Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property, 12838-12867 [E8-4466]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

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



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Part III





Department of the Treasury





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Internal Revenue Service



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26 CFR Part 1



Guidance Regarding Deduction and Capitalization of Expenditures Related 
to Tangible Property; Proposed Rule

Federal Register / Vol. 73, No. 47 / Monday, March 10, 2008 / 
Proposed Rules

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-168745-03]
RIN 1545-BE18


Guidance Regarding Deduction and Capitalization of Expenditures 
Related to Tangible Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking, a notice of public hearing, and 
withdrawal of previously proposed regulations.

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SUMMARY: This document contains proposed regulations that explain how 
section 263(a) of the Internal Revenue Code (Code) applies to amounts 
paid to acquire, produce, or improve tangible property. The proposed 
regulations clarify and expand the standards in the current regulations 
under section 263(a), as well as provide some bright-line tests (for 
example, a de minimis rule for acquisitions). The proposed regulations 
will affect all taxpayers that acquire, produce, or improve tangible 
property. This document also provides a notice of public hearing on the 
proposed regulations and withdraws the proposed regulations published 
in the Federal Register on August 21, 2006 (71 FR 161).

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

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

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Merrill D. Feldstein or Mon L. Lam, (202) 622-4950; concerning 
submission of comments, the hearing, and/or to be placed on the 
building access list to attend the hearing, 
Richard.A.Hurst@irscounsel.treas.gov.

SUPPLEMENTARY INFORMATION:

Background

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

Summary of Comments and Explanation of Provisions

I. Overview

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

II. Withdrawal and Re-Proposal of Regulations

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

III. Materials and Supplies Under Sec.  1.162-3

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

[[Page 12839]]

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

IV. Repairs under Sec.  1.162-4

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

V. Professional Expenses Under Sec.  1.162-6

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

VI. Capital Expenditures

A. Amounts Paid To Sell Property

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

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

B. Interests in Land

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

VII. Amounts Paid To Acquire or Produce Tangible Property

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

A. Definition of Produce

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

B. Transaction Costs

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

 C. De minimis rule

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

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

VIII. Improvements

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

[[Page 12842]]

provisions of the Code. The rules contained in these new proposed 
regulations attempt to address these concerns.
    Section 1.263(a)-3 of the 2006 proposed regulations provided that 
taxpayers are required to capitalize amounts paid to improve a unit of 
property. Under the general rule in the 2006 proposed regulations, a 
unit of property is improved if the amounts paid (i) materially 
increase the value of the unit of property; or (ii) restore the unit of 
property. Under the 2006 proposed regulations, amounts paid to adapt a 
unit of property to a new or different use were considered to 
materially increase the value of a unit of property. The 2006 proposed 
regulations also contained rules for determining the appropriate unit 
of property.
    These new proposed regulations remove the new or different use 
standard from the material increase in value rules and provide a 
separate category for new or different use. Additionally, the material 
increase in value standard has been renamed the ``betterment'' standard 
because the betterment standard more closely reflects the manner in 
which section 263(a) has been interpreted and applied under current 
law. Therefore, these new proposed regulations identify three 
categories of costs that result in an improvement to property. 
Taxpayers under the new proposed regulations must capitalize amounts 
paid that:
    (i) Result in a betterment to a unit of property;
    (ii) Restore a unit of property; or
    (ii) Adapt a unit of property to a new or different use.
    These new proposed regulations continue to include rules for 
defining the unit of property to be used in making these 
determinations.
    The 2006 proposed regulations did not prescribe a plan of 
rehabilitation doctrine as traditionally described in the case law. 
That judicially-created doctrine provides that a taxpayer must 
capitalize otherwise deductible repair costs if they are incurred as 
part of a general plan of rehabilitation to the property. See Norwest 
Corp. v. Commissioner, 108 T.C. 265 (1997); Moss v. Commissioner, 831 
F.2d 833 (9th Cir. 1987); United States v. Wehrli, 400 F.2d 686 (10th 
Cir. 1968). Commentators requested that the regulations specifically 
state that the plan of rehabilitation doctrine either is eradicated or 
is limited to clearly defined circumstances.
    Section 263A requires that all direct costs of an improvement and 
all indirect costs that directly benefit or are incurred by reason of 
the improvement must be capitalized. See section 263A(b), which states 
that section 263A applies to real or tangible property produced by the 
taxpayer, and section 263A(g)(1), which states that the definition of 
``produce'' includes improve. See also Sec.  1.263A-1(e), which 
requires the capitalization of direct costs and of all indirect costs 
that directly benefit or are incurred by reason of the performance of 
production activities. Section 263A, therefore, requires a taxpayer to 
capitalize otherwise deductible repair costs as part of an improvement 
if the taxpayer improves a unit of property and the otherwise 
deductible repair costs directly benefit or are incurred by reason of 
the improvement to the property. Thus, section 263A has eliminated the 
need for a plan of rehabilitation doctrine to determine the allocable 
costs that must be capitalized as part of an improvement. Although some 
commentators requested that the circumstances in which otherwise 
deductible repair costs must be capitalized as part of an improvement 
be limited, for example, to property that is totally dysfunctional and 
unsuitable for its intended purpose, there is no authority for doing so 
because section 263A specifically applies to improvements. The 
legislative history to the Tax Reform Act of 1986, Public Law 99-514 
(100 Stat. 2085) also indicates that Congress intended section 263A to 
apply to improvements to property. See, for example, S. Rep. No. 99-
313, 99th Cong., 2d Sess. 133-152 (1986), which states that the uniform 
capitalization rules will apply to assets or improvements to assets 
constructed by a taxpayer for its own use in a trade or business or in 
an activity engaged in for profit, and that the rules are not intended 
to apply to expenditures properly treated as repair costs under present 
law that do not relate to the manufacture, remanufacture, or production 
of property.
    Section 263A does not require otherwise deductible repair costs to 
be capitalized if the repairs do not directly benefit or are not 
incurred by reason of a production activity (for example, an 
improvement). The judicially-created plan of rehabilitation doctrine, 
however, has been cited to require capitalization of otherwise 
deductible repair costs solely because the taxpayer has a plan (written 
or otherwise) to perform periodic repairs or maintenance, or solely 
because the taxpayer performs several repairs to the same property at 
one time even though the property is not improved. As stated in the 
preamble to the 2006 proposed regulations, the IRS and Treasury 
Department do not think this characterization is appropriate. These new 
proposed regulations specifically provide that repairs that are made at 
the same time as an improvement, but that do not directly benefit or 
are not incurred by reason of the improvement, are not required to be 
capitalized under section 263(a). These new proposed regulations do not 
prescribe a plan of rehabilitation doctrine. Therefore, when these new 
proposed regulations are finalized, the judicially-created plan of 
rehabilitation doctrine will be obsolete, particularly with regard to 
the assertion that the doctrine transforms otherwise deductible repair 
costs into capital improvement costs solely because the repairs are 
performed at the same time as an improvement, or are pursuant to a 
maintenance plan, even though the repairs do not improve the property 
under Sec.  1.263(a)-3. However, section 263A continues to require a 
taxpayer to capitalize otherwise deductible repair costs if the 
taxpayer improves a unit of property and the otherwise deductible 
repair costs directly benefit or are incurred by reason of the 
improvement to the property.

A. Unit of Property

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

[[Page 12843]]

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

B. Routine Maintenance Safe Harbor

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

[[Page 12844]]

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

C. Betterments

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

[[Page 12845]]

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

D. Restorations

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

[[Page 12846]]

2. Restoration of Property Destroyed In a Casualty
    The 2006 proposed regulations required a taxpayer to capitalize 
amounts paid to repair property if the taxpayer properly deducted a 
casualty loss under section 165 with respect to a unit of property and 
the amounts paid restore the unit of property to a condition that is 
the same or better than before the casualty. The casualty loss rule 
provided in the 2006 proposed regulations was criticized. In general, 
commentators thought there should be no link between the recognition of 
a casualty loss under section 165 and the determination of whether the 
cost to replace the property destroyed (in part or in whole) after a 
casualty event constitutes a capital expenditure. However, significant 
authority implies that a casualty-type event generally may only be 
characterized either as an extraordinary event (thus giving rise to a 
``loss'' under section 165), or as an ordinary and necessary event in 
the operation of a trade or business (thus giving rise to an ordinary 
and necessary deduction under section 162). See, e.g., R. R. Hensler, 
Inc. v. Commissioner, 73 T.C. 168, 179 (1979), acq., (1980-2 CB 1); 
Hubinger v. Commissioner, 36 F.2d 724, 726 (2d Cir. 1929), cert. 
denied, 281 U.S. 741 (1930). Thus, a casualty is not an ordinary event, 
and the cost to repair property damaged by a casualty is not an 
ordinary expense. Stated differently, a loss under section 165 
represents a destruction of property necessitating a replacement, which 
is capital, while an ordinary event generally represents damage to 
property necessitating a repair, which may or may not be capital. 
Because the restoration cost resulting from a loss is not ordinary, it 
is not allowed as an ordinary and necessary expense under section 162, 
but is treated as a capital expenditure under section 263(a). Although 
it is clear that a casualty event generally results in two economic 
costs to the taxpayer (the destruction of the previously invested 
capital and the costs to replace the destruction), the event giving 
rise to both of these costs is the same.
    These new proposed regulations generally require consistent 
characterization of all costs arising from a single event. Therefore, 
under the rules provided in these new proposed regulations, a taxpayer 
that experiences an extraordinary loss event sufficiently destructive 
to invoke the provisions of section 165 will be required to treat the 
resulting restoration costs as a capitalized replacement of the 
destroyed property. This rule is required to ensure consistency in tax 
treatment among similarly situated taxpayers. For example, a taxpayer 
whose property is completely destroyed by a casualty event is required 
to capitalize the restoration of the loss because the restoration 
results in the replacement of the destroyed property with an entirely 
new unit of property. However, without a consistency rule, a taxpayer 
who experiences the same casualty event but only has part of a unit of 
property destroyed might argue that the cost to replace the destroyed 
portion of the unit of property is deductible because it simply returns 
the unit of property as a whole to its pre-casualty state. Allowing 
this type of disparity in tax treatment would provide an incentive to 
characterize destructions of property as partial destructions in order 
to leave open the position that a deduction may be taken for both the 
destruction of property resulting from the casualty event, as well as 
the ordinary and necessary expense of replacing the destroyed property. 
This rule also eliminates the dual characterization of minor costs 
incurred for items such as broken windows or blown-off shingles as both 
a casualty loss under section 165 and an ordinary and necessary expense 
under section 162.
    Commentators noted that a rule requiring the capitalization of 
restoration costs following the recognition of a casualty loss would 
unfairly burden taxpayers that routinely experience extraordinary loss 
events in their trade or business. However, it should be noted that 
under these new proposed regulations, capitalization is required only 
if a loss or basis adjustment to the property is recognized by the 
taxpayer with respect to the event.
    Various judicial authorities have held that events that generally 
are viewed as extraordinary loss events may nonetheless be considered 
ordinary occurrences in a particular industry. See Atlantic Greyhound 
Corp. v. United States, 111 F. Supp. 953 (Ct. Cl. 1953). In this 
situation, the costs to replace property destroyed in what would 
normally be characterized as a casualty event may result in an ordinary 
and necessary expenditure under section 162 rather than a loss under 
section 165. In this regard, the IRS and Treasury Department will 
consider providing guidance on what types of events may be considered 
ordinary in a particular industry. Taxpayers are e