48590 Federal Register / Vol. 71, No. 161 / Monday, August 21, 2006 / Proposed Rules 

DEPARTMENT OF THE TREASURY 

Internal Revenue Service 

26 CFR Part 1 

[REG–168745–03] 

RIN 1545–BE18 

Guidance Regarding Deduction and 

Capitalization of Expenditures Related 

to Tangible Property 

AGENCY: Internal Revenue Service (IRS), 

Treasury. 

ACTION: Notice of proposed rulemaking 

and notice of public hearing. 

SUMMARY: This document contains 

proposed regulations that explain how 

section 263(a) of the Internal Revenue 

Code (Code) applies to amounts paid to 

acquire, produce, or improve tangible 

property. The proposed regulations 

clarify and expand the standards in the 

current regulations under section 263(a), 

as well as provide some bright-line tests 

(for example, a 12-month rule for 

acquisitions and a repair allowance for 

improvements). The proposed 

regulations will affect all taxpayers that 

acquire, produce, or improve tangible 

property. This document also provides 

a notice of public hearing on the 

proposed regulations. 

DATES: Written or electronic comments 

must be received by November 20, 2006. 

Requests to speak and outlines of topics 

to be discussed at the public hearing 

scheduled for Tuesday, December 19, 

2006, at 10 a.m., must be received by 

November 28, 2006. 

ADDRESSES: Send submissions to: 

CC:PA:LPD:PR (REG–168745–03), room 

5203, Internal Revenue Service, POB 

7604, Ben Franklin Station, Washington, 

DC 20044. Alternatively, comments may 

be sent electronically, via the IRS 

Internet site at http://www.irs.gov/regs 

or via the Federal eRulemaking Portal at 

http://www.regulations.gov (IRS–REG– 

168745–03). The public hearing will be 

held in the auditorium of the New 

Carrollton Federal Building, 5000 Ellin 

Road, Lanham, MD 20706 at 10 a.m. 

FOR FURTHER INFORMATION CONTACT: 

Concerning the proposed regulations, 

Kimberly L. Koch, (202) 622–7739; 

concerning submission of comments, 

the hearing, and/or to be placed on the 

building access list to attend the 

hearing, Richard A. Hurst at 

Richard.A.Hurst@irscounsel.treas.gov or 

at (202) 622–7180 (not toll-free 

numbers). 

SUPPLEMENTARY INFORMATION:

Background 

In recent years, much debate has 

focused on the extent to which section 

263(a) of the Code requires taxpayers to 

capitalize as an improvement amounts 

paid to restore property to its former 

working condition; that is, whether, or 

the extent to which, the amounts paid 

to restore or improve the property are 

capital expenditures or deductible 

ordinary and necessary repair and 

maintenance expenses. There has been 

controversy, for example, regarding 

what tests to apply for determining 

capitalization or expensing, how to 

apply the tests, and the appropriate unit 

of property with respect to which to 

apply the tests. On January 20, 2004, the 

IRS and Treasury Department published 

Notice 2004–6 (2004–3 I.R.B. 308), 

announcing an intention to propose 

regulations providing guidance in this 

area. The notice identified issues under 

consideration by the IRS and Treasury 

Department and invited public 

comment on whether these or other 

issues should be addressed in the 

regulations and, if so, what specific 

rules and principles should be 

provided. To respond to various 

comments and provide a more 

comprehensive set of rules regarding 

tangible property, the proposed 

regulations include the treatment of 

amounts paid to acquire or produce 

tangible property. 

Explanation of Provisions 

I. Introduction 

The proposed regulations under 

section 263(a) of the Code set forth the 

general statutory principles of 

capitalization and provide that capital 

expenditures generally include amounts 

paid to sell, acquire, produce, or 

improve tangible property. The 

proposed regulations, if promulgated as 

final regulations, would replace current 

§§ 1.263(a)–1, 1.263(a)–2, and 1.263(a)– 

3 of the Income Tax Regulations. The 

treatment of amounts paid to acquire or 

create intangibles was addressed with 

the publication of §§ 1.263(a)–4 and 

1.263(a)–5 in the Federal Register on 

January 5, 2004 (TD 9107; 69 FR 436). 

Certain sections of the current 

regulations under section 263(a) are 

proposed to be removed entirely and are 

not restated in the proposed regulations. 

Section 1.263(a)–1(c) of the current 

regulations lists several Code and 

regulation sections to which the 

capitalization provisions do not apply. 

Section 1.263(a)–3 (election to deduct or 

capitalize certain expenditures) lists 

several Code sections under which a 

taxpayer may elect to treat certain 

capital expenditures as either 

deductible or deferred expenses, or to 

treat deductible expenses as capital 

expenditures. These two sections have 

not been carried over to the proposed 

regulations because the lists of items in 

these sections are outdated. This 

language is intended to have the same 

general effect as current §§ 1.263(a)–1(c) 

and 1.263(a)–3, without citing to 

specific Code and regulation sections 

that may have been repealed and 

without omitting specific Code and 

regulation sections that may have been 

added. 

Certain portions of § 1.263(a)–2 of the 

current regulations (examples of capital 

expenditures) also are not restated in 

the proposed regulations, or are 

incorporated into other sections of the 

proposed regulations. Section 1.263(a)– 

2(a) of the current regulations (the cost 

of acquisition of property with a useful 

life substantially beyond the taxable 

year) is incorporated into and expanded 

upon in § 1.263(a)–2 of the proposed 

regulations (amounts paid to acquire or 

produce tangible property). Section 

1.263(a)–2(b) of the current regulations 

(amounts expended for securing a 

copyright and plates) is proposed to be 

removed because these amounts are 

now addressed by § 1.263(a)–4(d)(5) and 

section 263A. The rules in § 1.263(a)– 

2(c) of the current regulations (the cost 

of defending or perfecting title to 

property) are addressed in § 1.263(a)– 

4(d)(9) of the current regulations with 

regard to intangibles and in § 1.263(a)– 

2(d)(2) of the proposed regulations with 

regard to tangible property. Section 

1.263(a)–2(d) of the current regulations 

(amounts expended for architect’s 

services) is proposed to be removed 

because those amounts are now 

included in section 263A. The rules in 

§ 1.263(a)–2(f) and (g) of the current 

regulations (relating to certain capital 

contributions) essentially are restated in 

§ 1.263(a)–1(b) of the proposed 

regulations. Finally, § 1.263(a)–2(h) of 

the current regulations (the cost of 

goodwill in connection with the 

acquisition of the assets of a going 

concern) is proposed to be removed 

because this cost is now addressed by 

§ 1.263(a)–4(c)(1)(x). 

Taking into account the provisions 

that are proposed to be removed and 

other modifications to the current 

regulations noted above, the remaining 

guidance in the current regulations is 

contained in § 1.263(a)–1(a) and (b) of 

the proposed regulations. Section 

1.263(a)–01(a) of the current regulations 

restates the statutory rules from section 

263(a), which are carried over in 

§ 1.263(a)–1(a) of the proposed 

regulations. The rules in § 1.263(a)–1(b) 

of the current regulations address 


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Federal Register / Vol. 71, No. 161 / Monday, August 21, 2006 / Proposed Rules 48591 

amounts paid to add to the value, or 

substantially prolong the useful life, of 

property owned by the taxpayer, and 

amounts paid to adapt property to a new 

or different use. They also address the 

treatment of those capitalized 

expenditures, for example, as a charge 

to capital account or basis. These rules 

are incorporated into and expanded 

upon in § 1.263(a)–3 of the proposed 

regulations. The proposed regulations 

also revise § 1.162–4 of the current 

regulations (allowing a deduction for 

the cost of incidental repairs) to provide 

rules consistent with § 1.263(a)–3 of the 

proposed regulations (requiring 

capitalization of amounts paid to 

improve property). 

The proposed regulations do not 

address amounts paid to acquire or 

create intangible interests in land, such 

as easements, life estates, mineral 

interests, timber rights, zoning 

variances, or other intangible interests 

in land. The IRS and Treasury 

Department request comments on 

whether these and similar amounts, or 

certain of these amounts, should be 

addressed in the final regulations and, 

if so, what rules should be provided. 

The proposed regulations also do not 

address the treatment of software 

development costs. 

II. General Principle of Capitalization 

A. Overview 

The proposed regulations require 

capitalization of amounts paid to 

acquire, produce, or improve tangible 

real and personal property, including 

amounts paid to facilitate the 

acquisition of tangible property. The 

proposed regulations do not address 

amounts paid to facilitate an acquisition 

of a trade or business because those 

amounts are addressed in § 1.263(a)–5 of 

the current regulations. 

The proposed regulations clarify that 

they do not change the treatment of any 

amount that is specifically provided for 

under any provision of the Code or 

regulations other than section 162(a) or 

section 212 and the regulations under 

those sections. This rule applies 

regardless of whether that specific 

provision is more or less favorable to the 

taxpayer than the treatment in the 

proposed regulations. Thus, where 

another section of the Code or 

regulations prescribes a specific 

treatment of an amount, the provisions 

of that section apply and not the rules 

contained in the proposed regulations. 

This rule is the same as that contained 

in §§ 1.263(a)–4(b)(4) and 1.263(a)–5(j) 

of the current regulations. The proposed 

regulations, for example, do not 

preclude taxpayers from deducting the 

cost of certain depreciable business 

assets under section 179. On the other 

hand, the proposed regulations do not 

exempt taxpayers from applying the 

uniform capitalization rules under 

section 263A when applicable, nor do 

they exempt taxpayers from complying 

with the timing rules regarding 

incurring a liability under section 461 

(including economic performance). 

The rule clarifying that the proposed 

regulations do not change the treatment 

of any other amount that is specifically 

provided for under any other provision 

of the Code or regulations provides an 

exception for the treatment of any 

amount that is specifically provided for 

under section 162(a) or section 212 or 

the regulations under those sections. 

Thus, the proposed regulations override 

any conflicting provisions in the 

regulations under sections 162(a) and 

212. For this reason, the proposed 

regulations amend the current rule for 

deductible repairs under § 1.162–4 to 

provide that amounts paid for repairs 

and maintenance to tangible property 

are deductible if the amounts paid are 

not required to be capitalized under 

§ 1.263(a)–3 of the proposed regulations. 

The proposed regulations, however, do 

not amend or remove any other 

provisions of the current regulations 

under section 162(a), including 

§§ 1.162–6 (regarding professional 

expenses) and 1.162–12 (regarding 

certain expenses of farmers). Section 

1.162–6 permits a deduction for 

amounts paid for books, furniture, and 

professional instruments and 

equipment, the useful life of which is 

short, while § 1.162–12 permits a 

deduction for the cost of ordinary tools 

of short life or small cost. The rules in 

current §§ 1.162–6 and 1.162–12 are 

consistent with the rules in the 

proposed regulations and are not 

revised. 

B. Amounts Paid To Sell Property 

The proposed regulations provide 

that, except in the case of dealers in 

property, commissions and other 

transaction costs paid to facilitate the 

sale of property generally must be 

capitalized and treated as a reduction in 

the amount realized. Dealers in property 

include taxpayers that maintain and sell 

inventories and taxpayers that produce 

property for sale in the ordinary course 

of business, for example, the home 

construction business. The language in 

this section is slightly broader than the 

current language of § 1.263(a)–2(e), 

which refers only to commissions paid 

in selling securities. However, the 

language in the proposed regulations is 

consistent with case law that generally 

treats all transaction costs paid in 

connection with the sale of any property 

as capitalized and offset against the 

amount realized. See, Wilson v. 

Commissioner, 49 T.C. 406, 414 (1968); 

rev’d on other grounds, 412 F.2d 314 

(6th Cir. 1969) (‘‘The rule is thoroughly 

engrained that commissions and similar 

charges must be treated as capital 

expenditures which reduce the selling 

price when gain or loss is computed on 

the transaction’’); Frick v. 

Commissioner, T.C. Memo 1983–733, 

aff’d without opinion, 774 F.2d 1168 

(7th Cir. 1985) (‘‘Fees paid in 

connection with the disposition of real 

property are capital expenditures and 

are deductible from the selling price in 

determining gain or loss on the ultimate 

disposition’’); Hindes v. United States, 

246 F. Supp. 147, 150 (W.D. Tex. 1965); 

affd. in part, revd. in part on other 

grounds, 371 F.2d 650 (5th Cir. 1967) 

(‘‘Fees and expenses paid in connection 

with the acquisition or disposition of 

property, real or personal, are capital 

expenditures, and, in the case of a 

taxpayer not engaged in the business of 

buying and selling real estate, are 

deductible from the selling price in 

determining gain or loss on the ultimate 

disposition’’). The sales cost rule in the 

proposed regulations, however, applies 

only to transaction costs and does not 

include other amounts that might be 

paid for the purpose of selling property, 

such as amounts paid to repair or 

improve the property in preparation for 

a sale. The treatment of those amounts 

is governed by the general rules under 

§ 1.263(a)–3 of the proposed regulations 

relating to improvements. 

III. Amounts Paid To Acquire or 

Produce Tangible Property 

A. In General 

The current regulations under section 

263(a) require capitalization of amounts 

paid for the acquisition, construction, or 

erection of buildings, machinery and 

equipment, furniture and fixtures, and 

similar property having a useful life 

substantially beyond the taxable year. 

See § 1.263(a)–2(a) of the current 

regulations. The proposed regulations 

are consistent with this rule, but treat 

amounts paid to construct or erect 

property as production costs. 

Specifically, the proposed regulations 

require capitalization of amounts paid 

for property having a useful life 

substantially beyond the taxable year, 

including land and land improvements, 

buildings, machinery and equipment, 

and furniture and fixtures, and a unit of 

property (as determined under 

§ 1.263(a)–3(d)(2)), having a useful life 

substantially beyond the taxable year. 

See § 1.263(a)–2(d) of the proposed 


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regulations. Thus, § 1.263(a)–2 of the 

proposed regulations requires 

capitalization of amounts paid for 

property that is not itself a unit of 

property, such as property (not treated 

as a material or supply under § 1.162–

3) that is intended to be used as a 

component in the repair or 

improvement of a unit of property. 

Additionally, the current regulations at 

§ 1.263(a)–1(b) list inventory costs as 

capital expenditures under § 1.263(a)–

1(a). Therefore, § 1.263(a)–2 of the 

proposed regulations also requires 

capitalization of amounts paid to 

acquire real or personal property for 

resale and to produce real or personal 

property for sale. 

The proposed regulations provide that 

the terms amounts paid and payment 

mean, in the case of a taxpayer using an 

accrual method of accounting, a liability 

incurred (within the meaning of 

§ 1.446–1(c)(1)(ii)). The definitions of 

real and tangible personal property are 

intended to be the same as the 

definitions used for depreciation 

purposes as derived from the language 

in the regulations at § 1.48–1. Thus, for 

purposes of the proposed regulations, 

tangible personal property means any 

tangible property except land and 

improvements thereto, such as buildings 

or other inherently permanent 

structures (including items that are 

structural components of buildings or 

structures). See, Whiteco Indus., Inc. v. 

Commissioner, 65 T.C. 664 (1975) 

(applying six factors in determining 

whether property is an inherently 

permanent structure). Under the 

proposed regulations, the definitions of 

building and structural components are 

the definitions provided in § 1.48–1(e). 

The IRS and Treasury Department 

considered other definitions of real and 

tangible personal property, including 

the definitions in the regulations under 

section 263A(f), but believe that the 

definitions used for depreciation 

purposes are the definitions most 

consistent with the purposes of the 

proposed regulations. 

The definition of produce in 

§ 1.263(a)–2(b)(4) of the proposed 

regulations is intended to be the same 

as the definition used for purposes of 

section 263A(g)(1) and § 1.263A–

2(a)(1)(i), except that improvements are 

separately defined in § 1.263(a)–3 of the 

proposed regulations. The costs that are 

required to be capitalized to property 

produced or to any improvement are the 

costs that must be capitalized under 

section 263A. Thus, for example, all 

direct materials and direct labor, and all 

indirect costs that directly benefit or are 

incurred by reason of production/ 

improvement activities are required to 

be capitalized to the property being 

produced or improved. 

The proposed regulations require 

taxpayers to capitalize an amount paid 

to defend or perfect title to tangible 

property. This rule is consistent with 

the current regulations at § 1.263(a)–2(c) 

and parallels the rule in § 1.263(a)–

4(d)(9) with regard to intangible 

property. The proposed regulations also 

require capitalization of amounts paid 

to facilitate the acquisition of real or 

personal property. The IRS and 

Treasury Department request comments 

on whether any specific guidance is 

needed with regard to employee 

compensation and overhead costs that 

facilitate the acquisition of tangible 

property and, if so, what that guidance 

should provide. The proposed 

regulations do not address transaction 

costs related to the production or 

improvement of tangible property 

because those costs are subject to 

capitalization under section 263A. 

B. Materials and Supplies 

As noted in section II.A. above, the 

proposed regulations generally do not 

change the treatment of any amount that 

is specifically provided for under any 

provision of the Code or regulations 

other than section 162(a) or section 212 

and the regulations under those 

sections. However, with regard to 

section 162(a), the proposed regulations 

provide an exception for amounts paid 

for materials and supplies that are 

properly treated as deductions or 

deferred expenses, as appropriate, under 

§ 1.162–3. Thus, the proposed 

regulations do not change the treatment 

of materials and supplies under § 1.162–

3, including property that is treated as 

a material and supply that is not 

incidental under Rev. Proc. 2002–28 

(2002–1 C.B. 815) (regarding the use of 

the cash method by certain qualifying 

small business taxpayers), Rev. Proc. 

2002–12 (2002–1 C.B. 374) (regarding 

smallwares), and Rev. Proc. 2001–10 

(2001–1 C.B 272) (regarding inventory of 

certain qualifying taxpayers). 

C. 12-Month Rule 

The current regulations under 

sections 263(a), 446, and 461 require 

taxpayers to capitalize amounts paid to 

acquire property having a useful life 

substantially beyond the taxable year. 

See §§ 1.263(a)–2(a), 1.446–1(c)(1)(ii), 

and 1.461–1(a)(2)(i) of the current 

regulations. Section 1.263(a)–2(d) of the 

proposed regulations retains this general 

rule. Some courts have adopted a 12- 

month rule for determining whether 

property has a useful life substantially 

beyond the taxable year. See Mennuto v. 

Commissioner, 56 T.C. 910 (1971), acq. 

(1973–2 C.B. 2); Zelco, Inc. v. 

Commissioner, 331 F.2d 418 (1st Cir. 

1964); International Shoe Co. v. 

Commissioner, 38 B.T.A. 81 (1938). 

Under the 12-month rule adopted by 

some courts, a taxpayer may deduct 

currently an amount paid for a benefit 

or paid for property having a useful life 

that does not extend beyond one year. 

This rule was adopted in the regulations 

relating to intangibles. See § 1.263(a)–

4(f). The proposed regulations provide a 

similar 12-month rule for amounts paid 

to acquire or produce certain tangible 

property. 

The proposed regulations generally 

provide that an amount (including 

transaction costs) paid for the 

acquisition or production of a unit of 

property with an economic useful life of 

12 months or less is not a capital 

expenditure. The unit of property and 

economic useful life determinations are 

made under the rules described in 

§ 1.263(a)–3 for improved property. The 

12-month rule generally applies unless 

the taxpayer elects not to apply the 12- 

month rule, which election may be 

made with regard to each unit of 

property that the taxpayer acquires or 

produces. An election not to apply the 

12-month rule may not be revoked. 

Taxpayers that have elected to use the 

original tire capitalization method of 

accounting for the cost of certain tires 

under Rev. Proc. 2002–27 (2002–1 C.B. 

802), must use that method for the 

original and replacement tires of all 

their qualifying vehicles. See section 

5.01 of Rev. Proc. 2002–27. Therefore, 

taxpayers that use that method cannot 

use the 12-month rule provided under 

the proposed regulations to deduct 

amounts paid to acquire original or 

replacement tires. 

The proposed regulations clarify the 

interaction of the 12-month rule with 

the timing rules contained in section 

461 of the Code. Nothing in the 

proposed regulations is intended to 

change the application of section 461, 

including the application of the 

economic performance rules in section 

461(h). This coordination rule is the 

same as that provided in the regulations 

under section 263(a) relating to 

intangibles. See § 1.263(a)–4(f). In the 

case of a taxpayer using an accrual 

method of accounting, section 461 

requires that an item be incurred before 

it is taken into account through 

capitalization or deduction. For 

example, under § 1.461–1(a)(2), a 

liability generally is not incurred until 

the taxable year in which all the events 

have occurred that establish the fact of 

the liability, the amount of the liability 

can be determined with reasonable 

accuracy, and economic performance 


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Federal Register / Vol. 71, No. 161 / Monday, August 21, 2006 / Proposed Rules 48593 

has occurred with respect to the 

liability. Thus, the 12-month rule 

provided by the proposed regulations 

does not permit an accrual method 

taxpayer to deduct an amount paid for 

tangible property if the amount has not 

been incurred under section 461 (for 

example, if the taxpayer does not have 

a fixed liability to acquire the property). 

The proposed regulations contain 

examples illustrating the interaction of 

the 12-month rule with section 461. 

The proposed regulations provide 

that, upon a sale or other disposition, 

property to which a taxpayer applies the 

12-month rule is not treated as a capital 

asset under section 1221 or as property 

used in the trade or business under 

section 1231. Thus, 12-month property 

is not of a character subject to 

depreciation and any amount realized 

upon disposition of 12-month property 

is ordinary income to the taxpayer. 

The IRS and Treasury Department do 

not believe that it is appropriate to 

apply the 12-month rule to certain types 

of property. Thus, the proposed 

regulations provide that the 12-month 

rule does not apply to property that is 

or will be included in property 

produced for sale or property acquired 

for resale, improvements to a unit of 

property, land, or a component of a unit 

of property. 

D. De Minimis Rule 

In Notice 2004–6, the IRS and 

Treasury Department requested 

comments on whether the regulations 

should provide a de minimis rule. 

Because the notice refers to the 

application of section 263(a) to amounts 

paid to repair, improve, or rehabilitate 

tangible property, most commentators 

focused on a de minimis rule for the 

cost of repairs rather than the cost to 

acquire property. However, one 

commentator requested that the 

regulations specifically provide a de 

minimis rule for acquisition costs, but 

allow taxpayers to continue to use their 

current method if they have reached a 

working agreement with their IRS 

examining agent regarding a de minimis 

rule. 

The IRS and Treasury Department 

recognize that for regulatory or financial 

accounting purposes, taxpayers often 

have a policy for deducting an amount 

paid below a certain dollar threshold for 

the acquisition of tangible property (de 

minimis rule). For Federal income tax 

purposes, the taxpayer generally would 

be required to capitalize the amount 

paid if the property has a useful life 

substantially beyond the taxable year. 

However, in this context some courts 

have permitted the use of a de minimis 

rule for Federal income tax purposes. 

See Union Pacific R.R. Co. v. United 

States, 524 F.2d 1343 (Ct. Cl. 1975) 

(permitting the use of the taxpayer’s 

$500 de minimis rule, which was in 

accordance with the Interstate 

Commerce Commission (ICC) minimum 

rule and generally accepted accounting 

principles); Cincinnati, N.O. & Tex. Pac. 

Ry. v. United States, 424 F.2d 563 (Ct. 

Cl. 1970) (same). But see Alacare Home 

Health Services, Inc. v. Commissioner, 

T.C. Memo 2001–149 (disallowing the 

taxpayer’s use of a $500 de minimis rule 

because it distorted income). 

The proposed regulations do not 

include a de minimis rule for 

acquisition costs. However, the IRS and 

Treasury Department recognize that 

taxpayers often reach an agreement with 

IRS examining agents that, as an 

administrative matter, based on risk 

analysis and/or materiality, the IRS 

examining agents do not select certain 

items for review such as the acquisition 

of tangible assets with a small cost. This 

often is referred to by taxpayers and IRS 

examining agents as a de minimis rule. 

The absence of a de minimis rule in the 

proposed regulations is not intended to 

change this practice. 

The IRS and Treasury Department 

considered including a de minimis rule 

in the proposed regulations. The de 

minimis rule considered would have 

provided that taxpayers are not required 

to capitalize certain de minimis 

amounts paid for the acquisition or 

production of a unit of property. Under 

the rule considered, if a taxpayer had 

written accounting procedures in place 

treating as an expense on its applicable 

financial statement (AFS) amounts paid 

for property costing less than a certain 

dollar amount, and treated the amounts 

paid during the taxable year as an 

expense on its AFS in accordance with 

those written accounting procedures, 

the taxpayer would not have been 

required to capitalize those amounts if 

they did not exceed a certain dollar 

threshold. A taxpayer that did not meet 

these criteria (for example, a taxpayer 

that did not have an AFS) would not 

have been required to capitalize 

amounts paid for a unit of property that 

did not exceed the established dollar 

threshold. Because taxpayers without an 

AFS generally are smaller than 

taxpayers with an AFS, the dollar 

threshold for the de minimis rule that 

would have applied to them would have 

been lower than the threshold for 

taxpayers with an AFS (although the de 

minimis rule for taxpayers with an AFS 

also would have been limited to the 

amount treated as an expense on their 

AFS). The de minimis rule considered 

by the IRS and Treasury Department 

would not have applied to inventory 

property, improvements, land, or a 

component of a unit of property. 

The de minimis rule considered also 

would have provided that property to 

which a taxpayer applies the de minimis 

rule is treated upon sale or disposition 

similar to section 179 property. Thus, de 

minimis property would have been 

property of a character subject to 

depreciation and amounts paid that 

were not capitalized under the de 

minimis rule would have been treated as 

amortization subject to recapture under 

section 1245. Thus, gain on disposition 

of the property would have been 

ordinary income to the taxpayer to the 

extent of the amount treated as 

amortization for purposes of section 

1245. 

The IRS and Treasury Department 

decided to not include a de minimis 

rule in the proposed regulations but 

instead to request comments on whether 

such a rule should be included in the 

final regulations or whether to continue 

to rely on the current administrative 

practice of IRS examining agents. 

Therefore, the IRS and Treasury 

Department request comments on 

whether a de minimis rule for 

acquisition costs should be included in 

the final regulations, and, if so, whether 

the de minimis rule should be the rule 

described above and what dollar 

thresholds are appropriate. 

The IRS and Treasury Department 

also request comments on the scope of 

costs that should be included in a de 

minimis rule if one is provided in the 

final regulations and on the character of 

de minimis rule property. For example, 

the de minimis rule considered by the 

IRS and Treasury Department would 

have applied to the aggregate of 

amounts paid for the acquisition or 

production (including any amounts paid 

to facilitate the acquisition or 

production) of a unit of property and 

including amounts paid for 

improvements prior to the unit of 

property being placed in service. If a de 

minimis rule should be provided in the 

final regulations, the IRS and Treasury 

Department request comments on what, 

if any, type of rule should be provided 

to prevent a distortion of income when 

taxpayers acquire a large number of 

assets, each of which individually is 

within the de minimis rule (for example, 

the purchase by a taxpayer of 2,000 

personal computers). 

If a de minimis rule for acquisition 

costs should be provided in the final 

regulations, the IRS and Treasury 

Department request comments on 

whether the rule should permit IRS 

examining agents and taxpayers to agree 

to the use of higher de minimis 

thresholds on the basis of materiality 


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and risk analysis and, if so, under what 

circumstances a higher threshold should 

be allowed. The IRS and Treasury 

Department also request comments on 

whether, if a de minimis rule should be 

provided in the final regulations, 

changes to begin using a de minimis 

rule or changes to a higher dollar 

amount within a de minimis rule should 

be treated as changes in a method of 

accounting. 

E. Recovery of Costs When Property Is 

Used in a Repair 

As noted in section III.A. of this 

preamble, § 1.263(a)–2 of the proposed 

regulations generally requires 

capitalization of amounts paid for the 

acquisition or production of property 

having a useful life substantially beyond 

the taxable year. Thus, § 1.263(a)–2(d) of 

the proposed regulations applies to 

property that is not itself a unit of 

property, such as property (not treated 

as a material or supply under § 1.162–

3) that is intended to be used as a 

component in the repair or 

improvement of a unit of property. It 

must be determined whether the 

subsequent use of the component 

property results in an improvement to 

the unit of property under § 1.263(a)–3 

or an otherwise deductible repair or 

maintenance cost under § 1.162–4. Even 

if the subsequent use of the component 

is an otherwise deductible expense 

under § 1.162–4, the amount paid 

nonetheless may be required to be 

capitalized. For example, it must be 

determined whether the amount paid 

for the component property is required 

to be capitalized under section 263A as 

an indirect cost that directly benefits or 

is incurred by reason of property 

produced or acquired for resale. The 

proposed regulations illustrate this 

concept in an example of a 

manufacturer that replaces one window 

in a building. The taxpayer initially 

must capitalize under § 1.263(a)–2(d) 

amounts paid to acquire the window. 

The replacement of the window 

subsequently is determined to be a 

repair to the building rather than an 

improvement. Amounts paid for the 

repair (or an allocable portion thereof) 

must then be capitalized under section 

263A to the inventory that the taxpayer 

produces to the extent that the repair 

directly benefits or is incurred by reason 

of the taxpayer’s production activities. 

IV. Amounts Paid To Improve Tangible 

Property 

A. In General 

In response to Notice 2004–6, the IRS 

and Treasury Department received 

several comments on the issues that 

should be addressed in the proposed 

regulations to provide guidance on 

amounts paid to repair, improve, and 

rehabilitate tangible property. These 

comments have been taken into account 

in drafting § 1.263(a)–3 of the proposed 

regulations. That section addresses 

amounts paid to improve tangible 

property and includes the following 

provisions: (1) Rules for determining the 

appropriate unit of property to which 

the improvement provisions apply; (2) 

general rules for improvements; (3) rules 

for determining whether an amount 

paid materially increases the value of 

the unit of property; (4) rules for 

determining whether an amount paid 

restores the unit of property; and (5) an 

optional repair allowance method. 

B. Unit of Property Rules 

1. In General 

A threshold issue in applying the 

improvement rules under § 1.263(a)–3 of 

the proposed regulations is determining 

the appropriate unit of property to 

which the rules should be applied. For 

example, to determine whether an 

amount paid materially increases the 

value of property, it is necessary to 

know what property is at issue. The 

smaller the unit of property, the more 

likely it is that amounts paid in 

connection with that unit of property 

will materially increase the value of, or 

restore, the property. Taxpayers and the 

IRS frequently disagree on the unit of 

property to which the capitalization 

rules should be applied. Thus, the unit 

of property rules in the proposed 

regulations are intended to provide 

guidance in determining whether an 

amount paid improves the unit of 

property under § 1.263(a)–3. The unit of 

property rules also apply for purposes of 

§ 1.263(a)–1 of the proposed regulations 

(which references the rules in 

§§ 1.263(a)–2 and 1.263(a)–3 of the 

proposed regulations) and § 1.263(a)–2 

of the proposed regulations (for 

example, with regard to the 12-month 

rule). The unit of property rules in the 

proposed regulations apply only for 

purposes of section 263(a) and 

§§ 1.263(a)–1, 1.263(a)–2, and 1.263(a)–

3 of the proposed regulations, and not 

any other Code or regulation section. 

For example, no inference is intended 

that these unit of property rules have 

any application for section 263A(f) 

interest capitalization purposes. 

The current regulations under section 

263(a) do not provide any guidance on 

determining the appropriate unit of 

property. Some courts have addressed 

the unit of property issue under section 

263(a), but their holdings are based on 

the particular facts of each case and do 

not contain rules that are generally 

applicable for purposes of section 

263(a). See, FedEx Corp. v. United 

States, 291 F. Supp. 2d 699 (W.D. Tenn. 

2003), aff’d, 412 F.3d 617 (6th Cir. 2005) 

(concluding that an aircraft, and not the 

aircraft engine, was the appropriate unit 

of property); Smith v. Commissioner, 

300 F.3d 1023 (9th Cir. 2002) 

(concluding that an aluminum 

reduction cell, rather than entire cell 

line, was the appropriate unit of 

property); Ingram Industries, Inc. v. 

Commissioner, T.C. Memo 2000–323 

(concluding that a towboat, and not the 

towboat engine, was the appropriate 

unit of property); LaSalle Trucking Co. 

v. Commissioner, T.C. Memo 1963–274 

(concluding that truck engines, tanks, 

and cabs were each separate units of 

property). 

In FedEx, the court ruled on whether 

an aircraft engine or the entire aircraft 

was the appropriate unit of property for 

determining whether the costs of engine 

shop visits (ESVs) must be treated as 

capital expenditures. Relying on the 

opinions in Ingram and Smith, the court 

concluded that the following four 

factors were relevant in determining the 

appropriate unit of property: (1) 

Whether the taxpayer and the industry 

treat the component part as a part of a 

larger unit of property for regulatory, 

market, management, or accounting 

purposes; (2) whether the economic 

useful life of the component part is 

coextensive with the economic useful 

life of the larger unit of property; (3) 

whether the larger unit of property and 

the smaller unit of property can 

function without each other; and (4) 

whether the component part can be and 

is maintained while affixed to the larger 

unit of property. Applying these factors 

to aircraft engines, the court concluded 

that the engines should not be 

considered a unit of property separate 

and apart from the airplane. 

In Notice 2004–6, the IRS and 

Treasury Department requested 

comments on the relevance of various 

unit of property factors derived from 

FedEx and other cases that addressed 

the unit of property issue. The factors 

listed in Notice 2004–6 included: (1) 

Whether the property is manufactured, 

marketed, or purchased separately; (2) 

whether the property is treated as a 

separate unit by a regulatory agency, in 

industry practice, or by the taxpayer in 

its books and records; (3) whether the 

property is designed to be easily 

removed from a larger assembly, is 

regularly or periodically replaced, or is 

one of a fungible set of interchangeable 

or rotable assets; (4) whether the 

property must be removed from a larger 

assembly to be fixed or improved; (5) 


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whether the property has a different 

economic life than the larger assembly; 

(6) whether the property is subject to a 

separate warranty; (7) whether the 

property serves a discrete purpose or 

functions independently from a larger 

assembly; or (8) whether the property 

serves a dual purpose function. 

The IRS and Treasury Department 

received nine comments on the unit of 

property issue, four of which 

specifically recommended that the 

proposed regulations adopt the factors 

used by the court in FedEx. These 

factors essentially are contained in 

factors 1, 2, 4, 5, and 7 of Notice 2004–

6. Several of the factors listed in Notice 

2004–6 have been incorporated into the 

proposed regulations. However, the IRS 

and Treasury Department determined 

that some factors were not relevant for 

certain types of property. For example, 

the factors listed in Notice 2004–6 

primarily derive from case law that 

addresses tangible personal property; 

therefore, the factors were not as helpful 

in determining the appropriate unit of 

property for real property, such as land. 

Further, some types of property lend 

themselves to specific unit of property 

rules, such as buildings and property 

owned by taxpayers in a regulated 

industry. The IRS and Treasury 

Department believe that the 

administrative burden associated with 

determining the appropriate unit of 

property can be reduced for both the IRS 

and taxpayers by identifying specific 

rules reflecting an approach appropriate 

for the taxpayer’s industry and the type 

of property at issue. Therefore, the 

proposed regulations provide different 

unit of property rules for four categories 

of property, rather than prescribing one 

rule for all types of property. 

The unit of property rules in the 

proposed regulations apply to all real 

and personal property other than 

network assets. For purposes of the unit 

of property rules, network assets means 

railroad track, oil and gas pipelines, 

water and sewage pipelines, power 

transmission and distribution lines, and 

telephone and cable lines that are 

owned or leased by taxpayers in each of 

those respective industries. Network 

assets include, for example, trunk and 

feeder lines, pole lines, and buried 

conduit. They do not include property 

that would be included as a structural 

component of a building under 

§ 1.263(a)–3(d)(2)(iv) of the proposed 

regulations, nor do they include 

separate property that is adjacent to, but 

not part of a network asset, such as 

bridges, culverts, or tunnels. The 

proposed regulations do not affect 

current guidance that addresses the unit 

of property or capitalization rules for 

network assets, such as Rev. Proc. 2001–

46 (2001–2 C.B. 263) (track maintenance 

allowance method for Class I railroads); 

Rev. Proc. 2002–65 (2002–2 C.B. 700) 

(track maintenance allowance method 

for Class II and III railroads); and Rev. 

Proc. 2003–63 (2003–2 C.B. 304) (safe 

harbor unit of property rule for cable 

television distribution systems). The IRS 

and Treasury Department request 

comments on the relevant rules for 

determining the appropriate unit of 

property for network assets. 

Additionally, the IRS and Treasury 

Department request comments on 

whether to include rules for network 

assets in final regulations, or whether to 

develop for network assets industryspecific guidance that is similar to the 

above referenced revenue procedures. 

With the exception of network assets, 

the four categories of property in the 

proposed regulations are intended to 

cover all real and personal property. In 

addition to the four categories of 

property, the unit of property rules 

provide for an initial unit of property 

determination, which, except with 

regard to buildings and structural 

components, is made prior to 

categorizing the property. The initial 

unit of property determination is based 

on the functional interdependence test 

in § 1.263A–10(a)(2), relating to the 

capitalization of interest. The initial 

unit of property determination is 

intended to be a common-sense 

approach to defining the largest possible 

unit of property as a starting point for 

analyzing the rules under one of the 

four relevant unit of property categories. 

After the initial unit of property is 

determined, the additional unit of 

property rules are intended to result in 

a determination that either confirms the 

initial unit of property as the unit of 

property, or that separates one or more 

components of the initial unit of 

property into separate units of property. 

Some commentators suggested that 

the functional interdependence test 

under § 1.263A–10(a)(2) regarding 

interest capitalization should be the sole 

test for determining the appropriate unit 

of property. The IRS and Treasury 

Department believe that the functional 

interdependence test is a relevant, but 

not dispositive factor. The purpose of 

that test under § 1.263A–10(a)(2) is to 

calculate the appropriate unit of 

property for determining the 

accumulated production expenditures at 

the beginning and end of the production 

period. The preamble that accompanied 

the promulgation of § 1.263A–10 

discusses the reasoning for adopting a 

broad formulation of the unit of 

property definition and states that ‘‘this 

concept of single property may differ 

from the concept of single or separate 

property that taxpayers use for other 

purposes (e.g., for computing amounts 

of depreciation deductions or separately 

tracking the bases of assets).’’ TD 8584 

(59 FR 67,187; 1995–1 C.B. 20, 25; Dec. 

29, 1994). 

In contrast to the unit of property 

rules in § 1.263A–10(a)(2), the purpose 

of the unit of property rules under 

section 263(a) is to provide a starting 

point for determining whether an 

amount paid materially increases the 

value of, or restores, the unit of 

property. Thus, § 1.263A–10(a)(2) has a 

different purpose than the proposed 

regulations under section 263(a). 

Further, in determining the appropriate 

unit of property for purposes of section 

263(a), the functional interdependence 

test does not always produce 

appropriate results. For example, a 

taxpayer might argue that application of 

that test results in an entire complex of 

structures and machinery, such as an 

entire power plant, being treated as a 

single unit of property. The IRS and 

Treasury Department do not believe that 

result is correct for purposes of section 

263(a). 

After the initial unit of property 

determination is made, the unit of 

property analysis continues with 

determining the appropriate category of 

property and applying the rules in that 

category. The proposed regulations 

provide specific rules for four categories 

of property: (1) Property owned by 

taxpayers in a regulated industry; (2) 

buildings and structural components; 

(3) other personal property; and (4) 

other real property. The unit of property 

determination made under the 

applicable category is then subject to an 

additional rule in § 1.263(a)-3(d)(2)(vii) 

regarding treatment for other Federal 

income tax purposes. The rules for each 

of the four categories are explained 

below. 

2. Category I: Taxpayers in Regulated 

Industries 

The first unit of property category in 

the proposed regulations is property 

owned by taxpayers in a regulated 

industry. The proposed regulations 

provide that if the taxpayer is in an 

industry for which a Federal regulator 

has a uniform system of accounts 

(USOA) identifying a particular unit of 

property, the taxpayer must use the 

same unit of property for Federal 

income tax purposes, regardless of 

whether the taxpayer is subject to the 

regulatory accounting rules of the 

Federal regulator and regardless of 

whether the property is particular to 

that industry. This rule derives from one 

of the factors cited by the court in FedEx 


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for determining the appropriate unit of 

property—whether the taxpayer and the 

industry treat the component part as 

part of the larger unit of property for 

regulatory, market, management, or 

accounting purposes. Thus, this rule ties 

into the regulatory accounting element 

of the FedEx factor, as well as the 

general concept of industry practice. 

The IRS and Treasury Department are 

aware of three Federal regulators that 

provide a USOA: (1) The Federal Energy 

Regulatory Commission (FERC); (2) the 

Federal Communications Commission 

(FCC); and (3) the Surface 

Transportation Board (STB). 

Accordingly, this unit of property 

category applies to taxpayers such as 

power companies, telecommunications 

companies, and railroads. 

The IRS and Treasury Department 

determined that the regulatory 

accounting rule should be applied 

similarly to all taxpayers in industries 

for which a Federal regulator provides 

a USOA, regardless of whether the 

taxpayer is subject to the regulatory 

accounting rules of the Federal 

regulator. This rule is consistent with 

the general standard of using industry 

practice to determine the appropriate 

unit of property. Further, it results in all 

taxpayers within a specific industry 

being treated the same for Federal 

income tax purposes, without regard to 

whether a particular taxpayer is subject 

to the accounting rules of the Federal 

regulator. The rule is limited to the 

regulator’s USOA and does not apply to 

other Federal regulatory rules, such as 

rules concerning safety or health. The 

proposed regulations apply only to 

USOA provided by Federal regulators 

and do not apply to USOA issued by 

any state or local agencies. Rules of state 

and local agencies may be different than 

Federal regulatory rules and can vary 

widely within an industry depending on 

the taxpayer’s location. 

Four of the commentators on this 

aspect of Notice 2004–6 recommended 

adopting the four factors cited in FedEx, 

from which the regulated industry rule 

was derived. None of the commentators 

specifically objected to a regulatory 

accounting rule, although one 

commentator suggested that where cost 

recovery is determined for non-tax 

purposes by a Federal or state agency, 

the regulations should provide a special 

election that may be made on an annual 

basis under which the taxpayer may use 

the same unit of property for tax 

purposes as it must use for regulatory 

purposes. The IRS and Treasury 

Department believe the unit of property 

inquiry should result in one clear 

determination that will be used 

consistently by the taxpayer unless the 

underlying facts change and, therefore, 

do not believe an annual election is 

appropriate. 

3. Category II: Buildings and Structural 

Components 

In general, a building and its 

structural components must be treated 

as one unit of property. This rule is 

based on the definitions of building and 

structural component in the regulations 

under section 48. The repair allowance 

regulations under the Class Life Asset 

Depreciation Range (CLADR) system 

also provide that a building and its 

structural components generally are a 

single unit of property. See § 1.167(a)–

11(d)(2)(vi). The IRS and Treasury 

Department believe that these 

definitions are useful in determining the 

appropriate unit of property for 

buildings and structural components. 

One commentator specifically requested 

that the proposed regulations use the 

definition of building under § 1.48–1(e) 

to determine a unit of property. The 

proposed regulations rely on the 

definition of building under § 1.48–1(e). 

Property located inside a building that 

is not a structural component of the 

building must be analyzed under one of 

the other three unit of property 

categories; for example, machinery and 

equipment inside a factory must be 

analyzed under Category III (the other 

personal property category). 

This Category II is the only category 

to which the initial unit of property 

determination does not apply. Applying 

the functional interdependence test to a 

building would raise issues in cases 

where certain floors or portions of a 

building are placed in service 

independently of another. The IRS and 

Treasury Department believe that, 

unless the additional rule in § 1.263(a)–

3(d)(2)(vii) of the proposed regulations 

(regarding treatment for other Federal 

income tax purposes) applies to require 

a component of a building to be treated 

as a separate unit of property, the 

building and its structural components 

should be the unit of property. The IRS 

and Treasury Department recognize, 

however, that it is not always 

appropriate to treat the entire building 

as the unit of property. For example, a 

taxpayer who owns a unit in a 

condominium building, whether the 

unit is used for personal or investment 

purposes, should not treat the entire 

building as the unit of property. 

Therefore, the IRS and Treasury request 

comments on how the unit of property 

rules should apply to condominiums, 

cooperatives, and similar types of 

property. 

4. Category III: Other Personal Property 

The unit of property determination for 

personal property not included in 

Category I (taxpayers in a regulated 

industry) is a facts and circumstances 

test, based on four exclusive factors, 

none of which is dispositive or weighs 

more heavily than the others. 

a. Factor 1: Marketplace Treatment 

Factor 

The first exclusive factor is whether 

the component is (1) marketed 

separately to or acquired or leased 

separately by the taxpayer (from a party 

other than the seller/lessor of the 

property of which the component is a 

part) at the time it is initially acquired 

or leased; (2) subject to a separate 

warranty contract (from a party other 

than the seller/lessor of the property of 

which the component is a part); (3) 

subject to a separate maintenance 

manual or written maintenance policy; 

(4) appraised separately; or (5) sold or 

leased separately by the taxpayer to 

another party. This factor contains a 

number of items intended to determine 

the treatment in the marketplace of the 

component as a separate unit of 

property. 

Whether the component is acquired 

separately was a factor addressed by the 

courts in FedEx and Ingram, and is also 

part of the CLADR repair allowance 

regulations under section 167 and the 

unit of property determination for 

interest capitalization in § 1.263A–10. In 

FedEx, the court discussed this issue in 

the context of whether the taxpayer and 

the industry treat the component part as 

part of the larger unit of property for 

regulatory, market, management, or 

accounting purposes. In finding that the 

aircraft engines were not purchased 

separately, the court relied on the fact 

that the engines and aircraft were 

designed to be compatible and were 

generally acquired by the taxpayer at the 

same time. The court disregarded the 

fact that the taxpayer purchased the 

engines and airframes from different 

sellers when the aircraft were initially 

acquired. The IRS and Treasury 

Department believe that the acquisition 

of a component from a different seller at 

the time the larger property is acquired 

should be a relevant factor, and that the 

same rule should apply if the taxpayer 

leases the component from a different 

party than the seller of the larger 

property. 

The IRS and Treasury Department 

recognize that this factor may produce 

different results depending on whether 

the property is new or used. When a 

taxpayer acquires or leases used 

property, it is possible that items that 


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were separate units of property when 

purchased new will be treated as one 

unit of property because the initial 

purchaser has assembled the units into 

one functional item that it sells or 

leases. The IRS and Treasury 

Department considered whether it was 

appropriate to have a factor that could 

treat new and used property differently, 

and decided that the difference 

reasonably reflects the substance of the 

transactions—where the taxpayer 

acquires or leases a component from a 

different party from whom it acquires or 

leases the larger property, the taxpayer 

typically is conducting different, but 

related, transactions with separately 

negotiated terms. 

Whether the component is subject to 

a separate warranty contract, 

maintenance manual, or written 

maintenance policy was cited as a factor 

in FedEx and is adopted as part of the 

marketplace treatment factor in the 

proposed regulations. The warranty 

contract factor applies only to a 

warranty that is provided by a party 

other than the seller/lessor of the larger 

property. It is not intended to apply to 

a warranty provided by the sellor/lessor 

that may contain separate warranties 

(for example, for different time periods) 

on various components of the larger 

property. Whether the property is 

manufactured separately was a possible 

factor cited in Notice 2004–6. The 

proposed regulations do not specifically 

adopt this factor because components 

that are subject to a separate warranty or 

maintenance procedures also are likely 

to be manufactured separately. The 

FedEx case used as a factor whether the 

component was appraised or valued 

separately and the CLADR repair 

allowance regulations under section 167 

addressed whether the component was 

sold separately to another party. The 

proposed regulations adopt these tests 

as part of the marketplace factor. 

The IRS and Treasury Department 

believe that it is important that all the 

criteria in this factor be taken into 

account together when weighing this 

factor with the other three factors. Some 

criteria may be stronger indicators 

warranting treatment of the component 

as a separate unit of property than 

others. The IRS and Treasury 

Department acknowledge that several of 

the criteria within this factor do not 

work well for property produced by the 

taxpayer, and request comments 

regarding how and whether a 

marketplace factor should apply to selfconstructed property. 

b. Factor 2: Industry Practice and 

Financial Accounting Factor 

The second exclusive factor in this 

Category III is whether the component is 

treated as a separate unit of property in 

industry practice or by the taxpayer in 

its books and records. This factor was 

cited by the court in FedEx. The IRS and 

Treasury Department believe that the 

taxpayer’s treatment of the component 

as separate in its books and records is 

a relevant factor in determining whether 

the component should be treated as a 

separate unit of property in the 

proposed regulations. In particular, if 

the taxpayer’s books and records assign 

different economic useful lives to the 

component and the larger property, this 

factor would weigh heavily toward 

treating the component as a separate 

unit of property. 

The IRS and Treasury Department 

considered whether to use as a factor 

whether the component has a different 

economic useful life than the property 

of which it is a part. This factor was 

cited by the courts in Smith, Ingram, 

and FedEx. However, for this factor to 

be useful, the regulations would need to 

define economic useful life. The 

proposed regulations at § 1.263(a)–3(f) 

(with regard to restoration of a unit of 

property) provide a definition of 

economic useful life, which has 

different meanings depending on 

whether a taxpayer has an AFS. If the 

unit of property rules adopted this 

definition, the economic useful life test 

under this factor would produce 

different results depending on whether 

the taxpayer has an AFS. These different 

results are not justified in this context. 

Further, a taxpayer’s treatment of the 

component in its books and records 

under this Factor 2 includes any useful 

life determinations of the component 

and the property of which the 

component is a part in the books and 

records. Therefore, the economic useful 

life factor was not specifically adopted 

as a separate factor. 

c. Factor 3: Rotable Part Factor 

The third exclusive factor in the other 

personal property category is whether 

the taxpayer treats the component as a 

rotable part. A rotable part is defined as 

a part that is removeable from property, 

repaired or improved, and either 

immediately reinstalled on other 

property or stored for later installation. 

This factor was cited by the courts in 

Smith and LaSalle. The court in FedEx 

ignored this factor, but considered as a 

separate concept whether the 

component can be and is maintained 

while affixed to the larger unit. The IRS 

and Treasury Department considered 

this separate concept as well, but 

believe that the rotable part factor 

incorporates this concept from FedEx. 

As the examples in the proposed 

regulations illustrate, this factor focuses 

on the particular taxpayer’s treatment of 

the property as a rotable part in 

determining whether the rotable is a 

separate unit of property. Therefore, for 

example, if the rotable part is a separate 

unit of property to the taxpayer and the 

taxpayer incorporates the rotable into 

other property for resale, the rotable part 

will not necessarily be a separate unit of 

property to the purchaser. 

Two commentators stated that the 

treatment of a component as a rotable 

part is of limited or no relevance. While 

treatment of minor parts as rotable 

would not weigh heavily toward 

separate unit of property treatment, the 

IRS and Treasury Department believe 

that the treatment of major components 

as rotable is a relevant factor in 

determining whether a component is a 

separate unit of property, particularly 

when the economic useful life of the 

larger property is limited by the 

expected useful life of the rotable part. 

Many taxpayers do not maintain an 

inventory of rotable spares for their 

major components. Although it is 

understood that the purpose for 

maintaining an inventory of rotables is 

to minimize the time that the larger 

property is out of service, treatment of 

a major component as a rotable has 

consequences that tend to be indicative 

of a separate unit of property. For 

example, in the case of a taxpayer that 

does not maintain an inventory of 

rotable spare parts, if a major 

component of the larger property breaks 

down, then the entire larger property 

must be taken out of service while the 

major component is being repaired. This 

is indicative of the larger property and 

the component collectively being 

treated as one unit of property. 

Conversely, a taxpayer that does 

maintain an inventory of rotable spare 

parts for a major component is able to 

continue to use the larger property 

without regard to the time required to 

repair the broken down component. In 

this instance, the IRS and Treasury 

Department believe that continued use 

of the larger property is indicative of 

separate unit of property treatment for 

the rotable part. In addition, rotables 

being depreciated as rotable spare parts 

is indicative of separate treatment 

because the components are depreciated 

separately from the larger property. 

In the request for comments, Notice 

2004–6 combined several other factors 

with the rotables factor, including 

whether a component is designed to be 

easily removed from a larger assembly, 


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is regularly or periodically replaced, or 

is one of a fungible set of 

interchangeable assets. These factors are 

broader than the rotables factor in the 

proposed regulations and would sweep 

in many minor components that rarely, 

if ever, would be appropriately 

considered a separate unit of property. 

Further, these factors are duplicative of 

the rotables part factor, because a 

rotable generally meets all of these 

factors. The IRS and Treasury 

Department believe that these factors are 

not more helpful in determining 

whether a component is a separate unit 

of property than the rotables factor 

described in the proposed regulations. 

Therefore, the proposed regulations do 

not include these other factors. 

d. Factor 4: Function Factor 

The fourth and final factor in Category 

III is whether the property of which the 

component is a part generally functions 

for its intended use without the 

component property. This factor was 

cited by the court in FedEx and is 

similar to the discrete purpose test 

under the CLADR repair allowance 

regulations. It is also similar to the 

functional interdependence test under 

§ 1.263A–10(a)(2) and the rules in these 

proposed regulations regarding the 

initial unit of property determination. 

As noted in the discussion of the initial 

unit of property determination, the IRS 

and Treasury Department agree with 

commentators that the functional 

interdependence test is a relevant, 

although not dispositive, factor in the 

unit of property analysis. Although the 

proposed regulations use the functional 

interdependence test to determine the 

initial unit of property, the functional 

interdependence test in that context is 

merely a starting point in determining 

the appropriate unit of property, rather 

than a specific factor to be considered. 

Providing this version of the functional 

interdependence test as a specific factor 

gives appropriate weight to that test in 

the unit of property analysis for other 

personal property. 

5. Category IV: Other Real Property 

The unit of property determination for 

real property not included in Category 

I or II is based on a facts and 

circumstances test. The property subject 

to this category is primarily land and 

land improvements owned or leased by 

taxpayers not in a regulated industry. 

This category does not list specific 

factors because land and land 

improvements are such unique assets 

that specific factors cannot uniformly 

provide appropriate results. Thus, the 

unit of property determination for 

property in this category may be based 

on some, all, or none of the factors listed 

in Category III for personal property, or 

may be based on other factors. The IRS 

and Treasury Department request 

comments on whether additional 

guidance is needed for this category of 

property and, if so, what unit of 

property guidance would be 

appropriate. 

6. Additional Rule for Unit of Property 

After determining the initial unit of 

property and applying the unit of 

property rules under the appropriate 

category, the additional rule in 

§ 1.263(a)–3(d)(2)(vii) must be applied. 

Under this rule, if a taxpayer properly 

treats a component as a separate unit of 

property for any Federal income tax 

purpose, the taxpayer must treat the 

component as a separate unit of 

property for purposes of § 1.263(a)–3. 

The purpose of this rule is to prevent 

taxpayers from taking inconsistent 

positions by arguing that a component 

of property is a unit of property for one 

tax purpose and that it is not a separate 

unit of property for capitalization 

purposes. For example, if a taxpayer 

does a cost segregation study on a 

building and properly identifies 

separate section 1245 property, the 

taxpayer must treat that separate 

property as the unit of property for 

capitalization purposes. 

As a further example, if a taxpayer 

properly recognizes a loss under section 

165, or under another applicable 

provision, from a retirement of a 

component of property or from the 

worthlessness or abandonment of a 

component of property, the taxpayer 

must treat the component as a separate 

unit of property. A loss arising under 

another applicable provision in this 

context includes a loss arising under (1) 

§ 1.167(a)–8 or 1.167(a)–11, as 

applicable, from a retirement of a 

component of property if the component 

is not subject to section 168 (MACRS 

property) or former section 168 (ACRS 

property); (2) § 1.167(a)–8(a) from a 

retirement of a component of property if 

the component is MACRS or ACRS 

property (applying § 1.167(a)–8(a) as 

though the retirement is a normal 

retirement from a single asset account) 

unless the component is a structural 

component or the component is in a 

mass asset account (ACRS property) or 

a general asset account (MACRS 

property); or (3) § 1.168(i)–1(e) from the 

disposition of a component of property 

if the component is MACRS property 

and in a general asset account. No 

inference is intended that this rule in 

the proposed regulations requires or 

allows taxpayers that are using a unit of 

property for purposes of the proposed 

regulations to use the same unit of 

property for purposes of any Code or 

regulation section other than section 

263(a) and §§ 1.263(a)–1, 1.263(a)–2, 

and 1.263(a)–3 of the proposed 

regulations. 

This rule is intended to prevent 

taxpayers from taking a loss deduction 

on a component of a unit of property, 

and then deducting the cost of the 

replaced component as a repair. The 

application of this rule results in the 

replacement component being treated as 

a separate unit of property, thus 

requiring capitalization under 

§ 1.263(a)–2 of amounts paid to acquire 

or produce the replacement component. 

The IRS and Treasury Department 

believe that taxpayers must be 

consistent in the treatment of a unit of 

property for capitalization (other than 

interest capitalization), depreciation, 

and loss deduction purposes. The IRS 

and Treasury Department recognize that 

the language of this consistency rule is 

very broad, and request comments 

regarding circumstances in which this 

rule should not apply. 

V. Improvements in General 

Section 1.263(a)–1(b) of the current 

regulations provides that an amount 

must be capitalized if it (1) adds to the 

value, or substantially prolongs the 

useful life, of property owned by the 

taxpayer, or (2) adapts the property to a 

new or different use. Notice 2004–6 

requested comments on what general 

principles of capitalization should 

apply to amounts paid to repair or 

improve tangible property. 

Commentators were almost unanimous 

in their suggestion that the current 

principles of value, useful life, and new 

or different use be retained. The IRS and 

Treasury Department agree with the 

commentators that the current 

guidelines generally are appropriate. 

However, the current regulations require 

a subjective inquiry into the application 

of the particular facts at issue, which 

often results in disagreements between 

taxpayers and the IRS. Accordingly, the 

proposed regulations attempt to clarify 

and expand the standards in the current 

regulations by setting forth rules to 

determine whether there has been a 

material increase in value (including 

adapting property to a new or different 

use) and to determine whether there has 

been a restoration of property (the 

useful life rules). In addition, the 

proposed regulations provide objective 

rules for improvements in an optional 

repair allowance method. 

The proposed regulations generally 

provide that a taxpayer must capitalize 

the aggregate of related amounts paid 

that improve a unit of property, whether 


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the improvements are made by the 

taxpayer or a third party. The aggregate 

of related amounts does not encompass 

otherwise deductible repair costs unless 

those costs directly benefit or are 

incurred by reason of a capital 

improvement. Instead, the aggregation 

language is intended to include amounts 

paid for an entire project, including 

removal costs and other project costs, 

regardless of whether amounts are paid 

to more than one party or whether the 

work spans more than one taxable year. 

The proposed regulations do not affect 

the treatment of amounts paid to retire 

and remove a unit of property in 

connection with the installation or 

production of a replacement asset. See 

Rev. Rul. 2000–7 (2000–1 C.B. 712). 

Several commentators suggested that 

the proposed regulations provide that 

the relevant distinction between capital 

improvements and deductible repairs is 

whether the amounts were paid to put 

the property in ordinarily efficient 

operating condition or to keep the 

property in ordinarily efficient 

operating condition. See Estate of 

Walling v. Commissioner, 373 F.2d 190 

(3d Cir. 1967); Illinois Merchants Trust 

Co. v. Commissioner, 4 B.T.A. 103 

(1926), acq. (V–2 C.B. 2); Rev. Rul. 

2001–4 (2001–1 C.B. 295). The 

improvement rules in the proposed 

regulations are consistent with the put 

versus keep standard, to the extent that 

standard is relevant. An amount paid 

may be a capital expenditure even if it 

does not put the property in ordinarily 

efficient operating condition because 

not all repair or improvement costs 

affect the functionality of the property. 

Thus, amounts paid that keep property 

in ordinarily efficient operating 

condition are not necessarily deductible 

repair costs, particularly if the useful 

life is extended. On the other hand, 

amounts that put property in ordinarily 

efficient operating condition are likely 

to be amounts paid prior to the 

property’s being placed in service or to 

ameliorate a pre-existing condition or 

defect. Amounts paid in these later 

situations would be capital 

expenditures under either the value rule 

or the restoration rule in the proposed 

regulations. 

Some commentators suggested that 

the frequency of the expenditure should 

be considered, noting that an 

expenditure being regularly incurred on 

a cyclical basis should be a strong 

indication of deductible maintenance. 

The IRS and Treasury Department 

considered this comment but concluded 

that the frequency of the expenditure 

was too vague a standard to be 

administrable. Further, the IRS and 

Treasury Department believe that the 

proposed regulations provide 

appropriate guidance on cyclical 

maintenance by clarifying other rules, 

such as the appropriate comparison rule 

for adding value and the rules relating 

to prolonging economic useful life. 

In accordance with several comments 

received in response to Notice 2004–6, 

the proposed regulations provide that a 

Federal, state, or local regulator’s 

requirement that a taxpayer perform 

certain repairs or maintenance is not 

relevant in determining whether the 

amount paid improves the unit of 

property. Several courts have held that 

amounts paid to bring property into 

compliance with government 

regulations were capital expenditures, 

in part because they made the taxpayer’s 

property more valuable for use in its 

trade or business. See, Swig Investment 

Co. v. United States, 98 F.3d 1359 (Fed. 

Cir. 1996) (replacing cornices and 

parapets on hotel to comply with city 

earthquake ordinance); Teitelbaum v. 

Commissioner, 294 F.2d 541 (7th Cir. 

1961) (converting electrical system from 

direct current to alternating current to 

comply with city ordinance); RKO 

Theatres, Inc. v. United States, 163 F. 

Supp. 598 (Ct. Cl. 1958) (installing fireproof doors and fire escapes to comply 

with city code); Hotel Sulgrave, Inc. v. 

Commissioner, 21 T.C. 619 (1954) 

(installing sprinkler system to comply 

with city code). In each case, however, 

the court did not rely entirely on 

regulatory compliance as a basis for 

requiring capitalization. For example, in 

Hotel Sulgrave and RKO Theatres, both 

involving the installation of certain 

equipment to comply with city fire 

codes, the courts emphasized that the 

work involved the addition of property 

with a useful life extending beyond the 

taxable year. Moreover, both Swig and 

Teitelbaum involved expenditures for 

the replacement of major structural 

components of a building (parapets and 

cornices in Swig and an electrical 

system in Teitelbaum) with upgraded 

components. Thus, in all these cases, 

even without the legal compulsion to 

make these changes, the taxpayers’

amounts paid would have constituted 

capital expenditures. 

In contrast to the cases discussed 

above, both the courts and the IRS have 

permitted a current deduction for some 

government mandated expenditures. For 

example, in Midland Empire Packing 

Co. v. Commissioner, 14 T.C. 635 (1950), 

acq. (1950–2 C.B. 3), the court allowed 

the taxpayer to deduct the costs of 

applying a concrete liner to its basement 

walls to satisfy Federal meat inspectors. 

Similarly, the IRS has permitted 

taxpayers to treat as otherwise 

deductible repairs amounts paid to 

remediate certain environmental 

contamination and to replace certain 

waste storage tanks to comply with 

applicable state and Federal regulations. 

See Rev. Rul. 94–38 (1994–1 C.B. 35); 

Rev. Rul. 98–25 (1998–1 C.B. 998). The 

IRS specifically recognized in Rev. Rul. 

2001–4 (2001–1 C.B. 295) that the 

requirement of a regulatory authority to 

make certain repairs or to perform 

certain maintenance on an asset to 

continue operating the asset does not 

mean that the work performed must be 

capitalized. Thus, the proposed 

regulations reiterate that statement in 

Rev. Rul. 2001–4 and provide that a 

legal compulsion to repair or maintain 

tangible property is not a relevant factor 

in the repair versus improvement 

analysis. The IRS and Treasury 

Department further believe that a new 

government requirement for existing 

property that mandates certain 

expenditures with respect to the 

property does not create an inherent 

defect in the property. 

In response to several comments, the 

proposed regulations provide that if a 

taxpayer needs to replace part of a unit 

of property that cannot practicably be 

replaced with the same type of part, the 

replacement of the part with an 

improved but comparable part does not, 

by itself, result in an improvement to 

the unit of property. This rule is 

intended to apply in cases where the 

same replacement part is no longer 

available, generally because of 

technological advancements or product 

enhancements. This rule, however, is 

not intended to apply if, instead of 

replacing an obsolete part with the most 

similar comparable part available, the 

taxpayer replaces the part with one of a 

better quality than what would have 

sufficed. 

The proposed regulations do not 

prescribe a plan of rehabilitation 

doctrine as traditionally described in 

the case law. That judicially-created 

doctrine provides that a taxpayer must 

capitalize otherwise deductible repair 

costs if they are incurred as part of a 

general plan of rehabilitation to the 

property. See, Norwest Corp. v. 

Commissioner, 108 T.C. 265 (1997); 

Moss v. Commissioner, 831 F.2d 833 

(9th Cir. 1987); United States v. Wehrli, 

400 F.2d 686 (10th Cir. 1968). 

Specifically, if an expenditure is made 

as part of a general plan of 

rehabilitation, modernization, and 

improvement of the property, the 

expenditure must be capitalized, even 

though, standing alone, the item may be 

classified as one of repair or 

maintenance. Wehrli, 400 F.2d at 689. 

Whether a general plan of rehabilitation 

exists, and whether a particular repair 


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or maintenance item is part of it, are 

questions of fact to be determined based 

upon all the surrounding facts and 

circumstances, including, but not 

limited to, the purpose, nature, extent, 

and value of the work done. Id. at 690. 

The issue of whether an amount paid 

must be capitalized under the plan of 

rehabilitation doctrine has been the 

subject of much litigation, with varying 

results. For example, some cases have 

limited application of the plan of 

rehabilitation doctrine to buildings that 

are not suitable for their intended use in 

the taxpayer’s trade or business. See 

Schroeder v. Commissioner, T.C. Memo 

1996–336; Koanis v. Commissioner, T.C. 

Memo 1978–184, aff’d mem., 639 F.2d 

788 (9th Cir. 1981); Keller Street Dev. 

Co. v. Commissioner, 37 T.C. 559 (1961); 

acq., 1962–2 C.B. 5, aff’d in part, rev’d 

in part on other grounds, 323 F.2d 166 

(9th Cir. 1963). Other courts, as well as 

the IRS, have viewed the plan of 

rehabilitation doctrine more broadly, 

emphasizing the planned aspect of the 

work done by the taxpayer, rather than 

the condition of the property. See 

Mountain Fuel Supply Co. v. United 

States, 449 F.2d 816 (10th Cir. 1971); 

Wolfsen Land & Cattle Co. v. 

Commissioner, 72 T.C. 1 (1979); Rev. 

Rul. 88–57 (1988–2 C.B. 36). 

In Rev. Rul. 2001–4 (2001–1 C.B. 295), 

the IRS clarified its view of the plan of 

rehabilitation doctrine. In applying the 

plan of rehabilitation doctrine to the 

facts in Situation 3 of that ruling, the 

IRS noted that (1) the taxpayer planned 

to perform substantial capital 

improvements to upgrade the unit of 

property; (2) the repairs were incidental 

to the taxpayer’s plan to upgrade the 

unit of property; and (3) the effect of all 

the work performed on the unit of 

property, including the repairs and 

maintenance work, was to materially 

increase the value or prolong the useful 

life of the unit of property. The ruling 

also notes that the existence of a written 

plan, by itself, is not sufficient to trigger 

the plan of rehabilitation doctrine. The 

ruling’s interpretation of the plan of 

rehabilitation doctrine is consistent 

with the majority of cases applying that 

doctrine. See California Casket Co. v. 

Commissioner, 19 T.C. 32 (1952), acq., 

1953–1 C.B. 3; Stoeltzing v. 

Commissioner, 266 F.2d 374 (3d Cir. 

1959); Bank of Houston v. 

Commissioner, T.C.M. 1960–110. 

The IRS and Treasury Department do 

not believe it is appropriate to capitalize 

as an improvement otherwise 

deductible repair costs solely because 

the taxpayer has a plan (written or 

otherwise) to perform periodic repairs 

or maintenance or solely because the 

taxpayer performs several repairs to the 

same property at one time. The IRS and 

Treasury Department believe that it is 

appropriate to capitalize otherwise 

deductible repair costs as part of an 

improvement only if the taxpayer 

improves a unit of property and the 

otherwise deductible repair costs 

directly benefit or are incurred by 

reason of the improvement to the 

property. Section 263A applies to these 

expenditures. Section 263A requires 

that all direct costs of an improvement 

and all indirect costs that directly 

benefit or are incurred by reason of the 

improvement must be capitalized. This 

application of section 263A to otherwise 

deductible repair costs in this context is 

consistent with the application of the 

plan of rehabilitation doctrine described 

in Rev. Rul. 2001–4. The proposed 

regulations provide that repairs that are 

made at the same time as an 

improvement, but that do not directly 

benefit or are not incurred by reason of 

the improvement, are not required to be 

capitalized under section 263(a). 

VI. Value 

A. In General 

The proposed regulations provide that 

a taxpayer must capitalize amounts paid 

that materially increase the value of a 

unit of property and provide an 

exclusive list of five tests for 

determining whether an amount paid 

materially increases value. An amount 

paid must be capitalized if it meets any 

of the five tests. The first test is whether 

the amount paid ameliorates a condition 

or defect that either existed prior to the 

taxpayer’s acquisition of the unit of 

property or arose during the production 

of the unit of property. See United Dairy 

Farmers, Inc. v. United States, 267 F.3d 

510 (6th Cir. 2001); Dominion 

Resources, Inc. v. United States, 219 

F.3d 359 (4th Cir. 2000); Jones v. 

Commissioner, 242 F.2d 616 (5th Cir. 

1957). This rule is consistent with the 

concept that amounts paid to put 

property into ordinarily efficient 

operating condition must be capitalized. 

This pre-existing defect rule applies 

regardless of whether the taxpayer was 

aware of the condition or defect at the 

time of acquisition or production. The 

IRS and Treasury Department 

considered but rejected as too subjective 

the idea of providing different treatment 

based on the taxpayer’s prior knowledge 

of the condition or defect. The IRS and 

Treasury Department request comments 

on whether, and in what circumstances, 

the pre-existing defect rule should take 

into account the condition of the 

property in the hands of a transferor. 

For example, if an individual transfers 

property to a corporation in exchange 

for stock in a transaction under section 

351, should the pre-existing defect rule 

take into account the condition of the 

property when acquired by the 

individual, rather than the condition of 

the property when received by the 

corporation? 

The second test for materially 

increasing value is whether the work 

was performed prior to the date the 

property is placed in service by the 

taxpayer. This test essentially restates 

the concept that amounts paid to put 

property into ordinarily efficient 

operating condition must be capitalized. 

The IRS and Treasury Department 

believe that if the property cannot be 

placed in service prior to work being 

performed, that work necessarily 

increases the value of the property. 

The third value test is whether the 

amounts paid adapt the property to a 

new or different use. The commentators 

agreed that this factor should remain a 

standard for capitalization. The new or 

different use standard is unchanged 

from the current regulations, but it is 

included in the value section of the 

proposed regulations, rather than as its 

own standard. The new or different use 

test is not intended to apply to amounts 

paid to prepare a unit of property for 

sale (for example, painting a house). 

The fourth value test is whether the 

amount paid results in a betterment or 

material addition to the unit of property. 

The betterment language is consistent 

with the statutory language of section 

263(a)(1) as well as the current 

regulations at § 1.263(a)-1(a)(1). A 

betterment is an improvement that does 

more than restore to a former good 

condition. The betterment test is 

intended to capture amounts paid that 

are qualitative improvements to the 

property that make the property better 

and more valuable than mere repairs 

would do, such as using upgraded 

materials when materials comparable to 

the original were available and would 

have sufficed. However, the betterment 

test is not intended to be a fair market 

value test. 

The fifth test in the value section of 

the proposed regulations is whether the 

amount paid results in a material 

increase in capacity, productivity, 

efficiency, or quality of output of the 

unit of property. These standards are 

consistent with case law under the 

current regulations. 

The proposed regulations provide an 

exception to the value tests if the 

original economic useful life of the unit 

of property is 12 months or less and the 

taxpayer does not elect to capitalize 

amounts paid for the property. The 

purpose of this rule is to not require 

capitalization under the value rules for 


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improvements made to 12-month 

property. This exception, however, does 

not apply to the restoration rule for 

determining whether an amount paid 

improves property. Thus, for example, if 

a taxpayer performs work on 12-month 

property that prolongs the economic 

useful life of the property, the amount 

paid must be capitalized. 

The proposed regulations do not 

adopt an increase in fair market value as 

a standard for capitalization. In 

response to Notice 2004–6, most 

commentators stated that value means 

fair market value. However, in practice, 

taxpayers generally do not measure, and 

would have no reason to measure, the 

fair market value of a unit of property 

prior to some condition necessitating 

the expenditure. Further, taxpayers 

generally have no reason to measure the 

fair market value of a unit of property 

after the work is performed. The IRS 

and Treasury Department did not want 

to propose regulations with a standard 

that required taxpayers to have property 

appraised solely for the purpose of 

applying a capitalization standard. In 

fact, the courts rarely have applied a 

strict increase in fair market value 

standard. Usually, the courts rely on 

some surrogate for fair market value to 

determine whether value is increased. 

For example, courts have looked to the 

amount of the expenditure versus (1) the 

cost of the property (see Stoeltzing v. 

Commissioner, 266 F.2d 374 (3d Cir. 

1959)); (2) the cost of comparable new 

property (see LaSalle Trucking Co. v. 

Commissioner, T.C. Memo 1963–274); 

and (3) the cost of comparable used 

property (see Ingram Industries, Inc. v. 

Commissioner, T.C. Memo 2000–323). 

Courts have considered fair market 

value only in a few cases when property 

has been appraised for some other 

purpose (see Jones v. United States, 279 

F. Supp. 772, 774 (D. Del. 1968)), or 

when property has been appraised in 

the course of the litigation (see FedEx, 

291 F. Supp. 2d at 706–707). 

Additionally, the fair market value of 

property may change over time without 

regard to the use, upkeep, or 

improvements made by the taxpayer, 

due to other factors such as supply and 

demand or changes in style, trends, 

technologies, etc. For example, land 

may increase in fair market value over 

time without the taxpayer performing 

any activities to improve it. Conversely, 

amounts paid to make substantial 

improvements to a unit of property may 

not always increase fair market value, or 

may not increase the fair market value 

by the full amount paid for the 

improvements. See, Harrah’s Club v. 

United States, 661 F.2d 203 (Ct. Cl. 

1981) (amount paid to restore antique 

automobiles must be capitalized even 

though restoration did not increase fair 

market value by the amount paid for the 

restoration). Attempting to adjust fair 

market value for factors like these 

further complicates any possible 

comparison. The IRS and Treasury 

Department believe that the fair market 

value standard is too subjective and 

impractical, particularly because most 

repairs also increase the fair market 

value of property if the value is 

compared immediately before and after 

the work is performed. Therefore, the 

IRS and Treasury Department do not 

believe that fair market value is an 

appropriate standard. The value factors 

in the proposed regulations are intended 

to be objective indications of work 

performed that generally would increase 

the fair market value of the unit of 

property. Whether amounts paid 

materially increase the value of a unit of 

property requires an analysis of the 

purpose, the physical nature, and the 

effect of the work for which the amounts 

were paid, and not an analysis of the 

fair market value of the property or the 

level of monetary expenditures. 

Some commentators requested that 

the regulations provide a bright line rule 

defining a material increase in value 

with respect to a specified percentage 

increase, for example a twenty-five 

percent increase in capacity. The IRS 

and Treasury Department do not believe 

that providing a fixed percentage as a 

presumption of what is a material 

increase would be an appropriate safe 

harbor. Although perhaps measurable, 

the same fixed percentage increase in 

capacity would not work well as a rule 

applicable to all types of property. A 

twenty-five percent increase in capacity 

may be a reasonable litmus test for 

determining whether there has been a 

material increase in value for certain 

types of property. However, for many 

types of property, a much smaller 

increase in capacity may be an 

extraordinary, or in some cases 

impossible, improvement. For example, 

an increase in the square footage of a 

50,000 square foot building by 5 percent 

would be a rather large improvement 

that should be capitalized. Therefore, 

the determination of whether an 

increase in capacity, productivity, 

efficiency, or quality is a material 

increase in value should be based on all 

the facts and circumstances. 

B. Appropriate Comparison 

Notice 2004–6 requested comments 

on the proper starting point for 

comparing whether an expenditure 

materially increases the value of 

property. Almost all the commentators 

suggested that the proposed regulations 

adopt the test set forth in PlainfieldUnion Water Co. v. Commissioner, 39 

T.C. 333 (1962), nonacq. on other 

grounds (1964–2 C.B. 8) (the PlainfieldUnion test). In that case, the court noted 

that almost any properly performed 

repair adds value as compared with the 

situation existing immediately prior to 

that repair. The proper test, the court 

said, is whether the expenditure 

materially enhances the value of the 

property as compared with the status of 

the property prior to the condition 

necessitating the expenditure. The court 

also noted that the test is appropriate 

even when the expenditure does not 

arise from a sudden, unexpected, or 

unusual external circumstance. 

The IRS and Treasury Department 

agree with this application of the 

Plainfield-Union test and believe that 

the test is appropriately applied to cases 

of normal wear and tear as well as cases 

when the expenditure arises from a 

sudden, unexpected, or unusual 

external circumstance. The proposed 

regulations adopt the Plainfield-Union 

test for cases in which a particular event 

necessitates the expenditure and clarify 

that when the event necessitating the 

expenditure is normal wear and tear, the 

condition of the property immediately 

prior to the event necessitating the 

expenditure is the condition of the 

property after the last time the taxpayer 

corrected the effects of normal wear and 

tear or, if the taxpayer has not 

previously corrected the effects of 

normal wear and tear, the condition of 

the property when placed in service by 

the taxpayer. This comparison rule for 

wear and tear is intended to apply when 

a taxpayer engages in regular, cyclical 

maintenance of a unit of property to 

correct the effects of normal wear and 

tear. Although wear and tear begins 

affecting the condition of property as 

soon as it is placed in service, the 

proposed regulations do not adopt the 

placed-in-service date as the appropriate 

comparison point. Although the placedin-service date would be the appropriate 

comparison point when the taxpayer 

first corrects the effects of normal wear 

and tear, the IRS and Treasury 

Department believe that the condition of 

the property after the previous 

maintenance cycle is the appropriate 

comparison point for each subsequent 

maintenance cycle. 

The Plainfield-Union test works well 

when the amount paid is necessitated 

by a specific event (like amounts paid 

to repair damage or amounts paid to 

maintain property by correcting the 

effects of wear and tear). However, the 

test does not work in a pure 

improvement setting; that is, when a 

taxpayer decides to improve property 


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without any event causing the taxpayer 

to perform the work to restore the 

property to a former good condition. 

Therefore, the proposed regulations do 

not apply the Plainfield-Union test to 

the first three value factors (pre-existing 

defects, work performed prior to the 

property being placed in service, and 

adapting the property to a new or 

different use). These factors are more 

appropriately analyzed on an absolute, 

rather than relative basis. Similarly, the 

test does not work well for betterments, 

which by definition are improvements 

that do more than restore property to a 

former good condition. 

VII. Restoration 

The proposed regulations provide that 

a taxpayer must capitalize amounts paid 

to restore property. The restoration 

language is from section 263(a)(2) and 

§ 1.263(a)–1(a)(2) of the current 

regulations and generally has been 

viewed as a rule requiring the 

capitalization of amounts paid that 

substantially prolong the useful life of 

the property. See § 1.263(a)–1(b). This 

section of the proposed regulations 

defines economic useful life and what it 

means to substantially prolong 

economic useful life. 

The comments received in response to 

Notice 2004–6 varied greatly with 

regard to useful life, with two 

commentators specifically suggesting 

that the concept of useful life be 

eliminated from the regulations. The 

other commentators suggested that 

economic useful life be defined as the 

period of time over which the property 

is expected to be useful to the taxpayer, 

taking into account the various factors 

listed in § 1.167(a)–1(b). The proposed 

regulations adopt this definition of 

economic useful life for taxpayers that 

do not have an AFS. Economic useful 

life is not determined by reference to the 

recovery period under section 168 for 

the property. 

For a taxpayer that has an AFS, the 

economic useful life of the property is 

presumed to be the same as the useful 

life used by the taxpayer for purposes of 

determining depreciation in its AFS. 

The IRS and Treasury Department 

believe that the economic useful life 

definition is subjective and difficult to 

apply; therefore, this rule provides 

certainty for taxpayers with an AFS. The 

regulations provide an exception to this 

rule for situations in which a taxpayer 

does not assign a useful life to certain 

property in its AFS, even though the 

property has a useful life of more than 

one year. For example, a taxpayer may 

treat amounts paid for a unit of property 

as an expense in its AFS if the property 

is used in a specific research project and 

has no alternative future uses. 

Additionally, many taxpayers have a 

policy of treating as an expense in their 

AFS an amount paid for tangible 

property below a certain dollar 

threshold, despite the fact that the 

property has a useful life of more than 

one year. This type of property does not 

have a useful life for purposes of 

determining depreciation in the 

taxpayer’s AFS, even though it may 

have a useful life of more than one year. 

Therefore, the IRS and Treasury 

Department believe that in these 

situations it is appropriate for taxpayers 

to use the economic useful life 

definition that applies to taxpayers 

without an AFS. 

One commentator stated that the 

useful life used for book depreciation 

purposes is not appropriate for tax 

purposes because the book useful life 

takes into account factors that do not 

measure the inherent useful life, but 

rather the period over which the 

property is expected to be useful (on 

average) to the taxpayer. The IRS and 

Treasury Department believe it is 

appropriate to take into account the 

period over which the property may 

reasonably be expected to be useful to 

the taxpayer, as required by taxpayers 

without an AFS, rather than the 

inherent useful life of the property. 

The proposed regulations also provide 

four rules for determining when an 

amount paid substantially prolongs 

economic useful life. The first rule 

requires capitalization when the amount 

paid extends the period over which the 

property may reasonably be expected to 

be useful to the taxpayer beyond the end 

of the taxable year immediately 

succeeding the taxable year in which 

the economic useful life of the property 

was originally expected to cease. One 

commentator suggested that the 

regulations provide a safe harbor bright 

line rule to define whether an amount 

substantially prolongs the useful life. 

The IRS and Treasury Department 

believe that a one year rule is an 

appropriate bright line. Therefore, the 

regulations require capitalization when 

the amount paid extends the original 

useful life of the property by more than 

one taxable year. The IRS and Treasury 

Department believe that a one year rule 

is a more appropriate bright line than a 

rule based on a percentage of the useful 

life, because the one-year rule 

corresponds with the 12-month safe 

harbor rule for the acquisition or 

production of property. 

The second rule requires 

capitalization if a major component or a 

substantial structural part of the unit of 

property is replaced and notes that the 

replacement of a relatively minor 

portion of the physical structure of the 

unit of property or a relatively minor 

portion of any of its major parts does not 

constitute the replacement of a major 

component or substantial structural part 

of the unit of property. It is possible, 

however, for amounts paid to replace a 

relatively minor portion of the physical 

structure of the unit of property or a 

relatively minor portion of any of its 

major parts to substantially prolong the 

economic useful life of the property if 

the property is near the end of its 

economic useful life, in which case the 

amounts paid nevertheless must be 

capitalized. The rule is not intended to 

require capitalization if a major 

component is replaced with a similar, 

used component that has not been 

rebuilt, for example, if the engine in a 

car is replaced with a used engine with 

similar mileage obtained from a 

junkyard, or a component of property 

subject to a warranty or maintenance 

agreement is replaced with a used part 

that has been repaired. 

Although the replacement of minor 

parts does not usually prolong the 

economic useful life of most property, 

the replacement of most or all minor 

parts for some types of property may be 

the equivalent of rebuilding the 

property, particularly in cases in which 

the property consists almost entirely of 

minor parts. Therefore, the third rule 

provides that amounts paid that restore 

a unit of property (or a major 

component or substantial structural part 

of the unit of property) to a like-new 

condition substantially prolong the 

useful life. The IRS and Treasury 

Department intend that this test be 

applied to situations in which the 

property undergoes the equivalent of 

being rebuilt. Merely reconditioning a 

property by dismantling the property, 

and cleaning and inspecting 

components, is not the equivalent of 

rebuilding. All or almost all major and 

minor parts of the unit of property (or 

the major component or substantial 

structural part of the unit of property) 

must be returned to the original 

manufacturers’ specifications. 

The fourth rule relates to the 

restoration of a unit of property after the 

taxpayer has properly deducted a 

casualty loss under section 165 with 

respect to the property. Section 165(a) 

allows a taxpayer to deduct any loss 

sustained during the taxable year and 

not compensated for by insurance or 

otherwise. Generally, any loss arising 

from a fire, storm, shipwreck, or other 

casualty is allowable as a deduction 

under section 165(a). Section 1.165–

7(a)(1). The amount of the deduction is 

the difference between the fair market 

value of the property before and after 


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the casualty, to the extent the amount 

does not exceed the property’s adjusted 

basis. Section 1.165–7(b)(1). A casualty 

loss deduction under section 165(a) 

results in a decrease in the taxpayer’s 

basis in the property. 

The courts have distinguished 

between losses that are deductible as 

casualties under section 165(a) and 

incidental repair costs that are 

deductible under section 162(a) as 

ordinary and necessary business 

expenses. In general, if property is lost, 

destroyed, or abandoned as a result of 

a casualty, a loss deduction under 

section 165(a) is appropriate; however, 

if property is simply damaged in a 

casualty and expenditures are made to 

repair the property in a manner that 

does not permanently improve or better 

it or prolong its useful life, those 

expenditures are business expenses 

deductible under section 162(a). Hensler 

v. Commissioner, 73 T.C. 168, 179 

(1979); see also Hubinger v. 

Commissioner, 36 F.2d 724, 726 (2d Cir. 

1929) (expenses resulting from ‘‘trifling 

accidental causes’’ are deductible only 

under section 162(a) and not under 

section 165(a)); Atlantic Greyhound 

Corp. v. United States, 111 F. Supp. 953 

(1953) (‘‘the provisions for deductions 

of ‘ordinary and necessary expenses’

and ‘casualty losses’ would seem to be 

mutually exclusive, for the normal 

connotation of one negates, at least by 

implication, the idea of the other’’). 

Thus, the mere fact that the damage 

results from a casualty is not 

controlling; instead, the nature of the 

damage resulting from the casualty is 

relevant in determining whether the 

expenditure should be treated as a loss 

or deduction. 

The IRS and Treasury Department 

believe that when a taxpayer properly 

deducts a casualty loss, the nature of the 

damage resulting from the casualty is 

such that any repairs done to restore the 

property after the casualty should not be 

treated as ordinary and necessary repair 

costs. Thus, the proposed regulations 

provide that any amounts paid to repair 

property after a casualty loss must be 

capitalized. 

Commentators stated that amounts 

paid at any point during the property’s 

economic useful life that do not change 

the function, design, etc., but enable 

property to be used for its expected 

useful life should not be determined to 

extend the useful life. The IRS and 

Treasury Department believe that there 

are circumstances in which amounts 

paid that merely restore property to a 

former good condition may properly be 

capitalized as substantially prolonging 

useful life, for example, when repairs 

are made to property after a casualty 

loss. As another example, work 

performed at the end of the economic 

useful life of the unit of property may 

extend the property’s useful life. 

Additionally, replacement of a major 

component or a substantial structural 

part of a unit of property extends the 

useful life, particularly when the 

expected life of the component is 

coterminous with the economic useful 

life of the unit of property, and the 

economic useful life of the unit of 

property is in fact limited by the period 

over which the component is expected 

to be useful. Thus, the proposed 

regulations do not adopt the 

commentators’ suggestion. 

VIII. Repair Allowance Method 

A. In General 

The primary focus of the proposed 

regulations is to provide guidance that 

distinguishes deductible repair 

expenses from capital expenditures. 

However, because this remains 

inherently a facts-and-circumstances 

based determination, the IRS and 

Treasury Department requested 

comments in Notice 2004–6 on whether 

the regulations should provide a repair 

allowance. Six commentators suggested 

the regulations should provide a repair 

allowance or other de minimis rules for 

repair expenditures. Two commentators 

specifically proposed a repair allowance 

system modeled on the former CLADR 

repair allowance system. The proposed 

regulations adopt these suggestions and 

provide an optional repair allowance 

method, similar to the CLADR repair 

allowance, to create objective rules in 

this area. Although some commentators 

additionally requested other de minimis 

rules for repair expenditures as well, the 

IRS and Treasury Department believe 

that a repair allowance is an appropriate 

safe harbor for repair expenditures. 

Therefore, the proposed regulations do 

not provide a safe harbor other than the 

repair allowance. 

Under the repair allowance in the 

proposed regulations, the taxpayer 

compares the amounts paid for 

materials and labor during the taxable 

year to repair, maintain, or improve 

repair allowance property to the repair 

allowance amount. The amounts paid 

are deductible under section 162 to the 

extent of the repair allowance amount, 

and any excess amounts paid are 

capitalized. Under the proposed repair 

allowance method, a repair allowance 

amount is determined separately for 

each MACRS class. The repair 

allowance amount for a particular class 

is determined by multiplying the repair 

allowance percentage in effect for that 

class by the average unadjusted basis of 

repair allowance property in that class. 

For buildings that are repair allowance 

property, the repair allowance method 

is applied separately to each building. 

This rule is consistent with the rule for 

buildings under the CLADR repair 

allowance system. 

B. Capitalized Amount 

The excess of amounts paid to repair, 

maintain, or improve all the repair 

allowance property in a MACRS class 

over the repair allowance amount for 

the class must be capitalized (the 

capitalized amount). The capitalized 

amount includes the taxpayer’s direct 

costs of repairing, maintaining, or 

improving repair allowance property in 

a particular MACRS class. In addition, 

the taxpayer must add to the capitalized 

amount any allocable indirect costs of 

producing the repair allowance property 

in the MACRS class, which must be 

capitalized in accordance with the 

taxpayer’s method of accounting for 

section 263A costs. Except with regard 

to repair allowance property that is 

depreciated under section 168(g) or 

repair allowance property that is public 

utility property (for which separate 

rules are provided), the proposed 

regulations permit taxpayers to choose 

one of two methods of treating the 

capitalized amount. The first method is 

to treat the capitalized amount as a 

separate single asset and to depreciate 

the asset in accordance with that 

MACRS class. The second method is to 

allocate the capitalized amount for a 

particular MACRS class to all repair 

allowance property in the particular 

MACRS class in proportion to the 

unadjusted basis of the property in that 

MACRS class as of the beginning of the 

taxable year. Under either the single 

asset method or the allocation method, 

the capitalized amount is treated as a 

section 168(i)(6) improvement and is 

treated as placed in service by the 

taxpayer on the last day of the first half 

of the taxable year in which the amount 

is paid, before application of the 

convention under section 168(d). For 

example, the capitalized amount for a 

calendar year taxpayer would be treated 

as placed in service on June 30 of the 

taxable year. 

Because the single asset treatment 

does not permit taxpayers to recognize 

a gain or loss on the disposition of 

repair allowance property, the IRS and 

Treasury Department request comments 

on whether, in the final regulations, 

taxpayers should be permitted to change 

to the allocation treatment for the 

taxable year of disposition and if so, 

what record keeping rules or other rules 

should be required for taxpayers to 

make that change. With regard to the 


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allocation treatment, the IRS and 

Treasury Department request comments 

on whether the allocation should be 

based on an amount other than the 

unadjusted basis as of the beginning of 

the taxable year, such as the unadjusted 

basis at the end of the taxable year or 

the average unadjusted basis. 

C. Repair Allowance Property 

Repair allowance property is defined 

in the proposed regulations as real or 

personal property subject to MACRS 

that is used in the taxpayer’s trade or 

business or for the production of 

income. It also includes certain tangible 

property not otherwise subject to 

MACRS if the taxpayer, solely for 

purposes of the repair allowance 

method, classifies the property in the 

appropriate MACRS class in which the 

property would be included if the 

property were subject to MACRS. 

Taxpayers are not required to classify 

non-MACRS property (property placed 

in service before the effective date of 

section 168 and property for which the 

taxpayer properly elected out of section 

168). Non-classified property will not be 

repair allowance property eligible for 

the repair allowance method. Certain 

types of property are not included in 

repair allowance property, including 

any property for which the taxpayer has 

elected to use the CLADR repair 

allowance method and property for 

which the taxpayer uses the method of 

accounting provided in Rev. Proc. 2001–

46 (2001–2 C.B. 263) or Rev. Proc. 2002–

65 (2002–2 C.B. 700) (both with regard 

to railroad track). Thus, the repair 

allowance in the proposed regulations 

does not repeal the CLADR repair 

allowance, nor does it prohibit 

taxpayers from using the repair 

allowance method in these regulations 

for repair allowance property, while 

continuing to use the CLADR repair 

allowance for other property. 

D. Excluded Additions 

Repair allowance property also does 

not include excluded additions, the cost 

of which must be capitalized. The 

CLADR repair allowance system has a 

similar rule. Under the CLADR repair 

allowance system, excluded additions 

are defined as any expenditures (1) that 

increase by 25% or more the 

productivity or capacity of an existing 

identifiable unit of property over its 

productivity or capacity when first 

acquired; (2) that modify an existing 

identifiable unit of property for a 

substantially different use; (3) for an 

additional identifiable unit of property 

or a replacement of an identifiable unit 

of property that was retired; (4) for a 

replacement of a part in or a component 

or portion of an existing identifiable 

unit of property if such part, 

component, or portion is for 

replacement of a part, component or 

portion which was retired in a 

retirement upon which gain or loss was 

recognized; (5) in the case of a building 

or other structure, for additional cubic 

or linear space; and (6) in the case of 

those units of property of pipelines, 

electric utilities, telephone companies, 

and telegraph companies consisting of 

lines, cables, and poles, for replacement 

of 5% or more of the unit of property 

with respect to which the replacement 

is made. 

One commentator suggested that the 

proposed regulations should not have 

excluded additions similar to those in 

the CLADR repair allowance because 

they are too qualitative and difficult to 

administer. The IRS and Treasury 

Department agree that some of the items 

listed as excluded additions under the 

CLADR system are too subjective and do 

not provide the kind of objective 

determination the proposed repair 

allowance is intended to provide. For 

this reason, the proposed regulations 

limit the excluded additions to amounts 

paid (1) For the acquisition or 

production of a specific unit of 

property; (2) for work that ameliorates a 

condition or defect that either existed 

prior to the taxpayer’s acquisition of the 

unit of property or arose during the 

production of the unit of property, 

whether or not the taxpayer was aware 

of the condition or defect at the time of 

acquisition or production; (3) for work 

performed prior to the date the unit of 

property is placed in service by the 

taxpayer (without regard to any 

applicable convention under section 

168(d)); (4) that adapts the unit of 

property to a new or different use; or (5) 

that increases the cubic or square space 

of a building. 

Thus, the proposed regulations adopt 

excluded additions 2, 3, and 5 in the 

CLADR repair allowance. These 

excluded additions are also listed in 

§ 1.263(a)–3(e)(1) of the proposed 

regulations as factors that indicate a 

material increase in value. The 

regulations do not adopt excluded 

addition 1 in the CLADR repair 

allowance because an increase in 

productivity or capacity of 25% or more 

may be too difficult to measure. The 

regulations do not specifically cite 

excluded addition 4 from the CLADR 

repair allowance; however, if a part, 

component, or portion of a unit of 

property is retired in a retirement upon 

which gain or loss properly was 

recognized, the replacement of that 

component is a separate unit of property 

under § 1.263(a)–3(d)(2) of the proposed 

regulations and thus is addressed by 

excluded addition 1 of the proposed 

regulations. Excluded addition 6 in the 

CLADR repair allowance addresses 

network assets and was not adopted in 

the proposed regulations pending 

comments on how the final regulations 

should address the unit of property 

rules relating to network assets. 

In addition to the three excluded 

additions that the proposed regulations 

carry over from the CLADR repair 

allowance, the excluded additions in 

the proposed regulations include 

amounts paid for work that ameliorates 

a pre-existing condition or defect and 

for work performed prior to the date the 

unit of property is placed in service by 

the taxpayer. These two excluded 

additions also are listed as factors in 

§ 1.263(a)–3(e)(1) of the proposed 

regulations that indicate a material 

increase value. The IRS and Treasury 

Department believe that the excluded 

additions provided in the repair 

allowance in the proposed regulations 

are more objective than those in the 

CLADR regulations and are easier to 

verify. 

E. Leased Property 

Like the repair allowance under 

CLADR, repair allowance property does 

not include property leased by the 

taxpayer from another party. One 

commentator suggested that the repair 

allowance apply to leased property. The 

IRS and Treasury Department recognize 

that taxpayers that lease property 

confront the same issues as owners in 

distinguishing deductible repairs from 

capital improvements. However, the 

application of the repair allowance 

method to leased property raises several 

difficult issues. The IRS and Treasury 

Department request comments on 

whether the repair allowance method 

should be extended to leased property 

and, if so, how the following issues 

should be resolved: (1) How should the 

unadjusted basis of leased property be 

determined? Should fair market value 

be used instead of unadjusted basis and, 

if so, how and when should fair market 

value be determined? (2) How should 

the regulations be drafted to prevent 

abuse between related lessors and 

lessees? (3) How should the regulations 

be drafted to prevent both the lessor and 

lessee from using the repair allowance 

method for the same property? (4) How 

should the regulations address qualified 

lessee construction allowances for shortterm leases under section 110? (5) What 

is the proper treatment of the 

capitalized amount for leased property 

under the repair allowance? (6) Should 

lessees be permitted to classify the 

leased property to a MACRS class and 


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use one of the treatments of the 

capitalized amount in the proposed 

regulations? (7) Should the capitalized 

amount be allocated to individual leases 

and amortized over the remaining term 

of each lease and, if so, how should that 

allocation be made? (8) If the taxpayer 

has a number of leases with varying 

lease terms, should the capitalized 

amount be allocated to certain groups of 

leases and amortized over the average 

remaining term of the leases and if so, 

how should the leases be grouped? (9) 

Are there any other issues with regard 

to the application of a repair allowance 

to leased property that need to be 

addressed? 

F. Network Assets 

The definition of repair allowance 

property in the proposed regulations 

does not specifically exclude network 

assets. However, application of the 

repair allowance requires a 

determination of the appropriate unit of 

property, in particular with regard to 

identifying excluded additions. The unit 

of property determination with regard to 

network assets is not addressed in the 

proposed regulations and is an issue on 

which the IRS and Treasury Department 

have requested comments. Therefore, 

the IRS and Treasury Department 

anticipate that final regulations 

specifically will include network assets 

as repair allowance property if 

appropriate unit of property rules can be 

determined. If appropriate unit of 

property rules cannot be determined for 

network assets, the IRS and Treasury 

Department request comments on 

whether to develop industry-specific 

guidance on how the repair allowance 

method should apply (in particular, 

how excluded additions should be 

determined) with regard to network 

assets in a particular industry. 

G. Repair Allowance Percentages 

The repair allowance percentages 

under the CLADR repair allowance were 

determined by the Treasury 

Department’s Office of Industrial 

Economics, which is no longer in 

existence. The percentages were 

published in various revenue 

procedures (most recently in Rev. Proc. 

83–35 (1983–1 C.B. 745)), made obsolete 

by Rev. Proc. 87–56 (1987–2 C.B. 674) 

with regard to property subject to 

section 168, and were revised and 

supplemented periodically. The 

proposed regulations create a new repair 

allowance percentage for each MACRS 

class. These rates are based on the 

principle that a taxpayer will spend 

50% of the property’s unadjusted basis 

on repairs over the property’s MACRS 

recovery period. Thus, the repair 

allowance percentages for a particular 

MACRS class in the proposed 

regulations were computed by: (1) 

Dividing 100% by the number of years 

in the recovery period for the MACRS 

class, which represents the portion of 

the property’s unadjusted basis that is 

allocable to each year of the recovery 

period, and; (2) multiplying the result 

by 50%. For example, if a taxpayer has 

repair allowance property in a MACRS 

class with a 5 year recovery period, 

100% divided by 5 is 20%, which 

represents the portion of the property’s 

unadjusted basis that is allocable to 

each year of the recovery period. 

Multiplying the 20% amount by 50% 

results in a repair allowance percentage 

of 10% for that MACRS class. 

The IRS and Treasury Department 

request comments on whether the repair 

allowance percentages should be 

different than those provided in the 

proposed regulations, whether the rates 

in Rev. Proc. 83–35 should be used, and 

whether the final regulations should 

permit taxpayers to choose between 

repair allowance percentages in Rev. 

Proc. 83–35 and the final regulations. 

The IRS and Treasury Department also 

request comments on whether a separate 

repair allowance percentage should be 

provided for certain types of property, 

such as repair allowance property 

subject to section 168(g) (for example, a 

percentage that reflects the recovery 

period under the alternative 

depreciation system in section 168(g) 

rather than the MACRS recovery period 

under section 168). Finally, the IRS and 

Treasury Department request comments 

on whether industries should be 

permitted to request guidance through 

the Industry Issue Resolution program 

to establish different repair allowance 

percentages for their particular industry. 

H. Manner of Electing and Manner of 

Revoking Election 

The proposed regulations reserve the 

issue of how a taxpayer will elect the 

repair allowance method. Two 

commentators suggested that taxpayers 

be permitted to elect the repair 

allowance on a year by year basis. The 

IRS and Treasury Department disagree 

with this suggestion. The repair 

allowance method is a method of 

accounting under section 446(e) and 

should be used consistently by 

taxpayers. Allowing a year by year 

election would complicate a taxpayer’s 

recordkeeping and would create a 

burden on IRS examining agents when 

auditing a taxpayer’s compliance with 

the repair allowance method. Therefore, 

the IRS and Treasury Department do not 

expect to permit a year by year election. 

However, even though the repair 

allowance method is a method of 

accounting under section 446(e), the IRS 

and Treasury Department expect to 

provide that taxpayers may elect the 

repair allowance method prospectively 

without having to file an application for 

change in accounting method and that 

the election be done on a cutoff basis. 

Procedures for electing the repair 

allowance method will be provided 

either in the final regulations or in 

published guidance in the Internal 

Revenue Bulletin. 

The proposed regulations provide that 

the repair allowance method, if elected, 

must be elected for all repair allowance 

property. A taxpayer may revoke an 

election made under the repair 

allowance method only by obtaining the 

Commissioner’s consent. Procedures for 

obtaining the Commissioner’s consent to 

revoke an election will be provided 

either in the final regulations or in 

published guidance in the Internal 

Revenue Bulletin. The IRS and Treasury 

Department expect to provide that a 

taxpayer that revokes an election may 

not re-elect the repair allowance method 

for a period of at least five taxable years, 

beginning with the year of the 

revocation unless, based on a showing 

of unusual and compelling 

circumstances, consent is specifically 

granted by the Commissioner to re-elect 

the repair allowance at an earlier time. 

The IRS and Treasury Department 

request comments on the 

appropriateness of the five year waiting 

period, as well as on the circumstances 

that should be considered unusual and 

compelling so that the Commissioner 

would grant consent to re-elect the 

repair allowance prior to expiration of 

the five year waiting period. 

I. Recordkeeping 

The proposed regulations do not 

impose any specific recordkeeping 

requirements. However, under section 

6001, taxpayers are required to keep 

books and records sufficient to establish 

the amounts used to compute a 

deduction under the repair allowance 

method. For example, taxpayers must 

maintain books and records reasonably 

sufficient to determine (1) The total 

amounts paid (other than amounts paid 

for excluded additions) during the 

taxpayer year for the repair, 

maintenance, or improvement of repair 

allowance property in the specific 

MACRS class; (2) the unadjusted basis 

of all repair allowance property in the 

specific MACRS class at the beginning 

and the end of the taxable year; (3) the 

repair allowance percentages used for 

the specific MACRS class for the taxable 

year; and (4) the treatment of the 

capitalized amounts (whether 


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capitalized as a single asset or allocated 

to all repair allowance property in the 

specific MACRS class). 

Proposed Effective Date 

These regulations are proposed to 

apply to taxable years beginning on or 

after the date the final regulations are 

published in the Federal Register. The 

final regulations will provide rules 

applicable to taxpayers that seek to 

change a method of accounting to 

comply with the rules contained in the 

final regulations. Taxpayers may not 

change a method of accounting in 

reliance upon the rules contained in the 

proposed regulations until the rules are 

published as final regulations in the 

Federal Register. 

The IRS and Treasury Department 

anticipate that, except as otherwise 

provided (for example, in the repair 

allowance section), the final regulations 

will provide that a taxpayer seeking to 

change to a method of accounting 

provided in the final regulations must 

follow the applicable procedures for 

obtaining the Commissioner’s automatic 

consent to a change in accounting 

method. Generally, a change in method 

of accounting is made using an 

adjustment under section 481(a). 

However, the IRS and Treasury 

Department are concerned about the 

potential administrative burden on 

taxpayers and the IRS that may result 

from section 481(a) adjustments that 

originate many years prior to the 

effective date of the final regulations. 

The IRS and Treasury Department 

request comments on whether there are 

circumstances in which it is appropriate 

to permit a change in method of 

accounting to be made using a cut-off 

basis instead of a section 481(a) 

adjustment. Finally, the IRS and 

Treasury Department request comments 

on any additional terms and conditions 

for changes in methods of accounting 

that would be helpful to taxpayers in 

adopting the rules contained in these 

proposed regulations. 

Special Analyses 

It has been determined that this notice 

of proposed rulemaking is not a 

significant regulatory action as defined 

in Executive Order 12866. Therefore, a 

regulatory assessment is not required. It 

also has been determined that section 

553(b) of the Administrative Procedure 

Act (5 U.S.C. chapter 5) does not apply 

to these regulations, and, because the 

regulation does not impose a collection 

of information on small entities, the 

Regulatory Flexibility Act (5 U.S.C. 

chapter 6) does not apply. Pursuant to 

section 7805(f) of the Code, this notice 

of proposed rulemaking will be 

submitted to the Chief Counsel for 

Advocacy of the Small Business 

Administration for comment on its 

impact on small business. 

Comments and Public Hearing 

Before the proposed regulations are 

adopted as final regulations, 

consideration will be given to any 

written comments (a signed original and 

eight (8) copies) or electronic comments 

that are submitted timely to the IRS. 

Comments are requested on all aspects 

of the proposed regulations. In addition, 

the IRS and Treasury Department 

specifically request comments on the 

clarity of the proposed rules and how 

they may be made easier to understand. 

All comments will be available for 

public inspection and copying. 

A public hearing has been scheduled 

for Tuesday, December 19, 2006, at 

10 a.m., in the auditorium of the New 

Carrollton Federal Building, 5000 Ellin 

Road, Lanham, MD 20706. Due to 

building security procedures, visitors 

must enter at the main front entrance. In 

addition, all visitors must present photo 

identification to enter the building. 

Because of access restrictions, visitors 

will not be admitted beyond the 

immediate entrance area more than 30 

minutes before the hearing starts. For 

information about having your name 

placed on the building access list to 

attend the hearing, see the FOR FURTHER

INFORMATION CONTACT section of this 

preamble. 

The rules of 26 CFR 601.601(a)(3) 

apply to the hearing. Persons who wish 

to present oral comments at the hearing 

must submit electronic or written 

comments and an outline of the topics 

to be discussed and the time to be 

devoted to each topic (signed original 

and eight (8) copies) by November 28, 

2006. A period of 10 minutes will be 

allotted to each person for making 

comments. An agenda showing the 

scheduling of the speakers will be 

prepared after the deadline for receiving 

outlines has passed. Copies of the 

agenda will be available free of charge 

at the hearing. 

Drafting Information 

The principal author of these 

regulations is Kimberly L. Koch, Office 

of the Associate Chief Counsel (Income 

Tax and Accounting), IRS. However, 

other personnel from the IRS and 

Treasury Department participated in 

their development. 

List of Subjects in 26 CFR Part 1 

Income taxes, Reporting and 

recordkeeping requirements. 

Proposed Amendments to the 

Regulations 

Accordingly, 26 CFR part 1 is 

proposed to be amended as follows: 

PART 1—INCOME TAXES 

Paragraph 1. The authority citation 

for part 1 continues to read in part as 

follows: 

Authority: 26 U.S.C. 7805 * * * 

Par. 2. Section 1.162–4 is revised to 

read as follows: 

§ 1.162–4 Repairs. 

Amounts paid for repairs and 

maintenance to tangible property are 

deductible if the amounts paid are not 

required to be capitalized under 

§ 1.263(a)–3. 

Par. 3. Section 1.263(a)–0 is amended 

by revising the entries for § 1.263(a)–1 

through § 1.263(a)–3 to read as follows: 

§ 1.263(a)–0 Table of contents. * * * 

§ 1.263(a)–1 Capital expenditures; in 

general. 

(a) General rule for capital expenditures. 

(b) Examples of capital expenditures. 

(c) Amounts paid to sell property. 

(1) In general. 

(2) Treatment of capitalized amount. 

(3) Examples. 

(d) Amount paid. 

(e) Effective date. 

(f) Accounting method changes. 

§ 1.263(a)–2 Amounts paid to acquire or 

produce tangible property. 

(a) Overview. 

(b) Definitions. 

(1) Amount paid. 

(2) Personal property. 

(3) Real property. 

(4) Produce. 

(c) Coordination with other provisions of 

the Internal Revenue Code. 

(1) In general. 

(2) Materials and supplies. 

(d) Acquired or produced tangible 

property. 

(1) In general. 

(i) Requirement of capitalization. 

(ii) Examples. 

(2) Defense or perfection of title to tangible 

property. 

(i) In general. 

(ii) Examples. 

(3) Transaction costs. 

(i) In general. 

(ii) Examples. 

(4) 12-month rule. 

(i) In general. 

(ii) Coordination with section 461. 

(iii) Exceptions to 12-month rule. 

(iv) Character of property subject to 12- 

month rule. 

(v) Election to capitalize. 

(vi) Examples. 

(e) Treatment of capital expenditures. 

(f) Recovery of capitalized amounts. 


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(1) In general. 

(2) Examples. 

(g) Effective date. 

(h) Accounting method changes. 

§ 1.263(a)–3 Amounts paid to improve 

tangible property. 

(a) Overview. 

(b) Definitions. 

(1) Amount paid. 

(2) Personal property. 

(3) Real property. 

(c) Coordination with other provisions of 

the Internal Revenue Code. 

(1) In general. 

(2) Example. 

(d) Improved property. 

(1) Capitalization rule. 

(2) Determining the appropriate unit of 

property. 

(i) In general. 

(ii) Initial unit of property determination. 

(iii) Category I: Taxpayers in regulated 

industries. 

(iv) Category II: Buildings and structural 

components. 

(v) Category III: Other personal property. 

(vi) Category IV: Other real property. 

(vii) Additional rule. 

(viii) Examples. 

(3) Compliance with regulatory 

requirements. 

(4) Unavailability of replacement parts. 

(5) Repairs performed during an 

improvement. 

(i) In general. 

(ii) Exception for individuals. 

(e) Value. 

(1) In general. 

(2) Exception. 

(3) Appropriate comparison. 

(4) Examples. 

(f) Restoration. 

(1) In general. 

(2) Economic useful life. 

(i) Taxpayers with an applicable financial 

statement. 

(ii) Taxpayers without an applicable 

financial statement. 

(iii) Definition of ‘‘applicable financial 

statement.’’

(3) Substantially prolonging economic 

useful life. 

(i) In general. 

(ii) Replacements. 

(iii) Restoration to like-new condition. 

(iv) Restoration after a casualty loss. 

(4) Examples. 

(g) Repair allowance method. 

(1) In general. 

(2) Election of repair allowance method. 

(3) Application of repair allowance 

method. 

(4) Repair allowance amount. 

(i) In general. 

(ii) Average unadjusted basis. 

(iii) Unadjusted basis. 

(iv) Buildings. 

(5) Capitalized amount. 

(i) In general. 

(ii) Single asset treatment of capitalized 

amount. 

(iii) Allocation treatment of capitalized 

amount. 

(iv) Section 168(g) repair allowance 

property. 

(v) Section 168(g) election. 

(vi) Public utility property. 

(6) Repair allowance property. 

(i) In general. 

(ii) Certain property not subject to section 

168. 

(iii) Exclusions from repair allowance 

property. 

(7) Excluded additions. 

(i) In general. 

(ii) Treatment of excluded additions. 

(8) Repair allowance percentage. 

(9) Manner of election. 

(10) Manner of revoking election. 

(11) Examples. 

(h) Treatment of capital expenditures. 

(i) Recovery of capitalized amounts. 

(j) Effective date. 

(k) Accounting method changes. 

* * * * * 

Par. 4. Sections 1.263(a)–1 through 

1.263(a)–3 are revised to read as follows: 

§ 1.263(a)–1 Capital expenditures; in 

general. 

(a) General rule for capital 

expenditures. Except as provided in 

chapter 1 of the Internal Revenue Code, 

no deduction is allowed for—

(1) Any amount paid for new 

buildings or for permanent 

improvements or betterments made to 

increase the value of any property or 

estate, or 

(2) Any amount paid in restoring 

property or in making good the 

exhaustion thereof for which an 

allowance is or has been made in the 

form of a deduction for depreciation, 

amortization, or depletion. 

(b) Examples of capital expenditures. 

The following amounts paid are 

examples of capital expenditures: 

(1) An amount paid to acquire or 

produce real or personal property. See 

§ 1.263(a)–2. 

(2) An amount paid to improve real or 

personal property. See § 1.263(a)–3. 

(3) An amount paid to acquire or 

create intangibles. See § 1.263(a)–4. 

(4) An amount paid or incurred to 

facilitate an acquisition of a trade or 

business, a change in capital structure of 

a business entity, and certain other 

transactions. See § 1.263(a)–5. 

(5) An amount assessed and paid 

under an agreement between 

bondholders or shareholders of a 

corporation to be used in a 

reorganization of the corporation or 

voluntary contributions by shareholders 

to the capital of the corporation for any 

corporate purpose. See section 118 and 

§ 1.118–1. 

(6) An amount paid by a holding 

company to carry out a guaranty of 

dividends at a specified rate on the 

stock of a subsidiary corporation for the 

purpose of securing new capital for the 

subsidiary and increasing the value of 

its stockholdings in the subsidiary. This 

amount must be added to the cost of the 

stock in the subsidiary. 

(c) Amounts paid to sell property—(1) 

In general. Commissions and other 

transaction costs paid to facilitate the 

sale of property generally must be 

capitalized. However, in the case of 

dealers in property, amounts paid to 

facilitate the sale of property are treated 

as ordinary and necessary business 

expenses. See § 1.263(a)–5(g) for the 

treatment of amounts paid to facilitate 

the disposition of assets that constitute 

a trade or business. 

(2) Treatment of capitalized amount. 

Amounts capitalized under paragraph 

(c)(1) of this section are treated as a 

reduction in the amount realized and 

generally are taken into account either 

in the taxable year in which the sale 

occurs or in the taxable year in which 

the sale is abandoned if a loss deduction 

is permissible. The capitalized amount 

is not added to the basis of the property 

and is not treated as an intangible under 

§ 1.263(a)–4. 

(3) Examples. The following 

examples, which assume the sale is not 

an installment sale under section 453, 

illustrate the rules of this paragraph (c): 

Example 1. Sales costs of real property. X 

owns a parcel of real estate. X sells the real 

estate and pays legal fees, recording fees, and 

sales commissions to facilitate the sale. X 

must capitalize the fees and commissions 

and, in the taxable year of the sale, offset the 

fees and commissions against the amount 

realized from the sale of the real estate. 

Example 2. Sales costs of dealers. Assume 

the same facts as in Example 1, except that 

X is a dealer in real estate. The commissions 

and fees paid to facilitate the sale of the real 

estate are treated as ordinary and necessary 

business expenses under section 162. 

Example 3. Sales costs of personal property 

used in the trade or business. X is a farmer 

and owns a truck for use in X’s trade or 

business. X decides to sell the truck and on 

November 15, 2008, X pays to advertise the 

sale of the truck in the local news media. On 

February 15, 2009, X sells the truck to Y. X 

is required to capitalize in 2008 the amount 

paid to advertise the sale of the truck and, 

in 2009, is required to offset the amount paid 

against the amount realized from the sale of 

the truck. 

Example 4. Costs of abandoned sale of 

personal property used in a trade or business. 

Assume the same facts as in Example 3, 

except that, instead of selling the truck on 

February 15, 2009, X decides on that date not 

to sell the truck and takes the truck off the 

market. X is required to capitalize in 2008 the 

amount paid to advertise the sale of the 

truck. However, X may treat the amount paid 

as a loss under section 165 in 2009 when the 

sale is abandoned. 

Example 5. Sales costs of personal property 

not used in a trade or business. Assume the 

same facts as in Example 3, except that X 

does not use the truck in X’s trade or 

business, but instead uses it for personal 


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purposes. X decides to sell the truck and on 

November 15, 2008, X pays to advertise the 

sale of the truck in the local news media. On 

February 15, 2009, X sells the truck to Y. X 

is required to capitalize in 2008 the amount 

paid to advertise the sale of the truck and, 

in 2009, is required to offset the amount paid 

against the amount realized from the sale of 

the truck. 

Example 6. Costs of abandoned sale of 

personal property not used in a trade or 

business. Assume the same facts as in 

Example 5, except that, instead of selling the 

truck on February 15, 2009, X decides on that 

date not to sell the truck and takes the truck 

off the market. X is required to capitalize in 

2008 the amount paid to advertise the sale of 

the truck. Although the sale is abandoned in 

2009, X may not treat the amount paid as a 

loss under section 165 because the truck was 

not used in X’s trade or business or in a 

transaction entered into for profit. 

(d) Amount paid. For purposes of this 

section, the terms amounts paid and 

payment mean, in the case of a taxpayer 

using an accrual method of accounting, 

a liability incurred (within the meaning 

of § 1.446–1(c)(1)(ii)). A liability may 

not be taken into account under this 

section prior to the taxable year during 

which the liability is incurred. 

(e) Effective date. The rules in this 

section apply to taxable years beginning 

on or after the date of publication of the 

Treasury decision adopting these rules 

as final regulations in the Federal 

Register. 

(f) Accounting method changes. 

[Reserved] 

§ 1.263(a)–2 Amounts paid to acquire or 

produce tangible property. 

(a) Overview. This section provides 

rules for applying section 263(a) to 

amounts paid to acquire or produce real 

or personal property. See § 1.263(a)–3 

for the treatment of amounts paid to 

improve tangible property, § 1.263(a)–4 

for the treatment of amounts paid to 

acquire or create intangibles, and 

§ 1.263(a)–5 for the treatment of 

amounts paid to facilitate an acquisition 

of a trade or business, a change in 

capital structure of a business entity, 

and certain other transactions. 

(b) Definitions. For purposes of this 

section, the following definitions apply: 

(1) Amount paid. In the case of a 

taxpayer using an accrual method of 

accounting, the terms amounts paid and 

payment mean a liability incurred 

(within the meaning of § 1.446–

1(c)(1)(ii)). A liability may not be taken 

into account under this section prior to 

the taxable year during which the 

liability is incurred. 

(2) Personal property. Personal 

property means tangible personal 

property as defined in § 1.48–1(c). 

(3) Real property. Real property 

means land and improvements thereto, 

such as buildings or other inherently 

permanent structures (including items 

that are structural components of such 

buildings or structures) that are not 

personal property as defined in 

paragraph (b)(2) of this section. Local 

law is not controlling in determining 

whether property is real property for 

purposes of this section. 

(4) Produce. Produce means construct, 

build, install, manufacture, develop, 

create, raise, or grow. See § 1.263(a)–3 

for capitalization rules applicable to 

amounts paid to improve property. 

(c) Coordination with other provisions 

of the Internal Revenue Code—(1) In 

general. Nothing in this section changes 

the treatment of any amount that is 

specifically provided for under any 

provision of the Internal Revenue Code 

or regulations other than section 162(a) 

or section 212 and the regulations under 

those sections. 

(2) Materials and supplies. Nothing in 

this section changes the treatment of 

amounts paid for materials and supplies 

that are properly treated as deductions 

or deferred expenses, as appropriate, 

under § 1.162–3. 

(d) Acquired or produced tangible 

property—(1) In general—(i) 

Requirement of capitalization. A 

taxpayer must capitalize amounts paid 

to acquire or produce real or personal 

property having a useful life 

substantially beyond the taxable year, 

including land and land improvements, 

buildings, machinery and equipment, 

and furniture and fixtures, and a unit of 

property (as determined under 

§ 1.263(a)–3(d)(2)), having a useful life 

substantially beyond the taxable year. A 

taxpayer also must capitalize amounts 

paid to acquire real or personal property 

for resale and to produce real or 

personal property for sale. See section 

263A for the scope of costs required to 

be capitalized to property produced by 

the taxpayer or to property acquired for 

resale. 

(ii) Examples. The following 

examples illustrate the rule of this 

paragraph (d)(1): 

Example 1. Acquisition of personal 

property—coordination with § 1.162–3. X, an 

airline, operates a fleet of aircraft. X 

purchases and maintains in stock for repairs 

to its aircraft a great number of different 

expendable flight equipment spare parts 

(including cartridges, canisters, cylinders, 

and disks), based in part on the 

manufacturer’s recommendations and in part 

on the airline’s experience. The expendable 

flight equipment spare parts are carried on 

hand by X until they are installed in the 

particular type of aircraft for which 

purchased. The expendable flight equipment 

spare parts are of a type normally not 

repaired and reused. As these parts are taken 

from stock and used to repair aircraft, the 

stock supply is replenished by X purchasing 

new parts. In 2008, X purchases expendable 

flight equipment spare parts. X properly 

treats the amount paid for the expendable 

flight equipment spare parts as a deferred 

expense under § 1.162–3. Nothing in this 

section changes the treatment of the original 

acquisition cost as a deferred expense. 

Example 2. Acquisition of personal 

property—coordination with § 1.162–3. X, an 

industrial laundry business, leases many 

products, including garments, linens, shop 

towels, continuous roll towels, and mops 

(rental items). X maintains a supply of rental 

items on hand to replace worn or damaged 

items. The rental items have useful lives of 

12 months or less. In 2008, X purchases a 

large quantity of rental items. The amount 

paid for the rental items is properly treated 

by X as a deferred expense under § 1.162–3. 

Nothing in this section changes the treatment 

of the original acquisition cost as a deferred 

expense. 

Example 3. Acquisition of personal 

property. In 2008, X purchases new cash 

registers, which have a useful life 

substantially beyond the taxable year, for use 

in its retail store located in a leased space in 

a shopping mall. X must capitalize under this 

paragraph (d)(1) the amount paid to purchase 

each cash register. 

Example 4. Relocation and installation of 

personal property. Assume the same facts as 

in Example 3, except that X’s lease expires 

in 2009 and X decides to relocate its retail 

store to a different building. In addition to 

various other costs, X pays $5,000 to move 

the cash registers and $1,000 to reinstall 

them in the other store. X is not required to 

capitalize under this paragraph (d)(1) the 

$5,000 amount paid for moving the cash 

registers; however, X must capitalize under 

this paragraph (d)(1) the $1,000 amount paid 

to reinstall the cash registers in its other store 

because, under paragraph (b)(4) of this 

section, installation costs are production 

costs. 

Example 5. Acquisition of land. X 

purchases a parcel of undeveloped real 

estate. X must capitalize under this 

paragraph (d)(1) the amount paid to acquire 

the real estate. See § 1.263(a)–2(d)(3) for the 

treatment of amounts paid to facilitate the 

acquisition of real property. 

Example 6. Acquisition of building. X 

purchases a building. X must capitalize 

under this paragraph (d)(1) the amount paid 

to acquire the building. See § 1.263(a)–2(d)(3) 

for the treatment of amounts paid to facilitate 

the acquisition of real property. 

Example 7. Acquisition of property for 

resale. X purchases goods for resale. X must 

capitalize under this paragraph (d)(1) the 

amounts paid to acquire the goods. See 

section 263A for the treatment of amounts 

paid to acquire property for resale. 

Example 8. Production of property for sale. 

X produces goods for sale. X must capitalize 

under this paragraph (d)(1) the amount paid 

to produce the goods. See section 263A for 

the treatment of amounts paid to produce 

property. 

Example 9. Production of building. X 

constructs a building. X must capitalize 

under this paragraph (d)(1) the amount paid 

to construct the building. See section 263A 


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for the treatment of amounts paid to produce 

real property. 

Example 10. Acquisition of assets 

constituting a trade or business. Y owns 

tangible and intangible assets that constitute 

a trade or business. X purchases all the assets 

of Y in a taxable transaction. X must 

capitalize under this paragraph (d)(1) the 

amount paid for the tangible assets of Y. See 

§ 1.263(a)–4 for the treatment of amounts 

paid to acquire intangibles and § 1.263(a)–5 

for the treatment of amounts paid to facilitate 

the acquisition of assets that constitute a 

trade or business. See section 1060 for 

special allocation rules for certain asset 

acquisitions. 

(2) Defense or perfection of title to 

property—(i) In general. Amounts paid 

to defend or perfect title to real or 

personal property constitute amounts 

paid to acquire or produce property 

within the meaning of this section and 

must be capitalized. See section 263A 

for the scope of costs required to be 

capitalized to property produced by the 

taxpayer or to property acquired for 

resale. 

(ii) Examples. The following 

examples illustrate the rule of this 

paragraph (d)(2): 

Example 1. Amounts paid to contest 

condemnation. X owns real property located 

in County. County filed an eminent domain 

complaint condemning a portion of X’s 

property to use as a roadway. X hired an 

attorney to contest the condemnation. 

Amounts paid by X to the attorney must be 

capitalized because they were to defend X’s 

title to the property. 

Example 2. Amounts paid to invalidate 

ordinance. X is in the business of quarrying 

and supplying sand and stone in a certain 

municipality. Several years after X 

established its business, the municipality in 

which it was located passed an ordinance 

that prohibited the operation of X’s business. 

X incurred attorney’s fees in a successful 

prosecution of a suit to invalidate the 

municipal ordinance. X prosecuted the suit 

to preserve its business activities and not to 

defend X’s title in the property. Therefore, 

attorney’s fees paid by X are not required to 

be capitalized under this paragraph (d)(2). 

However, under section 263A, all indirect 

costs, including otherwise deductible costs, 

that directly benefit or are incurred by reason 

of the taxpayer’s production activities must 

be capitalized to the property produced for 

sale. Therefore, because the amounts paid to 

invalidate the ordinance are incurred by 

reason of X’s production activities, the 

amounts paid must be capitalized under 

section 263A to the property produced for 

sale by X. 

Example 3. Amounts paid to challenge 

building line. The board of public works of 

a municipality established a building line 

across X’s business property, adversely 

affecting the value of the property. X 

incurred legal fees in unsuccessfully 

litigating the establishment of the building 

line. Amounts paid by X to the attorney must 

be capitalized because they were to defend 

X’s title to the property. 

(3) Transaction costs—(i) In general. 

A taxpayer must capitalize amounts 

paid to facilitate the acquisition of real 

or personal property, including 

shipping costs, bidding costs, sales and 

transfer taxes, legal and accounting fees, 

title fees, engineering fees, survey costs, 

inspection costs, appraisal fees, 

recording fees, application fees, 

commissions, and compensation for the 

services of a qualified intermediary or 

other facilitator of an exchange under 

section 1031. See § 1.263(a)–5 for the 

treatment of amounts paid to facilitate 

the acquisition of assets that constitute 

a trade or business. See section 263A for 

the scope of costs required to be 

capitalized to property produced by the 

taxpayer or to property acquired for 

resale. 

(ii) Examples. The following 

examples illustrate the rule of this 

paragraph (d)(3): 

Example 1. Legal fees, taxes, and 

commissions to facilitate an acquisition. X 

purchases a building and pays legal fees, 

sales taxes, and sales commissions to 

facilitate the acquisition. X must capitalize 

the amounts paid for legal fees, sales taxes, 

and sales commissions. 

Example 2. Moving costs to facilitate an 

acquisition. X purchases all the assets of Y 

and, in connection with the purchase, hires 

a transportation company to move storage 

tanks from Y’s plant to X’s plant. X must 

capitalize the amount paid to move the tanks 

from Y’s plant to X’s plant because the 

amount paid facilitates the acquisition of the 

storage tanks. 

(4) 12-month rule—(i) In general. 

Except as otherwise provided in this 

paragraph (d)(4), an amount paid for the 

acquisition or production (including 

any amount paid to facilitate the 

acquisition or production) of a unit of 

property (as determined under 

§ 1.263(a)–3(d)(2)) with an economic 

useful life (as defined in § 1.263(a)–

3(f)(2)) of 12 months or less is not a 

capital expenditure under paragraph (d) 

of this section. 

(ii) Coordination with section 461. In 

the case of a taxpayer using an accrual 

method of accounting, the rules of this 

paragraph (d)(4) do not affect the 

determination of whether a liability is 

incurred during the taxable year, 

including the determination of whether 

economic performance has occurred 

with respect to the liability. See § 1.461–

4 for rules relating to economic 

performance. 

(iii) Exceptions to 12-month rule. The 

12-month rule in paragraph (d)(4)(i) of 

this section does not apply to the 

following: 

(A) Amounts paid for property that is 

or will be included in property 

produced for sale or property acquired 

for resale; 

(B) Amounts paid to improve property 

under § 1.263(a)–3; 

(C) Amounts paid for land; and 

(D) Amounts paid for any component 

of a unit of property. 

(iv) Character of property subject to 

12-month rule. Property to which a 

taxpayer applies the 12-month rule 

contained in paragraph (d)(4)(i) of this 

section is not treated upon sale or 

disposition as a capital asset under 

section 1221 or as property used in the 

trade or business under section 1231. 

(v) Election to capitalize. A taxpayer 

may elect not to apply the 12-month 

rule contained in paragraph (d)(4)(i) of 

this section with regard to a unit of 

property. An election made under this 

paragraph (d)(4)(v) applies to any unit of 

property during the taxable year to 

which paragraph (d)(4)(i) of this section 

would apply (but for the election under 

this paragraph (d)(4)(v)). A taxpayer 

makes the election by treating the 

amount paid as a capital expenditure in 

its timely filed original Federal income 

tax return (including extensions) for the 

taxable year in which the amount is 

paid. In the case of a pass-through 

entity, the election is made by the passthrough entity, and not by the 

shareholders, partners, etc. An election 

may not be made through the filing of 

an application for change in accounting 

method or by an amended Federal 

income tax return and an election may 

not be revoked. 

(vi) Examples. The rules of this 

paragraph (d)(4) are illustrated by the 

following examples, in which it is 

assumed (unless otherwise stated) that 

the taxpayer is a calendar year, accrual 

method taxpayer that has not elected 

out of the 12-month rule under 

paragraph (d)(4)(v) of this section with 

regard to the unit of property, and that 

none of the property is materials and 

supplies under § 1.162–3: 

Example 1. Production cost. X corporation 

manufactures and sells aluminum storm 

windows and doors. To conduct its business, 

X purchases strips of aluminum called 

extrusions and applies paint electrostatically 

to the extrusions through a complex process. 

In 2008, X installs a leaching pit to provide 

a draining area for liquid waste produced in 

the process of painting the extrusions. X 

previously had dumped this waste into a 

creek bed, but the local water department 

ordered it to cease this practice. The 

economic useful life of the leaching pit is 12 

months, after which time the factory will be 

connected to the local sewer system. Assume 

that the leaching pit is the unit of property, 

as determined under § 1.263(a)–3(d)(2). X is 

not required to capitalize under paragraph (d) 

of this section the amount paid to produce 

the leaching pit because the useful life of the 

leaching pit is 12 months or less. However, 

under section 263A, all indirect costs, 


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including otherwise deductible costs, that 

directly benefit or are incurred by reason of 

the taxpayer’s manufacturing activities must 

be capitalized to the property produced for 

sale. Therefore, because the amounts paid for 

the leaching pit are incurred by reason of X’s 

manufacturing operations, the amounts paid 

must be capitalized under section 263A to 

the property produced for sale by X. 

Example 2. Acquisition or production cost. 

X purchases or produces jigs, dies, molds, 

and patterns for use in the manufacture of 

motor vehicles and motor vehicle parts. The 

economic useful life of the jigs, dies, molds, 

and patterns is 12 months. Assume each jig, 

die, mold, and pattern is a separate unit of 

property, as determined under § 1.263(a)–

3(d)(2). X is not required to capitalize under 

paragraph (d) of this section the amounts 

paid to produce or purchase the jigs, dies, 

molds, and patterns because the economic 

useful life is 12 months or less. However, 

under section 263A, all indirect costs, 

including otherwise deductible costs, that 

directly benefit or are incurred by reason of 

the taxpayer’s manufacturing activities must 

be capitalized to the property produced for 

sale. Therefore, because the amounts paid for 

the jigs, dies, molds, and patterns are 

incurred by reason of X’s manufacturing 

operations, the amounts paid must be 

capitalized under section 263A to the 

property produced for sale by X. 

Example 3. Acquisition or production cost. 

Assume the same facts as in Example 2, but 

the economic useful life of the jigs, dies, 

molds, and patterns is 3 years. X is required 

to capitalize under paragraph (d) of this 

section the amounts paid to produce or 

purchase the jigs, dies, molds, and patterns 

because the economic useful life is more than 

12 months. 

Example 4. Acquisition cost. X corporation 

is an interstate motor carrier. On December 

1, 2008, X purchases, pays for, and takes 

delivery of truck tires with an economic 

useful life of 12 months. Assume X does not 

use the original tire capitalization method 

described in Rev. Proc. 2002–27 (2002–1 C.B. 

802) (see § 601.601(d)(2) of this chapter). 

Also assume that each tire is a separate unit 

of property, as determined under § 1.263(a)–

3(d)(2). X is not required under paragraph (d) 

of this section to capitalize the amount paid 

for the tires because the economic useful life 

of the tires is 12 months or less. 

Example 5. Transaction costs. Assume the 

same facts as in Example 4, but in addition 

to the amount paid for the tires, X also pays 

sales tax and delivery charges for the tires. 

X is not required to capitalize under 

paragraph (d) of this section the sales tax and 

delivery charges because they were paid to 

facilitate the acquisition of property with an 

economic useful life of 12 months or less. 

Example 6. Coordination with section 461 

fixed liability rule. Assume the same facts as 

in Example 4, except that instead of 

purchasing the tires on December 1, 2008, X 

enters into a contract with the tire 

manufacturer on that date to purchase tires 

from the manufacturer in 2009. X purchases, 

pays for, and takes delivery of the tires on 

March 31, 2009. X does not incur a liability 

under section 461 for the tires in 2008 

because X does not have a fixed liability with 

respect to the tires until 2009. When X incurs 

the amount in 2009, X is not required under 

paragraph (d) of this section to capitalize that 

amount. 

Example 7. Coordination with section 461 

economic performance rule. Assume the 

same facts as in Example 4, except that the 

tires are not delivered to X until March 31, 

2009. X does not incur a liability under 

section 461 for the tires in 2008 because 

economic performance does not occur with 

respect to the liability until the property is 

provided to X in 2009. See § 1.461–4(d)(2). 

When X incurs the amount in 2009, X is not 

required under paragraph (d) of this section 

to capitalize that amount. 

Example 8. Election not to capitalize. 

Assume the same facts as in Example 4, 

except that X elects under paragraph (d)(4)(v) 

of this section not to apply the 12-month rule 

contained in paragraph (d)(4)(i) of this 

section to the tires purchased on December 

1, 2008. X must capitalize under paragraph 

(d) of this section the amount paid for the 

tires. 

Example 9. Exception to 12-month rule ‘‘

property acquired for resale. Assume the 

same facts as in Example 4, except that X 

purchases the tires for resale. The 12-month 

rule in paragraph (d)(4)(i) of this section does 

not apply because the tires are property 

acquired for resale. Thus, X is required under 

paragraph (d) of this section to capitalize the 

amount paid for the tires. 

Example 10. Exception to 12-month rule—

component of property. Assume the same 

facts as in Example 4, except that the tires 

are the first set of tires to be installed on a 

truck tractor acquired by X and X uses the 

original tire capitalization method described 

in Rev. Proc. 2002–27 (see § 601.601(d)(2) of 

this chapter) so that the truck tractor 

(including the tires) is the unit of property, 

as determined under § 1.263(a)–3(d)(2). Also 

assume that the truck tractor has an 

economic useful life of more than 12 months 

and that the invoice for the acquisition of the 

truck tractor separately states the cost of tires 

and various other components of the truck 

tractor. X is required under paragraph (d) of 

this section to capitalize the amount paid for 

the truck tractor because the economic useful 

life of the truck tractor is more than 12 

months. Further, X may not use the 12-month 

rule to currently deduct the amount paid for 

the tires or any other component of the truck 

tractor, regardless that some components may 

have an economic useful life of 12 months or 

less and regardless that the cost of individual 

components is separately stated in the 

invoice. 

(e) Treatment of capital expenditures. 

Amounts required to be capitalized 

under this section are capital 

expenditures and must be taken into 

account through a charge to capital 

account or basis, or in the case of 

property that is inventory in the hands 

of a taxpayer, through inclusion in 

inventory costs. See section 263A for 

the treatment of amounts referred to in 

this section as well as other amounts 

paid in connection with the production 

of real property and personal property, 

including films, sound recordings, video 

tapes, books, or similar properties. 

(f) Recovery of capitalized amounts—

(1) In general. Amounts that are 

capitalized under this section are 

recovered through depreciation, cost of 

goods sold, or by an adjustment to basis 

at the time the property is placed in 

service, sold, used, or otherwise 

disposed of by the taxpayer. Cost 

recovery is determined by the 

applicable Internal Revenue Code and 

regulation provisions relating to the use, 

sale, or disposition of property. For 

example, §§ 1.162–4 and 1.263(a)–3 

determine whether amounts capitalized 

under this section § 1.263(a)–2 for 

property that is used to replace a 

component of a unit of property are 

repair or maintenance expenses or 

capitalized as an improvement to the 

unit of property. 

(2) Examples. The following examples 

illustrate the rule of this paragraph (f)(1) 

and assume that the taxpayer does not 

treat the acquired property as materials 

and supplies under § 1.162–3: 

Example 1. Recovery when property placed 

in service. X owns a 10-unit apartment 

building. The refrigerator in one of the 

apartments stops functioning and X 

purchases a new refrigerator to replace the 

old one. X pays for the acquisition, delivery, 

and installation of the new refrigerator. 

Assume the refrigerator is the unit of 

property, as determined under § 1.263(a)–

3(d)(2). Section 1.263(a)–2(d) requires 

capitalization of amounts paid for the 

acquisition, delivery, and installation of the 

refrigerator. Under this paragraph (f), the 

capitalized amounts are recovered through 

depreciation when the refrigerator is placed 

in service by X. 

Example 2. Recovery when property used 

in a repair. Assume the same facts as in 

Example 1, except that a window in one of 

the apartments needs to be replaced. X pays 

for the acquisition, delivery, and installation 

of a new window. Assume the window is a 

structural component of the apartment 

building and that the apartment building is 

the unit of property, as determined under 

§ 1.263(a)–3(d)(2). Section 1.263(a)–2(d) 

requires capitalization of amounts paid for 

the acquisition and delivery of the window 

because the window is property with a useful 

life substantially beyond the end of the 

taxable year. Assume the replacement of the 

old window with the new one does not 

improve the apartment building under 

§ 1.263(a)–3. Under this paragraph (f), the 

capitalized amounts paid to acquire the 

window are recovered as ordinary and 

necessary repair expenses under § 1.162–4 

when the window is used in the repair by its 

installation in the apartment building. 

Example 3. Recovery when property used 

in a repair; coordination with section 263A. 

Assume the same facts as in Example 2, 

except that the window that is replaced is in 

an office in a plant where X manufactures 

widgets for sale. Section 1.263(a)–2(d) 

requires capitalization of amounts paid to 


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produce inventory. Under section 263A, all 

indirect costs, including otherwise 

deductible repair costs that directly benefit or 

are incurred by reason of the production of 

inventory must be capitalized to the 

inventory produced. Although the repair cost 

otherwise would be deductible as an expense 

under § 1.162–4, X must determine whether 

the cost of the repair, or an allocable portion 

thereof, is required to be capitalized to the 

inventory produced as an indirect expense 

that directly benefits or is incurred by reason 

of the production activities. Any portion of 

the repair capitalized to inventory is 

recovered through cost of goods at the time 

the property is sold or otherwise disposed of 

in accordance with the taxpayer’s method of 

accounting for inventories. 

(g) Effective date. The rules in this 

section apply to taxable years beginning 

on or after the date of publication of the 

Treasury decision adopting these rules 

as final regulations in the Federal 

Register. 

(h) Accounting method changes. 

[Reserved] 

§ 1.263(a)–3 Amounts paid to improve 

tangible property. 

(a) Overview. This section provides 

rules for applying section 263(a) to 

amounts paid to improve tangible 

property. Paragraph (b) of this section 

contains definitions. Paragraph (c) of 

this section contains rules for 

coordinating this section with other 

provisions of the Internal Revenue 

Code. Paragraph (d) of this section 

provides rules for determining the 

treatment of amounts paid to improve 

tangible property, including rules for 

determining the appropriate unit of 

property. Paragraph (e) of this section 

contains rules for determining whether 

amounts paid materially increase the 

value of the unit of property. Paragraph 

(f) of this section contains rules for 

determining whether amounts paid 

restore the unit of property. Paragraph 

(g) of this section describes an optional 

repair allowance method. 

(b) Definitions. For purposes this 

section, the following definitions apply: 

(1) Amount paid. In the case of a 

taxpayer using an accrual method of 

accounting, the terms amounts paid and 

payment mean a liability incurred 

(within the meaning of § 1.446–

1(c)(1)(ii)). A liability may not be taken 

into account under this section prior to 

the taxable year during which the 

liability is incurred. 

(2) Personal property. Personal 

property means tangible personal 

property as defined in § 1.48–1(c). 

(3) Real property. Real property 

means land and improvements thereto, 

such as buildings or other inherently 

permanent structures (including items 

that are structural components of such 

buildings or structures) that are not 

personal property as defined in 

paragraph (b)(2) of this section. Local 

law is not controlling in determining 

whether property is real property for 

purposes of this section. 

(c) Coordination with other provisions 

of the Internal Revenue Code—(1) In 

general. Nothing in this section changes 

the treatment of any amount that is 

specifically provided for under any 

provision of the Internal Revenue Code 

or regulations (other than section 162(a) 

or section 212 and the regulations under 

those sections). 

(2) Example. The following example 

illustrates the rules of this paragraph (c): 

Example. Railroad rolling stock. X is a 

railroad that properly treats amounts paid for 

the rehabilitation of railroad rolling stock as 

deductible expenses under section 263(d). X 

is not required to capitalize the amounts paid 

because nothing in this section changes the 

treatment of amounts specifically provided 

for under section 263(d). 

(d) Improved property—(1) 

Capitalization rule. Except as provided 

in the repair allowance method in 

paragraph (g) of this section, a taxpayer 

must capitalize the aggregate of related 

amounts paid to improve a unit of 

property (including a unit of property 

for which the acquisition or production 

costs were deducted under the 12- 

month rule in § 1.263(a)–2(d)(4)), 

whether the improvements are made by 

the taxpayer or by a third party. See 

section 263A for the scope of costs 

required to be capitalized to property 

produced by the taxpayer or to property 

acquired for resale; section 1016 for 

adding capitalized amounts to the basis 

of the unit of property; and section 

168(i)(6) for the treatment of additions 

or improvements to a unit of property. 

For purposes of this paragraph (d), a 

unit of property is improved if the 

amounts paid—

(i) Materially increase the value of the 

unit of property (see paragraph (e) of 

this section); or 

(ii) Restore the unit of property (see 

paragraph (f) of this section). 

(2) Determining the appropriate unit 

of property—(i) In general. The unit of 

property rules in this paragraph (d)(2) 

apply only for purposes of section 

263(a) and §§ 1.263(a)–1, 1.263(a)–2, 

and 1.263(a)–3, and not any other 

Internal Revenue Code or regulation 

section. Under this paragraph (d)(2), the 

appropriate unit of property is initially 

determined by applying the rules in 

paragraph (d)(2)(ii) of this section, 

except as provided in paragraph 

(d)(2)(iv) of this section (relating to 

buildings and structural components). 

The initial unit of property 

determination is further analyzed in 

accordance with the appropriate 

hierarchical category described in one of 

paragraphs (d)(2)(iii) through (d)(2)(vi) 

of this section and by applying the 

additional rule in paragraph (d)(2)(vii) 

of this section. The specific rules 

contained in paragraphs (d)(2)(iii) 

through (d)(2)(vii) of this section dictate 

whether one or more components of the 

initial unit of property determination 

must be treated as separate units of 

property. 

This paragraph (d)(2) applies to all 

real and personal property, other than 

network assets. For purposes of this 

paragraph (d)(2), network assets means 

railroad track, oil and gas pipelines, 

water and sewage pipelines, power 

transmission and distribution lines, and 

telephone and cable lines that are 

owned or leased by taxpayers in each of 

those respective industries. The term 

includes, for example, trunk and feeder 

lines, pole lines, and buried conduit. It 

does not include property that would be 

included as a structural component of a 

building under paragraph (d)(2)(iv), nor 

does it include separate property that is 

adjacent to, but not part of a network 

asset, such as bridges, culverts, or 

tunnels. 

(ii) Initial unit of property 

determination. Except for property 

described in paragraph (d)(2)(iv) of this 

section (regarding buildings and 

structural components), the unit of 

property determination under this 

paragraph (d)(2) begins by identifying 

property that consists entirely of 

components that are functionally 

interdependent. Components of 

property are functionally 

interdependent if the placing in service 

of one component by the taxpayer is 

dependent on the placing in service of 

the other component by the taxpayer. 

For purposes of this section, property 

that is aggregated and subject to a 

general asset account election may not 

be treated as a single unit of property. 

(iii) Category I: Taxpayers in 

regulated industries. In the case of a 

taxpayer engaged in a trade or business 

in a regulated industry, the unit of 

property is the USOA (uniform system 

of accounts) unit of property. For 

purposes of this section, a regulated 

industry is an industry for which a 

Federal regulator (including any Federal 

department, agency, commission, board, 

or similar entity) has a USOA 

identifying a particular unit of property 

(USOA unit of property). This rule 

applies to any taxpayer engaged in a 

trade or business in the regulated 

industry, regardless of whether the 

taxpayer is subject to the regulatory 

accounting rules of the Federal 

regulator. The unit of property 


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determination made under this 

paragraph (d)(2)(iii) is subject to 

paragraph (d)(2)(vii) of this section, 

which may require one or more 

components to be treated as separate 

units of property. 

(iv) Category II: Buildings and 

structural components. In the case of a 

building (as defined in § 1.48–1(e)(1)) 

other than that described in paragraph 

(d)(2)(iii) of this section, the building 

and its structural components (as 

defined in § 1.48–1(e)(2)) are a single 

unit of property. The unit of property 

determination made under this 

paragraph (d)(2)(iv) is subject to 

paragraph (d)(2)(vii) of this section, 

which may require one or more 

components to be treated as separate 

units of property. 

(v) Category III: Other personal 

property. In the case of personal 

property other than that described in 

paragraph (d)(2)(iii) of this section, the 

unit of property determination must be 

made on the basis of the four factors 

listed in this paragraph (d)(2)(v). These 

four factors are the exclusive factors 

under this paragraph (d)(2)(v). No one 

factor is determinative and it is not 

intended that a determination be made 

on the basis of the number of factors 

indicating that a component is, or is not, 

a separate unit of property. The unit of 

property determination made under this 

paragraph (d)(2)(v) is subject to 

paragraph (d)(2)(vii) of this section, 

which may require one or more 

components to be treated as separate 

units of property. The following factors 

must be taken into account: 

(A) Whether the component is—

(1) Marketed separately to the 

taxpayer by a party other than the seller/ 

lessor of the property of which the 

component is a part at the time the 

property is initially acquired or leased; 

(2) Acquired or leased separately by 

the taxpayer from a party other than the 

seller/lessor of the property of which 

the component is a part at the time the 

property is initially acquired or leased; 

(3) Subject to a separate warranty 

contract (from a party other than the 

seller/lessor of the property of which 

the component is a part); 

(4) Subject to a separate maintenance 

manual or written maintenance policy; 

(5) Appraised separately; or 

(6) Sold or leased separately by the 

taxpayer to another party; 

(B) Whether the component is treated 

as a separate unit of property in 

industry practice or by the taxpayer in 

its books and records; 

(C) Whether the taxpayer treats the 

component as a rotable part (a part that 

is removable from property, repaired or 

improved, and either immediately 

reinstalled on other property or stored 

for later installation); and 

(D) Whether the property of which the 

component is a part generally functions 

for its intended use without the 

component property. 

(vi) Category IV: Other real property. 

In the case of real property other than 

that described in paragraphs (d)(2)(iii) 

and (d)(2)(iv) of this section, the unit of 

property determination must be made 

on the basis of all the facts and 

circumstances. The unit of property 

determination made under this 

paragraph (d)(2)(vi) is subject to 

paragraph (d)(2)(vii) of this section, 

which may require one or more 

components to be treated as separate 

units of property. 

(vii) Additional rule. If the taxpayer 

properly treats a component as a 

separate unit of property for any Federal 

income tax purpose, the taxpayer must 

treat the component as a separate unit 

of property for purposes of this 

paragraph (d)(2). For purposes of 

paragraph (d)(2), the term any Federal 

income tax purpose includes, but is not 

limited to, the use of different placedin-service dates (other than the use of a 

new placed-in-service date for an 

improvement (as determined under this 

section) to the unit of property or a 

different placed-in-service date for a 

particular floor of a building) or 

different classes of property as set forth 

in section 168(e) (MACRS classes), for 

the component and the property of 

which the component is a part. If the 

taxpayer properly recognizes a loss 

under section 165, or under another 

applicable provision, from a retirement 

of a component of property or from the 

worthlessness or abandonment of a 

component of property, the taxpayer 

must treat the component as a separate 

unit of property for purposes of this 

paragraph (d)(2). Therefore, any 

property that replaces the component 

also will be treated as a separate unit of 

property. See § 1.263(a)–2(d)(1). For 

purposes of this paragraph (d)(2), 

merely claiming a tax credit related to 

tangible property does not constitute 

treatment of that property as a separate 

unit of property for a Federal income tax 

purpose. 

(viii) Examples. The rules of this 

paragraph (d)(2) are illustrated by the 

following examples, in which it is 

assumed (unless otherwise stated) that 

the taxpayer has not made a general 

asset account election with regard to the 

property and that paragraph (d)(2)(vii) 

of this section does not require the use 

of a different unit of property: 

Example 1. Category I. X is an electric 

utility company that operates a power plant 

to generate electricity. X’s operation 

previously was regulated by the Federal 

Energy Regulatory Commission (FERC) but, 

for various reasons, is no longer subject to 

regulation by FERC. Under FERC’s USOA, 

each turbine, economizer, generator, and 

pulverizer is treated as a separate unit of 

property for regulatory accounting purposes. 

The initial unit of property determined under 

paragraph (d)(2)(ii) of this section is the 

entire power plant, which consists entirely of 

components that are functionally 

interdependent. The power plant must next 

be analyzed under paragraph (d)(2)(iii) of this 

section because X is engaged in a trade or 

business in an industry for which a Federal 

regulator has a USOA. Under the rules in that 

paragraph, X must treat each turbine, 

economizer, generator, and pulverizer as a 

separate unit of property for determining 

whether an amount paid improves the unit 

of property for Federal income tax purposes. 

Example 2. Category I. X is a Class I 

railroad. All Class I railroads are regulated by 

the Surface Transportation Board (STB). 

Under STB’s USOA, each locomotive and 

each freight car is treated as a separate unit 

of property for regulatory accounting 

purposes. Although each locomotive consists 

of various components, such as an engine, 

generators, batteries, trucks, etc., those 

components are functionally interdependent. 

Thus, the locomotive is an initial unit of 

property as determined under paragraph 

(d)(2)(ii) of this section. Similarly, each 

freight car consists entirely of functionally 

interdependent components and, thus, each 

freight car is an initial unit of property under 

paragraph (d)(2)(ii) of this section. Each 

locomotive and freight car must next be 

analyzed under paragraph (d)(2)(iii) of this 

section because X is engaged in a trade or 

business in an industry for which a Federal 

regulator has a USOA. Under the rules in that 

paragraph, X must treat each locomotive and 

each freight car as a separate unit of property 

for determining whether an amount paid 

improves the unit of property for Federal 

income tax purposes. 

Example 3. Category I. Assume the same 

facts as in Example 2, except that X is a Class 

II railroad. The STB does not regulate Class 

II railroads. However, because X is engaged 

in a trade or business in an industry (the 

railroad industry) for which a Federal 

regulator has a USOA, the rules in paragraph 

(d)(2)(iii) of this section apply, regardless of 

whether X is subject to those rules. Based on 

these facts, X must treat each locomotive and 

each freight car as a separate unit of property 

for determining whether an amount paid 

improves the unit of property for Federal 

income tax purposes. 

Example 4. Category I. X is a 

telecommunications company regulated by 

the Federal Communications Commission 

(FCC) and subject to a USOA for telephone 

companies. The assets of X include a 

telephone central office switching center, 

which contains numerous switches and 

various other switching equipment that all 

work together to provide telephone service to 

customers. The initial unit of property 

determined under paragraph (d)(2)(ii) of this 

section is the central office switching center, 

which consists entirely of components that 


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are functionally interdependent. The 

telecommunications system must next be 

analyzed under paragraph (d)(2)(iii) of this 

section because X is engaged in a trade or 

business in an industry for which a Federal 

regulator has a USOA. Under the rules in that 

paragraph, X must treat each switch and/or 

piece of equipment as defined in the USOA 

of the FCC and used in the central office 

operation as a separate unit of property for 

determining whether an amount paid 

improves the unit of property for Federal 

income tax purposes. 

Example 5. Category II. X owns a 

manufacturing building containing various 

types of manufacturing equipment that are 

not structural components of the 

manufacturing building. Because the 

property is a building, as defined in § 1.48–

1(e)(1), paragraph (d)(2)(ii) of this section 

does not apply and the property must be 

analyzed under paragraph (d)(2)(iv) of this 

section. Under the rules in that paragraph, X 

must treat the manufacturing building and its 

structural components as a single unit of 

property for determining whether an amount 

paid improves the unit of property for 

Federal income tax purposes. The 

appropriate unit of property determination 

for the manufacturing equipment must be 

made separately under paragraph (d)(2)(v) of 

this section. 

Example 6. Category III; additional rule. 

Assume the same facts as in Example 5, 

except that X does a cost segregation study 

of the manufacturing building and properly 

determines that refrigeration equipment used 

to create a walk-in freezer in the 

manufacturing building is section 1245 

property as defined in section 1245(a)(3). The 

refrigeration equipment is not part of the 

HVAC system that relates to the general 

operation or maintenance of the building. For 

Federal income tax purposes, X properly 

treats the refrigeration equipment as a 

separate unit of property for depreciation 

purposes. The rules of paragraph (d)(2)(v) of 

this section apply to determine whether the 

refrigeration equipment, or some smaller 

component, is the appropriate unit of 

property. In this example, assume that no 

components of the refrigeration equipment 

meet any of the facts and circumstances 

listed in paragraph (d)(2)(v) of this section. 

Based on these facts, X must treat the 

refrigeration equipment as the unit of 

property for determining whether an amount 

paid improves the unit of property for 

Federal income tax purposes. 

Example 7. Category III; additional rule. 

Assume the same facts as in Example 6, 

except that the refrigeration equipment for 

the walk-in freezer ceases to function. X 

decides not to repair the refrigeration 

equipment, but to replace it altogether. X 

abandons the refrigeration equipment for the 

walk-in freezer and properly recognizes a 

loss under section 165 from the abandonment 

of the refrigeration equipment. Therefore, X 

must treat the refrigeration equipment for the 

walk-in freezer as a separate unit of property 

for determining whether amounts paid to 

replace the equipment must be capitalized 

for Federal income tax purposes. See 

§ 1.263(a)–2(d)(1). 

Example 8. Category III. (i) X is a 

commercial airline engaged in the business of 

transporting passengers and freight 

throughout the United States and abroad. To 

conduct its business, X owns or leases 

various types of aircraft. X purchases the 

aircraft engine separately at the time the 

aircraft is acquired. The engine is subject to 

a separate warranty and written maintenance 

policy provided by the engine manufacturer. 

For financial accounting purposes, X 

accounts for each type of aircraft by 

maintaining separate accounts on its books 

for each type of airframe and engine in its 

fleet. To perform maintenance on an engine, 

X removes the engine from the aircraft and 

replaces it with another used engine that has 

returned from a maintenance visit. 

(ii) The initial unit of property determined 

under paragraph (d)(2)(ii) of this section is 

the aircraft (and not the entire fleet of 

aircraft), which consists entirely of 

components that are functionally 

interdependent. The aircraft must next be 

analyzed under one of paragraphs (d)(2)(iii) 

through (d)(2)(vi) of this section. Although X 

is engaged in a trade or business in an 

industry regulated by the Federal Aviation 

Administration (FAA), the FAA does not 

have a USOA. Therefore, the rules of 

paragraph (d)(2)(iii) of this section do not 

apply to X; instead, the rules of paragraph 

(d)(2)(v) of this section apply to determine 

whether the entire aircraft, or the engine, is 

the appropriate unit of property. In this 

Example 8, the aircraft engine is acquired 

separately, is subject to a separate warranty 

and maintenance policy, is treated separately 

for financial accounting purposes, and is 

rotable. Based on these facts, X must treat the 

engine as the unit of property for determining 

whether an amount paid improves the engine 

for Federal income tax purposes. X must treat 

the aircraft without the engine as a unit of 

property for determining whether an amount 

paid improves the aircraft for Federal income 

tax purposes. 

Example 9. Category III. X is a corporation 

that owns a small aircraft for use in its trade 

or business. X performs required 

maintenance on its aircraft engines. The 

aircraft engine is not marketed, purchased, 

leased, appraised, or sold separately, but it is 

subject to a separate warranty and written 

maintenance policy provided by the engine 

manufacturer. For financial accounting 

purposes, X does not maintain separate 

accounts on its books for individual engines. 

X does not treat the engine as a rotable part. 

The initial unit of property determined under 

paragraph (d)(2)(ii) of this section is the 

aircraft, which consists entirely of 

components that are functionally 

interdependent. The aircraft must next be 

analyzed under paragraph (d)(2)(v) of this 

section to determine whether the entire 

aircraft, or the engine, is the appropriate unit 

of property. Based on these facts, the engine 

is not a separate unit of property. Therefore, 

X must treat the aircraft, including the 

aircraft engine, as the unit of property for 

determining whether an amount paid 

improves the unit of property for Federal 

income tax purposes. 

Example 10. Category III. X is a towboat 

operator that owns and leases a fleet of 

towboats. X performs maintenance on its 

towboat engines every 3 to 4 years, in 

accordance with the engine manufacturer’s 

maintenance manuals. Towboat engines are 

not marketed, purchased, leased, appraised, 

or sold separately; however, the engines are 

subject to a separate warranty and written 

maintenance policy provided by the engine 

manufacturer. For financial accounting 

purposes, X does not maintain separate 

accounts on its books for individual engines. 

X does not treat the engine as a rotable part. 

The initial unit of property determined under 

paragraph (d)(2)(ii) of this section is the 

towboat (and not the entire fleet of towboats), 

which consists entirely of components that 

are functionally interdependent. The towboat 

must next be analyzed under paragraph 

(d)(2)(v) of this section. Based on these facts, 

the engine is not a separate unit of property. 

Therefore, X must treat the towboat, 

including the towboat engine, as the unit of 

property for determining whether an amount 

paid improves the unit of property for 

Federal income tax purposes. 

Example 11. Category III. X purchases a car 

to use in X’s taxi service. The invoice 

received by X for the purchase of the car 

separately lists several options, including air 

conditioning, automatic transmission, 

antilock braking system, side impact air bags, 

power group, and special alloy wheels. 

Under paragraph (d)(2)(ii) of this section, the 

initial unit of property is the car because the 

options are functionally interdependent with 

the car. The options are not subject to 

separate warranties. X is an individual and 

does not keep books and records other than 

for tax purposes. For depreciation purposes, 

X properly treats the car and options as one 

unit of property. X does not treat any of the 

options as rotable parts. Based on these facts, 

the options are not separate units of property. 

X must treat the car, including the options, 

as the unit of property for determining 

whether an amount paid improves the unit 

of property for Federal income tax purposes. 

Example 12. Category III. X is a common 

carrier that owns a fleet of fuel hauling trucks 

and periodically performs maintenance on its 

truck engines. The entire fleet of trucks is 

subject to a general asset account election, 

one for the truck trailers and one for the truck 

tractors. Under paragraph (d)(2)(ii) of this 

section, X may not treat the entire fleet as the 

unit of property. Instead, the initial units of 

property determined under paragraph 

(d)(2)(ii) of this section are each truck tractor 

and each truck trailer. Each tractor consists 

entirely of functionally interdependent 

components and each trailer consists entirely 

of functionally interdependent components. 

To determine whether the engine is a 

separate unit of property from the tractor, the 

factors in paragraph (d)(2)(v) of this section 

apply. The engines are marketed separately 

from the tractor and are subject to a separate 

warranty and written maintenance policy 

provided by the engine manufacturer. The 

engines are not treated as a separate unit of 

property in industry practice or by X in its 

books and records. The engine is removed 

from the tractor, repaired or improved, and 

stored for later installation on another tractor. 

Based on these facts, the engine is a separate 

unit of property. Therefore, X must treat the 

engine as the unit of property for determining 

whether an amount paid improves the unit 

of property for Federal income tax purposes. 


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Example 13. Category III. Assume the same 

facts as in Example 12, except that the 

inquiry is whether the oil filter in the tractor 

engine is a separate unit of property. The oil 

filter is not marketed, acquired, leased, 

appraised, or sold separately, nor is it subject 

to a separate warranty or maintenance 

manual. The filter is not treated as a separate 

unit of property in industry practice or by X 

in its books and records, nor is it treated as 

a rotable part. Based on these facts, the oil 

filter is not a separate unit of property. 

Therefore, X must treat the engine, including 

the oil filter, as the unit of property for 

determining whether an amount paid 

improves the unit of property for Federal 

income tax purposes. 

Example 14. Category III. (i) X 

manufactures and sells computers and 

computer equipment. It also operates a 

separate computer maintenance business, for 

which X maintains pools of rotable spare 

parts that are primarily used to repair 

computer equipment purchased or leased by 

its customers. Most of X’s computer 

maintenance business is conducted pursuant 

to standardized maintenance agreements that 

obligate X to provide all parts and labor, 

product upgrades, preventive maintenance, 

and telephone assistance necessary to keep a 

customer’s computer operational for the 

duration of the contract (usually one year) in 

exchange for a predetermined fee. In its 

computer maintenance business, X sends 

technicians to its customer’s location, who 

use the supply of rotable spare parts to 

diagnose problems in the customer’s 

equipment, and then exchange the working 

parts for any malfunctioning parts. A 

customer’s part that is identified as the cause 

of the malfunction is replaced with the 

identical functioning part from X’s rotable 

spare parts pool. The malfunctioning part 

removed from the customer’s equipment is 

then repaired and placed in X’s rotable spare 

parts pool for continued use in the computer 

maintenance business. 

(ii) Under paragraph (d)(2)(ii) of this 

section, X may not treat the entire pool of 

rotable spare parts as the unit of property. 

Instead, the initial unit of property 

determined under paragraph (d)(2)(ii) of this 

section is each rotable spare part because 

each part consists entirely of functionally 

interdependent components. Assume for 

purposes of this Example 14 that paragraph 

(d)(2)(v) of this section does not require any 

components of the rotable spare parts to be 

treated as separate units of property. Based 

on these facts, the entire pool of spare parts 

is not the unit of property. Therefore, X must 

treat each rotable spare part as a unit of 

property for determining whether an amount 

paid improves the unit of property for 

Federal income tax purposes. 

Example 15. Category III. (i) X is a dentist 

and operates a small dental clinic. On March 

1, 2008, X purchases a new laptop computer, 

with a one-year warranty, for use in the 

dental business. On May 1, 2009, after the 

warranty has expired, the computer 

malfunctions and X contacts the 

manufacturer’s computer maintenance shop 

for assistance. The maintenance shop sends 

a technician to X’s dental clinic, who uses a 

supply of rotable spare parts to diagnose 

problems in X’s computer. The technician 

determines that the circuit board must be 

replaced and exchanges X’s malfunctioning 

circuit board with the identical functioning 

circuit board from the computer maintenance 

operation’s rotable spare parts pool. The 

malfunctioning circuit board removed from 

X’s computer is then repaired and placed in 

the manufacturer’s rotable spare parts pool 

for continued use in the computer 

maintenance business. 

(ii) The initial unit of property determined 

under paragraph (d)(2)(ii) of this section is 

the computer, which consists entirely of 

components (circuit board or motherboard, 

central processing unit or CPU, hard drive, 

RAM, keyboard, monitor, case, etc.) that are 

functionally interdependent. To determine 

whether the circuit board is a separate unit 

of property from the computer, the factors in 

paragraph (d)(2)(v) of this section apply. The 

circuit board was not marketed separately to 

X or acquired separately by X, nor is it 

subject to a separate warranty. The CPU, 

however, was marketed separately to the 

taxpayer, but not acquired separately. No 

component, including the circuit board and 

CPU of the laptop computer, is treated as a 

separate unit of property by X in its books 

and records, nor does X treat any component 

as a rotable part. The computer does not 

function for its intended use without the 

circuit board and the CPU. Based on these 

facts, neither the circuit board nor the CPU 

is a separate unit of property. X must treat 

the entire laptop computer, including the 

circuit board and CPU, as the unit of property 

for determining whether an amount paid 

improves the unit of property for Federal 

income tax purposes. 

(3) Compliance with regulatory 

requirements. For purposes of this 

section, a Federal, state, or local 

regulator’s requirement that a taxpayer 

perform certain repairs or maintenance 

on a unit of property to continue 

operating the property is not relevant in 

determining whether the amount paid 

improves the unit of property. 

(4) Unavailability of replacement 

parts. For purposes of this section, if a 

taxpayer needs to replace part of a unit 

of property that cannot practicably be 

replaced with the same type of part (for 

example, because of technological 

advancements or product 

enhancements), the replacement of the 

part with an improved but comparable 

part does not, by itself, result in an 

improvement to the unit of property. 

(5) Repairs performed during an 

improvement—(i) In general. Repairs 

that do not directly benefit or are not 

incurred by reason of an improvement 

are not required to be capitalized under 

section 263(a), regardless of whether 

they are made at the same time as an 

improvement. See section 263A for 

rules requiring capitalization of all 

direct costs of an improvement and all 

indirect costs that directly benefit or are 

incurred by reason of the improvement. 

(ii) Exception for individuals. A 

taxpayer who is an individual may 

capitalize amounts paid for repairs that 

are made at the same time as substantial 

capital improvements to property not 

used in the taxpayer’s trade or business 

or for the production of income if the 

repairs are done as part of a remodeling 

or restoration of the taxpayer’s 

residence. 

(e) Value—(1) In general. A taxpayer 

must capitalize amounts paid that 

materially increase the value of a unit of 

property. An amount paid materially 

increases the value of a unit of property 

only if it—

(i) Ameliorates a condition or defect 

that either existed prior to the taxpayer’s 

acquisition of the unit of property or 

arose during the production of the unit 

of property, whether or not the taxpayer 

was aware of the condition or defect at 

the time of acquisition or production; 

(ii) Is for work performed prior to the 

date the property is placed in service by 

the taxpayer (without regard to any 

applicable convention under section 

168(d)); 

(iii) Adapts the unit of property to a 

new or different use (including a 

permanent structural alteration to the 

unit of property); 

(iv) Results in a betterment (including 

a material increase in quality or 

strength) or a material addition 

(including an enlargement, expansion, 

or extension) to the unit of property; or 

(v) Results in a material increase in 

capacity (including additional cubic or 

square space), productivity, efficiency, 

or quality of output of the unit of 

property. 

(2) Exception. Notwithstanding the 

rules in paragraph (e)(1)(i) through 

(e)(1)(v) of this section, an amount paid 

does not result in a material increase in 

value to a unit of property if the 

economic useful life (as defined in 

§ 1.263(a)–3(f)(2)) of the unit of property 

is 12 months or less and the taxpayer 

did not elect to capitalize the amounts 

paid originally for the unit of property. 

(3) Appropriate comparison. For 

purposes of paragraphs (e)(1)(iv) and 

(e)(1)(v) of this section, in cases in 

which a particular event necessitates an 

expenditure, the determination of 

whether the amount paid materially 

increases the value of the unit of 

property is made by comparing the 

condition of the property immediately 

after the expenditure with the condition 

of the property immediately prior to the 

event necessitating the expenditure. 

When the event necessitating the 

expenditure is normal wear and tear to 

the unit of property, the condition of the 

property immediately prior to the event 

necessitating the expenditure is the 


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condition of the property after the last 

time the taxpayer corrected the effects of 

normal wear and tear (whether the 

amounts paid were for maintenance or 

improvements) or, if the taxpayer has 

not previously corrected the effects of 

normal wear and tear, the condition of 

the property when placed in service by 

the taxpayer. 

(4) Examples. The following examples 

illustrate the rules of this paragraph (e) 

and assume that the amounts paid are 

not required to be capitalized under any 

other provision of this section 

(paragraph (f), for example): 

Example 1. Pre-existing condition. In 2008, 

X purchased a store located on 10 acres of 

land that contained underground gasoline 

storage tanks left by prior occupants. The 

tanks had leaked, causing soil contamination. 

X was not aware of the contamination at the 

time of purchase. When X discovered the 

contamination, it incurred costs to remediate 

the soil. For purposes of this Example 1, 

assume the 10 acres of land is the appropriate 

unit of property. The amounts paid for soil 

remediation must be capitalized as an 

improvement to the land because they 

ameliorated a condition or defect that existed 

prior to the taxpayer’s acquisition of the land. 

The comparison rule in paragraph (e)(3) of 

this section does not apply to these amounts 

paid. 

Example 2. Not a pre-existing condition; 

repair performed during an improvement. (i) 

X owned land on which it constructed a 

building in 1969 for use as a bank. The 

building was constructed with asbestoscontaining materials. The health dangers of 

asbestos were not widely known when the 

building was constructed. The presence of 

asbestos did not necessarily endanger the 

health of building occupants. The danger 

arises when asbestos-containing materials are 

damaged or disturbed, thereby releasing 

asbestos fibers into the air (where they can 

be inhaled). In 1971, Federal regulatory 

agencies designated asbestos a hazardous 

substance. In 2008, X determined it needed 

additional space in its building to 

accommodate additional operations at its 

branch and decided to remodel the building. 

However, any remodeling work could not be 

undertaken without disturbing the asbestoscontaining materials. The governmental 

regulations required that asbestos be removed 

if any remodeling was undertaking that 

would disturb asbestos-containing materials. 

Therefore, X decided to remove the asbestoscontaining materials from the building in 

coordination with the overall remodeling 

project. 

(ii) For purposes of this Example 2, assume 

that the building is the appropriate unit of 

property and that the amounts paid to 

remodel are required to be capitalized under 

§ 1.263(a)–3. The amounts paid to remove the 

asbestos are not required to be capitalized as 

a separate improvement under paragraph 

(e)(1)(i) of this section because the asbestos, 

although later determined to be unsafe under 

certain circumstances, was not an inherent 

defect to the property. The removal of the 

asbestos, by itself, also did not result in a 

material increase in value under paragraphs 

(e)(1)(ii) through (e)(1)(v) of this section. 

Under paragraph (d)(5)(i) of this section, 

repairs that do not directly benefit or are not 

incurred by reason of an improvement are 

not required to be capitalized under section 

263(a). Under section 263A, all indirect costs, 

including otherwise deductible repair costs, 

that directly benefit or are incurred by reason 

of the improvement must be capitalized as 

part of the improvement. The amounts paid 

to remove the asbestos were incurred by 

reason of the remodeling project, which was 

an improvement. Therefore, X must 

capitalize under section 263A to the 

remodeling improvement amounts paid to 

remove the asbestos. 

Example 3. Work performed prior to 

placing the property in service. In 2008, X 

purchased a building for use as a business 

office. The building was in a state of 

disrepair. In 2009, X incurred costs to repair 

cement steps; shore up parts of the first and 

second floors; replace electrical wiring; 

remove and replace old plumbing; and paint 

the outside and inside of the building. 

Assume all the work was performed on the 

building or its structural components. In 

2010, X placed the building in service and 

began using the building as its business 

office. For purposes of this Example 3, 

assume the building and its structural 

components are the appropriate unit of 

property. The amounts paid must be 

capitalized as an improvement to the 

building because they were for work 

performed prior to X’s placing the building 

in service. The comparison rule in paragraph 

(e)(3) of this section does not apply to these 

amounts paid. 

Example 4. Work performed prior to 

placing the property in service. In January 

2008, X purchased new machinery for use in 

an existing production line of its 

manufacturing business. After the machinery 

was installed, X performed critical testing on 

the machinery to ensure that it was 

operational. On November 1, 2008, the new 

machinery became operational and, thus, the 

machinery was placed in service on 

November 1, 2008 (although X continued to 

perform testing for quality control). The 

amounts paid must be capitalized as an 

improvement to the machinery because they 

were for work performed prior to X’s placing 

the machinery in service. The comparison 

rule in paragraph (e)(3) of this section does 

not apply to these amounts paid. 

Example 5. New or different use. X is an 

interior decorating company and 

manufactures its own designs. In 2008, X 

decides to stop manufacturing and converts 

the manufacturing facility into a showroom 

for X’s business. To convert the facility, X 

removes certain load-bearing walls and 

builds new load-bearing walls to provide a 

better layout for the showroom and its 

offices. As part of building the new walls, X 

moves or replaces electrical, cable, and 

telephone wiring and paints the walls. X also 

repairs the floors, builds a fire escape, and 

performs small carpentry jobs related to 

making the showroom accessible, including 

installing ramps and widening doorways. For 

purposes of this Example 5, assume the 

building and its structural components are 

the unit of property and that the work is 

performed on the structural components. The 

amounts paid by X to convert the 

manufacturing facility into a showroom must 

be capitalized as an improvement to the 

building because they adapted the building 

to a new or different use. The comparison 

rule in paragraph (e)(3) of this section does 

not apply to these amounts paid. 

Example 6. New or different use. X owned 

a building consisting of five separate retail 

stores, each of which it rented to different 

tenants. In 2008, two of the stores rented 

became vacant and remained vacant for 

several months. One of the remaining tenants 

agreed to expand its occupancy to the two 

vacant stores, which adjoined its own retail 

store. X incurred costs to break down walls 

between the existing stores and construct an 

additional rear entrance. For purposes of this 

Example 6, assume the building and its 

structural components are the appropriate 

unit of property. The amounts paid by X to 

convert three retail stores into one larger 

store must be capitalized because they 

resulted in a permanent structural alteration, 

and thus a new or different use, to the 

building. The comparison rule in paragraph 

(e)(3) of this section does not apply to these 

amounts paid. 

Example 7. Not a new or different use. X 

owns a building for rental purposes and 

decides to sell it. In preparation of selling, X 

paints the interior walls, cleans the gutters, 

repairs cracks in the porch, and refinishes the 

hardwood floors. For purposes of this 

Example 7, assume the building and its 

structural components are the unit of 

property. Amounts paid for work done in 

anticipation of selling the building are not 

required to be capitalized unless the amounts 

paid materially increase the value as defined 

in paragraph (e)(3) of this section or prolong 

the economic useful life as defined in 

paragraph (f)(3). The amounts paid by X are 

not transaction costs paid to facilitate the sale 

of property under § 1.263(a)–1(c), nor do they 

materially increase the value of the building. 

Although the amounts were paid for the 

purpose of selling the building, the sale does 

not constitute a new or different use. 

Therefore, X is not required to capitalize as 

an improvement under paragraph (e) of this 

section the amounts paid for work performed 

on the building. The comparison rule in 

paragraph (e)(3) of this section does not 

apply to these amounts paid. 

Example 8. Not a material increase in 

value. (i) X is a commercial airline engaged 

in the business of transporting passengers 

and freight throughout the United States and 

abroad. To conduct its business, X owns or 

leases various types of aircraft. 

As a condition of maintaining its 

airworthiness certification for these aircraft, 

X is required by the Federal Aviation 

Administration (FAA) to establish and 

adhere to a continuous maintenance program 

for each aircraft within its fleet. These 

programs, which are designed by X and the 

aircraft’s manufacturer and approved by the 

FAA are incorporated into each aircraft’s 

maintenance manual. The maintenance 

manuals require a variety of periodic 

maintenance visits at various intervals during 

the operating lives of each aircraft. One type 


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of maintenance visit is an engine shop visit 

(ESV), which is performed on X’s aircraft 

engines approximately every 4 years. 

(ii) In 2004, X purchased a new aircraft and 

engine. In 2008, X performs its first ESV on 

the aircraft engine. The ESV includes some 

or all of the following activities: disassembly, 

cleaning, inspection, repair, replacement, 

reassembly, and testing. During the ESV, the 

engine is removed from the aircraft and 

shipped to an outside vendor who performs 

the ESV. When the engine arrives at the 

vendor, the engine is cleaned and externally 

inspected. Regardless of condition, it is 

thoroughly inspected visually and, as 

appropriate, further inspected using a 

number of non-destructive testing 

procedures. The engine is then disassembled 

into major parts and, if necessary, into 

smaller parts. If inspection or testing 

discloses a discrepancy in a part’s conformity 

to the specifications in X’s maintenance 

program, the part is repaired, or if necessary, 

replaced with a new or used serviceable part 

conforming to the specifications. If a part can 

be repaired, but not in time to be returned 

to the engine with which the part had 

arrived, the vendor first attempts to replace 

the part with a similar part from customer 

stock (used parts from X’s aircraft that were 

replaced or exchanged and repaired during 

an earlier ESV and then stored for future use 

on X’s aircraft). If a part is not available from 

customer stock, the part is exchanged with a 

used, serviceable part in the vendor’s 

inventory. A part is replaced (generally with 

a used serviceable part) only if the part 

removed from X’s engine cannot be repaired 

timely. 

(iii) For purposes of this Example 8, 

assume the aircraft engine is the appropriate 

unit of property. To determine whether the 

ESV results in a material increase in value 

under paragraph (e)(1)(iv) or (e)(1)(v) of this 

section, the comparison rule in paragraph 

(e)(3) of this section applies. Because the 

event necessitating the ESV was normal wear 

and tear, and X had not previously performed 

an ESV on the engine, the relevant 

comparison is the condition of the property 

immediately after the ESV with the condition 

of the property when placed in service by X. 

Using this comparison, the ESV did not 

result in a material addition, betterment, or 

material increase in capacity, productivity, 

efficiency, or quality of output of the engine 

compared to the condition of the engine 

when placed in service, nor did it adapt the 

engine to a new or different use. Therefore, 

the amounts paid by X for the ESV did not 

result in a material increase in value to the 

engine. X is not required to capitalize as an 

improvement under paragraph (e) of this 

section amounts paid for the ESV. 

Example 9. Betterment; regulatory 

requirement. X owned a hotel in City that 

included five foot high unreinforced terra 

cotta and concrete parapets with overhanging 

cornices around the entire roof perimeter. 

The parapets and cornices were in good 

condition. In 2008, City passed an ordinance 

setting higher safety standards for parapets 

and cornices because of the hazardous 

conditions caused by earthquakes. To comply 

with the ordinance, X replaced the old 

parapets and cornices with new ones made 

of glass fiber reinforced concrete, which 

made them lighter and stronger than the 

original ones. They were attached to the hotel 

using welded connections instead of wire 

supports, making them more resistant to 

damage from lateral movement. For purposes 

of this Example 9, assume the hotel building 

and its structural components are the 

appropriate unit of property. The event 

necessitating the expenditure was the 2008 

City ordinance. Prior to the ordinance, the 

old parapets and cornices were in good 

condition, but were determined by City to 

create a potential hazard. After the 

expenditure, the new parapets and cornices 

significantly improved the structural 

soundness of the hotel. Therefore, the 

amounts paid by X to replace the parapets 

and cornices must be capitalized because 

they resulted in a betterment to the hotel. 

City’s requirement that X correct the 

potential hazard to continue operating the 

hotel is not relevant in determining whether 

the amount paid improved the hotel. See 

paragraph (d)(3) of this section. 

Example 10. Not a material increase in 

value; regulatory requirement. X owned a 

meat processing plant. In 2008, X discovered 

that oil was seeping through the concrete 

walls of the plant, creating a fire hazard. 

Federal meat inspectors advised X that it 

must correct the seepage problem or shut 

down its plant. To correct the problem, X 

incurred costs to add a concrete lining to the 

walls from the floor to a height of about four 

feet and also to add concrete to the floor of 

the plant. For purposes of this Example 10, 

assume the plant building and its structural 

components are the appropriate unit of 

property. The event necessitating the 

expenditure was the seepage of the oil. Prior 

to the seepage, the plant did not leak and was 

functioning for its intended use. The 

expenditure did not result in a material 

addition, betterment, or material increase in 

capacity, productivity, efficiency, or quality 

of output of the plant compared to the 

condition of the plant prior to the seepage of 

the oil, nor did it adapt the plant to a new 

or different use. Therefore, the amounts paid 

by X to correct the seepage do not materially 

increase the value of the plant. X is not 

required to capitalize as an improvement 

under paragraph (e) of this section amounts 

paid to correct the seepage problem. The 

Federal meat inspectors’ requirement that X 

correct the seepage to continue operating the 

plant is not relevant in determining whether 

the amount paid improved the plant. See 

paragraph (d)(3) of this section. 

Example 11. Not a material increase in 

value; replacement with same part. X owns 

a small retail shop. In 2008, a storm damaged 

the roof of X’s shop by displacing numerous 

wooden shingles. X decides to replace all the 

wooden shingles on the roof and hired a 

contractor to replace all the shingles on the 

roof with new wooden shingles. No part of 

the sheathing, rafters, or joists was replaced. 

For purposes of this Example 11, assume the 

shop and its structural components are the 

appropriate unit of property. The event 

necessitating the expenditure was the storm. 

Prior to the storm, the retail shop was 

functioning for its intended use. The 

expenditure did not result in a material 

addition, betterment, or material increase in 

capacity, productivity, efficiency, or quality 

of output of the shop compared to the 

condition of the shop prior to the storm, nor 

did it adapt the shop to a new or different 

use. Therefore, the amounts paid by X to 

reshingle the roof with wooden shingles do 

not materially increase the value of the shop. 

X is not required to capitalize as an 

improvement under paragraph (e) of this 

section amounts paid to replace the shingles. 

Example 12. Not a material increase in 

value; replacement with comparable part. 

Assume the same facts as in Example 11, 

except that wooden shingles are not available 

on the market. X decides to replace all the 

wooden shingles with comparable asphalt 

shingles. The amounts paid by X to reshingle 

the roof with asphalt shingles do not 

materially increase the value of the shop, 

even though the asphalt shingles may be an 

improvement over the wooden shingles. 

Because the wooden shingles could not 

practicably be replaced with new wooden 

shingles, the replacement of the old shingles 

with comparable asphalt shingles does not, 

by itself, result in an improvement to the 

shop. X is not required to capitalize as an 

improvement under paragraph (e) of this 

section amounts paid to replace the shingles. 

Example 13. Betterment; replacement with 

improved parts. Assume the same facts as in 

Example 11, except that, instead of replacing 

the wooden shingles with asphalt shingles, X 

decides to replace all the wooden shingles 

with shingles made of lightweight composite 

materials that are maintenance-free and do 

not absorb moisture. The new shingles have 

a 50-year warranty and a Class A fire rating. 

X must capitalize as an improvement 

amounts paid to reshingle the roof because 

they result in a betterment to the shop. 

Example 14. Material increase in capacity. 

X owns a factory building with a storage area 

on the second floor. In 2008, X replaces the 

columns and girders supporting the second 

floor to permit storage of supplies with a 

gross weight 50 percent greater than the 

previous load-carrying capacity of the storage 

area. For purposes of this Example 14, 

assume the factory building and its structural 

components are the appropriate unit of 

property. X must capitalize as an 

improvement amounts paid for the columns 

and girders because they result in a material 

increase in the load-carrying capacity of the 

building. The comparison rule in paragraph 

(e)(3) of this section does not apply to these 

amounts paid because the expenditure was 

not necessitated by a particular event. 

Example 15. Material increase in capacity. 

In 2008, X purchased harbor facilities 

consisting of a slip for the loading and 

unloading of barges and a channel leading 

from the slip to the river. At the time of 

purchase, the channel was 150 feet wide, 

1,000 feet long, and 10 feet deep. To allow 

for ingress and egress and for the unloading 

of its barges, X needed to deepen the channel 

to a depth of 20 feet. X hired a contractor to 

dredge the channel to the required depth. For 

purposes of this Example 15, assume the 

channel is the appropriate unit of property. 

X must capitalize as an improvement 

amounts paid for the dredging because it 

resulted in a material increase in the capacity 


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of the channel. The comparison rule in 

paragraph (e)(3) of this section does not 

apply to these amounts paid because the 

expenditure was not necessitated by a 

particular event. 

Example 16. Not a material increase in 

capacity. Assume the same facts as in 

Example 15, except that the channel was 

susceptible to siltation and, by 2009, the 

channel depth had been reduced to 18 feet. 

X hired a contractor to redredge the channel 

to a depth of 20 feet. The event necessitating 

the expenditure was the siltation of the 

channel. Both prior to the siltation and after 

the redredging, the depth of the channel was 

20 feet. Therefore, the amounts paid by X for 

redredging the channel did not materially 

increase the capacity of the unit of property. 

X is not required to capitalize as an 

improvement under paragraph (e) of this 

section amounts paid to redredge. 

Example 17. Not a material increase in 

capacity. X owns a building used in its trade 

or business. The first floor has a drop-ceiling. 

X decides to remove the drop-ceiling and 

repaint the original ceiling. For purposes of 

this Example 17, assume the building and its 

structural components are the appropriate 

unit of property. The removal of the dropceiling does not create additional capacity in 

the building that was not there prior to the 

removal. Therefore, the amounts paid by X to 

remove the drop-ceiling and repaint the 

original ceiling did not materially increase 

the capacity of the unit of property. X is not 

required to capitalize as an improvement 

under paragraph (e) of this section amounts 

paid related to removing the drop-ceiling. 

The comparison rule in paragraph (e)(3) of 

this section does not apply to these amounts 

paid because the expenditure was not 

necessitated by a particular event. 

(f) Restoration—(1) In general. A 

taxpayer must capitalize amounts paid 

that restore a unit of property. Amounts 

paid restore property if the amounts 

paid substantially (as defined in 

paragraph (f)(3) of this section) prolong 

the economic useful life of the unit of 

property. 

(2) Economic useful life—(i) 

Taxpayers with an applicable financial 

statement. For taxpayers with an 

applicable financial statement (as 

defined in paragraph (f)(2)(iii) of this 

section), the economic useful life of a 

unit of property generally is presumed 

to be the same as the useful life used by 

the taxpayer for purposes of 

determining (at the time the property is 

originally acquired or produced by the 

taxpayer) depreciation in its applicable 

financial statement, regardless of any 

salvage value of the property. A 

taxpayer may rebut this presumption 

only if there is a clear and convincing 

basis that the economic useful life (as 

defined in paragraph (f)(2)(ii) of this 

section for taxpayers without an 

applicable financial statement) of the 

unit of property is significantly different 

than the useful life used by the taxpayer 

for purposes of determining 

depreciation in its applicable financial 

statement. If a taxpayer does not have an 

applicable financial statement at the 

time the property was originally 

acquired or produced, but does have an 

applicable financial statement at some 

later date, the economic useful life of 

the unit of property must be determined 

under paragraph (f)(2)(ii) of this section. 

Further, if a taxpayer treats amounts 

paid for a unit of property as an expense 

in its applicable financial statement on 

a basis other than the property having 

a useful life of one year or less, the 

economic useful life of the unit of 

property must be determined under 

paragraph (f)(2)(ii) of this section. For 

example, if a taxpayer has a policy of 

treating as an expense on its applicable 

financial statement amounts paid for 

property costing less than a certain 

dollar amount, notwithstanding that the 

property has a useful life of more than 

one year, the economic useful life of the 

property must be determined under 

paragraph (f)(2)(ii) of this section. 

(ii) Taxpayers without an applicable 

financial statement. For taxpayers that 

do not have an applicable financial 

statement (as defined in paragraph 

(f)(2)(iii) of this section), the economic 

useful life of a unit of property is not 

necessarily the useful life inherent in 

the property but is the period over 

which the property may reasonably be 

expected to be useful to the taxpayer or, 

if the taxpayer is engaged in a trade or 

business or an activity for the 

production of income, the period over 

which the property may reasonably be 

expected to be useful to the taxpayer in 

its trade or business or for the 

production of income, as applicable. 

This period is determined by reference 

to the taxpayer’s experience with 

similar property, taking into account 

present conditions and probable future 

developments. Factors to be considered 

in determining this period include, but 

are not limited to—

(A) Wear and tear and decay or 

decline from natural causes; 

(B) The normal progress of the art, 

economic changes, inventions, and 

current developments within the 

industry and the taxpayer’s trade or 

business; 

(C) The climatic and other local 

conditions peculiar to the taxpayer’s 

trade or business; and 

(D) The taxpayer’s policy as to repairs, 

renewals, and replacements. 

(iii) Definition of ‘‘applicable 

financial statement’’. The taxpayer’s 

applicable financial statement is the 

taxpayer’s financial statement listed in 

paragraphs (f)(2)(ii)(A) through (C) of 

this section that has the highest priority 

(including within paragraph (f)(2)(ii)(B) 

of this section). The financial statements 

are, in descending priority—

(A) A financial statement required to 

be filed with the Securities and 

Exchange Commission (SEC) (the 10–K 

or the Annual Statement to 

Shareholders); 

(B) A certified audited financial 

statement that is accompanied by the 

report of an independent CPA (or in the 

case of a foreign entity, by the report of 

a similarly qualified independent 

professional), that is used for—

(1) Credit purposes, 

(2) Reporting to shareholders, 

partners, or similar persons; or 

(3) Any other substantial non-tax 

purpose; or 

(C) A financial statement (other than 

a tax return) required to be provided to 

the Federal or a state government or any 

Federal or state agencies (other than the 

SEC or the Internal Revenue Service). 

(3) Substantially prolonging economic 

useful life—(i) In general. An amount 

paid substantially prolongs the 

economic useful life of the unit of 

property if it extends the period over 

which the property may reasonably be 

expected to be useful to the taxpayer in 

its trade or business or for the 

production of income, as applicable (or, 

if the taxpayer is not engaged in a trade 

or business or an activity for the 

production of income, the period over 

which the property may reasonably be 

expected to be useful to the taxpayer) 

beyond the end of the taxable year 

immediately succeeding the taxable year 

in which the economic useful life of the 

unit of property was originally expected 

to cease, or if the property’s economic 

useful life was previously prolonged (as 

determined under this paragraph 

(e)(3)(i)), the end of the taxable year 

immediately succeeding the taxable year 

in which the prolonged economic useful 

life was expected to cease. 

(ii) Replacements. Amounts paid will 

be deemed to substantially prolong the 

economic useful life of the unit of 

property if a major component or a 

substantial structural part of the unit of 

property is replaced with either a new 

part or a part that has been restored to 

like-new condition as described in 

paragraph (f)(3)(iii) of this section. Thus, 

the replacement of a part with another 

part that is not new or is not in like-new 

condition (for example, a used or 

reconditioned part) does not constitute 

the replacement of a major component 

or substantial structural part of the unit 

of property under this paragraph 

(f)(3)(ii). Further, replacement of a 

relatively minor portion of the physical 

structure of the unit of property or a 

relatively minor portion of any of its 


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major parts, even if those parts are new, 

does not constitute the replacement of a 

major component or substantial 

structural part of the unit of property. 

(iii) Restoration to like-new condition. 

Amounts paid will be deemed to 

substantially prolong the economic 

useful life of the unit of property if they 

result in the unit of property or a major 

component or substantial structural part 

of the unit of property being restored to 

a like-new condition (including bringing 

the unit of property or a major 

component or substantial structural part 

of the property to the status of new, 

rebuilt, remanufactured, or similar 

status under the terms of any Federal 

regulatory guideline or the 

manufacturer’s original specifications). 

(iv) Restoration after a casualty loss. 

Amounts paid will be deemed to 

substantially prolong the useful life of 

the unit of property if the taxpayer 

properly deducts a casualty loss under 

section 165 with respect to the unit of 

property and the amounts paid restore 

the unit of property to a condition that 

is the same or better than before the 

casualty. 

(4) Examples. The following examples 

illustrate the rules of this paragraph (f) 

and, except as otherwise provided, 

assume that the amounts paid would 

not be required to be capitalized under 

any other provision of this section 

(paragraph (e), for example): 

Example 1. Prolonged economic useful life. 

X is a Class I railroad that owns a fleet of 

locomotives. In 1989, X purchased a new 

locomotive with an economic useful life (as 

defined in paragraph (f)(2) of this section) of 

22 years (from 1989–2011). X performs 

substantially the same cyclical maintenance 

on its locomotives approximately every 6 

years. X performed cyclical maintenance on 

the locomotive in 1995, in 2001, and in 2007. 

Assume that the locomotive (which includes 

the engine) is the appropriate unit of 

property and that none of the cyclical 

maintenance projects resulted in a restoration 

under paragraph (f)(3)(ii) or (f)(3)(iii) of this 

section. Amounts paid for cyclical 

maintenance in 1995 and 2001 do not 

substantially prolong the economic useful 

life of the locomotive. However, the cyclical 

maintenance performed in 2007 will prolong 

the economic useful life of the locomotive to 

2013, which is beyond the end of the next 

succeeding taxable year after the economic 

useful life of the locomotive ceases (2011). 

Therefore, under paragraphs (f)(1) and 

(f)(3)(i) of this section, X must capitalize as 

an improvement to the locomotive amounts 

paid for the cyclical maintenance performed 

in 2007, regardless of whether X was 

required to capitalize the amounts paid in 

previous years for cyclical maintenance. 

Example 2. Economic useful life not 

prolonged. Assume the same facts as in 

Example 1, except that in 2009, X replaces 

a filter in the locomotive engine. X generally 

replaces this type of filter every 4 years. 

Although the filter itself would last beyond 

the end of the locomotive’s economic useful 

life in 2011, the amount paid for the filter 

does not substantially prolong the economic 

useful life of the locomotive because the filter 

will not extend beyond 2009 the period over 

which the locomotive may reasonably be 

expected to be useful to X in its trade or 

business. Additionally, although the filter is 

a necessary component of the locomotive, the 

filter is not a substantial structural part or 

major component of the locomotive. 

Therefore, the amount paid to replace the 

filter does not substantially prolong the 

economic useful life of the locomotive. 

Example 3. Minor part replacement. X 

owns a small retail shop. In 2008, a storm 

damaged the roof of X’s shop by displacing 

numerous wooden shingles. X decides to 

replace all the wooden shingles on the roof 

and hires a contractor to replace all the 

shingles on the roof with new wooden 

shingles. No part of the sheathing, rafters, or 

joists was replaced. For purposes of this 

Example 3, assume the shop and its 

structural components are the appropriate 

unit of property. The replacement of the 

shingles did not extend the useful life of the 

shop under paragraph (f)(3)(i) of this section. 

The portion of the roof replaced is not a 

substantial structural part of the shop, nor 

does the replacement of the shingles restore 

to a like-new condition a major component 

or substantial structural part of the shop. 

Therefore, the amounts paid by X to 

reshingle the roof with wooden shingles do 

not substantially prolong the economic 

useful life of the shop. 

Example 4. Major component or 

substantial structural part. Assume the same 

facts as in Example 3, except that when the 

contractor began work on the shingles, the 

contractor discovered that a major portion of 

the sheathing had rotted, and the rafters were 

weakened as well. The contractor replaced 

all the sheathing and a significant portion of 

the rafters. The roof (including the shingles, 

sheathing, rafters, and joists) is a substantial 

structural part of a building. The replacement 

of the shingles, sheathing, and rafters 

restored to a like-new condition a substantial 

structural part of the shop. Therefore, under 

paragraphs (f)(1) and (f)(3)(iii) of this section, 

X must capitalize as an improvement to the 

shop amounts paid to replace the roof of the 

shop. 

Example 5. Not a major component or 

structural part. X uses a car in providing a 

taxi service. X purchased the car in 2008. 

Assume that the unit of property is the car. 

The car has an economic useful life of 5 

years. In 2011, the battery dies and X takes 

the car to a repair shop, which replaces the 

battery. Although the battery itself may last 

beyond the end of the car’s economic useful 

life, the amount paid for the battery does not 

substantially prolong the economic useful 

life of the car because the battery will not 

extend beyond 2013 the period over which 

the car may reasonably be expected to be 

useful to X in its trade or business. Although 

the battery is a necessary component of the 

car, the battery is not a substantial structural 

part or major component of the car. 

Therefore, the amount paid to replace the 

battery does not substantially prolong the 

economic useful life of the car. 

Example 6. Major component or structural 

part. Assume the same facts as Example 5, 

except rather than the battery dying, the car 

overheats and causes so much damage that 

the engine has to be rebuilt. The engine is a 

major component of the car. Therefore, X is 

required to capitalize as an improvement to 

the car under paragraphs (f)(1) and (f)(3)(iii) 

of this section the amounts paid to rebuild 

the engine. 

Example 7. Repair performed during an 

improvement; coordination with section 

263A. Assume the same facts as Example 6, 

except that X has a broken taillight fixed at 

the same time that the engine was rebuilt. 

The repair to the taillight was not incurred 

because the engine was rebuilt, nor did it 

benefit the rebuild of the engine. The repair 

of the broken taillight is a deductible expense 

under § 1.162–4. Under section 263A, all 

indirect costs, including otherwise 

deductible repair and maintenance costs that 

directly benefit or are incurred by reason of 

the improvement must be capitalized as part 

of the improvement. Therefore, all amounts 

paid that are incurred by reason of the engine 

being rebuilt must be capitalized, including, 

for example, amounts paid for activities that 

would usually be deductible maintenance 

expenses, such as refilling the engine with oil 

and radiator fluid. Amounts paid to repair 

the broken taillight, however, are not 

incurred by reason of the engine being 

rebuilt, nor do the amounts paid directly 

benefit the engine rebuild, despite being 

repaired at the same time. Thus, X is not 

required to capitalize to the improvement of 

the car (the rebuild of the engine) the 

amounts paid to repair the broken taillight. 

Example 8. Related amounts to replace 

major component or structural part. (i) X 

owns a retail gasoline station, consisting of 

a paved area used for automobile access to 

the pumps and parking areas, a building used 

to market gasoline, and a canopy covering the 

gasoline pumps. The premises also consists 

of underground storage tanks (USTs) that are 

connected by piping to the pumps and are 

part of the machinery used in the immediate 

retail sale of gas. The pumps also are 

connected to a monitoring unit in the 

building that allows the sales clerk to 

monitor the gasoline sales. To comply with 

regulations issued by the Environmental 

Protection Agency, X is required to remove 

and replace leaking USTs. In 2008, X hires 

a contractor to perform the removal and 

replacement, which consists of removing the 

old tanks and installing new tanks with leak 

detection systems. The removal of the old 

tanks includes removing the paving material 

covering the tanks, excavating a hole large 

enough to gain access to the old tanks, 

disconnecting any strapping and pipe 

connections to the old tanks, and lifting the 

old tanks out of the hole. Installation of the 

new tanks includes placement of a liner in 

the excavated hole, placement of the new 

tanks, installation of a leak detection system, 

installation of an overfill system, connection 

of the tank to the pipes leading to the pumps, 

backfilling of the hole, and replacement of 

the paving. X is also required to pay a permit 

fee to the county to undertake the installation 

of the new tanks. 

(ii) X pays the permit fee to the county on 

October 15, 2008. The contractor performs all 


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of the required work and, on November 1, 

2008, bills X for the costs of removing the old 

USTs. On November 15, 2008, the contractor 

bills X for the remainder of the work. Assume 

the fuel distribution system is the 

appropriate unit of property. The USTs are 

major components of the fuel distribution 

system. Therefore, under paragraphs (f)(1) 

and (f)(3)(ii) of this section, X must capitalize 

as an improvement to the fuel distribution 

system the aggregate of related amounts paid 

to replace the USTs, which related amounts 

include the amount paid to the county, the 

amount paid to remove the old USTs, and the 

amount paid to install the new USTs 

(regardless that the amounts were separately 

invoiced and paid to two different parties). 

Example 9. Major component or 

substantial structural part. X is a common 

carrier that owns a fleet of petroleum hauling 

trucks. In 2008, X replaces the existing 

engine, cab, and petroleum tank of a truck 

with a new engine, cab, and tank. Assume 

the tractor of the truck (which includes the 

cab and the engine) is a separate unit of 

property from the rest of the truck. Also 

assume that the trailer (which contains the 

petroleum tank) is a separate unit of property 

from the truck. The engine and the cab are 

major components of the truck tractor, and 

the petroleum tank is a major component of 

the trailer. Therefore, under paragraphs (f)(1) 

and (f)(3)(ii) of this section, X must capitalize 

as an improvement to the tractor amounts 

paid to replace the engine and cab, and must 

capitalize as an improvement to the trailer 

amounts paid to replace the petroleum tank. 

Example 10. Restoration of major 

component to like-new condition. (i) X is a 

towboat operator that owns and leases a fleet 

of towboats. In 2008, X replaces an existing 

towboat engine with a rebuilt engine. A 

towboat engine is rebuilt through a series of 

steps designed to put the engine in like-new 

operating condition to the maximum extent 

possible. Engines in a towboat nearing the 

end of its useful life or engines that have 

been removed from towboats due to a 

catastrophic malfunction are likely 

candidates for the rebuilding process. The 

goal of the rebuilding process is to bring each 

of an engine’s component parts to the 

manufacturer’s original dimensional 

specifications for new parts. 

(ii) Replacement of the existing towboat 

engine with a rebuilt engine involves drydocking the towboat. The rebuilding and 

replacement process takes approximately 3 to 

5 months. The process requires the removal 

of the engine from the towboat and the 

removal of all of the moving and nonmoving 

components from the engine as well. The 

engine’s crankcase and oil pan are separated, 

and every part of the engine is cleaned, 

inspected using intense illumination, 

machined, and treated with special materials 

to restore the engine to like-new operating 

condition. The engine crankcase and oil pan 

are extensively machined and welded, and 

numerous dimensional tests and checks are 

performed to ensure that the engine is 

returned to a like-new condition through the 

rebuilding process. In addition, a 

reconditioned crankshaft and camshaft 

normally are installed in the engine during 

the rebuilding process. The power packs are 

completely rebuilt with a large number of 

new parts during the rebuilding process. The 

oil pumps, water pumps, engine 

turbochargers, and governors are normally 

removed and exchanged for rebuilt parts 

during the rebuilding process. The accessory 

drive gears, all of the piping on the front and 

aft ends of the engine, the governor drive 

gear, and the turbocharger drive gears are 

removed and normally exchanged for rebuilt 

parts during the rebuilding process. The goal 

of the rebuilding process is to bring each of 

an engine’s component parts to the engine 

manufacturer’s original dimensional 

specifications for new parts. Assume the 

towboat (which includes the engine) is the 

appropriate unit of property. The work done 

on the towboat engine constitutes a 

remanufacture or rebuild of the engine, 

which is a major component of the towboat. 

Therefore, under paragraphs (f)(1) and 

(f)(3)(iii) of this section, X must capitalize as 

an improvement to the towboat amounts paid 

to rebuild the towboat engine. 

Example 11. Repairs performed during an 

improvement; coordination with section 

263A. Assume the same facts as in Example 

10, except that while the towboat is in drydock to have the engine rebuilt, X also makes 

repairs to the hull and rudders that are not 

by themselves an improvement under this 

section. The amounts paid to repair the hull 

and rudders do not directly benefit nor are 

incurred by reason of the engine rebuild. 

Under section 263A, all indirect costs, 

including otherwise deductible repair costs 

that directly benefit or are incurred by reason 

of the improvement must be capitalized as 

part of the improvement. Therefore, all 

amounts paid that are incurred by reason of 

the engine being rebuilt must be capitalized 

to the improvement, including, for example, 

amounts paid for activities such as cleaning 

and inspecting the engine, which usually 

would be deductible maintenance costs. 

Amounts paid to repair the hull and rudders, 

however, are not incurred by reason of the 

engine being rebuilt, nor do the amounts paid 

directly benefit the engine rebuild, despite 

being incurred at the same time. Thus, in 

accordance with paragraph (d)(5)(i) of this 

section, X is not required to capitalize to the 

towboat amounts paid to repair the hull and 

rudders to the improvement. 

Example 12. Restoration to like-new 

condition; coordination with section 263A. 

Assume the same facts as Example 10, except 

that while the towboat is in dry-dock, X also 

makes substantial improvements to the 

propulsion systems and the mechanical 

systems, including rebuilding large sections 

of the hull, and rebuilding, replacing, or 

upgrading the steering systems, shafting 

systems, and electrical systems, such that 

almost the entire towboat is restored to likenew condition. This process constitutes a 

remanufacture or rebuild of the towboat. 

Under section 263A, all indirect costs, 

including otherwise deductible repair costs 

that directly benefit or are incurred by reason 

of the improvement must be capitalized as 

part of the improvement. Therefore, under 

paragraph (d)(5)(i) of this section, X must 

capitalize to the improvement of the towboat 

(the rebuild) amounts paid that otherwise 

would be deductible repair costs that directly 

benefit or are incurred by reason of the 

improvement. 

Example 13. Restoration to like-new 

condition. X is a Class I railroad that owns 

a fleet of freight cars. Approximately every 10 

years, X rebuilds its freight cars. The rebuild 

includes a complete disassembly, inspection, 

and reconditioning and/or replacement of 

components of the suspension and draft 

systems, trailer hitches, and other special 

equipment. Modifications are made to the car 

to upgrade various components to the latest 

engineering standards. The freight car 

essentially is stripped to the frame, with all 

of its substantial components either 

reconditioned or replaced. The frame itself is 

the longest-lasting part of the car and is 

reconditioned. The walls of the freight-train 

car are replaced or are sandblasted and 

repainted. New wheels typically are installed 

on the car. All the remaining components of 

the car are restored before they are 

reassembled. At the end of the rebuild, the 

freight cars have been restored to like-new 

condition. Assume the freight car is the 

appropriate unit of property. The work done 

to the freight car constitutes a remanufacture 

or rebuild of the freight car. Therefore, under 

paragraphs (f)(1) and (f)(3)(iii) of this section, 

X must capitalize as an improvement to the 

freight car amounts paid to rebuild the freight 

car. 

Example 14. Restoration of major 

component to like-new condition. X owned a 

factory that it acquired in 1997. In 2008, the 

factory roof began to leak. These leaks on 

occasion resulted in damage to X’s products 

and prevented the use of certain portions of 

the factory. X decided to reroof the entire 

factory and hired a contractor to perform the 

reroofing. The structure of the roof, including 

substantial portions of the rafters and joists, 

was restored to a like-new condition. Assume 

the factory building and its structural 

components are the appropriate unit of 

property. The roofing process constitutes a 

remanufacture or rebuild of the roof, which 

is a substantial structural part of the factory. 

Therefore, under paragraphs (f)(1) and 

(f)(3)(iii) of this section, X must capitalize as 

an improvement to the factory amounts paid 

to reroof the factory. 

Example 15. Minor part replacement; 

coordination with section 263A. X is in the 

business of smelting aluminum. X’s 

aluminum smelting facility includes a plant 

where molten aluminum is poured into 

molds and allowed to solidify. Because of the 

potential of fire from a molten metal 

explosion, the plant’s roof must be made of 

fire-resistant material. The roof must also be 

without leaks because rain water hitting the 

molten aluminum could cause an explosion. 

The roof of the plant was made of roofing 

material and corrugated sheet metal decking, 

which supports the roofing material. During 

2008, X removed and replaced a minor 

portion of the plant’s roof decking and 

roofing material. At the time of the 

replacement, the pattern of the original metal 

support decking was not available. Therefore, 

X used comparable fire resistant wood 

decking to replace the corrugated metal 

decking. For purposes of this Example 15, 

assume the plant building and its structural 

components are the appropriate unit of 


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property and that the amount paid does not 

prolong the economic useful life of the plant 

under paragraph (f)(3)(i) of this section. The 

portion of the roof structure being replaced 

is not a substantial structural part of the 

plant, nor does the work performed return to 

like-new condition a major component or 

substantial structural part of the plant. 

Further, because X could not practicably 

replace the roof material with the same type 

of material, the replacement of the original 

roof material with an improved, but 

comparable, material does not, by itself, 

result in an improvement. Therefore, the 

amount paid to remove and replace a minor 

part of the plant’s roof decking and roofing 

materially does not substantially prolong the 

economic useful life of the plant. However, 

under section 263A, all indirect costs, 

including otherwise deductible costs, that 

directly benefit or are incurred by reason of 

the taxpayer’s manufacturing activities must 

be capitalized to the property produced for 

sale. Therefore, because the amounts paid for 

the roof decking and materials are incurred 

by reason of X’s manufacturing operations, 

the amounts paid must be capitalized under 

section 263A to the property produced for 

sale by X. 

Example 16. Minor part replacement. (i) X 

is a commercial airline engaged in the 

business of transporting passengers and 

freight throughout the United States and 

abroad. To conduct its business, X owns or 

leases various types of aircraft. As a 

condition of maintaining its airworthiness 

certification for these aircraft, X is required 

by the Federal Aviation Administration 

(FAA) to establish and adhere to a 

continuous maintenance program for each 

aircraft within its fleet. These programs, 

which are designed by X and the aircraft’s 

manufacturer and approved by the FAA are 

incorporated into each aircraft’s maintenance 

manual. The maintenance manuals require a 

variety of periodic maintenance visits at 

various intervals during the operating lives of 

each aircraft. One type of maintenance visit 

is an engine shop visit (ESV), which is 

performed on X’s aircraft engines 

approximately every 4 years. 

(ii) In 2004, X purchased a new aircraft and 

engine. In 2008, X performs its first ESV on 

the aircraft engine. The ESV includes some 

or all of the following activities: Disassembly, 

cleaning, inspection, repair, replacement, 

reassembly, and testing. During the ESV, the 

engine is removed from the aircraft and 

shipped to an outside vendor who performs 

the ESV. When the engine arrives at the 

vendor, the engine is cleaned and externally 

inspected. Regardless of condition, it is 

thoroughly inspected visually and, as 

appropriate, further inspected using a 

number of non-destructive testing 

procedures. The engine is then disassembled 

into major parts and, if necessary, into 

smaller parts. If inspection or testing 

discloses a discrepancy in a part’s conformity 

to the specifications in X’s maintenance 

program, the part is repaired, or if necessary, 

replaced with a new or used serviceable part 

conforming to the specifications. If a part can 

be repaired, but not in time to be returned 

to the engine with which the part had 

arrived, the vendor first attempts to replace 

the part with a similar part from customer 

stock (used parts from X’s aircraft that were 

replaced or exchanged and repaired during 

an earlier ESV and then stored for future use 

on X’s aircraft). If a part is not available from 

customer stock, the part is exchanged with a 

used, serviceable part in the vendor’s 

inventory. A part is replaced (generally with 

a used serviceable part) only if the part 

removed from X’s engine cannot be repaired 

timely. Although many minor parts may be 

replaced during the ESV, the ESV does not 

return the engine to a like-new condition. 

(iii) For purposes of this Example 16, 

assume the aircraft engine is the appropriate 

unit of property. The ESV does not result in 

the replacement of the engine nor does it 

restore the engine to a like-new condition. 

Therefore, the amount paid for the ESV does 

not substantially prolong the economic 

useful life of the engine. 

Example 17. Repairs performed during an 

improvement; coordination with section 

263A. (i) Assume the same facts as in 

Example 16, except that X purchased the 

aircraft in 1986 and, in addition to the 

continuous maintenance program for 

engines, X adheres to a continuous 

maintenance program for its aircraft 

airframes. One type of maintenance visit is a 

heavy maintenance visit (HMV), which is 

performed on X’s aircraft airframes 

approximately every 8 years. In 2008, X 

decided to make substantial modifications to 

the airframe, which resulted in the 

restoration of the airframe to like-new 

condition. The modifications included 

removing all the belly skin panels on the 

aircraft’s fuselage and replacing them with 

new skin panels; replacing the metal 

supports under the lavatories and galleys; 

removing the wiring in the leading edges of 

both wings and replacing it with new wiring; 

removing the fuel tank bladders, harnesses, 

wiring systems, and connectors and replacing 

them with new components; opening every 

lap joint on the airframe and replacing the 

epoxy and rivets used to seal the lap joints 

with a non-corrosive sealant and larger rivets; 

reconfiguring and upgrading the avionics and 

the equipment in the cockpit; replacing all 

the seats, overhead bins, sidewall panels, 

partitions, carpeting, windows, galleys, 

lavatories, and ceiling panels with new 

items; installing a cabin smoke and fire 

detection system, and a ground proximity 

warning system; and painting the exterior of 

the aircraft. In addition, X performed much 

of the same work that would be performed 

during an HMV. 

(ii) For purposes of this Example 17, 

assume the aircraft airframe is the 

appropriate unit of property. The amounts 

paid to modify the airframe are required to 

be capitalized as an improvement to the 

airframe under paragraph (f) of this section 

because the modifications restored the 

airframe to a like-new condition. Assume the 

amounts paid for the HMV are not required 

to be capitalized as a separate improvement 

to the airframe. Under section 263A, all 

indirect costs, including otherwise 

deductible repair costs that directly benefit or 

are incurred by reason of the improvement 

must be capitalized as part of the 

improvement. Therefore, X must capitalize to 

the improvement of the airframe (the 

restoration) amounts paid that usually would 

be ordinary and necessary repair costs, 

including any amounts paid for the HMV that 

directly benefit or are incurred by reason of 

the improvement to the airframe. X is not 

required, however, to capitalize to the 

improvement of the airframe any amounts 

paid for the HMV that do not directly benefit 

or are not incurred by reason of the 

improvement to the airframe. 

Example 18. Restoration of major 

component to like-new condition; 

coordination with section 263A. (i) X is a 

Class I railroad that owns a fleet of 

locomotives. In 1994, X purchased a new 

locomotive (Locomotive A) with an economic 

useful life (as defined in paragraph (f)(2) of 

this section) of 20 years (from 1994–2014). X 

performed cyclical maintenance on 

Locomotive A in 2000, and again in 2008. In 

2000, X replaced the power cylinders on 

Locomotive A’s engine, and performed work 

on other components of Locomotive A. In 

2008, X removed the engine and replaced it 

with one it had previously remanufactured to 

the manufacturer’s original specifications, 

and again performed work on other 

components of Locomotive A. The engine 

that X removed from Locomotive A in 2008 

was remanufactured to the manufacturer’s 

original specifications and installed on 

Locomotive B later in 2008. 

(ii) Assume the locomotive (which 

includes the engine) is the appropriate unit 

of property. The replacement of the power 

cylinders and the other work performed on 

Locomotive A in 2000 did not prolong the 

economic useful life of Locomotive A under 

paragraph (f)(3) of this section. However, the 

amounts paid in 2008 to remove the engine 

and replace it with a previously 

manufactured engine must be capitalized 

under paragraph (f)(3)(ii) of this section. 

Assume the amounts paid in 2008 to perform 

work on other components of Locomotive A 

are not required to be capitalized as a 

separate improvement to Locomotive A. 

Under section 263A, all indirect costs, 

including otherwise deductible repair costs 

that directly benefit or are incurred by reason 

of the improvement must be capitalized as 

part of the improvement. Therefore, X must 

capitalize to the improvement of Locomotive 

A (the installation of the remanufactured 

engine) amounts paid that usually would be 

ordinary and necessary repair costs, 

including any amounts paid for work on 

other components that directly benefit or are 

incurred by reason of the improvement to 

Locomotive A. X is not required, however, to 

capitalize to the improvement of Locomotive 

A any amounts paid for work performed on 

other components that do not directly benefit 

or are not incurred by reason of the 

improvement to Locomotive A. Further, X 

must capitalize to the improvement of 

Locomotive B (the installation of 

remanufactured engine) the amounts paid to 

remanufacture the engine removed from 

Locomotive A and amounts paid to install 

the remanufactured engine on Locomotive B. 

(g) Repair allowance method—(1) In 

general. This paragraph (g) provides an 

optional simplified method (the repair 


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allowance method) for determining 

whether amounts paid to repair, 

maintain, or improve certain tangible 

property are to be treated as deductible 

expenses or capital expenditures. A 

taxpayer that elects to use the repair 

allowance method described in 

paragraph (g)(3) of this section may use 

that method instead of determining 

whether amounts paid to repair, 

maintain, or improve property are 

capital expenditures or deductible 

expenses under the general principles of 

sections 162(a), 212, and 263(a). Thus, 

except for the rules in paragraph (d)(2) 

of this section for determining the 

appropriate unit of property, the 

capitalization rules in § 1.263(a)–3(d) do 

not apply to property for which the 

taxpayer uses the repair allowance 

method under this paragraph (g). See 

section 263A for the scope of costs 

required to be capitalized to property 

produced by the taxpayer or to property 

acquired for resale. 

(2) Election of repair allowance 

method. In the case of repair allowance 

property (as defined in paragraph (g)(6) 

of this section), a taxpayer may elect to 

use the repair allowance method 

described in paragraph (g)(3) of this 

section. See paragraph (g)(9) of this 

section for the manner of electing the 

repair allowance. A taxpayer that elects 

to use the repair allowance method 

must use that method for all of its repair 

allowance property in all MACRS 

classes (including property classified 

into a MACRS class for purposes of the 

repair allowance method under 

paragraph (g)(6)(ii) of this section). A 

taxpayer electing the repair allowance 

method must use that method 

consistently for all future years unless 

the taxpayer revokes the election in 

accordance with paragraph (g)(10) of 

this section. 

(3) Application of repair allowance 

method. Under the repair allowance 

method, a taxpayer must treat all 

amounts paid (other than amounts paid 

for excluded additions, as defined in 

paragraph (g)(7) of this section) for 

materials and labor to repair, maintain, 

or improve all the repair allowance 

property in a particular MACRS class as 

deductible expenses under section 162 

for the taxable year, up to the repair 

allowance amount (as determined in 

paragraph (g)(4) of this section) for that 

MACRS class, and treat the excess of all 

amounts paid to repair, maintain, or 

improve all the repair allowance 

property in that MACRS class (the 

capitalized amount) in accordance with 

paragraph (g)(5) of this section. 

(4) Repair allowance amount—(i) In 

general. Except as provided in 

paragraph (g)(4)(iv) of this section (with 

regard to buildings), under the repair 

allowance method for a particular 

taxable year, the repair allowance 

amount for a particular MACRS class 

consisting of repair allowance property 

is an amount equal to the average 

unadjusted basis (as defined in 

paragraph (g)(4)(ii) of this section) of 

repair allowance property in the 

MACRS class multiplied by the repair 

allowance percentage in effect for the 

MACRS class for the taxable year. 

(ii) Average unadjusted basis. For 

purposes of this section, average 

unadjusted basis is the average of the 

unadjusted basis (as defined in 

paragraph (g)(4)(iii) of this section) of all 

repair allowance property in the 

MACRS class at the beginning of the 

taxable year and the unadjusted basis of 

all repair allowance property in the 

MACRS class at the end of the taxable 

year. 

(iii) Unadjusted basis. For purposes of 

this section, unadjusted basis is the 

basis as determined under section 1012, 

or other applicable sections of 

subchapter O, and subchapters C 

(relating to corporate distributions and 

adjustments), K (relating to partners and 

partnerships), and P (relating to capital 

gains and losses). Unadjusted basis is 

determined without regard to any 

adjustments described in section 

1016(a)(2) or (3) or to amounts for which 

the taxpayer has elected to treat as an 

expense (for example, under section 

179, 179B, or 179C), but with regard to 

basis reductions which are required 

because of credits taken on the property 

(for example, under section 44, 45G, 

45H, or 50(c)). Unadjusted basis also 

must reflect the reduction in basis for 

the percentage of the taxpayer’s use of 

property for the taxable year other than 

for use in the taxpayer’s trade or 

business (or for the production of 

income). 

(iv) Buildings. In the case of buildings 

and structural components that are 

repair allowance property, the repair 

allowance method is applied separately 

with respect to each unit of property. 

(5) Capitalized amount—(i) In 

general. Under the repair allowance 

method for a particular taxable year, the 

capitalized amount is the excess of all 

amounts paid to repair, maintain, or 

improve all the repair allowance 

property in a MACRS class over the 

repair allowance amount for that 

MACRS class. In addition, the 

capitalized amount includes all of the 

indirect costs of producing the repair 

allowance property in the MACRS class, 

which must be capitalized in 

accordance with the taxpayer’s method 

of accounting for section 263A costs. 

Except as provided in paragraphs 

(g)(5)(iv), (g)(5)(v), and (g)(5)(vi) of this 

section, a taxpayer may choose to treat 

the capitalized amount as a single asset 

under paragraph (g)(5)(ii) of this section 

or, alternatively, may choose to allocate 

the capitalized amount to specific repair 

allowance property in the MACRS class 

in accordance with paragraph (g)(5)(iii) 

of this section. 

(ii) Single asset treatment of 

capitalized amount. In general, the 

capitalized amount for a particular 

MACRS class may be treated by the 

taxpayer as a separate single asset and 

depreciated in accordance with that 

MACRS class. The single asset is treated 

as a section 168(i)(6) improvement and 

is treated as placed in service by the 

taxpayer on the last day of the first half 

of the taxable year in which the amount 

is paid, before application of the 

convention under section 168(d). Except 

for a sale of assets constituting a trade 

or business, no gain or loss is 

recognized on capitalized amounts 

treated as a single asset under this 

paragraph (g)(5)(ii) upon disposition of 

any repair allowance property to which 

the capitalized amounts are related. A 

disposition includes the sale, exchange, 

retirement, physical abandonment, or 

destruction of property. Taxpayers must 

continue to depreciate the single asset 

over the remainder of the MACRS 

applicable recovery period. 

(iii) Allocation treatment of 

capitalized amount. Instead of treating 

the capitalized amount as a single asset 

under paragraph (g)(5)(ii) of this section, 

a taxpayer may allocate the capitalized 

amount for a particular MACRS class to 

all repair allowance property in the 

particular MACRS class in proportion to 

the unadjusted basis of the property in 

that MACRS class as of the beginning of 

the taxable year. The capitalized amount 

allocated to repair allowance property is 

treated as a section 168(i)(6) 

improvement to the underlying repair 

allowance property and is treated as 

placed in service by the taxpayer on the 

last day of the first half of the taxable 

year in which the amount is paid, before 

application of the convention under 

section 168(d). 

(iv) Section 168(g) repair allowance 

property. If any repair allowance 

property in a particular MACRS class as 

of the beginning of the taxable year is 

depreciated under section 168(g) 

pursuant to section 168(g)(1)(A) through 

(D) or other provisions of the Internal 

Revenue Code, the portion of the 

capitalized amount for that MACRS 

class that is attributable to all section 

168(g) repair allowance property in that 

MACRS class (section 168(g) total 

capitalized amount) is determined by 

multiplying the capitalized amount for 


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that MACRS class (as determined under 

paragraph (g)(5)(i) of this section) by a 

percentage that is equal to the 

unadjusted basis of all section 168(g) 

repair allowance property in that 

MACRS class as of the beginning of the 

taxable year divided by the unadjusted 

basis of all repair allowance property in 

that MACRS class as of the beginning of 

the taxable year. The section 168(g) total 

capitalized amount for a particular 

MACRS class then is allocated to each 

section 168(g) repair allowance property 

in that MACRS class by multiplying the 

section 168(g) total capitalized amount 

for that MACRS class by a percentage 

that is equal to the unadjusted basis of 

the particular section 168(g) repair 

allowance property in that MACRS class 

as of the beginning of the taxable year 

divided by the unadjusted basis of all 

section 168(g) repair allowance property 

in that MACRS class as of the beginning 

of the taxable year. The capitalized 

amount allocated to each section 168(g) 

repair allowance property is depreciated 

in accordance with section 168(g), is 

treated as a section 168(i)(6) 

improvement to the underlying repair 

allowance property, and is treated as 

placed in service by the taxpayer on the 

last day of the first half of the taxable 

year in which the amount is paid, before 

application of the convention under 

section 168(d). 

(v) Section 168(g) election. If a 

taxpayer makes an election under 

section 168(g)(7) for a particular MACRS 

class with respect to property placed in 

service in the current taxable year, the 

election applies to the capitalized 

amount for that MACRS class. If such an 

election is made, the taxpayer must 

allocate the capitalized amount for that 

MACRS class to all repair allowance 

property in the MACRS class in 

proportion to the unadjusted basis of the 

property in that MACRS class as of the 

beginning of the taxable year. The 

capitalized amount is treated as a 

section 168(i)(6) improvement to the 

underlying repair allowance property 

and is treated as placed in service by the 

taxpayer on the last day of the first half 

of the taxable year in which the amount 

is paid, before application of the 

convention under section 168(d). The 

depreciation of the capitalized amount 

allocated to repair allowance property 

must be determined under section 

168(g) whether or not the repair 

allowance property in the MACRS class 

as of the beginning of the taxable year 

is depreciated under section 168(g). 

(vi) Public utility property. If any 

repair allowance property in a particular 

MACRS class is public utility property 

(as defined in section 168(i)(10) or 

former section 167(l)(3)(A)), the portion 

of the capitalized amount for that 

MACRS class that is attributable to all 

public utility property in that MACRS 

class (public utility property total 

capitalized amount) is determined by 

multiplying the capitalized amount for 

that MACRS class (as determined under 

paragraph (g)(5)(i) of this section) by a 

percentage that is equal to the 

unadjusted basis of all public utility 

property in that MACRS class as of the 

beginning of the taxable year divided by 

the unadjusted basis of all repair 

allowance property in that MACRS class 

as of the beginning of the taxable year. 

The public utility property total 

capitalized amount for a particular 

MACRS class then is subtracted from 

the unadjusted basis of all repair 

allowance property in that MACRS class 

as of beginning of the taxable year to 

determine the non-public utility 

property total capitalized amount. A 

taxpayer may choose to treat the public 

utility property total capitalized amount 

for a particular MACRS class as a single 

asset in accordance with paragraph 

(g)(5)(ii) of this section, and the nonpublic utility property total capitalized 

amount for that MACRS class as another 

single asset in accordance with 

paragraph (g)(5)(ii) of this section. 

Alternatively, the taxpayer may choose 

to allocate the public utility property 

total capitalized amount for a particular 

MACRS class in proportion to the 

unadjusted basis of the public utility 

property in that MACRS class as of the 

beginning of the taxable year in 

accordance with paragraph (g)(5)(iii) of 

this section, and allocate the non-public 

utility property total capitalized amount 

for a particular MACRS class in 

proportion to the unadjusted basis of the 

non-public utility property in that 

MACRS class as of the beginning of the 

taxable year in accordance with 

paragraph (g)(5)(iii) of this section. In 

either case, the public utility property 

total capitalized amount for a particular 

MACRS class is subject to the 

normalization requirements of section 

168(i)(9). 

(6) Repair allowance property—(i) In 

general. Except as provided in 

paragraph (g)(6)(iii) of this section, 

repair allowance property means real or 

personal property subject to section 168 

of the Internal Revenue Code of 1986, or 

treated as subject to section 168 under 

paragraph (g)(6)(ii) of this section, that 

is used in the taxpayer’s trade or 

business or for the production of 

income. 

(ii) Certain property not subject to 

section 168. Repair allowance property 

includes tangible depreciable property 

not otherwise in a MACRS class if the 

taxpayer classifies the property, only for 

purposes of the repair allowance 

method in paragraph (g)(4) of this 

section, to determine the appropriate 

MACRS class and either the taxpayer 

placed the property in service before the 

effective date of section 168 of the 

Internal Revenue Code of 1986 or the 

taxpayer properly elected out of section 

168 with regard to the property. 

(iii) Exclusions from repair allowance 

property. Repair allowance property 

does not include any property for which 

the taxpayer has elected to use the asset 

guideline class repair allowance in 

§ 1.167(a)–11(d)(2); the method of 

accounting provided in section 263(d) 

(with regard to certain railroad rolling 

stock); the method of accounting 

provided in Rev. Proc. 2001–46 (2001–

2 C.B. 263) or Rev. Proc. 2002–65 (2002–

2 C.B. 700) (with regard to railroad 

track) (see § 601.601(d)(2) of this 

chapter); or any other property or 

method of accounting that is designated 

in guidance published in the Federal 

Register or the Internal Revenue 

Bulletin (see § 601.601(d)(2) of this 

chapter). 

(7) Excluded additions—(i) In general. 

Excluded addition means any amount 

paid—

(A) For the acquisition or production 

of a specific unit of property; 

(B) For work that ameliorates a 

condition or defect that either existed 

prior to the taxpayer’s acquisition of the 

unit of property or arose during the 

production of the unit of property, 

whether or not the taxpayer was aware 

of the condition or defect at the time of 

acquisition or production; 

(C) For work performed prior to the 

date the unit of property is placed in 

service by the taxpayer (without regard 

to any applicable convention under 

section 168(d)); 

(D) That adapts the unit of property to 

a new or different use; or 

(E) That increases the cubic or square 

space of a building. 

(ii) Treatment of excluded additions. 

Any amount paid for an excluded 

addition is treated as a capital 

expenditure under sections 263(a) and 

263A. 

(8) Repair allowance percentage. 

Except as provided in any future 

guidance published in the Federal 

Register or the Internal Revenue 

Bulletin, the repair allowance 

percentage in effect for each MACRS 

class for a particular taxable year is as 

follows: 


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MACRS class 

MACRS recovery period 

(years) 

Repair 

allowance 

percentage 

3-year property .................................................................................................................................................... 3 16 .5 

5-year property .................................................................................................................................................... 5 10 

7-year property .................................................................................................................................................... 7 7 .14 

10-year property .................................................................................................................................................. 10 5 

15-year property .................................................................................................................................................. 15 3 .33 

20-year property .................................................................................................................................................. 20 2 .5 

Water utility property ............................................................................................................................................ 25 2 

Residential rental property ................................................................................................................................... 27 .5 1 .82 

Nonresidental rental property .............................................................................................................................. 39 1 .28 

Railroad grading or tunnel bore ........................................................................................................................... 50 1 

(9) Manner of election. [Reserved] 

(10) Manner of revoking election. A 

taxpayer may revoke an election made 

under the repair allowance method only 

by obtaining the Commissioner’s 

consent to revoke the election. An 

election must be revoked prospectively 

and may not be revoked through the 

filing of an amended Federal income tax 

return. A taxpayer that revokes an 

election may not re-elect the repair 

allowance method for a period of at 

least five taxable years, beginning with 

the year of the revocation unless, based 

on a showing of unusual and 

compelling circumstances, consent is 

specifically granted by the 

Commissioner to re-elect the repair 

allowance at an earlier time. 

(11) Examples. The following 

examples illustrate the rules of this 

paragraph (g) and assume that none of 

the rules in paragraph (g)(5)(iv) or 

(g)(5)(v) of this section applies: 

Example 1. X elects the repair allowance 

method described in this paragraph (g). X’s 

total unadjusted basis of all of its MACRS 10- 

year property as of January 1, 2008 is $10 

million. X’s total unadjusted basis of all 

MACRS 10-year property as of December 31, 

2008 is $15 million (computed without 

regard to amounts capitalized under this 

repair allowance provision). During 2008, X 

pays $1,000,000 to repair, maintain, or 

improve MACRS 10-year property. Assume 

that none of X’s property is an excluded 

addition as defined in paragraph (g)(7) of this 

section. The repair allowance percentage for 

MACRS 10-year property is 5 percent. X’s 

repair allowance amount and capitalized 

amount are computed as follows: 

(i) X determines its average unadjusted 

basis of MACRS 10-year property: 

($10,000,000 + $15,000,000)/2 = $12,500,000. 

(ii) X multiplies its average unadjusted 

basis of MACRS 10-year property by the 

prescribed repair allowance percentage for 

MACRS 10-year property to arrive at the 

repair allowance amount: $12,500,000 × 5% 

= $625,000. 

(iii) Because X’s amounts paid to repair, 

maintain, or improve MACRS 10-year 

property ($1,000,000) exceed the repair 

allowance amount for MACRS 10-year 

property ($625,000), X deducts under section 

162(a) amounts paid to the extent of the 

repair allowance amount ($625,000) and 

capitalizes the amounts paid in excess of the 

repair allowance amount 

($1,000,000¥$625,000 = $375,000). 

(iv) The capitalized amount ($375,000) is 

treated as an improvement under section 

168(i)(6). The improvement is depreciated as 

10-year property under section 168 and is 

considered placed in service on the last day 

of the first half of 2008. 

Example 2. X elects the repair allowance 

method described in this paragraph (g). X 

uses a car in providing a taxi service. X’s 

unadjusted basis in the car is $25,000. 

Assume that the unit of property (as 

determined under paragraph (d)(2) of this 

section) is the car. In 2008, X incurs various 

costs to maintain, repair, and improve the 

car, including: $4,500 for gasoline; $550 for 

car washes and detailing, $2,200 for 

scheduled maintenance such as oil changes, 

tire rotation, new brakes, minor parts, and 

fluid replacements, etc.; $80 for new 

headlights; $250 for new tires; and $4,800 to 

rebuild the engine after the car overheated. 

Assume that none of X’s expenditures are an 

excluded addition as defined in paragraph 

(g)(7) of this section. The car is classified as 

MACRS 5-year property. Assume that X has 

no other MACRS 5-year property. The repair 

allowance percentage for MACRS 5-year 

property is 10 percent. X’s repair allowance 

amount and capitalized amount are 

computed as follows: 

(i) X determines its average unadjusted 

basis of MACRS 5-year property is $25,000. 

(ii) X multiplies its average unadjusted 

basis of MACRS 5-year property by the 

prescribed repair allowance percentage for 

MACRS 5-year property to arrive at the repair 

allowance amount: $25,000 × 10% = $2,500. 

(iii) Because X’s amounts to repair, 

maintain, or improve MACRS 5-year property 

($2,200 + $80 + $250 + $4,800 = $7,330) 

exceed the repair allowance amount for 

MACRS 5-year property ($2,500), X treats 

$2,500 as an otherwise deductible ordinary 

and necessary expenditure under section 

162(a) and capitalizes $4,830 as the amounts 

paid in excess of the repair allowance 

amount. 

(iv) The capitalized amount ($4,830) is 

treated as an improvement under section 

168(i)(6). The improvement is depreciated as 

5-year property under section 168 and is 

considered placed in service on the last day 

of the first half of 2008. 

(h) Treatment of capital expenditures. 

Amounts required to be capitalized 

under this section are capital 

expenditures and must be taken into 

account through a charge to capital 

account or basis, or in the case of 

property that is inventory in the hands 

of a taxpayer, through inclusion in 

inventory costs. See section 263A for 

the treatment of amounts referred to in 

this section as well as other amounts 

paid in connection with the production 

of real property and personal property, 

including films, sound recordings, video 

tapes, books, or similar properties. 

(i) Recovery of capitalized amounts. 

Amounts that are capitalized under this 

section are recovered through 

depreciation, cost of goods sold, or by 

an adjustment to basis at the time the 

property is placed in service, sold, used, 

or otherwise disposed of by the 

taxpayer. Cost recovery is determined 

by the applicable Internal Revenue Code 

and regulation provisions relating to the 

use, sale, or disposition of property. 

(j) Effective date. The rules in this 

section apply to taxable years beginning 

on or after the date of publication of the 

Treasury decision adopting these rules 

as final regulations in the Federal 

Register. 

(k) Accounting method changes. 

[Reserved] 

Mark E. Matthews, 

Deputy Commissioner for Services and 

Enforcement. 

[FR Doc. 06–6969 Filed 8–18–06; 8:45 am] 

BILLING CODE 4830–01–P 


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