through 00.4 of Rev. Proc. 87-56 (1987-2 CB 674) (see Sec.  
601.601(d)(2)(ii)(b) of this chapter) or in one of the categories under 
section 168(e)(3), a taxpayer also may use any reasonable, consistent 
method to treat each of the asset's components as the asset.
    (ix) Examples. The following examples illustrate the application of 
this paragraph (e)(2):

    Example 1.  A, a calendar-year partnership, maintains one 
general asset account for one office building that cost $10 million. 
A discovers a leak in the roof of this building and, after 
consulting with a contractor, decides to replace the entire roof. 
The retirement of the roof, which is a structural component of the 
building, is a disposition under paragraph (e)(1) of this section. 
However, this roof has an unadjusted depreciable basis of zero 
pursuant to paragraph (e)(2)(i) of this section. Accordingly, A does 
not recognize any loss upon the retirement of the roof. Instead, the 
unadjusted depreciable basis of the general asset account for the 
office building is not affected by the retirement of the roof and, 
as a result, A continues to depreciate the $10 million cost of this 
general asset account.

    Example 2.  B, a calendar-year commercial airline company, 
maintains one general asset account for five aircrafts that cost a 
total of $500 million. B replaces the existing engines on one of the 
aircrafts with new engines and treats each engine of an aircraft as 
a major component of the aircraft. Assume each aircraft is a unit of 
property as determined under Sec.  1.263(a)-3T(e)(3). However, for 
disposition purposes of general asset accounts, B consistently 
treats each major component of an aircraft as the asset. Thus, the 
retirement of these replaced engines is a disposition under 
paragraph (e)(1) of this section. However, the engines have an 
unadjusted depreciable basis of zero pursuant to paragraph (e)(2)(i) 
of this section. Accordingly, B does not recognize any loss upon the 
retirement of the engines. Instead, the unadjusted depreciable basis 
of the general asset account for the five aircrafts is not affected 
by the retirement of the engines and, as a result, B continues to 
depreciate the $500 million cost of this general asset account.

    Example 3. (i) R, a calendar-year corporation, maintains one 
general asset account for ten machines. The machines cost a total of 
$10,000 and are placed in service in June 2012. Of the ten machines, 
one machine costs $8,200 and nine machines cost a total of $1,800. 
Assume R depreciates this general asset account using the optional 
depreciation table that corresponds with the general depreciation 
system, the 200-percent declining balance method, a 5-year recovery 
period, and a half-year convention. R does not make a section 179 
election for any of the machines, and all of the machines are not 
eligible for any additional first year depreciation deduction. As of 
January 1, 2013, the depreciation reserve of the account is $2,000 
[$10,000 x 20 percent].
    (ii) On February 8, 2013, R sells the machine that cost $8,200 
to an unrelated party for $9,000. Under paragraph (e)(2)(i) of this 
section, this machine has an adjusted depreciable basis of zero.
    (iii) On its 2013 tax return, R recognizes the amount realized 
of $9,000 as ordinary income because such amount does not exceed the 
unadjusted depreciable basis of the general asset account ($10,000), 
plus any expensed cost for assets in the account ($0), less amounts 
previously recognized as ordinary income ($0). Moreover, the 
unadjusted depreciable basis and depreciation reserve of the account 
are not affected by the disposition of the machine. Thus, the 
depreciation allowance for the account in 2013 is $3,200 ($10,000 x 
32 percent).


[[Page 81090]]


    Example 4. (i) The facts are the same as in Example 3. In 
addition, on June 4, 2014, R sells seven machines to an unrelated 
party for a total of $1,100. In accordance with paragraph (e)(2)(i) 
of this section, these machines have an adjusted depreciable basis 
of zero.
    (ii) On its 2014 tax return, R recognizes $1,000 as ordinary 
income (the unadjusted depreciable basis of $10,000, plus the 
expensed cost of $0, less the amount of $9,000 previously recognized 
as ordinary income). The recognition and character of the excess 
amount realized of $100 ($1,100-$1,000) are determined under 
applicable provisions of the Internal Revenue Code other than 
section 1245 (such as section 1231). Moreover, the unadjusted 
depreciable basis and depreciation reserve of the account are not 
affected by the disposition of the machines. Thus, the depreciation 
allowance for the account in 2014 is $1,920 ($10,000 x 19.2 
percent).

    (3) Special rules--(i) In general. This paragraph (e)(3) provides 
the rules for terminating general asset account treatment upon certain 
dispositions. While the rules under paragraphs (e)(3)(ii) and (iii) of 
this section are optional rules, the rules under paragraphs (e)(3)(iv), 
(v), (vi), and (vii) of this section are mandatory rules. A taxpayer 
elects to apply paragraph (e)(3)(ii) or (iii) of this section by 
reporting the gain, loss, or other deduction on the taxpayer's timely 
filed original Federal income tax return (including extensions) for the 
taxable year in which the disposition occurs. A taxpayer may revoke the 
election to apply paragraph (e)(3)(ii) or (iii) of this section only by 
filing a request for a private letter ruling and obtaining the 
Commissioner's consent to revoke the election. The Commissioner may 
grant a request to revoke this election if the taxpayer can demonstrate 
good cause for the revocation. The election to apply paragraph 
(e)(3)(ii) or (iii) of this section may not be made or revoked through 
the filing of an application for change in accounting method. For 
purposes of applying paragraph (e)(3)(iii) through (vii) of this 
section, see paragraph (j) of this section for identifying an asset 
disposed of and its unadjusted depreciable basis.
    (ii) Disposition of all assets remaining in a general asset 
account--(A) Optional termination of a general asset account. Upon the 
disposition of all of the assets, or the last asset, in a general asset 
account, a taxpayer may apply this paragraph (e)(3)(ii) to recover the 
adjusted depreciable basis of the general asset account (rather than 
having paragraph (e)(2) of this section apply). Under this paragraph 
(e)(3)(ii), the general asset account terminates and the amount of gain 
or loss for the general asset account is determined under section 
1001(a) by taking into account the adjusted depreciable basis of the 
general asset account at the time of the disposition (as determined 
under the applicable convention for the general asset account). The 
recognition and character of the gain or loss are determined under 
other applicable provisions of the Internal Revenue Code, except that 
the amount of gain subject to section 1245 (or section 1250) is limited 
to the excess of the depreciation allowed or allowable for the general 
asset account, including any expensed cost (or the excess of the 
additional depreciation allowed or allowable for the general asset 
account), over any amounts previously recognized as ordinary income 
under paragraph (e)(2) of this section.
    (B) Examples. The following examples illustrate the application of 
this paragraph (e)(3)(ii):

    Example 1.  (i) T, a calendar-year corporation, maintains a 
general asset account for 1,000 calculators. The calculators cost a 
total of $60,000 and are placed in service in 2012. Assume T 
depreciates this general asset account using the optional 
depreciation table that corresponds with the general depreciation 
system, the 200-percent declining balance method, a 5-year recovery 
period, and a half-year convention. T does not make a section 179 
election for any of the calculators, and all of the calculators are 
not eligible for any additional first year depreciation deduction. 
In 2013, T sells 200 of the calculators to an unrelated party for a 
total of $10,000 and recognizes the $10,000 as ordinary income in 
accordance with paragraph (e)(2) of this section.
    (ii) On March 26, 2014, T sells the remaining calculators in the 
general asset account to an unrelated party for $35,000. T elects to 
apply paragraph (e)(3)(ii) of this section. As a result, the account 
terminates and gain or loss is determined for the account.
    (iii) On the date of disposition, the adjusted depreciable basis 
of the account is $23,040 (unadjusted depreciable basis of $60,000 
less the depreciation allowed or allowable of $36,960). Thus, in 
2014, T recognizes gain of $11,960 (amount realized of $35,000 less 
the adjusted depreciable basis of $23,040). The gain of $11,960 is 
subject to section 1245 to the extent of the depreciation allowed or 
allowable for the account (plus the expensed cost for assets in the 
account) less the amounts previously recognized as ordinary income 
($36,960 + $0-$10,000 = $26,960). As a result, the entire gain of 
$11,960 is subject to section 1245.

    Example 2.  (i) J, a calendar-year corporation, maintains a 
general asset account for one item of equipment. This equipment 
costs $2,000 and is placed in service in 2012. Assume J depreciates 
this general asset account using the optional depreciation table 
that corresponds with the general depreciation system, the 200-
percent declining balance method, a 5-year recovery period, and a 
half-year convention. J does not make a section 179 election for the 
equipment, and it is not eligible for any additional first year 
depreciation deduction. In June 2014, J sells the equipment to an 
unrelated party for $1,000. J elects to apply paragraph (e)(3)(ii) 
of this section. As a result, the account terminates and gain or 
loss is determined for the account.
    (iii) On the date of disposition, the adjusted depreciable basis 
of the account is $768 (unadjusted depreciable basis of $2,000 less 
the depreciation allowed or allowable of $1,232). Thus, in 2014, J 
recognizes gain of $232 (amount realized of $1,000 less the adjusted 
depreciable basis of $768). The gain of $232 is subject to section 
1245 to the extent of the depreciation allowed or allowable for the 
account (plus the expensed cost for assets in the account) less the 
amounts previously recognized as ordinary income ($1,232 + $0-$0 = 
$1,232). As a result, the entire gain of $232 is subject to section 
1245.

    (iii) Disposition of an asset in a qualifying disposition--(A) 
Optional determination of the amount of gain, loss, or other deduction. 
In the case of a qualifying disposition of an asset (described in 
paragraph (e)(3)(iii)(B) of this section), a taxpayer may elect to 
apply this paragraph (e)(3)(iii) (rather than having paragraph (e)(2) 
of this section apply). Under this paragraph (e)(3)(iii), general asset 
account treatment for the asset terminates as of the first day of the 
taxable year in which the qualifying disposition occurs, and the amount 
of gain, loss, or other deduction for the asset is determined under 
Sec.  1.168(i)-8T by taking into account the asset's adjusted 
depreciable basis at the time of the disposition. The adjusted 
depreciable basis of the asset at the time of the disposition (as 
determined under the applicable convention for the general asset 
account in which the asset was included) equals the unadjusted 
depreciable basis of the asset less the depreciation allowed or 
allowable for the asset, computed by using the depreciation method, 
recovery period, and convention applicable to the general asset account 
in which the asset was included and by including the portion of the 
additional first year depreciation deduction claimed for the general 
asset account that is attributable to the asset disposed of. The 
recognition and character of the gain, loss, or other deduction are 
determined under other applicable provisions of the Internal Revenue 
Code, except that the amount of gain subject to section 1245 (or 
section 1250) is limited to the lesser of--
    (1) The depreciation allowed or allowable for the asset, including 
any expensed cost (or the additional depreciation allowed or allowable 
for the asset); or
    (2) The excess of--

[[Page 81091]]

    (i) The original unadjusted depreciable basis of the general asset 
account plus, in the case of section 1245 property originally included 
in the general asset account, any expensed cost; over
    (ii) The cumulative amounts of gain previously recognized as 
ordinary income under either paragraph (e)(2) of this section or 
section 1245 (or section 1250).
    (B) Qualifying dispositions. A qualifying disposition is a 
disposition that does not involve all the assets, or the last asset, 
remaining in a general asset account and that is not described in 
paragraphs (e)(3)(iv) (pertaining to transactions subject to section 
168(i)(7)), (v) (pertaining to transactions subject to section 1031 or 
1033), (vi) (pertaining to technical terminations of partnerships), or 
(vii) (anti-abuse rule) of this section.
    (C) Effect of a qualifying disposition on a general asset account. 
If the taxpayer elects to apply this paragraph (e)(3)(iii) to a 
qualifying disposition of an asset, then--
    (1) The asset is removed from the general asset account as of the 
first day of the taxable year in which the qualifying disposition 
occurs. For that taxable year, the taxpayer accounts for the asset in a 
single asset account in accordance with the rules under Sec.  1.168(i)-
7T(b);
    (2) The unadjusted depreciable basis of the general asset account 
is reduced by the unadjusted depreciable basis of the asset as of the 
first day of the taxable year in which the disposition occurs;
    (3) The depreciation reserve of the general asset account is 
reduced by the depreciation allowed or allowable for the asset as of 
the end of the taxable year immediately preceding the year of 
disposition, computed by using the depreciation method, recovery 
period, and convention applicable to the general asset account in which 
the asset was included and by including the portion of the additional 
first year depreciation deduction claimed for the general asset account 
that is attributable to the asset disposed of; and
    (4) For purposes of determining the amount of gain realized on 
subsequent dispositions that is subject to ordinary income treatment 
under paragraph (e)(2)(ii) of this section, the amount of any expensed 
cost with respect to the asset is disregarded.
    (D) Example. The following example illustrates the application of 
this paragraph (e)(3)(iii):

    Example.  (i) Z, a calendar-year corporation, maintains one 
general asset account for 12 machines. Each machine costs $15,000 
and is placed in service in 2012. Of the 12 machines, nine machines 
that cost a total of $135,000 are used in Z's Kentucky plant, and 
three machines that cost a total of $45,000 are used in Z's Ohio 
plant. Assume Z depreciates this general asset account using the 
optional depreciation table that corresponds with the general 
depreciation system, the 200-percent declining balance method, a 5-
year recovery period, and the half-year convention. Z does not make 
a section 179 election for any of the machines, and all of the 
machines are not eligible for any additional first year depreciation 
deduction. As of January 1, 2014, the depreciation reserve for the 
account is $93,600.
    (ii) On May 27, 2014, Z sells its entire manufacturing plant in 
Ohio to an unrelated party. The sales proceeds allocated to each of 
the three machines at the Ohio plant is $5,000. Because this 
transaction is a qualifying disposition under paragraph 
(e)(3)(iii)(B) of this section, Z elects to apply paragraph 
(e)(3)(iii) of this section.
    (iii) For Z's 2014 return, the depreciation allowance for the 
account is computed as follows. As of December 31, 2013, the 
depreciation allowed or allowable for the three machines at the Ohio 
plant is $23,400. Thus, as of January 1, 2014, the unadjusted 
depreciable basis of the account is reduced from $180,000 to 
$135,000 ($180,000 less the unadjusted depreciable basis of $45,000 
for the three machines), and the depreciation reserve of the account 
is decreased from $93,600 to $70,200 ($93,600 less the depreciation 
allowed or allowable of $23,400 for the three machines as of 
December 31, 2013). Consequently, the depreciation allowance for the 
account in 2014 is $25,920 ($135,000 x 19.2 percent).
    (iv) For Z's 2014 return, gain or loss for each of the three 
machines at the Ohio plant is determined as follows. The 
depreciation allowed or allowable in 2014 for each machine is $1,440 
[($15,000 x 19.2 percent)/2]. Thus, the adjusted depreciable basis 
of each machine under section 1011 is $5,760 (the adjusted 
depreciable basis of $7,200 removed from the account less the 
depreciation allowed or allowable of $1,440 in 2014). As a result, 
the loss recognized in 2014 for each machine is $760 ($5,000-
$5,760), which is subject to section 1231.

    (iv) Transactions subject to section 168(i)(7)--(A) In general. If 
a taxpayer transfers one or more assets in a general asset account in a 
transaction described in section 168(i)(7)(B) (pertaining to treatment 
of transferees in certain nonrecognition transactions), the taxpayer 
(the transferor) and the transferee must apply this paragraph 
(e)(3)(iv) to the asset (instead of applying paragraph (e)(2), 
(e)(3)(ii), or (e)(3)(iii) of this section). The transferee is bound by 
the transferor's election under paragraph (l) of this section for the 
portion of the transferee's basis in the asset that does not exceed the 
transferor's adjusted depreciable basis of the general asset account or 
the asset, as applicable (as determined under paragraph 
(e)(3)(iv)(B)(2) or (e)(3)(iv)(C)(2) of this section, as applicable).
    (B) All assets remaining in general asset account are transferred. 
If a taxpayer transfers all the assets, or the last asset, in a general 
asset account in a transaction described in section 168(i)(7)(B)--
    (1) The taxpayer (the transferor) must terminate the general asset 
account on the date of the transfer. The allowable depreciation 
deduction for the general asset account for the transferor's taxable 
year in which the section 168(i)(7)(B) transaction occurs is computed 
by using the depreciation method, recovery period, and convention 
applicable to the general asset account. This allowable depreciation 
deduction is allocated between the transferor and the transferee on a 
monthly basis. This allocation is made in accordance with the rules in 
Sec.  1.168(d)-1(b)(7)(ii) for allocating the depreciation deduction 
between the transferor and the transferee;
    (2) The transferee must establish a new general asset account for 
all the assets, or the last asset, in the taxable year in which the 
section 168(i)(7)(B) transaction occurs for the portion of its basis in 
the assets that does not exceed the transferor's adjusted depreciable 
basis of the general asset account in which all the assets, or the last 
asset, were included. The transferor's adjusted depreciable basis of 
this general asset account is equal to the adjusted depreciable basis 
of that account as of the beginning of the transferor's taxable year in 
which the transaction occurs, decreased by the amount of depreciation 
allocable to the transferor for the year of the transfer (as determined 
under paragraph (e)(3)(iv)(B)(1) of this section). The transferee is 
treated as the transferor for purposes of computing the allowable 
depreciation deduction for the new general asset account under section 
168. The new general asset account must be established in accordance 
with the rules in paragraph (c) of this section, except that the 
unadjusted depreciable bases of all the assets or the last asset, and 
the greater of the depreciation allowed or allowable for all the assets 
or the last asset (including the amount of depreciation for the 
transferred assets that is allocable to the transferor for the year of 
the transfer), are included in the newly established general asset 
account. Consequently, this general asset account in the year of the 
transfer will have a beginning balance for both the unadjusted 
depreciable basis and the depreciation reserve of the general asset 
account; and

[[Page 81092]]

    (3) For purposes of section 168 and this section, the transferee 
treats the portion of its basis in the assets that exceeds the 
transferor's adjusted depreciable basis of the general asset account in 
which all the assets, or the last asset, were included (as determined 
under paragraph (e)(3)(iv)(B)(2) of this section) as a separate asset 
that the transferee placed in service on the date of the transfer. The 
transferee accounts for this asset under Sec.  1.168(i)-7T or may make 
an election under paragraph (l) of this section to include the asset in 
a general asset account.
    (C) Not all assets remaining in general asset account are 
transferred. If a taxpayer transfers an asset in a general asset 
account in a transaction described in section 168(i)(7)(B) and if 
paragraph (e)(3)(iv)(B) of this section does not apply to this asset--
    (1) The taxpayer (the transferor) must remove the transferred asset 
from the general asset account in which the asset is included, as of 
the first day of the taxable year in which the section 168(i)(7)(B) 
transaction occurs. In addition, the adjustments to the general asset 
account described in paragraph (e)(3)(iii)(C)(2) through (4) of this 
section must be made. The allowable depreciation deduction for the 
asset for the transferor's taxable year in which the section 
168(i)(7)(B) transaction occurs is computed by using the depreciation 
method, recovery period, and convention applicable to the general asset 
account in which the asset was included. This allowable depreciation 
deduction is allocated between the transferor and the transferee on a 
monthly basis. This allocation is made in accordance with the rules in 
Sec.  1.168(d)-1(b)(7)(ii) for allocating the depreciation deduction 
between the transferor and the transferee;
    (2) The transferee must establish a new general asset account for 
the asset in the taxable year in which the section 168(i)(7)(B) 
transaction occurs for the portion of its basis in the asset that does 
not exceed the transferor's adjusted depreciable basis of the asset. 
The transferor's adjusted depreciable basis of this asset is equal to 
the adjusted depreciable basis of the asset as of the beginning of the 
transferor's taxable year in which the transaction occurs, decreased by 
the amount of depreciation allocable to the transferor for the year of 
the transfer (as determined under paragraph (e)(3)(iv)(C)(1) of this 
section). The transferee is treated as the transferor for purposes of 
computing the allowable depreciation deduction for the new general 
asset account under section 168. The new general asset account must be 
established in accordance with the rules in paragraph (c) of this 
section, except that the unadjusted depreciable basis of the asset, and 
the greater of the depreciation allowed or allowable for the asset 
(including the amount of depreciation for the transferred asset that is 
allocable to the transferor for the year of the transfer), are included 
in the newly established general asset account. Consequently, this 
general asset account in the year of the transfer will have a beginning 
balance for both the unadjusted depreciable basis and the depreciation 
reserve of the general asset account; and
    (3) For purposes of section 168 and this section, the transferee 
treats the portion of its basis in the asset that exceeds the 
transferor's adjusted depreciable basis of the asset (as determined 
under paragraph (e)(3)(iv)(C)(2) of this section) as a separate asset 
that the transferee placed in service on the date of the transfer. The 
transferee accounts for this asset under Sec.  1.168(i)-7T or may make 
an election under paragraph (l) of this section to include the asset in 
a general asset account.
    (v) Transactions subject to section 1031 or section 1033--(A) Like-
kind exchange or involuntary conversion of all assets remaining in a 
general asset account. If all the assets, or the last asset, in a 
general asset account are transferred by a taxpayer in a like-kind 
exchange (as defined under Sec.  1.168-6(b)(11)) or in an involuntary 
conversion (as defined under Sec.  1.168-6(b)(12)), the taxpayer must 
apply this paragraph (e)(3)(v)(A) (instead of applying paragraph 
(e)(2), (e)(3)(ii), or (e)(3)(iii) of this section). Under this 
paragraph (e)(3)(v)(A), the general asset account terminates as of the 
first day of the year of disposition (as defined in Sec.  1.168(i)-
6(b)(5)) and--
    (1) The amount of gain or loss for the general asset account is 
determined under section 1001(a) by taking into account the adjusted 
depreciable basis of the general asset account at the time of 
disposition (as defined in Sec.  1.168(i)-6(b)(3)). The depreciation 
allowance for the general asset account in the year of disposition is 
determined in the same manner as the depreciation allowance for the 
relinquished MACRS property (as defined in Sec.  1.168(i)-6(b)(2)) in 
the year of disposition is determined under Sec.  1.168(i)-6. The 
recognition and character of gain or loss are determined in accordance 
with paragraph (e)(3)(ii)(A) of this section (notwithstanding that 
paragraph (e)(3)(ii) of this section is an optional rule); and
    (2) The adjusted depreciable basis of the general asset account at 
the time of disposition is treated as the adjusted depreciable basis of 
the relinquished MACRS property.
    (B) Like-kind exchange or involuntary conversion of less than all 
assets remaining in a general asset account. If an asset in a general 
asset account is transferred by a taxpayer in a like-kind exchange or 
in an involuntary conversion and if paragraph (e)(3)(v)(A) of this 
section does not apply to this asset, the taxpayer must apply this 
paragraph (e)(3)(v)(B) (instead of applying paragraph (e)(2), 
(e)(3)(ii), or (e)(3)(iii) of this section). Under this paragraph 
(e)(3)(v)(B), general asset account treatment for the asset terminates 
as of the first day of the year of disposition (as defined in Sec.  
1.168(i)-6(b)(5)), and--
    (1) The amount of gain or loss for the asset is determined by 
taking into account the asset's adjusted depreciable basis at the time 
of disposition (as defined in Sec.  1.168(i)-6(b)(3)). The adjusted 
depreciable basis of the asset at the time of disposition equals the 
unadjusted depreciable basis of the asset less the depreciation allowed 
or allowable for the asset, computed by using the depreciation method, 
recovery period, and convention applicable to the general asset account 
in which the asset was included and by including the portion of the 
additional first year depreciation deduction claimed for the general 
asset account that is attributable to the relinquished asset. The 
depreciation allowance for the asset in the year of disposition is 
determined in the same manner as the depreciation allowance for the 
relinquished MACRS property (as defined in Sec.  1.168(i)-6(b)(2)) in 
the year of disposition is determined under Sec.  1.168(i)-6. The 
recognition and character of the gain or loss are determined in 
accordance with paragraph (e)(3)(iii)(A) of this section 
(notwithstanding that paragraph (e)(3)(iii) of this section is an 
optional rule); and
    (2) As of the first day of the year of disposition, the taxpayer 
must remove the relinquished asset from the general asset account and 
make the adjustments to the general asset account described in 
paragraph (e)(3)(iii)(C)(2) through (4) of this section.
    (vi) Technical termination of a partnership. In the case of a 
technical termination of a partnership under section 708(b)(1)(B), the 
terminated partnership must apply this paragraph (e)(3)(vi) (instead of 
applying paragraph (e)(2), (e)(3)(ii), or (e)(3)(iii) of this section). 
Under this paragraph (e)(3)(vi), all of the terminated partnership's

[[Page 81093]]

general asset accounts terminate as of the date of its termination 
under section 708(b)(1)(B). The terminated partnership computes the 
allowable depreciation deduction for each of its general asset accounts 
for the taxable year in which the technical termination occurs by using 
the depreciation method, recovery period, and convention applicable to 
the general asset account. The new partnership is not bound by the 
terminated partnership's election under paragraph (l) of this section.
    (vii) Anti-abuse rule--(A) In general. If an asset in a general 
asset account is disposed of by a taxpayer in a transaction described 
in paragraph (e)(3)(vii)(B) of this section, general asset account 
treatment for the asset terminates as of the first day of the taxable 
year in which the disposition occurs. Consequently, the taxpayer must 
determine the amount of gain, loss, or other deduction attributable to 
the disposition in the manner described in paragraph (e)(3)(iii)(A) of 
this section (notwithstanding that paragraph (e)(3)(iii)(A) of this 
section is an optional rule) and must make the adjustments to the 
general asset account described in paragraph (e)(3)(iii)(C)(1) through 
(4) of this section.
    (B) Abusive transactions. A transaction is described in this 
paragraph (e)(3)(vii)(B) if the transaction is not described in 
paragraph (e)(3)(iv), (e)(3)(v), or (e)(3)(vi) of this section, and if 
the transaction is entered into, or made, with a principal purpose of 
achieving a tax benefit or result that would not be available absent an 
election under this section. Examples of these types of transactions 
include--
    (1) A transaction entered into with a principal purpose of shifting 
income or deductions among taxpayers in a manner that would not be 
possible absent an election under this section in order to take 
advantage of differing effective tax rates among the taxpayers; or
    (2) An election made under this section with a principal purpose of 
disposing of an asset from a general asset account in order to utilize 
an expiring net operating loss or credit if the transaction is not a 
bona fide disposition. The fact that a taxpayer with a net operating 
loss carryover or a credit carryover transfers an asset to a related 
person or transfers an asset pursuant to an arrangement where the asset 
continues to be used (or is available for use) by the taxpayer pursuant 
to a lease (or otherwise) indicates, absent strong evidence to the 
contrary, that the transaction is described in this paragraph 
(e)(3)(vii)(B).
    (f) Assets generating foreign source income--(1) In general. This 
paragraph (f) provides the rules for determining the source of any 
income, gain, or loss recognized, and the appropriate section 904(d) 
separate limitation category or categories for any foreign source 
income, gain, or loss recognized on a disposition (within the meaning 
of paragraph (e)(1) of this section) of an asset in a general asset 
account that consists of assets generating both United States and 
foreign source income. These rules apply only to a disposition to which 
paragraphs (e)(2) (general disposition rules), (e)(3)(ii) (disposition 
of all assets remaining in a general asset account), (e)(3)(iii) 
(disposition of an asset in a qualifying disposition), (e)(3)(v) 
(transactions subject to section 1031 or 1033), or (e)(3)(vii) (anti-
abuse rule) of this section applies.
    (2) Source of ordinary income, gain, or loss--(i) Source determined 
by allocation and apportionment of depreciation allowed. The amount of 
any ordinary income, gain, or loss that is recognized on the 
disposition of an asset in a general asset account must be apportioned 
between United States and foreign sources based on the allocation and 
apportionment of the--
    (A) Depreciation allowed for the general asset account as of the 
end of the taxable year in which the disposition occurs if paragraph 
(e)(2) of this section applies to the disposition;
    (B) Depreciation allowed for the general asset account as of the 
time of disposition if the taxpayer applies paragraph (e)(3)(ii) of 
this section to the disposition of all assets, or the last asset, in 
the general asset account, or if all the assets, or the last asset, in 
the general asset account are disposed of in a transaction described in 
paragraph (e)(3)(v)(A) of this section; or
    (C) Depreciation allowed for the asset disposed of for only the 
taxable year in which the disposition occurs if the taxpayer applies 
paragraph (e)(3)(iii) of this section to the disposition of the asset 
in a qualifying disposition, if the asset is disposed of in a 
transaction described in paragraph (e)(3)(v)(B) of this section (like-
kind exchange or involuntary conversion), or if the asset is disposed 
of in a transaction described in paragraph (e)(3)(vii) of this section 
(anti-abuse rule).
    (ii) Formula for determining foreign source income, gain, or loss. 
The amount of ordinary income, gain, or loss recognized on the 
disposition that shall be treated as foreign source income, gain, or 
loss must be determined under the formula in this paragraph (f)(2)(ii). 
For purposes of this formula, the allowed depreciation deductions are 
determined for the applicable time period provided in paragraph 
(f)(2)(i) of this section. The formula is:

Foreign Source Income, Gain, or Loss      =  Total Ordinary Income, Gain, or   x  Allowed Depreciation
 from the Disposition of an Asset.            Loss from the Disposition of         Deductions Allocated and
                                              an Asset.                            Apportioned to Foreign Source
                                                                                   Income/Total Allowed
                                                                                   Depreciation Deductions for
                                                                                   the General Asset Account or
                                                                                   for the Asset Disposed of (as
                                                                                   applicable).
 

     (3) Section 904(d) separate categories. If the assets in the 
general asset account generate foreign source income in more than one 
separate category under section 904(d)(1) or another section of the 
Internal Revenue Code (for example, income treated as foreign source 
income under section 904(g)(10)), or under a United States income tax 
treaty that requires the foreign tax credit limitation to be determined 
separately for specified types of income, the amount of ``foreign 
source income, gain, or loss from the disposition of an asset'' (as 
determined under the formula in paragraph (f)(2)(ii) of this section) 
must be allocated and apportioned to the applicable separate category 
or categories under the formula in this paragraph (f)(3). For purposes 
of this formula, the allowed depreciation deductions are determined for 
the applicable time period provided in paragraph (f)(2)(i) of this 
section. The formula is:

[[Page 81094]]



Foreign Source Income, Gain, or Loss in   =  Foreign Source Income, Gain, or   x  Allowed Depreciation
 a Separate Category.                         Loss from The Disposition of         Deductions Allocated and
                                              an Asset.                            Apportioned to a Separate
                                                                                   Category Total/Allowed
                                                                                   Depreciation Deductions and
                                                                                   Apportioned to Foreign Source
                                                                                   Income.
 

     (g) Assets subject to recapture. If the basis of an asset in a 
general asset account is increased as a result of the recapture of any 
allowable credit or deduction (for example, the basis adjustment for 
the recapture amount under section 30(d)(2), 50(c)(2), 168(l)(7), 
168(n)(4), 179(d)(10), 179A(e)(4), or 1400N(d)(5)), general asset 
account treatment for the asset terminates as of the first day of the 
taxable year in which the recapture event occurs. Consequently, the 
taxpayer must remove the asset from the general asset account as of 
that day and must make the adjustments to the general asset account 
described in paragraph (e)(3)(iii)(C)(2) through (4) of this section.
    (h) Changes in use--(1) Conversion to personal use. An asset in a 
general asset account becomes ineligible for general asset account 
treatment if a taxpayer uses the asset in a personal activity during a 
taxable year. Upon a conversion to personal use, the taxpayer must 
remove the asset from the general asset account as of the first day of 
the taxable year in which the change in use occurs (the year of change) 
and must make the adjustments to the general asset account described in 
paragraph (e)(3)(iii)(C)(2) through (4) of this section.
    (2) Business or income-producing use percentage changes. If, after 
the placed-in-service year, a taxpayer uses an asset in a general asset 
account both in a trade or business (or for the production of income) 
and in a personal activity, general asset account treatment for the 
asset terminates as of the first day of the taxable year in which the 
business (or income-producing) use percentage decreases. Consequently, 
the taxpayer must remove the asset from the general asset account as of 
that day and must make the adjustments to the general asset account 
described in paragraph (e)(3)(iii)(C)(2) through (4) of this section.
    (3) Change in use results in a different recovery period or 
depreciation method--(i) No effect on general asset account election. A 
change in the use described in Sec.  1.168(i)-4(d) (change in use 
results in a different recovery period or depreciation method) of an 
asset in a general asset account shall not cause or permit the 
revocation of the election made under this section.
    (ii) Asset is removed from the general asset account. Upon a change 
in the use described in Sec.  1.168(i)-4(d), the taxpayer must remove 
the asset from the general asset account as of the first day of the 
year of change (as defined in Sec.  1.168(i)-4(a)) and must make the 
adjustments to the general asset account described in paragraphs 
(e)(3)(iii)(C)(2) through (4) of this section. If, however, the result 
of the change in use is described in Sec.  1.168(i)-4(d)(3) (change in 
use results in a shorter recovery period or a more accelerated 
depreciation method) and the taxpayer elects to treat the asset as 
though the change in use had not occurred pursuant to Sec.  1.168(i)-
4(d)(3)(ii), no adjustment is made to the general asset account upon 
the change in use.
    (iii) New general asset account is established--(A) Change in use 
results in a shorter recovery period or a more accelerated depreciation 
method. If the result of the change in use is described in Sec.  
1.168(i)-4(d)(3) (change in use results in a shorter recovery period or 
a more accelerated depreciation method) and adjustments to the general 
asset account are made pursuant to paragraph (h)(3)(ii) of this 
section, the taxpayer must establish a new general asset account for 
the asset in the year of change in accordance with the rules in 
paragraph (c) of this section, except that the adjusted depreciable 
basis of the asset as of the first day of the year of change is 
included in the general asset account. For purposes of paragraph (c)(2) 
of this section, the applicable depreciation method, recovery period, 
and convention are determined under Sec.  1.168(i)-4(d)(3)(i).
    (B) Change in use results in a longer recovery period or a slower 
depreciation method. If the result of the change in use is described in 
Sec.  1.168(i)-4(d)(4) (change in use results in a longer recovery 
period or a slower depreciation method), the taxpayer must establish a 
separate general asset account for the asset in the year of change in 
accordance with the rules in paragraph (c) of this section, except that 
the unadjusted depreciable basis of the asset, and the greater of the 
depreciation of the asset allowed or allowable in accordance with 
section 1016(a)(2), as of the first day of the year of change are 
included in the newly established general asset account. Consequently, 
this general asset account as of the first day of the year of change 
will have a beginning balance for both the unadjusted depreciable basis 
and the depreciation reserve of the general asset account. For purposes 
of paragraph (c)(2) of this section, the applicable depreciation 
method, recovery period, and convention are determined under Sec.  
1.168(i)-4(d)(4)(ii).
    (i) Redetermination of basis. If, after the placed-in-service year, 
the unadjusted depreciable basis of an asset in a general asset account 
is redetermined due to a transaction other than that described in 
paragraph (g) of this section (for example, due to contingent purchase 
price or discharge of indebtedness), the taxpayer's election under 
paragraph (l) of this section for the asset also applies to the 
increase or decrease in basis resulting from the redetermination. For 
the taxable year in which the increase or decrease in basis occurs, the 
taxpayer must establish a new general asset account for the amount of 
the increase or decrease in basis in accordance with the rules in 
paragraph (c) of this section. For purposes of paragraph (c)(2) of this 
section, the applicable recovery period for the increase or decrease in 
basis is the recovery period of the asset remaining as of the beginning 
of the taxable year in which the increase or decrease in basis occurs, 
the applicable depreciation method and applicable convention for the 
increase or decrease in basis are the same depreciation method and 
convention applicable to the asset that applies for the taxable year in 
which the increase or decrease in basis occurs, and the increase or 
decrease in basis is deemed to be placed in service in the same taxable 
year as the asset.
    (j) Identification of disposed of or converted asset--(1) In 
general. The rules of this paragraph (j) apply when an asset in a 
general asset account is disposed of or converted in a transaction 
described in paragraphs (e)(3)(iii) (disposition of an asset in a 
qualifying disposition), (e)(3)(iv)(B) (transactions subject to section 
168(i)(7)), (e)(3)(v)(B) (transactions subject to section 1031 or 
1033), (e)(3)(vii) (anti-abuse rule), (g) (assets subject to 
recapture), (h)(1) (conversion to personal use), or (h)(2) (business or 
income-producing use percentage changes) of this section.

[[Page 81095]]

    (2) Identifying which asset is disposed of or converted. For 
purposes of identifying which asset in a general asset account is 
disposed of or converted, a taxpayer must identify the disposed of or 
converted asset by using--
    (i) The specific identification method of accounting. Under this 
method of accounting, the taxpayer can determine the particular taxable 
year in which the disposed of or converted asset was placed in service 
by the taxpayer;
    (ii) A first-in, first-out method of accounting if the taxpayer can 
readily determine from its records the total dispositions of assets 
with the same recovery period during the taxable year but the taxpayer 
cannot readily determine from its records the unadjusted depreciable 
basis of the disposed of or converted asset. Under this method of 
accounting, the taxpayer identifies the general asset account with the 
earliest placed-in-service year that has the same recovery period as 
the disposed of or converted asset and that has assets at the beginning 
of the taxable year of the disposition or conversion, and the taxpayer 
treats the disposed of or converted asset as being from that general 
asset account. To determine which general asset account has assets at 
the beginning of the taxable year of the disposition or conversion, the 
taxpayer reduces the number of assets originally included in the 
account by the number of assets disposed of or converted in any prior 
taxable year in a transaction to which this paragraph (j) applies;
    (iii) A modified first-in, first-out method of accounting if the 
taxpayer can readily determine from its records the total dispositions 
of assets with the same recovery period during the taxable year and the 
unadjusted depreciable basis of the disposed of or converted asset. 
Under this method of accounting, the taxpayer identifies the general 
asset account with the earliest placed-in-service year that has the 
same recovery period as the disposed of or converted asset and that has 
assets at the beginning of the taxable year of the disposition or 
conversion with the same unadjusted depreciable basis as the disposed 
of or converted asset, and the taxpayer treats the disposed of or 
converted asset as being from that general asset account. To determine 
which general asset account has assets at the beginning of the taxable 
year of the disposition or conversion, the taxpayer reduces the number 
of assets originally included in the account by the number of assets 
disposed of or converted in any prior taxable year in a transaction to 
which this paragraph (j) applies;
    (iv) A mortality dispersion table if the asset is a mass asset 
accounted for in a separate general asset account in accordance with 
paragraph (c)(2)(ii)(H) of this section and if the taxpayer can readily 
determine from its records the total dispositions of assets with the 
same recovery period during the taxable year. The mortality dispersion 
table must be based upon an acceptable sampling of the taxpayer's 
actual disposition and conversion experience for mass assets or other 
acceptable statistical or engineering techniques. To use a mortality 
dispersion table, the taxpayer must adopt recordkeeping practices 
consistent with the taxpayer's prior practices and consonant with good 
accounting and engineering practices; or
    (v) Any other method as the Secretary may designate by publication 
in the Federal Register or in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2) of this chapter) on or after December 23, 2011. For this 
purpose, a last-in, first-out method of accounting is not a designated 
method. Under the last-in, first-out method of accounting, the taxpayer 
identifies the general asset account with the most recent placed-in-
service year that has the same recovery period as the disposed of or 
converted asset and that has assets at the beginning of the taxable 
year of the disposition or conversion, and the taxpayer treats the 
disposed of or converted asset as being from that general asset 
account. To determine which general asset account has assets at the 
beginning of the taxable year of the disposition or conversion, the 
taxpayer reduces the number of assets originally included in the 
account by the number of assets disposed of or converted in any prior 
taxable year in a transaction to which this paragraph (j) applies.
    (3) Basis of disposed of or converted asset. After identifying 
which asset in a general asset account is disposed of or converted, the 
taxpayer may use any reasonable method that is consistently applied to 
all its general asset accounts for purposes of determining the 
unadjusted depreciable basis of a disposed of or converted asset.
    (k) Effect of adjustments on prior dispositions. The adjustments to 
a general asset account under paragraph (e)(3)(iii), (e)(3)(iv), 
(e)(3)(v), (e)(3)(vii), (g), or (h) of this section have no effect on 
the recognition and character of prior dispositions subject to 
paragraph (e)(2) of this section.
    (l) Election--(1) Irrevocable election. If a taxpayer makes an 
election under this paragraph (l), the taxpayer consents to, and agrees 
to apply, all of the provisions of this section to the assets included 
in a general asset account. Except as provided in paragraph 
(c)(1)(ii)(A), (e)(3), (g), or (h) of this section, an election made 
under this section is irrevocable and will be binding on the taxpayer 
for computing taxable income for the taxable year for which the 
election is made and for all subsequent taxable years. An election 
under this paragraph (l) is made separately by each person owning an 
asset to which this section applies (for example, by each member of a 
consolidated group, at the partnership level (and not by the partner 
separately), or at the S corporation level (and not by the shareholder 
separately)).
    (2) [Reserved]. For further guidance, see Sec.  1.168(i)-1(l)(2).
    (3) [Reserved]. For further guidance, see Sec.  1.168(i)-1(l)(3).
    (m) Effective/applicability date--(1) In general. This section 
applies to taxable years beginning on or after January 1, 2012. For the 
applicability of Sec.  1.168(i)-1 in taxable years beginning before 
January 1, 2012, see Sec.  1.168(i)-1 in effect prior to January 1, 
2012 (Sec.  1.168(i)-1 as contained in 26 CFR part 1 edition revised as 
of April 1, 2011).
    (2) Change in method of accounting. A change to comply with this 
section for depreciable assets placed in service in a taxable year 
ending on or after December 30, 2003, is a change in method of 
accounting to which the provisions of section 446(e) and the 
regulations under section 446(e) apply. A taxpayer also may treat a 
change to comply with this section for depreciable assets placed in 
service in a taxable year ending before December 30, 2003, as a change 
in method of accounting to which the provisions of section 446(e) and 
the regulations under section 446(e) apply.
    (3) The applicability of this section expires on December 23, 2014.


0
Par. 21. Section 1.168(i)-7T is added to read as follows:


Sec.  1.168(i)-7T  Accounting for MACRS property (temporary).

    (a) In general. A taxpayer may account for MACRS property (as 
defined in Sec.  1.168(b)-1(a)(2)) by treating each individual asset as 
an account (a ``single asset account'' or an ``item account'') or by 
combining two or more assets in a single account (a ``multiple asset 
account'' or a ``pool''). A taxpayer may establish as many accounts for 
MACRS property as the taxpayer wants. This section does not apply to 
assets included in general asset accounts. For rules applicable to 
general asset accounts, see Sec.  1.168(i)-1T.

[[Page 81096]]

    (b) Required use of single asset accounts. A taxpayer must account 
for an asset in a single asset account if the taxpayer uses the asset 
both in a trade or business (or for the production of income) and in a 
personal activity, or if the taxpayer places in service and disposes of 
the asset during the same taxable year. Also, if general asset account 
treatment for an asset terminates under Sec.  1.168(i)-1T(c)(1)(ii)(A), 
(e)(3)(iii), (e)(3)(vii), (g), or (h)(2), the taxpayer must account for 
the asset in a single asset account beginning in the taxable year in 
which the general asset account treatment for the asset terminates. If 
a taxpayer accounts for an asset in a multiple asset account or pool 
treatment and the taxpayer disposes of the asset, the taxpayer must 
account for the asset in a single asset account beginning in the 
taxable year in which the disposition occurs. See Sec.  1.168(i)-
8T(g)(2)(i). If a taxpayer disposes of a component of a larger asset 
and the unadjusted depreciable basis of the disposed of component is 
included in the unadjusted depreciable basis of the larger asset, the 
taxpayer must account for the component in a single asset account 
beginning in the taxable year in which the disposition occurs. See 
Sec.  1.168(i)-8T(g)(3)(i).
    (c) Establishment of multiple asset accounts or pools--(1) Assets 
eligible for multiple asset accounts or pools. Except as provided in 
paragraph (b) of this section, assets that are subject to either the 
general depreciation system of section 168(a) or the alternative 
depreciation system of section 168(g) may be accounted for in one or 
more multiple asset accounts or pools.
    (2) Grouping assets in multiple asset accounts or pools--(i) 
General rules. Assets that are eligible to be grouped into a single 
multiple asset account or pool may be divided into more than one 
multiple asset account or pool. Each multiple asset account or pool 
must include only assets that--
    (A) Have the same applicable depreciation method;
    (B) Have the same applicable recovery period;
    (C) Have the same applicable convention; and
    (D) Are placed in service by the taxpayer in the same taxable year.
    (ii) Special rules. In addition to the general rules in paragraph 
(c)(2)(i) of this section, the following rules apply when establishing 
multiple asset accounts or pools--
    (A) Assets subject to the mid-quarter convention may only be 
grouped into a multiple asset account or pool with assets that are 
placed in service in the same quarter of the taxable year;
    (B) Assets subject to the mid-month convention may only be grouped 
into a multiple asset account or pool with assets that are placed in 
service in the same month of the taxable year;
    (C) Passenger automobiles for which the depreciation allowance is 
limited under section 280F(a) must be grouped into a separate multiple 
asset account or pool;
    (D) Assets not eligible for any additional first year depreciation 
deduction (including assets for which the taxpayer elected not to 
deduct the additional first year depreciation) provided by, for 
example, section 168(k) through (n), 1400L(b), or 1400N(d), must be 
grouped into a separate multiple asset account or pool;
    (E) Assets eligible for the additional first year depreciation 
deduction may only be grouped into a multiple asset account or pool 
with assets for which the taxpayer claimed the same percentage of the 
additional first year depreciation (for example, 30 percent, 50 
percent, or 100 percent);
    (F) Except for passenger automobiles described in paragraph 
(c)(2)(ii)(C) of this section, listed property (as defined in section 
280F(d)(4)) must be grouped into a separate multiple asset account or 
pool;
    (G) Assets for which the depreciation allowance for the placed-in-
service year is not determined by using an optional depreciation table 
(for further guidance, see section 8 of Rev. Proc. 87-57, 1987-2 CB 
687, 693 (see Sec.  601.601(d)(2) of this chapter) must be grouped into 
a separate multiple asset account or pool; and
    (H) Mass assets (as defined in Sec.  1.168(i)-8T(b)(2)) that are or 
will be subject to Sec.  1.168-8T(f)(2)(ii) (disposed of or converted 
mass asset is identified by a mortality dispersion table) must be 
grouped into a separate multiple asset account or pool.
    (d) Cross references. See Sec.  1.167(a)-7T(c) for the records to 
be maintained by a taxpayer for each account. In addition, see Sec.  
1.168(i)-1T for the records to be maintained by a taxpayer for each 
general asset account.
    (e) Effective/applicability date--(1) This section applies to 
taxable years beginning on or after January 1, 2012.
    (2) Change in method of accounting. A change to comply with this 
section for depreciable assets placed in service in a taxable year 
ending on or after December 30, 2003, is a change in method of 
accounting to which the provisions of section 446(e) and the 
regulations under section 446(e) apply. A taxpayer also may treat a 
change to comply with this section for depreciable assets placed in 
service in a taxable year ending before December 30, 2003, as a change 
in method of accounting to which the provisions of section 446(e) and 
the regulations under section 446(e) apply.
    (3) Expiration date. The applicability of this section expires on 
December 23, 2014.
0
Par. 22. Section 1.168(i)-8T is added to read as follows:


Sec.  1.168(i)-8T  Dispositions of MACRS property (temporary).

    (a) Scope. This section provides rules applicable to dispositions 
of MACRS property (as defined in Sec.  1.168(b)-1(a)(2)) or to 
depreciable property (as defined in Sec.  1.168(b)-1(a)(1)) that would 
be MACRS property but for an election made by the taxpayer either to 
expense all or some of the property's cost under section 179, 179A, 
179B, 179C, 179D, or 1400I(a)(1), or any similar provision, or to 
amortize all or some of the property's cost under section 1400I(a)(2) 
or any similar provision. Except as provided in Sec.  1.168(i)-
1T(e)(iii), this section does not apply to dispositions of assets 
included in a general asset account. For rules applicable to 
dispositions of assets included in a general asset account, see Sec.  
1.168(i)-1T(e).
    (b) Definitions. For purposes of this section--
    (1) Disposition occurs when ownership of the asset is transferred 
or when the asset is permanently withdrawn from use either in the 
taxpayer's trade or business or in the production of income. A 
disposition includes the sale, exchange, retirement, physical 
abandonment, or destruction of an asset. A disposition also includes 
the retirement of a structural component (as defined in Sec.  1.48-
1(e)(2)) of a building (as defined in Sec.  1.48-1(e)(1)). A 
disposition also occurs when an asset is transferred to a supplies, 
scrap, or similar account.
    (2) Mass assets is a mass or group of individual items of 
depreciable assets--
    (i) That are not necessarily homogenous;
    (ii) Each of which is minor in value relative to the total value of 
the mass or group;
    (iii) Numerous in quantity;
    (iv) Usually accounted for only on a total dollar or quantity 
basis;
    (v) With respect to which separate identification is impracticable; 
and
    (vi) Placed in service in the same taxable year.
    (3) Unadjusted depreciable basis of the multiple asset account or 
pool is the sum of the unadjusted depreciable bases (as defined in 
Sec.  1.168(b)-1(a)(3)) of all assets included in the multiple asset 
account or pool.

[[Page 81097]]

    (c) Special rules--(1) Manner of disposition. The manner of 
disposition (for example, normal retirement, abnormal retirement, 
ordinary retirement, or extraordinary retirement) is not taken into 
account in determining whether a disposition occurs or gain or loss is 
recognized.
    (2) Disposition by transfer to a supplies account. If a taxpayer 
made an election under Sec.  1.162-3T(d) to treat the cost of any 
material and supply as a capital expenditure subject to the allowance 
for depreciation, the taxpayer can dispose of the material and supply 
by transferring it to a supplies account only if the taxpayer has 
obtained the consent of the Commissioner to revoke the Sec.  1.162-
3T(d) election. See Sec.  1.162-3T(d)(3) for the procedures for 
revoking a Sec.  1.162-3T(d) election.
    (3) Leasehold improvements. This section also applies to--
    (i) A lessor of leased property that made an improvement to that 
property for the lessee of the property, has a depreciable basis in the 
improvement, and disposes of the improvement before or upon the 
termination of the lease with the lessee. See section 168(i)(8)(B); and
    (ii) A lessee of leased property that made an improvement to that 
property, has a depreciable basis in the improvement, and disposes of 
the improvement before or upon the termination of the lease.
    (4) Determination of asset disposed of--(i) In general. For 
purposes of applying this section, the facts and circumstances of each 
disposition are considered in determining what is the appropriate asset 
disposed of. Except as provided in paragraph (c)(4)(ii) of this 
section, the asset for disposition purposes cannot be larger than the 
unit of property as determined under Sec.  1.263(a)-3T(e)(2), (e)(3), 
and (e)(5) or as otherwise determined in published guidance in the 
Federal Register or in the Internal Revenue Bulletin (see, for example, 
Rev. Proc. 2011-38, 2011-18 IRB 743, for units of property for wireless 
network assets (see Sec.  601.601(d)(2)(ii)(b) of this chapter)).
    (ii) Exceptions. For purposes of applying this section:
    (A) Each building (not including its structural components) is the 
asset except as provided in Sec.  1.1250-1(a)(2)(ii) or in paragraph 
(c)(4)(ii)(B) or (E) of this section.
    (B) If a building has two or more condominium or cooperative units, 
each condominium or cooperative unit (not including its structural 
components) is the asset except as provided in Sec.  1.1250-1(a)(2)(ii) 
or in paragraph (c)(4)(ii)(E) of this section.
    (C) Each structural component (including all components thereof) of 
a building, condominium unit, or cooperative unit is the asset.
    (D) If a taxpayer properly includes an item in one of the asset 
classes 00.11 through 00.4 of Rev. Proc. 87-56 (1987-2 CB 674) (see 
Sec.  601.601(d)(2)(ii)(b) of this chapter) or properly classifies an 
item in one of the categories under section 168(e)(3) (except for a 
category that includes buildings or structural components; for example, 
retail motor fuels outlet, qualified leasehold improvement property, 
qualified restaurant property, and qualified retail improvement 
property), each item is the asset provided it is not larger than the 
unit of property as determined under Sec.  1.263(a)-3T(e)(3) or (e)(5) 
or as otherwise determined in published guidance in the Federal 
Register or in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), or provided paragraph 
(c)(4)(ii)(E) of this section does not apply to the item. For example, 
each desk is the asset, each computer is the asset, and each qualified 
smart electric meter is the asset (assuming these assets are not larger 
than the unit of property as determined under Sec.  1.263(a)-3T(e)(3) 
or (e)(5) or as otherwise determined in published guidance in the 
Federal Register or in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter)).
    (E) If the taxpayer places in service an improvement or addition to 
an asset after the taxpayer placed the asset in service, the 
improvement or addition is a separate asset provided it is not larger 
than the unit of property as determined under Sec.  1.263(a)-3T(e)(3) 
or (e)(5) or as otherwise determined in published guidance in the 
Federal Register or in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter).
    (E) If an asset is not described in one of the asset classes 00.11 
through 00.4 of Rev. Proc. 87-56 (1987-2 CB 674) (see Sec.  
601.601(d)(2)(ii)(b) of this chapter) or in one of the categories under 
section 168(e)(3), a taxpayer also may use any reasonable, consistent 
method to treat each of the asset's components as the asset.
    (d) Gain or loss on dispositions. Except as provided by section 
280B and Sec.  1.280B-1, the following rules apply when assets within 
the scope of this section are disposed of during a taxable year:
    (1) If an asset is disposed of by sale, exchange, or involuntary 
conversion, gain or loss must be recognized under the applicable 
provisions of the Internal Revenue Code.
    (2) If an asset is disposed of by physical abandonment, loss must 
be recognized in the amount of the adjusted depreciable basis (as 
defined in Sec.  1.168(b)-1(a)(4)) of the asset at the time of the 
abandonment (taking into account the applicable convention). However, 
if the abandoned asset is subject to nonrecourse indebtedness, 
paragraph (d)(1) of this section applies to the asset (instead of this 
paragraph (d)(2)). For a loss from physical abandonment to qualify for 
recognition under this paragraph (d)(2), the taxpayer must intend to 
discard the asset irrevocably so that the taxpayer will neither use the 
asset again nor retrieve it for sale, exchange, or other disposition.
    (3) If an asset is disposed of other than by sale, exchange, 
involuntary conversion, physical abandonment, or conversion to personal 
use (as, for example, when the asset is transferred to a supplies or 
scrap account), gain is not recognized. Loss must be recognized in the 
amount of the excess of the adjusted depreciable basis of the asset at 
the time of the disposition (taking into account the applicable 
convention) over the asset's fair market value at the time of the 
disposition (taking into account the applicable convention).
    (e) Basis of asset disposed of--(1) In general. The adjusted basis 
of an asset disposed of for computing gain or loss is its adjusted 
depreciable basis at the time of the asset's disposition (as determined 
under the applicable convention for the asset).
    (2) Assets disposed of are in multiple asset accounts or are 
components. If the taxpayer accounts for the asset disposed of in a 
multiple asset account or pool, or the asset disposed of is a component 
of a larger asset and it is impracticable from the taxpayer's records 
to determine the unadjusted depreciable basis (as defined in Sec.  
1.168(b)-1(a)(3)) of the asset disposed of, the taxpayer may use any 
reasonable method that is consistently applied to the taxpayer's 
multiple asset accounts or pools or to the taxpayer's larger assets for 
purposes of determining the unadjusted depreciable basis of assets 
disposed of. To determine the adjusted depreciable basis of an asset 
disposed of in a multiple asset account, the depreciation allowed or 
allowable for the asset disposed of is computed by using the 
depreciation method, recovery period, and convention applicable to the 
multiple asset account or pool in which the asset disposed of was 
included and by including the additional first year depreciation 
deduction claimed for the asset disposed of. To determine the adjusted 
depreciable basis of an asset disposed of that is a component of a 
larger asset, the depreciation allowed or

[[Page 81098]]

allowable for the asset disposed of is computed by using the 
depreciation method, recovery period, and convention applicable to the 
larger asset of which the asset disposed of is a component and by 
including the portion of the additional first year depreciation 
deduction claimed for the larger asset that is attributable to the 
asset disposed of.
    (f) Identification of asset disposed of--(1) In general. Except as 
provided in paragraph (f)(2) of this section, a taxpayer must use the 
specific identification method of accounting to identify which asset is 
disposed of by the taxpayer. Under this method of accounting, the 
taxpayer can determine the particular taxable year in which the asset 
disposed of was placed in service by the taxpayer.
    (2) Asset disposed of is in a multiple asset account. If a taxpayer 
accounts for the asset disposed of in a multiple asset account or pool 
and the total dispositions of assets with the same recovery period 
during the taxable year are readily determined from the taxpayer's 
records but it is impracticable from the taxpayer's records to 
determine the particular taxable year in which the asset disposed of 
was placed in service by the taxpayer, the taxpayer may identify the 
asset disposed of by using--
    (i) A first-in, first-out method of accounting if the unadjusted 
depreciable basis of the asset disposed of cannot be readily determined 
from the taxpayer's records. Under this method of accounting, the 
taxpayer identifies the multiple asset account or pool with the 
earliest placed-in-service year that has the same recovery period as 
the asset disposed of and that has assets at the beginning of the 
taxable year of the disposition, and the taxpayer treats the asset 
disposed of as being from that multiple asset account or pool;
    (ii) A modified first-in, first-out method of accounting if the 
unadjusted depreciable basis of the asset disposed of can be readily 
determined from the taxpayer's records. Under this method of 
accounting, the taxpayer identifies the multiple asset account or pool 
with the earliest placed-in-service year that has the same recovery 
period as the asset disposed of and that has assets at the beginning of 
the taxable year of the disposition with the same unadjusted 
depreciable basis as the asset disposed of, and the taxpayer treats the 
asset disposed of as being from that multiple asset account or pool;
    (iii) A mortality dispersion table if the asset disposed of is a 
mass asset. The mortality dispersion table must be based upon an 
acceptable sampling of the taxpayer's actual disposition experience for 
mass assets or other acceptable statistical or engineering techniques. 
To use a mortality dispersion table, the taxpayer must adopt 
recordkeeping practices consistent with the taxpayer's prior practices 
and consonant with good accounting and engineering practices; or
    (iv) Any other method as the Secretary may designate by publication 
in the Federal Register or in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2) of this chapter) on or after December 23, 2011. For this 
purpose, a last-in, first-out method of accounting is not a designated 
method. Under the last-in, first-out method of accounting, the taxpayer 
identifies the multiple asset account or pool with the most recent 
placed-in-service year that has the same recovery period as the asset 
disposed of and that has assets at the beginning of the taxable year of 
the disposition, and the taxpayer treats the asset disposed of as being 
from that multiple asset account or pool.
    (g) Accounting for asset disposed of--(1) Depreciation ends. 
Depreciation ends for an asset at the time of the asset's disposition 
(as determined under the applicable convention for the asset). See 
Sec.  1.167(a)-10(b). If the asset disposed of is in a single asset 
account, the single asset account terminates at the time of the asset's 
disposition (as determined under the applicable convention for the 
asset).
    (2) Asset disposed of in a multiple asset account or pool. If the 
taxpayer accounts for the asset disposed of in a multiple asset account 
or pool, then--
    (i) As of the first day of the taxable year in which the 
disposition occurs, the asset disposed of is removed from the multiple 
asset account or pool and is placed into a single asset account. See 
Sec.  1.168(i)-7T(b);
    (ii) The unadjusted depreciable basis of the multiple asset account 
or pool must be reduced by the unadjusted depreciable basis of the 
asset disposed of as of the first day of the taxable year in which the 
disposition occurs. See paragraph (e)(2) of this section for 
determining the unadjusted depreciable basis of the asset disposed of;
    (iii) The depreciation reserve of the multiple asset account or 
pool must be reduced by the depreciation allowed or allowable for the 
asset disposed of as of the end of the taxable year immediately 
preceding the year of disposition, computed by using the depreciation 
method, recovery period, and convention applicable to the multiple 
asset account or pool in which the asset disposed of was included and 
by including the additional first year depreciation deduction claimed 
for the asset disposed of; and
    (iv) In determining the adjusted depreciable basis of the asset 
disposed of at the time of disposition (taking into account the 
applicable convention), the depreciation allowed or allowable for the 
asset disposed of is computed by using the depreciation method, 
recovery period, and convention applicable to the multiple asset 
account or pool in which the asset disposed of was included and by 
including the additional first year depreciation deduction claimed for 
the asset disposed of.
    (3) Disposed of component of a larger asset. This paragraph (g)(3) 
applies only to a taxpayer that uses a reasonable, consistent method to 
treat each of the asset's components as the asset in accordance with 
paragraph (c)(4)(E) of this section. If the taxpayer disposes of a 
component of a larger asset and the unadjusted depreciable basis of the 
disposed component is included in the unadjusted depreciable basis of 
the larger asset, then--
    (i) As of the first day of the taxable year in which the 
disposition occurs, the disposed of component is removed from the 
larger asset and is placed into a single asset account. See Sec.  
1.168(i)-7T(b);
    (ii) The unadjusted depreciable basis of the larger asset must be 
reduced by the unadjusted depreciable basis of the disposed of 
component as of the first day of the taxable year in which the 
disposition occurs. See paragraph (e)(2) of this section for 
determining the unadjusted depreciable basis of the disposed of 
component;
    (iii) The depreciation reserve of the larger asset must be reduced 
by the depreciation allowed or allowable for the disposed of component 
as of the end of the taxable year immediately preceding the year of 
disposition, computed by using the depreciation method, recovery 
period, and convention applicable to the larger asset in which the 
disposed of component was included and by including the portion of the 
additional first year depreciation deduction claimed for the larger 
asset that is attributable to the disposed of component; and
    (iv) In determining the adjusted depreciable basis of the disposed 
of component at the time of disposition (taking into account the 
applicable convention), the depreciation allowed or allowable for the 
asset disposed of is computed by using the depreciation method, 
recovery period, and convention applicable to the larger asset in which 
the disposed of component was included and by including the portion of 
the additional first year depreciation deduction claimed for the

[[Page 81099]]

larger asset that is attributable to the disposed of component.
    (h) Examples. The application of this section is illustrated by the 
following examples:

    Example 1.  A owns an office building with four elevators. A 
decides to replace one of the elevators. The retirement of the 
replaced elevator, which is a structural component of the building, 
is a disposition. As a result, depreciation for the retired elevator 
ceases at the time of its retirement (taking into account the 
applicable convention). A recognizes a loss upon this retirement.
    Example 2.  B, a calendar-year commercial airline company, owns 
several aircrafts that are used in the commercial carrying of 
passengers. B replaces the existing engines on one of the aircrafts 
with new engines and treats each engine of an aircraft as a major 
component of the aircraft. Assume each aircraft is a unit of 
property as determined under Sec.  1.263(a)-3T(e)(3). However, for 
tax disposition purposes, B consistently treats each major component 
of an aircraft as the asset. Thus, the retirement of the replaced 
engines is a disposition. As a result, depreciation for the retired 
engines ceases at the time of their retirement (taking into account 
the applicable convention). B recognizes a loss upon this 
retirement.
    Example 3.  The facts are the same as in Example 2, except B 
treats each aircraft as the asset for tax disposition purposes. 
Assume each aircraft is a unit of property as determined under Sec.  
1.263(a)-3T(e)(3). Thus, the replacement of the engines on one of 
the aircrafts is not a disposition. As a result, depreciation 
continues for the cost of the aircraft (including the cost of the 
replaced engines) and B does not recognize a loss upon this 
replacement.
    Example 4.  C, a corporation, owns several trucks that are used 
in its trade or business and described in asset class 00.241 of Rev. 
Proc. 87-56. C replaces the engine on one of the trucks with a new 
engine and treats each engine of a truck as a major component of the 
truck. Assume each truck is a unit of property as determined under 
Sec.  1.263(a)-3T(e)(3). Because the trucks are described in asset 
class 00.241 of Rev. Proc. 87-56, C must treat each truck as the 
asset for tax disposition purposes. Thus, the replacement of the 
engine on the truck is not a disposition. As a result, depreciation 
continues for the cost of the truck (including the cost of the 
replaced engine) and C does not recognize a loss upon this 
replacement.
    Example 5.  (i) On July 1, 2009, D, a calendar-year taxpayer, 
purchased and placed in service a multi-story office building that 
costs $20,000,000. The cost of each structural component of the 
building was not separately stated. D accounts for the building in 
its records as a single asset with a cost of $20,000,000. D 
depreciates the building as nonresidential real property and uses 
the optional depreciation table that corresponds with the general 
depreciation system, the straight-line method, a 39-year recovery 
period, and the mid-month convention. As of January 1, 2012, the 
depreciation reserve for the building is $1,261,000.
    (ii) On June 30, 2012, D replaces one of the building's 
elevators. Because D cannot identify the cost of the structural 
components of the office building from its records, D uses a 
reasonable method that is consistently applied to all of the 
structural components of the office building to determine the cost 
of the elevator. Using this reasonable method, D allocates $150,000 
of the $20,000,000 purchase price for the building to the retired 
elevator. Using the optional depreciation table that corresponds 
with the general depreciation system, the straight-line method, a 
39-year recovery period, and the mid-month convention, the 
depreciation allowed or allowable for the retired elevator as of 
December 31, 2011, is $9,457.50.
    (iii) For D's 2012 Federal income tax return, loss for the 
retired elevator is determined as follows. The depreciation allowed 
or allowable for 2012 for the retired elevator is $1,923 
((unadjusted depreciable basis of $150,000 x depreciation rate of 
2.564 percent for 2012) x 6/12). Thus, the adjusted depreciable 
basis of the retired elevator is $138,619.50 (the adjusted 
depreciable basis of $140,542.50 removed from the building cost less 
the depreciation allowed or allowable of $1,923 for 2012). As a 
result, D recognizes a loss of $138,619.50 for the retired elevator 
in 2012, which is subject to section 1231.
    (iv) For D's 2012 Federal income tax return, the depreciation 
allowance for the building is computed as follows. As of January 1, 
2012, the unadjusted depreciable basis of the building is reduced 
from $20,000,000 to $19,850,000 ($20,000,000 less the unadjusted 
depreciable basis of $150,000 for the retired elevator), and the 
depreciation reserve of the building is reduced from $1,261,000 to 
$1,251,542.50 ($1,261,000 less the depreciation allowed or allowable 
of $9,457.50 for the retired elevator as of December 31, 2011). 
Consequently, the depreciation allowance for the building for 2012 
is $508,954 ($19,850,000 x depreciation rate of 2.564 percent for 
2012).
    Example 6.  (i) Since 2003, E, a calendar year taxpayer, has 
accounted for items of MACRS property that are mass assets in pools. 
Each pool includes only the mass assets that have the same 
depreciation method, recovery period, and convention, and are placed 
in service by E in the same taxable year. None of the pools are 
general asset accounts under section 168(i)(4) and the regulations 
under section 168(i)(4). E identifies any dispositions of these mass 
assets by specific identification.
    (ii) During 2012, E sells 10 items of mass assets with a 5-year 
recovery period each for $100. Under the specific identification 
method, E identifies these mass assets as being from the pool 
established by E in 2010 for mass assets with a 5-year recovery 
period. Assume E depreciates this pool using the optional 
depreciation table that corresponds with the general depreciation 
system, the 200-percent declining balance method, a 5-year recovery 
period, and the half-year convention. E elected not to deduct the 
additional first year depreciation provided by section 168(k) for 5-
year property placed in service during 2010. As of January 1, 2012, 
this pool contains 100 similar items of mass assets with a total 
cost of $25,000 and a total depreciation reserve of $13,000. Thus, E 
allocates a cost of $250 ($25,000 x (1/100)) to each disposed of 
mass asset and depreciation allowed or allowable of $130 ($13,000 x 
(1/100)) to each disposed of mass asset. The depreciation allowed or 
allowable in 2012 for each disposed of mass asset is $24 [($250 x 
19.2 percent)/2]. As a result, the adjusted depreciable basis of 
each disposed of mass asset under section 1011 is $96 ($250-$130-
$24). Thus, E recognizes a gain of $4 for each disposed of mass 
asset in 2012, which is subject to section 1245.
    (iii) Further, as of January 1, 2012, the unadjusted depreciable 
basis of the 2010 pool of mass assets with a 5-year recovery period 
is reduced from $25,000 to $22,500 ($25,000 less the unadjusted 
depreciable basis of $2,500 for the 10 disposed of items), and the 
depreciation reserve of this 2010 pool is reduced from $13,000 to 
$11,700 ($13,000 less the depreciation allowed or allowable of 
$1,300 for the 10 disposed of items as of December 31, 2011). 
Consequently, as of January 1, 2012, the 2010 pool of mass assets 
with a 5-year recovery period has 90 items with a total cost of 
$22,500 and a depreciation reserve of $11,700. Thus, the 
depreciation allowance for this pool for 2012 is $4,320 ($22,500 x 
19.2 percent).

    Example 7.  (i) Same facts as in Example 6. Because of changes 
in E's recordkeeping in 2013, it is impracticable for E to continue 
to identify disposed of mass assets using specific identification 
and to determine the unadjusted depreciable basis of the disposed of 
mass assets. As a result, E files a Form 3115, Application for 
Change in Accounting Method, to change to a first-in, first-out 
method beginning with the taxable year beginning on January 1, 2013, 
on a modified cut-off basis. See Sec.  1.446-1(e)(2)(ii)(d)(2)(vii). 
Under the first-in, first-out method, the mass assets disposed of in 
a taxable year are deemed to be from the pool with the earliest 
placed-in-service year that has assets as of the beginning of the 
taxable year of the disposition with the same recovery period as the 
asset disposed of. The Commissioner of Internal Revenue consents to 
this change in method of accounting.
    (ii) During 2013, E sells 20 items of mass assets with a 5-year 
recovery period each for $50. As of January 1, 2013, the 2006 pool 
is the pool with the earliest placed-in-service year for mass assets 
with a 5-year recovery period, and this pool contains 25 items of 
mass assets with a total cost of $10,000 and a total depreciation 
reserve of $10,000. Thus, E allocates a cost of $400 ($10,000 x (1/
25)) to each disposed of mass asset and depreciation allowed or 
allowable of $400 to each disposed of mass asset. As a result, the 
adjusted depreciable basis of each disposed of mass asset is $0. 
Thus, E recognizes a gain of $50 for each disposed of mass asset in 
2013, which is subject to section 1245.
    (iii) Further, as of January 1, 2013, the unadjusted depreciable 
basis of the 2006 pool of mass assets with a 5-year recovery period 
is reduced from $10,000 to $2,000 ($10,000 less the unadjusted 
depreciable basis of $8,000 for the 20 disposed of items ($400 x 
20)), and the depreciation reserve of this 2006 pool is reduced from 
$10,000 to $2,000 ($10,000 less the depreciation allowed or 
allowable of $8,000 for the 20 disposed of

[[Page 81100]]

items as of December 31, 2012). Consequently, as of January 1, 2013, 
the 2006 pool of mass assets with a 5-year recovery period has 5 
items with a total cost of $2,000 and a depreciation reserve of 
$2,000.
    (i) Effective/applicability date. (1) This section applies to 
taxable years beginning on or after January 1, 2012.
    (2) Change in method of accounting. A change to comply with this 
section for depreciable assets placed in service in a taxable year 
ending on or after December 30, 2003, is a change in method of 
accounting to which the provisions of section 446(e) and the 
regulations under section 446(e) apply. A taxpayer also may treat a 
change to comply with this section for depreciable assets placed in 
service in a taxable year ending before December 30, 2003, as a change 
in method of accounting to which the provisions of section 446(e) and 
the regulations under section 446(e) apply.
    (3) Expiration Date. The applicability of this section expires on 
December 23, 2014.

0
Par. 23. Section 1.263(a)-0 is amended by:
0
1. Revising the section headings of the table of contents for 
Sec. Sec.  1.263(a)-2 and 1.263(a)-3.
0
2. Adding entries to the table of contents for Sec. Sec.  1.263(a)-1, 
1.263(a)-2, and 1.263(a)-3.
    The revisions and additions read as follows:


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

* * * * *


Sec.  1.263(a)-1  Capital expenditures; in general.

    (a) through (h) [Reserved]. For further guidance, see the table of 
contents for Sec.  1.263(a)-1T(a) through (h) under Sec.  1.263(a)-0T.


Sec.  1.263(a)-2  Amounts paid to acquire or produce tangible property.

    (a) through (i) [Reserved]. For further guidance, see the table of 
contents for Sec.  1.263(a)-2T(a) through (i) under Sec.  1.263(a)-0T.


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

    (a) through (q) [Reserved]. For further guidance, see the table of 
contents for Sec.  1.263(a)-3T(a) though (q) under Sec.  1.263(a)-0T.
* * * * *

0
Par. 24. Section 1.263(a)-0T is added to read as follows:


Sec.  1.263(a)-0T  Table of contents (temporary).

    This section lists the table of contents for Sec. Sec.  1.263(a)-
1T, 1.263(a)-2T, and 1.263(a)-3T.


Sec.  1.263(a)-1T  Capital expenditures; in general (temporary).

    (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) Accounting method changes.
    (g) Effective/applicability date.
    (h) Expiration date.


Sec.  1.263(a)-2T  Amounts paid to acquire or produce tangible property 
(temporary).

    (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) Requirement to capitalize.
    (2) Examples.
    (e) Defense or perfection of title to property.
    (1) In general.
    (2) Examples.
    (f) Transaction costs.
    (1) In general.
    (2) Scope of facilitate.
    (i) In general.
    (ii) Inherently facilitative amounts.
    (iii) Special rule for acquisitions of real property.
    (A) In general.
    (B) Acquisitions of real and personal property in a single 
transaction.
    (iv) Employee compensation and overhead costs.
    (A) In general.
    (B) Election to capitalize.
    (3) Treatment of transaction costs.
    (i) In general.
    (ii) Treatment of inherently facilitative amounts.
    (4) Examples.
    (g) De minimis rule.
    (1) In general.
    (2) Exceptions to de minimis rule.
    (3) Additional rules.
    (4) Election to capitalize.
    (5) Materials and supplies.
    (6) Definition of applicable financial statement.
    (7) Application to consolidated group member.
    (8) Examples.
    (h) Treatment of capital expenditures.
    (i) Recovery of capitalized amounts.
    (1) In general.
    (2) Examples.
    (j) Accounting method changes.
    (k) Effective/applicability date.
    (l) Expiration date.


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

    (a) Overview.
    (b) Definitions.
    (1) Amount paid.
    (2) Personal property.
    (3) Real property.
    (4) Owner.
    (c) Coordination with other provisions of the Internal Revenue 
Code.
    (1) In general.
    (2) Materials and supplies.
    (3) Exception for amounts subject to de minimis rule.
    (4) Example.
    (d) Requirement to capitalize amounts paid for improvements.
    (e) Determining the unit of property.
    (1) In general.
    (2) Building.
    (i) In general.
    (ii) Application of improvement rules to a building.
    (A) Building structure.
    (B) Building system.
    (iii) Condominium.
    (A) In general.
    (B) Application of improvement rules to a condominium.
    (iv) Cooperative.
    (A) In general.
    (B) Application of improvement rules to a cooperative.
    (v) Leased building.
    (A) In general.
    (B) Application of improvement rules to a leased building.
    (1) Entire building.
    (2) Portion of building.
    (3) Property other than a building.
    (i) In general.
    (ii) Plant property.
    (A) Definition.
    (B) Unit of property for plant property.
    (iii) Network assets.
    (A) Definition.
    (B) Unit of property for network assets.
    (iv) Leased property other than buildings.
    (4) Improvements to property.
    (5) Additional rules.
    (i) Year placed in service.
    (ii) Change in subsequent taxable year.
    (6) Examples.
    (f) Special rules for determining improvement costs.
    (1) Improvements to leased property.
    (i) In general.
    (ii) Lessee improvements.
    (A) Requirement to capitalize.
    (B) Unit of property for lessee improvements.

[[Page 81101]]

    (iii) Lessor improvements.
    (A) Requirement to capitalize.
    (B) Unit of property for lessor improvements.
    (iv) Examples.
    (2) Compliance with regulatory requirements.
    (3) Certain costs incurred during an improvement.
    (i) In general.
    (ii) Exception for individuals' residences.
    (4) Aggregate of related amounts.
    (g) Safe harbor for routine maintenance on property other than 
buildings.
    (1) In general.
    (2) Rotable and temporary spare parts.
    (3) Exceptions.
    (4) Class life.
    (5) Examples.
    (h) Capitalization of betterments.
    (1) In general.
    (2) Betterments to buildings.
    (3) 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.
    (4) Examples.
    (i) Capitalization of restorations.
    (1) In general.
    (2) Restorations of buildings.
    (3) Rebuild to like-new condition.
    (4) Replacement of a major component or substantial structural 
part.
    (5) Examples.
    (j) Capitalization of amounts to adapt property to a new or 
different use.
    (1) In general.
    (2) Adapting buildings to new or different use.
    (3) Examples.
    (k) Optional regulatory accounting method.
    (1) In general.
    (2) Eligibility for regulatory accounting method.
    (3) Description of regulatory accounting method.
    (4) Examples.
    (l) Methods of accounting authorized in published guidance.
    (m) Treatment of capital expenditures.
    (n) Recovery of capitalized amounts.
    (o) Accounting method changes.
    (p) Effective/applicability date.
    (q) Expiration date.

0
Par. 25. Section 1.263(a)-1 is revised to read as follows:


Sec.  1.263(a)-1  Capital expenditures; in general.

    (a) through (c) [Reserved]. For further guidance, see Sec.  
1.263(a)&1T(a) through (c).
    (d) through (h) [Reserved]. For further guidance, see Sec.  
1.263(a)-1T(d) through (h).

0
Par. 26. Section 1.263(a)-1T is added to read as follows:


Sec.  1.263(a)-1T  Capital expenditures; in general (temporary)--

    (a) General rule for capital expenditures. Except as provided in 
chapter 1 of the Internal Revenue Code, no deduction is allowed for--
    (1) Any amount paid for new buildings or for permanent improvements 
or betterments made to increase the value of any property or estate; or
    (2) Any amount paid in restoring property or in making good the 
exhaustion thereof for which an allowance is or has been made.
    (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 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 a unit of real or personal 
tangible property. See Sec.  1.263(a)-2T.
    (2) An amount paid to improve a unit of real or personal tangible 
property. See Sec.  1.263(a)-3T.
    (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. 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 on November 15, Year 1. X pays for an 
appraisal to determine a reasonable asking price. On February 15, 
Year 2, X sells the truck to Y. X is required to capitalize in Year 
1 the amount paid to appraise the truck and, in Year 2, 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, Year 2, X decides 
on that date not to sell the truck and takes the truck off the 
market. X is required to capitalize in Year 1 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 Year 2 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, Year 1, X pays for an appraisal to determine a reasonable asking 
price. On February 15, Year 2, X sells the truck to Y.

[[Page 81102]]

X is required to capitalize in Year 1 the amount paid to appraise 
the truck and, in Year 2, 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, Year 2, X 
decides on that date not to sell the truck and takes the truck off 
the market. X is required to capitalize in Year 1 the amount paid to 
appraise the truck. Although the sale is abandoned in Year 2, 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) Accounting method changes. Except as otherwise provided in this 
section, a change to comply with this section is a change in method of 
accounting to which the provisions of sections 446 and 481, and the 
regulations thereunder apply. A taxpayer seeking to change to a method 
of accounting permitted in this section must secure the consent of the 
Commissioner in accordance with Sec.  1.446-1(e) and follow the 
administrative procedures issued under Sec.  1.446-1(e)(3)(ii) for 
obtaining the Commissioner's consent to change its accounting method.
    (g) Effective/applicability date. This section applies to taxable 
years beginning on or after January 1, 2012. For the applicability of 
regulations to taxable years beginning before January 1, 2012, see 
Sec.  1.263(a)-1 in effect prior to January 1, 2012 (Sec.  1.263(a)-1 
as contained in 26 CFR part 1 edition revised as of April 1, 2011).
    (h) Expiration date. The applicability of this section expires on 
December 23, 2014.

0
Par. 27. 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) through (h) [Reserved]. For further guidance, see Sec. Sec.  
1.263(a)-2T(a) through (h).
    (i) through (l) [Reserved]. For further guidance, see Sec. Sec.  
1.263(a)-2T(i) through (l).
0
Par. 28. Section 1.263(a)-2T is added to read as follows:


Sec.  1.263(a)-2T  Amounts paid to acquire or produce tangible property 
(temporary).

    (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. Paragraph (d) of 
this section provides the general requirement to capitalize amounts 
paid to acquire or produce a unit of real or personal property. 
Paragraph (e) of this section provides the requirement to capitalize 
amounts paid to defend or perfect title to real or personal property. 
Paragraph (f) of this section provides the rules for determining the 
extent to which taxpayers must capitalize transaction costs related to 
the acquisition of property. Paragraph (g) of this section provides a 
de minimis rule for certain amounts paid for the acquisition or 
production of property. Paragraphs (h) and (i) of this section address 
the treatment and recovery of capital expenditures. Paragraph (j) of 
this section provides for changes in methods of accounting to comply 
with this section, and paragraphs (k) and (l) of this section provide 
the effective, applicability, and expiration dates for the rules under 
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 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)-3T.
    (c) Coordination with other provisions of the Internal Revenue 
Code--(1) In general. Except as provided under the de minimis rule in 
paragraph (g) of this section, nothing in this section changes the 
treatment of any amount that is specifically provided for under any 
provision of the Internal Revenue Code or regulations thereunder 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 indirect costs of producing property or 
acquiring property for resale. See also section 195 requiring taxpayers 
to capitalize certain costs as start-up expenditures.
    (2) Materials and supplies. Except as provided under the de minimis 
rule in paragraph (g) of this section, 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.  1.162-3T.
    (d) Acquired or produced tangible property--(1) Requirement to 
capitalize. Except as provided in paragraph (g) of this section 
(providing the de minimis rule) and in Sec.  1.162-3T (relating to 
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)-3T(e)), 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 (f) 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.
    (2) 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 (g) of this section:

    Example 1. Acquisition of personal property. X purchases new 
cash registers for use in its retail store located in leased space 
in a shopping mall. Assume each cash

[[Page 81103]]

register is a unit of property as determined under Sec.  1.263(a)-
3T(e) and is not a material or supply under Sec.  1.162-3T. X must 
capitalize under this paragraph (d)(1) the amount paid to acquire 
each cash register.
    Example 2. Acquisition of personal property that is a material 
or supply; coordination with Sec.  1.162-3T.  X operates a fleet of 
aircraft. In Year 1, X acquires a stock of component parts, which it 
intends to use to maintain and repair its aircraft. X does not make 
elections under Sec.  1.162-3T(d) to treat the materials and 
supplies as capital expenditures. In Year 2, X uses the component 
parts in the repair and maintenance of its aircraft. Because the 
parts are materials and supplies under Sec.  1.162-3T, 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.  1.162-3T, 
governing the treatment of materials and supplies, to determine the 
treatment of these amounts.
    Example 3. Acquisition of unit of personal property; 
coordination with Sec.  1.162-3T.  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. X purchases a large quantity of rental items to be 
used in its business. Assume that each of these rental items is a 
unit of property under Sec.  1.263(a)-3T(e). Also assume that a 
portion of the rental items are materials and supplies under Sec.  
1.162-3T(c)(1). Under paragraph (d)(1) of this section, X must 
capitalize the amounts paid for the rental items that are not 
materials and supplies under Sec.  1.162-3T(c)(1). However, X must 
apply the rules in Sec.  1.162-3T to determine the treatment of the 
rental items that are materials and supplies under Sec.  1.162-
3T(c)(1).
    Example 4. Acquisition or production cost.  X purchases and 
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)-3T(e) and is not a 
material and supply under Sec.  1.162-3T(c)(1). X is required to 
capitalize under paragraph (d)(1) of this section the amounts paid 
to acquire and produce the jigs, dies, molds, and patterns. See 
section 263A for the costs required to be capitalized to the 
property acquired or produced by X.
    Example 5. Acquisition of land.  X purchases a parcel of 
undeveloped real estate. X must capitalize under paragraph (d)(1) of 
this section the amount paid to acquire the real estate. See 
paragraph (f) of this section for the treatment of amounts paid to 
facilitate the acquisition of real property.
    Example 6. Acquisition of building.  X purchases a building. X 
must capitalize under paragraph (d)(1) of this section the amount 
paid to acquire the building. See paragraph (f) of this section for 
the treatment of amounts paid to facilitate the acquisition of real 
property.
    Example 7. Acquisition of property for resale and production of 
property for sale.  X purchases goods for resale and produces other 
goods for sale. X must capitalize under paragraph (d)(1) of this 
section the amounts paid to acquire and produce the goods. See 
section 263A for the costs required to be capitalized to the 
property produced or property acquired for resale.
    Example 8. Production of building.  X constructs a building. X 
must capitalize under paragraph (d)(1) of this section the amount 
paid to construct the building. See section 263A for the costs 
required to be capitalized to the real property produced by X.
    Example 9. 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 paragraph (d)(1) of this 
section 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 10. Work performed prior to placing the property in 
service.  In Year 1, X purchases a building for use as a business 
office. Prior to placing the building in service, X incurs costs to 
repair cement steps, refinish wood floors, patch holes in walls, and 
paint the interiors and exteriors of the building. In Year 2, X 
places the building in service and begins using the building as its 
business office. Assume that the work that X performs does not 
constitute an improvement to the building or its structural 
components under Sec.  1.263(a)-3T. Under Sec.  1.263-3T(e)(2)(i), 
the building and its structural components is a single unit of 
property. Under paragraph (d)(1) of this section, 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 11. Work performed prior to placing the property in 
service.  In January Year 1, 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)-3T(e) and is 
not a material or supply under Sec.  1.162-3T. After the machine is 
installed, X performs a critical test on the machine to ensure that 
it will operate in accordance with quality standards. On November 1, 
Year 1, the critical test is complete, and X places the machine in 
service on the production line. X performs periodic quality control 
testing after the machine is placed in service. Under paragraph 
(d)(1) of this section, the amounts paid for the installation and 
the critical test performed before the machine is placed in service 
must be capitalized as costs of acquiring the machine. However, 
amounts paid for periodic quality control testing after X placed the 
machine in service are not required to be capitalized as a cost of 
acquiring the machine.
    (e) Defense or perfection of title to property--(1) 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.
    (2) Examples. The following examples illustrate the rule of 
paragraph (e):

    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. The amounts that X paid 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, the attorney's fees that X paid are not required to be 
capitalized under paragraph (e)(1) of this section. See section 263A 
for the rules requiring direct and allocable indirect costs 
(including otherwise deductible costs) to be capitalized to property 
produced or property acquired for resale.
    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. The amounts X paid to the 
attorney must be capitalized because they were to defend X's title 
to the property.

    (f) Transaction costs--(1) 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. See Sec.  1.167(a)-5 for allocations of facilitative costs 
between depreciable and non-depreciable property.
    (2) Scope of facilitate--(i) 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

[[Page 81104]]

relevant but is not determinative. Amounts paid to facilitate an 
acquisition include, but are not limited to, inherently facilitative 
amounts specified in paragraph (f)(2)(ii) of this section.
    (ii) Inherently facilitative amounts. An amount is paid in the 
process of investigating or otherwise pursuing the acquisition of real 
or personal property if the amount is inherently facilitative. An 
amount is inherently facilitative if the amount is paid for--
    (A) Transporting the property (for example, shipping fees and 
moving costs);
    (B) Securing an appraisal or determining the value or price of 
property;
    (C) Negotiating the terms or structure of the acquisition and 
obtaining tax advice on the acquisition;
    (D) Application fees, bidding costs, or similar expenses;
    (E) Preparing and reviewing the documents that effectuate the 
acquisition of the property (for example, preparing the bid, offer, 
sales contract, or purchase agreement);
    (F) Examining and evaluating the title of property;
    (G) Obtaining regulatory approval of the acquisition or securing 
permits related to the acquisition, including application fees;
    (H) Conveying property between the parties, including sales and 
transfer taxes, and title registration costs;
    (I) Finders' fees or brokers' commissions, including amounts paid 
that are contingent on the successful closing of the acquisition;
    (J) Architectural, geological, engineering, environmental, or 
inspection services pertaining to particular properties; or
    (K) Services provided by a qualified intermediary or other 
facilitator of an exchange under section 1031.
    (iii) Special rule for acquisitions of real property--(A) In 
general. Except as provided in paragraph (f)(2)(ii) 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.
    (B) Acquisitions of real and personal property in a single 
transaction. An amount paid by the taxpayer in the process of 
investigating or otherwise pursuing the acquisition of personal 
property facilitates the acquisition of such personal property even if 
such property is acquired in a single transaction that also includes 
the acquisition of real property subject to the special rule set out in 
paragraph (f)(2)(iii)(A) of this section. A taxpayer may use a 
reasonable allocation to determine which costs facilitate the 
acquisition of personal property and which costs relate to the 
acquisition of real property and are subject to the special rule of 
paragraph (f)(2)(iii)(A) of this section.
    (iv) Employee compensation and overhead costs--(A) In general. For 
purposes of paragraph (f) of this section, 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, however, 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.
    (B) 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 a 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 
(f)(2)(iv)(B) 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. The Commissioner may grant a request to revoke 
this election if the taxpayer can demonstrate good cause for the 
revocation. An election may not be made or revoked through the filing 
of an application for change in accounting method or, before obtaining 
the Commissioner's consent to make the late election or to revoke the 
election, by filing an amended Federal income tax return.
    (3) Treatment of transaction costs--(i) In general. All amounts 
paid to facilitate the acquisition or production of real or personal 
property are capital expenditures. Facilitative amounts allocable to 
real or personal property must be included in the basis of the property 
acquired or produced.
    (ii) Treatment of inherently facilitative amounts. 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. Inherently facilitative amounts 
allocable to real or personal property not acquired may be allocated to 
those properties and recovered as appropriate in accordance with the 
applicable provisions of the Internal Revenue Code and the regulations 
thereunder (for example, sections 165, 167, or 168). See paragraph (i) 
of this section for the recovery of capitalized amounts.
    (4) Examples. The following examples illustrate the rules of 
paragraph (f) of this section:

    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 
(f)(2)(ii)(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 (f)(2)(ii)(J) 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 (f)(2)(ii)(A) 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. Geological and geophysical costs; coordination with 
other provisions.  X is in the business of exploring, purchasing, 
and developing properties in the United States for the production of 
oil and gas. X considers acquiring a particular property but first 
incurs costs for the services of an engineering firm to perform 
geological and geophysical studies to determine if the property is 
suitable for oil or gas production. Assume that the amounts that X 
paid to the engineering firm constitute geological and geophysical 
expenditures under section 167(h). Although the amounts that X paid 
for the geological and geophysical services are inherently 
facilitative to the acquisition of real property under paragraph 
(f)(2)(ii)(J) of this section, X is not required to include those 
amounts in the basis of the real

[[Page 81105]]

property acquired. Rather, under paragraph (c) of this section, X 
must capitalize these costs separately and amortize such costs as 
required under section 167(h) (addressing the amortization of 
geological and geophysical expenditures).
    Example 5. 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 paragraphs (f)(1) and 
(2) 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 6. Transaction costs allocable to multiple properties.  
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. X incurs fees for the services 
of an architect to advise and evaluate the suitability of the sites 
for the type of facility that X intends to construct on the selected 
site. X must capitalize the architect fees as amounts paid to 
acquire land because these amounts are inherently facilitative to 
the acquisition of land under paragraph (f)(2)(ii)(J) of this 
section.
    Example 7. Transaction costs allocable to multiple properties.  
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. X incurs fees for the services 
of an architect to prepare preliminary floor plans for a building 
that X could construct at any of the sites. Under these facts, the 
architect's fees are not inherently facilitative to the acquisition 
of land under paragraph (f)(2)(iii)(J) of this section but are 
allocable as construction costs of the building under section 263A. 
Therefore, X does not capitalize the architect fees as amounts paid 
to acquire land but instead must capitalize these costs as indirect 
costs allocable to the production of property under section 263A.
    Example 8. 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, Year 1, 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, Year 1, 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, 
Year 2, 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 (f)(2)(iii) of this section, X is not 
required to capitalize amounts paid to the development consultant in 
Year 1 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 (f)(2)(ii) of this section. 
However, X must capitalize amounts paid to the appraiser in Year 1 
because the appraisal costs are inherently facilitative costs under 
paragraph (f)(2)(ii)(B) of this section. In Year 2, 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 paragraphs 
(f)(3)(ii) and (i) of this section.
    Example 9. 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 (f)(2)(iv)(A) 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 (f)(2)(iv)(B) 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.

    (g) De minimis rule--(1) In general. Except as otherwise provided 
in this paragraph (g), a taxpayer is not required to capitalize under 
paragraph (d)(1) of this section nor treat as a material or supply 
under Sec.  1.162-3T(a) 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)-
3T(e)) or for the acquisition or production of any material or supply 
(as defined in Sec.  1.162-3T(c)(1)) if--
    (i) The taxpayer has an applicable financial statement (as defined 
in paragraph (g)(6) of this section);
    (ii) 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;
    (iii) 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
    (iv) The total aggregate of amounts paid and not capitalized under 
paragraph (g)(1) of this section and Sec.  1.162-3T(f) (materials and 
supplies) for the taxable year are less than or equal to the greater 
of--
    (A) 0.1 percent of the taxpayer's gross receipts for the taxable 
year as determined for Federal income tax purposes; or
    (B) 2 percent of the taxpayer's total depreciation and amortization 
expense for the taxable year as determined in its applicable financial 
statement.
    (2) Exceptions to de minimis rule. The de minimis rule in paragraph 
(g)(1) of this section does not apply to the following:
    (i) Amounts paid for property that is or is intended to be included 
in inventory property; and
    (ii) Amounts paid for land.
    (3) Additional rules. Property to which a taxpayer applies the de 
minimis rule contained in paragraph (g) of this section is not treated 
upon sale or other disposition as a capital asset under section 1221 or 
as property used in the trade or business under section 1231. The cost 
of property to which a taxpayer properly applies the de minimis rule 
contained in paragraph (g) 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)(R) requiring taxpayers to capitalize the cost 
of tools and equipment allocable to property produced or property 
acquired for resale.
    (4) Election to capitalize. A taxpayer may elect not to apply the 
de minimis rule contained in paragraph (g)(1) of this section. An 
election made under this paragraph (g)(4) may apply to any unit of 
property during the taxable year to which paragraph (g)(1) of this 
section would apply (but for the election under this paragraph (g)(4)). 
A taxpayer makes the election by capitalizing the amounts paid to 
acquire or produce the unit of property in the taxable year the amounts 
are paid and by beginning to recover the costs when the unit of 
property is placed in service by the taxpayer for the purposes of 
determining depreciation under the applicable provisions of the 
Internal Revenue Code and the regulations thereunder. A taxpayer must 
make this election on its timely filed original Federal income tax 
return (including extensions) for the taxable year the unit of property 
is placed in service by the taxpayer for the purposes of determining 
depreciation. In the case of an S corporation or a 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 (g)(4) 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. The Commissioner may 
grant a request to revoke this election if the

[[Page 81106]]

taxpayer can demonstrate good cause for the revocation. An election may 
not be made or revoked through the filing of an application for change 
in accounting method or by filing an amended Federal income tax return.
    (5) Materials and supplies. A taxpayer must treat amounts paid to 
acquire or produce a unit of property that is a material or supply as 
defined under Sec.  1.162-3T(c)(1) under Sec.  1.162-3T unless the 
taxpayer elects under Sec.  1.162-3T(f) to apply the de minimis rule to 
that property under this paragraph (g). Property to which a taxpayer 
applies the de minimis rule contained in paragraph (g) of this section 
is not treated as a material or supply under Sec.  1.162-3T.
    (6) Definition of applicable financial statement. For purposes of 
this section (g), the taxpayer's applicable financial statement is the 
taxpayer's financial statement listed in paragraphs (g)(6)(i) through 
(iii) of this section that has the highest priority (including within 
paragraph (g)(6)(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).
    (7) Application to consolidated group member. If the taxpayer is a 
member of a consolidated group for federal income tax purposes and the 
member's financial results are reported on the applicable financial 
statement (as defined in paragraph (g)(6) of this section) for the 
consolidated group then, for purposes of paragraphs (g)(1)(ii) and 
(g)(1)(iii) of this section, the written accounting procedures provided 
for the group and utilized for the group's applicable financial 
statement may be treated as the written accounting procedures of the 
member.
    (8) Examples. The following examples illustrate the rule of this 
paragraph (g):

    Example 1. De minimis rule. X purchases 10 printers at $200 each 
for a total cost of $2,000. Assume that each printer is a unit of 
property under Sec.  1.263(a)-3T(e) and is not a material or supply 
under Sec.  1.162-3T. X has an applicable financial statement and 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. Assume that the total aggregate amounts treated 
as de minimis and not capitalized by X under paragraphs (g)(1)(i), 
(ii), and (iii) of this section, including the amounts paid for the 
printers, are less than or equal to the greater of 0.1 percent of 
total gross receipts or 2 percent of X's total financial statement 
depreciation under paragraph (g)(1)(iv) of this section. X is not 
required to capitalize the amounts paid for the 10 printers under 
paragraph (g)(1) of this section.
    Example 2. De minimis rule not met. X is a member of a 
consolidated group for federal income tax purposes. X's financial 
results are reported on the consolidated applicable financial 
statements for the affiliated group. X's affiliated group has a 
written policy at the beginning of Year 1, which is followed by X, 
to expense amounts paid for property costing less than $500. In Year 
1, X pays $160,000 to purchase 400 computers at $400 each. Assume 
that each computer is a unit of property under Sec.  1.263(a)-3T(e), 
is not a material or supply under Sec.  1.162-3T, and that X intends 
to treat the cost of only the computers as de minimis under 
paragraph (g)(1) of this section. X treats the amounts paid for the 
computers as an expense on the applicable financial statements for 
the affiliated group. For its Year 1 taxable year, X has gross 
receipts of $125,000,000 for Federal tax purposes and reports 
$7,000,000 of it's own depreciation and amortization expense on the 
affiliated group's applicable financial statement. Thus, in order to 
meet the criteria of paragraph (g)(1)(iv) of this section for Year 
1, the total aggregate amounts paid and not capitalized by X under 
paragraphs (g)(1)(i), (ii), and (iii) of this section must be less 
than or equal to the greater of $125,000 (0.1 percent of X's total 
gross receipts of $125,000,000) or $140,000 (2 percent of X's total 
deprecation and amortization of $7,000,000). Because X pays $160,000 
for the computers and this amount exceeds $140,000, the greater of 
the two limitations provided in paragraph (g)(1)(iv) of this 
section, X may not apply the de minimis rule under paragraph (g)(1) 
of this section to the total amounts paid for the 400 computers.
    Example 3. De minimis rule; election to capitalize. Assume the 
same facts as in Example 2, except that X makes an election under 
paragraph (g)(4) of this section to capitalize $20,000, the amounts 
paid to acquire 50 of the 400 computers purchased in Year 1. Under 
these facts, the $140,000 paid by X in Year 1 for the remaining 350 
computers qualifies for the de minimis rule under paragraph (g)(1) 
of this section because this amount is equal to 2 percent of X's 
total depreciation ($140,000), the greater of the two amounts 
calculated under paragraph (g)(1)(iv) of this section. Accordingly, 
X is not required to capitalize the amounts paid to acquire the 350 
computers in Year 1.
    Example 4. Election to apply de minimis rule to certain 
materials and supplies. (i) X is a corporation that provides 
consulting services to its customers. X has an applicable financial 
statement and a written policy at the beginning of the taxable year 
to expense amounts paid for property costing $500 or less. In Year 
1, X purchases 200 computers at $500 each for a total cost of 
$100,000. Assume that each computer is a unit of property under 
Sec.  1.263(a)-3T(e) and is not a material or supply under Sec.  
1.162-3T. In addition, X purchases 200 office chairs at $100 each 
for a total cost of $20,000 and 250 customized briefcases at $80 
each for a total cost of $20,000. Assume that each office chair and 
each briefcase is a material or supply under Sec.  1.162-3T(c)(1). 
In Year 1, X also acquires 10 books at $100 each, which are also 
materials and supplies under Sec.  1.162-3T(c)(1). X makes the 
election under Sec.  1.162-3T(f) to apply the de minimis rule to the 
office chairs and briefcases, but does not make that election for 
the books and treats the books as materials and supplies in 
accordance with the provisions of Sec.  1.162-3T. X treats the 
amounts paid for the computers, office chairs, and briefcases as 
expenses on its applicable financial statement. Assume also that for 
Year 1, the amounts that X paid for the computers, office chairs, 
and briefcases are the only amounts that X intends to treat as de 
minimis costs not capitalized under paragraph (g)(1) of this 
section. For its Year 1 taxable year, X has gross receipts of 
$125,000,000 and reports $7,000,000 of depreciation and amortization 
on its applicable financial statement.
    (ii) In order to meet the requirements of paragraph (g)(1)(iv) 
of this section for Year 1, X's total aggregate amounts paid and not 
capitalized under paragraphs (g)(1)(i), (ii), and (iii) of this 
section must be less than or equal to the greater of $125,000 (0.1 
percent of X's total gross receipts of $125,000,000) or $140,000 (2 
percent of X's total depreciation and amortization of $7,000,000). X 
pays a total of $140,000 ($100,000 + $20,000 + $20,000) for the 
computers, office chairs, and briefcases. X is not required to 
include the amounts paid for the books in this computation because X 
has not elected under Sec.  1.162-3T(f) to apply the de minimis rule 
to the books. Thus, the total aggregate amounts paid and not 
capitalized under paragraph (g)(1) of this section is equal to 
$140,000 (2 percent of X's total financial depreciation), the 
greater of the two limitations set out under paragraph (g)(1)(iv) of 
this section. Accordingly, under paragraph (g)(1) of this section, 
in Year 1, X may treat as de minimis and is not required to 
capitalize the $140,000 paid to acquire the computers, office 
chairs, and briefcases.

    (h) Treatment of capital expenditures. Amounts required to be 
capitalized under this section are capital expenditures and must be 
taken into account through a charge to capital account or basis, or in 
the case of property that is inventory in the hands of a taxpayer, 
through inclusion in inventory costs. See section 263A for the 
treatment of direct and certain indirect costs of producing property or 
acquiring property for resale.

[[Page 81107]]

    (i) 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 provisions 
of the Internal Revenue Code and regulations relating to the use, sale, 
or disposition of property.
    (2) Examples. The following examples illustrate the rule of 
paragraph (i)(1) of this section. Assume that X does not apply the de 
minimis rule under paragraph (g) 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. Assume that the refrigerator 
is the unit of property, as determined under Sec.  1.263(a)-3T(e), 
and is not a material or supply under Sec.  1.162-3T. Under 
paragraph (d)(1) of this section, X is required to capitalize the 
amounts paid for the acquisition, delivery, and installation of the 
refrigerator. Under paragraph (i) of this section, the capitalized 
amounts are recovered through depreciation, which begins 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)-
3T(e), and is not a material or supply under Sec.  1.162-3T. Under 
paragraph (d)(1) of this section, X is required to capitalize the 
amounts paid to acquire the tractor loader. Under paragraph (i) of 
this section, the capitalized amounts are recovered through 
depreciation, which begins when X places the tractor loader in 
service. 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).

    (j) Accounting method changes. Except as otherwise provided in this 
section, a change to comply with this section is a change in method of 
accounting to which the provisions of sections 446 and 481, and the 
regulations thereunder apply. A taxpayer seeking to change to a method 
of accounting permitted in this section must secure the consent of the 
Commissioner in accordance with Sec.  1.446-1(e) and follow the 
administrative procedures issued under Sec.  1.446-1(e)(3)(ii) for 
obtaining the Commissioner's consent to change its accounting method.
    (k) Effective/applicability date. Except for paragraphs 
(f)(2)(iii), (f)(2)(iv),(f)(3)(ii) and (g) of this section, this 
section generally applies to taxable years beginning on or after 
January 1, 2012. Paragraphs (f)(2)(iii), (f)(2)(iv), (f)(3)(ii), and 
(g) of this section apply to amounts paid or incurred (to acquire or 
produce property) in taxable years beginning on or after January 1, 
2012. For the applicability of regulations to taxable years beginning 
before January 1, 2012, see Sec.  1.263(a)- in effect prior to January 
1, 2012 (Sec.  1.263(a)-2 as contained in 26 CFR part 1 edition revised 
as of April 1, 2011).
    (l) Expiration Date. The applicability of this section expires on 
December 23, 2014.

0
Par. 29. Section 1.263(a)-3 is revised to read as follows:


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

    (a) and (b) [Reserved]. For further guidance, see Sec.  1.263(a)-
3T(a) and (b).
    (c) through (q) [Reserved]. For further guidance, see Sec. Sec.  
1.263(a)-3T(c) through (q).

0
Par. 30. Section 1.263(a)-3T is added to read as follows:


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

    (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. Paragraph (d) of this section provides the 
requirement to capitalize amounts paid to improve tangible property and 
provides the general rules for determining whether a unit of property 
is improved. Paragraph (e) of this section provides the rules for 
determining the appropriate unit of property. Paragraph (f) of this 
section provides special rules for determining improvement costs in 
particular contexts. Paragraph (g) provides a safe harbor for routine 
maintenance costs. Paragraph (h) of this section provides rules for 
determining whether amounts paid result in betterments to the unit of 
property. Paragraph (i) of this section provides rules for determining 
whether amounts paid restore the unit of property. Paragraph (j) of 
this section provides rules for amounts paid to adapt the unit of 
property to a new or different use. Paragraph (k) of this section 
provides an optional regulatory accounting method. Paragraph (l) of 
this section provides for a repair allowance or other methods of 
accounting identified in published guidance. Paragraphs (m) through (o) 
of this section provide additional rules related to these provisions. 
Paragraphs (p) and (q) of this section provides the effective/
applicability and expiration dates for the rules in this section.
    (b) Definitions. For purposes this section, the following 
definitions apply:
    (1) Amount paid. In the case of a taxpayer using an accrual method 
of accounting, the terms amounts paid and payment mean a liability 
incurred (within the meaning of Sec.  1.446-1(c)(1)(ii)). A liability 
may not be taken into account under this section prior to the taxable 
year during which the liability is incurred.
    (2) Personal property 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) Owner means the taxpayer that has the benefits and burdens of 
ownership of the unit of property for Federal income tax purposes.
    (c) Coordination with other provisions of the Internal Revenue 
Code--(1) In general. Nothing in this section changes the treatment of 
any amount that is specifically provided for under any provision of the 
Internal Revenue Code or the 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 indirect 
costs of producing property or acquiring property for resale.
    (2) Materials and supplies. A material or supply as defined in 
Sec.  1.162-3T(c)(1) that is acquired and used to improve a unit of 
tangible property is subject to this section and is not treated as a 
material or supply under Sec.  1.162-3T.
    (3) Exception for amounts subject to de minimis rule. A taxpayer is 
not required to capitalize amounts paid to acquire or produce units of 
property used in improvements under paragraph (d) of this section 
(including materials and supplies used in improvements) if these 
amounts are properly deducted

[[Page 81108]]

under the de minimis rule of section Sec.  1.263(a)-2(g).
    (3) Example. The following example illustrates the rules of this 
paragraph (c):

    Example. Railroad rolling stock.  X is a railroad that properly 
treats amounts paid for the rehabilitation of railroad rolling stock 
as deductible expenses under section 263(d). X is not required to 
capitalize the amounts paid because nothing in this section changes 
the treatment of amounts specifically provided for under section 
263(d).

    (d) Requirement to capitalize amounts paid for improvements. Except 
as provided in the optional regulatory accounting method in paragraph 
(k) of this section or under any other accounting method published in 
accordance with paragraph (l) of this section, a taxpayer generally 
must capitalize the aggregate of related amounts (as defined in 
paragraph (f)(4) of this section) paid to improve a unit of property 
owned by the taxpayer. However, see paragraph (f)(1) of this section 
for the treatment of amounts paid to improve leased property. 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--
    (1) Result in a betterment to the unit of property (see paragraph 
(h) of this section);
    (2) Restore the unit of property (see paragraph (i) of this 
section); or
    (3) Adapt the unit of property to a new or different use (see 
paragraph (j) of this section).
    (e) Determining the unit of property--(1) In general. The unit of 
property rules in this paragraph (e) apply only for purposes of section 
263(a) and Sec. Sec.  1.263(a)-1T, 1.263(a)-2T, 1.263(a)-3T, and 1.162-
3T. Unless otherwise specified, the unit of property determination is 
based upon the functional interdependence standard provided in 
paragraph (e)(3)(i) of this section. However, special rules are 
provided for buildings (see paragraph (e)(2) of this section), plant 
property (see paragraph (e)(3)(ii) of this section), network assets 
(see paragraph (e)(3)(iii) of this section), leased property (see 
paragraph (e)(2)(v) of this section for leased buildings and paragraph 
(e)(3)(iv) of this section for leased property other than buildings), 
and improvements to property (see paragraph (e)(4) of this section). 
Additional rules are provided if a taxpayer has assigned different 
MACRS classes or depreciation methods to components of property or 
subsequently changes the class or depreciation method of a component or 
other item of property (see paragraph (e)(5) of this section). Property 
that is aggregated or 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.
    (2) Building--(i) In general. Except as otherwise provided in 
paragraphs (e)(4), (e)(5)(ii), and (f)(1)(ii)(B) of this section, in 
the case of a building (as defined in Sec.  1.48-1(e)(1)), each 
building and its structural components (as defined in Sec.  1.48-
1(e)(2)) is a single unit of property (``building'').
    (ii) Application of improvement rules to a building. An amount is 
paid for an improvement to a building under paragraphs (d) and 
(f)(1)(iii) of this section if the amount paid results in an 
improvement under paragraph (h), (i), or (j) of this section to any of 
the following:
    (A) Building structure. A building structure consists of the 
building (as defined in Sec.  1.48-1(e)(1)), and its structural 
components (as defined in Sec.  1.48-1(e)(2)), other than the 
structural components designated as buildings systems in paragraph 
(e)(2)(ii)(B) of this section.
    (B) Building system. Each of the following structural components 
(as defined in Sec.  1.48-1(e)(2)), including the components thereof, 
constitutes a building system that is separate from the building 
structure, and to which the improvement rules must be applied--
    (1) Heating, ventilation, and air conditioning (``HVAC'') systems 
(including motors, compressors, boilers, furnace, chillers, pipes, 
ducts, radiators);
    (2) Plumbing systems (including pipes, drains, valves, sinks, 
bathtubs, toilets, water and sanitary sewer collection equipment, and 
site utility equipment used to distribute water and waste to and from 
the property line and between buildings and other permanent 
structures);
    (3) Electrical systems (including wiring, outlets, junction boxes, 
lighting fixtures and associated connectors, and site utility equipment 
used to distribute electricity from property line to and between 
buildings and other permanent structures);
    (4) All escalators;
    (5) All elevators;
    (6) Fire-protection and alarm systems (including sensing devices, 
computer controls, sprinkler heads, sprinkler mains, associated piping 
or plumbing, pumps, visual and audible alarms, alarm control panels, 
heat and smoke detection devices, fire escapes, fire doors, emergency 
exit lighting and signage, and fire fighting equipment, such as 
extinguishers, hoses);
    (7) Security systems for the protection of the building and its 
occupants (including window and door locks, security cameras, 
recorders, monitors, motion detectors, security lighting, alarm 
systems, entry and access systems, related junction boxes, associated 
wiring and conduit);
    (8) Gas distribution system (including associated pipes and 
equipment used to distribute gas to and from property line and between 
buildings or permanent structures); and
    (9) Other structural components 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) that are excepted from the 
building structure under paragraph (e)(2)(ii)(A) of this section and 
are specifically designated as building systems under this section.
    (iii) Condominium--(A) In general. In the case of a taxpayer that 
is the owner of an individual unit in a building with multiple units 
(such as a condominium), the unit of property is the individual unit 
owned by the taxpayer and the structural components (as defined in 
Sec.  1.48-1(e)(2)) that are part of the unit (condominium).
    (B) Application of improvement rules to a condominium. An amount is 
paid for an improvement to a condominium under paragraph (d) of this 
section if the amount paid results in an improvement under paragraph 
(h), (i), or (j) of this section to the building structure (as defined 
in paragraph (e)(2)(ii)(A) of this section) that is part of the 
condominium or to the portion of any building system (as defined in 
paragraph (e)(2)(ii)(B) of this section) that is part of the 
condominium. In the case of the condominium management association, the 
association must apply the improvement rules to the building structure 
or to any building system as determined under paragraphs (e)(2)(ii)(A) 
and (e)(2)(ii)(B) of this section.
    (iv) Cooperative--(A) In general. In the case of a taxpayer that 
has an ownership interest in a cooperative housing corporation, the 
unit of property is the portion of the building in which the taxpayer 
has possessory rights and the structural components (as defined in 
Sec.  1.48-1(e)(2)) that are part of the portion of the building 
subject to the taxpayer's possessory rights (cooperative).
    (B) Application of improvement rules to a cooperative. An amount is 
paid for

[[Page 81109]]

an improvement to a cooperative under paragraph (d) of this section if 
the amount paid results in an improvement under paragraph (h), (i), or 
(j) of this section to the portion of the building structure (as 
defined in paragraph (e)(2)(ii)(A) of this section) in which the 
taxpayer has possessory rights or to the portion of any building system 
(as defined in paragraph (e)(2)(ii)(B) of this section) that is part of 
the portion of the building structure subject to the taxpayer's 
possessory rights. In the case of a cooperative housing corporation, 
the corporation must apply the improvement rules to the building 
structure or to any building system as determined under paragraphs 
(e)(2)(ii)(A) and (e)(2)(ii)(B) of this section.
    (v) Leased building--(A) In general. In the case of a taxpayer that 
is a lessee of all or a portion of a building (such as an office, 
floor, or certain square footage), the unit of property is each 
building and its structural components or the portion of each building 
subject to the lease and the structural components associated with the 
leased portion.
    (B) Application of improvement rules to a leased building. An 
amount is paid for an improvement to a leased building or a leased 
portion of a building under paragraphs (d) and (f)(1)(ii) of this 
section if the amount paid results in an improvement under paragraph 
(h), (i), or (j) of this section to any of the following:
    (1) Entire building. In the case of a taxpayer that is a lessee of 
an entire building, the building structure (as defined under paragraph 
(e)(2)(ii)(A) of this section) or any building system (as defined under 
paragraph (e)(2)(ii)(B) of this section) to which the expenditure 
relates.
    (2) Portion of a building. In the case of a taxpayer that is a 
lessee of a portion of a building (such as an office, floor, or certain 
square footage), the portion of the building structure (as defined 
under paragraph (e)(2)(ii)(A) of this section) subject to the lease or 
the portion of any building system (as defined under paragraph 
(e)(2)(ii)(B) of this section) associated with that portion of the 
leased building structure.
    (3) Property other than building--(i) In general. Except as 
otherwise provided in paragraphs (e)(3), (e)(4), (e)(5), and (f)(1) of 
this section, in the case of real or personal property other than 
property described in paragraph (e)(2) 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.
    (ii) Plant property--(A) Definition. For purposes of this paragraph 
(e) 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.
    (B) Unit of property for plant property. In the case of plant 
property, the unit of property determined under the general rule of 
paragraph (e)(3)(i) of this section is further divided into smaller 
units comprised of each component (or group of components) that 
performs a discrete and major function or operation within the 
functionally interdependent machinery or equipment.
    (iii) Network assets--(A) Definition. For purposes of this 
paragraph (e), 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 
building structure or building systems under paragraphs (e)(2)(ii)(A) 
and (e)(2)(ii)(B) 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.
    (B) Unit of property for network assets. In the case of network 
assets, the unit of property is determined by the taxpayer's particular 
facts and circumstances except as otherwise provided in published 
guidance in the Federal Register or in the Internal Revenue Bulletin 
(see Sec.  601.601(d)(2)(ii)(b) of this chapter). For these purposes, 
the functional interdependence standard provided in paragraph (e)(3)(i) 
of this section is not determinative.
    (iv) Leased property other than buildings. In the case of a 
taxpayer that is a lessee of real or personal property other than 
property described in paragraph (e)(2) of this section, the unit of 
property for the leased property is determined under paragraphs 
(e)(3)(i), (ii), (iii), and (e)(5) of this section except that, after 
applying the applicable rules under those paragraphs, the unit of 
property may not be larger than the unit of leased property.
    (4) Improvements to property. An improvement to a unit of property, 
other than a lessee improvement as determined under paragraph 
(f)(1)(ii) of this section, is not a unit of property separate from the 
unit of property improved. For the unit of property for lessee 
improvements, see paragraph (f)(1)(ii)(B) of this section.
    (5) Additional rules--(i) Year placed in service. Notwithstanding 
the unit of property determination under paragraph (e)(3) of this 
section, a component (or a group of components) of a unit property must 
be treated as a separate unit of property if, at the time the unit of 
property is initially placed in service by the taxpayer, 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 has 
properly depreciated the component using a different depreciation 
method than the depreciation method of the unit of property of which 
the component is a part.
    (ii) Change in subsequent taxable year. Notwithstanding the unit of 
property determination under paragraphs (e)(2), (3), (4), or (5)(i) of 
this section, in any taxable year after the unit of property is 
initially placed in service by the taxpayer, if the taxpayer or the 
Internal Revenue Service changes the treatment of that property (or any 
portion thereof) to a proper MACRS class or a proper depreciation 
method (for example, as a result of a cost segregation study or a 
change in the use of the property), then the taxpayer must change the 
unit of property determination for that property (or the portion 
thereof) under this section to be consistent with the change in 
treatment for depreciation purposes. Thus, for example, if a portion of 
a unit of property is properly reclassified to a MACRS class different 
from the MACRS class of the unit of property of which it was previously 
treated as a part, then the reclassified portion of the property should 
be treated as a separate unit of property for purposes of this section.
    (6) Examples. The rules of this paragraph (e) 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. In addition, unless 
the facts specifically indicate otherwise, assume that the additional 
rules in paragraph (e)(5) of this section do not apply:

    Example 1. Building systems.  X owns an office building that 
contains a HVAC system. The HVAC system incorporates ten roof-
mounted units that service different parts of the building. The 
roof-mounted units are not

[[Page 81110]]

connected and have separate controls and duct work that distribute 
the heated or cooled air to different spaces in the building's 
interior. X pays an amount for labor and materials for work 
performed on the roof-mounted units. Under paragraph (e)(2)(i) of 
this section, X must treat the building and its structural 
components as a single unit of property. As provided under paragraph 
(e)(2)(ii) of this section, an amount is paid for an improvement to 
a building if it results in an improvement to the building structure 
or any designated building system. Under paragraph (e)(2)(ii)(B)(1) 
of this section, the entire HVAC system, including all of the roof-
mounted units and their components, comprise a building system. 
Therefore, under paragraph (e)(2)(ii) of this section, if an amount 
paid by X for work on the roof-mounted units results in an 
improvement (for example, a betterment) to the HVAC system, X must 
treat this amount as an improvement to the building.
    Example 2. Building systems. X owns a building that it uses in 
its retail business. The building contains two elevator banks in 
different locations in its building. Each elevator bank contains 
three elevators. X pays an amount for labor and materials for work 
performed on the elevators. Under paragraph (e)(2)(i) of this 
section, X must treat the building and its structural components as 
a single unit of property. As provided under paragraph (e)(2)(ii) of 
this section, an amount is paid for an improvement to a building if 
it results in an improvement to the building structure or any 
designated building system. Under paragraph (e)(2)(ii)(B)(5) of this 
section, all of the elevators, including all their components, 
comprise a building system. Therefore, under paragraph (e)(2)(ii) of 
this section, if an amount paid by X for work on the elevators 
results in an improvement (for example, a betterment) to the entire 
elevator system, X must treat these amounts as an improvement to the 
building.
    Example 3. Building structure and systems; condominium. X owns a 
condominium unit in a condominium office building. X uses the 
condominium unit in its business of providing medical services. The 
condominium unit contains two restrooms, each of which contains a 
sink, a toilet, water and drainage pipes and bathroom fixtures. X 
pays an amount for labor and materials to perform work on the pipes, 
sinks, toilets, and plumbing fixtures that are part of the 
condominium unit. Under paragraph (e)(2)(iii) of this section, X 
must treat the individual unit that it owns, including the 
structural components that are part of that unit, as a single unit 
of property. As provided under paragraph (e)(2)(iii)(B) of this 
section, an amount is paid for an improvement to the condominium if 
it results in an improvement to the building structure that is part 
of the unit or to a portion of any designated building system that 
is part of the unit. Under paragraph (e)(2)(ii)(B)(2) of this 
section, the pipes, sinks, toilets, and plumbing fixtures that are 
part of X's unit comprise the plumbing system for the condominium 
unit. Therefore, under paragraph (e)(2)(iii) of this section, if an 
amount paid by X for work on pipes, sinks, toilets, and plumbing 
fixtures results in an improvement (for example, a betterment) to 
the portion of the plumbing system that is part of X's condominium 
unit, X must treat this amount as an improvement to the condominium.
    Example 4. Building structure and systems; property other than 
buildings.  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 building structure or building systems. X pays an amount to 
add an extension to the office building. Under paragraph (e)(2)(i) 
of this section, X must treat the building and its structural 
components as a single unit of property. As provided under paragraph 
(e)(2)(ii) of this section, an amount is paid for an improvement to 
a building if it results in an improvement to the building structure 
or any designated building system. Therefore, under paragraph 
(e)(2)(ii) of this section, if an amount paid by X for the addition 
of an extension to the office building results in an improvement 
(for example, a betterment) to the building structure, X must treat 
this amount as an improvement to the building. In addition, because 
the equipment contained within the office building constitutes 
property other than the building, the units of property for the 
office equipment are initially determined under the general rule in 
paragraph (e)(3)(i) of this section and are comprised of the groups 
of components that are functionally interdependent.
    Example 5. 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. 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 (e)(3)(i) 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 (e)(3)(ii) 
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 6. Plant property; discrete and major function.  X is 
engaged in a uniform and linen rental business. X owns and operates 
a plant that utilizes many different machines and equipment in an 
assembly line-like process to treat, launder, and prepare rental 
items for its 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 property other than a building, the 
unit of property for the laundering equipment is initially 
determined under the general rule in paragraph (e)(3)(i) 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 (e)(3)(ii) of this section, X must further divide these 
initial units of property into smaller units of property by 
determining the components (or groups of components) that perform 
discrete and major functions within the line. Under paragraph 
(e)(3)(ii) 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.
    Example 7. 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 
property other than a building, the unit of property for the 
equipment is initially determined under the general rule in 
paragraph (e)(3)(i) 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. The equipment is not plant property under paragraph 
(e)(3)(ii) of this section because the equipment is not used in an 
industrial process, as it performs a small-scale function in X's 
retail restaurant operations. Thus, X is not required to further 
divide the equipment into separate units of property based on the 
components that perform discrete and major functions.
    Example 8. 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 treated all the 
components of the locomotive as being

[[Page 81111]]

within the same class of property under section 168(e) and 
depreciated all the components using the same depreciation method. 
Because X's locomotive is property other than a building, the 
initial unit of property is determined under the general rule in 
paragraph (e)(3)(i) of this section and is comprised of the 
components that are functionally interdependent. Under paragraph 
(e)(3)(i) of this section, the locomotive is a single unit of 
property because it consists entirely of components that are 
functionally interdependent.
    Example 9. Personal property. X provides legal services to its 
clients. X purchased a laptop computer and a printer for its 
employees to use in providing legal services. When X placed the 
computer and printer into service, X treated the computer and 
printer and all their components as being within the same class of 
property under section 168(e) and depreciated all the components 
using the same depreciation method. Because the computer and printer 
are property other than a building, the initial units of property 
are determined under the general rule in paragraph (e)(3)(i) of this 
section and are comprised of the components that are functionally 
interdependent. Under paragraph (e)(3)(i) of this section, 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).
    Example 10. Building structure and systems; leased building. X 
is a retailer of consumer products. X conducts its retail sales in a 
building that it leases from Y. The leased building consists of the 
building structure (including the floor, walls, and a roof) and 
various building systems, including a plumbing system, an electrical 
system, a HVAC system, a security system, and a fire protection and 
prevention system. X pays an amount for labor and materials to 
perform work on the HVAC system of the leased building. Under 
paragraph (e)(2)(v)(A) of this section, because X leases the entire 
building, X must treat the leased building and its structural 
components as a single unit of property. As provided under paragraph 
(e)(2)(v)(B) of this section, an amount is paid for an improvement 
to a leased building if it results in an improvement (for example, a 
betterment) to the leased building structure or to any building 
system within the leased building. Therefore, under paragraphs 
(e)(2)(v)(B)(1) and (e)(2)(ii)(B)(1) of this section, if an amount 
paid by X for work on the HVAC system results in an improvement to 
the heating and air conditioning system in the leased building, X 
must treat this amount as an improvement to the entire leased 
building.
    Example 11. Production of real property related to leased 
property. Assume the same facts as in Example 10, except that X 
receives a construction allowance from Y and X uses the construction 
allowance to build a driveway adjacent to the leased building. 
Assume that under the terms of the lease, X, the lessee, is treated 
as the owner of any property that it constructs on or nearby the 
leased building. Also assume that section 110 does not apply to the 
construction allowance. Finally, assume that the driveway is not 
plant property or a network asset. Because the construction of the 
driveway consists of the production of real property other than a 
building, all the components of the driveway that are functionally 
interdependent are a single unit of property under paragraphs 
(e)(3)(i) and (e)(3)(iv) of this section.
    Example 12. Leasehold improvements; construction allowance used 
for lessor-owned improvements. Assume the same facts as Example 11, 
except that under the terms of the lease Y, the lessor, is treated 
as the owner of any property constructed on the leased premises. 
Because Y, the lessor, is the owner of the driveway and the driveway 
is real property other than a building, all the components of the 
driveway that are functionally interdependent are a single unit of 
property under paragraph (e)(3)(i) of this section.
    Example 13. Buildings and structural components; leased office 
space. X provides consulting services to its clients. X conducts its 
consulting services business in two office spaces in the same 
building, each of which it leases from Y under separate lease 
agreements. Each office space contains a separate HVAC unit, which 
is part of the leased property. Both lease agreements provide that X 
is responsible for maintaining, repairing, and replacing the HVAC 
conditioning system that is part of the leased property. X pays 
amounts to perform work on the HVAC units in each office space. 
Because X leases two separate office spaces subject to two leases, X 
must treat the portion of the building structure and the structural 
components subject to each lease as a separate unit of property 
under paragraph (e)(2)(v)(A) of this section. As provided under 
paragraph (e)(2)(v)(B) of this section, an amount is paid for an 
improvement to a leased unit of property, if it results in an 
improvement to the leased portion of the building structure or the 
associated portion of any designated building system subject to each 
lease. Under paragraphs (e)(2)(v)(B)(1) and (e)(2)(ii)(B)(1) of this 
section, X must treat the HVAC unit associated with one leased 
office space as a building system of that leased space and the HVAC 
unit associated with the second leased office space as a building 
system of that second leased space. Thus, under paragraph 
(e)(2)(v)(B) of this section, if the amount paid by X for work on 
the HVAC unit in one leased space results in an improvement (for 
example, a betterment) to the HVAC system that is part of that one 
leased space, then X must treat the amount as an improvement to that 
one unit of leased property.
    Example 14. Leased property; personal property. X is engaged in 
the business of transporting passengers on private jet aircraft. To 
conduct its business, X leases several aircraft from Y. Assume that 
each aircraft is not plant property or a network asset. Under 
paragraph (e)(3)(iv) of this section (referencing paragraph 
(e)(3)(i) of this section), X must treat all of the components of 
each leased aircraft that are functionally interdependent as a 
single unit of property. Thus, X must treat each leased aircraft as 
a single unit of property.
    Example 15. Improvement property.  (i) X is a retailer of 
consumer products. In Year 1, X purchases a building from Y, which X 
intends to use as a retail sales facility. Under paragraph (e)(2)(i) 
of this section, X must treat the building and its structural 
components as a single unit of property. As provided under paragraph 
(e)(2)(ii) of this section, an amount is paid for an improvement to 
a building if it results in an improvement to the building structure 
or any designated building system.
    (ii) In Year 2, X pays an amount to construct an extension to 
the building to be used for additional warehouse space. Assume that 
the extension involves the addition of walls, floors, roof, and 
doors, but does not include the addition or extension of any 
building systems described in paragraph (e)(2)(ii)(B) of this 
section. Also assume that the amount paid to build the extension 
results in a betterment to the building structure under paragraph 
(h) of this section, and is therefore treated as an amount paid for 
an improvement to the entire building under paragraph (e)(2)(ii) of 
this section. Accordingly, X capitalizes the amount paid as an 
improvement to the building under paragraph (d) of this section. 
Under paragraph (e)(4) of this section, the extension is not a unit 
of property separate from the building, the unit of property 
improved. Thus, to determine whether any future expenditure 
constitutes an improvement to the building under paragraph 
(e)(2)(ii), X must determine whether the expenditure constitutes an 
improvement to the building structure, including the building 
extension, or any of the designated building systems.
    Example 16. Personal property; additional rules.  X is engaged 
in the business of transporting freight throughout the United 
States. To conduct its business, X owns a fleet of truck tractors 
and trailers. Each tractor and trailer is comprised of various 
components, including tires. X purchased a truck tractor with all of 
its components, including tires. The tractor tires have an average 
useful life to X of more than one year. At the time X placed the 
tractor in service, it treated the tractor tires as a separate asset 
for depreciation purposes under section 168. X properly treated the 
tractor (excluding the cost of the tires) as 3-year property and the 
tractor tires as 5-year property under section 168(e). Because X's 
tractor is property other than a building, the initial units of 
property for the tractor are determined under the general rule in 
paragraph (e)(3)(i) of this section, and are comprised of all the 
components that are functionally interdependent. Under this rule, X 
must treat the tractor, including its tires, as a single unit of 
property because the tractor and the tires are functionally 
interdependent (that is, the placing in service of the tires is 
dependent upon the placing in service of the tractor). However, 
under paragraph (e)(5)(i) of this section, X must treat the tractor 
and tires as separate units of property because X properly treated 
the tires as being within a different class of property under 
section 168(e).
    Example 17. Additional rules; change in subsequent year.  X is 
engaged in the business of leasing nonresidential real

[[Page 81112]]

property to retailers. In Year 1, X acquired and placed in service a 
building for use in its retail leasing operation. In Year 5, in 
order to accommodate the needs of a new lessee, X incurred costs to 
improve the building structure. X capitalized the costs of the 
improvement under paragraph (d) of this section and depreciated the 
improvement in accordance with section 168(i)(6) as nonresidential 
real property under section 168(e). In Year 7, X determined that the 
structural improvement made in Year 5 qualified under section 
168(e)(8) as qualified retail improvement property and, therefore, 
is 15-year property under section 168(e). In Year 5, X changed its 
method of accounting to use a 15-year recovery period for the 
improvement. Under the additional rule of paragraph (e)(5)(ii) of 
this section, in Year 7, X must treat the improvement as a unit of 
property separate from the building.
    Example 18. Additional rules; change in subsequent year. In Year 
1, X acquired and placed in service a building and parking lot for 
use in its retail operations. Under Sec.  1.263(a)-2T of the 
regulations, X capitalized the cost of the building and the parking 
lot and began depreciating the building and the parking lot as 
nonresidential real property under section 168(e). In Year 3, X 
completed a cost segregation study under which it properly 
determined that the parking lot qualifies as 15-year property under 
section 168(e). In Year 3, X changed its method of accounting to use 
a 15-year recovery period and the 150-percent declining balance 
method of depreciation for the parking lot. Under the additional 
rule of paragraph (e)(5)(ii) of this section, in Year 3, X must 
treat the parking lot as a unit of property separate from the 
building.
    Example 19. Additional rules; change in subsequent year. In Year 
1, X acquired and placed in service a building for use in its 
manufacturing business. X capitalized the costs allocable to the 
building's wiring separately from the building and depreciated the 
wiring as 7-year property under section 168(e). X capitalized the 
cost of the building and all other structural components of the 
building and began depreciating them as nonresidential real property 
under section 168(e). In Year 3, X completed a cost segregation 
study under which it properly determined that the wiring is a 
structural component of the building and, therefore, should have 
been depreciated as nonresidential real property. In Year 3, X 
changed its method of accounting to treat the wiring as 
nonresidential real property. Under the additional rule of paragraph 
(e)(5)(ii) of this section, in Year 3, X must change the unit of 
property for the wiring in a manner that is consistent with the 
change in treatment for depreciation purposes. Therefore, X must 
change the unit of property for the wiring to treat it as a 
structural component of the building, and as part of the building 
unit of property, in accordance with paragraph (e)(2)(i) of this 
section.
    (f) Special rules for determining improvement costs--(1) 
Improvements to leased property--(i) In general. This paragraph (f)(1) 
provides the exclusive rules for determining whether amounts paid by a 
taxpayer are for the improvement to a unit of leased property and must 
be capitalized. In the case of a leased building or a leased portion of 
a building, an amount results in an improvement to a unit of leased 
property if it results in an improvement to any of the properties 
designated under paragraph (e)(2)(ii) of this section (for lessor 
improvements) or under paragraph (e)(2)(v)(B) of this section (for 
lessee improvements except as provided in paragraph (f)(ii)(B) of this 
section). Section 1.263(a)-4 of the regulations does not apply to 
amounts paid for improvements to units of leased property or to amounts 
paid for the acquisition or production of leasehold improvement 
property.
    (ii) Lessee improvements--(A) Requirement to capitalize. A taxpayer 
lessee must capitalize the aggregate of related amounts that it pays to 
improve (as defined under paragraph (d) of this section) a unit of 
leased property except to the extent that section 110 applies to a 
construction allowance received by the lessee for the purpose of such 
improvement or where the improvement constitutes a substitute for rent. 
See Sec.  1.61-8(c) for the treatment of lessee expenditures that 
constitute a substitute for rent. A taxpayer lessee must also 
capitalize the aggregate of related amounts that a lessor pays to 
improve (as defined under paragraph (d) of this section) a unit of 
leased property if the lessee is the owner of the improvement except to 
the extent that section 110 applies to a construction allowance 
received by the lessee for the purpose of such improvement. An amount 
paid for a lessee improvement under this paragraph (f)(1)(ii)(A) is 
treated as an amount paid to acquire or produce a unit of real or 
personal property under Sec.  1.263(a)-2T(d)(1) of the regulations. See 
paragraph (e)(2)(v) of this section for the unit of property for a 
leased building and paragraph (e)(3)(iv) of this section for the unit 
of property for leased real or personal property other than a building.
    (B) Unit of property for lessee improvements. An amount capitalized 
as a lessee improvement under paragraph (f)(1)(ii)(A) of this section 
comprises a unit of property separate from the leased property being 
improved. However, an amount that a lessee pays to improve (as defined 
under paragraph (d) of this section) a lessee improvement under 
paragraph (f)(1)(ii)(A) is not a unit of property separate from such 
lessee improvement.
    (iii) Lessor improvements--(A) Requirement to capitalize. A 
taxpayer lessor must capitalize the aggregate of related amounts that 
it pays directly, or indirectly through a construction allowance to the 
lessee, to improve (as defined in paragraph (d) of this section) a unit 
of leased property where the lessor is the owner of the improvement or 
to the extent that section 110 applies to the construction allowance. A 
lessor must also capitalize the aggregate of related amounts that the 
lessee pays to improve a unit of property (as defined in paragraph (e) 
of this section) where the lessee's improvement constitutes a 
substitute for rent. See Sec.  1.61-8(c) for treatment of expenditures 
by lessees that constitute a substitute for rent. Amounts capitalized 
by the lessor under this paragraph (f)(1)(iii)(A) may not be 
capitalized by the lessee. See paragraphs (e)(2) of this section for 
the unit of property for a building and paragraph (e)(3) of this 
section for the unit of property for real or personal property other 
than a building.
    (B) Unit of property for lessor improvements. An amount capitalized 
as a lessor improvement under paragraph (f)(1)(iii)(A) of this section 
is not a unit of property separate from the unit of property improved. 
See paragraph (e)(4) of this section.
    (iv) Examples. The application of this paragraph (f)(1) is 
illustrated by the following examples, in which it is assumed that 
section 110 does not apply to the lessee.

    Example 1. Lessee improvements; additions to building.  (i) T is 
a retailer of consumer products. In Year 1, T leases a building from 
L, which T intends to use as a retail sales facility. The leased 
building consists of the building structure under paragraph 
(e)(2)(ii)(A) of this section and various building systems under 
paragraph (e)(2)(ii)(B) of this section, including a plumbing 
system, an electrical system, and an HVAC system. Under the terms of 
the lease, T is permitted to improve the building at its own 
expense. Under paragraph (e)(2)(v)(A) of this section, because T 
leases the entire building, T must treat the leased building and its 
structural components as a single unit of property. As provided 
under paragraph (e)(2)(v)(B)(1) of this section, an amount is paid 
for an improvement to the entire leased building if it results in an 
improvement to the leased building structure or to any building 
system within the leased building. Therefore, under paragraphs 
(e)(2)(v)(B)(1) and (e)(2)(ii) of this section, if T pays an amount 
that improves the building structure, the plumbing system, the 
electrical system, or the HVAC system, then T must treat this amount 
as an improvement to the entire leased building.
    (ii) In Year 2, T pays an amount to construct an extension to 
the building to be used for additional warehouse space. Assume that 
this amount results in a betterment (as defined under paragraph (h) 
of this section) to T's leased building structure and does not 
affect any building systems. Accordingly, the

[[Page 81113]]

amount that T pays for the building extension results in an 
improvement to the leased building structure, and thus, under 
paragraph (e)(2)(v)(B)(1) of this section, is treated as an 
improvement to the entire leased building under paragraph (d) of 
this section. Because T, the lessee, paid an amount to improve a 
unit of leased property, T is required to capitalize the amount paid 
for the building extension under paragraph (f)(1)(ii)(A) of this 
section. In addition, paragraph (f)(1)(ii)(A) of this section 
requires T to treat the amount paid for the improvement as the 
acquisition or production of a unit of property (leasehold 
improvement property) under Sec.  1.263(a)-2T(d)(1). Moreover, under 
paragraph (f)(1)(ii)(B) of this section, the building extension is a 
unit of property separate from the unit of leased property (the 
building and its structural components).
    (iii) In Year 5, T pays an amount to add a larger door to the 
building extension that it constructed in Year 2 in order to 
accommodate the loading of larger products into the warehouse space. 
Assume that the amount paid to add the larger door results in a 
betterment under paragraph (h) of this section to the building 
structure extension, the unit of property under paragraph 
(f)(1)(ii)(B) of this section. As a result, T must capitalize the 
amounts paid to add the larger door as an improvement to T's unit of 
property (the building extension) under paragraph (d) of this 
section. In addition, because the amount that T paid to add the 
larger door is for an improvement to the building extension (a 
lessee improvement under paragraph (f)(1)(ii)(A)), the larger door 
is not a unit of property separate from the unit of property 
improved. See paragraphs (e)(4) and (f)(1)(ii)(B) of this section.
    Example 2. Lessee improvements; additions to certain structural 
components of buildings.  (i) Assume the same facts as Example 1 
except that in Year 2, T also pays an amount to construct an 
extension of the HVAC system into the building extension. Assume 
that the extension is a betterment under paragraph (h) of this 
section to the leased HVAC system (a building system under paragraph 
(e)(2)(ii)(B)(1) of this section). Accordingly, the amount that T 
pays for the extension of the HVAC system results in an improvement 
to a leased building system, the HVAC system, and thus, under 
paragraph (e)(2)(v)(B)(1) of this section, is treated as an 
improvement to the entire leased building under paragraph (d) of 
this section. Because T, the lessee, incurs costs to improve a unit 
of leased property, T is required to capitalize the costs of the 
improvement under paragraph (f)(1)(ii)(A) of this section. Under 
paragraph (f)(1)(ii)(B), the extension to the leased HVAC is a unit 
of property separate from the unit of leased property (the leased 
building and its structural components). In addition, under 
paragraph (f)(1)(ii)(A) of this section, T must treat the amount 
paid for the HVAC extension as the acquisition and production of a 
unit of property under Sec.  1.263(a)-2T(d)(1).
    (ii) In Year 5, T pays an amount to add an additional chiller to 
the portion of the HVAC system that it constructed in Year 2 in 
order to accommodate the climate control requirements for new 
product offerings. Assume that the amount paid for the chiller 
results in a betterment under paragraph (h) of this section to the 
HVAC system extension, the unit of property under paragraph 
(f)(1)(ii)(B) of this section. Accordingly, T must capitalize the 
amount paid to add the chiller as an improvement to T's unit of 
property (the HVAC system extension) under paragraph (d) of this 
section. In addition, because the amount that T paid to add the 
chiller is for an improvement to the HVAC system extension (a lessee 
improvement under paragraph (f)(1)(ii)(A) of this section), the 
chiller is not a unit of property separate from the unit of property 
improved. See paragraphs (f)(1)(ii)(B) and (e)(4) of this section.
    Example 3. Lessor Improvements; additions to building.  (i) T is 
a retailer of consumer products. In Year 1, T leases a building from 
L, which T intends to use as a retail sales facility. Pursuant to 
the lease, L provides a construction allowance to T, which T intends 
to use to construct an extension to the retail sales facility for 
additional warehouse space. Assume that the amount paid for any 
improvement to the building does not exceed the construction 
allowance and that L is treated as the owner of any improvement to 
the building. Under paragraph (e)(2)(i) of this section, L must 
treat the leased building and its structural components as a single 
unit of property. As provided under paragraph (e)(2)(ii) of this 
section, an amount paid is for an improvement to the building if it 
results in an improvement to the building structure or to any 
building system.
    (ii) In Year 2, T uses L's construction allowance to construct 
an extension to the leased building to provide additional warehouse 
space in the building. Assume that the extension is a betterment (as 
defined under paragraph (h) of this section) to the building 
structure, and therefore, the amount paid for the extension results 
in an improvement to the building structure under paragraph (d) of 
this section. Under paragraph (f)(1)(iii)(A) of this section, L, the 
lessor and owner of the improvement, must capitalize the amounts 
paid to T to construct the extension to the retail sales facility. T 
is not permitted to capitalize the amounts paid for the lessor-owned 
improvement. Finally, under paragraph (f)(1)(iii)(B) of this 
section, the extension to L's building is not a unit of property 
separate from the building and its structural components.
    Example 4. Lessee property; personal property added to leased 
building.  T is a retailer of consumer products. T leases a building 
from L, which T intends to use as a retail sales facility. Pursuant 
to the lease, L provides a construction allowance to T, which T uses 
to acquire and construct partitions for fitting rooms, counters, and 
shelving. Assume that each partition, counter, and shelving unit is 
a unit of property under paragraph (e)(3) of this section. Assume 
that for federal income tax purposes T is treated as the owner of 
any personal property that it acquires or constructs with the 
construction allowance and that the amounts paid for acquisition or 
construction of any personal property used in the leased property do 
not constitute a substitute for rent. T's expenditures for the 
partitions, counters, and shelving are not improvements to the 
leased property under paragraph (d) of this section, but rather 
constitute amounts paid to acquire or produce separate units of 
personal property under Sec.  1.263(a)-2T.
    Example 5. Lessor property; buildings on leased property.  L is 
the owner of a parcel of unimproved real property that L leases to 
T. Pursuant to the lease, L provides a construction allowance to T 
of $500,000, which T agrees to use to construct a building costing 
not more than $500,000 on the leased real property and to lease the 
building from L after it is constructed. Assume that for Federal 
income tax purposes, L is treated as the owner of the building that 
T will construct. T uses the $500,000 to construct the building as 
required under the lease. The building consists of the building 
structure and the following building systems: (1) A plumbing system; 
(2) an electrical system; and (3) an HVAC system. Because L provides 
a construction allowance to T to construct a building, the total 
cost of the building equals $500,000, and L is treated as the owner 
of the building, under paragraph (f)(1)(iii)(A) of this section L 
must capitalize the amounts that it pays indirectly to acquire and 
produce the building under Sec.  1.263(a)-2T(d)(1). Under paragraph 
(e)(2)(i) of this section, L must treat the building and its 
structural components as a single unit of property. Under paragraph 
(f)(1)(iii)(A) of this section, T, the lessee, may not capitalize 
the amounts paid (with the construction allowance received from L) 
for construction of the building.
    Example 6. Lessee contribution to construction costs. Assume the 
same facts as in Example 5, except T spends $600,000 to construct 
the building. T uses the $500,000 construction allowance provided by 
L plus $100,000 of its own funds to construct the building that L 
will own pursuant to the lease. Also assume that the additional 
$100,000 that T incurs is not a substitute for rent. For the reasons 
discussed in Example 5, L must capitalize the $500,000 it paid T to 
construct the building under Sec.  1.263(a)-2T(d)(1). In addition, 
because T spends its own funds to complete the building, T has a 
depreciable interest of $100,000 in the building and must capitalize 
the $100,000 it paid to construct the building as a leasehold 
improvement under Sec.  1.263(a)-2T(d)(1) of the regulations. Under 
paragraph (e)(2)(i) of this section, L must treat the building as a 
single unit of property to the extent of its depreciable interest of 
$500,000 In addition, under paragraph (e)(2)(v)(A) of this section, 
T must also treat the building as a single unit of property to the 
extent of its depreciable interest of $100,000.

    (2) 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

[[Page 81114]]

determining whether the amount paid improves the unit of property.
    (3) Certain costs incurred during an improvement--(i) In general. A 
taxpayer must capitalize all the direct costs of an improvement and all 
the indirect costs (including, for example, otherwise deductible repair 
or component removal costs) that directly benefit or are incurred by 
reason of an improvement in accordance with the rules under section 
263A. Therefore, indirect costs that do not directly benefit and 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 capital improvements to units of property 
not used in the taxpayer's trade or business or for the production of 
income if the amounts are paid as part of a remodeling of the 
taxpayer's residence.
    (4) Aggregate of related amounts. For purposes of paragraph (d) 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.
    (g) Safe harbor for routine maintenance on property other than 
buildings--(1) In general. An amount paid for routine maintenance 
performed on a unit of property other than a building or a structural 
component of a building is deemed not to 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 (g)(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) Rotable and temporary spare parts. Except as provided in 
paragraph (g)(3) of this section, for purposes of paragraph (g)(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.  1.162-3T(a)(3), which provides generally 
that rotable and temporary spare parts are used or consumed by the 
taxpayer in the taxable year in which the taxpayer disposes of the 
parts.
    (3) Exceptions. Routine maintenance does not include the following:
    (i) Amounts paid 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) Amounts paid 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) 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.
    (iv) 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 is no longer functional for its intended use.
    (v) Amounts paid for repairs, maintenance, or improvement of 
rotable and temporary spare parts to which the taxpayer applies the 
optional method of accounting for rotable and temporary spare parts 
under Sec.  1.162-3T(e).
    (4) Class life. The class life of a unit of property is the 
recovery period prescribed for the property under sections 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 section, section 
168(g)(3)(A) (relating to tax-exempt use property subject to lease) 
does not apply. If the unit of property is comprised of more than one 
component with different class lives, then the class life of the unit 
of property is deemed to be the same as the component with the longest 
class life.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (g). Unless otherwise stated, assume that X has not applied 
the optional method of accounting for rotable and temporary spare parts 
under Sec.  1.162-3T(e):

    Example 1. Routine maintenance on 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 Year 1, X purchased a 
new aircraft, which included four new engines attached to the 
airframe. The four aircraft engines acquired with the aircraft are 
not materials or supplies under Sec.  1.162-3T(c)(1)(i) because they 
are acquired as part of a single unit of property, the aircraft. In 
Year 5, X performs its first ESV on the aircraft engines. The ESV 
includes disassembly, cleaning, inspection, repair, replacement, 
reassembly, and testing of the 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 that 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 (g)(3) 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 (g) 
of this section. Accordingly, the amounts paid for the ESVs are 
deemed not to improve the aircraft and are not required to be 
capitalized under paragraph (d) of this section.

[[Page 81115]]

    Example 2. Routine maintenance after class life.  Assume the 
same facts as in Example 1, except that in year 15, X pays amounts 
to perform an ESV on one of the original aircraft engines, after the 
end of the class life of 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 (g) of this section. 
Accordingly, the amounts paid for this ESV, even though performed 
after the class life of the aircraft, are deemed not to improve the 
aircraft and are not required to be capitalized under paragraph (d) 
of this section.
    Example 3. Routine maintenance on rotable spare parts. (i) 
Assume the same facts as in Example 1, except that in addition to 
the four engines purchased as part of the aircraft, X separately 
purchases four additional new engines that X intends to use in its 
aircraft fleet to avoid operational downtime when ESVs are required 
to be performed on the engines previously installed on an aircraft. 
Later in Year 1, X installs these four engines on an aircraft in its 
fleet. In Year 5, X performs the first ESVs on these four engines. 
Assume that these ESVs involve the same routine maintenance 
activities that were performed on the engines in Example 1, and that 
none of the exceptions set out in paragraph (g)(3) of this section 
apply to these ESVs. After the ESVs were performed, these engines 
were reinstalled on other aircraft or stored for later installation.
    (ii) The additional aircraft engines are rotable spare parts 
because they were acquired separately from the aircraft, they are 
removable from the aircraft, and are repaired and reinstalled on 
other aircraft or stored for later installation. See Sec.  1.162-
3T(c)(2) (definition of rotable and temporary spare parts). The 
class life of an engine is the same as the airframe, 12 years. 
Because the ESVs involve the recurring activities that X expects to 
perform as a result of its use of the engines to keep the engines 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 engine, the ESVs fall within the routine 
maintenance safe harbor under paragraph (g) of this section. 
Accordingly, the amounts paid for the ESVs for the four additional 
engines are deemed not to improve these engines and are not required 
to be capitalized under paragraph (d) of this section. For the 
treatment of amounts paid to acquire the engines, see Sec.  1.162-
3T(a).
    Example 4. Routine maintenance resulting from prior owner's use. 
(i) In January, Year 1, X purchases a used machine for use in its 
manufacturing operations. Assume that the machine is the unit of 
property and has a class life of 10 years. X places the machine in 
service in January, Year 1, and at that time, 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 X purchased the machine, 
the machine was approaching the end of a three-year scheduled 
maintenance period. As a result, in February, Year 1, X pays amounts 
to perform the manufacturer recommended scheduled maintenance. 
Assume that none of the exceptions set out in paragraph (g)(3) of 
this section apply to the amounts paid for the scheduled 
maintenance.
    (ii) The majority of X's costs do not qualify under the routine 
maintenance safe harbor in paragraph (g) of this section because the 
costs were incurred primarily as a result of the prior owner's use 
of the property and not X's use. X acquired the machine just before 
it had received its three-year scheduled maintenance. Accordingly, 
the amounts paid for the scheduled maintenance resulted from the 
prior owner's, and not the taxpayer's, use of the property and must 
be capitalized if those amounts result in a betterment under 
paragraph (h) of this section, including the amelioration of a 
material condition or defect, or otherwise result in an improvement 
under paragraph (d) of this section. See also section 263A and the 
regulations thereunder for the requirement to capitalize indirect 
costs (including otherwise deductible repair costs) that directly 
benefit or are incurred by reason of production activities.
    Example 5. Routine maintenance resulting from new owner's use. 
Assume the same facts as in Example 4, except that after X pays 
amounts for the maintenance in Year 1, X continues to operate the 
machine in its manufacturing business. In Year 4, X pays amounts 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 4 and that none 
of the exceptions set out in paragraph (g)(3) of this section apply 
to the amounts paid for the scheduled maintenance. Because the 
scheduled maintenance performed in Year 4 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 (g) of this section. Accordingly, the amounts 
paid for the scheduled maintenance in Year 4 are deemed not to 
improve the machine and are not required to be capitalized under 
paragraph (d) of this section. But see section 263A and the 
regulations thereunder for the requirement to capitalize indirect 
costs (including otherwise deductible repair costs) that directly 
benefit or are incurred by reason of production activities.
    Example 6. 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 
percent 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 Year 1, X acquired 
10 new containers and placed them into service. In Year 4, Year 7, 
Year 9, and Year 12, 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 (g)(3) 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 (g) of 
this section. Accordingly, the amounts that X paid for the 
replacement of the container linings are deemed not to improve the 
containers and are not required to be capitalized under paragraph 
(d) of this section. But see section 263A and the regulations 
thereunder for the requirement to capitalize indirect costs 
(including otherwise deductible repair costs) that directly benefit 
or are incurred by reason of production activities.
    Example 7. 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 pays amounts to disassemble, inspect, and 
recondition or replace components of the freight car with comparable 
and commercially available and reasonable replacement parts. Ten 
years after X places the freight car in service, X pays amounts 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 amounts X pays for the reconditioning do not 
qualify for the routine maintenance safe harbor under paragraph (g) 
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) of this section.
    Example 8. 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-

[[Page 81116]]

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 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.  1.162-3T(c)(2). In Year 1, X acquired a new 
towboat, including its two engines, and placed the towboat into 
service. In Year 5, X pays amounts to perform scheduled maintenance 
on both engines in the towboat. Assume that none of the exceptions 
set out in paragraph (g)(3) 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, the maintenance results from 
X's use of the towboat and the maintenance 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 (g) of this section. 
Accordingly, the amounts paid for the scheduled maintenance to its 
towboat engines in Year 5 are deemed not to improve the towboat and 
are not required to be capitalized under paragraph (d) of this 
section.
    Example 9. Routine maintenance with betterments.  Assume the 
same facts as Example 8, except that in Year 9, 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 Year 9, X pays amounts 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 of the boats when X placed them in 
service. 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, under 
paragraph (f)(3)(i) of this section, the scheduled maintenance 
procedures directly benefit the upgrades. Therefore, the amounts 
that X paid in Year 9 for the maintenance and upgrade of the engines 
do not qualify for the routine maintenance safe harbor described 
under paragraph (g) of this section. These amounts must be 
capitalized if they result in a betterment under paragraph (h) of 
this section, including a material increase in the capacity of the 
towboat, or otherwise result in an improvement under paragraph (d) 
of this section.
    Example 10. 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. At the time 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 includes 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 Year 1 and 
did not perform any maintenance on the canals until Year 6. At that 
time, the canals had fallen into a state of disrepair and no longer 
functioned for irrigation. In Year 6, X pays 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 (g)(3)(iv) of this 
section, routine maintenance does not include activities that 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 that X pays for work performed on the canals in Year 6 must 
be capitalized if they result in improvements under paragraph (d) of 
this section (for example, restorations under paragraph (i) of this 
section).

    (h) 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) Betterments to buildings. In the case of a building, an amount 
results in a betterment to the unit of property if it results in a 
betterment to any of the properties designated in paragraphs 
(e)(2)(ii), (e)(2)(iii)(B), (e)(2)(iv)(B), or (e)(2)(v)(B) of this 
section.
    (3) Application of general rule--(i) Facts and circumstances. To 
determine whether an amount paid results in a betterment described in 
paragraph (h)(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

[[Page 81117]]

property immediately prior to the circumstances necessitating the 
expenditure is the condition of the property immediately prior to the 
particular event.
    (4) Examples. The following examples illustrate the application of 
this paragraph (h) only and do not address whether capitalization is 
required under another provision of this section or another provision 
of the Internal Revenue Code (for example, section 263A):

    Example 1. Amelioration of pre-existing material condition or 
defect.  In Year 1, 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 Year 2, X discovers 
the contamination and incurs costs to remediate the soil. The 
remediation costs result in a betterment to the land under paragraph 
(h)(1)(i) of this section because X incurred the costs to ameliorate 
a material condition or defect that existed prior to X's acquisition 
of the land.
    Example 2. Not amelioration of pre-existing condition or defect. 
 X owns a building that was constructed with insulation that 
contained asbestos. The health dangers of asbestos were not widely 
known when the building was constructed. X determines that certain 
areas of asbestos-containing insulation had begun to deteriorate and 
could eventually pose a health risk to employees. Therefore, X pays 
an amount to remove the asbestos-containing insulation from the 
building structure and replace it with new insulation that is safer 
to employees, but no more efficient or effective than the asbestos 
insulation. Under paragraph (e)(2)(ii) of this section, if the 
amount paid results in a betterment to the building structure or any 
building system, X must treat the amount as an improvement to the 
building. Although the asbestos is determined to be unsafe under 
certain circumstances, the asbestos is not a preexisting or material 
defect of the building structure under paragraph (h)(1)(i) of this 
section. In addition, the removal and replacement of the asbestos 
does not result in a material addition to the building structure 
under paragraph (h)(1)(ii) of this section or result in a material 
increase in capacity, productivity, efficiency, strength, or quality 
of the building structure or the output of the building structure 
under paragraph (h)(1)(iii) of this section. Therefore, the amount 
paid to remove and replace the asbestos insulation does not result 
in a betterment to the building structure under paragraph (h) of 
this section.
    Example 3. Not amelioration of pre-existing material condition 
or defect.  (i) In January, Year 1, X purchased a used machine for 
use in its manufacturing operations. Assume that the machine is a 
unit of property and has a class life of 10 years. X placed the 
machine in service in January, Year 1 and at that time expected 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 X purchased the machine, it was 
approaching the end of a three-year scheduled maintenance period. As 
a result, in February, Year 1, X pays an amount to perform the 
manufacturer recommended scheduled maintenance to keep the machine 
in its ordinarily efficient operating condition.
    (ii) The amount that X pays does not qualify under the routine 
maintenance safe harbor in paragraph (g) of this section because the 
cost primarily results from the prior owner's use of the property 
and not the taxpayer's use. X acquired the machine just before it 
had received its three-year scheduled maintenance. Accordingly, the 
amount that X pays for the scheduled maintenance results from the 
prior owner's use of the property and ameliorates conditions or 
defects that existed prior to X's ownership of the machine. 
Nevertheless, considering the facts and circumstances under 
paragraph (h)(2)(i) of this section, including the purpose and minor 
nature of the work performed, this amount does not ameliorate a 
material condition or defect in the machine under paragraph 
(h)(1)(i) of this section, result in a material addition to the 
machine under paragraph (h)(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 
under paragraph (h)(1)(iii) of this section. Therefore, X is not 
required to capitalize the amount paid for the scheduled maintenance 
as a betterment to the machine under this paragraph (h).
    Example 4. Not amelioration of pre-existing material condition 
or defect.  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 monitor routinely 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 pays an amount 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 (g) 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 X placed it in service. The 
amount that X pays to inspect, retune, and replace minor components 
of the ice resurfacing machine ameliorates a condition or defect 
that existed prior to X's acquisition of the equipment. 
Nevertheless, considering the facts and circumstances under 
paragraph (h)(3)(i) of this section, including the purpose and minor 
nature of the work performed, this amount does not ameliorate a 
material condition or defect in the machine under paragraph 
(h)(1)(i) of this section, result in a material addition to the 
machine under paragraph (h)(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 
under paragraph(h)(1)(iii) of this section. Therefore, X is not 
required to capitalize the amount paid to inspect, retune, and 
replace minor components of the machine as a betterment under this 
paragraph (h).
    Example 5. Amelioration of material condition or defect.  (i) 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. Immediately after the acquisition and during the following 
two years, while X continues to use the building as an assisted 
living facility, X pays amounts 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 on 
X's building includes repairing damaged drywall, repainting, re-
wallpapering, replacing windows, repairing and replacing doors; 
replacing and regrouting tile; repairing millwork; and repairing and 
replacing roofing materials. The work also involves the replacement 
of section 1245 property including window treatments, furniture, and 
cabinets. On its applicable financial statements, X capitalizes the 
costs of the repairs and maintenance to the building. The work that 
X performs affects only the building structure under paragraph 
(e)(2)(ii)(A) of this section and does not affect any of the 
building systems described in paragraph (e)(2)(ii)(B) of this 
section. Assume that each section 1245 property is a separate unit 
of property.
    (ii) Under paragraph (e)(2)(ii) of this section, if an amount 
paid results in a betterment to the building structure or any 
building system, X must treat the amount as an improvement to the 
building. Considering the facts and circumstances, as required under 
paragraph (h)(3)(i) of this section, including the purpose of the 
expenditures, the effect of the expenditures on the building 
structure, and the treatment of the expenditures in X's applicable 
financial statements, the amounts that X paid for repairs and 
maintenance to the building structure comprises a betterment to the 
building structure under paragraph (h)(1)(i) of this section because 
the amounts ameliorate material conditions or defects that existed 
prior to X's acquisition of the building. Therefore, in accordance 
with paragraph (e)(2)(ii) of this section, X must treat the amounts 
paid for the betterment to the building structure as an improvement 
to the building and must capitalize the amounts under paragraph 
(d)(1) of this section. Moreover, X is required to capitalize the 
amounts paid to acquire and install each

[[Page 81118]]

section 1245 property, including each window treatment, each item of 
furniture, and each cabinet, in accordance with Sec.  1.263(a)-
2T(d)(1).
    Example 6. Not a betterment; building refresh.  (i) X owns a 
nationwide chain of retail stores that sell a wide variety of items. 
To remain competitive in the industry and increase customer traffic 
and sales volume, X periodically refreshes the appearance and layout 
of its stores. The work that X performs to refresh a store consists 
of cosmetic and layout changes to the store's interiors and general 
repairs and maintenance to the store building to make the stores 
more attractive and the merchandise more accessible to customers. 
The work to each store building consists of replacing and 
reconfiguring a small number of display tables and racks to provide 
better exposure of the merchandise, making corresponding lighting 
relocations and flooring repairs, moving one wall to accommodate the 
reconfiguration of tables and racks, patching holes in walls, 
repainting the interior structure with a new color scheme to 
coordinate with new signage, replacing damaged ceiling tiles, 
cleaning and repairing vinyl flooring throughout the store building, 
and power washing building exteriors. The display tables and the 
racks all constitute section 1245 property. X pays amounts to 
refresh 50 stores during the taxable year. In its applicable 
financial statement, X capitalizes all the costs to refresh the 
store buildings and amortizes them over a 5-year period. Assume that 
each section 1245 property within each store is a separate unit of 
property. Finally, assume that the work does not ameliorate any 
material conditions or defects that existed when X acquired the 
store buildings or result in any material additions to the store 
buildings.
    (ii) Under paragraph (e)(2)(ii) of this section, if an amount 
paid results in a betterment to the building structure or any 
building system, X must treat the amount as an improvement to the 
building. Considering the facts and circumstances, as required under 
paragraph (h)(3)(i) of this section, including the purpose of the 
expenditure, the physical nature of the work performed, the effect 
of the expenditure on buildings' structure and systems, and the 
treatment of the work on X's applicable financial statements, the 
amounts paid for the refresh of each building do not result in 
material increases in capacity, productivity, efficiency, strength, 
or quality of the buildings' structures or any building systems as 
compared to the condition of the buildings' structures and systems 
after the previous refresh. Rather, the work performed keeps X's 
store buildings' structures and buildings' systems in the ordinary 
efficient operating condition that is necessary for X to continue to 
attract customers to its stores. Therefore, X is not required to 
treat the amounts paid for the refresh of its store buildings' 
structures and buildings' systems as betterments under paragraph 
(h)(1)(iii) of this section. However, X is required to capitalize 
the amounts paid to acquire and install each section 1245 property 
in accordance with Sec.  1.263(a)-2T(d)(1).
    Example 7. Building refresh; limited improvement.  Assume the 
same facts as Example 6 except, in the course of X's refresh of its 
stores, X pays amounts to remove and replace the bathroom fixtures 
(that is, the toilets, sinks, and plumbing fixtures) with upgraded 
bathroom fixtures in all of the restrooms in X's retail buildings in 
order to update the restroom facilities. As part of the update of 
the restrooms, X also pays amounts to replace the floor and wall 
tiles that were removed or damaged in the installation of the new 
plumbing fixtures. Under paragraph (e)(2)(ii) of this section, if 
any of the amounts paid result in betterments to the building 
structure or any building system, X must treat the amounts as an 
improvement to the building. Under paragraph (e)(2)(ii)(B)(2) of 
this section, the plumbing system in each of X's store buildings, 
including the plumbing fixtures, is a building system. X must treat 
the amounts paid to replace the bathroom fixtures with upgraded 
fixtures as a betterment because they result in a material increase 
in the quality of each plumbing system under paragraph (h)(1)(iii) 
of this section. Under paragraph (f)(3) of this section, X is 
required to capitalize all the indirect costs that directly benefit 
or are incurred by reason of the betterment, or improvement, to each 
plumbing system. Because the costs to remove the old plumbing 
fixtures and to remove and replace the bathroom tiles directly 
benefit and are incurred by reason of the improvement to the 
plumbing system, these costs must also be capitalized under 
paragraph (f)(3) of this section. Therefore, in accordance with 
paragraph (e)(2)(ii) of this section, X must treat the amounts paid 
for a betterment to each plumbing system as an improvement to X's 
retail building to which the costs relate, and must capitalize the 
amounts under paragraph (d)(1) of this section. However, X is not 
required under paragraph (f)(3) of this section to capitalize the 
costs described in Example 6 to refresh the appearance and layout of 
its stores because those costs do not directly benefit and are not 
incurred by reason of the improvements to the stores' plumbing 
systems. Thus, X is not required to capitalize under paragraphs 
(f)(3) of this section any costs specified in Example 6 for the 
reconfiguration, cosmetic changes, repairs, and maintenance to the 
other parts of X's store buildings.
    Example 8. Betterment; building remodel.  (i) Assume the same 
facts as Example 6, but assume that the work performed to refresh 
the stores directly benefits or was incurred by reason of a 
substantial remodel to X's store buildings. In addition to the 
reconfiguration, cosmetic changes, repairs, and maintenance 
activities performed in Example 6, X performs significant additional 
work to alter the appearance and layout of its stores in order to 
increase customer traffic and sales volume. First, X pays amounts to 
upgrade the buildings' structures as defined under (e)(2)(ii)(A). 
This work includes removing and rebuilding walls to move built-in 
changing rooms and specialty departments to different areas of the 
stores, replacing ceilings with acoustical tiles to reduce noise and 
create a more pleasant shopping environment, rebuilding the interior 
and exterior facades around the main doors to create a more 
appealing entrance, replacing conventional doors with automatic 
doors, and replacing carpet with ceramic flooring of different 
textures and styles to delineate departments and direct customer 
traffic. Second, X pays amounts for work on the electrical systems, 
which are building systems under paragraph (e)(2)(ii)(B)(3) of this 
section. Specifically, X upgrades the wiring in the buildings so 
that X can add video monitors and an expanded electronics 
department. X also removes and replaces the recessed lighting 
throughout the buildings with more efficient and brighter lighting. 
The work performed on the buildings' structures and the electrical 
systems includes the removal and replacement of both section 1250 
and section 1245 property. In its applicable financial statement, X 
capitalizes all the costs incurred over a 10-year period. Upon 
completion of this period, X anticipates that it will have to 
remodel the store buildings again.
    (ii) Under paragraph (e)(2)(ii) of this section, if any of the 
amounts paid result in a betterment to the building structure or any 
building system, X must treat those amounts as an improvement to the 
building. Considering the facts and circumstances, as required under 
paragraph (h)(3)(i) of this section, including the purpose of the 
expenditure, the physical nature of the work performed, the effect 
of the work on the buildings' structures and buildings' systems, and 
the treatment of the work on X's applicable financial statements, 
the amounts that X pays for the remodeling of its stores result in 
betterments to the buildings' structures and electrical systems 
under paragraph (h) of this section. Specifically, amounts paid to 
upgrade the wiring and to remove and replace the recess lighting 
throughout the stores materially increase the productivity, 
efficiency, and quality of X's stores' electrical systems under 
paragraph (h)(1)(iii) of this section. Also, the amounts paid to 
remove and rebuild walls, to replace ceilings, to rebuild facades, 
to replace doors, and replace flooring materially increase the 
productivity, efficiency, and quality of X's store buildings' 
structures under paragraph (h)(1)(iii) of this section. In addition, 
the amounts paid for the refresh of the store buildings described in 
Example 6 must be capitalized under paragraph (f)(3)(i) of this 
section because these expenditures directly benefitted or were 
incurred by reason of the improvements to X's store buildings' 
structures and electrical systems. Therefore, in accordance with 
paragraph (e)(2)(ii) of this section, X must treat the costs of 
improving the buildings' structures and systems, including the costs 
to refresh, as improvements to X's retail buildings and must 
capitalize the amounts paid for these improvements under paragraph 
(d)(1) of this section. Moreover, X is required to capitalize the 
amounts paid to acquire and install each section 1245 property in 
accordance with Sec.  1.263(a)-2T(d)(1).
    Example 9. Not betterment; relocation and reinstallation of 
personal property.  In Year 1, X purchases new cash registers for 
use in its retail store located in leased space in a shopping mall. 
Assume that each cash register is a unit of property as determined 
under paragraph (e)(3) of this section. In Year

[[Page 81119]]

1, X capitalizes the costs of acquiring and installing the new cash 
registers under Sec.  1.263(a)-2T(d)(1). In Year 3, X's lease 
expires and X decides to relocate its retail store to a different 
building. In addition to various other costs, X pays $5,000 to move 
the cash registers and $1,000 to reinstall them in the new store. 
The cash registers are used for the same purposes and in the same 
manner that they were used in the former location. The amounts that 
X pays to move and reinstall the cash registers into its new store 
do not result in a betterment to the cash registers under paragraph 
(h) of this section.
    Example 10. Betterment; relocation and reinstallation of 
manufacturing equipment.  X operates a manufacturing facility in 
Building A, which contains various machines that X uses in its 
manufacturing business. X decides to expand part of its operations 
by relocating a machine to Building B to reconfigure the machine 
with additional components. Assume that the machine is a single unit 
of property under paragraph (e)(3) of this section. X pays amounts 
to disassemble the machine, to move the machine to the new location, 
and to reinstall the machine in a new configuration with additional 
components. Assume that the reinstallation, including the 
reconfiguration and the addition of components, results in an 
increase in capacity of the machine, and therefore results in a 
betterment to the machine under paragraph (h)(3)(iii) of this 
section. Accordingly, X must capitalize the costs of reinstalling 
the machine as an improvement to the machine under paragraph (d)(1) 
of this section. X is also required to capitalize the costs of 
disassembling and moving the machine to Building B because these 
costs directly benefit and are incurred by reason of the improvement 
to the machine under paragraph (f)(3)(i) of this section.
    Example 11. Betterment; regulatory requirement.  X owns a hotel 
that includes five feet high unreinforced terra cotta and concrete 
parapets with overhanging cornices around the entire roof perimeter. 
The parapets and cornices are in good condition. In Year 1, 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 pays an amount to remove the old 
parapets and cornices and replace them with new ones made of glass 
fiber reinforced concrete, which makes them lighter and stronger 
than the original components. They are attached to the hotel using 
welded connections instead of wire supports, making them more 
resistant to damage from lateral movement. Under paragraph 
(e)(2)(ii) of this section, if the amount paid results in a 
betterment to the building structure or any building system, X must 
treat the amount as an improvement to the building. The parapets and 
cornices are part of the building structure as defined in paragraph 
(e)(2)(ii)(A) of this section. The event necessitating the 
expenditure was the 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 structure. X must treat the 
amount paid to remove and replace the parapets and cornices as an 
improvement because it results in a betterment to the building 
structure under paragraph (h)(1)(iii) of this section. Therefore, in 
accordance with paragraph (e)(2)(ii) of this section, X must treat 
the amount paid for the betterment to the building structure as an 
improvement to the hotel building and must capitalize the amount 
paid under paragraph (d)(1) of this section. 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 (f)(2) of this section.
    Example 12. Not a betterment; regulatory requirement.  X owns a 
meat processing plant. X discovers that oil is 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 pays an amount 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. Under 
paragraph (e)(2)(ii) of this section, if the amount paid results in 
a betterment to the building structure or any building system, X 
must treat the amount as an improvement to the building. 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. X is not required to treat the amount paid as a 
betterment under paragraph (h) of this section because it does not 
result in a material addition or material increase in capacity, 
productivity, efficiency, strength or quality of the building 
structure or its output compared to the condition of the structure 
prior to the seepage of the oil. The federal meat inspectors' 
requirement that X correct the seepage to continue operating the 
plant is not relevant in determining whether the amount paid 
improves the plant. See paragraph (f)(2) of this section.
    Example 13. Not a betterment; replacement with same part.  X 
owns a small retail shop. A storm damages the roof of X's shop by 
displacing numerous wooden shingles. X pays a contractor to replace 
all the wooden shingles on the roof with new wooden shingles. Under 
paragraph (e)(2)(ii) of this section, if the amount paid results in 
a betterment to the building structure or any building system, X 
must treat the amount as an improvement to the building. The roof is 
part of the building structure under paragraph (e)(2)(ii)(A) of this 
section. The event necessitating the expenditure was the storm. 
Prior to the storm, the building structure was functioning for its 
intended use. X is not required to treat the amount paid to replace 
the shingles as a betterment under paragraph (h) of this section 
because it does not result in a material addition, or material 
increase in the capacity, productivity, efficiency, strength, or 
quality of the building structure or the output of the building 
structure compared to the condition of the building structure prior 
to the storm.
    Example 14. Not a betterment; replacement with comparable part.  
Assume the same facts as in Example 13, except that wooden shingles 
are not available on the market. X pays a contractor to replace all 
the wooden shingles with comparable asphalt shingles. The amount 
that X pays to reshingle the roof with asphalt shingles does not 
result in a betterment to the shop building structure, 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 a 
betterment, and therefore, an improvement, to the shop building 
structure under this paragraph (h).
    Example 15. Betterment; replacement with improved parts.  Assume 
the same facts as in Example 14, except that, instead of replacing 
the wooden shingles with asphalt shingles, X pays a contractor 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 amount paid for these shingles results in a 
betterment to the shop building structure under paragraphs 
(h)(1)(iii) and (h)(3)(iii) of this section because it results in a 
material increase in the quality of the shop building structure as 
compared to the condition of the shop building structure prior to 
the storm. Therefore, in accordance with paragraph (e)(2)(ii), X 
must treat the amount paid for the betterment of the building 
structure as an improvement to the building and must capitalize the 
amount paid under paragraph (d)(1) of this section.
    Example 16. Material increase in capacity.  X owns a factory 
building with a storage area on the second floor. X pays an amount 
to replace 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. Under 
paragraph (e)(2)(ii) of this section, if the amount results in a 
betterment to the building structure or any building system, X must 
treat the amount as an improvement to the building. The columns and 
girders are part of the building structure defined under paragraph 
(e)(2)(ii)(A) of this section. X must treat the amount paid to 
replace the columns and girders as a betterment under paragraph 
(h)(1)(iii) of this section because it materially increases the 
load-carrying capacity of the building structure. The comparison 
rule in paragraph (h)(3)(iii) of this section does not apply to this 
amount because the expenditure was not necessitated by a particular 
event. Therefore, in accordance with paragraph (e)(2)(ii) of this 
section, X must treat the amount paid for betterment of the building 
structure as an improvement to the building and must capitalize the 
amount paid under paragraph (d)(1) of this section.
    Example 17. Material increase in capacity.  X owns harbor 
facilities consisting of a slip for the loading and unloading of 
barges and a channel leading from the slip to the river. At the time 
of purchase, the channel was 150 feet wide, 1,000 feet long, and 10 
feet deep. To allow for ingress and egress and for the unloading of 
its barges, X needs to deepen the channel to a depth of 20 feet. X 
pays a

[[Page 81120]]

contractor to dredge the channel to the required depth. Assume the 
channel is the unit of property. X must capitalize as an improvement 
the amounts paid for the dredging because they result in a material 
increase in the capacity of the channel under paragraph (h)(1)(iii) 
of this section. The comparison rule in paragraph (h)(3)(iii) of 
this section does not apply to these amounts paid because the 
expenditure was not necessitated by a particular event.
    Example 18. Not a material increase in capacity.  Assume the 
same facts as in Example 17, except that the channel was susceptible 
to siltation and, by the next taxable year, the channel depth had 
been reduced to 18 feet. X pays 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. X is not 
required to treat the amounts paid to redredge the channel as a 
betterment under paragraphs (h)(1)(ii) or (h)(1)(iii) of this 
section because they do 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.
    Example 19. Not a material increase in capacity.  X owns a 
building used in its trade or business. The first floor has a drop-
ceiling. X pays an amount to remove the drop-ceiling and repaint the 
original ceiling. Under paragraph (e)(2)(ii) of this section, if the 
amount paid results in a betterment to the building structure or any 
building system, X must treat the amount as an improvement to the 
building. The ceiling is part of the building structure as defined 
under paragraph (e)(2)(ii)(A) of this section. X is not required to 
treat the amount paid to remove the drop-ceiling as a betterment 
because it did not result in a material addition under paragraph 
(h)(1)(ii) of this section or a material increase to the capacity, 
productivity, efficiency, strength, or quality of the building 
structure or output of the building structure under paragraph 
(h)(1)(iii) of this section. The comparison rule in paragraph 
(h)(3)(iii) of this section does not apply to these amounts paid 
because the expenditure was not necessitated by a particular event.

    (i) 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 only 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 class life as defined in paragraph 
(g)(4) of this section (see paragraph (i)(3) of this section); or
    (vi) Is for the replacement of a part or a combination of parts 
that comprise a major component or a substantial structural part of a 
unit of property (see paragraph (i)(4) of this section).
    (2) Restorations of buildings. In the case of a building, an amount 
is paid to restore the unit of property if it restores any of the 
properties designated in paragraphs (e)(2)(ii), (e)(2)(iii)(B), 
(e)(2)(iv)(B), (e)(2)(v)(B) of this section.
    (3) Rebuild to like-new condition. For purposes of paragraph 
(i)(1)(v) of this section, 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.
    (4) Replacement of a major component or a substantial structural 
part. To determine whether an amount is for the replacement of a part 
or a combination of parts that comprise a major component or a 
substantial structural part of the unit of property, it is appropriate 
to consider all the facts and circumstances. These facts and 
circumstances include the quantitative or qualitative significance of 
the part or combination of parts in relation to the unit of property. A 
major component or substantial structural part includes a part or 
combination of parts that comprise a large portion of the physical 
structure of the unit of property or that perform a discrete and 
critical function in the operation of the unit of property. However, 
the replacement of a minor component of the unit of property, even 
though such component may affect the function of the unit of property, 
will not generally, by itself, constitute a major component or 
substantial structural part.
    (5) Examples. The following examples illustrate the application of 
this paragraph (i) only and do not address whether capitalization is 
required under another provision of this section or another provision 
of the Internal Revenue Code (for example, section 263A). Unless 
otherwise stated, assume that X has not properly deducted a loss for, 
nor taken into account the adjusted basis on a sale or exchange of, any 
unit of property, asset, or component of a unit of property that is 
replaced:

    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 building is section 1245 property as defined in 
section 1245(a)(3). The freezer is not part of the building 
structure under paragraph (e)(2)(i) of this section or the HVAC 
system, which is a separate building system under paragraph 
(e)(2)(ii)(B)(1) of this section. Several components of the walk-in 
freezer cease to function and X decides to replace them. X abandons 
the old 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 (i)(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 (i)(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 properly 
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 
(i)(1)(iii) of this section, X must capitalize the $50,000 amount 
paid to the contractor because X properly adjusted its basis in that 
amount 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 (i)(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.

[[Page 81121]]

    Example 5. Restoration of property in a state of disrepair.  X 
owns and operates a farm with several barns and outbuildings. X did 
not use or maintain one of the outbuildings on a regular basis, and 
the outbuilding fell 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 pays an amount to shore up the walls and 
replace the siding. Under paragraph (e)(2)(ii) of this section, if 
the amount paid results in a restoration of the building structure 
or any building system, X must treat the amount as an improvement to 
the building. The walls and siding are part of the building 
structure under paragraph (e)(2)(ii)(A) of this section. Under 
paragraph (i)(1)(iv) of this section, X must treat the amount paid 
to shore up the walls and replace the siding as a restoration of the 
building structure because the amounts return the building structure 
to its ordinarily efficient operating condition after it had 
deteriorated to a state of disrepair and was no longer functional 
for its intended use. Therefore, in accordance with paragraph 
(e)(2)(ii) of this section, X must treat the amount paid as an 
improvement to the building and must capitalize the amount paid 
under paragraph (d)(2) of this section.
    Example 6. Rebuild of property to like-new condition before end 
of class 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 a class life of 14 years. Every 8 to 10 years, X rebuilds 
its freight cars. Ten years after X places the freight car in 
service, X performs a rebuild, which includes a complete 
disassembly, inspection, and reconditioning 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 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 (i)(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 class life of the freight car.
    Example 7. Rebuild of property to like-new condition after end 
of class life.  Assume the same facts as in Example 6, except that X 
rebuilds the freight car 15 years after X places it in service. 
Under paragraph (i)(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 
class life of the freight car.
    Example 8. Replacement of major component or substantial 
structural part; personal property.  X is a common carrier that owns 
a fleet of petroleum hauling trucks. X pays amounts to replace the 
existing engine, cab, and petroleum tank with a new engine, cab, and 
tank. Assume the tractor of the truck (which includes the cab and 
the engine) is a single unit of property, and that the trailer 
(which contains the petroleum tank) is a separate unit of property. 
The new engine and cab constitute parts or combinations of parts 
that comprise a major component or substantial structural part of 
X's tractor. Therefore, the amounts paid for the replacement of 
those components must be capitalized under paragraph (i)(1)(vi) of 
this section. The new petroleum tank constitutes a part or 
combination of parts that comprise a major component and a 
substantial structural part of the trailer. Accordingly, the amounts 
paid for the replacement of the tank also must be capitalized under 
paragraph (i)(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 pays amounts to paint the cab 
of the tractor with its company logo and to fix a broken taillight 
on the tractor. The repair of the broken taillight and the painting 
of the cab generally are deductible expenses under Sec.  1.162-4T. 
However, under paragraph (f)(3)(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. Under paragraph (f)(3)(i) of this section, X must 
capitalize the amounts paid to paint the cab as part of the 
improvement to the tractor because these amounts directly benefit 
and are incurred by reason of the restoration 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, even though the repair was 
performed at the same time as the restoration. Thus, X must 
capitalize the amounts paid to paint the cab under paragraph 
(i)(1)(vi) and (f)(3)(i) of this section, but X is not required to 
capitalize the amounts paid to repair the broken taillight.
    Example 10. Related amounts to replace major component or 
substantial structural part; personal property.  (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 Year 1, 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. 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, Year 1. 
On December 15, Year 1, the contractor completes the removal of the 
old USTs and bills X for the costs of removal. On January 15, Year 
2, the contractor completes the installation of the new USTs and 
bills X for the remainder of the work. Assume that X computes its 
taxes on a calendar year basis and X's gasoline distribution system 
is the unit of property. Under paragraph (i)(1)(vi) of this section, 
X must capitalize the amounts paid to replace the USTs as a 
restoration to the gasoline distribution system because the USTs are 
parts or combinations of parts that comprise a major component and 
substantial structural part of the gasoline distribution system. 
Moreover, under paragraph (f)(3) of this section, X must capitalize 
the costs of removing the old USTs because these amounts directly 
benefit and are incurred by reason of the improvement to the 
gasoline distribution system. Finally, under paragraph (f)(4) of 
this section, X must capitalize the aggregate of related amounts 
paid to improve the gasoline distribution system, including the 
amount paid to the county, the amount paid to remove the old USTs, 
and the amount paid to install the new USTs, even though the amounts 
were separately invoiced, paid to different parties, and incurred in 
different tax years.
    Example 11. Not replacement of major component or substantial 
structural part; personal property.  X owns a machine shop in which 
it makes dies used by manufacturers. In Year 1, X purchased a drill 
press for use in its production process. In Year 3, X discovers that 
the power switch assembly, which controls the supply of electric 
power to the drill press, has become damaged and could not operate. 
To correct this problem, X paid amounts to replace the power switch 
assembly with comparable, commercially available and reasonable 
replacement parts. Assume that the drill press is a unit of property 
under paragraph (e) of this section and the power switch assembly is 
a small component of the drill press that may be removed and 
installed with relative ease. Thus, the power switch assembly is not 
a major component or substantial structural part of X's drill press 
under paragraph (i)(3) of this section. X is not required to 
capitalize the costs to replace the power switch assembly under 
paragraph

[[Page 81122]]

(i)(1)(vi) of this section because the replacement, by itself, does 
not constitute the replacement of a part or a combination of parts 
that comprise a major component or substantial structural part of 
X's drill press. But see section 263A and the regulations thereunder 
for the requirement to capitalize indirect costs that directly 
benefit or are incurred by reason of production activities.
    Example 12. Replacement of major component or substantial 
structural part; roof. 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 entire roof 
with a new roof. Under paragraph (e)(2)(ii) of this section, if the 
amount paid results in a restoration of the building structure or 
any building system, X must treat the amount as an improvement to 
the building. The roof is part of the building structure under 
paragraph (e)(2)(ii)(A) of this section and comprises a major 
component or substantial structural part of X's building structure 
under paragraph (i)(4) of this section. Under paragraph (i)(1)(vi) 
of this section, X must treat the amount paid to replace the roof as 
a restoration because X paid the amount to replace a major component 
or substantial structural part of X's building structure. Therefore, 
in accordance with paragraph (e)(2)(ii) of this section, X must 
treat the amount paid to restore the building structure as an 
improvement to the building and must capitalize the amount paid 
under paragraph (d)(2) of this section.
    Example 13. Replacement of major component or substantial 
structural part; roof. Assume the same facts as Example 12 except 
the contractor recommends replacement of a significant portion of 
the roof, but not the entire roof. Accordingly, X pays an amount to 
replace a large portion of the decking, insulation, and membrane of 
the roof of X's retail building. The portion of the roof replaced 
comprises a major component or substantial structural part of the 
building structure under paragraph (i)(4) of this section. Thus, 
under paragraph (i)(1)(vi) of this section, X must treat the amount 
paid for the roof work as a restoration of the building structure 
because X paid the amount to replace a major component or 
substantial structural part of the building structure. Therefore, in 
accordance with paragraph (e)(2)(ii) of this section, X must treat 
the amount paid as an improvement to the building and must 
capitalize the amount paid under paragraph (d)(2) of this section.
    Example 14. Not replacement of major component or substantial 
structural part; roof membrane. X is in the business of 
manufacturing parts. X owns a factory facility in which the parts 
are manufactured. The roof over X's facility is comprised of 
structural elements, insulation, and a waterproof membrane. Over 
time, the waterproof membrane began to wear and leakage began to 
occur. Consequently, X pays an amount to replace the plant's worn 
roof membrane with a similar but new membrane. Under paragraph 
(e)(2)(ii) of this section, if the amount paid results in a 
restoration of the building structure or any building system, X must 
treat the amount as an improvement to the building. The roof, 
including the membrane, is part of the building structure as defined 
under paragraph (e)(2)(ii)(A) of this section. Although the roof 
membrane may affect the function of the building structure, it is 
not, by itself, a major component or substantial structural part of 
X's building structure under paragraph (i)(4) of this section. 
Because the roof membrane is not a major component or substantial 
structural part of the building structure, X is not required to 
treat the amount paid to replace the roof membrane as a restoration 
of the building structure under paragraph (i)(1)(vi) of this 
section. But see section 263A and the regulations thereunder for the 
requirement to capitalize indirect costs that directly benefit or 
are incurred by reason of production activities.
    Example 15. Replacement of major component or substantial 
structural part; HVAC system. X owns a building in which it operates 
an office that provides medical services. The building contains one 
HVAC system, which is comprised of a furnace, an air conditioning 
unit, and duct work that runs throughout the building to distribute 
the heat or air conditioning throughout the building. The furnace in 
X's building breaks down and X pays an amount to replace it with a 
new furnace. Under paragraph (e)(2)(ii) of this section, if the 
amount paid results in a restoration of the building structure or 
any building system, X must treat the amount as an improvement to 
the building. The heating and air conditioning system, including the 
furnace, is a building system under paragraph (e)(2)(ii)(B)(1) of 
this section. The furnace performs a discrete and critical function 
in the operation of the HVAC system, and is therefore a major 
component or substantial structural part of the building system 
under paragraph (i)(4) of this section. Because the furnace 
comprises a major component or substantial structural part of a 
building system, X must treat the amount paid to replace the furnace 
as a restoration of the building system under paragraph (i)(1)(vi) 
of this section. Therefore, in accordance with paragraph (e)(2)(ii) 
of this section, X must treat the amount paid as an improvement to 
the building and must capitalize the amount paid under paragraph 
(d)(2) of this section.
    Example 16. Replacement of major component or substantial 
structural part; HVAC system.  X owns a large office building in 
which it provides consulting services. The building contains one 
HVAC system, which is comprised of one chiller unit, one boiler, 
pumps, duct work, diffusers, air handlers, outside air intake and a 
cooling tower. The chiller unit includes the compressor, evaporator, 
condenser, and expansion valve, and functions to cool the water used 
to generate air conditioning throughout the building. X pays an 
amount to replace the chiller with a more energy efficient unit. 
Under paragraph (e)(2)(ii) of this section, if the amount paid 
results in a restoration of the building structure or any building 
system, X must treat the amount as an improvement to the building. 
The HVAC system, including the chiller unit, is a building system 
under paragraph (e)(2)(ii)(B)(1) of this section. The chiller unit 
performs a discrete and critical function in the operation of the 
HVAC system and is therefore a major component or substantial 
structural part of the HVAC system under paragraph (i)(4) of this 
section. Because the chiller unit comprises a major component or 
substantial structural part of a building system, X must treat the 
amount paid to replace the chiller unit as a restoration to a 
building system under paragraph (i)(1)(vi) of this section. 
Therefore, in accordance with paragraph (e)(2)(ii) of this section, 
X must treat the amount paid as an improvement to the building and 
must capitalize the amount paid under paragraph (d)(2) of this 
section.
    Example 17. Not replacement of major component or substantial 
structural part; HVAC system. X owns an office building that it uses 
to provide services to customers. The building contains an HVAC 
system that incorporates ten roof-mounted units that provide heating 
and air conditioning for different parts of the building. The HVAC 
system also consists of controls for the entire system and duct work 
that distributes the heated or cooled air to the various spaces in 
the building's interior. X begins to experience climate control 
problems in various offices throughout the office building and 
consults with a contractor to determine the cause. The contractor 
recommends that X replace two of the roof-mounted units. X pays an 
amount to replace the two specified units. No work is performed on 
the other roof-mounted heating/cooling units, the duct work, or the 
controls. Under paragraph (e)(2)(ii) of this section, if the amount 
paid results in a restoration of the building structure or any 
building system, X must treat the amount as an improvement to the 
building. The HVAC system, including the two-roof mounted units, is 
a building system under paragraph (e)(2)(ii)(B)(1) of this section. 
The two roof-mounted heating/cooling units, by themselves, do not 
comprise a large portion of the physical structure of the HVAC 
system or perform a discrete and critical function in the operation 
of the system. Therefore, under paragraph (i)(4) of this section, 
the two units do not constitute a major component or substantial 
structural part of the building system. Accordingly, X is not 
required to treat the amount paid to replace the two roof-mounted 
heating/cooling units as a restoration of a building system under 
paragraph (i)(1)(iv) of this section.
    Example 18. Replacement of major component or substantial 
structural part; fire protection system.  X owns a building that it 
uses to operate its business. X pays an amount to replace the 
sprinkler system in the building with a new sprinkler system. Under 
paragraph (e)(2)(ii) of this section, if the amount paid results in 
a restoration of the building structure or any building system, X 
must treat the amount as an improvement to the building. The fire 
protection and alarm system, including the sprinkler system, is a 
building system under paragraph (e)(2)(ii)(B)(6) of this section. 
The sprinkler system performs a discrete and critical function in 
the operation of the fire protection and alarm system and is 
therefore

[[Page 81123]]

a major component or substantial structural part of the fire 
protection and alarm system under paragraph (i)(4) of this section. 
Because the sprinkler system comprises a major component or 
substantial structural part of a building system, X must treat the 
amount paid to replace the sprinkler system as a restoration to a 
building system under paragraph (i)(1)(vi) of this section. 
Therefore, in accordance with paragraph (e)(2)(ii) of this section, 
X must treat the amount paid as an improvement to the building and 
must capitalize the amount paid under paragraph (d)(2) of this 
section.
    Example 19. Replacement of major component or substantial 
structural part; electrical system. X owns a building that it uses 
to operate its business. X pays an amount to replace the wiring 
throughout the building with new wiring that meets building code 
requirements. Under paragraph (e)(2)(ii) of this section, if the 
amount paid results in a restoration of the building structure or 
any building system, X must treat the amount as an improvement to 
the building. The electrical system, including the wiring, is a 
building system under paragraph (e)(2)(ii)(B)(3) of this section. 
The wiring performs a discrete and critical function in the 
operation of the electrical system and is therefore a major 
component or substantial structural part of the electrical system 
under paragraph (i)(4) of this section. Because the wiring comprises 
a major component or substantial structural part of a building 
system, X must treat the amount paid to replace the wiring as a 
restoration to a building system under paragraph (i)(1)(vi) of this 
section. Therefore, in accordance with paragraph (e)(2)(ii) of this 
section, X must treat the amount paid as an improvement to the 
building and must capitalize the amount paid under paragraph (d)(2) 
of this section.
    Example 20. Replacement of major component or substantial 
structural part; plumbing system.  X owns a building in which it 
conducts a retail business. The retail building has three floors. 
The retail building has men's and women's restrooms on two of the 
three floors. X decides to update the restrooms by paying an amount 
to replace the plumbing fixtures in all of the restrooms, including 
the toilets, sinks, and associated fixtures, with modern style 
plumbing fixtures of similar quality and function. X does not 
replace the pipes connecting the fixtures to the building's plumbing 
system. Under paragraph (e)(2)(ii) of this section, if the amount 
paid results in a restoration of the building structure or any 
building system, X must treat the amount as an improvement to the 
building. The plumbing system, including the plumbing fixtures, is a 
building system under paragraph (e)(2)(ii)(B)(2) of this section. 
The plumbing fixtures in all the restrooms perform a discrete and 
critical function in the operation of the plumbing system and 
comprise a large portion of the physical structure of plumbing 
system. Therefore, under paragraph (i)(4) of this section, the 
plumbing fixtures comprise a major component or substantial 
structural part of the plumbing system, and X must treat the amount 
paid to replace all of the plumbing fixtures as a restoration of a 
building system under paragraph (i)(1)(vi) of this section. As a 
result, in accordance with paragraph (e)(2)(ii) of this section, X 
must treat the amount paid to restore the plumbing system as an 
improvement to the building and must capitalize these amounts under 
paragraph (d)(2) of this section.
    Example 21. Not replacement of major component or substantial 
structural part; plumbing system.  Assume the same facts as Example 
20 except that X does not update all the bathroom fixtures. Instead, 
X only pays an amount to replace three of the twenty sinks located 
in the various restrooms because these sinks had cracked. The three 
replaced sinks, by themselves, do not comprise a large portion of 
the physical structure of the plumbing system nor do they perform a 
discrete and critical function in the operation of the plumbing 
system. Therefore, under paragraph (i)(4) of this section, the sinks 
do not constitute a major component or substantial structural part 
of the building system. Accordingly, X is not required to treat the 
amount paid to replace the sinks as a restoration of a building 
system under paragraph (i)(1)(iv) of this section.
    Example 22. Replacement of major component or substantial 
structural part; remodel.  (i) X owns and operates a hotel building. 
X decides that to attract customers and to remain competitive, it 
needs to update the guest rooms in its facility. Accordingly, X pays 
amounts to replace the bathtubs, toilets, sinks, plumbing fixtures, 
and to repair, repaint, and retile the bathroom walls and floors, 
which was necessitated by the installation of the new plumbing 
components. The replacement bathtubs, toilets, sinks, plumbing 
fixtures, and tile are new and in a different style, but are similar 
in function and quality to the replaced items. X also pays amounts 
to replace certain section 1245 property, such as the guest room 
furniture, carpeting, drapes, table lamps, and partition-walls 
separating the bathroom area. X completes this work on two floors at 
a time, closing those floors and leaving the rest of the hotel open 
for business. In Year 1, X pays amounts to perform the updates for 
eight of the twenty hotel room floors, and expects to complete the 
renovation of the remaining rooms over the next 2 years.
    (ii) Under paragraph (e)(2)(ii) of this section, if the amount 
paid results in a restoration of the building structure or any 
building system, X must treat the amount as an improvement to the 
building. The plumbing system, including the bathtubs, toilets, 
sinks, and plumbing fixtures, is a building system under paragraph 
(e)(2)(ii)(B)(2) of this section. All the bathtubs, toilets, sinks, 
and plumbing fixtures in the hotel building perform a discrete and 
critical function in the operation of the plumbing system and 
comprise a large portion of the physical structure of plumbing 
system. Therefore, under paragraph (i)(4) of this section, these 
plumbing components comprise major components or substantial 
structural parts of the plumbing system, and X must treat the amount 
paid to replace these plumbing components as a restoration of a 
building system under paragraph (i)(1)(vi) of this section. In 
addition, under paragraph (f)(3)(i) of this section, X must treat 
the costs of repairing, repainting, and retiling the bathroom walls 
and floors as improvement costs because these costs directly benefit 
and are incurred by reason of the improvement to the plumbing 
system. Further, under paragraph (f)(4) of this section, X must 
treat the costs incurred in Years 1, 2, and 3 for the bathroom 
remodeling as improvement costs, even though they are incurred over 
a period of several taxable years, because they are part of the 
aggregate of related amounts paid to improve the plumbing system. 
Therefore, in accordance with paragraph (e)(2)(ii) of this section, 
X must treat the amounts it paid to improve the plumbing system as 
the costs of improving the building and must capitalize the amounts 
under paragraph (d)(2) of this section. In addition, X must 
capitalize the amounts paid to acquire and install each section 1245 
property under Sec.  1.263(a)-2T of the regulations.
    Example 23. Not replacement of major component or substantial 
structural part; windows.  X owns a large office building that it 
uses to provide office space for employees that manage X's 
operations. The building has 300 exterior windows. In Year 1, X pays 
an amount to replace 30 of the exterior windows that had become 
damaged. At the time of these replacements, X has no plans to 
replace any other windows in the near future. Under paragraph 
(e)(2)(ii) of this section, if the amount paid results in a 
restoration of the building structure or any building system, X must 
treat the amount as an improvement to the building. The exterior 
windows are part of the building structure as defined under 
paragraph (e)(2)(ii)(A) of this section. The 30 replacement windows 
do not comprise a large portion of the physical structure of the 
office building structure and, by themselves, do not perform a 
discrete and critical function in the operation of X's building 
structure. Therefore, under paragraph (i)(4) of this section, the 
replacement windows do not constitute major components or 
substantial structural parts of the building structure. Accordingly, 
X is not required to treat the amount paid to replace the windows a 
restoration of a building system under paragraph (i)(1)(iv) of this 
section.
    Example 24. Replacement of major component or substantial 
structural part; windows. Assume the same facts as Example 23 except 
that X replaces 200 of the 300 windows on the building. In addition, 
as a result of damage caused during the window replacements, X also 
pays an amount to repaint the interior trims associated with the 
replaced windows. The 200 replacement windows comprise a large 
portion of the physical structure of X's building and perform a 
discrete and critical function in the operation of the building 
structure. Therefore, under paragraph (i)(4) of this section, the 
200 windows comprise a major component or substantial structural 
part of the building structure, and X must treat the amount paid to 
replace the windows as a restoration of the building structure under 
paragraph (i)(1)(vi) of this section. As a result, in accordance 
with paragraph (e)(2)(ii) of this section, X must treat the amounts 
paid to restore the building structure as an improvement to the 
building and must capitalize the amounts under paragraph (d)(2) of 
this section.

[[Page 81124]]

    Example 25. Not replacement of major component or substantial 
structural part; floors.  X owns and operates a hotel building. X 
decides to refresh the appearance of the hotel lobby by replacing 
the floors in the lobby. The hotel lobby comprises a small portion 
of the entire hotel building. X pays an amount to replace the wood 
flooring in the lobby with new wood flooring. X did not replace any 
other flooring in the building. Assume that the wood flooring 
constitutes section 1250 property. Under paragraph (e)(2)(ii) of 
this section, if the amount paid results in a restoration of the 
building structure or any building system, X must treat the amount 
as an improvement to the building. The wood flooring is part of the 
building structure under paragraph (e)(2)(ii)(A) of this section. 
The replacement wood flooring in the lobby of the building does not 
comprise a large portion of the physical structure of the hotel 
building or perform a discrete and critical function in the 
operation of the hotel building structure. Therefore, under 
paragraph (i)(4) of this section, the wood flooring does not a 
constitute major component or substantial structural part of the 
hotel building structure. Accordingly, X is not required to treat 
the amount paid to replace the wood flooring in the hotel lobby as a 
restoration under paragraph (i)(1)(vi) of this section.
    Example 26. Replacement of major component or substantial 
structural part; floors.  Assume the same facts as Example 25 except 
that X decides to refresh the appearance of all the public areas of 
the hotel building by replacing the floors. To that end, X pays an 
amount to replace all the wood floors in all the public areas of the 
hotel building with new wood floors. The public areas include the 
lobby, the hallways, the meeting rooms, and other public rooms 
throughout the hotel interiors. The replacement wood floors in all 
the public areas comprise a large portion of the physical structure 
of the hotel building structure and perform a discrete and critical 
function in the operation of X's hotel building structure. 
Therefore, under paragraph (i)(4) of this section, replacement wood 
floors comprise a major component or substantial structural part of 
the building structure, and X must treat the amount paid to replace 
the floors as a restoration of the building structure under 
paragraph (i)(1)(vi) of this section. As a result, in accordance 
with paragraph (e)(2)(ii) of this section, X must treat the amounts 
paid to restore the building structure as an improvement to the 
building and must capitalize the amounts under paragraph (d)(2) of 
this section.

    (j) 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) Adapting buildings to new or different use. In the case of a 
building, an amount is paid to adapt the unit of property to a new or 
different use if it adapts to a new or different use any of the 
properties designated in paragraphs (e)(2)(ii), (e)(2)(iii)(B), 
(e)(2)(iv)(B), or (e)(2)(v)(B) of this section.
    (3) Examples. The following examples illustrate solely the rules of 
this paragraph (j). Even if capitalization is not required in an 
example under this paragraph (j), the amounts paid in the example may 
be subject to capitalization under a different provision of this 
section or another provision of the Internal Revenue Code (for example, 
section 263A). Unless otherwise stated, assume that X has not properly 
deducted a loss for any unit of property, asset, or component of a unit 
of property that is removed and replaced.

    Example 1. New or different use.  X is a manufacturer and owns a 
manufacturing building that it has used for manufacturing since Year 
1, when X placed it in service. In Year 30, X pays an amount to 
convert its manufacturing building into a showroom for its business. 
To convert the facility, X removes and replaces various structural 
components to provide a better layout for the showroom and its 
offices. X also repaints the building interiors as part of the 
conversion. None of the materials used are better than existing 
materials in the building. Under paragraph (e)(2)(ii) of this 
section, if the amount paid adapts the building structure to a new 
or different use, X must treat the amount as an improvement to the 
building. Under paragraph (j)(1) of this section, the amount paid to 
convert the manufacturing facility into a showroom adapts the 
building structure to a new or different use because the conversion 
is not consistent with X's intended ordinary use of the building 
structure at the time it was placed in service. Therefore, in 
accordance with paragraph (e)(2)(ii) of this section, X must treat 
the amount paid for the adaptation of the building structure as an 
amount that improves the building. Accordingly, X must capitalize 
the amount as an improvement under paragraph (d)(3) of this section.
    Example 2. Not a new or different use.  X owns a building 
consisting of twenty retail spaces. The space was designed to be 
reconfigured; that is, adjoining spaces could be combined into one 
space. One of the tenants expands its occupancy to include two 
adjoining retail spaces. To facilitate the new lease, X pays an 
amount to remove the walls between the three retail spaces. Assume 
that the walls between spaces are part of the building and its 
structural components. Under paragraph (e)(2)(ii) of this section, 
if the amount paid adapts the buildings structure to a new or 
different use, X must treat the amount as an improvement to the 
building. Under paragraph (j)(1) of this section, the amount paid to 
convert three retail spaces into one larger space for an existing 
tenant does not adapt X's building structure to a new or different 
use because the combination of retail spaces is consistent with X's 
intended, ordinary use of the building structure. Therefore, the 
amount paid by X to remove the walls does not improve the building 
under paragraph (d)(3) of this section.
    Example 3. Not a new or different use.  X owns a building 
consisting of twenty retail spaces. X decides to sell the building. 
In anticipation of selling the building, X pays an amount to repaint 
the interior walls and to refinish the hardwood floors. Under 
paragraph (e)(2)(ii) of this section, if the amount paid adapts the 
buildings structure to a new or different use, X must treat the 
amount as an improvement to the building. Preparing the building for 
sale does not constitute a new or different use for the building 
structure under paragraph (j)(1) of this section. Therefore, the 
amount paid to prepare the building structure for sale does not 
improve the building under paragraphs (d)(3) of this section.
    Example 4. New or different use.  X owns 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. X discontinues 
manufacturing operations at the site, and 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 an 
amount to cleanup the land to a standard that is required for the 
land to be used for residential purposes. In addition, X pays an 
amount to regrade the land so that it can be used for residential 
purposes. Amounts that X pays 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. Therefore, X is not required to capitalize the 
amount paid for the cleanup under paragraph (j)(1) of this section. 
However, the amount paid 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 
to regrade the land must be capitalized as improvements under 
paragraphs (j)(1) of this section.

    (k) Optional regulatory accounting method--(1) In general. This 
paragraph (k) 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 
uses the regulatory accounting method described in paragraph (k)(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 paragraph (d) (and the 
routine maintenance safe

[[Page 81125]]

harbor described in paragraph (g)) of this section do not apply to 
amounts paid to repair, maintain, or improve property subject to 
regulatory accounting by taxpayers that use the regulatory accounting 
method under this paragraph (k). 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 (k). For purposes of 
this paragraph (k), 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. The method also does not apply to property for the taxable years 
in which the taxpayer elected to apply the repair allowance under Sec.  
1.167(a)-11(d)(2).
    (4) Examples. The rules of this paragraph (k) 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 
that generates electricity and that owns and operates network assets 
to transmit and distribute the electricity to its customers. X is 
subject to the regulatory accounting rules of FERC and X chooses to 
use the regulatory accounting method under paragraph (k) of this 
section. X does not capitalize on its books and records for 
regulatory accounting purposes the cost of repairs and maintenance 
performed on its turbines or its network assets. Under the 
regulatory accounting method, X must not capitalize for Federal 
income tax purposes amounts paid for repairs performed on its 
turbines or its network assets.
    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 (k).
    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 (k). X's assets 
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 (k). 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.

    (l) Methods of accounting authorized in published guidance. A 
taxpayer may use a repair allowance method of accounting or any other 
method of accounting that is authorized in published guidance in the 
Federal Register or in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter).
    (m) 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 direct and indirect costs of producing property or 
acquiring property for resale.
    (n) Recovery of capitalized amounts. Amounts that are capitalized 
under this section are recovered through depreciation, cost of goods 
sold, or by an adjustment to basis at the time the property is placed 
in service, sold, used, or otherwise disposed of by the taxpayer. Cost 
recovery is determined by the applicable Internal Revenue Code and 
regulation provisions relating to the use, sale, or disposition of 
property.
    (o) Accounting method changes. Except as otherwise provided in this 
section, a change to comply with this section is a change in method of 
accounting to which the provisions of sections 446 and 481, and the 
regulations thereunder apply. A taxpayer seeking to change to a method 
of accounting permitted in this section must secure the consent of the 
Commissioner in accordance with Sec.  1.446-1(e) and follow the 
administrative procedures issued under Sec.  1.446-1(e)(3)(ii) for 
obtaining the Commissioner's consent to change its accounting method.
    (p) Effective/applicability date. This section applies to taxable 
years beginning on or after January 1, 2012. For the applicability of 
regulations to taxable years beginning before January 1, 2012, see 
Sec.  1.263(a)-3 in effect prior to January 1, 2012 (Sec.  1.263(a)-3 
as contained in 26 CFR part 1 edition revised as of April 1, 2011).
    (q) Expiration date. The applicability of this section expires on 
of before December 23, 2014.

0
Par. 31. Section 1.263(a)-6T is added to read as follows:


Sec.  1.263(a)-6T  Election to deduct or capitalize certain 
expenditures (temporary).

    (a) In general. Under certain provisions of the Internal Revenue 
Code, taxpayers may elect to treat capital expenditures as deductible 
expenses or as deferred expenses, or to treat deductible expenses as 
capital expenditures.
    (b) Election provisions. The sections referred to in paragraph (a) 
of this section include:
    (1) Section 173 (circulation expenditures);
    (2) Section 174 (research and experimental expenditures);
    (3) Section 175 (soil and water conservation expenditures; 
endangered species recovery expenditures);
    (4) Section 179 (election to expenses certain depreciable business 
assets);
    (5) Section 179A (deduction for clean-fuel vehicles and certain 
refueling property);
    (6) Section 179B (deduction for capital costs incurred in complying 
with environmental protection agency sulfur regulations);
    (7) Section 179C (election to expense certain refineries);
    (8) Section 179D (energy efficient commercial buildings deduction);
    (9) Section 179E (election to expense advanced mine safety 
equipment);
    (10) Section 180 (expenditures by farmers for fertilizer);
    (11) Section 181 (treatment of certain qualified film and 
television productions);
    (12) Section 190 (expenditures to remove architectural and 
transportation

[[Page 81126]]

barriers to the handicapped and elderly);
    (13) Section 191 (tertiary injectants);
    (14) Section 194 (treatment of reforestation expenditures);
    (15) Section 195 (start-up expenditures);
    (16) Section 198 (expensing of environmental remediation costs);
    (17) Section 198A (expensing of qualified disaster expenses);
    (18) Section 248 (organization expenditures of a corporation);
    (19) Section 266 (carrying charges);
    (20) Section 616 (development expenditures); and
    (21) Section 709 (organization and syndication fees of a 
partnership).
    (c) Effective/applicability date. This section applies to taxable 
years beginning on or after January 1, 2012. For the applicability of 
regulations to taxable years beginning before January 1, 2012, see 
Sec.  1.263(a)-3 in effect prior to January 1, 2012 (Sec.  1.263(a)-3 
as contained in 26 CFR part 1 edition revised as of April 1, 2011). For 
the effective dates of the enumerated election provisions, see those 
Internal Revenue Code sections and the regulations thereunder.
    (d) Expiration date. The applicability of this section expires on 
of before December 23, 2014.

0
Par. 32. Section 1.263A-1 is amended by:
0
1. Adding paragraph (b)(14).
0
2. Revising paragraph (c)(4).
0
3. Revising paragraph (e)(2)(i)(A).
0
4. Revising paragraph (e)(3)(ii)(E).
0
5. Revising paragraph (l).
0
6. Adding paragraph (m).
    The additions and revisions read as follows:


Sec.  1.263A-1  Uniform capitalization of costs.

* * * * *
    (b) * * *
    (14) [Reserved]. For further guidance, see Sec.  1.263A-1T(b)(14).
    (c) * * *
    (4) [Reserved]. For further guidance, see Sec.  1.263A-1T(c)(4).
* * * * *
    (e) * * *
    (2) * * *
    (i) * * *
    (A) [Reserved]. For further guidance, see Sec.  1.263A-
1T(e)(2)(i)(A).
* * * * *
    (3) * * *
    (ii) * * *
    (E) [Reserved]. For further guidance, see Sec.  1.263A-
1T(e)(3)(ii)(E).
* * * * *
    (l) [Reserved]. For further guidance, see Sec.  1.263A-1T(l).
    (m) [Reserved]. For further guidance, see Sec.  1.263A-1T(m).

0
Par. 33. Section 1.263A-1T is added to read as follows:


Sec.  1.263A-1T  Uniform capitalization of costs (temporary).

    (a) through (b)(13) [Reserved]. For further guidance, see Sec.  
1.263A-1(a) through (b)(13).
    (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)-
2T(g). However, the cost of property to which a taxpayer properly 
applies the de minimis rule under Sec.  1.263(a)-2T(g) 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.
    (c)(1) through (c)(3) [Reserved]. For further guidance, see Sec.  
1.263A-1(c)(1) through (c)(3).
    (4) Recovery of capitalized costs. Except as provided in Sec.  
1.162-3T(a)(2) (amounts paid to produce incidental materials and 
supplies), costs that are capitalized under section 263A are recovered 
through depreciation, amortization, cost of goods sold, or by an 
adjustment to basis at the time the property is used, sold, placed in 
service, or otherwise disposed of by the taxpayer. Cost recovery is 
determined by the applicable Internal Revenue Code and regulation 
provisions relating to use, sale, or disposition of property.
    (d)(1) through (e)(2)(i) [Reserved]. For further guidance, see 
Sec.  1.263A-1(d)(1) through (e)(2)(i).
    (A) Direct material costs. Direct materials costs include the cost 
of those materials that become an integral part of specific property 
produced and those materials that are consumed in the ordinary course 
of production and that can be identified or associated with particular 
units or groups of units of property produced. For example, a cost 
described in Sec.  1.162-3T, relating to the cost of a material or 
supply, may be a direct material cost.
    (e)(2)(i)(B) through (e)(2)(ii)(D) [Reserved]. For further 
guidance, see Sec.  1.263A-1(e)(2)(i)(B) through (e)(2)(ii)(D).
    (E) Indirect material costs. Indirect material costs include the 
cost of materials that are not an integral part of specific property 
produced and the cost of materials that are consumed in the ordinary 
course of performing production or resale activities that cannot be 
identified or associated with particular units of property. Thus, for 
example, a cost described in Sec.  1.162-3T, relating to the cost of a 
material or supply, may be an indirect cost.
    (e)(2)(ii)(F) through (k)(5) [Reserved]. For further guidance, see 
Sec.  1.263A-1(e)(2)(ii)(F) through (k)(5).
    (l) Change in method of accounting for de minimis costs. A change 
in the treatment of amounts paid for property subject to the de minimis 
rule to comply with paragraph (b)(14) of this section is a change in 
method of accounting to which the provisions of sections 446 and 481, 
and the regulations thereunder apply. A taxpayer seeking to change to a 
method of accounting permitted in paragraph (b)(14) of this section 
must secure the consent of the Commissioner in accordance with Sec.  
1.446-1(e) and follow the administrative procedures issued under Sec.  
1.446-1(e)(3)(ii) for obtaining the Commissioner's consent to change 
its accounting method.
    (m) Effective/applicability date. (1) Paragraphs (h)(2)(i)(D), (k), 
and (m)(1) of this section apply for taxable years ending on or after 
August 2, 2005.
    (2) Paragraph (b)(14), the introductory phrase of paragraph (c)(4), 
the last sentence of paragraphs (e)(2)(i)(A) and (e)(2)(ii)(E), 
paragraph (l), and paragraph (m)(2) of this section apply to amounts 
paid or incurred (to acquire or produce property) in taxable years 
beginning on or after January 1, 2012. For the applicability of Sec.  
1.263A-1 to taxable years beginning before January 1, 2012, see Sec.  
1.263A-1 in effect prior to January 1, 2012 (Sec.  1.263A-1 as 
contained in 26 CFR part 1 edition revised as of April 1, 2011).
    (3) Expiration date. The applicability of this section expires on 
December 23, 2014.

0
Par. 34. Section 1.1016-3 is amended by:
0
1. Revising paragraphs (a)(1)(ii) and (j)(1).
0
2. Adding paragraph (j)(3).
    The addition and revision read as follows:


Sec.  1.1016-3  Exhaustion, wear and tear, obsolescence, amortization, 
and depletion for periods since February 13, 1913.

    (a) * * *
    (1) * * *
    (ii) [Reserved]. For further guidance, see Sec.  1.1016-
3T(a)(1)(ii).
* * * * *
    (j) * * *
    (1) In general. [Reserved]. For further guidance, see Sec.  1.1016-
3T(j)(1).
* * * * *
    (3) Application of Sec.  1.1016-3T(a)(1)(ii). [Reserved]. For 
further guidance, see Sec.  1.1016-3T(j)(3).

0
Par. 35. Section 1.1016-3T is added to read as follows:

[[Page 81127]]

Sec.  1.1016-3T  Exhaustion, wear and tear, obsolescence, amortization, 
and depletion for periods since February 13, 1913 (temporary).

    (a)(1)(i) [Reserved]. For further guidance, see Sec.  1.1016-
3(a)(1)(i).
    (a)(1)(ii) The determination of the amount properly allowable for 
exhaustion, wear and tear, obsolescence, amortization, and depletion 
must be made on the basis of facts reasonably known to exist at the end 
of the taxable year. A taxpayer is not permitted to take advantage in a 
later year of the taxpayer's prior failure to take any such allowance 
or the taxpayer's taking an allowance plainly inadequate under the 
known facts in prior years. In the case of depreciation, if in prior 
years the taxpayer has consistently taken proper deductions under one 
method, the amount allowable for such prior years must not be increased 
even though a greater amount would have been allowable under another 
proper method. For rules governing losses on retirement or disposition 
of depreciable property, including rules for determining basis, see 
Sec.  1.167(a)-8T, Sec.  1.168(i)-1T, or Sec.  1.168(i)-8T, as 
applicable. The application of this paragraph is illustrated by the 
following example:

    Example.  On July 1, 2011, A, a calendar-year taxpayer, 
purchased and placed in service ``off-the-shelf'' computer software 
at a cost of $36,000. This computer software is not an amortizable 
section 197 intangible. Pursuant to section 167(f)(1), the useful 
life of the computer software is 36 months. It has no salvage value. 
For 2011, A elected not to deduct the additional first year 
depreciation deduction provided by section 168(k). A did not deduct 
any depreciation for the computer software for 2011 and deducted 
depreciation of $12,000 for the computer software for 2012. As a 
result, the total amount of depreciation allowed for the computer 
software as of December 31, 2012, was $12,000. However, the total 
amount of depreciation allowable for the computer software as of 
December 31, 2012, is $18,000 ($6,000 for 2011 + $12,000 for 2012). 
As a result, the unrecovered cost of the computer software as of 
December 31, 2012, is $18,000 (cost of $36,000 less the depreciation 
allowable of $18,000 as of December 31, 2012). Accordingly, 
depreciation for 2013 for the computer software is $12,000 
(unrecovered cost of $18,000 divided by the remaining useful life of 
18 months as of January 1, 2013, multiplied by 12 full months in 
2013).

    (a)(2) through (i) [Reserved]. For further guidance, see Sec.  
1.1016-3(a)(2) through (i).
    (j)(1) In general. Except as provided in paragraphs (j)(2) and 
(j)(3) of this section, this section applies on or after December 30, 
2003. For the applicability of regulations before December 30, 2003, 
see Sec.  1.1016-3 in effect prior to December 30, 2003 (Sec.  1.1016-3 
as contained in 26 CFR part 1 edition revised as of April 1, 2003).
    (2) [Reserved]. For further guidance, see Sec.  1.1016-3(j)(2).
    (3) Application of Sec.  1.1016-3T(a)(1)(ii). Paragraph (a)(1)(ii) 
of this section applies to taxable years beginning on or after January 
1, 2012. For the applicability of Sec.  1.1016-3(a)(1)(ii) to taxable 
years beginning before January 1, 2012, see Sec.  1.1016-3(a)(1)(ii) in 
effect prior to January 1, 2012 (Sec.  1.1016-3(a)(1)(ii) as contained 
in 26 CFR part 1 edition revised as of April 1, 2010).
    (4) Expiration date. The applicability of this section expires on 
December 23, 2014.

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
    Approved: December 5, 2011.
Emily S. McMahon,
(Acting) Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2011-32024 Filed 12-23-11; 8:45 am]
BILLING CODE 4830-01-P