Vol. 76 Tuesday, No. 248 December 27, 2011

Part III

Department of the Treasury

Internal Revenue Service 26 CFR Part 1 Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property; Temporary Regulation and Proposed Rule

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DEPARTMENT OF THE TREASURY SUPPLEMENTARY INFORMATION: situation prompting the expenditure arose and does not make the property Background Internal Revenue Service more valuable, more useful, or longer- Section 263(a) provides that no lived, then such an expenditure is 26 CFR Part 1 deduction is allowed for (1) any amount usually considered a deductible repair. paid out for new buildings or permanent [TD 9564] In contrast, a capital expenditure is improvements or betterments made to generally considered to be a more RIN 1545–BJ93 increase the value of any property or permanent increment in the longevity, estate, or (2) any amount expended in utility, or worth of the property. Guidance Regarding Deduction and restoring property or in making good the Capitalization of Expenditures Related exhaustion thereof for which an The standards for applying section to Tangible Property allowance has been made. Regulations 263(a), as set forth in the regulations, issued under section 263(a) provided case law, and administrative guidance, AGENCY: Internal Revenue Service (IRS), are difficult to discern and apply in Treasury. that capital expenditures included amounts paid or incurred to (1) add to practice and have led to considerable ACTION: Temporary regulations. the value, or substantially prolong the uncertainty and controversy for taxpayers. On January 20, 2004, the IRS SUMMARY: This document contains useful life, of property owned by the and the Treasury Department published temporary regulations that provide taxpayer, or (2) adapt the property to a Notice 2004–6 (2004–3 IRB 308) guidance on the application of sections new or different use. However, those announcing an intention to propose 162(a) and 263(a) of the Internal regulations also provided that amounts regulations providing guidance in this Revenue Code to amounts paid to paid or incurred for incidental repairs acquire, produce, or improve tangible and maintenance of property within the area. The notice identified issues under property. The temporary regulations meaning of section 162 and § 1.162–4 of consideration by the IRS and the clarify and expand the standards in the the Income Tax Regulations are not Treasury Department and invited public current regulations under sections capital expenditures under § 1.263(a)–1. comment on whether these or other 162(a) and 263(a) and provide certain The United States Supreme Court has issues should be addressed in the bright-line tests (for example, a de recognized the highly factual nature of regulations and, if so, what specific determining whether expenditures are minimis rule for certain acquisitions) for rules and principles should be for capital improvements or for ordinary applying these standards. The provided. repairs. See Welch v. Helvering, 290 temporary regulations also provide On August 21, 2006, the IRS and the U.S. 111, 114 (1933) (‘‘decisive guidance under section 168 regarding Treasury Department published in the distinctions [between capital and the accounting for, and dispositions of, Federal Register (71 FR 48590–01) ordinary expenditures] are those of property subject to section 168. The proposed amendments to the degree and not of kind’’); Deputy v. du temporary regulations also amend the regulations under section 263(a) (2006 Pont, 308 U.S. 488, 496 (1940) (each general asset account regulations. The proposed regulations) relating to case ‘‘turns on its special facts’’). temporary regulations will affect all Because of the factual nature of the amounts paid to acquire, produce, or taxpayers that acquire, produce, or issue, the courts have articulated a improve tangible property. The IRS and improve tangible property. The text of number of ways to distinguish between the Treasury Department received the temporary regulations also serves as deductible repairs and non-deductible numerous written comments on the the text of proposed regulations set forth capital improvements. For example, in 2006 proposed regulations and held a in the notice of proposed rulemaking on Illinois Merchants Trust Co. v. public hearing on December 19, 2006. this subject appearing elsewhere in this Commissioner, 4 B.T.A. 103, 106 (1926), On March 10, 2008, after consideration issue of the Federal Register. acq. (V–2 CB 2), the court explained that of the comment letters and the DATES: Effective Date: These regulations repair and maintenance expenses are statements at the public hearing, the IRS are effective on January 1, 2012. incurred for the purpose of keeping and the Treasury Department withdrew Applicability Dates: For dates of property in an ordinarily efficient the 2006 proposed regulations and applicability of the temporary operating condition over its probable proposed new regulations (2008 regulations, see §§ 1.162–3T, 1.162–4T, useful life for the uses for which the proposed regulations) in the Federal 1.162–11T, 1.165–2T, 1.167(a)–4T, property was acquired. Capital Register (73 FR 47 12838–01) under 1.167(a)–7T, 1.167(a)–8T, 1.168(i)–1T, expenditures, in contrast, are for sections 162(a) (relating to the 1.168(i)–7T, 1.168(i)–8T, 1.263(a)–1T, replacements, alterations, deduction for ordinary and necessary 1.263(a)–2T, 1.263(a)–3T, 1.263(a)–6T, improvements, or additions that trade or business expenses) and section 1.263A–1T, and 1.1016–3T. appreciably prolong the life of the 263(a) (relating to the capitalization FOR FURTHER INFORMATION CONTACT: property, materially increase its value, requirement). The IRS and the Treasury Concerning §§ 1.162–3T, 1.162–4T, or make it adaptable to a different use. Department received several comment 1.162–11T, 1.263(a)–1T, 1.263(a)–2T, In Estate of Walling v. Commissioner, letters on the 2008 proposed regulations 1.263(a)–3T, 1.263(a)–6T, Merrill D. 373 F.2d 190, 192–193 (3rd Cir. 1966), and held a public hearing on the 2008 Feldstein or Alan S. Williams, Office of the court explained that the relevant proposed regulations on June 24, 2008. Associate Chief Counsel (Income Tax & distinction between capital After considering the comment letters Accounting), (202) 622–4950 (not a toll- improvements and repairs is whether and the statements at the public hearing, free call); Concerning §§ 1.165–2T, the expenditures were made to ‘‘put’’ or the IRS and the Treasury Department 1.167(a)–4T, 1.167(a)–7T, 1.167(a)–8T, ‘‘keep’’ property in efficient operating are issuing temporary regulations 1.168(i)–1T, 1.168(i)–7T, 1.168(i)–8T, condition. In Plainfield-Union Water Co. amending 26 CFR part 1. The IRS and 1.263A–1T, and 1.1016–3T, Kathleen v. Commissioner, 39 T.C. 333, 338 the Treasury Department are also Reed or Patrick Clinton, Office (1962), nonacq. on other grounds (1964– withdrawing the 2008 proposed Associate Chief Counsel (Income Tax & 2 CB 8), the court stated that if the regulations and are proposing new Accounting), (202) 622–4930 (not a toll- expenditure merely restores the regulations that incorporate the text of free call). property to the state it was in before the these temporary regulations.

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Explanation of Provisions section 168 to include the retirement of 2008 proposed regulations for materials I. Overview a structural component of a building. and supplies. In response to practitioner and industry comments, however, the II. Materials and Supplies Under Section 263(a) generally requires the temporary regulations modify and § 1.162–3 capitalization of amounts paid to expand the definition of materials and acquire, produce, or improve tangible Section 1.162–3 provides, in part, that supplies, provide an alternative optional property. These temporary regulations a taxpayer carrying materials and method of accounting for rotable and provide a general framework for supplies on hand should include in temporary spare parts, and provide an capitalization and retain many of the expenses the charges for materials and election to treat certain materials and provisions of the 2008 proposed supplies only in the amount that are supplies under the de minimis rule of regulations, which in many instances actually consumed and used in § 1.263(a)–2T. In addition, consistent incorporated standards from existing operation during the taxable year for with the 2008 proposed regulations, the authorities under section 263(a). The which the return is made. Section temporary regulations allow a taxpayer temporary regulations also modify 1.162–3 does not define materials and to elect to capitalize certain materials several sections of the 2008 proposed supplies; however various judicial and and supplies. regulations in response to comments administrative authorities have ruled on received and to achieve results that are whether property constitutes a material A. Definition of Materials and Supplies more consistent with the established or supply (rather than inventory or The 2008 proposed regulations authorities. The temporary regulations depreciable property). See, for example, defined the first category of materials adopt the same general format as the Rev. Rul. 81–185 (1981–2 CB 59); Rev. and supplies as tangible property used 2006 and 2008 proposed regulations, Rul. 78–382 (1978–2 CB 111). and consumed in the taxpayers whereby § 1.263(a)–1T provides general In response to practitioner comments operations, not constituting a unit of rules for capital expenditures, that the 2006 proposed regulations property under § 1.263(a)–3(d)(2), and § 1.263(a)–2T provides rules for failed to address the relationship not acquired as part of a single unit of amounts paid for the acquisition or between the treatment of acquisition property. Under this definition, many production of tangible property, and costs and the treatment of materials and component parts acquired separately § 1.263(a)–3T provides rules for supplies, the 2008 proposed regulations from an existing unit of property would amounts paid for the improvement of proposed substantial modifications to not be treated as materials and supplies tangible property. The temporary § 1.162–3. The 2008 proposed if they were treated as separate units of regulations also adopt and refine many regulations defined materials and property under § 1.263(a)–3(d)(2). The of the rules contained in the 2008 supplies as tangible property that is IRS and the Treasury Department proposed regulations. For example, the used or consumed in the taxpayer’s intended that these components temporary regulations adopt and refine operations that (1) is not a unit of generally qualify as materials and the definition and treatment of materials property or acquired as part of a single supplies. Therefore, the temporary and supplies under § 1.162–3T, the de unit of property; (2) is a unit of property regulations redefine the first category of minimis rule for the acquisition and that had an economic useful life of 12 materials and supplies by further production of property under months or less, beginning when the describing the types of components that § 1.263(a)–2T, and the safe harbor for property was used or consumed; (3) is qualify and by eliminating the routine maintenance under § 1.263(a)– a unit of property that had an requirement that such property not be a 3T. acquisition or production cost (as unit of property under section The temporary regulations also determined under section 263A) of $100 § 1.263(a)–3T(d)(2). Under the modify some of the rules set out in the or less; or (4) is identified as a material temporary regulations, the first category 2008 proposed regulations. For and supply in future published of materials and supplies includes example, the temporary regulations guidance. In addition, the 2008 components that are acquired to revise certain rules for determining proposed regulations adopted the maintain, repair, or improve a unit of whether there has been an improvement general rule that incidental materials tangible property owned, leased, or to a unit of property under § 1.263(a)– and supplies (for which no inventories serviced by the taxpayer and that are not 3T. Notably, the temporary regulations or records of consumption are acquired as part of any single unit of revise the rules for determining whether maintained) are deductible in the year property. an amount is paid for an improvement purchased and that non-incidental In addition, the temporary regulations to a building. The temporary regulations materials and supplies are not provide a new category of materials and also revise the rule for determining deductible until the year in which they supplies. One commentator suggested whether an amount is paid for the are used or consumed in the taxpayer’s that the IRS and the Treasury replacement of a major component or operations. Department consider the treatment of substantial structural part of a unit of The 2008 proposed regulations certain property that does not fit clearly property. In addition, the temporary included a specific rule for the into any of the categories set out in the regulations include numerous new and treatment of rotable or temporary spare 2008 proposed regulations but that revised examples to illustrate the parts that otherwise met the definition generally is not considered depreciable application of the improvement rules. of materials and supplies. Because property or inventory property, such as Finally, the temporary regulations rotable and temporary spare parts are fuel, water, or lubricants. The temporary provide several additional rules that typically removed, repaired, and reused regulations add a category of materials were not included in the 2008 proposed over a period of years, the 2008 and supplies for fuel, lubricants, water, regulations. For example, the temporary proposed regulations treated rotable and and similar items that are reasonably regulations provide rules under temporary spare parts as used or expected to be consumed in 12 months § 1.263(a)–3T(f) for the treatment of consumed in the taxable year in which or less, beginning when used in the amounts paid to improve leased a taxpayer disposed of the rotable or taxpayer’s operations. property and provide rules under temporary part. In addition, the IRS and the Treasury § 1.168(i)–8T that revise the definition The temporary regulations generally Department received several comments of disposition for property subject to retain the framework set forth in the requesting that the definition of

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materials and supplies raise the in its equipment. The taxpayer includes costs meet the requirements of the de specified acquisition or production cost in income and assigns a cost basis equal minimis rule. Thus, a taxpayer may threshold from $100 or less to $500 or to the fair market value of the used, non- apply a single timing rule (that is, less and that this specified amount be functioning part, and capitalizes the deduction when paid or incurred) to indexed for inflation. The temporary costs of repairing the part. If the any unit of property, including regulations retain the $100 limitation to repaired part is later used as a materials and supplies, to the extent the avoid possible inappropriate distortions replacement part in the taxpayer’s aggregate amount paid for such property of a taxpayer’s income. The temporary equipment, the taxpayer deducts the does not exceed the limit described in regulations add language, however, that basis of the part in the taxable year it is § 1.263(a)–2T(g)(1)(iv). gives the IRS and the Treasury re-installed. This cycle continues until Department the flexibility to change the disposition of the part. D. Election To Capitalize Materials and amount of the limitation by future The temporary regulations generally Supplies published guidance. Moreover, a adopt the recommendations of the The temporary regulations retain the taxpayer with applicable financial commentator and include the proposed rule from the 2008 proposed regulations statements will be permitted to deduct method of accounting for rotable parts that permits a taxpayer to elect to amounts paid for property up to higher as an optional method. This optional capitalize and depreciate amounts paid thresholds if it complies with the method may be used as an alternative to for certain materials and supplies. requirements set out in the de minimis treating the parts as used or consumed Several commentators questioned the rule provided in § 1.263(a)–2T. in the year of disposition or electing to effect of this provision and the other Finally, several commentators treat the parts as depreciable assets. If a new rules under proposed § 1.162–3 on questioned the effect of proposed taxpayer chooses to use the optional previous IRS pronouncements that § 1.162–3 on certain safe harbor revenue method, the method must be used for all distinguished certain depreciable procedures that permit taxpayers to treat of the taxpayer’s rotable and temporary property from materials and supplies. certain property as materials and spare parts in the same trade or See, for example, Rev. Rul. 2003–37 supplies. For example, Rev. Proc. 2002– business. (2003–1 CB 717) (permitting taxpayers 12 (2002–1 CB 374) allows a taxpayer to C. Election To Deduct Materials and to treat certain rotable spare parts used treat smallwares as materials and Supplies Under the De Minimis Rule in a service business as depreciable supplies that are not incidental under assets); Rev. Rul. 81–185 (1981–2 CB 59) § 1.162–3. Similarly, Rev. Proc. 2002–28 The IRS and the Treasury Department received several comments requesting (concluding that major standby (2002–1 CB 815) allows a qualifying emergency spare parts are depreciable small business taxpayer to treat certain that the regulations clarify whether a taxpayer may apply the de minimis rule property); Rev. Rul. 69–201 (1969–1 CB inventoriable items in the same manner 60) (holding that standby replacement as materials and supplies that are not contained in § 1.263(a)–2 of the 2008 proposed regulations to units of parts used in pit mining business are incidental under § 1.162–3. The items for which depreciation is temporary regulations do not supersede, property that were also treated as allowable); Rev. Rul. 69–200 (1969–1 CB obsolete, or replace these revenue materials and supplies under § 1.162–3 60) (holding that flight equipment procedures to the extent they deem of the proposed regulation. Under the rotatable spare parts and assemblies are certain property to constitute materials proposed de minimis rule, a taxpayer tangible property for which depreciation and supplies under § 1.162–3. This was not required to capitalize amounts is allowable while expendable flight designated property continues to qualify paid for the acquisition or production of equipment spare parts are materials and as materials and supplies under the a unit of property if the taxpayer met supplies); Rev. Proc. 2007–48 (2007–2 temporary regulations because the certain requirements set out in that CB 110) (providing a safe harbor method property is identified in published regulation. The proposed de minimis of accounting to treat certain rotable guidance as materials and supplies. rule provided a taxpayer with more favorable treatment (that is, deduction spare parts as depreciable assets). B. Optional Method for Rotable or when an amount is paid or incurred) Section 1.162–3T is applicable to all Temporary Spare Parts than the treatment of materials and materials and supplies as defined under The 2008 proposed regulations supplies under the general rule of that provision, including certain types proposed to allow a deduction for § 1.162–3 (that is, deduction when of property that were treated as amounts paid for rotable or temporary property is used or consumed). depreciable property under previously spare parts when the parts were Commentators indicated that the published guidance. Thus, for example, discarded from the taxpayer’s requirement to differentiate and the temporary regulations modify Rev. operations. Alternatively, a taxpayer separately account for certain materials Rul. 2003–37, Rev. Rul. 81–185, Rev. could elect to capitalize and depreciate and supplies is impractical and presents Rul. 69–200, and Rev. Rul. 69–201 to rotable spare parts over the parts’ an administrative burden that is the extent that the temporary applicable recovery period. inconsistent with the purpose of the de regulations characterize certain tangible The IRS and the Treasury Department minimis rule. Thus, commentators properties addressed in these rulings as received comments stating that the requested that a taxpayer be permitted materials and supplies. However, the requirement to defer the deduction of to apply the de minimis rule of temporary regulations permit taxpayers rotable spare parts until the year of § 1.263(a)–2, rather than the materials to elect to treat these properties as assets disposition is inconsistent with the and supplies rules, to the costs of any subject to the allowance for depreciation method that many taxpayers currently unit of property that meets the consistent with the holdings in these use for rotable spare parts and would definition of materials and supplies. revenue rulings. In addition, the IRS result in an administrative burden for The temporary regulations adopt this and the Treasury Department recognize those taxpayers. One commentator recommendation and allow a taxpayer that Rev. Proc. 2007–48 may need to be explained that, under this method, a to elect to apply the de minimis rule of revised to address the treatment of taxpayer deducts an amount paid for a § 1.263(a)–2T(g) to the costs of acquiring certain rotable spare parts defined as new rotable spare part in the taxable or producing any type of material or materials and supplies under the year in which it installs the rotable part supply defined in § 1.162–3T if such temporary regulations. Thus, comments

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are requested on the application of the depreciate or amortize its leasehold required to be capitalized. The safe harbor method in this context. improvements under the cost recovery temporary regulations address these provisions of the Internal Revenue Code types of moving and reinstallation costs III. Repairs Under § 1.162–4 applicable to the improvements, in examples provided in § 1.263(a)– The 2008 proposed regulations without regard to the term of the lease, 3T(h)(4), governing improvements to proposed to revise § 1.162–4 (the repairs and also remove the rules permitting property. regulation) to provide rules consistent amortization over the shorter of the B. Work Performed Prior To Placing with the improvement rules under estimated useful life or the term of the Property Into Service § 1.263(a)–3 of the proposed regulations. lease. For example, if the leasehold The 2008 proposed regulations provided improvement is property to which The 2008 proposed regulations that amounts paid for repairs and section 168 applies, the leasehold provided that acquisition costs include maintenance to tangible property are improvement is depreciated under costs for work performed on a unit of deductible if the amounts paid are not section 168. Section 1.162–11 of the property prior to the date the unit of required to be capitalized under temporary regulations also includes property is placed in service. Several § 1.263(a)–3. The IRS and Treasury cross references to § 1.263(a)–3T(f)(1) commentators expressed concern that Department received no comments on (regarding improvements to leased this rule would require a taxpayer to this proposed regulation. The temporary property) and to § 1.167(a)–4T capitalize generally deductible costs, regulations retain the rule from the 2008 (regarding depreciation or amortization such as repair costs, if they were proposed regulations and clarify that a deductions for leasehold incurred prior to placing the unit of taxpayer is permitted to deduct amounts improvements). property in service. One commentator paid to repair and maintain tangible suggested that the regulations allow a property provided such amounts are not V. Amounts Paid To Acquire or taxpayer to rebut the presumption that required to be capitalized under section Produce Tangible Property Under these costs are acquisition costs. 263(a) or any other provision of the § 1.263(a)–2T Amounts paid for work performed on Code or regulations. See, for example, The 2008 proposed regulations a unit of property prior to placing the section 263A and the regulations provided rules for the capitalization of property in service are related to the thereunder. amounts paid to acquire or produce acquisition of the unit of property and, units of tangible property. The therefore, must be treated as an IV. Rentals Under § 1.162–11 and temporary regulations retain most of acquisition cost. The temporary Leased Property Under § 1.167(a)–4 these rules, including the general regulations do not incorporate a The existing regulations under requirement to capitalize acquisition rebuttable presumption in this rule § 1.162–11 provide rules for the and production costs, and the because there are very few, if any, costs treatment of amounts paid (1) to acquire requirement to capitalize amounts paid to which the presumption would apply. a leasehold and (2) for leasehold to defend and perfect title to property. Moreover, a rebuttable presumption is improvements by a lessee on a lessor’s In response to comments received, the more subjective and difficult to property. The temporary regulations do temporary regulations clarify the administer. Thus, the temporary not amend the rule in § 1.162–11(a) that application of the rules to moving and regulations retain the bright-line rule provides that a taxpayer may amortize reinstallation costs; retain the rule for that requires a taxpayer to capitalize the cost of acquiring a leasehold over costs incurred prior to placing property costs that are incurred prior to the date the term of the lease. The temporary into service; add and clarify certain a unit of property is placed in service. regulations make only minor revisions rules with respect to transaction costs; C. Transaction Costs to the rule in § 1.162–11(b) that provides and modify and refine the de minimis that the cost of erecting a building or rule. The 2008 proposed regulations making a permanent improvement to provided that a taxpayer must, in property leased by the taxpayer is a A. Moving and Reinstallation Costs general, capitalize amounts paid to capital expenditure and is not An example in the 2008 proposed facilitate the acquisition or production deductible as a business expense. regulations illustrated that a taxpayer of real or personal property. They Section 1.162–11(b) of the existing generally is not required to capitalize included a rule that provided that costs regulations also provides that a taxpayer the costs of moving tangible personal relating to activities performed in the lessee may amortize a leasehold property already placed in service from process of determining whether to improvement over the shorter of the one facility to another similar facility. acquire real property and which real estimated useful life of the improvement Several commentators expressed property to acquire generally are or the remaining period of the lease. A concern, however, that the example in deductible pre-decisional costs unless similar rule exists in § 1.167(a)–4. In the 2008 proposed regulations omitted they are described in the regulations as that respect, the existing regulations do any discussion of the treatment of inherently facilitative costs. The not reflect the amendments made to amounts paid to reinstall the unit of temporary regulations retain the general sections 168 and 178 by sections 201(a) property in the new location. Amounts rule in the 2008 proposed regulations and 201(d)(2)(A), respectively, of the paid to move and reinstall a unit of and the rules defining the costs that Tax Reform Act of 1986, Public Law 99– property that has already been placed in facilitate the acquisition or production 514. See sections 168(i)(6) and (8), service by the taxpayer generally are not of real or tangible property. The which require a lessee or lessor to amounts paid to acquire or produce a temporary regulations also clarify that a depreciate or amortize leasehold unit of property. Thus, these costs are taxpayer may be required to allocate improvements under the cost recovery not required to be capitalized under the certain facilitative costs between provisions of the Code applicable to the rules for acquisition or production of personal property and real property improvements, without regard to the property. But, if the costs of moving and acquired in a single transaction. term of the lease. Accordingly, the reinstalling a unit of property directly Accordingly, the temporary regulations temporary regulations both amend the benefit, or are incurred by reason of, an add a ‘‘reasonable allocation’’ rule to rules in §§ 1.162–11(b) and 1.167(a)–4 to improvement to the unit of property that assist a taxpayer in making allocations provide that a lessee or lessor must is moved and reinstalled, such costs are of facilitative costs between personal

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

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certain items. It is not intended that proposed regulations limited the that no loss shall be recognized upon examining agents must now revise their circumstances in which an amount paid the retirement of a structural component materiality thresholds in accordance would be capitalized as an of a building. Thus, if a taxpayer with the de minimis rule ceiling. Thus, improvement. First, the 2008 proposed replaced a structural component of a if examining agents and a taxpayer agree regulations defined the unit of property building during the recovery period of that certain amounts in excess of the de for a building as the building and its the building, the taxpayer could not minimis rule ceiling are immaterial and structural components. Thus, work immediately recover the basis allocable should not be subject to review, that performed on a building would rise to to the removed component, but rather agreement should be respected, the level of an improvement only if it had to continue to depreciate it as part notwithstanding the requirements of the resulted in a betterment or restoration of the building. If the taxpayer were de minimis rule in the temporary (or a new or different use) when applied required to capitalize the costs of the regulations. However, a taxpayer that to the building and its structural replacement component under section seeks a deduction for amounts in excess components as a whole. Second, the 263(a), then the taxpayer would be of the amount allowed by this rule or by restoration rules under the 2008 required to depreciate agreement with IRS examining agents proposed regulations provided that a contemporaneously both the retired will have the burden of showing that taxpayer did not have to capitalize, or component and the replacement such treatment clearly reflects income. treat as an improvement, amounts paid component. Finally, the temporary regulations do to replace a major component or To achieve results more consistent not expand the de minimis rule to a substantial structural part of a unit of with existing law and to provide relief taxpayer without an AFS or provide property unless those amounts were from the potential inequities that can specific de minimis amounts deductible paid after the recovery period for the result from the application of the by a taxpayer in this context. A taxpayer property, and either (1) the replacement depreciation and disposition rules, the without an AFS does not have a cost comprised 50 percent or more of temporary regulations revise and amend consistent, audited methodology for the replacement cost of the entire unit the 2008 proposed regulations in several determining de minimis expenses, and of property, or (2) the replacement parts respects. First, the temporary as a result, the IRS would have little or comprised 50 percent or more of the regulations retain the rule from the 2008 no assurance that a taxpayer without an physical structure of the unit of proposed regulations that the unit of AFS was using a reasonable, consistent property (‘‘the 50 percent thresholds’’). property for a building consists of the methodology that clearly reflects Thus, capitalization under the major building and its structural components. income. However, the temporary component rule applied only if the However, the temporary regulations regulations provide some relief for a property was fully depreciated and revise the manner in which the taxpayer without an AFS by providing either of the 50 percent thresholds were improvement standards must be applied a deduction under § 1.162–3T for triggered. to the building and its structural materials and supplies that cost $100 or These sections of the 2008 proposed components. In determining whether an less. The IRS and the Treasury regulations would have led to results amount paid is for an improvement to Department request comments that were contrary to long-standing case the building, the temporary regulations addressing de minimis rule alternatives law (discussed below) and inconsistent require a taxpayer to consider the effect that would substantiate the use of a with the way most taxpayers had treated of the expenditure on certain significant reasonable and consistent methodology these items for tax purposes. Although and specifically defined components of and ensure clear reflection of income for the preamble to the 2008 proposed the building, rather than the building determining de minimis expenses for a regulations provided that a taxpayer and its structural components as a taxpayer without an AFS. should not rely on the proposed rules, whole. Second, the temporary many taxpayers applied to change their regulations do not include the 50 VI. Amounts To Improve Property methods of accounting from capitalizing percent thresholds and recovery period Under § 1.263(a)–3T certain expenditures to deducting these limitation for determining whether a expenditures as repairs based on the replacement rises to the level of a major A. Overview standards in the 2008 proposed component or substantial structural part The temporary regulations retain the regulations. of a unit of property. Finally, the basic framework of the 2008 proposed The 2008 proposed regulations temporary regulations include new regulations for determining the unit of limited capitalization and allowed more provisions under section 168 that property and for determining whether frequent deductions for work performed expand the definition of dispositions to there is an improvement to the unit of on tangible property, in part, to lessen include the retirement of a structural property. The temporary regulations the effects of depreciation and component of a building. This change also retain many of the simplifying disposition rules under section 168 allows a taxpayer to recognize a loss on conventions set out in the 2008 (MACRS). Under section 168(i)(6), a the disposition of a structural proposed regulations, including the taxpayer is required to depreciate an component of a building before the routine maintenance safe harbor and the amount paid for an improvement using disposition of the entire building, so optional regulatory accounting method. the same recovery period and the same that a taxpayer will not have to continue As explained below, the temporary depreciation method as the underlying to depreciate amounts allocable to regulations also modify the 2008 property, with the recovery period structural components that are no longer proposed regulations in several areas. beginning when the improvement is in service. Thus, under the temporary A goal of both the 2006 and 2008 placed in service. In addition, § 1.168– regulations, a taxpayer is not required to proposed regulations was to reduce 2(l)(1) of the proposed ACRS regulations capitalize and depreciate controversy and provide clarity in (which have been generally applied to simultaneously amounts paid for both determining whether an amount is paid MACRS property) provides that a the removed and the replacement for an improvement that must be disposition does not include the properties. capitalized under section 263(a). In retirement of a structural component of The IRS and the Treasury Department several respects, however, the more a building. Accordingly, § 1.168–6(b) of recognize that it may be difficult for objective rules provided in the 2008 the proposed ACRS regulations provides taxpayers to determine specifically the

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

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

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explained below, the temporary cost of improving a lessee improvement which the component is a part, or regulations provide that only a ‘‘lessee is not a unit of property separate from depreciated the component using a improvement,’’ rather than a ‘‘leasehold the lessee improvement being improved. section 167 or section 168 depreciation improvement,’’ is a unit of property Treating the lessee’s initial method different from the depreciation separate from the unit of property improvement as a separate unit of method for the unit property of which improved. Moreover, this rule has been property is based on the premise that, the component is a part (the moved to a separate subsection when making a leasehold improvement, ‘‘depreciation consistency rule’’). governing the unit of property for the lessee should be treated as if it has The IRS and the Treasury Department improvements. acquired or produced new property. received several comments requesting This new property interest is separate that the book life consistency rule be 5. Unit of Property for Leasehold and distinguishable from the lessee’s removed from the final regulation. Improvements interest in the underlying property. Commentators noted that tax and Current law provides that if a lessee Also, this approach is consistent with financial accounting have different goals makes a leasehold improvement that is the depreciation rules under sections and that a taxpayer generally has non- not a substitute for rent, the lessee is 168(i)(6) and (i)(8)(A), which treat the tax reasons for classifying property generally required to capitalize the cost leasehold improvement as a separate differently for financial accounting of the improvement under section asset for purposes of section 168. purposes. For these reasons, the 263(a) and §§ 1.162–11(b) and 1.167(a)– Finally, treatment of a lessee’s temporary regulations do not adopt the 4 and, if the leasehold improvement is subsequent improvement as part of the book life consistency rule contained in property to which section 168 applies, lessee’s initial leasehold improvement is the 2008 proposed regulations. depreciate the improvement under consistent with the rule governing the The temporary regulations retain the section 168. See section 168(i)(8)(A). unit of property determination for depreciation consistency rule that Current law, however, does not clearly improvements to owned property, applies to property, other than address the unit of property for which generally treats the improvement buildings, in the taxable year the leasehold improvements. and the property improved as a single property is initially placed in service. The 2008 proposed regulations unit of property. The temporary regulations add a second provided that, in the case of a leasehold The temporary regulations also depreciation consistency rule that improvement made by a lessee that is provide a rule for determining the unit applies if a taxpayer or the IRS properly section 1250 property, the leasehold of property for a lessor improvement. changes the MACRS class or improvement is a separate unit of The temporary regulations provide that depreciation method for any type of property. The 2008 proposed an amount capitalized as a lessor property (for example, as a result of a regulations did not address leased improvement is not a unit of property cost segregation study or a change in the section 1245 property or discuss the separate from the unit of property use of the property) in a taxable year unit of property for improvements made improved. This rule is based on the after the year the property was initially by a lessor. The IRS and the Treasury premise that the lessor of property placed in service. Under this rule, the Department received several comments generally should be treated in the same taxpayer must change the unit of requesting that the regulations provide manner as any other owner of property property determination for the effected additional guidance on the unit of when it makes an improvement to its property to be consistent with the property for improvements to leased property. Thus, in accordance with the change in treatment for depreciation section 1250 property and address the general rule for property owners, a purposes. Thus, for example, if a unit of property for improvements to lessor improvement to a unit of property taxpayer performs a cost segregation leased section 1245 property. In is not a unit of property separate from study and changes the classification of addition, commentators suggested that the property being improved. components in a building from section revised regulations provide operative 1250 property to section 1245 property, rules for determining when there has 6. Additional Rules for Determining the taxpayer must use the same been an improvement to leased Units of Property classifications to define the unit of property. In response to the comments, The 2008 proposed regulations the temporary regulations address included two additional rules that, if property for capitalization purposes. whether amounts paid by a lessee or applicable, would more narrowly define C. Special Rules for Improvements lessor are for the improvement of a unit the unit of property for property other of leased property, requiring capital than buildings. The 2008 proposed 1. Improvements to Leased Property treatment. The temporary regulations regulations provided that a component The 2008 proposed regulations also define the unit of property for must be treated as a separate unit of provided that a taxpayer must capitalize purposes of determining whether property if, at the time the unit of amounts paid to acquire or produce a amounts paid subsequent to an initial property is placed in service by the unit of real or personal property, leasehold improvement must be taxpayer, the taxpayer has recorded on including leasehold improvement capitalized. its books and records for financial or property. The 2008 proposed The temporary regulations for lessee regulatory accounting purposes an regulations also noted that a taxpayer improvements are consistent with the economic useful life for the component must capitalize amounts paid to rule in the 2008 proposed regulations that is different from the economic improve a unit of property whether the but provide further elaboration and are useful life of the unit of property of taxpayer is the owner or lessee of the extended to section 1245 property. The which the component is a part (the unit of property. However, the 2008 temporary regulations provide that an ‘‘book life consistency rule’’). The 2008 proposed regulations did not provide amount initially capitalized as a lessee proposed regulations also provided that operative rules for determining whether improvement is treated as a cost of a component must be treated as a there was an improvement to leased acquiring or producing a unit of separate unit of property if the taxpayer property (‘‘leasehold improvement’’) property, and constitutes a unit of has properly treated the component as and did not clarify how a leasehold property separate from the leased being within a different MACRS class improvement must be treated under the property being improved. However, the than the class of the unit of property of regulations.

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

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maintenance that do not directly benefit repair and maintenance costs incurred was deemed not to improve the unit of and that are not incurred by reason of during an improvement, the costs of property if it was for the ongoing an improvement are not required to be removing a component of a unit of activities that a taxpayer (or a lessor) capitalized under section 263(a), property must be capitalized if they expected to perform as a result of the regardless of whether the repairs and directly benefit or are incurred by taxpayer’s (or the lessee’s) use of the maintenance are performed at the same reason of an improvement to a unit of unit of property to keep the unit of time as an improvement. The 2008 property. See, for example, Towanda property in its ordinarily efficient proposed regulations also included an Coke Corp. v. Commissioner, 95 T.C. operating condition. The activities were exception for an individual residence, 124 (1990) (holding that costs of routine only if, at the time the unit of which permitted an individual taxpayer removing piping damaged in a fire and property was placed in service, the to capitalize repair and maintenance installing new pipe were capital taxpayer reasonably expected to perform costs incurred at the time of a expenditures); Phillips Easton Supply the activities more than once during the substantial remodel of its residence. Co. v. Commissioner, 20 T.C. 455 (1953) class life of the unit of property (that is, The temporary regulations retain the (holding that costs of removing a cement the recovery period prescribed under general rule from the 2008 proposed floor in a building and replacing it with sections 168(g)(2) and 168(g)(3), regulations for otherwise deductible a concrete floor were capital regardless of whether the property was indirect costs incurred during an expenditures to improve the property); depreciated under section 168(g)). improvement but clarify that all indirect Rev. Rul. 2000–7 (2000–1 CB 712) The IRS and the Treasury Department costs, including repair and removal (providing that the costs of removing a received comments criticizing the safe costs, are subject to the section 263A component of a depreciable asset are harbor’s use of defined class life as the standard. The temporary regulations either capitalized or deducted based on testing period. Instead, the comments also retain the exception for substantial whether the replacement of the suggested that the safe harbor should improvements to individual residences. component constitutes an improvement utilize the economic useful life of the The rules provided in section 263A or a repair). As with other costs incurred unit of property as the appropriate and § 1.263A–1(e) regarding the during an improvement, a taxpayer may testing period. The temporary capitalization of indirect costs require deduct the costs of removing a regulations retain the requirement that a the capitalization of indirect costs that component if the taxpayer can taxpayer must expect to perform routine directly benefit or are incurred by demonstrate that such costs relate only maintenance more than once during the reason of an improvement to property. to the disposition of the removed defined class life of the unit of property. By adopting the § 1.263A–1(e) standard property and that the costs do not have The class life based standard is more for purposes of section 263(a), the the requisite relationship to any objective, is more consistent among temporary regulations set out a clearly improvement. taxpayers, and is more administrable articulated standard that provides In addition, the temporary regulations than a standard based on the economic appropriate parameters for determining do not affect the holding of Rev. Rul. useful life of the property. Notably, when otherwise deductible indirect 2000–7 as it applies to the costs of during the consideration of the 2006 costs must be capitalized as part of an removing an entire unit of property. proposed regulations, many improvement to property. Accordingly, Under Rev. Rul. 2000–7, a taxpayer is commentators expressed concern that the temporary regulations obsolete the not required to capitalize the cost of the economic useful life of property is plan of rehabilitation doctrine to the removing a retired depreciable asset not an accurate determinant of its actual extent the court created doctrine under section 263(a) or section 263A, useful life and that reliance on this provided different standards for even where the retirement and removal standard would create disparate determining whether an otherwise occurred in connection with the treatment among taxpayers in deductible indirect cost must be installation of a replacement asset. characterizing similar costs. capitalized as part of an improvement. Historically, the costs of removing a The IRS and the Treasury Department depreciable asset generally have been also received comments regarding the 3. Removal Costs allocable to the removed asset and, thus, application of the routine maintenance The 2008 proposed regulations did generally have been deductible when safe harbor to buildings. Because not address the treatment of amounts the asset is retired. See § 1.165–3(b); buildings typically have a long class life paid to remove a unit of property, asset, § 1.167(a)–1(c); § 1.167(a)–11(d)(3)(x); (for example, 39.5 years for or a component of a unit of property. Rev. Rul. 74–455 (1974–2 CB 63); Rev. nonresidential real property), many Examples in the 2008 proposed Rul. 75–150 (1975–1 CB 73). Because remodeling projects arguably could be regulations, however, suggested that if a the costs of removing a retired asset deducted under the safe harbor, taxpayer removes a component in order typically relate to the depreciable asset regardless of the nature or extent of the to facilitate a replacement and the costs being removed and are not allocable to work involved. For example, if a of the replacement component the improvements, § 1.263(a)–3T taxpayer expected to replace a major constitute an improvement to the unit of generally is not applicable to such component, such as a roof, an HVAC property, then the costs of removing the removal costs. Moreover, the temporary system, or an electrical system, more old component must be treated a part of regulations do not change the treatment than once during the long class life of the improvement. of any amounts addressed under section the building, then the costs of such No comments were received 280B, which governs amounts expended replacements generally would have addressing the treatment of removal and losses sustained for the demolition been deductible under the safe harbor. costs, and the temporary regulations do of structures. Allowing a deduction for costs not include a specific rule for such attributable to these types of projects is costs. But the costs of removing a D. Safe Harbor for Routine Maintenance inconsistent with much of the case law component of a unit of property should The 2008 proposed regulations addressing building improvements. be analyzed in the same manner as any provided a safe harbor from Generally, the courts have held that other indirect cost incurred during an capitalization for the costs of performing amounts paid for replacements of major improvement to property. Thus, similar certain routine maintenance activities. components or substantial structural to the treatment of otherwise deductible Under the safe harbor, an amount paid parts of buildings and their structural

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components are capital expenditures. expressed concern that the 2008 suggestion to add a two-year limitation See, for example, Tsakopoulous v. proposed regulations’ definition of on the application of the rule because Commissioner, T.C. Memo 2002–8 betterments would require a taxpayer to such a limitation might encourage a (holding that costs to replace the roof on capitalize costs that do not extend the taxpayer simply to postpone its a portion of the suites of a shopping useful life of the unit of property as a expenditures to avoid treatment as an center were capital expenditures); Hill whole and suggested that the MACRS improvement. v. Commissioner, T.C. Memo 1983–112 rules be modified so that betterments b. Environmental Cleanup of Reacquired (holding that costs to replace the water would be assigned a recovery period Property heater and the furnace in rental property based on the remaining recovery period were capital expenditures); Stewart of the unit of property. Such a revision As mentioned above, the 2008 Supply Co. v. Commissioner, T.C. Memo to the MACRS regulations would be proposed regulations required a 1963–62 (holding that costs to replace contrary to section 168(i)(6), which taxpayer to capitalize an amount paid to the front wall of a building and make generally requires that the depreciation ameliorate a material condition or defect electrical connections to that wall were deduction for an addition or that existed at the time the taxpayer capital expenditures); First Nat’l Bank v. improvement be computed in the same acquired or produced the property. The Commissioner, 30 B.T.A. 632 (1934) manner as the depreciation deduction rule follows the general principle that a (holding that costs of replacing the for the underlying property would be taxpayer must capitalize costs incurred electrical system in a bank building computed if the underlying property to correct a pre-existing defect in were capital expenditures); Georgia Car had been placed in service at the same acquired property regardless of whether and Locomotive Co., 2 B.T.A. 986 (1925) time as the addition or improvement. the taxpayer was aware of the defect at (holding that costs of a new roof on a the time of acquisition. See United Dairy building were capital expenditures). 1. Amounts Paid to Ameliorate Material Farmers, Inc. v. United States, 267 F.3d Accordingly, the routine maintenance Conditions and Defects 510 (6th Cir. 2001). The preamble to the safe harbor is not appropriate for work a. Knowledge of Defect 2008 proposed regulations stated that performed on buildings. Rather, the under this rule a taxpayer would be proper analysis requires the application Several commentators suggested required to capitalize environmental of the general rules for improvements, changes to the 2008 proposed rule that remediation costs in the situation in including the rules for determining defined a betterment as an amount paid which the taxpayer contaminated whether the costs are incurred for a to ameliorate a material condition or property in the course of its business betterment or restoration to the building defect that existed prior to acquisition operations, disposed of the property (for or the building systems, or to adapt the or arose during the production of the example, by sale), and later reacquired building or any of its systems to a new unit of property, whether or not the property to clean up the contamination. or different use. The temporary taxpayer was aware of the defect at the The preamble requested comments regulations revise the routine time of acquisition or production. One regarding the appropriate treatment of maintenance safe harbor to apply only commentator suggested that a taxpayer environmental remediation costs in to property other than buildings. In should be required to capitalize the these situations, including how to addition, the temporary regulations costs of ameliorating a defect only if the determine whether the taxpayer’s own include new rules clarifying the taxpayer was aware of or should have use, or a prior owner’s use, caused the application of the improvement been aware of the defect at the time of contamination. standards to a building and provide new acquisition. Another commentator Several commentators recommended examples illustrating the application of suggested that a taxpayer should be that the regulations allow a deduction these rules. required to capitalize these costs only if for clean-up costs under certain they were incurred within two years of circumstances after a taxpayer acquires, E. Betterments the acquisition of the property. or reacquires, property that the taxpayer The 2008 proposed regulations The temporary regulations do not had previously contaminated. The provided that an amount paid results in revise the rule to require that a commentators generally asserted that a a betterment, and accordingly, an taxpayer’s knowledge be taken into taxpayer that acquires or reacquires improvement, if it ameliorates a account in determining whether property that it had previously material condition or material defect expenditures to ameliorate a preexisting contaminated should be treated no that existed prior to the acquisition of condition or defect must be capitalized. differently than a taxpayer that the property or arose during the The rule provided in the 2008 proposed continuously owns the property and production of the property; results in a regulations is consistent with contaminated the property through the material addition to the unit of property established case law, which requires a course of its operations. See Rev. Rul. (including a physical enlargement, taxpayer to capitalize these costs 94–38 (1994–1 CB 35), in which a expansion, or extension); or results in a whether or not the taxpayer was aware taxpayer was permitted to deduct the material increase in the capacity, of the defect at the time of acquisition. costs of remediating property that it productivity, efficiency, strength, or See United Dairy Farmers, Inc. v. United continuously owned and contaminated quality of the unit of property or its States, 267 F.3d 510 (6th Cir. 2001); in the course of its operations because output. The temporary regulations Dominion Resources, Inc. v. United the taxpayer restored the property to the retain all of these criteria, as well as the States, 219 F.3d 359 (4th Cir. 2000); La condition it was in prior to the 2008 proposed rules that detail how the France Wine Co. v. Commissioner, T.C. circumstances necessitating the betterment standards are applied. Memo 1974–254. In addition, a rule that expenditure. One commentator The IRS and the Treasury Department would require a subjective inquiry as to addressed the situation in which a received several comment letters the taxpayer’s knowledge at the time of taxpayer contaminates property as a recommending that the drafters modify acquisition or production would be lessee of property and later acquires the the betterment rules in several areas, difficult for the IRS to administer and to property in an effort to minimize create exceptions for particular enforce. disputes with the lessor over clean-up situations, and clarify or modify some of Finally, the IRS and the Treasury obligations. The commentator the examples. One commentator Department did not adopt the recommended an exception to

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capitalization for amounts incurred to the subjective nature of determining any revised to create an exception for minor clean up contamination that existed at increase in ‘‘quality’’ of a unit of and recurring store refresh or remodel the time a taxpayer acquires property property. The temporary regulations do costs. The analysis of whether store provided (1) the taxpayer is legally not change this standard but revise the refresh or remodel costs result in a liable for the cost of cleaning up the examples from the 2008 proposed betterment requires an examination of property prior to its acquisition by the regulations and add a number of new all the facts and circumstances. The taxpayer, and (2) the taxpayer’s sole examples to help illustrate and clarify application of a per se exception to purpose for acquiring the property is to the application of the increase in quality capitalization for all costs incurred as minimize the cost of clean-up. The standard to particular facts and part of a recurring store refresh or commentator also indicated that a circumstances. remodel would be inappropriate, for taxpayer that acquires contaminated Another commentator requested an example, in situations where a taxpayer property for an amount that is at least example that permitted a deduction for performs major structural work on the equal to the remediated fair market the costs of earthquake retrofitting. The building during a refresh or remodel. value of the property should be treated temporary regulations do not include an To provide additional guidance in no differently than a taxpayer that example allowing a deduction for this area, however, the temporary continuously owned the property. earthquake retrofitting. Earthquake regulations expand upon the facts and The IRS and the Treasury Department retrofitting encompasses various factual analysis provided in Example 6 and set recognize that a taxpayer that acquires, scenarios and could involve substantial out additional examples addressing the or reacquires, contaminated property for structural additions that strengthen the refreshing and remodeling of retail an amount at least equal to the unit of property and that may constitute buildings. The additional examples remediated fair market value of the betterments under the temporary demonstrate a range of outcomes based property may be in a position similar to regulations. Also, the temporary on the amount and type of work that of a taxpayer that had continuously regulations retain an example from the performed on the building and its owned the property. However, the IRS 2008 proposed regulations that structural components. The examples in and the Treasury Department are illustrates that certain amounts paid to the temporary regulations illustrate a reluctant to create a rule that would strengthen a building to make it safer in refresh of retail buildings that merely hinge on the taxpayer’s purpose for the event of an earthquake may keeps the buildings in ordinarily acquiring the property and a subjective constitute a betterment to the unit of efficient operating condition; a refresh determination of the remediated fair property. The temporary regulations of retail buildings that also includes an market value of the property. Moreover, illustrate that a taxpayer’s treatment of improvement to a building system; and Congress specifically provides a amounts paid for earthquake retrofitting finally, a large scale refresh and remodel deduction under section 198 for depends on the taxpayer’s particular of retail buildings that involve an taxpayers that incur certain facts and circumstances. improvement to the buildings. These environmental remediation 3. Refreshing and Remodeling Buildings expenditures that are otherwise required examples also illustrate the application to be capitalized under section 263(a), The 2008 proposed regulations of the rule governing the treatment of including costs incurred by taxpayers provided an example that addressed indirect costs incurred during an conducting remediation on reacquired whether amounts paid to update or improvement of property. property. Taxpayers that elect to deduct remodel a building resulted in a F. Restorations these remediation costs under section betterment because they materially 198 must comply with the requirements increased the capacity, productivity, The 2008 proposed regulations of that provision. efficiency, strength, or quality of the provided that an amount is paid to The IRS and the Treasury Department unit of property. In Example 6 of restore, and therefore improve, a unit of recognize, however, that a taxpayer may § 1.263(a)–3(f)(3) of the 2008 proposed property if it (1) is for the replacement encounter an unusual situation for regulations, a taxpayer was not required of a component of a unit of property and which section 198 does not provide to capitalize as betterments the amounts the taxpayer has properly deducted a relief or to which the rationale paid to change periodically the layout loss for that component (other than a underlying the temporary regulations and appearance of its retail stores. The casualty loss under § 1.165–7); (2) is for does not apply. The IRS and the IRS and the Treasury Department the replacement of a component of a Treasury Department believe that these received several comments suggesting unit of property and the taxpayer had situations are better addressed through that additional examples be added to properly taken into account the adjusted subject-specific guidance outside the the regulations to clarify the types of basis of the component in realizing gain regulations. Any taxpayer with a refresh or remodel expenses that would or loss resulting from the sale or specific concern regarding the treatment not result in a betterment. One exchange of the component; (3) is for of these types of costs should consider commentator suggested the addition of the repair of damage to a unit of submitting a request for a private letter an example illustrating that a remodel property for which the taxpayer has ruling under Rev. Proc. 2011–1 (2011– expense intended to increase sales properly taken a basis adjustment as a 1 IRB 1) (or its successor). should not, by itself, be evidence of a result of a casualty loss under section material increase in the quality of the 165, or relating to a casualty event 2. Material Increase in Capacity, unit of property under the betterment described in section 165; (4) returns the Productivity, Efficiency, Strength, or standards. Another commentator unit of property to its ordinarily Quality recommended revising the betterment efficient operating condition if the The 2008 proposed regulations standards to clarify that minor costs property has deteriorated to a state of defined betterments to include incurred as part of regularly recurring disrepair and was no longer functional expenditures that result in a material store updates are treated as currently for its intended use; (5) results in the increase in the capacity, productivity, deductible selling or marketing rebuilding of the unit of property to a efficiency, strength, or quality of the expenses. like-new condition after the end of its unit of property or its output. One The betterment standards in the economic useful life; or (6) is for the commentator expressed concern about temporary regulations have not been replacement of a major component or a

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

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

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building were deductible); Rev. Rul. physical structure of the unit of loss upon the disposition of MACRS 2001–4, 2001–1 CB 295 (holding, in property or that perform a discrete and property. part, that costs of certain heavy critical function in the operation of the Currently, a taxpayer may account for maintenance on aircraft airframe were unit of property. The replacement of a its MACRS property by accounting for deductible); Smith v. Commissioner, minor component of the unit of an asset individually in a single asset 300 F.3d 1023, 1032 (9th Cir. 2002) property, even though such component account, by combining two or more (holding that costs of relining aluminum may affect the function of the unit of assets in a multiple asset account (or smelting cells were capital expenditures property, will not generally by itself pool), or by electing to include the asset even though they amounted to only constitute a major component or in a general asset account. The 22.21 percent of the costs of replacing substantial structural part under the temporary regulations continue to allow an entire cell); Denver & Rio Grande temporary regulations. The temporary these types of accounts. However, the Western R.R. Co. v. Commissioner, 279 regulations add a number of examples to rules under § 1.167(a)–7 for the different F.2d 368 (10th Cir. 1960) (holding that illustrate the application of the revised types of multiple asset accounts costs to replace the floor planks and standards in a variety of situations, (specifically group account, classified stringers of a viaduct were capital including its application to a building account, and composite account) are expenditures); P. Dougherty Co. v. structure and building systems. based on a taxpayer being permitted to Commissioner, 159 F.2d 272 (4th Cir. In addition, the temporary regulations depreciate assets in the account over 1946) (holding that costs of replacing revise the disposition and depreciation their useful lives or average useful lives the stern section of a barge were capital rules to minimize the harsh result that (less salvage value). Since the enactment expenditures); Tsakopoulous v. occurs when an original part and any of the Accelerated Cost Recovery Commissioner, T.C. Memo 2002–8 subsequent replacements of the same System (ACRS) in 1981, a taxpayer is (holding that costs to replace the roof on part are required to be capitalized and required to depreciate assets over their a portion of the suites of a shopping recovered simultaneously. As recovery periods instead of their useful center were capital expenditures); mentioned, in the case of buildings, lives. Consequently, the temporary Stewart Supply Co. v. Commissioner, taxpayers are currently required to regulations eliminate group accounts, T.C. Memo 1963–62 (holding that costs capitalize and depreciate the costs to classified accounts, and composite to replace a front wall of a building and replace a structural component and to accounts. Instead, the temporary make electrical connections to that wall continue to recover the cost of the regulations provide that each multiple were capital expenditures). original structural component (for asset account must include, in most The IRS and the Treasury Department example, a taxpayer could not take a cases, assets that have the same are concerned that the 50 percent retirement loss on the disposition of a depreciation method, recovery period, thresholds and the recovery period structural component of a building). For and convention, and that are placed in limitation, although objective, will lead example, if a taxpayer were required to service in the same taxable year. to results that are drastically different capitalize the costs of replacing an Section 1.168–6 of the proposed from the results reached in the case law entire roof, it could not recover its basis ACRS regulations provides the rules for and rulings in this area. The 50 percent in the original roof that was removed. determining gain or loss upon the thresholds and the recovery period Rather, the taxpayer would have to disposition of ACRS property. These limitation would, in many cases, allow continue depreciating the removed roof, rules generally have been applied to the replacement of a major component and at the same time, capitalize and MACRS property. The temporary or substantial structural part to be depreciate the replacement roof over the regulations provide rules for treated as deductible repair rather than same recovery period as the building. determining gain or loss upon the a capital expenditure, in effect reversing The temporary regulations revise the disposition of MACRS property that are most of the existing authorities. definition of disposition so that a consistent with the disposition rules The temporary regulations therefore taxpayer may treat the retirement of a under § 1.168–6 of the proposed ACRS retain the standard that requires structural component of a building as a regulations. However, as previously capitalization of an amount paid for the disposition of property. Furthermore, mentioned, the temporary regulations replacement of a major component or the temporary regulations clarify that a expand the definition of disposition for substantial structural part of the unit of taxpayer may recognize a loss on a MACRS property to include the property but revise the standard to more component of a unit of property that is retirement of a structural component of closely follow the facts and section 1245 property if the taxpayer a building and, accordingly, the circumstances approach used by the consistently treats the component as a temporary regulations allow the courts. Under the temporary regulations, separate asset for disposition purposes. recognition of a loss upon such in determining whether an amount is As a result, the 50 percent thresholds retirement. The temporary regulations paid for the replacement of a part or a and the recovery period limitation are also clarify that, if an asset is disposed combination of parts that comprise a not necessary to prevent of by physical abandonment and that major component or a substantial contemporaneous depreciation of both asset is subject to nonrecourse structural part of the unit of property, the retired component and the indebtedness, the asset is treated in the the taxpayer must consider all the facts replacement component and, therefore, same manner as an asset disposed of by and circumstances, including the are not included in the temporary sale. In addition, the temporary quantitative or qualitative significance regulations as exceptions to the major regulations provide rules for of the part or combination of parts in component and substantial structural determining the asset disposed of and relation to the unit of property or, in the part rule. identifying which multiple asset case of a building, in relation to the account includes the asset disposed of. building structure or the relevant VII. Accounting and Disposition Rules The temporary regulations also amend building system. The temporary for MACRS Property the rules for general asset accounts regulations also define a major The temporary regulations revise the under § 1.168(i)–1. Section 1.168(i)– component or substantial structural part rules for accounting for assets to which 1(e)(2) provides that, in general, no loss to include a part or combination of parts section 168 applies (MACRS property) is recognized upon the disposition of an that comprise a large portion of the and the rules for determining gain or asset from a general asset account.

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However, § 1.168–1(e)(3)(iii) provides flexibility to a taxpayer in establishing also required for an asset that was that a taxpayer may elect to recognize its depreciable accounts for MACRS included in a general asset account but gain or loss upon the disposition of an property. The temporary regulations general asset account treatment for the asset in a general asset account if there under § 1.168(i)–7T allow a taxpayer to asset was terminated under the rules in is a qualifying disposition. A qualifying account for its MACRS property by § 1.168(i)–1T. Section 1.168(i)–7T does disposition is defined to include a treating each asset as a single asset not apply to assets while they are casualty loss, a charitable contribution, account or by combining two or more included in general asset accounts termination of a business or income assets in a multiple asset account. A subject to § 1.168(i)–1T. producing activity, and certain types of taxpayer also may establish as many B. Dispositions of MACRS Property transactions. The temporary regulations accounts for assets as the taxpayer amend the general asset account rules wants. If a taxpayer chooses to account Section 168(i)(6) provides that an by expanding the definition of for its assets in multiple asset accounts, improvement or addition to property is disposition to include the retirement of the temporary regulations provide that depreciated under section 168 by using a structural component of a building each multiple asset account must the depreciation method, recovery and by expanding the definition of a include assets that have the same period, and convention that would be qualifying disposition to allow the depreciation method, recovery period, applicable to the underlying property if recognition of gain or loss upon most and convention, and are placed in the underlying property is placed in dispositions of assets in general asset service in the same taxable year. For service at the same time as the accounts. Thus, by electing general asset example, in one multiple asset account, improvement or addition. If an account treatment, a taxpayer will have a taxpayer in the wholesale distribution improvement or addition to the the option of recognizing gain or loss on business may account for most of its underlying property is placed in service an expanded list of qualifying items of 5-year property that are placed after the taxpayer placed the underlying dispositions, which are not all treated as in service in 2012 and have the same property in service, the recovery period qualifying dispositions under the depreciation method, recovery period, for the improvement or addition begins current general asset account rules. In and convention even though the assets on the placed-in-service date of the addition, the temporary regulations may have different uses (for example, improvement or addition. In effect, that modify the rules for establishing general copiers, forklifts, and equipment in the improvement or addition is treated as a asset accounts and clarify the distribution warehouse). Alternatively, separate asset for purposes of section computation of depreciation for a the taxpayer may choose to account for 168. general asset account when the assets in the items of 5-year property in more If a lessor made an improvement for the account are eligible for the than one multiple asset account, each as a lessee and that improvement is additional first year depreciation a single asset account, or in a irrevocably disposed of or abandoned by deduction. combination of single and multiple asset the lessor at the termination of the lease, accounts. section 168(i)(8)(B) allows the lessor to A. Accounting for MACRS property Even if assets have the same recognize gain or loss upon the The existing regulations under depreciation method, recovery period, disposition of that improvement. This § 1.167(a)–7 allow a taxpayer to account and convention, depreciation for the rule applies to improvements that are for its depreciable assets by treating assets may be computed differently. For structural components of a building. each asset as a single asset account or example, depreciation may be limited Similarly, if a lessee of a leased building by combining two or more assets in a for passenger automobiles subject to makes an improvement that is a multiple asset account (or pool). A section 280F(a), or some assets may be structural component of that building, taxpayer may establish as many eligible for the additional first year the lessee may recognize gain or loss accounts for depreciable assets as the depreciation while others are not. As a upon its disposition of that taxpayer wants and may group the result, the temporary regulations improvement. assets in multiple asset accounts in provide additional rules for establishing However, § 1.168–2(l)(1) of the different ways. When depreciation was multiple asset accounts. For example, proposed ACRS regulations (which have determined using the useful lives of assets subject to the mid-month been generally applied to MACRS assets and average useful lives were convention may be grouped in a property) provides that a disposition permitted for an account, the common multiple asset account only with assets does not include the retirement of a multiple asset accounts were a group placed in service in the same month. structural component of a building. account (assets similar in kind with Similarly, assets eligible for the Consequently, § 1.168–6(b) of the approximately the same useful lives), a additional first year depreciation proposed ACRS regulations provides classified account (assets based on use deduction cannot be grouped with that no loss is recognized upon the without regard to useful life), and a assets ineligible for the additional first retirement of a structural component of composite account (assets in the same year depreciation deduction. Also, a building. account without regard to their assets eligible for the additional first As previously mentioned, the character or useful lives). The temporary year depreciation deduction may be temporary regulations for determining regulations amend § 1.167(a)–7 to grouped only with assets eligible for the whether there is an improvement to the provide generally that those rules same percentage of the additional first unit of property take an approach (which were originally issued in 1956) year depreciation. different from the 2008 proposed apply only to property subject to section In limited circumstances, the regulations in order to achieve results 167 and not to MACRS property temporary regulations require the use of more consistent with existing case law (generally property placed in service a single asset account. A taxpayer must and to avoid the potential inequities after 1986) or ACRS property (generally account for an asset in a single asset resulting from the depreciation and property placed in service after 1980 account if the taxpayer uses the asset disposition rules. As explained below, and before 1987). both for business use and personal use, the temporary regulations expand the The temporary regulations will, or the taxpayer places the asset in definition of disposition to include consistent with the rules under service and disposes of it in the same retirements of structural components of § 1.167(a)–7, continue to provide taxable year. A single asset account is buildings and clarify that, in some

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

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with the earliest placed-in-service year C. General Asset Accounts for each general asset account. However, that has assets with the same recovery Section 168(i)(4) provides that under these rules do not reflect the additional period as the asset disposed of and with regulations, a taxpayer may maintain first year depreciation provisions added the same unadjusted depreciable basis one or more general asset accounts for to section 168 since the promulgation of of the asset disposed of. If the asset any MACRS property. Except as § 1.168(i)–1 in 1994. Accordingly, the temporary regulations provide rules for disposed of is a mass asset in a multiple provided in regulations, all proceeds determining the depreciation for a asset account, the temporary regulations realized on any disposition of property general asset account where all the also allow the taxpayer to use a in a general asset account shall be assets in the account are eligible for the mortality dispersion table to identify included in income as ordinary income. additional first year depreciation when the asset was placed in service. The existing rules for general asset deduction and where all the assets in Finally, the temporary regulations allow accounts are provided under § 1.168(i)– the account are not eligible for that a taxpayer to use any other method 1. The provisions of § 1.168(i)–1 apply deduction. designated by the Secretary. The IRS only to assets for which the taxpayer has and the Treasury Department invite made an election to account for the 3. Disposition of an Asset From a taxpayers to submit comments on assets in general asset accounts. The General Asset Account reasonable methods to be considered for temporary regulations for general asset Consistent with the expansion of the this purpose. However, the IRS and the accounts under § 1.168(i)–1T retain this Treasury Department do not consider a definition of disposition of MACRS rule. Under the existing rules and property, the temporary regulations last-in, last-out (LIFO) method to be a temporary regulations, each general reasonable method. Under the LIFO expand the definition of disposition asset account is effectively treated as the under § 1.168(i)–1(e)(1) to include a method, the taxpayer treats the asset asset. disposed of as being from the multiple retirement of a structural component of asset account with the most recent 1. Establishing General Asset Accounts a building. Immediately before any disposition of placed-in-service year that has assets Consistent with the existing general an asset in a general asset account, the with the same recovery period as the asset account rules under § 1.168(i)– existing rules treat the asset as having asset disposed of. 1(c), the temporary regulations provide an adjusted depreciable basis of zero for 4. Accounting for Assets Disposed of that assets may be grouped into one or purposes of section 1011. Therefore, no more general asset accounts. The loss is realized upon the disposition of The IRS and the Treasury Department temporary regulations, however, expand the asset. The existing rules also provide recognize that it may be impracticable the assets that may be included in each that any amount realized on a for a taxpayer that accounts for assets in general asset account. The temporary disposition generally is recognized as multiple asset accounts to determine regulations eliminate the existing rule ordinary income. Further, the existing from the taxpayer’s records the that each general asset account must rules provide that the unadjusted unadjusted depreciable basis of the asset include only assets that have the same depreciable basis and depreciation disposed of. Accordingly, the temporary asset class. Thus, under the temporary reserve of the general asset account are regulations provide that the taxpayer regulations, each general asset account not affected by the disposition. may use any reasonable, consistent must include only assets that have the Accordingly, a taxpayer continues to method to make that determination. same depreciation method, recovery depreciate the general asset account, Similar rules are provided if the asset period, and convention, and are placed including the asset disposed of, as disposed of is a component of a larger in service in the same taxable year. though no disposition occurred. The asset. The existing general asset account temporary regulations do not change When an asset is disposed of, the rules also provide special rules for any of these rules. temporary regulations provide that establishing general asset accounts. The existing rules also allow a depreciation ends for that asset. See These rules are necessary because even taxpayer to terminate general asset § 1.167(a)–10(b). Accordingly, if the though assets have the same account treatment upon certain asset disposed of is in a single asset depreciation method, recovery period, dispositions. Under the existing rules, account, the temporary regulations and convention, depreciation for the the taxpayer may elect to recognize gain provide that the single asset account assets may be computed differently. As or loss for a general asset account when terminates as of the date of disposition a result, the temporary regulations do the taxpayer disposes of all of the assets, (taking into account the applicable not change the existing rules, but they or the last asset, in the account. The convention of the asset disposed of). add new rules to be consistent with the temporary regulations retain this rule. Also, if the asset disposed of is in a temporary regulations for establishing The existing rules further allow a multiple asset account, the temporary multiple asset accounts for MACRS taxpayer to elect to terminate general regulations provide that the asset is property. For example, assets eligible for asset account treatment for an asset in removed from that account and the the additional first year depreciation a general asset account when the unadjusted depreciable basis and deduction cannot be grouped with taxpayer disposes of the asset in a depreciation reserve of the account are assets ineligible for the additional first qualifying disposition. Under the adjusted. Similar rules are provided if year depreciation deduction. Also, existing rules, a qualifying disposition the asset disposed of is a component of assets eligible for the additional first generally is a casualty or extraordinary a larger asset. year depreciation deduction may be event. The temporary regulations The temporary regulations also grouped only with assets eligible for the expand a qualifying disposition to provide that the § 1.167(a)–8 rules apply same percentage of the additional first include generally any disposition. If a to property subject to section 167 and year depreciation. taxpayer elects to terminate general not to MACRS property (generally asset account treatment for an asset property placed in service after 1986) or 2. Depreciation of General Asset disposed of in a qualifying disposition, ACRS property (generally property Account the temporary regulations do not change placed in service after 1980 and before Section 1.168(i)–1(d) provides the the existing rules that require the 1987). rules for determining the depreciation taxpayer to remove the asset disposed of

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from the general asset account and VIII. Effective Dates and Changes in consistent rule for all taxpayers and adjust the unadjusted depreciable basis Methods of Accounting ultimately reduces the administrative and depreciation reserve of the account. The preamble to the 2008 proposed burdens on taxpayers and the IRS in The temporary regulations also do not regulations provided that a change to enforcing the requirements of section 263(a). Although the IRS and the change the existing rules that require a conform to the proposed regulations Treasury Department recognize that taxpayer to terminate general asset upon finalization will be considered a change in method of accounting under requiring a section 481(a) adjustment account treatment for assets in a general may place a burden on taxpayers to asset account that are disposed of in section 446(e). The 2008 proposed regulations, however, were not effective calculate reasonable adjustments, transactions subject to section taxpayers have shown a willingness and until issued as final regulations and 167(i)(7)(B), section 1031, or section ability to make these calculations in thus did not provide specific procedures 1033, or in an abusive transaction requesting method changes after the described under the existing rules. In for changes in method of accounting. The IRS and the Treasury Department publication of the 2008 proposed addition, the temporary regulations regulations. In addition, taxpayers and received several comments regarding require a partnership to terminate its the IRS routinely reach agreements on the procedures that a taxpayer should general asset accounts upon the calculation methodologies and amounts. utilize to change its method of Moreover, by utilizing a section 481(a) technical termination of the partnership accounting to comply with the adjustment to make the change, a under section 708(b)(1)(B). regulations. Several commentators taxpayer is put on the same method of favored the use of a cut-off method, 4. Other Transactions accounting for all amounts or costs primarily for reasons of administrative incurred both prior to and after the The temporary regulations require a convenience. However, other effective date of these regulations. taxpayer to terminate general asset commentators asserted that any change Furthermore, a section 481(a) account treatment for an asset that the in method of accounting must include a adjustment results in similar treatment taxpayer uses for both business use and section 481(a) adjustment. for all taxpayers, including those that The temporary regulations under personal use. If there is a changed their method of accounting in § 1.162–3T are generally effective for redetermination of basis of an asset in response to the 2008 proposed a general asset account (for example, amounts paid or incurred (to acquire or regulations. Finally, requiring a section due to contingent purchase price or produce property) in taxable years 481(a) adjustment reduces the burden discharge of indebtedness), the beginning on or after January 1, 2012, for taxpayers and the IRS during temporary regulations provide that the except for § 1.162–3T(e), which is examinations that include years both election for the asset also applies to the effective for taxable years beginning on before and after the effective date of increase or decrease in basis and require or after January 1, 2012. The temporary these regulations because the parties the taxpayer to establish a new general regulations under §§ 1.167(a)–4, will need to apply only the temporary 1.167(a)–7T, 1.167(a)–8T, 1.168(i)–1T, asset account for that increase or regulations, and will not need to apply 1.168(i)–7T, 1.168(i)–8T, 1.263(a)–1T, decrease in basis. the rules in effect prior to the effective 1.263(a)–2T, 1.263(a)–3T, 1.263(a)–6T, date of the temporary regulation. 5. Identification of Disposed of or and 1.1016–3T are generally effective Converted Asset for taxable years beginning on or after Comments and Public Hearing January 1, 2012, except for §§ 1.263(a)– The text of these temporary Because the general asset account is 2T(f)(2)(iii), (f)(2)(iv), (f)(3)(ii), and (g), regulations also serves as the text of the the asset, the existing rules provide that which are effective for amounts paid or proposed regulations set forth in a a taxpayer may use any reasonable incurred (to acquire or produce notice of proposed rulemaking on this method that is consistently applied to property) in taxable years beginning on subject appearing elsewhere in this all of its general asset accounts for or after January 1, 2012. In addition, the issue of the Federal Register. Please see determining the unadjusted depreciable temporary regulations under § 1.263A– the ‘‘Comments and Public Hearing’’ basis of an asset for which general asset 1T are effective for amounts paid or section of the notice of proposed account treatment is terminated. The incurred (to acquire or produce rulemaking for the procedures to follow temporary regulations retain this rule property) in taxable years beginning on for submitting comments and requesting but provide what methods are or after January 1, 2012. to speak at the public hearing on the reasonable for identifying the placed-in- As stated in the preamble to the 2008 proposed regulations on this subject. proposed regulations, a change to service year of the asset disposed of. Special Analyses These methods are the same as those conform to these regulations will be a discussed above for identifying the change in method of accounting under It has been determined that this placed-in-service year of an asset section 446(e). In general, a taxpayer Treasury decision is not a significant disposed of in a multiple asset account: seeking a change in method of regulatory action as defined in the specific identification method, the accounting to comply with these Executive Order 12866, as FIFO method, the modified FIFO temporary regulations must take into supplemented by Executive Order 13563. Therefore, a regulatory method, a mortality dispersion table if account an adjustment under section assessment is not required. It also has the asset disposed of is a mass asset 481(a). Procedures will be provided under which taxpayers may obtain been determined that section 553(b) of grouped in a general asset account with automatic consent for a taxable year the Administrative Procedure Act (5 other mass assets, or any method beginning on or after Jan 1, 2012 to U.S.C. chapter 5) does not apply to these designated by the Secretary. The LIFO change to a method of accounting regulations, and, because the regulation method is not permitted. provided in the temporary regulations. does not impose a collection of The temporary regulations also amend The imposition of a section 481(a) information on small entities, the §§ 1.165–2 and 1.1016–3 to include adjustment for a change in method of Regulatory Flexibility Act (5 U.S.C. cross-references to §§ 1.168(i)–1T and accounting to conform to the temporary chapter 6) does not apply. Pursuant to 1.168(i)–8T. regulations provides for a uniform and section 7805(f), these temporary

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regulations will be submitted to the (b) Coordination with other provisions the same or other property or stored for Chief Counsel for Advocacy of the Small of the Internal Revenue Code. Nothing later installation. Temporary spare parts Business Administration for comment in this section changes the treatment of are materials and supplies under on their impact on small business. any amount that is specifically provided paragraph (c)(1)(i) of this section that for under any provision of the Internal are used temporarily until a new or Drafting Information Revenue Code or regulations other than repaired part can be installed and then The principal authors of these section 162(a) or section 212 and the are removed and stored for later regulations are Merrill D. Feldstein and regulations under those sections. For (emergency or temporary) installation. Kathleen Reed, Office of the Associate example, see section § 1.263(a)–3T, (3) Economic useful life—(i) General Chief Counsel (Income Tax and which requires taxpayers to capitalize rule. The economic useful life of a unit Accounting). Other personnel from the amounts paid to improve tangible of property is not necessarily the useful IRS and the Treasury Department have property and section 263A and the life inherent in the property but is the participated in their development. regulations under section 263A, which period over which the property may require taxpayers to capitalize the direct reasonably be expected to be useful to List of Subjects in 26 CFR Part 1 and allocable indirect costs, including the taxpayer or, if the taxpayer is Income taxes, Reporting and the cost of materials and supplies, to engaged in a trade or business or an recordkeeping requirements. property produced or to property activity for the production of income, the period over which the property may Amendments to the Regulations acquired for resale. See also § 1.471–1, which requires taxpayers to include in reasonably be expected to be useful to Accordingly, 26 CFR part 1 is inventory certain materials and the taxpayer in its trade or business or amended as follows: supplies. for the production of income, as (c) Definitions—(1) Materials and applicable. See § 1.167(a)–1(b) for the PART 1—INCOME TAXES supplies. For purposes of this section, factors to be considered in determining materials and supplies means tangible this period. ■ Paragraph 1. The authority citation property that is used or consumed in the (ii) Taxpayers with an applicable for part 1 is amended by adding an entry taxpayer’s operations that is not financial statement. For taxpayers with in numerical order to read as follows: inventory and that— an applicable financial statement (as Authority: 26 U.S.C. 7805 * * * (i) Is a component acquired to defined in paragraph (c)(3)(iii) of this Section 1.168(i)–1T also issued under 26 maintain, repair, or improve a unit of section), the economic useful life of a U.S.C. 168(i)(4). * * * tangible property (as determined under unit of property, solely for the purposes ■ Par. 2. Section 1.162–3 is revised to § 1.263(a)–3T(e)) owned, leased, or of applying the provisions of paragraph read as follows: serviced by the taxpayer and that is not (c)(1)(iii) of this section, is the useful acquired as part of any single unit of life initially used by the taxpayer for § 1.162–3 Materials and Supplies. tangible property; purposes of determining depreciation in (a) through (j) [Reserved]. For further (ii) Consists of fuel, lubricants, water, its applicable financial statement, guidance, see § 1.162–3T(a) through (j). and similar items, that are reasonably regardless of any salvage value of the ■ Par. 3. Section 1.162–3T is added to expected to be consumed in 12 months property. If a taxpayer does not have an read as follows: or less, beginning when used in applicable financial statement for the taxpayer’s operations; taxable year in which a unit of property § 1.162–3T Materials and supplies (iii) Is a unit of property as was originally acquired or produced, the (temporary). determined under § 1.263(a)–3T(e) that economic useful life of the unit of (a) In general—(1) Non-incidental has an economic useful life of 12 property must be determined under materials and supplies. Amounts paid months or less, beginning when the paragraph (c)(3)(i) of this section. to acquire or produce materials and property is used or consumed in the Further, if a taxpayer treats amounts supplies are deductible in the taxable taxpayer’s operations; paid for a unit of property as an expense year in which the materials and (iv) Is a unit of property as in its applicable financial statement on supplies are used or consumed in the determined under § 1.263(a)-3T(e) that a basis other than the useful life of the taxpayer’s operations. has an acquisition cost or production property or if a taxpayer does not (2) Incidental materials and supplies. cost (as determined under section 263A) depreciate the unit of property on its Amounts paid to acquire or produce of $100 or less (or other amount as applicable financial statement, the incidental materials and supplies that identified in published guidance in the economic useful life of the unit of are carried on hand and for which no Federal Register or in the Internal property must be determined under record of consumption is kept or of Revenue Bulletin (see paragraph (c)(3)(i) of this section. For which physical inventories at the § 601.601(d)(2)(ii)(b) of this chapter)); or example, if a taxpayer has a policy of beginning and end of the taxable year (v) Is identified in published guidance treating as an expense on its applicable are not taken, are deductible in the in the Federal Register or in the Internal financial statement amounts paid for a taxable year in which these amounts are Revenue Bulletin (see unit of property costing less than a paid, provided taxable income is clearly § 601.601(d)(2)(ii)(b) of this chapter) as certain dollar amount, notwithstanding reflected. materials and supplies for which that the unit of property has a useful life (3) Use or consumption of rotable and treatment is permitted under this of more than one year, the economic temporary spare parts. Except as section. useful life of the unit of property must provided in paragraphs (d), (e), and (f) (2) Rotable and temporary spare be determined under paragraph (c)(3)(i) of this section, for purposes of parts. For purposes of this section, of this section. paragraph (a)(1) of this section, rotable rotable spare parts are materials and (iii) Definition of applicable financial and temporary spare parts (defined supplies under paragraph (c)(1)(i) of this statement. The taxpayer’s applicable under paragraph (c)(2) of this section) section that are acquired for installation financial statement is the taxpayer’s are used or consumed in the taxpayer’s on a unit of property, removable from financial statement listed in paragraphs operations in the taxable year in which that unit of property, generally repaired (c)(3)(iii)(A) through (C) of this section the taxpayer disposes of the parts. or improved, and either reinstalled on that has the highest priority (including

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within paragraph (c)(3)(iii)(B) of this (i) Any amount paid to acquire or account for its rotable and temporary section). The financial statements are, in produce a material or supply described spare parts as defined in paragraph descending priority— in paragraph (c)(1)(i) of this section if— (c)(2) of this section. A taxpayer that (A) A financial statement required to (A) The material or supply is intended uses the optional method for rotables be filed with the Securities and to be used as a component of a unit of must use this method for all of its Exchange Commission (SEC) (the 10–K property that is a material or supply rotable and temporary spare parts in the or the Annual Statement to under paragraph (c)(1)(iii), (iv), or (v) of same trade or business. The optional Shareholders); this section; and method for rotables is a method of (B) The taxpayer has not elected to (B) A certified audited financial accounting under section 446(a). Under capitalize and depreciate that unit of statement that is accompanied by the the optional method for rotables, the property under this paragraph (d); or taxpayer must apply the rules in this report of an independent CPA (or in the (ii) Any amount paid to acquire or case of a foreign entity, by the report of paragraph (e) to each rotable or produce a rotable or temporary spare temporary spare part (part) upon the a similarly qualified independent part if the taxpayer has applied the professional), that is used for— taxpayer’s initial installation, removal, optional method of accounting for repair, maintenance or improvement, (1) Credit purposes; rotable and temporary spare parts under reinstallation, and disposal of each part. (2) Reporting to shareholders, paragraph (e) of this section. (2) Description of optional method for partners, or similar persons; or (3) Manner of electing. A taxpayer rotables—(i) Initial installation. The (3) Any other substantial non-tax makes the election under paragraph (d) taxpayer must deduct the amount paid purpose; or of this section by capitalizing the to acquire or produce the part in the (C) A financial statement (other than amounts paid to acquire or produce a taxable year that the part is first a tax return) required to be provided to material or supply in the taxable year installed on a unit of property for use the Federal or a state government or any the amounts are paid and by beginning in the taxpayer’s operations. Federal or state agencies (other than the to recover the costs when the asset is (ii) Removal from unit of property. In SEC or the Internal Revenue Service). placed in service by the taxpayer for the each taxable year in which the part is (4) Amount paid. For purposes of this purposes of determining depreciation removed from a unit of property to section, in the case of a taxpayer using under the applicable provisions of which it was initially or subsequently an accrual method of accounting, the Internal Revenue Code and regulations installed, the taxpayer must— terms amount paid and payment mean thereunder. A taxpayer must make this (A) Include in gross income the fair a liability incurred (within the meaning election in its timely filed original market value of the part; and of § 1.446–1(c)(1)(ii)). A liability may Federal income tax return (including (B) Include in the basis of the part the not be taken into account under this extensions) for the taxable year the asset fair market value of the part included in section prior to the taxable year during is placed in service by the taxpayer for income under paragraph (e)(2)(ii)(A) of purposes of determining depreciation. which the liability is incurred. this section and the amount paid to See § 1.263(a)–2 for the treatment of remove the part from the unit of (5) Produce. For purposes of this amounts paid to acquire or produce real property. section, produce means construct, build, or personal tangible property. In the (iii) Repair, maintenance, or install, manufacture, develop, create, case of a pass-through entity, the improvement of part. The taxpayer may raise, or grow. This definition is election is made by the pass-through not currently deduct and must include intended to have the same meaning as entity, and not by the shareholders or in the basis of the part any amounts the definition used for purposes of partners. A taxpayer may make an paid to maintain, repair, or improve the section 263A(g)(1) and § 1.263A– election for each material or supply that part in the taxable year these amounts 2(a)(1)(i), except that improvements are qualifies for the election under this are paid. excluded from the definition in this paragraph (d). A taxpayer may revoke an (iv) Reinstallation of part. The paragraph (c)(5) and are separately election made under this paragraph (d) taxpayer must deduct the amounts paid defined and addressed in § 1.263(a)–3T. with respect to a material or supply only to reinstall the part and those amounts Amounts paid to produce materials and by filing a request for a private letter included in the basis of the part under supplies are subject to section 263A. ruling and obtaining the paragraphs (e)(2)(ii)(B) and (e)(2)(iii) of (d) Election to capitalize and Commissioner’s consent to revoke the this section, to the extent that those depreciate—(1) In general. A taxpayer election. The Commissioner may grant a amounts have not been previously may elect to treat as a capital request to revoke this election if the deducted under this paragraph (e)(2)(iv), expenditure and to treat as an asset taxpayer can demonstrate good cause for in the taxable year that the part is subject to the allowance for depreciation the revocation. An election may not be reinstalled on a unit of property. the cost of any material or supply as made or revoked through the filing of an (v) Disposal of the part. The taxpayer defined in paragraph (c)(1) of this application for change in accounting must deduct the amounts included in section. Except as specified in method or, before obtaining the the basis of the part under paragraphs paragraph (d)(2) of this section, an Commissioner’s consent to make the (e)(2)(ii)(B) and (e)(2)(iii) of this section, election made under this paragraph (d) late election or to revoke the election, by to the extent that those amounts have applies to amounts paid during the filing an amended Federal income tax not been previously deducted under taxable year to acquire or produce any return. paragraph (e)(2)(iv) of this section, in material or supply to which paragraph (e) Optional method of accounting for the taxable year in which the part is (a) of this section would apply (but for rotable and temporary spare parts—(1) disposed of by the taxpayer. the election under this paragraph (d)). In general. This paragraph (e) provides (f) Election to apply de minimis rule— Any asset for which this election is an optional method of accounting for (1) In general. A taxpayer may elect to made shall not be treated as a material rotable and temporary spare parts (the apply the de minimis rule under or a supply. optional method for rotables). A § 1.263(a)–2T(g) to any material or (2) Exceptions. A taxpayer may not taxpayer may use the optional method supply defined in paragraph (c)(1) this elect to capitalize and depreciate under for rotables, instead of the general rule section. Any material or supply to paragraph (d) of this section— under paragraph (a)(3) of this section, to which the taxpayer elects to apply the

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de minimis rule under § 1.263(a)–2T(g) each aircraft is a unit of property under parts are first installed by X in X’s vehicles. is not treated as a material or supply § 1.263(a)–3T(e) and that spare parts are not In Year 3, when X removes the Year 1 under this section. See § 1.263(a)– rotable or temporary spare parts under rotables from its vehicles, X must include in 2T(g)(5). paragraph (c)(2) of this section. Assume these its gross income the fair market value of each (2) Manner of electing. A taxpayer repair and maintenance activities do not part. Also, in Year 3, X must include in the improve the aircraft under § 1.263(a)–3T. basis of each Year 1 rotable the fair market makes the election by deducting the These parts are materials and supplies under value of the rotable and the amount paid to amounts paid to acquire or produce a paragraph (c)(1)(i) of this section because remove the rotable from the vehicle. In Year material or supply in the taxable year they are components acquired and used to 4, X must include in the basis of each Year that the amounts are paid and by maintain and repair X’s aircraft. Under 1 rotable the amounts paid to maintain, complying with the requirements set out paragraph (a)(1) of this section, the amounts repair, or improve each rotable. In Year 5, the in § 1.263(a)–2T(g). A taxpayer must that X paid for the spare parts in Year 1 are year that X reinstalls the Year 1 rotables (as make this election in its timely filed deductible in Year 2, the taxable year in repaired or improved) in other vehicles, X original Federal income tax return which the spare parts are used to repair and must deduct the reinstallation costs and the maintain the aircraft. amounts previously included in the basis of (including extensions) for the taxable Example 2. Rotable spare parts. X operates each part. In Year 8, the year that X removes year that amounts are paid for the a fleet of specialized vehicles that it uses in the Year 1 rotables from the vehicles, X must material or supply. In the case of a pass- its service business. Assume that each include in income the fair market value of through entity, the election is made by vehicle is a unit of property under § 1.263(a)– each rotable part removed. In addition, in the pass-through entity and not by the 3T(e). At the time that it acquires a new type Year 8, X must include in the basis of each shareholders or partners. A taxpayer of vehicle, X also acquires a substantial part the fair market value of that part and the may make an election for each material number of rotable spare parts that it will keep amount paid to remove the each rotable from or supply that qualifies for the election on hand to quickly replace similar parts in the vehicle. In Year 9, the year that X X’s vehicles as those parts break down or disposes of the Year 1 rotables, X may deduct under paragraph (f) of this section. A wear out. These rotable parts are removable the amounts remaining in the basis of each taxpayer may revoke an election made from the vehicles and are repaired so that rotable. under paragraph (f) of this section with they can be reinstalled on the same or similar Example 4.′ Rotable part acquired as part respect to a material or supply only by vehicles. X does not use the optional method of a single unit of property; not material or filing a request for a private letter ruling of accounting for rotable and temporary spare supply. X operates a fleet of aircraft. In Year and obtaining the Commissioner’s parts provided in paragraph (e) of this 1, X acquires a new aircraft, which includes consent to revoke the election. The section. In Year 1, X acquires several vehicles two new aircraft engines. The aircraft costs Commissioner may grant a request to and a number of rotable spare parts to be $500,000 and has an economic useful life of revoke this election if the taxpayer can used as replacement parts in these vehicles. more than 12 months, beginning when it is In Year 2, X repairs several vehicles by using placed in service. In Year 5, after the aircraft demonstrate good cause for the these rotable spare parts to replace worn or is operated for several years in X’s business, revocation. An election may not be damaged parts. In Year 3, X removes these X removes the engines from the aircraft, made or revoked through the filing of an rotable spare parts from its vehicles, repairs repairs or improves the engines, and either application for change in accounting the parts, and reinstalls them on other similar reinstalls the engines on a similar aircraft or method or, before obtaining the vehicles. In Year 5, X can no longer use the stores the engines for later reinstallation. Commissioner’s consent to make the rotable parts it acquired in Year 1 and Assume the aircraft purchased in Year 1, late election or to revoke the election, by disposes of them as scrap. Under paragraph including its two engines, is a unit of filing an amended Federal income tax (c)(1)(i) of this section, the rotable spare parts property under § 1.263(a)–3T(e). Because the return. acquired in Year 1 are materials and engines were acquired as part of the aircraft, (g) Sale or disposition of materials supplies. Under paragraph (a)(3) of this a single unit of property, the engines are not section, rotable spare parts are generally used materials or supplies under paragraph and supplies. Upon sale or other or consumed in the taxable year in which the (c)(1)(i) of this section nor rotable or disposition, materials and supplies as taxpayer disposes of the parts. Therefore, temporary spare parts under paragraph (c)(2) defined in this section are not treated as under paragraph (a)(1) of this section, the of this section. Accordingly, X may not apply a capital asset under section 1221 or as amounts that X paid for the rotable spare the rules of this section to the aircraft engines property used in the trade or business parts in Year 1 are deductible in Year 5, the upon the original acquisition of the aircraft under section 1231. Any asset for which taxable year in which X disposes of the parts. nor after the removal of the engines from the the taxpayer makes the election to Example 3. Rotable spare parts; aircraft for use in the same or similar aircraft. capitalize and depreciate under application of optional method of Rather, X must apply the rules under paragraph (d) of this section shall not be accounting. Assume the same facts as in §§ 1.263(a)–2T and 1.263(a)–3T to the Example 2, except X uses the optional aircraft, including its engines, to determine treated as a material or supply. method of accounting for all its rotable and the treatment of amounts paid to acquire, (h) Examples. The rules of this section temporary spare parts under paragraph (e) of produce, or improve the unit of property. are illustrated by the following this section. In Year 1, X acquires several Example 5. Components of real property. X examples, in which it is assumed vehicles and a number of rotable spare parts owns an apartment building that it leases in (unless otherwise stated) that the (the ‘‘Year 1 rotables’’) to be used as its business operation and discovers that a property is not an incidental material or replacement parts in these vehicles. In Year window in one of the apartments is broken. supply, that the taxpayer is a calendar 2, X repairs several vehicles and uses the Assume that the building, including its year, accrual method taxpayer, and that Year 1 rotables to replace worn or damaged windows, is a unit of property under the taxpayer has not elected to parts. In Year 3, X pays amounts to remove § 1.263(a)–3T(e) and the window is not a capitalize under paragraph (d) of this these Year 1 rotables from its vehicles. In rotable or temporary spare part under Year 4, X pays amounts to maintain, repair, paragraph (c)(2) of this section. X pays for the section or to apply the de minimis rule or improve the Year 1 rotables. In Year 5, X acquisition and delivery of a new window to under paragraph (f) of this section. pays amounts to reinstall the Year 1 rotables replace the broken window. In the same Example 1. Non-rotable components. X on other similar vehicles. In Year 8, X taxable year, the new window is installed. owns a fleet of aircraft that it operates in its removes the Year 1 rotables from these Assume that the replacement of the window business. In Year 1, X purchases a stock of vehicles and stores these parts for possible does not improve the property under spare parts, which it uses to maintain and later use. In Year 9, X disposes of the Year § 1.263(a)–3T and that X does not recognize repair its aircraft. X keeps a record of 1 rotables. Under paragraph (e) of this gain or loss on the disposition of the broken consumption of these spare parts. In Year 2, section, X must deduct the amounts paid to window. The new window is a material or X uses the spare parts for the repair and acquire and install the Year 1 rotables in Year supply under paragraph (c)(1)(i) of this maintenance of one of its aircraft. Assume 2, the taxable year in which the rotable spare section because it is a component acquired

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

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costs of each part on its timely filed Federal (j) Expiration date. The applicability erecting buildings or making permanent income tax return for the taxable year in of this section expires on December 23, improvements on property of which the which the part is placed in service for 2014. taxpayer is a lessee is a capital purposes of determining depreciation under ■ expenditure and is not deductible as a the applicable provisions of the Internal Par. 4. Section 1.162–4 is revised to Revenue Code and the regulations read as follows: business expense. For the rules thereunder. See § 1.263(a)–2T(h) for the regarding improvements to leased § 1.162–4 Repairs. treatment of capital expenditures and section property where the improvements are 263A for the requirement to capitalize the (a) through (d) [Reserved]. For further tangible property, see § 1.263(a)– direct and allocable indirect costs of property guidance, see § 1.162–4T(a) through (d). 3T(f)(1). For the rules regarding produced or property acquired for resale. ■ Par. 5. Section 1.162–4T is added to depreciation or amortization deductions Example 14. Election to apply de minimis read as follows: for leasehold improvements, see rule. X provides consulting services to its § 1.167(a)–4T. customers. X purchases 50 office chairs to be § 1.162–4T Repairs (temporary). (c) Effective/applicability date. This used by its employees. Each office chair is a (a) In general. A taxpayer may deduct section applies to taxable years unit of property that costs $80. Also in the amounts paid for repairs and beginning on or after January 1, 2012. same taxable year, X pays amounts to maintenance to tangible property if the purchase 50 customized briefcases. Assume For the applicability of regulations to each briefcase is a unit of property under amounts paid are not otherwise required taxable years beginning before January § 1.263(a)–3T(e), costs $120, and has an to be capitalized. 1, 2012, see § 1.162–11 in effect prior to economic useful life of 12 months or less, (b) Accounting method changes. January 1, 2012 (§ 1.162–11 as contained beginning when used and consumed. X has Except as otherwise provided in this in 26 CFR part 1 edition revised as of an applicable financial statement (as defined section, a change to comply with this April 1, 2011). in § 1.263(a)–2T(g)(6)), and X has a written section is a change in method of (d) Expiration date. The applicability policy at the beginning of the taxable year to accounting to which the provisions of of this section expires on December 23, expense amounts paid for units of property sections 446 and 481, and the 2014. costing less than $300. The briefcases and the regulations thereunder, apply. A office chairs are materials and supplies under taxpayer seeking to change to a method ■ Par. 9. Section 1.165–2 is amended by paragraph (c)(1)(iii) and (c)(1)(iv), revising paragraph (c) and adding respectively, of this section. Under paragraph of accounting permitted in this section (a)(1) of this section, the amounts paid for the must secure the consent of the paragraphs (d) and (e) to read as follows: office chairs and briefcases are deductible in Commissioner in accordance with § 1.165–2 Obsolescence of nondepreciable the taxable year in which they are used or § 1.446–1(e) and follow the property. consumed. However, assuming X meets all administrative procedures issued under the requirements of § 1.263(a)–2T(g), X may * * * * * § 1.446–1(e)(3)(ii) for obtaining the (c) Cross references. [Reserved]. For elect under paragraph (f) of this section to Commissioner’s consent to change its apply the de minimis rule under § 1.263(a)– further guidance, see § 1.165–2T(c). accounting method. (d) Effective/applicability date. 2T(g) to amounts paid for the office chairs (c) Effective/applicability date. This and briefcases, rather than treat these [Reserved]. For further guidance, see section applies to taxable years amounts as the costs of materials and § 1.165–2T(d). supplies under § 1.162–3T. beginning on or after January 1, 2012. (e) Expiration date. [Reserved]. For For the applicability of regulations to further guidance, see § 1.165–2T(e). (h) Accounting method changes. taxable years beginning before January Except as otherwise provided in this 1, 2012, see § 1.162–4 in effect prior to ■ Par. 10. Section 1.165–2T is added to section, a change to comply with this January 1, 2012 (§ 1.162–4 as contained read as follows: section is a change in method of in 26 CFR part 1 edition revised as of accounting to which the provisions of April 1, 2011). § 1.165–2T Obsolescence of nondepreciable property (temporary). sections 446 and 481, and the (d) Expiration date. The applicability regulations thereunder, apply. A of this section expires on December 23, (a) and (b) [Reserved]. For further taxpayer seeking to change to a method 2014 guidance, see § 1.165–2(a) and (b). of accounting permitted in this section (c) Cross references. For the allowance must secure the consent of the § 1.162–6 [Removed] under section 165(a) of losses arising Commissioner in accordance with ■ Par. 6. Section 1.162–6 is removed. from the permanent withdrawal of § 1.446–1(e) and follow the ■ Par. 7. Section 1.162–11 is amended depreciable property from use in the administrative procedures issued under by revising paragraph (b), and adding trade or business or in the production of § 1.446–1(e)(3)(ii) for obtaining the paragraphs (c) and (d) to read as follows: income, see § 1.167(a)–8T, § 1.168(i)–1T, Commissioner’s consent to change its or § 1.168(i)–8T, as applicable. For accounting method. § 1.162–11 Rentals. provisions respecting the obsolescence (i) Effective/applicability date. This * * * * * of depreciable property for which section generally applies to amounts (b) [Reserved]. For further guidance, depreciation is determined under paid or incurred (to acquire or produce see § 1.162–11T(b). section 167 (but not under section 168, property) in taxable years beginning on (c) [Reserved]. For further guidance, section 1400I, section 1400L(c), section or after January 1, 2012. However, a see § 1.162–11T(c). 168 prior to its amendment by the Tax taxpayer may apply § 1.162–3(e) (the (d) [Reserved]. For further guidance, Reform Act of 1986 (100 Stat. 2121), or optional method of accounting for see § 1.162–11T(d). under an additional first year rotable and temporary spare parts) to ■ Par. 8. Section 1.162–11T is added to depreciation deduction provision of the taxable years beginning on or after read as follows: Internal Revenue Code (for example, January 1, 2012. For the applicability of section 168(k) through (n), 1400L(b), or regulations to taxable years beginning § 1.162–11T Rentals (temporary). 1400N(d))), see § 1.167(a)–9. For the before January 1, 2012, see § 1.162–3 in (a) [Reserved]. For further guidance, allowance of casualty losses, see effect prior to January 1, 2012 (§ 1.162– see § 1.162–11(a). § 1.165–7. 3 as contained in 26 CFR part 1 edition (b) Improvements by lessee on lessor’s (d) Effective/applicability date. This revised as of April 1, 2011). property. The cost to a taxpayer of section applies to taxable years

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beginning on or after January 1, 2012. section 168 does not apply under the 1400N(d))). Paragraph (c) of this section For the applicability of regulations to provisions of the Internal Revenue Code does not apply to general asset accounts taxable years beginning before January that are applicable to the cost recovery as provided by section 168(i)(4) and 1, 2012, see § 1.165–2 in effect prior to of that leasehold improvement, without § 1.168(i)–1T. January 1, 2012 (§ 1.165–2 as contained regard to the period of the lease. (f) Effective/applicability date. This in 26 CFR part 1 edition revised as of (3) Application of this section to section applies to taxable years April 1, 2011). leasehold improvements placed in beginning on or after January 1, 2012. (e) Expiration date. The applicability service before January 1, 1987. For For the applicability of regulations to of this section expires on December 23, leasehold improvements placed in taxable years beginning before January 2014. service before January 1, 1987, see 1, 2012, see § 1.167(a)–7 in effect prior ■ Par. 11. Section 1.167(a)–4 is revised § 1.167(a)–4 in effect prior to January 1, to January 1, 2012 (§ 1.167(a)–7 as to read as follows: 2012 (§ 1.167(a)–4 as contained in 26 contained in 26 CFR part 1 edition CFR part 1 edition revised as of April 1, revised as of April 1, 2011). § 1.167(a)–4 Leased property. 2011). (g) Expiration date. The applicability (a) In general. [Reserved]. For further (4) Change in method of accounting. of this section expires on December 23, guidance, see § 1.167(a)–4T(a). Except as provided in § 1.446– 2014. (b) Effective/applicability date. 1(e)(2)(ii)(d)(3)(i), a change to comply ■ [Reserved]. For further guidance, see with this section for depreciable assets Par. 15. Section 1.167(a)–8 is § 1.167(a)–4T(b). placed in service in a taxable year amended by adding paragraphs (g), (h), and (i) to read as follows: ■ ending on or after December 30, 2003, Par. 12. Section 1.167(a)–4T is added is a change in method of accounting to to read as follows: § 1.167(a)–8 Retirements. which the provisions of section 446(e) * * * * * § 1.167(a)–4T Leased property and the regulations under section 446(e) (g) Applicability. [Reserved]. For (temporary). apply. Except as provided in § 1.446– further guidance, see § 1.167(a)–8T(g). (a) In general. Capital expenditures 1(e)(2)(ii)(d)(3)(i), a taxpayer also may (h) Effective/applicability date. made by either a lessee or lessor for the treat a change to comply with this [Reserved]. For further guidance, see erection of a building or for other section for depreciable assets placed in § 1.167(a)–8T(h). permanent improvements on leased service in a taxable year ending before (i) [Reserved]. For further guidance, property are recovered by the lessee or December 30, 2003, as a change in see § 1.167(a)–8T(i). lessor under the provisions of the method of accounting to which the ■ Par. 16. Section 1.167(a)–8T is added Internal Revenue Code applicable to the provisions of section 446(e) and the to read as follows: cost recovery of the building or regulations under section 446(e) apply. improvements, if subject to depreciation (5) Expiration date. The applicability § 1.167(a)–8T Retirements (temporary). or amortization, without regard to the of this section expires on December 23, (a) through (f) [Reserved]. For further period of the lease. For example, if the 2014. guidance, see § 1.167(a)–8(a) through (f). building or improvement is property to ■ Par. 13. Section 1.167(a)–7 is (g) Applicability. This section applies which section 168 applies, the lessee or amended by adding paragraphs (e), (f), to property for which depreciation is lessor determines the depreciation and (g) to read as follows: determined under section 167 (but not deduction for the building or under section 168, section 1400I, improvement under section 168. See § 1.167(a)–7 Accounting for depreciable section 1400L(c), section 168 prior to its property. section 168(i)(8)(A). If the improvement amendment by the Tax Reform Act of is property to which section 167 or * * * * * 1986 (100 Stat. 2121), or under an section 197 applies, the lessee or lessor (e) Applicability. [Reserved]. For additional first year depreciation determines the depreciation or further guidance, see § 1.167(a)–7T(e). deduction provision of the Internal amortization deduction for the (f) Effective/applicability date. Revenue Code (for example, section improvement under section 167 or [Reserved]. For further guidance, see 168(k) through (n), 1400L(b), or section 197, as applicable. § 1.167(a)–7T(f). 1400N(d))). (b) Effective/applicability date—(1) In (g) Expiration date. [Reserved]. For (h) Effective/applicability date. This general. Except as provided in further guidance, see § 1.167(a)–7T(g). section applies to taxable years paragraphs (b)(2) and (b)(3) of this ■ Par. 14. Section 1.167(a)–7T is added beginning on or after January 1, 2012. section, this section applies to taxable to read as follows: For the applicability of regulations to years beginning on or after January 1, taxable years beginning before January 2012. § 1.167(a)–7T Accounting for depreciable 1, 2012, see § 1.167(a)–8 in effect prior (2) Application of this section to property (temporary). to January 1, 2012 (§ 1.167(a)–8 as leasehold improvements placed in (a) through (d) [Reserved]. For further contained in 26 CFR part 1 edition service after December 31, 1986, in guidance, see § 1.167(a)–7(a) through revised as of April 1, 2011). taxable years beginning before January (d). (i) Expiration date. The applicability 1, 2012. For leasehold improvements (e) Applicability. Paragraphs (a), (b), of this section expires on December 23, placed in service after December 31, and (d) of this section apply to property 2014. 1986, in taxable years beginning before for which depreciation is determined ■ Par. 17. Section 1.168(i)–0 is amended January 1, 2012, a taxpayer may— under section 167 (but not under section by: (i) Apply the provisions of this 168, section 1400I, section 1400L(c), ■ 1. Adding entries for paragraphs (b)(5) section; or section 168 prior to its amendment by and (b)(6). (ii) Depreciate any leasehold the Tax Reform Act of 1986 (100 Stat. ■ 2. Adding entry for paragraph (c)(3). improvement to which section 168 2121), or under an additional first year ■ 3. Redesignating the entry for applies under the provisions of section depreciation deduction provision of the paragraph (d)(2) as (d)(4) and adding 168 and depreciate or amortize any Internal Revenue Code (for example, new entries for paragraphs (d)(2) and leasehold improvement to which section 168(k) through (n), 1400L(b), or (d)(3).

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■ 4. Redesignating the entry for § 1.168(i)–1T General asset accounts 168(i)(4). The provisions of this section paragraph (e)(2)(v) as the entry for (temporary). apply only to assets for which an paragraph (e)(2)(ix). (a) through (b)(4) [Reserved]. For election has been made under paragraph ■ 5. Adding entries for paragraphs further guidance, see the entries for (l) of this section. (e)(2)(v), (vi), (vii), (viii). § 1.168(i)–1(a) through (b)(4). (b) Definitions. For purposes of this ■ 6. Redesignating paragraph (e)(3)(vi) (5) Mass assets. section, the following definitions apply: as (e)(3)(vii) and adding a new (6) Remaining adjusted depreciable (1) Unadjusted depreciable basis has paragraph (e)(3)(vi). basis of the general asset account. the same meaning given such term in (c)(1) through (c)(2) [Reserved]. For ■ 7. Redesignating the entry for § 1.168(b)–1(a)(3). further guidance, see the entries for paragraph (h)(2) as (h)(3), and adding a (2) Unadjusted depreciable basis of § 1.168(i)–1(c)(1) through (c)(2). new paragraph (h)(2). the general asset account is the sum of (3) Examples. the unadjusted depreciable bases of all ■ 8. Redesignating the entry for (d)(1) [Reserved]. For further assets included in the general asset paragraph (i) as (j) and adding a new guidance, see the entry for § 1.168(i)– account. paragraph (i). 1(d)(1). (3) Adjusted depreciable basis of the ■ 9. Redesignating the entry for (d)(2) Assets in general asset account general asset account is the unadjusted paragraph (j) as (k). are eligible for additional first year depreciable basis of the general asset ■ 10. Redesignating the entries for depreciation deduction. account less the adjustments to basis paragraphs (k), (k)(1), (k)(2), and (k)(3) (d)(3) No assets in general asset described in section 1016(a)(2) and (3). as (l), (l)(1), (l)(2), and (l)(3) respectively account are eligible for additional first (4) Expensed cost is the amount of and year depreciation deduction. any allowable credit or deduction ■ 11. Redesignating paragraph (l) as (d)(4) through (e)(2)(iv) [Reserved]. treated as a deduction allowable for paragraph (m). For further guidance, see the entries for depreciation or amortization for § 1.168(i)–1(d)(4) through (e)(2)(iv). purposes of section 1245 (for example, § 1.168(i)–0 Table of contents for the (v) Manner of disposition. a credit allowable under section 30 or a general asset account rules. (vi) Disposition by transfer to a deduction allowable under section 179, supplies account. * * * * * 179A, or 190). Expensed cost does not (vii) Leasehold improvements. § 1.168(i)–1 General asset accounts. (viii) Determination of asset disposed include any additional first year of. depreciation deduction. * * * * * (5) Mass assets is a mass or group of (b) * * * (e)(2)(ix) through (e)(3)(v) [Reserved]. For further guidance, see the entries for individual items of depreciable assets— (5) and (6) [Reserved]. For further (i) That are not necessarily guidance, see the entries for § 1.168(i)– § 1.168(i)–1(e)(2)(ix) through (e)(3)(v). (vi) Technical termination of a homogenous; 1T(b)(5) and (6). (ii) Each of which is minor in value (c) * * * partnership. (e)(3)(vii) through (h)(1) [Reserved]. relative to the total value of the mass or (3) [Reserved]. For further guidance, For further guidance, see the entries for group; see the entry for § 1.168(i)–1T(c)(3). § 1.168(i)–1(e)(3)(vii) through (h)(1). (iii) Numerous in quantity; * * * * * (h)(2) Business or income-producing (iv) Usually accounted for only on a (d)(2) and (3) [Reserved]. For further use percentage changes. total dollar or quantity basis; guidance, see the entries for § 1.168(i)– (h)(3) [Reserved]. For further (v) With respect to which separate 1T(d)(2) and (3). guidance, see the entry for § 1.168(i)– identification is impracticable; and (vi) Placed in service in the same * * * * * 1(h)(3). (i) Redetermination of basis. taxable year. (e)(2) * * * (6) Remaining adjusted depreciable (v) through (viii) [Reserved]. For (j) through (l) [Reserved]. For further guidance, see the entries for § 1.168(i)– basis of the general asset account is the further guidance, see the entries for unadjusted depreciable basis of the § 1.168(i)–1T(e)(2)(v) through (viii). 1(j) through (l). (m) Effective/applicability date. general asset account less the amount of * * * * * the additional first year depreciation ■ Par. 19. Section 1.168(i)–1 is amended deduction allowed or allowable, (e)(3) * * * by: (vi) [Reserved]. For further guidance, ■ 1. Revising paragraphs (a) through whichever is greater, for the general see the entry for § 1.168(i)–1T(e)(3)(vi). (l)(1); and asset account. * * * * * ■ 2. Adding paragraph (m). (c) Establishment of general asset (h) * * * The revisions and additions read as accounts—(1) Assets eligible for general asset accounts—(i) General rules. Assets (2) [Reserved]. For further guidance, follows: that are subject to either the general see the entry for § 1.168(i)–1T(h)(2). § 1.168(i)–1 General asset accounts. depreciation system of section 168(a) or * * * * * (a) through (l)(1) [Reserved]. For the alternative depreciation system of (i) [Reserved]. For further guidance, further guidance, see § 1.168(i)–1T(a) section 168(g) may be accounted for in see the entry for § 1.168(i)–1T(i). through (l)(1). one or more general asset accounts. An * * * * * * * * * * asset is included in a general asset (m) [Reserved]. For further guidance, (m) [Reserved]. For further guidance, account only to the extent of the asset’s see the entry for § 1.168(i)–1T(m). see § 1.168(i)–1T(m). unadjusted depreciable basis. However, ■ Par. 18. Section 1.168(i)–0T is added ■ Par. 20. Section 1.168(i)–1T is added an asset is not to be included in a to read as follows: to read as follows: general asset account if the asset is used both in a trade or business (or for the § 1.168(i)–0T Table of contents for the § 1.168(i)–1T General asset accounts production of income) and in a personal general asset account rules (temporary). (temporary). activity at any time during the taxable This section lists the major (a) Scope. This section provides rules year in which the asset is placed in paragraphs contained in § 1.168(i)–1T. for general asset accounts under section service by the taxpayer or if the asset is

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placed in service and disposed of during are placed in service in the same month include only $50,000 of the equipment’s cost the same taxable year. of the taxable year; in the general asset account. (ii) Special rules for assets generating (C) Passenger automobiles for which Example 2. The facts are the same as in foreign source income. (A) Assets that the depreciation allowance is limited Example 1, except that J also places in service 99 other items of equipment in 2012. generate foreign source income, both under section 280F(a) must be grouped On its Federal income tax return for 2012, J United States and foreign source into a separate general asset account; does not make an election under section 179 income, or combined gross income of a (D) Assets not eligible for any to expense the cost of any of the 100 items FSC (as defined in former section 922), additional first year depreciation of equipment and does make an election DISC (as defined in section 992(a)), or deduction (including assets for which under paragraph (l) of this section to include possessions corporation (as defined in the taxpayer elected not to deduct the the 100 items of equipment in a general asset section 936) and its related supplier, additional first year depreciation) account. All of the 100 items of equipment may be included in a general asset placed in service in 2012 are 5-year property provided by, for example, section 168(k) under section 168(e), are not listed property, account if the requirements of paragraph through (n), 1400L(b), or 1400N(d), must and are not eligible for any additional first (c)(2)(i) of this section are satisfied. If, be grouped into a separate general asset year depreciation deduction. J depreciates its however, the inclusion of these assets in account; 5-year property placed in service in 2012 a general asset account results in a (E) Assets eligible for the additional using the optional depreciation table that substantial distortion of income, the first year depreciation deduction may corresponds with the general depreciation Commissioner may disregard the only be grouped into a general asset system, the 200-percent declining balance general asset account election and make account with assets for which the method, a 5-year recovery period, and the any reallocations of income or expense half-year convention. In accordance with taxpayer claimed the same percentage of paragraph (c)(2) of this section, J includes all necessary to clearly reflect income. the additional first year depreciation of the 100 items of equipment in one general (B) A general asset account shall be (for example, 30 percent, 50 percent, or asset account. treated as a single asset for purposes of 100 percent); Example 3. The facts are the same as in applying the rules in § 1.861–9T(g)(3) (F) Except for passenger automobiles Example 2, except that J decides not to (relating to allocation and described in paragraph (c)(2)(ii)(C) of include all of the 100 items of equipment in apportionment of interest expense this section, listed property (as defined one general asset account. Instead and in under the asset method). A general asset in section 280F(d)(4)) must be grouped accordance with paragraph (c)(2) of this account that generates income in more into a separate general asset account; section, J establishes 100 general asset than one grouping of income (statutory accounts and includes one item of equipment (G) Assets for which the depreciation in each general asset account. and residual) is a multiple category allowance for the placed-in-service year Example 4. K, a calendar-year corporation, asset (as defined in § 1.861–9T(g)(3)(ii)), is not determined by using an optional is a wholesale distributer. In 2012, K places and the income yield from the general depreciation table (for further guidance, in service the following properties for use in asset account must be determined by see section 8 of Rev. Proc. 87–57, 1987– its wholesale distribution business: applying the rules for multiple category 2 CB 687, 693 (see § 601.601(d)(2) of this computers, automobiles, and forklifts. On its assets as if the general asset account chapter)) must be grouped into a federal income tax return for 2012, K does were a single asset. separate general asset account; not make an election under section 179 to (2) Grouping assets in general asset (H) Mass assets that are or will be expense the cost of any of these items of accounts—(i) General rules. If a equipment and does make an election under subject to paragraph (j)(2)(iii) of this paragraph (l) of this section to include all of taxpayer makes the election under section (disposed of or converted mass these items of equipment in a general asset paragraph (l) of this section, assets that asset is identified by a mortality account. All of these items are 5-year are subject to the election are grouped dispersion table) must be grouped into property under section 168(e) and are not into one or more general asset accounts. a separate general asset account; and eligible for any additional first year Assets that are eligible to be grouped (I) Assets subject to paragraph depreciation deduction. The computers are into a single general asset account may (h)(3)(iii)(A) of this section (change in listed property, and the automobiles are be divided into more than one general use results in a shorter recovery period listed property and are subject to section asset account. Each general asset or a more accelerated depreciation 280F(a). K depreciates its 5-year property account must include only assets that— placed in service in 2012 using the optional method) for which the depreciation depreciation table that corresponds with the (A) Have the same applicable allowance for the year of change (as general depreciation system, the 200-percent depreciation method; defined in § 1.168(i)–4(a)) is not declining balance method, a 5-year recovery (B) Have the same applicable recovery determined by using an optional period, and the half-year convention. period; depreciation table must be grouped into Although the computers, automobiles, and (C) Have the same applicable a separate general asset account. forklifts are 5-year property, K cannot convention; and (3) Examples. The following examples include all of them in one general asset (D) Are placed in service by the illustrate the application of this account because the computers and taxpayer in the same taxable year. automobiles are listed property. Further, paragraph (c): even though the computers and automobiles (ii) Special rules. In addition to the Example 1. In 2012, J, a proprietorship are listed property, K cannot include them in general rules in paragraph (c)(2)(i) of with a calendar year-end, purchases and one general asset account because the this section, the following rules apply places in service one item of equipment that automobiles also are subject to section when establishing general asset costs $550,000. This equipment is section 280F(a). In accordance with paragraph (c)(2) accounts— 179 property and also is 5-year property of this section, K establishes three general (A) Assets subject to the mid-quarter under section 168(e). On its Federal income asset accounts: One for the computers, one convention may only be grouped into a tax return for 2012, J makes an election under for the automobiles, and one for the forklifts. general asset account with assets that section 179 to expense $500,000 of the Example 5. L, a fiscal-year corporation with a taxable year ending June 30, purchases are placed in service in the same quarter equipment’s cost and makes an election under paragraph (l) of this section to include and places in service ten items of new of the taxable year; the equipment in a general asset account. As equipment in October 2011, and purchases (B) Assets subject to the mid-month a result, the unadjusted depreciable basis of and places in service five other items of new convention may only be grouped into a the equipment is $50,000. In accordance with equipment in February 2012. On its federal general asset account with assets that paragraph (c)(1) of this section, J must income tax return for the taxable year ending

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June 30, 2012, L does not make an election adjusted depreciable basis of the general having an adjusted depreciable basis (as under section 179 to expense the cost of any asset account then is depreciated using defined in § 1.168(b)–1(a)(4)) of zero for of these items of equipment and does make the applicable depreciation method, purposes of section 1011. Therefore, no an election under paragraph (l) of this section recovery period, and convention for the loss is realized upon the disposition of to include all of these items of equipment in a general asset account. All of these items of assets in the account. an asset from the general asset account. equipment are 7-year property under section (3) No assets in general asset account Similarly, where an asset is disposed of 168(e), are not listed property, and are not are eligible for additional first year by transfer to a supplies, scrap, or property described in section 168(k)(2)(B) or depreciation deduction. If none of the similar account, the basis of the asset in (C). All of the ten items of equipment placed assets in a general asset account are the supplies, scrap, or similar account in service in October 2011 are eligible for the eligible for the additional first year will be zero. 100-percent additional first year depreciation depreciation deduction, the taxpayer (ii) Treatment of amount realized. deduction provided by section 168(k)(5). All must determine the allowable Any amount realized on a disposition is of the five items of equipment placed in depreciation deduction for the general recognized as ordinary income service in February 2012 are eligible for the asset account for the placed-in-service (notwithstanding any other provision of 50-percent additional first year depreciation deduction provided by section 168(k)(1). L year and any subsequent taxable year by subtitle A of the Internal Revenue Code) depreciates its 7-year property placed in using the applicable depreciation to the extent the sum of the unadjusted service for the taxable year ending June 30, method, recovery period, and depreciable basis of the general asset 2012, using the optional depreciation table convention for the assets in the account. account and any expensed cost (as that corresponds with the general (4) Special rule for passenger defined in paragraph (b)(4) of this depreciation system, the 200-percent automobiles. For purposes of applying section) for assets in the account declining balance method, a 7-year recovery section 280F(a), the depreciation exceeds any amounts previously period, and the half-year convention. allowance for a general asset account recognized as ordinary income upon the Although the 15 items of equipment are established for passenger automobiles is disposition of other assets in the depreciated using the same depreciation method, recovery period, and convention, L limited for each taxable year to the account. The recognition and character cannot include all of them in one general amount prescribed in section 280F(a) of any excess amount realized are asset account because they are eligible for multiplied by the excess of the number determined under other applicable different percentages of the additional first of automobiles originally included in provisions of the Internal Revenue Code year depreciation deduction. In accordance the account over the number of (other than sections 1245 and 1250 or with paragraph (c)(2) of this section, L automobiles disposed of during the provisions of the Internal Revenue Code establishes two general asset accounts: one taxable year or in any prior taxable year that treat gain on a disposition as for the ten items of equipment eligible for the in a transaction described in paragraphs subject to section 1245 or 1250). 100-percent additional first year depreciation (e)(3)(iii) (disposition of an asset in a (iii) Effect of disposition on a general deduction, and one for the five items of qualifying disposition), (e)(3)(iv) asset account. The unadjusted equipment eligible for the 50-percent depreciable basis and the depreciation additional first year depreciation deduction. (transactions subject to section 168(i)(7)), (e)(3)(v) (transactions subject reserve of the general asset account are (d) Determination of depreciation to section 1031 or 1033), (e)(3)(vi) not affected as a result of a disposition allowance—(1) In general. Depreciation (technical termination of a partnership), of an asset from the general asset allowances are determined for each (e)(3)(vii) (anti-abuse rule), (g) (assets account. general asset account. The depreciation subject to recapture), (h)(1) (conversion (iv) Coordination with nonrecognition allowances must be recorded in a to personal use), or (h)(2) (business or provisions. For purposes of determining depreciation reserve account for each income-producing use percentage the basis of an asset acquired in a general asset account. The allowance for changes) of this section. transaction, other than a transaction depreciation under this section (e) Disposition of an asset from a described in paragraphs (e)(3)(iv) constitutes the amount of depreciation general asset account—(1) Scope. This (pertaining to transactions subject to allowable under section 167(a). paragraph (e) provides rules applicable section 168(i)(7)), (e)(3)(v) (pertaining to (2) Assets in general asset account are to dispositions of assets included in a transactions subject to section 1031 or eligible for additional first year general asset account. For purposes of 1033), and (e)(3)(vi) (pertaining to depreciation deduction. If all the assets this paragraph (e), an asset in a general technical terminations of partnerships) in a general asset account are eligible for asset account is disposed of when of this section, to which a the additional first year depreciation ownership of the asset is transferred or nonrecognition section of the Internal deduction, the taxpayer first must when the asset is permanently Revenue Code applies (determined determine the allowable additional first withdrawn from use either in the without regard to this section), the year depreciation deduction for the taxpayer’s trade or business or in the amount of ordinary income recognized general asset account for the placed-in- production of income. A disposition under this paragraph (e)(2) is treated as service year and then must determine includes the sale, exchange, retirement, the amount of gain recognized on the the amount otherwise allowable as a physical abandonment, or destruction of disposition. depreciation deduction for the general an asset. A disposition also occurs when (v) Manner of disposition. The asset account for the placed-in-service an asset is transferred to a supplies, manner of disposition of an asset in a year and any subsequent taxable year. scrap, or similar account. A disposition general asset account (for example, The allowable additional first year also includes the retirement of a normal retirement, abnormal retirement, depreciation deduction for the general structural component (as defined in ordinary retirement, or extraordinary asset account for the placed-in-service § 1.48–1(e)(2)) of a building (as defined retirement) is not taken into account in year is determined by multiplying the in § 1.48–1(e)(1)). determining whether a disposition unadjusted depreciable basis of the (2) General rules for a disposition—(i) occurs or gain or loss is recognized. general asset account by the additional No immediate recovery of basis. Except (vi) Disposition by transfer to a first year depreciation deduction as provided in paragraph (e)(3) of this supplies account. If a taxpayer made an percentage applicable to the assets in section, immediately before a election under § 1.162–3T(d) to treat the the account (for example, 30 percent, 50 disposition of any asset in a general cost of any material and supply as a percent, or 100 percent). The remaining asset account, the asset is treated as capital expenditure subject to the

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allowance for depreciation and also the asset except as provided in retirement of the roof, which is a structural made an election under paragraph (l) of § 1.1250–1(a)(2)(ii) or in paragraph component of the building, is a disposition this section to include that material and (e)(2)(viii)(B)(5) of this section. under paragraph (e)(1) of this section. supply in a general asset account, the (3) Each structural component However, this roof has an unadjusted (including all components thereof) of a depreciable basis of zero pursuant to taxpayer can dispose of the material and paragraph (e)(2)(i) of this section. supply by transferring it to a supplies building, condominium unit, or Accordingly, A does not recognize any loss account only if the taxpayer has cooperative unit is the asset. upon the retirement of the roof. Instead, the obtained the consent of the (4) If a taxpayer properly includes an unadjusted depreciable basis of the general Commissioner to revoke the § 1.162– item in one of the asset classes 00.11 asset account for the office building is not 3T(d) election. See § 1.162–3T(d)(3) for through 00.4 of Rev. Proc. 87–56 (1987– affected by the retirement of the roof and, as the procedures for revoking a § 1.162– 2 CB 674) (see § 601.601(d)(2)(ii)(b) of a result, A continues to depreciate the $10 3T(d) election. this chapter) or properly classifies an million cost of this general asset account. (vii) Leasehold improvements. The item in one of the categories under Example 2. B, a calendar-year commercial rules of paragraph (e) of this section also section 168(e)(3) (except for a category airline company, maintains one general asset apply to— that includes buildings or structural account for five aircrafts that cost a total of (A) A lessor of leased property that components; for example, retail motor $500 million. B replaces the existing engines made an improvement to that property fuels outlet, qualified leasehold on one of the aircrafts with new engines and for the lessee of the property, has a improvement property, qualified treats each engine of an aircraft as a major depreciable basis in the improvement, restaurant property, and qualified retail component of the aircraft. Assume each made an election under paragraph (l) of aircraft is a unit of property as determined improvement property), each item is the under § 1.263(a)–3T(e)(3). However, for this section to include the improvement asset provided it is not larger than the disposition purposes of general asset in a general asset account, and disposes unit of property as determined under accounts, B consistently treats each major of the improvement before or upon the § 1.263(a)–3T(e)(3) or (e)(5) or as component of an aircraft as the asset. Thus, termination of the lease with the lessee. otherwise determined in published the retirement of these replaced engines is a See section 168(i)(8)(B); and guidance in the Federal Register or in disposition under paragraph (e)(1) of this (B) A lessee of leased property that the Internal Revenue Bulletin (see section. However, the engines have an made an improvement to that property, § 601.601(d)(2)(ii)(b) of this chapter), or unadjusted depreciable basis of zero has a depreciable basis in the provided paragraph (e)(2)(viii)(B)(5) of pursuant to paragraph (e)(2)(i) of this section. Accordingly, B does not recognize any loss improvement, made an election under this section does not apply to the item. paragraph (l) of this section to include upon the retirement of the engines. Instead, For example, each desk is the asset, the unadjusted depreciable basis of the the improvement in a general asset each computer is the asset, and each general asset account for the five aircrafts is account, and disposes of the qualified smart electric meter is the not affected by the retirement of the engines improvement before or upon the asset (assuming these assets are not and, as a result, B continues to depreciate the termination of the lease. larger than the unit of property as $500 million cost of this general asset (viii) Determination of asset disposed determined under § 1.263(a)–3T(e)(3) or account. of—(A) In general. For purposes of (e)(5) or as otherwise determined in Example 3. (i) R, a calendar-year applying paragraph (e) of this section to published guidance in the Federal corporation, maintains one general asset the disposition of an asset in a general Register or in the Internal Revenue account for ten machines. The machines cost asset account (instead of the disposition Bulletin (see § 601.601(d)(2)(ii)(b) of this a total of $10,000 and are placed in service of the general asset account), the facts chapter)). in June 2012. Of the ten machines, one and circumstances of each disposition (5) If the taxpayer places in service an machine costs $8,200 and nine machines cost are considered in determining what is a total of $1,800. Assume R depreciates this improvement or addition to an asset general asset account using the optional the appropriate asset disposed of. after the taxpayer placed the asset in Except as provided in paragraph depreciation table that corresponds with the service, the improvement or addition is general depreciation system, the 200-percent (e)(2)(viii)(B) of this section, the asset a separate asset provided it is not larger declining balance method, a 5-year recovery cannot be larger than the unit of than the unit of property as determined period, and a half-year convention. R does property as determined under under § 1.263(a)–3T(e)(3) or (e)(5) or as not make a section 179 election for any of the § 1.263(a)–3T(e)(2), (e)(3), and (e)(5) or otherwise determined in published machines, and all of the machines are not as otherwise determined in published guidance in the Federal Register or in eligible for any additional first year guidance in the Federal Register or in the Internal Revenue Bulletin (see depreciation deduction. As of January 1, the Internal Revenue Bulletin (see, for § 601.601(d)(2)(ii)(b) of this chapter). 2013, the depreciation reserve of the account is $2,000 [$10,000 x 20 percent]. example, Rev. Proc. 2011–38, 2011–18 (6) If an asset is not described in one IRB 743, for units of property for (ii) On February 8, 2013, R sells the of the asset classes 00.11 through 00.4 machine that cost $8,200 to an unrelated wireless network assets (see of Rev. Proc. 87–56 (1987–2 CB 674) party for $9,000. Under paragraph (e)(2)(i) of § 601.601(d)(2)(ii)(b) of this chapter)). (see § 601.601(d)(2)(ii)(b) of this chapter) this section, this machine has an adjusted (B) Exceptions. For purposes of or in one of the categories under section depreciable basis of zero. applying paragraph (e) of this section to 168(e)(3), a taxpayer also may use any (iii) On its 2013 tax return, R recognizes the disposition of an asset in a general reasonable, consistent method to treat the amount realized of $9,000 as ordinary asset account (instead of the disposition each of the asset’s components as the income because such amount does not of the general asset account): asset. exceed the unadjusted depreciable basis of (1) Each building (not including its (ix) Examples. The following the general asset account ($10,000), plus any expensed cost for assets in the account ($0), structural components) is the asset examples illustrate the application of except as provided in § 1.1250– less amounts previously recognized as this paragraph (e)(2): ordinary income ($0). Moreover, the 1(a)(2)(ii) or in paragraph Example 1. A, a calendar-year partnership, unadjusted depreciable basis and (e)(2)(viii)(B)(2) or (5) of this section. maintains one general asset account for one depreciation reserve of the account are not (2) If a building has two or more office building that cost $10 million. A affected by the disposition of the machine. condominium or cooperative units, each discovers a leak in the roof of this building Thus, the depreciation allowance for the condominium or cooperative unit (not and, after consulting with a contractor, account in 2013 is $3,200 ($10,000 x 32 including its structural components) is decides to replace the entire roof. The percent).

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Example 4. (i) The facts are the same as in section 1001(a) by taking into account make a section 179 election for the Example 3. In addition, on June 4, 2014, R the adjusted depreciable basis of the equipment, and it is not eligible for any sells seven machines to an unrelated party general asset account at the time of the additional first year depreciation deduction. for a total of $1,100. In accordance with In June 2014, J sells the equipment to an paragraph (e)(2)(i) of this section, these disposition (as determined under the unrelated party for $1,000. J elects to apply machines have an adjusted depreciable basis applicable convention for the general paragraph (e)(3)(ii) of this section. As a of zero. asset account). The recognition and result, the account terminates and gain or (ii) On its 2014 tax return, R recognizes character of the gain or loss are loss is determined for the account. $1,000 as ordinary income (the unadjusted determined under other applicable (iii) On the date of disposition, the depreciable basis of $10,000, plus the provisions of the Internal Revenue adjusted depreciable basis of the account is expensed cost of $0, less the amount of Code, except that the amount of gain $768 (unadjusted depreciable basis of $2,000 $9,000 previously recognized as ordinary subject to section 1245 (or section 1250) less the depreciation allowed or allowable of income). The recognition and character of the $1,232). Thus, in 2014, J recognizes gain of excess amount realized of $100 is limited to the excess of the $232 (amount realized of $1,000 less the ($1,100¥$1,000) are determined under depreciation allowed or allowable for adjusted depreciable basis of $768). The gain applicable provisions of the Internal Revenue the general asset account, including any of $232 is subject to section 1245 to the Code other than section 1245 (such as section expensed cost (or the excess of the extent of the depreciation allowed or 1231). Moreover, the unadjusted depreciable additional depreciation allowed or allowable for the account (plus the expensed basis and depreciation reserve of the account allowable for the general asset account), cost for assets in the account) less the are not affected by the disposition of the over any amounts previously recognized amounts previously recognized as ordinary machines. Thus, the depreciation allowance income ($1,232 + $0¥$0 = $1,232). As a for the account in 2014 is $1,920 ($10,000 x as ordinary income under paragraph result, the entire gain of $232 is subject to 19.2 percent). (e)(2) of this section. section 1245. (B) Examples. The following (3) Special rules—(i) In general. This examples illustrate the application of (iii) Disposition of an asset in a paragraph (e)(3) provides the rules for this paragraph (e)(3)(ii): qualifying disposition—(A) Optional terminating general asset account determination of the amount of gain, treatment upon certain dispositions. Example 1. (i) T, a calendar-year loss, or other deduction. In the case of While the rules under paragraphs corporation, maintains a general asset a qualifying disposition of an asset account for 1,000 calculators. The calculators (e)(3)(ii) and (iii) of this section are cost a total of $60,000 and are placed in (described in paragraph (e)(3)(iii)(B) of optional rules, the rules under service in 2012. Assume T depreciates this this section), a taxpayer may elect to paragraphs (e)(3)(iv), (v), (vi), and (vii) general asset account using the optional apply this paragraph (e)(3)(iii) (rather of this section are mandatory rules. A depreciation table that corresponds with the than having paragraph (e)(2) of this taxpayer elects to apply paragraph general depreciation system, the 200-percent section apply). Under this paragraph (e)(3)(ii) or (iii) of this section by declining balance method, a 5-year recovery (e)(3)(iii), general asset account reporting the gain, loss, or other period, and a half-year convention. T does treatment for the asset terminates as of deduction on the taxpayer’s timely filed not make a section 179 election for any of the the first day of the taxable year in which calculators, and all of the calculators are not original Federal income tax return eligible for any additional first year the qualifying disposition occurs, and (including extensions) for the taxable depreciation deduction. In 2013, T sells 200 the amount of gain, loss, or other year in which the disposition occurs. A of the calculators to an unrelated party for a deduction for the asset is determined taxpayer may revoke the election to total of $10,000 and recognizes the $10,000 under § 1.168(i)–8T by taking into apply paragraph (e)(3)(ii) or (iii) of this as ordinary income in accordance with account the asset’s adjusted depreciable section only by filing a request for a paragraph (e)(2) of this section. basis at the time of the disposition. The private letter ruling and obtaining the (ii) On March 26, 2014, T sells the adjusted depreciable basis of the asset at Commissioner’s consent to revoke the remaining calculators in the general asset the time of the disposition (as election. The Commissioner may grant a account to an unrelated party for $35,000. T determined under the applicable elects to apply paragraph (e)(3)(ii) of this request to revoke this election if the section. As a result, the account terminates convention for the general asset account taxpayer can demonstrate good cause for and gain or loss is determined for the in which the asset was included) equals the revocation. The election to apply account. the unadjusted depreciable basis of the paragraph (e)(3)(ii) or (iii) of this section (iii) On the date of disposition, the asset less the depreciation allowed or may not be made or revoked through the adjusted depreciable basis of the account is allowable for the asset, computed by filing of an application for change in $23,040 (unadjusted depreciable basis of using the depreciation method, recovery accounting method. For purposes of $60,000 less the depreciation allowed or period, and convention applicable to the applying paragraph (e)(3)(iii) through allowable of $36,960). Thus, in 2014, T general asset account in which the asset (vii) of this section, see paragraph (j) of recognizes gain of $11,960 (amount realized of $35,000 less the adjusted depreciable basis was included and by including the this section for identifying an asset of $23,040). The gain of $11,960 is subject to portion of the additional first year disposed of and its unadjusted section 1245 to the extent of the depreciation depreciation deduction claimed for the depreciable basis. allowed or allowable for the account (plus general asset account that is attributable (ii) Disposition of all assets remaining the expensed cost for assets in the account) to the asset disposed of. The recognition in a general asset account—(A) less the amounts previously recognized as and character of the gain, loss, or other Optional termination of a general asset ordinary income ($36,960 + $0¥$10,000 = deduction are determined under other account. Upon the disposition of all of $26,960). As a result, the entire gain of applicable provisions of the Internal the assets, or the last asset, in a general $11,960 is subject to section 1245. Revenue Code, except that the amount asset account, a taxpayer may apply this Example 2. (i) J, a calendar-year of gain subject to section 1245 (or paragraph (e)(3)(ii) to recover the corporation, maintains a general asset section 1250) is limited to the lesser adjusted depreciable basis of the general account for one item of equipment. This of— asset account (rather than having equipment costs $2,000 and is placed in (1) The depreciation allowed or service in 2012. Assume J depreciates this paragraph (e)(2) of this section apply). general asset account using the optional allowable for the asset, including any Under this paragraph (e)(3)(ii), the depreciation table that corresponds with the expensed cost (or the additional general asset account terminates and the general depreciation system, the 200-percent depreciation allowed or allowable for amount of gain or loss for the general declining balance method, a 5-year recovery the asset); or asset account is determined under period, and a half-year convention. J does not (2) The excess of—

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(i) The original unadjusted total of $135,000 are used in Z’s Kentucky (e)(3)(iv)(C)(2) of this section, as depreciable basis of the general asset plant, and three machines that cost a total of applicable). account plus, in the case of section 1245 $45,000 are used in Z’s Ohio plant. Assume (B) All assets remaining in general Z depreciates this general asset account using property originally included in the the optional depreciation table that asset account are transferred. If a general asset account, any expensed corresponds with the general depreciation taxpayer transfers all the assets, or the cost; over system, the 200-percent declining balance last asset, in a general asset account in (ii) The cumulative amounts of gain method, a 5-year recovery period, and the a transaction described in section previously recognized as ordinary half-year convention. Z does not make a 168(i)(7)(B)— income under either paragraph (e)(2) of section 179 election for any of the machines, (1) The taxpayer (the transferor) must this section or section 1245 (or section and all of the machines are not eligible for terminate the general asset account on any additional first year depreciation 1250). the date of the transfer. The allowable (B) Qualifying dispositions. A deduction. As of January 1, 2014, the depreciation reserve for the account is depreciation deduction for the general qualifying disposition is a disposition $93,600. asset account for the transferor’s taxable that does not involve all the assets, or (ii) On May 27, 2014, Z sells its entire year in which the section 168(i)(7)(B) the last asset, remaining in a general manufacturing plant in Ohio to an unrelated transaction occurs is computed by using asset account and that is not described party. The sales proceeds allocated to each of the depreciation method, recovery in paragraphs (e)(3)(iv) (pertaining to the three machines at the Ohio plant is period, and convention applicable to the transactions subject to section 168(i)(7)), $5,000. Because this transaction is a qualifying disposition under paragraph general asset account. This allowable (v) (pertaining to transactions subject to depreciation deduction is allocated section 1031 or 1033), (vi) (pertaining to (e)(3)(iii)(B) of this section, Z elects to apply paragraph (e)(3)(iii) of this section. between the transferor and the technical terminations of partnerships), (iii) For Z’s 2014 return, the depreciation transferee on a monthly basis. This or (vii) (anti-abuse rule) of this section. allowance for the account is computed as allocation is made in accordance with (C) Effect of a qualifying disposition follows. As of December 31, 2013, the the rules in § 1.168(d)–1(b)(7)(ii) for on a general asset account. If the depreciation allowed or allowable for the allocating the depreciation deduction taxpayer elects to apply this paragraph three machines at the Ohio plant is $23,400. between the transferor and the (e)(3)(iii) to a qualifying disposition of Thus, as of January 1, 2014, the unadjusted depreciable basis of the account is reduced transferee; an asset, then— (2) The transferee must establish a (1) The asset is removed from the from $180,000 to $135,000 ($180,000 less the new general asset account for all the general asset account as of the first day unadjusted depreciable basis of $45,000 for the three machines), and the depreciation assets, or the last asset, in the taxable of the taxable year in which the reserve of the account is decreased from year in which the section 168(i)(7)(B) qualifying disposition occurs. For that $93,600 to $70,200 ($93,600 less the transaction occurs for the portion of its taxable year, the taxpayer accounts for depreciation allowed or allowable of $23,400 basis in the assets that does not exceed the asset in a single asset account in for the three machines as of December 31, the transferor’s adjusted depreciable accordance with the rules under 2013). Consequently, the depreciation basis of the general asset account in § 1.168(i)–7T(b); allowance for the account in 2014 is $25,920 (2) The unadjusted depreciable basis ($135,000 × 19.2 percent). which all the assets, or the last asset, of the general asset account is reduced (iv) For Z’s 2014 return, gain or loss for were included. The transferor’s adjusted by the unadjusted depreciable basis of each of the three machines at the Ohio plant depreciable basis of this general asset is determined as follows. The depreciation the asset as of the first day of the taxable account is equal to the adjusted allowed or allowable in 2014 for each depreciable basis of that account as of year in which the disposition occurs; machine is $1,440 [($15,000 x 19.2 percent)/ (3) The depreciation reserve of the the beginning of the transferor’s taxable 2]. Thus, the adjusted depreciable basis of year in which the transaction occurs, general asset account is reduced by the each machine under section 1011 is $5,760 depreciation allowed or allowable for (the adjusted depreciable basis of $7,200 decreased by the amount of depreciation the asset as of the end of the taxable removed from the account less the allocable to the transferor for the year of year immediately preceding the year of depreciation allowed or allowable of $1,440 the transfer (as determined under disposition, computed by using the in 2014). As a result, the loss recognized in paragraph (e)(3)(iv)(B)(1) of this depreciation method, recovery period, 2014 for each machine is $760 section). The transferee is treated as the ($5,000¥$5,760), which is subject to section transferor for purposes of computing the and convention applicable to the 1231. general asset account in which the asset allowable depreciation deduction for was included and by including the (iv) Transactions subject to section the new general asset account under portion of the additional first year 168(i)(7)—(A) In general. If a taxpayer section 168. The new general asset depreciation deduction claimed for the transfers one or more assets in a general account must be established in general asset account that is attributable asset account in a transaction described accordance with the rules in paragraph to the asset disposed of; and in section 168(i)(7)(B) (pertaining to (c) of this section, except that the (4) For purposes of determining the treatment of transferees in certain unadjusted depreciable bases of all the amount of gain realized on subsequent nonrecognition transactions), the assets or the last asset, and the greater dispositions that is subject to ordinary taxpayer (the transferor) and the of the depreciation allowed or allowable income treatment under paragraph transferee must apply this paragraph for all the assets or the last asset (e)(2)(ii) of this section, the amount of (e)(3)(iv) to the asset (instead of (including the amount of depreciation any expensed cost with respect to the applying paragraph (e)(2), (e)(3)(ii), or for the transferred assets that is asset is disregarded. (e)(3)(iii) of this section). The transferee allocable to the transferor for the year of (D) Example. The following example is bound by the transferor’s election the transfer), are included in the newly illustrates the application of this under paragraph (l) of this section for established general asset account. paragraph (e)(3)(iii): the portion of the transferee’s basis in Consequently, this general asset account the asset that does not exceed the in the year of the transfer will have a Example. (i) Z, a calendar-year corporation, maintains one general asset transferor’s adjusted depreciable basis of beginning balance for both the account for 12 machines. Each machine costs the general asset account or the asset, as unadjusted depreciable basis and the $15,000 and is placed in service in 2012. Of applicable (as determined under depreciation reserve of the general asset the 12 machines, nine machines that cost a paragraph (e)(3)(iv)(B)(2) or account; and

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

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

Foreign Source Income, Gain, or Loss = Total Ordinary Income, Gain, or Loss × Allowed Depreciation Deductions Allo- from the Disposition of an Asset. from the Disposition of an Asset. cated and Apportioned to Foreign Source Income/Total Allowed Depre- ciation Deductions for the General Asset Account or for the Asset Dis- posed of (as applicable).

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

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Foreign Source Income, Gain, or Loss in a = Foreign Source Income, Gain, or Loss × Allowed Depreciation Deductions Allo- Separate Category. from The Disposition of an Asset. cated and Apportioned to a Separate Category Total/Allowed Depreciation Deductions and Apportioned to For- eign Source Income.

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

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(2) Identifying which asset is disposed transaction to which this paragraph (j) to, and agrees to apply, all of the of or converted. For purposes of applies; provisions of this section to the assets identifying which asset in a general (iv) A mortality dispersion table if the included in a general asset account. asset account is disposed of or asset is a mass asset accounted for in a Except as provided in paragraph converted, a taxpayer must identify the separate general asset account in (c)(1)(ii)(A), (e)(3), (g), or (h) of this disposed of or converted asset by accordance with paragraph (c)(2)(ii)(H) section, an election made under this using— of this section and if the taxpayer can section is irrevocable and will be (i) The specific identification method readily determine from its records the binding on the taxpayer for computing of accounting. Under this method of total dispositions of assets with the taxable income for the taxable year for accounting, the taxpayer can determine same recovery period during the taxable which the election is made and for all the particular taxable year in which the year. The mortality dispersion table subsequent taxable years. An election disposed of or converted asset was must be based upon an acceptable under this paragraph (l) is made placed in service by the taxpayer; sampling of the taxpayer’s actual separately by each person owning an (ii) A first-in, first-out method of disposition and conversion experience asset to which this section applies (for accounting if the taxpayer can readily for mass assets or other acceptable example, by each member of a determine from its records the total statistical or engineering techniques. To consolidated group, at the partnership dispositions of assets with the same use a mortality dispersion table, the level (and not by the partner separately), recovery period during the taxable year taxpayer must adopt recordkeeping or at the S corporation level (and not by but the taxpayer cannot readily practices consistent with the taxpayer’s the shareholder separately)). determine from its records the prior practices and consonant with good (2) [Reserved]. For further guidance, unadjusted depreciable basis of the accounting and engineering practices; or see § 1.168(i)–1(l)(2). (v) Any other method as the Secretary (3) [Reserved]. For further guidance, disposed of or converted asset. Under may designate by publication in the see § 1.168(i)–1(l)(3). this method of accounting, the taxpayer Federal Register or in the Internal (m) Effective/applicability date— identifies the general asset account with Revenue Bulletin (see § 601.601(d)(2) of (1) In general. This section applies to the earliest placed-in-service year that this chapter) on or after December 23, taxable years beginning on or after has the same recovery period as the 2011. For this purpose, a last-in, first- January 1, 2012. For the applicability of disposed of or converted asset and that out method of accounting is not a § 1.168(i)–1 in taxable years beginning has assets at the beginning of the taxable designated method. Under the last-in, before January 1, 2012, see § 1.168(i)–1 year of the disposition or conversion, first-out method of accounting, the in effect prior to January 1, 2012 and the taxpayer treats the disposed of taxpayer identifies the general asset (§ 1.168(i)–1 as contained in 26 CFR part or converted asset as being from that account with the most recent placed-in- 1 edition revised as of April 1, 2011). general asset account. To determine service year that has the same recovery (2) Change in method of accounting. which general asset account has assets period as the disposed of or converted A change to comply with this section for at the beginning of the taxable year of asset and that has assets at the depreciable assets placed in service in a the disposition or conversion, the beginning of the taxable year of the taxable year ending on or after taxpayer reduces the number of assets disposition or conversion, and the December 30, 2003, is a change in originally included in the account by taxpayer treats the disposed of or method of accounting to which the the number of assets disposed of or converted asset as being from that provisions of section 446(e) and the converted in any prior taxable year in a general asset account. To determine regulations under section 446(e) apply. transaction to which this paragraph (j) which general asset account has assets A taxpayer also may treat a change to applies; at the beginning of the taxable year of comply with this section for depreciable (iii) A modified first-in, first-out the disposition or conversion, the assets placed in service in a taxable year method of accounting if the taxpayer taxpayer reduces the number of assets ending before December 30, 2003, as a can readily determine from its records originally included in the account by change in method of accounting to the total dispositions of assets with the the number of assets disposed of or which the provisions of section 446(e) same recovery period during the taxable converted in any prior taxable year in a and the regulations under section 446(e) year and the unadjusted depreciable transaction to which this paragraph (j) apply. basis of the disposed of or converted applies. (3) The applicability of this section asset. Under this method of accounting, (3) Basis of disposed of or converted expires on December 23, 2014. the taxpayer identifies the general asset asset. After identifying which asset in a ■ Par. 21. Section 1.168(i)–7T is added account with the earliest placed-in- general asset account is disposed of or to read as follows: service year that has the same recovery converted, the taxpayer may use any period as the disposed of or converted reasonable method that is consistently § 1.168(i)–7T Accounting for MACRS asset and that has assets at the applied to all its general asset accounts property (temporary). beginning of the taxable year of the for purposes of determining the (a) In general. A taxpayer may disposition or conversion with the same unadjusted depreciable basis of a account for MACRS property (as defined unadjusted depreciable basis as the disposed of or converted asset. in § 1.168(b)–1(a)(2)) by treating each disposed of or converted asset, and the (k) Effect of adjustments on prior individual asset as an account (a ‘‘single taxpayer treats the disposed of or dispositions. The adjustments to a asset account’’ or an ‘‘item account’’) or converted asset as being from that general asset account under paragraph by combining two or more assets in a general asset account. To determine (e)(3)(iii), (e)(3)(iv), (e)(3)(v), (e)(3)(vii), single account (a ‘‘multiple asset which general asset account has assets (g), or (h) of this section have no effect account’’ or a ‘‘pool’’). A taxpayer may at the beginning of the taxable year of on the recognition and character of prior establish as many accounts for MACRS the disposition or conversion, the dispositions subject to paragraph (e)(2) property as the taxpayer wants. This taxpayer reduces the number of assets of this section. section does not apply to assets originally included in the account by (l) Election—(1) Irrevocable election. included in general asset accounts. For the number of assets disposed of or If a taxpayer makes an election under rules applicable to general asset converted in any prior taxable year in a this paragraph (l), the taxpayer consents accounts, see § 1.168(i)–1T.

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(b) Required use of single asset assets that are placed in service in the assets placed in service in a taxable year accounts. A taxpayer must account for same quarter of the taxable year; ending before December 30, 2003, as a an asset in a single asset account if the (B) Assets subject to the mid-month change in method of accounting to taxpayer uses the asset both in a trade convention may only be grouped into a which the provisions of section 446(e) or business (or for the production of multiple asset account or pool with and the regulations under section 446(e) income) and in a personal activity, or if assets that are placed in service in the apply. the taxpayer places in service and same month of the taxable year; (3) Expiration date. The applicability disposes of the asset during the same (C) Passenger automobiles for which of this section expires on December 23, taxable year. Also, if general asset the depreciation allowance is limited 2014. account treatment for an asset under section 280F(a) must be grouped ■ Par. 22. Section 1.168(i)–8T is added terminates under § 1.168(i)– into a separate multiple asset account or to read as follows: 1T(c)(1)(ii)(A), (e)(3)(iii), (e)(3)(vii), (g), pool; (D) Assets not eligible for any § 1.168(i)–8T Dispositions of MACRS or (h)(2), the taxpayer must account for property (temporary). additional first year depreciation the asset in a single asset account (a) Scope. This section provides rules beginning in the taxable year in which deduction (including assets for which the taxpayer elected not to deduct the applicable to dispositions of MACRS the general asset account treatment for property (as defined in § 1.168(b)– the asset terminates. If a taxpayer additional first year depreciation) provided by, for example, section 168(k) 1(a)(2)) or to depreciable property (as accounts for an asset in a multiple asset defined in § 1.168(b)–1(a)(1)) that would account or pool treatment and the through (n), 1400L(b), or 1400N(d), must be grouped into a separate multiple be MACRS property but for an election taxpayer disposes of the asset, the made by the taxpayer either to expense taxpayer must account for the asset in asset account or pool; (E) Assets eligible for the additional all or some of the property’s cost under a single asset account beginning in the section 179, 179A, 179B, 179C, 179D, or taxable year in which the disposition first year depreciation deduction may only be grouped into a multiple asset 1400I(a)(1), or any similar provision, or occurs. See § 1.168(i)–8T(g)(2)(i). If a to amortize all or some of the property’s taxpayer disposes of a component of a account or pool with assets for which the taxpayer claimed the same cost under section 1400I(a)(2) or any larger asset and the unadjusted similar provision. Except as provided in depreciable basis of the disposed of percentage of the additional first year depreciation (for example, 30 percent, § 1.168(i)–1T(e)(iii), this section does component is included in the not apply to dispositions of assets 50 percent, or 100 percent); unadjusted depreciable basis of the included in a general asset account. For larger asset, the taxpayer must account (F) Except for passenger automobiles described in paragraph (c)(2)(ii)(C) of rules applicable to dispositions of assets for the component in a single asset included in a general asset account, see account beginning in the taxable year in this section, listed property (as defined in section 280F(d)(4)) must be grouped § 1.168(i)–1T(e). which the disposition occurs. See (b) Definitions. For purposes of this into a separate multiple asset account or § 1.168(i)–8T(g)(3)(i). section— (c) Establishment of multiple asset pool; (1) Disposition occurs when (G) Assets for which the depreciation accounts or pools—(1) Assets eligible for ownership of the asset is transferred or allowance for the placed-in-service year multiple asset accounts or pools. Except when the asset is permanently is not determined by using an optional as provided in paragraph (b) of this withdrawn from use either in the depreciation table (for further guidance, section, assets that are subject to either taxpayer’s trade or business or in the see section 8 of Rev. Proc. 87–57, 1987– the general depreciation system of production of income. A disposition 2 CB 687, 693 (see § 601.601(d)(2) of this section 168(a) or the alternative includes the sale, exchange, retirement, chapter) must be grouped into a separate depreciation system of section 168(g) physical abandonment, or destruction of multiple asset account or pool; and an asset. A disposition also includes the may be accounted for in one or more (H) Mass assets (as defined in retirement of a structural component (as multiple asset accounts or pools. § 1.168(i)–8T(b)(2)) that are or will be defined in § 1.48–1(e)(2)) of a building (2) Grouping assets in multiple asset subject to § 1.168–8T(f)(2)(ii) (disposed (as defined in § 1.48–1(e)(1)). A accounts or pools—(i) General rules. of or converted mass asset is identified Assets that are eligible to be grouped disposition also occurs when an asset is by a mortality dispersion table) must be transferred to a supplies, scrap, or into a single multiple asset account or grouped into a separate multiple asset pool may be divided into more than one similar account. account or pool. (2) Mass assets is a mass or group of multiple asset account or pool. Each (d) Cross references. See § 1.167(a)– multiple asset account or pool must individual items of depreciable assets— 7T(c) for the records to be maintained (i) That are not necessarily include only assets that— by a taxpayer for each account. In (A) Have the same applicable homogenous; addition, see § 1.168(i)–1T for the (ii) Each of which is minor in value depreciation method; records to be maintained by a taxpayer relative to the total value of the mass or (B) Have the same applicable recovery for each general asset account. group; period; (e) Effective/applicability date—(1) (iii) Numerous in quantity; (C) Have the same applicable This section applies to taxable years (iv) Usually accounted for only on a convention; and beginning on or after January 1, 2012. total dollar or quantity basis; (D) Are placed in service by the (2) Change in method of accounting. (v) With respect to which separate taxpayer in the same taxable year. A change to comply with this section for identification is impracticable; and (ii) Special rules. In addition to the depreciable assets placed in service in a (vi) Placed in service in the same general rules in paragraph (c)(2)(i) of taxable year ending on or after taxable year. this section, the following rules apply December 30, 2003, is a change in (3) Unadjusted depreciable basis of when establishing multiple asset method of accounting to which the the multiple asset account or pool is the accounts or pools— provisions of section 446(e) and the sum of the unadjusted depreciable bases (A) Assets subject to the mid-quarter regulations under section 446(e) apply. (as defined in § 1.168(b)–1(a)(3)) of all convention may only be grouped into a A taxpayer also may treat a change to assets included in the multiple asset multiple asset account or pool with comply with this section for depreciable account or pool.

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

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

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larger asset that is attributable to the identify the cost of the structural components allocates a cost of $250 ($25,000 × (1/100)) disposed of component. of the office building from its records, D uses to each disposed of mass asset and a reasonable method that is consistently depreciation allowed or allowable of $130 (h) Examples. The application of this × section is illustrated by the following applied to all of the structural components of ($13,000 (1/100)) to each disposed of mass the office building to determine the cost of asset. The depreciation allowed or allowable examples: the elevator. Using this reasonable method, D in 2012 for each disposed of mass asset is $24 Example 1. A owns an office building with allocates $150,000 of the $20,000,000 [($250 × 19.2 percent)/2]. As a result, the four elevators. A decides to replace one of the purchase price for the building to the retired adjusted depreciable basis of each disposed elevators. The retirement of the replaced elevator. Using the optional depreciation of mass asset under section 1011 is $96 elevator, which is a structural component of table that corresponds with the general ($250–$130–$24). Thus, E recognizes a gain the building, is a disposition. As a result, depreciation system, the straight-line of $4 for each disposed of mass asset in 2012, depreciation for the retired elevator ceases at method, a 39-year recovery period, and the which is subject to section 1245. the time of its retirement (taking into account mid-month convention, the depreciation (iii) Further, as of January 1, 2012, the the applicable convention). A recognizes a allowed or allowable for the retired elevator unadjusted depreciable basis of the 2010 pool loss upon this retirement. as of December 31, 2011, is $9,457.50. of mass assets with a 5-year recovery period Example 2. B, a calendar-year commercial (iii) For D’s 2012 Federal income tax is reduced from $25,000 to $22,500 ($25,000 airline company, owns several aircrafts that return, loss for the retired elevator is less the unadjusted depreciable basis of are used in the commercial carrying of determined as follows. The depreciation $2,500 for the 10 disposed of items), and the passengers. B replaces the existing engines allowed or allowable for 2012 for the retired depreciation reserve of this 2010 pool is on one of the aircrafts with new engines and elevator is $1,923 ((unadjusted depreciable reduced from $13,000 to $11,700 ($13,000 treats each engine of an aircraft as a major basis of $150,000 × depreciation rate of 2.564 less the depreciation allowed or allowable of component of the aircraft. Assume each percent for 2012) × 6/12). Thus, the adjusted $1,300 for the 10 disposed of items as of aircraft is a unit of property as determined depreciable basis of the retired elevator is December 31, 2011). Consequently, as of under § 1.263(a)–3T(e)(3). However, for tax $138,619.50 (the adjusted depreciable basis January 1, 2012, the 2010 pool of mass assets disposition purposes, B consistently treats of $140,542.50 removed from the building with a 5-year recovery period has 90 items each major component of an aircraft as the cost less the depreciation allowed or with a total cost of $22,500 and a asset. Thus, the retirement of the replaced allowable of $1,923 for 2012). As a result, D depreciation reserve of $11,700. Thus, the engines is a disposition. As a result, recognizes a loss of $138,619.50 for the depreciation allowance for this pool for 2012 depreciation for the retired engines ceases at retired elevator in 2012, which is subject to is $4,320 ($22,500 × 19.2 percent). the time of their retirement (taking into section 1231. Example 7. (i) Same facts as in Example account the applicable convention). B (iv) For D’s 2012 Federal income tax recognizes a loss upon this retirement. 6. Because of changes in E’s recordkeeping in return, the depreciation allowance for the 2013, it is impracticable for E to continue to Example 3. The facts are the same as in building is computed as follows. As of Example 2, except B treats each aircraft as identify disposed of mass assets using January 1, 2012, the unadjusted depreciable the asset for tax disposition purposes. specific identification and to determine the basis of the building is reduced from Assume each aircraft is a unit of property as unadjusted depreciable basis of the disposed $20,000,000 to $19,850,000 ($20,000,000 less determined under § 1.263(a)–3T(e)(3). Thus, of mass assets. As a result, E files a Form the unadjusted depreciable basis of $150,000 the replacement of the engines on one of the 3115, Application for Change in Accounting for the retired elevator), and the depreciation aircrafts is not a disposition. As a result, Method, to change to a first-in, first-out depreciation continues for the cost of the reserve of the building is reduced from method beginning with the taxable year aircraft (including the cost of the replaced $1,261,000 to $1,251,542.50 ($1,261,000 less beginning on January 1, 2013, on a modified engines) and B does not recognize a loss the depreciation allowed or allowable of cut-off basis. See § 1.446–1(e)(2)(ii)(d)(2)(vii). upon this replacement. $9,457.50 for the retired elevator as of Under the first-in, first-out method, the mass Example 4. C, a corporation, owns several December 31, 2011). Consequently, the assets disposed of in a taxable year are depreciation allowance for the building for deemed to be from the pool with the earliest trucks that are used in its trade or business × and described in asset class 00.241 of Rev. 2012 is $508,954 ($19,850,000 depreciation placed-in-service year that has assets as of Proc. 87–56. C replaces the engine on one of rate of 2.564 percent for 2012). the beginning of the taxable year of the the trucks with a new engine and treats each Example 6. (i) Since 2003, E, a calendar disposition with the same recovery period as engine of a truck as a major component of the year taxpayer, has accounted for items of the asset disposed of. The Commissioner of truck. Assume each truck is a unit of MACRS property that are mass assets in Internal Revenue consents to this change in property as determined under § 1.263(a)– pools. Each pool includes only the mass method of accounting. 3T(e)(3). Because the trucks are described in assets that have the same depreciation (ii) During 2013, E sells 20 items of mass asset class 00.241 of Rev. Proc. 87–56, C must method, recovery period, and convention, assets with a 5-year recovery period each for treat each truck as the asset for tax and are placed in service by E in the same $50. As of January 1, 2013, the 2006 pool is disposition purposes. Thus, the replacement taxable year. None of the pools are general the pool with the earliest placed-in-service of the engine on the truck is not a asset accounts under section 168(i)(4) and the year for mass assets with a 5-year recovery disposition. As a result, depreciation regulations under section 168(i)(4). E period, and this pool contains 25 items of continues for the cost of the truck (including identifies any dispositions of these mass mass assets with a total cost of $10,000 and the cost of the replaced engine) and C does assets by specific identification. a total depreciation reserve of $10,000. Thus, not recognize a loss upon this replacement. (ii) During 2012, E sells 10 items of mass E allocates a cost of $400 ($10,000 × (1/25)) Example 5. (i) On July 1, 2009, D, a assets with a 5-year recovery period each for to each disposed of mass asset and calendar-year taxpayer, purchased and $100. Under the specific identification depreciation allowed or allowable of $400 to placed in service a multi-story office building method, E identifies these mass assets as each disposed of mass asset. As a result, the that costs $20,000,000. The cost of each being from the pool established by E in 2010 adjusted depreciable basis of each disposed structural component of the building was not for mass assets with a 5-year recovery period. of mass asset is $0. Thus, E recognizes a gain separately stated. D accounts for the building Assume E depreciates this pool using the of $50 for each disposed of mass asset in in its records as a single asset with a cost of optional depreciation table that corresponds 2013, which is subject to section 1245. $20,000,000. D depreciates the building as with the general depreciation system, the (iii) Further, as of January 1, 2013, the nonresidential real property and uses the 200-percent declining balance method, a 5- unadjusted depreciable basis of the 2006 pool optional depreciation table that corresponds year recovery period, and the half-year of mass assets with a 5-year recovery period with the general depreciation system, the convention. E elected not to deduct the is reduced from $10,000 to $2,000 ($10,000 straight-line method, a 39-year recovery additional first year depreciation provided by less the unadjusted depreciable basis of period, and the mid-month convention. As of section 168(k) for 5-year property placed in $8,000 for the 20 disposed of items ($400 × January 1, 2012, the depreciation reserve for service during 2010. As of January 1, 2012, 20)), and the depreciation reserve of this the building is $1,261,000. this pool contains 100 similar items of mass 2006 pool is reduced from $10,000 to $2,000 (ii) On June 30, 2012, D replaces one of the assets with a total cost of $25,000 and a total ($10,000 less the depreciation allowed or building’s elevators. Because D cannot depreciation reserve of $13,000. Thus, E allowable of $8,000 for the 20 disposed of

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items as of December 31, 2012). § 1.263(a)–1T Capital expenditures; in (j) Accounting method changes. Consequently, as of January 1, 2013, the 2006 general (temporary). (k) Effective/applicability date. pool of mass assets with a 5-year recovery (a) General rule for capital (l) Expiration date. period has 5 items with a total cost of $2,000 expenditures. and a depreciation reserve of $2,000. (b) Coordination with section 263A. § 1.263(a)–3T Amounts paid to improve (i) Effective/applicability date. (1) tangible property (temporary). (c) Examples of capital expenditures. This section applies to taxable years (d) Amounts paid to sell property. (a) Overview. beginning on or after January 1, 2012. (1) In general. (b) Definitions. (2) Change in method of accounting. (2) Treatment of capitalized amount. (1) Amount paid. A change to comply with this section for (3) Examples. (2) Personal property. depreciable assets placed in service in a (e) Amount paid. (3) Real property. taxable year ending on or after (f) Accounting method changes. (4) Owner. December 30, 2003, is a change in (g) Effective/applicability date. (c) Coordination with other provisions method of accounting to which the (h) Expiration date. of the Internal Revenue Code. provisions of section 446(e) and the (1) In general. regulations under section 446(e) apply. § 1.263(a)–2T Amounts paid to acquire or (2) Materials and supplies. A taxpayer also may treat a change to produce tangible property (temporary). (3) Exception for amounts subject to comply with this section for depreciable (a) Overview. de minimis rule. assets placed in service in a taxable year (b) Definitions. (4) Example. ending before December 30, 2003, as a (1) Amount paid. (d) Requirement to capitalize amounts change in method of accounting to (2) Personal property. paid for improvements. which the provisions of section 446(e) (3) Real property. (e) Determining the unit of property. and the regulations under section 446(e) (4) Produce. (1) In general. apply. (c) Coordination with other provisions (2) Building. (3) Expiration Date. The applicability of the Internal Revenue Code. (i) In general. of this section expires on December 23, (1) In general. (ii) Application of improvement rules 2014. (2) Materials and supplies. to a building. ■ Par. 23. Section 1.263(a)–0 is (d) Acquired or produced tangible (A) Building structure. amended by: property. (B) Building system. ■ 1. Revising the section headings of the (1) Requirement to capitalize. (iii) Condominium. table of contents for §§ 1.263(a)–2 and (2) Examples. (A) In general. 1.263(a)–3. (e) Defense or perfection of title to (B) Application of improvement rules ■ 2. Adding entries to the table of property. to a condominium. contents for §§ 1.263(a)–1, 1.263(a)–2, (1) In general. (iv) Cooperative. and 1.263(a)–3. (2) Examples. (A) In general. The revisions and additions read as (f) Transaction costs. (B) Application of improvement rules follows: (1) In general. to a cooperative. (2) Scope of facilitate. (v) Leased building. § 1.263(a)–0 Table of contents. (i) In general. (A) In general. * * * * * (ii) Inherently facilitative amounts. (B) Application of improvement rules § 1.263(a)–1 Capital expenditures; in (iii) Special rule for acquisitions of to a leased building. general. real property. (1) Entire building. (A) In general. (2) Portion of building. (a) through (h) [Reserved]. For further (B) Acquisitions of real and personal (3) Property other than a building. guidance, see the table of contents for property in a single transaction. (i) In general. § 1.263(a)–1T(a) through (h) under (iv) Employee compensation and (ii) Plant property. § 1.263(a)–0T. overhead costs. (A) Definition. § 1.263(a)–2 Amounts paid to acquire or (A) In general. (B) Unit of property for plant produce tangible property. (B) Election to capitalize. property. (a) through (i) [Reserved]. For further (3) Treatment of transaction costs. (iii) Network assets. guidance, see the table of contents for (i) In general. (A) Definition. § 1.263(a)–2T(a) through (i) under (ii) Treatment of inherently (B) Unit of property for network § 1.263(a)–0T. facilitative amounts. assets. (4) Examples. (iv) Leased property other than § 1.263(a)–3 Amounts paid to improve (g) De minimis rule. buildings. tangible property. (1) In general. (4) Improvements to property. (a) through (q) [Reserved]. For further (2) Exceptions to de minimis rule. (5) Additional rules. guidance, see the table of contents for (3) Additional rules. (i) Year placed in service. § 1.263(a)–3T(a) though (q) under (4) Election to capitalize. (ii) Change in subsequent taxable § 1.263(a)–0T. (5) Materials and supplies. year. * * * * * (6) Definition of applicable financial (6) Examples. ■ Par. 24. Section 1.263(a)–0T is added statement. (f) Special rules for determining to read as follows: (7) Application to consolidated group improvement costs. member. (1) Improvements to leased property. § 1.263(a)–0T Table of contents (8) Examples. (i) In general. (temporary). (h) Treatment of capital expenditures. (ii) Lessee improvements. This section lists the table of contents (i) Recovery of capitalized amounts. (A) Requirement to capitalize. for §§ 1.263(a)–1T, 1.263(a)–2T, and (1) In general. (B) Unit of property for lessee 1.263(a)–3T. (2) Examples. improvements.

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(iii) Lessor improvements. (d) through (h) [Reserved]. For further (d) Amounts paid to sell property— (A) Requirement to capitalize. guidance, see § 1.263(a)–1T(d) through (1) In general. Commissions and other (B) Unit of property for lessor (h). transaction costs paid to facilitate the improvements. ■ Par. 26. Section 1.263(a)–1T is added sale of property generally must be (iv) Examples. to read as follows: capitalized. However, in the case of (2) Compliance with regulatory dealers in property, amounts paid to requirements. § 1.263(a)–1T Capital expenditures; in facilitate the sale of property are treated (3) Certain costs incurred during an general (temporary)— as ordinary and necessary business improvement. (a) General rule for capital expenses. See § 1.263(a)–5(g) for the (i) In general. expenditures. Except as provided in treatment of amounts paid to facilitate (ii) Exception for individuals’ chapter 1 of the Internal Revenue Code, the disposition of assets that constitute residences. no deduction is allowed for— a trade or business. (4) Aggregate of related amounts. (1) Any amount paid for new (2) Treatment of capitalized amount. (g) Safe harbor for routine buildings or for permanent Amounts capitalized under paragraph maintenance on property other than improvements or betterments made to (d)(1) of this section are treated as a buildings. increase the value of any property or reduction in the amount realized and (1) In general. estate; or generally are taken into account either (2) Rotable and temporary spare parts. (2) Any amount paid in restoring in the taxable year in which the sale (3) Exceptions. property or in making good the occurs or in the taxable year in which (4) Class life. exhaustion thereof for which an the sale is abandoned if a loss deduction (5) Examples. allowance is or has been made. is permissible. The capitalized amount (h) Capitalization of betterments. (b) Coordination with section 263A. is not added to the basis of the property (1) In general. Section 263(a) generally requires (2) Betterments to buildings. and is not treated as an intangible under taxpayers to capitalize an amount paid § 1.263(a)–4. (3) Application of general rule. to acquire, produce, or improve real or (i) Facts and circumstances. (3) Examples. The following personal tangible property. Section examples, which assume the sale is not (ii) Unavailability of replacement 263A generally prescribes the direct and parts. an installment sale under section 453, indirect costs that must be capitalized to illustrate the rules of this paragraph (d): (iii) Appropriate comparison. property produced by the taxpayer and (A) In general. Example 1. Sales costs of real property. X property acquired for resale. (B) Normal wear and tear. owns a parcel of real estate. X sells the real (c) Examples of capital expenditures. (C) Particular event. estate and pays legal fees, recording fees, and The following amounts paid are (4) Examples. sales commissions to facilitate the sale. X (i) Capitalization of restorations. examples of capital expenditures: must capitalize the fees and commissions (1) In general. (1) An amount paid to acquire or and, in the taxable year of the sale, offset the fees and commissions against the amount (2) Restorations of buildings. produce a unit of real or personal tangible property. See § 1.263(a)–2T. realized from the sale of the real estate. (3) Rebuild to like-new condition. Example 2. Sales costs of dealers. Assume (4) Replacement of a major (2) An amount paid to improve a unit of real or personal tangible property. See the same facts as in Example 1, except that component or substantial structural X is a dealer in real estate. The commissions part. § 1.263(a)–3T. and fees paid to facilitate the sale of the real (5) Examples. (3) An amount paid to acquire or estate are treated as ordinary and necessary (j) Capitalization of amounts to adapt create intangibles. See § 1.263(a)–4. business expenses under section 162. property to a new or different use. (4) An amount paid or incurred to Example 3. Sales costs of personal property (1) In general. facilitate an acquisition of a trade or used in a trade or business. X owns a truck (2) Adapting buildings to new or business, a change in capital structure of for use in X’s trade or business. X decides to sell the truck on November 15, Year 1. X pays different use. a business entity, and certain other transactions. See § 1.263(a)–5. for an appraisal to determine a reasonable (3) Examples. asking price. On February 15, Year 2, X sells (k) Optional regulatory accounting (5) An amount paid to acquire or create interests in land, such as the truck to Y. X is required to capitalize in method. Year 1 the amount paid to appraise the truck (1) In general. easements, life estates, mineral interests, and, in Year 2, is required to offset the (2) Eligibility for regulatory timber rights, zoning variances, or other amount paid against the amount realized accounting method. interests in land. from the sale of the truck. (3) Description of regulatory (6) An amount assessed and paid Example 4. Costs of abandoned sale of accounting method. under an agreement between personal property used in a trade or business. bondholders or shareholders of a Assume the same facts as in Example 3, (4) Examples. except that, instead of selling the truck on (l) Methods of accounting authorized corporation to be used in a reorganization of the corporation or February 15, Year 2, X decides on that date in published guidance. not to sell the truck and takes the truck off (m) Treatment of capital expenditures. voluntary contributions by shareholders the market. X is required to capitalize in Year (n) Recovery of capitalized amounts. to the capital of the corporation for any 1 the amount paid to appraise the truck. (o) Accounting method changes. corporate purpose. See section 118 and However, X may treat the amount paid to (p) Effective/applicability date. § 1.118–1. appraise the truck as a loss under section 165 (q) Expiration date. (7) An amount paid by a holding in Year 2 when the sale is abandoned. ■ Par. 25. Section 1.263(a)–1 is revised company to carry out a guaranty of Example 5. Sales costs of personal property not used in a trade or business. Assume the to read as follows: dividends at a specified rate on the stock of a subsidiary corporation for the same facts as in Example 3, except that X § 1.263(a)–1 Capital expenditures; in purpose of securing new capital for the does not use the truck in X’s trade or general. business, but instead uses it for personal subsidiary and increasing the value of purposes. X decides to sell the truck and on (a) through (c) [Reserved]. For further its stockholdings in the subsidiary. This November 15, Year 1, X pays for an appraisal guidance, see § 1.263(a)&1T(a) through amount must be added to the cost of the to determine a reasonable asking price. On (c). stock in the subsidiary. February 15, Year 2, X sells the truck to Y.

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X is required to capitalize in Year 1 the § 1.263(a)–2T Amounts paid to acquire or 2(a)(1)(i), except that improvements are amount paid to appraise the truck and, in produce tangible property (temporary). excluded from the definition in this Year 2, is required to offset the amount paid (a) Overview. This section provides paragraph (b)(4) and are separately against the amount realized from the sale of rules for applying section 263(a) to defined and addressed in § 1.263(a)–3T. the truck. amounts paid to acquire or produce a (c) Coordination with other provisions Example 6. Costs of abandoned sale of personal property not used in a trade or unit of real or personal property. of the Internal Revenue Code—(1) In business. Assume the same facts as in Paragraph (b) of this section contains general. Except as provided under the Example 5, except that, instead of selling the definitions. Paragraph (c) of this section de minimis rule in paragraph (g) of this truck on February 15, Year 2, X decides on contains the rules for coordinating this section, nothing in this section changes that date not to sell the truck and takes the section with other provisions of the the treatment of any amount that is truck off the market. X is required to Internal Revenue Code. Paragraph (d) of specifically provided for under any capitalize in Year 1 the amount paid to this section provides the general provision of the Internal Revenue Code appraise the truck. Although the sale is requirement to capitalize amounts paid or regulations thereunder other than abandoned in Year 2, X may not treat the to acquire or produce a unit of real or section 162(a) or section 212 and the amount paid to appraise the truck as a loss personal property. Paragraph (e) of this regulations under those sections. For under section 165 because the truck was not used in X’s trade or business or in a section provides the requirement to example, see section 263A requiring transaction entered into for profit. capitalize amounts paid to defend or taxpayers to capitalize the direct and perfect title to real or personal property. indirect costs of producing property or (e) Amount paid. In the case of a Paragraph (f) of this section provides the acquiring property for resale. See also taxpayer using an accrual method of rules for determining the extent to section 195 requiring taxpayers to accounting, the terms amount paid and which taxpayers must capitalize capitalize certain costs as start-up payment mean a liability incurred transaction costs related to the expenditures. (within the meaning of § 1.446– acquisition of property. Paragraph (g) of (2) Materials and supplies. Except as 1(c)(1)(ii)). A liability may not be taken this section provides a de minimis rule provided under the de minimis rule in into account under this section prior to for certain amounts paid for the paragraph (g) of this section, nothing in the taxable year during which the acquisition or production of property. this section changes the treatment of liability is incurred. Paragraphs (h) and (i) of this section amounts paid to acquire or produce (f) Accounting method changes. address the treatment and recovery of property that is properly treated as Except as otherwise provided in this capital expenditures. Paragraph (j) of materials and supplies under § 1.162– section, a change to comply with this this section provides for changes in 3T. section is a change in method of methods of accounting to comply with (d) Acquired or produced tangible accounting to which the provisions of this section, and paragraphs (k) and (l) property—(1) Requirement to capitalize. sections 446 and 481, and the of this section provide the effective, Except as provided in paragraph (g) of regulations thereunder apply. A applicability, and expiration dates for this section (providing the de minimis taxpayer seeking to change to a method the rules under this section. rule) and in § 1.162–3T (relating to of accounting permitted in this section (b) Definitions. For purposes of this materials and supplies), a taxpayer must must secure the consent of the section, the following definitions apply: capitalize amounts paid to acquire or Commissioner in accordance with (1) Amount paid. In the case of a produce a unit of real or personal § 1.446–1(e) and follow the taxpayer using an accrual method of property (as determined under administrative procedures issued under accounting, the terms amount paid and § 1.263(a)–3T(e)), including leasehold § 1.446–1(e)(3)(ii) for obtaining the payment mean a liability incurred improvement property, land and land Commissioner’s consent to change its (within the meaning of § 1.446– improvements, buildings, machinery accounting method. 1(c)(1)(ii)). A liability may not be taken and equipment, and furniture and (g) Effective/applicability date. This into account under this section prior to fixtures. Amounts paid to acquire or section applies to taxable years the taxable year during which the produce a unit of real or personal beginning on or after January 1, 2012. liability is incurred. property include the invoice price, For the applicability of regulations to (2) Personal property means tangible transaction costs as determined under taxable years beginning before January personal property as defined in § 1.48– paragraph (f) of this section, and costs 1, 2012, see § 1.263(a)–1 in effect prior 1(c). for work performed prior to the date that to January 1, 2012 (§ 1.263(a)–1 as (3) Real property means land and the unit of property is placed in service contained in 26 CFR part 1 edition improvements thereto, such as buildings by the taxpayer (without regard to any revised as of April 1, 2011). or other inherently permanent applicable convention under section (h) Expiration date. The applicability structures (including items that are 168(d)). A taxpayer also must capitalize of this section expires on December 23, structural components of the buildings amounts paid to acquire real or personal 2014. or structures) that are not personal property for resale and to produce real property as defined in paragraph (b)(2) or personal property. See section 263A ■ Par. 27. Section 1.263(a)–2 is revised of this section. Any property that for the costs required to be capitalized to read as follows: constitutes other tangible property to property produced by the taxpayer or § 1.263(a)–2 Amounts paid to acquire or under § 1.48–1(d) is treated as real to property acquired for resale. produce tangible property. property for purposes of this section. (2) Examples. The rules of this section Local law is not controlling in are illustrated by the following (a) through (h) [Reserved]. For further determining whether property is real examples, in which it is assumed that guidance, see §§ 1.263(a)–2T(a) through property for purposes of this section. the taxpayer does not apply the de (h). (4) Produce means construct, build, minimis rule under paragraph (g) of this (i) through (l) [Reserved]. For further install, manufacture, develop, create, section: guidance, see §§ 1.263(a)–2T(i) through raise, or grow. This definition is Example 1. Acquisition of personal (l). intended to have the same meaning as property. X purchases new cash registers for ■ Par. 28. Section 1.263(a)–2T is added the definition used for purposes of use in its retail store located in leased space to read as follows: section 263A(g)(1) and § 1.263A– in a shopping mall. Assume each cash

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register is a unit of property as determined section 263A for the costs required to be costs required to be capitalized to under § 1.263(a)–3T(e) and is not a material capitalized to the property produced or property produced by the taxpayer or to or supply under § 1.162–3T. X must property acquired for resale. property acquired for resale. capitalize under this paragraph (d)(1) the Example 8. Production of building. X (2) Examples. The following examples constructs a building. X must capitalize amount paid to acquire each cash register. illustrate the rule of paragraph (e): Example 2. Acquisition of personal under paragraph (d)(1) of this section the property that is a material or supply; amount paid to construct the building. See Example 1. Amounts paid to contest coordination with § 1.162–3T. X operates a section 263A for the costs required to be condemnation. X owns real property located fleet of aircraft. In Year 1, X acquires a stock capitalized to the real property produced by in County. County files an eminent domain of component parts, which it intends to use X. complaint condemning a portion of X’s to maintain and repair its aircraft. X does not Example 9. Acquisition of assets property to use as a roadway. X hires an make elections under § 1.162–3T(d) to treat constituting a trade or business. Y owns attorney to contest the condemnation. The the materials and supplies as capital tangible and intangible assets that constitute amounts that X paid to the attorney must be expenditures. In Year 2, X uses the a trade or business. X purchases all the assets capitalized because they were to defend X’s component parts in the repair and of Y in a taxable transaction. X must title to the property. maintenance of its aircraft. Because the parts capitalize under paragraph (d)(1) of this Example 2. Amounts paid to invalidate are materials and supplies under § 1.162–3T, section the amount paid for the tangible ordinance. X is in the business of quarrying X is not required to capitalize the amounts assets of Y. See § 1.263(a)–4 for the treatment and supplying for sale sand and stone in a paid for the parts under this paragraph (d)(1). of amounts paid to acquire intangibles and certain municipality. Several years after X Rather, X must apply the rules in § 1.162–3T, § 1.263(a)–5 for the treatment of amounts establishes its business, the municipality in governing the treatment of materials and paid to facilitate the acquisition of assets that which it is located passes an ordinance that supplies, to determine the treatment of these constitute a trade or business. See section prohibits the operation of X’s business. X amounts. 1060 for special allocation rules for certain incurs attorney’s fees in a successful Example 3. Acquisition of unit of personal asset acquisitions. prosecution of a suit to invalidate the property; coordination with § 1.162–3T. X Example 10. Work performed prior to municipal ordinance. X prosecutes the suit to operates a rental business that rents out a placing the property in service. In Year 1, X preserve its business activities and not to variety of small individual items to purchases a building for use as a business defend X’s title in the property. Therefore, customers (rental items). X maintains a office. Prior to placing the building in the attorney’s fees that X paid are not supply of rental items on hand to replace service, X incurs costs to repair cement steps, required to be capitalized under paragraph worn or damaged items. X purchases a large refinish wood floors, patch holes in walls, (e)(1) of this section. See section 263A for the quantity of rental items to be used in its and paint the interiors and exteriors of the rules requiring direct and allocable indirect business. Assume that each of these rental building. In Year 2, X places the building in costs (including otherwise deductible costs) items is a unit of property under § 1.263(a)– service and begins using the building as its to be capitalized to property produced or 3T(e). Also assume that a portion of the business office. Assume that the work that X property acquired for resale. rental items are materials and supplies under performs does not constitute an improvement Example 3. Amounts paid to challenge § 1.162–3T(c)(1). Under paragraph (d)(1) of to the building or its structural components building line. The board of public works of this section, X must capitalize the amounts under § 1.263(a)–3T. Under § 1.263– a municipality establishes a building line paid for the rental items that are not 3T(e)(2)(i), the building and its structural across X’s business property, adversely materials and supplies under § 1.162– components is a single unit of property. affecting the value of the property. X incurs 3T(c)(1). However, X must apply the rules in Under paragraph (d)(1) of this section, the legal fees in unsuccessfully litigating the establishment of the building line. The § 1.162–3T to determine the treatment of the amounts paid must be capitalized as costs of amounts X paid to the attorney must be rental items that are materials and supplies acquiring the building because they were for capitalized because they were to defend X’s under § 1.162–3T(c)(1). work performed prior to X’s placing the title to the property. Example 4. Acquisition or production cost. building in service. X purchases and produces jigs, dies, molds, Example 11. Work performed prior to (f) Transaction costs—(1) In general. placing the property in service. In January and patterns for use in the manufacture of X’s Year 1, X purchases a new machine for use A taxpayer must capitalize amounts products. Assume that each of these items is in an existing production line of its paid to facilitate the acquisition or a unit of property as determined under manufacturing business. Assume that the production of real or personal property. § 1.263(a)–3T(e) and is not a material and machine is a unit of property under See section 263A for the costs required supply under § 1.162–3T(c)(1). X is required § 1.263(a)–3T(e) and is not a material or to capitalize under paragraph (d)(1) of this to be capitalized to property produced supply under § 1.162–3T. After the machine section the amounts paid to acquire and by the taxpayer or to property acquired is installed, X performs a critical test on the produce the jigs, dies, molds, and patterns. for resale. See § 1.263(a)–5 for the machine to ensure that it will operate in See section 263A for the costs required to be treatment of amounts paid to facilitate accordance with quality standards. On capitalized to the property acquired or November 1, Year 1, the critical test is the acquisition of assets that constitute produced by X. complete, and X places the machine in a trade or business. See § 1.167(a)–5 for Example 5. Acquisition of land. X service on the production line. X performs allocations of facilitative costs between purchases a parcel of undeveloped real periodic quality control testing after the depreciable and non-depreciable estate. X must capitalize under paragraph machine is placed in service. Under property. (d)(1) of this section the amount paid to paragraph (d)(1) of this section, the amounts (2) Scope of facilitate—(i) In general. acquire the real estate. See paragraph (f) of paid for the installation and the critical test Except as otherwise provided in this this section for the treatment of amounts paid performed before the machine is placed in to facilitate the acquisition of real property. section, an amount is paid to facilitate service must be capitalized as costs of the acquisition of real or personal Example 6. Acquisition of building. X acquiring the machine. However, amounts purchases a building. X must capitalize paid for periodic quality control testing after property if the amount is paid in the under paragraph (d)(1) of this section the X placed the machine in service are not process of investigating or otherwise amount paid to acquire the building. See required to be capitalized as a cost of pursuing the acquisition. Whether an paragraph (f) of this section for the treatment acquiring the machine. amount is paid in the process of of amounts paid to facilitate the acquisition (e) Defense or perfection of title to investigating or otherwise pursuing the of real property. property—(1) In general. Amounts paid acquisition is determined based on all of Example 7. Acquisition of property for resale and production of property for sale. to defend or perfect title to real or the facts and circumstances. In X purchases goods for resale and produces personal property are amounts paid to determining whether an amount is paid other goods for sale. X must capitalize under acquire or produce property within the to facilitate an acquisition, the fact that paragraph (d)(1) of this section the amounts meaning of this section and must be the amount would (or would not) have paid to acquire and produce the goods. See capitalized. See section 263A for the been paid but for the acquisition is

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relevant but is not determinative. property is acquired in a single expenditures. Facilitative amounts Amounts paid to facilitate an transaction that also includes the allocable to real or personal property acquisition include, but are not limited acquisition of real property subject to must be included in the basis of the to, inherently facilitative amounts the special rule set out in paragraph property acquired or produced. specified in paragraph (f)(2)(ii) of this (f)(2)(iii)(A) of this section. A taxpayer (ii) Treatment of inherently section. may use a reasonable allocation to facilitative amounts. Inherently (ii) Inherently facilitative amounts. determine which costs facilitate the facilitative amounts allocable to real or An amount is paid in the process of acquisition of personal property and personal property are capital investigating or otherwise pursuing the which costs relate to the acquisition of expenditures related to such property acquisition of real or personal property real property and are subject to the even if the property is not eventually if the amount is inherently facilitative. special rule of paragraph (f)(2)(iii)(A) of acquired or produced. Inherently An amount is inherently facilitative if this section. facilitative amounts allocable to real or the amount is paid for— (iv) Employee compensation and personal property not acquired may be (A) Transporting the property (for overhead costs—(A) In general. For allocated to those properties and example, shipping fees and moving purposes of paragraph (f) of this section, recovered as appropriate in accordance costs); amounts paid for employee with the applicable provisions of the (B) Securing an appraisal or compensation (within the meaning of Internal Revenue Code and the determining the value or price of § 1.263(a)–4(e)(4)(ii)) and overhead are regulations thereunder (for example, property; treated as amounts that do not facilitate sections 165, 167, or 168). See (C) Negotiating the terms or structure the acquisition of real or personal paragraph (i) of this section for the of the acquisition and obtaining tax property. See section 263A, however, recovery of capitalized amounts. advice on the acquisition; for the treatment of employee (4) Examples. The following examples (D) Application fees, bidding costs, or compensation and overhead costs illustrate the rules of paragraph (f) of similar expenses; required to be capitalized to property this section: (E) Preparing and reviewing the produced by the taxpayer or to property Example 1. Broker’s fees to facilitate an documents that effectuate the acquired for resale. acquisition. X decides to purchase a building acquisition of the property (for example, (B) Election to capitalize. A taxpayer in which to relocate its offices and hires a preparing the bid, offer, sales contract, may elect to treat amounts paid for real estate broker to find a suitable building. or purchase agreement); employee compensation or overhead as X pays fees to the broker to find property for (F) Examining and evaluating the title amounts that facilitate the acquisition of X to acquire. Under paragraph (f)(2)(ii)(I) of of property; property. The election is made this section, X must capitalize the amounts (G) Obtaining regulatory approval of separately for each acquisition and paid to the broker because these costs are the acquisition or securing permits applies to employee compensation or inherently facilitative of the acquisition of related to the acquisition, including overhead, or both. For example, a real property. Example 2. Inspection and survey costs to application fees; taxpayer may elect to treat overhead, but facilitate an acquisition. X decides to (H) Conveying property between the not employee compensation, as amounts purchase building A and pays amounts to parties, including sales and transfer that facilitate the acquisition of third-party contractors for a termite taxes, and title registration costs; property. A taxpayer makes the election inspection and an environmental survey of (I) Finders’ fees or brokers’ by treating the amounts to which the building A. Under paragraph (f)(2)(ii)(J) of commissions, including amounts paid election applies as amounts that this section, X must capitalize the amounts that are contingent on the successful facilitate the acquisition in the paid for the inspection and the survey of the closing of the acquisition; taxpayer’s timely filed original Federal building because these costs are inherently (J) Architectural, geological, income tax return (including facilitative of the acquisition of real property. engineering, environmental, or extensions) for the taxable year during Example 3. Moving costs to facilitate an inspection services pertaining to acquisition. X purchases all the assets of Y which the amounts are paid. In the case and, in connection with the purchase, hires particular properties; or of an S corporation or a partnership, the a transportation company to move storage (K) Services provided by a qualified election is made by the S corporation or tanks from Y’s plant to X’s plant. Under intermediary or other facilitator of an by the partnership, and not by the paragraph (f)(2)(ii)(A) of this section, X must exchange under section 1031. shareholders or partners. A taxpayer capitalize the amount paid to move the (iii) Special rule for acquisitions of may revoke an election made under this storage tanks from Y’s plant to X’s plant real property—(A) In general. Except as paragraph (f)(2)(iv)(B) with respect to because this cost is inherently facilitative to provided in paragraph (f)(2)(ii) of this each acquisition only by filing a request the acquisition of personal property. section (relating to inherently for a private letter ruling and obtaining Example 4. Geological and geophysical facilitative amounts), an amount paid by the Commissioner’s consent to revoke costs; coordination with other provisions. X the taxpayer in the process of is in the business of exploring, purchasing, the election. The Commissioner may and developing properties in the United investigating or otherwise pursuing the grant a request to revoke this election if States for the production of oil and gas. X acquisition of real property does not the taxpayer can demonstrate good considers acquiring a particular property but facilitate the acquisition if it relates to cause for the revocation. An election first incurs costs for the services of an activities performed in the process of may not be made or revoked through the engineering firm to perform geological and determining whether to acquire real filing of an application for change in geophysical studies to determine if the property and which real property to accounting method or, before obtaining property is suitable for oil or gas production. acquire. the Commissioner’s consent to make the Assume that the amounts that X paid to the (B) Acquisitions of real and personal late election or to revoke the election, by engineering firm constitute geological and property in a single transaction. An geophysical expenditures under section filing an amended Federal income tax 167(h). Although the amounts that X paid for amount paid by the taxpayer in the return. the geological and geophysical services are process of investigating or otherwise (3) Treatment of transaction costs—(i) inherently facilitative to the acquisition of pursuing the acquisition of personal In general. All amounts paid to facilitate real property under paragraph (f)(2)(ii)(J) of property facilitates the acquisition of the acquisition or production of real or this section, X is not required to include such personal property even if such personal property are capital those amounts in the basis of the real

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property acquired. Rather, under paragraph determining whether to acquire real property (B) 2 percent of the taxpayer’s total (c) of this section, X must capitalize these and which real property to acquire and the depreciation and amortization expense costs separately and amortize such costs as amounts are not inherently facilitative costs for the taxable year as determined in its required under section 167(h) (addressing the under paragraph (f)(2)(ii) of this section. applicable financial statement. amortization of geological and geophysical However, X must capitalize amounts paid to (2) Exceptions to de minimis rule. The expenditures). the appraiser in Year 1 because the appraisal Example 5. Scope of facilitate. X is in the costs are inherently facilitative costs under de minimis rule in paragraph (g)(1) of business of providing legal services to paragraph (f)(2)(ii)(B) of this section. In Year this section does not apply to the clients. X is interested in acquiring a new 2, X must include the appraisal costs following: conference table for its office. X hires and allocable to property acquired in the basis of (i) Amounts paid for property that is incurs fees for an interior designer to shop the property acquired and may recover the or is intended to be included in for, evaluate, and make recommendations to appraisal costs allocable to the property not inventory property; and X regarding which new table to acquire. acquired in accordance with paragraphs (ii) Amounts paid for land. Under paragraphs (f)(1) and (2) of this (f)(3)(ii) and (i) of this section. (3) Additional rules. Property to section, X must capitalize the amounts paid Example 9. Employee compensation and which a taxpayer applies the de to the interior designer to provide these overhead. X, a freight carrier, maintains an minimis rule contained in paragraph (g) services because they are paid in the process acquisition department whose sole function of this section is not treated upon sale of investigating or otherwise pursuing the is to arrange for the purchase of vehicles and acquisition of personal property. aircraft from manufacturers or other parties or other disposition as a capital asset Example 6. Transaction costs allocable to to be used in its freight carrying business. As under section 1221 or as property used multiple properties. X, a retailer, wants to provided in paragraph (f)(2)(iv)(A) of this in the trade or business under section acquire land for the purpose of building a section, X is not required to capitalize any 1231. The cost of property to which a new distribution facility for its products. X portion of the compensation paid to taxpayer properly applies the de considers various properties on highway A in employees in its acquisition department or minimis rule contained in paragraph (g) state B. X incurs fees for the services of an any portion of its overhead allocable to its of this section is not required to be architect to advise and evaluate the acquisition department. However, under capitalized under section 263A to a suitability of the sites for the type of facility paragraph (f)(2)(iv)(B) of this section, X may separate unit of property but may be elect to capitalize the compensation and that X intends to construct on the selected required to be capitalized as a cost of site. X must capitalize the architect fees as overhead costs allocable to the acquisition of amounts paid to acquire land because these a vehicle or aircraft by treating these amounts other property if incurred by reason of amounts are inherently facilitative to the as costs that facilitate the acquisition of that the production of the other property. acquisition of land under paragraph property in its timely filed original federal See, for example, § 1.263A–1(e)(3)(ii)(R) (f)(2)(ii)(J) of this section. income tax return for the year the amounts requiring taxpayers to capitalize the cost Example 7. Transaction costs allocable to are paid. of tools and equipment allocable to multiple properties. X, a retailer, wants to (g) De minimis rule—(1) In general. property produced or property acquired acquire land for the purpose of building a Except as otherwise provided in this for resale. new distribution facility for its products. X (4) Election to capitalize. A taxpayer considers various properties on highway A in paragraph (g), a taxpayer is not required to capitalize under paragraph (d)(1) of may elect not to apply the de minimis state B. X incurs fees for the services of an rule contained in paragraph (g)(1) of this architect to prepare preliminary floor plans this section nor treat as a material or for a building that X could construct at any supply under § 1.162–3T(a) amounts section. An election made under this of the sites. Under these facts, the architect’s paid for the acquisition or production paragraph (g)(4) may apply to any unit fees are not inherently facilitative to the (including any amounts paid to of property during the taxable year to acquisition of land under paragraph facilitate the acquisition or production) which paragraph (g)(1) of this section (f)(2)(iii)(J) of this section but are allocable as of a unit of property (as determined would apply (but for the election under construction costs of the building under under § 1.263(a)–3T(e)) or for the this paragraph (g)(4)). A taxpayer makes section 263A. Therefore, X does not acquisition or production of any the election by capitalizing the amounts capitalize the architect fees as amounts paid paid to acquire or produce the unit of to acquire land but instead must capitalize material or supply (as defined in § 1.162–3T(c)(1)) if— property in the taxable year the amounts these costs as indirect costs allocable to the are paid and by beginning to recover the production of property under section 263A. (i) The taxpayer has an applicable Example 8. Special rule for acquisitions of financial statement (as defined in costs when the unit of property is real property. X owns several retail stores. X paragraph (g)(6) of this section); placed in service by the taxpayer for the decides to examine the feasibility of opening (ii) The taxpayer has at the beginning purposes of determining depreciation a new store in city A. In October, Year 1, X of the taxable year written accounting under the applicable provisions of the hires and incurs costs for a development procedures treating as an expense for Internal Revenue Code and the consulting firm to study city A and perform non-tax purposes the amounts paid for regulations thereunder. A taxpayer must market surveys, evaluate zoning and property costing less than a certain make this election on its timely filed environmental requirements, and make dollar amount; original Federal income tax return preliminary reports and recommendations as (including extensions) for the taxable to areas that X should consider for purposes (iii) The taxpayer treats the amounts of locating a new store. In December, Year 1, paid during the taxable year as an year the unit of property is placed in X continues to consider whether to purchase expense on its applicable financial service by the taxpayer for the purposes real property in city A and which property statement in accordance with its written of determining depreciation. In the case to acquire. X hires, and incurs fees for, an accounting procedures; and of an S corporation or a partnership, the appraiser to perform appraisals on two (iv) The total aggregate of amounts election is made by the S corporation or different sites to determine a fair offering paid and not capitalized under by the partnership, and not by the price for each site. In March, Year 2, X paragraph (g)(1) of this section and shareholders or partners. A taxpayer decides to acquire one of these two sites for § 1.162–3T(f) (materials and supplies) may revoke an election made under this the location of its new store. At the same paragraph (g)(4) with respect to a unit of time, X determines not to acquire the other for the taxable year are less than or site. Under paragraph (f)(2)(iii) of this equal to the greater of— property only by filing a request for a section, X is not required to capitalize (A) 0.1 percent of the taxpayer’s gross private letter ruling and obtaining the amounts paid to the development consultant receipts for the taxable year as Commissioner’s consent to revoke the in Year 1 because the amounts relate to determined for Federal income tax election. The Commissioner may grant a activities performed in the process of purposes; or request to revoke this election if the

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taxpayer can demonstrate good cause for $2,000. Assume that each printer is a unit of is a corporation that provides consulting the revocation. An election may not be property under § 1.263(a)–3T(e) and is not a services to its customers. X has an applicable made or revoked through the filing of an material or supply under § 1.162–3T. X has financial statement and a written policy at application for change in accounting an applicable financial statement and a the beginning of the taxable year to expense written policy at the beginning of the taxable amounts paid for property costing $500 or method or by filing an amended Federal year to expense amounts paid for property less. In Year 1, X purchases 200 computers income tax return. costing less than $500. X treats the amounts at $500 each for a total cost of $100,000. (5) Materials and supplies. A taxpayer paid for the printers as an expense on its Assume that each computer is a unit of must treat amounts paid to acquire or applicable financial statement. Assume that property under § 1.263(a)–3T(e) and is not a produce a unit of property that is a the total aggregate amounts treated as de material or supply under § 1.162–3T. In material or supply as defined under minimis and not capitalized by X under addition, X purchases 200 office chairs at § 1.162–3T(c)(1) under § 1.162–3T paragraphs (g)(1)(i), (ii), and (iii) of this $100 each for a total cost of $20,000 and 250 unless the taxpayer elects under section, including the amounts paid for the customized briefcases at $80 each for a total § 1.162–3T(f) to apply the de minimis printers, are less than or equal to the greater cost of $20,000. Assume that each office chair of 0.1 percent of total gross receipts or 2 and each briefcase is a material or supply rule to that property under this percent of X’s total financial statement paragraph (g). Property to which a under § 1.162–3T(c)(1). In Year 1, X also depreciation under paragraph (g)(1)(iv) of acquires 10 books at $100 each, which are taxpayer applies the de minimis rule this section. X is not required to capitalize also materials and supplies under § 1.162– contained in paragraph (g) of this the amounts paid for the 10 printers under 3T(c)(1). X makes the election under § 1.162– section is not treated as a material or paragraph (g)(1) of this section. 3T(f) to apply the de minimis rule to the supply under § 1.162–3T. Example 2. De minimis rule not met. X is office chairs and briefcases, but does not a member of a consolidated group for federal (6) Definition of applicable financial make that election for the books and treats income tax purposes. X’s financial results are statement. For purposes of this section the books as materials and supplies in reported on the consolidated applicable accordance with the provisions of § 1.162– (g), the taxpayer’s applicable financial financial statements for the affiliated group. 3T. X treats the amounts paid for the statement is the taxpayer’s financial X’s affiliated group has a written policy at the statement listed in paragraphs (g)(6)(i) beginning of Year 1, which is followed by X, computers, office chairs, and briefcases as through (iii) of this section that has the to expense amounts paid for property costing expenses on its applicable financial statement. Assume also that for Year 1, the highest priority (including within less than $500. In Year 1, X pays $160,000 to purchase 400 computers at $400 each. amounts that X paid for the computers, office paragraph (g)(6)(ii) of this section). The chairs, and briefcases are the only amounts financial statements are, in descending Assume that each computer is a unit of property under § 1.263(a)–3T(e), is not a that X intends to treat as de minimis costs priority— material or supply under § 1.162–3T, and not capitalized under paragraph (g)(1) of this (i) A financial statement required to that X intends to treat the cost of only the section. For its Year 1 taxable year, X has be filed with the Securities and computers as de minimis under paragraph gross receipts of $125,000,000 and reports Exchange Commission (SEC) (the 10–K (g)(1) of this section. X treats the amounts $7,000,000 of depreciation and amortization or the Annual Statement to paid for the computers as an expense on the on its applicable financial statement. Shareholders); applicable financial statements for the (ii) In order to meet the requirements of (ii) A certified audited financial affiliated group. For its Year 1 taxable year, paragraph (g)(1)(iv) of this section for Year 1, statement that is accompanied by the X has gross receipts of $125,000,000 for X’s total aggregate amounts paid and not capitalized under paragraphs (g)(1)(i), (ii), report of an independent CPA (or in the Federal tax purposes and reports $7,000,000 of it’s own depreciation and amortization and (iii) of this section must be less than or case of a foreign entity, by the report of expense on the affiliated group’s applicable equal to the greater of $125,000 (0.1 percent a similarly qualified independent financial statement. Thus, in order to meet of X’s total gross receipts of $125,000,000) or professional), that is used for— the criteria of paragraph (g)(1)(iv) of this $140,000 (2 percent of X’s total depreciation (A) Credit purposes; section for Year 1, the total aggregate and amortization of $7,000,000). X pays a (B) Reporting to shareholders, amounts paid and not capitalized by X under total of $140,000 ($100,000 + $20,000 + partners, or similar persons; or paragraphs (g)(1)(i), (ii), and (iii) of this $20,000) for the computers, office chairs, and (C) Any other substantial non-tax section must be less than or equal to the briefcases. X is not required to include the purpose; or greater of $125,000 (0.1 percent of X’s total amounts paid for the books in this (iii) A financial statement (other than gross receipts of $125,000,000) or $140,000 (2 computation because X has not elected under a tax return) required to be provided to percent of X’s total deprecation and § 1.162–3T(f) to apply the de minimis rule to the federal or a state government or any amortization of $7,000,000). Because X pays the books. Thus, the total aggregate amounts $160,000 for the computers and this amount paid and not capitalized under paragraph federal or state agencies (other than the exceeds $140,000, the greater of the two (g)(1) of this section is equal to $140,000 (2 SEC or the Internal Revenue Service). limitations provided in paragraph (g)(1)(iv) of percent of X’s total financial depreciation), (7) Application to consolidated group this section, X may not apply the de minimis the greater of the two limitations set out member. If the taxpayer is a member of rule under paragraph (g)(1) of this section to under paragraph (g)(1)(iv) of this section. a consolidated group for federal income the total amounts paid for the 400 computers. Accordingly, under paragraph (g)(1) of this tax purposes and the member’s financial Example 3. De minimis rule; election to section, in Year 1, X may treat as de minimis results are reported on the applicable capitalize. Assume the same facts as in and is not required to capitalize the $140,000 financial statement (as defined in Example 2, except that X makes an election paid to acquire the computers, office chairs, paragraph (g)(6) of this section) for the under paragraph (g)(4) of this section to and briefcases. capitalize $20,000, the amounts paid to consolidated group then, for purposes of acquire 50 of the 400 computers purchased (h) Treatment of capital expenditures. paragraphs (g)(1)(ii) and (g)(1)(iii) of this in Year 1. Under these facts, the $140,000 Amounts required to be capitalized section, the written accounting paid by X in Year 1 for the remaining 350 under this section are capital procedures provided for the group and computers qualifies for the de minimis rule expenditures and must be taken into utilized for the group’s applicable under paragraph (g)(1) of this section because account through a charge to capital financial statement may be treated as this amount is equal to 2 percent of X’s total account or basis, or in the case of the written accounting procedures of the depreciation ($140,000), the greater of the property that is inventory in the hands member. two amounts calculated under paragraph of a taxpayer, through inclusion in (8) Examples. The following examples (g)(1)(iv) of this section. Accordingly, X is not required to capitalize the amounts paid to inventory costs. See section 263A for illustrate the rule of this paragraph (g): acquire the 350 computers in Year 1. the treatment of direct and certain Example 1. De minimis rule. X purchases Example 4. Election to apply de minimis indirect costs of producing property or 10 printers at $200 each for a total cost of rule to certain materials and supplies. (i) X acquiring property for resale.

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(i) Recovery of capitalized amounts— Commissioner’s consent to change its section provides for a repair allowance (1) In general. Amounts that are accounting method. or other methods of accounting capitalized under this section are (k) Effective/applicability date. Except identified in published guidance. recovered through depreciation, cost of for paragraphs (f)(2)(iii), Paragraphs (m) through (o) of this goods sold, or by an adjustment to basis (f)(2)(iv),(f)(3)(ii) and (g) of this section, section provide additional rules related at the time the property is placed in this section generally applies to taxable to these provisions. Paragraphs (p) and service, sold, used, or otherwise years beginning on or after January 1, (q) of this section provides the effective/ disposed of by the taxpayer. Cost 2012. Paragraphs (f)(2)(iii), (f)(2)(iv), applicability and expiration dates for recovery is determined by the (f)(3)(ii), and (g) of this section apply to the rules in this section. applicable provisions of the Internal amounts paid or incurred (to acquire or (b) Definitions. For purposes this Revenue Code and regulations relating produce property) in taxable years section, the following definitions apply: to the use, sale, or disposition of beginning on or after January 1, 2012. (1) Amount paid. In the case of a property. For the applicability of regulations to taxpayer using an accrual method of (2) Examples. The following examples taxable years beginning before January accounting, the terms amounts paid and illustrate the rule of paragraph (i)(1) of 1, 2012, see § 1.263(a)– in effect prior to payment mean a liability incurred this section. Assume that X does not January 1, 2012 (§ 1.263(a)–2 as (within the meaning of § 1.446– apply the de minimis rule under contained in 26 CFR part 1 edition 1(c)(1)(ii)). A liability may not be taken paragraph (g) of this section. revised as of April 1, 2011). into account under this section prior to Example 1. Recovery when property (l) Expiration Date. The applicability the taxable year during which the placed in service. X owns a 10-unit of this section expires on December 23, liability is incurred. apartment building. The refrigerator in one of 2014. (2) Personal property means tangible the apartments stops functioning, and X ■ Par. 29. Section 1.263(a)–3 is revised personal property as defined in § 1.48– purchases a new refrigerator to replace the to read as follows: 1(c). old one. X pays for the acquisition, delivery, and installation of the new refrigerator. § 1.263(a)–3 Amounts paid to improve (3) Real property means land and Assume that the refrigerator is the unit of tangible property. improvements thereto, such as buildings property, as determined under § 1.263(a)– (a) and (b) [Reserved]. For further or other inherently permanent 3T(e), and is not a material or supply under guidance, see § 1.263(a)–3T(a) and (b). structures (including items that are § 1.162–3T. Under paragraph (d)(1) of this (c) through (q) [Reserved]. For further structural components of the buildings section, X is required to capitalize the or structures) that are not personal amounts paid for the acquisition, delivery, guidance, see §§ 1.263(a)–3T(c) through (q). property as defined in paragraph (b)(2) and installation of the refrigerator. Under of this section. Any property that paragraph (i) of this section, the capitalized ■ Par. 30. Section 1.263(a)–3T is added constitutes other tangible property amounts are recovered through depreciation, to read as follows: which begins when the refrigerator is placed under § 1.48–1(d) is also treated as real in service by X. § 1.263(a)–3T Amounts paid to improve property for purposes of this section. Example 2. Recovery when property used tangible property (temporary). Local law is not controlling in in the production of property. X operates a (a) Overview. This section provides determining whether property is real plant where it manufactures widgets. X rules for applying section 263(a) to property for purposes of this section. purchases a tractor loader to move raw amounts paid to improve tangible (4) Owner means the taxpayer that has materials into and around the plant for use property. Paragraph (b) of this section the benefits and burdens of ownership in the manufacturing process. Assume that the tractor loader is a unit of property, as provides definitions. Paragraph (c) of of the unit of property for Federal determined under § 1.263(a)–3T(e), and is not this section provides rules for income tax purposes. a material or supply under § 1.162–3T. Under coordinating this section with other (c) Coordination with other provisions paragraph (d)(1) of this section, X is required provisions of the Internal Revenue of the Internal Revenue Code—(1) In to capitalize the amounts paid to acquire the Code. Paragraph (d) of this section general. Nothing in this section changes tractor loader. Under paragraph (i) of this provides the requirement to capitalize the treatment of any amount that is section, the capitalized amounts are amounts paid to improve tangible specifically provided for under any recovered through depreciation, which property and provides the general rules provision of the Internal Revenue Code begins when X places the tractor loader in service. However, because the tractor/loader for determining whether a unit of or the regulations other than section is used in the production of property, under property is improved. Paragraph (e) of 162(a) or section 212 and the regulations section 263A the cost recovery (that is, the this section provides the rules for under those sections. For example, see depreciation) on the capitalized amounts determining the appropriate unit of section 263A requiring taxpayers to must be capitalized to X’s property produced, property. Paragraph (f) of this section capitalize the direct and indirect costs and, consequently, recovered through cost of provides special rules for determining of producing property or acquiring goods sold. See § 1.263A–1(e)(3)(ii)(I). improvement costs in particular property for resale. (j) Accounting method changes. contexts. Paragraph (g) provides a safe (2) Materials and supplies. A material Except as otherwise provided in this harbor for routine maintenance costs. or supply as defined in § 1.162–3T(c)(1) section, a change to comply with this Paragraph (h) of this section provides that is acquired and used to improve a section is a change in method of rules for determining whether amounts unit of tangible property is subject to accounting to which the provisions of paid result in betterments to the unit of this section and is not treated as a sections 446 and 481, and the property. Paragraph (i) of this section material or supply under § 1.162–3T. regulations thereunder apply. A provides rules for determining whether (3) Exception for amounts subject to taxpayer seeking to change to a method amounts paid restore the unit of de minimis rule. A taxpayer is not of accounting permitted in this section property. Paragraph (j) of this section required to capitalize amounts paid to must secure the consent of the provides rules for amounts paid to adapt acquire or produce units of property Commissioner in accordance with the unit of property to a new or different used in improvements under paragraph § 1.446–1(e) and follow the use. Paragraph (k) of this section (d) of this section (including materials administrative procedures issued under provides an optional regulatory and supplies used in improvements) if § 1.446–1(e)(3)(ii) for obtaining the accounting method. Paragraph (l) of this these amounts are properly deducted

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under the de minimis rule of section if a taxpayer has assigned different alarm control panels, heat and smoke § 1.263(a)–2(g). MACRS classes or depreciation methods detection devices, fire escapes, fire (3) Example. The following example to components of property or doors, emergency exit lighting and illustrates the rules of this paragraph (c): subsequently changes the class or signage, and fire fighting equipment, Example. Railroad rolling stock. X is a depreciation method of a component or such as extinguishers, hoses); railroad that properly treats amounts paid for other item of property (see paragraph (7) Security systems for the protection the rehabilitation of railroad rolling stock as (e)(5) of this section). Property that is of the building and its occupants deductible expenses under section 263(d). X aggregated or subject to a general asset (including window and door locks, is not required to capitalize the amounts paid account election or accounted for in a security cameras, recorders, monitors, because nothing in this section changes the multiple asset account (that is, pooled) motion detectors, security lighting, treatment of amounts specifically provided alarm systems, entry and access for under section 263(d). may not be treated as a single unit of property. systems, related junction boxes, (d) Requirement to capitalize amounts (2) Building—(i) In general. Except as associated wiring and conduit); paid for improvements. Except as otherwise provided in paragraphs (e)(4), (8) Gas distribution system (including provided in the optional regulatory (e)(5)(ii), and (f)(1)(ii)(B) of this section, associated pipes and equipment used to accounting method in paragraph (k) of in the case of a building (as defined in distribute gas to and from property line this section or under any other § 1.48–1(e)(1)), each building and its and between buildings or permanent accounting method published in structural components (as defined in structures); and accordance with paragraph (l) of this § 1.48–1(e)(2)) is a single unit of (9) Other structural components section, a taxpayer generally must property (‘‘building’’). identified in published guidance in the capitalize the aggregate of related (ii) Application of improvement rules Federal Register or in the Internal amounts (as defined in paragraph (f)(4) to a building. An amount is paid for an Revenue Bulletin (see of this section) paid to improve a unit improvement to a building under § 601.601(d)(2)(ii)(b) of this chapter) that of property owned by the taxpayer. paragraphs (d) and (f)(1)(iii) of this are excepted from the building structure However, see paragraph (f)(1) of this section if the amount paid results in an under paragraph (e)(2)(ii)(A) of this section for the treatment of amounts improvement under paragraph (h), (i), or section and are specifically designated paid to improve leased property. See (j) of this section to any of the following: as building systems under this section. section 263A for the costs required to be (A) Building structure. A building (iii) Condominium—(A) In general. In capitalized to property produced by the structure consists of the building (as the case of a taxpayer that is the owner taxpayer or to property acquired for defined in § 1.48–1(e)(1)), and its of an individual unit in a building with resale; section 1016 for adding structural components (as defined in multiple units (such as a capitalized amounts to the basis of the § 1.48–1(e)(2)), other than the structural condominium), the unit of property is unit of property; and section 168 for the components designated as buildings the individual unit owned by the treatment of additions or improvements systems in paragraph (e)(2)(ii)(B) of this taxpayer and the structural components for depreciation purposes. For purposes section. (as defined in § 1.48–1(e)(2)) that are of this section, a unit of property is (B) Building system. Each of the part of the unit (condominium). improved if the amounts paid for following structural components (as (B) Application of improvement rules activities performed after the property is defined in § 1.48–1(e)(2)), including the to a condominium. An amount is paid placed in service by the taxpayer— components thereof, constitutes a for an improvement to a condominium (1) Result in a betterment to the unit building system that is separate from the under paragraph (d) of this section if the of property (see paragraph (h) of this building structure, and to which the amount paid results in an improvement section); improvement rules must be applied— under paragraph (h), (i), or (j) of this (2) Restore the unit of property (see (1) Heating, ventilation, and air section to the building structure (as paragraph (i) of this section); or conditioning (‘‘HVAC’’) systems defined in paragraph (e)(2)(ii)(A) of this (3) Adapt the unit of property to a (including motors, compressors, boilers, section) that is part of the condominium new or different use (see paragraph (j) furnace, chillers, pipes, ducts, or to the portion of any building system of this section). radiators); (as defined in paragraph (e)(2)(ii)(B) of (e) Determining the unit of property— (2) Plumbing systems (including this section) that is part of the (1) In general. The unit of property rules pipes, drains, valves, sinks, bathtubs, condominium. In the case of the in this paragraph (e) apply only for toilets, water and sanitary sewer condominium management association, purposes of section 263(a) and collection equipment, and site utility the association must apply the §§ 1.263(a)–1T, 1.263(a)–2T, 1.263(a)– equipment used to distribute water and improvement rules to the building 3T, and 1.162–3T. Unless otherwise waste to and from the property line and structure or to any building system as specified, the unit of property between buildings and other permanent determined under paragraphs determination is based upon the structures); (e)(2)(ii)(A) and (e)(2)(ii)(B) of this functional interdependence standard (3) Electrical systems (including section. provided in paragraph (e)(3)(i) of this wiring, outlets, junction boxes, lighting (iv) Cooperative—(A) In general. In section. However, special rules are fixtures and associated connectors, and the case of a taxpayer that has an provided for buildings (see paragraph site utility equipment used to distribute ownership interest in a cooperative (e)(2) of this section), plant property (see electricity from property line to and housing corporation, the unit of paragraph (e)(3)(ii) of this section), between buildings and other permanent property is the portion of the building network assets (see paragraph (e)(3)(iii) structures); in which the taxpayer has possessory of this section), leased property (see (4) All escalators; rights and the structural components (as paragraph (e)(2)(v) of this section for (5) All elevators; defined in § 1.48–1(e)(2)) that are part of leased buildings and paragraph (e)(3)(iv) (6) Fire-protection and alarm systems the portion of the building subject to the of this section for leased property other (including sensing devices, computer taxpayer’s possessory rights than buildings), and improvements to controls, sprinkler heads, sprinkler (cooperative). property (see paragraph (e)(4) of this mains, associated piping or plumbing, (B) Application of improvement rules section). Additional rules are provided pumps, visual and audible alarms, to a cooperative. An amount is paid for

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an improvement to a cooperative under placing in service of the other than a lessee improvement as paragraph (d) of this section if the component by the taxpayer. determined under paragraph (f)(1)(ii) of amount paid results in an improvement (ii) Plant property—(A) Definition. For this section, is not a unit of property under paragraph (h), (i), or (j) of this purposes of this paragraph (e) of this separate from the unit of property section to the portion of the building section, the term plant property means improved. For the unit of property for structure (as defined in paragraph functionally interdependent machinery lessee improvements, see paragraph (e)(2)(ii)(A) of this section) in which the or equipment, other than network (f)(1)(ii)(B) of this section. taxpayer has possessory rights or to the assets, used to perform an industrial (5) Additional rules—(i) Year placed portion of any building system (as process, such as manufacturing, in service. Notwithstanding the unit of defined in paragraph (e)(2)(ii)(B) of this generation, warehousing, distribution, property determination under paragraph section) that is part of the portion of the automated materials handling in service (e)(3) of this section, a component (or a building structure subject to the industries, or other similar activities. group of components) of a unit property taxpayer’s possessory rights. In the case (B) Unit of property for plant must be treated as a separate unit of of a cooperative housing corporation, property. In the case of plant property, property if, at the time the unit of the corporation must apply the the unit of property determined under property is initially placed in service by improvement rules to the building the general rule of paragraph (e)(3)(i) of the taxpayer, the taxpayer has properly structure or to any building system as this section is further divided into treated the component as being within determined under paragraphs smaller units comprised of each a different class of property under (e)(2)(ii)(A) and (e)(2)(ii)(B) of this component (or group of components) section 168(e) (MACRS classes) than the section. that performs a discrete and major class of the unit of property of which (v) Leased building—(A) In general. In function or operation within the the component is a part, or the taxpayer the case of a taxpayer that is a lessee of functionally interdependent machinery has properly depreciated the component all or a portion of a building (such as an or equipment. using a different depreciation method office, floor, or certain square footage), (iii) Network assets—(A) Definition. than the depreciation method of the unit the unit of property is each building and For purposes of this paragraph (e), the of property of which the component is its structural components or the portion term network assets means railroad a part. of each building subject to the lease and track, oil and gas pipelines, water and (ii) Change in subsequent taxable the structural components associated sewage pipelines, power transmission year. Notwithstanding the unit of with the leased portion. and distribution lines, and telephone property determination under (B) Application of improvement rules and cable lines that are owned or leased paragraphs (e)(2), (3), (4), or (5)(i) of this to a leased building. An amount is paid by taxpayers in each of those respective section, in any taxable year after the for an improvement to a leased building industries. The term includes, for unit of property is initially placed in or a leased portion of a building under example, trunk and feeder lines, pole service by the taxpayer, if the taxpayer paragraphs (d) and (f)(1)(ii) of this lines, and buried conduit. It does not or the Internal Revenue Service changes section if the amount paid results in an include property that would be the treatment of that property (or any improvement under paragraph (h), (i), or included as building structure or portion thereof) to a proper MACRS (j) of this section to any of the following: building systems under paragraphs class or a proper depreciation method (1) Entire building. In the case of a (e)(2)(ii)(A) and (e)(2)(ii)(B) of this (for example, as a result of a cost taxpayer that is a lessee of an entire section, nor does it include separate segregation study or a change in the use building, the building structure (as property that is adjacent to, but not part of the property), then the taxpayer must defined under paragraph (e)(2)(ii)(A) of of a network asset, such as bridges, change the unit of property this section) or any building system (as culverts, or tunnels. determination for that property (or the defined under paragraph (e)(2)(ii)(B) of (B) Unit of property for network portion thereof) under this section to be this section) to which the expenditure assets. In the case of network assets, the consistent with the change in treatment relates. unit of property is determined by the for depreciation purposes. Thus, for (2) Portion of a building. In the case taxpayer’s particular facts and example, if a portion of a unit of of a taxpayer that is a lessee of a portion circumstances except as otherwise property is properly reclassified to a of a building (such as an office, floor, or provided in published guidance in the MACRS class different from the MACRS certain square footage), the portion of Federal Register or in the Internal class of the unit of property of which it the building structure (as defined under Revenue Bulletin (see was previously treated as a part, then paragraph (e)(2)(ii)(A) of this section) § 601.601(d)(2)(ii)(b) of this chapter). the reclassified portion of the property subject to the lease or the portion of any For these purposes, the functional should be treated as a separate unit of building system (as defined under interdependence standard provided in property for purposes of this section. paragraph (e)(2)(ii)(B) of this section) paragraph (e)(3)(i) of this section is not (6) Examples. The rules of this associated with that portion of the determinative. paragraph (e) are illustrated by the leased building structure. (iv) Leased property other than following examples, in which it is (3) Property other than building—(i) buildings. In the case of a taxpayer that assumed that the taxpayer has not made In general. Except as otherwise is a lessee of real or personal property a general asset account election with provided in paragraphs (e)(3), (e)(4), other than property described in regard to property or accounted for (e)(5), and (f)(1) of this section, in the paragraph (e)(2) of this section, the unit property in a multiple asset account. In case of real or personal property other of property for the leased property is addition, unless the facts specifically than property described in paragraph determined under paragraphs (e)(3)(i), indicate otherwise, assume that the (e)(2) of this section, all the components (ii), (iii), and (e)(5) of this section except additional rules in paragraph (e)(5) of that are functionally interdependent that, after applying the applicable rules this section do not apply: comprise a single unit of property. under those paragraphs, the unit of Example 1. Building systems. X owns an Components of property are property may not be larger than the unit office building that contains a HVAC system. functionally interdependent if the of leased property. The HVAC system incorporates ten roof- placing in service of one component by (4) Improvements to property. An mounted units that service different parts of the taxpayer is dependent on the improvement to a unit of property, other the building. The roof-mounted units are not

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connected and have separate controls and improvement (for example, a betterment) to turbine blades, as separate units of property duct work that distribute the heated or the portion of the plumbing system that is because each of these components does not cooled air to different spaces in the part of X’s condominium unit, X must treat perform a discrete and major function within building’s interior. X pays an amount for this amount as an improvement to the the plant. labor and materials for work performed on condominium. Example 6. Plant property; discrete and the roof-mounted units. Under paragraph Example 4. Building structure and systems; major function. X is engaged in a uniform (e)(2)(i) of this section, X must treat the property other than buildings. X, a and linen rental business. X owns and building and its structural components as a manufacturer, owns a building adjacent to its operates a plant that utilizes many different single unit of property. As provided under manufacturing facility that contains office machines and equipment in an assembly paragraph (e)(2)(ii) of this section, an amount space and related facilities for X’s employees line-like process to treat, launder, and is paid for an improvement to a building if that manage and administer X’s prepare rental items for its customers. X it results in an improvement to the building manufacturing operations. The office utilizes two laundering lines in its plant, structure or any designated building system. building contains equipment, such as desks, each of which can operate independently. Under paragraph (e)(2)(ii)(B)(1) of this chairs, computers, telephones, and One line is used for uniforms and another section, the entire HVAC system, including bookshelves that are not building structure or line is used for linens. Both lines incorporate all of the roof-mounted units and their building systems. X pays an amount to add several sorters, boilers, washers, dryers, components, comprise a building system. an extension to the office building. Under ironers, folders, and waste water treatment Therefore, under paragraph (e)(2)(ii) of this paragraph (e)(2)(i) of this section, X must systems. Because the laundering equipment section, if an amount paid by X for work on treat the building and its structural contained within the plant is property other the roof-mounted units results in an components as a single unit of property. As than a building, the unit of property for the improvement (for example, a betterment) to provided under paragraph (e)(2)(ii) of this laundering equipment is initially determined the HVAC system, X must treat this amount section, an amount is paid for an under the general rule in paragraph (e)(3)(i) as an improvement to the building. improvement to a building if it results in an of this section and is comprised of all the Example 2. Building systems. X owns a improvement to the building structure or any components that are functionally building that it uses in its retail business. The designated building system. Therefore, under interdependent. Under this rule, the initial building contains two elevator banks in paragraph (e)(2)(ii) of this section, if an units of property are each laundering line different locations in its building. Each amount paid by X for the addition of an because each line is functionally elevator bank contains three elevators. X pays extension to the office building results in an independent and is comprised of an amount for labor and materials for work improvement (for example, a betterment) to components that are functionally performed on the elevators. Under paragraph the building structure, X must treat this interdependent. However, because each line (e)(2)(i) of this section, X must treat the amount as an improvement to the building. is comprised of plant property under building and its structural components as a In addition, because the equipment paragraph (e)(3)(ii) of this section, X must single unit of property. As provided under contained within the office building further divide these initial units of property paragraph (e)(2)(ii) of this section, an amount constitutes property other than the building, into smaller units of property by determining is paid for an improvement to a building if the units of property for the office equipment the components (or groups of components) it results in an improvement to the building are initially determined under the general that perform discrete and major functions structure or any designated building system. rule in paragraph (e)(3)(i) of this section and within the line. Under paragraph (e)(3)(ii) of Under paragraph (e)(2)(ii)(B)(5) of this are comprised of the groups of components this section, X must treat each sorter, boiler, section, all of the elevators, including all that are functionally interdependent. washer, dryer, ironer, folder, and waste water their components, comprise a building Example 5. Plant property; discrete and treatment system in each line as a separate system. Therefore, under paragraph (e)(2)(ii) major function. X is an electric utility unit of property because each of these of this section, if an amount paid by X for company that operates a power plant to components performs a discrete and major work on the elevators results in an generate electricity. The power plant function within the line. improvement (for example, a betterment) to includes a structure that is not a building Example 7. Plant property; industrial the entire elevator system, X must treat these under § 1.48–1(e)(1), four pulverizers that process. X operates a restaurant that prepares amounts as an improvement to the building. grind coal, one boiler that produces steam, and serves food to retail customers. Within Example 3. Building structure and systems; one turbine that converts the steam into its restaurant, X has a large piece of condominium. X owns a condominium unit mechanical energy, and one generator that equipment that uses an assembly line-like in a condominium office building. X uses the converts mechanical energy into electrical process to prepare and cook tortillas that X condominium unit in its business of energy. In addition, the turbine contains a serves to its customers. Because the tortilla- providing medical services. The series of blades that cause the turbine to making equipment is property other than a condominium unit contains two restrooms, rotate when affected by the steam. Because building, the unit of property for the each of which contains a sink, a toilet, water the plant is composed of real and personal equipment is initially determined under the and drainage pipes and bathroom fixtures. X tangible property other than a building, the general rule in paragraph (e)(3)(i) of this pays an amount for labor and materials to unit of property for the generating equipment section and is comprised of all the perform work on the pipes, sinks, toilets, and is initially determined under the general rule components that are functionally plumbing fixtures that are part of the in paragraph (e)(3)(i) of this section and is interdependent. Under this rule, the initial condominium unit. Under paragraph comprised of all the components that are unit of property is the entire tortilla-making (e)(2)(iii) of this section, X must treat the functionally interdependent. Under this rule, equipment because the various components individual unit that it owns, including the the initial unit of property is the entire plant of the equipment are functionally structural components that are part of that because the components of the plant are interdependent. The equipment is not plant unit, as a single unit of property. As provided functionally interdependent. However, property under paragraph (e)(3)(ii) of this under paragraph (e)(2)(iii)(B) of this section, because the power plant is plant property section because the equipment is not used in an amount is paid for an improvement to the under paragraph (e)(3)(ii) of this section, the an industrial process, as it performs a small- condominium if it results in an improvement initial unit of property is further divided into scale function in X’s retail restaurant to the building structure that is part of the smaller units of property by determining the operations. Thus, X is not required to further unit or to a portion of any designated components (or groups of components) that divide the equipment into separate units of building system that is part of the unit. perform discrete and major functions within property based on the components that Under paragraph (e)(2)(ii)(B)(2) of this the plant. Under this paragraph, X must treat perform discrete and major functions. section, the pipes, sinks, toilets, and the structure, the boiler, the turbine, and the Example 8. Personal property. X owns plumbing fixtures that are part of X’s unit generator each as a separate unit of property, locomotives that it uses in its railroad comprise the plumbing system for the and each of the four pulverizers as a separate business. Each locomotive consists of various condominium unit. Therefore, under unit of property because each of these components, such as an engine, generators, paragraph (e)(2)(iii) of this section, if an components performs a discrete and major batteries and trucks. X acquired a locomotive amount paid by X for work on pipes, sinks, function within the power plant. X is not with all its components and treated all the toilets, and plumbing fixtures results in an required to treat components, such as the components of the locomotive as being

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

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

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

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determining whether the amount paid performing routine maintenance are the than one component with different class improves the unit of property. recurring nature of the activity, industry lives, then the class life of the unit of (3) Certain costs incurred during an practice, manufacturers’ property is deemed to be the same as the improvement—(i) In general. A taxpayer recommendations, the taxpayer’s component with the longest class life. must capitalize all the direct costs of an experience, and the taxpayer’s treatment (5) Examples. The following examples improvement and all the indirect costs of the activity on its applicable financial illustrate the rules of this paragraph (g). (including, for example, otherwise statement (as defined in paragraph (b)(4) Unless otherwise stated, assume that X deductible repair or component removal of this section). With respect to a has not applied the optional method of costs) that directly benefit or are taxpayer that is a lessor of a unit of accounting for rotable and temporary incurred by reason of an improvement property, the taxpayer’s use of the unit spare parts under § 1.162–3T(e): in accordance with the rules under of property includes the lessee’s use of Example 1. Routine maintenance on section 263A. Therefore, indirect costs the unit of property. component. (i) X is a commercial airline that do not directly benefit and are not (2) Rotable and temporary spare engaged in the business of transporting incurred by reason of an improvement parts. Except as provided in paragraph passengers and freight throughout the United are not required to be capitalized under (g)(3) of this section, for purposes of States and abroad. To conduct its business, section 263(a), regardless of whether paragraph (g)(1) of this section, amounts X owns or leases various types of aircraft. As they are made at the same time as an paid for routine maintenance include a condition of maintaining its airworthiness improvement. routine maintenance performed on (and certification for these aircraft, X is required (ii) Exception for individuals’ with regard to) rotable and temporary by the Federal Aviation Administration residences. A taxpayer who is an (FAA) to establish and adhere to a spare parts. But see § 1.162–3T(a)(3), continuous maintenance program for each individual may capitalize amounts paid which provides generally that rotable aircraft within its fleet. These programs, for repairs and maintenance that are and temporary spare parts are used or which are designed by X and the aircraft’s made at the same time as capital consumed by the taxpayer in the taxable manufacturer and approved by the FAA, are improvements to units of property not year in which the taxpayer disposes of incorporated into each aircraft’s maintenance used in the taxpayer’s trade or business the parts. manual. The maintenance manuals require a or for the production of income if the (3) Exceptions. Routine maintenance variety of periodic maintenance visits at amounts are paid as part of a does not include the following: various intervals. One type of maintenance remodeling of the taxpayer’s residence. (i) Amounts paid for the replacement visit is an engine shop visit (ESV), which X (4) Aggregate of related amounts. For expects to perform on its aircraft engines of a component of a unit of property and approximately every 4 years in order to keep purposes of paragraph (d) of this the taxpayer has properly deducted a its aircraft in its ordinarily efficient operating section, the aggregate of related amounts loss for that component (other than a condition. In Year 1, X purchased a new paid to improve a unit of property may casualty loss under § 1.165–7). aircraft, which included four new engines be incurred over a period of more than (ii) Amounts paid for the replacement attached to the airframe. The four aircraft one taxable year. Whether amounts are of a component of a unit of property and engines acquired with the aircraft are not related to the same improvement the taxpayer has properly taken into materials or supplies under § 1.162– depends on the facts and circumstances account the adjusted basis of the 3T(c)(1)(i) because they are acquired as part of the activities being performed and component in realizing gain or loss of a single unit of property, the aircraft. In whether the costs are incurred by reason Year 5, X performs its first ESV on the resulting from the sale or exchange of aircraft engines. The ESV includes of a single improvement or directly the component. disassembly, cleaning, inspection, repair, benefit a single improvement. (iii) Amounts paid for the repair of replacement, reassembly, and testing of the (g) Safe harbor for routine damage to a unit of property for which engine and its component parts. During the maintenance on property other than the taxpayer has taken a basis ESV, the engine is removed from the aircraft buildings—(1) In general. An amount adjustment as a result of a casualty loss and shipped to an outside vendor who paid for routine maintenance performed under section 165, or relating to a performs the ESV. If inspection or testing on a unit of property other than a casualty event described in section 165. discloses a discrepancy in a part’s conformity building or a structural component of a (iv) Amounts paid to return a unit of to the specifications in X’s maintenance building is deemed not to improve that property to its ordinarily efficient program, the part is repaired, or if necessary, unit of property. Routine maintenance is replaced with a comparable and operating condition, if the property has commercially available and reasonable the recurring activities that a taxpayer deteriorated to a state of disrepair and replacement part. After the ESVs, the engines expects to perform as a result of the is no longer functional for its intended are returned to X to be reinstalled on another taxpayer’s use of the unit of property to use. aircraft or stored for later installation. keep the unit of property in its (v) Amounts paid for repairs, Assume that the unit of property for X’s ordinarily efficient operating condition. maintenance, or improvement of rotable aircraft is the entire aircraft, including the Routine maintenance activities include, and temporary spare parts to which the aircraft engines, and that the class life for X’s for example, the inspection, cleaning, taxpayer applies the optional method of aircraft is 12 years. Assume that none of the and testing of the unit of property, and exceptions set out in paragraph (g)(3) of this accounting for rotable and temporary section applies to the costs of performing the the replacement of parts of the unit of spare parts under § 1.162–3T(e). ESVs. property with comparable and (4) Class life. The class life of a unit (ii) Because the ESVs involve the recurring commercially available and reasonable of property is the recovery period activities that X expects to perform as a result replacement parts. The activities are prescribed for the property under of its use of the aircraft to keep the aircraft routine only if, at the time the unit of sections 168(g)(2) and (3) for purposes in ordinarily efficient operating condition, property is placed in service by the of the alternative depreciation system, and consist of maintenance activities that X taxpayer, the taxpayer reasonably regardless of whether the property is expects to perform more than once during the expects to perform the activities more depreciated under section 168(g). For 12 year class life of the aircraft, X’s ESVs are within the routine maintenance safe harbor than once during the class life (as purposes of determining class life under under paragraph (g) of this section. defined in paragraph (g)(4) of this this section, section 168(g)(3)(A) Accordingly, the amounts paid for the ESVs section) of the unit of property. Among (relating to tax-exempt use property are deemed not to improve the aircraft and the factors to be considered in subject to lease) does not apply. If the are not required to be capitalized under determining whether a taxpayer is unit of property is comprised of more paragraph (d) of this section.

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Example 2. Routine maintenance after commercially available and reasonable comprises 60 percent of the total physical class life. Assume the same facts as in replacement parts. At the time X purchased structure of the container. Assume that each Example 1, except that in year 15, X pays the machine, the machine was approaching container, including its lining, is the unit of amounts to perform an ESV on one of the the end of a three-year scheduled property and that a container has a class life original aircraft engines, after the end of the maintenance period. As a result, in February, of 12 years. At the time that X placed the class life of the aircraft. Because this ESV Year 1, X pays amounts to perform the container into service, X was aware that involves the same routine maintenance manufacturer recommended scheduled approximately every three years, X would be activities that were performed on aircraft maintenance. Assume that none of the required to replace the lining in the container engines in Example 1, this ESV also is within exceptions set out in paragraph (g)(3) of this with comparable and commercially available the routine maintenance safe harbor under section apply to the amounts paid for the and reasonable replacement materials. At the paragraph (g) of this section. Accordingly, the scheduled maintenance. end of that period, the container will amounts paid for this ESV, even though (ii) The majority of X’s costs do not qualify continue to function, but will become less performed after the class life of the aircraft, under the routine maintenance safe harbor in efficient and the replacement of the lining are deemed not to improve the aircraft and paragraph (g) of this section because the costs will be necessary to keep the container in an are not required to be capitalized under were incurred primarily as a result of the ordinarily efficient operating condition. In paragraph (d) of this section. prior owner’s use of the property and not X’s Year 1, X acquired 10 new containers and Example 3. Routine maintenance on use. X acquired the machine just before it placed them into service. In Year 4, Year 7, rotable spare parts. (i) Assume the same facts had received its three-year scheduled Year 9, and Year 12, X pays amounts to as in Example 1, except that in addition to maintenance. Accordingly, the amounts paid replace the containers’ linings with the four engines purchased as part of the for the scheduled maintenance resulted from comparable and commercially available and aircraft, X separately purchases four the prior owner’s, and not the taxpayer’s, use reasonable replacement parts. Assume that additional new engines that X intends to use of the property and must be capitalized if none of the exceptions set out in paragraph in its aircraft fleet to avoid operational those amounts result in a betterment under (g)(3) of this section apply to the amounts downtime when ESVs are required to be paragraph (h) of this section, including the paid for the replacement linings. Because the performed on the engines previously amelioration of a material condition or replacement of the linings involves recurring installed on an aircraft. Later in Year 1, X defect, or otherwise result in an improvement activities that X expects to perform as a result installs these four engines on an aircraft in under paragraph (d) of this section. See also of its use of the containers to keep the its fleet. In Year 5, X performs the first ESVs section 263A and the regulations thereunder containers in their ordinarily efficient on these four engines. Assume that these for the requirement to capitalize indirect operating condition, and consists of ESVs involve the same routine maintenance costs (including otherwise deductible repair maintenance activities that X expects to activities that were performed on the engines costs) that directly benefit or are incurred by perform more than once during the 12 year in Example 1, and that none of the reason of production activities. class lives of the containers, X’s lining exceptions set out in paragraph (g)(3) of this Example 5. Routine maintenance resulting replacement costs are within the routine section apply to these ESVs. After the ESVs from new owner’s use. Assume the same facts maintenance safe harbor under paragraph (g) were performed, these engines were as in Example 4, except that after X pays of this section. Accordingly, the amounts that reinstalled on other aircraft or stored for later amounts for the maintenance in Year 1, X X paid for the replacement of the container installation. continues to operate the machine in its linings are deemed not to improve the (ii) The additional aircraft engines are manufacturing business. In Year 4, X pays containers and are not required to be rotable spare parts because they were amounts to perform the next scheduled capitalized under paragraph (d) of this acquired separately from the aircraft, they are manufacturer recommended maintenance on section. But see section 263A and the removable from the aircraft, and are repaired the machine. Assume that the scheduled regulations thereunder for the requirement to and reinstalled on other aircraft or stored for maintenance activities performed are the capitalize indirect costs (including otherwise later installation. See § 1.162–3T(c)(2) same as those performed in Example 4 and deductible repair costs) that directly benefit (definition of rotable and temporary spare that none of the exceptions set out in or are incurred by reason of production parts). The class life of an engine is the same paragraph (g)(3) of this section apply to the activities. as the airframe, 12 years. Because the ESVs amounts paid for the scheduled maintenance. Example 7. Routine maintenance once involve the recurring activities that X expects Because the scheduled maintenance during class life. X is a Class I railroad that to perform as a result of its use of the engines performed in Year 4 involves the recurring owns a fleet of freight cars. Assume that a to keep the engines in ordinarily efficient activities that X performs as a result of its use freight car, including all its components, is operating condition, and consist of of the machine, keeps the machine in an a unit of property and has a class life of 14 maintenance activities that X expects to ordinarily efficient operating condition, and years. At the time that X places a freight car perform more than once during the 12 year consists of maintenance activities that X into service, X expects to perform cyclical class life of the engine, the ESVs fall within expects to perform more than once during the reconditioning to the car every 8 to 10 years the routine maintenance safe harbor under 10 year class life of the machine, X’s in order to keep the freight car in ordinarily paragraph (g) of this section. Accordingly, the scheduled maintenance costs are within the efficient operating condition. During this amounts paid for the ESVs for the four routine maintenance safe harbor under reconditioning, X pays amounts to additional engines are deemed not to paragraph (g) of this section. Accordingly, the disassemble, inspect, and recondition or improve these engines and are not required amounts paid for the scheduled maintenance replace components of the freight car with to be capitalized under paragraph (d) of this in Year 4 are deemed not to improve the comparable and commercially available and section. For the treatment of amounts paid to machine and are not required to be reasonable replacement parts. Ten years after acquire the engines, see § 1.162–3T(a). capitalized under paragraph (d) of this X places the freight car in service, X pays Example 4. Routine maintenance resulting section. But see section 263A and the amounts to perform a cyclical reconditioning from prior owner’s use. (i) In January, Year regulations thereunder for the requirement to on the car. Because X expects to perform the 1, X purchases a used machine for use in its capitalize indirect costs (including otherwise reconditioning only once during the 14 year manufacturing operations. Assume that the deductible repair costs) that directly benefit class life of the freight car, the amounts X machine is the unit of property and has a or are incurred by reason of production pays for the reconditioning do not qualify for class life of 10 years. X places the machine activities. the routine maintenance safe harbor under in service in January, Year 1, and at that time, Example 6. Routine maintenance; paragraph (g) of this section. Accordingly, X X expects to perform manufacturer replacement of substantial structural part. X must capitalize the amounts paid for the recommended scheduled maintenance on the is in the business of producing commercial reconditioning of the freight car if these machine approximately every three years. products for sale. As part of the production amounts result in an improvement under The scheduled maintenance includes the process, X places raw materials into lined paragraph (d) of this section. cleaning and oiling of the machine, the containers in which a chemical reaction is Example 8. Routine maintenance on non- inspection of parts for defects, and the used to convert raw materials into the rotable part. X is a towboat operator that replacement of minor items such as springs, finished product. The lining is a substantial owns and leases a fleet of towboats. Each bearings, and seals with comparable and structural part of the container, and towboat is equipped with two diesel-

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powered engines. Assume that each towboat, that X paid in Year 9 for the maintenance and square space), productivity, efficiency, including its engines, is the unit of property upgrade of the engines do not qualify for the strength, or quality of the unit of and that a towboat has a class life of 18 years. routine maintenance safe harbor described property or the output of the unit of At the time that X places its towboats into under paragraph (g) of this section. These property. service, X is aware that approximately every amounts must be capitalized if they result in (2) Betterments to buildings. In the three to four years, X will need to perform a betterment under paragraph (h) of this scheduled maintenance on the two towboat section, including a material increase in the case of a building, an amount results in engines to keep the engines in their capacity of the towboat, or otherwise result a betterment to the unit of property if it ordinarily efficient operating condition. This in an improvement under paragraph (d) of results in a betterment to any of the maintenance is completed while the engines this section. properties designated in paragraphs are attached to the towboat and involves the Example 10. Exceptions to routine (e)(2)(ii), (e)(2)(iii)(B), (e)(2)(iv)(B), or cleaning and inspecting of the engines to maintenance. X owns and operates a farming (e)(2)(v)(B) of this section. determine which parts are within acceptable and cattle ranch with an irrigation system (3) Application of general rule—(i) operating tolerances and can continue to be that provides water for crops. Assume that Facts and circumstances. To determine used, which parts must be reconditioned to each canal in the irrigation system is a single whether an amount paid results in a be brought back to acceptable tolerances, and unit of property and has a class life of 20 which parts must be replaced. Engine parts years. At the time X placed the canals into betterment described in paragraph (h)(1) replaced during these procedures are service, X expected to have to perform major of this section, it is appropriate to replaced with comparable and commercially maintenance on the canals every 3 years to consider all the facts and circumstances available and reasonable replacement parts. keep the canals in their ordinarily efficient including, but not limited to, the Assume the towboat engines are not rotable operating condition. This maintenance purpose of the expenditure, the physical spare parts under § 1.162–3T(c)(2). In Year 1, includes draining the canals, and then nature of the work performed, the effect X acquired a new towboat, including its two cleaning, inspecting, repairing, of the expenditure on the unit of engines, and placed the towboat into service. reconditioning or replacing parts of the canal property, and the taxpayer’s treatment In Year 5, X pays amounts to perform with comparable and commercially available of the expenditure on its applicable and reasonable replacement parts. X placed scheduled maintenance on both engines in financial statement (as described in the towboat. Assume that none of the the canals into service in Year 1 and did not exceptions set out in paragraph (g)(3) of this perform any maintenance on the canals until paragraph (b)(4) of this section). section apply to the scheduled maintenance Year 6. At that time, the canals had fallen (ii) Unavailability of replacement costs. Because the scheduled maintenance into a state of disrepair and no longer parts. If a taxpayer needs to replace part involves recurring activities that X expects to functioned for irrigation. In Year 6, X pays of a unit of property that cannot perform more than once during the 18 year amounts to drain the canals, and do practicably be replaced with the same class life of the towboat, the maintenance extensive cleaning, repairing, reconditioning, type of part (for example, because of results from X’s use of the towboat and the and replacing parts of the canals with technological advancements or product maintenance is performed to keep the comparable and commercially available and enhancements), the replacement of the towboat in an ordinarily efficient operating reasonable replacement parts. Although the part with an improved, but comparable, work performed on X’s canals was similar to condition, the scheduled maintenance on X’s part does not, by itself, result in a towboat is within the routine maintenance the activities that X expected to perform, but did not perform, every three years, the costs betterment to the unit of property. safe harbor under paragraph (g) of this (iii) Appropriate comparison—(A) In section. Accordingly, the amounts paid for of these activities do not fall within the the scheduled maintenance to its towboat routine maintenance safe harbor. general. In cases in which a particular engines in Year 5 are deemed not to improve Specifically, under paragraph (g)(3)(iv) of this event necessitates an expenditure, the the towboat and are not required to be section, routine maintenance does not determination of whether an capitalized under paragraph (d) of this include activities that return a unit of expenditure results in a betterment of section. property to its former ordinary efficient the unit of property is made by Example 9. Routine maintenance with operating condition if the property has comparing the condition of the property deteriorated to a state of disrepair and is no betterments. Assume the same facts as immediately after the expenditure with Example 8, except that in Year 9, X’s towboat longer functional for its intended use. Accordingly, amounts that X pays for work the condition of the property engines are due for another scheduled immediately prior to the circumstances maintenance visit. At this time, X decides to performed on the canals in Year 6 must be upgrade the engines to increase their capitalized if they result in improvements necessitating the expenditure. horsepower and propulsion, which would under paragraph (d) of this section (for (B) Normal wear and tear. If the permit the towboats to tow heavier loads. example, restorations under paragraph (i) of expenditure is made to correct the Accordingly, in Year 9, X pays amounts to this section). effects of normal wear and tear to the perform many of the same activities that it (h) Capitalization of betterments—(1) unit of property (including the would perform during the typical scheduled In general. A taxpayer must capitalize amelioration of a condition or defect maintenance activities such as cleaning, amounts paid that result in the that existed prior to the taxpayer’s inspecting, reconditioning, and replacing betterment of a unit of property. An acquisition of the unit of property minor parts, but at the same time, X incurs resulting from normal wear and tear), costs to upgrade certain engine parts to amount paid results in the betterment of increase the towing capacity of the boats in a unit of property only if it— the condition of the property excess of the capacity of the boats when X (i) Ameliorates a material condition or immediately prior to the circumstances placed them in service. Both the scheduled defect that either existed prior to the necessitating the expenditure is the maintenance procedures and the replacement taxpayer’s acquisition of the unit of condition of the property after the last of parts with new and upgraded parts are property or arose during the production time the taxpayer corrected the effects of necessary to increase the horsepower of the of the unit of property, whether or not normal wear and tear (whether the engines and the towing capacity of the boat. the taxpayer was aware of the condition amounts paid were for maintenance or Thus, the work done on the engines or defect at the time of acquisition or improvements) or, if the taxpayer has encompasses more than the recurring production; not previously corrected the effects of activities that X expected to perform as a result of its use of the towboats and did more (ii) Results in a material addition normal wear and tear, the condition of than keep the towboat in its ordinarily (including a physical enlargement, the property when placed in service by efficient operating condition. In addition, expansion, or extension) to the unit of the taxpayer. under paragraph (f)(3)(i) of this section, the property; or (C) Particular event. If the scheduled maintenance procedures directly (iii) Results in a material increase in expenditure is made as a result of a benefit the upgrades. Therefore, the amounts capacity (including additional cubic or particular event, the condition of the

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property immediately prior to the maintenance on the machine every three circumstances under paragraph (h)(3)(i) of circumstances necessitating the years. The scheduled maintenance includes this section, including the purpose and expenditure is the condition of the the cleaning and oiling of the machine, the minor nature of the work performed, this property immediately prior to the inspection of parts for defects, and the amount does not ameliorate a material replacement of minor items such as springs, condition or defect in the machine under particular event. bearings, and seals with comparable and paragraph (h)(1)(i) of this section, result in a (4) Examples. The following examples commercially available and reasonable material addition to the machine under illustrate the application of this replacement parts. The scheduled paragraph (h)(1)(ii) of this section, or result paragraph (h) only and do not address maintenance does not result in any material in a material increase in the capacity, whether capitalization is required under additions or material increases in capacity, productivity, efficiency, strength, or quality another provision of this section or productivity, efficiency, strength or quality of of the machine or the output of the machine another provision of the Internal the machine or the output of the machine. At under paragraph(h)(1)(iii) of this section. Revenue Code (for example, section the time X purchased the machine, it was Therefore, X is not required to capitalize the 263A): approaching the end of a three-year amount paid to inspect, retune, and replace scheduled maintenance period. As a result, minor components of the machine as a Example 1. Amelioration of pre-existing in February, Year 1, X pays an amount to betterment under this paragraph (h). material condition or defect. In Year 1, X perform the manufacturer recommended Example 5. Amelioration of material purchases a store located on a parcel of land scheduled maintenance to keep the machine condition or defect. (i) X acquires a building that contained underground gasoline storage in its ordinarily efficient operating condition. for use in its business of providing assisted tanks left by prior occupants. Assume that (ii) The amount that X pays does not living services. Before and after the purchase, the parcel of land is the unit of property. The qualify under the routine maintenance safe the building functions as an assisted living tanks had leaked, causing soil contamination. harbor in paragraph (g) of this section facility. However, at the time of the purchase, X is not aware of the contamination at the because the cost primarily results from the X is aware that the building is in a condition time of purchase. In Year 2, X discovers the prior owner’s use of the property and not the that is below the standards that X requires for contamination and incurs costs to remediate taxpayer’s use. X acquired the machine just facilities used in its business. Immediately the soil. The remediation costs result in a before it had received its three-year after the acquisition and during the following betterment to the land under paragraph scheduled maintenance. Accordingly, the two years, while X continues to use the (h)(1)(i) of this section because X incurred amount that X pays for the scheduled building as an assisted living facility, X pays the costs to ameliorate a material condition maintenance results from the prior owner’s amounts for repairs, maintenance, and the or defect that existed prior to X’s acquisition use of the property and ameliorates acquisition of new property to bring the of the land. conditions or defects that existed prior to X’s facility into the high-quality condition for Example 2. Not amelioration of pre- ownership of the machine. Nevertheless, which X’s facilities are known. The work on existing condition or defect. X owns a considering the facts and circumstances X’s building includes repairing damaged building that was constructed with insulation under paragraph (h)(2)(i) of this section, drywall, repainting, re-wallpapering, that contained asbestos. The health dangers including the purpose and minor nature of replacing windows, repairing and replacing of asbestos were not widely known when the the work performed, this amount does not doors; replacing and regrouting tile; repairing building was constructed. X determines that ameliorate a material condition or defect in millwork; and repairing and replacing certain areas of asbestos-containing the machine under paragraph (h)(1)(i) of this roofing materials. The work also involves the insulation had begun to deteriorate and could section, result in a material addition to the replacement of section 1245 property eventually pose a health risk to employees. machine under paragraph (h)(1)(ii) of this including window treatments, furniture, and Therefore, X pays an amount to remove the section, or result in a material increase in the cabinets. On its applicable financial asbestos-containing insulation from the capacity, productivity, efficiency, strength, or statements, X capitalizes the costs of the building structure and replace it with new quality of the machine or the output of the repairs and maintenance to the building. The insulation that is safer to employees, but no machine under paragraph (h)(1)(iii) of this work that X performs affects only the more efficient or effective than the asbestos section. Therefore, X is not required to building structure under paragraph insulation. Under paragraph (e)(2)(ii) of this capitalize the amount paid for the scheduled (e)(2)(ii)(A) of this section and does not affect section, if the amount paid results in a maintenance as a betterment to the machine any of the building systems described in betterment to the building structure or any under this paragraph (h). paragraph (e)(2)(ii)(B) of this section. Assume building system, X must treat the amount as Example 4. Not amelioration of pre- that each section 1245 property is a separate an improvement to the building. Although existing material condition or defect. X unit of property. the asbestos is determined to be unsafe under purchases a used ice resurfacing machine for (ii) Under paragraph (e)(2)(ii) of this certain circumstances, the asbestos is not a use in the operation of its ice skating rink. section, if an amount paid results in a preexisting or material defect of the building To comply with local regulations, X is betterment to the building structure or any structure under paragraph (h)(1)(i) of this required to monitor routinely the air quality building system, X must treat the amount as section. In addition, the removal and in the ice skating rink. One week after X an improvement to the building. Considering replacement of the asbestos does not result in places the machine into service, during a the facts and circumstances, as required a material addition to the building structure routine air quality check, X discovers that the under paragraph (h)(3)(i) of this section, under paragraph (h)(1)(ii) of this section or operation of the machine is adversely including the purpose of the expenditures, result in a material increase in capacity, affecting the air quality in the skating rink. the effect of the expenditures on the building productivity, efficiency, strength, or quality As a result, X pays an amount to inspect and structure, and the treatment of the of the building structure or the output of the retune the machine, which includes expenditures in X’s applicable financial building structure under paragraph (h)(1)(iii) replacing minor components of the engine, statements, the amounts that X paid for of this section. Therefore, the amount paid to which had worn out prior to X’s acquisition repairs and maintenance to the building remove and replace the asbestos insulation of the machine. Assume the resurfacing structure comprises a betterment to the does not result in a betterment to the machine, including the engine, is the unit of building structure under paragraph (h)(1)(i) building structure under paragraph (h) of this property. The routine maintenance safe of this section because the amounts section. harbor in paragraph (g) of this section does ameliorate material conditions or defects that Example 3. Not amelioration of pre- not apply to the amounts paid because the existed prior to X’s acquisition of the existing material condition or defect. (i) In activities performed do more than return the building. Therefore, in accordance with January, Year 1, X purchased a used machine machine to the condition that existed at the paragraph (e)(2)(ii) of this section, X must for use in its manufacturing operations. time X placed it in service. The amount that treat the amounts paid for the betterment to Assume that the machine is a unit of X pays to inspect, retune, and replace minor the building structure as an improvement to property and has a class life of 10 years. X components of the ice resurfacing machine the building and must capitalize the amounts placed the machine in service in January, ameliorates a condition or defect that existed under paragraph (d)(1) of this section. Year 1 and at that time expected to perform prior to X’s acquisition of the equipment. Moreover, X is required to capitalize the manufacturer recommended scheduled Nevertheless, considering the facts and amounts paid to acquire and install each

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

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1, X capitalizes the costs of acquiring and (that is, the strength) of the hotel structure. shingles are not available on the market. X installing the new cash registers under X must treat the amount paid to remove and pays a contractor to replace all the wooden § 1.263(a)–2T(d)(1). In Year 3, X’s lease replace the parapets and cornices as an shingles with comparable asphalt shingles. expires and X decides to relocate its retail improvement because it results in a The amount that X pays to reshingle the roof store to a different building. In addition to betterment to the building structure under with asphalt shingles does not result in a various other costs, X pays $5,000 to move paragraph (h)(1)(iii) of this section. betterment to the shop building structure, the cash registers and $1,000 to reinstall Therefore, in accordance with paragraph even though the asphalt shingles may be them in the new store. The cash registers are (e)(2)(ii) of this section, X must treat the stronger than the wooden shingles. Because used for the same purposes and in the same amount paid for the betterment to the the wooden shingles could not practicably be manner that they were used in the former building structure as an improvement to the replaced with new wooden shingles, the location. The amounts that X pays to move hotel building and must capitalize the replacement of the old shingles with and reinstall the cash registers into its new amount paid under paragraph (d)(1) of this comparable asphalt shingles does not, by store do not result in a betterment to the cash section. City’s requirement that X correct the itself, result in a betterment, and therefore, an registers under paragraph (h) of this section. potential hazard to continue operating the improvement, to the shop building structure Example 10. Betterment; relocation and hotel is not relevant in determining whether under this paragraph (h). reinstallation of manufacturing equipment. the amount paid improved the hotel. See Example 15. Betterment; replacement with X operates a manufacturing facility in paragraph (f)(2) of this section. improved parts. Assume the same facts as in Building A, which contains various machines Example 12. Not a betterment; regulatory Example 14, except that, instead of replacing that X uses in its manufacturing business. X requirement. X owns a meat processing the wooden shingles with asphalt shingles, X decides to expand part of its operations by plant. X discovers that oil is seeping through pays a contractor to replace all the wooden relocating a machine to Building B to the concrete walls of the plant, creating a fire shingles with shingles made of lightweight reconfigure the machine with additional hazard. Federal meat inspectors advise X that composite materials that are maintenance- components. Assume that the machine is a it must correct the seepage problem or shut free and do not absorb moisture. The new single unit of property under paragraph (e)(3) down its plant. To correct the problem, X shingles have a 50-year warranty and a Class of this section. X pays amounts to pays an amount to add a concrete lining to A fire rating. The amount paid for these disassemble the machine, to move the the walls from the floor to a height of about shingles results in a betterment to the shop machine to the new location, and to reinstall four feet and also to add concrete to the floor building structure under paragraphs the machine in a new configuration with of the plant. Under paragraph (e)(2)(ii) of this (h)(1)(iii) and (h)(3)(iii) of this section additional components. Assume that the section, if the amount paid results in a because it results in a material increase in the reinstallation, including the reconfiguration betterment to the building structure or any quality of the shop building structure as and the addition of components, results in an building system, X must treat the amount as compared to the condition of the shop increase in capacity of the machine, and an improvement to the building. The event building structure prior to the storm. therefore results in a betterment to the necessitating the expenditure was the Therefore, in accordance with paragraph machine under paragraph (h)(3)(iii) of this seepage of the oil. Prior to the seepage, the (e)(2)(ii), X must treat the amount paid for the section. Accordingly, X must capitalize the plant did not leak and was functioning for its betterment of the building structure as an costs of reinstalling the machine as an intended use. X is not required to treat the improvement to the building and must improvement to the machine under amount paid as a betterment under paragraph capitalize the amount paid under paragraph paragraph (d)(1) of this section. X is also (h) of this section because it does not result (d)(1) of this section. required to capitalize the costs of in a material addition or material increase in Example 16. Material increase in capacity. disassembling and moving the machine to capacity, productivity, efficiency, strength or X owns a factory building with a storage area Building B because these costs directly quality of the building structure or its output on the second floor. X pays an amount to benefit and are incurred by reason of the compared to the condition of the structure replace the columns and girders supporting improvement to the machine under prior to the seepage of the oil. The federal the second floor to permit storage of supplies paragraph (f)(3)(i) of this section. meat inspectors’ requirement that X correct with a gross weight 50 percent greater than Example 11. Betterment; regulatory the seepage to continue operating the plant the previous load-carrying capacity of the requirement. X owns a hotel that includes is not relevant in determining whether the storage area. Under paragraph (e)(2)(ii) of this five feet high unreinforced terra cotta and amount paid improves the plant. See section, if the amount results in a betterment concrete parapets with overhanging cornices paragraph (f)(2) of this section. to the building structure or any building around the entire roof perimeter. The Example 13. Not a betterment; replacement system, X must treat the amount as an parapets and cornices are in good condition. with same part. X owns a small retail shop. improvement to the building. The columns In Year 1, City passes an ordinance setting A storm damages the roof of X’s shop by and girders are part of the building structure higher safety standards for parapets and displacing numerous wooden shingles. X defined under paragraph (e)(2)(ii)(A) of this cornices because of the hazardous conditions pays a contractor to replace all the wooden section. X must treat the amount paid to caused by earthquakes. To comply with the shingles on the roof with new wooden replace the columns and girders as a ordinance, X pays an amount to remove the shingles. Under paragraph (e)(2)(ii) of this betterment under paragraph (h)(1)(iii) of this old parapets and cornices and replace them section, if the amount paid results in a section because it materially increases the with new ones made of glass fiber reinforced betterment to the building structure or any load-carrying capacity of the building concrete, which makes them lighter and building system, X must treat the amount as structure. The comparison rule in paragraph stronger than the original components. They an improvement to the building. The roof is (h)(3)(iii) of this section does not apply to are attached to the hotel using welded part of the building structure under this amount because the expenditure was not connections instead of wire supports, making paragraph (e)(2)(ii)(A) of this section. The necessitated by a particular event. Therefore, them more resistant to damage from lateral event necessitating the expenditure was the in accordance with paragraph (e)(2)(ii) of this movement. Under paragraph (e)(2)(ii) of this storm. Prior to the storm, the building section, X must treat the amount paid for section, if the amount paid results in a structure was functioning for its intended betterment of the building structure as an betterment to the building structure or any use. X is not required to treat the amount improvement to the building and must building system, X must treat the amount as paid to replace the shingles as a betterment capitalize the amount paid under paragraph an improvement to the building. The under paragraph (h) of this section because (d)(1) of this section. parapets and cornices are part of the building it does not result in a material addition, or Example 17. Material increase in capacity. structure as defined in paragraph (e)(2)(ii)(A) material increase in the capacity, X owns harbor facilities consisting of a slip of this section. The event necessitating the productivity, efficiency, strength, or quality for the loading and unloading of barges and expenditure was the City ordinance. Prior to of the building structure or the output of the a channel leading from the slip to the river. the ordinance, the old parapets and cornices building structure compared to the condition At the time of purchase, the channel was 150 were in good condition, but were determined of the building structure prior to the storm. feet wide, 1,000 feet long, and 10 feet deep. by City to create a potential hazard. After the Example 14. Not a betterment; replacement To allow for ingress and egress and for the expenditure, the new parapets and cornices with comparable part. Assume the same unloading of its barges, X needs to deepen materially increased the structural soundness facts as in Example 13, except that wooden the channel to a depth of 20 feet. X pays a

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contractor to dredge the channel to the resulting from the sale or exchange of another provision of the Internal required depth. Assume the channel is the the component; Revenue Code (for example, section unit of property. X must capitalize as an (iii) Is for the repair of damage to a 263A). Unless otherwise stated, assume improvement the amounts paid for the unit of property for which the taxpayer that X has not properly deducted a loss dredging because they result in a material has properly taken a basis adjustment as for, nor taken into account the adjusted increase in the capacity of the channel under paragraph (h)(1)(iii) of this section. The a result of a casualty loss under section basis on a sale or exchange of, any unit comparison rule in paragraph (h)(3)(iii) of 165, or relating to a casualty event of property, asset, or component of a this section does not apply to these amounts described in section 165; unit of property that is replaced: (iv) Returns the unit of property to its paid because the expenditure was not Example 1. Replacement of loss necessitated by a particular event. ordinarily efficient operating condition component. X owns a manufacturing Example 18. Not a material increase in if the property has deteriorated to a state building containing various types of capacity. Assume the same facts as in of disrepair and is no longer functional manufacturing equipment. X does a cost Example 17, except that the channel was for its intended use; segregation study of the manufacturing susceptible to siltation and, by the next (v) Results in the rebuilding of the building and properly determines that a taxable year, the channel depth had been unit of property to a like-new condition walk-in freezer in the manufacturing building reduced to 18 feet. X pays a contractor to after the end of its class life as defined is section 1245 property as defined in section redredge the channel to a depth of 20 feet. in paragraph (g)(4) of this section (see 1245(a)(3). The freezer is not part of the The event necessitating the expenditure was building structure under paragraph (e)(2)(i) of the siltation of the channel. Both prior to the paragraph (i)(3) of this section); or this section or the HVAC system, which is a siltation and after the redredging, the depth (vi) Is for the replacement of a part or separate building system under paragraph of the channel was 20 feet. X is not required a combination of parts that comprise a (e)(2)(ii)(B)(1) of this section. Several to treat the amounts paid to redredge the major component or a substantial components of the walk-in freezer cease to channel as a betterment under paragraphs structural part of a unit of property (see function and X decides to replace them. X (h)(1)(ii) or (h)(1)(iii) of this section because paragraph (i)(4) of this section). abandons the old freezer components and they do not result in a material addition to (2) Restorations of buildings. In the properly recognizes a loss from the the unit of property or a material increase in case of a building, an amount is paid to abandonment of the components. X replaces the capacity, productivity, efficiency, restore the unit of property if it restores the abandoned freezer components with new strength, or quality of the unit of property or components and incurs costs to acquire and any of the properties designated in install the new components. Under the output of the unit of property. paragraphs (e)(2)(ii), (e)(2)(iii)(B), Example 19. Not a material increase in paragraph (i)(1)(i) of this section, X must capacity. X owns a building used in its trade (e)(2)(iv)(B), (e)(2)(v)(B) of this section. capitalize the amounts paid to acquire and or business. The first floor has a drop-ceiling. (3) Rebuild to like-new condition. For install the new freezer components because X pays an amount to remove the drop-ceiling purposes of paragraph (i)(1)(v) of this X replaced components for which it had and repaint the original ceiling. Under section, a unit of property is rebuilt to properly deducted a loss. paragraph (e)(2)(ii) of this section, if the a like-new condition if it is brought to Example 2. Replacement of sold amount paid results in a betterment to the the status of new, rebuilt, component. Assume the same facts as in Example 1 except that X did not abandon the building structure or any building system, X remanufactured, or similar status under must treat the amount as an improvement to components, but instead sold them to the terms of any federal regulatory another party and properly recognized a loss the building. The ceiling is part of the guideline or the manufacturer’s original building structure as defined under on the sale. Under paragraph (i)(1)(ii) of this specifications. section, X must capitalize the amounts paid paragraph (e)(2)(ii)(A) of this section. X is not to acquire and install the new freezer required to treat the amount paid to remove (4) Replacement of a major components because X replaced components the drop-ceiling as a betterment because it component or a substantial structural for which it had properly taken into account did not result in a material addition under part. To determine whether an amount is for the replacement of a part or a the adjusted basis of the components in paragraph (h)(1)(ii) of this section or a realizing a loss from the sale of the material increase to the capacity, combination of parts that comprise a components. productivity, efficiency, strength, or quality major component or a substantial Example 3. Restoration after casualty loss. of the building structure or output of the structural part of the unit of property, it X owns an office building that it uses in its building structure under paragraph (h)(1)(iii) is appropriate to consider all the facts trade or business. A storm damages the office of this section. The comparison rule in and circumstances. These facts and building at a time when the building has an paragraph (h)(3)(iii) of this section does not circumstances include the quantitative adjusted basis of $500,000. X deducts under apply to these amounts paid because the section 165 a casualty loss in the amount of expenditure was not necessitated by a or qualitative significance of the part or combination of parts in relation to the $50,000 and properly reduces its basis in the particular event. office building to $450,000. X hires a unit of property. A major component or (i) Capitalization of restorations—(1) contractor to repair the damage to the substantial structural part includes a building and pays the contractor $50,000 for In general. A taxpayer must capitalize part or combination of parts that the work. Under paragraph (i)(1)(iii) of this amounts paid to restore a unit of comprise a large portion of the physical section, X must capitalize the $50,000 property, including amounts paid in structure of the unit of property or that amount paid to the contractor because X making good the exhaustion for which perform a discrete and critical function properly adjusted its basis in that amount as an allowance is or has been made. An in the operation of the unit of property. a result of a casualty loss under section 165. Example 4. Restoration after casualty amount is paid to restore a unit of However, the replacement of a minor property only if it— event. Assume the same facts as in Example component of the unit of property, even 3, except that X receives insurance proceeds (i) Is for the replacement of a though such component may affect the of $50,000 after the casualty to compensate component of a unit of property and the function of the unit of property, will not for its loss. X cannot deduct a casualty loss taxpayer has properly deducted a loss generally, by itself, constitute a major under section 165 because its loss was for that component (other than a component or substantial structural compensated by insurance. However, X casualty loss under § 1.165–7); part. properly reduces its basis in the property by (ii) Is for the replacement of a (5) Examples. The following examples the amount of the insurance proceeds. Under paragraph (i)(1)(iii) of this section, X must component of a unit of property and the illustrate the application of this capitalize the $50,000 amount paid to the taxpayer has properly taken into paragraph (i) only and do not address contractor because X has properly taken a account the adjusted basis of the whether capitalization is required under basis adjustment relating to a casualty event component in realizing gain or loss another provision of this section or described in section 165.

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Example 5. Restoration of property in a Example 8. Replacement of major leaking USTs. In Year 1, X hires a contractor state of disrepair. X owns and operates a component or substantial structural part; to perform the removal and replacement, farm with several barns and outbuildings. X personal property. X is a common carrier which consists of removing the old tanks and did not use or maintain one of the that owns a fleet of petroleum hauling trucks. installing new tanks with leak detection outbuildings on a regular basis, and the X pays amounts to replace the existing systems. The removal of the old tanks outbuilding fell into a state of disrepair. The engine, cab, and petroleum tank with a new includes removing the paving material outbuilding previously was used for storage engine, cab, and tank. Assume the tractor of covering the tanks, excavating a hole large but can no longer be used for that purpose the truck (which includes the cab and the enough to gain access to the old tanks, because the building is not structurally engine) is a single unit of property, and that disconnecting any strapping and pipe sound. X decides to restore the outbuilding the trailer (which contains the petroleum connections to the old tanks, and lifting the and pays an amount to shore up the walls tank) is a separate unit of property. The new old tanks out of the hole. Installation of the and replace the siding. Under paragraph engine and cab constitute parts or new tanks includes placement of a liner in (e)(2)(ii) of this section, if the amount paid combinations of parts that comprise a major the excavated hole, placement of the new results in a restoration of the building component or substantial structural part of tanks, installation of a leak detection system, structure or any building system, X must X’s tractor. Therefore, the amounts paid for installation of an overfill system, connection treat the amount as an improvement to the the replacement of those components must of the tanks to the pipes leading to the building. The walls and siding are part of the be capitalized under paragraph (i)(1)(vi) of pumps, backfilling of the hole, and building structure under paragraph this section. The new petroleum tank replacement of the paving. X also is required (e)(2)(ii)(A) of this section. Under paragraph constitutes a part or combination of parts that to pay a permit fee to the county to undertake (i)(1)(iv) of this section, X must treat the comprise a major component and a the installation of the new tanks. amount paid to shore up the walls and substantial structural part of the trailer. (ii) X pays the permit fee to the county on replace the siding as a restoration of the Accordingly, the amounts paid for the October 15, Year 1. On December 15, Year 1, building structure because the amounts replacement of the tank also must be the contractor completes the removal of the return the building structure to its ordinarily capitalized under paragraph (i)(1)(vi) of this old USTs and bills X for the costs of removal. efficient operating condition after it had section. On January 15, Year 2, the contractor deteriorated to a state of disrepair and was Example 9. Repair performed during a completes the installation of the new USTs no longer functional for its intended use. restoration. Assume the same facts as in and bills X for the remainder of the work. Therefore, in accordance with paragraph Example 8, except that, at the same time the Assume that X computes its taxes on a (e)(2)(ii) of this section, X must treat the engine and cab of the tractor are replaced, X calendar year basis and X’s gasoline amount paid as an improvement to the pays amounts to paint the cab of the tractor distribution system is the unit of property. building and must capitalize the amount paid with its company logo and to fix a broken Under paragraph (i)(1)(vi) of this section, X under paragraph (d)(2) of this section. taillight on the tractor. The repair of the must capitalize the amounts paid to replace Example 6. Rebuild of property to like-new broken taillight and the painting of the cab the USTs as a restoration to the gasoline condition before end of class life. X is a Class generally are deductible expenses under distribution system because the USTs are I railroad that owns a fleet of freight cars. § 1.162–4T. However, under paragraph parts or combinations of parts that comprise Freight cars have a recovery period of 7 years (f)(3)(i) of this section, a taxpayer must a major component and substantial structural under section 168(c) and a class life of 14 capitalize all the direct costs of an part of the gasoline distribution system. years. Every 8 to 10 years, X rebuilds its improvement and all the indirect costs that Moreover, under paragraph (f)(3) of this freight cars. Ten years after X places the directly benefit or are incurred by reason of section, X must capitalize the costs of freight car in service, X performs a rebuild, an improvement in accordance with the rules removing the old USTs because these which includes a complete disassembly, under section 263A. Repairs and amounts directly benefit and are incurred by inspection, and reconditioning or maintenance that do not directly benefit or reason of the improvement to the gasoline replacement of components of the are not incurred by reason of an distribution system. Finally, under paragraph suspension and draft systems, trailer hitches, improvement are not required to be (f)(4) of this section, X must capitalize the and other special equipment. X modifies the capitalized under section 263(a), regardless aggregate of related amounts paid to improve car to upgrade various components to the of whether they are made at the same time the gasoline distribution system, including latest engineering standards. The freight car as an improvement. Under paragraph (f)(3)(i) the amount paid to the county, the amount essentially is stripped to the frame, with all of this section, X must capitalize the amounts paid to remove the old USTs, and the amount of its substantial components either paid to paint the cab as part of the paid to install the new USTs, even though reconditioned or replaced. The frame itself is improvement to the tractor because these the amounts were separately invoiced, paid the longest-lasting part of the car and is amounts directly benefit and are incurred by to different parties, and incurred in different reconditioned. The walls of the freight car are reason of the restoration of the cab. Amounts tax years. replaced or are sandblasted and repainted. paid to repair the broken taillight, however, Example 11. Not replacement of major New wheels are installed on the car. All the are not incurred by reason of the restoration component or substantial structural part; remaining components of the car are restored of the tractor, nor do the amounts paid personal property. X owns a machine shop before they are reassembled. At the end of the directly benefit the tractor restoration, even in which it makes dies used by rebuild, the freight car has been restored to though the repair was performed at the same manufacturers. In Year 1, X purchased a drill rebuilt condition under the manufacturer’s time as the restoration. Thus, X must press for use in its production process. In specifications. Assume the freight car is the capitalize the amounts paid to paint the cab Year 3, X discovers that the power switch unit of property. X is not required to under paragraph (i)(1)(vi) and (f)(3)(i) of this assembly, which controls the supply of capitalize under paragraph (i)(1)(v) of this section, but X is not required to capitalize the electric power to the drill press, has become section the amounts paid to rebuild the amounts paid to repair the broken taillight. damaged and could not operate. To correct freight car because, although the amounts Example 10. Related amounts to replace this problem, X paid amounts to replace the paid restore the freight car to like-new major component or substantial structural power switch assembly with comparable, condition, the amounts were not paid after part; personal property. (i) X owns a retail commercially available and reasonable the end of the class life of the freight car. gasoline station, consisting of a paved area replacement parts. Assume that the drill Example 7. Rebuild of property to like-new used for automobile access to the pumps and press is a unit of property under paragraph condition after end of class life. Assume the parking areas, a building used to market (e) of this section and the power switch same facts as in Example 6, except that X gasoline, and a canopy covering the gasoline assembly is a small component of the drill rebuilds the freight car 15 years after X places pumps. The premises also consist of press that may be removed and installed with it in service. Under paragraph (i)(1)(v) of this underground storage tanks (USTs) that are relative ease. Thus, the power switch section, X must capitalize the amounts paid connected by piping to the pumps and are assembly is not a major component or to rebuild the freight car because the amounts part of the machinery used in the immediate substantial structural part of X’s drill press paid restore the freight car to like-new retail sale of gas. To comply with regulations under paragraph (i)(3) of this section. X is not condition after the end of the class life of the issued by the Environmental Protection required to capitalize the costs to replace the freight car. Agency, X is required to remove and replace power switch assembly under paragraph

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

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

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Example 25. Not replacement of major an amount is paid to adapt the unit of paid by X to remove the walls does not component or substantial structural part; property to a new or different use if it improve the building under paragraph (d)(3) floors. X owns and operates a hotel building. adapts to a new or different use any of of this section. X decides to refresh the appearance of the Example 3. Not a new or different use. X hotel lobby by replacing the floors in the the properties designated in paragraphs owns a building consisting of twenty retail lobby. The hotel lobby comprises a small (e)(2)(ii), (e)(2)(iii)(B), (e)(2)(iv)(B), or spaces. X decides to sell the building. In portion of the entire hotel building. X pays (e)(2)(v)(B) of this section. anticipation of selling the building, X pays an an amount to replace the wood flooring in (3) Examples. The following examples amount to repaint the interior walls and to the lobby with new wood flooring. X did not illustrate solely the rules of this refinish the hardwood floors. Under replace any other flooring in the building. paragraph (j). Even if capitalization is paragraph (e)(2)(ii) of this section, if the Assume that the wood flooring constitutes not required in an example under this amount paid adapts the buildings structure to section 1250 property. Under paragraph paragraph (j), the amounts paid in the a new or different use, X must treat the (e)(2)(ii) of this section, if the amount paid amount as an improvement to the building. results in a restoration of the building example may be subject to capitalization Preparing the building for sale does not structure or any building system, X must under a different provision of this constitute a new or different use for the treat the amount as an improvement to the section or another provision of the building structure under paragraph (j)(1) of building. The wood flooring is part of the Internal Revenue Code (for example, this section. Therefore, the amount paid to building structure under paragraph section 263A). Unless otherwise stated, prepare the building structure for sale does (e)(2)(ii)(A) of this section. The replacement assume that X has not properly not improve the building under paragraphs wood flooring in the lobby of the building deducted a loss for any unit of property, (d)(3) of this section. does not comprise a large portion of the asset, or component of a unit of property Example 4. New or different use. X owns physical structure of the hotel building or a parcel of land on which it previously perform a discrete and critical function in the that is removed and replaced. operated a manufacturing facility. Assume operation of the hotel building structure. Example 1. New or different use. X is a that the land is the unit of property. During Therefore, under paragraph (i)(4) of this manufacturer and owns a manufacturing the course of X’s operation of the section, the wood flooring does not a building that it has used for manufacturing manufacturing facility, the land became constitute major component or substantial since Year 1, when X placed it in service. In contaminated with wastes from its structural part of the hotel building structure. Year 30, X pays an amount to convert its manufacturing processes. X discontinues Accordingly, X is not required to treat the manufacturing building into a showroom for manufacturing operations at the site, and amount paid to replace the wood flooring in its business. To convert the facility, X decides to sell the property to a developer the hotel lobby as a restoration under removes and replaces various structural that intends to use the property for paragraph (i)(1)(vi) of this section. components to provide a better layout for the residential housing. In anticipation of selling Example 26. Replacement of major showroom and its offices. X also repaints the the land, X pays an amount to cleanup the component or substantial structural part; building interiors as part of the conversion. land to a standard that is required for the floors. Assume the same facts as Example 25 None of the materials used are better than land to be used for residential purposes. In except that X decides to refresh the existing materials in the building. Under addition, X pays an amount to regrade the appearance of all the public areas of the hotel paragraph (e)(2)(ii) of this section, if the land so that it can be used for residential building by replacing the floors. To that end, amount paid adapts the building structure to purposes. Amounts that X pays to cleanup X pays an amount to replace all the wood a new or different use, X must treat the wastes that were discharged in the course of floors in all the public areas of the hotel amount as an improvement to the building. X’s manufacturing operations do not adapt building with new wood floors. The public Under paragraph (j)(1) of this section, the the land to a new or different use, regardless areas include the lobby, the hallways, the amount paid to convert the manufacturing of the extent to which the land was cleaned. meeting rooms, and other public rooms facility into a showroom adapts the building Therefore, X is not required to capitalize the throughout the hotel interiors. The structure to a new or different use because amount paid for the cleanup under paragraph replacement wood floors in all the public the conversion is not consistent with X’s (j)(1) of this section. However, the amount areas comprise a large portion of the physical intended ordinary use of the building paid to regrade the land so that it can be used structure of the hotel building structure and structure at the time it was placed in service. for residential purposes adapts the land to a perform a discrete and critical function in the Therefore, in accordance with paragraph new or different use that is inconsistent with operation of X’s hotel building structure. (e)(2)(ii) of this section, X must treat the X’s intended ordinary use of the property at Therefore, under paragraph (i)(4) of this amount paid for the adaptation of the the time it was placed in service. section, replacement wood floors comprise a building structure as an amount that Accordingly, the amounts paid to regrade the major component or substantial structural improves the building. Accordingly, X must land must be capitalized as improvements part of the building structure, and X must capitalize the amount as an improvement under paragraphs (j)(1) of this section. under paragraph (d)(3) of this section. treat the amount paid to replace the floors as (k) Optional regulatory accounting a restoration of the building structure under Example 2. Not a new or different use. X paragraph (i)(1)(vi) of this section. As a owns a building consisting of twenty retail method—(1) In general. This paragraph result, in accordance with paragraph (e)(2)(ii) spaces. The space was designed to be (k) provides an optional simplified of this section, X must treat the amounts paid reconfigured; that is, adjoining spaces could method (the regulatory accounting to restore the building structure as an be combined into one space. One of the method) for regulated taxpayers to improvement to the building and must tenants expands its occupancy to include two determine whether amounts paid to capitalize the amounts under paragraph adjoining retail spaces. To facilitate the new repair, maintain, or improve tangible (d)(2) of this section. lease, X pays an amount to remove the walls property are to be treated as deductible between the three retail spaces. Assume that (j) Capitalization of amounts to adapt the walls between spaces are part of the expenses or capital expenditures. A property to a new or different use—(1) building and its structural components. taxpayer that uses the regulatory In general. Taxpayers must capitalize Under paragraph (e)(2)(ii) of this section, if accounting method described in amounts paid to adapt a unit of property the amount paid adapts the buildings paragraph (k)(3) of this section must use to a new or different use. In general, an structure to a new or different use, X must that method for property subject to amount is paid to adapt a unit of treat the amount as an improvement to the regulatory accounting instead of property to a new or different use if the building. Under paragraph (j)(1) of this determining whether amounts paid to adaptation is not consistent with the section, the amount paid to convert three repair, maintain, or improve property retail spaces into one larger space for an are capital expenditures or deductible taxpayer’s intended ordinary use of the existing tenant does not adapt X’s building unit of property at the time originally structure to a new or different use because expenses under the general principles of placed in service by the taxpayer. the combination of retail spaces is consistent sections 162(a), 212, and 263(a). Thus, (2) Adapting buildings to new or with X’s intended, ordinary use of the the capitalization rules in paragraph (d) different use. In the case of a building, building structure. Therefore, the amount (and the routine maintenance safe

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harbor described in paragraph (g)) of income tax purposes amounts paid for section, a change to comply with this this section do not apply to amounts repairs performed on its turbines or its section is a change in method of paid to repair, maintain, or improve network assets. accounting to which the provisions of property subject to regulatory Example 2. Taxpayer not subject to sections 446 and 481, and the regulatory accounting rules of FERC. X is an accounting by taxpayers that use the electric utility company that operates a regulations thereunder apply. A regulatory accounting method under power plant to generate electricity. X taxpayer seeking to change to a method this paragraph (k). However, section previously was subject to the regulatory of accounting permitted in this section 263A continues to apply to costs accounting rules of FERC but, for various must secure the consent of the required to be capitalized to property reasons, X is no longer required to use Commissioner in accordance with produced by the taxpayer or to property FERC’s regulatory accounting rules. X cannot § 1.446–1(e) and follow the acquired for resale. use the regulatory accounting method administrative procedures issued under (2) Eligibility for regulatory provided in this paragraph (k). § 1.446–1(e)(3)(ii) for obtaining the Example 3. Taxpayer subject to regulatory accounting method. A taxpayer that is accounting rules of FCC. X is a Commissioner’s consent to change its engaged in a trade or business in a telecommunications company that is subject accounting method. regulated industry may use the to the regulatory accounting rules of the FCC. (p) Effective/applicability date. This regulatory accounting method under X chooses to use the regulatory accounting section applies to taxable years this paragraph (k). For purposes of this method under this paragraph (k). X’s assets beginning on or after January 1, 2012. paragraph (k), a taxpayer in a regulated include a telephone central office switching For the applicability of regulations to industry is a taxpayer that is subject to center, which contains numerous switches taxable years beginning before January the regulatory accounting rules of the and various switching equipment. X 1, 2012, see § 1.263(a)–3 in effect prior capitalizes on its books and records for Federal Energy Regulatory Commission regulatory accounting purposes the cost of to January 1, 2012 (§ 1.263(a)–3 as (FERC), the Federal Communications replacing each switch. Under the regulatory contained in 26 CFR part 1 edition Commission (FCC), or the Surface accounting method, X is required to revised as of April 1, 2011). Transportation Board (STB). capitalize for Federal income tax purposes (q) Expiration date. The applicability (3) Description of regulatory amounts paid to replace each switch. of this section expires on of before accounting method. Under the Example 4. Taxpayer subject to regulatory December 23, 2014. regulatory accounting method, a accounting rules of STB. X is a Class I ■ Par. 31. Section 1.263(a)–6T is added taxpayer must follow its method of railroad that is subject to the regulatory to read as follows: accounting rules of the STB. X chooses to use accounting for regulatory accounting the regulatory accounting method under this purposes in determining whether an § 1.263(a)–6T Election to deduct or paragraph (k). X capitalizes on its books and capitalize certain expenditures (temporary). amount paid improves property under records for regulatory accounting purposes this section. Therefore, a taxpayer must the cost of locomotive rebuilds. Under the (a) In general. Under certain capitalize for Federal income tax regulatory accounting method, X is required provisions of the Internal Revenue purposes an amount paid that is to capitalize for federal income tax purposes Code, taxpayers may elect to treat capitalized as an improvement for amounts paid to rebuild its locomotives. capital expenditures as deductible regulatory accounting purposes. A (l) Methods of accounting authorized expenses or as deferred expenses, or to taxpayer must not capitalize for Federal in published guidance. A taxpayer may treat deductible expenses as capital income tax purposes under this section use a repair allowance method of expenditures. (b) Election provisions. The sections an amount paid that is not capitalized accounting or any other method of referred to in paragraph (a) of this as an improvement for regulatory accounting that is authorized in section include: published guidance in the Federal accounting purposes. A taxpayer that (1) Section 173 (circulation Register or in the Internal Revenue uses the regulatory accounting method expenditures); must use that method for all of its Bulletin (see § 601.601(d)(2)(ii)(b) of this (2) Section 174 (research and tangible property that is subject to chapter). experimental expenditures); regulatory accounting rules. The method (m) Treatment of capital (3) Section 175 (soil and water does not apply to tangible property that expenditures. Amounts required to be conservation expenditures; endangered is not subject to regulatory accounting capitalized under this section are capital species recovery expenditures); rules. The method also does not apply expenditures and must be taken into (4) Section 179 (election to expenses to property for the taxable years in account through a charge to capital certain depreciable business assets); which the taxpayer elected to apply the account or basis, or in the case of (5) Section 179A (deduction for clean- repair allowance under § 1.167(a)– property that is inventory in the hands fuel vehicles and certain refueling 11(d)(2). of a taxpayer, through inclusion in property); (4) Examples. The rules of this inventory costs. See section 263A for (6) Section 179B (deduction for paragraph (k) are illustrated by the the treatment of direct and indirect costs capital costs incurred in complying with following examples: of producing property or acquiring environmental protection agency sulfur property for resale. regulations); Example 1. Taxpayer subject to regulatory (n) Recovery of capitalized amounts. accounting rules of FERC. X is an electric (7) Section 179C (election to expense utility company that operates a power plant Amounts that are capitalized under this certain refineries); that generates electricity and that owns and section are recovered through (8) Section 179D (energy efficient operates network assets to transmit and depreciation, cost of goods sold, or by commercial buildings deduction); distribute the electricity to its customers. X an adjustment to basis at the time the (9) Section 179E (election to expense is subject to the regulatory accounting rules property is placed in service, sold, used, advanced mine safety equipment); of FERC and X chooses to use the regulatory or otherwise disposed of by the (10) Section 180 (expenditures by accounting method under paragraph (k) of taxpayer. Cost recovery is determined farmers for fertilizer); this section. X does not capitalize on its books and records for regulatory accounting by the applicable Internal Revenue Code (11) Section 181 (treatment of certain purposes the cost of repairs and maintenance and regulation provisions relating to the qualified film and television performed on its turbines or its network use, sale, or disposition of property. productions); assets. Under the regulatory accounting (o) Accounting method changes. (12) Section 190 (expenditures to method, X must not capitalize for Federal Except as otherwise provided in this remove architectural and transportation

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barriers to the handicapped and ■ Par. 33. Section 1.263A–1T is added (e)(2)(ii)(F) through (k)(5) [Reserved]. elderly); to read as follows: For further guidance, see § 1.263A– (13) Section 191 (tertiary injectants); 1(e)(2)(ii)(F) through (k)(5). (14) Section 194 (treatment of § 1.263A–1T Uniform capitalization of costs (temporary). (l) Change in method of accounting reforestation expenditures); for de minimis costs. A change in the (a) through (b)(13) [Reserved]. For (15) Section 195 (start-up treatment of amounts paid for property further guidance, see § 1.263A–1(a) expenditures); subject to the de minimis rule to comply (16) Section 198 (expensing of through (b)(13). (14) Property subject to de minimis with paragraph (b)(14) of this section is environmental remediation costs); a change in method of accounting to (17) Section 198A (expensing of rule. Section 263A does not apply to the costs of property produced by a which the provisions of sections 446 qualified disaster expenses); and 481, and the regulations thereunder (18) Section 248 (organization taxpayer to which the taxpayer properly applies the de minimis rule under apply. A taxpayer seeking to change to expenditures of a corporation); a method of accounting permitted in (19) Section 266 (carrying charges); § 1.263(a)–2T(g). However, the cost of paragraph (b)(14) of this section must (20) Section 616 (development property to which a taxpayer properly secure the consent of the Commissioner expenditures); and applies the de minimis rule under (21) Section 709 (organization and § 1.263(a)–2T(g) may be required to be in accordance with § 1.446–1(e) and syndication fees of a partnership). capitalized to other property as a cost follow the administrative procedures (c) Effective/applicability date. This incurred by reason of the production of issued under § 1.446–1(e)(3)(ii) for section applies to taxable years the other property that is subject to obtaining the Commissioner’s consent to beginning on or after January 1, 2012. section 263A. change its accounting method. For the applicability of regulations to (c)(1) through (c)(3) [Reserved]. For (m) Effective/applicability date. (1) taxable years beginning before January further guidance, see § 1.263A–1(c)(1) Paragraphs (h)(2)(i)(D), (k), and (m)(1) of 1, 2012, see § 1.263(a)–3 in effect prior through (c)(3). this section apply for taxable years to January 1, 2012 (§ 1.263(a)–3 as (4) Recovery of capitalized costs. ending on or after August 2, 2005. contained in 26 CFR part 1 edition Except as provided in § 1.162–3T(a)(2) (2) Paragraph (b)(14), the introductory revised as of April 1, 2011). For the (amounts paid to produce incidental phrase of paragraph (c)(4), the last effective dates of the enumerated materials and supplies), costs that are sentence of paragraphs (e)(2)(i)(A) and election provisions, see those Internal capitalized under section 263A are (e)(2)(ii)(E), paragraph (l), and paragraph Revenue Code sections and the recovered through depreciation, (m)(2) of this section apply to amounts regulations thereunder. amortization, cost of goods sold, or by paid or incurred (to acquire or produce (d) Expiration date. The applicability an adjustment to basis at the time the property) in taxable years beginning on of this section expires on of before property is used, sold, placed in service, or after January 1, 2012. For the December 23, 2014. or otherwise disposed of by the applicability of § 1.263A–1 to taxable ■ Par. 32. Section 1.263A–1 is amended taxpayer. Cost recovery is determined years beginning before January 1, 2012, by: by the applicable Internal Revenue Code see § 1.263A–1 in effect prior to January ■ 1. Adding paragraph (b)(14). and regulation provisions relating to 1, 2012 (§ 1.263A–1 as contained in 26 ■ 2. Revising paragraph (c)(4). use, sale, or disposition of property. CFR part 1 edition revised as of April 1, ■ 3. Revising paragraph (e)(2)(i)(A). (d)(1) through (e)(2)(i) [Reserved]. For 2011). ■ 4. Revising paragraph (e)(3)(ii)(E). further guidance, see § 1.263A–1(d)(1) (3) Expiration date. The applicability ■ 5. Revising paragraph (l). through (e)(2)(i). of this section expires on December 23, ■ 6. Adding paragraph (m). (A) Direct material costs. Direct 2014. The additions and revisions read as materials costs include the cost of those ■ Par. 34. Section 1.1016–3 is amended follows: materials that become an integral part of by: specific property produced and those ■ § 1.263A–1 Uniform capitalization of costs. materials that are consumed in the 1. Revising paragraphs (a)(1)(ii) and * * * * * ordinary course of production and that (j)(1). (b) * * * can be identified or associated with ■ 2. Adding paragraph (j)(3). (14) [Reserved]. For further guidance, particular units or groups of units of The addition and revision read as see § 1.263A–1T(b)(14). property produced. For example, a cost follows: (c) * * * described in § 1.162–3T, relating to the § 1.1016–3 Exhaustion, wear and tear, (4) [Reserved]. For further guidance, cost of a material or supply, may be a see § 1.263A–1T(c)(4). obsolescence, amortization, and depletion direct material cost. for periods since February 13, 1913. * * * * * (e)(2)(i)(B) through (e)(2)(ii)(D) (e) * * * [Reserved]. For further guidance, see (a) * * * (2) * * * § 1.263A–1(e)(2)(i)(B) through (1) * * * (i) * * * (e)(2)(ii)(D). (ii) [Reserved]. For further guidance, (A) [Reserved]. For further guidance, (E) Indirect material costs. Indirect see § 1.1016–3T(a)(1)(ii). see § 1.263A–1T(e)(2)(i)(A). material costs include the cost of * * * * * * * * * * materials that are not an integral part of (j) * * * (3) * * * specific property produced and the cost (1) In general. [Reserved]. For further (ii) * * * of materials that are consumed in the guidance, see § 1.1016–3T(j)(1). (E) [Reserved]. For further guidance, ordinary course of performing see § 1.263A–1T(e)(3)(ii)(E). production or resale activities that * * * * * * * * * * cannot be identified or associated with (3) Application of § 1.1016– (l) [Reserved]. For further guidance, particular units of property. Thus, for 3T(a)(1)(ii). [Reserved]. For further see § 1.263A–1T(l). example, a cost described in § 1.162–3T, guidance, see § 1.1016–3T(j)(3). (m) [Reserved]. For further guidance, relating to the cost of a material or ■ Par. 35. Section 1.1016–3T is added to see § 1.263A–1T(m). supply, may be an indirect cost. read as follows:

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§ 1.1016–3T Exhaustion, wear and tear, Example. On July 1, 2011, A, a calendar- December 30, 2003. For the applicability obsolescence, amortization, and depletion year taxpayer, purchased and placed in of regulations before December 30, 2003, for periods since February 13, 1913 service ‘‘off-the-shelf’’ computer software at a see § 1.1016–3 in effect prior to (temporary). cost of $36,000. This computer software is not an amortizable section 197 intangible. December 30, 2003 (§ 1.1016–3 as (a)(1)(i) [Reserved]. For further Pursuant to section 167(f)(1), the useful life contained in 26 CFR part 1 edition guidance, see § 1.1016–3(a)(1)(i). of the computer software is 36 months. It has revised as of April 1, 2003). (a)(1)(ii) The determination of the no salvage value. For 2011, A elected not to (2) [Reserved]. For further guidance, deduct the additional first year depreciation see § 1.1016–3(j)(2). amount properly allowable for deduction provided by section 168(k). A did exhaustion, wear and tear, obsolescence, not deduct any depreciation for the computer (3) Application of § 1.1016– amortization, and depletion must be software for 2011 and deducted depreciation 3T(a)(1)(ii). Paragraph (a)(1)(ii) of this made on the basis of facts reasonably of $12,000 for the computer software for section applies to taxable years known to exist at the end of the taxable 2012. As a result, the total amount of beginning on or after January 1, 2012. year. A taxpayer is not permitted to take depreciation allowed for the computer For the applicability of § 1.1016– advantage in a later year of the software as of December 31, 2012, was 3(a)(1)(ii) to taxable years beginning $12,000. However, the total amount of taxpayer’s prior failure to take any such depreciation allowable for the computer before January 1, 2012, see § 1.1016– allowance or the taxpayer’s taking an software as of December 31, 2012, is $18,000 3(a)(1)(ii) in effect prior to January 1, allowance plainly inadequate under the ($6,000 for 2011 + $12,000 for 2012). As a 2012 (§ 1.1016–3(a)(1)(ii) as contained known facts in prior years. In the case result, the unrecovered cost of the computer in 26 CFR part 1 edition revised as of of depreciation, if in prior years the software as of December 31, 2012, is $18,000 April 1, 2010). taxpayer has consistently taken proper (cost of $36,000 less the depreciation allowable of $18,000 as of December 31, (4) Expiration date. The applicability deductions under one method, the 2012). Accordingly, depreciation for 2013 for of this section expires on December 23, amount allowable for such prior years the computer software is $12,000 2014. must not be increased even though a (unrecovered cost of $18,000 divided by the Steven T. Miller, greater amount would have been remaining useful life of 18 months as of allowable under another proper method. January 1, 2013, multiplied by 12 full months Deputy Commissioner for Services and For rules governing losses on retirement in 2013). Enforcement. or disposition of depreciable property, (a)(2) through (i) [Reserved]. For Approved: December 5, 2011. including rules for determining basis, further guidance, see § 1.1016–3(a)(2) Emily S. McMahon, see § 1.167(a)–8T, § 1.168(i)–1T, or through (i). (Acting) Assistant Secretary of the Treasury § 1.168(i)–8T, as applicable. The (j)(1) In general. Except as provided in (Tax Policy). application of this paragraph is paragraphs (j)(2) and (j)(3) of this [FR Doc. 2011–32024 Filed 12–23–11; 8:45 am] illustrated by the following example: section, this section applies on or after BILLING CODE 4830–01–P

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