Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property

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.

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 §§ 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 §§ 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 §§ 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 § 1.162-4 of the Income Tax Regulations are not capital expenditures under § 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.

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 § 1.263(a)-1T provides general rules for capital expenditures, § 1.263(a)-2T provides rules for amounts paid for the acquisition or production of tangible property, and § 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 § 1.162-3T, the de minimis rule for the acquisition and production of property under § 1.263(a)-2T, and the safe harbor for routine maintenance under § 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 § 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 § 1.263(a)-3T(f) for the treatment of amounts paid to improve leased property and provide rules under § 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 § 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 § 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 § 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 § 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 § 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 § 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

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 § 1.263(a)-2T.

Finally, several commentators questioned the effect of proposed § 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 § 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 § 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 § 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 § 1.263(a)-2 of the 2008 proposed regulations to units of property that were also treated as materials and supplies under § 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 § 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 § 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 § 1.263(a)-2T(g) to the costs of acquiring or producing any type of material or supply defined in § 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 § 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 § 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

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

III. Repairs Under § 1.162-4

The 2008 proposed regulations proposed to revise § 1.162-4 (the repairs regulation) to provide rules consistent with the improvement rules under § 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 § 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 § 1.162-11 and Leased Property Under § 1.167(a)-4

The existing regulations under § 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 § 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 § 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 § 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 §§ 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 § 1.263(a)-3T(f)(1) (regarding improvements to leased property) and to § 1.167(a)-4T (regarding depreciation or amortization deductions for leasehold improvements).

V. Amounts Paid To Acquire or Produce Tangible Property Under § 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 § 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

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 § 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 § 1.162-3T to treat those materials or supplies under the de minimis rule of § 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

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 § 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 § 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, § 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, § 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

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 § 1.48-1(e)(1)) and its structural components (as defined in § 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 § 1.48-1(e)(1)) and its structural components (as defined in § 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

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

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 §§ 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.

a. Application of Intangible Regulation Under § 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 § 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 § 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 § 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 § 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

§ 1.263A-1(e). Thus, the 2008 proposed regulations concluded that repairs and

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 § 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 § 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

§ 1.165-3(b); § 1.167(a)-1(c); § 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, § 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

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

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 § 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 § 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

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 § 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

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 § 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

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 § 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 § 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 § 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.

However, § 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 § 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 § 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 § 1.167(a)-7, continue to provide flexibility to a taxpayer in establishing its depreciable accounts for MACRS property. The temporary regulations under § 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 § 1.168(i)-1T. Section 1.168(i)-7T does not apply to assets while they are included in general asset accounts subject to § 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, § 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, § 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

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 § 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 § 1.167(a)-8 and § 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

§ 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 § 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 § 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 § 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 § 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

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

§ 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 § 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 § 1.168(i)-1. The provisions of § 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 § 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 § 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 § 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 § 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

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 §§ 1.165-2 and 1.1016-3 to include cross-references to §§ 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 § 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 § 1.162-3T(e), which is effective for taxable years beginning on or after January 1, 2012. The temporary regulations under §§ 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 §§ 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 § 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

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

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). * * *

Par. 2.

Section 1.162-3 is revised to read as follows:

§ 1.162-3

Materials and Supplies.

(a) through (j) [Reserved]. For further guidance, see § 1.162-3T(a) through (j).

Par. 3.

Section 1.162-3T is added to read as follows:

§ 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 § 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 § 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 § 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 § 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 § 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 § 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 § 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 § 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

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 § 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 § 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 § 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 § 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-t

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