Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property, 81060-81127 [2011-32024]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

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



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Vol. 76

Tuesday,

No. 248

December 27, 2011

Part III





Department of the Treasury





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Internal Revenue Service





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26 CFR Part 1





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

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

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9564]
RIN 1545-BJ93


Guidance Regarding Deduction and Capitalization of Expenditures 
Related to Tangible Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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

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

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

SUPPLEMENTARY INFORMATION: 

Background

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

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Explanation of Provisions

I. Overview

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

II. Materials and Supplies Under Sec.  1.162-3

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

A. Definition of Materials and Supplies

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

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

B. Optional Method for Rotable or Temporary Spare Parts

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

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

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

D. Election To Capitalize Materials and Supplies

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

[[Page 81063]]

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

III. Repairs Under Sec.  1.162-4

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

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

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

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

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

A. Moving and Reinstallation Costs

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

B. Work Performed Prior To Placing Property Into Service

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

C. Transaction Costs

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

[[Page 81064]]

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

D. De Minimis Rule

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

[[Page 81065]]

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

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

A. Overview

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

[[Page 81066]]

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

B. Determining the Unit of Property

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

[[Page 81067]]

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

[[Page 81068]]

explained below, the temporary regulations provide that only a ``lessee 
improvement,'' rather than a ``leasehold improvement,'' is a unit of 
property separate from the unit of property improved. Moreover, this 
rule has been moved to a separate subsection governing the unit of 
property for improvements.
5. Unit of Property for Leasehold Improvements
    Current law provides that if a lessee makes a leasehold improvement 
that is not a substitute for rent, the lessee is generally required to 
capitalize the cost of the improvement under section 263(a) and 
Sec. Sec.  1.162-11(b) and 1.167(a)-4 and, if the leasehold improvement 
is property to which section 168 applies, depreciate the improvement 
under section 168. See section 168(i)(8)(A). Current law, however, does 
not clearly address the unit of property for leasehold improvements.
    The 2008 proposed regulations provided that, in the case of a 
leasehold improvement made by a lessee that is section 1250 property, 
the leasehold improvement is a separate unit of property. The 2008 
proposed regulations did not address leased section 1245 property or 
discuss the unit of property for improvements made by a lessor. The IRS 
and the Treasury Department received several comments requesting that 
the regulations provide additional guidance on the unit of property for 
improvements to leased section 1250 property and address the unit of 
property for improvements to leased section 1245 property. In addition, 
commentators suggested that revised regulations provide operative rules 
for determining when there has been an improvement to leased property. 
In response to the comments, the temporary regulations address whether 
amounts paid by a lessee or lessor are for the improvement of a unit of 
leased property, requiring capital treatment. The temporary regulations 
also define the unit of property for purposes of determining whether 
amounts paid subsequent to an initial leasehold improvement must be 
capitalized.
    The temporary regulations for lessee improvements are consistent 
with the rule in the 2008 proposed regulations but provide further 
elaboration and are extended to section 1245 property. The temporary 
regulations provide that an amount initially capitalized as a lessee 
improvement is treated as a cost of acquiring or producing a unit of 
property, and constitutes a unit of property separate from the leased 
property being improved. However, the cost of improving a lessee 
improvement is not a unit of property separate from the lessee 
improvement being improved.
    Treating the lessee's initial improvement as a separate unit of 
property is based on the premise that, when making a leasehold 
improvement, the lessee should be treated as if it has acquired or 
produced new property. This new property interest is separate and 
distinguishable from the lessee's interest in the underlying property. 
Also, this approach is consistent with the depreciation rules under 
sections 168(i)(6) and (i)(8)(A), which treat the leasehold improvement 
as a separate asset for purposes of section 168. Finally, treatment of 
a lessee's subsequent improvement as part of the lessee's initial 
leasehold improvement is consistent with the rule governing the unit of 
property determination for improvements to owned property, which 
generally treats the improvement and the property improved as a single 
unit of property.
    The temporary regulations also provide a rule for determining the 
unit of property for a lessor improvement. The temporary regulations 
provide that an amount capitalized as a lessor improvement is not a 
unit of property separate from the unit of property improved. This rule 
is based on the premise that the lessor of property generally should be 
treated in the same manner as any other owner of property when it makes 
an improvement to its property. Thus, in accordance with the general 
rule for property owners, a lessor improvement to a unit of property is 
not a unit of property separate from the property being improved.
6. Additional Rules for Determining Units of Property
    The 2008 proposed regulations included