form 3115 and the new repair regulations · 2015-05-14 · if the law changes and requires a...

FORM 3115 AND THE NEW REPAIR REGULATIONS

The Tax Curriculum℠ Nichols Patrick CPE, Inc.


EDWARD K. ZOLLARS, CPA

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TABLE OF CONTENTS

Page

Form 3115 .......................................................................................................................... 1 I. Governing Revenue Procedures .................................................................... 1 II. Definition of an Accounting method ............................................................... 2III. §481(a) Adjustment ........................................................................................ 3 IV. IRS Initiated Changes .................................................................................... 3V. Requesting a Change of Method ................................................................... 4

Repair/Capitalization Regulations ................................................................................. 12 I. Tangible Property/Repair Regulations Finalzied in 2013 (TD 9636,

REG 110732-13 and Revenue Procedures 2014-16 and 2014-17, 9/19/13 and 1/24/14) .................................................................................... 12

II. Final 2014 revisions to §168(i) Partial Disposition/General AssetAccounts (TD 9689, 8/18/14, Revenue Procedure 2014-54, 9/18/14) ......... 25

Accounting Methods to be Changed ............................................................................. 29 I. Section 6 – Depreciation .............................................................................. 29 II. Section 10 – Capitalization under §263(a) ................................................... 37

Author’s Presentation ........................................................................................... Slides-1

Final Regulations under §263(a) and Related Areas .................................................. A-1

Final Regulations under §168(i) (Partial Disposition)................................................. B-1

Form 3115 and Instructions (December 2009 Version) ............................................. C-1

(1/28/2015 ekz)

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other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought." -- from a declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations.

1 The Tax Curriculum℠ Nichols Patrick CPE, Inc.

FORM 3115

A Form 3115 must be filed any time a taxpayer changes his/her method of accounting, as IRS permission must be obtained to make such a change. This permission must be obtained even though it may seem absurd to do so. For instance, permission must be obtained:

For a taxpayer who had been using a method not allowed under the law, permissionmust still be obtained to use an allowable method

If the law changes and requires a taxpayer to change his/her methods, permissionmust still be obtained (such as for the repair regulations)

Under “normal” conditions a taxpayer must file the application, pay a user fee and get specific IRS permission prior to filing a return using the new method. However, quite often (such as for the repair regulations) the IRS will publish methods to automatically obtain permission.

I. GOVERNING REVENUE PROCEDURES

A pair of recently issued Revenue Procedures govern accounting method changes. The new procedures replace Revenue Procedures 2011-14 (previously the main ruling governing automatic changes, along with the list of changes) and Revenue Procedure 97-27 (the general procedure that, with the portions not previously superseded, governed non-automatic changes).

A. Revenue Procedure 2015-13

This ruling contains the procedures to be used to request a change of accounting method, both for automatic change requests and those for which specific permission is requested.

It is effective for requests made on or after January 16, 2015.

B. Revenue Procedure 2015-14

This procedure contains the material that used to be found in the appendix to the automatic change procedure (now superseded Revenue Procedure 2011-14), along with those automatic changes added by a number of additional rulings issued after Revenue Procedure 2011-14.

http://www.irs.gov/pub/irs-drop/rp-15-13.pdf


http://www.currentfederaltaxdevelopments.com


That means this procedure now has incorporated the guidance previously found in Revenue Procedures 2014-16, 2014-17 and 2014-54 related to the new repair regulations. If you have taken courses earlier that dealt with the repair regulations and accounting method changes, those courses would have references to those rulings.

You need to update the references to the new ruling. However, for all practical purposes the details in those old rulings were adopted in unchanged form in the new rulings.

II. DEFINITION OF AN ACCOUNTING METHOD

Many advisers have difficulty seeing the difference between an erroneous accounting method and a mistake. But, in reality, the definition provides a fairly simple dividing line between an error (which can be dealt with on an amended return) and an accounting method.

An accounting method does affect the ultimate amount of income or deduction a taxpayer will recognize. However, it does affect the timing of such recognition.

Example. ABC CPAs, Inc. is an accounting firm. Whether the firm recognizes income from clients when it bills the client or when it is paid by the client on that bill is an accounting method issue. Assume ABC, a calendar year taxpayer, billed a client $5,000 on December 15, 2014 and was paid by the client on January 15, 2015.

On the cash basis of accounting ABC would recognize $5,000 of income on its 2015 income tax return with no amount on the 2014 return. However, if ABC were on the accrual basis, the income of $5,000 would be recognized on the 2014 return with no amount recognized on the 2015 return.

In both cases the same amount ($5,000) has been recognized. However the methods of accounting caused the amount to be recognized at different times.

If the issue affects the amount of an income of income or deduction, that is not an accounting method. For instance, in Chief Counsel Advice CCA 201345025 the National Office noted that a taxpayer had been deducting commissions twice (once when it accrued the commission and a second time when the commission was paid) was not changing its accounting method when it stopped this practice and only deducted the commission once.

One minor exception to the accounting method rule occurs if a taxpayer discovers that he/she had computed an item using an impermissible method before filing a second return using that method. In that situation, the law presumes the matter was really an error. But once the taxpayer continues to treat an item in that manner, even if the law does not allow it, a method has been established.


III. §481(A) ADJUSTMENT

Since an accounting method affects the timing of income or deduction, but not the amount, when a taxpayer changes methods there would be a problem that income or deductions would be either included on multiple returns or never shown on a return. The Internal Revenue Code has a method of dealing with this issue.

When a taxpayer changes an accounting method, the taxpayer takes a look at what would have been the effect on cumulative income or loss had the taxpayer been using the new method for its entire history. This difference is referred as the §481(a) adjustment and may represent either a positive or negative adjustment.

Generally a taxpayer takes a positive §481(a) adjustment for a method change initiated by the taxpayer over 4 years. One quarter of the adjustment is reported in the year of change, with an additional quarter reported in each of the following three years.

If an adjustment is negative, the taxpayer takes the entire adjustment into account in the year of change. As well, if a positive adjustment is less than $50,000 (this used to be $25,000 before Revenue Procedure 2015-13), the taxpayer may, but is not required to, elect to pick up the entire adjustment in one year rather than spreading it over four years.

Note that this cumulative effect is not limited to items arising out of years still within the statute of limitations for IRS assessments. Rather this rule may reach back decades to pick up positive or negative adjustments—and it also means that computing the §481(a) adjustment and, more importantly, defending it can require having access to records going back that far.

But, for instance, in the situation outlined in CCA 201345025 with a double deduction of commissions, the taxpayer was “protected” from having to pick up income to correct the additional deductions taken in prior years for any year outside of the statute, unless the IRS could carry a showing of fraud (a difficult task for the IRS to carry).

IV. IRS INITIATED CHANGES

While the taxpayer must have permission to change his/her accounting methods, the IRS can, on exam, require a taxpayer to change its accounting method in a year under examination.

The IRS does not have an absolute power to force an accounting method change. Rather the IRS may only force the change if the taxpayer’s current method of accounting does not “properly reflect income” under the tax law.

Generally when the IRS forces a change the taxpayer will end up with a much favorable period over which any positive adjustment resulting from such a change must be picked in income. The law is structured this way to encourage taxpayers to come forward to correct problems, rather than “hoping the IRS won’t find” the issue.


Taxpayers who receive permission to change their methods also receive protection against the IRS being able to go back to an earlier year to force the change.

V. REQUESTING A CHANGE OF METHOD

A taxpayer requests a change of method using Form 3115. If the change is not an automatic change the taxpayer must submit the request early enough before the due date of the year the taxpayer wishes to adopt the change to allow the IRS to rule on the issue.

However, under the automatic procedures outlined in Revenue Procedure 2015-13, the taxpayer does not file the Form 3115 until the taxpayer files his/her return for the year of change. At that point the taxpayer files the original Form 3115 with his/her original return for the year of change. At the same time, the taxpayer files a copy of the Form 3115 with another IRS office—normally the IRS Service Center in Ogden, Utah.

If the taxpayer has submitted a properly completed Form 3115 for an automatic change, the taxpayer is deemed to have been given permission to change his/her method on the return to which the Form 3115 was attached.

The pages of Form 3115 are reproduced on the following pages. Note that the Form 3115 we have now was last revised in 2009—well before Revenue Procedure 2015-13 was issued. Given certain changes in Revenue Procedure 2015-13 certain information on the Form 3115 and in the instructions are not currently correct. Presumably the IRS will be issuing a revised Form 3115 at some point. For now, any Form 3115 should be completed using the rules found in the 2015 Revenue Procedures if those rules are in conflict with information found in the instruction or on the form itself.

The form itself is somewhat misleading at first glance. The good news is that only the applicable sections need to be filled in, and by design that generally means most sections are not filled in for any particular change. The bad news is that changes generally require additional “plain paper” attachments and computations in support of the change request and §481(a) adjustment, so completing the form most often requires the creation of spreadsheets and additional statements.


Note that many of the sections of the Form 3115 will not be relevant for any particular accounting method change—rather, the taxpayer fills in the portions that are relevant to the change being requested.

As well, note that a number of lines request that the taxpayer attach separately prepared schedules and statements to the Form 3115.

Finally, remember that both the taxpayer and the paid preparer must sign the Form 3115 in addition to the underlying tax return.

REPAIR/CAPITALIZATION REGULATIONS

The IRS finalized in September of 2013 most of the provisions in the tangible property capitalization rules, finalizing the remaining items (related to the general asset/partial disposition rules) in 2014.

Below is a summary of these rules.

I. TANGIBLE PROPERTY/REPAIR REGULATIONS FINALZIED IN 2013 (TD 9636, REG 110732-13 AND REVENUE PROCEDURES 2014-16 AND 2014-17, 9/19/13 AND 1/24/14)

The latest round of revisions to the repair and capitalization regulations have made their way out of the IRS, but this time the majority of the regulations were issued as final regulations (TD 9636, https://s3.amazonaws.com/public-inspection.federalregister.gov/2013-21756.pdf) with the regulations under IRC §168(i) reissued as proposed regulations with further revisions (REG 110732-13, https://s3.amazonaws.com/public-inspection.federalregister.gov/2013-21753.pdf).

Late in 2012 the IRS had issued Notice 2012-73 which delayed the effective date of the then temporary regulations. The notice also indicated specifically that the IRS expected to make changes to simplify compliance, and the notice provides that such changes are to be expected in the following provisions:

De Minimis Rule: § 1.263(a)-2T(g);

Dispositions: §§ 1.168(i)-1T and 1.168(i)-8T; and

Safe Harbor for Routine Maintenance: § 1.263(a)-3T(g)

The final regulations did introduce changes to the De Minimis Rule and the Safe Harbor for Routine Maintenance, while the proposed regulations deal with modifications to the dispositions rules.

Originally the IRS issued in late 2011 the third revision of the proposed regulations on capitalization, this time issuing at the same time identical temporary regulations, in TD 9564. These regulations would, among other things, attempt to outline rules for determining whether an expenditure was a repair that could be currently expensed, or a capitalized improvement that must be depreciated for tax purposes.

https://s3.amazonaws.com/public-inspection.federalregister.gov/2013-21756.pdf




A rough flowchart of how the final regulations may be viewed is presented below:

Reg. §1.263(a)-1 outlines general rules for capital expenditures, Reg. §1.263(a)-2 provides provisions related to the acquisition of tangible property while Reg. §1.263(a)-3 deals with the improvement of tangible property. Temporary regulations were also added under IRC §§162 (related to materials and supplies, repairs and rentals), 165 (related to obsolescence of nondepreciable property), 167 (related to depreciation), 168 (related to cost recovery), 263A (related to uniform capitalization) and §1016 (related to the basis of assets).

While the temporary regulations roughly followed the 2008 proposed regulations, certain changes were made by the IRS, with additional changes made in the final regulations. Many provisions in these regulations will require a change of accounting method involving an automatic change request on a Form 3115 and a §481(a) adjustment. In the preamble to the regulations the IRS justified a §481(a) adjustment as opposed to a cut-off adjustment to insure the same standards applied to all assets and transactions in a year under examination.

MATERIALS AND SUPPLIES AND ROTABLE SPARE PARTS [Reg. §1.162-3]

The regulations clarify the nature of materials and supplies. Generally such items that are “nonincidental” must be deducted against income in the year in which they are used or consumed. If the materials and supplies are “incidental” they can be expensed in the year in which they are acquired so long as a) no record of consumption is kept by the taxpayer and b) income continues to be clearly reflected even with such immediate expensing. [Reg. §1.162-3(a)]

Qualifies for De Minimis?

Is this a supply?

Expense the Item

Do Regulations under §263(a)

require capitalization?

Does entity track the items?

Yes

No

No

Yes No(Incidental)

Item used by end of year?

Yes

Capitalize item

Yes

Repair?

No

Yes

Consider other options (including

nondeductible)

No


Reg. §1.162-3(b) notes that this regulation does not change the treatment of items under any provision of the IRC, thus if another provision requires an expense to be capitalized the fact that the above rules would allow expensing would not justify such expensing.

Materials and supplies are defined as tangible personal property other than inventory that falls into one of the following categories:

A component acquired to maintain, repair, or improve a unit of tangible property owned, leased, or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property;

Fuel, lubricants, water, and similar items reasonably expected to be consumed within 12 months;

A unit of property as determined under § 1.263(a)-3T(e) that has an economic useful life of 12 months or less;

A unit of property as determined under § 1.263(a)-3T(e) that has an acquisition cost or production cost (as determined under IRC §263A) of $200 or less (or such amount as the IRS may later publish to adjust this figure in the future)

The final category of materials and supplies was modified in the final regulations, raising the level at which an item can be treated as a supply regardless of other factors from $100 to $200.

Rotable spare parts are treated differently from other materials and supplies. Such items are generally treated as expensed in the year in which the taxpayer disposes of such parts. [Reg. §1.162-3(a)(3)] Rotable spares parts are defined as materials and supplies “that are acquired for installation on a unit of property, removable from that unit of property, generally repaired or improved, and either reinstalled on the same or other property or stored for later installation.” [Reg. §1.162-3(c)(2)] Temporary spare parts are materials and supplies “that are used temporarily until a new or repaired part can be installed and then are removed and stored for later (emergency or temporary) installation.”

The regulations provide an alternative method that can be used for such parts. The taxpayer can deduct the cost of the parts when the part is first installed. However if such a part is later removed from a piece of property the taxpayer must include the fair value of the part in income at that point, deducting that amount only when the part is installed in another piece of equipment or is disposed of. The taxpayer also may not currently deduct any amounts paid to maintain, repair or improve the part, but must add them to the basis of the part. Both of the permissible methods are considered a method of accounting for income tax purposes, thus a taxpayer must ask for permission before being able to switch from one method to another.

A somewhat more generous option than the $200 cost option is available to taxpayers who meet certain criteria, and this option applies to items beyond merely materials and supplies (though the $200 rule is limited to materials and supplies).. The rule is somewhat different depending on whether a taxpayer has an “applicable financial


statement” or not. In the original proposed regulations only taxpayers with applicable financial statements could use the de minimis rule.

A more generous de minimis rule can be applied by a taxpayer who meets all of the following criteria [Reg. §1.263(a)-1T]:

A financial statement that is either:

o Filed with the Securities and Exchange Commission;

o A statement audited by an independent CPA that is used for credit purposes, reporting to equity holders or for any substantial non-tax purpose or

o A statement other than a tax return required to be provided to an agency of the federal or a state government (other than the IRS or the SEC)

The taxpayer had written accounting procedures in place at the beginning of the taxable year treating amounts below a certain figure as an expense for nontax purposes

The amounts are treated as an expense on the applicable financial statement

Items falling into this category have an invoice price of no more than $5,000

The temporary regulations previously had an aggregate limitation based the greater of a percentage of gross revenue or of financial statement depreciation. The invoice cost rule was substituted for this test to respond to complaints that the aggregate tests would have required accounting for all small items, while the whole purposes of a capitalization policy was to simplify the accounting process by eliminating such tracking.

Note that many privately held entities will not have an “applicable financial statement” under these rules and thus will not qualify for the de minimis method. However, the final regulations added a provision for such taxpayers, though with a significantly lowered invoice limit.

Such taxpayers must have procedures in place that insure consistent policies are followed regarding the capitalization policy and the items in question must be reflected as an expense on the taxpayer’s books and records. In this case, the taxpayer without an applicable financial statement may use a de minimis method, but the method is not available for any item whose invoiced price is more than $500.

The regulations do not require any specific language for such a capitalization policy—just that it be in force prior to the beginning of the tax year and that it be followed by the taxpayer for either its applicable financial statement (if the taxpayer has one) or in keeping its books and records (for a taxpayer without an applicable financial statement).


The preamble does make clear, though, that the IRS does intend to strictly enforce the rule that the accounting policy must be in force prior to the beginning of the tax year. The preamble gives the following comments in rejecting a suggestion to allow for a retroactive adoption of such a policy:

...[T]he final regulations are not applicable until taxable years beginning on or after January 1, 2014. Therefore, taxpayers without written accounting procedures that choose to elect the de minimis safe harbor for their 2014 taxable years should have sufficient time to consider and draft appropriate procedures prior to the applicability date of the final regulations. Moreover, the de minimis safe harbor is intended to provide recordkeeping simplicity to taxpayers by allowing them to follow an established financial accounting policy for federal tax purposes, and allowing retroactive application is inconsistent with such purpose.

Or, to put it more simply, the IRS believes that since taxpayers had over three months notice of the need to have such a policy in place, those who wished to use this method had ample notice of the need to develop such a policy.

Technically the final regulations do not specifically require the accounting procedures to be in writing for a taxpayer without an applicable financial statement (though a taxpayer with one must have it in writing), a lack of a written set of procedures would make it very difficult to show the procedures were actually in place as of the beginning of the year. [Reg. §1.263(a)-1(f)(1)(i)(B) as compared with Reg. §1.263(a)-1(f)(1)(ii)(B)]

The de minimis method cannot be used for amounts in inventory nor for land. [Reg. §1.263(a)-1]

A taxpayer using the de minimis rule must attach an election in conformity with the provisions of Reg. §1.263(a)-1 to its income tax return for the year in question.

Advisers should note that these rules do not mean that all items costing more than the allowed de minimis amounts will need to be capitalized even if the item otherwise qualifies for capitalization. The preamble to the proposed regulations contain the following language that clarifies that this is a relief provision, and that prior law rules (does your policy misstate income) will continue to be used for amounts in excess of the applicable invoice amount:

Finally, for both taxpayers with applicable financial statements and taxpayers without applicable financial statements, the de minimis safe harbor is not intended to prevent a taxpayer from reaching an agreement with its IRS examining agents that, as an administrative matter, based on risk analysis or materiality, the IRS examining agents will not review certain items. It is not intended that examining agents must now revise their materiality thresholds in accordance with the de minimis safe harbor limitations provided in the final regulation. Thus, if examining agents and a taxpayer agree that certain amounts in excess of the de minimis safe harbor limitations are not material or otherwise should not be subject to review, that agreement should be respected, notwithstanding the requirements of the de minimis safe harbor.


However, a taxpayer that seeks a deduction for amounts in excess of the amount allowed by the safe harbor has the burden of showing that such treatment clearly reflects income.

REPAIRS [Reg. §1.162-4]

The repairs regulation is modified to specify that an item may only be taken as a repair to tangible property if the amounts are not otherwise required to be capitalized.

CAPITAL EXPENDITURES – GENERAL RULE [Reg. §1.263(a)-1]

The regulation provides the general rule for capitalization in Reg. §1.263(a)-1 (a), noting that except as otherwise provided for in Title 1 of the IRC no deduction will be allowed for:

Any amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property or estate; or

Any amount paid in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.

Amounts paid to sell property, such as commissions and other transaction costs must be capitalized and treated as a reduction of the amount realized. The amount is taken into account in which the sale occurs or when the sale is abandoned if a loss is allowed. The capitalized amount does not add to the basis of the property, nor is it treated as an intangible under the intangible capitalization regulations of §1.263(a)-4. [Reg. §1.263-1(d)]

This provision is also effective for years beginning on or after January 1, 2014. Changes to comply with these provisions will be treated as a change in accounting method to which §§446 and 481 apply.

AMOUNTS PAID TO PRODUCE TANGIBLE PROPERTY [Reg. §1.263-2]

A taxpayer must capitalize amounts paid to “acquire or produce a unit of real or personal property” under this provision. Such items specifically include:

Leasehold improvements;

Land and land improvements;

Buildings;

Machinery;

Equipment;

Furniture and fixtures

The amount to be capitalized includes the invoice price, amounts paid to facilitate the acquisition or production of the property and costs for work performed prior to the


date the unit of property is placed in service (even if such work would have been treated as a repair had the property been in service, per the preamble the regulations). The general capitalization rules extend to amounts paid to acquire tangible property for resale, or costs to produce such property. [Reg. §1.263(a)-2(d)(1)]

An amount is treated as paid to facilitate the acquisition of the property if it is paid in the process of investigating or otherwise pursuing the acquisition. [Reg. §1.263(a)-2(f)(1)] The following costs are deemed inherently facilitative under Reg. §1.263(a)-2(f)(ii):

Transporting the property

Appraisals (or other costs to determine the value or price of the property)

Negotiation expenses

Tax advice related to the acquisition

Application fees, bidding costs or similar expenses

Preparing documents for the acquisition process

Examining and evaluating the title for the property

Obtaining regulatory approval or securing permits

Costs of conveying the property (such as sales taxes and title registration costs)

Finders fees and brokers commissions

Architectural, geological, engineering, environmental, or inspection services

Services of a qualified intermediary or other facilitator of a §1031 exchange

However, for real property amounts paid to determine which real property to obtain or whether to acquire the property are not considered an inherently facilitating amount. [Reg. §1.263(a)-2(f)(2)(iii)] Similarly, amounts paid for employee compensation and overhead are also treated as amounts that do not facilitate acquisition of either real or personal property, although a taxpayer may elect to capitalize such amounts. [Reg. §1.263(a)-2(f)(2)(iv)]

Amounts paid to defend or perfect title to real or personal property are considered a cost of acquisition and must also be capitalized. [Reg. §1.263(a)-2(e)(1)]

Changes in the treatment of items by a taxpayer are considered a change of accounting method subject to IRC §§446 and 481.

AMOUNTS TO IMPROVE TANGIBLE PROPERTY [REG. §1.263(a)-3T]


Generally a taxpayer must capitalize expenses paid to improve a unit of property owned by the taxpayer. [Reg. §1.263(a)-3(d)] A unit of property is improved if the amounts paid:

Result in a betterment of the property

Restore the unit of property

Adapt the unit of property to a new or different use

A unit of property is defined in Reg. §1.263(a)-3(e). Generally, each building and its structural components are treated as a single unit of property. For such buildings, an amount is to be treated as an improvement if the amount paid results to an improvement in any of the following:

Building structure

Building systems:

o HVAC systems

o Plumbing systems

o Electrical systems

o Escalators

o Elevators

o Fire protection and alarm systems

o Security systems

o Gas distribution systems

o Other structural components identified by the IRS in published guidance [Reg. §1.263(a)-3(e)(2)]

In the case of the owner of a condominium or cooperative, the unit of property is that portion of the building the taxpayer owns (for a condominium) or has rights to possess (in a cooperative). [Reg. §1.263(a)-3(e)(2)(iii), (iv)]

For property other than a building, generally, subject to the specified exceptions in the regulation, all the components that are functionally interdependent constitute a single unit of property. Functional interdependence is defined by looking at whether the placing of in service of one component is dependent on placing in service another component. [Reg. §1.263(a)-3(e)(3)(i)]

The “specially defined” units are listed below:


Plant Property – Such property is compromised of functionally interdependent machinery or equipment, other than network assets (defined next), used to perform an industrial process. In determining a unit of property in this case, the functionally interdependent group must be further subdivided, going beyond the general rule. In this case, the unit is each component (or group of components) that performs a discrete and major function or operation within the functionally interdependent group. [Reg. §1.263(a)-3(e)(ii)]

Network Property – This property is narrowly defined to include “railroad track, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines that are owned or leased by taxpayers in each of those respective industries.” However, it excludes any item that would be considered a building structure or building systems under the regulation, as well separate property adjacent to, but not a part of, the network asset. The determination of a unit of property in these cases is based on the taxpayer’s particular facts and circumstances (unless the IRS provides overriding published guidance). The functional interdependence test does not serve to determine the unit of property for this type of asset. [Reg. §1.263(a)-3(e)(iii)]

Leased Property Other Than Buildings – The general rule or, if applicable, one of the two special rules above, will apply to such property but with the caveat that the unit of property may not be larger than the unit of leased property. That is, the leased property could end up being multiple “units” of property under the regulations, but the property itself may not be incorporated into other property to determine a unit of property. [Reg. §1.263(a)-3(e)(iv)]

Regardless of the above rules, a component of a unit of property must be treated as separate units of property if the property belongs to a different MACRS class of property or the taxpayer had depreciated the component using a different method of depreciation than was used on the unit of property of which the component is a part. Similarly, if the taxpayer or IRS changes the determination of the MACRS class of property for the component in a later tax year, the component must be separated from the unit of property of which it was a part of and treated as a separate unit of property. [Reg. §1.263(a)-3(5)]

Special rules apply to improvements to leased property, as noted below:

Lessee Improvements – A lessee must capitalize the total amounts it pays to improve a unit of leased property unless IRC §110 (related to construction allowances) applies to the item or where the payment for the improvement constitutes a substitute for rent pursuant to Reg. §1.61-8(c). The lessee must also capitalize the amount the lessor pays to improve a unit of leased property if the lessee is the owner of the improvement except to the extent that section 110 applies to a construction allowance received by the lessee for the purpose of such improvement. The amount capitalized as a lessee improvement is a unit of property separate from the leased property. However any later expenditure to improve the leasehold improvement itself is not a separate unit of property, but rather is considered part of the leasehold improvement under the unit of property rules. [Reg. §1.263(a)-3(f)(1)]


Lessor Improvements – A lessor must capitalize amounts it pays to improve a unit of leased property (either directly or via a construction allowance) where the lessor is the owner of the improvement or to the extent that IRC §110 applies to the construction allowance. The lessor must also capitalize an improvement to the property paid for by the lessee that is a substitute for rent under Reg. §1.61-8(c). [Reg. §1.263(a)-3(f)(1)(iii)(A)] An amount capitalized by the lessor is not treated as a unit of property separate from the leased property. [Reg. §1.263(c)-3(f)(1)(iii)(B)]

Generally a taxpayer must capitalize all direct costs of an improvement and indirect costs that directly benefit or are incurred by reason of an improvement, using the uniform capitalization rules of §263A. Other costs, such as indirect costs that do not directly benefit and are not incurred by a reason of an improvement are not to be capitalized. An elective exception exists for property used as a residence. For such property not used in the taxpayer’s trade or business and not held for the production of income, an individual may capitalize amounts paid for repairs and maintenance that are made at the same time as capital improvements to the residence if paid as part of a remodeling of the taxpayer’s residence. [Reg. §1.263(a)-3(f)(3)]

A single improvement may be the aggregate of related amounts incurred over a period of more than one taxable year. Such a determination of individual improvements is made based on the facts and circumstances of the situation. [Reg. §1.263(a)-3(f)(4)]

A safe harbor is provided for routine maintenance on property other than buildings in Reg. §1.263(a)-3(g). Such maintenance will be deemed not to improve that unit of property. Routine maintenance includes the inspection, cleaning, and testing of the unit of property and replacement of parts of the unit of property with comparable and commercially available and reasonable replacement parts. To be considered such routine maintenance, the taxpayer has to expect to perform these services more than once during the class life (determined for purposes of the alternative depreciation system) of the property in question. [Reg. §1.263(a)-3(g)]

Regardless of the above, routine maintenance does not include any of the following:

Amounts paid for the replacement of a component of a unit of property and the taxpayer has properly deducted a loss for that component (other than a casualty loss under § 1.165-7).

Amounts paid for the replacement of a component of a unit of property and the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component.

Amounts paid for the repair of damage to a unit of property for which the taxpayer has taken a basis adjustment as a result of a casualty loss under section 165, or relating to a casualty event described in section 165.

Amounts paid to return a unit of property to its ordinarily efficient operating condition, if the property has deteriorated to a state of disrepair and is no longer functional for its intended use.


Amounts paid for repairs, maintenance, or improvement of rotable and temporary spare parts to which the taxpayer applies the optional method of accounting for rotable and temporary spare parts under § 1.162-3T(e). [Reg. §1.263(a)-3T(g)(3)]

The final regulations also add a provision for a small taxpayer building de minimis rule. For a taxpayer with average gross receipts for the prior 3 years of less than $10 million, if the total amount of maintenance type expenses on a building for the year is less than the lesser of $10,000 or 2% of the unadjusted basis of the building, the taxpayer will not have to make a determination regarding whether any of those expenses are an improvement if the taxpayer elects to use this option. The election limited to buildings with an unadjusted basis of $1,000,000 or less, and it’s an all or nothing situation—all such expenses, even if otherwise not required to be capitalized, must be totaled to see if an election is possible. If the total goes above the limit, then the taxpayer must use the other provisions of the regulations to determine whether any of the expenditures must be capitalized.

Generally a taxpayer must capitalize amounts that result in a betterment of the unit of property as defined in Reg. §1.263(a)-3(h). An amount paid results in a betterment only if the expenditure:

Ameliorates a material condition or defect that either existed prior to the taxpayer's acquisition of the unit of property or arose during the production of the unit of property, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production;

Results in a material addition (including a physical enlargement, expansion, or extension) to the unit of property; or

Results in a material increase in capacity (including additional cubic or square space), productivity, efficiency, strength, or quality of the unit of property or the output of the unit of property. [Reg. §1.263(a)-3(h)(1)]

For real property, a betterment occurs if there is an improvement in either the building structure or any of the enumerated building systems noted above, even if there is not a betterment in the building taken as a whole. [Reg. §1.263(a)-3(h)(2)]

The determination of whether there has been a betterment is based on the overall facts and circumstances of the situation. Factors to consider include:

Purpose of the expenditure

Physical nature of work performed

Effect of the expenditure on the unit of property

As well, other factors that appear relevant in the particular case should also be considered. [Reg. §1.263(a)-3(h)(3)(i)]


If a taxpayer is unable to obtain a comparable replacement part (due to technological advancements, product improvements, etc.), the mere fact that the part is replaced with an improved part will not, by itself, cause an expenditure to be treated as a betterment of the property. [Reg. §1.263(a)-3(h)(3)(ii)]

If a particular event (such as the failure of a part) necessitates the expenditure, a comparison to determine if a betterment has taken place is made by comparing the condition of the property immediately after the expenditure with that immediately before the circumstance triggering the need for the expenditure. If that event was normal wear and tear, the comparison is made to the property immediately after either the last time the maintenance for wear and tear was performed or, if such maintenance has not previously taken place, with the condition of the property when placed in service by the taxpayer. [Reg. §1.263(a)-3(h)(3)(iii)]

Expenditures to restore a unit of property must be capitalized. For purposes of these rules an amount is paid to restore a unit of property only if it:

Is for the replacement of a component of a unit of property and the taxpayer has properly deducted a loss for that component (other than a casualty loss under § 1.165-7);

Is for the replacement of a component of a unit of property and the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;

Is for the repair of damage to a unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss under section 165, or relating to a casualty event described in section 165;

Returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;

Results in the rebuilding of the unit of property to a like-new condition after the end of its class life; or

Is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property. [Reg. §1.263(a)-3(i)(1)]

As with betterments, with restorations of buildings the rules are applied to either the building structure or any of the enumerated building systems, with a restoration of either having to be capitalized. [Reg. §1.263(a)-3 (i)(2)]

Restoration to a “like-new” condition occurs if the unit of property is brought to “the status of new, rebuilt, remanufactured, or similar status under the terms of any federal regulatory guideline or the manufacturer's original specifications.” [Reg. §1.263(a)-3(i)(3)]


The test or replacement of a major component or substantial part of a unit of property is a facts and circumstances test, including both the qualitative and quantitative significance of the replaced component(s) in relation to the unit of property taken as a whole. A major component or structural part “includes a part or combination of parts that comprise a large portion of the physical structure of the unit of property or that perform a discrete and critical function in the operation of the unit of property.” [Reg. §1.263(a)-3(i)(4)]

Adapting a property to a new or different use involves an adaption that “is not consistent with the taxpayer's intended ordinary use of the unit of property at the time originally placed in service by the taxpayer.” Again for buildings this test is applied to the building structure and any of the building systems separately. [Reg. §1.263(a)-3(j)]

Taxpayers subject to the regulatory accounting rules of the Federal Energy Regulatory Commission (FERC), the Federal Communications Commission (FCC), or the Surface Transportation Board (STB) may elect to use the optional regulatory accounting method. A taxpayer must use this method for determining capitalized expenditures as opposed to repair expenditures for all property subject to the regulatory accounting rules and bases the determination on the position taken for regulatory accounting purposes. [Reg. §1.263(a)-4(k)]

The IRS has also reserved to itself the ability to outline new repair allowance methods by publishing them in the Federal Register or in an Internal Revenue Bulletin. [Reg. §1.263(a)-4(l)]

The temporary regulation applies to taxable years beginning on or after January 1, 2012 [Reg. §1.263(a)-4(p)]. The items covered in this regulation are methods of accounting subject to IRC §§446 and 481. Taxpayers changing their accounting methods to comply with this regulation will need to obtain the consent of the IRS to the change of method.

Conforming changes are made to the regulations under §§168 and 263A to take into account this guidance.

Each of the regulations have numerous examples illustrating the applications of the provisions. Taxpayers should review those examples as they attempt to implement this new capitalization vs. expense regulation. As well, taxpayers need to review what changes, if any, need to be made to capitalized assets and/or their own capitalization procedures to comply with the new regulation.

JULY 2014 REVISIONS

The IRS made some minor changes to the regulations in July 2014, primarily to clarify the election to capitalize materials and supplies that otherwise could be expensed. That election, found at Reg. §1.162-3(d)(3), was clarified to:

Change the wording for electing to capitalize. The original regulation said the election could be made by capitalizing the cost of the item and beginning to


recover the cost. The IRS decided that “depreciate” was more appropriate than “recover” and the word has been changed.

The revision also clarifies that this election is not available if an asset is acquired and disposed of in the same year.

ACCOUNTING METHOD CHANGE

In early 2014 the IRS updated the automatic accounting method change Revenue Procedure to deal with a portion of these revisions, modifying Revenue Procedure 2012-19 which previously had implemented method changes for the temporary regulations.

Revenue Procedures 2014-16 (http://www.irs.gov/pub/irs-drop/rp-14-16.pdf) and 2014-17 (http://www.irs.gov/pub/irs-drop/rp-14-17.pdf) provided updated relief for method changes. The Procedure also added new automatic change provisions for taxpayers to change from using UNICAP methods under §263A for real property acquired via a foreclosure proceeding or deed-in-lieu of foreclosure transaction. In Legal Advice Memorandum AM2013-001 the IRS had concluded that such lender acquired OREO (other real estate owned) was not subject to the UNICAP rules.

The procedure also contains an extension of time for electric transmission and distribution companies to apply the safe harbor method of accounting described in Revenue Procedure 2011-43 through the fourth taxpayer year ending after December 31, 2010. Previously the automatic change only applied for two taxable years ending after December 31, 2010.

Automatic accounting method changes are requested at the time the tax return is filed by completing Form 3115 in duplicate. One copy is sent to the designated IRS office (in this case Ogden, Utah) and the second copy is attached to the tax return for the year in question. Any necessary cumulative adjustment will be recovered under the standard rules found in IRC §481(a)—normally ratably over four years (beginning with the year of change) if the change is an addition to income and in the year of change if the change results in a decrease in cumulative income.

The automatic changes found in Revenue Procedures 2014-16 and 2014-17 were incorporated into Revenue Procedures 2015-13 (http://www.irs.gov/pub/irs-drop/rp-15-13.pdf) and 2015-14 Procedures 2015-13 (http://www.irs.gov/pub/irs-drop/rp-15-14.pdf), discussed under Section 446 in this manual.

II. FINAL 2014 REVISIONS TO §168(I) PARTIAL DISPOSITION/GENERAL ASSET ACCOUNTS (TD 9689, 8/18/14, REVENUE PROCEDURE 2014-54, 9/18/14)

The IRS has issued the last portion of the “repair” regulations, finalizing the rules for general asset accounts under §168(i) in TD 9689 (https://s3.amazonaws.com/public-inspection.federalregister.gov/2014-19403.pdf).










The final regulations generally follow the provisions found in the 2013 proposed regulations issued at the same time as all other final regulations that were part of the tangible asset/repairs project (TD 9636, 9/19/13).

Only minor changes were made to the proposed regulations issued in 2013. One set of changes related to dispositions involving demolition of structures governed by IRC §280B. The preamble describes these changes as follows:

In the case of a loss sustained on account of the demolition of a structure to which section 280B and §1.280B-1 apply, however, the loss is capitalized to the land on which the demolished structure was located, and no gain or loss is reported at the time of demolition. Nevertheless, a taxpayer generally will report a depreciation deduction for the demolished structure for the taxable year in which the demolition occurs.

The IRS also clarified rules related to determination of the unadjusted basis when disposing of a portion of a group asset. These rules interact with the revised treatment of buildings under the capitalization regulations for §280(a) by allowing taxpayers to write off, for instance, a structural component of a building (such as a roof) when that component is replaced and required to be capitalized under Reg. §1.263(a)-2.

The preamble notes:

The final regulations generally retain the rules in the 2013 proposed regulations on determining the unadjusted depreciable basis of an asset for which general asset account treatment is terminated. Because the general asset account is the asset, the final regulations provide that a taxpayer may use any reasonable method that is consistently applied to all assets in the same general asset account to determine the unadjusted depreciable basis of a disposed asset in that account if it is impracticable from the taxpayer's records to determine the unadjusted depreciable basis of that asset.

This rule also applies when the partial disposition rule applies to a disposition of a portion of an asset included in a general asset account. The IRS and the Treasury Department expect that reasonable methods are available that use information readily available or known to the taxpayer and do not necessitate undertaking an expensive study.

These final regulations also provide nonexclusive examples of reasonable methods. These examples are the same examples in the 2013 proposed regulations, except the final regulations do not include the Consumer Price Index as an example of a reasonable method for the reason previously discussed in II.E. Similar to the rules for determining the unadjusted depreciable basis of a disposed asset under §1.168(i)-8, the final regulations clarify that, when discounting the cost of the replacement asset, using the Producer Price Index for Finished Goods (or its successor, the Producer Price Index for Final Demand) is a reasonable method. The examples in the final regulations include the following: (1) discounting the cost of the replacement asset to its placed-in service year cost using the Producer Price Index for Finished Goods (or its successor, the Producer Price Index for Final Demand, or any other index


designated by guidance in the Internal Revenue Bulletin (see §601.601(d)(2) of the chapter) only if the replacement asset is a restoration under §1.263(a)-3(k) and is not a betterment under §1.263(a)-3(j) or is not an adaptation to a new or different use under §1.263(a)-3(l); (2) a pro rata allocation of the unadjusted depreciable basis of the general asset account based on the replacement cost of the disposed asset and the replacement cost of all of the assets in the general asset account; and (3) a study allocating the cost of the asset to its individual components.

The PPI tables are, unfortunately, not the simplest to extract from the Bureau of Labor Statistics site. However, the Federal Reserve Bank of St. Louis does maintain a site that, technically, is designed to provide a graphical view of the various Producer Price Indices. However, the data for both indices may be downloaded there as well.

The data for the older Producer Price Index: Finished Goods can be found at http://research.stlouisfed.org/fred2/series/PPIFGS/downloaddata while the data for the newer Producer Price Index for Final Demand (which begins in November 2009) can be found at http://research.stlouisfed.org/fred2/series/PPIFIS/downloaddata.

To use this method, the taxpayer would look up the index for the month when the building was first placed in service, then the month when the replacement took place. The portion of the unadjusted basis of the building that would be deemed to represent the replaced item would be computed as follows:

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑅𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 ×𝑃𝑃𝐼 𝑜𝑛 𝐵𝑢𝑖𝑙𝑑𝑖𝑛𝑔 𝑃𝑙𝑎𝑐𝑒𝑑 𝑖𝑛 𝑆𝑒𝑟𝑣𝑖𝑐𝑒 𝐷𝑎𝑡𝑒

𝑃𝑃𝐼 𝑜𝑛 𝑅𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝐷𝑎𝑡𝑒

A proportionate share of the depreciation taken on the building would be allocated to the replaced component, at which point a loss on disposition would be claimed based on the original cost of the component less its allocable share of depreciation on the building taken through the date of disposition.

The final regulations illustrate this calculation in the following example:

On July 1, 2011, E, a calendar-year taxpayer, purchased and placed in service an existing multi-story office building that costs $20,000,000. The cost of each structural component of the building was not separately stated. E accounts for the building and its structural components in its tax and financial accounting records as a single asset with a cost of $20,000,000. E depreciates the building as nonresidential real property and uses the optional depreciation table that corresponds with the general depreciation system, the straight-line method, a 39-year recovery period, and the mid-month convention. As of January 1, 2014, the depreciation reserve for the building is $1,261,000.

On June 30, 2014, E replaces one of the two elevators in the office building. E did not dispose of any other structural components of this building in 2014 and prior years. E makes the partial disposition election provided under paragraph (d)(2) of this section for this elevator. Although the office building, including its structural components, is the asset for disposition purposes, the result of E making the partial disposition election for the elevator is that the retirement of the replaced elevator is a disposition. Assume the replacement elevator is a

http://research.stlouisfed.org/fred2/categories/31

http://research.stlouisfed.org/fred2/categories/31

http://research.stlouisfed.org/fred2/series/PPIFGS/downloaddata

http://research.stlouisfed.org/fred2/series/PPIFIS/downloaddata


restoration under §1.263(a)-3(k), and not a betterment under § 1.263(a)-3(j)) or an adaptation to a new or different use under § 1.263(a)-3(l)).

Because E cannot identify the cost of the elevator from its records and the replacement elevator is a restoration under § 1.263(a)-3(k), E determines the cost of the disposed elevator by discounting the cost of the replacement elevator to its placed-in-service year cost using the Producer Price Index for Final Demand. Using this reasonable method, E determines the cost of the retired elevator by discounting the cost of the replacement elevator to its cost in 2011 (the placed-in-service year) using the Producer Price Index for Final Demand, resulting in $150,000 of the $20,000,000 purchase price for the building to be the cost of the retired elevator. Using the optional depreciation table that corresponds with the general depreciation system, the straight-line method, a 39-year recovery period, and the mid-month convention, the depreciation allowed or allowable for the retired elevator as of December 31, 2013, is $9,458.

For E’s 2014 Federal tax return, the loss for the retired elevator is determined as follows. The depreciation allowed or allowable for 2014 for the retired elevator is $1,763 ((unadjusted depreciable basis of $150,000 x depreciation rate of 2.564% for 2014) x 5.5/12 months). Thus, the adjusted depreciable basis of the retired elevator is $138,779 (the adjusted depreciable basis of $140,542 removed from the building cost less the depreciation allowed or allowable of $1,763 for 2014). As a result, E recognizes a loss of $138,779 for the retired elevator in 2014.

For E’s 2014 Federal tax return, the depreciation allowance for the building is computed as follows. As of January 1, 2014, the unadjusted depreciable basis of the building is reduced from $20,000,000 to $19,850,000 ($20,000,000 less the unadjusted depreciable basis of $150,000 for the retired elevator), and the depreciation reserve of the building is reduced from $1,261,000 to $1,251,542 ($1,261,000 less the depreciation allowed or allowable of $9,458 for the retired elevator as of December 31, 2013). Consequently, the depreciation allowance for the building for 2014 is $508,954 ($19,850,000 x depreciation rate of 2.564% for 2014).

E also must capitalize the amount paid for the replacement elevator pursuant to § 1.263(a)-3(k)(1). The replacement elevator is a separate asset for disposition purposes pursuant to paragraph (c)(4)(ii)(D) of this section and for depreciation purposes pursuant to section 168(i)(6).

Approximately a month after the final regulations were issue the IRS issued Revenue Procedure 2014-54, a 93 page document that provides additional automatic accounting method change options to handle the modifications made by these final regulations. This procedure is essentially the final portion of the accounting method change provisions related to the revised tangible property repair/capitalization regulations that took effect for years beginning after December 31, 2013.

The changes in the above Revenue Procedure were incorporated into Revenue Procedure 2015-14 which consolidated the outstanding automatic procedures into a






single, update list. Information on that procedure is round elsewhere under §446 in this manual.

ACCOUNTING METHODS TO BE CHANGED

Revenue Procedure 2015-14 provides the list of automatic changes which used to be in the appendix of Revenue Procedure 2011-14. Each of the sections has details on the nature of the change, the authority for the change, any special provisions that apply to the change, whether there is a deadline to obtain automatic relief and information that must be supplied with a request for the change.

As well, the change will contain information regarding whether an application for the specific change may be combined with another request on the same Form 3115, or whether separate Forms 3115 are required for each change.

Below is a list of the changes that are most likely to be relevant for dealing with the new repair/capitalization regulations.

Important note: This only a brief cross-reference to the key issues. Advisers must study and read the appropriate sections of the regulations as well as the accounting method change revenue procedures when completing Forms 3115 for specific taxpayers.

I. SECTION 6 – DEPRECIATION

Depreciation is affected by the repair/capitalization regulations largely because depreciation is the method generally used to recover costs that may end up having to be capitalize, as well as being the method previously used to recover costs that under the new rules would be recovered in the year of expenditure.

A. 6.01 Impermissible to Permissible Method of Accounting for Depreciation or Amortization

While not technically part of most repair regulations changes, the fact that taxpayers will likely due a more detailed review of depreciation schedules means that advisers may be confronted with property that has been depreciated over an erroneous MACRS life. This change allows correcting for that issue for any property that is still held by the taxpayer at the end of the tax year.

This automatic change does not generally apply to taxpayers using various “non-MACRS” depreciation methods. But for most taxpayers this allows a “one year fix” for a depreciable life problem.

Section 6.01(c)(3)(b) provides that the following statements, if applicable, must be attached to a request for a change under this provision:

a detailed description of the present and proposed methods of accounting. A general description of these methods of accounting is unacceptable (for example, MACRS to MACRS, erroneous method to


proper method, claiming less than the depreciation allowable to claiming the depreciation allowable);

to the extent not provided elsewhere on the Form 3115, a statement describing the taxpayer's business or income-producing activities. Also, if the taxpayer has more than one business or income-producing activity, a statement describing the taxpayer's business or income-producing activity in which the item of property at issue is primarily used by the taxpayer;

to the extent not provided elsewhere on the Form 3115, a statement of the facts and law supporting the proposed method of accounting, new classification of the item of property, and new asset class in, as appropriate, Rev. Proc. 87-56 or Rev. Proc. 83-35. If the taxpayer is the owner and lessor of the item of property at issue, the statement of the facts and law supporting the new asset class also must describe the business or income-producing activity in which that item of property is primarily used by the lessee;

to the extent not provided elsewhere on the Form 3115, a statement identifying the year in which the item of property was placed in service by the taxpayer;

if any item of property is public utility property within the meaning of § 168(i)(10) or former § 167(I)(3)(A), as applicable, a statement providing that the taxpayer agrees to the following additional terms and conditions:

o a normalization method of accounting (within the meaning of former § 167(I)(3)(G), former § 168(e)(3)(B), or § 168(i)(9), as applicable) will be used for the public utility property subject to the Form 3115;

o as of the beginning of the year of change, the taxpayer will adjust its deferred tax reserve account or similar reserve account in the taxpayer's regulatory books of account by the amount of the deferral of federal income tax liability associated with the § 481(a) adjustment applicable to the public utility property subject to the Form 3115; and

o within 30 calendar days of filing the federal income tax return for the year of change, the taxpayer will provide a copy of the completed Form 3115 to any regulatory body having jurisdiction over the public utility property subject to the Form 3115;

if the taxpayer is changing the classification of an item of § 1250 property placed in service after August 19, 1996, to a retail motor fuels outlet under § 168(e)(3)(E)(iii), a statement containing the following representation: “For purposes of § 168(e)(3)(E)(iii) of the Internal Revenue Code, the taxpayer represents that (A) 50 percent or more of


the gross revenue generated from the item of § 1250 property is from the sale of petroleum products (not including gross revenue from related services, such as the labor cost of oil changes and gross revenue from the sale of nonpetroleum products such as tires and oil filters), (B) 50 percent or more of the floor space in the item of property is devoted to the sale of petroleum products (not including floor space devoted to related services, such as oil changes and floor space devoted to nonpetroleum products such as tires and oil filters), or (C) the item of § 1250 property is 1,400 square feet or less.”; and

if the taxpayer is changing the classification of an item of property from § 1250 property to § 1245 property under § 168 or former § 168, a statement of the facts and law supporting the new § 1245 property classification, and a statement containing the following representation: “Each item of depreciable property that is the subject of the Form 3115 filed under section 6.01 of Rev. Proc. 2015-14 for the year of change beginning [Insert the date], and that is reclassified from [Insert, as appropriate: nonresidential real property, residential rental property, qualified leasehold improvement property, qualified restaurant property, qualified retail improvement property, 19-year real property, 18-year real property, or 15-year real property] to an asset class of [Insert, as appropriate, either: Rev. Proc. 87-56, 1987-2 C.B. 674, or Rev. Proc. 83-35, 1983-1 C.B. 745] that does not explicitly include § 1250 property, is § 1245 property for depreciation purposes.”

The ruling provides for a simplified Form 3115 filing for qualifying small taxpayers. To qualify for this reduced filing requirement, the taxpayer must be one whose average annual gross receipts, as determined under §1.263(a)-3(h)(3), for the three preceding taxable years is less than or equal to $10,000,000.

In that case, the taxpayer files the following information as part of the Form 3115:

The identification section of page 1 (above Part I);

The signature section at the bottom of page 1;

Part I;

Part II, all lines except lines 11, 13, 14, 15, and 17;

Part IV, all lines except line 24; and

Schedule E

If multiple assets are affected by the change, the taxpayer may file a single Form 3115 covering all assets. The ruling provides:


A taxpayer making this change for more than one asset for the same year of change should file a single Form 3115 for all such assets and provide a single net § 481(a) adjustment for all the changes included in that Form 3115. If one or more of the changes in that single Form 3115 generate a negative § 481(a) adjustment and other changes in that same Form 3115 generate a positive § 481(a) adjustment, the taxpayer may provide a single negative § 481(a) adjustment for all the changes that are included in that Form 3115 generating such adjustment and a single positive § 481(a) adjustment for all the changes that are included in that Form 3115 generating such adjustment. For example, a taxpayer files a single Form 3115 to change the depreciation methods, recovery periods, and/or conventions under § 168(a) resulting from the reclassification of two computers from nonresidential real property to 5-year property, one office desk from nonresidential real property to 7-year property, and two office desks from 5-year property to 7-year property. On that Form 3115, the taxpayer must provide either (i) a single net § 481(a) adjustment that covers all the changes resulting from all of these reclassifications, or (ii) a single negative § 481(a) adjustment that covers the changes resulting from the reclassifications of the two computers and one office desk from nonresidential real property to 5-year property and 7-year property, respectively, and a single positive § 481(a) adjustment that covers the changes resulting from the reclassifications of the two office desks from 5-year property to 7-year property.

The taxpayer may also file a single Form 3115 if it is making a related change to various UNICAP issues under §263A.

The designated accounting method change for this change is “7.”

B. 6.17 Impermissible to Permissible Method of Accounting for Depreciation for Disposed Depreciable or Amortizable Property

This ruling is the sister provision to 6.01 described above. This deals with the case where the taxpayer discovers the error that affects an asset not held at year end, thus impacting the depreciation that should have been claimed on disposed of asset as opposed to the depreciation that actually was claimed.

The depreciation issue will have an impact on the gain/loss on sale, including the nature and amount of such gain/loss. It also may allow a taxpayer to avoid the “allowed/allowable” problem where a taxpayer that should have depreciated an asset more quickly is penalized upon the sale of the asset with having gain/loss computed as if the larger depreciation amount had been computed.

A taxpayer making this change must take the entire change into account in th year of disposition.


The small taxpayer reduced filing rules noted above apply to this change. Similarly, if the taxpayer had more than one affected asset that is not around at year end a single 3115 may be used for all affected assets.

The designated automatic change is “107.”

C. 6.38 Disposition of a building or structural component (§ 168; § 1.168(i)-8)

This change affects the ability to dispose of “part” of a building.

The change only applies to the following changes in methods of accounting for a building (including its structural components), condominium unit (including its structural components), cooperative unit (including its structural components), or an improvement or addition (including its structural components) thereto:

For purposes of applying § 1.168(i)-8(c)(4) (determination of asset disposed of), a change to the appropriate asset as determined under § 1.168(i)-8(c)(4)(ii)(A), (B), or (D), as applicable;

If the taxpayer makes the change specified in section 6.38(3)(a) of this revenue procedure, and if the taxpayer disposed of the asset as determined under section 6.38(3)(a) of this revenue procedure or disposed of a portion of such asset in a taxable year prior to the year of change but under its present method of accounting continues to deduct depreciation for such disposed asset or such disposed portion, a change from depreciating the disposed asset or disposed portion to recognizing gain or loss upon disposition;

If the taxpayer’s present method of accounting for its buildings (including their structural components), condominium units (including their structural components), cooperative units (including their structural components), and improvements or additions (including its structural components) thereto that are depreciated under § 168 is in accord with § 1.168(i)-8(c)(4)(ii)(A), (B), and (D), and if the taxpayer disposed of an asset as determined under § 1.168(i)-8(c)(4)(ii)(A), (B), or (D), as applicable, or disposed of a portion of such asset in a taxable year prior to the year of change but under its present method of accounting continues to deduct depreciation for such disposed asset or such disposed portion, a change from depreciating the disposed asset or disposed portion to recognizing gain or loss upon disposition;

A change in the method of identifying which assets in multiple asset accounts or which portions of assets have been disposed of from a method of accounting not specified in § 1.168(i)-8(g)(1) or (2)(i), (ii), or (iii) (for example, the last-in, first-out (LIFO) method of accounting) to a method of accounting specified in § 1.168(i)-8(g)(1) or (2)(i), (ii), or (iii), as applicable;


If § 1.168(i)-8(f)(2) applies (disposition of an asset in a multiple asset account) and it is practicable from the taxpayer’s records to determine the unadjusted depreciable basis of the disposed asset, a change in the method of determining the unadjusted depreciable basis of the disposed asset from a method of not using the taxpayer’s records to a method of using the taxpayer’s records;

If § 1.168(i)-8(f)(2) applies (disposition of an asset in a multiple asset account) and it is impracticable from the taxpayer’s records to determine the unadjusted depreciable basis of the disposed asset, a change in the method of determining the unadjusted depreciable basis of all assets in the same multiple asset account from an unreasonable method (for example, discounting the cost of the replacement asset to its placed-in-service year cost using the Consumer Price Index) to a reasonable method;

If § 1.168(i)-8(f)(3) applies (disposition of a portion of an asset) and it is practicable from the taxpayer’s records to determine the unadjusted depreciable basis of the disposed portion of the asset, a change in the method of determining the unadjusted depreciable basis of the disposed portion of the asset from a method of not using the taxpayer’s records to a method of using the taxpayer’s records;

If § 1.168(i)-8(f)(3) applies (disposition of a portion of an asset) and it is impracticable from the taxpayer’s records to determine the unadjusted depreciable basis of the disposed portion of the asset, a change in the method of determining the unadjusted depreciable basis of the disposed portion of the asset from an unreasonable method (for example, discounting the cost of the replacement portion of the asset to its placed-in-service year cost using the Consumer Price Index) to a reasonable method; or

A change from recognizing gain or loss under § 1.168(i)-8T upon the disposition of an asset (as determined under § 1.168(i)-8(c)(4)(ii)(A), (B), or (D), as applicable) included in a general asset account to recognizing gain or loss upon the disposition of the same asset under § 1.168(i)-8 if: (A) the taxpayer makes the change specified in section 6.34 of this revenue procedure (revocation of a general asset account election); (B) the taxpayer made a qualifying disposition election under § 1.168(i)-1T(e)(3)(iii) in a taxable year prior to the year of change for the disposition of such asset; (C) the taxpayer’s present method of accounting for such asset is in accord with § 1.168(i)-8(c)(4)(ii)(A), (B), or (D), as applicable; and (D) the taxpayer recognized a gain or loss under § 1.168(i)-8T upon the disposition of such asset in a taxable year prior to the year of change.

Put more simply, this change will allow a taxpayer who currently has, say, a roof on his/her depreciation schedule to determine a write off the portion of the building that represented the roof when acquired.


To compute this adjustment you must take the cost of the prior replacement, then discount that using the appropriate producer price index (at least if you wish to use the safe harbor, which seems most appropriate) to the date of the original acquisition.

However you don’t stop here. Now you have to determine how much depreciation was taken on that part of the building through the start of the year. That’s not difficult—it will be the proportionate share of the total building depreciation (if the replacement, when discounted, represents 5% of the original building cost, then 5% of the accumulated depreciation at the first of the year will relate to this item to be disposed of).

As well, the depreciation schedule will need to be adjusted to remove both the cost and proportionate share of assets.

The IRS provides three examples of applying this automatic change:

Example 1. X, a calendar-year taxpayer, acquired and placed in service a building and its structural components in 2000. In 2005, X constructed and placed in service an addition to this building. X depreciates the building, the addition, and their structural components under § 168. A change by X to treating the original building (including its structural components) as an asset and the addition to the building (including the structural components of such addition) as a separate asset for disposition purposes is a change described in section 6.38(3)(a) of this revenue procedure solely for purposes of § 1.168(i)-8(c)(4).

Example 2. Y, a calendar year taxpayer, acquired and placed in service a building and its structural components in 1990. Y depreciates this building and its structural components under § 168. In 2000, a tornado damaged the roof and, as a result, Y replaced the entire roof of the building. Y did not recognize a loss on the retirement of the original roof and continues to depreciate the original roof. Y also capitalized the cost of the replacement roof and has been depreciating this roof under § 168 since 2000. Because the original roof was disposed of as a result of a casualty event described in § 165, a change by Y from depreciating the original roof to recognizing a loss upon its retirement is a covered change described in section 6.38(3)(c) of this revenue procedure solely for purposes of § 1.168(i)-8.

Example 3. The facts are the same as in Example 2, except a tornado did not occur, but Y still replaced the entire roof of the building in 2000. Because the original roof was not disposed of as a result of any of the events described in § 1.168(i)-8(d)(1) that require a partial disposition, a partial disposition election must be made to change from depreciating the original roof to recognizing a loss upon its retirement. Pursuant to section 6.38(1)(b)(iv) of this revenue procedure, section 6.38 does not apply to the disposition of the original roof in 2000. But see section 6.33 of this revenue procedure for making the late partial disposition election under § 1.168(i)-8(d)(2)(i) for the original roof.


Certain information must be attached to a return when making this change. That information includes:

A description of the assets to which this change applies;

If the taxpayer is making a change specified in section 6.38(3)(a) of this revenue procedure [a change in determining the appropriate asset], a description of the assets for disposition purposes under the taxpayer’s present and proposed methods of accounting;

If the taxpayer is making the change specified in section 6.38(3)(d) of this revenue procedure [assets in multiple asset accounts], a description of the methods of identifying which assets have been disposed of under the taxpayer’s present and proposed methods of accounting;

If the taxpayer is making the change specified in section 6.38(3)(f) or (h) [change in discounting from impermissible to permissible method—that is, using the PPI instead of the CPI] of this revenue procedure, a description of the methods of determining the unadjusted depreciable basis of the disposed asset or disposed portion of the asset, as applicable, under the taxpayer’s present and proposed methods of accounting; and

If any asset is public utility property within the meaning of § 168(i)(10), a statement providing that the taxpayer agrees to the following additional terms and conditions:

o A normalization method of accounting (within the meaning of § 168(i)(9)) will be used for the public utility property subject to the application;

o As of the beginning of the year of change, the taxpayer will adjust its deferred tax reserve account or similar account in the taxpayer’s regulatory books of account by the amount of the deferral of federal income tax liability associated with the § 481(a) adjustment applicable to the public utility property subject to the application; and

o Within 30 calendar days of filing the federal income tax return for the year of change, the taxpayer will provide a copy of the completed application to any regulatory body having jurisdiction over the public utility property subject to the application.

This automatic change also qualifies for reduced reporting rules on the Form 3115 for small taxpayers.

A taxpayer making this change for multiple assets can file a single Form 3115. As well, the taxpayer can combine this request on a single Form 3115 with changes under the following provisions:


A change under section 6.01 of this revenue procedure [Impermissible to permissible method of depreciation or amortization];

A change under section 6.37 of this revenue procedure;

A change under section 6.39 of this revenue procedure; and

A change under section 6.40 of this revenue procedure.

There is another list of “combined” rulings if the taxpayer is making a concurrent change for revocation of a general asset election.

The designated change number for this change is “205.”

D. 6.39 Dispositions of tangible depreciable assets (other than a building or its structural components) (§ 168; § 1.168(i)-8)

This is a similar exception to the one found at 6.38, except it applies to assets other than buildings (such as land improvements, including parking lots and the like).

The designated automatic change number for this change is “206.”

E. 6.40 Dispositions of tangible depreciable assets in a general asset account (§ 168(i)(4); § 1.168(i)-1)

Another “similar” change, this time relating to assets subject to a general asset account election.


F. 6.41 Summary Table of Changes

This section contains a summary table of changes affecting dispositions of MACRS property. So if you are looking for something, this is a place to start.

II. SECTION 10 – CAPITALIZATION UNDER §263(A)

Section 10 deals with capital expenditures in general. This includes the general purpose “tangible property” changes under which a large number of changes in the final repair/capitalization changes are consolidated.

A. 10.03 Removal Costs

Under the final regulations, a taxpayer may write off removal costs when it replaces an asset (such as a roof) as part of the costs of the old assets. If taxpayer had instead been capitalizing such costs, this provides another opportunity for a negative adjustment and a reduction in taxes.

The small taxpayer rules described earlier apply to this ruling.



B. 10.11 Tangible property

This particular automatic change is actually a combination of a number of changes contained in both the original temporary and now new final regulations.

The ruling starts with a list of changes in the regulations which are not covered by the items listed in this section. Note that for these generally either there is another accounting method change provided for in Revenue Procedure 2013-14 or an election that, for a single year, allows a taxpayer to ignore the standard rules is involved.

The changes not covered by 10.11 include:

A taxpayer that wants to change its method of accounting for dispositions of depreciable property, including a change in the asset disposed of (but see sections 6.29, 6.30, 6.31, 6.33, 6.34, and 6.35 of this revenue procedure);

Amounts paid or incurred for certain materials and supplies that the taxpayer has elected to capitalize and depreciate under § 1.162-3(d);

Amounts paid or incurred to which the taxpayer has elected to apply the de minimis safe harbor under § 1.263(a)-1(f);

Amounts paid or incurred for employee compensation or overhead that the taxpayer has elected to capitalize under § 1.263(a)-2(f)(2)(iv)(B);

Amounts paid or incurred to which the taxpayer has elected to apply the safe harbor for small taxpayers under § 1.263(a)-3(h);

Amounts paid or incurred for repair and maintenance costs that the taxpayer has elected to capitalize under § 1.263(a)-3(n); or

Amounts paid or incurred to facilitate the acquisition or disposition of assets that constitute a trade or business (but see section 10.05 of this revenue procedure)

Changes that are covered by 10.11 in the final regulations are listed as:

A change to deducting amounts paid or incurred to acquire or produce non-incidental materials and supplies in the taxable year in which they are first used in the taxpayer’s operations or consumed in the taxpayer’s operations in accordance with §§ 1.162-3(a)(1) and 1.162-3(c)(1);

A change to deducting amounts to acquire or produce incidental materials and supplies in the taxable year in which paid or incurred in accordance with §§ 1.162-3(a)(2) and 1.162-3(c)(1);


A change to deducting amounts paid or incurred to acquire or produce non-incidental rotable and temporary spare parts in the taxable year which the taxpayer disposes of the parts in accordance with §§ 1.162-3(a)(3) and 1.162-3(c)(2);

A change to the optional method of accounting for rotable and temporary spare parts in accordance with § 1.162-3(e);

A change to deducting amounts paid or incurred for repair and maintenance in accordance with § 1.162-4, including a change, if any, in identifying the unit of property under § 1.263(a)-3(e) or, in the case of a building, identifying the building structure or building systems under § 1.263(a)-3(e)(2) for purposes of making the change to deducting the amounts;

A change to capitalizing amounts paid or incurred for improvements to tangible property in accordance with § 1.263(a)-3 and, if depreciable, to depreciating such property under § 167 or § 168, including a change, if any, in identifying the unit of property under § 1.263(a)-3(e) or, in the case of a building, identifying the building structure or building systems under § 1.263(a)-3(e)(2) for purposes of making the change to capitalizing the amounts;

A change by a dealer in property to deduct amounts paid or incurred for commissions and other costs that facilitate the sale of property in accordance with § 1.263(a)-1(e)(2);

A change by a non-dealer in property to capitalizing amounts paid or incurred for commissions and other costs that facilitate the sale of property in accordance with § 1.263(a)-1(e);

A change to capitalizing amounts paid or incurred to acquire or produce property in accordance with § 1.263(a)-2, and if depreciable, to depreciating such property under § 167 or § 168;

A change to deducting amounts paid or incurred in the process of investigating or otherwise pursuing the acquisition of real property if the amounts meet the requirements of § 1.263(a)-2(f)(2)(iii); and

A change to the optional regulatory accounting method in accordance with § 1.263(a)-3(m) to determine whether amounts paid or incurred to repair, maintain, or improve tangible property are treated as deductible expenses or capital expenditures.

Note that a similar list is provided for provisions in the temporary regulations, assuming a taxpayer is adopting those for the interim years.

The following additional information is required to be provided as part of the request for changes under 10.11:


The citation to the paragraph of the final tangible property regulations or temporary tangible property regulations that provides for the proposed method, or methods, of accounting to which the taxpayer is changing (for example, § 1.162-3(a), § 1.263(a)-3(i), § 1.263(a)-3(k)); and

If the taxpayer is changing any unit(s) of property under § 1.263(a)-3(e) (or § 1.263(a)-3T(e)) or, in the case of a building, is changing the identification of any building structure(s) or building system(s) under § 1.263-3(e)(2) (or § 1.263-3T(e)(2)) for purposes of determining whether amounts are deducted as repair and maintenance costs under section § 1.162-4 (or § 1.162-4T) or capitalized as improvement costs under § 1.263(a)-3 (or § 1.263(a)-3T), the taxpayer must include a detailed description of the unit(s) of property, building structure(s), or buildings system(s) used under its present method of accounting and a detailed description of the unit(s) of property, building structure(s), and building system(s) under its proposed method of accounting, together with a citation to the paragraph of the final regulation or temporary regulation under which the unit of property is permitted.

A taxpayer changing its method of accounting under this section 10.11 to capitalizing amounts paid or incurred and to depreciating such property under § 167 or § 168, as applicable, must complete Schedule E of Form 3115.

Obviously, advisers are going to want to pay particular attention the 1.XXX-0 regulations in the set, as they contain the tables of contents for each set of regulations that will greatly assist in picking up the proper regulation section—as well as the list of regulation citations in the DCN table reproduced below and found in a table at the end of 10.11.

As well, the taxpayer must provide an itemized listing of each change being made under 10.11. The taxpayer making more than one change must also include:

The information required by Part IV, line 25 for each change in method of accounting (including the amount of the § 481(a) adjustment for each change in method of accounting, which includes the portion of the § 481(a) adjustment attributable to UNICAP);

The information required by Part II, line 12 of Form 3115 for each change; and

The citation to the paragraph of the final tangible property regulations or temporary tangible property regulations that provides for each proposed method of accounting.

For certain changes, the §481(a) adjustment is only to take into account only amounts paid or incurred for taxable years beginning on or after January 1,


2014—that is, a “cut-off” method for those adopting in 2014. For all other adjustments the adjustment is not so limited.

Those adjustments that only consider amounts paid for taxable years beginning on or after January 1, 2014 are:

§ 1.162-3 [Materials and supplies] (except § 1.162-3(e)) [Optional method of accounting for rotable spare parts],

§ 1.263(a)-2(f)(2)(iii) [Special rules on acquisition costs of real property]

§ 1.263(a)-2(f)(3)(ii), [Treatment of inherently facilitative costs allocable to property not acquired]

§ 1.263(a)-3(m), [Optional regulatory accounting method]

§ 1.263A-1(e)(2)(i)(A), [Direct material costs] and

§ 1.263A-1(e)(3)(ii)(E) [Indirect material costs]

The changes covered by Section 10.11 (and which, therefore, may be combined on a single Form 3115 filing) are:

1. DCN 184 General Repair to Depreciable (§§1.162-4, 1.263(a)-3)

2. DCN 185 Change to Regulatory Accounting Method (§1.263(a)-3(m)

3. DCN 186 Deducting Non-Incidental Supplies When Used or Consumed (§§ 1.162-3(a)(1), (c)(1))

4. DCN 187 Change to Deducting Incidental Materials and Supplies When Paid or Incurred

5. DCN 188 Change to Deducting Non-Incidental Rotable and Temporary Spare Parts When Disposed Of

6. DCN 189 Change to the Optional Method for Rotable and Temporary Spare Parts

7. DCN 190 Change by a Dealer in Property to Deduct Commissions and Other Costs That Facilitate the Sale of Property

8. DCN 191 Change by a Non-Dealer in Property to Capitalizing Commissions and Other Costs That Facilitate the Sale of Property

9. DCN 192 Change to capitalizing acquisition or production costs and, if depreciable, to depreciating such property under § 167 or § 168

10. DCN 193 Change to Deducting Certain Costs for Investigating or Pursuing the Acquisition of Real Property (Whether and Which).

Form 3115 and the New Repair Regulations

Nichols Patrick CPE, Inc.Edward K. Zollars, CPA

[email protected]

www.currentfederaltaxdevelopments.com

Executive Summary

• Officially requires lots of Forms 3115

• Expected practical impact will be

– Change how repair vs. capitalize is determined

– New elections that need to be tracked

– Force fewer repairs for buildings

• What now?

– Start using new rules and consider elections

– Understand issues on Form 3115

Nichols Patrick CPE, Inc. © 2015

The Tax Curriculum Slides-1 Nichols Patrick CPE, Incorporated

mailto:[email protected]

http://www.cperesources.com/

http://www.currentfederaltaxdevelopments.com/

Repair vs. Capitalize

• Always a matter of dispute between taxpayers and the IRS

• Supreme Court found the default treatment is capitalization


Indopco v. Commissioner, 503 US 79

In exploring the relationship between deductions and capital expenditures, this Court has noted the "familiar rule" that "an income tax deduction is a matter of legislative grace and that the burden of clearly showing the right to the claimed deduction is on the taxpayer." Interstate Transit Lines v. Commissioner, 319 U.S. 590, 593 (1943); Deputy v. Du Pont, 308 U.S. 488, 493 (1940); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). The notion that deductions are exceptions to the norm of capitalization finds support in various aspects of the Code. Deductions are specifically enumerated and thus are subject to disallowance in favor of capitalization. See sections 161 and 261. Nondeductible capital expenditures, by contrast, are not exhaustively enumerated in the Code; rather than providing a "complete list of nondeductible expenditures," Lincoln Savings, 403 U.S., at 358, section 263 serves as a general means of distinguishing capital expenditures from current expenses. See Commissioner v. Idaho Power Co., 418 U.S., at 16. For these reasons, deductions are strictly construed and allowed only "as there is a clear provision therefor." New Colonial Ice Co. v. Helvering, 292 U.S., at 440; Deputy v. Du Pont, 308 U.S., at 493. 4



Section 263 & 162

• Despite default, IRS found courts were looking at the repair regulation first

• Thus we got results under the old regulations that weren't always to the IRS’s liking, though they sometimes were


No “Capitalization Policy” Policy

• Prior law provided no option for using a capitalization policy – see Alacare Home Services, TC Memo 2001-149

Petitioner contends that we have sanctioned the use of a minimum expensing rule, citing Galazin v. Commissioner, T.C. Memo. 1979-206, in which we allowed the taxpayer to deduct the cost of a calculator due to the small amount of the expenditure ($52.45) and the relatively short (2-year) useful life of the asset. Here, respondent disallowed deductions of $467,944 and $351,543 for the disputed items. These amounts are not comparable to the amount at issue in Galazin. Cf. Sharon v. Commissioner, 66 T.C. 515, 527 (1976) (taxpayer must capitalize $801 bar examination fees and expenses to practice law in California because amount was too large to disregard its capital nature), affd. 591 F.2d 1273 (9th Cir. 1978).



IRS Repair Losses Under Old Regulations

• Roof cases – amount of expense not the key, rather it is an issue of proper thing to measure improvement against

– Oberman Manufacturing Co. v. Commissioner, 47 T.C. 471 (1967)

– Thomas J. Northen v. Commissioner, TC Summary Opinion 2003-113 (among others)

• Aircraft engine rebuild also a repair – FedEx Corporation v. U.S., CA6, 2005-1 USTC ¶50,186


Overview• Latest attempt by IRS to provide guidance on the

deductibility (or required capitalization) of amounts paid (or incurred) to acquire, produce, or improve tangible property– Changes to fifteen regulation sections

• Nine relate to Code Secs. 162 – 168• Four relate to Code Sec. 263(a)• One relates to Code Sec. 263A• One relates to Code Sec. 1016

– Numerous examplesReleased as final 9/19/13 (except general asset disposition,

issued 8/18/14), all effective 1/1/2014 (elective 1/1/12)



Overview (continued)• IRS acknowledges difficulty of applying the rules in

practice, but offers these general distinctions

– Repair – deduct

– Renovation – capitalize

– Betterment – capitalize

– Adapt - capitalize


Overview (continued)• The overriding purpose of these regulations is

to change the approach to deductibility, from:

– Looking 1st to Sec. 162 . . . Is it deductible ? To . . .

– Looking 1st to Sec. 263 . . . Is it capitalizable ?

• Some of the rules changed by these regulations were last addressed in 1956 and 1960



Overview (continued)• Two Revenue Procedures issued in early

January 2014

– Offered instructions for changing accounting methods

– Generally will need to use for first tax year beginning in 2014 (date of required use of revised regulations)

– If change made under old Rev. Procs

• By default those rules apply

• However taxpayer may file an amended change


Overview (continued)

• Rev. Proc. 2014-16 explains automatic accounting method changes to determining the amount of allowable deduction

• Rev. Proc. 2014-17 explains automatic accounting method changes to depreciation and cost recovery

• Note – officially large numbers of taxpayers will be required to prepare a Form 3115 to handle the various changes in accounting methods



Overview (Continued)

• Revenue Procedure 2014-54, issued 9/18/14

– Follow issuance of final regulations on disposals

– 93 pages, gives additional guidance

– Again, automatic changes


Overview (Continued)

• Revenue Procedures 2015-13 and 2013-14

– Revenue Procedure 2015-13 contains procedures for accounting method changes

– Revenue Procedure 2015-14 contains the list of automatic changes

– Replaces older procedures, including earlier repair regulations ones



Course Overview

• Will look at issues in new regulations

• Examples of Form 3115 information

– Should not be used verbatim—must adopt the disclosures to the particular taxpayer

– Meant to show the basic templates to be used for the various changes

• Also consider the annual election


Accounting Methods

What Are They?


Accounting Methods

• Accounting method

– Affects timing of recognition

– Does not change ultimate amount recognized

• CCA 201345025 example of difference

– Deducted commissions twice, once when accrued and once when paid

– Not accounting method


Accounting Method

• Generally must method used on taxpayer’s books [IRC §446(a)], but IRC may override

• Taxpayer is required to have books and records to support return [Reg. §1.1446-1(a)(4)]

• Books is not necessary a formal ledger [Reg. §1.446-1(b)(7)]

• Generally need multiple years consistent treatment to establish a method



Requesting a Change

• Governed by Section 6 of Revenue Procedure 2015-13

• Generally separate Form 3115 for each method change unless IRS allows for combination [Sec 6.02(1)]

• For automatic change, must provide change number [Sec 6.02(3)]

• Must be signed by taxpayer and preparer [Sec 6.02(8)]


Automatic Changes

• Not filed within year of change [Sec 6.03(1)(a)]

– Original attached to original tax return for year of change [Sec 6.03(1)(a)(i)(A)]

– Copy to IRS Office in Ogden, Utah

• Must be filed after year ends but

• On or before date return is filed [Sec 6.03(1)(a)(i)(B)]

• No user fee [Sec 6.03(1)(c)]

• No IRS acknowledgment [Sec 6.03(1)(d)]



§481(a) Adjustment

• Tax equivalent of cumulative effect of accounting change under GAAP

• Not impacted by “statute of limitations” issue

• Recover difference

– Positive difference for voluntary change, ¼ in year of change, ¼ in each of next 3 years

– Negative change taken into account in year of change


Example Adjustment


Example 1. A taxpayer that is not required to use inventories uses the overall cash receipts and disbursements method of accounting and changes to an overall accrual method of accounting. The taxpayer has $120,000 of income earned but not yet received (accounts receivable) and $100,000 of expenses incurred but not yet paid (accounts payable) as of the end of the taxable year preceding the year of change in method of accounting. A positive net § 481(a) adjustment of $20,000 ($120,000 accounts receivable less $100,000 accounts payable) is required as a result of the change in method of accounting.


IRS Adjustment

• Change made under exam, adjustment period is two years for positive adjustments [Rev Proc2015-13, 7.03(3)(b)]

• Incentive offered to taxpayer to make change voluntarily rather than playing “audit lottery” with the IRS

• Taxpayer who changes voluntarily generally gets audit protection on change




Simplified 3115 Filing

• Applies to small taxpayers for most repair regulation changes

– Average gross receipts over past three years less than or equal to $10 million

– Limits portions of Form 3115 to be filled in [Rev Proc 2014-17, Section 3.02]

– Required items on following slides


Identification Section of Page 1



Signature Section


Part I, Line 1(a)



Automatic Method Change

• Number provided in Revenue Procedure 2015-14

• Must provide number on Form 3115 for each change

• Remember, can combine only if Revenue Procedure 2015-14 allows combining items


Part II Except 11, 14, 15 & 17

• Goes from bottom of page 1 to top of page 3

• Question numbers 3-17

• Next slides are ones you don’t need to answer if you have a qualifying taxpayer



Part IV, Line 25(Back to What Is Filled In)


§481(a) Adjustment

• Must enter amount of adjustment

• Must also detail how arrived at the adjustment amount

• If have multiple changes allowed on Form 3115, will need to to detail each item

• Zero is an acceptable number



Part IV, Line 26


Increased to $50,000 by Revenue Procedure 2015-13

Schedule E



Schedule E

• Will generally need this when change impacts depreciation

• Thus will include cases where taxpayer is capitalizing items formerly expensed or changing amount that is depreciable


Final Regulations TD 9636

• First available 9/13/13• Published in Federal Register 9/19/13• Indicates we will get new automatic election

provisions – expect update to Rev. Proc. 2012-19 and 2012-20

• Made a few changes to proposed regulations• Finalized§168(i) disposition regulations in 2014

(TD 9689, 8/18/14)• Can (but don’t have to) use temporary

regulations from 2012-2014 or use final regulations



Rough Summary


Qualifies for De Minimis?

Is this a supply?

Expense the Item

Do Regulations under §263(a)

require capitalization?

Does entity track the items?

Yes

No

No

Yes No(Incidental)

Item used by end of year?

Yes

Capitalize item

Yes

Repair?

No

Yes

Consider other options (including

nondeductible)

No

How This Presentation is Organized

By regulation, looking at automatic changes per Revenue Procedure

2015-13


1.162-3Materials and Supplies: Defined

• Tangible property that is used or consumed in the taxpayer’s operations that is not inventory and is:– Required to maintain, repair, or improve a unit of tangible

property [see 1.263(a)-3(e)] owned or leased or serviced by taxpayer, not acquired as part of a unit of tangible property

– Fuel, lubricants, water and similar items expected to be consumed within 12 months of first use

– A unit of property with “economic useful life of 12 months or less” after first use in taxpayers operations

– A “unit of property” costing less than $100 $200

– Identified in other guidance as “materials and supplies” for which deductibility is permitted


1.162-3Materials and Supplies: Defined

• Tangible property that is used or consumed in the taxpayer’s operations that is not inventory and is:– Standby emergency spare parts

• Acquired when item acquired

• Set aside to avoid substantial time loss

• Located at or near equipment

• Directly related to particular machinery

• Normally expensive

• Not subject to normal replacement

• Not interchangeable in other machines

• Not acquired in quantity

• Not repaired and reused



$100 $200 Rule Example

Example 6. F operates a business that rents out a variety of small individual items to customers (rental items). F maintains a supply of rental items on hand. In Year 1, F purchases a large quantity of rental items to use in its rental business. Assume that each rental item is a unit of property under §1.263(a)-3(e) and costs $200 or less. In Year 2, F begins using all the rental items purchased in Year 1 by providing them to customers of its rental business. F does not sell or exchange these items on established retail markets at any time after the items are used in the rental business. The rental items are materials and supplies under paragraph (c)(1)(iv) of this section. Under paragraph (a)(1) of this section, the amounts that F paid for the rental items in Year 1 are deductible in Year 2, the taxable year in which the rental items are first used in F's business.


$100 $200 Rule Example

Example 7. G provides billing services to its customers. In Year 1, G pays amounts to purchase 50 scanners to be used by its employees. Assume each scanner is a unit of property under §1.263(a)-3(e) and costs less than $200. In Year 1, G's employees begin using 35 of the scanners, and F stores the remaining 15 scanners for use in a later taxable year. The scanners are materials and supplies under paragraph (c)(1)(iv) of this section. Under paragraph (a)(1) of this section, the amounts G paid for 35 of the scanners are deductible in Year 1, the taxable year in which G first uses each of those scanners. The amounts that G paid for each of the remaining 15 scanners are deductible in the taxable year in which each machine is first used in G's business.



Materials and Supplies• Non-incidental materials and supplies:

– Deductible in taxable year in which used or consumed in taxpayers operations

• Incidental materials and supplies:

– Carried on hand, but no record of consumption and no inventories maintained

– Deductible in taxable year when amounts are paid or incurred subject to “clear reflection of income”

• Rotable and temporary spare parts (Later slides)

• Nothing in this section changes the treatment of any amount other than Sections 162(a) and 212


Example of Application

Example 1. Non-rotable components. X owns a fleet of aircraft that it operates in its business. In Year 1, X purchases a stock of spare parts, which it uses to maintain and repair its aircraft. X keeps a record of consumption of these spare parts. In Year 2, X uses the spare parts for the repair and maintenance of one of its aircraft. Assume each aircraft is a unit of property under § 1.263(a)-3T(e) and that spare parts are not rotable or temporary spare parts under paragraph (c)(2) of this section. Assume these repair and maintenance activities do not improve the aircraft under § 1.263(a)-3T.

These parts are materials and supplies under paragraph (c)(1)(i) of this section because they are components acquired and used to maintain and repair X's aircraft. Under paragraph (a)(1) of this section, the amounts that X paid for the spare parts in Year 1 are deductible in Year 2, the taxable year in which the spare parts are used to repair and maintain the aircraft.



Accounting Method Changes

• DCN 186 Deducting Non-Incidental Supplies When Used or Consumed [§§ 1.162-3(a)(1), (c)(1)]

• DCN 187 Change to Deducting Incidental Materials and Supplies When Paid or Incurred[§§ 1.162-3(a)(2), (c)(1)]

• Small taxpayer reduced filing exception applies [Section 10.11(4)(a)]


Accounting Method Change

• Section 10.11 change so required information includes:

– Separate §481(a) adjustment for each DCN

– Information required by Part IV, Line 25 (Detail for computation of §481(a) adjustment)




• Section 10.11 change so required information includes:– Information required by Part II, line 12 for each

change• Item being changed

• Present method

• New method

• Overall method of accounting

– Citation back to section of regulations that provide for new method of accounting


Example

• Taxpayer has been expensing all supplies when purchased

• However, taxpayer maintains a list of certain supplies to insure they aren’t stolen

• Balance of such supplies

– December 31, 2013 = $20,000

– December 31, 2014 = $5,000



Example


Example



Example


Information Required by Part II, Line 12

Item Being Changed

Accounting for non-incidental supplies

Current Method

Taxpayer has been deducting such supplies as they are purchased even

though the taxpayer is maintaining a count of amounts not yet used

Proposed Method

Supplies for which the taxpayer is maintaining a count of items on hand

will not deducted until such items are used

Regulation Authorizing Proposed Treatment

The proposed treatment is the method specified to be used pursuant

to Reg. §§ 1.162-3(a)(1), (c)(1)

Example


Supplies on Hand for Which Taxpayer Maintained Count as of December 31, 2013

Fuel 10,000$

Parts for Trucks 5,000

Oil 5,000

§481(a) Adjustment as of January 1, 2014 20,000$

Attachment for Part IV, Question 25


Example


Non-incidental supplies purchased in 2015 125,000$

Less ending inventory (5,000)

Add beginning inventory 20,000

Deduction for non-incidental supplies 2015 140,000

§481(a) adjustment due to change in accounting for supplies 5,000

Net amount of deduction in 2015 return for supplies (135,000)$

Decrease in taxable income on 2015 return (10,000)$

Impact on Return for 2015

Rotable & Temporary Spare Parts

• Acquired for installation on a unit of property, removable, repaired and reinstalled or stored for later installation on another unit of property

• General rule: deductible in taxable year when taxpayer disposes of the part

• Two methods

– Deductible in year disposed of (Disposal Method)

– Optional method: Deduct when part is first installed• May not currently deduct maintenance and repair of part

• Must include FMV in income when removed



Regular (Disposal) Method

Example 2. Rotable spare parts. X operates a fleet of specialized vehicles that it uses in its service business. Assume that each vehicle is a unit of property under §1.263(a)-3T(e). At the time that it acquires a new type of vehicle, X also acquires a substantial number of rotable spare parts that it will keep on hand to quickly replace similar parts in X's vehicles as those parts break down or wear out. These rotable parts are removable from the vehicles and are repaired so that they can be reinstalled on the same or similar vehicles. X does not use the optional method of accounting for rotable and temporary spare parts provided in paragraph (e) of this section.


Regular Method

In Year 1, X acquires several vehicles and a number of rotable spare parts to be used as replacement parts in these vehicles. In Year 2, X repairs several vehicles by using these rotable spare parts to replace worn or damaged parts. In Year 3, X removes these rotable spare parts from its vehicles, repairs the parts, and reinstalls them on other similar vehicles. In Year 5, X can no longer use the rotable parts it acquired in Year 1 and disposes of them as scrap.

Under paragraph (c)(1)(i) of this section, the rotable spare parts acquired in Year 1 are materials and supplies. Under paragraph (a)(3) of this section, rotable spare parts are generally used or consumed in the taxable year in which the taxpayer disposes of the parts. Therefore, under paragraph (a)(1) of this section, the amounts that X paid for the rotable spare parts in Year 1 are deductible in Year 5, the taxable year in which X disposes of the parts.



Optional Method

Example 3. Rotable spare parts; application of optional method of accounting. Assume the same facts as in Example 2, except X uses the optional method of accounting for all its rotable and temporary spare parts under paragraph (e) of this section.

In Year 1, X acquires several vehicles and a number of rotable spare parts (the "Year 1 rotables") to be used as replacement parts in these vehicles. In Year 2, X repairs several vehicles and uses the Year 1 rotables to replace worn or damaged parts. In Year 3, X pays amounts to remove these Year 1 rotables from its vehicles. In Year 4, X pays amounts to maintain, repair, or improve the Year 1 rotables. In Year 5, X pays amounts to reinstall the Year 1 rotables on other similar vehicles. In Year 8, X removes the Year 1 rotables from these vehicles and stores these parts for possible later use. In Year 9, X disposes of the Year 1 rotables.


Optional MethodUnder paragraph (e) of this section, X must deduct the amounts paid to acquire and install the Year 1 rotables in Year 2, the taxable year in which the rotable spare parts are first installed by X in X's vehicles. In Year 3, when X removes the Year 1 rotables from its vehicles, X must include in its gross income the fair market value of each part. Also, in Year 3, X must include in the basis of each Year 1 rotable the fair market value of the rotable and the amount paid to remove the rotable from the vehicle. In Year 4, X must include in the basis of each Year 1 rotable the amounts paid to maintain, repair, or improve each rotable.

In Year 5, the year that X reinstalls the Year 1 rotables (as repaired or improved) in other vehicles, X must deduct the reinstallation costs and the amounts previously included in the basis of each part. In Year 8, the year that X removes the Year 1 rotables from the vehicles, X must include in income the fair market value of each rotable part removed. In addition, in Year 8, X must include in the basis of each part the fair market value of that part and the amount paid to remove the each rotable from the vehicle. In Year 9, the year that X disposes of the Year 1 rotables, X may deduct the amounts remaining in the basis of each rotable.



Acquired With PropertyExample 4. Rotable part acquired as part of a single unit of property; not material or supply. X operates a fleet of aircraft. In Year 1, X acquires a new aircraft, which includes two new aircraft engines. The aircraft costs $500,000 and has an economic useful life of more than 12 months, beginning when it is placed in service. In Year 5, after the aircraft is operated for several years in X's business, X removes the engines from the aircraft, repairs or improves the engines, and either reinstalls the engines on a similar aircraft or stores the engines for later reinstallation. Assume the aircraft purchased in Year 1, including its two engines, is a unit of property under §1.263(a)-3T(e). Because the engines were acquired as part of the aircraft, a single unit of property, the engines are not materials or supplies under paragraph (c)(1)(i) of this section nor rotable or temporary spare parts under paragraph (c)(2) of this section. Accordingly, X may not apply the rules of this section to the aircraft engines upon the original acquisition of the aircraft nor after the removal of the engines from the aircraft for use in the same or similar aircraft. Rather, X must apply the rules under §§1.263(a)- 2T and 1.263(a)-3T to the aircraft, including its engines, to determine the treatment of amounts paid to acquire, produce, or improve the unit of property.



• DCN 188 - Change to deducting non-incidental rotable and temporary spare parts when disposed of [§ 1.162-3(a)(3), (c)(2)]

• DCN 189 - Change to the optional method for rotable and temporary spare parts [§ 1.162-3(e)]

• Attach information required for changes under Section 10.11 (see example for non-incidental supplies)






Item Being Changed

Accounting for rotable and temporary spare parts

Current Method

Taxpayer has been deducting such parts as they are purchased

Proposed Method

Taxpayer will deduct rotable and temporary spare parts under the

optional method outlined in Reg. §1.162-3(e)



to Reg.Reg. §1.162-3(e)


Economic Useful Life• “. . . Not necessarily the useful life inherent in the property,

but the period over which the property may reasonably be expected to be useful to the taxpayer or, if the taxpayer is engaged in a trade or business or an activity for the production of income, the period over which the property may reasonably be expected to be useful to the taxpayer in its trade or business or for the production of income . . .”

• Cross-referenced to 1.167(a)-1(b) , consider:– Wear & tear and decay from natural causes

– Normal economic changes, inventions, and developments

– Climate & other local conditions affecting taxpayers business

– Taxpayers repair & replacement policy

• Conformity required if taxpayer has “applicable financial statement”


De Minimis Rule

An Annual Election


1.263(a)-1 De Minimis Safe Harbor Election

• Rules found here to cover– Materials and supplies [Reg. §1.162-3]

– Acquisition [Reg. §1.263(a)-2]

– Improvement/Betterment [Reg. §1.263(a)-3]

• Not applicable for– Property used as inventory

– Amounts paid for land

– Rotable, temporary and emergency spare parts taxpayer either elects to depreciate or use optional method



• Taxpayer with applicable financial statement

– Written policy in place as of first day of tax year regarding capitalization

– Policy followed on applicable financial statement

– Invoice cost $5,000 or less




• Taxpayer without applicable financial statement

– Procedures in place as of first day of year (no mention of written but…)

– Policy followed on books

– Invoice cost of $500 or less


Applicable Financial Statement• First one of the following the taxpayer has for tax year is

its AFS:

– Financial statement required to be filed with SEC,

– Certified audited statement used for

• Credit purposes

• Reporting to owners

• Other substantial non-tax purpose, or

– Financial statement (other than tax return) required to be provided to federal or state government or agency (other than SEC or IRS) [Apparently, not required to be certified]

• If do not have any of these, does not have an AFS



Invoice Costs

• Cost to include/not include

– Ignore costs not included in invoice

– Include any additional costs on the invoice

– Must reasonably allocate such expenses if relate to multiple pieces of property

– If use method for §263(a) must also use for materials and supplies


Invoice Cost Example


Quantity Unit Price Total

Servers 5 5,000.00 25,000.00$

Sales Tax 2,075.00

Total Cost 27,075.00$

Invoice Price for De Minimis Test 5,415.00$


Invoice Cost Example


Quantity Unit Price Total

Servers 5 5,000.00 25,000.00$

Sales Tax -

Total Cost 25,000.00$

Use tax paid directly to state 2,075.00$

Invoice Price for De Minimis Test 5,000.00$

Buy from Out of State

Final Regulation De Minimis

• Reg. §1.263(a)-1(f) – Relocated and Changes Made

• Taxpayer with applicable financial statement

– Got rid of % of sales/depreciation limits

– Allowed 12 month economic life policy

– Cap of $5,000 per invoice rather than aggregate limit

– Allowed modified method for taxpayers without AFS




• Administrative modification with examining agents

– Preamble allows for agreed upon higher limit

– Important to point out on exam that can still argue “clear reflection of income”

– Note “clear reflection of income” always applies under §446, so taxpayer can maintain “unallowed” method if it still clearly reflects income




Finally, for both taxpayers with applicable financial statements and taxpayers without applicable financial statements, the de minimis safe harbor is not intended to prevent a taxpayer from reaching an agreement with its IRS examining agents that, as an administrative matter, based on risk analysis or materiality, the IRS examining agents will not review certain items. It is not intended that examining agents must now revise their materiality thresholds in accordance with the de minimis safe harbor limitations provided in the final regulation. Thus, if examining agents and a taxpayer agree that certain amounts in excess of the de minimis safe harbor limitations are not material or otherwise should not be subject to review, that agreement should be respected, notwithstanding the requirements of the de minimis safe harbor. However, a taxpayer that seeks

a deduction for amounts in excess of the amount allowed by the safe

harbor has the burden of showing that such treatment clearly reflects

income.



• So essentially

– No policy (or procedures if no AFS) - $200 limit

– With AFS and policy – protection up to $5,000 for items expensed per policy

– Without AFS but with procedures – protection up to $500 for items expensed per policy



• Groups that report on same applicable financial statement can use single accounting procedures

• Making election– Required statement [Reg. §1.263(a)-1(f)(5)

– Titled “Section 1.263(a)-1(f) de minimis safe harbor election”

– Include name, EIN and statement making election under Reg. §1.263(a)-1(f)

– Partnership/S corporation must elect at entity, not equity holder, level



Example


Section 1.263(a)-1(f) de minimis safe harbor election

Taxpayer Information

ABC Widgets

4000 East 1st Street

Anywhere, USA 00000

EIN: 99-9999999

Statement RequiredThe taxpayer is making the de minimis safe harbor election

under §1.263(a)-1(f)


• Anti-abuse rule– Example of attempting to “componentize” via invoices

– Other methods that appear to attempt to use option in unintended fashion

• Eleven examples





Example 1. De minimis safe harbor; taxpayer without AFS. In Year 1, A purchases 10 printers at $250 each for a total cost of $2,500 as indicated by the invoice. Assume that each printer is a unit of property under §1.263(a)-3(e). A does not have an AFS. A has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing less than $500, and A treats the amounts paid for the printers as an expense on its books and records. The amounts paid for the printers meet the requirements for the de minimis safe harbor under paragraph (f)(1)(ii) of this section. If A elects to apply the de minimis safe harbor under this paragraph (f) in Year 1, A may not capitalize the amounts paid for the 10 printers or any other amounts meeting the criteria for the de minimis safe harbor under paragraph (f)(1). Instead, in accordance with paragraph (f)(3)(iv) of this section, A may deduct these amounts under §1.162-1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.



Example 2. De minimis safe harbor; taxpayer without AFS. In Year 1, B purchases 10 computers at $600 each for a total cost of $6,000 as indicated by the invoice. Assume that each computer is a unit of property under §1.263(a)-3(e). B does not have an AFS. B has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing less than $1,000 and B treats the amounts paid for the computers as an expense on its books and records. The amounts paid for the printers do not meet the requirements for the de minimis safe harbor under paragraph (f)(1)(ii) of this section because the amount paid for the property exceeds $500 per invoice (or per item as substantiated by the invoice). B may not apply the de minimis safe harbor election to the amounts paid for the 10 computers under paragraph (f)(1) of this section.




Example 3. De minimis safe harbor; taxpayer with AFS. C is a member of a consolidated group for Federal income tax purposes. C's financial results are reported on the consolidated applicable financial statements for the affiliated group. C's affiliated group has a written accounting policy at the beginning of Year 1, which is followed by C, to expense amounts paid for property costing $5,000 or less. In Year 1, C pays $6,250,000 to purchase 1,250 computers at $5,000 each. C receives an invoice from its supplier indicating the total amount due ($6,250,000) and the price per item ($5,000).



Assume that each computer is a unit of property under §1.263(a)-3(e). The amounts paid for the computers meet the requirements for the de minimis safe harbor under paragraph (f)(1)(i) of this section. If C elects to apply the de minimis safe harbor under this paragraph (f) for Year 1, C may not capitalize the amounts paid for the 1,250 computers or any other amounts meeting the criteria for the de minimis safe harbor under paragraph (f)(1) of this section. Instead, in accordance with paragraph (f)(3)(iv) of this section, C may deduct these amounts under §1.162-1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.




Example 4. De minimis safe harbor; taxpayer with AFS. D is a member of a consolidated group for Federal income tax purposes. D's financial results are reported on the consolidated applicable financial statements for the affiliated group. D's affiliated group has a written accounting policy at the beginning of Year 1, which is followed by D, to expense amounts paid for property costing less than $15,000. In Year 1, D pays $4,800,000 to purchase 800 elliptical machines at $6,000 each. D receives an invoice from its supplier indicating the total amount due ($4,800,000) and the price per item ($6,000). Assume that each elliptical machine is a unit of property under §1.263(a)- 3(e). D may not apply the de minimis safe harbor election to the amounts paid for the 800 elliptical machines under paragraph (f)(1) of this section because the amount paid for the property exceeds $5,000 per invoice (or per item as substantiated by the invoice).



Example 4. De minimis safe harbor; taxpayer with AFS. D is a member of a consolidated group for Federal income tax purposes. D's financial results are reported on the consolidated applicable financial statements for the affiliated group. D's affiliated group has a written accounting policy at the beginning of Year 1, which is followed by D, to expense amounts paid for property costing less than $15,000. In Year 1, D pays $4,800,000 to purchase 800 elliptical machines at $6,000 each. D receives an invoice from its supplier indicating the total amount due ($4,800,000) and the price per item ($6,000). Assume that each elliptical machine is a unit of property under §1.263(a)- 3(e). D may not apply the de minimis safe harbor election to the amounts paid for the 800 elliptical machines under paragraph (f)(1) of this section because the amount paid for the property exceeds $5,000 per invoice (or per item as substantiated by the invoice).




Example 5. De minimis safe harbor; additional invoice costs. E is a member of a consolidated group for Federal income tax purposes. E's financial results are reported on the consolidated applicable financial statements for the affiliated group. E's affiliated group has a written accounting policy at the beginning of Year 1, which is followed by E, to expense amounts paid for property costing less than $5,000. In Year 1, E pays $45,000 for the purchase and installation of wireless routers in each of its 10 office locations. Assume that each wireless router is a unit of property under §1.263(a)-3(e). E receives an invoice from its supplier indicating the total amount due ($45,000), including the material price per item ($2,500), and total delivery and installation ($20,000).



E allocates the additional invoice costs to the materials on a pro rata basis, bringing the cost of each router to $4,500 ($2,500 materials + $2,000 labor and overhead). The amounts paid for each router, including the allocable additional invoice costs, meet the requirements for the de minimis safe harbor under paragraph (f)(1)(i) of this section. If E elects to apply the de minimis safe harbor under this paragraph (f) for Year 1, E may not capitalize the amounts paid for the 10 routers (including the additional invoice costs) or any other amounts meeting the criteria for the de minimis safe harbor under paragraph (f)(1) of this section. Instead, in accordance with paragraph (f)(3)(iv) of this section, E may deduct these amounts under §1.162-1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.




Example 6. De minims safe harbor; non-invoice additional costs. F is a corporation that provides consulting services to its customer. F does not have an AFS, but F has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing less than $500. In Year 1, F pays $600 to an interior designer to shop for, evaluate, and make recommendations regarding purchasing new furniture for F's conference room. As a result of the interior designer's recommendations, F acquires a conference table for $500 and 10 chairs for $300 each. In Year 1, F receives an invoice from the interior designer for $600 for his services, and F receives a separate invoice from the furniture supplier indicating a total amount due of $500 for the table and $300 for each chair. For Year 1, F treats the amount paid for the table and each chair as an expense on its books and records, and F elects to use the de minimis safe harbor for amounts paid for tangible property that qualify under the safe harbor.



The amount paid to the interior designer is a cost of facilitating the acquisition of the table and chairs under §1.263(a)-2(f). Under paragraph (f)(3)(i) of this section, F is not required to include in the cost of tangible property the additional costs of acquiring such property if these costs are not included in the same invoice as the tangible property. Thus, F is not required to include a pro rata allocation of the amount paid to the interior designer to determine the application of the de minimis safe harbor to the table and the chairs. Accordingly, the amounts paid by F for the table and each chair meet the requirements for the de minimis safe harbor under paragraph (f)(1)(ii) of this section, and F may not capitalize the amounts paid for the table or each chair under paragraph (f)(1) of this section. In addition, F is not required to capitalize the amounts paid to the interior designer as a cost that facilitates the acquisition of tangible property under §1.263(a)-2(f)(3)(i). Instead, F may deduct the amounts paid for the table, chairs, and interior designer under §1.162-1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.




Example 7. De minimis safe harbor; 12-month economic useful life. G operates a restaurant. In Year 1, G purchases 10 hand-held point-of-service devices at $300 each for a total cost of $3,000 as indicated by invoice. G also purchases 3 tablet computers at $500 each for a total cost of $1,500 as indicated by invoice. Assume each point-of-service device and each tablet computer has an economic useful life of 12 months or less, beginning when they are used in G's business. Assume that each device and each tablet is a unit of property under §1.263(a)-3(e). G does not have an AFS, but G has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing $300 or less and to expense amounts paid for property with an economic useful life of 12 months or less. Thus, G expenses the amounts paid for the hand-held devices on its books and records because each device costs $300. G also expenses the amounts paid for the tablet computers on its books and records because the computers have an economic useful life of 12 months of less, beginning when they are used.



The amounts paid for the hand-held devices and the tablet computers meet the requirements for the de minimis safe harbor under paragraph (f)(1)(ii) of this section. If G elects to apply the de minimis safe harbor under this paragraph (f) in Year 1, G may not capitalize the amounts paid for the hand-held devices, the tablet computers, or any other amounts meeting the criteria for the de minimis safe harbor under paragraph (f)(1) of this section. Instead, in accordance with paragraph (f)(3)(iv) of this section, G may deduct the amounts paid for the hand-held devices and tablet computers under §1.162-1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary business expenses incurred in carrying on a trade or business.




The amounts paid for the hand-held devices and the tablet computers meet the requirements for the de minimis safe harbor under paragraph (f)(1)(ii) of this section. If G elects to apply the de minimis safe harbor under this paragraph (f) in Year 1, G may not capitalize the amounts paid for the hand-held devices, the tablet computers, or any other amounts meeting the criteria for the de minimis safe harbor under paragraph (f)(1) of this section. Instead, in accordance with paragraph (f)(3)(iv) of this section, G may deduct the amounts paid for the hand-held devices and tablet computers under §1.162-1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary business expenses incurred in carrying on a trade or business.



Example 8. De minimis safe harbor; limitation. Assume the facts as in Example 7, except G purchases the 3 tablet computers at $600 each for a total cost of $1,800. The amounts paid for the tablet computers do not meet the de minimis rule safe harbor under paragraphs (f)(1)(ii) and (f)(3)(vii) of this section because the cost of each computer exceeds $500. Therefore, the amounts paid for the tablet computers may not be deducted under the safe harbor.




Example 9. De minimis safe harbor; materials and supplies. H is a corporation that provides consulting services to its customers. H has an AFS and a written accounting policy at the beginning of the taxable year to expense amounts paid for property costing $5,000 or less. In Year 1, H purchases 1,000 computers at $500 each for a total cost of $500,000. Assume that each computer is a unit of property under §1.263(a)-3(e) and is not a material or supply under §1.162-3. In addition, H purchases 200 office chairs at $100 each for a total cost of $20,000 and 250 customized briefcases at $80 each for a total cost of $20,000. Assume that each office chair and each briefcase is a material or supply under §1.162-3(c)(1). H treats the amounts paid for the computers, office chairs, and briefcases as expenses on its AFS.



The amounts paid for computers, office chairs, and briefcases meet the requirements for the de minimis safe harbor under paragraph (f)(1)(i) of this section. If H elects to apply the de minimis safe harbor under this paragraph (f) in Year 1, H may not capitalize the amounts paid for the 1,000 computers, the 200 office chairs, and the 250 briefcases under paragraph (f)(1) of this section. H may deduct the amounts paid for the computers, the office chairs, and the briefcases under §1.162-1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.




Example 10. De minimis safe harbor; coordination with section 263A. J is a member of a consolidated group for Federal income tax purposes. J's financial results are reported on the consolidated AFS for the affiliated group. J's affiliated group has a written accounting policy at the beginning of Year 1, which is followed by J, to expense amounts paid for property costing less than $1,000 or that has an economic useful life of 12 months or less. In Year 1, J acquires jigs, dies, molds, and patterns for use in the manufacture of J's products. Assume each jig, die, mold, and pattern is a unit of property under §1.263(a)-3(e) and costs less than $1,000..



In Year 1, J begins using the jigs, dies, molds and patterns to manufacture its products. Assume these items are materials and supplies under §1.162-3(c)(1)(iii), and J elects to apply the de minimis safe harbor under paragraph (f)(1)(i) of this section to amounts qualifying under the safe harbor in Year 1. Under paragraph (f)(3)(v) of this section, the amounts paid for the jigs, dies, molds, and patterns may be subject to capitalization under section 263A if the amounts paid for these tangible properties comprise the direct or allocable indirect costs of other property produced by the taxpayer or property acquired for resale.




Example 11. De minimis safe harbor; anti-abuse rule. K is a corporation that provides hauling services to its customers. In Year 1, K decides to purchase a truck to use in its business. K does not have an AFS. K has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing less than $500. K arranges to purchase a used truck for a total of $1,500. Prior to the acquisition, K requests the seller to provide multiple invoices for different parts of the truck. Accordingly, the seller provides K with four invoices during Year 1--one invoice of $500 for the cab, one invoice of $500 for the engine, one invoice of $300 for the trailer, and a fourth invoice of $200 for the tires. K treats the amounts paid under each invoice as an expense on its books and records. K elects to apply the de minimis safe harbor under paragraph (f) of this section in Year 1 and does not capitalize the amounts paid for each invoice pursuant to the safe harbor.



Under paragraph (f)(6) of this section, K has applied the de minimis rule to amounts substantiated with invoices created to componentize property that is generally acquired as a single unit of tangible property in the taxpayer's type of business, and this property, if treated as single unit, would exceed the limitations provided under the de minimis rule. Accordingly, K is deemed to manipulate the transaction to acquire the truck with the intent to avoid the purposes of this paragraph (f). As a result, K may not apply the de minimis rule to these amounts and is subject to appropriate adjustments.


De Minimis Rule Example

Example 14. Election to apply de minimis safe harbor. (i) N provides consulting services to its customers. In Year 1, N pays amounts to purchase 50 laptop computers. Each laptop computer is a unit of property under §1.263(a)-3(e), costs $400, and has an economic useful life of more than 12 months. Also in Year 1, N purchases 50 office chairs to be used by its employees. Each office chair is a unit of property that costs $100. N has an applicable financial statement (as defined in §1.263(a)-1(f)(4)) and N has a written accounting policy at the beginning Year 1 to expense amounts paid for units of property costing $500 or less. N treats amounts paid for property costing $500 or less as an expense on its applicable financial statement in Year 1.


De Minimis Rule Example

(ii) The laptop computers are not materials or supplies under paragraph (c) of this section. Therefore, the amounts N pays for the computers must generally be capitalized under §1.263(a)-2(d) as amounts paid for the acquisition of tangible property. The office chairs are materials and supplies under paragraph (c)(1)(iv) of this section. Thus, under paragraph (a)(1) of this section, the amounts paid for the office chairs are deductible in the taxable year in which they are first used in N's business. However, under paragraph (f) of this section, if N properly elects to apply the de minimis safe harbor under §1.263(a)-1(f) to amounts paid in Year 1, then N must apply the de minimis safe harbor under §1.263(a)-1(f) to amounts paid for the computers and the office chairs, rather than treat the office chairs as the costs of materials and supplies under §1.162-3. Under the de minimis safe harbor, N may not capitalize the amounts paid for the computers under §1.263(a)-2 nor treat the office chairs as materials and supplies under §1.162-3. Instead, in accordance with §1.263(a)-1(f)(3)(iv), under §1.162-1, N may deduct the amounts paid for the computers and the office chairs in the taxable year paid.



Election to Capitalize and Depreciate

• Taxpayer may “elect” (by simply doing so) to capitalize and depreciate any “material and supply” except:

– Parts to be used in unit of property that will not be capitalized and appreciated, or

– Cost of a rotable or temporary spare part for which taxpayer has elected the optional method of accounting


Election Example

Example 13. Election to capitalize and depreciate. M is in the mining business. M acquires certain temporary spare parts, which it keeps on hand to avoid operational time loss in the event it must make temporary repairs to a unit of property that is subject to depreciation. These parts are not used to improve property under §1.263(a)-3(d). These temporary spare parts are used until a new or repaired part can be installed and then are removed and stored for later temporary installation. M does not use the optional method of accounting for rotable and temporary spare parts in paragraph (e) of this section for any of its rotable or temporary spare parts. The temporary spare parts are materials and supplies under paragraph (c)(1)(i) of this section. Under paragraphs (a)(1) and (a)(3) of this section, the amounts paid for the temporary spare parts are deductible in the taxable year in which they are disposed of by M.



Election Example

However, because it is unlikely that the temporary spare parts will be disposed of in the near future, M would prefer to treat the amounts paid for the spare parts as capital expenditures subject to depreciation. M may elect under paragraph (d) of this section to treat the cost of each temporary spare part as a capital expenditure and as an asset subject to an allowance for depreciation. M makes this election by capitalizing the amounts paid for each spare part in the taxable year that M acquires the spare parts and by beginning to recover the costs of each part on its timely filed Federal tax return for the taxable year in which the part is placed in service for purposes of determining depreciation under the applicable provisions of the Internal Revenue Code and the Treasury Regulations. See §1.263(a)- 2(g) for the treatment of capital expenditures


Other Definitions, Elections, and Examples

• Elect to apply de minimis rule making election

• Disposition of materials and supplies is ordinary income transaction, not 1221 or 1231

• 14 examples illustrate the new rules governing materials, supplies, and rotable spare parts



1.162-4 Repairs

• Modifies “repair rules” in 1.162-4 to be consistent with “improvement rules” in 1.263(a)-3T

• New rule . . . amounts paid to repair and maintain tangible property are deductible provided they are not otherwise required to be capitalized by any other provision of Code or regulations. (Think 263A “UNICAP” rules or temporary 263(a) rules adopted concurrently with these temporary 162 rules


Old Reg. §1.162-4

The cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted as an expense, provided the cost of acquisition or production or the gain or loss basis of the taxpayer's plant, equipment, or other property, as the case may be, is not increased by the amount of such expenditures. Repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, shall either be capitalized and depreciated in accordance with section 167 or charged against the depreciation reserve if such an account is kept.



New Reg. §1.162-4(a)

(a) In general.

A taxpayer may deduct amounts paid for repairs and maintenance to tangible property if the amounts paid are not otherwise required to be capitalized. For the election to capitalize amounts paid for repair and maintenance consistent with the taxpayer's books and records, see §1.263(a)-3(n).


1.162-4 Repairs

• Final regulations add option to capitalize what would otherwise be repairs to be consistent with taxpayer’s books and records (See §1.263(a)-3(n))

• Effective 1/1/2014 (can elect as of 1/1/2012). . .




• DCN 184 - A change to deducting amounts paid or incurred for repair and maintenance or a change to capitalizing amounts paid or incurred for improvements to tangible property and, if depreciable, to depreciating such property under § 167 or § 168. Includes a change, if any, in the method of identifying the unit of property, or in the case of a building, identifying the building structure or building systems for the purpose of making this change.

• §§ 1.162-4, 1.263(a)-3



• Note that this change encompasses both getting rid of repairs and

• Capitalizing the asset and putting on depreciation schedule

• Also will involve changes to definition of “unit of property” with major change to buildings



Steps for this Change

1. Review prior returns for items expensed as repairs that should be capitalized as improvement

2. Determine depreciable life of property

3. Compute YTD depreciation as of first of year assuming had been capitalized

4. Compute §481(a) adjustments

5. Consider if there are missing retirements (another change)


Example

• Have $12,000 on 6/21/2008 taken as a repair on 2008 return

• Determine actually improved commercial building

• On calendar year



Example


Depreciation to 12/31/132008 Depreciation (mid-month June) 167$

2009 Depreciation 308





Prior cost recovered under new method through 12/31/13 1,707$

Cost Capitalized 12,000

Net §481(a) adjustment 10,293$

Example



Example


Example



Example


Statement for Schedule E, Question 4(a)The property involved improvements made to the plumbing

systems of a piece of commercial real estate being leased by

the taxpayer


Statement for Schedule E, Question 5The taxpayer had treated the improvements in question as

repair expense under former Reg. §1.162-4 and deducted the

cost at the time it was incurred.



Statement for Schedule E, Question 6Taxpayer had determined the item is properly classified as a

betterment to the real property pursuant to Reg. §1.263(a)-3




Statement for Schedule E, Question 7a. The property will be depreciated under §168.

b. The property is classified as non-residential real property

under Rev Proc 87-56 with a MACRS life of 39 years.

c. The property that was improved houses the main business

office of the taxpayer, making the property non-residential real

property.

d. The asset will be depreciatied under the straght-line method

pursuant to IRC §168(b)(3)

e. The recovery period is 39 years

f. The applicable convention is the mid-month convention

g. No special first year depreciation allowance will be claimed

because the property was not of a type that qualified for

§168(k) additional first year depreciation.

Rentals and Leases: Secs. 1.162-11

• Improvements by lessee (tenant) on lessor’s (landlord’s) property

– Cost of buildings and improvements on leased land is not deductible as an expense

– See Reg. Sec. 1.263(a)-3(f) for rules regarding capitalization of improvements that are tangible property

– For amortization of leasehold improvements: See 1.167(a)-4



Reg. §1.162-11(b)

(b) Improvements by lessee on lessor's property.

The cost to a taxpayer of erecting buildings or making permanent improvements on property of which the taxpayer is a lessee is a capital expenditure. For the rules regarding improvements to leased property when the improvements are tangible property, see §1.263(a)-3(f). For the rules regarding depreciation or amortization deductions for leasehold improvements, see §1.167(a)-4.


1.165-2 Obsolescence ofNon-Depreciable Property

• See 1.167(a)-8, 1.168(i)-1, or 1.168(i)-8, for losses arising from permanent withdrawal of depreciable property from use in trade or business or production of income

• See 1.167-7 for casualty losses

• See 1.167(a)-9 for obsolescence of property depreciated under Sec. 167

– But not 168, 1400I, 1400L(c), 168 prior to TRA 86, or any additional first-year depreciation deduction



Reg. §1.165-2(a)/(b) (Still in Force)(a) Allowance of deduction.

A loss incurred in a business or in a transaction entered into for profit and arising from the sudden termination of the usefulness in such business or transaction of any nondepreciable property, in a case where such business or transaction is discontinued or where such property is permanently discarded from use therein, shall be allowed as a deduction under section 165(a) for the taxable year in which the loss is actually sustained. For this purpose, the taxable year in which the loss is sustained is not necessarily the taxable year in which the overt act of abandonment, or the loss of title to the property, occurs.

(b) Exceptions.

This section does not apply to losses sustained upon the sale or exchange of property, losses sustained upon the obsolescence or worthlessness of depreciable property, casualty losses, or losses reflected in inventories required to be taken under section 471. The limitations contained in sections 1211 and 1212 upon losses from the sale or exchange of capital assets do not apply to losses allowable under this section.


1.167(a)-4 Leased Property

• Capital expenditures by either lessee or lessor on leased property are recovered under applicable Code provisions, without regard to period of lease

– Sections 168, 167, or 197 as applicable

– Taxpayer may change method of accounting

– Procedure for change may be slightly different based on year in which capital expenditures were paid or incurred



Reg. §1.167(a)-4(a)

(a) In general.

Capital expenditures made by either a lessee or lessor for the erection of a building or for other permanent improvements on leased property are recovered by the lessee or lessor under the provisions of the Internal Revenue Code applicable to the cost recovery of the building or improvements, if subject to depreciation or amortization, without regard to the period of the lease. For example, if the building or improvement is property to which section 168 applies, the lessee or lessor determines the depreciation deduction for the building or improvement under section 168. See section 168(i)(8)(A). If the improvement is property to which section 167 or section 197 applies, the lessee or lessor determines the depreciation or amortization deduction for the improvement under section 167 or section 197, as applicable.


1.167(a)-7 Accounting for Depreciable Property

• Clarifies that following paragraphs of existing regulation 1.167(a)-7 only apply to depreciation determined under Section 167

– (a) . . . Permits grouping

– (b) . . . Explains operation of grouped accounts

– (d) . . . Requires redetermination of average useful life and rate when additions, retirements, or replacements alter relative proportion of types of assets in group accounts

– Effective 1/1/2014 (can elect as of 1/1/2012 . . . Nichols Patrick CPE, Inc. © 2015


Reg. §1.167(a)-7(e)

(e) Applicability.

Paragraphs (a), (b), and (d) of this section apply to property for which depreciation is determined under section 167 (but not under section 168, section 1400I, section 1400L(c), section 168 prior to its amendment by the Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 2121 (1986)), or under an additional first year depreciation deduction provision of the Internal Revenue Code (for example, section 168(k) through (n), 1400L(b), or 1400N(d))). Paragraph (c) of this section does not apply to general asset accounts as provided by section 168(i)(4), §1.168(i)-1, §1.168(i)- 1T and Prop. Reg. §1.168(i)-1.


1.167(a)-8 Retirements

• Clarifies that existing regulation 1.168(a)-8 only applies to property for which depreciation determined under Section 167

– Does not apply to 168, 1400l, 1400L(c), 168 before TRA 86, or any additional 1st year depreciation

– Effective 1/1/2014 (can elect 1/1/2012) . . .



Reg. §1.167(a)-8

(g) Applicability.

This section applies to property for which depreciation is determined under section 167 (but not under section 168, section 1400I, section 1400L(c), section 168 prior to its amendment by the Tax Reform Act of 1986 (100 Stat. 2121), or under an additional first year depreciation deduction provision of the Internal Revenue Code (for example, section 168(k) through (n), 1400L(b), or 1400N(d))).


1.168(i)-0

• Table of Contents for:

– 1.168(i)-1

– 12 new sections are added and some paragraph references are changed

• Final regulations issued 8/18/14 – minor revisions

• In course primary concern related to “slicing away” structural components of buildings when forced to capitalize



Executive Summary

• IRS “borrowed” general asset account rules due to change in real estate capitalization

• Will be able to “slice off” portions of the building when incur certain capitalized improvements


1.168(i)-1 Disposition of An Asset From a General Asset Account

• Under unit of property rules for §1.263(a)-3, discussed later, a building exists in two views– The building as a whole is a unit of property

– But the structural components of the building as treated as separate units in a special “group asset account”

• Thus can dispose of the structural component of building in some cases

• But, of course, you didn’t put the building on the depreciation schedule as a bunch of components when it was acquired

• Fine, regulations make an “assumed” general asset account election



1.168(i)-1 Disposition of An Asset From a General Asset Account

• Elect to have a qualifying disposition [Reg. §1.168(i)-1(e)(3)(iii)(B)] if dispose of structural component in

– Direct result of casualty, fire, theft

– Charitable contribution

– Disposition of part of business

– Certain nonrecognition transfers

• Claim loss on return


1.168(i)-8 Disposition of MACRS Property

• Special partial disposition election on buildings at Reg. §1.168(i)-8(d)(2) for replacement– “Nike” election (just do it)

– Determine portion of asset retired using reasonable method [PPI Method most likely to be used – Reg. §1.168(i)-8(f)(2)(A)]

– Discount using Producer Price Index for Finished Goods or its successor, the Producer Price Index for Final Demand




• Finding Producer Price Index

– Federal Reserve Bank of St Louis – ask for detailed Excel data

• PPI Finished Goods http://research.stlouisfed.org/fred2/series/PPIFGS

• PPI Final Demand http://research.stlouisfed.org/fred2/series/PPIFIS

– Google Docs worksheet for PPI Finished Goods http://bit.ly/1KG597D




http://research.stlouisfed.org/fred2/series/PPIFGS

http://research.stlouisfed.org/fred2/series/PPIFIS

http://bit.ly/1KG597D


• IRS Exam Issue

– Can make late disposition election if IRS requires capitalizing asset on exam

– Do so by requesting a change in accounting method [Reg. §1.168(i)-8(d)(2)(iii)]


Calculating Loss on Disposition Using PPI Method

• Discount replacement cost as stand-in for portion of total basis

– PPI for date property acquired

– PPI for date of replacement

– Divide replacement PPI into acquisition PPI

– Multiply ratio times replacement cost = portion of unadjusted basis

– Compute depreciation to date – remaining balance is loss on replacement



Example of Partial Disposition Calculations


Example 9. (i) On July 1, 2011, E, a calendar-year taxpayer, purchased and placed in service an existing multi-story office building that costs $20,000,000. The cost of each structural component of the building was not separately stated. E accounts for the building and its structural components in its tax and financial accounting records as a single asset with a cost of $20,000,000. E depreciates the building as nonresidential real property and uses the optional depreciation table that corresponds with the general depreciation system, the straight-line method, a 39-year recovery period, and the mid-month convention. As of January 1, 2014, the depreciation reserve for the building is $1,261,000.

Office building unadjusted basis 20,000,000$

Accumulated depreciation as of January 1, 2014 1,261,000

Adjusted basis January 1, 2014 18,739,000$



(ii) On June 30, 2014, E replaces one of the two elevators in the office building. E did not dispose of any other structural components of this building in 2014 and prior years. E makes the partial disposition election provided under paragraph (d)(2) of this section for this elevator. Although the office building, including its structural components, is the asset for disposition purposes, the result of E making the partial disposition election for the elevator is that the retirement of the replaced elevator is a disposition. Assume the replacement elevator is a restoration under §1.263(a)-3(k), and not a betterment under § 1.263(a)-3(j)) or an adaptation to a new or different use under § 1.263(a)-3(l)).




Because E cannot identify the cost of the elevator from its records and the replacement elevator is a restoration under § 1.263(a)-3(k), E determines the cost of the disposed elevator by discounting the cost of the replacement elevator to its placed-in-service year cost using the Producer Price Index for Final Demand. Using this reasonable method, E determines the cost of the retired elevator by discounting the cost of the replacement elevator to its cost in 2011 (the placed-in-service year) using the Producer Price Index for Final Demand, resulting in $150,000 of the $20,000,000 purchase price for the building to be the cost of the retired elevator. Using the optional depreciation table that corresponds with the general depreciation system, the straight-line method, a 39-year recovery period, and the mid-month convention, the depreciation allowed or allowable for the retired elevator as of December 31, 2013, is $9,458.



(iii) For E's 2014 Federal tax return, the loss for the retired elevator is determined as follows. The depreciation allowed or allowable for 2014 for the retired elevator is $1,763 ((unadjusted depreciable basis of $150,000 x depreciation rate of 2.564% for 2014) x 5.5/12 months). Thus, the adjusted depreciable basis of the retired elevator is $138,779 (the adjusted depreciable basis of $140,542 removed from the building cost less the depreciation allowed or allowable of $1,763 for 2014). As a result, E recognizes a loss of $138,779 for the retired elevator in 2014.

Elevator Basis 150,000$

Accumulated depreciation as of January 1, 2014 (9,458)

Depreciation for 2014 (1,763)

Basis upon disposition 138,779$




(iv) For E's 2014 Federal tax return, the depreciation allowance for the building is computed as follows. As of January 1, 2014, the unadjusted depreciable basis of the building is reduced from $20,000,000 to $19,850,000 ($20,000,000 less the unadjusted depreciable basis of $150,000 for the retired elevator), and the depreciation reserve of the building is reduced from $1,261,000 to $1,251,542 ($1,261,000 less the depreciation allowed or allowable of $9,458 for the retired elevator as of December 31, 2013). Consequently, the depreciation allowance for the building for 2014 is $508,954 ($19,850,000 x depreciation rate of 2.564% for 2014).

Full Building Elevator

Building Minus

Elevator

Office building unadjusted basis 20,000,000$ 150,000$ 19,850,000$

Accumulated depreciation as of January 1, 2014 1,261,000 9,458 1,251,542

Adjusted basis January 1, 2014 18,739,000$ 140,542$ 18,598,458$



(v) E also must capitalize the amount paid for the replacement elevator pursuant to § 1.263(a)-3(k)(1). The replacement elevator is a separate asset for disposition purposes pursuant to paragraph (c)(4)(ii)(D) of this section and for depreciation purposes pursuant to section 168(i)(6).

Depreciation schedule will have (before 2014 depreciation):

Building Cost 19,850,000$

Accumulated Depreciation - Building 1,251,542

New Elevator - 39 year asset placed in service 6/30/14 175,000

*IRS didn't provide this number so we'll guess


Automatic Changes

• DCN 196 – Late partial disposition election (§168; § 1.168(i)-8) [6.33 change]

• DCN 205 -Disposition of a building or structural component (§ 168; § 1.168(i)-8) [6.38 change]

• Include

– Description of assets to which change applies

– How you are identifying assets disposed of under current and proposed method

– Special rules for utility property




Item Being Changed

Late partial disposition election for disposal of a

structural component of a building

Current Method

Taxpayer had not been accounting for a disposition of

structural components when they were replaced

Proposed Method

Taxpayer proposes to claim a deduction for the portion

of the original cost of the item disposed of, using the

Producer Price Index for Finished Goods to discount

the cost of the replacement to determine the basis of

the replaced item.

Regulation Authorizing Proposed TreatmentThe proposed treatment is the method specified to be

used pursuant to § 1.168(i)-8



PPI for Finished Goods Reg. §1.168(i)-1(j)(3)(A)

Date Placed in Service 6/30/2005

Date Restored/Replaced 1/2/2011

Restoration/Replacement Cost 180,604

PPI for Date Placed in Service 153.9

PPI for Date Restored Replaced 185.3

Factor 0.830545062

Calculated Cost at Acquisition 150,000$

Accumulated depreciation through 12/31/2010 9,458

Depreciation for 2010 160

Accumulated depreciation upon disposal 9,618

Loss on disposition 140,382

Depreciation on disposed of assets from disposition to 12/31/13 11,378

Net Negative §481(a) adjustment 129,004$


1.263(a)-0

• Table of Contents for:

– 1.263(a)-1

– 1.263(a)-2

– 1.263(a)-3

• All New (well, as far as final regulations go) !



1.263(a)-1 Capital Expenditures;In General

• General rule . . . Except as provided in chapter 1 of the IRC (elsewhere in the Code) no deduction is allowed for

– Any amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property

– Any amount paid to restore property or make good the exhaustion thereof for which an allowance is or has been made


1.263(a)-1 (continued)• Coordination with 263A . . .

– 263(a) requires capitalization of costs to acquire produce or improve real or tangible property

– 263A prescribes direct and indirect costs that must be capitalized to property produced or acquired for resale by the taxpayer

– Examples of capital expenditures:

• Amount paid to acquire or produce a unit of property - 1.263(a)-2

• Amount paid to improve a unit of property – 1.263(a)-3

• Amount paid to acquire or create intangibles – 1.263(a)-4

• Amount paid or incurred to facilitate acquisition of a trade or business or changing capital structure of the same – 1.263(a)-5

• Amount paid to acquire or create interests in land; easements, life estates, mineral interests, zoning variances, etc.



1.263(a)-1 Amounts Paid to Sell Property

• In general . . . Commissions and other transaction costs to facilitate sale of property must be capitalized

– Dealers in property treat such amounts as 162 expenses

• Capitalized amounts are treated as reduction in amount realized and taken into account in year sale is abandoned if loss is permissible

• Amount paid . . . For accrual basis taxpayer means a liability incurred as defined in 1.446-1(c)(1)(ii)

• Taxpayer changing to a method of accounting allowed by these rules must follow admin. process



• Six examples

– All commissions, legal fees, etc. to sell property must be capitalized

– Dealer deducts as ordinary and necessary

– Other than dealers, appraisals must be capitalized (examples 4, 5, & 6)




Example 1. Sales costs of real property. X owns a parcel of real estate. X sells the real estate and pays legal fees, recording fees, and sales commissions to facilitate the sale. X must capitalize the fees and commissions and, in the taxable year of the sale, offset the fees and commissions against the amount realized from the sale of the real estate.



Example 2. Sales costs of dealers. Assume the same facts as in Example 1, except that X is a dealer in real estate. The commissions and fees paid to facilitate the sale of the real estate are treated as ordinary and necessary business expenses under section 162.




Example 3. Sales costs of personal property used in a trade or business. X owns a truck for use in X's trade or business. X decides to sell the truck on November 15, Year 1. X pays for an appraisal to determine a reasonable asking price. On February 15, Year 2, X sells the truck to Y. X is required to capitalize in Year 1 the amount paid to appraise the truck and, in Year 2, is required to offset the amount paid against the amount realized from the sale of the truck.



Example 4. Costs of abandoned sale of personal property used in a trade or business. Assume the same facts as in Example 3, except that, instead of selling the truck on February 15, Year 2, X decides on that date not to sell the truck and takes the truck off the market. X is required to capitalize in Year 1 the amount paid to appraise the truck. However, X may treat the amount paid to appraise the truck as a loss under section 165 in Year 2 when the sale is abandoned.




Example 5. Sales costs of personal property not used in a trade or business. Assume the same facts as in Example 3, except that X does not use the truck in X's trade or business, but instead uses it for personal purposes. X decides to sell the truck and on November 15, Year 1, X pays for an appraisal to determine a reasonable asking price. On February 15, Year 2, X sells the truck to Y. X is required to capitalize in Year 1 the amount paid to appraise the truck and, in Year 2, is required to offset the amount paid against the amount realized from the sale of the truck.



Example 6. Costs of abandoned sale of personal property not used in a trade or business. Assume the same facts as in Example 5, except that, instead of selling the truck on February 15, Year 2, X decides on that date not to sell the truck and takes the truck off the market. X is required to capitalize in Year 1 the amount paid to appraise the truck. Although the sale is abandoned in Year 2, X may not treat the amount paid to appraise the truck as a loss under section 165 because the truck was not used in X's trade or business or in a transaction entered into for profit.



Accounting Changes

• Both are 10.11 changes (thus covered by the “catch-all”)

• DCN 190 - Change by a dealer in property to deduct commissions and other costs that facilitate the sale of property [Reg. §1.263(a)-1(e)(2)]

• DCN 191 - Change by a non-dealer in property to capitalizing commissions and other costs that facilitate the sale of property. [Reg. §1.263(a)-1(e)(1)]




Item Being Changed

Accounting for costs that facilitate the sale of property

Current Method

Taxpayer has been currently appraisals for property to be sold at the

time the costs are incurred. The taxpayer is not a dealer.

Proposed MethodThe taxpayer will capitalize appraisals for property to be sold until such

time as the sale takes place or the taxpayer abandons efforts to sell the

property



to § 1.263(a)-1(e)(1)




Taxpayer was not attempting to sell any property as of December 31,

2013, thus there is no §481(a) adjustment.

Sec. 1.263(a)-2 Payments to Acquire or Produce Tangible Property

• Overview . . . 2 provides rules for applying 263(a) to amounts paid to acquire or produce a unit of real or personal property

– (b) . . . definitions

– (c) . . . rules for coordinating with other provisions of the code

– (d) . . . general requirement to capitalize amounts paid to acquire or produce a unit of property

– (e) . . . requirement to capitalize amounts paid to defend or perfect title to property



1.263(a)-2 Overview (continued)

– (f) . . . rules for capitalizing transaction costs related to acquisition of property

– (g) & (h) . . . treatment and recovery of capital expenditures

– (i) . . . changes in methods of accounting to comply with new rules

– (j) . . . effective for tax years beginning on or after 1/1/14 (though can elect application as of 1/1/12)

– Note – removed old “(g)” which was de minimis rules and moved it to §1.263(a)-1 discussed earlier


1.263(a)-2 Definitions• Amount paid . . . Amount paid or liability incurred by

taxpayer using the accrual method of accounting

• Personal property . . . Tangible personal property as defined in 1.48-1(c)

• Real property . . . Land and improvements thereto

– Buildings or other inherently permanent structures (including structural components of the buildings or structures)

– Not personal property

– Tangible property under 1.48-1(d)

– Local law does not determine real property

• Produce . . . Construct, build, install, manufacture, develop, create, raise, or grow [See 1.263A-2(a)(1)(i)]



1.263(a)-2 Coordination with Other Provisions of Code

• In general . . . Except as provided in de minimis rule which follows, nothing in 1.263(a)-2 changes the treatment of any amount specifically dealt with in the Code other than in 162(a) and 212 and their regulations

• Materials and supplies . . . Except as provided in de minimis rule, nothing in 1.263(a)-2 changes the treatment of amounts paid to acquire or produce property properly treated as materials and supplies under 1.162-3


1.263(a)-2 When to Capitalize Acquisition or Production Cost

• Requirement to capitalize . . . Except as provided in de minimis rule, and in 1.162-3 (relating to materials and supplies) a taxpayer must capitalize amounts paid to acquire or produce a unit of real or personal property (as determined under 1.263(a)-3(e), including:

– Leasehold improvements

– Land and land improvements

– Buildings

– Machinery and equipment

• “amounts paid” include invoice price, transaction costs, and costs incurred prior to property being placed in service




• Eleven examples – capitalize . . . ?

– New Cash Registers - yes

– Stock of aircraft parts to be used for maintenance & repair – no?

– Small items held for rent and held for replacement – maybe !

– Jigs, dies, molds and patterns - yes

– Acquisition of building (costs to facilitate) - yes

– Acquisition of property for resale - yes

– Production of building (See 263A for cost to capitalize) - yes

– Section 1060 acquisition (capitalize FMV of tangible assets)

– Work prior to placed in service - yes

– Testing prior to placed in service – yes . . . After - no



Example 1. Acquisition of personal property. A purchases new cash registers for use in its retail store located in leased space in a shopping mall. Assume each cash register is a unit of property as determined under §1.263(a)-3(e) and is not a material or supply under §1.162-3. A must capitalize under paragraph (d)(1) of this section the amount paid to acquire each cash register.




Example 2. Acquisition of personal property that is a material or supply; coordination with §1.162-3. B operates a fleet of aircraft. In Year 1, B acquires a stock of component parts, which it intends to use to maintain and repair its aircraft. Assume that each component part is a material or supply under §1.162-3(c)(1) and B does not make elections under §1.162-3(d) to treat the materials and supplies as capital expenditures. In Year 2, B uses the component parts in the repair and maintenance of its aircraft. Because the parts are materials and supplies under §1.162-3, B is not required to capitalize the amounts paid for the parts under paragraph (d)(1) of this section. Rather, to determine the treatment of these amounts, B must apply the rules under §1.162-3, governing the treatment of materials and supplies.



Example 3. Acquisition of unit of personal property; coordination with §1.162-3. C operates a rental business that rents out a variety of small individual items to customers (rental items). C maintains a supply of rental items on hand to replace worn or damaged items. C purchases a large quantity of rental items to be used in its business. Assume that each of these rental items is a unit of property under §1.263(a)- 3(e). Also assume that a portion of the rental items are materials and supplies under §1.162-3(c)(1). Under paragraph (d)(1) of this section, C must capitalize the amounts paid for the rental items that are not materials and supplies under §1.162-3(c)(1). However, C must apply the rules in §1.162-3 to determine the treatment of the rental items that are materials and supplies under §1.162-3(c)(1).




Example 4. Acquisition or production cost. D purchases and produces jigs, dies, molds, and patterns for use in the manufacture of D's products. Assume that each of these items is a unit of property as determined under §1.263(a)-3(e) and is not a material and supply under §1.162-3(c)(1). D is required to capitalize under paragraph (d)(1) of this section the amounts paid to acquire and produce the jigs, dies, molds, and patterns.



Example 5. Acquisition of land. F purchases a parcel of undeveloped real estate. F must capitalize under paragraph (d)(1) of this section the amount paid to acquire the real estate. See paragraph (f) of this section for the treatment of amounts paid to facilitate the acquisition of real property.




Example 6. Acquisition of building. G purchases a building. G must capitalize under paragraph (d)(1) of this section the amount paid to acquire the building. See paragraph (f) of this section for the treatment of amounts paid to facilitate the acquisition of real property.



Example 7. Acquisition of property for resale and production of property for sale; coordination with section 263A. H purchases goods for resale and produces other goods for sale. H must capitalize under paragraph (d)(1) of this section the amounts paid to acquire and produce the goods. See section 263A for the amounts required to be capitalized to the property produced or to the property acquired for resale




Example 8. Production of building; coordination with section 263A. J constructs a building. J must capitalize under paragraph (d)(1) of this section the amount paid to construct the building. See section 263A for the costs required to be capitalized to the real property produced by J.



Example 9. Acquisition of assets constituting a trade or business. K owns tangible and intangible assets that constitute a trade or business. L purchases all the assets of K in a taxable transaction. L must capitalize under paragraph (d)(1) of this section the amount paid for the tangible assets of K. See §1.263(a)-4 for the treatment of amounts paid to acquire or create intangibles and §1.263(a)-5 for the treatment of amounts paid to facilitate the acquisition of assets that constitute a trade or business. See section 1060 for special allocation rules for certain asset acquisitions.




Example 10. Work performed prior to placing the property in service. In Year 1, M purchases a building for use as a business office. Prior to placing the building in service, M pays amounts to repair cement steps, refinish wood floors, patch holes in walls, and paint the interiors and exteriors of the building. In Year 2, M places the building in service and begins using the building as its business office. Assume that the work that M performs does not constitute an improvement to the building or its structural components under §1.263(a)-3. Under §1.263-3(e)(2)(i), the building and its structural components is a single unit of property. Under paragraph (d)(1) of this section, the amounts paid must be capitalized as amounts to acquire the building unit of property because they were for work performed prior to M's placing the building in service



Example 11. Work performed prior to placing the property in service. In January Year 1, N purchases a new machine for use in an existing production line of its manufacturing business. Assume that the machine is a unit of property under §1.263(a)-3(e) and is not a material or supply under §1.162-3. N pays amounts to install the machine, and after the machine is installed, N pays amounts to perform a critical test on the machine to ensure that it will operate in accordance with quality standards. On November 1, Year 1, the critical test is complete, and N places the machine in service on the production line. N pays amounts to perform periodic quality control testing after the machine is placed in service. Under paragraph (d)(1) of this section, the amounts paid for the installation and the critical test performed before the machine is placed in service must be capitalized by N as amounts to acquire the machine. However, amounts paid for periodic quality control testing after N placed the machine in service are not required to be capitalized as amounts paid to acquire the machine.



1.263(a)-2 When to Capitalize Payments for Defense of Title

• In general . . . Amounts paid to defend or perfect title to real or personal property are considered paid to acquire or produce the property and must be capitalized

• Examples

– Attorney fees paid to contest condemnation - capitalize

– Attorney fees paid to invalidate ordinance – deduct

– Attorney fees paid to challenge building line - capitalize



Example 1. Amounts paid to contest condemnation. X owns real property located in County. County files an eminent domain complaint condemning a portion of X's property to use as a roadway. X hires an attorney to contest the condemnation. The amounts that X paid to the attorney must be capitalized because they were to defend X's title to the property.




Example 2. Amounts paid to invalidate ordinance. Y is in the business of quarrying and supplying for sale sand and stone in a certain municipality. Several years after Y establishes its business, the municipality in which it is located passes an ordinance that prohibits the operation of Y's business. Y incurs attorney's fees in a successful prosecution of a suit to invalidate the municipal ordinance. Y prosecutes the suit to preserve its business activities and not to defend Y's title in the property. Therefore, the attorney's fees that Y paid are not required to be capitalized under paragraph (e)(1) of this section.



Example 3. Amounts paid to challenge building line. The board of public works of a municipality establishes a building line across Z's business property, adversely affecting the value of the property. Z incurs legal fees in unsuccessfully litigating the establishment of the building line. The amounts Z paid to the attorney must be capitalized because they were to defend Z's title to the property..



1.263(a)-2 Transaction Costs to Facilitate Acquisition or Production• In general . . . Costs to facilitate acquisition or production

of real or personal property must be capitalized

– See 263A for rules relating to property produced by taxpayer

– See 1.263(a)-5 for rules relating to amounts paid to facilitate acquisition of assets constituting a trade or business

– See 1.167(a)-5 for allocation of facilitative costs between depreciable and non-depreciable property

• Paid to facilitate an acquisition . . . Paid in process of investigating or otherwise pursuing an acquisition


1.263(a)-2 Transaction Costs to Facilitate Acquisition or Production• Employee compensation and overhead

– Generally do not capitalize [Reg. §1.263(a)-2(f)(2)(iv)(A)]

– Can elect to do so [Reg. §1.263(a)-2(f)(2)(iv)(B)]• Cannot undo election once made

• Partnerships/S corporations must make at the entity level



1.263(a)-2 Transaction Costs to Facilitate Acquisition or Production• Inherently facilitative costs include . . .

– Transporting property

– Appraisals and value determinations

– Negotiating terms and obtaining tax advice on acquisition

– Application fees, bidding costs, etc.

– Preparing and reviewing sales contract, etc.

– Examining and evaluating title to property

– Obtaining regulatory approval, costs of permits and fees

– Conveyance costs; transfer taxes and title registration

– Finders fee or brokers commission including contingencies

– Various inspection services performed before closing

– Services provided by Q I to facilitate 1031 exchange


1.263(a)-2 Transaction Costs to Facilitate Acquisition or Production• Special rules for acquisition of real property

– Cost is not facilitative if related to determining whether to acquire real property and which real property to acquire

– Use reasonable allocation method for costs incurred to acquire real and personal property in a single transaction

– Except as required by 263A, employee compensation and overhead are not required to be capitalized

– Taxpayer may elect to capitalize amounts otherwise deductible

– All facilitative costs are required to be capitalized



1.263(a)-2 Transaction Costs to Facilitate Acquisition or Production• Added definition of “contingency fee”

– Contingent on successful closing of the property

– Must be allocated only to property acquired—cannot treat part as allocable to property not acquired


1.263(a)-2 Transaction Costs to Facilitate Acquisition or Production• Ten examples . . .

– Broker’s fees to facilitate acquisition – capitalize

– Inspection and survey costs – capitalize

– Moving costs to facilitate acquisition – capitalize

– Geological and geophysical costs; oil and gas production –capitalize as a separate asset from real property

– Fee to interior designer – capitalize

– Fees to evaluate alternative sites – capitalize

– Fees for building plan – capitalize as building cost, not land

– Fees to development consultant – not capitalized

– Costs of purchasing function – not capitalized

– Compensation – not capitalized unless elect to do so



1.263(a)-2 Transaction Costs to Facilitate Acquisition or Production

Example 1. Broker’s fees to facilitate an acquisition. A decides to purchase abuilding in which to relocate its offices and hires a real estate broker to find a suitable building. A pays fees to the broker to find property for A to acquire. Under paragraph (f)(2)(ii)(I) of this section, A must capitalize the amounts paid to the broker because these costs are inherently facilitative of the acquisition of real property.



Example 2. Inspection and survey costs to facilitate an acquisition. B decides to purchase Building X and pays amounts to third-party contractors for a termite inspection and an environmental survey of Building X. Under paragraph (f)(2)(ii)(J) of this section, B must capitalize the amounts paid for the inspection and the survey of the building because these costs are inherently facilitative of the acquisition of real property.




Example 3. Moving costs to facilitate an acquisition. C purchases all the assets of D and, in connection with the purchase, hires a transportation company to move storage tanks from D's plant to C's plant. Under paragraph (f)(2)(ii)(A) of this section, C must capitalize the amount paid to move the storage tanks from D's plant to C's plant because this cost is inherently facilitative to the acquisition of personal property.



Example 4. Geological and geophysical costs; coordination with other provisions. E is in the business of exploring, purchasing, and developing properties in the United States for the production of oil and gas. E considers acquiring a particular property but first incurs costs for the services of an engineering firm to perform geological and geophysical studies to determine if the property is suitable for oil or gas production. Assume that the amounts that E paid to the engineering firm constitute geological and geophysical expenditures under section 167(h). Although the amounts that E paid for the geological and geophysical services are inherently facilitative to the acquisition of real property under paragraph (f)(2)(ii)(J) of this section, E is not required to include those amounts in the basis of the real property acquired. Rather, under paragraph (c) of this section, E must capitalize these costs separately and amortize such costs as required under section 167(h) (addressing the amortization of geological and geophysical expenditures).




Example 5. Scope of facilitate. F is in the business of providing legal services to clients. F is interested in acquiring a new conference table for its office. F hires and incurs fees for an interior designer to shop for, evaluate, and make recommendations to F regarding which new table to acquire. Under paragraphs (f)(1) and (2) of this section, F must capitalize the amounts paid to the interior designer to provide these services because they are paid in the process of investigating or otherwise pursuing the acquisition of personal property.



Example 6. Transaction costs allocable to multiple properties. G, a retailer, wants to acquire land for the purpose of building a new distribution facility for its products. G considers various properties on Highway X in State Y. G incurs fees for the services of an architect to advise and evaluate the suitability of the sites for the type of facility that G intends to construct on the selected site. G must capitalize the architect fees as amounts paid to acquire land because these amounts are inherently facilitative to the acquisition of land under paragraph (f)(2)(ii)(J) of this section.




Example 7. Transaction costs; coordination with section 263A. H, a retailer, wants to acquire land for the purpose of building a new distribution facility for its products. H considers various properties on Highway X in State Y. H incurs fees for the services of an architect to prepare preliminary floor plans for a building that H could construct at any of the sites. Under these facts, the architect's fees are not facilitative to the acquisition of land under paragraph (f) of this section. Therefore, H is not required to capitalize the architect fees as amounts paid to acquire land. However, the amounts paid for the architect's fees may be subject to capitalization under section 263A if these amounts comprise the direct or allocable indirect cost of property produced by H, such as the building.



Example 8. Special rule for acquisitions of real property. J owns several retail stores. J decides to examine the feasibility of opening a new store in City X. In October, Year 1, J hires and incurs costs for a development consulting firm to study City X and perform market surveys, evaluate zoning and environmental requirements, and make preliminary reports and recommendations as to areas that J should consider for purposes of locating a new store. In December, Year 1, J continues to consider whether to purchase real property in City X and which property to acquire. J hires, and incurs fees for, an appraiser to perform appraisals on two different sites to determine a fair offering price for each site. In March, Year 2, J decides to acquire one of these two sites for the location of its new store. At the same time, J determines not to acquire the other site.




Under paragraph (f)(2)(iii) of this section, J is not required to capitalize amounts paid to the development consultant in Year 1 because the amounts relate to activities performed in the process of determining whether to acquire real property and which real property to acquire, and the amounts are not inherently facilitative costs under paragraph (f)(2)(ii) of this section. However, J must capitalize amounts paid to the appraiser in Year 1 because the appraisal costs are inherently facilitative costs under paragraph (f)(2)(ii)(B) of this section. In Year 2, J must include the appraisal costs allocable to property acquired in the basis of the property acquired. In addition, J may recover the appraisal costs allocable to the property not acquired in accordance with paragraphs (f)(3)(ii) and (h) of this section. See, for example, §1.165-2 for losses on the permanent withdrawal of non-depreciable property.



Example 9. Contingency fee. K owns several restaurant properties. K decides to open a new restaurant in City X. In October, Year 1, K hires a real estate consultant to identify potential property upon which K may locate its restaurant, and is obligated to compensate the consultant upon the acquisition of property. The real estate consultant identifies three properties, and K decides to acquire one of those properties. Upon closing of the acquisition of that property, K pays the consultant its fee. The amount paid to the consultant constitutes a contingency fee under paragraph (f)(3)(iii) of this section because the payment is contingent on the successful closing of the acquisition of property. Accordingly, under paragraph (f)(3)(iii) of this section, K must include the amount paid to the consultant in the basis of the property acquired. K is not permitted to allocate the amount paid between the properties acquired and not acquired.




Example 10. Employee compensation and overhead. L, a freight carrier, maintains an acquisition department whose sole function is to arrange for the purchase of vehicles and aircraft from manufacturers or other parties to be used in its freight carrying business. As provided in paragraph (f)(2)(iv)(A) of this section, L is not required to capitalize any portion of the compensation paid to employees in its acquisition department or any portion of its overhead allocable to its acquisition department. However, under paragraph (f)(2)(iv)(B) of this section, L may elect to capitalize the compensation and/or overhead costs allocable to the acquisition of a vehicle or aircraft by treating these amounts as costs that facilitate the acquisition of that property in its timely filed original Federal tax return for the year the amounts are paid.


1.263(a)-2 Recovery of Capital Expenditures

• Amounts required to be capitalized by this section are capital expenditures, to be recovered by a charge to the basis of capital assets or inclusion in inventory costs

• Such amounts are recovered through depreciation, cost of goods sold or an adjustment to basis when property is placed in service, sold, used, or otherwise disposed of

• 2 examples

– New refrigerator in apartment – capitalize and depreciate

– Tractor/loader to move materials in manufacturing plant –capitalize. Depreciation will be a cost of goods manufactured to be recovered through cost of goods sold.




Example 1. Recovery when property placed in service. X owns a 10-unit apartment building. The refrigerator in one of the apartments stops functioning, and X purchases a new refrigerator to replace the old one. X pays for the acquisition, delivery, and installation of the new refrigerator. Assume that the refrigerator is the unit of property, as determined under §1.263(a)-3(e), and is not a material or supply under §1.162-3. Under paragraph (d)(1) of this section, X is required to capitalize the amounts paid for the acquisition, delivery, and installation of the refrigerator. Under this paragraph (h), the capitalized amounts are recovered through depreciation, which begins when the refrigerator is placed in service by X.



Example 2. Recovery when property used in the production of property. Y operates a plant where it manufactures widgets. Y purchases a tractor loader to move raw materials into and around the plant for use in the manufacturing process. Assume that the tractor loader is a unit of property, as determined under §1.263(a)-3(e), and is not a material or supply under §1.162-3. Under paragraph (d)(1) of this section, Y is required to capitalize the amounts paid to acquire the tractor loader. Under this paragraph (h), the capitalized amounts are recovered through depreciation, which begins when Y places the tractor loader in service. However, because the tractor loader is used in the production of property, under section 263A the cost recovery (that is, the depreciation) may also be capitalized to Y's property produced, and, consequently, recovered through cost of goods sold. See §1.263A-1(e)(3)(ii)(I).




• Change under Section 10.11 of Revenue Procedure 2015-14

• DCN 192 - Change to capitalizing acquisition or production costs and, if depreciable, to depreciating such property under § 167 or §168 [§ 1.263(a)-2]


Example

• Taxpayer paid $20,000 to attorneys in 1995 to contest eminent domain proceeding related to land owned by the taxpayer

• Originally expensed these fees when incurred





Item Being Changed

Accounting for legal fees incurred to protect title to property

Current Method

Taxpayer had expensed such legal fees at the time the cost is

incurred.

Proposed MethodThe taxpayer proposed to add such legal fees to the basis of

the property when title to the property is contested.


The proposed treatment is the method specified to be used

pursuant to §1.263(a)-2


Legal Fees Incurred for Eminent Domain Proceeding

Challenge to land from city - June 1995 20,000

§481(a) Adjustment as of January 1, 2014 20,000

Additonal to income for 2014-2017 5,000



1.263(a)-3 Payments to Improve Property

• Overview . . . 3 provides rules for applying 263(a) to amounts paid to improve tangible property

– (b) . . . definitions

– (c) . . . rules for coordinating with other code provisions

– (d) . . . requirement to capitalize amounts paid to improve property and tests to determine

whether property is improved

– (e) . . . rules to determine appropriate unit of property

– (f) . . . Rules for determining improvement costs in particular contexts



– (g) . . . Rules for determining improvement costs

– (h) . . . Safe harbor for small taxpayers

– (i) . . . Safe harbor for routine maintenance

– (j) . . . Capitalization of betterments

– (k) . . . Rules to determine restoration

– (l) . . . Rules to determine adaptation - new or different use

– (m) . . . Optional regulatory accounting method




– (n) . . . Election to capitalize repairs and maintenance

– (o) . . . Treatment of capital expenditures

– (p) . . . Recovery of capitalized amounts

– (q) . . . Accounting method changes

– (r) . . . Effective dates


1.263(a)-3 Definitions

• Amount paid . . . Includes a liability incurred by an accrual basis taxpayer

• Personal property . . . Tangible personal property as defined in 1.48-1(c)

• Real property . . . Land and improvements, buildings and other inherently permanent structures (including their structural components). Also includes other tangible property under 1.48-1(d). Local law does not control.

• Owner . . . Taxpayer that has benefits and burdens of ownership for federal income tax purposes



1.263(a)-3 Coordination With Other Code Provisions

• In general . . . Nothing in this section changes treatment of any amount specifically provided for under any other provision of the Code or regulations other than 162(a) and 212 and of their regulations

– Materials and supplies . . . A material or supply [as defined in 1.162-3(c)], used to improve a unit of tangible property is subject to capitalization and not treated as a material or supply

– De minimis exception . . . Taxpayer is not required to capitalize amounts properly deducted under the de minimis rule of 1.263(a)-1(f)

– Small taxpayer building safe harbor . . . Taxpayer is not required to capitalize amounts properly deducted under the small taxpayer building property safe harbor of 1.263(a)-3(h)


1.263(a)-3 Coordination With Other Code Provisions

• In general . . . Nothing in this section changes treatment of any amount specifically provided for under any other provision of the Code or regulations other than 162(a) and 212 and of their regulations

– Elective capitalization of repairs and maintenance . . . Taxpayer may capitalize otherwise deductible repairs and maintenance under the elective capitalization rules of 1.263(a)-3(n)

• Example . . . This section does not change deduction for rehabilitation of railroad rolling stock specifically allowed by 263A(d)



1.263(a)-3 Amounts Paid to Improve Property

• Taxpayer must generally capitalize aggregate of amounts paid to improve a unit of property. Unit of property is improved if amounts paid for work done after property is placed in service:

– Result in a betterment of the unit of property

– Restore the unit of property

– Adapt the unit of property to a new or different use

• Note that amounts paid for repairs and “routine maintenance” continue to be deductible. It is the distinction between repair, betterment, restoration, and adaptation that will continue to be troublesome


1.263(a)-3 Appropriate Unit of Property

• Unit of Property Rule [Reg. §1.263(a)-3(e)]

• Default classification – look for functional interdependence [Reg. §1.263(a)-3(e)(3)(i)]

• However have special rules that override functional interdependence test for

– Buildings

– Plant property

– Network assets

– Leased Property




Reg. §1.263(a)-3(e)(3) – Functional Interdependence

(i)In general.

Except as otherwise provided in paragraphs (e)(3), (e)(4), (e)(5), and (f)(1) of this section, in the case of real or personal property other than property described in paragraph (e)(2) of this section, all the components that are functionally interdependent comprise a single unit of property. Components of property are functionally interdependent if the placing in service of one component by the taxpayer is dependent on the placing in service of the other component by the taxpayer.



• Special cases outside of “functional interdependence”test for unit of property

– Building structure . . . a building and its structural components (watch the definition) are a single unit of property. An amount is paid for an improvement to a building if it improves

• Building structure and/or its structural components [1.48-1(e)(2)]




(2) The term "structural components" includes such parts of a building as walls, partitions, floors, and ceilings, as well as any permanent coverings therefor such as paneling or tiling; windows and doors; all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts; plumbing and plumbing fixtures, such as sinks and bathtubs; electric wiring and lighting fixtures; chimneys; stairs, escalators, and elevators, including all components thereof; sprinkler systems; fire escapes; and other components relating to the operation or maintenance of a building.



However, the term "structural components" does not include machinery the sole justification for the installation of which is the fact that such machinery is required to meet temperature or humidity requirements which are essential for the operation of other machinery or the processing of materials or foodstuffs. Machinery may meet the "sole justification" test provided by the preceding sentence even though it incidentally provides for the comfort of employees, or serves, to an insubstantial degree, areas where such temperature or humidity requirements are not essential. For example, an air conditioning and humidification system installed in a textile plant in order to maintain the temperature or humidity within a narrow optimum range which is critical in processing particular types of yarn or cloth is not included within the term "structural components". For special rules with respect to an elevator or escalator, the construction, reconstruction, or erection of which is completed by the taxpayer after June 30, 1963, or which is acquired after June 30, 1963, and the original use of which commences with the taxpayer and commences after such date, see section 48(a)(1)(C) and paragraph (m) of this section.




• Special cases outside of “functional interdependence”test for unit of property

– Building systems . . . These structural components are identified as separate from the building structure for the purpose of determining unit of property as required by these rules

• HVAC systems

• Plumbing systems

• Electrical systems

• Escalators

• Elevators

• Fire protection and alarm systems

• Security systems


1.263(a)-3 Appropriate Unit of Property (continued)

• Gas distribution system

• Other structural components identified in published guidance may be excepted from the building structure and are specifically designated as building systems

– Condominium . . . Unit of property is individual unit owned by the taxpayer and its structural components [1.48-1(e)(2)]

• Amount paid for improvement to a condominium is not deductible if it results in a betterment, restoration, or adaptation

• Condominium Association must apply the improvement rules to the building structure or any building system




– Cooperative . . . Unit of property is that portion of the building in which taxpayer has possessory rights and structural components that are part of that portion

• Amount paid for improvement to a cooperative unit is not deductible if it results in a betterment, restoration, or adaptation

• Cooperative housing corporation must apply the improvement rules to the building structure or any building system

– Leased building . . . Unit of property is that portion of a building subject to the lease and structural components associated with the leased portion

• Amount paid for improvement to leased premises is not deductible if it results in a betterment, restoration, or adaptation to entire building or the leased portion



• Property other than building . . . All the components that are functionally interdependent make up a single unit of property.

– Plant property . . . Functionally interdependent machinery or equipment, other than network assets, performing industrial process - - manufacturing, generation, warehousing, distribution, automated materials handling, etc.

• unit of property for plant property . . . Determined under the general rule but further divided into smaller units of each component (or group of components) that perform separate and major function or operation

– Network assets . . . Railroad track, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines. Unit of property determined by each taxpayer’s facts and circumstances




• Leased property other than buildings . . . Unit of property determined under general rules of this section but may not be larger than unit of leased property

• Improvements to property . . . Improvement, except for lessee improvement, cannot be unit of property separate from property improved

• Additional rules . . .

– Year placed in service . . . Component may be treated as separate unit of property if properly in a different class

– Change in subsequent taxable year . . . If taxpayer or IRS changes the treatment of property in a subsequent year, then reclassified portion must be treated as a separate asset



• Nineteen examples . . .

– Replacement of roof mounted HVAC units – capitalize

– Work on elevators – capitalize if “improvement”

– Work on plumbing system – capitalize if “improvement”

– Expanding office building – capitalize

– Power plant boiler, generator, and turbine are separate systems

– Laundry sorter, boiler, washer, dryer, etc. are separate systems

– Tortilla machine in restaurant is discrete system

– Locomotive is single unit of property because its systems are functionally interdependent

– Computer and printer are not functionally interdependent




– Lease of entire building requires separate consideration of building structure and building systems, such as HVAC

– Driveway constructed by lessee, using construction allowance from lessor, is a separate unit of property

– Same driveway, constructed by lessor, is also a separate unit of property

– Lessee is responsible for maintenance of building systems and must capitalize any improvements

– Leased aircraft are separate units of property

– Expanding size of warehouse is capitalizable

– Semi-truck tractor, including its tires, is single unit of property

– Leasehold improvement is separate unit of property from building in which it was constructed



– Change in classification based on cost segregation study requires parking lot to be treated as separate asset from associated building

– Change in classification of previously segregated cost to structural component of building requires change in depreciation method




Example 1. Building systems. A owns an office building that contains a HVAC system. The HVAC system incorporates ten roof-mounted units that service different parts of the building. The roof-mounted units are not connected and have separate controls and duct work that distribute the heated or cooled air to different spaces in the building's interior. A pays an amount for labor and materials for work performed on the roof-mounted units. Under paragraph (e)(2)(i) of this section, A must treat the building and its structural components as a single unit of property. As provided under paragraph (e)(2)(ii) of this section, an amount is paid to improve a building if it is for an improvement to the building structure or any designated building system. Under paragraph (e)(2)(ii)(B)(1) of this section, the entire HVAC system, including all of the roof-mounted units and their components, comprise a building system. Therefore, under paragraph (e)(2)(ii) of this section, if an amount paid by A for work on the roof-mounted units is an improvement (for example, a betterment) to the HVAC system, A must treat this amount as an improvement to the building.



Example 2. Building systems. B owns a building that it uses in its retail business. The building contains two elevator banks in different locations in its building. Each elevator bank contains three elevators. B pays an amount for labor and materials for work performed on the elevators. Under paragraph (e)(2)(i) of this section, B must treat the building and its structural components as a single unit of property. As provided under paragraph (e)(2)(ii) of this section, an amount is paid to improve a building if it is for an improvement to the building structure or any designated building system. Under paragraph (e)(2)(ii)(B)(5) of this section, all six elevators, including all their components, comprise a building system. Therefore, under paragraph (e)(2)(ii) of this section, if an amount paid by B for work on the elevators is an improvement (for example, a betterment) to the elevator system, B must treat this amount as an improvement to the building.




Example 3. Building structure and systems; condominium. C owns a condominium unit in a condominium office building. C uses the condominium unit in its business of providing medical services. The condominium unit contains two restrooms, each of which contains a sink, a toilet, water and drainage pipes and other bathroom fixtures. C pays an amount for labor and materials to perform work on the pipes, sinks, toilets, and plumbing fixtures that are part of the condominium. Under paragraph (e)(2)(iii) of this section, C must treat the individual unit that it owns, including the structural components that are part of that unit, as a single unit of property. As provided under paragraph (e)(2)(iii)(B) of this section, an amount is paid to improve the condominium if it is for an improvement to the building structure that is part of the condominium or to a portion of any designated building system that is part of the condominium.



Example 3. Building structure and systems; condominium (continued).

Under paragraph (e)(2)(ii)(B)(2) of this section, the pipes, sinks, toilets, and plumbing fixtures that are part of C's condominium comprise the plumbing system for the condominium. Therefore, under paragraph (e)(2)(iii) of this section, if an amount paid by C for work on pipes, sinks, toilets, and plumbing fixtures is an improvement (for example, a betterment) to the portion of the plumbing system that is part of C's condominium, C must treat this amount as an improvement to the condominium.




Example 4. Building structure and systems; property other than

buildings. D, a manufacturer, owns a building adjacent to its manufacturing facility that contains office space and related facilities for D's employees that manage and administer D's manufacturing operations. The office building contains equipment, such as desks, chairs, computers, telephones, and bookshelves that are not building structure or building systems. D pays an amount to add an extension to the office building. Under paragraph (e)(2)(i) of this section, D must treat the building and its structural components as a single unit of property. As provided under paragraph (e)(2)(ii) of this section, an amount is paid to improve a building if it is for an improvement to the building structure or any designated building system.



Example 4. Building structure and systems; property other than buildings

(continued).

Therefore, under paragraph (e)(2)(ii) of this section, if an amount paid by D for the addition of an extension to the office building is an improvement (for example, a betterment) to the building structure or any of the building systems, D must treat this amount as an improvement to the building. In addition, because the equipment contained within the office building constitutes property other than the building, the units of property for the office equipment are initially determined under paragraph (e)(3)(i) of this section and are comprised of all the components that are functionally interdependent (for example, each desk, each chair, and each book shelf).




Example 5. Plant property; discrete and major function. E is an electric utility company that operates a power plant to generate electricity. The power plant includes a structure that is not a building under §1.48-1(e)(1), and, among other things, one pulverizer that grinds coal, a single boiler that produces steam, one turbine that converts the steam into mechanical energy, and one generator that converts mechanical energy into electrical energy. In addition, the turbine contains a series of blades that cause the turbine to rotate when affected by the steam. Because the plant is composed of real and personal tangible property other than a building, the unit of property for the generating equipment is initially determined under the general rule in paragraph (e)(3)(i) of this section and is comprised of all the components that are functionally interdependent.



Example 5. Plant property; discrete and major function (continued).

Under this rule, the initial unit of property is the entire plant because the components of the plant are functionally interdependent. However, because the power plant is plant property under paragraph (e)(3)(ii) of this section, the initial unit of property is further divided into smaller units of property by determining the components (or groups of components) that perform discrete and major functions within the plant. Under this paragraph, E must treat the structure, the boiler, the turbine, the generator, and the pulverizer each as a separate unit of property because each of these components performs a discrete and major function within the power plant. E may not treat components, such as the turbine blades, as separate units of property because each of these components does not perform a discrete and major function within the plant.




Example 6. Plant property; discrete and major function. F is engaged in a uniform and linen rental business. F owns and operates a plant that utilizes many different machines and equipment in an assembly line-like process to treat, launder, and prepare rental items for its customers. F utilizes two laundering lines in its plant, each of which can operate independently. One line is used for uniforms and another line is used for linens. Both lines incorporate a sorter, boiler, washer, dryer, ironer, folder, and waste water treatment system. Because the laundering equipment contained within the plant is property other than a building, the unit of property for the laundering equipment is initially determined under the general rule in paragraph (e)(3)(i) of this section and is comprised of all the components that are functionally interdependent.



Example 6. Plant property; discrete and major function (continued).

Under this rule, the initial units of property are each laundering line because each line is functionally independent and is comprised of components that are functionally interdependent. However, because each line is comprised of plant property under paragraph (e)(3)(ii) of this section, F must further divide these initial units of property into smaller units of property by determining the components (or groups of components) that perform discrete and major functions within the line. Under paragraph (e)(3)(ii) of this section, F must treat each sorter, boiler, washer, dryer, ironer, folder, and waste water treatment system in each line as a separate unit of property because each of these components performs a discrete and major function within the line.




Example 7. Plant property; industrial process. G operates a restaurant that prepares and serves food to retail customers. Within its restaurant, G has a large piece of equipment that uses an assembly line-like process to prepare and cook tortillas that G serves only to its restaurant customers. Because the tortilla-making equipment is property other than a building, the unit of property for the equipment is initially determined under the general rule in paragraph (e)(3)(i) of this section and is comprised of all the components that are functionally interdependent. Under this rule, the initial unit of property is the entire tortilla-making equipment because the various components of the equipment are functionally interdependent. The equipment is not plant property under paragraph (e)(3)(ii) of this section because the equipment is not used in an industrial process, as it performs a small-scale function in G's restaurant operations. Thus, G is not required to further divide the equipment into separate units of property based on the components that perform discrete and major functions.



Example 8. Personal property. H owns locomotives that it uses in its railroad business. Each locomotive consists of various components, such as an engine, generators, batteries, and trucks. H acquired a locomotive with all its components. Because H's locomotive is property other than a building, the initial unit of property is determined under the general rule in paragraph (e)(3)(i) of this section and is comprised of the components that are functionally interdependent. Under paragraph (e)(3)(i) of this section, the locomotive is a single unit of property because it consists entirely of components that are functionally interdependent.




Example 9. Personal property. J provides legal services to its clients. J purchased a laptop computer and a printer for its employees to use in providing legal services. Because the computer and printer are property other than a building, the initial units of property are determined under the general rule in paragraph (e)(3)(i) of this section and are comprised of the components that are functionally interdependent. Under paragraph (e)(3)(i) of this section, the computer and the printer are separate units of property because the computer and the printer are not components that are functionally interdependent (that is, the placing in service of the computer is not dependent on the placing in service of the printer).



Example 10. Building structure and systems; leased building. K is a retailer of consumer products. K conducts its retail sales in a building that it leases from L. The leased building consists of the building structure (including the floor, walls, and roof) and various building systems, including a plumbing system, an electrical system, an HVAC system, a security system, and a fire protection and prevention system. K pays an amount for labor and materials to perform work on the HVAC system of the leased building. Under paragraph (e)(2)(v)(A) of this section, because K leases the entire building, K must treat the leased building and its structural components as a single unit of property. As provided under paragraph (e)(2)(v)(B) of this section, an amount is paid to improve a leased building property if it is for an improvement (for example, a betterment) to the leased building structure or to any building system within the leased building. Therefore, under paragraphs (e)(2)(v)(B)(1) and (e)(2)(ii)(B)(1) of this section, if an amount paid by K for work on the HVAC system is for an improvement to the HVAC system in the leased building, K must treat this amount as an improvement to the entire leased building property.




Example 11. Production of real property related to leased property.

Assume the same facts as in Example 10, except that K receives a construction allowance from L, and K uses the construction allowance to build a driveway adjacent to the leased building. Assume that under the terms of the lease, K, the lessee, is treated as the owner of any property that it constructs on or nearby the leased building. Also assume that section 110 does not apply to the construction allowance. Finally, assume that the driveway is not plant property or a network asset. Because the construction of the driveway consists of the production of real property other than a building, all the components of the driveway are functionally interdependent and are a single unit of property under paragraphs (e)(3)(i) and (e)(3)(iv) of this section.



Example 12. Leasehold improvements; construction allowance used for

lessor-owned improvements. Assume the same facts as Example 11, except that, under the terms of the lease, L, the lessor, is treated as the owner of any property constructed on the leased premises. Because L, the lessor, is the owner of the driveway and the driveway is real property other than a building, all the components of the driveway are functionally interdependent and are a single unit of property under paragraph (e)(3)(i) of this section.




Example 13. Buildings and structural components; leased office space. M provides consulting services to its clients. M conducts its consulting services business in two office spaces in the same building, each of which it leases from N under separate lease agreements. Each office space contains a separate HVAC system, which is part of the leased property. Both lease agreements provide that M is responsible for maintaining, repairing, and replacing the HVAC system that is part of the leased property. M pays amounts to perform work on the HVAC system in each office space. Because M leases two separate office spaces subject to two leases, M must treat the portion of the building structure and the structural components subject to each lease as a separate unit of property under paragraph (e)(2)(v)(A) of this section. As provided under paragraph (e)(2)(v)(B) of this section, an amount is paid to improve a leased building property, if it is for an improvement to the leased portion of the building structure or the portion of any designated building system subject to each lease.



Example 13. Buildings and structural components; leased office space

(continued).

Under paragraphs (e)(2)(v)(B)(1) and (e)(2)(ii)(B)(1) of this section, M must treat the HVAC system associated with each leased office space as a building system of that leased building property. Thus, M must treat the HVAC system associated with the first leased office space as a building system of the first leased office space and the HVAC system associated with the second leased office space as a building system of the second leased office space. Under paragraph (e)(2)(v)(B) of this section, if the amount paid by M for work on the HVAC system in one leased office space is for an improvement (for example, a betterment) to the HVAC system that is part of that leased space, then M must treat the amount as an improvement to that individual leased property.




Example 14. Leased property; personal property. N is engaged in the business of transporting passengers on private jet aircraft. To conduct its business, N leases several aircraft from O. Under paragraph (e)(3)(iv) of this section (referencing paragraph (e)(3)(i) of this section), N must treat all of the components of each leased aircraft that are functionally interdependent as a single unit of property. Thus, N must treat each leased aircraft as a single unit of property.



Example 15. Improvement property. (i) P is a retailer of consumer products. In Year 1, P purchases a building from Q, which P intends to use as a retail sales facility. Under paragraph (e)(2)(i) of this section, P must treat the building and its structural components as a single unit of property. As provided under paragraph (e)(2)(ii) of this section, an amount is paid to improve a building if it is for an improvement to the building structure or any designated building system.




Example 15. Improvement property (continued).

(ii) In Year 2, P pays an amount to construct an extension to the building to be used for additional warehouse space. Assume that the extension involves the addition of walls, floors, roof, and doors, but does not include the addition or extension of any building systems described in paragraph (e)(2)(ii)(B) of this section. Also assume that the amount paid to build the extension is a betterment to the building structure under paragraph (j) of this section, and is therefore treated as an amount paid for an improvement to the entire building under paragraph (e)(2)(ii) of this section. Accordingly, P capitalizes the amount paid as an improvement to the building under paragraph (d) of this section. Under paragraph (e)(4) of this section, the extension is not a unit of property separate from the building, the unit of property improved. Thus, to determine whether any future expenditure constitutes an improvement to the building under paragraph (e)(2)(ii) of this section, P must determine whether the expenditure constitutes an improvement to the building structure, including the building extension, or to any of the designated building systems.



Example 16. Additional rules; year placed in service. R is engaged in the business of transporting freight throughout the United States. To conduct its business, R owns a fleet of truck tractors and trailers. Each tractor and trailer is comprised of various components, including tires. R purchased a truck tractor with all of its components, including tires. The tractor tires have an average useful life to R of more than one year. At the time R placed the tractor in service, it treated the tractor tires as a separate asset for depreciation purposes under section 168. R properly treated the tractor (excluding the cost of the tires) as 3-year property and the tractor tires as 5-year property under section 168(e).




Example 16. Additional rules; year placed in service (continued).

Because R's tractor is property other than a building, the initial units of property for the tractor are determined under the general rule in paragraph (e)(3)(i) of this section and are comprised of all the components that are functionally interdependent. Under this rule, R must treat the tractor, including its tires, as a single unit of property because the tractor and the tires are functionally interdependent (that is, the placing in service of the tires is dependent upon the placing in service of the tractor). However, under paragraph (e)(5)(i) of this section, R must treat the tractor and tires as separate units of property because R properly treated the tires as being within a different class of property under section 168(e).



Example 17. Additional rules; change in subsequent year. S is engaged in the business of leasing nonresidential real property to retailers. In Year 1, S acquired and placed in service a building for use in its retail leasing operation. In Year 5, to accommodate the needs of a new lessee, S incurred costs to improve the building structure. S capitalized the costs of the improvement under paragraph (d) of this section and depreciated the improvement in accordance with section 168(i)(6) as nonresidential real property under section 168(e). In Year 7, S determined that the structural improvement made in Year 5 qualified under section 168(e)(8) as qualified retail improvement property and, therefore, was 15-year property under section 168(e). In Year 7, S changed its method of accounting to use a 15-year recovery period for the improvement. Under paragraph (e)(5)(ii) of this section, in Year 7, S must treat the improvement as a unit of property separate from the building.




Example 18. Additional rules; change in subsequent year. In Year 1, T acquired and placed in service a building and parking lot for use in its retail operations. Under §1.263(a)-2 of the regulations, T capitalized the cost of the building and the parking lot and began depreciating the building and the parking lot as nonresidential real property under section 168(e). In Year 3, T completed a cost segregation study under which it properly determined that the parking lot qualified as 15-year property under section 168(e). In Year 3, T changed its method of accounting for the parking lot to use a 15- year recovery period and the 150-percent declining balance method of depreciation. Under paragraph (e)(5)(ii) of this section, beginning in Year 3, T must treat the parking lot as a unit of property separate from the building.



Example 19. Additional rules; change in subsequent year. In Year 1, U acquired and placed in service a building for use in its manufacturing business. U capitalized the costs allocable to the building's wiring separately from the building and depreciated the wiring as 7-year property under section 168(e). U capitalized the cost of the building and all other structural components of the building and began depreciating them as nonresidential real property under section 168(e). In Year 3, U completed a cost segregation study under which it properly determined that the wiring is a structural component of the building and, therefore, should have been depreciated as nonresidential real property. In Year 3, U changed its method of accounting to treat the wiring as nonresidential real property. Under paragraph (e)(5)(ii) of this section, U must change the unit of property for the wiring in a manner that is consistent with the change in treatment for depreciation purposes. Therefore, U must change the unit of property for the wiring to treat it as a structural component of the building, and as part of the building unit of property, in accordance with paragraph (e)(2)(i) of this section.



Accounting Method

• Change in identification of unit of property is covered by Section 10.11, DCN 184

• Note that this issue can impact your ability to claim repair expenses in the future

• Arguably you have established a method simply by deciding if items are repairs or not in the past


Accounting Method

• Key likely changes

– Building and structural components for UOP, as well as testing for betterment, restoration and adaptation

– Plant property issues

– Network property (watch for guidance—we have revised cable television system safe harbors)

• Likely dovetails with your change in repairs



1.263(a)-3 Leased Property• Improvements to leased property generally follow same

rules as improvements to property owned by taxpayer. Capitalize improvements, betterments, and adaptations, while deducting repairs and routine maintenance.

– Amount capitalized by lessee is separate unit of property

– Amount capitalized by lessor is not separate unit of property

– Landlord must capitalize construction allowance . . . !




Example 1. Lessee improvements; additions to building. (i) T is a retailer of consumer products. In Year 1, T leases a building from L, which T intends to use as a retail sales facility. The leased building consists of the building structure under paragraph (e)(2)(ii)(A) of this section and various building systems under paragraph (e)(2)(ii)(B) of this section, including a plumbing system, an electrical system, and an HVAC system. Under the terms of the lease, T is permitted to improve the building at its own expense. Under paragraph (e)(2)(v)(A) of this section, because T leases the entire building, T must treat the leased building and its structural components as a single unit of property. As provided under paragraph (e)(2)(v)(B)(1) of this section, an amount is paid to improve a leased building property if the amount is paid for an improvement to the leased building structure or to any building system within the leased building. Therefore, under paragraphs (e)(2)(v)(B)(1) and (e)(2)(ii) of this section, if T pays an amount that improves the building structure, the plumbing system, the electrical system, or the HVAC system, then T must treat this amount as an improvement to the entire leased building property.




Example 1. Lessee improvements; additions to building (continued).

(ii) In Year 2, T pays an amount to construct an extension to the building to be used for additional warehouse space. Assume that this amount is for a betterment (as defined under paragraph (j) of this section) to T's leased building structure and does not affect any building systems. Accordingly, the amount that T pays for the building extension is for a betterment to the leased building structure, and thus, under paragraph (e)(2)(v)(B)(1) of this section, is treated as an improvement to the entire leased building under paragraph (d) of this section. Because T, the lessee, paid an amount to improve a leased building property, T is required to capitalize the amount paid for the building extension as a leasehold improvement under paragraph (f)(2)(i) of this section. In addition, paragraph (f)(2)(i) of this section requires T to treat the amount paid for the improvement as the acquisition or production of a unit of property (leasehold improvement property) under §1.263(a)-2(d)(1).




(iii) In Year 5, T pays an amount to add a large overhead door to the building extension that it constructed in Year 2 to accommodate the loading of larger products into the warehouse space. Under paragraph (f)(2)(ii) of this section, to determine whether the amount paid by T is for a leasehold improvement, the unit of property and the improvement rules are applied in accordance with paragraph (e)(2)(v) of this section and include T's previous improvements to the leased property. Therefore, under paragraph (e)(2)(v)(A) of this section, the unit of property is the entire leased building, including the extension built in Year 2. In addition, under paragraph (e)(2)(v)(B) of this section, the leased building property is improved if the amount is paid for an improvement to the building structure or any building system.





Assume that the amount paid to add the overhead door is for a betterment, under paragraph (j) of this section, to the building structure, which includes the extension. Accordingly, T must capitalize the amounts paid to add the overhead door as a leasehold improvement to the leased building property. In addition, paragraph (f)(2)(i) of this section requires T to treat the amount paid for the improvement as the acquisition or production of a unit of property (leasehold improvement property) under §1.263(a)-2(d)(1). However, to determine whether a future amount paid by T is for a leasehold improvement to the leased building, the unit of property and the improvement rules are again applied in accordance with paragraph (e)(2)(v) of this section and include the new overhead door.



Example 2. Lessee improvements; additions to certain structural

components of buildings. (i) Assume the same facts as Example 1 except that in Year 2, T also pays an amount to construct an extension of the HVAC system into the building extension. Assume that the extension is a betterment, under paragraph (j) of this section, to the leased HVAC system (a building system under paragraph (e)(2)(ii)(B)(1) of this section). Accordingly, the amount that T pays for the extension of the HVAC system is for a betterment to the leased building system, the HVAC system, and thus, under paragraph (e)(2)(v)(B)(1) of this section, is treated as an improvement to the entire leased building property under paragraph (d) of this section. Because T, the lessee, pays an amount to improve a leased building property, T is required to capitalize the amount paid as a leasehold improvement under paragraph (f)(2)(i) of this section. Under paragraph (f)(2)(i) of this section, T must treat the amount paid for the HVAC extension as the acquisition and production of a unit of property (leasehold improvement property) under §1.263(a)-2(d)(1).





components of buildings (continued).

(ii) In Year 5, T pays an amount to add an additional chiller to the portion of the HVAC system that it constructed in Year 2 to accommodate the climate control requirements for new product offerings. Under paragraph (f)(2)(ii) of this section, to determine whether the amount paid by T is for a leasehold improvement, the unit of property and the improvement rules are applied in accordance with paragraph (e)(2)(v) of this section and include T's previous improvements to the leased building property. Therefore, under paragraph (e)(2)(v)(B) of this section, the leased building property is improved if the amount is paid for an improvement to the building structure or any building system.




components of buildings (continued).

Assume that the amount paid to add the chiller is for a betterment, under paragraph (j) of this section, to the HVAC system, which includes the extension of the system in Year 2. Accordingly, T must capitalize the amounts paid to add the chiller as a leasehold improvement to the leased building property. In addition, paragraph (f)(2)(i) of this section requires T to treat the amount paid for the chiller as the acquisition or production of a unit of property (leasehold improvement property) under §1.263(a)-2(d)(1). However, to determine whether a future amount paid by T is for a leasehold improvement to the leased building, the unit of property and the improvement rules are again applied in accordance with paragraph (e)(2)(v) of this section and include the new chiller.




Example 3. Lessor Improvements; additions to building. (i) T is a retailer of consumer products. In Year 1, T leases a building from L, which T intends to use as a retail sales facility. Pursuant to the lease, L provides a construction allowance to T, which T intends to use to construct an extension to the retail sales facility for additional warehouse space. Assume that the amount paid for any improvement to the building does not exceed the construction allowance and that L is treated as the owner of any improvement to the building. Under paragraph (e)(2)(i) of this section, L must treat the building and its structural components as a single unit of property. As provided under paragraph (e)(2)(ii) of this section, an amount is paid to improve a building if it is paid for an improvement to the building structure or to any building system.



Example 3. Lessor Improvements; additions to building (continued).

(ii) In Year 2, T uses L's construction allowance to construct an extension to the leased building to provide additional warehouse space in the building. Assume that the extension is a betterment (as defined under paragraph (j) of this section) to the building structure, and therefore, the amount paid for the extension results in an improvement to the building under paragraph (d) of this section. Under paragraph (f)(3)(i) of this section, L, the lessor and owner of the improvement, must capitalize the amounts paid to T to construct the extension to the retail sales facility. T is not permitted to capitalize the amounts paid for the lessor-owned improvement. Finally, under paragraph (f)(3)(ii) of this section, the extension to L's building is not a unit of property separate from the building and its structural components.




Example 4. Lessee property; personal property added to leased building.

T is a retailer of consumer products. T leases a building from L, which T intends to use as a retail sales facility. Pursuant to the lease, L provides a construction allowance to T, which T uses to acquire and construct partitions for fitting rooms, counters, and shelving. Assume that each partition, counter, and shelving unit is a unit of property under paragraph (e)(3) of this section. Assume that for Federal income tax purposes T is treated as the owner of the partitions, counters, and shelving. T's expenditures for the partitions, counters, and shelving are not improvements to the leased property under paragraph (d) of this section, but rather constitute amounts paid to acquire or produce separate units of personal property under §1.263(a)-2(d)(1).



Example 5. Lessor property; buildings on leased property. L is the owner of a parcel of unimproved real property that L leases to T. Pursuant to the lease, L provides a construction allowance to T of $500,000, which T agrees to use to construct a building costing not more than $500,000 on the leased real property and to lease the building from L after it is constructed. Assume that for Federal income tax purposes, L is treated as the owner of the building that T will construct. T uses the $500,000 to construct the building as required under the lease. The building consists of the building structure and the following building systems: (1) a plumbing system; (2) an electrical system; and (3) an HVAC system.




Example 5. Lessor property; buildings on leased property (continued).

Because L provides a construction allowance to T to construct a building and L is treated as the owner of the building, L must capitalize the amounts that it pays indirectly to T to construct the building as a lessor improvement under paragraph (f)(3)(i) of this section. In addition, the amounts paid by L for the construction allowance are treated as amounts paid by L to acquire and produce the building under §1.263(a)- 2(d)(1). Further, under paragraph (e)(2)(i) of this section, L must treat the building and its structural components as a single unit of property. Under paragraph (f)(3)(i) of this section, T, the lessee, may not capitalize the amounts paid (with the construction allowance received from L) for construction of the building.



Example 6. Lessee contribution to construction costs. Assume the same facts as in Example 5, except T spends $600,000 to construct the building. T uses the $500,000 construction allowance provided by L plus $100,000 of its own funds to construct the building that L will own pursuant to the lease. Also assume that the additional $100,000 that T pays is not a substitute for rent. For the reasons discussed in Example 5, L must capitalize the $500,000 it paid T to construct the building under §1.263(a)-2(d)(1). In addition, because T spends its own funds to complete the building, T has a depreciable interest of $100,000 in the building and must capitalize the $100,000 it paid to construct the building as a leasehold improvement under §1.263(a)- 2(d)(1) of the regulations. Under paragraph (e)(2)(i) of this section, L must treat the building as a single unit of property to the extent of its depreciable interest of $500,000 In addition, under paragraphs (f)(2)(ii) and (e)(2)(i) of this section, T must also treat the building as a single unit of property to the extent of its depreciable interest of $100,000.


Accounting Method

• This one is likely not different from what you should have been doing

• But may find issues that can be “cleaned up” at this point


1.263(a)-3(g) Improvement Costs

• Capitalize

– Direct costs

– Indirect costs that directly benefit or incurred as result of improvement

• Residence exception – limited to significant renovation (so ignore all of those minor receipts).



1.263(a)-3(g) Improvement Costs

• Removal costs

– Generally removal costs apply to old asset

– However, if not a disposition for tax purposes, then costs are capitalized

– Method originally allowed per Revenue Ruling 2000-7


1.263(a)-3 Improvement Costs


Example 1. Component removed during improvement; no disposition. X owns a factory building with a storage area on the second floor. X pays an amount to remove the original columns and girders supporting the second floor and replace them with new columns and girders to permit storage of supplies with a gross weight 50 percent greater than the previous load-carrying capacity of the storage area. Assume that the replacement of the columns and girders constitutes a betterment to the building structure and is therefore an improvement to the building unit of property under paragraphs (d)(1) and (j) of this section. Assume that X disposes of the original columns and girders and the disposal of these structural components is not a disposition under Prop. Reg. §1.168(i)-1(e), or Prop. Reg. §1.168(i)-8. Under paragraphs (g)(2)(i) and (j) of this section, the amount paid to remove the columns and girders must be capitalized as a cost of the improvement, because it directly benefits and is incurred by reason of the improvement to the building.




Example 2.Component removed during improvement; disposition.

Assume the same facts as Example 1, except X disposes of the original columns and girders and elects to treat the disposal of these structural components as a partial disposition of the factory building under Prop. Reg. §1.168(i)-8(d), taking into account the adjusted basis of the components in realizing loss on the disposition. Under paragraph (g)(2)(i) of this section, the amount paid to remove the columns and girders is not required to be capitalized as part of the cost of the improvement regardless of their relation to the improvement. However, all the remaining costs of replacing the columns and girders must be capitalized as improvements to the building unit of property under paragraphs (d)(1), (j), and (g)(1) of this section.



Example 3. Component removed during repair or maintenance; no

disposition. Y owns a building in which it conducts its retail business. The roof over Y's building is covered with shingles. Over time, the shingles begin to wear and Y begins to experience leaks into its retail premises. However, the building still functions in Y's business. To eliminate the problems, a contractor recommends that Y remove the original shingles and replace them with new shingles. Accordingly, Y pays the contractor to replace the old shingles with new but comparable shingles. The new shingles are comparable to original shingles but correct the leakage problems. Assume that Y disposes of the original shingles, and the disposal of these shingles is not a disposition under Prop. Reg. §1.168(i)-1(e), or Prop. Reg. §1.168(i)-8.




Example 3. Component removed during repair or maintenance; no

disposition (continued).

Assume that replacement of old shingles with new shingles to correct the leakage is not a betterment or a restoration of the building structure or systems under paragraph (j) or (k) of this section and does not adapt the building structure or systems to a new or different use under paragraph (l) of this section. Thus, the amounts paid by Y to replace the shingles are not improvements to the building unit of property under paragraph (d) of this section. Under paragraph (g)(2)(i) of this section, the amounts paid to remove the shingles are not required to be capitalized because they directly benefit and are incurred by reason of repair or maintenance to the building structure.



Example 4. Component removed with disposition and restoration. Assume the same facts as Example 3 except Y disposes of the original shingles, and Y elects to treat the disposal of these components as a partial disposition of the building under Prop. Reg. §1.168(i)-8(d), and deducts the adjusted basis of the components as a loss on the disposition. Under paragraph (k)(1)(i) of this section, amounts paid for replacement of the shingles constitute a restoration of the building structure because the amounts are paid for the replacement of a component of the structure and the taxpayer has properly deducted a loss for that component. Thus, under paragraphs (d)(2) and (k) of this section, Y is required to capitalize the amounts paid for the replacement of the shingles as an improvement to the building unit of property. However, under paragraph (g)(2)(i) of this section, the amounts paid by Y to remove the original shingles are not required to be capitalized as part of the costs of the improvement, regardless of their relation to the improvement.


Accounting Method

• DCN 21 – Removal Costs [Revenue Ruling 2000-7 and Reg. §1.263(a)-3(g)(2)(i)]

• Does not fix issue if taxpayer has deducted costs when not treating item as disposition

• Generally requires obtaining details on work done – split out the removal costs


Example

• Taxpayer had paid expenses to have old roof taken off and made partial disposition election (makes it as a current method change on another Form 3115)

• Cost of removal of that roof was $25,000, paid in May of 2005




Removal costs that have been depreciated since 2005 25,000$

2005 Depreciation (5/12 of 1/39) (267)

2006 Depreciation (641)








Undepreciated Basis at 12/31/13 (§481(a) Adjustment) 19,605$

Note: Would reduce unadjusted basis of building by $25,000 and reduce

accumulated depreciation by $5,395


• If amounts paid over multiple years, must aggregate to determine if there is an improvement overall

• Regulatory requirement to make certain repairs or maintenance is not relevant in determination of an improvement



1.263(a)-3(h) Small Taxpayer Building Safe Harbor

• New in the final regulations

• Taxpayer with average annual gross receipts of < $10 million over past three years can elect to use

• Applies if total amount paid for maintenance, improvement and similar activity is less than the lesser of– $10,000

– 2% of the unadjusted basis of the building



• Must count items that would otherwise be excludable under

– De minimis rule

– Routine maintenance safe harbor

• Applies only to buildings with unadjusted basis of $1,000,000 or less (or total rent expected to be paid if leased)




• Is a “pass/fail” test

– If amounts < cap, can be treated as repairs

– If amounts > cap, then cannot use safe harbor and must apply standard rules to all items

• Now can use de minimis rule, routine maintenance

• Test other expenditures under standard rules

• Meant to be “simplifying” option for taxpayers for whom keeping the detailed records would be a burden



• Election– Found at Reg. §1.263(a)-3(h)(6)

– Attach statement to tax return for year in question (due with return)

• Titled “Section 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers”

• Include taxpayer's name, address, taxpayer identification number, and a description of each eligible building property to which the taxpayer is applying the election

– Partnership/S Corporation election at entity level





Example 1. Safe harbor for small taxpayers applicable. A is a qualifying taxpayer under paragraph (h)(3) of this section. A owns an office building in which A provides consulting services. In Year 1, A's building has an unadjusted basis of $750,000 as determined under paragraph (h)(5)(i) of this section. In Year 1, A pays $5,500 for repairs, maintenance, improvements and similar activities to the office building. Because A's building unit of property has an unadjusted basis of $1,000,000 or less, A's building constitutes eligible building property under paragraph (h)(4) of this section.



Example 1. Safe harbor for small taxpayers applicable (continued).

The aggregate amount paid by A during Year 1 for repairs, maintenance, improvements and similar activities on this eligible building property does not exceed the lesser of $15,000 (2 percent of the building's unadjusted basis of $750,000) or $10,000. Therefore, under paragraph (h)(1) of this section, A may elect to not apply the capitalization rule of paragraph (d) of this section to the amounts paid for repair, maintenance, improvements, or similar activities on the office building in Year 1. If A properly makes the election under paragraph (h)(6) of this section for the office building and the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business, A may deduct these amounts under §1.162- 1 in Year 1.




Example 2. Safe harbor for small taxpayers inapplicable. Assume the same facts as in Example 1, except that A pays $10,500 for repairs, maintenance, improvements, and similar activities performed on its office building in Year 1. Because this amount exceeds $10,000, the lesser of the two limitations provided in paragraph (h)(1) of this section, A may not apply the safe harbor for small taxpayers under paragraph (h)(1) of this section to the total amounts paid for repairs, maintenance, improvements, and similar activities performed on the building. Therefore, A must apply the general improvement rules under this section to determine which of the aggregate amounts paid are for improvements and must be capitalized under paragraph (d) of this section and which of the amounts are for repair and maintenance under § 1.162-4.



Example 3. Safe harbor applied building-by-building. (i) B is a qualifying taxpayer under paragraph (h)(3) of this section. B owns two rental properties, Building M and Building N. Building M and Building N are both multi-family residential buildings. In Year 1, each property has an unadjusted basis of $300,000 under paragraph (h)(5) of this section. Because Building M and Building N each have an unadjusted basis of $1,000,000 or less, Building M and Building N each constitute eligible building property in Year 1 under paragraph (h)(4) of this section. In Year 1, B pays $5,000 for repairs, maintenance, improvements, and similar activities performed on Building M. In Year 1, B also pays $7,000 for repairs, maintenance, improvements, and similar activities performed on Building N.




Example 3. Safe harbor applied building-by-building (continued).

(ii) The total amount paid by B during Year 1 for repairs, maintenance, improvements and similar activities on Building M ($5,000) does not exceed the lesser of $6,000 (2 percent of the building's unadjusted basis of $300,000) or $10,000. Therefore, under paragraph (h)(1) of this section, for Year 1, B may elect to not apply the capitalization rule under paragraph (d) of this section to the amounts it paid for repairs, maintenance, improvements, and similar activities on Building M. If B properly makes the election under paragraph (h)(6) of this section for Building M and the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on B's trade or business, B may deduct these amounts under §1.162-1.



Example 3. Safe harbor applied building-by-building (continued).

(iii) The total amount paid by B during Year 1 for repairs, maintenance, improvements and similar activities on Building N ($7,000) exceeds $6,000 (2 percent of the building's unadjusted basis of $300,000), the lesser of the two limitations provided under paragraph (h)(1) of this section. Therefore, B may not apply the safe harbor under paragraph (h)(1) of this section to the total amounts paid for repairs, maintenance, improvements, and similar activities performed on Building N. Instead, B must apply the general improvement rules under this section to determine which of the total amounts paid for work performed on Building N are for improvements and must be capitalized under paragraph (d) of this section and which amounts are for repair and maintenance under § 1.162-4.




Example 4. Safe harbor applied to leased building property. C is a qualifying taxpayer under paragraph (h)(3) of this section. C is the lessee of a building in which C operates a retail store. The lease is a triple-net lease, and the lease term is 20 years, including reasonably expected renewals. C pays $4,000 per month in rent. In Year 1, C pays $7,000 for repairs, maintenance, improvements, and similar activities performed on the building. Under paragraph (h)(5)(ii) of this section, the unadjusted basis of C's leased unit of property is $960,000 ($4,000 monthly rent x 12 months x 20 years). Because C's leased building has an unadjusted basis of $1,000,000 or less, the building is eligible building property for Year 1 under paragraph (h)(4) of this section.



Example 4. Safe harbor applied to leased building property (continued).

The total amount paid by C during Year 1 for repairs, maintenance, improvements, and similar activities on the leased building ($7,000) does not exceed the lesser of $19,200 (2 percent of the building's unadjusted basis of $960,000) or $10,000. Therefore, under paragraph (h)(1) of this section, for Year 1, C may elect to not apply the capitalization rule under paragraph (d) of this section to the amounts it paid for repairs, maintenance, improvements, and similar activities on the leased building. If C properly makes the election under paragraph (h)(6) of this section for the leased building and the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on C's trade or business, C may deduct these amounts under §1.162-1.


1.263(a)-3(i) Routine Maintenance Costs

• In general . . . An amount paid for routine maintenance on a unit of property other than a building or structural component of the building is deemed not to improve that unit of property. Routine maintenance includes:

– Inspection, cleaning, and testing

– Replacement of parts with comparable, commercially available, and reasonable replacements

– Activities reasonably expected to be required more than once during the class life (See Rev. Proc. 87-56) of the unit of property

– Consider recurring nature of activity, industry practice, maker’s recommendations, taxpayer’s experience, and taxpayers treatment of the activity in its “applicable financial statement”






• Final regulations add a building routine maintenance provision [Reg. §1.263(a)-3(i)(1)(i)]– Keep each building system and structure in ordinary efficient

operating condition

– Use “10 years” rather than ADR class life for testing

– Thus only building maintenance expected to be performed twice within 10 years can meet this test



• Ten (now fifteen) examples . . .

– Routine maintenance of aircraft engine during its class life** is deductible (engine is not separate unit of property)

– Same maintenance after engine’s class life is also deductible because it does not improve the aircraft

– Spare aircraft engines are rotable spare parts subject to same repair requirements - - routine maintenance is deductible

– Routine maintenance relating to prior owners use – capitalize

– Routine maintenance – new owners use – deduct

– Routine maintenance – scheduled replacement of substantial structural part – deduct

** Class Life . . . See Rev. Proc. 87-56 or IRS Pub. 946, Appendix B




– Reconditioning of railcar once during class life would be capitalizable, but for 263A(d)

– Scheduled preventive maintenance on towboat engines – not

required to be capitalized (Ingram Industries, T.C. Memo. 2000-323; 10/18/2000)

– Scheduled preventive maintenance on towboat engines with upgrade to increase their horse power and propulsion permitting them to tow heavier loads must be capitalized

– Routine maintenance not performed on schedule, allowing asset to fall into state of disrepair, not deductible

• This example has caused great controversy. Why should routine maintenance be capitalized simply because it is deferred due to financial considerations ? It’s still the same maintenance !



Example 1. Routine maintenance on component. (i) A is a commercial airline engaged in the business of transporting passengers and freight throughout the United States and abroad. To conduct its business, A owns or leases various types of aircraft. As a condition of maintaining its airworthiness certification for these aircraft, A is required by the Federal Aviation Administration (FAA) to establish and adhere to a continuous maintenance program for each aircraft within its fleet. These programs, which are designed by A and the aircraft's manufacturer and approved by the FAA, are incorporated into each aircraft's maintenance manual. The maintenance manuals require a variety of periodic maintenance visits at various intervals. One type of maintenance visit is an engine shop visit (ESV), which A expects to perform on its aircraft engines approximately every 4 years to keep its aircraft in its ordinarily efficient operating condition.




Example 1. Routine maintenance on component (continued).

In Year 1, A purchased a new aircraft, which included four new engines attached to the airframe. The four aircraft engines acquired with the aircraft are not materials or supplies under §1.162-3(c)(1)(i) because they are acquired as part of a single unit of property, the aircraft. In Year 5, A performs its first ESV on the aircraft engines. The ESV includes disassembly, cleaning, inspection, repair, replacement, reassembly, and testing of the engine and its component parts. During the ESV, the engine is removed from the aircraft and shipped to an outside vendor who performs the ESV. If inspection or testing discloses a discrepancy in a part's conformity to the specifications in A's maintenance program, the part is repaired, or if necessary, replaced with a comparable and commercially available replacement part. After the ESVs, the engines are returned to A to be reinstalled on another aircraft or stored for later installation. Assume that the class life for A's aircraft, including the engines, is 12 years. Assume that none of the exceptions set out in paragraph (i)(3) of this section apply to the costs of performing the ESVs.



Example 1. Routine maintenance on component (continued).

(ii) Because the ESVs involve the recurring activities that A expects to perform as a result of its use of the aircraft to keep the aircraft in ordinarily efficient operating condition and consist of maintenance activities that A expects to perform more than once during the 12 year class life of the aircraft, A's ESVs are within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts paid for the ESVs are deemed not to improve the aircraft and are not required to be capitalized under paragraph (d) of this section.




Example 2. Routine maintenance after class life. Assume the same facts as in Example 1, except that in year 15 A pays amounts to perform an ESV on one of the original aircraft engines after the end of the class life of the aircraft. Because this ESV involves the same routine maintenance activities that were performed on aircraft engines in Example 1, this ESV also is within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts paid for this ESV, even though performed after the class life of the aircraft, are deemed not to improve the aircraft and are not required to be capitalized under paragraph (d) of this section.



Example 3. Routine maintenance on rotable spare parts. (i) Assume the same facts as in Example 1, except that in addition to the four engines purchased as part of the aircraft, A separately purchases four additional new engines that A intends to use in its aircraft fleet to avoid operational downtime when ESVs are required to be performed on the engines previously installed on an aircraft. Later in Year 1, A installs these four engines on an aircraft in its fleet. In Year 5, A performs the first ESVs on these four engines. Assume that these ESVs involve the same routine maintenance activities that were performed on the engines in Example 1, and that none of the exceptions set out in paragraph (i)(3) of this section apply to these ESVs. After the ESVs were performed, these engines were reinstalled on other aircraft or stored for later installation.




Example 3. Routine maintenance on rotable spare parts (continued).

(ii) The additional aircraft engines are rotable spare parts because they were acquired separately from the aircraft, they are removable from the aircraft, and are repaired and reinstalled on other aircraft or stored for later installation. See §1.162- 3(c)(2) (definition of rotable and temporary spare parts). Assume the class life of an engine is the same as the airframe, 12 years. Because the ESVs involve the recurring activities that A expects to perform as a result of its use of the engines to keep the engines in ordinarily efficient operating condition, and consist of maintenance activities that A expects to perform more than once during the 12 year class life of the engine, the ESVs fall within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts paid for the ESVs for the four additional engines are deemed not to improve these engines and are not required to be capitalized under paragraph (d) of this section. For the treatment of amounts paid to acquire the engines, see §1.162-3(a).



Example 4. Routine maintenance resulting from prior owner's use. (i) In January, Year 1, B purchases a used machine for use in its manufacturing operations. Assume that the machine is the unit of property and has a class life of 10 years. B places the machine in service in January, Year 1, and at that time, B expects to perform manufacturer recommended scheduled maintenance on the machine approximately every three years. The scheduled maintenance includes the cleaning and oiling of the machine, the inspection of parts for defects, and the replacement of minor items such as springs, bearings, and seals with comparable and commercially available replacement parts. At the time B purchased the machine, the machine was approaching the end of a three-year scheduled maintenance period. As a result, in February, Year 1, B pays amounts to perform the manufacturer recommended scheduled maintenance. Assume that none of the exceptions set out in paragraph (i)(3) of this section apply to the amounts paid for the scheduled maintenance.




Example 4. Routine maintenance resulting from prior owner's use

(continued).

(ii) The majority of B’s costs do not qualify under the routine maintenance safe harbor in paragraph (i)(1)(ii) of this section because the costs were incurred primarily as a result of the prior owner's use of the property and not B's use. B acquired the machine just before it had received its three-year scheduled maintenance. Accordingly, the amounts paid for the scheduled maintenance resulted from the prior owner's, and not B's, use of the property and must be capitalized if those amounts result in a betterment under paragraph (i) of this section, including the amelioration of a material condition or defect, or otherwise result in an improvement under paragraph (d) of this section.



Example 5. Routine maintenance resulting from new owner's use.

Assume the same facts as in Example 4, except that after B pays amounts for the maintenance in Year 1, B continues to operate the machine in its manufacturing business. In Year 4, B pays amounts to perform the next scheduled manufacturer recommended maintenance on the machine. Assume that the scheduled maintenance activities performed are the same as those performed in Example 4 and that none of the exceptions set out in paragraph (i)(3) of this section apply to the amounts paid for the scheduled maintenance. Because the scheduled maintenance performed in Year 4 involves the recurring activities that B performs as a result of its use of the machine, keeps the machine in an ordinarily efficient operating condition, and consists of maintenance activities that B expects to perform more than once during the 10-year class life of the machine, B's scheduled maintenance costs are within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts paid for the scheduled maintenance in Year 4 are deemed not to improve the machine and are not required to be capitalized under paragraph (d) of this section.




Example 6. Routine maintenance; replacement of substantial structural

part; coordination with section 263A. C is in the business of producing commercial products for sale. As part of the production process, C places raw materials into lined containers in which a chemical reaction is used to convert raw materials into the finished product. The lining, which comprises 60 percent of the total physical structure of the container, is a substantial structural part of the container. Assume that each container, including its lining, is the unit of property and that a container has a class life of 12 years. At the time that C placed the container into service, C was aware that approximately every three years, the container lining would need to be replaced with comparable and commercially available replacement materials. At the end of three years, the container will continue to function, but will become less efficient and the replacement of the lining will be necessary to keep the container in an ordinarily efficient operating condition. this maintenance comprise the direct or allocable indirect costs of the property produced by C. See §1.263A-1(e)(3)(ii)(O).




part; coordination with section 263A (continued).

In Year 1, C acquired 10 new containers and placed them into service. In Year 4, Year 7, Year 9, and Year 12, C pays amounts to replace the containers' linings with comparable and commercially available replacement parts. Assume that none of the exceptions set out in paragraph (i)(3) of this section apply to the amounts paid for the replacement linings. Because the replacement of the linings involves recurring activities that C expects to perform as a result of its use of the containers to keep the containers in their ordinarily efficient operating condition and consists of maintenance activities that C expects to perform more than once during the 12-year class life of the containers, C's lining replacement costs are within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section.





part; coordination with section 263A (continued).

Accordingly, the amounts that C paid for the replacement of the container linings are deemed not to improve the containers and are not required to be capitalized under paragraph (d) of this section. However, the amounts paid to replace the lining may be subject to capitalization under section 263A if the amounts paid for this maintenance comprise the direct or allocable indirect costs of the property produced by C. See §1.263A-1(e)(3)(ii)(O).



Example 7. Routine maintenance once during class life. D is a Class I railroad that owns a fleet of freight cars. Assume that a freight car, including all its components, is a unit of property and has a class life of 14 years. At the time that D places a freight car into service, D expects to perform cyclical reconditioning to the car every 8 to 10 years to keep the freight car in ordinarily efficient operating condition. During this reconditioning, D pays amounts to disassemble, inspect, and recondition or replace components of the freight car with comparable and commercially available replacement parts. Ten years after D places the freight car in service, D pays amounts to perform a cyclical reconditioning on the car. Because D expects to perform the reconditioning only once during the 14 year class life of the freight car, the amounts D pays for the reconditioning do not qualify for the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, D must capitalize the amounts paid for the reconditioning of the freight car if these amounts result in an improvement under paragraph (d) of this section.




Example 8. Routine maintenance; reasonable expectation. Assume the same facts as Example 7, except in Year 1, D acquires and places in service several refrigerated freight cars, which also have a class life of 14 years. Because of the special requirements of these cars, at the time they are placed in service, D expects to perform a reconditioning of the refrigeration components of the freight car every 6 years to keep the freight car in an ordinarily efficient operating condition. During the reconditioning, D pays amounts to disassemble, inspect, and recondition or replace the refrigeration components of the freight car with comparable and commercially available replacement parts. Assume that none of the exceptions set out in paragraph (i)(3) of this section apply to the amounts paid for the reconditioning of these freight cars.



Example 8. Routine maintenance; reasonable expectation (continued).

In Year 6, D pays amounts to perform a reconditioning on the refrigeration components on one of the freight cars. However, because of changes in the frequency that D utilizes this freight car, D does not perform the second reconditioning on the same freight car until Year 15, after the end of the 14-year class life of the car. Under paragraph (i)(1)(ii) of this section, D's reasonable expectation that it would perform the reconditioning every 6 years will not be deemed unreasonable merely because D did not actually perform the reconditioning a second time during the 14-year class life, provided that D can substantiate that its expectation was reasonable at the time the property was placed in service. If D can demonstrate that its expectation was reasonable in Year 1 using the factors provided in paragraph (i)(1)(ii) of this section, then the amounts paid by D to recondition the refrigerated freight car components in Year 6 and in Year 15 are within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section.




Example 9. Routine maintenance on non-rotable part. E is a towboat operator that owns and leases a fleet of towboats. Each towboat is equipped with two diesel-powered engines. Assume that each towboat, including its engines, is the unit of property and that a towboat has a class life of 18 years. At the time that E places its towboats into service, E is aware that approximately every three to four years E will need to perform scheduled maintenance on the two towboat engines to keep the engines in their ordinarily efficient operating condition. This maintenance is completed while the engines are attached to the towboat and involves the cleaning and inspecting of the engines to determine which parts are within acceptable operating tolerances and can continue to be used, which parts must be reconditioned to be brought back to acceptable tolerances, and which parts must be replaced. Engine parts replaced during these procedures are replaced with comparable and commercially available replacement parts.



Example 9. Routine maintenance on non-rotable part (continued).

Assume the towboat engines are not rotable spare parts under §1.162-3(c)(2). In Year 1, E acquired a new towboat, including its two engines, and placed the towboat into service. In Year 5, E pays amounts to perform scheduled maintenance on both engines in the towboat. Assume that none of the exceptions set out in paragraph (i)(3) of this section apply to the scheduled maintenance costs. Because the scheduled maintenance involves recurring activities that E expects to perform more than once during the 18-year class life of the towboat, the maintenance results from E's use of the towboat, and the maintenance is performed to keep the towboat in an ordinarily efficient operating condition, the scheduled maintenance on E's towboat is within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts paid for the scheduled maintenance to its towboat engines in Year 5 are deemed not to improve the towboat and are not required to be capitalized under paragraph (d) of this section.




Example 10. Routine maintenance with related betterments. Assume the same facts as Example 9, except that in Year 9 E's towboat engines are due for another scheduled maintenance visit. At this time, E decides to upgrade the engines to increase their horsepower and propulsion, which would permit the towboats to tow heavier loads. Accordingly, in Year 9, E pays amounts to perform many of the same activities that it would perform during the typical scheduled maintenance activities such as cleaning, inspecting, reconditioning, and replacing minor parts, but at the same time, E incurs costs to upgrade certain engine parts to increase the towing capacity of the boats in excess of the capacity of the boats when E placed them in service. In combination with the replacement of parts with new and upgraded parts, the scheduled maintenance must be completed to perform the horsepower and propulsion upgrade.



Example 10. Routine maintenance with related betterments (continued).

Thus, the work done on the engines encompasses more than the recurring activities that E expected to perform as a result of its use of the towboats and did more than keep the towboat in its ordinarily efficient operating condition. Rather under paragraph (j) of this section, the amounts paid to increase the horsepower and propulsion of the engines are for a betterment to the towboat, and such amounts are excepted from the routine maintenance safe harbor under paragraph (i)(3)(i) of this section. In addition, under paragraph (g)(1)(i) of this section, the scheduled maintenance procedures directly benefit the upgrades. Therefore, the amounts that E paid in Year 9 for the maintenance and upgrade of the engines do not qualify for the routine maintenance safe harbor described under paragraph (i)(1)(ii) of this section. Rather, E must capitalize the amounts paid for maintenance and upgrades of the engines as an improvement to the towboats under paragraph (d) of this section.




Example 11. Routine maintenance with unrelated improvements.

Assume the same facts as Example 9, except in Year 5, in addition to paying amounts to perform the scheduled engine maintenance on both engines, E also incurs costs to upgrade the communications and navigation systems in the pilot house of the towboat with new state-of-the-art systems. Assume the amounts paid to upgrade the communications and navigation systems are for betterments under paragraph (j) of this section, and therefore result in an improvement to the towboat under paragraph (d) of this section. In contrast with Example 9, the amounts paid for the scheduled maintenance on E's towboat engines are not otherwise related to the upgrades to the navigation systems.



Example 11. Routine maintenance with unrelated improvements

(continued).

Because the scheduled maintenance on the towboat engines does not directly benefit and is not incurred by reason of the upgrades to the communication and navigation systems, the amounts paid for the scheduled engine maintenance are not a direct or indirect cost of the improvement under paragraph (g)(1)(i) of this section. Accordingly, the amounts paid for the scheduled maintenance to its towboat engines in Year 5 are routine maintenance deemed not to improve the towboat and are not required to be capitalized under paragraph (d) of this section.




Example 12. Exceptions to routine maintenance. F owns and operates a farming and cattle ranch with an irrigation system that provides water for crops. Assume that each canal in the irrigation system is a single unit of property and has a class life of 20 years. At the time F placed the canals into service, F expected to have to perform major maintenance on the canals every three years to keep the canals in their ordinarily efficient operating condition. This maintenance includes draining the canals, and then cleaning, inspecting, repairing, and reconditioning or replacing parts of the canal with comparable and commercially available replacement parts. F placed the canals into service in Year 1 and did not perform any maintenance on the canals until Year 6. At that time, the canals had fallen into a state of disrepair and no longer functioned for irrigation. In Year 6, F pays amounts to drain the canals and do extensive cleaning, repairing, reconditioning, and replacing parts of the canals with comparable and commercially available replacement parts.



Example 12. Exceptions to routine maintenance (continued).

Although the work performed on F's canals was similar to the activities that F expected to perform, but did not perform, every three years, the costs of these activities do not fall within the routine maintenance safe harbor. Specifically, under paragraph (i)(3)(v) of this section, routine maintenance does not include activities that return a unit of property to its former ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use. Accordingly, amounts that F pays for work performed on the canals in Year 6 must be capitalized if they result in improvements under paragraph (d) of this section (for example, restorations under paragraph (k) of this section).




Example 13. Routine maintenance on a building; escalator system. In Year 1, G acquires a large retail mall in which it leases space to retailers. The mall contains an escalator system with 40 escalators, which includes landing platforms, trusses, tracks, steps, handrails, and safety brushes. In Year 1, when G placed its building into service, G reasonably expected that it would need to replace the handrails on the escalators approximately every four years to keep the escalator system in its ordinarily efficient operating condition. After a routine inspection and test of the escalator system in Year 4, G determines that the handrails need to be replaced and pays an amount to replace the handrails with comparable and commercially available handrails. The escalator system, including the handrails, is a building system under paragraph (e)(2)(ii)(B)(4) of this section. Assume that none of the exceptions in paragraph (i)(3) of this section apply to the scheduled maintenance costs.



Example 13. Routine maintenance on a building; escalator system

(continued).

Because the replacement of the handrails involves recurring activities that G expects to perform as a result of its use of the escalator system to keep the escalator system in an ordinarily efficient operating condition, and G reasonably expects to perform these activities more than once during the 10-year period beginning at the time building system was placed in service, the amounts paid by G for the handrail replacements are within the routine maintenance safe harbor under paragraph (i)(1)(i) of this section. Accordingly, the amounts paid for the replacement of the handrails in Year 4 are deemed not to improve the building unit of property and are not required to be capitalized under paragraph (d) of this section.




Example 14. Not routine maintenance; escalator system. Assume the same facts as in Example 13, except that in Year 9, G pays amounts to replace the steps of the escalators. In Year 1, when G placed its building into service, G reasonably expected that approximately every 18 to 20 years G would need to replace the steps to keep the escalator system in its ordinarily efficient operating condition. Because the replacement does not involve recurring activities that G expects to perform more than once during the 10-year period beginning at the time the building structure or the building system was placed in service, the costs of these activities do not fall within the routine maintenance safe harbor. Accordingly, amounts that G pays to replace the steps in Year 9 must be capitalized if they result in improvements under paragraph (d) of this section (for example, restorations under paragraph (k) of this section).



Example 15. Routine maintenance on building; reasonable expectation.

In Year 1, H acquires a new office building, which it uses to provide services. The building contains an HVAC system, which is a building system under paragraph (e)(2)(ii)(B)(1) of this section. In Year 1, when H placed its building into service, H reasonably expected that every four years H would need to pay an outside contractor to perform detailed testing, monitoring, and preventative maintenance on its HVAC system to keep the HVAC system in its ordinarily efficient operating condition. This scheduled maintenance includes disassembly, cleaning, inspection, repair, replacement, reassembly, and testing of the HVAC system and many of its component parts. If inspection or testing discloses a problem with any component, the part is repaired, or if necessary, replaced with a comparable and commercially available replacement part.




Example 15. Routine maintenance on building; reasonable expectation

(continued).

The scheduled maintenance at these intervals is recommended by the manufacturer of the HVAC system and is routinely performed on similar systems in similar buildings. Assume that none of the exceptions in paragraph (i)(3) of this section apply to the amounts paid for the maintenance on the HVAC system. In Year 4, H pays amounts to a contractor to perform the scheduled maintenance. However, H does not perform this scheduled maintenance on its building again until Year 11. Under paragraph (i)(1)(i) of this section, H's reasonable expectation that it would perform the maintenance every 4 years will not be deemed unreasonable merely because H did not actually perform the maintenance a second time during the 10-year period, provided that H can substantiate that its expectation was reasonable at the time the property was placed in service.



Example 15. Routine maintenance on building; reasonable expectation

(continued).

If H can demonstrate that its expectation was reasonable in Year 1 using the other factors considered in paragraph (i)(1)(i), then the amounts H paid for the maintenance of the HVAC system in Year 4 and in Year 11 are within the routine maintenance safe harbor under paragraph (i)(1)(i) of this section.



Accounting Method

• Again part of DCN 184 in Section 10.11 of Revenue Procedure 2015-14

• Will provide method for selecting what is to be a repair vs. what is not


1.263(a)-3 Betterments

• In general . . . Taxpayer must capitalize amounts paid that it reasonably expects will be a betterment of a unit of property. A betterment:

– Corrects a material condition or defect regardless of when discovered by the taxpayer,

– Results in a material addition (physical enlargement, expansion, or extension) to a unit of property, or

– Results in a material increase in capacity (additional space), productivity, efficiency, strength, or quality of the unit of property or its output

• A building is made better by improvements and/or expansion of square footage



1.263(a)-3 Betterments• Facts and circumstances . . . Consider all facts and

circumstances including, but not limited to, purpose of the expenditure, physical nature of the work performed, effect of the expenditure on the unit of property, and the taxpayer’s treatment of the expenditure in its applicable financial statement

– Replacement with improved, but comparable part is not necessarily a betterment

– When particular event necessitates an expenditure determine whether a betterment is made by comparing condition of property immediately after expenditure with its condition immediately before the event necessitating the expenditure


1.263(a)-3 Betterments

– Expenditure made to correct effects of normal wear and tear to the unit of property must be judged based on condition of the property after last correction of effects of normal wear and tear

– Condition of property requiring expenditure made as result of a particular event, is condition immediately before the event

• Twenty three examples



1.263(a)-3 BettermentsExample 1. Amelioration of pre-existing material condition or defect. In Year 1, A purchases a store located on a parcel of land that contains underground gasoline storage tanks left by prior occupants. Assume that the parcel of land is the unit of property. The tanks had leaked prior to A's purchase, causing soil contamination. A is not aware of the contamination at the time of purchase. In Year 2, A discovers the contamination and incurs costs to remediate the soil. The remediation costs are for a betterment to the land under paragraph (j)(1)(i) of this section because A incurred the costs to ameliorate a material condition or defect that existed prior to A's acquisition of the land.


1.263(a)-3 BettermentsExample 2. Not amelioration of pre-existing condition or defect. B owns an office building that was constructed with insulation that contained asbestos. The health dangers of asbestos were not widely known when the building was constructed. Several years after B places the building into service, B determines that certain areas of asbestos-containing insulation have begun to deteriorate and could eventually pose a health risk to employees. Therefore, B pays an amount to remove the asbestos-containing insulation from the building structure and replace it with new insulation that is safer to employees, but no more efficient or effective than the asbestos insulation. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. Although the asbestos is determined to be unsafe under certain circumstances, the presence of asbestos insulation in a building, by itself, is not a preexisting material condition or defect of the building structure under paragraph (j)(1)(i) of this section.



1.263(a)-3 BettermentsExample 2. Not amelioration of pre-existing condition or defect (continued).

In addition, the removal and replacement of the asbestos is not for a material addition to the building structure or a material increase in the capacity of the building structure under paragraphs (j)(1)(ii) and (j)(2)(iv) of this section as compared to the condition of the property prior to the deterioration of the insulation. Similarly, the removal and replacement of asbestos is not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the building structure under paragraphs (j)(1)(iii) and (j)(2)(iv) of this section as compared to the condition of the property prior to the deterioration of the insulation. Therefore, the amount paid to remove and replace the asbestos insulation is not for a betterment to the building structure or an improvement to the building under paragraph (j) of this section.


1.263(a)-3 BettermentsExample 3. Not amelioration of pre-existing material condition or defect. (i) In January, Year 1, C purchased a used machine for use in its manufacturing operations. Assume that the machine is a unit of property and has a class life of 10 years. C placed the machine in service in January, Year 1 and at that time expected to perform manufacturer recommended scheduled maintenance on the machine every three years. The scheduled maintenance includes cleaning and oiling the machine, inspecting parts for defects, and replacing minor items, such as springs, bearings, and seals, with comparable and commercially available replacement parts. The scheduled maintenance does not include any material additions or materially increase the capacity, productivity, efficiency, strength, quality, or output of the machine. At the time C purchased the machine, it was approaching the end of a three-year scheduled maintenance period. As a result, in February, Year 1, C pays an amount to perform the manufacturer recommended scheduled maintenance to keep the machine in its ordinarily efficient operating condition.



1.263(a)-3 BettermentsExample 3. Not amelioration of pre-existing material condition or defect

(continued).

(ii) The amount that C pays does not qualify under the routine maintenance safe harbor in paragraph (i) of this section, because the cost primarily results from the prior owner's use of the property and not the taxpayer's use. C acquired the machine just before it had received its three-year scheduled maintenance. Accordingly, the amount that C pays for the scheduled maintenance results from the prior owner's use of the property and ameliorates conditions or defects that existed prior to C's ownership of the machine. Nevertheless, considering the purpose and minor nature of the work performed, this amount does not ameliorate a material condition or defect in the machine under paragraph (j)(1)(i) of this section, is not for a material addition to or increase in capacity of the machine under paragraph (j)(1)(ii) of this section, and is not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the machine under paragraph (j)(1)(iii) of this section. Therefore, C is not required to capitalize the amount paid for the scheduled maintenance as a betterment to the unit of property under this paragraph (j).


1.263(a)-3 BettermentsExample 4. Not amelioration of pre-existing material condition or defect. D purchases a used ice resurfacing machine for use in the operation of its ice skating rink. To comply with local regulations, D is required to routinely monitor the air quality in the ice skating rink. One week after D places the machine into service, during a routine air quality check, D discovers that the operation of the machine is adversely affecting the air quality in the skating rink. As a result, D pays an amount to inspect and retune the machine, which includes replacing minor components of the engine that had worn out prior to D's acquisition of the machine. Assume the resurfacing machine, including the engine, is the unit of property. The routine maintenance safe harbor in paragraph (i) of this section does not apply to the amounts paid, because the activities performed do not relate solely to the taxpayer's use of the machine. The amount that D pays to inspect, retune, and replace minor components of the ice resurfacing machine ameliorates a condition or defect that existed prior to D's acquisition of the equipment.



1.263(a)-3 BettermentsExample 4. Not amelioration of pre-existing material condition or defect

(continued).

Nevertheless, considering the purpose and minor nature of the work performed, this amount does not ameliorate a material condition or defect in the machine under paragraph (j)(1)(i) of this section. In addition, the amount is not paid for a material addition to the machine or a material increase in the capacity of the machine under paragraph (j)(1)(ii) of this section. Also, the activities are not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the machine under paragraph (j)(1)(iii) of this section. Therefore, D is not required to capitalize the amount paid to inspect, retune, and replace minor components of the machine as a betterment under this paragraph (j).


1.263(a)-3 BettermentsExample 5.Amelioration of material condition or defect. (i) E acquires a building for use in its business of providing assisted living services. Before and after the purchase, the building functions as an assisted living facility. However, at the time of the purchase, E is aware that the building is in a condition that is below the standards that E requires for facilities used in its business. Immediately after the acquisition and during the following two years, while E continues to use the building as an assisted living facility, E pays amounts for extensive repairs and maintenance, and the acquisition of new property to bring the facility into the high-quality condition for which E's facilities are known. The work on E's building includes repairing damaged drywall, repainting, re-wallpapering, replacing windows, repairing and replacing doors, replacing and regrouting tile, repairing millwork, and repairing and replacing roofing materials. The work also involves the replacement of section 1245 property, including window treatments, furniture, and cabinets. The work that E performs affects only the building structure under paragraph (e)(2)(ii)(A) of this section and does not affect any of the building systems described in paragraph (e)(2)(ii)(B) of this section. Assume that each section 1245 property is a separate unit of property.



1.263(a)-3 BettermentsExample 5.Amelioration of material condition or defect (continued).

(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. Considering the purpose of the expenditure and the effect of the expenditures on the building structure, the amounts that E paid for repairs and maintenance to the building structure comprise a betterment to the building structure under paragraph (j)(1)(i) of this section because the amounts ameliorate material conditions that existed prior to E's acquisition of the building. Therefore, E must treat the amounts paid for the betterment to the building structure as an improvement to the building and must capitalize the amounts under paragraphs (j) and (d)(1) of this section. Moreover, E is required to capitalize the amounts paid to acquire and install each section 1245 property, including each window treatment, each item of furniture, and each cabinet, in accordance with §1.263(a)-2(d)(1).


1.263(a)-3 BettermentsExample 6. Not a betterment; building refresh. (i) F owns a nationwide chain of retail stores that sell a wide variety of items. To maintain the appearance and functionality of its store buildings after several years of wear, F periodically pays amounts to refresh the look and layout of its stores. The work that F performs during a refresh consists of cosmetic and layout changes to the store's interiors and general repairs and maintenance to the store building to modernize the store buildings and reorganize the merchandise displays. The work to each store consists of replacing and reconfiguring display tables and racks to provide better exposure of the merchandise, making corresponding lighting relocations and flooring repairs, moving one wall to accommodate the reconfiguration of tables and racks, patching holes in walls, repainting the interior structure with a new color scheme to coordinate with new signage, replacing damaged ceiling tiles, cleaning and repairing wood flooring throughout the store building, and power washing building exteriors.



1.263(a)-3 BettermentsExample 6. Not a betterment; building refresh (continued).

The display tables and the racks all constitute section 1245 property. F pays amounts to refresh 50 stores during the taxable year. Assume that each section 1245 property within each store is a separate unit of property. Finally, assume that the work does not ameliorate any material conditions or defects that existed when F acquired the store buildings or result in any material additions to the store buildings.

(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. Considering the facts and circumstances including the purpose of the expenditure, the physical nature of the work performed, and the effect of the expenditure on the buildings' structure and systems, the amounts paid for the refresh of each building are not for any material additions to, or material increases in the capacity of, the buildings' structure or systems as compared with the condition of the structure or systems after the previous refresh.


1.263(a)-3 BettermentsExample 6. Not a betterment; building refresh (continued).

Moreover, the amounts paid are not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of any building structure or system under as compared to the condition of the structures or systems after the previous refresh. Rather, the work performed keeps F's store buildings' structures and buildings' systems in their ordinarily efficient operating condition. Therefore, F is not required to treat the amounts paid for the refresh of its store buildings' structures and buildings' systems as betterments under paragraphs (j)(1)(ii), (j)(1)(iii), and (j)(2)(iv) of this section. However, F is required to capitalize the amounts paid to acquire and install each section 1245 property in accordance with §1.263(a)-2(d)(1).



1.263(a)-3 BettermentsExample 7.Building refresh; limited improvement. (i) Assume the same facts as Example 6 except, in the course of the refresh to one of its store buildings, F also pays amounts to increase the building's storage space, add a second loading dock, and add a second overhead door. Specifically, at the same time F pays amounts to perform the refresh, F pays additional amounts to construct an addition to the back of the store building, including adding a new overhead door and loading dock to the building. The work also involves upgrades to the electrical system of the building, including the addition of a second service box with increased amperage and new wiring from the service box to provide lighting and power throughout the new space. Although it is performed at the same time, the construction of the additions does not affect, and is not otherwise related to, the refresh of the retail space.


1.263(a)-3 BettermentsExample 7.Building refresh; limited improvement (continued).

(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. Under paragraph (j)(1)(ii) of this section, the amounts paid by F to add the storage space, loading dock, overhead door, and expand the electrical system are for betterments to F's building structure and to the electrical system because they are for material additions to, and a material increase in capacity of, the structure and the electrical system of F's store building. Accordingly, F must treat the amounts paid for these betterments as improvements to the building unit of property and capitalize these amounts under paragraphs (d)(1) and (j) of this section.



1.263(a)-3 BettermentsExample 7.Building refresh; limited improvement (continued).

However, for the reasons discussed in Example 6, F is not required to treat the amounts paid for the refresh of its store building structure and systems as a betterments under paragraph (j)(1) of this section. In addition, F is not required under paragraph (g)(1) of this section to capitalize the refresh costs described in Example 6 because these costs do not directly benefit and are not incurred by reason of the additions to the building structure and electrical system. As in Example 6, F is required to capitalize the amounts paid to acquire and install each section 1245 property in accordance with §1.263(a)-2(d)(1).


1.263(a)-3 BettermentsExample 8. Betterment; building remodel. (i) G owns a large chain of retail stores that sell a variety of items. G determines that due to changes in the retail market, it can no longer compete in its current store class and decides to upgrade its stores to offer higher end products to a different type of customer. To offer these products and attract different types of customers, G must substantially remodel its stores. Thus, G pays amounts to remodel its stores by performing work on the buildings' structures and systems as defined under paragraphs (e)(2)(ii)(A) and (e)(2)(ii)(B) of this section. This work includes replacing large parts of the exterior walls with windows, replacing the escalators with a monumental staircase, adding a new glass enclosed elevator, rebuilding the interior and exterior facades, replacing vinyl floors with ceramic flooring, replacing ceiling tiles with acoustical tiles, and removing and rebuilding walls to move changing rooms and create specialty departments.



1.263(a)-3 BettermentsExample 8. Betterment; building remodel (continued).

The work also includes upgrades to increase the capacity of the buildings' electrical system to accommodate the structural changes and the addition of new section 1245 property, such as new product information kiosks and point of sale systems. The work to the electrical system also involves the installation of new more efficient and mood enhancing lighting fixtures. In addition, the work includes remodeling all bathrooms by replacing contractor-grade plumbing fixtures with designer-grade fixtures that conserve water and energy. Finally, G also pays amounts to clean debris resulting from construction during the remodel, patch holes in walls that were made to upgrade the electrical system, repaint existing walls with a new color scheme to match the new interior construction, and to power wash building exteriors to enhance the new exterior facade.



(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. Considering the facts and circumstances, including the purpose of the expenditure, the physical nature of the work performed, and the effect of the work on the buildings' structures and buildings' systems, the amounts that G pays for the remodeling of its stores result in betterments to the buildings' structures and several of its systems under paragraph (j) of this section. Specifically, the amounts paid to replace large parts of the exterior walls with windows, replace the escalators with a monumental staircase, add a new elevator, rebuild the interior and exterior facades, replace vinyl floors with ceramic flooring, replace the ceiling tiles with acoustical tiles, and to remove and rebuild walls are for material additions, that is the addition of major components, to the building structure under paragraph (j)(1)(ii) of this section and are reasonably expected to increase the quality of the building structure under paragraph (j)(1)(iii) of this section.




Similarly, the amounts paid to upgrade the electrical system are to materially increase the capacity of the electrical system under paragraph (j)(1)(ii) of this section and are reasonably expected to increase the quality of this system under paragraph (j)(1)(iii) of this section. In addition, the amounts paid to remodel the bathrooms with higher grade and more resource-efficient materials are reasonably expected to increase the efficiency and quality of the plumbing system under paragraph (j)(1)(iii) of this section. Finally, the amounts paid to clean debris, patch and repaint existing walls with a new color scheme, and to power wash building exteriors, while not betterments by themselves, directly benefitted and were incurred by reason of the improvements to G's store buildings' structures and electrical systems under paragraph (g)(1) of this section.



Therefore, G must treat the amounts paid for betterments to the store buildings' structures and systems, including the costs of cleaning, patching, repairing, and power washing the building, as improvements to G's buildings and must capitalize these amounts under paragraphs (d)(1) and (j) of this section. Moreover, G is required to capitalize the amounts paid to acquire and install each section 1245 property in accordance with §1.263(a)-2(d)(1). For the treatment of amounts paid to remove components of property, see paragraph (g)(2) of this section.



1.263(a)-3 BettermentsExample 9. Not betterment; relocation and reinstallation of personal

property. In Year 1, H purchases new cash registers for use in its retail store located in leased space in a shopping mall. Assume that each cash register is a unit of property as determined under paragraph (e)(3) of this section. In Year 1, H capitalizes the costs of acquiring and installing the new cash registers under §1.263(a)-2(d)(1). In Year 3, H's lease expires, and H decides to relocate its retail store to a different building. In addition to various other costs, H pays $5,000 to move the cash registers and $1,000 to reinstall them in the new store. The cash registers are used for the same purpose and in the same manner that they were used in the former location. The amounts that H pays to move and reinstall the cash registers into its new store do not result in a betterment to the cash registers under paragraph (j) of this section.


1.263(a)-3 BettermentsExample 10. Betterment; relocation and reinstallation of equipment. J operates a manufacturing facility in Building A, which contains various machines that J uses in its manufacturing business. J decides to expand part of its operations by relocating a machine to Building B to reconfigure the machine with additional components. Assume that the machine is a single unit of property under paragraph (e)(3) of this section. J pays amounts to disassemble the machine, to move the machine to the new location, and to reinstall the machine in a new configuration with additional components. Assume that the reinstallation, including the reconfiguration and the addition of components, is for an increase in capacity of the machine, and therefore is for a betterment to the machine under paragraph (j)(1)(ii) of this section. Accordingly, J must capitalize the costs of reinstalling the machine as an improvement to the machine under paragraphs (j) and (d)(1) of this section. J is also required to capitalize the costs of disassembling and moving the machine to Building B because these costs directly benefit and are incurred by reason of the improvement to the machine under paragraph (g)(1) of this section.



1.263(a)-3 BettermentsExample 11. Betterment; regulatory requirement. K owns a building that it uses in its business. In Year 1, City C passes an ordinance setting higher safety standards for buildings because of the hazardous conditions caused by earthquakes. To comply with the ordinance, K pays an amount to add expansion bolts to its building structure. These bolts anchor the wooden framing of K's building to its cement foundation, providing additional structural support and resistance to seismic forces, making the building more resistant to damage from lateral movement. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The framing and foundation are part of the building structure as defined in paragraph (e)(2)(ii)(A) of this section. Prior to the ordinance, the old building was in good condition but did not meet City C's new requirements for earthquake resistance. The amount paid by K for the addition of the expansion bolts met City C's new requirement, but also materially increased the strength of the building structure under paragraph (j)(1)(iii) of this section.


1.263(a)-3 BettermentsExample 11. Betterment; regulatory requirement (continued).

Therefore, K must treat the amount paid to add the expansion bolts as a betterment to the building structure and must capitalize this amount as an improvement to building under paragraphs (d)(1) and (j) of this section. City C's new requirement that K's building meet certain safety standards to continue to operate is not relevant in determining whether the amount paid improved the building. See paragraph (g)(4) of this section.



1.263(a)-3 BettermentsExample 12. Not a betterment; regulatory requirement. L owns a meat processing plant. After operating the plant for many years, L discovers that oil is seeping through the concrete walls of the plant. Federal inspectors advise L that it must correct the seepage problem or shut down its plant. To correct the problem, L pays an amount to add a concrete lining to the walls from the floor to a height of about four feet and also to add concrete to the floor of the plant. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The walls are part of the building structure as defined in paragraph (e)(2)(ii)(A) of this section. The condition necessitating the expenditure was the seepage of the oil into the plant. Prior to the seepage, the walls did not leak and were functioning for their intended use. L is not required to treat the amount paid as a betterment under paragraphs (j)(1)(ii) and (j)(2)(iv) of this section because it is not paid for a material addition to, or a material increase in the capacity of, the building's structure as compared to the condition of the structure prior to the seepage of oil.


1.263(a)-3 BettermentsExample 12. Not a betterment; regulatory requirement (continued).

Moreover, the amount paid is not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the building structure under paragraphs (j)(1)(iii) and (j)(2)(iv) as compared to the condition of the structure prior to the seepage of the oil Therefore, L is not required to treat the amount paid to correct the seepage as a betterment to the building under paragraph (d)(1) or (j) of this section. The federal inspectors' requirement that L correct the seepage to continue operating the plant is not relevant in determining whether the amount paid improves the plant.



1.263(a)-3 BettermentsExample 13. Not a betterment; new roof membrane. M owns a building that it uses for its retail business. Over time, the waterproof membrane (top layer) on the roof of M's building begins to wear, and M began to experience water seepage and leaks throughout its retail premises. To eliminate the problems, a contractor recommends that M put a new rubber membrane on the worn membrane. Accordingly, M pays the contractor to add the new membrane. The new membrane is comparable to the worn membrane when it was originally placed in service by the taxpayer. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The roof is part of the building structure under paragraph (e)(2)(ii)(A) of this section. The condition necessitating the expenditure was the normal wear of M's roof. Under paragraph (j)(2)(iv) of this section, to determine whether the amounts are for a betterment, the condition of the building structure after the expenditure must be compared to the condition of the structure when M placed the building into service because M has not previously corrected the effects of normal wear and tear.


1.263(a)-3 BettermentsExample 13. Not a betterment; new roof membrane (continued).

Under these facts, the amount paid to add the new membrane to the roof is not for a material addition or a material increase in the capacity of the building structure under paragraph (j)(1)(ii) of this section as compared to the condition of the structure when it was placed in service. Moreover, the new membrane is not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the building structure under paragraph (j)(1)(iii) of this section as compared to the condition of the building structure when it was placed in service. Therefore, M is not required to treat the amount paid to add the new membrane as a betterment to the building under paragraph (d)(1) or (j) of this section.



1.263(a)-3 BettermentsExample 14. Material increase in capacity; building. N owns a factory building with a storage area on the second floor. N pays an amount to reinforce the columns and girders supporting the second floor to permit storage of supplies with a gross weight 50 percent greater than the previous load-carrying capacity of the storage area. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The columns and girders are part of the building structure defined under paragraph (e)(2)(ii)(A) of this section. N must treat the amount paid to reinforce the columns and girders as a betterment under paragraphs (j)(1)(ii) and (j)(1)(iii) of this section because it materially increases the load-carrying capacity and the strength of the building structure. Therefore, N must capitalize this amount as an improvement to the building under paragraphs (d)(1) and (j) of this section.


1.263(a)-3 BettermentsExample 15. Material increase in capacity; channel. O owns harbor facilities consisting of a slip for the loading and unloading of barges and a channel leading from the slip to the river. At the time of purchase, the channel was 150 feet wide, 1,000 feet long, and 10 feet deep. Several years after purchasing the harbor facilities, to allow for ingress and egress and for the unloading of larger barges, O decides to deepen the channel to a depth of 20 feet. O pays a contractor to dredge the channel to 20 feet. Assume the channel is the unit of property. O must capitalize the amounts paid for the dredging as an improvement to the channel because they are for a material increase in the capacity of the unit of property under paragraph (j)(1)(ii) of this section.



1.263(a)-3 BettermentsExample 16. Not a material increase in capacity; channel. Assume the same facts as in Example 15, except that the channel was susceptible to siltation and, after dredging to 20 feet, the channel depth had been reduced to 18 feet. O pays a contractor to redredge the channel to a depth of 20 feet. The expenditure was necessitated by the siltation of the channel. Both prior to the siltation and after the redredging, the depth of the channel was 20 feet. Applying the comparison rule under paragraph (j)(2)(iv) of this section, the amounts paid by O to redredge the channel are not for a betterment under paragraph (j)(1)(ii) of this section because they are not for a material addition to, or a material increase in the capacity of, the unit of property as compared to the condition of the property prior to the siltation. Similarly, these amounts are not for a betterment under paragraph (j)(1)(iii) of this section because the amounts are not reasonably expected to increase the productivity, efficiency, strength, quality, or output of the unit of property as compared to the condition of the property before the siltation. Therefore, O is not required to capitalize these amounts as improvement under paragraphs (d)(1) and (j) of this section.


1.263(a)-3 BettermentsExample 17. Material increase in capacity; channel. Assume the same facts as in Example 16 except that after the redredging, there is more siltation, and the channel depth is reduced back to 18 feet. In addition, to allow for additional ingress and egress and for the unloading of even larger barges, O decides to deepen the channel to a depth of 25 feet. O pays a contractor to redredge the channel to 25 feet. O must capitalize the amounts paid for the dredging as an improvement to the channel because the amounts are for a material increase in the capacity of the unit of property under paragraph (j)(1)(ii) of this section as compared to condition of the unit of property before the siltation. As part of this improvement, O is also required to capitalize the portion of the redredge costs allocable to restoring the depth lost to the siltation because, under paragraph (g)(1)(i) of this section, these amounts directly benefit and are incurred by reason of the improvement to the unit of property.



1.263(a)-3 BettermentsExample 18. Not a material increase in capacity; building. P owns a building used in its trade or business. The first floor has a drop-ceiling. To fully expose windows on the first floor, P pays an amount to remove the drop-ceiling and repaint the original ceiling. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The ceiling is part of the building structure as defined under paragraph (e)(2)(ii)(A) of this section. P is not required to treat the amount paid to remove the drop-ceiling as a betterment to the building because it was not for a material addition or material increase in the capacity of the building structure under paragraph (j)(1)(ii) of this section and it was not reasonably expected to materially increase to the efficiency, strength, or quality of the building structure under paragraph (j)(1)(iii) of this section. In addition, under paragraph (j)(2)(i) of this section, because the effect on productivity and output of the building structure cannot be measured in this context, these factors are not relevant in determining whether there is a betterment to the building structure.


1.263(a)-3 BettermentsExample 19. Material increase in capacity; building. Q owns a building that it uses in its retail business. The building contains one floor of retail space with very high ceilings. Q pays an amount to add a stairway and a mezzanine for the purposes of adding additional selling space within its building. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The stairway and the mezzanine are part of the building structure as defined under paragraph (e)(2)(ii)(A) of this section. Q is required to treat the amount paid to add the stairway and mezzanine as a betterment because it is for a material addition to, and an increase in the capacity of, the building structure under paragraph (j)(1)(ii) of this section. Therefore, Q must capitalize this amount as an improvement to the building unit of property under paragraphs (d)(1) and (j) of this section.



1.263(a)-3 BettermentsExample 20. Not material increase in efficiency; HVAC system. R owns an office building that it uses to provide services to customers. The building contains an HVAC system that incorporates 10 roof-mounted units that provide heating and air conditioning for different parts of the building. The HVAC system also consists of controls for the entire system and duct work that distributes the heated or cooled air to the various spaces in the building's interior. After many years of use of the HVAC system, R begins to experience climate control problems in various offices throughout the office building and consults with a contractor to determine the cause. The contractor recommends that R replace two of the roof-mounted units. R pays an amount to replace the two specified units. The two new units are expected to eliminate the climate control problems and to be 10 percent more energy efficient than the replaced units in their original condition. No work is performed on the other roof mounted heating/cooling units, the duct work, or the controls. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The HVAC system, including the two-roof mounted units, is a building system under paragraph (e)(2)(ii)(B)(1) of this section.


1.263(a)-3 BettermentsExample 20. Not material increase in efficiency; HVAC system (continued).

The replacement of the two roof mounted units is not a material addition to or a material increase in the capacity of the HVAC system under paragraphs (j)(1)(ii) and (j)(3)(ii) of this section as compared to the condition of the system prior to the climate control problems. In addition, given the 10 percent efficiency increase in two units of the entire HVAC system, the replacement is not expected to materially increase the productivity, efficiency, strength, quality, or output of the HVAC system under paragraphs (j)(1)(iii) and (j)(2)(iv) of this section as compared to the condition of the system prior to the climate control problems. Therefore, R is not required to capitalize the amounts paid for these replacements as betterments to the building unit of property under paragraphs (d)(1) and (j) of this section.



1.263(a)-3 BettermentsExample 21. Material increase in efficiency; building. S owns a building that it uses in its service business. S conducts an energy assessment and determines that it could significantly reduce its energy costs by adding insulation to its building. S pays an insulation contractor to apply a combination of loose-fill, spray foam, and blanket insulation throughout S's building structure, including within the attic, walls, and crawl spaces. S reasonably expects the new insulation to make the building more energy efficient because the contractor indicated that the new insulation would reduce its annual energy and power costs by approximately 50 percent of its annual costs during the last five years. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building if the amount is paid for a betterment to the building structure or any building system. Therefore, under paragraphs (d)(1) and (j) of this section, S must capitalize as a betterment the amount paid to add the insulation because the insulation is reasonably expected to materially increase the efficiency of the building structure under paragraph (j)(1)(iii) of this section.


1.263(a)-3 BettermentsExample 22. Material addition; building. T owns and operates a restaurant, which provides a variety of prepared foods to its customers. To better accommodate its customers and increase customer traffic, T decides to add a drive-through service area. As a result, T pays amounts to partition an area within its restaurant for a drive-through service counter, to construct a service window with necessary security features, to build an overhang for vehicles, and to construct a drive-up menu board. Assume that the drive-up menu board is section 1245 property that is a separate unit of property under paragraph (e)(3) of this section. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The amounts paid for the partition, service window and overhang are betterments to the building structure because they comprise a material addition (that is, a physical expansion, extension, and addition of a major component) to the building structure under paragraph (j)(1)(ii) of this section.



1.263(a)-3 BettermentsExample 22. Material addition; building (continued).

Accordingly, T must capitalize as an improvement the amounts paid to add the partition, drive-through window, and overhang under paragraphs (d)(1) and (j) of this section. T is also required to capitalize the amounts paid to acquire and install each section 1245 property in accordance with §1.263(a)-2(d)(1).


1.263(a)-3 BettermentsExample 23. Costs incurred during betterment. U owns a building that it uses in its service business. To accommodate new employees and equipment, U pays amounts to increase the load capacity of its electrical system by adding a second electrical panel with additional circuits and adding wiring and outlets throughout the electrical system of its building. To complete the upgrades to the electrical system, the contractor makes several holes in walls. As a result, U also incurs costs to patch the holes and repaint several walls. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The amounts paid to upgrade the panel and wiring are for betterments to U's electrical system because they increase the capacity of the electrical system under paragraph (j)(1)(ii) of this section and increase the strength and output of the electrical system under paragraph (j)(1)(iii) of this section. Accordingly, U is required to capitalize the costs of the upgrade to the electrical system as an improvement to the building unit of property under paragraphs (d)(1) and (j) of this section.



1.263(a)-3 BettermentsExample 23. Costs incurred during betterment (continued).

Moreover, under paragraph (g)(1) of this section, U is required to capitalize the amounts paid to patch holes and repaint several walls in its building because these costs directly benefit and are incurred by reason of the improvement to U's building unit of property.


Accounting Method

• Again, part of DCN 184, Section 10.11 of Revenue Procedure 2015-14

• See if have not been following these provisions—if not, convert now



1.263(a)-3 Restorations

• In general . . . Amounts paid to restore a unit of property, including making good the exhaustion for which an allowance is or has been made must be capitalized. An amount is paid to restore a unit of property only if it:

– Replaces a component of a unit of property for which the taxpayer has properly claimed a deduction,

– Replaces a component of a unit of property for which the taxpayer has taken the adjusted basis of the component into account in realizing gain or loss

– Is for repair of damage to the unit of property for which taxpayer has properly taken a basis adjustment for a casualty loss under 165 (however, now special cap at basis level)


1.263(a)-3 Restorations– Returns a deteriorated unit of property, no longer functional for

its intended use, to its ordinarily efficient operating condition

– Results in rebuilding the unit of property to like-new condition after the end of its class life

– Is for replacement of a part or combination of parts comprising a major component or substantial structural part of the unit of property

– An amount is paid to restore a building if it restores the building structure or any building system

– A unit of property is rebuilt to like new condition if it is brought to status of new, rebuilt, remanufactured or similar status under any federal guideline or manufacturer’s original specifications



1.263(a)-3 Restorations• IRS claims to have clarified in final regulations “major

component” or “substantial structural part”– Major component

• A part or combination of parts that performs a discrete and critical function in the operation of the unit of property

• An incidental component of the unit of property, even though such component performs a discrete and critical function in the operation of the unit of property, generally will not, by itself, constitute a major component.

– Substantial structural part - A part or combination of parts that comprises a large portion of the physical structure of the unit of property.

– Rejected comments that asked for a fixed percentage test

• Thirty one examples (up from 26 in temporary regulations)


1.263(a)-3 RestorationsExample 1. Replacement of loss component. A owns a manufacturing building containing various types of manufacturing equipment. A does a cost segregation study of the manufacturing building and properly determines that a walk-in freezer in the manufacturing building is section 1245 property as defined in section 1245(a)(3). The freezer is not part of the building structure or the HVAC system under paragraph (e)(2)(i) or (e)(2)(ii)(B)(1) of this section. Several components of the walk-in freezer cease to function, and A decides to replace them. A abandons the old freezer components and properly recognizes a loss from the abandonment of the components. A replaces the abandoned freezer components with new components and incurs costs to acquire and install the new components. Under paragraph (k)(1)(i) of this section, A must capitalize the amounts paid to acquire and install the new freezer components because A replaced components for which it had properly deducted a loss.



1.263(a)-3 RestorationsExample 2. Replacement of sold component. Assume the same facts as in Example 1, except that A did not abandon the components but instead sold them to another party and properly recognized a loss on the sale. Under paragraph (k)(1)(ii) of this section, A must capitalize the amounts paid to acquire and install the new freezer components because A replaced components for which it had properly taken into account the adjusted basis of the components in realizing a loss from the sale of the components.


1.263(a)-3 RestorationsExample 3. Restoration after casualty loss. B owns an office building that it uses in its trade or business. A storm damages the office building at a time when the building has an adjusted basis of $500,000. B deducts under section 165 a casualty loss in the amount of $50,000, and properly reduces its basis in the office building to $450,000. B hires a contractor to repair the damage to the building, including the repair of the building roof and the removal of debris from the building premises. B pays the contractor $50,000 for the work. Under paragraph (k)(1)(iii) of this section, B must treat the $50,000 amount paid to the contractor as a restoration of the building structure because B properly adjusted its basis in that amount as a result of a casualty loss under section 165, and the amount does not exceed the limit in paragraph (k)(4) of this section. Therefore, B must treat the amount paid as an improvement to the building unit of property and, under paragraph (d)(2) of this section, must capitalize the amount paid.



1.263(a)-3 RestorationsExample 4. Restoration after casualty event. Assume the same facts as in Example 3, except that B receives insurance proceeds of $50,000 after the casualty to compensate for its loss. B cannot deduct a casualty loss under section 165 because its loss was compensated by insurance. However, B properly reduces its basis in the property by the amount of the insurance proceeds. Under paragraph (k)(1)(iii) of this section, B must treat the $50,000 amount paid to the contractor as a restoration of the building structure because B has properly taken a basis adjustment relating to a casualty event described in section 165, and the amount does not exceed the limit in paragraph (k)(4) of this section. Therefore, B must treat the amount paid as an improvement to the building unit of property and, under paragraph (d)(2) of this section, must capitalize the amount paid.


1.263(a)-3 RestorationsExample 5. Restoration after casualty loss; limitation. (i) C owns a building that it uses in its trade or business. A storm damages the building at a time when the building has an adjusted basis of $500,000. C determines that the cost of restoring its property is $750,000, deducts a casualty loss under section 165 in the amount of $500,000, and properly reduces its basis in the building to $0. C hires a contractor to repair the damage to the building and pays the contractor $750,000 for the work. The work involves replacing the entire roof structure of the building at a cost of $350,000 and pumping water from the building, cleaning debris from the interior and exterior, and replacing areas of damaged dry wall and flooring at a cost of $400,000. Although resulting from the casualty event, the pumping, cleaning, and replacing damaged drywall and flooring, does not directly benefit and is not incurred by reason of the roof replacement.



1.263(a)-3 RestorationsExample 5. Restoration after casualty loss; limitation (continued).

(ii) Under paragraph (k)(1)(vi) of this section, C must capitalize as an improvement the $350,000 amount paid to the contractor to replace the roof structure because the roof structure constitutes a major component and a substantial structural part of the building unit of property. In addition, under paragraphs (k)(1)(iii) and (k)(4)(i), C must treat as a restoration the remaining costs, limited to the excess of the adjusted basis of the building over the amounts paid for the improvement under paragraph (k)(1)(vi). Accordingly, C must treat as a restoration $150,000 ($500,000 - $350,000) of the $400,000 paid for the portion of the costs related to repairing and cleaning the building structure under paragraph (k)(1)(iii) of this section. Thus, in addition to the $350,000 to replace the roof structure, C must also capitalize the $150,000 as an improvement to the building unit of property under paragraph (d)(2) of this section. C is not required to capitalize the remaining $250,000 repair and cleaning costs under paragraph (k)(1)(iii) of this section.


1.263(a)-3 RestorationsExample 6. Restoration of property in a state of disrepair. D owns and operates a farm with several barns and outbuildings. D did not use or maintain one of the outbuildings on a regular basis, and the outbuilding fell into a state of disrepair. The outbuilding previously was used for storage but can no longer be used for that purpose because the building is not structurally sound. D decides to restore the outbuilding and pays an amount to shore up the walls and replace the siding. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount is paid to restore the building structure or any building system. The walls and siding are part of the building structure under paragraph (e)(2)(ii)(A) of this section. Under paragraph (k)(1)(iv) of this section, D must treat the amount paid to shore up the walls and replace the siding as a restoration of the building structure because the amounts return the building structure to its ordinarily efficient operating condition after it had deteriorated to a state of disrepair and was no longer functional for its intended use. Therefore, D must treat the amount paid to shore up the walls and replace the siding as an improvement to the building unit of property and, under paragraph (d)(2) of this section, must capitalize the amount paid.



1.263(a)-3 RestorationsExample 7. Rebuild of property to like-new condition before end of class

life. E is a Class I railroad that owns a fleet of freight cars. Assume the freight cars have a recovery period of 7 years under section 168(c) and a class life of 14 years. Every 8 to 10 years, E rebuilds its freight cars. Ten years after E places the freight car in service, E performs a rebuild to the manufacturer's original specification, which includes a complete disassembly, inspection, and reconditioning or replacement of components of the suspension and draft systems, trailer hitches, and other special equipment. E also modifies the car to upgrade various components to the latest engineering standards. The freight car is stripped to the frame, with all of its substantial components either reconditioned or replaced. The frame itself is the longest-lasting part of the car and is reconditioned. The walls of the freight car are replaced or are sandblasted and repainted. New wheels are installed on the car. All the remaining components of the car are restored before they are reassembled. At the end of the rebuild, the freight car has been restored to like-new condition under the manufacturer's specifications.


1.263(a)-3 RestorationsExample 7. Rebuild of property to like-new condition before end of class

life (continued).

Assume the freight car is the unit of property. E is not required to treat as an improvement and capitalize the amounts paid to rebuild the freight car under paragraph (k)(1)(v) of this section because, although the amounts paid restore the freight car to like-new condition, the amounts were not paid after the end of the class life of the freight car. However, see paragraphs (k)(1)(vi) and (k)(6) of this section to determine whether any amounts must be capitalized because they are paid for the replacement of a major component or a substantial structural part of the unit of property.



1.263(a)-3 RestorationsExample 8. Rebuild of property to like-new condition after end of class

life. Assume the same facts as in Example 7, except that E rebuilds the freight car 15 years after E places it in service. Under paragraph (k)(1)(v) of this section, E must treat as an improvement and capitalize the amounts paid to rebuild the freight car because the amounts paid restore the freight car to like-new condition after the end of the class life of the freight car.


1.263(a)-3 RestorationsExample 9. Not a rebuild to a like-new condition. F is a commercial airline engaged in the business of transporting freight and passengers. To conduct its business, F owns several aircraft. As a condition of maintaining its airworthiness certificates, F is required by the FAA to establish and adhere to a continuous maintenance program for each aircraft in its fleet. F performs heavy maintenance on its airframes every 8 to 10 years. In Year 1, F purchased an aircraft for $15 million. In Year 16, F paid $2 million for the labor and materials necessary to perform the second heavy maintenance visit on the airframe of an aircraft. To perform the heavy maintenance visit, F extensively disassembles the airframe, removing items such as engines, landing gear, cabin and passenger compartment seats, side and ceiling panels, baggage stowage bins, galleys, lavatories, floor boards, cargo loading systems, and flight control surfaces. As specified by F's maintenance manual for the aircraft, F then performs certain tasks on the disassembled airframe for the purpose of preventing deterioration of the inherent safety and reliability levels of the airframe.



1.263(a)-3 RestorationsExample 9. Not a rebuild to a like-new condition (continued).

These tasks include lubrication and service, operational and visual checks, inspection and functional checks, reconditioning of minor parts and components, and removal, discard, and replacement of certain life-limited single cell parts, such as cartridges, canisters, cylinders, and disks. Reconditioning of parts includes burnishing corrosion, repairing cracks, dents, gouges, punctures, tightening or replacing loose or missing fasteners, replacing damaged seals, gaskets, or valves, and similar activities. In addition to the tasks described above, to comply with certain FAA airworthiness directives, F inspects specific skin locations, applies doublers over small areas where cracks were found, adds structural reinforcements, and replaces skin panels on a small section of the fuselage. However, the heavy maintenance does not include the replacement of any major components or substantial structural parts of the aircraft with new components. In addition, the heavy maintenance visit does not bring the aircraft to the status of new, rebuilt, remanufactured, or a similar status under FAA guidelines or the manufacturer's original specifications. After the heavy maintenance, the aircraft was reassembled..


1.263(a)-3 RestorationsExample 9. Not a rebuild to a like-new condition (continued).

Assume the aircraft, including the engines, is a unit of property and has a class life of 12 years under section 168(c). Although the heavy maintenance is performed after the end of the class life of the aircraft, F is not required to treat the heavy maintenance as a restoration and improvement of the unit of property under paragraph (k)(1)(v) of this section because, although extensive, the amounts paid do not restore the aircraft to like-new condition. See also paragraph (i)(1)(iii) of this section for the application of the safe harbor for routine maintenance.



1.263(a)-3 RestorationsExample 10. Replacement of major component or substantial structural

part; personal property. G is a common carrier that owns a fleet of petroleum hauling trucks. G pays amounts to replace the existing engine, cab, and petroleum tank with a new engine, cab, and tank. Assume the tractor of the truck (which includes the cab and the engine) is a single unit of property and that the trailer (which contains the petroleum tank) is a separate unit of property. The new engine and the cab each constitute a part or combination of parts that comprise a major component of G's tractor, because they perform a discrete and critical function in the operation of the tractor. In addition, the cab constitutes a part or combination of parts that comprise a substantial structural part of G's tractor. Therefore, the amounts paid for the replacement of the engine and the cab must be capitalized under paragraph (k)(1)(vi) of this section. Moreover, the new petroleum tank constitutes a part or combination of parts that comprise a major component and a substantial structural part of the trailer. Accordingly, the amounts paid for the replacement of the tank also must be capitalized under paragraph (k)(1)(vi) of this section.


1.263(a)-3 RestorationsExample 11. Repair performed during restoration. Assume the same facts as in Example 10, except that, at the same time the engine and cab of the tractor are replaced, G pays amounts to paint the cab of the tractor with its company logo and to fix a broken taillight on the tractor. The repair of the broken taillight and the painting of the cab generally are deductible expenses under §1.162-4. However, under paragraph (g)(1)(i) of this section, a taxpayer must capitalize all the direct costs of an improvement and all the indirect costs that directly benefit or are incurred by reason of an improvement. Repairs and maintenance that do not directly benefit or are not incurred by reason of an improvement are not required to be capitalized under section 263(a), regardless of whether they are made at the same time as an improvement. For the amounts paid to paint the logo on the cab, G's need to paint the logo arose from the replacement of the cab with a new cab. Therefore, under paragraph (g)(1)(i) of this section, G must capitalize the amounts paid to paint the cab as part of the improvement to the tractor because these amounts directly benefit and are incurred by reason of the restoration of the tractor.



1.263(a)-3 RestorationsExample 11. Repair performed during restoration (continued).

The amounts paid to repair the broken taillight are not for the replacement of a major component, do not directly benefit, and are not incurred by reason of the replacement of the cab or the engine under paragraph (g)(1)(i) of this section, even though the repair was performed at the same time as these replacements. Thus, G is not required to capitalize the amounts paid to repair the broken taillight.


1.263(a)-3 RestorationsExample 12. Related amounts to replace major component or substantial

structural part; personal property. (i) H owns a retail gasoline station, consisting of a paved area used for automobile access to the pumps and parking areas, a building used to market gasoline, and a canopy covering the gasoline pumps. The premises also consist of underground storage tanks (USTs) that are connected by piping to the pumps and are part of the gasoline pumping system used in the immediate retail sale of gas. The USTs are components of the gasoline pumping system. To comply with regulations issued by the Environmental Protection Agency, H is required to remove and replace leaking USTs. In Year 1, H hires a contractor to perform the removal and replacement, which consists of removing the old tanks and installing new tanks with leak detection systems. The removal of the old tanks includes removing the paving material covering the tanks, excavating a hole large enough to gain access to the old tanks, disconnecting any strapping and pipe connections to the old tanks, and lifting the old tanks out of the hole.




structural part; personal property (continued).

Installation of the new tanks includes placement of a liner in the excavated hole, placement of the new tanks, installation of a leak detection system, installation of an overfill system, connection of the tanks to the pipes leading to the pumps, backfilling of the hole, and replacement of the paving. H also is required to pay a permit fee to the county to undertake the installation of the new tanks.

(ii) H pays the permit fee to the county on October 15, Year 1. On December 15, Year 1, the contractor completes the removal of the old USTs and bills H for the costs of removal. On January 15, Year 2, the contractor completes the installation of the new USTs and bills H for the remainder of the work. Assume that H computes its taxes on a calendar year basis and H's gasoline pumping system is the unit of property.




Under paragraph (k)(1)(vi) of this section, H must capitalize the amounts paid to replace the USTs as a restoration to the gasoline pumping system because the USTs are parts or combinations of parts that comprise a major component and substantial structural part of the gasoline pumping system. Moreover, under paragraph (g)(2) of this section, H must capitalize the costs of removing the old USTs because H has not taken a loss on the disposition of the USTs, and the amounts to remove the USTs directly benefit and are incurred by reason of the restoration of, and improvement to, the gasoline pumping system. In addition, under paragraph (g)(1) of this section, H must capitalize the permit fees because they directly benefit and are incurred by reason of the improvement to the gasoline pumping system.





Finally, under paragraph (g)(3) of this section, H must capitalize the related amounts paid to improve the gasoline pumping system, including the permit fees, the amount paid to remove the old USTs, and the amount paid to install the new USTs, even though the amounts were separately invoiced, paid to different parties, and incurred in different tax years.


1.263(a)-3 RestorationsExample 13. Not replacement of major component; incidental. J owns a machine shop in which it makes dies used by manufacturers. In Year 1, J purchased a drill press for use in its production process. In Year 3, J discovers that the power switch assembly, which controls the supply of electric power to the drill press, has become damaged and cannot operate. To correct this problem, J pays amounts to replace the power switch assembly with comparable and commercially available replacement parts. Assume that the drill press is a unit of property under paragraph (e) of this section and the power switch assembly is a small component of the drill press that may be removed and installed with relative ease. The power switch assembly is not a major component of the unit of property under paragraph (k)(6)(i)(A) of this section because, although the power assembly may affect the function of J's drill press by controlling the supply of electric power, the power assembly is an incidental component of the drill press. In addition, the power assembly is not a substantial structural part of J's drill press under paragraph (k)(6)(i)(B) of this section. Therefore, J is not required to capitalize the costs to replace the power switch assembly under paragraph (k)(1)(vi) of this section.




part; roof. K owns a manufacturing building. K discovers several leaks in the roof of the building and hires a contractor to inspect and fix the roof. The contractor discovers that a major portion of the decking has rotted and recommends the replacement of the entire roof. K pays the contractor to replace the entire roof, including the decking, insulation, asphalt, and various coatings. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount is paid to restore the building structure or any building system. The roof is part of the building structure as defined under paragraph (e)(2)(ii)(A) of this section. Because the entire roof performs a discrete and critical function in the building structure, the roof comprises a major component of the building structure under paragraph (k)(6)(ii)(A) of this section.


1.263(a)-3 RestorationsExample 15. Not replacement of major component or substantial

structural part; roof membrane. L owns a building in which it conducts its retail business. The roof decking over L's building is covered with a waterproof rubber membrane. Over time, the rubber membrane begins to wear, and L begins to experience leaks into its retail premises. However, the building is still functioning in L's business. To eliminate the problems, a contractor recommends that L replace the membrane on the roof with a new rubber membrane. Accordingly, L pays the contractor to strip the original membrane and replace it with a new rubber membrane. The new membrane is comparable to the original membrane but corrects the leakage problems. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount is paid to restore the building structure or any building system. The roof, including the membrane, is part of the building structure as defined under paragraph (e)(2)(ii)(A) of this section. Because the entire roof performs a discrete and critical function in the building structure, the roof comprises a major component of the building structure under paragraph (k)(6)(ii)(A) of this section.




structural part; roof membrane (continued).

Although the replacement membrane may aid in the function of the building structure, it does not, by itself, comprise a significant portion of the roof major component under paragraph (k)(6)(ii)(A) of this section. In addition, the replacement membrane does not comprise a substantial structural part of L's building structure under paragraph (k)(6)(ii)(B) of this section. Therefore, L is not required to capitalize the amount paid to replace the membrane as a restoration of the building under paragraph (k)(1)(vi) of this section.


1.263(a)-3 RestorationsExample 16. Not a replacement of major component or substantial

structural part; HVAC system. M owns a building in which it operates an office that provides medical services. The building contains one HVAC system, which is comprised of three furnaces, three air conditioning units, and duct work that runs throughout the building to distribute the hot or cold air throughout the building. One furnace in M's building breaks down, and M pays an amount to replace it with a new furnace. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount is paid to restore the building structure or any building system. The HVAC system, including the furnaces, is a building system under paragraph (e)(2)(ii)(B)(1) of this section. As the parts that provide the heating function in the system, the three furnaces, together, perform a discrete and critical function in the operation of the HVAC system and are therefore a major component of the HVAC system under paragraph (k)(6)(i)(A) of this section.




structural part; HVAC system (continued).

However, the single furnace is not a significant portion of this major component of the HVAC system under paragraph (k)(6)(ii)(A) of this section, or a substantial structural part of the HVAC system under paragraph (k)(6)(ii)(B) of this section. Therefore, M is not required to treat the amount paid to replace the furnace as a restoration of the building under paragraph (k)(1)(vi) of this section.



part; HVAC system. N owns a large office building in which it provides consulting services. The building contains one HVAC system, which is comprised of one chiller unit, one boiler, pumps, duct work, diffusers, air handlers, outside air intake, and a cooling tower. The chiller unit includes the compressor, evaporator, condenser, and expansion valve, and it functions to cool the water used to generate air conditioning throughout the building. N pays an amount to replace the chiller with a comparable unit. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount is paid to restore the building structure or any building system. The HVAC system, including the chiller unit, is a building system under paragraph (e)(2)(ii)(B)(1) of this section. The chiller unit performs a discrete and critical function in the operation of the HVAC system because it provides the cooling mechanism for the entire system. Therefore, the chiller unit is a major component of the HVAC system under paragraph (k)(6)(ii)(A) of this section.




part; HVAC system (continued).

Because the chiller unit comprises a major component of a building system, N must treat the amount paid to replace the chiller unit as a restoration to the building under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an improvement to the building under paragraph (d)(2) of this section.



structural part; HVAC system. O owns an office building that it uses to provide services to customers. The building contains a HVAC system that incorporates ten roof-mounted units that provide heating and air conditioning for the building. The HVAC system also consists of controls for the entire system and duct work that distributes the heated or cooled air to the various spaces in the building's interior. O begins to experience climate control problems in various offices throughout the office building and consults with a contractor to determine the cause. The contractor recommends that O replace three of the roof-mounted heating and cooling units. O pays an amount to replace the three specified units. No work is performed on the other roof-mounted heating and cooling units, the duct work, or the controls. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system.




structural part; HVAC system (continued).

The HVAC system, including the 10 roof-mounted heating and cooling units, is a building system under paragraph (e)(2)(ii)(B)(1) of this section. As the components that generate the heat and the air conditioning in the HVAC system, the 10 roof-mounted units, together, perform a discrete and critical function in the operation of the HVAC system and, therefore, are a major component of the HVAC system under paragraph (k)(6)(ii)(A) of this section. The three roof-mounted heating and cooling units are not a significant portion of a major component of the HVAC system under (k)(6)(ii)(A) of this section, or a substantial structural part of the HVAC system, under paragraph (k)(6)(ii)(B) of this section. Accordingly, O is not required to treat the amount paid to replace the three roof-mounted heating and cooling units as a restoration of the building under paragraph (k)(1)(iv) of this section.



part; fire protection system. P owns a building that it uses to operate its business. P pays an amount to replace the sprinkler system in the building with a new sprinkler system. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The fire protection and alarm system, including the sprinkler system, is a building system under paragraph (e)(2)(ii)(B)(6) of this section. As the component that provides the fire suppression mechanism in the system, the sprinkler system performs a discrete and critical function in the operation of the fire protection and alarm system and is therefore a major component of the system under paragraph (k)(6)(ii)(A) of this section. Because the sprinkler system comprises a major component of a building system, P must treat the amount paid to replace the sprinkler system as restoration to the building unit of property under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an improvement to the building under paragraph (d)(2) of this section.




part; electrical system. Q owns a building that it uses to operate its business. Q pays an amount to replace the wiring throughout the building with new wiring that meets building code requirements. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The electrical system, including the wiring, is a building system under paragraph (e)(2)(ii)(B)(3) of this section. As the component that distributes the electricity throughout the system, the wiring performs a discrete and critical function in the operation of the electrical system under paragraph (k)(6)(ii)(A) of this section. The wiring also comprises a large portion of the physical structure of the electrical system under paragraph (k)(6)(ii)(B) of this section. Because the wiring comprises a major component and a substantial structural part of a building system, Q must treat the amount paid to replace the wiring as a restoration to the building under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an improvement to the building under paragraph (d)(2) of this section.



structural part; electrical system. R owns a building that it uses to operate its business. R pays an amount to replace 30 percent of the wiring throughout the building with new wiring that meets building code requirements. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The electrical system, including the wiring, is a building system under paragraph (e)(2)(ii)(B)(3) of this section. All the wiring in the building comprises a major component because it performs a discrete and critical function in the operation of the electrical system. However, the portion of the wiring that was replaced is not a significant portion of the wiring major component under paragraph (k)(6)(ii)(A) of this section, nor does it comprise a substantial structural part of the electrical system under paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this section, the replacement of 30 percent of the wiring is not the replacement of a major component or substantial structural part of the building, and R is not required to treat the amount paid to replace 30 percent of the wiring as a restoration to the building under paragraph (k)(1)(iv) of this section.




part; plumbing system. S owns a building in which it conducts a retail business. The retail building has three floors. The retail building has men's and women's restrooms on two of the three floors. S decides to update the restrooms by paying an amount to replace the plumbing fixtures in all of the restrooms, including all the toilets and sinks, with modern style plumbing fixtures of similar quality and function. S does not replace the pipes connecting the fixtures to the building's plumbing system. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The plumbing system, including the plumbing fixtures, is a building system under paragraph (e)(2)(ii)(B)(2) of this section. All the toilets together perform a discrete and critical function in the operation of the plumbing system, and all the sinks, together, also perform a discrete and critical function in the operation of the plumbing system.



part; plumbing system (continued).

Therefore, under paragraph (k)(6)(ii)(A) of this section, all the toilets comprise a major component of the plumbing system, and all the sinks comprise a major component of the plumbing system. Accordingly, S must treat the amount paid to replace all of the toilets and all of the sinks as a restoration of the building under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an improvement to the building under paragraph (d)(2) of this section.




structural part; plumbing system. Assume the same facts as Example 22 except that S does not update all the bathroom fixtures. Instead, S only pays an amount to replace 8 of the total of 20 sinks located in the various restrooms. The 8 replaced sinks, by themselves, do not comprise a significant portion of a major component (the 20 sinks) of the plumbing system under paragraph (k)(6)(ii)(A) of this section nor do they comprise a large portion of the physical structure of the plumbing system under paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this section, the replacement of the eight sinks does not constitute the replacement of a major component or substantial structural part of the building, and S is not required to treat the amount paid to replace the eight sinks as a restoration of a building under paragraph (k)(1)(iv) of this section.



part; plumbing system. (i) T owns and operates a hotel building. T decides that, to attract customers and to remain competitive, it needs to update the guest rooms in its facility. Accordingly, T pays amounts to replace the bathtubs, toilets, and sinks, and to repair, repaint, and retile the bathroom walls and floors, which is necessitated by the installation of the new plumbing components. The replacement bathtubs, toilets, sinks, and tile are new and in a different style, but are similar in function and quality to the replaced items. T also pays amounts to replace certain section 1245 property, such as the guest room furniture, carpeting, drapes, table lamps, and partition walls separating the bathroom area. T completes this work on two floors at a time, closing those floors and leaving the rest of the hotel open for business. In Year 1, T pays amounts to perform the updates for 4 of the 20 hotel room floors and expects to complete the renovation of the remaining rooms over the next two years.





(ii) Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The plumbing system, including the bathtubs, toilets, and sinks, is a building system under paragraph (e)(2)(ii)(B)(2) of this section. All the bathtubs, together, all the toilets, together, and all the sinks together in the hotel building perform discrete and critical functions in the operation of the plumbing system under paragraph (k)(6)(ii)(A) of this section and comprise a large portion of the physical structure of the plumbing system under paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6)(ii) of this section, these plumbing components comprise major components and substantial structural parts of the plumbing system, and T must treat the amount paid to replace these plumbing components as a restoration of, and improvement to, the building under paragraphs (k)(1)(vi) and (k)(2) of this section.




In addition, under paragraph (g)(1)(i) of this section, T must treat the costs of repairing, repainting, and retiling the bathroom walls and floors as improvement costs because these costs directly benefit and are incurred by reason of the improvement to the building. Further, under paragraph (g)(3) of this section, T must treat the costs incurred in Years 1, 2, and 3 for the bathroom remodeling as improvement costs, even though they are incurred over a period of several taxable years, because they are related amounts paid to improve the building unit of property. Accordingly, under paragraph (d)(2) of this section, T must treat all the amounts it incurs to update its hotel restrooms as an improvement to the hotel building and capitalize these amounts. In addition, under §1.263(a)-2 of the regulations, T must capitalize the amounts paid to acquire and install each section 1245 property.




structural part; windows. U owns a large office building that it uses to provide office space for employees that manage U's operations. The building has 300 exterior windows that represent 25 percent of the total surface area of the building. In Year 1, U pays an amount to replace 100 of the exterior windows that had become damaged. At the time of these replacements, U has no plans to replace any other windows in the near future. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The exterior windows are part of the building structure as defined under paragraph (e)(2)(ii)(A) of this section. The 300 exterior windows perform a discrete and critical function in the operation of the building structure and are, therefore, a major component of the building structure under paragraph (k)(6)(i)(A) of this section. However, the 100 windows do not comprise a significant portion of this major component of the building structure under paragraph (k)(6)(ii)(A) of this section or a substantial structural part of the building structure under paragraph (k)(6)(ii)(B) of this section.



structural part; windows (continued).

Therefore, under paragraph (k)(6) of this section, the replacement of the 100 windows does not constitute the replacement of a major component or substantial structural part of the building, and U is not required to treat the amount paid to replace the 100 windows as restoration of the building under paragraph (k)(1)(iv) of this section.



1.263(a)-3 RestorationsExample 26. Replacement of major component; windows. Assume the same facts as Example 25, except that that U replaces 200 of the 300 windows on the building. The 300 exterior windows perform a discrete and critical function in the operation of the building structure and are, therefore, a major component of the building structure under paragraph (k)(6)(i)(A) of this section. The 200 windows comprise a significant portion of this major component of the building structure under paragraph (k)(6)(ii)(A) of this section. Therefore, under paragraph (k)(6) of this section, the replacement of the 200 windows comprise the replacement of a major component of the building structure. Accordingly, U must treat the amount paid to replace the 200 windows as a restoration of the building under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an improvement to the building under paragraph (d)(2) of this section.


1.263(a)-3 RestorationsExample 27. Replacement of substantial structural part; windows. Assume the same facts as Example 25, except that the building is a modern design and the 300 windows represent 90 percent of the total surface area of the building. U replaces 100 of the 300 windows on the building. The 300 exterior windows perform a discrete and critical function in the operation of the building structure and are, therefore, a major component of the building structure under paragraph (k)(6)(i)(A) of this section. The 100 windows do not comprise a significant portion of this major component of the building structure under paragraph (k)(6)(ii)(A) of this section, however, they do comprise a substantial structural part of the building structure under paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this section, the replacement of the 100 windows comprise the replacement of a substantial structural part of the building structure. Accordingly, U must treat the amount paid to replace the 100 windows as a restoration of the building unit of property under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an improvement to the building under paragraph (d)(2) of this section.




structural part; floors. V owns and operates a hotel building. V decides to refresh the appearance of the hotel lobby by replacing the floors in the lobby. The hotel lobby comprises less than 10 percent of the square footage of the entire hotel building. V pays an amount to replace the wood flooring in the lobby with new wood flooring of a similar quality. V did not replace any other flooring in the building. Assume that the wood flooring constitutes section 1250 property. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The wood flooring is part of the building structure under paragraph (e)(2)(ii)(A) of this section. All the floors in the hotel building comprise a major component of the building structure because they perform a discrete and critical function in the operation of the building structure. However, the lobby floors are not a significant portion of a major component (that is, all the floors) under paragraph (k)(6)(ii)(A) of this section, nor do the lobby floors comprise a substantial structural part of the building structure under paragraph (k)(6)(ii)(B) of this section.



structural part; floors (continued).

Therefore, under paragraph (k)(6) of this section, the replacement of the lobby floors is not the replacement of a major component or substantial structural part of the building unit of property, and V is not required to treat the amount paid for the replacement of the lobby floors as a restoration to the building under paragraph (k)(1)(iv) of this section.




part; floors. Assume the same facts as Example 28, except that V decides to refresh the appearance of all the public areas of the hotel building by replacing all the floors in the public areas. To that end, V pays an amount to replace all the wood floors in all the public areas of the hotel building with new wood floors. The public areas include the lobby, the hallways, the meeting rooms, the ballrooms, and other public rooms throughout the hotel interiors. The public areas comprise approximately 40 percent of the square footage of the entire hotel building. All the floors in the hotel building comprise a major component of the building structure because they perform a discrete and critical function in the operation of the building structure. The floors in all the public areas of the hotel comprise a significant portion of a major component (that is, all the building floors) of the building structure. Therefore, under paragraph (k)(6)(ii)(A) of this section, the replacement of all the public area floors constitutes the replacement of a major component of the building structure.



part; floors (continued).

Accordingly, V must treat the amount paid to replace the public area floors as a restoration of the building unit of property under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amounts as an improvement to the building under paragraph (d)(2) of this section.



1.263(a)-3 RestorationsExample 30. Replacement with no disposition. (i) X owns an office building with four elevators serving all floors in the building. X replaces one of the elevators. The elevator is a structural component of the office building. X chooses to apply Prop. Reg. §1.168(i)-8 to taxable years beginning on or after January 1, 2012, and before the applicability date of the final regulations. In accordance with Prop. Reg. §1.168(i)- 8(c)(4)(ii)(A), the office building (including its structural components) is the asset for tax disposition purposes. X does not treat the structural components of the office building as assets under Prop. Reg. §1.168(i)-8(c)(4)(iii). X also does not make the partial disposition election provided under Prop. Reg. §1.168(i)-8(d)(2), for the elevator. Thus, the retirement of the replaced elevator is not a disposition under section 168, and no loss is taken into account for purposes of paragraph (k)(1)(i) of this section.


1.263(a)-3 RestorationsExample 30. Replacement with no disposition (continued).

(ii) Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The elevator system, including all four elevators, is a building system under paragraph (e)(2)(ii)(B)(5) of this section. The replacement elevator does not perform a discrete and critical function in the operation of elevator system under paragraph (k)(6)(ii)(A) of this section nor does it comprise a large portion of the physical structure of the elevator system under paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this section, the replacement elevator does not constitute the replacement of a major component or substantial structural part of the elevator system. Accordingly, X is not required to treat the amount paid to replace the elevator as a restoration to the building under either paragraph (k)(1)(i) or paragraph (k)(1)(vi) of this section.



1.263(a)-3 RestorationsExample 31. Replacement with disposition. The facts are the same as in Example 30, except X makes the partial disposition election provided under paragraph Prop. Reg. §1.168(i)-8(d)(2), for the elevator. Although the office building (including its structural components) is the asset for disposition purposes, the result of X making the partial disposition election for the elevator is that the retirement of the replaced elevator is a disposition. Thus, depreciation for the retired elevator ceases at the time of its retirement (taking into account the applicable convention), and X recognizes a loss upon this retirement. Accordingly, X must treat the amount paid to replace the elevator as a restoration of the building under paragraphs (k)(1)(i) and (k)(2) of this section and must capitalize the amount paid as an improvement to the building under paragraph (d)(2) of this section. In addition, the replacement elevator is treated as a separate asset for tax disposition purposes pursuant to Prop. Reg. §1.168(i)- 8(c)(4)(ii)(D), and for depreciation purposes pursuant to section 168(i)(6).


Accounting Method

• DCN 184 covers these issues

• Review to see if client has followed these rules, if not consider amount of adjustment



1.263(a)-3 Adaptation toNew or Different Use

• In general . . . Capitalize amounts paid to adapt a unit of property to a new or different use

– Adaptation is not consistent with the taxpayer's ordinary use of the unit of property at the time originally placed in service by the taxpayer.

– Building . . . Adapts to a new or different use building structure or any building system

• Seven examples (up from four in temporary regulations)



Example 1. New or different use; change in building use. A is a manufacturer and owns a manufacturing building that it has used for manufacturing since Year 1, when A placed it in service. In Year 30, A pays an amount to convert its manufacturing building into a showroom for its business. To convert the facility, A removes and replaces various structural components to provide a better layout for the showroom and its offices. A also repaints the building interiors as part of the conversion. When building materials are removed and replaced, A uses comparable and commercially available replacement materials. Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve A's manufacturing building if the amount adapts the building structure or any designated building system to a new or different use. Under paragraph (l)(1) of this section, the amount paid to convert the manufacturing building into a showroom adapts the building structure to a new or different use because the conversion to a showroom is not consistent with A's ordinary use of the building structure at the time it was placed in service.




Example 1. New or different use; change in building use (continued).

Therefore, A must capitalize the amount paid to convert the building into a showroom as an improvement to the building under paragraphs (d)(3) and (l) of this section.



Example 2. Not a new or different use; leased building. B owns and leases out space in a building consisting of twenty retail spaces. The space was designed to be reconfigured; that is, adjoining spaces could be combined into one space. One of the tenants expands its occupancy by leasing two adjoining retail spaces. To facilitate the new lease, B pays an amount to remove the walls between the three retail spaces. Assume that the walls between spaces are part of the building and its structural components. Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve B's building if it adapts the building structure or any of the building systems to a new or different use. Under paragraph (l)(1) of this section, the amount paid to convert three retail spaces into one larger space for an existing tenant does not adapt B's building structure to a new or different use because the combination of retail spaces is consistent with B's intended, ordinary use of the building structure. Therefore, the amount paid by B to remove the walls does not improve the building under paragraph (l) of this section and is not required to be capitalized under paragraph (d)(3) of this section.




Example 3. Not a new or different use; preparing building for sale. C owns a building consisting of twenty retail spaces. C decides to sell the building. In anticipation of selling the building, C pays an amount to repaint the interior walls and to refinish the hardwood floors. Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve C's building to a new or different use if it adapts the building structure or any of the building systems to a new or different use. Preparing the building for sale does not constitute a new or different use for the building structure under paragraph (l)(1) of this section. Therefore, the amount paid by C to prepare the building structure for sale does not improve the building under paragraph (l) of this section and is not required to be capitalized under paragraph (d)(3) of this section.



Example 4. New or different use; land. D owns a parcel of land on which it previously operated a manufacturing facility. Assume that the land is the unit of property. During the course of D's operation of the manufacturing facility, the land became contaminated with wastes from its manufacturing processes. D discontinues manufacturing operations at the site and decides to develop the property for residential housing. In anticipation of building residential property, D pays an amount to remediate the contamination caused by D's manufacturing process. In addition, D pays an amount to regrade the land so that it can be used for residential purposes. Amounts that D pays to clean up wastes do not adapt the land to a new or different use, regardless of the extent to which the land was cleaned, because this cleanup merely returns the land to the condition it was in before the land was contaminated in D's operations. Therefore, D is not required to capitalize the amount paid for the cleanup under paragraph (l)(1) of this section.




Example 4. New or different use; land (continued).

However, the amount paid to regrade the land so that it can be used for residential purposes adapts the land to a new or different use that is inconsistent with D's intended ordinary use of the property at the time it was placed in service. Accordingly, the amounts paid to regrade the land must be capitalized as improvements to the land under paragraphs (d)(3) and (l) of this section.



Example 5. New or different use; part of building. (i) E owns a building in which it operates a retail drug store. The store consists of a pharmacy for filling medication prescriptions and various departments where customers can purchase food, toiletries, home goods, school supplies, cards, over-the-counter medications, and other similar items. E decides to create a walk-in medical clinic where nurse practitioners and physicians' assistants diagnose, treat, and write prescriptions for common illnesses and injuries, administer common vaccinations, conduct physicals and wellness screenings, and provide routine lab tests and services for common chronic conditions. To create the clinic, E pays amounts to reconfigure the pharmacy building. E incurs costs to build new walls creating an examination room, lab room, reception area, and waiting area. E installs additional plumbing, electrical wiring, and outlets to support the lab. E also acquires section 1245 property, such as computers, furniture, and equipment necessary for the new clinic. E treats the amounts paid for those units of property as costs of acquiring new units of property under §1.263(a)-2.




Example 5. New or different use; part of building (continued).

(ii) Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve E's building if it adapts the building structure or any of the building systems to a new or different use. Under paragraph (l)(1) of this section, the amount paid to convert part of the retail drug store building structure into a medical clinic adapts the building structure to a new and different use, because the use of the building structure to provide clinical medical services is not consistent with E's intended ordinary use of the building structure at the time it was placed in service. Similarly, the amounts paid to add to the plumbing system and the electrical systems to support the new medical services is not consistent with E's intended ordinary use of these systems when the systems were placed in service. Therefore, E must treat the amount paid for the conversion of the building structure, plumbing system, and electrical system as an improvement to the building and capitalize the amount under paragraphs (d)(3) and (l) of this section.



Example 6. Not a new or different use; part of building. (i) F owns a building in which it operates a grocery store. The grocery store includes various departments for fresh produce, frozen foods, fresh meats, dairy products, toiletries, and over-the-counter medicines. The grocery store also includes separate counters for deli meats, prepared foods, and baked goods, often made to order. To better accommodate its customers' shopping needs, F decides to add a sushi bar where customers can order freshly prepared sushi from the counter for take-home or to eat at the counter. To create the sushi bar, F pays amounts to add a sushi counter and chairs, add additional wiring and outlets to support the counter, and install additional pipes and a sink, to provide for the safe handling of the food. F also pays amounts to replace flooring and wall coverings in the sushi bar area with decorative coverings to reflect more appropriate décor. Assume the sushi counter and chairs are section 1245 property, and F treats the amounts paid for those units of property as costs of acquiring new units of property under §1.263(a)-2.




Example 6. Not a new or different use; part of building (continued).

(ii) Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve F's building if it adapts the building structure or any of the building systems to a new or different use. Under paragraph (l)(1) of this section, the amount paid to convert a part of F's retail grocery into a sushi bar area does not adapt F's building structure, plumbing system, or electrical system to a new or different use, because the sale of sushi is consistent with F's intended, ordinary use of the building structure and these systems in its grocery sales business, which includes selling food to its customers at various specialized counters. Accordingly, the amount paid by F to replace the wall and floor finishes, add wiring, and add plumbing to create the sushi bar space does not improve the building unit of property under paragraph (l) of this section and is not required to be capitalized under paragraph (d)(3) of this section.




(ii) Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve F's building if it adapts the building structure or any of the building systems to a new or different use. Under paragraph (l)(1) of this section, the amount paid to convert a part of F's retail grocery into a sushi bar area does not adapt F's building structure, plumbing system, or electrical system to a new or different use, because the sale of sushi is consistent with F's intended, ordinary use of the building structure and these systems in its grocery sales business, which includes selling food to its customers at various specialized counters. Accordingly, the amount paid by F to replace the wall and floor finishes, add wiring, and add plumbing to create the sushi bar space does not improve the building unit of property under paragraph (l) of this section and is not required to be capitalized under paragraph (d)(3) of this section.




Example 7. Not a new or different use; part of building. (i) G owns a hospital with various departments dedicated to the provision of clinical medical care. To better accommodate its patients' needs, G decides to modify the emergency room space to provide both emergency care and outpatient surgery. To modify the space, G pays amounts to move interior walls, add additional wiring and outlets, replace floor tiles and doors, and repaint the walls. To complete the outpatient surgery center, G also pays amounts to install miscellaneous medical equipment necessary for the provision of surgical services. Assume the medical equipment is section 1245 property, and G treats the amounts paid for those units of property as costs of acquiring new units of property under §1.263(a)-2.




(ii) Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve G's building if it adapts the building structure or any of the building systems to a new or different use. Under paragraph (l)(1) of this section, the amount paid to convert part of G's emergency room into an outpatient surgery center does not adapt G's building structure or electrical system to a new or different use, because the provision of outpatient surgery is consistent with G's intended, ordinary use of the building structure and these systems in its clinical medical care business. Accordingly, the amounts paid by G to relocate interior walls, add additional wiring and outlets, replace floor tiles and doors, and repaint the walls to create outpatient surgery space do not improve the building under paragraph (l) of this section and are not required to be capitalized under paragraph (d)(3) of this section.



Accounting Method

• DCN 184 Issue

• May have some funds “on the table” if taxpayer capitalized item that was not truly an adaptation


1.263(a)-3 Optional Regulatory Accounting Method

• In general . . . Taxpayer engaged in regulated industry may use the regulatory accounting method for repairs, maintenance, and improvements required by:

– Federal Energy Regulatory Commission

– Federal Communications Commission

– Surface Transportation Board

– Four examples restate above points

• Final regulations merely clarify must use standards of those agencies




Example 1. Taxpayer subject to regulatory accounting rules of FERC. W is an electric utility company that operates a power plant that generates electricity and that owns and operates network assets to transmit and distribute the electricity to its customers. W is subject to the regulatory accounting rules of FERC, and W uses the regulatory accounting method under paragraph (m) of this section. W does not capitalize on its books and records for regulatory accounting purposes the cost of repairs and maintenance performed on its turbines or its network assets. Under the regulatory accounting method, W may not capitalize for Federal income tax purposes amounts paid for repairs performed on its turbines or its network assets.



Example 2. Taxpayer not subject to regulatory accounting rules of FERC. X is an electric utility company that operates a power plant to generate electricity. X previously was subject to the regulatory accounting rules of FERC, but currently X is not required to use FERC's regulatory accounting rules. X cannot use the regulatory accounting method provided in this paragraph (m).




Example 3. Taxpayer subject to regulatory accounting rules of FCC. Y is a telecommunications company that is subject to the regulatory accounting rules of the FCC. Y uses the regulatory accounting method under this paragraph (m). Y's assets include a telephone central office switching center, which contains numerous switches and various switching equipment. Y capitalizes on its books and records for regulatory accounting purposes the cost of replacing each switch. Under the regulatory accounting method, Y is required to capitalize for Federal income tax purposes amounts paid to replace each switch.



Example 4. Taxpayer subject to regulatory accounting rules of STB. Z is a Class I railroad that is subject to the regulatory accounting rules of the STB. Z uses the regulatory accounting method under this paragraph (m). Z capitalizes on its books and records for regulatory accounting purposes the cost of locomotive rebuilds. Under the regulatory accounting method, Z is required to capitalize for Federal income tax purposes amounts paid to rebuild its locomotives.



Accounting Method

• If qualify to use this one (or end up doing so in the future), then DCN 185 of Section 10.11 applies

• Can be made with other changes found in Section 10.11


1.263(a)-3(n) Election to Capitalize Repairs and Maintenance

• Added in the final regulations

• Allows a taxpayer to elect to capitalize tangible property that otherwise would be treated as repairs and maintenance– Must treat the same way on books and records

– Must file statement with return to elect• Title statement “Section 1.263(a)-3(n) Election”

• Taxpayer's name, address, taxpayer identification number, and a statement that the taxpayer is making the election to capitalize repair and maintenance costs under §1.263(a)-3(n)





Example 1. Election to capitalize routine maintenance on non-rotable part.

(i) Q is a towboat operator that owns a fleet of towboats that it uses in its trade or business. Each towboat is equipped with two diesel-powered engines. Assume that each towboat, including its engines, is the unit of property and that a towboat has a class life of 18 years. Assume the towboat engines are not rotable spare parts under §1.162- 3(c)(2). In Year 1, Q acquired a new towboat, including its two engines, and placed the towboat into service. In Year 4, Q pays amounts to perform scheduled maintenance on both engines in the towboat. Assume that none of the exceptions set out in paragraph (i)(3) of this section apply to the scheduled maintenance costs and that the scheduled maintenance on Q's towboat is within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts paid for the scheduled maintenance to its towboat engines in Year 4 are deemed not to improve the towboat and are not required to be capitalized under paragraph (d) of this section.



Example 1. Election to capitalize routine maintenance on non-rotable part

(continued).

(ii) On its books and records, Q treats amounts paid for scheduled maintenance on its towboat engines as capital expenditures. For administrative convenience, Q decides to account for these costs in the same way for Federal income tax purposes. Under paragraph (n) of this section, in Year 4, Q may elect to capitalize the amounts paid for the scheduled maintenance on its towboat engines. If Q elects to capitalize such amounts, Q must capitalize all amounts paid for repair and maintenance to tangible property that Q treats as capital expenditures on its books and records in Year 4.




Example 2. No election to capitalize routine maintenance. Assume the same facts as Example 1, except in Year 8, Q pays amounts to perform scheduled maintenance for a second time on the towboat engines. On its books and records, Q treats the amounts paid for this scheduled maintenance as capital expenditures. However, in Year 8, Q decides not to make the election to capitalize the amounts paid for scheduled maintenance under paragraph (n) of this section. Because Q does not make the election under paragraph (n) for Year 8, Q may apply the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section to the amounts paid in Year 8, and not treat these amounts as capital expenditures. Because the election is made for each taxable year, there is no effect on the scheduled maintenance costs capitalized by Q on its Federal tax return for Year 4.



Example 3. Election to capitalize replacement of building component. (i) R owns an office building that it uses to provide services to customers. The building contains a HVAC system that incorporates ten roof-mounted units that provide heating and air conditioning for different parts of the building. In Year 1, R pays an amount to replace 2 of the 10 units to address climate control problems in various offices throughout the office building. Assume that the replacement of the two units does not constitute an improvement to the HVAC system, and, accordingly, to the building unit of property under paragraph (d) of this section, and that R may deduct these amounts as repairs and maintenance under §1.162-4.




Example 3. Election to capitalize replacement of building component

(continued).

(ii)On its books and records, R treats amounts paid for the two HVAC components as capital expenditures. R determines that it would prefer to account for these amounts in the same way for Federal income tax purposes. Under this paragraph (n), in Year 1, R may elect to capitalize the amounts paid for the new HVAC components. If R elects to capitalize such amounts, R must capitalize all amounts paid for repair and maintenance to tangible property that R treats as capital expenditures on its books and records in Year 1.

1.263(a)-3 Amounts Capitalized

• Reg .§1.263(a)-3(o) simply states that anything treated as capitalized by this provision must be appropriately classified

• Reg. §1.263(a)-3(p) goes on to state that costs can only be recovered by reference to another Code provision.



1.263(a)-3 Effective Date/Accounting Method

• Effective date generally 1/1/14

• For years beginning after 1/1/12 and before 1/1/14

– May use old rules

– Can elect to use temporary regulations

– Can elect to use final regulations (180 day relief option for missing elections)

• All modifications will be accounting method changes


1.263(a)-6 Election to Deduct or Capitalize Certain Expenditures

• Lists 21 code sections permitting an election to treat capital expenditures as deductible or deferred expenses, or vice versa

– Section 173 (circulation expenditures);

– Section 174 (research and experiment expenditures);

– Section 175 (soil and water conservation expenditures, and endangered species recovery expenditures);

– Section 179 (election to expense depreciable business assets);

– Section 179A (deduction for clean-fuel vehicles and certain refueling property)

– Section 179B (deduction for costs incurred for EPA compliance)



1.263(a)-6 (continued)

– 179C (election to expense certain refineries);

– 179D (energy efficient commercial buildings deduction);

– 179E (election to expense mine safety equipment);

– 180 (expenditures by farmers for fertilizer);

– 181 (certain qualified film and television productions);

– 190 (removal of architectural and transportation barriers to handicapped and elderly

– 191 (tertiary injectants);

– 194 (re-for a station expenditures);

– 195 (startup expenditures);

– 198 (expensing environmental remediation costs);


1.263(a)-6 (continued)

– 198A (qualified disaster expenses);

– 248 (organization expenditures of Corporation);

– 266 (carrying charges);

– 616 (development expenditures); and

– 709 (organization and syndication fees of partnership).

• Applies to taxable years beginning on or after 1/1/2014 (again can elect to use effective 1/1/2012)



1.263A-1 Uniform Capitalization of Costs

• No changes to (a) through (b)(13) . . . New paragraphs define or explain following terms:

– (a)(14) . . . 263A does not apply to cost of property to which taxpayer properly applies de minimis rule

– (c)(4) . . . Except for amounts paid to produce incidental materials and supplies, 263A costs are recovered through depreciation, amortization, COGS, or basis adjustment when property is used, placed in service, or disposed of

– (e)(2)(i)(A) . . . A cost described in 1.162-3 , relating to a material or supply, may be a 263A direct material cost


1.263A-1 Uniform Capitalization of Costs (continued)

– (e)(2)(i)(E) . . . A cost described in 1.162-3 , relating to a material or supply, may be a 263A indirect material cost

– (e)(2)(ii)(F)(l) . . . A change in treatment of costs subject to de minimis rule is a change in method of accounting

• Changes listed above apply in tax years beginning after 1/1/2014 (elective for 1/1/2012)

• Certain changes, not part of these temporary regulations apply to taxable years ending on or after 8/2/2005

– (h)(2)(i)(D) re: self-constructed assets

– (k) re: Change in method of accounting



1.1016-3• Exhaustion, wear and tear, obsolescence, amortization,

and depletion for periods since February 13, 1913

– (a)(1)(ii) . . . Determination of amount properly allowable as deduction must be made based on facts reasonably known to exist at end of taxable year.

– (j)(1) . . . Except as provided in (j)(2) or (j)(3) this section applies on or after December 30, 2003

– (j)(3) . . . (a)(1)(ii) applies to taxable years beginning on or after 1/1/2014 (elective for 1/1/2012)


IRS Public Comments

• AICPA letter to IRS requesting

– Increase in $500 de minimis and

– Get rid of retroactive application

– http://www.aicpa.org/Advocacy/Tax/DownloadableDocuments/AICPACommentLetter-TangiblePropertyRegsFINAL-2014-10-08.pdf

• IRS response

– Not going to change

– Do your best (?)



http://www.aicpa.org/Advocacy/Tax/DownloadableDocuments/AICPACommentLetter-TangiblePropertyRegsFINAL-2014-10-08.pdf

Dealing with Clients

• Look back over books and returns for recent years

• Inquire of clients for likely issues that might exist

• Remember there are both positive and negative adjustments


Client Refuses

• Be sure to document that you advised client

– Need to file the form

– Potential problems (lost deductions) if not done

• Decide if return now misstates income (remember general exception for “impermissible” accounting methods)

• In extreme cases may need to resign



What Firms are Doing

• Prepare some basic Form 3115s with proper sections filled in

• Determine reasonable search for items

– For some items can use statistical sampling—but likely not to save much work in small entity

– Cost/benefit issues and the “does not misstate income” defense

• Procedures to insure both copies of Form 3115 are handled properly


THANK YOU !



57686 Federal Register / Vol. 78, No. 182 / Thursday, September 19, 2013 / Rules and Regulations

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9636]

RIN 1545–BE18

Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property

AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final regulations and removal of temporary regulations.

SUMMARY: This document contains final regulations that provide guidance on the application of sections 162(a) and 263(a) of the Internal Revenue Code (Code) to amounts paid to acquire, produce, or improve tangible property. The final regulations clarify and expand the standards in the current regulations under sections 162(a) and 263(a). These final regulations replace and remove temporary regulations under sections 162(a) and 263(a) and withdraw proposed regulations that cross referenced the text of those temporary regulations. This document also contains final regulations under section 167 regarding accounting for and retirement of depreciable property and final regulations under section 168 regarding accounting for property under the Modified Accelerated Cost Recovery System (MACRS) other than general asset accounts. The final regulations will affect all taxpayers that acquire, produce, or improve tangible property. These final regulations do not finalize or remove the 2011 temporary regulations under section 168 regarding general asset accounts and disposition of property subject to section 168, which are addressed in the notice of proposed rulemaking on this subject in the Proposed Rules section in this issue of the Federal Register. DATES: Effective Date: These regulations are effective on September 19, 2013.

Applicability Dates: In general, these final regulations apply to taxable years beginning on or after January 1, 2014. However, certain rules apply only to amounts paid or incurred in taxable years beginning on or after January 1, 2014. For dates of applicability of the final regulations, see §§ 1.162–3(j), 1.162–4(c), 1.162–11(b)(2), 1.165–2(d), 1.167(a)–4(b), 1.167(a)–7(f), 1.167(a)– 8(h), 1.168(i)–7(e), 1.263(a)–1(h), 1.263(a)–2(j), 1.263(a)–3(r), 1.263(a)– 6(c), 1.263A–1(l), and 1.1016–3(j). FOR FURTHER INFORMATION CONTACT: Concerning §§ 1.162–3, 1.162–4, 1.162–

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

Paperwork Reduction Act

The collection of information contained in this final regulation has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under control number 1545– 2248. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number assigned by the Office of Management and Budget.

The collection of information in this regulation is in §§ 1.263(a)–1(f)(5), 1.263(a)–3(h)(6), and 1.263(a)–3(n)(2). This information is required in order for a taxpayer to elect to use the de minimis safe harbor, to elect to use the safe harbor for small taxpayers, and to elect to capitalize repair and maintenance costs. This information will inform the IRS that the taxpayer is electing to use these provisions, which allows taxpayers to obtain beneficial treatment for the amounts that qualify for these elections. The collection of information is voluntary to obtain a benefit under the final regulations. The likely respondents are business or other for- profit institutions, and small businesses or organizations.

Estimated total annual reporting burden: 1,100,000 hours.

Estimated annual burden hours per respondent varies from .25 hours to .5 hours, depending on individual circumstances, with an estimated average of .275 hours.

Estimated number of respondents: 4,000,000.

Estimated frequency of responses: Annually.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by section 6103.

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. Final regulations previously issued under section 263(a) provided that capital expenditures included amounts paid or incurred to (1) add to the value, or substantially prolong the useful life, of property owned by the taxpayer, or (2) adapt the property to a new or different use. However, those regulations also provided that amounts paid or incurred for incidental repairs and maintenance of property within the meaning of section 162 and § 1.162–4 of the Income Tax Regulations are not capital expenditures under § 1.263(a)–1.

The determination of whether an expense may be deducted as a repair or must be capitalized generally requires an examination of all of a taxpayer’s particular facts and circumstances. Moreover, the subjective nature of the existing standards described above has resulted in considerable controversy between taxpayers and the IRS over many years.

In 2006, in an effort to reduce the controversy in this area, the IRS and the Treasury Department published in the Federal Register August 21, 2006 (71 FR 48590) proposed amendments to the regulations under section 263(a) relating to amounts paid to acquire, produce, or improve tangible property. The IRS and the Treasury Department received numerous written comments in response to these proposed regulations. After considering these comments and the statements at the public hearing, in 2008 the IRS and the Treasury Department withdrew the 2006 proposed regulations and proposed new regulations in the Federal Register March 10, 2008 (73 FR 12838). The IRS and the Treasury Department also received many written comments and held a public hearing on the 2008 proposed regulations. On December 27, 2011, the IRS and the Treasury Department published temporary regulations in the Federal Register regarding the deduction and capitalization of expenditures related to tangible property (TD 9564; 76 FR 81060), withdrew the 2008 proposed regulations, and published new proposed regulations that cross referenced the text of the 2011 temporary regulations. The 2011 temporary regulations initially applied

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The Tax Curriculum A-1 Nichols Patrick CPE, Inc.


to taxable years beginning on or after January 1, 2012. The IRS and the Treasury Department received numerous written comments in response to the 2011 temporary and proposed regulations and held a public hearing on May 9, 2012. After considering these comments and the statements at the public hearing, the IRS and the Treasury Department published Notice 2012–73 (2012–51 IRB 713), on November 20, 2012, announcing that, to assist taxpayers in their transitions to the 2011 temporary regulations and final regulations, the IRS and the Treasury Department would change the applicability date of the 2011 temporary regulations to taxable years beginning on or after January 1, 2014, while permitting taxpayers to choose to apply the 2011 temporary regulations to taxable years beginning on or after January 1, 2012, and before the applicability date of the final regulations. The Notice also alerted taxpayers that the IRS and the Treasury Department intended to publish final regulations in 2013 and expected the final regulations to apply to taxable years beginning on or after January 1, 2014, but that the final regulations would permit taxpayers to apply its provisions to taxable years beginning on or after January 1, 2012. On December 17, 2012, the Treasury Department and the IRS published technical amendments to TD 9564, which amended the applicability date of the 2011 temporary regulations to taxable years beginning on or after January 1, 2014, while permitting taxpayers to choose to apply the 2011 temporary regulations to taxable years beginning on or after January 1, 2012, and before the applicability date of the final regulations. See Federal Register (77 FR 74583).

After considering all of the comments and the statements made at the public hearing on the 2011 temporary and proposed regulations, the IRS and the Treasury Department are removing the 2011 temporary regulations under sections 162, 165, 167, 263(a), 263A, 1016, and § 1.168(i)–7 and are issuing final regulations. The IRS and the Treasury Department are also removing the 2011 proposed regulations and are issuing new proposed regulations regarding the disposition of property subject to section 168. The proposed regulations are set forth in the notice of proposed rulemaking on this subject in the Proposed Rules section in this issue of the Federal Register.

Explanation of Provisions I. Overview

Section 263(a) generally requires the capitalization of amounts paid to acquire, produce, or improve tangible property. Section 162 allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including the costs of certain supplies, repairs, and maintenance. These final regulations provide a general framework for distinguishing capital expenditures from supplies, repairs, maintenance, and other deductible business expenses. The final regulations retain many of the provisions of the 2011 temporary and proposed regulations (2011 temporary regulations), which in many instances incorporated standards from case law and other existing authorities under sections 162 and 263(a). The final regulations also modify several sections of the 2011 temporary regulations in response to comments received and to clarify and simplify the rules while achieving results that are consistent with the case law. The final regulations adopt the same general format as the 2011 temporary regulations, where § 1.162–3 provides rules for materials and supplies, § 1.162–4 addresses repairs and maintenance, § 1.263(a)–1 provides general rules for capital expenditures, § 1.263(a)–2 provides rules for amounts paid for the acquisition or production of tangible property, and § 1.263(a)–3 provides rules for amounts paid for the improvement of tangible property. However, the final regulations refine and simplify some of the rules contained in the 2011 temporary regulations and create a number of new safe harbors. For example, the final regulations adopt a revised and simplified de minimis safe harbor under § 1.263(a)–1(f) and extend the safe harbor for routine maintenance under § 1.263(a)–3(i) to buildings. The final regulations also add a safe harbor for small taxpayers to the rules governing improvements to tangible property under § 1.263(a)–3. In addition, the final regulations refine several of the criteria for defining betterments and restorations to tangible property.

In addition, these regulations finalize certain temporary regulations under section 167 regarding accounting for and retirement of depreciable property and section 168 regarding accounting for MACRS property, other than general asset accounts. However, these regulations do not finalize the rules under § 1.168(i)–1T or § 1.168(i)–8T addressing the definition of disposition

for property subject to section 168. Instead, to address significant changes in this area, revised regulations under section 168 are being proposed concurrently with these final regulations (and appear in the Proposed Rules section of this issue of the Federal Register).

II. Materials and Supplies Under § 1.162–3

Responding to generally favorable comments on the treatment of materials and supplies in the 2011 temporary regulations, the final regulations retain the framework and many of the rules set forth in the 2011 temporary regulations. In response to comments, however, the final regulations expand the definition of materials and supplies to include property that has an acquisition or production cost of $200 or less (increased from $100 or less), clarify application of the optional method of accounting for rotable and temporary spare parts, and simplify the application of the de minimis safe harbor of § 1.263(a)–1(f) to materials and supplies. The final regulations also define standby emergency spare parts and limit the application of the election to capitalize materials and supplies to only rotable, temporary, and standby emergency spare parts.

A. Definition of Materials and Supplies Commenters requested that the dollar

threshold for characterizing a unit of property as a material or supply be increased from property with an acquisition cost of $100 or less to property with an acquisition cost of $500 or $1,000. Specifically, commenters were concerned that the low $100 threshold would not capture many common supplies such as calculators and coffee makers. Balancing concerns over distortions to income that could result from increasing the acquisition cost to $500 (or more) with the need to include the typical materials and supplies ordinarily used by many taxpayers, the final regulations increase the $100 threshold to $200. In addition, the final regulations retain the language providing the IRS and the Treasury Department with the authority to change the amount of this threshold through published guidance.

Commenters also continued to question the effect of the 2011 temporary regulations on the treatment of standby emergency spare parts under Rev. Rul. 81–185 (1981–2 CB 59). To resolve questions in this area, the final regulations generally incorporate the definition of standby emergency spare parts provided in Rev. Rul. 81–185 into the definition of materials and supplies


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and provide that these parts are eligible for the optional election to capitalize certain materials and supplies provided in § 1.162–3(d).

B. Election To Capitalize Certain Materials and Supplies

The 2011 temporary regulations retained the rule from the 2008 proposed regulations permitting a taxpayer to elect to capitalize and depreciate amounts paid for certain materials and supplies. Several comments noted that the requirement to elect to capitalize certain material and supply costs continued to be inconsistent with prior 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 rotable 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). In addition, several comments noted that the rule under the 2011 temporary regulations could lead to problematic results, such as permitting a component acquired to improve a unit of tangible property owned by the taxpayer to be treated as an asset and depreciated over a recovery period different from the unit of tangible property intended to be improved.

To address these concerns, the final regulations retain the rule permitting a taxpayer to elect to capitalize and depreciate amounts paid for certain materials and supplies but provide that this rule is only applicable to rotable, temporary, or standby emergency spare parts. By limiting the application of the rule to rotable, temporary, or standby emergency spare parts, the final regulations resolve the potentially problematic results arising in the 2011 temporary regulations. And while the final rule modifies Rev. Rul. 2003–37, Rev. Rul. 81–185, Rev. Rul. 69–200, and Rev. Rul. 69–201 to the extent that the regulations characterize certain tangible properties addressed in these rulings as

materials and supplies, the treatment is consistent with the holdings of the revenue rulings, which permit taxpayers to treat rotable, temporary, or standby emergency spare parts as assets subject to the allowance for depreciation.

The final regulations also clarify the procedure for a taxpayer that wants to revoke the election to capitalize and depreciate certain materials and supplies. The taxpayer may revoke this election by filing a request for a letter ruling and obtaining the consent of the Commissioner of Internal Revenue to revoke this election. The Commissioner may grant a request to revoke this election if the taxpayer acted reasonably and in good faith, and the revocation will not prejudice the interests of the Government. In deciding whether to grant such a request, the Commissioner anticipates applying standards similar to the standards under § 301.9100–3 of this chapter for granting extensions of time for making regulatory elections.

Finally, one commenter requested that the rules governing materials and supplies be modified to address the cost of acquiring or producing rotable spare parts that a taxpayer leases to customers in the ordinary course of the taxpayer’s leasing business. This commenter requested that the final regulations clarify that these leased rotable spare parts are included in the definition of rotable and temporary spare parts and that a taxpayer may elect to capitalize and depreciate these leased rotable spare parts under the materials and supplies rules. Under the 2011 temporary regulations, the definition of rotable and temporary spare parts includes only components acquired to maintain, repair, or improve a unit of property owned, leased, or serviced by the taxpayer. This definition of rotable and temporary spare parts does not include components that the taxpayer leases to its customers and that are unrelated to other property owned, leased to other parties, or serviced by the taxpayer. The final regulations do not expand the definition of rotable and temporary spare parts to include leased rotable spare parts. The IRS and the Treasury Department believe that these parts are outside the scope of regulations governing materials and supplies.

C. Optional Method for Rotable and Temporary Spare Parts

One commenter requested that the final regulations remove the requirement that the optional method for rotable and temporary spare parts, if elected, be used for all of a taxpayer’s rotable and temporary spare parts in the same trade or business. Recognizing that

taxpayers may have pools of rotable or temporary parts that are treated differently for financial statement purposes, the final regulations modify this rule. The final regulations provide that a taxpayer that uses the optional method for rotable and temporary spare parts for Federal tax purposes must use the optional method for all of the pools of rotable and temporary spare parts used in the same trade or business for which the optional method is used for the taxpayer’s books and records. Thus, a taxpayer generally is not required to use the optional method for those pools of rotable or temporary spare parts for which it does not use the optional method in its books and records for the trade or business. However, if a taxpayer chooses to use the optional method for any pool of rotable or temporary spare parts for which the taxpayer does not use the optional method in its books and records for the trade or business, then the taxpayer must use the optional method for all its pools of rotable and temporary spare parts in that trade or business.

Commenters also requested that the optional method for rotable and temporary spare parts be treated as the default method of accounting for rotable and temporary spare parts, instead of treating rotable and temporary spare parts as used and consumed in the taxable year when disposed. Many taxpayers do not use the optional method of accounting for rotable and temporary spare parts, and that method requires a degree of record keeping that would be overly burdensome for all taxpayers. Therefore, the final regulations do not adopt this suggestion and continue to generally treat rotable and temporary spare parts as materials and supplies that are used and consumed in the taxable year when disposed of by the taxpayer, unless the taxpayer chooses a different treatment under § 1.162–3.

D. Materials and Supplies Under the de Minimis Safe Harbor

There were numerous comments on the application of the de minimis rule provided in the 2011 temporary regulations to materials and supplies under §§ 1.162–3T(f) (election to apply de minimis rule to materials and supplies) and 1.263(a)–2T(g) (general de minimis rule) and the interaction between the two sections. In response to these comments, the final regulations more clearly coordinate the two provisions as addressed below in the discussion of the de minimis safe harbor.


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E. Property Treated as Materials and Supplies in Published Guidance

Several commenters questioned the effect of the 2011 temporary regulations on prior published guidance that permits taxpayers to treat certain property as materials and supplies. For example, Rev. Proc. 2002–12 (2002–1 CB 374) allows a taxpayer to treat smallwares as materials and supplies that are not incidental under § 1.162–3. Similarly, Rev. Proc. 2002–28 (2002–1 CB 815) allows a qualifying small business taxpayer to treat certain inventoriable items in the same manner as materials and supplies that are not incidental under § 1.162–3. The final regulations do not supersede, obsolete, or replace these revenue procedures to the extent they deem certain property to constitute materials and supplies under § 1.162–3. This designated property continues to qualify as materials and supplies under the final regulations, because the definition of material and supplies includes property that is identified as materials and supplies in published guidance.

III. Repairs Under § 1.162–4 The 2011 temporary regulations

provided that amounts paid for repairs and maintenance to tangible property are deductible if the amounts paid are not required to be capitalized under § 1.263(a)–3. The IRS and the Treasury Department received no comments on this regulation. The final regulations retain the rule from the 2011 temporary regulations. In addition, the final regulations add a cross reference to § 1.263(a)–3(n), the new election to capitalize amounts paid for repair and maintenance consistent with the taxpayer’s books and records, discussed later in this preamble.

IV. De Minimis Safe Harbor Under §§ 1.263(a)–1(f) and 1.162–3(f)

A. De Minimis Safe Harbor Ceiling The 2011 temporary regulations

required a taxpayer to capitalize amounts paid to acquire or produce a unit of real or personal property, including the related transaction costs. However, § 1.263(a)–2T(g) provided a de minimis exception permitting a taxpayer to deduct certain amounts paid for tangible property if the taxpayer had an applicable financial statement, had written accounting procedures for expensing amounts paid for such property under specified dollar amounts, and treated such amounts as expenses on its applicable financial statement. Under § 1.263(a)–2T(g)(1)(iv), a taxpayer’s de minimis deduction for the taxable year was limited to a ceiling:

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 percent of the taxpayer’s total depreciation and amortization expense for the taxable year as determined on the taxpayer’s applicable financial statement.

The IRS and the Treasury Department received a significant number of comments addressing the de minimis safe harbor provided in § 1.263(a)–2T(g). Nearly all comments raised concerns about the administrative burden the ceiling would place on taxpayers, noting that taxpayers would be required to keep detailed accounts of amounts that they generally do not track because such amounts are expensed under their financial accounting capitalization policies. Thus, while the ceiling itself could be calculated relatively simply, the financial accounting systems employed by most taxpayers would not allow them to easily determine which costs the de minimis rule applied to and, therefore, whether or not applicable costs exceeded the ceiling. Commenters also pointed out that the operation of the ceiling requirement did not allow taxpayers to anticipate when they had reached the gross receipts or depreciation limitation or to identify assets that would be excluded under the de minimis rule during a taxable year, because the ceiling amount could only be calculated after the end of a taxable year. Commenters also highlighted the complexities inherent in the application of the ceiling requirement for consolidated groups. In many cases, commenters suggested that the administrative burden imposed would outweigh any potential tax benefit. Many commenters suggested that this problem be resolved by removing the ceiling altogether and permitting taxpayers to deduct for Federal income tax purposes amounts properly expensed under their financial accounting policies.

The final regulations adopt commenters’ suggestions that the ceiling in the de minimis rule in the 2011 temporary regulations be eliminated and that amounts properly expensed under a taxpayer’s financial accounting policies be deductible for tax purposes. To both address taxpayers’ concerns and ensure that the de minimis safe harbor in the final regulations requires taxpayers to use a reasonable, consistent methodology that clearly reflects income for Federal income tax purposes, the ceiling in § 1.263(a)– 2T(g)(1)(iv) has been replaced with a new safe harbor determined at the invoice or item level and based on the policies that the taxpayer utilizes for its

financial accounting books and records. A taxpayer with an applicable financial statement may rely on the de minimis safe harbor under § 1.263(a)–1(f) of the final regulations only if the amount paid for property does not exceed $5,000 per invoice, or per item as substantiated by the invoice. The final regulations provide the IRS and the Treasury Department with the authority to change the safe harbor amount through published guidance.

Commenters also asked that the de minimis safe harbor be expanded to include not only amounts paid for property costing less than a certain dollar amount but also amounts paid for property having a useful life less than a certain period of time. The final regulations adopt this suggestion and provide that the de minimis safe harbor also applies to a financial accounting procedure that expenses amounts paid for property with an economic useful life of 12 months or less as long as the amount per invoice (or item) does not exceed $5,000. Such amounts are deductible under the de minims rule whether this financial accounting procedure applies in isolation or in combination with a financial accounting procedure for expensing amounts paid for property that does not exceed a specified dollar amount. Under either procedure, if the cost exceeds $5,000 per invoice (or item), then the amounts paid for the property will not fall within the de minimis safe harbor. In addition, an anti-abuse rule is provided to aggregate costs that are improperly split among multiple invoices.

B. Taxpayers Without an Applicable Financial Statement

The 2011 temporary regulations did not provide a de minimis safe harbor for taxpayers without an applicable financial statement, but the preamble requested comments addressing alternatives that would provide the IRS and the Treasury Department with assurance that a taxpayer is using a reasonable, consistent methodology that clearly reflects income. One commenter suggested that the definition of applicable financial statement be expanded to include financial statements subject to a compliance review under the rules of the American Institute of Certified Public Accountants’ (AICPA) Statement of Standards for Accounting and Review Services. Numerous comments also requested that the de minimis rule be generally expanded to taxpayers without an applicable financial statement.

The final regulations include a de minimis rule for taxpayers without an


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applicable financial statement. While careful consideration was given to the suggestion of relying on reviewed financial statements as defined in the AICPA’s Statement of Standards for Accounting and Review Services, the final regulations do not adopt this standard. While the AICPA standard for reviewed financial statements ensures that the taxpayer’s policies comply with the applicable financial accounting framework, the standard does not contemplate a review of the taxpayer’s internal control, fraud risk, or accounting records. Thus, the standard does not provide sufficient assurance to the IRS that such policies are being followed and, accordingly, that the taxpayer is using a reasonable, consistent methodology that clearly reflects its income. However, the final regulations do provide a de minimis safe harbor for taxpayers without an applicable financial statement if accounting procedures are in place to deduct amounts paid for property costing less than a specified dollar amount or amounts paid for property with an economic useful life of 12 months or less. The de minimis safe harbor for taxpayers without an applicable financial statement provides a reduced per invoice (or item) threshold because there is less assurance that the accounting procedures clearly reflect income. A taxpayer without an applicable financial statement may rely on the de minimis safe harbor only if the amount paid for property does not exceed $500 per invoice, or per item as substantiated by the invoice. If the cost exceeds $500 per invoice (or item), then no portion of the cost of the property will fall within the de minimis safe harbor. Similar to the safe harbor for a taxpayer with an applicable financial statement, this provision provides the IRS and the Treasury Department with the authority to change the safe harbor amount through published guidance. In addition, an anti-abuse rule is provided to aggregate costs that are improperly split among multiple invoices.

Finally, for both taxpayers with applicable financial statements and taxpayers without applicable financial statements, the de minimis safe harbor is not intended to prevent a taxpayer from reaching an agreement with its IRS examining agents that, as an administrative matter, based on risk analysis or materiality, the IRS examining agents will not review certain items. It is not intended that examining agents must now revise their materiality thresholds in accordance with the de minimis safe harbor

limitations provided in the final regulation. Thus, if examining agents and a taxpayer agree that certain amounts in excess of the de minimis safe harbor limitations are not material or otherwise should not be subject to review, that agreement should be respected, notwithstanding the requirements of the de minimis safe harbor. However, a taxpayer that seeks a deduction for amounts in excess of the amount allowed by the safe harbor has the burden of showing that such treatment clearly reflects income.

C. Safe Harbor Election Commenters asked whether the de

minimis rule in the 2011 temporary regulations was mandatory or elective and, if mandatory, requested a change to make the safe harbor elective. The final regulations adopt these suggestions and provide that the de minimis rule is a safe harbor, elected annually by including a statement on the taxpayer’s timely filed original Federal tax return for the year elected. The final regulations provide that, if elected, the de minimis safe harbor must be applied to all amounts paid in the taxable year for tangible property that meet the requirements of the de minimis safe harbor, including amounts paid for materials and supplies that meet the requirements. In addition, the final regulations provide that a taxpayer may not revoke an election to use the de minimis safe harbor. An election to use the de minimis safe harbor may not be made through the filing of an application for change in accounting method.

D. Written Accounting Procedures The 2011 temporary regulations

required that to utilize the de minimis safe harbor, a taxpayer must have written accounting procedures in place at the beginning of the taxable year treating the amounts paid for property costing less than a certain dollar amount as an expense for financial accounting purposes. Commenters suggested that transition guidance be issued for taxpayers that did not have written accounting procedures in place at the beginning of 2012. Alternatively, one commenter suggested that taxpayers be allowed to make the drafting of a written accounting procedure retroactive to the beginning of 2012.

The final regulations do not adopt these suggestions for transition relief. Although the publication of the 2011 temporary regulations late in the calendar year (December 27, 2011) likely prevented taxpayers without written accounting procedures at that time from implementing such

procedures prior to the beginning of the 2012 taxable year, the provisions of the 2011 temporary regulations are elective for taxable years beginning prior to January 1, 2014. In addition, the final regulations are not applicable until taxable years beginning on or after January 1, 2014. Therefore, taxpayers without written accounting procedures that choose to elect the de minimis safe harbor for their 2014 taxable years should have sufficient time to consider and draft appropriate procedures prior to the applicability date of the final regulations. Moreover, the de minimis safe harbor is intended to provide recordkeeping simplicity to taxpayers by allowing them to follow an established financial accounting policy for federal tax purposes, and allowing retroactive application is inconsistent with such purpose.

E. Application to Consolidated Group Members

Several comments noted that the rule for use of a consolidated group’s applicable financial statement failed to consider situations in which taxpayers are included on a consolidated applicable financial statement but are not members in an underlying consolidated group for Federal income tax purposes. Comments requested that taxpayers in this situation be permitted to rely on the financial policies of the group that apply to them as well as the group’s consolidated applicable financial statement to satisfy the requirements of the de minimis rule. The final regulations adopt this suggestion and provide that if a taxpayer’s financial results are reported on the applicable financial statement for a group of entities, then the group’s applicable financial statement may be treated as the applicable financial statement of the taxpayer. Furthermore, in this situation, the written accounting procedures provided for the group and utilized for the group’s applicable financial statement may be treated as the written accounting procedures of the taxpayer.

F. Transaction and Other Additional Costs

The preamble to the 2011 temporary regulations provided that the de minimis rule did not apply to amounts paid for labor and overhead incurred in repairing or improving property. Commenters pointed out that the preamble did not provide any policy reason for excluding labor and overhead costs from the de minimis rule and that the exclusion would require rules to allocate additional invoice costs, such as freight and installation costs, between


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tangible property costs and labor and overhead costs, requiring additional recordkeeping by taxpayers. Additionally, one commenter pointed out that the de minimis rule in the 2011 temporary regulations did not expressly provide for an exclusion of labor and overhead costs. Commenters requested that additional costs included on an invoice for tangible property be included within the scope of the de minimis rule.

The final regulations adopt the commenters’ suggestions, in part, and clarify the treatment under the de minimis safe harbor of transaction costs and other additional costs of acquiring and producing property subject to the safe harbor. To simplify the application of the de minimis rule to tangible property, the final regulations provide that a taxpayer electing to apply the de minimis safe harbor is not required to include in the cost of the tangible property the additional costs of acquiring or producing such property if these costs are not included in the same invoice as the tangible property. However, the final regulations also provide that a taxpayer electing to apply the de minimis safe harbor must include in the cost of such property all additional costs (for example, delivery fees, installation services, or similar costs) of acquiring or producing such property if these costs are included on the same invoice with the tangible property. If an invoice includes amounts paid for multiple tangible properties and the invoice includes additional invoice costs related to the multiple properties, then the taxpayer must allocate the additional invoice costs to each property using a reasonable method. The final regulations specify that a reasonable allocation method includes, but is not limited to, specific identification, a pro rata allocation, or a weighted average method based on each property’s relative cost. The final regulations also clarify that additional costs consist of the transaction costs (that is, the facilitative costs under § 1.263(a)–2(f)) of acquiring or producing the property and the costs under § 1.263(a)–2(d) for work performed prior to the date that the unit of tangible property is placed in service.

G. Materials and Supplies The IRS and Treasury Department

received numerous comments on the application of the de minimis rule to materials and supplies under § 1.162–3T of the 2011 temporary regulations. Under the 2011 temporary regulations, taxpayers were permitted to select materials and supplies to be expensed under the de minimis rule provided that

these materials and supplies satisfied all requirements of the de minimis rule, including the ceiling. Many comments raised concerns about the administrative burdens associated with identifying and allocating materials and supplies between the de minimis rule and the general rules for materials and supplies in a manner that would not exceed the de minimis rule ceiling. In many cases, commenters suggested that the administrative burden imposed would outweigh any potential tax benefit. Thus, commenters requested revisions to the de minimis rule to reduce taxpayers’ administrative burden of complying with the 2011 temporary regulations.

To simplify application of the de minimis safe harbor, the final regulations require that the de minimis safe harbor be applied to all eligible materials and supplies (other than rotable, temporary, and standby emergency spare parts subject to the election to capitalize or rotable and temporary spare parts subject to the optional method of accounting for such parts) if the taxpayer elects the de minimis safe harbor under § 1.263(a)- 1(f). Unlike the 2011 temporary regulations rule permitting taxpayers to select materials and supplies for application of the de minimis safe harbor, the requirement in the final regulations to apply the de minimis safe harbor, if elected, to all eligible materials and supplies simplifies the application of the de minimis rule and reduces the administrative burden on the IRS. Taxpayers that do not elect the de minimis safe harbor provided in the final regulations for the taxable year must treat their amounts paid for materials and supplies in accordance with the rules provided in § 1.162–3.

H. Coordination With Section 263A Commenters asked for clarification on

the interaction of the de minimis rule with section 263A. Several comments asked whether the application of the de minimis rule resulted in property with an unadjusted basis of zero, which would then be subject to section 263A, or, alternatively, whether section 263A required taxpayers to capitalize the cost of property subject to section 263A, regardless of whether the de minimis rule applied.

The final regulations clarify the interaction between the two provisions. The final regulations provide that amounts paid for tangible property eligible for the de minimis safe harbor may, nonetheless, be subject to capitalization under section 263A if the amounts paid for this tangible property comprise the direct or allocable indirect

costs of other property produced by the taxpayer or property acquired for resale.

In general, under section 263A, if property is held for future production, taxpayers must capitalize direct and indirect costs allocable to such property (for example, purchasing, storage, and handling costs), even though production has not begun. If property is not held for production, indirect costs incurred prior to the beginning of the production period must be allocated to the property and capitalized if, at the time the costs are incurred, it is reasonably likely that production will occur at some future date. Thus, for example, a manufacturer must capitalize the costs of storing and handling raw materials before the raw materials are committed to production. In addition, § 1.263A–1T(e)(2)(i) provides that indirect material costs include the cost of materials that are not an integral part of specific property produced and the cost of materials that are consumed in the ordinary course of performing production or resale activities that cannot be identified or associated with particular units of property.

Therefore, if tangible property is acquired with the expectation of being used in the production of other property, and it is reasonably likely that production will occur at some future date, section 263A may apply to capitalize the cost of the property acquired. Thus, for example, if a taxpayer acquires a component part, the cost of which is otherwise eligible for the de minimis safe harbor, but the component part is installed, or expected to be installed in the future, in the taxpayer’s manufacturing equipment used to produce property for sale, under section 263A, the cost of the component part must be capitalized as an indirect cost of property produced by the taxpayer. On the other hand, if property is acquired without the expectation of being used in the production of property and the taxpayer elects and properly applies the de minimis rule to the amount paid for property in the taxable year, if expectations change in a subsequent taxable year and the property is actually used in production, then section 263A will not require capitalization of the cost of the property at the time the expectation changes or when the property is used in production.

I. Change in Accounting Procedures Not Change in Method of Accounting

Several commenters questioned whether a change in a taxpayer’s financial accounting procedures (for example, its financial accounting capitalization policy) is a change in


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method of accounting for de minimis expenses to which the provisions of sections 446 and 481 and the accompanying regulations apply. The final regulations provide that the use of the de minimis safe harbor is a taxable year election and may not be made by the filing of an application for a change in method of accounting. Thus, if a taxpayer meets the requirements for the safe harbor, which requires, in part, having written accounting procedures in place at the beginning of the taxable year and treating amounts paid for property as an expense in accordance with those procedures, then a change in the procedures, by itself, is not a change in accounting method. For example, if a taxpayer’s written financial accounting capitalization policy at the beginning of 2014 states that amounts paid for property costing less than $200 will be treated as an expense, and the taxpayer changes its written policy as of the beginning of 2015 to treat amounts paid for property costing less that $500 as an expense, the taxpayer is not required to file an application for its 2015 taxable year to change its method of accounting for applying the de minimis safe harbor or determining amounts paid to acquire or produce tangible property under § 1.263(a)–1(f).

V. Amounts Paid To Acquire or Produce Tangible Property Under § 1.263(a)–2

Section 1.263(a)–2T of the 2011 temporary regulations provided rules for applying section 263(a) to amounts paid to acquire or produce a unit of real or personal property. In general, the final regulations retain the rules from the 2011 temporary regulations, including general requirements to capitalize amounts paid to acquire or produce a unit of real or personal property, requirements to capitalize amounts paid to defend or perfect title to real or personal property, and rules for determining the extent to which taxpayers must capitalize transaction costs related to the acquisition of property. In the final regulations, the de minimis safe harbor has been moved to § 1.263(a)–1(f) to reflect its broader application to amounts paid for tangible property, including amounts paid for improvements and materials and supplies, except as otherwise provided under section 263A.

The 2011 temporary regulations provided that a taxpayer must, in general, capitalize amounts paid to facilitate the acquisition or production of real or personal property. To alleviate controversy between taxpayers and the IRS, the 2011 temporary regulations included a list of inherently facilitative

amounts. In addition, the 2011 temporary regulations 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 2011 temporary regulations also provided that inherently facilitative amounts allocable to real or personal property are capital expenditures related to such property, even if such property is not eventually acquired or produced.

Commenters requested that the requirement to capitalize facilitative costs be removed as overbroad. Commenters also stated that it was inappropriate to provide a special rule that depends on the nature of the property acquired (real property or personal property) and inappropriate to require capitalization of inherently facilitative amounts allocable to property not acquired. Other commenters recommended that the list describing inherently facilitative amounts be revised to exclude activities that are dependent on the type of service provider (for example, a broker), rather than being based on a specific activity (for example, securing an appraisal). One commenter asked for clarification regarding the treatment of a broker’s commission if the commission was contingent on the buyer’s successful acquisition of real property but a portion of the broker’s activities were performed in investigating the acquisition.

The final regulations generally retain the 2011 temporary regulation rules addressing facilitative amounts. As in the 2011 temporary regulations, the final regulations include the special rule for the acquisition of real property providing that, except for amounts specifically identified as inherently facilitative, an amount paid by a taxpayer in the process of investigating or otherwise pursuing the acquisition of real property does not facilitate the acquisition if it relates to activities performed in the process of determining whether to acquire real property and which real property to acquire. The final regulations do not expand the deduction of such pre-decisional, investigatory costs to personal property because, unlike real property acquisitions, personal property acquisitions do not typically raise issues of whether the transaction costs should be characterized as deductible business expansion costs rather than costs to acquire a specific property. In addition, personal property acquisitions do not typically provide clear evidence

establishing the timing of decisions. Thus, such a rule could generate significant controversy over unduly small amounts.

Moreover, the final regulations retain the list of inherently facilitative costs that generally must be capitalized as transaction costs. However, in response to comments, the final regulations clarify the meaning of finders’ fees and brokers’ commissions and provide a definition of contingency fees. The final regulations provide that for purposes of § 1.263(a)–2, a contingency fee is an amount paid that is contingent on the successful closing of the acquisition of real or personal property. The final regulations also clarify that contingency fees facilitate the acquisition of the property ultimately acquired and are not allocable to real or personal property not acquired. Therefore, if a real estate broker’s commission is contingent on the successful closing of the acquisition of real property, the amount paid as the broker’s commission inherently facilitates the acquisition of the property acquired and, therefore, must be capitalized as part of the basis of such property. However, no portion of the broker’s contingency fee is allocable to real property that the taxpayer did not acquire. In addition, the final regulations retain the rule that inherently facilitative amounts allocable to real or personal property are capital expenditures related to such property, even if such property is not eventually acquired or produced. As discussed in the preamble to the 2008 proposed regulations, the IRS and the Treasury Department believe that this rule is consistent with established authorities. See, for example, Sibley, Lindsay & Curr Co. v. Commissioner, 15 T.C. 106 (1950), acq., 1951–1 CB 3. The final regulations also clarify that, except for contingency fees as discussed above, inherently facilitative amounts allocable to property not acquired may be allocated to those properties and recovered in accordance with the applicable provisions of the Code, including sections 165, 167, and 168.

VI. Amounts Paid To Improve Property Under § 1.263(a)–3

A. Overview Comments received with respect to

the rules under the 2011 temporary regulations for determining whether an amount improves, betters, or restores property largely focused on the application of the rules to building property, the lack of a safe harbor for routine maintenance for building property, the standards to be applied in determining whether a betterment has


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occurred, the treatment of post-casualty expenditures under the restoration standards, and the standards to be applied in determining whether a replacement of a major component or substantial structural part has occurred.

The final regulations generally retain the rules of the 2011 temporary regulations for determining the unit of property and for determining whether there is an improvement to a unit of property. The final regulations also retain the simplifying conventions set out in the 2011 temporary regulations, including the routine maintenance safe harbor and the optional regulatory accounting method. In addition, in response to the comments, the final regulations modify the 2011 temporary regulations in several areas. The concerns raised by commenters and the relevant changes to the 2011 temporary regulations are discussed in this preamble.

B. Determining the Unit of Property The 2011 temporary regulations

generally defined the unit of property as consisting of all the components of property that are functionally interdependent, but provided special rules for determining the unit of property for buildings, plant property, and network assets. The 2011 temporary regulations also provided special rules for determining the units of property for condominiums, cooperatives, and leased property, and for the treatment of improvements (including leasehold improvements). The final regulations retain the unit of property rules contained in the 2011 temporary regulations.

The 2011 temporary regulations generally defined a building as a unit of property, but required the application of the improvement standards to the building structure and the enumerated building systems. A number of comments objected to the requirement that the taxpayer perform the improvement analysis at the building structure and system level. The comments stated that such treatment is inconsistent with the treatment of other complex property under the 2011 temporary regulations, is inconsistent with the treatment of building property under depreciation rules, and fails to take into account the relative importance of the various building systems. Several comments requested that the building, including its structural components, should be treated as the unit of property for applying the improvement rules to buildings. Other commenters pointed out that a functional interdependence standard, used in the 2011 temporary

regulations for non-building property and applied by the courts and the IRS for determining when components of a single property are placed in service for cost recovery purposes, may be a more consistent general standard for identifying the relevant property upon which to apply the improvement analysis.

Like plant property, buildings are complex properties composed of numerous component parts that perform discrete and major functions or operations. Unlike plant property, however, where the discrete and major functions or operations are not consistent from plant to plant, the discrete and major functions or operations performed from building to building are frequently similar. The building system definitions set forth in the 2011 temporary regulations are based on well understood costing standards that have been routinely applied to buildings for many years for valuations, cost accounting, and financial reporting. To help ensure that the improvement standards are applied equitably and consistently across building property, the final regulations continue to apply the improvement rules to both the building structure and the defined building systems. To the extent the particular facts and circumstances of a subset of buildings used in one or more industries present unique challenges to application of the building structure or building system definitions, taxpayers are encouraged to request guidance under the Industry Issue Resolution (IIR) procedures.

C. Unit of Property for Leasehold Improvements

The 2011 temporary regulations provide rules for determining the unit of property for leased property and for determining the unit of property for leasehold improvements. The IRS and the Treasury Department received no written comments on these rules, and the final regulations retain the rules from the 2011 temporary regulations, with some clarifications. Under the rule in the 2011 temporary regulations, a question could arise regarding the property to be analyzed for determining whether an improvement to a lessee improvement constitutes an improvement to the lessee’s property. In this context, the 2011 temporary regulations suggested that the taxpayer must determine whether there has been an improvement to the lessee improvement by itself, rather than by applying the improvement standards to the general unit of property rules for leased buildings or for leased property other than buildings. The final

regulations clarify that for purposes of determining whether an amount paid by a lessee constitutes a leasehold improvement, the unit of property and the improvement rules are applied in accordance with the rules for leased buildings (or leased portions of building) under § 1.263(a)–3(e)(2)(v) or for leased property other than buildings under § 1.263(a)–3(e)(3)(iv). Thus, for example, if a lessee pays an amount for work on an addition that it previously made to a leased building, the taxpayer determines whether the work performed constitutes an improvement to the entire leased building structure, not merely to the addition. The final regulations also clarify that when a lessee or lessor improvement is comprised of a building erected on leased property, then the unit of property for the building and the application of the improvement rules are determined under the provisions for buildings, rather than under the provisions for leased buildings.

D. Special Rules for Determining Improvement Costs

1. Costs Incurred During an Improvement

The 2011 temporary regulations did not prescribe rules related to the ‘‘plan of rehabilitation’’ doctrine as traditionally described in the case law. The judicially-created plan of rehabilitation doctrine provides that a taxpayer must capitalize otherwise deductible repair or maintenance costs if they are incurred as part of a general plan of rehabilitation, modernization, and improvement to the property. See, for example, Moss v. Commissioner, 831 F.2d 833 (9th Cir. 1987); United States v. Wehrli, 400 F.2d 686 (10th Cir. 1968); Norwest Corp. v. Commissioner, 108 T.C. 265 (1997). The 2011 temporary regulations did not restate the plan of rehabilitation doctrine but, rather, used the language of the section 263A rule providing that a taxpayer must capitalize both the direct costs of an improvement as well as the indirect costs that directly benefit or are incurred by reason of the improvement. The 2011 temporary regulations also included an exception to this provision for an individual residence, which permitted an individual taxpayer to capitalize repair and maintenance costs incurred at the time of a substantial residential remodel.

The final regulations retain the rules from the 2011 temporary regulations and continue to provide that indirect costs, such as repair and maintenance costs, that do not directly benefit and that are not incurred by reason of an improvement are not required to be


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capitalized under section 263(a), regardless of whether they are incurred at the same time as an improvement. In addition, in response to comments requesting examples of the application of this standard, the final regulations add this analysis to several examples. By providing a standard based on the section 263A language, the final regulations set out a clear rule for determining when otherwise deductible indirect costs must be capitalized as part of an improvement to property and obsolete the plan of rehabilitation doctrine to the extent that the court- created doctrine provides different standards.

2. Removal Costs The 2011 temporary regulations did

not provide a separate rule for the treatment of removal costs. Rather, the 2011 temporary regulations addressed component removal costs as an example of a type of indirect cost that must be capitalized if the removal costs directly benefit or are incurred by reason of an improvement. The preamble to the 2011 temporary regulations stated that the costs of removing a component of a unit of property should be analyzed in the same manner as any other indirect cost (such as a repair cost) incurred during a repair or an improvement to property. Therefore, the preamble concluded, if the cost of removing a component of a unit of property directly benefitted or was incurred by reason of an improvement to the unit of property, the cost must be capitalized. The preamble to the 2011 temporary regulations also noted that the 2011 temporary regulations were not intended to affect the holding of Rev. Rul. 2000–7 (2000– 1 CB 712) as it applied to the cost of removing an entire unit of property. Under Rev. Rul. 2000–7, a taxpayer is not required to capitalize the cost of removing a retired depreciable asset under section 263(a) or section 263A, even when the retirement and removal occur in connection with the installation of a replacement asset. Rev. Rul. 2000–7 reasoned that the costs of removing a depreciable asset generally have been allocable to the removed asset and, thus, generally have been deductible when the asset is retired. See §§ 1.165–3(b); 1.167(a)–1(c); 1.167(a)– 11(d)(3)(x); Rev. Rul. 74–455 (1974–2 CB 63); Rev. Rul. 75–150 (1975–1 CB 73).

Commenters acknowledged the preamble language but observed that the 2011 temporary regulations did not explicitly state that the costs incurred to remove an entire unit of property are not required to be capitalized, even when incurred in connection with the

installation of a replacement asset. Commenters requested that the final regulations include this explicit conclusion. Commenters also asked whether the principles of Rev. Rul. 2000–7 would apply to allow the deduction of removal costs when the taxpayer disposes of a component of a unit of property and the taxpayer takes into account the adjusted basis of the component in realizing loss. Commenters also questioned whether a taxpayer would be required to capitalize component removal costs if these costs were an indirect cost of a restoration (for example, the replacement of a component when the taxpayer has properly deducted a loss for that component) rather than a betterment to the underlying unit of property.

The final regulations provide a specific rule clarifying the treatment of removal costs in these contexts. The final regulations state that if a taxpayer disposes of a depreciable asset (including a partial disposition under Prop. Reg. § 1.168(i)–1(e)(2)(ix) September 19, 2013, or Prop. Reg. § 1.168(i)–8(d) (September 19, 2013)) for Federal tax purposes and has taken into account the adjusted basis of the asset or component of the asset in realizing gain or loss, the costs of removing the asset or component are not required to be capitalized under section 263(a). The final regulations also provide that if a taxpayer disposes of a component of a unit of property and the disposal is not a disposition for Federal tax purposes, then the taxpayer must deduct or capitalize the costs of removing the component based on whether the removal costs directly benefit or are incurred by reason of a repair to the unit of property or an improvement to the unit of property. In addition, the final regulations provide several examples illustrating these principles.

E. Safe Harbor for Small Taxpayers The 2011 temporary regulations did

not provide any special rules for small taxpayers to assist them in applying the general rules for improvements to buildings. One commenter stated that small taxpayers generally do not have the administrative means or sufficient documentation or information to apply the improvement rules to their building structures and systems as required under the 2011 temporary regulations. Therefore, the commenter requested that an annual dollar threshold, such as $10,000, be established for buildings with an initial cost of $1,000,000 or less and that taxpayers be permitted to deduct annual amounts spent on the building if they did not exceed the threshold amount. In response to this

request, the final regulations include a safe harbor election for building property held by taxpayers with gross receipts of $10,000,000 or less (‘‘a qualifying small taxpayer’’). The final regulations permit a qualifying small taxpayer to elect to not apply the improvement rules to an eligible building property if the total amount paid during the taxable year for repairs, maintenance, improvements, and similar activities performed on the eligible building does not exceed the lesser of $10,000 or 2 percent of the unadjusted basis of the building. Eligible building property includes a building unit of property that is owned or leased by the qualifying taxpayer, provided the unadjusted basis of the building unit of property is $1,000,000 or less. The final regulations provide the IRS and the Treasury Department with the authority to adjust the amounts of the safe harbor and gross receipts limitations through published guidance. The final regulations provide simple rules for determining the unadjusted basis of both owned and leased building units of property. In this situation, the final regulations also eliminate the need to separately analyze the building structure and the building systems, as required elsewhere in the improvement rules in the final regulations.

Under the safe harbor for small taxpayers, a taxpayer includes amounts not capitalized under the de minimis safe harbor election of § 1.263(a)–1(f) and under the routine maintenance safe harbor for buildings (discussed later in this preamble) to determine the annual amount paid for repairs, maintenance, improvements, and similar activities performed on the building. If the amount paid for repairs, maintenance, improvements, and similar activities performed on a building unit of property exceeds the safe harbor threshold for a taxable year, then the safe harbor is not applicable to any amounts spent during the taxable year. In that case, the taxpayer must apply the general rules for determining improvements, including the routine maintenance safe harbor for buildings. The taxpayer may also elect to apply the de minimis safe harbor under § 1.263(a)–1(f) to amounts qualifying under the de minimis safe harbor, regardless of the application of the safe harbor for small taxpayers.

The safe harbor for building property held small taxpayers may be elected annually on a building-by-building basis by including a statement on the taxpayer’s timely filed original Federal tax return, including extensions, for the year the costs are incurred for the building. Amounts paid by the taxpayer


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to which the taxpayer properly applies and elects the safe harbor are not treated as improvements to the building under § 1.263(a)–3 and may be deducted under § 1.162–1 or § 1.212–1, as applicable, in the taxable year that the amounts are paid or incurred, provided the amounts otherwise qualify for deduction under those sections. A taxpayer may not revoke an election to apply the safe harbor for small taxpayers.

F. Safe Harbor for Routine Maintenance

1. Buildings The 2011 temporary regulations

provided that the costs of performing certain routine maintenance activities for property other than a building or the structural components of a building are not required to be capitalized as an improvement. Under the routine maintenance safe harbor, an amount paid was deemed not to improve a unit of property if it was for the recurring activities that a taxpayer (or a lessor) expected to perform as a result of the taxpayer’s (or the lessee’s) use of the unit of property to keep the unit of property in its ordinarily efficient operating condition. The 2011 temporary regulations provided that the activities are routine only if, at the time the unit of property was placed in service, the taxpayer reasonably expected to perform the activities more than once during the period prescribed under sections 168(g)(2) and 168(g)(3) (the Alternative Depreciation System class life), regardless of whether the property was depreciated under the Alternative Depreciation System. The preamble to the 2011 temporary regulations explained that the routine maintenance safe harbor did not apply to building property, because the long class life for such property (40 years under section 168(g)(2)) arguably could allow major remodeling or restoration projects to be deducted under the safe harbor, regardless of the nature or extent of the work involved, and that deducting such costs would be inconsistent with case law. The 2011 temporary regulations provided several factors for taxpayers to consider in determining whether a taxpayer is performing routine maintenance, including the recurring nature of the activity, industry practice, manufacturers’ recommendations, the taxpayer’s experience, and the taxpayer’s treatment of the activity on its applicable financial statement.

Comments on the routine maintenance safe harbor generally requested that the safe harbor be extended to building property. One commenter stated that because the

improvement standards under the 2011 temporary regulations must now be applied to the building structure and each building system separately, these components are more analogous to section 1245 property, which qualifies for the routine maintenance safe harbor. Commenters suggested that using a period shorter than a building’s class life, such as 20 years, could alleviate the IRS and the Treasury Department’s concern that the cost of true improvements would not be properly capitalized if the safe harbor were extended to buildings. Another commenter argued that the distinction between building property and non- building property for purposes of the safe harbor is arbitrary because, in many respects, retail buildings are similar to other complex property, such as aircraft, which are not excluded from the safe harbor.

In response to these comments, the final regulations contain a safe harbor for routine maintenance for buildings. The inclusion of a routine maintenance safe harbor for buildings is expected to alleviate some of the difficulties that could arise in applying the improvement standards for certain restorations to building structures and building systems. To balance commenters’ suggestions of using a shorter period, such as 20 years, with the concerns expressed in the preamble to the 2011 temporary regulations, the final regulations use 10 years as the period of time in which a taxpayer must reasonably expect to perform the relevant activities more than once. While periods longer than 10 years were considered, the use of a period much longer than 10 years would, contrary to current authority, permit the costs of many major remodeling and restoration projects to be deducted under the safe harbor, regardless of the nature or extent of the work involved.

2. Other Changes The final regulations make several

additional changes and clarifications to the safe harbor for routine maintenance, which are applicable to both buildings and other property. First, the regulations confirm that routine maintenance can be performed any time during the life of the property provided that the activities qualify as routine under the regulation. Second, for purposes of determining whether a taxpayer is performing routine maintenance, the final regulations remove the taxpayer’s treatment of the activity on its applicable financial statement from the factors to be considered. Taxpayers may have several different reasons for capitalizing maintenance activities on

their applicable financial statements, and such treatment may not be indicative of whether the activities are routine. Third, the final regulations clarify the applicability of the routine maintenance safe harbor by adding three items to the list of exceptions from the routine maintenance safe harbor: (1) Amounts paid for a betterment to a unit of property, (2) amounts paid to adapt a unit of property to a new or different use, and (3) amounts paid for repairs, maintenance, or improvement of network assets. The first two exceptions were included in the general rule for the safe harbor in the 2011 temporary regulations, but were not clearly stated as exceptions. The exception for network assets was added because of the difficulty in defining the unit of property for network assets and the preference for resolving issues involving network assets through the IIR program. Finally, the exception relating to amounts paid for property for which a taxpayer has taken a basis adjustment resulting from a casualty loss is slightly modified to be consistent with the revised casualty loss restoration rule, which is discussed in this preamble.

3. Reasonable Expectation That Activities Will Be Performed More Than Once

A taxpayer’s reasonable expectation of whether it will perform qualifying maintenance activities more than once during the relevant period will be determined at the time the unit of property (or building structure or system, as applicable) is placed in service. The final regulations modify the safe harbor for routine maintenance by adding that a taxpayer’s expectation will not be deemed unreasonable merely because the taxpayer does not actually perform the maintenance a second time during the relevant period, provided that the taxpayer can otherwise substantiate that its expectation was reasonable at the time the property was placed in service. Thus, for a unit of property previously placed in service, whether the maintenance is actually performed more than once during the relevant period is not controlling for assessing the reasonableness of a taxpayer’s original expectation. However, if a similar or identical unit of property is placed in service in a future tax year, the taxpayer’s experience with the original property may be taken into account as a factor in assessing whether the taxpayer reasonably expects to perform the activities more than once during the relevant period for the similar or identical unit of property. The taxpayer’s actual experience, therefore, may be used in assessing the


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reasonableness of the taxpayer’s expectation of the frequency of restoration or replacement at the time a new unit of property is placed in service, but hindsight should not be used to invalidate a taxpayer’s reasonable expectation as established at the time the unit of property was first placed in service when subsequent events do not conform to the taxpayer’s reasonable expectation.

4. Amounts Not Qualifying for the Routine Maintenance Safe Harbor

The final regulations clarify that amounts incurred for activities falling outside the routine maintenance safe harbor are not necessarily expenditures required to be capitalized under § 1.263(a)–3. Amounts incurred for activities that do not meet the routine maintenance safe harbor are subject to analysis under the general rules for improvements.

G. Betterments

1. Overview The 2011 temporary regulations

provided that an amount paid results in a betterment, and accordingly, an improvement, if it (1) ameliorates a material condition or defect that existed prior to the acquisition of the property or arose during the production of the property; (2) results in a material addition to the unit of property (including a physical enlargement, expansion, or extension); or (3) results in a material increase in the capacity, productivity, efficiency, strength, or quality of the unit of property or its output. As applied to buildings, an amount results in a betterment to the building if it results in a betterment to the building structure or any of the building systems.

The final regulations retain the provisions of the 2011 temporary regulations related to betterments with several refinements. Specifically, the final regulations reorganize and clarify the types of activities that constitute betterments to property. Also, the final regulations no longer phrase the betterment test in terms of amounts that result in a betterment. Rather, the final regulations provide that a taxpayer must capitalize amounts that are reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of a unit of property or that are for a material addition to a unit of property. Elimination of the ‘‘results in’’ standard should reduce controversy for expenditures that span more than one tax year or when the outcome of the expenditure is uncertain when the expenditure is made.

2. Amelioration of Material Condition or Defect

Commenters requested that certain examples be clarified to distinguish more clearly between circumstances that require capitalization of amounts paid to ameliorate a material condition or defect and circumstances that do not require capitalization. One commenter requested that the final regulations include a rule that would provide for an allocation of expenditures between pre- and post-acquisition periods based on facts and circumstances if an expenditure both ameliorates a pre- existing condition and ameliorates normal wear and tear that results from the taxpayer’s use of the property. With respect to whether amounts paid to ameliorate conditions are betterments, other comments reiterated suggestions provided in response to the 2008 proposed regulations, as described in the preamble to the 2011 temporary regulations.

The final regulations do not adopt the comments with respect to expenditures to ameliorate pre-existing conditions or defects. The facts and circumstances rule provided in the final regulations is consistent with established case law and represents an administrable standard for determining whether an improvement has occurred.

3. Material Addition or Increase in Productivity, Efficiency, Strength, Quality, or Output

Many commenters requested that the final regulations provide explanations and quantitative bright lines for determining the materiality of an addition to a unit of property or an increase in capacity, productivity, efficiency, strength, quality, or output of a unit of property. Additionally, commenters requested more explanation of terms such as productivity, quality, and output, and how such standards should be applied across a variety of different types of tangible property.

These suggestions were extensively considered, but the final regulations do not adopt the suggestions to establish quantitative bright lines. Quantitative bright lines, although objective, would produce inconsistent results given the broad array of factual settings where the betterment rules apply. Instead, the final regulations continue to rely on qualitative factors to provide fair and equitable treatment for all taxpayers in determining whether a particular cost constitutes a betterment.

The final regulations clarify, however, that not every single quantitative or qualitative factor listed in the betterment standard applies to every

type of property. Whether any single factor applies to a particular unit of property depends on the nature of the property. For example, while amounts paid for work performed on an office building or a retail building may clearly comprise a physical enlargement or increase the capacity, efficiency, strength, or quality of such building under certain facts, it is unclear how to measure whether work performed on an office building or retail building increases the productivity or output of such buildings, as those terms are generally understood. Thus, the productivity and output factors would not generally apply to buildings. On the other hand, it is appropriate to evaluate many items of manufacturing equipment in terms of output or productivity as well as size, capacity, efficiency, strength, and quality. Accordingly, the final regulations clarify that the applicability of each quantitative and qualitative factor depends on the nature of the unit of property, and if an addition or increase in a particular factor cannot be measured in the context of a specific type of property, then the factor is not relevant in determining whether there has been a betterment to the property.

4. Application of Betterment Rule Several commenters questioned the

betterment rule in the 2011 temporary regulations that requires consideration of all facts and circumstances, including the treatment of the expenditures on a taxpayer’s applicable financial statement. One commenter questioned whether the treatment of an expenditure on a taxpayer’s applicable financial statement should be relevant in determining whether an amount paid results in a betterment and suggested removal of this factor from the facts and circumstances test provided in the 2011 temporary regulations. The IRS and the Treasury Department recognize that taxpayers may apply different standards for capitalizing amounts on their applicable financial statements and such standards may not be controlling for whether the activities are betterments for Federal tax purposes. Thus, the final regulations remove the taxpayer’s treatment of the expenditure on its financial statement as a factor to be considered in performing a betterment analysis under the final regulations. In addition, the final regulations omit the reference to the taxpayer’s facts and circumstances in determining whether amounts are paid for a betterment to the taxpayer’s property. The IRS and the Treasury Department believe that an analysis of a taxpayer’s particular facts and


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circumstances is implicit in the application of all the final regulations governing improvements and need not be specifically provided in the application of the betterment rules.

The 2011 temporary regulations provided that, when an expenditure is necessitated by a particular event, the determination of whether an expenditure is for the betterment of a unit of property is made by comparing the condition of the property immediately after the expenditure with the condition of the property immediately prior to the event necessitating the expenditure. The IRS and the Treasury Department received comments requesting that the final regulations clarify the application of the appropriate comparison rule for determining whether an expenditure is for a betterment of a unit of property. The final regulations retain this general rule but clarify that the rule applies when the event necessitating the expenditure is either normal wear and tear or damage to the unit of property during the taxpayer’s use of the property. Thus, the final regulations clarify that the appropriate comparison rule focuses on events affecting the condition of the property and not on business decisions made by taxpayers. In addition, the final regulations confirm that the rule does not apply to wear, tear, or damage that occurs prior to the taxpayer’s acquisition or use of the property. In these situations, the amelioration of a material condition or defect rule may apply.

5. Retail Store Refresh or Remodels

A substantial number of comments were received with respect to the betterment examples in the 2011 temporary regulations that address retail store refresh or remodel projects, requesting the addition of quantitative bright lines and the inclusion of additional detail in the examples.

As discussed previously in this preamble, the final regulations do not adopt the suggestions to provide quantitative bright lines in applying the betterment rules. However, the final regulations include additional detail in a number of the examples, including the examples related to building refresh or remodels, illustrating distinctions between betterments and maintenance activities when a taxpayer undertakes multiple simultaneous activities on a building. To the extent the rules in the final regulations present situations that might be addressed through the IIR program, taxpayers may pursue additional guidance through the IIR process.

H. Restorations

1. Overview The 2011 temporary regulations

provided that an amount is paid to restore, and therefore improve, a unit of property if it meets one of six tests: (1) it is for the replacement of a component of a unit of property and the taxpayer has properly deducted a loss for that component (other than a casualty loss under § 1.165–7); (2) it is for the replacement of a component of a unit of property and the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component; (3) it is for the repair of damage to a unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss under section 165, or relating to a casualty event described in section 165 (‘‘casualty loss rule’’); (4) it returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use; (5) it results in the rebuilding of the unit of property to a like-new condition after the end of its class life; or (6) it is for the replacement of a major component or a substantial structural part of the unit of property (‘‘major component rule’’).

The IRS and the Treasury Department received a number of comments regarding the 2011 temporary regulations restoration rules. The final regulations generally retain the restoration standards set forth in the 2011 temporary regulations but revise both the major component rule and the casualty loss rule in response to comments.

2. Replacement of a Major Component or Substantial Structural Part a. Definition of Major Component and Substantial Structural Part

The 2011 temporary regulations provided that an amount paid for the replacement of a major component or substantial structural part of a unit of property is an amount paid to restore (and, therefore, improve) the unit of property. The determination of whether a component or part was ‘‘major’’ or ‘‘substantial’’ depended on the facts and circumstances, including both qualitative and quantitative factors.

Commenters expressed concern that the lack of a bright-line test or additional definitions would result in uncertainty and disputes in applying the restoration rules contained in the 2011 temporary regulations. Several commenters stated that the standards

provided in the 2011 temporary regulations were too subjective, and numerous commenters requested that the final regulations reintroduce a bright-line definition of what constitutes a major component or substantial structural part for purposes of applying the restoration standards, particularly with regard to buildings. Several commenters suggested that a fixed percentage of a building should be defined as the major component. In addition, commenters asked for clarifying guidance or more examples, arguing that the major component test of the 2011 temporary regulations uses broad, undefined, and subjective terms.

The final regulations retain the substantive rules of the 2011 temporary regulations, but clarify the definition of major component, and, more significantly, add a new definition for major components and substantial structural parts of buildings. Although the IRS and the Treasury Department considered several bright-line tests, none were found to fairly, equitably, and in a readily implementable manner distinguish between expenditures that constitute restorations and expenditures that constitute deductible repairs or maintenance consistent with the case law and administrative rulings in the area.

In many cases, particularly with regard to buildings, establishing a clear threshold, such as 30 percent of a defined amount, would be unworkable. Largely due to the complex nature of the property involved and the fact that units of property include assets placed in service in multiple taxable years, applying a fixed percentage to a building structure or a building system in a way that creates a consistent and equitable result proved exceedingly intricate and complex, thereby failing to achieve the simplifying objective of a bright line test. The final regulations, therefore, do not adopt any of the bright- line tests suggested.

b. General Rule for Major Component and Substantial Structural Part

To provide additional guidance for determining what constitutes a major component or substantial structural part, the final regulations clarify the distinction between a major component and a substantial structural part. Specifically, the final regulations separate ‘‘major component,’’ which focuses on the function of the component in the unit of property, from ‘‘substantial structural part,’’ which focuses on the size of the replacement component in relation to the unit of property. The final regulations define a major component as a part or


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combination of parts that performs a discrete and critical function in the operation of the unit of property. The final regulations define a substantial structural part as a part or combination of parts that comprises a large portion of the physical structure of the unit of property.

In response to comments, the final regulations retain, but also clarify, the exception to the major component rule. The 2011 temporary regulations provided that the replacement of a minor component, even though such component might affect the function of the unit of property, generally would not, by itself, constitute a major component. The exception was meant to apply to relatively minor components, such as a switch, which generally performs a discrete function (turning property on and off) and is critical to the operation of a unit of property (that is, property will not run without it). To provide additional clarification regarding this exception, the final regulations clarify that an incidental component of a unit of property, even though such component performs a discrete and critical function in the operation of the unit of property, generally will not, by itself, constitute a major component.

c. Major Component and Substantial Structural Part of Buildings

The final regulations address the request for additional clarity regarding the definition of major component for buildings by adding a new definition for major components and substantial structural parts of buildings. In the case of buildings, the final regulations provide that an amount is for the replacement of a major component or substantial structural part if the replacement includes a part or combination of parts that (1) comprises a major component or a significant portion of a major component of the building structure or any building system, or (2) comprises a large portion of the physical structure of the building structure or any building system.

While the definition of major component for buildings introduces an additional level of analysis (a significant portion of a major component) that must be applied in determining whether an amount spent on a building constitutes a restoration, the rule provides an analytical framework and reaches conclusions that are generally consistent with the case law. Therefore, in practice this framework should be readily applicable for amounts spent on buildings. In combination with the addition of a routine maintenance safe harbor for buildings, the modifications

to the section 168 disposition regulations, the safe harbor for small taxpayers, and the addition and revision of many examples, the revised definition of major component for buildings should relieve much of the controversy in determining whether the replacement of a major component or a substantial structural part of a unit of property is an amount paid to restore a building.

3. Casualty Loss Rule The 2011 temporary regulations

provided that an amount is paid to restore a unit of property if it is for the repair of damage to the unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss under section 165, or relating to a casualty event described in section 165 (‘‘casualty loss rule’’). Capitalization of restoration costs is required under the casualty loss rule, even when the amounts paid for the repair exceed the adjusted basis remaining in the property and regardless of whether the amounts may otherwise qualify as repair costs. The 2011 temporary regulations recognized a taxpayer’s ability to deduct a casualty loss under section 165 or, to the extent eligible, to deduct the repair expense associated with the casualty damage. But the 2011 temporary regulations did not permit a taxpayer to deduct both amounts arising from the same event in the same taxable year.

Commenters requested that the final regulations eliminate the casualty loss rule. Commenters argued that recognition of a casualty loss under section 165 is irrelevant in determining whether the costs to restore the damage resulting from a casualty should be capitalized, and the 2011 temporary regulations should not deny one tax benefit (the ability to deduct repair costs) based on a taxpayer’s realization of another tax benefit (the ability to deduct a casualty loss). Similarly, commenters argued that the Code allows both a casualty loss and a repair deduction, and the IRS and the Treasury Department had not offered any justification for denying a deduction for the cost to repair damaged property only because the taxpayer has taken a casualty loss deduction. Commenters argued that the 2011 temporary regulations penalize taxpayers that have suffered a casualty as a result of property damage. Commenters suggested that the casualty loss rule in the 2011 temporary regulations results in similarly situated taxpayers being treated differently, based on whether an asset has adjusted basis at the time of a casualty event. As an alternative to

eliminating the casualty loss rule, commenters requested that the final regulations allow a taxpayer to elect to forego recognizing the casualty loss and making a corresponding adjustment to basis to avoid application of the casualty loss rule.

The casualty loss rule in 2011 temporary regulations was based on the capitalization rule provided in section 263(a)(2), which states that no deduction shall be allowed for any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made. When property has been damaged in a casualty and a loss for such property has been claimed, amounts paid to replace the damaged property are incurred to restore property for which an allowance has been made. Thus, under section 263(a)(2), when the basis in replaced property has been recovered by the taxpayer, capitalization of the replacement property is appropriate.

Recognizing that such a rule can provide harsh results for a taxpayer with valuable property with low adjusted basis that is destroyed in a casualty event, considerable consideration was given to the suggestion that the regulations provide an election to forgo a casualty loss deduction. Ultimately, however, it was concluded that the IRS and the Treasury Department do not have the authority to permit taxpayers to electively avoid the basis adjustment requirement imposed by section 1016(a). Section 1016(a) states that ‘‘a proper adjustment in respect of the property shall in all cases be made for . . . losses, or other items, properly chargeable to capital account. . .’’ Therefore, even if a taxpayer could choose to forgo claiming a loss for property damage under section 165, section 1016 requires an adjustment to the basis of the property because a loss properly could be claimed.

In response to commenters’ suggestions, the final regulations revise the casualty loss rule to permit a deduction, where otherwise permissible, for amounts spent in excess of the adjusted basis of the property damaged in a casualty event. Thus, a taxpayer is still required to capitalize amounts paid to restore damage to property for which the taxpayer has properly recorded a basis adjustment, but the costs required to be capitalized under the casualty loss rule are limited to the excess of (1) the taxpayer’s basis adjustments resulting from the casualty event, over (2) the amount paid for restoration of damage to the unit of property that also constitutes a restoration under the other criteria of


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§ 1.263(a)–3(k)(1) (excluding the casualty loss rule). Casualty-related expenditures in excess of this limitation are not treated as restoration costs under § 1.263(a)–3(k)(1)(iii) and may be properly deducted if they otherwise constitute ordinary and necessary business expenses (for example, repair and maintenance expenses) under section 162. The final regulations contain several examples illustrating the casualty loss rule, including one example that demonstrates the operation of the new limitation on amounts required to be capitalized.

4. Salvage Value Exception Under the 2011 temporary

regulations, a restoration includes amounts paid for the replacement of a component of a unit of property when the taxpayer has properly deducted a loss for that component (other than a casualty loss under § 1.165–7) and for the replacement of a component of a unit of property when the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component. In response to comments, the final regulations retain these rules but provide an exception for property that cannot be depreciated to an adjusted basis of zero due to the application of salvage value (for example, property placed in service before 1981, and post-1980 assets that do not qualify for the Accelerated Cost Recovery System of former section 168 (ACRS) or MACRS). When a loss is properly deducted or the adjusted basis of the component is realized from a sale or exchange, and the amount of loss or basis adjustment is attributable only to the remaining salvage value (the amount a taxpayer is expected to receive in cash or trade-in allowance upon disposition of an asset at the end of its useful life) as computed for Federal income tax purposes, a taxpayer is not required to treat amounts paid for the replacement of the component as a restoration under § 1.263(a)–3(k)(1)(i) or (k)(1)(ii). Amounts subject to this exception must be evaluated under other provisions of the regulations to determine if the amounts are paid to improve tangible property.

5. Rebuild to Like-New Condition The 2011 temporary regulations

provided that a unit of property is rebuilt to a like-new condition if it is brought to the status of new, rebuilt, remanufactured, or similar status under the terms of any federal regulatory guideline or the manufacturer’s original specifications. Commenters asked for clarification on whether comprehensive

maintenance programs, conducted according to manufacturer’s original specifications, constitute rebuilding a unit of property to like-new condition. The final regulations adopt the standard provided in the 2011 temporary regulations but clarify that generally a comprehensive maintenance program, even though substantial, does not return a unit of property to like-new condition.

I. Adaptation to a New or Different Use The 2011 temporary regulations

required a taxpayer to capitalize amounts paid to adapt a unit of property to a new or different use (that is, a use inconsistent with the taxpayer’s intended ordinary use at the time the property was originally placed in service by the taxpayer). As applied to buildings, the new or different use standard is applied separately to the building structure and its building systems. Commenters requested clarification of the adaptation rules and additional examples. Commenters also asked that, for specific industries, the regulations provide that changes to facilities in response to a change in product mix, a reallocation of floor space, the need to rebrand, or the introduction of a new product line do not constitute a new or different use.

The final regulations retain the substantive rules of the 2011 temporary regulations but add additional examples to illustrate the rules. The final regulations provide that if an amount adapts the unit of property in a manner inconsistent with the taxpayer’s intended ordinary use of the property when placed in service, the amount must be capitalized as an adaptation of the unit of property to a new or different use. In response to comments, two new examples address circumstances in which part of a retail building unit of property is converted to provide new services or products. However, providing tailored guidance for specific industries or specific types of property (for example, retail sales facilities) is not appropriate for broadly applicable guidance. Specific industry guidance is better addressed through the IIR program.

VII. Optional Regulatory Accounting Method

The 2011 temporary regulations provided an optional regulatory method, which permitted certain regulated taxpayers to follow the method of accounting they used for regulatory accounting purposes in determining whether an amount paid improves property. For purposes of the optional method, a taxpayer in a regulated industry is a taxpayer subject to the

regulatory accounting rules of the Federal Energy Regulatory Commission (FERC), the Federal Communications Commission (FCC), or the Surface Transportation Board (STB). A taxpayer that uses the regulatory accounting method does not apply the rules under sections 162, 212, or 263(a) in determining whether amounts paid to repair, maintain, or improve property are capital expenditures or deductible expenses. Section 263A continues to apply to costs required to be capitalized to property produced by the taxpayer or to property acquired for resale.

The IRS and the Treasury Department received no comments on this methodology, and the final regulations retain the rule from the 2011 temporary regulations, with one modification. The final regulations modify the description of the regulatory accounting method to clarify that, for purposes of determining whether an amount is for a capital expenditure, an eligible taxpayer must apply the method of accounting that it is required to follow by FERC, FCC, or STB (whichever is applicable).

VIII. Election To Capitalize Repair and Maintenance Costs

The 2011 temporary regulations did not contain an election for taxpayers to capitalize expenditures made with respect to tangible property that would otherwise be deductible under these regulations. Commenters requested that, to reduce uncertainty in applying subjective standards and to reduce administrative burden, the final regulations include an election to capitalize repair and maintenance expenditures as improvements if the taxpayer treats such costs as capital expenditures for financial accounting purposes. In response to these comments as well as in recognition of the significant administrative burden reduction achieved by permitting a taxpayer to follow for Federal income tax purposes the capitalization policies used for its books and records, the final regulations permit a taxpayer to elect to treat amounts paid during the taxable year for repair and maintenance to tangible property as amounts paid to improve that property and as an asset subject to the allowance for depreciation, as long as the taxpayer incurs the amounts in carrying on a trade or business and the taxpayer treats the amounts as capital expenditures on its books and records used for regularly computing income. Under the final regulations, a taxpayer that elects this treatment must apply the election to all amounts paid for repair and maintenance to tangible property that it treats as capital expenditures on its


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books and records in that taxable year. A taxpayer making the election must begin to depreciate the cost of such improvements when the improvements are placed in service by the taxpayer under the applicable provisions of the Code and regulations. The election is made by attaching a statement to the taxpayer’s timely filed original Federal tax return (including extensions) for the taxable year in which the improvement is placed in service. Once made, the election may not be revoked.

A taxpayer that capitalizes repair and maintenance costs under the election is still eligible to apply the de minimis safe harbor, the safe harbor for small taxpayers, and the routine maintenance safe harbor to repair and maintenance costs that are not treated as capital expenditures on its books and records.

IX. Applicability Dates The final regulations generally apply

to taxable years beginning on or after January 1, 2014. However, certain provisions of the final regulations only apply to amounts paid or incurred in taxable years beginning on or after January 1, 2014. For example, the de minimis safe harbor election under § 1.263(a)–1(f) only applies to amounts paid or incurred for tangible property after January 1, 2014, for taxable years beginning on or after January 1, 2014.

Alternatively, a taxpayer may generally choose to apply the final regulations to taxable years beginning on or after January 1, 2012. For taxpayers choosing this early application, certain provisions of the final regulations only apply to amounts paid or incurred in taxable years beginning on or after January 1, 2012. For example, for these taxpayers, the de minimis safe harbor election only applies to amounts paid or incurred for tangible property after January 1, 2012, for taxable years beginning on or after January 1, 2012.

For taxpayers choosing to apply the final regulations to taxable years beginning on or after January 1, 2012, or where applicable, to amounts paid or incurred in taxable years beginning on or after January 1, 2012, the final regulations provide transition relief for taxpayers that did not make the certain elections (for example, the election to apply the de minimis safe harbor or the election to apply the safe harbor for small taxpayers) on their timely filed original Federal tax return for their 2012 or 2013 taxable year (the applicable taxable year). Specifically, for taxable years beginning on or after January 1, 2012, and ending on or before September 19, 2013, a taxpayer is permitted to make these elections by

filing an amended Federal tax return (including any applicable statements) for the applicable taxable year on or before 180 days from the due date including extensions of the taxpayer’s Federal tax return for the applicable taxable year, notwithstanding that the taxpayer may not have extended the due date.

Finally, a taxpayer may also choose to apply the 2011 temporary regulations to taxable years beginning on or after January 1, 2012, and before January 1, 2014. For taxpayers choosing to apply the temporary regulations to these taxable years, certain provisions of the temporary regulations only apply to amounts paid or incurred in taxable years beginning on or after January 1, 2012, and before January 1, 2014.

X. Change in Method of Accounting The IRS and the Treasury Department

received several comments regarding the procedures that a taxpayer should utilize to change its method of accounting to comply with the regulations. Several commenters favored the use of a cut-off method, primarily for reasons of administrative convenience. However, other commenters asserted that any change in method of accounting must include a section 481(a) adjustment.

The final regulations provide that, except as otherwise stated, a change to comply with the final regulations is a change in method of accounting to which the provisions of sections 446 and 481 and the accompanying regulations apply. A taxpayer seeking to change to a method of accounting permitted in the final regulations must secure the consent of the Commissioner in accordance with § 1.446–1(e) and follow the administrative procedures issued under § 1.446–1(e)(3)(ii) for obtaining the Commissioner’s consent to change its accounting method. In general, a taxpayer seeking a change in method of accounting to comply with these regulations must take into account a full adjustment under section 481(a).

The imposition of a section 481(a) adjustment for a change in method of accounting to conform to the final regulations provides for a uniform and consistent rule for all taxpayers and ultimately reduces the administrative burdens on taxpayers and the IRS in enforcing the requirements of section 263(a). Although the IRS and the Treasury Department recognize that requiring a section 481(a) adjustment may place a burden on taxpayers to calculate reasonable adjustments, taxpayers have shown a willingness and ability to make these calculations in requesting method changes after the

publication of the 2008 proposed regulations and after the publication of the 2011 temporary regulations. In addition, taxpayers and the IRS routinely reach agreements on calculation methodologies and amounts.

Separate procedures will be provided under which taxpayers may obtain automatic consent for a taxable year beginning on or after January 1, 2012, to change to a method of accounting provided in the final regulations. Although a taxpayer seeking a change in method of accounting to comply with these regulations generally must take into account a full adjustment under section 481(a), it is anticipated that for the specific situation where a taxpayer seeks to change to a method of accounting that is applicable only to amounts paid or incurred in taxable years beginning on or after January 1, 2014, a limited section 481(a) adjustment will apply, taking into account only amounts paid or incurred in taxable years beginning on or after January 1, 2014, or at a taxpayer’s option, amounts paid or incurred in taxable years beginning on or after January 1, 2012.

Special Analyses It has been determined that this

Treasury decision is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations.

Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it is hereby certified that these final regulations will not have a significant economic impact on a substantial number of small entities. This regulation affects all small business taxpayers. While a collection of information is required by this regulation in §§ 1.263(a)–1(f)(5), 1.263(a)–2(h)(6), and 1.263(a)–3(n), this collection will not have a significant economic impact on small entities. This information is required for a taxpayer to elect to use the de minimis safe harbor, to elect a safe harbor for determining the treatment of amounts related to buildings owned or leased by small taxpayers, and to elect to capitalize certain repair and maintenance costs. These elections were provided in the regulations in response to comment letters submitted on behalf of small business taxpayers requesting that these types of provisions be added to the regulations to assist small businesses. All of these elections are voluntary,


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beneficial, and were designed to simplify the application of sections 162 and 263(a) to small taxpayers. The provisions require a taxpayer to file a statement with the taxpayer’s timely filed original tax return to inform the IRS that the taxpayer is electing to use these provisions. The estimated time to prepare a statement should not exceed 15 minutes, and the filing of the statement allows the taxpayer to receive the beneficial treatment for the amounts that qualify for the statement. Based on these facts, a regulatory flexibility analysis under Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Code, this regulation was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Statement of Availability for IRS Documents

For copies of recently issued revenue procedures, revenue rulings, notices, and other guidance published in the Internal Revenue Bulletin or Cumulative Bulletin, please visit the IRS Web site at http://www.irs.gov.

Drafting Information The principal authors of these

regulations are Merrill D. Feldstein and Kathleen Reed, Office of the Associate Chief Counsel (Income Tax and Accounting). Other personnel from the IRS and the Treasury Department have participated in their development.

List of Subjects

26 CFR Part 1 Income taxes, Reporting and

recordkeeping requirements.

26 CFR Part 602 Record and recordkeeping

requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1—INCOME TAXES

! Paragraph 1. The authority citation for part 1 continues to read in part as follows:

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

! Par. 2. Section 1.162–3 is revised to read as follows:

§ 1.162–3 Materials and supplies. (a) In general—(1) Non-incidental

materials and supplies. Except as provided in paragraphs (d), (e), and (f) of this section, amounts paid to acquire

or produce materials and supplies (as defined in paragraph (c) of this section) are deductible in the taxable year in which the materials and supplies are first used in the taxpayer’s operations or are consumed in the taxpayer’s operations.

(2) Incidental materials and supplies. Amounts paid to acquire or produce incidental materials and supplies (as defined in paragraph (c) of this section) that are carried on hand and for which no record of consumption is kept or of which physical inventories at the beginning and end of the taxable year are not taken, are deductible in the taxable year in which these amounts are paid, provided taxable income is clearly reflected.

(3) Use or consumption of rotable and temporary spare parts. Except as provided in paragraphs (d), (e), and (f) of this section, for purposes of paragraph (a)(1) of this section, rotable and temporary spare parts (defined under paragraph (c)(2) of this section) are first used in the taxpayer’s operations or are consumed in the taxpayer’s operations in the taxable year in which the taxpayer disposes of the parts.

(b) Coordination with other provisions of the Internal Revenue Code. Nothing in this section changes the treatment of any amount that is specifically provided for under any provision of the Internal Revenue Code (Code) or regulations other than section 162(a) or section 212 and the regulations under those sections. For example, see § 1.263(a)–3, which requires taxpayers to capitalize amounts paid to improve tangible property and section 263A and the regulations under section 263A, which require taxpayers to capitalize the direct and allocable indirect costs, including the cost of materials and supplies, of property produced by the taxpayer and property acquired for resale. See also § 1.471–1, which requires taxpayers to include in inventory certain materials and supplies.

(c) Definitions—(1) Materials and supplies. For purposes of this section, materials and supplies means tangible property that is used or consumed in the taxpayer’s operations that is not inventory and that—

(i) Is a component acquired to maintain, repair, or improve a unit of tangible property (as determined under § 1.263(a)–3(e)) owned, leased, or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property;

(ii) Consists of fuel, lubricants, water, and similar items, reasonably expected to be consumed in 12 months or less,

beginning when used in the taxpayer’s operations;

(iii) Is a unit of property as determined under § 1.263(a)–3(e) that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer’s operations;

(iv) Is a unit of property as determined under § 1.263(a)–3(e) that has an acquisition cost or production cost (as determined under section 263A) of $200 or less (or other amount as identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(b) of this chapter); or

(v) Is identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(b) of this chapter) as materials and supplies for which treatment is permitted under this section.

(2) Rotable and temporary spare parts. For purposes of this section, rotable spare parts are materials and supplies under paragraph (c)(1)(i) of this section that are acquired for installation on a unit of property, removable from that unit of property, generally repaired or improved, and either reinstalled on the same or other property or stored for later installation. Temporary spare parts are materials and supplies under paragraph (c)(1)(i) of this section that are used temporarily until a new or repaired part can be installed and then are removed and stored for later installation.

(3) Standby emergency spare parts. Standby emergency spare parts are materials and supplies under paragraph (c)(1)(i) of this section that are—

(i) Acquired when particular machinery or equipment is acquired (or later acquired and set aside for use in particular machinery or equipment);

(ii) Set aside for use as replacements to avoid substantial operational time loss caused by emergencies due to particular machinery or equipment failure;

(iii) Located at or near the site of the installed related machinery or equipment so as to be readily available when needed;

(iv) Directly related to the particular machinery or piece of equipment they serve;

(v) Normally expensive; (vi) Only available on special order

and not readily available from a vendor or manufacturer;

(vii) Not subject to normal periodic replacement;

(viii) Not interchangeable in other machines or equipment;


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(x) Not acquired in quantity (generally only one is on hand for each piece of machinery or equipment); and

(xi) Not repaired and reused. (4) Economic useful life—(i) General

rule. The economic useful life of a unit of property is not necessarily the useful life inherent in the property but is the period over which the property may reasonably be expected to be useful to the taxpayer or, if the taxpayer is engaged in a trade or business or an activity for the production of income, the period over which the property may reasonably be expected to be useful to the taxpayer in its trade or business or for the production of income, as applicable. See § 1.167(a)-1(b) for the factors to be considered in determining this period.

(ii) Taxpayers with an applicable financial statement. For taxpayers with an applicable financial statement (as defined in paragraph (c)(4)(iii) of this section), the economic useful life of a unit of property, solely for the purposes of applying the provisions of paragraph (c)(4)(iii) of this section, is the useful life initially used by the taxpayer for purposes of determining depreciation in its applicable financial statement, regardless of any salvage value of the property. If a taxpayer does not have an applicable financial statement for the taxable year in which a unit of property was originally acquired or produced, the economic useful life of the unit of property must be determined under paragraph (c)(4)(i) of this section. Further, if a taxpayer treats amounts paid for a unit of property as an expense in its applicable financial statement on a basis other than the useful life of the property or if a taxpayer does not depreciate the unit of property on its applicable financial statement, the economic useful life of the unit of property must be determined under paragraph (c)(4)(i) of this section. For example, if a taxpayer has a policy of treating as an expense on its applicable financial statement amounts paid for a unit of property costing less than a certain dollar amount, notwithstanding that the unit of property has a useful life of more than one year, the economic useful life of the unit of property must be determined under paragraph (c)(4)(i) of this section.

(iii) Definition of applicable financial statement. The taxpayer’s applicable financial statement is the taxpayer’s financial statement listed in paragraphs (c)(4)(iii)(A) through (C) of this section that has the highest priority (including within paragraph (c)(4)(iii)(B) of this section). The financial statements are, in descending priority—

(A) A financial statement required to be filed with the Securities and Exchange Commission (SEC) (the 10–K or the Annual Statement to Shareholders);

(B) A certified audited financial statement that is accompanied by the report of an independent certified public accountant (or in the case of a foreign entity, by the report of a similarly qualified independent professional), that is used for—

(1) Credit purposes; (2) Reporting to shareholders,

partners, or similar persons; or (3) Any other substantial non-tax

purpose; or (C) A financial statement (other than

a tax return) required to be provided to the federal or a state government or any federal or state agency (other than the SEC or the Internal Revenue Service).

(5) Amount paid. For purposes of this section, in the case of a taxpayer using an accrual method of accounting, the terms amount paid and payment mean a liability incurred (within the meaning of § 1.446–1(c)(1)(ii)). A liability may not be taken into account under this section prior to the taxable year during which the liability is incurred.

(6) Produce. For purposes of this section, produce means construct, build, install, manufacture, develop, create, raise, or grow. This definition is intended to have the same meaning as the definition used for purposes of section 263A(g)(1) and § 1.263A– 2(a)(1)(i), except that improvements are excluded from the definition in this paragraph (c)(6) and are separately defined and addressed in § 1.263(a)–3. Amounts paid to produce materials and supplies are subject to section 263A.

(d) Election to capitalize and depreciate certain materials and supplies—(1) In general. A taxpayer may elect to treat as a capital expenditure and to treat as an asset subject to the allowance for depreciation the cost of any rotable spare part, temporary spare part, or standby emergency spare part as defined in paragraph (c)(3) or (c)(4) of this section. Except as specified in paragraph (d)(2) of this section, an election made under this paragraph (d) applies to amounts paid during the taxable year to acquire or produce any rotable, temporary, or standby emergency spare part to which paragraph (a) of this section would apply (but for the election under this paragraph (d)). Any property for which this election is made shall not be treated as a material or a supply.

(2) Exceptions. A taxpayer may not elect to capitalize and depreciate under paragraph (d) of this section any amount paid to acquire or produce a rotable,

temporary, or standby emergency spare part defined in paragraph (c)(3) or (c)(4) of this section if—

(i) The rotable, temporary, or standby emergency spare part is intended to be used as a component of a unit of property under paragraph (c)(1)(iii), (iv), or (v) of this section;

(ii) The rotable, temporary, or standby emergency spare part is intended to be used as a component of a property described in paragraph (c)(1)(i) and the taxpayer cannot or has not elected to capitalize and depreciate that property under this paragraph (d); or

(iii) The amount is paid to acquire or produce a rotable or temporary spare part and the taxpayer uses the optional method of accounting for rotable and temporary spare parts under paragraph (e) to of this section.

(3) Manner of electing. A taxpayer makes the election under paragraph (d) of this section by capitalizing the amounts paid to acquire or produce a rotable, temporary, or standby emergency spare part in the taxable year the amounts are paid and by beginning to recover the costs when the asset is placed in service by the taxpayer for the purposes of determining depreciation under the applicable provisions of the Internal Revenue Code and the Treasury Regulations. See § 1.263(a)–2 for the treatment of amounts paid to acquire or produce real or personal tangible property. A taxpayer must make this election in its timely filed original Federal tax return (including extensions) for the taxable year the asset is placed in service by the taxpayer for purposes of determining depreciation. See §§ 301.9100–1 through 301.9100–3 of this chapter for the provisions governing extensions of time to make regulatory elections. In the case of an S corporation or a partnership, the election is made by the S corporation or partnership, and not by the shareholders or partners. A taxpayer may make an election for each rotable, temporary, or standby emergency spare part that qualifies for the election under this paragraph (d). A taxpayer may revoke an election made under this paragraph (d) with respect to a rotable, temporary, or standby emergency spare part only by filing a request for a private letter ruling and obtaining the Commissioner’s consent to revoke the election. The Commissioner may grant a request to revoke this election if the taxpayer acted reasonably and in good faith and the revocation will not prejudice the interests of the Government. See generally § 301.9100–3 of this chapter. The manner of electing and revoking the election to capitalize under this paragraph (d) may be modified through


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guidance of general applicability (see §§ 601.601(d)(2) and 601.602 of this chapter). An election may not be made or revoked through the filing of an application for change in accounting method or, before obtaining the Commissioner’s consent to make the late election or to revoke the election, by filing an amended Federal tax return.

(e) Optional method of accounting for rotable and temporary spare parts—(1) In general. This paragraph (e) provides an optional method of accounting for rotable and temporary spare parts (the optional method for rotable parts). A taxpayer may use the optional method for rotable parts, instead of the general rule under paragraph (a)(3) of this section, to account for its rotable and temporary spare parts as defined in paragraph (c)(2) of this section. A taxpayer that uses the optional method for rotable parts must use this method for all of its pools of rotable and temporary spare parts used in the same trade or business and for which it uses this method for its books and records. If a taxpayer uses the optional method for rotable and temporary spare parts for pools of rotable or temporary spare parts for which the taxpayer does not use the optional method for its book and records, then the taxpayer must use the optional method for all its pools of rotable spare parts in the same trade or business. The optional method for rotable parts is a method of accounting under section 446(a). Under the optional method for rotable parts, the taxpayer must apply the rules in this paragraph (e) to each rotable or temporary spare part (part) upon the taxpayer’s initial installation, removal, repair, maintenance or improvement, reinstallation, and disposal of each part.

(2) Description of optional method for rotable parts—(i) Initial installation. The taxpayer must deduct the amount paid to acquire or produce the part in the taxable year that the part is first installed on a unit of property for use in the taxpayer’s operations.

(ii) Removal from unit of property. In each taxable year in which the part is removed from a unit of property to which it was initially or subsequently installed, the taxpayer must—

(A) Include in gross income the fair market value of the part; and

(B) Include in the basis of the part the fair market value of the part included in income under paragraph (e)(2)(ii)(A) of this section and the amount paid to remove the part from the unit of property.

(iii) Repair, maintenance, or improvement of part. The taxpayer may not currently deduct and must include in the basis of the part any amounts

paid to maintain, repair, or improve the part in the taxable year these amounts are paid.

(iv) Reinstallation of part. The taxpayer must deduct the amounts paid to reinstall the part and those amounts included in the basis of the part under paragraphs (e)(2)(ii)(B) and (e)(2)(iii) of this section, to the extent that those amounts have not been previously deducted under this paragraph (e)(2)(iv), in the taxable year that the part is reinstalled on a unit of property.

(v) Disposal of the part. The taxpayer must deduct the amounts included in the basis of the part under paragraphs (e)(2)(ii)(B) and (e)(2)(iii) of this section, to the extent that those amounts have not been previously deducted under paragraph (e)(2)(iv) of this section, in the taxable year in which the part is disposed of by the taxpayer.

(f) Application of de minimis safe harbor. If a taxpayer elects to apply the de minimis safe harbor under § 1.263(a)–1(f) to amounts paid for the production or acquisition of tangible property, then the taxpayer must apply the de minimis safe harbor to amounts paid for all materials and supplies that meet the requirements of § 1.263(a)–1(f), except for those materials and supplies that the taxpayer elects to capitalize and depreciate under paragraph (d) of this section or for which the taxpayer properly uses the optional method of accounting for rotable and temporary spare parts under paragraph (e) of this section. If the taxpayer properly applies the de minimis safe harbor under § 1.263(a)–1(f) to amounts paid for materials and supplies, then these amounts are not treated as amounts paid for materials and supplies under this section. See § 1.263(a)–1(f)(5) for the time and manner of electing the de minimis safe harbor and § 1.263(a)– 1(f)(3)(iv) for the treatment of safe harbor amounts.

(g) Sale or disposition of materials and supplies. Upon sale or other disposition, materials and supplies as defined in this section are not treated as a capital asset under section 1221 or as property used in the trade or business under section 1231. Any asset for which the taxpayer makes the election to capitalize and depreciate under paragraph (d) of this section shall not be treated as a material or supply, and the recognition and character of the gain or loss for such depreciable asset are determined under other applicable provisions of the Code.

(h) Examples. The rules of this section are illustrated by the following examples, in which it is assumed, unless otherwise stated, that the property is not an incidental material or

supply, that the taxpayer computes its income on a calendar year basis, that the taxpayer does not make the election to apply paragraph (d) of this section, or use the method of accounting described in paragraph (e) of this section, and that the taxpayer has not elected to apply the de minimis safe harbor under § 1.263(a)–1(f). The following examples illustrate only the application of this section and, unless otherwise stated, do not address the treatment under other provisions of the Code (for example, section 263A).

Example 1. Non-rotable components. A owns a fleet of aircraft that it operates in its business. In Year 1, A purchases a stock of spare parts, which it uses to maintain and repair its aircraft. A keeps a record of consumption of these spare parts. In Year 2, A uses the spare parts for the repair and maintenance of one of its aircraft. Assume each aircraft is a unit of property under § 1.263(a)–3(e) and that spare parts are not rotable or temporary spare parts under paragraph (c)(2) of this section. Assume these repair and maintenance activities do not improve the aircraft under § 1.263(a)–3. These parts are materials and supplies under paragraph (c)(1)(i) of this section because they are components acquired and used to maintain and repair A’s aircraft. Under paragraph (a)(1) of this section, the amounts that A paid for the spare parts in Year 1 are deductible in Year 2, the taxable year in which the spare parts are first used to repair and maintain the aircraft.

Example 2. Rotable spare parts; disposal method. B operates a fleet of specialized vehicles that it uses in its service business. Assume that each vehicle is a unit of property under § 1.263(a)–3(e). At the time that it acquires a new type of vehicle, B also acquires a substantial number of rotable spare parts that it will keep on hand to quickly replace similar parts in B’s vehicles as those parts break down or wear out. These rotable parts are removable from the vehicles and are repaired so that they can be reinstalled on the same or similar vehicles. In Year 1, B acquires several vehicles and a number of rotable spare parts to be used as replacement parts in these vehicles. In Year 2, B repairs several vehicles by using these rotable spare parts to replace worn or damaged parts. In Year 3, B removes these rotable spare parts from its vehicles, repairs the parts, and reinstalls them on other similar vehicles. In Year 5, B can no longer use the rotable parts it acquired in Year 1 and disposes of them as scrap. Assume that B does not improve any of the rotable spare parts under § 1.263(a)–3. Under paragraph (c)(1)(i) of this section, the rotable spare parts acquired in Year 1 are materials and supplies. Under paragraph (a)(3) of this section, rotable spare parts are generally used or consumed in the taxable year in which the taxpayer disposes of the parts. Therefore, under paragraph (a)(1) of this section, the amounts that B paid for the rotable spare parts in Year 1 are deductible in Year 5, the taxable year in which B disposes of the parts.

Example 3. Rotable spare parts; application of optional method of


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accounting. C operates a fleet of specialized vehicles that it uses in its service business. Assume that each vehicle is a unit of property under § 1.263(a)–3(e). At the time that it acquires a new type of vehicle, C also acquires a substantial number of rotable spare parts that it will keep on hand to replace similar parts in C’s vehicles as those parts break down or wear out. These rotable parts are removable from the vehicles and are repaired so that they can be reinstalled on the same or similar vehicles. C uses the optional method of accounting for all its rotable and temporary spare parts under paragraph (e) of this section. In Year 1, C acquires several vehicles and a number of rotable spare parts (the ‘‘Year 1 rotable parts’’) to be used as replacement parts in these vehicles. In Year 2, C repairs several vehicles and uses the Year 1 rotable parts to replace worn or damaged parts. In Year 3, C pays amounts to remove these Year 1 rotable parts from its vehicles. In Year 4, C pays amounts to maintain, repair, or improve the Year 1 rotable parts. In Year 5, C pays amounts to reinstall the Year 1 rotable parts on other similar vehicles. In Year 8, C removes the Year 1 rotable parts from these vehicles and stores these parts for possible later use. In Year 9, C disposes of the Year 1 rotable parts. Under paragraph (e) of this section, C must deduct the amounts paid to acquire and install the Year 1 rotable parts in Year 2, the taxable year in which the rotable parts are first installed by C in C’s vehicles. In Year 3, when C removes the Year 1 rotable parts from its vehicles, C must include in its gross income the fair market value of each part. Also, in Year 3, C must include in the basis of each Year 1 rotable part the fair market value of the rotable part and the amount paid to remove the rotable part from the vehicle. In Year 4, C must include in the basis of each Year 1 rotable part the amounts paid to maintain, repair, or improve each rotable part. In Year 5, the year that C reinstalls the Year 1 rotable parts (as repaired or improved) in other vehicles, C must deduct the reinstallation costs and the amounts previously included in the basis of each part. In Year 8, the year that C removes the Year 1 rotable parts from the vehicles, C must include in income the fair market value of each rotable part removed. In addition, in Year 8, C must include in the basis of each part the fair market value of that part and the amount paid to remove each rotable part from the vehicle. In Year 9, the year that C disposes of the Year 1 rotable parts, C may deduct the amounts remaining in the basis of each rotable part.

Example 4. Rotable part acquired as part of a single unit of property; not material or supply. D operates a fleet of aircraft. In Year 1, D acquires a new aircraft, which includes two new aircraft engines. The aircraft costs $500,000 and has an economic useful life of more than 12 months, beginning when it is placed in service. In Year 5, after the aircraft is operated for several years in D’s business, D removes the engines from the aircraft, repairs or improves the engines, and either reinstalls the engines on a similar aircraft or stores the engines for later reinstallation. Assume the aircraft purchased in Year 1, including its two engines, is a unit of

property under § 1.263(a)–3(e). Because the engines were acquired as part of the aircraft, a single unit of property, the engines are not materials or supplies under paragraph (c)(1)(i) of this section nor rotable or temporary spare parts under paragraph (c)(2) of this section. Accordingly, D may not apply the rules of this section to the aircraft engines upon the original acquisition of the aircraft nor after the removal of the engines from the aircraft for use in the same or similar aircraft. Rather, D must apply the rules under §§ 1.263(a)–2 and 1.263(a)–3 to the aircraft, including its engines, to determine the treatment of amounts paid to acquire, produce, or improve the unit of property.

Example 5. Consumable property. E operates a fleet of aircraft that carries freight for its customers. E has several storage tanks on its premises, which hold jet fuel for its aircraft. Assume that once the jet fuel is placed in E’s aircraft, the jet fuel is reasonably expected to be consumed within 12 months or less. On December 31, Year 1, E purchases a two-year supply of jet fuel. In Year 2, E uses a portion of the jet fuel purchased on December 31, Year 1, to fuel the aircraft used in its business. The jet fuel that E purchased in Year 1 is a material or supply under paragraph (c)(1)(ii) of this section because it is reasonably expected to be consumed within 12 months or less from the time it is placed in E’s aircraft. Under paragraph (a)(1) of this section, E may deduct in Year 2 the amounts paid for the portion of jet fuel used in the operation of E’s aircraft in Year 2.

Example 6. Unit of property that costs $200 or less. F operates a business that rents out a variety of small individual items to customers (rental items). F maintains a supply of rental items on hand. In Year 1, F purchases a large quantity of rental items to use in its rental business. Assume that each rental item is a unit of property under § 1.263(a)–3(e) and costs $200 or less. In Year 2, F begins using all the rental items purchased in Year 1 by providing them to customers of its rental business. F does not sell or exchange these items on established retail markets at any time after the items are used in the rental business. The rental items are materials and supplies under paragraph (c)(1)(iv) of this section. Under paragraph (a)(1) of this section, the amounts that F paid for the rental items in Year 1 are deductible in Year 2, the taxable year in which the rental items are first used in F’s business.

Example 7. Unit of property that costs $200 or less. G provides billing services to its customers. In Year 1, G pays amounts to purchase 50 scanners to be used by its employees. Assume each scanner is a unit of property under § 1.263(a)–3(e) and costs less than $200. In Year 1, G’s employees begin using 35 of the scanners, and F stores the remaining 15 scanners for use in a later taxable year. The scanners are materials and supplies under paragraph (c)(1)(iv) of this section. Under paragraph (a)(1) of this section, the amounts G paid for 35 of the scanners are deductible in Year 1, the taxable year in which G first uses each of those scanners. The amounts that G paid for each of the remaining 15 scanners are deductible in the taxable year in which each machine is first used in G’s business.

Example 8. Materials and supplies that cost less than $200; de minimis safe harbor. Assume the same facts as in Example 7 except that G’s scanners qualify for the de minimis safe harbor under § 1.263(a)–1(f), and G properly elects to apply the de minimis safe harbor under § 1.263(a)–1(f) to amounts paid in Year 1. G must apply the de minimis safe harbor under § 1.263(a)–1(f) to amounts paid for the scanners, rather than treat these amounts as costs of materials and supplies under this section. In accordance with § 1.263(a)–1(f)(3)(iv), G may deduct the amounts paid for all 50 scanners under § 1.162–1 in the taxable year the amounts are paid.

Example 9. Unit of property that costs $200 or less; bulk purchase. H provides consulting services to its customers. In Year 1, H pays $500 to purchase one box of 10 toner cartridges to use as needed for H’s printers. Assume each toner cartridge is a unit of property under § 1.263(a)–3(e). In Year 1, H’s employees place 8 of the toner cartridges in printers in H’s office, and store the remaining 2 cartridges for use in a later taxable year. The toner cartridges are materials and supplies under paragraph (c)(1)(iv) of this section because even though purchased in one box costing more than $200, the allocable cost of each unit of property equals $50. Therefore, under paragraph (a)(1) of this section, the $400 paid by H for 8 of the cartridges is deductible in Year 1, the taxable year in which H first uses each of those cartridges. The amounts paid by H for each of the remaining 2 cartridges ($50 each) are deductible in the taxable year in which each cartridge is first used in H’s business.

Example 10. Materials and supplies used in improvements; coordination with § 1.263(a)–3. J owns various machines that are used in its business. Assume that each machine is a unit of property under § 1.263(a)–3(e). In Year 1, J purchases a supply of spare parts for its machines. J acquired the parts to use in the repair or maintenance of the machines under § 1.162– 4 or in the improvement of the machines under § 1.263(a)–3. The spare parts are not rotable or temporary spare parts under paragraph (c)(2) of this section. In Year 2, J uses all of these spare parts in an activity that improves a machine under § 1.263(a)–3. Under paragraph (c)(1)(i) of this section, the spare parts purchased by J in Year 1 are materials and supplies. Under paragraph (a)(1) of this section, the amounts paid for the spare parts are otherwise deductible as materials and supplies in Year 2, the taxable year in which J uses those parts. However, because these materials and supplies are used to improve J’s machine, J is required to capitalize the amounts paid for those spare parts under § 1.263(a)–3.

Example 11. Cost of producing materials and supplies; coordination with section 263A. K is a manufacturer that produces liquid waste as part of its operations. K determines that its current liquid waste disposal process is inadequate. To remedy the problem, in Year 1, K constructs a leaching pit to provide a draining area for the liquid waste. Assume the leaching pit is a unit of property under § 1.263(a)–3(e) and has an economic useful life of 12 months or


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less, starting on the date that K begins to use the leaching pit as a draining area. At the end of this period, K’s factory will be connected to the local sewer system. In Year 2, K starts using the leaching pit in its operations. The amounts paid to construct the leaching pit (including the direct and allocable indirect costs of property produced under section 263A) are amounts paid for a material or supply under paragraph (c)(1)(iii) of this section. However, the amounts paid to construct the leaching pit may be subject to capitalization under section 263A if these amounts comprise the direct or allocable indirect costs of property produced by K.

Example 12. Costs of acquiring materials and supplies for production of property; coordination with section 263A. In Year 1, L purchases jigs, dies, molds, and patterns for use in the manufacture of L’s products. Assume each jig, die, mold, and pattern is a unit of property under § 1.263(a)–3(e). The economic useful life of each jig, die, mold, and pattern is 12 months or less, beginning when each item is used in the manufacturing process. The jigs, dies, molds, and patterns are not components acquired to maintain, repair, or improve any of L’s equipment under paragraph (c)(1)(i) of this section. L begins using the jigs, dies, molds and patterns in Year 2 to manufacture its products. These items are materials and supplies under paragraph (c)(1)(iii) of this section. Under paragraph (a)(1) of this section, the amounts paid for the items are otherwise deductible in Year 2, the taxable year in which L first uses those items. However, the amounts paid for these materials and supplies may be subject to capitalization under section 263A if these amounts comprise the direct or allocable indirect costs of property produced by L.

Example 13. Election to capitalize and depreciate. M is in the mining business. M acquires certain temporary spare parts, which it keeps on hand to avoid operational time loss in the event it must make temporary repairs to a unit of property that is subject to depreciation. These parts are not used to improve property under § 1.263(a)–3(d). These temporary spare parts are used until a new or repaired part can be installed and then are removed and stored for later temporary installation. M does not use the optional method of accounting for rotable and temporary spare parts in paragraph (e) of this section for any of its rotable or temporary spare parts. The temporary spare parts are materials and supplies under paragraph (c)(1)(i) of this section. Under paragraphs (a)(1) and (a)(3) of this section, the amounts paid for the temporary spare parts are deductible in the taxable year in which they are disposed of by M. However, because it is unlikely that the temporary spare parts will be disposed of in the near future, M would prefer to treat the amounts paid for the spare parts as capital expenditures subject to depreciation. M may elect under paragraph (d) of this section to treat the cost of each temporary spare part as a capital expenditure and as an asset subject to an allowance for depreciation. M makes this election by capitalizing the amounts paid for each spare part in the taxable year that M acquires the spare parts and by beginning to recover the

costs of each part on its timely filed Federal tax return for the taxable year in which the part is placed in service for purposes of determining depreciation under the applicable provisions of the Internal Revenue Code and the Treasury Regulations. See § 1.263(a)–2(g) for the treatment of capital expenditures.

Example 14. Election to apply de minimis safe harbor. (i) N provides consulting services to its customers. In Year 1, N pays amounts to purchase 50 laptop computers. Each laptop computer is a unit of property under § 1.263(a)–3(e), costs $400, and has an economic useful life of more than 12 months. Also in Year 1, N purchases 50 office chairs to be used by its employees. Each office chair is a unit of property that costs $100. N has an applicable financial statement (as defined in § 1.263(a)–1(f)(4)) and N has a written accounting policy at the beginning Year 1 to expense amounts paid for units of property costing $500 or less. N treats amounts paid for property costing $500 or less as an expense on its applicable financial statement in Year 1.

(ii) The laptop computers are not materials or supplies under paragraph (c) of this section. Therefore, the amounts N pays for the computers must generally be capitalized under § 1.263(a)–2(d) as amounts paid for the acquisition of tangible property. The office chairs are materials and supplies under paragraph (c)(1)(iv) of this section. Thus, under paragraph (a)(1) of this section, the amounts paid for the office chairs are deductible in the taxable year in which they are first used in N’s business. However, under paragraph (f) of this section, if N properly elects to apply the de minimis safe harbor under § 1.263(a)–1(f) to amounts paid in Year 1, then N must apply the de minimis safe harbor under § 1.263(a)–1(f) to amounts paid for the computers and the office chairs, rather than treat the office chairs as the costs of materials and supplies under § 1.162–3. Under the de minimis safe harbor, N may not capitalize the amounts paid for the computers under § 1.263(a)–2 nor treat the office chairs as materials and supplies under § 1.162–3. Instead, in accordance with § 1.263(a)–1(f)(3)(iv), under § 1.162–1, N may deduct the amounts paid for the computers and the office chairs in the taxable year paid.

(i) Accounting method changes. Except as otherwise provided in this section, a change to comply with this section is a change in method of accounting to which the provisions of sections 446 and 481 and the accompanying regulations apply. A taxpayer seeking to change to a method of accounting permitted in this section must secure the consent of the Commissioner in accordance with § 1.446–1(e) and follow the administrative procedures issued under § 1.446–1(e)(3)(ii) for obtaining the Commissioner’s consent to change its accounting method.

(j) Effective/applicability date—(1) In general. This section generally applies to amounts paid or incurred in taxable years beginning on or after January 1,

2014. However, a taxpayer may apply paragraph (e) of this section (the optional method of accounting for rotable and temporary spare parts) to taxable years beginning on or after January 1, 2014. Except as provided in paragraphs (j)(2) and (j)(3) of this section, § 1.162–3 as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014.

(2) Early application of this section— (i) In general. Except for paragraph (e) of this section, a taxpayer may choose to apply this section to amounts paid or incurred in taxable years beginning on or after January 1, 2012. A taxpayer may choose to apply paragraph (e) of this section (the optional method of accounting for rotable and temporary spare parts) to taxable years beginning on or after January 1, 2012.

(ii) Transition rule for election to capitalize materials and supplies on 2012 and 2013 returns. If under paragraph (j)(2)(i) of this section, a taxpayer chooses to make the election to capitalize and depreciate certain materials and supplies under paragraph (d) of this section for its taxable year beginning on or after January 1, 2012, and ending on or before September 19, 2013 (applicable taxable year), and the taxpayer did not make the election specified in paragraph (d)(3) of this section on its timely filed original Federal tax return for the applicable taxable year, the taxpayer must make the election specified in paragraph (d)(3) of this section for the applicable taxable year by filing an amended Federal tax return for the applicable taxable year on or before 180 days from the due date including extensions of the taxpayer’s Federal tax return for the applicable taxable year, notwithstanding that the taxpayer may not have extended the due date.

(3) Optional application of TD 9564. Except for section 1.162–3T(e), a taxpayer may choose to apply § 1.162– 3T as contained in TD 9564 (76 FR 81060) December 27, 2011, to amounts paid or incurred (to acquire or produce property) in taxable years beginning on or after January 1, 2012, and before January 1, 2014. A taxpayer may choose to apply section 1.162–3T(e) (the optional method of accounting for rotable and temporary spare parts) as contained in TD 9564 (76 FR 81060) December 27, 2011, to taxable years beginning on or after January 1, 2012, and before January 1, 2014.

§ 1.162–3T [Removed]

! Par. 3. Section 1.162–3T is removed. ! Par. 4. Section 1.162–4 is revised to read as follows:


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§ 1.162–4 Repairs. (a) In general. A taxpayer may deduct

amounts paid for repairs and maintenance to tangible property if the amounts paid are not otherwise required to be capitalized. For the election to capitalize amounts paid for repair and maintenance consistent with the taxpayer’s books and records, see § 1.263(a)–3(n).

(b) Accounting method changes. A change to comply with this section is a change in method of accounting to which the provisions of sections 446 and 481 and the accompanying regulations apply. A taxpayer seeking to change to a method of accounting permitted in this section must secure the consent of the Commissioner in accordance with § 1.446–1(e) and follow the administrative procedures issued under § 1.446–1(e)(3)(ii) for obtaining the Commissioner’s consent to change its accounting method.

(c) Effective/applicability date—(1) In general. This section applies to taxable years beginning on or after January 1, 2014. Except as provided in paragraphs (c)(2) and (c)(3) of this section, § 1.162– 4 as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014.

(2) Early application of this section. A taxpayer may choose to apply this section to taxable years beginning on or after January 1, 2012.

(3) Optional application of TD 9564. A taxpayer may choose to apply § 1.162–4T as contained in TD 9564 (76 FR 81060), December 27, 2011, to taxable years beginning on or after January 1, 2012, and before January 1, 2014.


! Par. 5. Section 1.162–4T is removed. ! Par. 6. Section 1.162–11 is amended by: ! 1. Revising paragraph (b). ! 2. Removing paragraphs (c) and (d).

The revision reads as follows:

§ 1.162–11 Rentals. * * * * *

(b) Improvements by lessee on lessor’s property—(1) In general. The cost to a taxpayer of erecting buildings or making permanent improvements on property of which the taxpayer is a lessee is a capital expenditure. For the rules regarding improvements to leased property when the improvements are tangible property, see § 1.263(a)–3(f). For the rules regarding depreciation or amortization deductions for leasehold improvements, see § 1.167(a)–4.

(2) Effective/applicability date—(i) In general. This paragraph (b) applies to

taxable years beginning on or after January 1, 2014. Except as provided in paragraphs (b)(2)(ii) and (b)(2)(iii) of this section, § 1.162–11(b) as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014.

(ii) Early application of this paragraph. A taxpayer may choose to apply this paragraph (b) to taxable years beginning on or after January 1, 2012.

(iii) Optional application of TD 9564. A taxpayer may choose to apply § 1.162–11T(b) as contained in TD 9564 (76 FR 81060) December 27, 2011, to taxable years beginning on or after January 1, 2012, and before January 1, 2014.

§ 1.162–11T [Removed]

! Par. 7. Section 1.162–11T is removed. ! Par. 8. Section 1.165–2 is amended by: ! 1. Revising paragraphs (c) and (d). ! 2. Removing paragraph (e).

The revisions read as follows:

§ 1.165–2 Obsolescence of nondepreciable property. * * * * *

(c) Cross references. For the allowance under section 165(a) of losses arising from the permanent withdrawal of depreciable property from use in the trade or business or in the production of income, see § 1.167(a)–8, § 1.168(i)–1, § 1.168(i)–1T, § 1.168(i)–8T, Prop. Reg. § 1.168(i)–1 (September 19, 2013), or Prop. Reg. § 1.168(i)–8 (September 19, 2013), as applicable. For provisions respecting the obsolescence of depreciable property for which depreciation is determined under section 167 (but not under section 168, section 1400I, section 1400L(c), section 168 prior to its amendment by the Tax Reform Act of 1986, Public Law 99–514 (100 Stat. 2121 (1986)), or under an additional first year depreciation deduction provision of the Internal Revenue Code (for example, section 168(k) through (n), 1400L(b), or 1400N(d))), see § 1.167(a)–9. For the allowance of casualty losses, see § 1.165–7.

(d) Effective/applicability date—(1) In general. This section applies to taxable years beginning on or after January 1, 2014. Except as provided in paragraphs (d)(2) and (d)(3) of this section, § 1.165– 2 as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014.

(2) Early application of § 1.165–2(c). A taxpayer may choose to apply paragraph (c) of this section to taxable years beginning on or after January 1, 2012.

(3) Optional application of TD 9564. A taxpayer may choose to apply § 1.165–2T as contained in TD 9564 (76 FR 81060) December 27, 2011, to taxable years beginning on or after January 1, 2012, and before January 1, 2014.


! Par. 9. Section 1.165–2T is removed. ! Par. 10. Section 1.167(a)–4 is revised to read as follows:

§ 1.167(a)–4 Leased property. (a) In general. Capital expenditures

made by either a lessee or lessor for the erection of a building or for other permanent improvements on leased property are recovered by the lessee or lessor under the provisions of the Internal Revenue Code (Code) applicable to the cost recovery of the building or improvements, if subject to depreciation or amortization, without regard to the period of the lease. For example, if the building or improvement is property to which section 168 applies, the lessee or lessor determines the depreciation deduction for the building or improvement under section 168. See section 168(i)(8)(A). If the improvement is property to which section 167 or section 197 applies, the lessee or lessor determines the depreciation or amortization deduction for the improvement under section 167 or section 197, as applicable.

(b) Effective/applicability date—(1) In general. Except as provided in paragraph (b)(2) or (b)(3) of this section, this section applies to taxable years beginning on or after January 1, 2014.

(2) Application of this section to leasehold improvements placed in service after December 31, 1986, in taxable years beginning before January 1, 2014. For leasehold improvements placed in service after December 31, 1986, in taxable years beginning before January 1, 2014, a taxpayer may—

(i) Apply the provisions of this section; or

(ii) Depreciate any leasehold improvement to which section 168 applies under the provisions of section 168 and depreciate or amortize any leasehold improvement to which section 168 does not apply under the provisions of the Code that are applicable to the cost recovery of that leasehold improvement, without regard to the period of the lease.

(3) Application of this section to leasehold improvements placed in service before January 1, 1987. Section 1.167(a)–4 as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to leasehold improvements placed in service before January 1, 1987.


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(4) Change in method of accounting. Except as provided in § 1.446– 1(e)(2)(ii)(d)(3)(i), a change to comply with this section for depreciable assets placed in service in a taxable year ending on or after December 30, 2003, is a change in method of accounting to which the provisions of section 446(e) and the regulations under section 446(e) apply. Except as provided in § 1.446– 1(e)(2)(ii)(d)(3)(i), a taxpayer also may treat a change to comply with this section for depreciable assets placed in service in a taxable year ending before December 30, 2003, as a change in method of accounting to which the provisions of section 446(e) and the regulations under section 446(e) apply.

§ 1.167(a)–4T [Removed]

! Par. 11. Section 1.167(a)–4T is removed. ! Par. 12. Section 1.167(a)–7 is amended by: ! 1. Revising paragraphs (e) and (f). ! 2. Removing paragraph (g).


§ 1.167(a)–7 Accounting for depreciable property. * * * * *

(e) Applicability. Paragraphs (a), (b), and (d) of this section apply to property for which depreciation is determined under section 167 (but not under section 168, section 1400I, section 1400L(c), section 168 prior to its amendment by the Tax Reform Act of 1986, Public Law 99–514 (100 Stat. 2121 (1986)), or under an additional first year depreciation deduction provision of the Internal Revenue Code (for example, section 168(k) through (n), 1400L(b), or 1400N(d))). Paragraph (c) of this section does not apply to general asset accounts as provided by section 168(i)(4), § 1.168(i)–1, § 1.168(i)–1T and Prop. Reg. § 1.168(i)–1 (September 19, 2013).

(f) Effective/applicability date—(1) In general. This section applies to taxable years beginning on or after January 1, 2014. Except as provided in paragraphs (f)(2) and (f)(3) of this section, § 1.167(a)–7 as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014.

(2) Early application of § 1.167(a)– 7(e). A taxpayer may choose to apply paragraph (e) of this section to taxable years beginning on or after January 1, 2012.

(3) Optional application of TD 9564. A taxpayer may choose to apply § 1.167(a)–7T as contained in TD 9564 (76 FR 81060) December 27, 2011, to taxable years beginning on or after January 1, 2012, and before January 1, 2014.

§ 1.167(a)–7T [Removed]

! Par. 13. Section 1.167(a)–7T is removed. ! Par. 14. Section 1.167(a)–8 is amended by: ! 1. Revising paragraphs (g) and (h). ! 2. Removing paragraph (i).


§ 1.167(a)–8 Retirements. * * * * *

(g) Applicability. This section applies to property for which depreciation is determined under section 167 (but not under section 168, section 1400I, section 1400L(c), section 168 prior to its amendment by the Tax Reform Act of 1986, Public Law 99–514 (100 Stat. 2121(1986)), or under an additional first year depreciation deduction provision of the Internal Revenue Code (for example, section 168(k) through (n), 1400L(b), or 1400N(d))).

(h) Effective/applicability date—(1) In general. This section applies to taxable years beginning on or after January 1, 2014. Except as provided in paragraphs (h)(2) and (h)(3) of this section, § 1.167(a)–8 as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014.

(2) Early application of § 1.167(a)– 8(g). A taxpayer may choose to apply paragraph (g) of this section to taxable years beginning on or after January 1, 2012.


§ 1.167(a)–8T [Removed]

! Par. 15. Section 1.167(a)–8T is removed. ! Par. 16. Section 1.168(i)–7 is added to read as follows:

§ 1.168(i)–7 Accounting for MACRS property.

(a) In general. A taxpayer may account for MACRS property (as defined in § 1.168(b)–1(a)(2)) by treating each individual asset as an account (a ‘‘single asset account’’ or an ‘‘item account’’) or by combining two or more assets in a single account (a ‘‘multiple asset account’’ or a ‘‘pool’’). A taxpayer may establish as many accounts for MACRS property as the taxpayer wants. This section does not apply to assets included in general asset accounts. For rules applicable to general asset accounts, see § 1.168(i)–1, § 1.168(i)–1T, or Prop. Reg. § 1.168(i)–1 (September 19, 2013), as applicable.

(b) Required use of single asset accounts. A taxpayer must account for an asset in a single asset account if the taxpayer uses the asset both in a trade or business (or for the production of income) and in a personal activity, or if the taxpayer places in service and disposes of the asset during the same taxable year. Also, if general asset account treatment for an asset terminates under § 1.168(i)– 1T(c)(1)(ii)(A), (e)(3)(iii), (e)(3)(vii), (g), or (h)(2) or Prop. Reg. § 1.168(i)– 1(c)(1)(ii)(A), (e)(3)(iii), (e)(3)(vii), (g), or (h)(2) (September 19, 2013), as applicable, the taxpayer must account for the asset in a single asset account beginning in the taxable year in which the general asset account treatment for the asset terminates. If a taxpayer accounts for an asset in a multiple asset account or a pool and the taxpayer disposes of the asset, the taxpayer must account for the asset in a single asset account beginning in the taxable year in which the disposition occurs. See § 1.168(i)–8T(g)(2)(i) or Prop. Reg. § 1.168(i)–8(h)(2)(i) (September 19, 2013), as applicable. If a taxpayer disposes of a component of a larger asset and the unadjusted depreciable basis of the disposed of component is included in the unadjusted depreciable basis of the larger asset, the taxpayer must account for the component in a single asset account beginning in the taxable year in which the disposition occurs. See Prop. Reg. § 1.168(i)–8(g)(3)(i) (September 19, 2013).

(c) Establishment of multiple asset accounts or pools—(1) Assets eligible for multiple asset accounts or pools. Except as provided in paragraph (b) of this section, assets that are subject to either the general depreciation system of section 168(a) or the alternative depreciation system of section 168(g) may be accounted for in one or more multiple asset accounts or pools.

(2) Grouping assets in multiple asset accounts or pools—(i) General rules. Assets that are eligible to be grouped into a single multiple asset account or pool may be divided into more than one multiple asset account or pool. Each multiple asset account or pool must include only assets that—

(A) Have the same applicable depreciation method;

(B) Have the same applicable recovery period;

(C) Have the same applicable convention; and

(D) Are placed in service by the taxpayer in the same taxable year.

(ii) Special rules. In addition to the general rules in paragraph (c)(2)(i) of this section, the following rules apply


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when establishing multiple asset accounts or pools—

(A) Assets subject to the mid-quarter convention may only be grouped into a multiple asset account or pool with assets that are placed in service in the same quarter of the taxable year;

(B) Assets subject to the mid-month convention may only be grouped into a multiple asset account or pool with assets that are placed in service in the same month of the taxable year;

(C) Passenger automobiles for which the depreciation allowance is limited under section 280F(a) must be grouped into a separate multiple asset account or pool;

(D) Assets not eligible for any additional first year depreciation deduction (including assets for which the taxpayer elected not to deduct the additional first year depreciation) provided by, for example, section 168(k) through (n), 1400L(b), or 1400N(d), must be grouped into a separate multiple asset account or pool;

(E) Assets eligible for the additional first year depreciation deduction may only be grouped into a multiple asset account or pool with assets for which the taxpayer claimed the same percentage of the additional first year depreciation (for example, 30 percent, 50 percent, or 100 percent);

(F) Except for passenger automobiles described in paragraph (c)(2)(ii)(C) of this section, listed property (as defined in section 280F(d)(4)) must be grouped into a separate multiple asset account or pool;

(G) Assets for which the depreciation allowance for the placed-in-service year is not determined by using an optional depreciation table (for further guidance, see section 8 of Rev. Proc. 87–57, 1987– 2 CB 687, 693 (see § 601.601(d)(2) of this chapter)) must be grouped into a separate multiple asset account or pool; and

(H) Mass assets (as defined in § 1.168(i)–8T(b)(2) or Prop. Reg. § 1.168(i)–8(b)(3) (September 19, 2013), as applicable) that are or will be subject to § 1.168(i)–8T(f)(2)(iii) or Prop. Reg. § 1.168(i)–8(g)(2)(iii) (September 19, 2013), as applicable,(disposed of or converted mass asset is identified by a mortality dispersion table) must be grouped into a separate multiple asset account or pool.

(d) Cross references. See § 1.167(a)– 7(c) for the records to be maintained by a taxpayer for each account. In addition, see § 1.168(i)–1(l)(3) for the records to be maintained by a taxpayer for each general asset account.

(e) Effective/applicability date—(1) In general. This section applies to taxable

years beginning on or after January 1, 2014.

(2) Early application of this section. A taxpayer may choose to apply the provisions of this section to taxable years beginning on or after January 1, 2012.

(3) Optional application of TD 9564. A taxpayer may choose to apply § 1.168(i)–7T as contained in TD 9564 (76 FR 81060) December 27, 2011, to taxable years beginning on or after January 1, 2012, and before January 1, 2014.

(4) Change in method of accounting. A change to comply with this section for depreciable assets placed in service in a taxable year ending on or after December 30, 2003, is a change in method of accounting to which the provisions of section 446(e) and the regulations under section 446(e) apply. A taxpayer also may treat a change to comply with this section for depreciable assets placed in service in a taxable year ending before December 30, 2003, as a change in method of accounting to which the provisions of section 446(e) and the regulations under section 446(e) apply.

§ 1.168(i)–7T [Removed]

! Par. 17. Section 1.168(i)–7T is removed. ! Par. 18. Section 1.263(a)–0 is amended by: ! 1. The table of contents introductory text is revised. ! 2. Revising the section heading and entries to the table of contents for §§ 1.263(a)–1, 1.263(a)–2 and 1.263(a)– 3. ! 3. Adding § 1.263(a)–6 to the table of contents. The revisions and additions read as follows:

§ 1.263(a)–0 Outline of regulations under section 263(a).

This section lists the paragraphs in §§ 1.263(a)–1 through 1.263(a)–3 and § 1.263(a)–6.

§ 1.263(a)–1 Capital expenditures; in general.

(a) General rule for capital expenditures.

(b) Coordination with other provisions of the Internal Revenue Code.

(c) Definitions. (1) Amount paid. (2) Produce. (d) Examples of capital expenditures. (e) Amounts paid to sell property. (1) In general. (2) Dealer in property. (3) Examples. (f) De minimis safe harbor election. (1) In general.

(i) Taxpayer with applicable financial statement.

(ii) Taxpayer without applicable financial statement.

(iii) Taxpayer with both an applicable financial statement and a non-qualifying financial statement.

(2) Exceptions to de minimis safe harbor.

(3) Additional rules. (i) Transaction and other additional

costs. (ii) Materials and supplies. (iii) Sale or disposition. (iv) Treatment of de minimis

amounts. (v) Coordination with section 263A. (vi) Written accounting procedures for

groups of entities. (vii) Combined expensing accounting

procedures. (4) Definition of applicable financial

statement. (5) Time and manner of making

election. (6) Anti-abuse rule. (7) Examples. (g) Accounting method changes. (h) Effective/applicability date. (1) In general. (2) Early application of this section. (i) In general. (ii) Transition rule for de minimis safe

harbor election on 2012 or 2013 returns. (3) Optional application of TD 9564.

§ 1.263(a)–2 Amounts paid to acquire or produce tangible property.

(a) Overview. (b) Definitions. (1) Amount paid. (2) Personal property. (3) Real property. (4) Produce. (c) Coordination with other provisions

of the Internal Revenue Code. (1) In general. (2) Materials and supplies. (d) Acquired or produced tangible

property. (1) Requirement to capitalize. (2) Examples. (e) Defense or perfection of title to

property. (1) In general. (2) Examples. (f) Transaction costs. (1) In general. (2) Scope of facilitate. (i) In general. (ii) Inherently facilitative amounts. (iii) Special rule for acquisitions of

real property. (A) In general. (B) Acquisitions of real and personal

property in a single transaction. (iv) Employee compensation and

overhead costs. (A) In general.


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(B) Election to capitalize. (3) Treatment of transaction costs. (i) In general. (ii) Treatment of inherently

facilitative amounts. (iii) Contingency fees. (4) Examples. (g) Treatment of capital expenditures. (h) Recovery of capitalized amounts. (1) In general. (2) Examples. (i) Accounting method changes. (j) Effective/applicability date. (1) In general. (2) Early application of this section. (i) In general. (ii) Transition rule for election to

capitalize employee compensation and overhead costs on 2012 or 2013 returns.

(3) Optional application of TD 9564. § 1.263(a)–3 Amounts paid to improve

tangible property. (a) Overview. (b) Definitions. (1) Amount paid. (2) Personal property. (3) Real property. (4) Owner. (c) Coordination with other provisions

of the Internal Revenue Code. (1) In general. (2) Materials and supplies. (3) Example. (d) Requirement to capitalize amounts

paid for improvements. (e) Determining the unit of property. (1) In general. (2) Building. (i) In general. (ii) Application of improvement rules

to a building. (A) Building structure. (B) Building system. (iii) Condominium. (A) In general. (B) Application of improvement rules

to a condominium. (iv) Cooperative. (A) In general. (B) Application of improvement rules

to a cooperative. (v) Leased building. (A) In general. (B) Application of improvement rules

to a leased building. (1) Entire building. (2) Portion of building. (3) Property other than a building. (i) In general. (ii) Plant property. (A) Definition. (B) Unit of property for plant

property. (iii) Network assets. (A) Definition. (B) Unit of property for network

assets. (iv) Leased property other than

buildings.

(4) Improvements to property. (5) Additional rules. (i) Year placed in service. (ii) Change in subsequent taxable

year. (6) Examples. (f) Improvements to leased property. (1) In general. (2) Lessee improvements. (i) Requirement to capitalize. (ii) Unit of property for lessee

improvements. (3) Lessor improvements. (i) Requirement to capitalize. (ii) Unit of property for lessor

improvements. (4) Examples. (g) Special rules for determining

improvement costs. (1) Certain costs incurred during an

improvement. (i) In general. (ii) Exception for individuals’

residences. (2) Removal costs. (i) In general. (ii) Examples. (3) Related amounts. (4) Compliance with regulatory

requirements. (h) Safe harbor for small taxpayers. (1) In general. (2) Application with other safe harbor

provisions. (3) Qualifying taxpayer. (i) In general. (ii) Application to new taxpayers. (iii) Treatment of short taxable year. (iv) Definition of gross receipts. (4) Eligible building property. (5) Unadjusted basis. (i) Eligible building property owned

by the taxpayer. (ii) Eligible building property leased

to the taxpayer. (6) Time and manner of election. (7) Treatment of safe harbor amounts. (8) Safe harbor exceeded. (9) Modification of safe harbor

amounts. (10) Examples. (i) Safe harbor for routine

maintenance. (1) In general. (i) Routine maintenance for buildings. (ii) Routine maintenance for property

other than buildings. (2) Rotable and temporary spare parts. (3) Exceptions. (4) Class life. (5) Coordination with section 263A. (6) Examples. (j) Capitalization of betterments. (1) In general. (2) Application of betterment rules. (i) In general. (ii) Application of betterment rules to

buildings. (iii) Unavailability of replacement

parts.

(iv) Appropriate comparison. (A) In general. (B) Normal wear and tear. (C) Damage to property. (4) Examples. (k) Capitalization of restorations. (1) In general. (2) Application of restorations to

buildings. (3) Exception for losses based on

salvage value. (4) Restoration of damage from

casualty. (i) Limitation. (ii) Amounts in excess of limitation. (5) Rebuild to like-new condition. (6) Replacement of a major

component or substantial structural part.

(i) In general. (A) Major component. (B) Substantial structural part. (ii) Major components and substantial

structural parts of buildings. (7) Examples. (l) Capitalization of amounts to adapt

property to a new or different use. (1) In general. (2) Application of adaptation rule to

buildings. (3) Examples. (m) Optional regulatory accounting

method. (1) In general. (2) Eligibility for regulatory

accounting method. (3) Description of regulatory

accounting method. (4) Examples. (n) Election to capitalize repair and

maintenance costs. (1) In general. (2) Time and manner of election. (3) Exception. (4) Examples. (o) Treatment of capital expenditures. (p) Recovery of capitalized amounts. (q) Accounting method changes. (r) Effective/applicability date. (1) In general. (2) Early application of this section. (i) In general. (ii) Transition rule for elections on

2012 and 2013 returns. (3) Optional application of TD 9564.

* * * * * § 1.263(a)–6 Election to deduct or

capitalize certain expenditures. (a) In general. (b) Election provisions. (c) Effective/applicability date. (1) In general. (2) Early application of this section. (3) Optional application of TD 9564.

§ 1.263(a)–0T [Removed]

! Par. 19. Section 1.263(a)–0T is removed.


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Par. 20. Section 1.263(a)–1 is revised to read as follows:

§ 1.263(a)–1 Capital expenditures; in general.

(a) General rule for capital expenditures. Except as provided in chapter 1 of the Internal Revenue Code, no deduction is allowed for—

(1) Any amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property or estate; or

(2) Any amount paid in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.

(b) Coordination with other provisions of the Internal Revenue Code. Nothing in this section changes the treatment of any amount that is specifically provided for under any provision of the Internal Revenue Code or the Treasury Regulations other than section 162(a) or section 212 and the regulations under those sections. For example, see section 263A, which requires taxpayers to capitalize the direct and allocable indirect costs to property produced by the taxpayer and property acquired for resale. See also section 195 requiring taxpayers to capitalize certain costs as start-up expenditures.

(c) Definitions. For purposes of this section, the following definitions apply:

(1) Amount paid. In the case of a taxpayer using an accrual method of accounting, the terms amount paid and payment mean a liability incurred (within the meaning of § 1.446– 1(c)(1)(ii)). A liability may not be taken into account under this section prior to the taxable year during which the liability is incurred.

(2) Produce means construct, build, install, manufacture, develop, create, raise, or grow. This definition is intended to have the same meaning as the definition used for purposes of section 263A(g)(1) and § 1.263A– 2(a)(1)(i), except that improvements are excluded from the definition in this paragraph (c)(2) and are separately defined and addressed in § 1.263(a)–3.

(d) Examples of capital expenditures. The following amounts paid are examples of capital expenditures:

(1) An amount paid to acquire or produce a unit of real or personal tangible property. See § 1.263(a)–2.

(2) An amount paid to improve a unit of real or personal tangible property. See § 1.263(a)–3.

(3) An amount paid to acquire or create intangibles. See § 1.263(a)–4.

(4) An amount paid or incurred to facilitate an acquisition of a trade or business, a change in capital structure of

a business entity, and certain other transactions. See § 1.263(a)–5.

(5) An amount paid to acquire or create interests in land, such as easements, life estates, mineral interests, timber rights, zoning variances, or other interests in land.

(6) An amount assessed and paid under an agreement between bondholders or shareholders of a corporation to be used in a reorganization of the corporation or voluntary contributions by shareholders to the capital of the corporation for any corporate purpose. See section 118 and § 1.118–1.

(7) An amount paid by a holding company to carry out a guaranty of dividends at a specified rate on the stock of a subsidiary corporation for the purpose of securing new capital for the subsidiary and increasing the value of its stockholdings in the subsidiary. This amount must be added to the cost of the stock in the subsidiary.

(e) Amounts paid to sell property—(1) In general. Commissions and other transaction costs paid to facilitate the sale of property are not currently deductible under section 162 or 212. Instead, the amounts are capitalized costs that reduce the amount realized in the taxable year in which the sale occurs or are taken into account in the taxable year in which the sale is abandoned if a deduction is permissible. These amounts are not added to the basis of the property sold or treated as an intangible asset under § 1.263(a)–4. See § 1.263(a)–5(g) for the treatment of amounts paid to facilitate the disposition of assets that constitute a trade or business.

(2) Dealer in property. In the case of a dealer in property, amounts paid to facilitate the sale of such property are treated as ordinary and necessary business expenses.

(3) Examples. The following examples, which assume the sale is not an installment sale under section 453, illustrate the rules of this paragraph (e):

Example 1. Sales costs of real property. A owns a parcel of real estate. A sells the real estate and pays legal fees, recording fees, and sales commissions to facilitate the sale. A must capitalize the fees and commissions and, in the taxable year of the sale, must reduce the amount realized from the sale of the real estate by the fees and commissions.

Example 2. Sales costs of dealers. Assume the same facts as in Example 1, except that A is a dealer in real estate. The commissions and fees paid to facilitate the sale of the real estate may be deducted as ordinary and necessary business expenses under section 162.

Example 3. Sales costs of personal property used in a trade or business. B owns a truck for use in B’s trade or business. B decides to

sell the truck on November 15, Year 1. B pays for an appraisal to determine a reasonable asking price. On February 15, Year 2, B sells the truck to C. In Year 1, B must capitalize the amount paid to appraise the truck, and in Year 2, must reduce the amount realized from the sale of the truck by the amount paid for the appraisal.

Example 4. Costs of abandoned sale of personal property used in a trade or business. Assume the same facts as in Example 3, except that, instead of selling the truck on February 15, Year 2, B decides on that date not to sell the truck and takes the truck off the market. In Year 1, B must capitalize the amount paid to appraise the truck. However, B may recognize the amount paid to appraise the truck as a loss under section 165 in Year 2, the taxable year when the sale is abandoned.

Example 5. Sales costs of personal property not used in a trade or business. Assume the same facts as in Example 3, except that B does not use the truck in B’s trade or business but instead uses it for personal purposes. In Year 1, B must capitalize the amount paid to appraise the truck, and in Year 2, must reduce the amount realized from the sale of the truck by the amount paid for the appraisal.

Example 6. Costs of abandoned sale of personal property not used in a trade or business. Assume the same facts as in Example 5, except that, instead of selling the truck on February 15, Year 2, B decides on that date not to sell the truck and takes the truck off the market. In Year 1, B must capitalize the amount paid to appraise the truck. Although B abandons the sale in Year 2, B may not treat the amount paid to appraise the truck as a loss under section 165 because the truck was not used in B’s trade or business or in a transaction entered into for profit.

(f) De minimis safe harbor election— (1) In general. Except as otherwise provided in paragraph (f)(2) of this section, a taxpayer electing to apply the de minimis safe harbor under this paragraph (f) may not capitalize under § 1.263(a)–2(d)(1) or § 1.263(a)–3(d) any amount paid in the taxable year for the acquisition or production of a unit of tangible property nor treat as a material or supply under § 1.162–3(a) any amount paid in the taxable year for tangible property if the amount specified under this paragraph (f)(1) meets the requirements of paragraph (f)(1)(i) or (f)(1)(ii) of this section. But see section 263A and the regulations under section 263A, which require taxpayers to capitalize the direct and allocable indirect costs of property produced by the taxpayer (for example, property improved by the taxpayer) and property acquired for resale.

(i) Taxpayer with applicable financial statement. A taxpayer electing to apply the de minimis safe harbor may not capitalize under § 1.263(a)–2(d)(1) or § 1.263(a)–3(d) nor treat as a material or supply under § 1.162–3(a) any amount


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paid in the taxable year for property described in paragraph (f)(1) of this section if—

(A) The taxpayer has an applicable financial statement (as defined in paragraph (f)(4) of this section);

(B) The taxpayer has at the beginning of the taxable year written accounting procedures treating as an expense for non-tax purposes—

(1) Amounts paid for property costing less than a specified dollar amount; or

(2) Amounts paid for property with an economic useful life (as defined in § 1.162–3(c)(3)) of 12 months or less;

(C) The taxpayer treats the amount paid for the property as an expense on its applicable financial statement in accordance with its written accounting procedures; and

(D) The amount paid for the property does not exceed $5,000 per invoice (or per item as substantiated by the invoice) or other amount as identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(b) of this chapter).

(ii) Taxpayer without applicable financial statement. A taxpayer electing to apply the de minimis safe harbor may not capitalize under § 1.263(a)–2(d)(1) or § 1.263(a)–3(d) nor treat as a material or supply under § 1.162–3(a) any amount paid in the taxable year for property described in paragraph (f)(1) of this section if—

(A) The taxpayer does not have an applicable financial statement (as defined in paragraph (f)(4) of this section);

(B) The taxpayer has at the beginning of the taxable year accounting procedures treating as an expense for non-tax purposes—

(1) Amounts paid for property costing less than a specified dollar amount; or

(2) Amounts paid for property with an economic useful life (as defined in § 1.162–3(c)(3)) of 12 months or less;

(C) The taxpayer treats the amount paid for the property as an expense on its books and records in accordance with these accounting procedures; and

(D) The amount paid for the property does not exceed $500 per invoice (or per item as substantiated by the invoice) or other amount as identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(b) of this chapter).

(iii) Taxpayer with both an applicable financial statement and a non- qualifying financial statement. For purposes of this paragraph (f)(1), if a taxpayer has an applicable financial statement defined in paragraph (f)(4) of this section in addition to a financial statement that does not meet

requirements of paragraph (f)(4) of this section, the taxpayer must meet the requirements of paragraph (f)(1)(i) of this section to qualify to elect the de minimis safe harbor under this paragraph (f).

(2) Exceptions to de minimis safe harbor. The de minimis safe harbor in paragraph (f)(1) of this section does not apply to the following:

(i) Amounts paid for property that is or is intended to be included in inventory property;

(ii) Amounts paid for land; (iii) Amounts paid for rotable,

temporary, and standby emergency spare parts that the taxpayer elects to capitalize and depreciate under § 1.162– 3(d); and

(iv) Amounts paid for rotable and temporary spare parts that the taxpayer accounts for under the optional method of accounting for rotable parts pursuant to § 1.162–3(e).

(3) Additional rules—(i) Transaction and other additional costs. A taxpayer electing to apply the de minimis safe harbor under paragraph (f)(1) of this section is not required to include in the cost of the tangible property the additional costs of acquiring or producing such property if these costs are not included in the same invoice as the tangible property. However, the taxpayer electing to apply the de minimis safe harbor under paragraph (f)(1) of this section must include in the cost of such property all additional costs (for example, delivery fees, installation services, or similar costs) if these additional costs are included on the same invoice with the tangible property. For purposes of this paragraph, if the invoice includes amounts paid for multiple tangible properties and such invoice includes additional invoice costs related to these multiple properties, then the taxpayer must allocate the additional invoice costs to each property using a reasonable method, and each property, including allocable labor and overhead, must meet the requirements of paragraph (f)(1)(i) or paragraph (f)(1)(ii) of this section, whichever is applicable. Reasonable allocation methods include, but are not limited to specific identification, a pro rata allocation, or a weighted average method based on the property’s relative cost. For purposes of this paragraph (f)(3)(i), additional costs consist of the costs of facilitating the acquisition or production of such tangible property under § 1.263(a)–2(f) and the costs for work performed prior to the date that the tangible property is placed in service under § 1.263(a)–2(d).

(ii) Materials and supplies. If a taxpayer elects to apply the de minimis

safe harbor provided under this paragraph (f), then the taxpayer must also apply the de minimis safe harbor to amounts paid for all materials and supplies (as defined under § 1.162–3) that meet the requirements of § 1.263(a)–1(f). See paragraph (f)(3)(iv) of this section for treatment of materials and supplies under the de minimis safe harbor.

(iii) Sale or disposition. Property to which a taxpayer applies the de minimis safe harbor contained in this paragraph (f) is not treated upon sale or other disposition as a capital asset under section 1221 or as property used in the trade or business under section 1231.

(iv) Treatment of de minimis amounts. An amount paid for property to which a taxpayer properly applies the de minimis safe harbor contained in this paragraph (f) is not treated as a capital expenditure under § 1.263(a)–2(d)(1) or § 1.263(a)–3(d) or as a material and supply under § 1.162–3, and may be deducted under § 1.162–1 in the taxable year the amount is paid provided the amount otherwise constitutes an ordinary and necessary expenses incurred in carrying on a trade or business.

(v) Coordination with section 263A. Amounts paid for tangible property described in paragraph (f)(1) of this section may be subject to capitalization under section 263A if the amounts paid for tangible property comprise the direct or allocable indirect costs of other property produced by the taxpayer or property acquired for resale. See, for example, § 1.263A–1(e)(3)(ii)(R) requiring taxpayers to capitalize the cost of tools and equipment allocable to property produced or property acquired for resale.

(vi) Written accounting procedures for groups of entities. If the taxpayer’s financial results are reported on the applicable financial statement (as defined in paragraph (f)(4) of this section) for a group of entities then, for purposes of paragraph (f)(1)(i)(A) of this section, the group’s applicable financial statement may be treated as the applicable financial statement of the taxpayer, and for purposes of paragraphs (f)(1)(i)(B) and (f)(1)(i)(C) of this section, the written accounting procedures provided for the group and utilized for the group’s applicable financial statement may be treated as the written accounting procedures of the taxpayer.

(vii) Combined expensing accounting procedures. For purposes of paragraphs (f)(1)(i) and (f)(1)(ii) of this section, if the taxpayer has, at the beginning of the taxable year accounting procedures


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treating as an expense for non-tax purposes (1) amounts paid for property costing less than a specified dollar amount; and (2) amounts paid for property with an economic useful life (as defined in § 1.162–3(c)(3)) of 12 months or less, then a taxpayer electing to apply the de minimis safe harbor under this paragraph (f) must apply the provisions of this paragraph (f) to amounts qualifying under either accounting procedure.

(4) Definition of applicable financial statement. For purposes of this paragraph (f), the taxpayer’s applicable financial statement (AFS) is the taxpayer’s financial statement listed in paragraphs (f)(4)(i) through (iii) of this section that has the highest priority (including within paragraph (f)(4)(ii) of this section). The financial statements are, in descending priority—

(i) A financial statement required to be filed with the Securities and Exchange Commission (SEC) (the 10–K or the Annual Statement to Shareholders);

(ii) A certified audited financial statement that is accompanied by the report of an independent certified public accountant (or in the case of a foreign entity, by the report of a similarly qualified independent professional) that is used for—

(A) Credit purposes; (B) Reporting to shareholders,

partners, or similar persons; or (C) Any other substantial non-tax

purpose; or (iii) A financial statement (other than

a tax return) required to be provided to the federal or a state government or any federal or state agency (other than the SEC or the Internal Revenue Service).

(5) Time and manner of election. A taxpayer that makes the election under this paragraph (f) must make the election for all amounts paid during the taxable year for property described in paragraph (f)(1) of this section and meeting the requirements of paragraph (f)(1)(i) or paragraph (f)(1)(ii) of this section, as applicable. A taxpayer makes the election by attaching a statement to the taxpayer’s timely filed original Federal tax return (including extensions) for the taxable year in which these amounts are paid. See §§ 301.9100–1 through 301.9100–3 of this chapter for the provisions governing extensions of time to make regulatory elections. The statement must be titled ‘‘Section 1.263(a)–1(f) de minimis safe harbor election’’ and include the taxpayer’s name, address, taxpayer identification number, and a statement that the taxpayer is making the de minimis safe harbor election under § 1.263(a)–1(f). In the case of a

consolidated group filing a consolidated income tax return, the election is made for each member of the consolidated group by the common parent, and the statement must also include the names and taxpayer identification numbers of each member for which the election is made. In the case of an S corporation or a partnership, the election is made by the S corporation or the partnership and not by the shareholders or partners. An election may not be made through the filing of an application for change in accounting method or, before obtaining the Commissioner’s consent to make a late election, by filing an amended Federal tax return. A taxpayer may not revoke an election made under this paragraph (f). The manner of electing the de minimis safe harbor under this paragraph (f) may be modified through guidance of general applicability (see §§ 601.601(d)(2) and 601.602 of this chapter).

(6) Anti-abuse rule. If a taxpayer acts to manipulate transactions with the intent to achieve a tax benefit or to avoid the application of the limitations provided under paragraphs (f)(1)(i)(B)(1), (f)(1)(i)(D), (f)(1)(ii)(B)(1), and (f)(1)(ii)(D) of this section, appropriate adjustments will be made to carry out the purposes of this section. For example, a taxpayer is deemed to act to manipulate transactions with an intent to avoid the purposes and requirements of this section if—

(i) The taxpayer applies the de minimis safe harbor to amounts substantiated with invoices created to componentize property that is generally acquired or produced by the taxpayer (or other taxpayers in the same or similar trade or business) as a single unit of tangible property; and

(ii) This property, if treated as a single unit, would exceed any of the limitations provided under paragraphs (f)(1)(i)(B)(1), (f)(1)(i)(D), (f)(1)(ii)(B)(1), and (f)(1)(ii)(D) of this section, as applicable.

(7) Examples. The following examples illustrate the application of this paragraph (f). Unless otherwise provided, assume that section 263A does not apply to the amounts described.

Example 1. De minimis safe harbor; taxpayer without AFS. In Year 1, A purchases 10 printers at $250 each for a total cost of $2,500 as indicated by the invoice. Assume that each printer is a unit of property under § 1.263(a)–3(e). A does not have an AFS. A has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing less than $500, and A treats the amounts paid for the printers as an expense on its books and records. The amounts paid for the printers meet the

requirements for the de minimis safe harbor under paragraph (f)(1)(ii) of this section. If A elects to apply the de minimis safe harbor under this paragraph (f) in Year 1, A may not capitalize the amounts paid for the 10 printers or any other amounts meeting the criteria for the de minimis safe harbor under paragraph (f)(1). Instead, in accordance with paragraph (f)(3)(iv) of this section, A may deduct these amounts under § 1.162–1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.

Example 2. De minimis safe harbor; taxpayer without AFS. In Year 1, B purchases 10 computers at $600 each for a total cost of $6,000 as indicated by the invoice. Assume that each computer is a unit of property under § 1.263(a)–3(e). B does not have an AFS. B has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing less than $1,000 and B treats the amounts paid for the computers as an expense on its books and records. The amounts paid for the printers do not meet the requirements for the de minimis safe harbor under paragraph (f)(1)(ii) of this section because the amount paid for the property exceeds $500 per invoice (or per item as substantiated by the invoice). B may not apply the de minimis safe harbor election to the amounts paid for the 10 computers under paragraph (f)(1) of this section.

Example 3. De minimis safe harbor; taxpayer with AFS. C is a member of a consolidated group for Federal income tax purposes. C’s financial results are reported on the consolidated applicable financial statements for the affiliated group. C’s affiliated group has a written accounting policy at the beginning of Year 1, which is followed by C, to expense amounts paid for property costing $5,000 or less. In Year 1, C pays $6,250,000 to purchase 1,250 computers at $5,000 each. C receives an invoice from its supplier indicating the total amount due ($6,250,000) and the price per item ($5,000). Assume that each computer is a unit of property under § 1.263(a)–3(e). The amounts paid for the computers meet the requirements for the de minimis safe harbor under paragraph (f)(1)(i) of this section. If C elects to apply the de minimis safe harbor under this paragraph (f) for Year 1, C may not capitalize the amounts paid for the 1,250 computers or any other amounts meeting the criteria for the de minimis safe harbor under paragraph (f)(1) of this section. Instead, in accordance with paragraph (f)(3)(iv) of this section, C may deduct these amounts under § 1.162–1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.

Example 4. De minimis safe harbor; taxpayer with AFS. D is a member of a consolidated group for Federal income tax purposes. D’s financial results are reported on the consolidated applicable financial statements for the affiliated group. D’s affiliated group has a written accounting policy at the beginning of Year 1, which is followed by D, to expense amounts paid for property costing less than $15,000. In Year 1,


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D pays $4,800,000 to purchase 800 elliptical machines at $6,000 each. D receives an invoice from its supplier indicating the total amount due ($4,800,000) and the price per item ($6,000). Assume that each elliptical machine is a unit of property under § 1.263(a)–3(e). D may not apply the de minimis safe harbor election to the amounts paid for the 800 elliptical machines under paragraph (f)(1) of this section because the amount paid for the property exceeds $5,000 per invoice (or per item as substantiated by the invoice).

Example 5. De minimis safe harbor; additional invoice costs. E is a member of a consolidated group for Federal income tax purposes. E’s financial results are reported on the consolidated applicable financial statements for the affiliated group. E’s affiliated group has a written accounting policy at the beginning of Year 1, which is followed by E, to expense amounts paid for property costing less than $5,000. In Year 1, E pays $45,000 for the purchase and installation of wireless routers in each of its 10 office locations. Assume that each wireless router is a unit of property under § 1.263(a)–3(e). E receives an invoice from its supplier indicating the total amount due ($45,000), including the material price per item ($2,500), and total delivery and installation ($20,000). E allocates the additional invoice costs to the materials on a pro rata basis, bringing the cost of each router to $4,500 ($2,500 materials + $2,000 labor and overhead). The amounts paid for each router, including the allocable additional invoice costs, meet the requirements for the de minimis safe harbor under paragraph (f)(1)(i) of this section. If E elects to apply the de minimis safe harbor under this paragraph (f) for Year 1, E may not capitalize the amounts paid for the 10 routers (including the additional invoice costs) or any other amounts meeting the criteria for the de minimis safe harbor under paragraph (f)(1) of this section. Instead, in accordance with paragraph (f)(3)(iv) of this section, E may deduct these amounts under § 1.162–1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.

Example 6. De minims safe harbor; non- invoice additional costs. F is a corporation that provides consulting services to its customer. F does not have an AFS, but F has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing less than $500. In Year 1, F pays $600 to an interior designer to shop for, evaluate, and make recommendations regarding purchasing new furniture for F’s conference room. As a result of the interior designer’s recommendations, F acquires a conference table for $500 and 10 chairs for $300 each. In Year 1, F receives an invoice from the interior designer for $600 for his services, and F receives a separate invoice from the furniture supplier indicating a total amount due of $500 for the table and $300 for each chair. For Year 1, F treats the amount paid for the table and each chair as an expense on its books and records, and F elects to use the de minimis safe harbor for amounts paid for tangible property that

qualify under the safe harbor. The amount paid to the interior designer is a cost of facilitating the acquisition of the table and chairs under § 1.263(a)–2(f). Under paragraph (f)(3)(i) of this section, F is not required to include in the cost of tangible property the additional costs of acquiring such property if these costs are not included in the same invoice as the tangible property. Thus, F is not required to include a pro rata allocation of the amount paid to the interior designer to determine the application of the de minimis safe harbor to the table and the chairs. Accordingly, the amounts paid by F for the table and each chair meet the requirements for the de minimis safe harbor under paragraph (f)(1)(ii) of this section, and F may not capitalize the amounts paid for the table or each chair under paragraph (f)(1) of this section. In addition, F is not required to capitalize the amounts paid to the interior designer as a cost that facilitates the acquisition of tangible property under § 1.263(a)–2(f)(3)(i). Instead, F may deduct the amounts paid for the table, chairs, and interior designer under § 1.162–1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.

Example 7. De minimis safe harbor; 12- month economic useful life. G operates a restaurant. In Year 1, G purchases 10 hand- held point-of-service devices at $300 each for a total cost of $3,000 as indicated by invoice. G also purchases 3 tablet computers at $500 each for a total cost of $1,500 as indicated by invoice. Assume each point-of-service device and each tablet computer has an economic useful life of 12 months or less, beginning when they are used in G’s business. Assume that each device and each tablet is a unit of property under § 1.263(a)–3(e). G does not have an AFS, but G has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing $300 or less and to expense amounts paid for property with an economic useful life of 12 months or less. Thus, G expenses the amounts paid for the hand-held devices on its books and records because each device costs $300. G also expenses the amounts paid for the tablet computers on its books and records because the computers have an economic useful life of 12 months of less, beginning when they are used. The amounts paid for the hand-held devices and the tablet computers meet the requirements for the de minimis safe harbor under paragraph (f)(1)(ii) of this section. If G elects to apply the de minimis safe harbor under this paragraph (f) in Year 1, G may not capitalize the amounts paid for the hand-held devices, the tablet computers, or any other amounts meeting the criteria for the de minimis safe harbor under paragraph (f)(1) of this section. Instead, in accordance with paragraph (f)(3)(iv) of this section, G may deduct the amounts paid for the hand-held devices and tablet computers under § 1.162–1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary business expenses incurred in carrying on a trade or business.

Example 8. De minimis safe harbor; limitation. Assume the facts as in Example 7,

except G purchases the 3 tablet computers at $600 each for a total cost of $1,800. The amounts paid for the tablet computers do not meet the de minimis rule safe harbor under paragraphs (f)(1)(ii) and (f)(3)(vii) of this section because the cost of each computer exceeds $500. Therefore, the amounts paid for the tablet computers may not be deducted under the safe harbor.

Example 9. De minimis safe harbor; materials and supplies. H is a corporation that provides consulting services to its customers. H has an AFS and a written accounting policy at the beginning of the taxable year to expense amounts paid for property costing $5,000 or less. In Year 1, H purchases 1,000 computers at $500 each for a total cost of $500,000. Assume that each computer is a unit of property under § 1.263(a)–3(e) and is not a material or supply under § 1.162–3. In addition, H purchases 200 office chairs at $100 each for a total cost of $20,000 and 250 customized briefcases at $80 each for a total cost of $20,000. Assume that each office chair and each briefcase is a material or supply under § 1.162–3(c)(1). H treats the amounts paid for the computers, office chairs, and briefcases as expenses on its AFS. The amounts paid for computers, office chairs, and briefcases meet the requirements for the de minimis safe harbor under paragraph (f)(1)(i) of this section. If H elects to apply the de minimis safe harbor under this paragraph (f) in Year 1, H may not capitalize the amounts paid for the 1,000 computers, the 200 office chairs, and the 250 briefcases under paragraph (f)(1) of this section. H may deduct the amounts paid for the computers, the office chairs, and the briefcases under § 1.162–1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.

Example 10. De minimis safe harbor; coordination with section 263A. J is a member of a consolidated group for Federal income tax purposes. J’s financial results are reported on the consolidated AFS for the affiliated group. J’s affiliated group has a written accounting policy at the beginning of Year 1, which is followed by J, to expense amounts paid for property costing less than $1,000 or that has an economic useful life of 12 months or less. In Year 1, J acquires jigs, dies, molds, and patterns for use in the manufacture of J’s products. Assume each jig, die, mold, and pattern is a unit of property under § 1.263(a)–3(e) and costs less than $1,000. In Year 1, J begins using the jigs, dies, molds and patterns to manufacture its products. Assume these items are materials and supplies under § 1.162–3(c)(1)(iii), and J elects to apply the de minimis safe harbor under paragraph (f)(1)(i) of this section to amounts qualifying under the safe harbor in Year 1. Under paragraph (f)(3)(v) of this section, the amounts paid for the jigs, dies, molds, and patterns may be subject to capitalization under section 263A if the amounts paid for these tangible properties comprise the direct or allocable indirect costs of other property produced by the taxpayer or property acquired for resale.

Example 11. De minimis safe harbor; anti- abuse rule. K is a corporation that provides


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hauling services to its customers. In Year 1, K decides to purchase a truck to use in its business. K does not have an AFS. K has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing less than $500. K arranges to purchase a used truck for a total of $1,500. Prior to the acquisition, K requests the seller to provide multiple invoices for different parts of the truck. Accordingly, the seller provides K with four invoices during Year 1—one invoice of $500 for the cab, one invoice of $500 for the engine, one invoice of $300 for the trailer, and a fourth invoice of $200 for the tires. K treats the amounts paid under each invoice as an expense on its books and records. K elects to apply the de minimis safe harbor under paragraph (f) of this section in Year 1 and does not capitalize the amounts paid for each invoice pursuant to the safe harbor. Under paragraph (f)(6) of this section, K has applied the de minimis rule to amounts substantiated with invoices created to componentize property that is generally acquired as a single unit of tangible property in the taxpayer’s type of business, and this property, if treated as single unit, would exceed the limitations provided under the de minimis rule. Accordingly, K is deemed to manipulate the transaction to acquire the truck with the intent to avoid the purposes of this paragraph (f). As a result, K may not apply the de minimis rule to these amounts and is subject to appropriate adjustments.

(g) Accounting method changes. Except for paragraph (f) of this section (the de minimis safe harbor election), a change to comply with this section is a change in method of accounting to which the provisions of sections 446 and 481 and the accompanying regulations apply. A taxpayer seeking to change to a method of accounting permitted in this section must secure the consent of the Commissioner in accordance with § 1.446–1(e) and follow the administrative procedures issued under § 1.446–1(e)(3)(ii) for obtaining the Commissioner’s consent to change its accounting method.

(h) Effective/applicability date—(1) In general. Except for paragraph (f) of this section, this section generally applies to taxable years beginning on or after January 1, 2014. Paragraph (f) of this section applies to amounts paid in taxable years beginning on or after January 1, 2014. Except as provided in paragraph (h)(1) and paragraph (h)(2) of this section, § 1.263(a)–1 as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014.

(2) Early application of this section— (i) In general. Except for paragraph (f) of this section, a taxpayer may choose to apply this section to taxable years beginning on or after January 1, 2012. A taxpayer may choose to apply paragraph (f) of this section to amounts paid in

taxable years beginning on or after January 1, 2012.

(ii) Transition rule for de minimis safe harbor election on 2012 or 2013 returns. If under paragraph (h)(2)(i) of this section, a taxpayer chooses to make the election to apply the de minimis safe harbor under paragraph (f) of this section for amounts paid in its taxable year beginning on or after January 1, 2012, and ending on or before September 19, 2013 (applicable taxable year), and the taxpayer did not make the election specified in paragraph (f)(5) of this section on its timely filed original Federal tax return for the applicable taxable year, the taxpayer must make the election specified in paragraph (f)(5) of this section for the applicable taxable year by filing an amended Federal tax return for the applicable taxable year on or before 180 days from the due date including extensions of the taxpayer’s Federal tax return for the applicable taxable year, notwithstanding that the taxpayer may not have extended the due date.


§ 1.263(a)–1T [Removed]

! Par. 21. Section 1.263(a)–1T is removed. ! Par. 22. Section 1.263(a)–2 is revised to read as follows:

§ 1.263(a)–2 Amounts paid to acquire or produce tangible property.

(a) Overview. This section provides rules for applying section 263(a) to amounts paid to acquire or produce a unit of real or personal property. Paragraph (b) of this section contains definitions. Paragraph (c) of this section contains the rules for coordinating this section with other provisions of the Internal Revenue Code (Code). Paragraph (d) of this section provides the general requirement to capitalize amounts paid to acquire or produce a unit of real or personal property. Paragraph (e) of this section provides the requirement to capitalize amounts paid to defend or perfect title to real or personal property. Paragraph (f) of this section provides the rules for determining the extent to which taxpayers must capitalize transaction costs related to the acquisition of tangible property. Paragraphs (g) and (h) of this section address the treatment and recovery of capital expenditures. Paragraph (i) of this section provides for changes in methods of accounting to

comply with this section, and paragraph (j) of this section provides the effective and applicability dates for the rules under this section.

(b) Definitions. For purposes of this section, the following definitions apply:

(1) Amount paid. In the case of a taxpayer using an accrual method of accounting, the terms amount paid and payment mean a liability incurred (within the meaning of § 1.446– 1(c)(1)(ii)). A liability may not be taken into account under this section prior to the taxable year during which the liability is incurred.

(2) Personal property means tangible personal property as defined in § 1.48– 1(c).

(3) Real property means land and improvements thereto, such as buildings or other inherently permanent structures (including items that are structural components of the buildings or structures) that are not personal property as defined in paragraph (b)(2) of this section. Any property that constitutes other tangible property under § 1.48–1(d) is treated as real property for purposes of this section. Local law is not controlling in determining whether property is real property for purposes of this section.

(4) Produce means construct, build, install, manufacture, develop, create, raise, or grow. This definition is intended to have the same meaning as the definition used for purposes of section 263A(g)(1) and § 1.263A– 2(a)(1)(i), except that improvements are excluded from the definition in this paragraph (b)(4) and are separately defined and addressed in § 1.263(a)–3.

(c) Coordination with other provisions of the Code—(1) In general. Nothing in this section changes the treatment of any amount that is specifically provided for under any provision of the Code or the Treasury Regulations other than section 162(a) or section 212 and the regulations under those sections. For example, see section 263A requiring taxpayers to capitalize the direct and allocable indirect costs of property produced by the taxpayer and property acquired for resale. See also section 195 requiring taxpayers to capitalize certain costs as start-up expenditures.

(2) Materials and supplies. Nothing in this section changes the treatment of amounts paid to acquire or produce property that is properly treated as materials and supplies under § 1.162–3.

(d) Acquired or produced tangible property—(1) Requirement to capitalize. Except as provided in § 1.162–3 (relating to materials and supplies) and in § 1.263(a)–1(f) (providing a de minimis safe harbor election), a taxpayer must capitalize amounts paid


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to acquire or produce a unit of real or personal property (as determined under § 1.263(a)–3(e)), including leasehold improvements, land and land improvements, buildings, machinery and equipment, and furniture and fixtures. See § 1.263(a)–3(f) for the rules for determining whether amounts are for leasehold improvements. Amounts paid to acquire or produce a unit of real or personal property include the invoice price, transaction costs as determined under paragraph (f) of this section, and costs for work performed prior to the date that the unit of property is placed in service by the taxpayer (without regard to any applicable convention under section 168(d)). A taxpayer also must capitalize amounts paid to acquire real or personal property for resale.

(2) Examples. The following examples illustrate the rules of this paragraph (d). Unless otherwise provided, assume that the taxpayer does not elect the de minimis safe harbor under § 1.263(a)– 1(f) and that the property is not acquired for resale under section 263A.

Example 1. Acquisition of personal property. A purchases new cash registers for use in its retail store located in leased space in a shopping mall. Assume each cash register is a unit of property as determined under § 1.263(a)–3(e) and is not a material or supply under § 1.162–3. A must capitalize under paragraph (d)(1) of this section the amount paid to acquire each cash register.

Example 2. Acquisition of personal property that is a material or supply; coordination with § 1.162–3. B operates a fleet of aircraft. In Year 1, B acquires a stock of component parts, which it intends to use to maintain and repair its aircraft. Assume that each component part is a material or supply under § 1.162–3(c)(1) and B does not make elections under § 1.162–3(d) to treat the materials and supplies as capital expenditures. In Year 2, B uses the component parts in the repair and maintenance of its aircraft. Because the parts are materials and supplies under § 1.162–3, B is not required to capitalize the amounts paid for the parts under paragraph (d)(1) of this section. Rather, to determine the treatment of these amounts, B must apply the rules under § 1.162–3, governing the treatment of materials and supplies.

Example 3. Acquisition of unit of personal property; coordination with § 1.162–3. C operates a rental business that rents out a variety of small individual items to customers (rental items). C maintains a supply of rental items on hand to replace worn or damaged items. C purchases a large quantity of rental items to be used in its business. Assume that each of these rental items is a unit of property under § 1.263(a)– 3(e). Also assume that a portion of the rental items are materials and supplies under § 1.162–3(c)(1). Under paragraph (d)(1) of this section, C must capitalize the amounts paid for the rental items that are not materials and supplies under § 1.162–3(c)(1). However, C must apply the rules in § 1.162–3 to

determine the treatment of the rental items that are materials and supplies under § 1.162–3(c)(1).

Example 4. Acquisition or production cost. D purchases and produces jigs, dies, molds, and patterns for use in the manufacture of D’s products. Assume that each of these items is a unit of property as determined under § 1.263(a)–3(e) and is not a material and supply under § 1.162–3(c)(1). D is required to capitalize under paragraph (d)(1) of this section the amounts paid to acquire and produce the jigs, dies, molds, and patterns.

Example 5. Acquisition of land. F purchases a parcel of undeveloped real estate. F must capitalize under paragraph (d)(1) of this section the amount paid to acquire the real estate. See paragraph (f) of this section for the treatment of amounts paid to facilitate the acquisition of real property.

Example 6. Acquisition of building. G purchases a building. G must capitalize under paragraph (d)(1) of this section the amount paid to acquire the building. See paragraph (f) of this section for the treatment of amounts paid to facilitate the acquisition of real property.

Example 7. Acquisition of property for resale and production of property for sale; coordination with section 263A. H purchases goods for resale and produces other goods for sale. H must capitalize under paragraph (d)(1) of this section the amounts paid to acquire and produce the goods. See section 263A for the amounts required to be capitalized to the property produced or to the property acquired for resale.

Example 8. Production of building; coordination with section 263A. J constructs a building. J must capitalize under paragraph (d)(1) of this section the amount paid to construct the building. See section 263A for the costs required to be capitalized to the real property produced by J.

Example 9. Acquisition of assets constituting a trade or business. K owns tangible and intangible assets that constitute a trade or business. L purchases all the assets of K in a taxable transaction. L must capitalize under paragraph (d)(1) of this section the amount paid for the tangible assets of K. See § 1.263(a)–4 for the treatment of amounts paid to acquire or create intangibles and § 1.263(a)–5 for the treatment of amounts paid to facilitate the acquisition of assets that constitute a trade or business. See section 1060 for special allocation rules for certain asset acquisitions.

Example 10. Work performed prior to placing the property in service. In Year 1, M purchases a building for use as a business office. Prior to placing the building in service, M pays amounts to repair cement steps, refinish wood floors, patch holes in walls, and paint the interiors and exteriors of the building. In Year 2, M places the building in service and begins using the building as its business office. Assume that the work that M performs does not constitute an improvement to the building or its structural components under § 1.263(a)–3. Under § 1.263–3(e)(2)(i), the building and its structural components is a single unit of property. Under paragraph (d)(1) of this section, the amounts paid must be capitalized as amounts to acquire the

building unit of property because they were for work performed prior to M’s placing the building in service.

Example 11. Work performed prior to placing the property in service. In January Year 1, N purchases a new machine for use in an existing production line of its manufacturing business. Assume that the machine is a unit of property under § 1.263(a)–3(e) and is not a material or supply under § 1.162–3. N pays amounts to install the machine, and after the machine is installed, N pays amounts to perform a critical test on the machine to ensure that it will operate in accordance with quality standards. On November 1, Year 1, the critical test is complete, and N places the machine in service on the production line. N pays amounts to perform periodic quality control testing after the machine is placed in service. Under paragraph (d)(1) of this section, the amounts paid for the installation and the critical test performed before the machine is placed in service must be capitalized by N as amounts to acquire the machine. However, amounts paid for periodic quality control testing after N placed the machine in service are not required to be capitalized as amounts paid to acquire the machine.

(e) Defense or perfection of title to property—(1) In general. Amounts paid to defend or perfect title to real or personal property are amounts paid to acquire or produce property within the meaning of this section and must be capitalized.

(2) Examples. The following examples illustrate the rule of this paragraph (e):

Example 1. Amounts paid to contest condemnation. X owns real property located in County. County files an eminent domain complaint condemning a portion of X’s property to use as a roadway. X hires an attorney to contest the condemnation. The amounts that X paid to the attorney must be capitalized because they were to defend X’s title to the property.

Example 2. Amounts paid to invalidate ordinance. Y is in the business of quarrying and supplying for sale sand and stone in a certain municipality. Several years after Y establishes its business, the municipality in which it is located passes an ordinance that prohibits the operation of Y’s business. Y incurs attorney’s fees in a successful prosecution of a suit to invalidate the municipal ordinance. Y prosecutes the suit to preserve its business activities and not to defend Y’s title in the property. Therefore, the attorney’s fees that Y paid are not required to be capitalized under paragraph (e)(1) of this section.

Example 3. Amounts paid to challenge building line. The board of public works of a municipality establishes a building line across Z’s business property, adversely affecting the value of the property. Z incurs legal fees in unsuccessfully litigating the establishment of the building line. The amounts Z paid to the attorney must be capitalized because they were to defend Z’s title to the property.


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(f) Transaction costs—(1) In general. Except as provided in § 1.263(a)– 1(f)(3)(i) (for purposes of the de minimis safe harbor), a taxpayer must capitalize amounts paid to facilitate the acquisition of real or personal property. See § 1.263(a)–5 for the treatment of amounts paid to facilitate the acquisition of assets that constitute a trade or business. See § 1.167(a)–5 for allocations of facilitative costs between depreciable and non-depreciable property.

(2) Scope of facilitate—(i) In general. Except as otherwise provided in this section, an amount is paid to facilitate the acquisition of real or personal property if the amount is paid in the process of investigating or otherwise pursuing the acquisition. Whether an amount is paid in the process of investigating or otherwise pursuing the acquisition is determined based on all of the facts and circumstances. In determining whether an amount is paid to facilitate an acquisition, the fact that the amount would (or would not) have been paid but for the acquisition is relevant but is not determinative. Amounts paid to facilitate an acquisition include, but are not limited to, inherently facilitative amounts specified in paragraph (f)(2)(ii) of this section.

(ii) Inherently facilitative amounts. An amount is paid in the process of investigating or otherwise pursuing the acquisition of real or personal property if the amount is inherently facilitative. An amount is inherently facilitative if the amount is paid for—

(A) Transporting the property (for example, shipping fees and moving costs);

(B) Securing an appraisal or determining the value or price of property;

(C) Negotiating the terms or structure of the acquisition and obtaining tax advice on the acquisition;

(D) Application fees, bidding costs, or similar expenses;

(E) Preparing and reviewing the documents that effectuate the acquisition of the property (for example, preparing the bid, offer, sales contract, or purchase agreement);

(F) Examining and evaluating the title of property;

(G) Obtaining regulatory approval of the acquisition or securing permits related to the acquisition, including application fees;

(H) Conveying property between the parties, including sales and transfer taxes, and title registration costs;

(I) Finders’ fees or brokers’ commissions, including contingency

fees (defined in paragraph (f)(3)(iii) of this section);

(J) Architectural, geological, survey, engineering, environmental, or inspection services pertaining to particular properties; or

(K) Services provided by a qualified intermediary or other facilitator of an exchange under section 1031.

(iii) Special rule for acquisitions of real property—(A) In general. Except as provided in paragraph (f)(2)(ii) of this section (relating to inherently facilitative amounts), an amount paid by the taxpayer in the process of investigating or otherwise pursuing the acquisition of real property does not facilitate the acquisition if it relates to activities performed in the process of determining whether to acquire real property and which real property to acquire.

(B) Acquisitions of real and personal property in a single transaction. An amount paid by the taxpayer in the process of investigating or otherwise pursuing the acquisition of personal property facilitates the acquisition of such personal property, even if such property is acquired in a single transaction that also includes the acquisition of real property subject to the special rule set out in paragraph (f)(2)(iii)(A) of this section. A taxpayer may use a reasonable allocation method to determine which costs facilitate the acquisition of personal property and which costs relate to the acquisition of real property and are subject to the special rule of paragraph (f)(2)(iii)(A) of this section.

(iv) Employee compensation and overhead costs—(A) In general. For purposes of paragraph (f) of this section, amounts paid for employee compensation (within the meaning of § 1.263(a)–4(e)(4)(ii)) and overhead are treated as amounts that do not facilitate the acquisition of real or personal property. See section 263A, however, for the treatment of employee compensation and overhead costs required to be capitalized to property produced by the taxpayer or to property acquired for resale.

(B) Election to capitalize. A taxpayer may elect to treat amounts paid for employee compensation or overhead as amounts that facilitate the acquisition of property. The election is made separately for each acquisition and applies to employee compensation or overhead, or both. For example, a taxpayer may elect to treat overhead, but not employee compensation, as amounts that facilitate the acquisition of property. A taxpayer makes the election by treating the amounts to which the election applies as amounts that

facilitate the acquisition in the taxpayer’s timely filed original Federal tax return (including extensions) for the taxable year during which the amounts are paid. See §§ 301.9100–1 through 301.9100–3 of this chapter for the provisions governing extensions of time to make regulatory elections. In the case of an S corporation or a partnership, the election is made by the S corporation or by the partnership, and not by the shareholders or partners. A taxpayer may revoke an election made under this paragraph (f)(2)(iv)(B) with respect to each acquisition only by filing a request for a private letter ruling and obtaining the Commissioner’s consent to revoke the election. The Commissioner may grant a request to revoke this election if the taxpayer acted reasonably and in good faith and the revocation will not prejudice the interests of Government. See generally § 301.9100–3 of this chapter. The manner of electing and revoking the election to capitalize under this paragraph (f)(2)(iv)(B) may be modified through guidance of general applicability (see §§ 606.601(d)(2) and 601.602 of this section). An election may not be made or revoked through the filing of an application for change in accounting method or, before obtaining the Commissioner’s consent to make the late election or to revoke the election, by filing an amended Federal tax return.

(3) Treatment of transaction costs—(i) In general. Except as provided under § 1.263(a)–1(f)(3)(i) (for purposes of the de minimis safe harbor), all amounts paid to facilitate the acquisition of real or personal property are capital expenditures. Facilitative amounts allocable to real or personal property must be included in the basis of the property acquired.

(ii) Treatment of inherently facilitative amounts. Inherently facilitative amounts allocable to real or personal property are capital expenditures related to such property, even if the property is not eventually acquired. Except for contingency fees as defined in paragraph (f)(3)(iii) of this section, inherently facilitative amounts allocable to real or personal property not acquired may be allocated to those properties and recovered as appropriate in accordance with the applicable provisions of the Code and the Treasury Regulations (for example, sections 165, 167, or 168). See paragraph (h) of this section for the recovery of capitalized amounts.

(iii) Contingency Fees. For purposes of this section, a contingency fee is an amount paid that is contingent on the successful closing of the acquisition of real or personal property. Contingency fees must be included in the basis of the


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property acquired and may not be allocated to the property not acquired.

(4) Examples. The following examples illustrate the rules of paragraph (f) of this section. For purposes of these examples, assume that the taxpayer does not elect the de minimis safe harbor under § 1.263(a)–1(f):

Example 1. Broker’s fees to facilitate an acquisition. A decides to purchase a building in which to relocate its offices and hires a real estate broker to find a suitable building. A pays fees to the broker to find property for A to acquire. Under paragraph (f)(2)(ii)(I) of this section, A must capitalize the amounts paid to the broker because these costs are inherently facilitative of the acquisition of real property.

Example 2. Inspection and survey costs to facilitate an acquisition. B decides to purchase Building X and pays amounts to third-party contractors for a termite inspection and an environmental survey of Building X. Under paragraph (f)(2)(ii)(J) of this section, B must capitalize the amounts paid for the inspection and the survey of the building because these costs are inherently facilitative of the acquisition of real property.

Example 3. Moving costs to facilitate an acquisition. C purchases all the assets of D and, in connection with the purchase, hires a transportation company to move storage tanks from D’s plant to C’s plant. Under paragraph (f)(2)(ii)(A) of this section, C must capitalize the amount paid to move the storage tanks from D’s plant to C’s plant because this cost is inherently facilitative to the acquisition of personal property.

Example 4. Geological and geophysical costs; coordination with other provisions. E is in the business of exploring, purchasing, and developing properties in the United States for the production of oil and gas. E considers acquiring a particular property but first incurs costs for the services of an engineering firm to perform geological and geophysical studies to determine if the property is suitable for oil or gas production. Assume that the amounts that E paid to the engineering firm constitute geological and geophysical expenditures under section 167(h). Although the amounts that E paid for the geological and geophysical services are inherently facilitative to the acquisition of real property under paragraph (f)(2)(ii)(J) of this section, E is not required to include those amounts in the basis of the real property acquired. Rather, under paragraph (c) of this section, E must capitalize these costs separately and amortize such costs as required under section 167(h) (addressing the amortization of geological and geophysical expenditures).

Example 5. Scope of facilitate. F is in the business of providing legal services to clients. F is interested in acquiring a new conference table for its office. F hires and incurs fees for an interior designer to shop for, evaluate, and make recommendations to F regarding which new table to acquire. Under paragraphs (f)(1) and (2) of this section, F must capitalize the amounts paid to the interior designer to provide these services because they are paid in the process of investigating or otherwise pursuing the acquisition of personal property.

Example 6. Transaction costs allocable to multiple properties. G, a retailer, wants to acquire land for the purpose of building a new distribution facility for its products. G considers various properties on Highway X in State Y. G incurs fees for the services of an architect to advise and evaluate the suitability of the sites for the type of facility that G intends to construct on the selected site. G must capitalize the architect fees as amounts paid to acquire land because these amounts are inherently facilitative to the acquisition of land under paragraph (f)(2)(ii)(J) of this section.

Example 7. Transaction costs; coordination with section 263A. H, a retailer, wants to acquire land for the purpose of building a new distribution facility for its products. H considers various properties on Highway X in State Y. H incurs fees for the services of an architect to prepare preliminary floor plans for a building that H could construct at any of the sites. Under these facts, the architect’s fees are not facilitative to the acquisition of land under paragraph (f) of this section. Therefore, H is not required to capitalize the architect fees as amounts paid to acquire land. However, the amounts paid for the architect’s fees may be subject to capitalization under section 263A if these amounts comprise the direct or allocable indirect cost of property produced by H, such as the building.

Example 8. Special rule for acquisitions of real property. J owns several retail stores. J decides to examine the feasibility of opening a new store in City X. In October, Year 1, J hires and incurs costs for a development consulting firm to study City X and perform market surveys, evaluate zoning and environmental requirements, and make preliminary reports and recommendations as to areas that J should consider for purposes of locating a new store. In December, Year 1, J continues to consider whether to purchase real property in City X and which property to acquire. J hires, and incurs fees for, an appraiser to perform appraisals on two different sites to determine a fair offering price for each site. In March, Year 2, J decides to acquire one of these two sites for the location of its new store. At the same time, J determines not to acquire the other site. Under paragraph (f)(2)(iii) of this section, J is not required to capitalize amounts paid to the development consultant in Year 1 because the amounts relate to activities performed in the process of determining whether to acquire real property and which real property to acquire, and the amounts are not inherently facilitative costs under paragraph (f)(2)(ii) of this section. However, J must capitalize amounts paid to the appraiser in Year 1 because the appraisal costs are inherently facilitative costs under paragraph (f)(2)(ii)(B) of this section. In Year 2, J must include the appraisal costs allocable to property acquired in the basis of the property acquired. In addition, J may recover the appraisal costs allocable to the property not acquired in accordance with paragraphs (f)(3)(ii) and (h) of this section. See, for example, § 1.165–2 for losses on the permanent withdrawal of non-depreciable property.

Example 9. Contingency fee. K owns several restaurant properties. K decides to

open a new restaurant in City X. In October, Year 1, K hires a real estate consultant to identify potential property upon which K may locate its restaurant, and is obligated to compensate the consultant upon the acquisition of property. The real estate consultant identifies three properties, and K decides to acquire one of those properties. Upon closing of the acquisition of that property, K pays the consultant its fee. The amount paid to the consultant constitutes a contingency fee under paragraph (f)(3)(iii) of this section because the payment is contingent on the successful closing of the acquisition of property. Accordingly, under paragraph (f)(3)(iii) of this section, K must include the amount paid to the consultant in the basis of the property acquired. K is not permitted to allocate the amount paid between the properties acquired and not acquired.

Example 10. Employee compensation and overhead. L, a freight carrier, maintains an acquisition department whose sole function is to arrange for the purchase of vehicles and aircraft from manufacturers or other parties to be used in its freight carrying business. As provided in paragraph (f)(2)(iv)(A) of this section, L is not required to capitalize any portion of the compensation paid to employees in its acquisition department or any portion of its overhead allocable to its acquisition department. However, under paragraph (f)(2)(iv)(B) of this section, L may elect to capitalize the compensation and/or overhead costs allocable to the acquisition of a vehicle or aircraft by treating these amounts as costs that facilitate the acquisition of that property in its timely filed original Federal tax return for the year the amounts are paid.

(g) Treatment of capital expenditures. Amounts required to be capitalized under this section are capital expenditures and must be taken into account through a charge to capital account or basis, or in the case of property that is inventory in the hands of a taxpayer, through inclusion in inventory costs.

(h) Recovery of capitalized amounts— (1) In general. Amounts that are capitalized under this section are recovered through depreciation, cost of goods sold, or by an adjustment to basis at the time the property is placed in service, sold, used, or otherwise disposed of by the taxpayer. Cost recovery is determined by the applicable provisions of the Code and regulations relating to the use, sale, or disposition of property.

(2) Examples. The following examples illustrate the rule of paragraph (h)(1) of this section. For purposes of these examples, assume that the taxpayer does not elect the de minimis safe harbor under section § 1.263(a)–1(f).

Example 1. Recovery when property placed in service. X owns a 10-unit apartment building. The refrigerator in one of the apartments stops functioning, and X purchases a new refrigerator to replace the


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old one. X pays for the acquisition, delivery, and installation of the new refrigerator. Assume that the refrigerator is the unit of property, as determined under § 1.263(a)– 3(e), and is not a material or supply under § 1.162–3. Under paragraph (d)(1) of this section, X is required to capitalize the amounts paid for the acquisition, delivery, and installation of the refrigerator. Under this paragraph (h), the capitalized amounts are recovered through depreciation, which begins when the refrigerator is placed in service by X.

Example 2. Recovery when property used in the production of property. Y operates a plant where it manufactures widgets. Y purchases a tractor loader to move raw materials into and around the plant for use in the manufacturing process. Assume that the tractor loader is a unit of property, as determined under § 1.263(a)–3(e), and is not a material or supply under § 1.162–3. Under paragraph (d)(1) of this section, Y is required to capitalize the amounts paid to acquire the tractor loader. Under this paragraph (h), the capitalized amounts are recovered through depreciation, which begins when Y places the tractor loader in service. However, because the tractor loader is used in the production of property, under section 263A the cost recovery (that is, the depreciation) may also be capitalized to Y’s property produced, and, consequently, recovered through cost of goods sold. See § 1.263A– 1(e)(3)(ii)(I).

(i) Accounting method changes. Unless otherwise provided under this section, a change to comply with this section is a change in method of accounting to which the provisions of sections 446 and 481 and the accompanying regulations apply. A taxpayer seeking to change to a method of accounting permitted in this section must secure the consent of the Commissioner in accordance with § 1.446–1(e) and follow the administrative procedures issued under § 1.446–1(e)(3)(ii) for obtaining the Commissioner’s consent to change its accounting method.

(j) Effective/applicability date—(1) In general. Except for paragraphs (f)(2)(iii), (f)(2)(iv), and (f)(3)(ii) of this section, this section generally applies to taxable years beginning on or after January 1, 2014. Paragraphs (f)(2)(iii), (f)(2)(iv), and (f)(3)(ii) of this section apply to amounts paid in taxable years beginning on or after January 1, 2014. Except as provided in paragraphs (j)(1) and (j)(2) of this section, § 1.263(a)–2 as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014.

(2) Early application of this section– (i) In general. Except for paragraphs (f)(2)(iii), (f)(2)(iv), and (f)(3)(ii) of this section of this section, a taxpayer may choose to apply this section to taxable years beginning on or after January 1, 2012. A taxpayer may choose to apply

paragraphs (f)(2)(iii), (f)(2)(iv), and (f)(3)(ii) of this section to amounts paid in taxable years beginning on or after January 1, 2012.

(ii) Transition rule for election to capitalize employee compensation and overhead costs on 2012 or 2013 returns. If under paragraph (j)(2)(i) of this section, a taxpayer chooses to make the election to capitalize employee compensation and overhead costs under paragraph (f)(2)(iv)(B) of this section for amounts paid in its taxable year beginning on or after January 1, 2012, and ending on or before September 19, 2013 (applicable taxable year), and the taxpayer did not make the election specified in paragraph (f)(2)(iv)(B) of this section on its timely filed original Federal tax return for the applicable taxable year, the taxpayer must make the election specified in paragraph (f)(2)(iv)(B) of this section for the applicable taxable year by filing an amended Federal tax return for the applicable taxable year on or before 180 days from the due date including extensions of the taxpayer’s Federal tax return for the applicable taxable year, notwithstanding that the taxpayer may not have extended the due date.

(3) Optional application of TD 9564. Except for § 1.263(a)–2T(f)(2)(iii), (f)(2)(iv), (f)(3)(ii), and (g), a taxpayer may choose to apply § 1.263(a)–2T as contained in TD 9564 (76 FR 81060) December 27, 2011, to taxable years beginning on or after January 1, 2012, and before January 1, 2014. A taxpayer may choose to apply § 1.263(a)– 2T(f)(2)(iii), (f)(2)(iv), (f)(3)(ii) and (g) as contained in TD 9564 (76 FR 81060) December 27, 2011, to amounts paid in taxable years beginning on or after January 1, 2012, and before January 1, 2014.

§ 1.263(a)–2T [Removed]

! Par. 23. Section 1.263(a)–2T is removed. ! Par. 24. Section 1.263(a)–3 is revised to read as follows:

§ 1.263(a)–3 Amounts paid to improve tangible property.

(a) Overview. This section provides rules for applying section 263(a) to amounts paid to improve tangible property. Paragraph (b) of this section provides definitions. Paragraph (c) of this section provides rules for coordinating this section with other provisions of the Internal Revenue Code (Code). Paragraph (d) of this section provides the requirement to capitalize amounts paid to improve tangible property and provides the general rules for determining whether a unit of property is improved. Paragraph (e) of

this section provides the rules for determining the appropriate unit of property. Paragraph (f) of this section provides rules for leasehold improvements. Paragraph (g) of this section provides special rules for determining improvement costs in particular contexts, including indirect costs incurred during an improvement, removal costs, aggregation of related costs, and regulatory compliance costs. Paragraph (h) of this section provides a safe harbor for small taxpayers. Paragraph (i) provides a safe harbor for routine maintenance costs. Paragraph (j) of this section provides rules for determining whether amounts are paid for betterments to the unit of property. Paragraph (k) of this section provides rules for determining whether amounts are paid to restore the unit of property. Paragraph (l) of this section provides rules for amounts paid to adapt the unit of property to a new or different use. Paragraph (m) of this section provides an optional regulatory accounting method. Paragraph (n) of this section provides an election to capitalize repair and maintenance costs consistent with books and records. Paragraphs (o) and (p) of this section provide for the treatment and recovery of amounts capitalized under this section. Paragraphs (q) and (r) of this section provide for accounting method changes and state the effective/applicability date for the rules in this section.


(1) Amount paid. In the case of a taxpayer using an accrual method of accounting, the terms amounts paid and payment mean a liability incurred (within the meaning of § 1.446– 1(c)(1)(ii)). A liability may not be taken into account under this section prior to the taxable year during which the liability is incurred.

(2) Personal property means tangible personal property as defined in § 1.48– 1(c).

(3) Real property means land and improvements thereto, such as buildings or other inherently permanent structures (including items that are structural components of the buildings or structures) that are not personal property as defined in paragraph (b)(2) of this section. Any property that constitutes other tangible property under § 1.48–1(d) is also treated as real property for purposes of this section. Local law is not controlling in determining whether property is real property for purposes of this section.

(4) Owner means the taxpayer that has the benefits and burdens of ownership of the unit of property for Federal income tax purposes.


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(c) Coordination with other provisions of the Code—(1) In general. Nothing in this section changes the treatment of any amount that is specifically provided for under any provision of the Code or the regulations other than section 162(a) or section 212 and the regulations under those sections. For example, see section 263A requiring taxpayers to capitalize the direct and allocable indirect costs of property produced and property acquired for resale.

(2) Materials and supplies. A material or supply as defined in § 1.162–3(c)(1) that is acquired and used to improve a unit of tangible property is subject to this section and is not treated as a material or supply under § 1.162–3.

(3) Example. The following example illustrates the rules of this paragraph (c):

Example. Railroad rolling stock. X is a railroad that properly treats amounts paid for the rehabilitation of railroad rolling stock as deductible expenses under section 263(d). X is not required to capitalize the amounts paid because nothing in this section changes the treatment of amounts specifically provided for under section 263(d).

(d) Requirement to capitalize amounts paid for improvements. Except as provided in paragraph (h) or paragraph (n) of this section or under § 1.263(a)– 1(f), a taxpayer generally must capitalize the related amounts (as defined in paragraph (g)(3) of this section) paid to improve a unit of property owned by the taxpayer. However, see paragraph (f) of this section for the treatment of amounts paid to improve leased property. See section 263A for the requirement to capitalize the direct and allocable indirect costs of property produced by the taxpayer and property acquired for resale; section 1016 for adding capitalized amounts to the basis of the unit of property; and section 168 for the treatment of additions or improvements for depreciation purposes. For purposes of this section, a unit of property is improved if the amounts paid for activities performed after the property is placed in service by the taxpayer—

(1) Are for a betterment to the unit of property (see paragraph (j) of this section);

(2) Restore the unit of property (see paragraph (k) of this section); or

(3) Adapt the unit of property to a new or different use (see paragraph (l) of this section).

(e) Determining the unit of property— (1) In general. The unit of property rules in this paragraph (e) apply only for purposes of section 263(a) and §§ 1.263(a)–1, 1.263(a)–2, 1.263(a)–3, and 1.162–3. Unless otherwise specified, the unit of property determination is based upon the functional interdependence standard

provided in paragraph (e)(3)(i) of this section. However, special rules are provided for buildings (see paragraph (e)(2) of this section), plant property (see paragraph (e)(3)(ii) of this section), network assets (see paragraph (e)(3)(iii) of this section), leased property (see paragraph (e)(2)(v) of this section for leased buildings and paragraph (e)(3)(iv) of this section for leased property other than buildings), and improvements to property (see paragraph (e)(4) of this section). Additional rules are provided if a taxpayer has assigned different MACRS classes or depreciation methods to components of property or subsequently changes the class or depreciation method of a component or other item of property (see paragraph (e)(5) of this section). Property that is aggregated or subject to a general asset account election or accounted for in a multiple asset account (that is, pooled) may not be treated as a single unit of property.

(2) Building—(i) In general. Except as otherwise provided in paragraphs (e)(4), and (e)(5)(ii) of this section, in the case of a building (as defined in § 1.48– 1(e)(1)), each building and its structural components (as defined in § 1.48– 1(e)(2)) is a single unit of property (‘‘building’’). See paragraph (e)(2)(iii) of this section for condominiums, paragraph (e)(2)(iv) of this section for cooperatives, and paragraph (e)(2)(v) of this section for leased buildings.

(ii) Application of improvement rules to a building. An amount is paid to improve a building under paragraph (d) of this section if the amount is paid for an improvement under paragraphs (j), (k), or paragraph (l) of this section to any of the following:

(A) Building structure. A building structure consists of the building (as defined in § 1.48–1(e)(1)), and its structural components (as defined in § 1.48–1(e)(2)), other than the structural components designated as buildings systems in paragraph (e)(2)(ii)(B) of this section.

(B) Building system. Each of the following structural components (as defined in § 1.48–1(e)(2)), including the components thereof, constitutes a building system that is separate from the building structure, and to which the improvement rules must be applied—

(1) Heating, ventilation, and air conditioning (‘‘HVAC’’) systems (including motors, compressors, boilers, furnace, chillers, pipes, ducts, radiators);

(2) Plumbing systems (including pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment, and site utility equipment used to distribute water and

waste to and from the property line and between buildings and other permanent structures);

(3) Electrical systems (including wiring, outlets, junction boxes, lighting fixtures and associated connectors, and site utility equipment used to distribute electricity from the property line to and between buildings and other permanent structures);

(4) All escalators; (5) All elevators; (6) Fire-protection and alarm systems

(including sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detection devices, fire escapes, fire doors, emergency exit lighting and signage, and fire fighting equipment, such as extinguishers, and hoses);

(7) Security systems for the protection of the building and its occupants (including window and door locks, security cameras, recorders, monitors, motion detectors, security lighting, alarm systems, entry and access systems, related junction boxes, associated wiring and conduit);

(8) Gas distribution system (including associated pipes and equipment used to distribute gas to and from the property line and between buildings or permanent structures); and

(9) Other structural components identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(b) of this chapter) that are excepted from the building structure under paragraph (e)(2)(ii)(A) of this section and are specifically designated as building systems under this section.

(iii) Condominium—(A) In general. In the case of a taxpayer that is the owner of an individual unit in a building with multiple units (such as a condominium), the unit of property (‘‘condominium’’) is the individual unit owned by the taxpayer and the structural components (as defined in § 1.48–1(e)(2)) that are part of the unit.

(B) Application of improvement rules to a condominium. An amount is paid to improve a condominium under paragraph (d) of this section if the amount is paid for an improvement under paragraphs (j), (k), or paragraph (l) of this section to the building structure (as defined in paragraph (e)(2)(ii)(A) of this section) that is part of the condominium or to the portion of any building system (as defined in paragraph (e)(2)(ii)(B) of this section) that is part of the condominium. In the case of the condominium management association, the association must apply the improvement rules to the building


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structure or to any building system described under paragraphs (e)(2)(ii)(A) and (e)(2)(ii)(B) of this section.

(iv) Cooperative—(A) In general. In the case of a taxpayer that has an ownership interest in a cooperative housing corporation, the unit of property (‘‘cooperative’’) is the portion of the building in which the taxpayer has possessory rights and the structural components (as defined in § 1.48– 1(e)(2)) that are part of the portion of the building subject to the taxpayer’s possessory rights (cooperative).

(B) Application of improvement rules to a cooperative. An amount is paid to improve a cooperative under paragraph (d) of this section if the amount is paid for an improvement under paragraphs (j), (k), or (l) of this section to the portion of the building structure (as defined in paragraph (e)(2)(ii)(A) of this section) in which the taxpayer has possessory rights or to the portion of any building system (as defined in paragraph (e)(2)(ii)(B) of this section) that is part of the portion of the building structure subject to the taxpayer’s possessory rights. In the case of a cooperative housing corporation, the corporation must apply the improvement rules to the building structure or to any building system as described under paragraphs (e)(2)(ii)(A) and (e)(2)(ii)(B) of this section.

(v) Leased building—(A) In general. In the case of a taxpayer that is a lessee of all or a portion of a building (such as an office, floor, or certain square footage), the unit of property (‘‘leased building 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.

(B) Application of improvement rules to a leased building. An amount is paid to improve a leased building property under paragraphs (d) and (f)(2) of this section if the amount is paid for an improvement, under paragraphs (j), (k), or (l) of this section, to any of the following:

(1) Entire building. In the case of a taxpayer that is a lessee of an entire building, the building structure (as defined under paragraph (e)(2)(ii)(A) of this section) or any building system (as defined under paragraph (e)(2)(ii)(B) of this section) that is part of the leased building.

(2) Portion of a building. In the case of a taxpayer that is a lessee of a portion of a building (such as an office, floor, or certain square footage), the portion of the building structure (as defined under paragraph (e)(2)(ii)(A) of this section) subject to the lease or the portion of any building system (as defined under

paragraph (e)(2)(ii)(B) of this section) subject to the lease.

(3) Property other than building—(i) In general. Except as otherwise provided in paragraphs (e)(3), (e)(4), (e)(5), and (f)(1) of this section, in the case of real or personal property other than property described in paragraph (e)(2) of this section, all the components that are functionally interdependent comprise a single unit of property. Components of property are functionally interdependent if the placing in service of one component by the taxpayer is dependent on the placing in service of the other component by the taxpayer.

(ii) Plant property—(A) Definition. For purposes of this paragraph (e), the term plant property means functionally interdependent machinery or equipment, other than network assets, used to perform an industrial process, such as manufacturing, generation, warehousing, distribution, automated materials handling in service industries, or other similar activities.

(B) Unit of property for plant property. In the case of plant property, the unit of property determined under the general rule of paragraph (e)(3)(i) of this section is further divided into smaller units comprised of each component (or group of components) that performs a discrete and major function or operation within the functionally interdependent machinery or equipment.

(iii) Network assets—(A) Definition. For purposes of this paragraph (e), the term network assets means railroad track, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines that are owned or leased by taxpayers in each of those respective industries. The term includes, for example, trunk and feeder lines, pole lines, and buried conduit. It does not include property that would be included as building structure or building systems under paragraphs (e)(2)(ii)(A) and (e)(2)(ii)(B) of this section, nor does it include separate property that is adjacent to, but not part of a network asset, such as bridges, culverts, or tunnels.

(B) Unit of property for network assets. 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 published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(b) of this chapter). For these purposes, the functional interdependence standard provided in

paragraph (e)(3)(i) of this section is not determinative.

(iv) Leased property other than buildings. In the case of a taxpayer that is a lessee of real or personal property other than property described in paragraph (e)(2) of this section, the unit of property for the leased property is determined under paragraphs (e)(3)(i),(ii), (iii), and (e)(5) of this section except that, after applying the applicable rules under those paragraphs, the unit of property may not be larger than the property subject to the lease.

(4) Improvements to property. An improvement to a unit of property generally is not a unit of property separate from the unit of property improved. For the unit of property for lessee improvements, see also paragraph (f)(2)(ii)) of this section. If a taxpayer elects to treat as a capital expenditure under § 1.162–3(d) the amount paid for a rotable spare part, temporary spare part, or standby emergency spare part, and such part is used in an improvement to a unit of property, then for purposes of applying paragraph (d) of this section to the unit of property improved, the part is not a unit of property separate from the unit of property improved.

(5) Additional rules—(i) Year placed in service. Notwithstanding the unit of property determination under paragraph (e)(3) of this section, a component (or a group of components) of a unit property must be treated as a separate unit of property if, at the time the unit of property is initially placed in service by the taxpayer, the taxpayer has properly treated the component as being within a different class of property under section 168(e) (MACRS classes) than the class of the unit of property of which the component is a part, or the taxpayer has properly depreciated the component using a different depreciation method than the depreciation method of the unit of property of which the component is a part.

(ii) Change in subsequent taxable year. Notwithstanding the unit of property determination under paragraphs (e)(2), (3), (4), or (5)(i) of this section, in any taxable year after the unit of property is initially placed in service by the taxpayer, if the taxpayer or the Internal Revenue Service changes the treatment of that property (or any portion thereof) to a proper MACRS class or a proper depreciation method (for example, as a result of a cost segregation study or a change in the use of the property), then the taxpayer must change the unit of property determination for that property (or the portion thereof) under this section to be consistent with the change in treatment


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for depreciation purposes. Thus, for example, if a portion of a unit of property is properly reclassified to a MACRS class different from the MACRS class of the unit of property of which it was previously treated as a part, then the reclassified portion of the property should be treated as a separate unit of property for purposes of this section.

(6) Examples. The following examples illustrate the application of this paragraph (e) and assume that the taxpayer has not made a general asset account election with regard to property or accounted for property in a multiple asset account. In addition, unless the facts specifically indicate otherwise, assume that the additional rules in paragraph (e)(5) of this section do not apply:

Example 1. Building systems. A owns an office building that contains a HVAC system. The HVAC system incorporates ten roof- mounted units that service different parts of the building. The roof-mounted units are not connected and have separate controls and duct work that distribute the heated or cooled air to different spaces in the building’s interior. A pays an amount for labor and materials for work performed on the roof-mounted units. Under paragraph (e)(2)(i) of this section, A must treat the building and its structural components as a single unit of property. As provided under paragraph (e)(2)(ii) of this section, an amount is paid to improve a building if it is for an improvement to the building structure or any designated building system. Under paragraph (e)(2)(ii)(B)(1) of this section, the entire HVAC system, including all of the roof- mounted units and their components, comprise a building system. Therefore, under paragraph (e)(2)(ii) of this section, if an amount paid by A for work on the roof- mounted units is an improvement (for example, a betterment) to the HVAC system, A must treat this amount as an improvement to the building.

Example 2. Building systems. B owns a building that it uses in its retail business. The building contains two elevator banks in different locations in its building. Each elevator bank contains three elevators. B pays an amount for labor and materials for work performed on the elevators. Under paragraph (e)(2)(i) of this section, B must treat the building and its structural components as a single unit of property. As provided under paragraph (e)(2)(ii) of this section, an amount is paid to improve a building if it is for an improvement to the building structure or any designated building system. Under paragraph (e)(2)(ii)(B)(5) of this section, all six elevators, including all their components, comprise a building system. Therefore, under paragraph (e)(2)(ii) of this section, if an amount paid by B for work on the elevators is an improvement (for example, a betterment) to the elevator system, B must treat this amount as an improvement to the building.

Example 3. Building structure and systems; condominium. C owns a condominium unit in a condominium office building. C uses the condominium unit in its business of

providing medical services. The condominium unit contains two restrooms, each of which contains a sink, a toilet, water and drainage pipes and other bathroom fixtures. C pays an amount for labor and materials to perform work on the pipes, sinks, toilets, and plumbing fixtures that are part of the condominium. Under paragraph (e)(2)(iii) of this section, C must treat the individual unit that it owns, including the structural components that are part of that unit, as a single unit of property. As provided under paragraph (e)(2)(iii)(B) of this section, an amount is paid to improve the condominium if it is for an improvement to the building structure that is part of the condominium or to a portion of any designated building system that is part of the condominium. Under paragraph (e)(2)(ii)(B)(2) of this section, the pipes, sinks, toilets, and plumbing fixtures that are part of C’s condominium comprise the plumbing system for the condominium. Therefore, under paragraph (e)(2)(iii) of this section, if an amount paid by C for work on pipes, sinks, toilets, and plumbing fixtures is an improvement (for example, a betterment) to the portion of the plumbing system that is part of C’s condominium, C must treat this amount as an improvement to the condominium.

Example 4. Building structure and systems; property other than buildings. D, a manufacturer, owns a building adjacent to its manufacturing facility that contains office space and related facilities for D’s employees that manage and administer D’s manufacturing operations. The office building contains equipment, such as desks, chairs, computers, telephones, and bookshelves that are not building structure or building systems. D pays an amount to add an extension to the office building. Under paragraph (e)(2)(i) of this section, D must treat the building and its structural components as a single unit of property. As provided under paragraph (e)(2)(ii) of this section, an amount is paid to improve a building if it is for an improvement to the building structure or any designated building system. Therefore, under paragraph (e)(2)(ii) of this section, if an amount paid by D for the addition of an extension to the office building is an improvement (for example, a betterment) to the building structure or any of the building systems, D must treat this amount as an improvement to the building. In addition, because the equipment contained within the office building constitutes property other than the building, the units of property for the office equipment are initially determined under paragraph (e)(3)(i) of this section and are comprised of all the components that are functionally interdependent (for example, each desk, each chair, and each book shelf).

Example 5. Plant property; discrete and major function. E is an electric utility company that operates a power plant to generate electricity. The power plant includes a structure that is not a building under § 1.48–1(e)(1), and, among other things, one pulverizer that grinds coal, a single boiler that produces steam, one turbine that converts the steam into mechanical energy, and one generator that converts

mechanical energy into electrical energy. In addition, the turbine contains a series of blades that cause the turbine to rotate when affected by the steam. Because the plant is composed of real and personal tangible property other than a building, the unit of property for the generating equipment is initially determined under the general rule in paragraph (e)(3)(i) of this section and is comprised of all the components that are functionally interdependent. Under this rule, the initial unit of property is the entire plant because the components of the plant are functionally interdependent. However, because the power plant is plant property under paragraph (e)(3)(ii) of this section, the initial unit of property is further divided into smaller units of property by determining the components (or groups of components) that perform discrete and major functions within the plant. Under this paragraph, E must treat the structure, the boiler, the turbine, the generator, and the pulverizer each as a separate unit of property because each of these components performs a discrete and major function within the power plant. E may not treat components, such as the turbine blades, as separate units of property because each of these components does not perform a discrete and major function within the plant.

Example 6. Plant property; discrete and major function. F is engaged in a uniform and linen rental business. F owns and operates a plant that utilizes many different machines and equipment in an assembly line-like process to treat, launder, and prepare rental items for its customers. F utilizes two laundering lines in its plant, each of which can operate independently. One line is used for uniforms and another line is used for linens. Both lines incorporate a sorter, boiler, washer, dryer, ironer, folder, and waste water treatment system. Because the laundering equipment contained within the plant is property other than a building, the unit of property for the laundering equipment is initially determined under the general rule in paragraph (e)(3)(i) of this section and is comprised of all the components that are functionally interdependent. Under this rule, the initial units of property are each laundering line because each line is functionally independent and is comprised of components that are functionally interdependent. However, because each line is comprised of plant property under paragraph (e)(3)(ii) of this section, F must further divide these initial units of property into smaller units of property by determining the components (or groups of components) that perform discrete and major functions within the line. Under paragraph (e)(3)(ii) of this section, F must treat each sorter, boiler, washer, dryer, ironer, folder, and waste water treatment system in each line as a separate unit of property because each of these components performs a discrete and major function within the line.

Example 7. Plant property; industrial process. G operates a restaurant that prepares and serves food to retail customers. Within its restaurant, G has a large piece of equipment that uses an assembly line-like process to prepare and cook tortillas that G


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serves only to its restaurant customers. Because the tortilla-making equipment is property other than a building, the unit of property for the equipment is initially determined under the general rule in paragraph (e)(3)(i) of this section and is comprised of all the components that are functionally interdependent. Under this rule, the initial unit of property is the entire tortilla-making equipment because the various components of the equipment are functionally interdependent. The equipment is not plant property under paragraph (e)(3)(ii) of this section because the equipment is not used in an industrial process, as it performs a small-scale function in G’s restaurant operations. Thus, G is not required to further divide the equipment into separate units of property based on the components that perform discrete and major functions.

Example 8. Personal property. H owns locomotives that it uses in its railroad business. Each locomotive consists of various components, such as an engine, generators, batteries, and trucks. H acquired a locomotive with all its components. Because H’s locomotive is property other than a building, the initial unit of property is determined under the general rule in paragraph (e)(3)(i) of this section and is comprised of the components that are functionally interdependent. Under paragraph (e)(3)(i) of this section, the locomotive is a single unit of property because it consists entirely of components that are functionally interdependent.

Example 9. Personal property. J provides legal services to its clients. J purchased a laptop computer and a printer for its employees to use in providing legal services. Because the computer and printer are property other than a building, the initial units of property are determined under the general rule in paragraph (e)(3)(i) of this section and are comprised of the components that are functionally interdependent. Under paragraph (e)(3)(i) of this section, the computer and the printer are separate units of property because the computer and the printer are not components that are functionally interdependent (that is, the placing in service of the computer is not dependent on the placing in service of the printer).

Example 10. Building structure and systems; leased building. K is a retailer of consumer products. K conducts its retail sales in a building that it leases from L. The leased building consists of the building structure (including the floor, walls, and roof) and various building systems, including a plumbing system, an electrical system, an HVAC system, a security system, and a fire protection and prevention system. K pays an amount for labor and materials to perform work on the HVAC system of the leased building. Under paragraph (e)(2)(v)(A) of this section, because K leases the entire building, K must treat the leased building and its structural components as a single unit of property. As provided under paragraph (e)(2)(v)(B) of this section, an amount is paid to improve a leased building property if it is for an improvement (for example, a betterment) to the leased building structure

or to any building system within the leased building. Therefore, under paragraphs (e)(2)(v)(B)(1) and (e)(2)(ii)(B)(1) of this section, if an amount paid by K for work on the HVAC system is for an improvement to the HVAC system in the leased building, K must treat this amount as an improvement to the entire leased building property.

Example 11. Production of real property related to leased property. Assume the same facts as in Example 10, except that K receives a construction allowance from L, and K uses the construction allowance to build a driveway adjacent to the leased building. Assume that under the terms of the lease, K, the lessee, is treated as the owner of any property that it constructs on or nearby the leased building. Also assume that section 110 does not apply to the construction allowance. Finally, assume that the driveway is not plant property or a network asset. Because the construction of the driveway consists of the production of real property other than a building, all the components of the driveway are functionally interdependent and are a single unit of property under paragraphs (e)(3)(i) and (e)(3)(iv) of this section.

Example 12. Leasehold improvements; construction allowance used for lessor-owned improvements. Assume the same facts as Example 11, except that, under the terms of the lease, L, the lessor, is treated as the owner of any property constructed on the leased premises. Because L, the lessor, is the owner of the driveway and the driveway is real property other than a building, all the components of the driveway are functionally interdependent and are a single unit of property under paragraph (e)(3)(i) of this section.

Example 13. Buildings and structural components; leased office space. M provides consulting services to its clients. M conducts its consulting services business in two office spaces in the same building, each of which it leases from N under separate lease agreements. Each office space contains a separate HVAC system, which is part of the leased property. Both lease agreements provide that M is responsible for maintaining, repairing, and replacing the HVAC system that is part of the leased property. M pays amounts to perform work on the HVAC system in each office space. Because M leases two separate office spaces subject to two leases, M must treat the portion of the building structure and the structural components subject to each lease as a separate unit of property under paragraph (e)(2)(v)(A) of this section. As provided under paragraph (e)(2)(v)(B) of this section, an amount is paid to improve a leased building property, if it is for an improvement to the leased portion of the building structure or the portion of any designated building system subject to each lease. Under paragraphs (e)(2)(v)(B)(1) and (e)(2)(ii)(B)(1) of this section, M must treat the HVAC system associated with each leased office space as a building system of that leased building property. Thus, M must treat the HVAC system associated with the first leased office space as a building system of the first leased office space and the HVAC system associated with the second leased office space as a building system of the

second leased office space. Under paragraph (e)(2)(v)(B) of this section, if the amount paid by M for work on the HVAC system in one leased office space is for an improvement (for example, a betterment) to the HVAC system that is part of that leased space, then M must treat the amount as an improvement to that individual leased property.

Example 14. Leased property; personal property. N is engaged in the business of transporting passengers on private jet aircraft. To conduct its business, N leases several aircraft from O. Under paragraph (e)(3)(iv) of this section (referencing paragraph (e)(3)(i) of this section), N must treat all of the components of each leased aircraft that are functionally interdependent as a single unit of property. Thus, N must treat each leased aircraft as a single unit of property.

Example 15. Improvement property. (i) P is a retailer of consumer products. In Year 1, P purchases a building from Q, which P intends to use as a retail sales facility. Under paragraph (e)(2)(i) of this section, P must treat the building and its structural components as a single unit of property. As provided under paragraph (e)(2)(ii) of this section, an amount is paid to improve a building if it is for an improvement to the building structure or any designated building system.

(ii) In Year 2, P pays an amount to construct an extension to the building to be used for additional warehouse space. Assume that the extension involves the addition of walls, floors, roof, and doors, but does not include the addition or extension of any building systems described in paragraph (e)(2)(ii)(B) of this section. Also assume that the amount paid to build the extension is a betterment to the building structure under paragraph (j) of this section, and is therefore treated as an amount paid for an improvement to the entire building under paragraph (e)(2)(ii) of this section. Accordingly, P capitalizes the amount paid as an improvement to the building under paragraph (d) of this section. Under paragraph (e)(4) of this section, the extension is not a unit of property separate from the building, the unit of property improved. Thus, to determine whether any future expenditure constitutes an improvement to the building under paragraph (e)(2)(ii) of this section, P must determine whether the expenditure constitutes an improvement to the building structure, including the building extension, or to any of the designated building systems.

Example 16. Additional rules; year placed in service. R is engaged in the business of transporting freight throughout the United States. To conduct its business, R owns a fleet of truck tractors and trailers. Each tractor and trailer is comprised of various components, including tires. R purchased a truck tractor with all of its components, including tires. The tractor tires have an average useful life to R of more than one year. At the time R placed the tractor in service, it treated the tractor tires as a separate asset for depreciation purposes under section 168. R properly treated the tractor (excluding the cost of the tires) as 3-year property and the tractor tires as 5-year property under section 168(e). Because R’s tractor is property other


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than a building, the initial units of property for the tractor are determined under the general rule in paragraph (e)(3)(i) of this section and are comprised of all the components that are functionally interdependent. Under this rule, R must treat the tractor, including its tires, as a single unit of property because the tractor and the tires are functionally interdependent (that is, the placing in service of the tires is dependent upon the placing in service of the tractor). However, under paragraph (e)(5)(i) of this section, R must treat the tractor and tires as separate units of property because R properly treated the tires as being within a different class of property under section 168(e).

Example 17. Additional rules; change in subsequent year. S is engaged in the business of leasing nonresidential real property to retailers. In Year 1, S acquired and placed in service a building for use in its retail leasing operation. In Year 5, to accommodate the needs of a new lessee, S incurred costs to improve the building structure. S capitalized the costs of the improvement under paragraph (d) of this section and depreciated the improvement in accordance with section 168(i)(6) as nonresidential real property under section 168(e). In Year 7, S determined that the structural improvement made in Year 5 qualified under section 168(e)(8) as qualified retail improvement property and, therefore, was 15-year property under section 168(e). In Year 7, S changed its method of accounting to use a 15-year recovery period for the improvement. Under paragraph (e)(5)(ii) of this section, in Year 7, S must treat the improvement as a unit of property separate from the building.

Example 18. Additional rules; change in subsequent year. In Year 1, T acquired and placed in service a building and parking lot for use in its retail operations. Under § 1.263(a)–2 of the regulations, T capitalized the cost of the building and the parking lot and began depreciating the building and the parking lot as nonresidential real property under section 168(e). In Year 3, T completed a cost segregation study under which it properly determined that the parking lot qualified as 15-year property under section 168(e). In Year 3, T changed its method of accounting for the parking lot to use a 15- year recovery period and the 150-percent declining balance method of depreciation. Under paragraph (e)(5)(ii) of this section, beginning in Year 3, T must treat the parking lot as a unit of property separate from the building.

Example 19. Additional rules; change in subsequent year. In Year 1, U acquired and placed in service a building for use in its manufacturing business. U capitalized the costs allocable to the building’s wiring separately from the building and depreciated the wiring as 7-year property under section 168(e). U capitalized the cost of the building and all other structural components of the building and began depreciating them as nonresidential real property under section 168(e). In Year 3, U completed a cost segregation study under which it properly determined that the wiring is a structural component of the building and, therefore, should have been depreciated as nonresidential real property. In Year 3, U

changed its method of accounting to treat the wiring as nonresidential real property. Under paragraph (e)(5)(ii) of this section, U must change the unit of property for the wiring in a manner that is consistent with the change in treatment for depreciation purposes. Therefore, U must change the unit of property for the wiring to treat it as a structural component of the building, and as part of the building unit of property, in accordance with paragraph (e)(2)(i) of this section.

(f) Improvements to leased property— (1) In general. Except as provided in paragraph (h) of this section (safe harbor for small taxpayers) and under § 1.263(a)–1(f) (de minimis safe harbor), this paragraph (f) provides the exclusive rules for determining whether amounts paid by a taxpayer are for an improvement to a leased property and must be capitalized. In the case of a leased building or a leased portion of a building, an amount is paid to improve a leased property if the amount is paid for an improvement to any of the properties specified in paragraph (e)(2)(ii) of this section (for lessor improvements) or in paragraph (e)(2)(v)(B) of this section (for lessee improvements, except as provided in paragraph (f)(2)(ii) of this section). Section 1.263(a)–4 does not apply to amounts paid for improvements to leased property or to amounts paid for the acquisition or production of leasehold improvement property.

(2) Lessee improvements—(i) Requirement to capitalize. A taxpayer lessee must capitalize the related amounts (see paragraph (g)(3) of this section) that it pays to improve (as defined under paragraph (d) of this section) a leased property except to the extent that section 110 applies to a construction allowance received by the lessee for the purpose of such improvement or when the improvement constitutes a substitute for rent. See § 1.61–8(c) for the treatment of lessee expenditures that constitute a substitute for rent. A taxpayer lessee must also capitalize the related amounts that a lessor pays to improve (as defined under paragraph (d) of this section) a leased property if the lessee is the owner of the improvement, except to the extent that section 110 applies to a construction allowance received by the lessee for the purpose of such improvement. An amount paid for a lessee improvement under this paragraph (f)(2)(i) is treated as an amount paid to acquire or produce a unit of real or personal property under § 1.263(a)–2(d)(1) of the regulations.

(ii) Unit of property for lessee improvements. For purposes of determining whether an amount paid by a lessee constitutes a lessee

improvement to a leased property under paragraph (f)(2)(i) of this section, the unit of property and the improvement rules are applied to the leased property in accordance with paragraph (e)(2)(v) (leased buildings) or paragraph (e)(3)(iv) (leased property other than buildings) of this section and include previous lessee improvements. However, if a lessee improvement is comprised of an entire building erected on leased property, then the unit of property for the building and the application of the improvement rules to the building are determined under paragraphs (e)(2)(i) and (e)(2)(ii) of this section.

(3) Lessor improvements—(i) Requirement to capitalize. A taxpayer lessor must capitalize the related amounts (see paragraph (g)(3) of this section) that it pays directly, or indirectly through a construction allowance to the lessee, to improve (as defined in paragraph (d) of this section) a leased property when the lessor is the owner of the improvement or to the extent that section 110 applies to the construction allowance. A lessor must also capitalize the related amounts that the lessee pays to improve a leased property (as defined in paragraph (e) of this section) when the lessee’s improvement constitutes a substitute for rent. See § 1.61–8(c) for treatment of expenditures by lessees that constitute a substitute for rent. Amounts capitalized by the lessor under this paragraph (f)(3)(i) may not be capitalized by the lessee. If a lessor improvement is comprised of an entire building erected on leased property, then the amount paid for the building is treated as an amount paid by the lessor to acquire or produce a unit of property under § 1.263(a)–2(d)(1). See paragraphs (e)(2) of this section for the unit of property for a building and paragraph (e)(3) of this section for the unit of property for real or personal property other than a building.

(ii) Unit of property for lessor improvements. In general, an amount capitalized as a lessor improvement under paragraph (f)(3)(i) of this section is not a unit of property separate from the unit of property improved. See paragraph (e)(4) of this section. However, if a lessor improvement is comprised of an entire building erected on leased property, then the unit of property for the building and the application of the improvement rules to the building are determined under paragraphs (e)(2)(i) and (e)(2)(ii) of this section.

(4) Examples. The following examples illustrate the application of this paragraph (f) and do not address whether capitalization is required under


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another provision of the Code (for example, section 263A). For purposes of the following examples, assume that section 110 does not apply to the lessee and the amounts paid by the lessee are not a substitute for rent.

Example 1. Lessee improvements; additions to building. (i) T is a retailer of consumer products. In Year 1, T leases a building from L, which T intends to use as a retail sales facility. The leased building consists of the building structure under paragraph (e)(2)(ii)(A) of this section and various building systems under paragraph (e)(2)(ii)(B) of this section, including a plumbing system, an electrical system, and an HVAC system. Under the terms of the lease, T is permitted to improve the building at its own expense. Under paragraph (e)(2)(v)(A) of this section, because T leases the entire building, T must treat the leased building and its structural components as a single unit of property. As provided under paragraph (e)(2)(v)(B)(1) of this section, an amount is paid to improve a leased building property if the amount is paid for an improvement to the leased building structure or to any building system within the leased building. Therefore, under paragraphs (e)(2)(v)(B)(1) and (e)(2)(ii) of this section, if T pays an amount that improves the building structure, the plumbing system, the electrical system, or the HVAC system, then T must treat this amount as an improvement to the entire leased building property.

(ii) In Year 2, T pays an amount to construct an extension to the building to be used for additional warehouse space. Assume that this amount is for a betterment (as defined under paragraph (j) of this section) to T’s leased building structure and does not affect any building systems. Accordingly, the amount that T pays for the building extension is for a betterment to the leased building structure, and thus, under paragraph (e)(2)(v)(B)(1) of this section, is treated as an improvement to the entire leased building under paragraph (d) of this section. Because T, the lessee, paid an amount to improve a leased building property, T is required to capitalize the amount paid for the building extension as a leasehold improvement under paragraph (f)(2)(i) of this section. In addition, paragraph (f)(2)(i) of this section requires T to treat the amount paid for the improvement as the acquisition or production of a unit of property (leasehold improvement property) under § 1.263(a)–2(d)(1).

(iii) In Year 5, T pays an amount to add a large overhead door to the building extension that it constructed in Year 2 to accommodate the loading of larger products into the warehouse space. Under paragraph (f)(2)(ii) of this section, to determine whether the amount paid by T is for a leasehold improvement, the unit of property and the improvement rules are applied in accordance with paragraph (e)(2)(v) of this section and include T’s previous improvements to the leased property. Therefore, under paragraph (e)(2)(v)(A) of this section, the unit of property is the entire leased building, including the extension built in Year 2. In addition, under paragraph (e)(2)(v)(B) of this section, the leased building property is

improved if the amount is paid for an improvement to the building structure or any building system. Assume that the amount paid to add the overhead door is for a betterment, under paragraph (j) of this section, to the building structure, which includes the extension. Accordingly, T must capitalize the amounts paid to add the overhead door as a leasehold improvement to the leased building property. In addition, paragraph (f)(2)(i) of this section requires T to treat the amount paid for the improvement as the acquisition or production of a unit of property (leasehold improvement property) under § 1.263(a)–2(d)(1). However, to determine whether a future amount paid by T is for a leasehold improvement to the leased building, the unit of property and the improvement rules are again applied in accordance with paragraph (e)(2)(v) of this section and include the new overhead door.

Example 2. Lessee improvements; additions to certain structural components of buildings. (i) Assume the same facts as Example 1 except that in Year 2, T also pays an amount to construct an extension of the HVAC system into the building extension. Assume that the extension is a betterment, under paragraph (j) of this section, to the leased HVAC system (a building system under paragraph (e)(2)(ii)(B)(1) of this section). Accordingly, the amount that T pays for the extension of the HVAC system is for a betterment to the leased building system, the HVAC system, and thus, under paragraph (e)(2)(v)(B)(1) of this section, is treated as an improvement to the entire leased building property under paragraph (d) of this section. Because T, the lessee, pays an amount to improve a leased building property, T is required to capitalize the amount paid as a leasehold improvement under paragraph (f)(2)(i) of this section. Under paragraph (f)(2)(i) of this section, T must treat the amount paid for the HVAC extension as the acquisition and production of a unit of property (leasehold improvement property) under § 1.263(a)–2(d)(1).

(ii) In Year 5, T pays an amount to add an additional chiller to the portion of the HVAC system that it constructed in Year 2 to accommodate the climate control requirements for new product offerings. Under paragraph (f)(2)(ii) of this section, to determine whether the amount paid by T is for a leasehold improvement, the unit of property and the improvement rules are applied in accordance with paragraph (e)(2)(v) of this section and include T’s previous improvements to the leased building property. Therefore, under paragraph (e)(2)(v)(B) of this section, the leased building property is improved if the amount is paid for an improvement to the building structure or any building system. Assume that the amount paid to add the chiller is for a betterment, under paragraph (j) of this section, to the HVAC system, which includes the extension of the system in Year 2. Accordingly, T must capitalize the amounts paid to add the chiller as a leasehold improvement to the leased building property. In addition, paragraph (f)(2)(i) of this section requires T to treat the amount paid for the chiller as the acquisition or production of a unit of property (leasehold

improvement property) under § 1.263(a)– 2(d)(1). However, to determine whether a future amount paid by T is for a leasehold improvement to the leased building, the unit of property and the improvement rules are again applied in accordance with paragraph (e)(2)(v) of this section and include the new chiller.

Example 3. Lessor Improvements; additions to building. (i) T is a retailer of consumer products. In Year 1, T leases a building from L, which T intends to use as a retail sales facility. Pursuant to the lease, L provides a construction allowance to T, which T intends to use to construct an extension to the retail sales facility for additional warehouse space. Assume that the amount paid for any improvement to the building does not exceed the construction allowance and that L is treated as the owner of any improvement to the building. Under paragraph (e)(2)(i) of this section, L must treat the building and its structural components as a single unit of property. As provided under paragraph (e)(2)(ii) of this section, an amount is paid to improve a building if it is paid for an improvement to the building structure or to any building system.

(ii) In Year 2, T uses L’s construction allowance to construct an extension to the leased building to provide additional warehouse space in the building. Assume that the extension is a betterment (as defined under paragraph (j) of this section) to the building structure, and therefore, the amount paid for the extension results in an improvement to the building under paragraph (d) of this section. Under paragraph (f)(3)(i) of this section, L, the lessor and owner of the improvement, must capitalize the amounts paid to T to construct the extension to the retail sales facility. T is not permitted to capitalize the amounts paid for the lessor-owned improvement. Finally, under paragraph (f)(3)(ii) of this section, the extension to L’s building is not a unit of property separate from the building and its structural components.

Example 4. Lessee property; personal property added to leased building. T is a retailer of consumer products. T leases a building from L, which T intends to use as a retail sales facility. Pursuant to the lease, L provides a construction allowance to T, which T uses to acquire and construct partitions for fitting rooms, counters, and shelving. Assume that each partition, counter, and shelving unit is a unit of property under paragraph (e)(3) of this section. Assume that for Federal income tax purposes T is treated as the owner of the partitions, counters, and shelving. T’s expenditures for the partitions, counters, and shelving are not improvements to the leased property under paragraph (d) of this section, but rather constitute amounts paid to acquire or produce separate units of personal property under § 1.263(a)–2(d)(1).

Example 5. Lessor property; buildings on leased property. L is the owner of a parcel of unimproved real property that L leases to T. Pursuant to the lease, L provides a construction allowance to T of $500,000, which T agrees to use to construct a building costing not more than $500,000 on the leased


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real property and to lease the building from L after it is constructed. Assume that for Federal income tax purposes, L is treated as the owner of the building that T will construct. T uses the $500,000 to construct the building as required under the lease. The building consists of the building structure and the following building systems: (1) a plumbing system; (2) an electrical system; and (3) an HVAC system. Because L provides a construction allowance to T to construct a building and L is treated as the owner of the building, L must capitalize the amounts that it pays indirectly to T to construct the building as a lessor improvement under paragraph (f)(3)(i) of this section. In addition, the amounts paid by L for the construction allowance are treated as amounts paid by L to acquire and produce the building under § 1.263(a)–2(d)(1). Further, under paragraph (e)(2)(i) of this section, L must treat the building and its structural components as a single unit of property. Under paragraph (f)(3)(i) of this section, T, the lessee, may not capitalize the amounts paid (with the construction allowance received from L) for construction of the building.

Example 6. Lessee contribution to construction costs. Assume the same facts as in Example 5, except T spends $600,000 to construct the building. T uses the $500,000 construction allowance provided by L plus $100,000 of its own funds to construct the building that L will own pursuant to the lease. Also assume that the additional $100,000 that T pays is not a substitute for rent. For the reasons discussed in Example 5, L must capitalize the $500,000 it paid T to construct the building under § 1.263(a)– 2(d)(1). In addition, because T spends its own funds to complete the building, T has a depreciable interest of $100,000 in the building and must capitalize the $100,000 it paid to construct the building as a leasehold improvement under § 1.263(a)–2(d)(1) of the regulations. Under paragraph (e)(2)(i) of this section, L must treat the building as a single unit of property to the extent of its depreciable interest of $500,000. In addition, under paragraphs (f)(2)(ii) and (e)(2)(i) of this section, T must also treat the building as a single unit of property to the extent of its depreciable interest of $100,000.

(g) Special rules for determining improvement costs—(1) Certain costs incurred during an improvement—(i) In general. A taxpayer must capitalize all the direct costs of an improvement and all the indirect costs (including, for example, otherwise deductible repair costs) that directly benefit or are incurred by reason of an improvement. Indirect costs arising from activities that do not directly benefit and are not incurred by reason of an improvement are not required to be capitalized under section 263(a), regardless of whether the activities are performed at the same time as an improvement.

(ii) Exception for individuals’ residences. A taxpayer who is an individual may capitalize amounts paid for repairs and maintenance that are made at the same time as capital

improvements to units of property not used in the taxpayer’s trade or business or for the production of income if the amounts are paid as part of an improvement (for example, a remodeling) of the taxpayer’s residence.

(2) Removal Costs—(i) In general. If a taxpayer disposes of a depreciable asset, including a partial disposition under Prop. Reg. § 1.168(i)–1(e)(2)(ix) (September 19, 2013), or Prop. Reg. § 1.168(i)–8(d) (September 19, 2013), for Federal income tax purposes and has taken into account the adjusted basis of the asset or component of the asset in realizing gain or loss, then the costs of removing the asset or component are not required to be capitalized under this section. If a depreciable asset is included in a general asset account under section 168(i)(4), and neither the regulations under section 168(i)(4) and § 1.168(i)–1T(e)(3) nor Prop. Reg. § 1.168(i)–1(e)(3) (September 19, 2013), apply to a disposition of such asset, or a portion of such asset under Prop. Reg. § 1.168(i)–1(e)(2)(ix) (September 19, 2013), a loss is treated as being realized in the amount of zero upon the disposition of the asset solely for purposes of this paragraph (g)(2)(i). If a taxpayer disposes of a component of a unit of property, but the disposal of the component is not a disposition for Federal tax purposes, then the taxpayer must deduct or capitalize the costs of removing the component based on whether the removal costs directly benefit or are incurred by reason of a repair to the unit of property or an improvement to the unit of property. But see § 1.280B–1 for the rules applicable to demolition of structures.

(ii) Examples. The following examples illustrate the application of paragraph (g)(2)(i) of this section and, unless otherwise stated, do not address whether capitalization is required under another provision of this section or another provision of the Code (for example, section 263A). For purposes of the following examples, assume that Prop. Reg. § 1.168(i)–1(e) (September 19, 2013), or Prop. Reg. § 1.168(i)–8 (September 19, 2013), applies and that § 1.280B–1 does not apply.

Example 1. Component removed during improvement; no disposition. X owns a factory building with a storage area on the second floor. X pays an amount to remove the original columns and girders supporting the second floor and replace them with new columns and girders to permit storage of supplies with a gross weight 50 percent greater than the previous load-carrying capacity of the storage area. Assume that the replacement of the columns and girders constitutes a betterment to the building structure and is therefore an improvement to the building unit of property under

paragraphs (d)(1) and (j) of this section. Assume that X disposes of the original columns and girders and the disposal of these structural components is not a disposition under Prop. Reg. § 1.168(i)–1(e) (September 19, 2013), or Prop. Reg. § 1.168(i)- 8 (September 19, 2013). Under paragraphs (g)(2)(i) and (j) of this section, the amount paid to remove the columns and girders must be capitalized as a cost of the improvement, because it directly benefits and is incurred by reason of the improvement to the building.

Example 2. Component removed during improvement; disposition. Assume the same facts as Example 1, except X disposes of the original columns and girders and elects to treat the disposal of these structural components as a partial disposition of the factory building under Prop. Reg. § 1.168(i)- 8(d) (September 19, 2013), taking into account the adjusted basis of the components in realizing loss on the disposition. Under paragraph (g)(2)(i) of this section, the amount paid to remove the columns and girders is not required to be capitalized as part of the cost of the improvement regardless of their relation to the improvement. However, all the remaining costs of replacing the columns and girders must be capitalized as improvements to the building unit of property under paragraphs (d)(1), (j), and (g)(1) of this section.

Example 3. Component removed during repair or maintenance; no disposition. Y owns a building in which it conducts its retail business. The roof over Y’s building is covered with shingles. Over time, the shingles begin to wear and Y begins to experience leaks into its retail premises. However, the building still functions in Y’s business. To eliminate the problems, a contractor recommends that Y remove the original shingles and replace them with new shingles. Accordingly, Y pays the contractor to replace the old shingles with new but comparable shingles. The new shingles are comparable to original shingles but correct the leakage problems. Assume that Y disposes of the original shingles, and the disposal of these shingles is not a disposition under Prop. Reg. § 1.168(i)–1(e) (September 19, 2013), or Prop. Reg. § 1.168(i)–8 (September 19, 2013). Assume that replacement of old shingles with new shingles to correct the leakage is not a betterment or a restoration of the building structure or systems under paragraph (j) or (k) of this section and does not adapt the building structure or systems to a new or different use under paragraph (l) of this section. Thus, the amounts paid by Y to replace the shingles are not improvements to the building unit of property under paragraph (d) of this section. Under paragraph (g)(2)(i) of this section, the amounts paid to remove the shingles are not required to be capitalized because they directly benefit and are incurred by reason of repair or maintenance to the building structure.

Example 4. Component removed with disposition and restoration. Assume the same facts as Example 3 except Y disposes of the original shingles, and Y elects to treat the disposal of these components as a partial disposition of the building under Prop. Reg.


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§ 1.168(i)–8(d) (September 19, 2013), and deducts the adjusted basis of the components as a loss on the disposition. Under paragraph (k)(1)(i) of this section, amounts paid for replacement of the shingles constitute a restoration of the building structure because the amounts are paid for the replacement of a component of the structure and the taxpayer has properly deducted a loss for that component. Thus, under paragraphs (d)(2) and (k) of this section, Y is required to capitalize the amounts paid for the replacement of the shingles as an improvement to the building unit of property. However, under paragraph (g)(2)(i) of this section, the amounts paid by Y to remove the original shingles are not required to be capitalized as part of the costs of the improvement, regardless of their relation to the improvement.

(3) Related amounts. For purposes of paragraph (d) of this section, amounts paid to improve a unit of property include amounts paid over a period of more than one taxable year. Whether amounts are related to the same improvement depends on the facts and circumstances of the activities being performed.

(4) Compliance with regulatory requirements. For purposes of this section, a Federal, state, or local regulator’s requirement that a taxpayer perform certain repairs or maintenance on a unit of property to continue operating the property is not relevant in determining whether the amount paid improves the unit of property.

(h) Safe harbor for small taxpayers— (1) In general. A qualifying taxpayer (as defined in paragraph (h)(3) of this section) may elect to not apply paragraph (d) or paragraph (f) of this section to an eligible building property (as defined in paragraph (h)(4) of this section) if the total amount paid during the taxable year for repairs, maintenance, improvements, and similar activities performed on the eligible building property does not exceed the lesser of—

(i) 2 percent of the unadjusted basis (as defined under paragraph (h)(5) of this section) of the eligible building property; or

(ii) $10,000. (2) Application with other safe harbor

provisions. For purposes of paragraph (h)(1) of this section, amounts paid for repairs, maintenance, improvements, and similar activities performed on eligible building property include those amounts not capitalized under the de minimis safe harbor election under § 1.263(a)-1(f) and those amounts deemed not to improve property under the safe harbor for routine maintenance under paragraph (i) of this section.

(3) Qualifying taxpayer—(i) In general. For purposes of this paragraph

(h), the term qualifying taxpayer means a taxpayer whose average annual gross receipts as determined under this paragraph (h)(3) for the three preceding taxable years is less than or equal to $10,000,000.

(ii) Application to new taxpayers. If a taxpayer has been in existence for less than three taxable years, the taxpayer determines its average annual gross receipts for the number of taxable years (including short taxable years) that the taxpayer (or its predecessor) has been in existence.

(iii) Treatment of short taxable year. In the case of any taxable year of less than 12 months (a short taxable year), the gross receipts shall be annualized by—

(A) Multiplying the gross receipts for the short period by 12; and

(B) Dividing the product determined in paragraph (h)(3)(iii)(A) of this section by the number of months in the short period.

(iv) Definition of gross receipts. For purposes of applying paragraph (h)(3)(i) of this section, the term gross receipts means the taxpayer’s receipts for the taxable year that are properly recognized under the taxpayer’s methods of accounting used for Federal income tax purposes for the taxable year. For this purpose, gross receipts include total sales (net of returns and allowances) and all amounts received for services. In addition, gross receipts include any income from investments and from incidental or outside sources. For example, gross receipts include interest (including original issue discount and tax-exempt interest within the meaning of section 103), dividends, rents, royalties, and annuities, regardless of whether such amounts are derived in the ordinary course of the taxpayer’s trade of business. Gross receipts are not reduced by cost of goods sold or by the cost of property sold if such property is described in section 1221(a)(1), (3), (4), or (5). With respect to sales of capital assets as defined in section 1221, or sales of property described in section 1221(a)(2) (relating to property used in a trade or business), gross receipts shall be reduced by the taxpayer’s adjusted basis in such property. Gross receipts do not include the repayment of a loan or similar instrument (for example, a repayment of the principal amount of a loan held by a commercial lender) and, except to the extent of gain recognized, do not include gross receipts derived from a non-recognition transaction, such as a section 1031 exchange. Finally, gross receipts do not include amounts received by the taxpayer with respect to sales tax or other similar state and local

taxes if, under the applicable state or local law, the tax is legally imposed on the purchaser of the good or service, and the taxpayer merely collects and remits the tax to the taxing authority. If, in contrast, the tax is imposed on the taxpayer under the applicable law, then gross receipts include the amounts received that are allocable to the payment of such tax.

(4) Eligible building property. For purposes of this section, the term, eligible building property refers to each unit of property defined in paragraph (e)(2)(i) (building), paragraph (e)(2)(iii)(A) (condominium), paragraph (e)(2)(iv)(A) (cooperative), or paragraph (e)(2)(v)(A) (leased building or portion of building) of this section, as applicable, that has an unadjusted basis of $1,000,0000 or less.

(5) Unadjusted basis—(i) Eligible building property owned by taxpayer. For purposes of this section, the unadjusted basis of eligible building property owned by the taxpayer means the basis as determined under section 1012, or other applicable sections of Chapter 1, including subchapters O (relating to gain or loss on dispositions of property), C (relating to corporate distributions and adjustments), K (relating to partners and partnerships), and P (relating to capital gains and losses). Unadjusted basis is determined without regard to any adjustments described in section 1016(a)(2) or (3) or to amounts for which the taxpayer has elected to treat as an expense (for example, under sections 179, 179B, or 179C).

(ii) Eligible building property leased to the taxpayer. For purposes of this section, the unadjusted basis of eligible building property leased to the taxpayer is the total amount of (undiscounted) rent paid or expected to be paid by the lessee under the lease for the entire term of the lease, including renewal periods if all the facts and circumstances in existence during the taxable year in which the lease is entered indicate a reasonable expectancy of renewal. See § 1.263(a)–4(f)(5)(ii) for the factors significant in determining whether there exists a reasonable expectancy of renewal.

(6) Time and manner of election. A taxpayer makes the election described in paragraph (h)(1) of this section by attaching a statement to the taxpayer’s timely filed original Federal tax return (including extensions) for the taxable year in which amounts are paid for repairs, maintenance, improvements, and similar activities performed on the eligible building property providing that such amounts qualify under the safe harbor provided in paragraph (h)(1) of


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this section. See §§ 301.9100–1 through 301.9100–3 of this chapter for the provisions governing extensions of time to make regulatory elections. The statement must be titled, ‘‘Section 1.263(a)–3(h) Safe Harbor Election for Small Taxpayers’’ and include the taxpayer’s name, address, taxpayer identification number, and a description of each eligible building property to which the taxpayer is applying the election. In the case of an S corporation or a partnership, the election is made by the S corporation or by the partnership, and not by the shareholders or partners. An election may not be made through the filing of an application for change in accounting method or, before obtaining the Commissioner’s consent to make a late election, by filing an amended Federal tax return. A taxpayer may not revoke an election made under this paragraph (h). The time and manner of making the election under this paragraph (h) may be modified through guidance of general applicability (see §§ 601.601(d)(2) and 601.602 of this chapter).

(7) Treatment of safe harbor amounts. Amounts paid by the taxpayer for repairs, maintenance, improvements, and similar activities to which the taxpayer properly applies the safe harbor under paragraph (h)(1) of this section and for which the taxpayer properly makes the election under paragraph (h)(6) of this section are not treated as improvements under paragraph (d) or (f) of this section and may be deducted under § 1.162–1 or § 1.212–1, as applicable, in the taxable year these amounts are paid, provided the amounts otherwise qualify for a deduction under these sections.

(8) Safe harbor exceeded. If total amounts paid by a qualifying taxpayer during the taxable year for repairs, maintenance, improvements, and similar activities performed on an eligible building property exceed the safe harbor limitations specified in paragraph (h)(1) of this section, then the safe harbor election is not available for that eligible building property and the taxpayer must apply the general improvement rules under this section to determine whether amounts are for improvements to the unit of property, including the safe harbor for routine maintenance under paragraph (i) of this section. The taxpayer may also elect to apply the de minimis safe harbor under § 1.263(a)–1(f) to amounts qualifying under that safe harbor irrespective of the application of this paragraph (h).

(9) Modification of safe harbor amounts. The amount limitations provided in paragraphs (h)(1)(i), (h)(1)(ii), and (h)(3) of this section may

be modified through published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(b) of this chapter).

(10) Examples. The following examples illustrate the rules of this paragraph (h). Assume that § 1.212–1 does not apply to the amounts paid.

Example 1. Safe harbor for small taxpayers applicable. A is a qualifying taxpayer under paragraph (h)(3) of this section. A owns an office building in which A provides consulting services. In Year 1, A’s building has an unadjusted basis of $750,000 as determined under paragraph (h)(5)(i) of this section. In Year 1, A pays $5,500 for repairs, maintenance, improvements and similar activities to the office building. Because A’s building unit of property has an unadjusted basis of $1,000,000 or less, A’s building constitutes eligible building property under paragraph (h)(4) of this section. The aggregate amount paid by A during Year 1 for repairs, maintenance, improvements and similar activities on this eligible building property does not exceed the lesser of $15,000 (2 percent of the building’s unadjusted basis of $750,000) or $10,000. Therefore, under paragraph (h)(1) of this section, A may elect to not apply the capitalization rule of paragraph (d) of this section to the amounts paid for repair, maintenance, improvements, or similar activities on the office building in Year 1. If A properly makes the election under paragraph (h)(6) of this section for the office building and the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business, A may deduct these amounts under § 1.162–1 in Year 1.

Example 2. Safe harbor for small taxpayers inapplicable. Assume the same facts as in Example 1, except that A pays $10,500 for repairs, maintenance, improvements, and similar activities performed on its office building in Year 1. Because this amount exceeds $10,000, the lesser of the two limitations provided in paragraph (h)(1) of this section, A may not apply the safe harbor for small taxpayers under paragraph (h)(1) of this section to the total amounts paid for repairs, maintenance, improvements, and similar activities performed on the building. Therefore, A must apply the general improvement rules under this section to determine which of the aggregate amounts paid are for improvements and must be capitalized under paragraph (d) of this section and which of the amounts are for repair and maintenance under § 1.162–4.

Example 3. Safe harbor applied building- by-building. (i) B is a qualifying taxpayer under paragraph (h)(3) of this section. B owns two rental properties, Building M and Building N. Building M and Building N are both multi-family residential buildings. In Year 1, each property has an unadjusted basis of $300,000 under paragraph (h)(5) of this section. Because Building M and Building N each have an unadjusted basis of $1,000,000 or less, Building M and Building N each constitute eligible building property in Year 1 under paragraph (h)(4) of this section. In Year 1, B pays $5,000 for repairs, maintenance, improvements, and similar

activities performed on Building M. In Year 1, B also pays $7,000 for repairs, maintenance, improvements, and similar activities performed on Building N.

(ii) The total amount paid by B during Year 1 for repairs, maintenance, improvements and similar activities on Building M ($5,000) does not exceed the lesser of $6,000 (2 percent of the building’s unadjusted basis of $300,000) or $10,000. Therefore, under paragraph (h)(1) of this section, for Year 1, B may elect to not apply the capitalization rule under paragraph (d) of this section to the amounts it paid for repairs, maintenance, improvements, and similar activities on Building M. If B properly makes the election under paragraph (h)(6) of this section for Building M and the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on B’s trade or business, B may deduct these amounts under § 1.162–1.

(iii) The total amount paid by B during Year 1 for repairs, maintenance, improvements and similar activities on Building N ($7,000) exceeds $6,000 (2 percent of the building’s unadjusted basis of $300,000), the lesser of the two limitations provided under paragraph (h)(1) of this section. Therefore, B may not apply the safe harbor under paragraph (h)(1) of this section to the total amounts paid for repairs, maintenance, improvements, and similar activities performed on Building N. Instead, B must apply the general improvement rules under this section to determine which of the total amounts paid for work performed on Building N are for improvements and must be capitalized under paragraph (d) of this section and which amounts are for repair and maintenance under § 1.162–4.

Example 4. Safe harbor applied to leased building property. C is a qualifying taxpayer under paragraph (h)(3) of this section. C is the lessee of a building in which C operates a retail store. The lease is a triple-net lease, and the lease term is 20 years, including reasonably expected renewals. C pays $4,000 per month in rent. In Year 1, C pays $7,000 for repairs, maintenance, improvements, and similar activities performed on the building. Under paragraph (h)(5)(ii) of this section, the unadjusted basis of C’s leased unit of property is $960,000 ($4,000 monthly rent ! 12 months ! 20 years). Because C’s leased building has an unadjusted basis of $1,000,000 or less, the building is eligible building property for Year 1 under paragraph (h)(4) of this section. The total amount paid by C during Year 1 for repairs, maintenance, improvements, and similar activities on the leased building ($7,000) does not exceed the lesser of $19,200 (2 percent of the building’s unadjusted basis of $960,000) or $10,000. Therefore, under paragraph (h)(1) of this section, for Year 1, C may elect to not apply the capitalization rule under paragraph (d) of this section to the amounts it paid for repairs, maintenance, improvements, and similar activities on the leased building. If C properly makes the election under paragraph (h)(6) of this section for the leased building and the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on C’s trade or business, C may deduct these amounts under § 1.162– 1.


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(i) Safe harbor for routine maintenance on property—(1) In general. An amount paid for routine maintenance (as defined in paragraph (i)(1)(i) or (i)(1)(ii) of this section, as applicable) on a unit of tangible property, or in the case of a building, on any of the properties designated in paragraphs (e)(2)(ii), (e)(2)(iii)(B), (e)(2)(iv)(B), or paragraph (e)(2)(v)(B) of this section, is deemed not to improve that unit of property.

(i) Routine maintenance for buildings. Routine maintenance for a building unit of property is the recurring activities that a taxpayer expects to perform as a result of the taxpayer’s use of any of the properties designated in paragraphs (e)(2)(ii), (e)(2)(iii)(B), (e)(2)(iv)(B), or (e)(2)(v)(B) of this section to keep the building structure or each building system in its ordinarily efficient operating condition. Routine maintenance activities include, for example, the inspection, cleaning, and testing of the building structure or each building system, and the replacement of damaged or worn parts with comparable and commercially available replacement parts. Routine maintenance may be performed any time during the useful life of the building structure or building systems. However, the activities are routine only if the taxpayer reasonably expects to perform the activities more than once during the 10-year period beginning at the time the building structure or the building system upon which the routine maintenance is performed is placed in service by the taxpayer. A taxpayer’s expectation will not be deemed unreasonable merely because the taxpayer does not actually perform the maintenance a second time during the 10-year period, provided that the taxpayer can otherwise substantiate that its expectation was reasonable at the time the property was placed in service. Factors to be considered in determining whether maintenance is routine and whether a taxpayer’s expectation is reasonable include the recurring nature of the activity, industry practice, manufacturers’ recommendations, and the taxpayer’s experience with similar or identical property. With respect to a taxpayer that is a lessor of a building or a part of the building, the taxpayer’s use of the building unit of property includes the lessee’s use of its unit of property.

(ii) Routine maintenance for property other than buildings. Routine maintenance for property other than buildings is the recurring activities that a taxpayer expects to perform 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. Routine maintenance activities include, for example, the inspection, cleaning, and testing of the unit of property, and the replacement of damaged or worn parts of the unit of property with comparable and commercially available replacement parts. Routine maintenance may be performed any time during the useful life of the unit of property. However, the activities are routine only if, at the time the unit of property is placed in service by the taxpayer, the taxpayer reasonably expects to perform the activities more than once during the class life (as defined in paragraph (i)(4) of this section) of the unit of property. A taxpayer’s expectation will not be deemed unreasonable merely because the taxpayer does not actually perform the maintenance a second time during the class life of the unit of property, provided that the taxpayer can otherwise substantiate that its expectation was reasonable at the time the property was placed in service. Factors to be considered in determining whether maintenance is routine and whether the taxpayer’s expectation is reasonable include the recurring nature of the activity, industry practice, manufacturers’ recommendations, and the taxpayer’s experience with similar or identical property. With respect to a taxpayer that is a lessor of a unit of property, the taxpayer’s use of the unit of property includes the lessee’s use of the unit of property.

(2) Rotable and temporary spare parts. Except as provided in paragraph (i)(3) of this section, for purposes of paragraph (i)(1)(ii) of this section, amounts paid for routine maintenance include routine maintenance performed on (and with regard to) rotable and temporary spare parts.

(3) Exceptions. Routine maintenance does not include the following:

(i) Amounts paid for a betterment to a unit of property under paragraph (j) of this section;

(ii) Amounts paid for the replacement of a component of a unit of property for which the taxpayer has properly deducted a loss for that component (other than a casualty loss under § 1.165–7) (see paragraph (k)(1)(i) of this section);

(iii) Amounts paid for the replacement of a component of a unit of property for which the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component (see paragraph (k)(1)(ii) of this section);

(iv) Amounts paid for the restoration of damage to a unit of property for which the taxpayer is required to take

a basis adjustment as a result of a casualty loss under section 165, or relating to a casualty event described in section 165, subject to the limitation in paragraph (k)(4) of this section (see paragraph (k)(1)(iii) of this section);

(v) Amounts paid to return a unit of property to its ordinarily efficient operating condition, if the property has deteriorated to a state of disrepair and is no longer functional for its intended use (see paragraph (k)(1)(iv) of this section);

(vi) Amounts paid to adapt a unit of property to a new or different use under paragraph (l) of this section;

(vii) Amounts paid for repairs, maintenance, or improvement of network assets (as defined in paragraph (e)(3)(iii)(A) of this section); or

(viii) Amounts paid for repairs, maintenance, or improvement of rotable and temporary spare parts to which the taxpayer applies the optional method of accounting for rotable and temporary spare parts under § 1.162–3(e).

(4) Class life. The class life of a unit of property is the recovery period prescribed for the property under sections 168(g)(2) and (3) for purposes of the alternative depreciation system, regardless of whether the property is depreciated under section 168(g). For purposes of determining class life under this section, section 168(g)(3)(A) (relating to tax-exempt use property subject to lease) does not apply. If the unit of property is comprised of components with different class lives, then the class life of the unit of property is deemed to be the same as the component with the longest class life.

(5) Coordination with section 263A. Amounts paid for routine maintenance under this paragraph (i) may be subject to capitalization under section 263A if these amounts comprise the direct or allocable indirect costs of other property produced by the taxpayer or property acquired for resale. See, for example, § 1.263A–1(e)(3)(ii)(O) requiring taxpayers to capitalize the cost of repairing equipment or facilities allocable to property produced or property acquired for resale.

(6) Examples. The following examples illustrate the application of this paragraph (i) and, unless otherwise stated, do not address the treatment under other provisions of the Code (for example, section 263A). In addition, unless otherwise stated, assume that the taxpayer has not applied the optional method of accounting for rotable and temporary spare parts under § 1.162– 3(e).

Example 1. Routine maintenance on component. (i) A is a commercial airline


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engaged in the business of transporting passengers and freight throughout the United States and abroad. To conduct its business, A owns or leases various types of aircraft. As a condition of maintaining its airworthiness certification for these aircraft, A is required by the Federal Aviation Administration (FAA) to establish and adhere to a continuous maintenance program for each aircraft within its fleet. These programs, which are designed by A and the aircraft’s manufacturer and approved by the FAA, are incorporated into each aircraft’s maintenance manual. The maintenance manuals require a variety of periodic maintenance visits at various intervals. One type of maintenance visit is an engine shop visit (ESV), which A expects to perform on its aircraft engines approximately every 4 years to keep its aircraft in its ordinarily efficient operating condition. In Year 1, A purchased a new aircraft, which included four new engines attached to the airframe. The four aircraft engines acquired with the aircraft are not materials or supplies under § 1.162–3(c)(1)(i) because they are acquired as part of a single unit of property, the aircraft. In Year 5, A performs its first ESV on the aircraft engines. The ESV includes disassembly, cleaning, inspection, repair, replacement, reassembly, and testing of the engine and its component parts. During the ESV, the engine is removed from the aircraft and shipped to an outside vendor who performs the ESV. If inspection or testing discloses a discrepancy in a part’s conformity to the specifications in A’s maintenance program, the part is repaired, or if necessary, replaced with a comparable and commercially available replacement part. After the ESVs, the engines are returned to A to be reinstalled on another aircraft or stored for later installation. Assume that the class life for A’s aircraft, including the engines, is 12 years. Assume that none of the exceptions set out in paragraph (i)(3) of this section apply to the costs of performing the ESVs.

(ii) Because the ESVs involve the recurring activities that A expects to perform as a result of its use of the aircraft to keep the aircraft in ordinarily efficient operating condition and consist of maintenance activities that A expects to perform more than once during the 12 year class life of the aircraft, A’s ESVs are within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts paid for the ESVs are deemed not to improve the aircraft and are not required to be capitalized under paragraph (d) of this section.

Example 2. Routine maintenance after class life. Assume the same facts as in Example 1, except that in year 15 A pays amounts to perform an ESV on one of the original aircraft engines after the end of the class life of the aircraft. Because this ESV involves the same routine maintenance activities that were performed on aircraft engines in Example 1, this ESV also is within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts paid for this ESV, even though performed after the class life of the aircraft, are deemed not to improve the aircraft and are not required to be capitalized under paragraph (d) of this section.

Example 3. Routine maintenance on rotable spare parts. (i) Assume the same facts as in Example 1, except that in addition to the four engines purchased as part of the aircraft, A separately purchases four additional new engines that A intends to use in its aircraft fleet to avoid operational downtime when ESVs are required to be performed on the engines previously installed on an aircraft. Later in Year 1, A installs these four engines on an aircraft in its fleet. In Year 5, A performs the first ESVs on these four engines. Assume that these ESVs involve the same routine maintenance activities that were performed on the engines in Example 1, and that none of the exceptions set out in paragraph (i)(3) of this section apply to these ESVs. After the ESVs were performed, these engines were reinstalled on other aircraft or stored for later installation.

(ii) The additional aircraft engines are rotable spare parts because they were acquired separately from the aircraft, they are removable from the aircraft, and are repaired and reinstalled on other aircraft or stored for later installation. See § 1.162–3(c)(2) (definition of rotable and temporary spare parts). Assume the class life of an engine is the same as the airframe, 12 years. Because the ESVs involve the recurring activities that A expects to perform as a result of its use of the engines to keep the engines in ordinarily efficient operating condition, and consist of maintenance activities that A expects to perform more than once during the 12 year class life of the engine, the ESVs fall within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts paid for the ESVs for the four additional engines are deemed not to improve these engines and are not required to be capitalized under paragraph (d) of this section. For the treatment of amounts paid to acquire the engines, see § 1.162–3(a).

Example 4. Routine maintenance resulting from prior owner’s use. (i) In January, Year 1, B purchases a used machine for use in its manufacturing operations. Assume that the machine is the unit of property and has a class life of 10 years. B places the machine in service in January, Year 1, and at that time, B expects to perform manufacturer recommended scheduled maintenance on the machine approximately every three years. The scheduled maintenance includes the cleaning and oiling of the machine, the inspection of parts for defects, and the replacement of minor items such as springs, bearings, and seals with comparable and commercially available replacement parts. At the time B purchased the machine, the machine was approaching the end of a three- year scheduled maintenance period. As a result, in February, Year 1, B pays amounts to perform the manufacturer recommended scheduled maintenance. Assume that none of the exceptions set out in paragraph (i)(3) of this section apply to the amounts paid for the scheduled maintenance.

(ii) The majority of B’s costs do not qualify under the routine maintenance safe harbor in paragraph (i)(1)(ii) of this section because the costs were incurred primarily as a result of the prior owner’s use of the property and not

B’s use. B acquired the machine just before it had received its three-year scheduled maintenance. Accordingly, the amounts paid for the scheduled maintenance resulted from the prior owner’s, and not B’s, use of the property and must be capitalized if those amounts result in a betterment under paragraph (i) of this section, including the amelioration of a material condition or defect, or otherwise result in an improvement under paragraph (d) of this section.

Example 5. Routine maintenance resulting from new owner’s use. Assume the same facts as in Example 4, except that after B pays amounts for the maintenance in Year 1, B continues to operate the machine in its manufacturing business. In Year 4, B pays amounts to perform the next scheduled manufacturer recommended maintenance on the machine. Assume that the scheduled maintenance activities performed are the same as those performed in Example 4 and that none of the exceptions set out in paragraph (i)(3) of this section apply to the amounts paid for the scheduled maintenance. Because the scheduled maintenance performed in Year 4 involves the recurring activities that B performs as a result of its use of the machine, keeps the machine in an ordinarily efficient operating condition, and consists of maintenance activities that B expects to perform more than once during the 10-year class life of the machine, B’s scheduled maintenance costs are within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts paid for the scheduled maintenance in Year 4 are deemed not to improve the machine and are not required to be capitalized under paragraph (d) of this section.

Example 6. Routine maintenance; replacement of substantial structural part; coordination with section 263A. C is in the business of producing commercial products for sale. As part of the production process, C places raw materials into lined containers in which a chemical reaction is used to convert raw materials into the finished product. The lining, which comprises 60 percent of the total physical structure of the container, is a substantial structural part of the container. Assume that each container, including its lining, is the unit of property and that a container has a class life of 12 years. At the time that C placed the container into service, C was aware that approximately every three years, the container lining would need to be replaced with comparable and commercially available replacement materials. At the end of three years, the container will continue to function, but will become less efficient and the replacement of the lining will be necessary to keep the container in an ordinarily efficient operating condition. In Year 1, C acquired 10 new containers and placed them into service. In Year 4, Year 7, Year 9, and Year 12, C pays amounts to replace the containers’ linings with comparable and commercially available replacement parts. Assume that none of the exceptions set out in paragraph (i)(3) of this section apply to the amounts paid for the replacement linings. Because the replacement of the linings involves recurring activities that C expects to perform as a result


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of its use of the containers to keep the containers in their ordinarily efficient operating condition and consists of maintenance activities that C expects to perform more than once during the 12-year class life of the containers, C’s lining replacement costs are within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts that C paid for the replacement of the container linings are deemed not to improve the containers and are not required to be capitalized under paragraph (d) of this section. However, the amounts paid to replace the lining may be subject to capitalization under section 263A if the amounts paid for this maintenance comprise the direct or allocable indirect costs of the property produced by C. See § 1.263A– 1(e)(3)(ii)(O).

Example 7. Routine maintenance once during class life. D is a Class I railroad that owns a fleet of freight cars. Assume that a freight car, including all its components, is a unit of property and has a class life of 14 years. At the time that D places a freight car into service, D expects to perform cyclical reconditioning to the car every 8 to 10 years to keep the freight car in ordinarily efficient operating condition. During this reconditioning, D pays amounts to disassemble, inspect, and recondition or replace components of the freight car with comparable and commercially available replacement parts. Ten years after D places the freight car in service, D pays amounts to perform a cyclical reconditioning on the car. Because D expects to perform the reconditioning only once during the 14 year class life of the freight car, the amounts D pays for the reconditioning do not qualify for the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, D must capitalize the amounts paid for the reconditioning of the freight car if these amounts result in an improvement under paragraph (d) of this section.

Example 8. Routine maintenance; reasonable expectation. Assume the same facts as Example 7, except in Year 1, D acquires and places in service several refrigerated freight cars, which also have a class life of 14 years. Because of the special requirements of these cars, at the time they are placed in service, D expects to perform a reconditioning of the refrigeration components of the freight car every 6 years to keep the freight car in an ordinarily efficient operating condition. During the reconditioning, D pays amounts to disassemble, inspect, and recondition or replace the refrigeration components of the freight car with comparable and commercially available replacement parts. Assume that none of the exceptions set out in paragraph (i)(3) of this section apply to the amounts paid for the reconditioning of these freight cars. In Year 6, D pays amounts to perform a reconditioning on the refrigeration components on one of the freight cars. However, because of changes in the frequency that D utilizes this freight car, D does not perform the second reconditioning on the same freight car until Year 15, after the end of the 14-year class life of the car. Under paragraph (i)(1)(ii) of this section, D’s

reasonable expectation that it would perform the reconditioning every 6 years will not be deemed unreasonable merely because D did not actually perform the reconditioning a second time during the 14-year class life, provided that D can substantiate that its expectation was reasonable at the time the property was placed in service. If D can demonstrate that its expectation was reasonable in Year 1 using the factors provided in paragraph (i)(1)(ii) of this section, then the amounts paid by D to recondition the refrigerated freight car components in Year 6 and in Year 15 are within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section.

Example 9. Routine maintenance on non- rotable part. E is a towboat operator that owns and leases a fleet of towboats. Each towboat is equipped with two diesel- powered engines. Assume that each towboat, including its engines, is the unit of property and that a towboat has a class life of 18 years. At the time that E places its towboats into service, E is aware that approximately every three to four years E will need to perform scheduled maintenance on the two towboat engines to keep the engines in their ordinarily efficient operating condition. This maintenance is completed while the engines are attached to the towboat and involves the cleaning and inspecting of the engines to determine which parts are within acceptable operating tolerances and can continue to be used, which parts must be reconditioned to be brought back to acceptable tolerances, and which parts must be replaced. Engine parts replaced during these procedures are replaced with comparable and commercially available replacement parts. Assume the towboat engines are not rotable spare parts under § 1.162–3(c)(2). In Year 1, E acquired a new towboat, including its two engines, and placed the towboat into service. In Year 5, E pays amounts to perform scheduled maintenance on both engines in the towboat. Assume that none of the exceptions set out in paragraph (i)(3) of this section apply to the scheduled maintenance costs. Because the scheduled maintenance involves recurring activities that E expects to perform more than once during the 18-year class life of the towboat, the maintenance results from E’s use of the towboat, and the maintenance is performed to keep the towboat in an ordinarily efficient operating condition, the scheduled maintenance on E’s towboat is within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts paid for the scheduled maintenance to its towboat engines in Year 5 are deemed not to improve the towboat and are not required to be capitalized under paragraph (d) of this section.

Example 10. Routine maintenance with related betterments. Assume the same facts as Example 9, except that in Year 9 E’s towboat engines are due for another scheduled maintenance visit. At this time, E decides to upgrade the engines to increase their horsepower and propulsion, which would permit the towboats to tow heavier loads. Accordingly, in Year 9, E pays amounts to perform many of the same activities that it would perform during the

typical scheduled maintenance activities such as cleaning, inspecting, reconditioning, and replacing minor parts, but at the same time, E incurs costs to upgrade certain engine parts to increase the towing capacity of the boats in excess of the capacity of the boats when E placed them in service. In combination with the replacement of parts with new and upgraded parts, the scheduled maintenance must be completed to perform the horsepower and propulsion upgrade. Thus, the work done on the engines encompasses more than the recurring activities that E expected to perform as a result of its use of the towboats and did more than keep the towboat in its ordinarily efficient operating condition. Rather under paragraph (j) of this section, the amounts paid to increase the horsepower and propulsion of the engines are for a betterment to the towboat, and such amounts are excepted from the routine maintenance safe harbor under paragraph (i)(3)(i) of this section. In addition, under paragraph (g)(1)(i) of this section, the scheduled maintenance procedures directly benefit the upgrades. Therefore, the amounts that E paid in Year 9 for the maintenance and upgrade of the engines do not qualify for the routine maintenance safe harbor described under paragraph (i)(1)(ii) of this section. Rather, E must capitalize the amounts paid for maintenance and upgrades of the engines as an improvement to the towboats under paragraph (d) of this section.

Example 11. Routine maintenance with unrelated improvements. Assume the same facts as Example 9, except in Year 5, in addition to paying amounts to perform the scheduled engine maintenance on both engines, E also incurs costs to upgrade the communications and navigation systems in the pilot house of the towboat with new state-of-the-art systems. Assume the amounts paid to upgrade the communications and navigation systems are for betterments under paragraph (j) of this section, and therefore result in an improvement to the towboat under paragraph (d) of this section. In contrast with Example 9, the amounts paid for the scheduled maintenance on E’s towboat engines are not otherwise related to the upgrades to the navigation systems. Because the scheduled maintenance on the towboat engines does not directly benefit and is not incurred by reason of the upgrades to the communication and navigation systems, the amounts paid for the scheduled engine maintenance are not a direct or indirect cost of the improvement under paragraph (g)(1)(i) of this section. Accordingly, the amounts paid for the scheduled maintenance to its towboat engines in Year 5 are routine maintenance deemed not to improve the towboat and are not required to be capitalized under paragraph (d) of this section.

Example 12. Exceptions to routine maintenance. F owns and operates a farming and cattle ranch with an irrigation system that provides water for crops. Assume that each canal in the irrigation system is a single unit of property and has a class life of 20 years. At the time F placed the canals into service, F expected to have to perform major maintenance on the canals every three years


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to keep the canals in their ordinarily efficient operating condition. This maintenance includes draining the canals, and then cleaning, inspecting, repairing, and reconditioning or replacing parts of the canal with comparable and commercially available replacement parts. F placed the canals into service in Year 1 and did not perform any maintenance on the canals until Year 6. At that time, the canals had fallen into a state of disrepair and no longer functioned for irrigation. In Year 6, F pays amounts to drain the canals and do extensive cleaning, repairing, reconditioning, and replacing parts of the canals with comparable and commercially available replacement parts. Although the work performed on F’s canals was similar to the activities that F expected to perform, but did not perform, every three years, the costs of these activities do not fall within the routine maintenance safe harbor. Specifically, under paragraph (i)(3)(v) of this section, routine maintenance does not include activities that return a unit of property to its former ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use. Accordingly, amounts that F pays for work performed on the canals in Year 6 must be capitalized if they result in improvements under paragraph (d) of this section (for example, restorations under paragraph (k) of this section).

Example 13. Routine maintenance on a building; escalator system. In Year 1, G acquires a large retail mall in which it leases space to retailers. The mall contains an escalator system with 40 escalators, which includes landing platforms, trusses, tracks, steps, handrails, and safety brushes. In Year 1, when G placed its building into service, G reasonably expected that it would need to replace the handrails on the escalators approximately every four years to keep the escalator system in its ordinarily efficient operating condition. After a routine inspection and test of the escalator system in Year 4, G determines that the handrails need to be replaced and pays an amount to replace the handrails with comparable and commercially available handrails. The escalator system, including the handrails, is a building system under paragraph (e)(2)(ii)(B)(4) of this section. Assume that none of the exceptions in paragraph (i)(3) of this section apply to the scheduled maintenance costs. Because the replacement of the handrails involves recurring activities that G expects to perform as a result of its use of the escalator system to keep the escalator system in an ordinarily efficient operating condition, and G reasonably expects to perform these activities more than once during the 10-year period beginning at the time building system was placed in service, the amounts paid by G for the handrail replacements are within the routine maintenance safe harbor under paragraph (i)(1)(i) of this section. Accordingly, the amounts paid for the replacement of the handrails in Year 4 are deemed not to improve the building unit of property and are not required to be capitalized under paragraph (d) of this section.

Example 14. Not routine maintenance; escalator system. Assume the same facts as

in Example 13, except that in Year 9, G pays amounts to replace the steps of the escalators. In Year 1, when G placed its building into service, G reasonably expected that approximately every 18 to 20 years G would need to replace the steps to keep the escalator system in its ordinarily efficient operating condition. Because the replacement does not involve recurring activities that G expects to perform more than once during the 10-year period beginning at the time the building structure or the building system was placed in service, the costs of these activities do not fall within the routine maintenance safe harbor. Accordingly, amounts that G pays to replace the steps in Year 9 must be capitalized if they result in improvements under paragraph (d) of this section (for example, restorations under paragraph (k) of this section).

Example 15. Routine maintenance on building; reasonable expectation. In Year 1, H acquires a new office building, which it uses to provide services. The building contains an HVAC system, which is a building system under paragraph (e)(2)(ii)(B)(1) of this section. In Year 1, when H placed its building into service, H reasonably expected that every four years H would need to pay an outside contractor to perform detailed testing, monitoring, and preventative maintenance on its HVAC system to keep the HVAC system in its ordinarily efficient operating condition. This scheduled maintenance includes disassembly, cleaning, inspection, repair, replacement, reassembly, and testing of the HVAC system and many of its component parts. If inspection or testing discloses a problem with any component, the part is repaired, or if necessary, replaced with a comparable and commercially available replacement part. The scheduled maintenance at these intervals is recommended by the manufacturer of the HVAC system and is routinely performed on similar systems in similar buildings. Assume that none of the exceptions in paragraph (i)(3) of this section apply to the amounts paid for the maintenance on the HVAC system. In Year 4, H pays amounts to a contractor to perform the scheduled maintenance. However, H does not perform this scheduled maintenance on its building again until Year 11. Under paragraph (i)(1)(i) of this section, H’s reasonable expectation that it would perform the maintenance every 4 years will not be deemed unreasonable merely because H did not actually perform the maintenance a second time during the 10- year period, provided that H can substantiate that its expectation was reasonable at the time the property was placed in service. If H can demonstrate that its expectation was reasonable in Year 1 using the other factors considered in paragraph (i)(1)(i), then the amounts H paid for the maintenance of the HVAC system in Year 4 and in Year 11 are within the routine maintenance safe harbor under paragraph (i)(1)(i) of this section.

(j) Capitalization of betterments—(1) In general. A taxpayer must capitalize as an improvement an amount paid for a betterment to a unit of property. An amount is paid for a betterment to a unit of property only if it—

(i) Ameliorates a material condition or defect that either existed prior to the taxpayer’s acquisition of the unit of property or arose during the production of the unit of property, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production;

(ii) Is for a material addition, including a physical enlargement, expansion, extension, or addition of a major component (as defined in paragraph (k)(6) of this section) to the unit of property or a material increase in the capacity, including additional cubic or linear space, of the unit of property; or

(iii) Is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the unit of property.

(2) Application of betterment rules— (i) In general. The applicability of each quantitative and qualitative factor provided in paragraphs (j)(1)(ii) and (j)(1)(iii) of this section to a particular unit of property depends on the nature of the unit of property. For example, if an addition or an increase in a particular factor cannot be measured in the context of a specific type of property, this factor is not relevant in the determination of whether an amount has been paid for a betterment to the unit of property.

(ii) Application of betterment rules to buildings. An amount is paid to improve a building if it is paid for a betterment, as defined under paragraph (j)(1) of this section, to a property specified under paragraph (e)(2)(ii) (building), paragraph (e)(2)(iii)(B) (condominium), paragraph (e)(2)(iv)(B) (cooperative), or paragraph (e)(2)(v)(B) (leased building or leased portion of building) of this section. For example, an amount is paid to improve a building if it is paid for an increase in the efficiency of the building structure or any one of its building systems (for example, the HVAC system).

(iii) Unavailability of replacement parts. If a taxpayer replaces a part of a unit of property that cannot reasonably be replaced with the same type of part (for example, because of technological advancements or product enhancements), the replacement of the part with an improved, but comparable, part does not, by itself, result in a betterment to the unit of property.

(iv) Appropriate comparison—(A) In general. In cases in which an expenditure is necessitated by normal wear and tear or damage to the unit of property that occurred during the taxpayer’s use of the unit of property, the determination of whether an expenditure is for the betterment of the unit of property is made by comparing


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the condition of the property immediately after the expenditure with the condition of the property immediately prior to the circumstances necessitating the expenditure.

(B) Normal wear and tear. If the expenditure is made to correct the effects of normal wear and tear to the unit of property that occurred during the taxpayer’s use of the unit of property, the condition of the property immediately prior to the circumstances necessitating the expenditure is the condition of the property after the last time the taxpayer corrected the effects of normal wear and tear (whether the amounts paid were for maintenance or improvements) or, if the taxpayer has not previously corrected the effects of normal wear and tear, the condition of the property when placed in service by the taxpayer.

(C) Damage to property. If the expenditure is made to correct damage to a unit of property that occurred during the taxpayer’s use of the unit of property, the condition of the property immediately prior to the circumstances necessitating the expenditure is the condition of the property immediately prior to damage.

(3) Examples. The following examples illustrate the application of this paragraph (j) only and do not address whether capitalization is required under another provision of this section or another provision of the Internal Revenue Code (for example, section 263A). Unless otherwise provided, assume that the appropriate comparison in paragraph (j)(2)(iv) of this section is not applicable under the facts.

Example 1. Amelioration of pre-existing material condition or defect. In Year 1, A purchases a store located on a parcel of land that contains underground gasoline storage tanks left by prior occupants. Assume that the parcel of land is the unit of property. The tanks had leaked prior to A’s purchase, causing soil contamination. A is not aware of the contamination at the time of purchase. In Year 2, A discovers the contamination and incurs costs to remediate the soil. The remediation costs are for a betterment to the land under paragraph (j)(1)(i) of this section because A incurred the costs to ameliorate a material condition or defect that existed prior to A’s acquisition of the land.

Example 2. Not amelioration of pre- existing condition or defect. B owns an office building that was constructed with insulation that contained asbestos. The health dangers of asbestos were not widely known when the building was constructed. Several years after B places the building into service, B determines that certain areas of asbestos- containing insulation have begun to deteriorate and could eventually pose a health risk to employees. Therefore, B pays an amount to remove the asbestos-containing insulation from the building structure and

replace it with new insulation that is safer to employees, but no more efficient or effective than the asbestos insulation. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. Although the asbestos is determined to be unsafe under certain circumstances, the presence of asbestos insulation in a building, by itself, is not a preexisting material condition or defect of the building structure under paragraph (j)(1)(i) of this section. In addition, the removal and replacement of the asbestos is not for a material addition to the building structure or a material increase in the capacity of the building structure under paragraphs (j)(1)(ii) and (j)(2)(iv) of this section as compared to the condition of the property prior to the deterioration of the insulation. Similarly, the removal and replacement of asbestos is not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the building structure under paragraphs (j)(1)(iii) and (j)(2)(iv) of this section as compared to the condition of the property prior to the deterioration of the insulation. Therefore, the amount paid to remove and replace the asbestos insulation is not for a betterment to the building structure or an improvement to the building under paragraph (j) of this section.

Example 3. Not amelioration of pre- existing material condition or defect. (i) In January, Year 1, C purchased a used machine for use in its manufacturing operations. Assume that the machine is a unit of property and has a class life of 10 years. C placed the machine in service in January, Year 1 and at that time expected to perform manufacturer recommended scheduled maintenance on the machine every three years. The scheduled maintenance includes cleaning and oiling the machine, inspecting parts for defects, and replacing minor items, such as springs, bearings, and seals, with comparable and commercially available replacement parts. The scheduled maintenance does not include any material additions or materially increase the capacity, productivity, efficiency, strength, quality, or output of the machine. At the time C purchased the machine, it was approaching the end of a three-year scheduled maintenance period. As a result, in February, Year 1, C pays an amount to perform the manufacturer recommended scheduled maintenance to keep the machine in its ordinarily efficient operating condition.

(ii) The amount that C pays does not qualify under the routine maintenance safe harbor in paragraph (i) of this section, because the cost primarily results from the prior owner’s use of the property and not the taxpayer’s use. C acquired the machine just before it had received its three-year scheduled maintenance. Accordingly, the amount that C pays for the scheduled maintenance results from the prior owner’s use of the property and ameliorates conditions or defects that existed prior to C’s ownership of the machine. Nevertheless, considering the purpose and minor nature of the work performed, this amount does not

ameliorate a material condition or defect in the machine under paragraph (j)(1)(i) of this section, is not for a material addition to or increase in capacity of the machine under paragraph (j)(1)(ii) of this section, and is not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the machine under paragraph (j)(1)(iii) of this section. Therefore, C is not required to capitalize the amount paid for the scheduled maintenance as a betterment to the unit of property under this paragraph (j).

Example 4. Not amelioration of pre- existing material condition or defect. D purchases a used ice resurfacing machine for use in the operation of its ice skating rink. To comply with local regulations, D is required to routinely monitor the air quality in the ice skating rink. One week after D places the machine into service, during a routine air quality check, D discovers that the operation of the machine is adversely affecting the air quality in the skating rink. As a result, D pays an amount to inspect and retune the machine, which includes replacing minor components of the engine that had worn out prior to D’s acquisition of the machine. Assume the resurfacing machine, including the engine, is the unit of property. The routine maintenance safe harbor in paragraph (i) of this section does not apply to the amounts paid, because the activities performed do not relate solely to the taxpayer’s use of the machine. The amount that D pays to inspect, retune, and replace minor components of the ice resurfacing machine ameliorates a condition or defect that existed prior to D’s acquisition of the equipment. Nevertheless, considering the purpose and minor nature of the work performed, this amount does not ameliorate a material condition or defect in the machine under paragraph (j)(1)(i) of this section. In addition, the amount is not paid for a material addition to the machine or a material increase in the capacity of the machine under paragraph (j)(1)(ii) of this section. Also, the activities are not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the machine under paragraph (j)(1)(iii) of this section. Therefore, D is not required to capitalize the amount paid to inspect, retune, and replace minor components of the machine as a betterment under this paragraph (j).

Example 5. Amelioration of material condition or defect. (i) E acquires a building for use in its business of providing assisted living services. Before and after the purchase, the building functions as an assisted living facility. However, at the time of the purchase, E is aware that the building is in a condition that is below the standards that E requires for facilities used in its business. Immediately after the acquisition and during the following two years, while E continues to use the building as an assisted living facility, E pays amounts for extensive repairs and maintenance, and the acquisition of new property to bring the facility into the high- quality condition for which E’s facilities are known. The work on E’s building includes repairing damaged drywall, repainting, re- wallpapering, replacing windows, repairing and replacing doors, replacing and regrouting


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tile, repairing millwork, and repairing and replacing roofing materials. The work also involves the replacement of section 1245 property, including window treatments, furniture, and cabinets. The work that E performs affects only the building structure under paragraph (e)(2)(ii)(A) of this section and does not affect any of the building systems described in paragraph (e)(2)(ii)(B) of this section. Assume that each section 1245 property is a separate unit of property.

(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. Considering the purpose of the expenditure and the effect of the expenditures on the building structure, the amounts that E paid for repairs and maintenance to the building structure comprise a betterment to the building structure under paragraph (j)(1)(i) of this section because the amounts ameliorate material conditions that existed prior to E’s acquisition of the building. Therefore, E must treat the amounts paid for the betterment to the building structure as an improvement to the building and must capitalize the amounts under paragraphs (j) and (d)(1) of this section. Moreover, E is required to capitalize the amounts paid to acquire and install each section 1245 property, including each window treatment, each item of furniture, and each cabinet, in accordance with § 1.263(a)–2(d)(1).

Example 6. Not a betterment; building refresh. (i) F owns a nationwide chain of retail stores that sell a wide variety of items. To maintain the appearance and functionality of its store buildings after several years of wear, F periodically pays amounts to refresh the look and layout of its stores. The work that F performs during a refresh consists of cosmetic and layout changes to the store’s interiors and general repairs and maintenance to the store building to modernize the store buildings and reorganize the merchandise displays. The work to each store consists of replacing and reconfiguring display tables and racks to provide better exposure of the merchandise, making corresponding lighting relocations and flooring repairs, moving one wall to accommodate the reconfiguration of tables and racks, patching holes in walls, repainting the interior structure with a new color scheme to coordinate with new signage, replacing damaged ceiling tiles, cleaning and repairing wood flooring throughout the store building, and power washing building exteriors. The display tables and the racks all constitute section 1245 property. F pays amounts to refresh 50 stores during the taxable year. Assume that each section 1245 property within each store is a separate unit of property. Finally, assume that the work does not ameliorate any material conditions or defects that existed when F acquired the store buildings or result in any material additions to the store buildings.

(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. Considering the facts and circumstances including the

purpose of the expenditure, the physical nature of the work performed, and the effect of the expenditure on the buildings’ structure and systems, the amounts paid for the refresh of each building are not for any material additions to, or material increases in the capacity of, the buildings’ structure or systems as compared with the condition of the structure or systems after the previous refresh. Moreover, the amounts paid are not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of any building structure or system under as compared to the condition of the structures or systems after the previous refresh. Rather, the work performed keeps F’s store buildings’ structures and buildings’ systems in their ordinarily efficient operating condition. Therefore, F is not required to treat the amounts paid for the refresh of its store buildings’ structures and buildings’ systems as betterments under paragraphs (j)(1)(ii), (j)(1)(iii), and (j)(2)(iv) of this section. However, F is required to capitalize the amounts paid to acquire and install each section 1245 property in accordance with § 1.263(a)–2(d)(1).

Example 7. Building refresh; limited improvement. (i) Assume the same facts as Example 6 except, in the course of the refresh to one of its store buildings, F also pays amounts to increase the building’s storage space, add a second loading dock, and add a second overhead door. Specifically, at the same time F pays amounts to perform the refresh, F pays additional amounts to construct an addition to the back of the store building, including adding a new overhead door and loading dock to the building. The work also involves upgrades to the electrical system of the building, including the addition of a second service box with increased amperage and new wiring from the service box to provide lighting and power throughout the new space. Although it is performed at the same time, the construction of the additions does not affect, and is not otherwise related to, the refresh of the retail space.

(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. Under paragraph (j)(1)(ii) of this section, the amounts paid by F to add the storage space, loading dock, overhead door, and expand the electrical system are for betterments to F’s building structure and to the electrical system because they are for material additions to, and a material increase in capacity of, the structure and the electrical system of F’s store building. Accordingly, F must treat the amounts paid for these betterments as improvements to the building unit of property and capitalize these amounts under paragraphs (d)(1) and (j) of this section. However, for the reasons discussed in Example 6, F is not required to treat the amounts paid for the refresh of its store building structure and systems as a betterments under paragraph (j)(1) of this section. In addition, F is not required under paragraph (g)(1) of this section to capitalize the refresh costs described in Example 6 because these costs do not directly benefit

and are not incurred by reason of the additions to the building structure and electrical system. As in Example 6, F is required to capitalize the amounts paid to acquire and install each section 1245 property in accordance with § 1.263(a)– 2(d)(1).

Example 8. Betterment; building remodel. (i) G owns a large chain of retail stores that sell a variety of items. G determines that due to changes in the retail market, it can no longer compete in its current store class and decides to upgrade its stores to offer higher end products to a different type of customer. To offer these products and attract different types of customers, G must substantially remodel its stores. Thus, G pays amounts to remodel its stores by performing work on the buildings’ structures and systems as defined under paragraphs (e)(2)(ii)(A) and (e)(2)(ii)(B) of this section. This work includes replacing large parts of the exterior walls with windows, replacing the escalators with a monumental staircase, adding a new glass enclosed elevator, rebuilding the interior and exterior facades, replacing vinyl floors with ceramic flooring, replacing ceiling tiles with acoustical tiles, and removing and rebuilding walls to move changing rooms and create specialty departments. The work also includes upgrades to increase the capacity of the buildings’ electrical system to accommodate the structural changes and the addition of new section 1245 property, such as new product information kiosks and point of sale systems. The work to the electrical system also involves the installation of new more efficient and mood enhancing lighting fixtures. In addition, the work includes remodeling all bathrooms by replacing contractor-grade plumbing fixtures with designer-grade fixtures that conserve water and energy. Finally, G also pays amounts to clean debris resulting from construction during the remodel, patch holes in walls that were made to upgrade the electrical system, repaint existing walls with a new color scheme to match the new interior construction, and to power wash building exteriors to enhance the new exterior facade.

(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. Considering the facts and circumstances, including the purpose of the expenditure, the physical nature of the work performed, and the effect of the work on the buildings’ structures and buildings’ systems, the amounts that G pays for the remodeling of its stores result in betterments to the buildings’ structures and several of its systems under paragraph (j) of this section. Specifically, the amounts paid to replace large parts of the exterior walls with windows, replace the escalators with a monumental staircase, add a new elevator, rebuild the interior and exterior facades, replace vinyl floors with ceramic flooring, replace the ceiling tiles with acoustical tiles, and to remove and rebuild walls are for material additions, that is the addition of major components, to the building structure under paragraph (j)(1)(ii) of this section and are reasonably expected to increase the quality of the building structure under


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paragraph (j)(1)(iii) of this section. Similarly, the amounts paid to upgrade the electrical system are to materially increase the capacity of the electrical system under paragraph (j)(1)(ii) of this section and are reasonably expected to increase the quality of this system under paragraph (j)(1)(iii) of this section. In addition, the amounts paid to remodel the bathrooms with higher grade and more resource-efficient materials are reasonably expected to increase the efficiency and quality of the plumbing system under paragraph (j)(1)(iii) of this section. Finally, the amounts paid to clean debris, patch and repaint existing walls with a new color scheme, and to power wash building exteriors, while not betterments by themselves, directly benefitted and were incurred by reason of the improvements to G’s store buildings’ structures and electrical systems under paragraph (g)(1) of this section. Therefore, G must treat the amounts paid for betterments to the store buildings’ structures and systems, including the costs of cleaning, patching, repairing, and power washing the building, as improvements to G’s buildings and must capitalize these amounts under paragraphs (d)(1) and (j) of this section. Moreover, G is required to capitalize the amounts paid to acquire and install each section 1245 property in accordance with § 1.263(a)–2(d)(1). For the treatment of amounts paid to remove components of property, see paragraph (g)(2) of this section.

Example 9. Not betterment; relocation and reinstallation of personal property. In Year 1, H purchases new cash registers for use in its retail store located in leased space in a shopping mall. Assume that each cash register is a unit of property as determined under paragraph (e)(3) of this section. In Year 1, H capitalizes the costs of acquiring and installing the new cash registers under § 1.263(a)–2(d)(1). In Year 3, H’s lease expires, and H decides to relocate its retail store to a different building. In addition to various other costs, H pays $5,000 to move the cash registers and $1,000 to reinstall them in the new store. The cash registers are used for the same purpose and in the same manner that they were used in the former location. The amounts that H pays to move and reinstall the cash registers into its new store do not result in a betterment to the cash registers under paragraph (j) of this section.

Example 10. Betterment; relocation and reinstallation of equipment. J operates a manufacturing facility in Building A, which contains various machines that J uses in its manufacturing business. J decides to expand part of its operations by relocating a machine to Building B to reconfigure the machine with additional components. Assume that the machine is a single unit of property under paragraph (e)(3) of this section. J pays amounts to disassemble the machine, to move the machine to the new location, and to reinstall the machine in a new configuration with additional components. Assume that the reinstallation, including the reconfiguration and the addition of components, is for an increase in capacity of the machine, and therefore is for a betterment to the machine under paragraph (j)(1)(ii) of this section. Accordingly, J must capitalize the costs of reinstalling the machine as an

improvement to the machine under paragraphs (j) and (d)(1) of this section. J is also required to capitalize the costs of disassembling and moving the machine to Building B because these costs directly benefit and are incurred by reason of the improvement to the machine under paragraph (g)(1) of this section.

Example 11. Betterment; regulatory requirement. K owns a building that it uses in its business. In Year 1, City C passes an ordinance setting higher safety standards for buildings because of the hazardous conditions caused by earthquakes. To comply with the ordinance, K pays an amount to add expansion bolts to its building structure. These bolts anchor the wooden framing of K’s building to its cement foundation, providing additional structural support and resistance to seismic forces, making the building more resistant to damage from lateral movement. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The framing and foundation are part of the building structure as defined in paragraph (e)(2)(ii)(A) of this section. Prior to the ordinance, the old building was in good condition but did not meet City C’s new requirements for earthquake resistance. The amount paid by K for the addition of the expansion bolts met City C’s new requirement, but also materially increased the strength of the building structure under paragraph (j)(1)(iii) of this section. Therefore, K must treat the amount paid to add the expansion bolts as a betterment to the building structure and must capitalize this amount as an improvement to building under paragraphs (d)(1) and (j) of this section. City C’s new requirement that K’s building meet certain safety standards to continue to operate is not relevant in determining whether the amount paid improved the building. See paragraph (g)(4) of this section.

Example 12. Not a betterment; regulatory requirement. L owns a meat processing plant. After operating the plant for many years, L discovers that oil is seeping through the concrete walls of the plant. Federal inspectors advise L that it must correct the seepage problem or shut down its plant. To correct the problem, L pays an amount to add a concrete lining to the walls from the floor to a height of about four feet and also to add concrete to the floor of the plant. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The walls are part of the building structure as defined in paragraph (e)(2)(ii)(A) of this section. The condition necessitating the expenditure was the seepage of the oil into the plant. Prior to the seepage, the walls did not leak and were functioning for their intended use. L is not required to treat the amount paid as a betterment under paragraphs (j)(1)(ii) and (j)(2)(iv) of this section because it is not paid for a material addition to, or a material increase in the capacity of, the building’s structure as compared to the condition of the structure prior to the seepage of oil.

Moreover, the amount paid is not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the building structure under paragraphs (j)(1)(iii) and (j)(2)(iv) as compared to the condition of the structure prior to the seepage of the oil Therefore, L is not required to treat the amount paid to correct the seepage as a betterment to the building under paragraph (d)(1) or (j) of this section. The federal inspectors’ requirement that L correct the seepage to continue operating the plant is not relevant in determining whether the amount paid improves the plant.

Example 13. Not a betterment; new roof membrane. M owns a building that it uses for its retail business. Over time, the waterproof membrane (top layer) on the roof of M’s building begins to wear, and M began to experience water seepage and leaks throughout its retail premises. To eliminate the problems, a contractor recommends that M put a new rubber membrane on the worn membrane. Accordingly, M pays the contractor to add the new membrane. The new membrane is comparable to the worn membrane when it was originally placed in service by the taxpayer. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The roof is part of the building structure under paragraph (e)(2)(ii)(A) of this section. The condition necessitating the expenditure was the normal wear of M’s roof. Under paragraph (j)(2)(iv) of this section, to determine whether the amounts are for a betterment, the condition of the building structure after the expenditure must be compared to the condition of the structure when M placed the building into service because M has not previously corrected the effects of normal wear and tear. Under these facts, the amount paid to add the new membrane to the roof is not for a material addition or a material increase in the capacity of the building structure under paragraph (j)(1)(ii) of this section as compared to the condition of the structure when it was placed in service. Moreover, the new membrane is not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the building structure under paragraph (j)(1)(iii) of this section as compared to the condition of the building structure when it was placed in service. Therefore, M is not required to treat the amount paid to add the new membrane as a betterment to the building under paragraph (d)(1) or (j) of this section.

Example 14. Material increase in capacity; building. N owns a factory building with a storage area on the second floor. N pays an amount to reinforce the columns and girders supporting the second floor to permit storage of supplies with a gross weight 50 percent greater than the previous load-carrying capacity of the storage area. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The


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columns and girders are part of the building structure defined under paragraph (e)(2)(ii)(A) of this section. N must treat the amount paid to reinforce the columns and girders as a betterment under paragraphs (j)(1)(ii) and (j)(1)(iii) of this section because it materially increases the load-carrying capacity and the strength of the building structure. Therefore, N must capitalize this amount as an improvement to the building under paragraphs (d)(1) and (j) of this section.

Example 15. Material increase in capacity; channel. O owns harbor facilities consisting of a slip for the loading and unloading of barges and a channel leading from the slip to the river. At the time of purchase, the channel was 150 feet wide, 1,000 feet long, and 10 feet deep. Several years after purchasing the harbor facilities, to allow for ingress and egress and for the unloading of larger barges, O decides to deepen the channel to a depth of 20 feet. O pays a contractor to dredge the channel to 20 feet. Assume the channel is the unit of property. O must capitalize the amounts paid for the dredging as an improvement to the channel because they are for a material increase in the capacity of the unit of property under paragraph (j)(1)(ii) of this section.

Example 16. Not a material increase in capacity; channel. Assume the same facts as in Example 15, except that the channel was susceptible to siltation and, after dredging to 20 feet, the channel depth had been reduced to 18 feet. O pays a contractor to redredge the channel to a depth of 20 feet. The expenditure was necessitated by the siltation of the channel. Both prior to the siltation and after the redredging, the depth of the channel was 20 feet. Applying the comparison rule under paragraph (j)(2)(iv) of this section, the amounts paid by O to redredge the channel are not for a betterment under paragraph (j)(1)(ii) of this section because they are not for a material addition to, or a material increase in the capacity of, the unit of property as compared to the condition of the property prior to the siltation. Similarly, these amounts are not for a betterment under paragraph (j)(1)(iii) of this section because the amounts are not reasonably expected to increase the productivity, efficiency, strength, quality, or output of the unit of property as compared to the condition of the property before the siltation. Therefore, O is not required to capitalize these amounts as improvement under paragraphs (d)(1) and (j) of this section.

Example 17. Material increase in capacity; channel. Assume the same facts as in Example 16 except that after the redredging, there is more siltation, and the channel depth is reduced back to 18 feet. In addition, to allow for additional ingress and egress and for the unloading of even larger barges, O decides to deepen the channel to a depth of 25 feet. O pays a contractor to redredge the channel to 25 feet. O must capitalize the amounts paid for the dredging as an improvement to the channel because the amounts are for a material increase in the capacity of the unit of property under paragraph (j)(1)(ii) of this section as compared to condition of the unit of property before the siltation. As part of this

improvement, O is also required to capitalize the portion of the redredge costs allocable to restoring the depth lost to the siltation because, under paragraph (g)(1)(i) of this section, these amounts directly benefit and are incurred by reason of the improvement to the unit of property.

Example 18. Not a material increase in capacity; building. P owns a building used in its trade or business. The first floor has a drop-ceiling. To fully expose windows on the first floor, P pays an amount to remove the drop-ceiling and repaint the original ceiling. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The ceiling is part of the building structure as defined under paragraph (e)(2)(ii)(A) of this section. P is not required to treat the amount paid to remove the drop-ceiling as a betterment to the building because it was not for a material addition or material increase in the capacity of the building structure under paragraph (j)(1)(ii) of this section and it was not reasonably expected to materially increase to the efficiency, strength, or quality of the building structure under paragraph (j)(1)(iii) of this section. In addition, under paragraph (j)(2)(i) of this section, because the effect on productivity and output of the building structure cannot be measured in this context, these factors are not relevant in determining whether there is a betterment to the building structure.

Example 19. Material increase in capacity; building. Q owns a building that it uses in its retail business. The building contains one floor of retail space with very high ceilings. Q pays an amount to add a stairway and a mezzanine for the purposes of adding additional selling space within its building. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The stairway and the mezzanine are part of the building structure as defined under paragraph (e)(2)(ii)(A) of this section. Q is required to treat the amount paid to add the stairway and mezzanine as a betterment because it is for a material addition to, and an increase in the capacity of, the building structure under paragraph (j)(1)(ii) of this section. Therefore, Q must capitalize this amount as an improvement to the building unit of property under paragraphs (d)(1) and (j) of this section.

Example 20. Not material increase in efficiency; HVAC system. R owns an office building that it uses to provide services to customers. The building contains an HVAC system that incorporates 10 roof-mounted units that provide heating and air conditioning for different parts of the building. The HVAC system also consists of controls for the entire system and duct work that distributes the heated or cooled air to the various spaces in the building’s interior. After many years of use of the HVAC system, R begins to experience climate control problems in various offices throughout the office building and consults with a contractor to determine the cause. The contractor

recommends that R replace two of the roof- mounted units. R pays an amount to replace the two specified units. The two new units are expected to eliminate the climate control problems and to be 10 percent more energy efficient than the replaced units in their original condition. No work is performed on the other roof-mounted heating/cooling units, the duct work, or the controls. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The HVAC system, including the two-roof mounted units, is a building system under paragraph (e)(2)(ii)(B)(1) of this section. The replacement of the two roof-mounted units is not a material addition to or a material increase in the capacity of the HVAC system under paragraphs (j)(1)(ii) and (j)(3)(ii) of this section as compared to the condition of the system prior to the climate control problems. In addition, given the 10 percent efficiency increase in two units of the entire HVAC system, the replacement is not expected to materially increase the productivity, efficiency, strength, quality, or output of the HVAC system under paragraphs (j)(1)(iii) and (j)(2)(iv) of this section as compared to the condition of the system prior to the climate control problems. Therefore, R is not required to capitalize the amounts paid for these replacements as betterments to the building unit of property under paragraphs (d)(1) and (j) of this section.

Example 21. Material increase in efficiency; building. S owns a building that it uses in its service business. S conducts an energy assessment and determines that it could significantly reduce its energy costs by adding insulation to its building. S pays an insulation contractor to apply a combination of loose-fill, spray foam, and blanket insulation throughout S’s building structure, including within the attic, walls, and crawl spaces. S reasonably expects the new insulation to make the building more energy efficient because the contractor indicated that the new insulation would reduce its annual energy and power costs by approximately 50 percent of its annual costs during the last five years. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building if the amount is paid for a betterment to the building structure or any building system. Therefore, under paragraphs (d)(1) and (j) of this section, S must capitalize as a betterment the amount paid to add the insulation because the insulation is reasonably expected to materially increase the efficiency of the building structure under paragraph (j)(1)(iii) of this section.

Example 22. Material addition; building. T owns and operates a restaurant, which provides a variety of prepared foods to its customers. To better accommodate its customers and increase customer traffic, T decides to add a drive-through service area. As a result, T pays amounts to partition an area within its restaurant for a drive-through service counter, to construct a service window with necessary security features, to build an overhang for vehicles, and to construct a drive-up menu board. Assume that the drive-up menu board is section 1245


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property that is a separate unit of property under paragraph (e)(3) of this section. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The amounts paid for the partition, service window and overhang are betterments to the building structure because they comprise a material addition (that is, a physical expansion, extension, and addition of a major component) to the building structure under paragraph (j)(1)(ii) of this section. Accordingly, T must capitalize as an improvement the amounts paid to add the partition, drive-through window, and overhang under paragraphs (d)(1) and (j) of this section. T is also required to capitalize the amounts paid to acquire and install each section 1245 property in accordance with § 1.263(a)–2(d)(1).

Example 23. Costs incurred during betterment. U owns a building that it uses in its service business. To accommodate new employees and equipment, U pays amounts to increase the load capacity of its electrical system by adding a second electrical panel with additional circuits and adding wiring and outlets throughout the electrical system of its building. To complete the upgrades to the electrical system, the contractor makes several holes in walls. As a result, U also incurs costs to patch the holes and repaint several walls. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. The amounts paid to upgrade the panel and wiring are for betterments to U’s electrical system because they increase the capacity of the electrical system under paragraph (j)(1)(ii) of this section and increase the strength and output of the electrical system under paragraph (j)(1)(iii) of this section. Accordingly, U is required to capitalize the costs of the upgrade to the electrical system as an improvement to the building unit of property under paragraphs (d)(1) and (j) of this section. Moreover, under paragraph (g)(1) of this section, U is required to capitalize the amounts paid to patch holes and repaint several walls in its building because these costs directly benefit and are incurred by reason of the improvement to U’s building unit of property.

(k) Capitalization of restorations—(1) In general. A taxpayer must capitalize as an improvement an amount paid to restore a unit of property, including an amount paid to make good the exhaustion for which an allowance is or has been made. An amount restores a unit of property only if it—

(i) Is for the replacement of a component of a unit of property for which the taxpayer has properly deducted a loss for that component, other than a casualty loss under § 1.165– 7;

(ii) Is for the replacement of a component of a unit of property for which the taxpayer has properly taken

into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;

(iii) Is for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss under section 165, or relating to a casualty event described in section 165, subject to the limitation in paragraph (k)(4) of this section;

(iv) Returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;

(v) Results in the rebuilding of the unit of property to a like-new condition after the end of its class life as defined in paragraph (i)(4) of this section (see paragraph (k)(5) of this section); or

(vi) Is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property (see paragraph (k)(6) of this section).

(2) Application of restorations to buildings. An amount is paid to improve a building if it is paid to restore (as defined under paragraph (k)(1) of this section) a property specified under paragraph (e)(2)(ii) (building), paragraph (e)(2)(iii)(B) (condominium), paragraph (e)(2)(iv)(B) (cooperative), or paragraph (e)(2)(v)(B) (leased building or portion of building) of this section. For example, an amount is paid to improve a building if it is paid for the replacement of a part or combination of parts that comprise a major component or substantial structural part of the building structure or any one of its building systems (for example, the HVAC system). See paragraph (k)(6) of this section.

(3) Exception for losses based on salvage value. A taxpayer is not required to treat as a restoration amounts paid under paragraph (k)(1)(i) or paragraph (k)(1)(ii) of this section if the unit of property has been fully depreciated and the loss is attributable only to remaining salvage value as computed for federal income tax purposes.

(4) Restoration of damage from casualty—(i) Limitation. For purposes of paragraph (k)(1)(iii) of this section, the amount paid for restoration of damage to the unit of property that must be capitalized under this paragraph (k) is limited to the excess (if any) of—

(A) The amount prescribed by § 1.1011–1 as the adjusted basis of the single, identifiable property (under § 1.167–7(b)(2)(i)) for determining the loss allowable on account of the casualty, over

(B) The amount paid for restoration of damage to the unit of property under paragraph (k)(1)(iii) of this section that also constitutes an improvement under any other provision of paragraph (k)(1) of this section.

(ii) Amounts in excess of limitation. The amounts paid for restoration of damage to a unit of property as described in paragraph (k)(1)(iii) of this section, but that exceed the limitation provided in paragraph (k)(4)(i) of this section, must be treated in accordance with the provisions of the Internal Revenue Code and regulations that are otherwise applicable. See, for example, § 1.162–4 (repairs and maintenance); § 1.263(a)–2 (costs to acquire and produce units of property); and § 1.263(a)-3 (costs to improve units of property).

(5) Rebuild to like-new condition. For purposes of paragraph (k)(1)(v) of this section, a unit of property is rebuilt to a like-new condition if it is brought to the status of new, rebuilt, remanufactured, or a similar status under the terms of any federal regulatory guideline or the manufacturer’s original specifications. Generally, a comprehensive maintenance program, even though substantial, does not return a unit of property to a like-new condition.

(6) Replacement of a major component or a substantial structural part—(i) In general. To determine whether an amount is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of the unit of property under paragraph (k)(1)(vi) of this section, it is appropriate to consider all the facts and circumstances. These facts and circumstances include the quantitative and qualitative significance of the part or combination of parts in relation to the unit of property.

(A) Major component. A major component is a part or combination of parts that performs a discrete and critical function in the operation of the unit of property. An incidental component of the unit of property, even though such component performs a discrete and critical function in the operation of the unit of property, generally will not, by itself, constitute a major component.

(B) Substantial structural part. A substantial structural part is a part or combination of parts that comprises a large portion of the physical structure of the unit of property.

(ii) Major components and substantial structural parts of buildings. In the case of a building, an amount is for the replacement of a major component or a


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substantial structural part of the building unit of property if—

(A) The replacement includes a part or combination of parts that comprise a major component (as defined in paragraph (k)(6)(i)(A) of this section), or a significant portion of a major component, of any of the properties designated in paragraph (e)(2)(ii) (building), paragraph (e)(2)(iii)(B) (condominium), paragraph (e)(2)(iv)(B) (cooperative), or paragraph (e)(2)(v)(B) (leased building or leased portion of a building) of this section; or

(B) The replacement includes a part or combination of parts that comprises a large portion of the physical structure of any of the properties designated in paragraph (e)(2)(ii) (building), paragraph (e)(2)(iii)(B) (condominium), paragraph (e)(2)(iv)(B) (cooperative), or paragraph (e)(2)(v)(B) (leased building or portion of building) of this section.

(7) Examples. The following examples illustrate the application of this paragraph (k) only and do not address whether capitalization is required under another provision of this section or another provision of the Code (for example, section 263A). Unless otherwise stated, assume that the taxpayer has not properly deducted a loss for, nor taken into account the adjusted basis on a sale or exchange of, any unit of property, asset, or component of a unit of property that is replaced.

Example 1. Replacement of loss component. A owns a manufacturing building containing various types of manufacturing equipment. A does a cost segregation study of the manufacturing building and properly determines that a walk-in freezer in the manufacturing building is section 1245 property as defined in section 1245(a)(3). The freezer is not part of the building structure or the HVAC system under paragraph (e)(2)(i) or (e)(2)(ii)(B)(1) of this section. Several components of the walk-in freezer cease to function, and A decides to replace them. A abandons the old freezer components and properly recognizes a loss from the abandonment of the components. A replaces the abandoned freezer components with new components and incurs costs to acquire and install the new components. Under paragraph (k)(1)(i) of this section, A must capitalize the amounts paid to acquire and install the new freezer components because A replaced components for which it had properly deducted a loss.

Example 2. Replacement of sold component. Assume the same facts as in Example 1, except that A did not abandon the components but instead sold them to another party and properly recognized a loss on the sale. Under paragraph (k)(1)(ii) of this section, A must capitalize the amounts paid to acquire and install the new freezer components because A replaced components for which it had properly taken into account the adjusted basis of the components in

realizing a loss from the sale of the components.

Example 3. Restoration after casualty loss. B owns an office building that it uses in its trade or business. A storm damages the office building at a time when the building has an adjusted basis of $500,000. B deducts under section 165 a casualty loss in the amount of $50,000, and properly reduces its basis in the office building to $450,000. B hires a contractor to repair the damage to the building, including the repair of the building roof and the removal of debris from the building premises. B pays the contractor $50,000 for the work. Under paragraph (k)(1)(iii) of this section, B must treat the $50,000 amount paid to the contractor as a restoration of the building structure because B properly adjusted its basis in that amount as a result of a casualty loss under section 165, and the amount does not exceed the limit in paragraph (k)(4) of this section. Therefore, B must treat the amount paid as an improvement to the building unit of property and, under paragraph (d)(2) of this section, must capitalize the amount paid.

Example 4. Restoration after casualty event. Assume the same facts as in Example 3, except that B receives insurance proceeds of $50,000 after the casualty to compensate for its loss. B cannot deduct a casualty loss under section 165 because its loss was compensated by insurance. However, B properly reduces its basis in the property by the amount of the insurance proceeds. Under paragraph (k)(1)(iii) of this section, B must treat the $50,000 amount paid to the contractor as a restoration of the building structure because B has properly taken a basis adjustment relating to a casualty event described in section 165, and the amount does not exceed the limit in paragraph (k)(4) of this section. Therefore, B must treat the amount paid as an improvement to the building unit of property and, under paragraph (d)(2) of this section, must capitalize the amount paid.

Example 5. Restoration after casualty loss; limitation. (i) C owns a building that it uses in its trade or business. A storm damages the building at a time when the building has an adjusted basis of $500,000. C determines that the cost of restoring its property is $750,000, deducts a casualty loss under section 165 in the amount of $500,000, and properly reduces its basis in the building to $0. C hires a contractor to repair the damage to the building and pays the contractor $750,000 for the work. The work involves replacing the entire roof structure of the building at a cost of $350,000 and pumping water from the building, cleaning debris from the interior and exterior, and replacing areas of damaged dry wall and flooring at a cost of $400,000. Although resulting from the casualty event, the pumping, cleaning, and replacing damaged drywall and flooring, does not directly benefit and is not incurred by reason of the roof replacement.

(ii) Under paragraph (k)(1)(vi) of this section, C must capitalize as an improvement the $350,000 amount paid to the contractor to replace the roof structure because the roof structure constitutes a major component and a substantial structural part of the building unit of property. In addition, under

paragraphs (k)(1)(iii) and (k)(4)(i), C must treat as a restoration the remaining costs, limited to the excess of the adjusted basis of the building over the amounts paid for the improvement under paragraph (k)(1)(vi). Accordingly, C must treat as a restoration $150,000 ($500,000—$350,000) of the $400,000 paid for the portion of the costs related to repairing and cleaning the building structure under paragraph (k)(1)(iii) of this section. Thus, in addition to the $350,000 to replace the roof structure, C must also capitalize the $150,000 as an improvement to the building unit of property under paragraph (d)(2) of this section. C is not required to capitalize the remaining $250,000 repair and cleaning costs under paragraph (k)(1)(iii) of this section.

Example 6. Restoration of property in a state of disrepair. D owns and operates a farm with several barns and outbuildings. D did not use or maintain one of the outbuildings on a regular basis, and the outbuilding fell into a state of disrepair. The outbuilding previously was used for storage but can no longer be used for that purpose because the building is not structurally sound. D decides to restore the outbuilding and pays an amount to shore up the walls and replace the siding. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount is paid to restore the building structure or any building system. The walls and siding are part of the building structure under paragraph (e)(2)(ii)(A) of this section. Under paragraph (k)(1)(iv) of this section, D must treat the amount paid to shore up the walls and replace the siding as a restoration of the building structure because the amounts return the building structure to its ordinarily efficient operating condition after it had deteriorated to a state of disrepair and was no longer functional for its intended use. Therefore, D must treat the amount paid to shore up the walls and replace the siding as an improvement to the building unit of property and, under paragraph (d)(2) of this section, must capitalize the amount paid.

Example 7. Rebuild of property to like-new condition before end of class life. E is a Class I railroad that owns a fleet of freight cars. Assume the freight cars have a recovery period of 7 years under section 168(c) and a class life of 14 years. Every 8 to 10 years, E rebuilds its freight cars. Ten years after E places the freight car in service, E performs a rebuild to the manufacturer’s original specification, which includes a complete disassembly, inspection, and reconditioning or replacement of components of the suspension and draft systems, trailer hitches, and other special equipment. E also modifies the car to upgrade various components to the latest engineering standards. The freight car is stripped to the frame, with all of its substantial components either reconditioned or replaced. The frame itself is the longest- lasting part of the car and is reconditioned. The walls of the freight car are replaced or are sandblasted and repainted. New wheels are installed on the car. All the remaining components of the car are restored before they are reassembled. At the end of the rebuild, the freight car has been restored to like-new condition under the manufacturer’s


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specifications. Assume the freight car is the unit of property. E is not required to treat as an improvement and capitalize the amounts paid to rebuild the freight car under paragraph (k)(1)(v) of this section because, although the amounts paid restore the freight car to like-new condition, the amounts were not paid after the end of the class life of the freight car. However, see paragraphs (k)(1)(vi) and (k)(6) of this section to determine whether any amounts must be capitalized because they are paid for the replacement of a major component or a substantial structural part of the unit of property.

Example 8. Rebuild of property to like-new condition after end of class life. Assume the same facts as in Example 7, except that E rebuilds the freight car 15 years after E places it in service. Under paragraph (k)(1)(v) of this section, E must treat as an improvement and capitalize the amounts paid to rebuild the freight car because the amounts paid restore the freight car to like-new condition after the end of the class life of the freight car.

Example 9. Not a rebuild to a like-new condition. F is a commercial airline engaged in the business of transporting freight and passengers. To conduct its business, F owns several aircraft. As a condition of maintaining its airworthiness certificates, F is required by the FAA to establish and adhere to a continuous maintenance program for each aircraft in its fleet. F performs heavy maintenance on its airframes every 8 to 10 years. In Year 1, F purchased an aircraft for $15 million. In Year 16, F paid $2 million for the labor and materials necessary to perform the second heavy maintenance visit on the airframe of an aircraft. To perform the heavy maintenance visit, F extensively disassembles the airframe, removing items such as engines, landing gear, cabin and passenger compartment seats, side and ceiling panels, baggage stowage bins, galleys, lavatories, floor boards, cargo loading systems, and flight control surfaces. As specified by F’s maintenance manual for the aircraft, F then performs certain tasks on the disassembled airframe for the purpose of preventing deterioration of the inherent safety and reliability levels of the airframe. These tasks include lubrication and service, operational and visual checks, inspection and functional checks, reconditioning of minor parts and components, and removal, discard, and replacement of certain life- limited single cell parts, such as cartridges, canisters, cylinders, and disks. Reconditioning of parts includes burnishing corrosion, repairing cracks, dents, gouges, punctures, tightening or replacing loose or missing fasteners, replacing damaged seals, gaskets, or valves, and similar activities. In addition to the tasks described above, to comply with certain FAA airworthiness directives, F inspects specific skin locations, applies doublers over small areas where cracks were found, adds structural reinforcements, and replaces skin panels on a small section of the fuselage. However, the heavy maintenance does not include the replacement of any major components or substantial structural parts of the aircraft with new components. In addition, the heavy maintenance visit does not bring the aircraft to the status of new, rebuilt, remanufactured,

or a similar status under FAA guidelines or the manufacturer’s original specifications. After the heavy maintenance, the aircraft was reassembled. Assume the aircraft, including the engines, is a unit of property and has a class life of 12 years under section 168(c). Although the heavy maintenance is performed after the end of the class life of the aircraft, F is not required to treat the heavy maintenance as a restoration and improvement of the unit of property under paragraph (k)(1)(v) of this section because, although extensive, the amounts paid do not restore the aircraft to like-new condition. See also paragraph (i)(1)(iii) of this section for the application of the safe harbor for routine maintenance.

Example 10. Replacement of major component or substantial structural part; personal property. G is a common carrier that owns a fleet of petroleum hauling trucks. G pays amounts to replace the existing engine, cab, and petroleum tank with a new engine, cab, and tank. Assume the tractor of the truck (which includes the cab and the engine) is a single unit of property and that the trailer (which contains the petroleum tank) is a separate unit of property. The new engine and the cab each constitute a part or combination of parts that comprise a major component of G’s tractor, because they perform a discrete and critical function in the operation of the tractor. In addition, the cab constitutes a part or combination of parts that comprise a substantial structural part of G’s tractor. Therefore, the amounts paid for the replacement of the engine and the cab must be capitalized under paragraph (k)(1)(vi) of this section. Moreover, the new petroleum tank constitutes a part or combination of parts that comprise a major component and a substantial structural part of the trailer. Accordingly, the amounts paid for the replacement of the tank also must be capitalized under paragraph (k)(1)(vi) of this section.

Example 11. Repair performed during restoration. Assume the same facts as in Example 10, except that, at the same time the engine and cab of the tractor are replaced, G pays amounts to paint the cab of the tractor with its company logo and to fix a broken taillight on the tractor. The repair of the broken taillight and the painting of the cab generally are deductible expenses under § 1.162–4. However, under paragraph (g)(1)(i) of this section, a taxpayer must capitalize all the direct costs of an improvement and all the indirect costs that directly benefit or are incurred by reason of an improvement. Repairs and maintenance that do not directly benefit or are not incurred by reason of an improvement are not required to be capitalized under section 263(a), regardless of whether they are made at the same time as an improvement. For the amounts paid to paint the logo on the cab, G’s need to paint the logo arose from the replacement of the cab with a new cab. Therefore, under paragraph (g)(1)(i) of this section, G must capitalize the amounts paid to paint the cab as part of the improvement to the tractor because these amounts directly benefit and are incurred by reason of the restoration of the tractor. The amounts paid to repair the broken taillight are not for the replacement

of a major component, do not directly benefit, and are not incurred by reason of the replacement of the cab or the engine under paragraph (g)(1)(i) of this section, even though the repair was performed at the same time as these replacements. Thus, G is not required to capitalize the amounts paid to repair the broken taillight.

Example 12. Related amounts to replace major component or substantial structural part; personal property. (i) H owns a retail gasoline station, consisting of a paved area used for automobile access to the pumps and parking areas, a building used to market gasoline, and a canopy covering the gasoline pumps. The premises also consist of underground storage tanks (USTs) that are connected by piping to the pumps and are part of the gasoline pumping system used in the immediate retail sale of gas. The USTs are components of the gasoline pumping system. To comply with regulations issued by the Environmental Protection Agency, H is required to remove and replace leaking USTs. In Year 1, H hires a contractor to perform the removal and replacement, which consists of removing the old tanks and installing new tanks with leak detection systems. The removal of the old tanks includes removing the paving material covering the tanks, excavating a hole large enough to gain access to the old tanks, disconnecting any strapping and pipe connections to the old tanks, and lifting the old tanks out of the hole. Installation of the new tanks includes placement of a liner in the excavated hole, placement of the new tanks, installation of a leak detection system, installation of an overfill system, connection of the tanks to the pipes leading to the pumps, backfilling of the hole, and replacement of the paving. H also is required to pay a permit fee to the county to undertake the installation of the new tanks.

(ii) H pays the permit fee to the county on October 15, Year 1. On December 15, Year 1, the contractor completes the removal of the old USTs and bills H for the costs of removal. On January 15, Year 2, the contractor completes the installation of the new USTs and bills H for the remainder of the work. Assume that H computes its taxes on a calendar year basis and H’s gasoline pumping system is the unit of property. Under paragraph (k)(1)(vi) of this section, H must capitalize the amounts paid to replace the USTs as a restoration to the gasoline pumping system because the USTs are parts or combinations of parts that comprise a major component and substantial structural part of the gasoline pumping system. Moreover, under paragraph (g)(2) of this section, H must capitalize the costs of removing the old USTs because H has not taken a loss on the disposition of the USTs, and the amounts to remove the USTs directly benefit and are incurred by reason of the restoration of, and improvement to, the gasoline pumping system. In addition, under paragraph (g)(1) of this section, H must capitalize the permit fees because they directly benefit and are incurred by reason of the improvement to the gasoline pumping system. Finally, under paragraph (g)(3) of this section, H must capitalize the related amounts paid to improve the gasoline


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pumping system, including the permit fees, the amount paid to remove the old USTs, and the amount paid to install the new USTs, even though the amounts were separately invoiced, paid to different parties, and incurred in different tax years.

Example 13. Not replacement of major component; incidental. J owns a machine shop in which it makes dies used by manufacturers. In Year 1, J purchased a drill press for use in its production process. In Year 3, J discovers that the power switch assembly, which controls the supply of electric power to the drill press, has become damaged and cannot operate. To correct this problem, J pays amounts to replace the power switch assembly with comparable and commercially available replacement parts. Assume that the drill press is a unit of property under paragraph (e) of this section and the power switch assembly is a small component of the drill press that may be removed and installed with relative ease. The power switch assembly is not a major component of the unit of property under paragraph (k)(6)(i)(A) of this section because, although the power assembly may affect the function of J’s drill press by controlling the supply of electric power, the power assembly is an incidental component of the drill press. In addition, the power assembly is not a substantial structural part of J’s drill press under paragraph (k)(6)(i)(B) of this section. Therefore, J is not required to capitalize the costs to replace the power switch assembly under paragraph (k)(1)(vi) of this section.

Example 14. Replacement of major component or substantial structural part; roof. K owns a manufacturing building. K discovers several leaks in the roof of the building and hires a contractor to inspect and fix the roof. The contractor discovers that a major portion of the decking has rotted and recommends the replacement of the entire roof. K pays the contractor to replace the entire roof, including the decking, insulation, asphalt, and various coatings. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount is paid to restore the building structure or any building system. The roof is part of the building structure as defined under paragraph (e)(2)(ii)(A) of this section. Because the entire roof performs a discrete and critical function in the building structure, the roof comprises a major component of the building structure under paragraph (k)(6)(ii)(A) of this section. In addition, because the roof comprises a large portion of the physical structure of the building structure, the roof comprises a substantial structural part of the building structure under paragraph (k)(6)(ii)(B) of this section. Therefore, under either analysis, K must treat the amount paid to replace the roof as a restoration of the building under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an improvement under paragraph (d)(2) of this section.

Example 15. Not replacement of major component or substantial structural part; roof membrane. L owns a building in which it conducts its retail business. The roof decking over L’s building is covered with a waterproof rubber membrane. Over time, the

rubber membrane begins to wear, and L begins to experience leaks into its retail premises. However, the building is still functioning in L’s business. To eliminate the problems, a contractor recommends that L replace the membrane on the roof with a new rubber membrane. Accordingly, L pays the contractor to strip the original membrane and replace it with a new rubber membrane. The new membrane is comparable to the original membrane but corrects the leakage problems. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount is paid to restore the building structure or any building system. The roof, including the membrane, is part of the building structure as defined under paragraph (e)(2)(ii)(A) of this section. Because the entire roof performs a discrete and critical function in the building structure, the roof comprises a major component of the building structure under paragraph (k)(6)(ii)(A) of this section. Although the replacement membrane may aid in the function of the building structure, it does not, by itself, comprise a significant portion of the roof major component under paragraph (k)(6)(ii)(A) of this section. In addition, the replacement membrane does not comprise a substantial structural part of L’s building structure under paragraph (k)(6)(ii)(B) of this section. Therefore, L is not required to capitalize the amount paid to replace the membrane as a restoration of the building under paragraph (k)(1)(vi) of this section.

Example 16. Not a replacement of major component or substantial structural part; HVAC system. M owns a building in which it operates an office that provides medical services. The building contains one HVAC system, which is comprised of three furnaces, three air conditioning units, and duct work that runs throughout the building to distribute the hot or cold air throughout the building. One furnace in M’s building breaks down, and M pays an amount to replace it with a new furnace. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount is paid to restore the building structure or any building system. The HVAC system, including the furnaces, is a building system under paragraph (e)(2)(ii)(B)(1) of this section. As the parts that provide the heating function in the system, the three furnaces, together, perform a discrete and critical function in the operation of the HVAC system and are therefore a major component of the HVAC system under paragraph (k)(6)(i)(A) of this section. However, the single furnace is not a significant portion of this major component of the HVAC system under paragraph (k)(6)(ii)(A) of this section, or a substantial structural part of the HVAC system under paragraph (k)(6)(ii)(B) of this section. Therefore, M is not required to treat the amount paid to replace the furnace as a restoration of the building under paragraph (k)(1)(vi) of this section.

Example 17. Replacement of major component or substantial structural part; HVAC system. N owns a large office building in which it provides consulting services. The building contains one HVAC system, which is comprised of one chiller unit, one boiler,

pumps, duct work, diffusers, air handlers, outside air intake, and a cooling tower. The chiller unit includes the compressor, evaporator, condenser, and expansion valve, and it functions to cool the water used to generate air conditioning throughout the building. N pays an amount to replace the chiller with a comparable unit. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount is paid to restore the building structure or any building system. The HVAC system, including the chiller unit, is a building system under paragraph (e)(2)(ii)(B)(1) of this section. The chiller unit performs a discrete and critical function in the operation of the HVAC system because it provides the cooling mechanism for the entire system. Therefore, the chiller unit is a major component of the HVAC system under paragraph (k)(6)(ii)(A) of this section. Because the chiller unit comprises a major component of a building system, N must treat the amount paid to replace the chiller unit as a restoration to the building under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an improvement to the building under paragraph (d)(2) of this section.

Example 18. Not replacement of major component or substantial structural part; HVAC system. O owns an office building that it uses to provide services to customers. The building contains a HVAC system that incorporates ten roof-mounted units that provide heating and air conditioning for the building. The HVAC system also consists of controls for the entire system and duct work that distributes the heated or cooled air to the various spaces in the building’s interior. O begins to experience climate control problems in various offices throughout the office building and consults with a contractor to determine the cause. The contractor recommends that O replace three of the roof- mounted heating and cooling units. O pays an amount to replace the three specified units. No work is performed on the other roof-mounted heating and cooling units, the duct work, or the controls. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The HVAC system, including the 10 roof-mounted heating and cooling units, is a building system under paragraph (e)(2)(ii)(B)(1) of this section. As the components that generate the heat and the air conditioning in the HVAC system, the 10 roof-mounted units, together, perform a discrete and critical function in the operation of the HVAC system and, therefore, are a major component of the HVAC system under paragraph (k)(6)(ii)(A) of this section. The three roof-mounted heating and cooling units are not a significant portion of a major component of the HVAC system under (k)(6)(ii)(A) of this section, or a substantial structural part of the HVAC system, under paragraph (k)(6)(ii)(B) of this section. Accordingly, O is not required to treat the amount paid to replace the three roof- mounted heating and cooling units as a restoration of the building under paragraph (k)(1)(iv) of this section.

Example 19. Replacement of major component or substantial structural part; fire


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protection system. P owns a building that it uses to operate its business. P pays an amount to replace the sprinkler system in the building with a new sprinkler system. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The fire protection and alarm system, including the sprinkler system, is a building system under paragraph (e)(2)(ii)(B)(6) of this section. As the component that provides the fire suppression mechanism in the system, the sprinkler system performs a discrete and critical function in the operation of the fire protection and alarm system and is therefore a major component of the system under paragraph (k)(6)(ii)(A) of this section. Because the sprinkler system comprises a major component of a building system, P must treat the amount paid to replace the sprinkler system as restoration to the building unit of property under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an improvement to the building under paragraph (d)(2) of this section.

Example 20. Replacement of major component or substantial structural part; electrical system. Q owns a building that it uses to operate its business. Q pays an amount to replace the wiring throughout the building with new wiring that meets building code requirements. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The electrical system, including the wiring, is a building system under paragraph (e)(2)(ii)(B)(3) of this section. As the component that distributes the electricity throughout the system, the wiring performs a discrete and critical function in the operation of the electrical system under paragraph (k)(6)(ii)(A) of this section. The wiring also comprises a large portion of the physical structure of the electrical system under paragraph (k)(6)(ii)(B) of this section. Because the wiring comprises a major component and a substantial structural part of a building system, Q must treat the amount paid to replace the wiring as a restoration to the building under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an improvement to the building under paragraph (d)(2) of this section.

Example 21. Not a replacement of major component or substantial structural part; electrical system. R owns a building that it uses to operate its business. R pays an amount to replace 30 percent of the wiring throughout the building with new wiring that meets building code requirements. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The electrical system, including the wiring, is a building system under paragraph (e)(2)(ii)(B)(3) of this section. All the wiring in the building comprises a major component because it performs a discrete and critical function in the operation of the electrical system. However, the portion of the wiring that was replaced is not a significant portion of the

wiring major component under paragraph (k)(6)(ii)(A) of this section, nor does it comprise a substantial structural part of the electrical system under paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this section, the replacement of 30 percent of the wiring is not the replacement of a major component or substantial structural part of the building, and R is not required to treat the amount paid to replace 30 percent of the wiring as a restoration to the building under paragraph (k)(1)(iv) of this section.

Example 22. Replacement of major component or substantial structural part; plumbing system. S owns a building in which it conducts a retail business. The retail building has three floors. The retail building has men’s and women’s restrooms on two of the three floors. S decides to update the restrooms by paying an amount to replace the plumbing fixtures in all of the restrooms, including all the toilets and sinks, with modern style plumbing fixtures of similar quality and function. S does not replace the pipes connecting the fixtures to the building’s plumbing system. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The plumbing system, including the plumbing fixtures, is a building system under paragraph (e)(2)(ii)(B)(2) of this section. All the toilets together perform a discrete and critical function in the operation of the plumbing system, and all the sinks, together, also perform a discrete and critical function in the operation of the plumbing system. Therefore, under paragraph (k)(6)(ii)(A) of this section, all the toilets comprise a major component of the plumbing system, and all the sinks comprise a major component of the plumbing system. Accordingly, S must treat the amount paid to replace all of the toilets and all of the sinks as a restoration of the building under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an improvement to the building under paragraph (d)(2) of this section.

Example 23. Not replacement of major component or substantial structural part; plumbing system. Assume the same facts as Example 22 except that S does not update all the bathroom fixtures. Instead, S only pays an amount to replace 8 of the total of 20 sinks located in the various restrooms. The 8 replaced sinks, by themselves, do not comprise a significant portion of a major component (the 20 sinks) of the plumbing system under paragraph (k)(6)(ii)(A) of this section nor do they comprise a large portion of the physical structure of the plumbing system under paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this section, the replacement of the eight sinks does not constitute the replacement of a major component or substantial structural part of the building, and S is not required to treat the amount paid to replace the eight sinks as a restoration of a building under paragraph (k)(1)(iv) of this section.

Example 24. Replacement of major component or substantial structural part; plumbing system. (i) T owns and operates a hotel building. T decides that, to attract

customers and to remain competitive, it needs to update the guest rooms in its facility. Accordingly, T pays amounts to replace the bathtubs, toilets, and sinks, and to repair, repaint, and retile the bathroom walls and floors, which is necessitated by the installation of the new plumbing components. The replacement bathtubs, toilets, sinks, and tile are new and in a different style, but are similar in function and quality to the replaced items. T also pays amounts to replace certain section 1245 property, such as the guest room furniture, carpeting, drapes, table lamps, and partition walls separating the bathroom area. T completes this work on two floors at a time, closing those floors and leaving the rest of the hotel open for business. In Year 1, T pays amounts to perform the updates for 4 of the 20 hotel room floors and expects to complete the renovation of the remaining rooms over the next two years.

(ii) Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The plumbing system, including the bathtubs, toilets, and sinks, is a building system under paragraph (e)(2)(ii)(B)(2) of this section. All the bathtubs, together, all the toilets, together, and all the sinks together in the hotel building perform discrete and critical functions in the operation of the plumbing system under paragraph (k)(6)(ii)(A) of this section and comprise a large portion of the physical structure of the plumbing system under paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6)(ii) of this section, these plumbing components comprise major components and substantial structural parts of the plumbing system, and T must treat the amount paid to replace these plumbing components as a restoration of, and improvement to, the building under paragraphs (k)(1)(vi) and (k)(2) of this section. In addition, under paragraph (g)(1)(i) of this section, T must treat the costs of repairing, repainting, and retiling the bathroom walls and floors as improvement costs because these costs directly benefit and are incurred by reason of the improvement to the building. Further, under paragraph (g)(3) of this section, T must treat the costs incurred in Years 1, 2, and 3 for the bathroom remodeling as improvement costs, even though they are incurred over a period of several taxable years, because they are related amounts paid to improve the building unit of property. Accordingly, under paragraph (d)(2) of this section, T must treat all the amounts it incurs to update its hotel restrooms as an improvement to the hotel building and capitalize these amounts. In addition, under § 1.263(a)–2 of the regulations, T must capitalize the amounts paid to acquire and install each section 1245 property.

Example 25. Not replacement of major component or substantial structural part; windows. U owns a large office building that it uses to provide office space for employees that manage U’s operations. The building has 300 exterior windows that represent 25 percent of the total surface area of the building. In Year 1, U pays an amount to replace 100 of the exterior windows that had


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become damaged. At the time of these replacements, U has no plans to replace any other windows in the near future. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The exterior windows are part of the building structure as defined under paragraph (e)(2)(ii)(A) of this section. The 300 exterior windows perform a discrete and critical function in the operation of the building structure and are, therefore, a major component of the building structure under paragraph (k)(6)(i)(A) of this section. However, the 100 windows do not comprise a significant portion of this major component of the building structure under paragraph (k)(6)(ii)(A) of this section or a substantial structural part of the building structure under paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this section, the replacement of the 100 windows does not constitute the replacement of a major component or substantial structural part of the building, and U is not required to treat the amount paid to replace the 100 windows as restoration of the building under paragraph (k)(1)(iv) of this section.

Example 26. Replacement of major component; windows. Assume the same facts as Example 25, except that that U replaces 200 of the 300 windows on the building. The 300 exterior windows perform a discrete and critical function in the operation of the building structure and are, therefore, a major component of the building structure under paragraph (k)(6)(i)(A) of this section. The 200 windows comprise a significant portion of this major component of the building structure under paragraph (k)(6)(ii)(A) of this section. Therefore, under paragraph (k)(6) of this section, the replacement of the 200 windows comprise the replacement of a major component of the building structure. Accordingly, U must treat the amount paid to replace the 200 windows as a restoration of the building under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an improvement to the building under paragraph (d)(2) of this section.

Example 27. Replacement of substantial structural part; windows. Assume the same facts as Example 25, except that the building is a modern design and the 300 windows represent 90 percent of the total surface area of the building. U replaces 100 of the 300 windows on the building. The 300 exterior windows perform a discrete and critical function in the operation of the building structure and are, therefore, a major component of the building structure under paragraph (k)(6)(i)(A) of this section. The 100 windows do not comprise a significant portion of this major component of the building structure under paragraph (k)(6)(ii)(A) of this section, however, they do comprise a substantial structural part of the building structure under paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this section, the replacement of the 100 windows comprise the replacement of a substantial structural part of the building structure. Accordingly, U must treat the amount paid to replace the 100 windows as a restoration of the building unit

of property under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an improvement to the building under paragraph (d)(2) of this section.

Example 28. Not replacement of major component or substantial structural part; floors. V owns and operates a hotel building. V decides to refresh the appearance of the hotel lobby by replacing the floors in the lobby. The hotel lobby comprises less than 10 percent of the square footage of the entire hotel building. V pays an amount to replace the wood flooring in the lobby with new wood flooring of a similar quality. V did not replace any other flooring in the building. Assume that the wood flooring constitutes section 1250 property. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The wood flooring is part of the building structure under paragraph (e)(2)(ii)(A) of this section. All the floors in the hotel building comprise a major component of the building structure because they perform a discrete and critical function in the operation of the building structure. However, the lobby floors are not a significant portion of a major component (that is, all the floors) under paragraph (k)(6)(ii)(A) of this section, nor do the lobby floors comprise a substantial structural part of the building structure under paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this section, the replacement of the lobby floors is not the replacement of a major component or substantial structural part of the building unit of property, and V is not required to treat the amount paid for the replacement of the lobby floors as a restoration to the building under paragraph (k)(1)(iv) of this section.

Example 29. Replacement of major component or substantial structural part; floors. Assume the same facts as Example 28, except that V decides to refresh the appearance of all the public areas of the hotel building by replacing all the floors in the public areas. To that end, V pays an amount to replace all the wood floors in all the public areas of the hotel building with new wood floors. The public areas include the lobby, the hallways, the meeting rooms, the ballrooms, and other public rooms throughout the hotel interiors. The public areas comprise approximately 40 percent of the square footage of the entire hotel building. All the floors in the hotel building comprise a major component of the building structure because they perform a discrete and critical function in the operation of the building structure. The floors in all the public areas of the hotel comprise a significant portion of a major component (that is, all the building floors) of the building structure. Therefore, under paragraph (k)(6)(ii)(A) of this section, the replacement of all the public area floors constitutes the replacement of a major component of the building structure. Accordingly, V must treat the amount paid to replace the public area floors as a restoration of the building unit of property under paragraphs (k)(1)(vi) and (k)(2) of this section

and must capitalize the amounts as an improvement to the building under paragraph (d)(2) of this section.

Example 30. Replacement with no disposition. (i) X owns an office building with four elevators serving all floors in the building. X replaces one of the elevators. The elevator is a structural component of the office building. X chooses to apply Prop. Reg. § 1.168(i)–8 to taxable years beginning on or after January 1, 2012, and before the applicability date of the final regulations. In accordance with Prop. Reg. § 1.168(i)– 8(c)(4)(ii)(A) (September 19, 2013), the office building (including its structural components) is the asset for tax disposition purposes. X does not treat the structural components of the office building as assets under Prop. Reg. § 1.168(i)–8(c)(4)(iii) (September 19, 2013). X also does not make the partial disposition election provided under Prop. Reg. § 1.168(i)–8(d)(2) (September 19, 2013), for the elevator. Thus, the retirement of the replaced elevator is not a disposition under section 168, and no loss is taken into account for purposes of paragraph (k)(1)(i) of this section.

(ii) Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The elevator system, including all four elevators, is a building system under paragraph (e)(2)(ii)(B)(5) of this section. The replacement elevator does not perform a discrete and critical function in the operation of elevator system under paragraph (k)(6)(ii)(A) of this section nor does it comprise a large portion of the physical structure of the elevator system under paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this section, the replacement elevator does not constitute the replacement of a major component or substantial structural part of the elevator system. Accordingly, X is not required to treat the amount paid to replace the elevator as a restoration to the building under either paragraph (k)(1)(i) or paragraph (k)(1)(vi) of this section.

Example 31. Replacement with disposition. The facts are the same as in Example 30, except X makes the partial disposition election provided under paragraph Prop. Reg. § 1.168(i)–8(d)(2) (September 19, 2013), for the elevator. Although the office building (including its structural components) is the asset for disposition purposes, the result of X making the partial disposition election for the elevator is that the retirement of the replaced elevator is a disposition. Thus, depreciation for the retired elevator ceases at the time of its retirement (taking into account the applicable convention), and X recognizes a loss upon this retirement. Accordingly, X must treat the amount paid to replace the elevator as a restoration of the building under paragraphs (k)(1)(i) and (k)(2) of this section and must capitalize the amount paid as an improvement to the building under paragraph (d)(2) of this section. In addition, the replacement elevator is treated as a separate asset for tax disposition purposes pursuant to Prop. Reg. § 1.168(i)–8(c)(4)(ii)(D) (September 19, 2013), and for depreciation purposes pursuant to section 168(i)(6).


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(l) Capitalization of amounts to adapt property to a new or different use—(1) In general. A taxpayer must capitalize as an improvement an amount paid to adapt a unit of property to a new or different use. In general, an amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer’s ordinary use of the unit of property at the time originally placed in service by the taxpayer.

(2) Application of adaption rule to buildings. In the case of a building, an amount is paid to improve a building if it is paid to adapt to a new or different use a property specified under paragraph (e)(2)(ii) (building), paragraph (e)(2)(iii)(B) (condominium), paragraph (e)(2)(iv)(B) (cooperative), or paragraph (e)(2)(v)(B) (leased building or leased portion of building) of this section. For example, an amount is paid to improve a building if it is paid to adapt the building structure or any one of its buildings systems to a new or different use.

(3) Examples. The following examples illustrate the application of this paragraph (l) only and do not address whether capitalization is required under another provision of this section or under another provision of the Code (for example, section 263A). Unless otherwise stated, assume that the taxpayer has not properly deducted a loss for any unit of property, asset, or component of a unit of property that is removed and replaced.

Example 1. New or different use; change in building use. A is a manufacturer and owns a manufacturing building that it has used for manufacturing since Year 1, when A placed it in service. In Year 30, A pays an amount to convert its manufacturing building into a showroom for its business. To convert the facility, A removes and replaces various structural components to provide a better layout for the showroom and its offices. A also repaints the building interiors as part of the conversion. When building materials are removed and replaced, A uses comparable and commercially available replacement materials. Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve A’s manufacturing building if the amount adapts the building structure or any designated building system to a new or different use. Under paragraph (l)(1) of this section, the amount paid to convert the manufacturing building into a showroom adapts the building structure to a new or different use because the conversion to a showroom is not consistent with A’s ordinary use of the building structure at the time it was placed in service. Therefore, A must capitalize the amount paid to convert the building into a showroom as an improvement to the building under paragraphs (d)(3) and (l) of this section.

Example 2. Not a new or different use; leased building. B owns and leases out space

in a building consisting of twenty retail spaces. The space was designed to be reconfigured; that is, adjoining spaces could be combined into one space. One of the tenants expands its occupancy by leasing two adjoining retail spaces. To facilitate the new lease, B pays an amount to remove the walls between the three retail spaces. Assume that the walls between spaces are part of the building and its structural components. Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve B’s building if it adapts the building structure or any of the building systems to a new or different use. Under paragraph (l)(1) of this section, the amount paid to convert three retail spaces into one larger space for an existing tenant does not adapt B’s building structure to a new or different use because the combination of retail spaces is consistent with B’s intended, ordinary use of the building structure. Therefore, the amount paid by B to remove the walls does not improve the building under paragraph (l) of this section and is not required to be capitalized under paragraph (d)(3) of this section.

Example 3. Not a new or different use; preparing building for sale. C owns a building consisting of twenty retail spaces. C decides to sell the building. In anticipation of selling the building, C pays an amount to repaint the interior walls and to refinish the hardwood floors. Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve C’s building to a new or different use if it adapts the building structure or any of the building systems to a new or different use. Preparing the building for sale does not constitute a new or different use for the building structure under paragraph (l)(1) of this section. Therefore, the amount paid by C to prepare the building structure for sale does not improve the building under paragraph (l) of this section and is not required to be capitalized under paragraph (d)(3) of this section.

Example 4. New or different use; land. D owns a parcel of land on which it previously operated a manufacturing facility. Assume that the land is the unit of property. During the course of D’s operation of the manufacturing facility, the land became contaminated with wastes from its manufacturing processes. D discontinues manufacturing operations at the site and decides to develop the property for residential housing. In anticipation of building residential property, D pays an amount to remediate the contamination caused by D’s manufacturing process. In addition, D pays an amount to regrade the land so that it can be used for residential purposes. Amounts that D pays to clean up wastes do not adapt the land to a new or different use, regardless of the extent to which the land was cleaned, because this cleanup merely returns the land to the condition it was in before the land was contaminated in D’s operations. Therefore, D is not required to capitalize the amount paid for the cleanup under paragraph (l)(1) of this section. However, the amount paid to regrade the land so that it can be used for residential purposes adapts the land to a new or different use that is inconsistent with D’s

intended ordinary use of the property at the time it was placed in service. Accordingly, the amounts paid to regrade the land must be capitalized as improvements to the land under paragraphs (d)(3) and (l) of this section.

Example 5. New or different use; part of building. (i) E owns a building in which it operates a retail drug store. The store consists of a pharmacy for filling medication prescriptions and various departments where customers can purchase food, toiletries, home goods, school supplies, cards, over-the- counter medications, and other similar items. E decides to create a walk-in medical clinic where nurse practitioners and physicians’ assistants diagnose, treat, and write prescriptions for common illnesses and injuries, administer common vaccinations, conduct physicals and wellness screenings, and provide routine lab tests and services for common chronic conditions. To create the clinic, E pays amounts to reconfigure the pharmacy building. E incurs costs to build new walls creating an examination room, lab room, reception area, and waiting area. E installs additional plumbing, electrical wiring, and outlets to support the lab. E also acquires section 1245 property, such as computers, furniture, and equipment necessary for the new clinic. E treats the amounts paid for those units of property as costs of acquiring new units of property under § 1.263(a)–2.

(ii) Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve E’s building if it adapts the building structure or any of the building systems to a new or different use. Under paragraph (l)(1) of this section, the amount paid to convert part of the retail drug store building structure into a medical clinic adapts the building structure to a new and different use, because the use of the building structure to provide clinical medical services is not consistent with E’s intended ordinary use of the building structure at the time it was placed in service. Similarly, the amounts paid to add to the plumbing system and the electrical systems to support the new medical services is not consistent with E’s intended ordinary use of these systems when the systems were placed in service. Therefore, E must treat the amount paid for the conversion of the building structure, plumbing system, and electrical system as an improvement to the building and capitalize the amount under paragraphs (d)(3) and (l) of this section.

Example 6. Not a new or different use; part of building. (i) F owns a building in which it operates a grocery store. The grocery store includes various departments for fresh produce, frozen foods, fresh meats, dairy products, toiletries, and over-the-counter medicines. The grocery store also includes separate counters for deli meats, prepared foods, and baked goods, often made to order. To better accommodate its customers’ shopping needs, F decides to add a sushi bar where customers can order freshly prepared sushi from the counter for take-home or to eat at the counter. To create the sushi bar, F pays amounts to add a sushi counter and chairs, add additional wiring and outlets to support the counter, and install additional pipes and a sink, to provide for the safe handling of the


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food. F also pays amounts to replace flooring and wall coverings in the sushi bar area with decorative coverings to reflect more appropriate decor. Assume the sushi counter and chairs are section 1245 property, and F treats the amounts paid for those units of property as costs of acquiring new units of property under § 1.263(a)–2.

(ii) Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve F’s building if it adapts the building structure or any of the building systems to a new or different use. Under paragraph (l)(1) of this section, the amount paid to convert a part of F’s retail grocery into a sushi bar area does not adapt F’s building structure, plumbing system, or electrical system to a new or different use, because the sale of sushi is consistent with F’s intended, ordinary use of the building structure and these systems in its grocery sales business, which includes selling food to its customers at various specialized counters. Accordingly, the amount paid by F to replace the wall and floor finishes, add wiring, and add plumbing to create the sushi bar space does not improve the building unit of property under paragraph (l) of this section and is not required to be capitalized under paragraph (d)(3) of this section.

Example 7. Not a new or different use; part of building. (i) G owns a hospital with various departments dedicated to the provision of clinical medical care. To better accommodate its patients’ needs, G decides to modify the emergency room space to provide both emergency care and outpatient surgery. To modify the space, G pays amounts to move interior walls, add additional wiring and outlets, replace floor tiles and doors, and repaint the walls. To complete the outpatient surgery center, G also pays amounts to install miscellaneous medical equipment necessary for the provision of surgical services. Assume the medical equipment is section 1245 property, and G treats the amounts paid for those units of property as costs of acquiring new units of property under § 1.263(a)–2.

(ii) Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve G’s building if it adapts the building structure or any of the building systems to a new or different use. Under paragraph (l)(1) of this section, the amount paid to convert part of G’s emergency room into an outpatient surgery center does not adapt G’s building structure or electrical system to a new or different use, because the provision of outpatient surgery is consistent with G’s intended, ordinary use of the building structure and these systems in its clinical medical care business. Accordingly, the amounts paid by G to relocate interior walls, add additional wiring and outlets, replace floor tiles and doors, and repaint the walls to create outpatient surgery space do not improve the building under paragraph (l) of this section and are not required to be capitalized under paragraph (d)(3) of this section.

(m) Optional regulatory accounting method—(1) In general. This paragraph (m) provides an optional simplified method (the regulatory accounting

method) for regulated taxpayers to determine whether amounts paid to repair, maintain, or improve tangible property are to be treated as deductible expenses or capital expenditures. A taxpayer that uses the regulatory accounting method described in paragraph (m)(3) of this section must use that method for property subject to regulatory accounting instead of determining whether amounts paid to repair, maintain, or improve property are capital expenditures or deductible expenses under the general principles of sections 162(a), 212, and 263(a). Thus, the capitalization rules in paragraph (d) (and the routine maintenance safe harbor described in paragraph (i)) of this section do not apply to amounts paid to repair, maintain, or improve property subject to regulatory accounting by taxpayers that use the regulatory accounting method under this paragraph (m).

(2) Eligibility for regulatory accounting method. A taxpayer that is engaged in a trade or business in a regulated industry is a regulated taxpayer and may use the regulatory accounting method under this paragraph (m). For purposes of this paragraph (m), a taxpayer is in a regulated industry only if the taxpayer is subject to the regulatory accounting rules of the Federal Energy Regulatory Commission (FERC), the Federal Communications Commission (FCC), or the Surface Transportation Board (STB).

(3) Description of regulatory accounting method. Under the regulatory accounting method, a taxpayer must follow the method of accounting for regulatory accounting purposes that it is required to follow for FERC, FCC, or STB (whichever is applicable) in determining whether an amount paid repairs, maintains, or improves property under this section. Therefore, a taxpayer must capitalize for Federal income tax purposes an amount paid that is capitalized as an improvement for regulatory accounting purposes. A taxpayer may not capitalize for Federal income tax purposes under this section an amount paid that is not capitalized as an improvement for regulatory accounting purposes. A taxpayer that uses the regulatory accounting method must use that method for all of its tangible property that is subject to regulatory accounting rules. The method does not apply to tangible property that is not subject to regulatory accounting rules. The method also does not apply to property for the taxable years in which the taxpayer elected to apply the repair allowance under § 1.167(a)–11(d)(2). The regulatory accounting method is a

method of accounting under section 446(a).

(4) Examples. The following examples illustrate the application of this paragraph (m):

Example 1. Taxpayer subject to regulatory accounting rules of FERC. W is an electric utility company that operates a power plant that generates electricity and that owns and operates network assets to transmit and distribute the electricity to its customers. W is subject to the regulatory accounting rules of FERC, and W uses the regulatory accounting method under paragraph (m) of this section. W does not capitalize on its books and records for regulatory accounting purposes the cost of repairs and maintenance performed on its turbines or its network assets. Under the regulatory accounting method, W may not capitalize for Federal income tax purposes amounts paid for repairs performed on its turbines or its network assets.

Example 2. Taxpayer not subject to regulatory accounting rules of FERC. X is an electric utility company that operates a power plant to generate electricity. X previously was subject to the regulatory accounting rules of FERC, but currently X is not required to use FERC’s regulatory accounting rules. X cannot use the regulatory accounting method provided in this paragraph (m).

Example 3. Taxpayer subject to regulatory accounting rules of FCC. Y is a telecommunications company that is subject to the regulatory accounting rules of the FCC. Y uses the regulatory accounting method under this paragraph (m). Y’s assets include a telephone central office switching center, which contains numerous switches and various switching equipment. Y capitalizes on its books and records for regulatory accounting purposes the cost of replacing each switch. Under the regulatory accounting method, Y is required to capitalize for Federal income tax purposes amounts paid to replace each switch.

Example 4. Taxpayer subject to regulatory accounting rules of STB. Z is a Class I railroad that is subject to the regulatory accounting rules of the STB. Z uses the regulatory accounting method under this paragraph (m). Z capitalizes on its books and records for regulatory accounting purposes the cost of locomotive rebuilds. Under the regulatory accounting method, Z is required to capitalize for Federal income tax purposes amounts paid to rebuild its locomotives.

(n) Election to capitalize repair and maintenance costs—(1) In general. A taxpayer may elect to treat amounts paid during the taxable year for repair and maintenance (as defined under § 1.162– 4) to tangible property as amounts paid to improve that property under this section and as an asset subject to the allowance for depreciation if the taxpayer incurs these amounts in carrying on the taxpayer’s trade or business and if the taxpayer treats these amounts as capital expenditures on its books and records regularly used in


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computing income (‘‘books and records’’). A taxpayer that elects to apply this paragraph (n) in a taxable year must apply this paragraph to all amounts paid for repair and maintenance to tangible property that it treats as capital expenditures on its books and records in that taxable year. Any amounts for which this election is made shall not be treated as amounts paid for repair or maintenance under § 1.162–4.

(2) Time and manner of election. A taxpayer makes this election under this paragraph (n) by attaching a statement to the taxpayer’s timely filed original Federal tax return (including extensions) for the taxable year in which the taxpayer pays amounts described under paragraph (n)(1) of this paragraph. See §§ 301.9100–1 through 301.9100–3 of this chapter for the provisions governing extensions of time to make regulatory elections. The statement must be titled ‘‘Section 1.263(a)–3(n) Election’’ and include the taxpayer’s name, address, taxpayer identification number, and a statement that the taxpayer is making the election to capitalize repair and maintenance costs under § 1.263(a)–3(n). In the case of a consolidated group filing a consolidated income tax return, the election is made for each member of the consolidated group by the common parent, and the statement must also include the names and taxpayer identification numbers of each member for which the election is made. In the case of an S corporation or a partnership, the election is made by the S corporation or partnership and not by the shareholders or partners. A taxpayer making this election for a taxable year must treat any amounts paid for repairs and maintenance during the taxable year that are capitalized on the taxpayer’s books and records as improvements to tangible property. The taxpayer must begin to depreciate the cost of such improvements amounts when they are placed in service by the taxpayer under the applicable provisions of the Code and regulations. An election may not be made through the filing of an application for change in accounting method or, before obtaining the Commissioner’s consent to make a late election, by filing an amended Federal tax return. The time and manner of electing to capitalize repair and maintenance costs under this paragraph (n) may be modified through guidance of general applicability (see §§ 601.601(d)(2) and 601.602 of this chapter).

(3) Exception. This paragraph (n) does not apply to amounts paid for repairs or maintenance of rotable or temporary

spare parts to which the taxpayer applies the optional method of accounting for rotable and temporary spare parts under § 1.162–3(e).

(4) Examples. The following examples illustrate the application of this paragraph (n):

Example 1. Election to capitalize routine maintenance on non-rotable part. (i) Q is a towboat operator that owns a fleet of towboats that it uses in its trade or business. Each towboat is equipped with two diesel- powered engines. Assume that each towboat, including its engines, is the unit of property and that a towboat has a class life of 18 years. Assume the towboat engines are not rotable spare parts under § 1.162–3(c)(2). In Year 1, Q acquired a new towboat, including its two engines, and placed the towboat into service. In Year 4, Q pays amounts to perform scheduled maintenance on both engines in the towboat. Assume that none of the exceptions set out in paragraph (i)(3) of this section apply to the scheduled maintenance costs and that the scheduled maintenance on Q’s towboat is within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts paid for the scheduled maintenance to its towboat engines in Year 4 are deemed not to improve the towboat and are not required to be capitalized under paragraph (d) of this section.

(ii) On its books and records, Q treats amounts paid for scheduled maintenance on its towboat engines as capital expenditures. For administrative convenience, Q decides to account for these costs in the same way for Federal income tax purposes. Under paragraph (n) of this section, in Year 4, Q may elect to capitalize the amounts paid for the scheduled maintenance on its towboat engines. If Q elects to capitalize such amounts, Q must capitalize all amounts paid for repair and maintenance to tangible property that Q treats as capital expenditures on its books and records in Year 4.

Example 2. No election to capitalize routine maintenance. Assume the same facts as Example 1, except in Year 8, Q pays amounts to perform scheduled maintenance for a second time on the towboat engines. On its books and records, Q treats the amounts paid for this scheduled maintenance as capital expenditures. However, in Year 8, Q decides not to make the election to capitalize the amounts paid for scheduled maintenance under paragraph (n) of this section. Because Q does not make the election under paragraph (n) for Year 8, Q may apply the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section to the amounts paid in Year 8, and not treat these amounts as capital expenditures. Because the election is made for each taxable year, there is no effect on the scheduled maintenance costs capitalized by Q on its Federal tax return for Year 4.

Example 3. Election to capitalize replacement of building component. (i) R owns an office building that it uses to provide services to customers. The building contains a HVAC system that incorporates ten roof-mounted units that provide heating and air conditioning for different parts of the

building. In Year 1, R pays an amount to replace 2 of the 10 units to address climate control problems in various offices throughout the office building. Assume that the replacement of the two units does not constitute an improvement to the HVAC system, and, accordingly, to the building unit of property under paragraph (d) of this section, and that R may deduct these amounts as repairs and maintenance under § 1.162–4.

(ii) On its books and records, R treats amounts paid for the two HVAC components as capital expenditures. R determines that it would prefer to account for these amounts in the same way for Federal income tax purposes. Under this paragraph (n), in Year 1, R may elect to capitalize the amounts paid for the new HVAC components. If R elects to capitalize such amounts, R must capitalize all amounts paid for repair and maintenance to tangible property that R treats as capital expenditures on its books and records in Year 1.

(o) Treatment of capital expenditures. Amounts required to be capitalized under this section are capital expenditures and must be taken into account through a charge to capital account or basis, or in the case of property that is inventory in the hands of a taxpayer, through inclusion in inventory costs.

(p) Recovery of capitalized amounts. Amounts that are capitalized under this section are recovered through depreciation, cost of goods sold, or by an adjustment to basis at the time the property is placed in service, sold, used, or otherwise disposed of by the taxpayer. Cost recovery is determined by the applicable Code and regulation provisions relating to the use, sale, or disposition of property.

(q) Accounting method changes. Except as otherwise provided in this section, a change to comply with this section is a change in method of accounting to which the provisions of sections 446 and 481 and the accompanying regulations apply. A taxpayer seeking to change to a method of accounting permitted in this section must secure the consent of the Commissioner in accordance with § 1.446–1(e) and follow the administrative procedures issued under § 1.446–1(e)(3)(ii) for obtaining the Commissioner’s consent to change its accounting method.

(r) Effective/applicability date—(1) In general. Except for paragraphs (h), (m), and (n) of this section, this section applies to taxable years beginning on or after January 1, 2014. Paragraphs (h), (m), and (n) of this section apply to amounts paid in taxable years beginning on or after January 1, 2014. Except as provided in paragraphs (r)(2) and (r)(3) of this section, § 1.263(a)–3 as contained in 26 CFR part 1 edition revised as of


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April 1, 2011, applies to taxable years beginning before January 1, 2014.

(2) Early application of this section— (i) In general. Except for paragraphs (h), (m), and (n) of this section, a taxpayer may choose to apply this section to taxable years beginning on or after January 1, 2012. A taxpayer may choose to apply paragraphs (h), (m), and (n) of this section to amounts paid in taxable years beginning on or after January 1, 2012.

(ii) Transition rule for certain elections on 2012 or 2013 returns. If under paragraph (r)(2)(i) of this section, a taxpayer chooses to make the election to apply the safe harbor for small taxpayers under paragraph (h) of this section or the election to capitalize repair and maintenance costs under paragraph (n) of this section for amounts paid in its taxable year beginning on or after January 1, 2012, and ending on or before September 19, 2013 (applicable taxable year), and the taxpayer did not make the election specified in paragraph (h)(6) or paragraph (n)(2) of this section on its timely filed original Federal tax return for the applicable taxable year, the taxpayer must make the election specified in paragraph (h)(6) or paragraph (n)(2) of this section for the applicable taxable year by filing an amended Federal tax return (including the required statements) for the applicable taxable year on or before 180 days from the due date including extensions of the taxpayer’s Federal tax return for the applicable taxable year, notwithstanding that the taxpayer may not have extended the due date.


§ 1.263(a)–3T [Removed]

! Par. 25. Section 1.263(a)–3T is removed. ! Par. 26. Section 1.263(a)–6 is added to read as follows:

§ 1.263(a)–6 Election to deduct or capitalize certain expenditures.

(a) In general. Under certain provisions of the Internal Revenue Code (Code), taxpayers may elect to treat capital expenditures as deductible expenses or as deferred expenses, or to treat deductible expenses as capital expenditures.

(b) Election provisions. The sections referred to in paragraph (a) of this section include:

(1) Section 173 (circulation expenditures);

(2) Section 174 (research and experimental expenditures);

(3) Section 175 (soil and water conservation expenditures; endangered species recovery expenditures);

(4) Section 179 (election to expense certain depreciable business assets);

(5) Section 179A (deduction for clean- fuel vehicles and certain refueling property);

(6) Section 179B (deduction for capital costs incurred in complying with environmental protection agency sulfur regulations);

(7) Section 179C (election to expense certain refineries);

(8) Section 179D (energy efficient commercial buildings deduction);

(9) Section 179E (election to expense advanced mine safety equipment);

(10) Section 180 (expenditures by farmers for fertilizer);

(11) Section 181 (treatment of certain qualified film and television productions);

(12) Section 190 (expenditures to remove architectural and transportation barriers to the handicapped and elderly);

(13) Section 193 (tertiary injectants); (14) Section 194 (treatment of

reforestation expenditures); (15) Section 195 (start-up

expenditures); (16) Section 198 (expensing of

environmental remediation costs); (17) Section 198A (expensing of

qualified disaster expenses); (18) Section 248 (organization

expenditures of a corporation); (19) Section 266 (carrying charges); (20) Section 616 (development

expenditures); and (21) Section 709 (organization and

syndication fees of a partnership). (c) Effective/applicability date—(1) In

general. This section applies to taxable years beginning on or after January 1, 2014. Except as provided in paragraphs (c)(2) and (c)(3) of this section, § 1.263(a)–3 as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014. For the effective dates of the enumerated election provisions, see those Code sections and the regulations under those sections.

(2) Early application of this section. A taxpayer may choose to apply this section to taxable years beginning on or after January 1, 2012.


§ 1.263(a)–6T [Removed] ! Par. 27. Section 1.263(a)–6T is removed. ! Par. 28. Section 1.263A–0 is amended by adding new entries in the outline for § 1.263A–1(k) and (l) to read as follows:

§ 1.263A–0 Outline of the Regulations under Section 263A. * * * * * § 1.263A–1 Uniform Capitalization of Costs. * * * * *

(k) Change in method of accounting. (1) In general. (2) Scope limitations. (3) Audit protection. (4) Section 481(a) adjustment. (5) Time for requesting change. (l) Effective/applicability date. (1) In general. (2) Mixed service costs; self-constructed

tangible personal property produced on a routine and repetitive basis.

(3) Materials and supplies. (i) In general (ii) Early application of this section. (iii) Optional application of TD 9564.

* * * * * ! Par. 29. Section 1.263A–1 is amended by: ! 1. Removing paragraphs (b)(14) and (m). ! 2. Revising paragraphs (c)(4), (e)(2)(i)(A), (e)(3)(ii)(E) and (l).


§ 1.263A–1 Uniform capitalization of costs. * * * * *

(c) * * * (4) Recovery of capitalized costs.

Costs that are capitalized under section 263A are recovered through depreciation, amortization, cost of goods sold, or by an adjustment to basis at the time the property is used, sold, placed in service, or otherwise disposed of by the taxpayer. Cost recovery is determined by the applicable Internal Revenue Code and regulation provisions relating to use, sale, or disposition of property. * * * * *

(e) * * * (2) * * * (i) * * * (A) Direct material costs. Direct

materials costs include the cost of those materials that become an integral part of specific property produced and those materials that are consumed in the ordinary course of production and that can be identified or associated with particular units or groups of units of property produced. For example, a cost described in § 1.162–3, relating to the cost of a material or supply, may be a direct material cost. * * * * *

(3) * * * (ii) * * *


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(E) Indirect material costs. Indirect material costs include the cost of materials that are not an integral part of specific property produced and the cost of materials that are consumed in the ordinary course of performing production or resale activities that cannot be identified or associated with particular units of property. Thus, for example, a cost described in § 1.162–3, relating to the cost of a material or supply, may be an indirect cost. * * * * *

(l) Effective/applicability dates—(1) In general. Except as provided in paragraphs (l)(2) and (l)(3) of this section, the effective dates for this section are provided in paragraph (a)(2) of this section.

(2) Mixed service costs; self- constructed tangible personal property produced on a routine and repetitive basis. Paragraphs (h)(2)(i)(D), (k), and (l)(2) of this section apply for taxable years ending on or after August 2, 2005.

(3) Materials and supplies—(i) In general. The last sentence of paragraphs (e)(2)(i)(A) and (e)(2)(ii)(E) of this section, and paragraph (l)(3) of this section apply to amounts paid (to acquire or produce property) in taxable years beginning on or after January 1, 2014. Except as provided in paragraph (l)(3)(ii) or paragraph (l)(3)(iii) of this section, section 1.263A–1 as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014.

(ii) Early application of this section. A taxpayer may choose to apply the last sentence of paragraphs (e)(2)(i)(A) and (e)(2)(ii)(E) of this section, and paragraph (l)(3) of this section to amounts paid (to acquire or produce property) in taxable years beginning on or after January 1, 2012.

(iii) Optional application of TD 9564. A taxpayer may choose to apply § 1.263A–1T(b)(14), the introductory phrase of § 1.263A–1T(c)(4), the last sentence of § 1.263A–1T(e)(2)(i)(A), the last sentence of § 1.263A–1T(e)(2)(ii)(E), § 1.263A–1T(l), and § 1.263A–1T(m)(2), as these provisions are contained in TD 9564 (76 FR 81060) December 27, 2011, to amounts paid (to acquire or produce property) in taxable years beginning on or after January 1, 2012, and before January 1, 2014.

§ 1.263A–1T [Removed]

! Par. 30. Section 1.263A–1T is removed.

! Par. 31. Section 1.1016–3 is amended by revising paragraphs (a)(1)(ii), (j)(1), and (j)(3) to read as follows:

§ 1.1016–3 Exhaustion, wear and tear, obsolescence, amortization, and depletion for periods since February 13, 1913.

(a) * * * (1) * * * (ii) The determination of the amount

properly allowable for exhaustion, wear and tear, obsolescence, amortization, and depletion must be made on the basis of facts reasonably known to exist at the end of the taxable year. A taxpayer is not permitted to take advantage in a later year of the taxpayer’s prior failure to take any such allowance or the taxpayer’s taking an allowance plainly inadequate under the known facts in prior years. In the case of depreciation, if in prior years the taxpayer has consistently taken proper deductions under one method, the amount allowable for such prior years may not be increased, even though a greater amount would have been allowable under another proper method. For rules governing losses on retirement or disposition of depreciable property, including rules for determining basis, see § 1.167(a)–8, § 1.168(i)–1T(e), § 1.168(i)–8T, Prop. Reg. § 1.168(i)–1(e) (September 19, 2013), or Prop. Reg. § 1.168(i)–8 (September 19, 2013), as applicable. The application of this paragraph is illustrated by the following example (for purposes of this example, assume section 167(f)(1) as in effect on September 19, 2013, applies to taxable years beginning on or after January 1, 2014):

Example. On July 1, 2014, A, a calendar- year taxpayer, purchased and placed in service ‘‘off-the-shelf’’ computer software at a cost of $36,000. This computer software is not an amortizable section 197 intangible. Pursuant to section 167(f)(1), the useful life of the computer software is 36 months. It has no salvage value. Computer software placed in service in 2014 is not eligible for the additional first year depreciation deduction provided by section 168(k). A did not deduct any depreciation for the computer software for 2014 and deducted depreciation of $12,000 for the computer software for 2015. As a result, the total amount of depreciation allowed for the computer software as of December 31, 2015, was $12,000. However, the total amount of depreciation allowable for the computer software as of December 31, 2015, is $18,000 ($6,000 for 2014 + $12,000 for 2015). As a result, the unrecovered cost of the computer software as of December 31, 2015, is $18,000 (cost of $36,000 less the depreciation allowable of $18,000 as of December 31, 2015). Accordingly, depreciation for 2016 for the computer software is $12,000 (unrecovered cost of $18,000 divided by the remaining useful life of 18 months as of January 1, 2016, multiplied by 12 full months in 2016). * * * * *

(j) Effective/applicability dates—(1) In general. Except as provided in

paragraphs (j)(2) and (j)(3) of this section, this section applies on or after December 30, 2003. For the applicability of regulations before December 30, 2003, see § 1.1016–3 in effect prior to December 30, 2003 (§ 1.1016–3 as contained in 26 CFR part 1 edition revised as of April 1, 2003). * * * * *

(3) Application of § 1.1016– 3T(a)(1)(ii)—(i) In general. Paragraph (a)(1)(ii) of this section applies to taxable years beginning on or after January 1, 2014. Except as provided in paragraphs (j)(3)(ii) and (j)(3)(iii) of this section, § 1.1016–3(a)(1)(ii) as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014.

(ii) Early application of § 1.1016– 3(a)(1)(ii). A taxpayer may choose to apply paragraph (a)(1)(ii) of this section to taxable years beginning on or after January 1, 2012.

(iii) Optional application of TD 9564. A taxpayer may choose to apply § 1.1016–3T(a)(1)(ii) as contained in TD 9564 (76 FR 81060) December 27, 2011, to taxable years beginning on or after January 1, 2012, and before January 1, 2014.

§ 1.1016–3T [Removed]

! Par. 32. Section 1.1016–3T is removed.

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

! Par. 33. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

! Par. 34. In § 602.101, paragraph (b) is amended by adding the following entries to the table in numerical order to read as follows:

§ 602.101 OMB Control numbers.

* * * * * (b) * * *

CFR part or section where Identified and described

Current OMB control No.

* * * * * 1.263(a)–1 ............................ 1545–2248 1.263(a)–3 ............................ 1545–2248

* * * * *


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48661 Federal Register / Vol. 79, No. 159 / Monday, August 18, 2014 / Rules and Regulations

2. The Department of Commerce finds that there is good cause under 5 U.S.C. 553(b)(B) to waive the provisions of the Administrative Procedure Act otherwise requiring prior notice and the opportunity for public comment because they are unnecessary. The revisions made by this rule are technical corrections to provisions that have already been subject to public notice and the opportunity to comment. These revisions in this rule are important to get in place as soon as possible to avoid confusion by the public regarding the intent and meaning of recent changes to the EAR. In addition, BIS finds good cause to waive the 30-day delay in effectiveness under 5 U.S.C. 553(d)(3). As mentioned previously, the revisions made by this rule are technical corrections that need to be in place as soon as possible to avoid confusion by the public regarding the intent and meaning of recent changes to the EAR.

3. Because a notice of proposed rulemaking and an opportunity for public comment are not required to be given for these amendments by 5 U.S.C. 553, or by any other law, the analytical requirements of the Regulatory Flexibility Act, 5 U.S.C. 601 et seq., are not applicable.

List of Subjects

15 CFR Parts 740 and 758 Administrative practice and

procedure, Exports, Reporting and recordkeeping requirements.

15 CFR Part 742 Exports, Terrorism. Accordingly, parts 740, 742 and 758

of the Export Administration Regulations (15 CFR parts 730–774) are corrected as follows:

PART 740—[AMENDED]

■ 1. The authority citation for 15 CFR part 740 is revised to read as follows:

Authority: 50 U.S.C. app. 2401 et seq.; 50 U.S.C. 1701 et seq.; 22 U.S.C. 7201 et seq.; E.O. 13026, 61 FR 58767, 3 CFR, 1996 Comp., p. 228; E.O. 13222, 66 FR 44025, 3 CFR, 2001 Comp., p. 783; Notice of August 7, 2014, 79 FR 46959 (Aug. 11, 2014).

■ 2. In § 740.10, revise paragraph (b)(1) to read as follows:

§ 740.10 License Exception Servicing and replacement of parts and equipment (RPL). * * * * *

(b) * * * (1) The provisions of this paragraph

(b) authorize the export and reexport to any destination, except for 9x515 or ‘‘600 series’’ items to destinations identified in Country Group D:5 (see

Supplement No. 1 to this part) or otherwise prohibited under the EAR, of commodities and software that were sent to the United States or to a foreign party for servicing and replacement of commodities and software ‘‘subject to the EAR’’ (see § 734.2(a) of the EAR) that are defective or that an end user or ultimate consignee has found unacceptable. * * * * * ■ 3. In § 740.20, add two new sentences after the second sentence and revise the last two sentences of paragraph (d)(2) to read as follows:

§ 740.20 License Exception Strategic Trade Authorization (STA). * * * * *

(d) * * * (2) Prior Consignee Statement. One

statement may be used for multiple shipments of the same items between the same parties so long as the party names, the description(s) of the item(s), and the ECCNs are correct. The exporter, reexporter, and transferor must maintain a log or other record that identifies each shipment made pursuant to this section and the specific consignee statement that is associated with each shipment. Paragraph (d)(2)(viii) is also required for transactions including 9x515 items.

[INSERT NAME OF CONSIGNEE]: * * * * *


■ 4. The authority citation for 15 CFR part 742 is revised to read as follows:

Authority: 50 U.S.C. app. 2401 et seq.; 50 U.S.C. 1701 et seq.; 22 U.S.C. 3201 et seq.; 42 U.S.C. 2139a; 22 U.S.C. 7201 et seq.; 22 U.S.C. 7210; Sec. 1503, Pub. L. 108–11, 117 Stat. 559; E.O. 12058, 43 FR 20947, 3 CFR, 1978 Comp., p. 179; E.O. 12851, 58 FR 33181, 3 CFR, 1993 Comp., p. 608; E.O. 12938, 59 FR 59099, 3 CFR, 1994 Comp., p. 950; E.O. 13026, 61 FR 58767, 3 CFR, 1996 Comp., p. 228; E.O. 13222, 66 FR 44025, 3 CFR, 2001 Comp., p. 783; Presidential Determination 2003–23 of May 7, 2003, 68 FR 26459, May 16, 2003; Notice of August 7, 2014, 79 FR 46959 (Aug. 11, 2014); Notice of November 7, 2013, 78 FR 67289 (November 12, 2013).

■ 5. In § 742.6, revise the first sentence of paragraph (b)(1) to read as follows:

§ 742.6 Regional Stability. * * * * *

(b) * * * (1) Applications for exports and reexports of 9x515 and ‘‘600 series’’ items will be reviewed on a case-by-case basis to determine whether the transaction is contrary to the national security or foreign policy interests of the United States, including the foreign policy interest of promoting the

observance of human rights throughout the world. * * * * * * * *


■ 6. The authority citation for part 758 is revised to read as follows:

Authority: 50 U.S.C. app. 2401 et seq.; 50 U.S.C. 1701 et seq.; E.O. 13222, 66 FR 44025, 3 CFR, 2001 Comp., p. 783; Notice of August 7, 2014, 79 FR 46959 (Aug. 11, 2014). ■ 7. In section 758.1, revise paragraph (b)(3) to read as follows:

§ 758.1 The Electronic Export Information (EEI) filing to the Automated Export System (AES). * * * * *

(b) * * * (3) For all exports of 9x515 or ‘‘600

series’’ items enumerated or otherwise described in paragraphs .a through .x of a 9x515 or ‘‘600 series’’ ECCN regardless of value or destination, including exports to Canada; * * * * *

Dated: August 11, 2014. Matthew S. Borman, Deputy Assistant Secretary for Export Administration. [FR Doc. 2014–19348 Filed 8–15–14; 8:45 am] BILLING CODE 3510–33–P

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9689]

RIN 1545–BL52

Guidance Regarding Dispositions of Tangible Depreciable Property

AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final regulations and removal of temporary regulations.

SUMMARY: This document contains final regulations regarding dispositions of property subject to depreciation under section 168 of the Internal Revenue Code (Code) (Modified Accelerated Cost Recovery System (MACRS) property). The final regulations also amend the general asset account regulations and the accounting for MACRS property regulations. The final regulations provide rules for determining gain or loss upon the disposition of MACRS property, determining the asset disposed of, and accounting for partial dispositions of MACRS property. The final regulations affect taxpayers that dispose of MACRS property. The final

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The Tax Curriculum C-1 Nichols Patrick CPE, Incorporated


regulations also remove temporary regulations under section 168 regarding general asset accounts and disposition of MACRS property. DATES: Effective Date: These regulations are effective on August 18, 2014.

Applicability Dates: These regulations apply to taxable years beginning on or after January 1, 2014. For dates of applicability of the final regulations, see §§ 1.168(i)–1(m), 1.168(i)–7(e), and 1.168(i)–8(j). FOR FURTHER INFORMATION CONTACT: Kathleen Reed or Patrick Clinton, Office of Associate Chief Counsel (Income Tax and Accounting), (202) 317–7005 (not a toll-free number). SUPPLEMENTARY INFORMATION:

Background On December 27, 2011, the IRS and

the Treasury Department published in the Federal Register (76 FR 81060) temporary regulations (TD 9564) regarding the accounting for, and dispositions of, property subject to depreciation under section 168 (MACRS property). The temporary regulations also amended the general asset account regulations under § 1.168(i)–1. On the same date, the IRS published in the Federal Register (76 FR 81128) a notice of proposed rulemaking (REG–168745– 03) cross-referencing the temporary regulations (2011 proposed regulations). The IRS and the Treasury Department received numerous written comments responding to the 2011 proposed regulations and held a public hearing on May 9, 2012.

The temporary regulations initially applied to taxable years beginning on or after January 1, 2012. In response to the comments received and the statements made at the public hearing, the IRS and the Treasury Department released Notice 2012–73, 2012–51 IRB 713, on November 20, 2012, announcing that, to help taxpayers transition to the final regulations, the IRS and the Treasury Department would change the applicability date of the temporary regulations to taxable years beginning on or after January 1, 2014, while permitting taxpayers to choose to apply the temporary regulations to taxable years beginning on or after January 1, 2012, and before the applicability date of the final regulations. Notice 2012–73 also alerted taxpayers that the IRS and the Treasury Department intended to publish final regulations in 2013 and expected the final regulations to apply to taxable years beginning on or after January 1, 2014, but that the final regulations would permit taxpayers to apply the provisions of the final regulations to taxable years beginning

on or after January 1, 2012. On December 17, 2012, the IRS and the Treasury Department published in the Federal Register (77 FR 74583) a technical amendment to TD 9564, which amended the applicability date of the temporary regulations to taxable years beginning on or after January 1, 2014, while permitting taxpayers to choose to apply the temporary regulations to taxable years beginning on or after January 1, 2012, and before the applicability date of the final regulations.

Notice 2012–73 also alerted taxpayers that the IRS and the Treasury Department intended to revise the disposition rules in the temporary regulations. After considering the comment letters and the statements made at the public hearing, the IRS and the Treasury Department removed the temporary regulations under section 167 and § 1.168(i)–7 and issued final regulations in the Federal Register on September 19, 2013 (78 FR 57686). The final regulations under section 167 provide rules for depreciation of leasehold improvements and amend existing regulations under section 167 regarding accounting for and retirement of depreciable property. Section 1.168(i)–7 provides rules for how to account for MACRS property. On the same date, the IRS also withdrew the 2011 proposed regulations under §§ 1.168(i)–1 and 1.168(i)–8 and published a notice of proposed rulemaking (REG–110732–13) under §§ 1.168(i)–1, 1.168(i)–7, and 1.168(i)–8 (2013 proposed regulations) in the Federal Register (78 FR 57547). The 2011 proposed regulations under § 1.168(i)–1 amended the existing regulations on general asset accounts, and the 2011 proposed regulations under § 1.168(i)–8 provided rules for dispositions of MACRS property. The IRS and the Treasury Department did not withdraw or remove the temporary regulations under §§ 1.168(i)–1T and 1.168(i)–8T and taxpayers continued to have the option of applying those temporary regulations to taxable years beginning on or after January 1, 2012, and before the applicability date of the final regulations.

No comments were received from the public in response to the 2013 proposed regulations. No public hearing was requested or held. However, the IRS and the Treasury Department are making clarifying changes to the 2013 proposed regulations regarding the determination of the unadjusted depreciable basis of a disposed asset in a general or multiple asset account or a disposed portion of an asset, and the manner of making certain disposition elections for assets

included in a general asset account when section 280B applies. These revisions are discussed in this preamble. The IRS and the Treasury Department are removing the temporary regulations under §§ 1.168(i)–1T and 1.168(i)–8T and are issuing final regulations under §§ 1.168(i)–1, 1.168(i)–7, and 1.168(i)–8. The 2013 proposed regulations are adopted as amended by this Treasury decision.

Explanation of Provisions and Revisions I. Overview

The final regulations under §§ 1.168(i)–1, 1.168(i)–7, and 1.168(i)–8 generally retain all of the provisions of the 2013 proposed regulations. Section 1.168(i)–1 amends the existing general asset account regulations regarding establishment of general asset accounts, depreciation of a general asset account, and dispositions of assets in a general asset account. Section 1.168(i)–7 amends the existing regulations on accounting for MACRS property to address partial dispositions of MACRS property. Section 1.168(i)–8 provides rules for dispositions of MACRS property. These final regulations generally apply to taxable years beginning on or after January 1, 2014.

II. Disposition Rules for MACRS Property Under § 1.168(i)–8

Section 1.168(i)–8 provides the basic rules applicable to dispositions of MACRS property, and § 1.168(i)–1 provides special rules applicable to MACRS property included in a general asset account.

A. Definition of Disposition

The final regulations retain the definition of ‘‘disposition’’ for MACRS property that is set forth in the 2013 proposed regulations. A disposition occurs when ownership of the asset is transferred or when the asset is permanently withdrawn from use either in the taxpayer’s trade or business or in the production of income. A disposition includes the sale, exchange, retirement, physical abandonment, or destruction of an asset. A disposition also includes the retirement of a structural component (or a portion thereof) of a building only if the partial disposition rule (discussed in II.C) applies to such structural component (or a portion thereof). Finally, the manner of disposition (for example, abnormal retirement or normal retirement) is not taken into consideration in determining whether a disposition occurs or gain or loss is recognized.


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B. Determining Appropriate Disposed Asset

The final regulations also retain the rules in the 2013 proposed regulations for determining the disposed asset for tax disposition purposes. In general, the facts and circumstances of each disposition are considered in determining the appropriate disposed asset. However and as provided in the 2013 proposed regulations, the asset for tax disposition purposes may not consist of items placed in service by the taxpayer on different dates (without taking into account the applicable convention). Further, the unit of property as determined under § 1.263(a)–3(e) or in published guidance in the Internal Revenue Bulletin under section 263(a) does not apply for purposes of determining what is the appropriate disposed asset.

In addition to these general rules, the final regulations provide special rules for certain types of properties. The final regulations retain the rule in the 2013 proposed regulations that each building (including its structural components) is the asset for tax disposition purposes, unless more than one building (including its structural components) is treated as the asset under § 1.1250– 1(a)(2)(ii), there is an improvement or addition to an existing building (including its structural components), or the building includes two or more condominium or cooperative units. If there is an improvement or addition to an existing building (including its structural components), the improvement or addition is the asset. If a building includes two or more condominium or cooperative units, each condominium or cooperative unit (including its structural components) is the asset.

The final regulations also provide that if a taxpayer properly includes an item in one of the asset classes 00.11 through 00.4 of Rev. Proc. 87–56 (1987–2 CB 674) or classifies an item in one of the categories under section 168(e)(3) (other than a category that includes buildings or structural components; for example, retail motor fuels outlet and qualified leasehold improvement property), each item is the asset provided it is not an improvement or addition to an existing asset.

Finally, and consistent with section 168(i)(6), the final regulations provide that if the taxpayer places in service an improvement or addition to an asset after the taxpayer placed the asset in service, the improvement or addition is a separate asset.

C. Partial Dispositions The final regulations also retain the

partial disposition rule in the 2013 proposed regulations. Consequently, the disposition rules in the final regulations apply to a partial disposition of an asset (for example, the disposition of a roof (or a portion of a roof)). The partial disposition rule allows taxpayers to claim a loss upon the disposition of a structural component (or a portion thereof) of a building or upon the disposition of a component (or a portion thereof) of any other asset without identifying the component as an asset before the disposition event. The partial disposition rule also minimizes circumstances in which an original part and any subsequent replacements of the same part are required to be capitalized and depreciated simultaneously. These final regulations provide examples demonstrating the application of the partial disposition rule.

In many cases, the partial disposition rule is elective (‘‘partial disposition election’’). However, consistent with the 2013 proposed regulations and the operation of sections 165, 168(i)(7), 1031, and 1033, and because sales of a portion of an asset are common, the partial disposition rule is required to be applied to a disposition of a portion of an asset as a result of a casualty event described in section 165, to a disposition of a portion of an asset for which gain (determined without regard to section 1245 or 1250) is not recognized in whole or in part under section 1031 or 1033, to a transfer of a portion of an asset in a step-in-the-shoes transaction described in section 168(i)(7)(B), or to a sale of a portion of an asset. Consequently, a disposition includes a disposition of a portion of an asset under these circumstances, even if the taxpayer does not make the partial disposition election for that disposed portion. For other transactions, a disposition includes a disposition of a portion of an asset only if the taxpayer makes the partial disposition election for that disposed portion.

A taxpayer may make the partial disposition election for the disposition of a portion of any type of MACRS property, including an asset that is properly included in one of the asset classes 00.11 through 00.4 of Rev. Proc. 87–56. However, consistent with section 168(i)(6) and the 2013 proposed regulations, a taxpayer making the partial disposition election for the disposition of a portion of an asset that is properly included in one of the asset classes 00.11 through 00.4 of Rev. Proc. 87–56 must classify the replacement portion of the asset under the same asset

class as the disposed portion of the asset.

The partial disposition election is made on the taxpayer’s timely filed original Federal tax return, including extensions, for the taxable year in which the portion of the asset is disposed of by the taxpayer. This election may not be made or revoked by the filing of an application for a change in method of accounting. A taxpayer may revoke a partial disposition election by filing a request for a letter ruling and obtaining the consent of the Commissioner of Internal Revenue to revoke this election. The Commissioner may grant a request to revoke this election if the taxpayer acted reasonably and in good faith, and the revocation will not prejudice the interests of the Government. In deciding whether to grant such a request, the Commissioner anticipates applying standards similar to the standards under § 301.9100–3 of this chapter for granting extensions of time for making regulatory elections. If a taxpayer chooses to apply these final regulations to its taxable year beginning in 2012 or 2013, these final regulations also provide rules for making the partial disposition election for the portion of an asset disposed of by the taxpayer during those taxable years.

The final regulations also provide a special partial disposition rule to address the effect of an IRS disallowance of a taxpayer’s characterization of the replacement of a portion of an asset as a repair. When the IRS disallows a taxpayer’s repair deduction for the amount paid or incurred for the replacement of a portion of an asset and capitalizes such amount under § 1.263(a)–2 or § 1.263(a)–3, the taxpayer may make the partial disposition election for the disposition of the portion of the asset to which the IRS’s adjustment pertains by filing an application for change in accounting method, provided the asset of which the disposed portion was a part is owned by the taxpayer at the beginning of the year of change (as defined for purposes of section 446(e)).

D. Gain or Loss The final regulations also retain the

rules in the 2013 proposed regulations for determining gain or loss upon the disposition of MACRS property. These rules are generally consistent with the disposition rules under § 1.168–6 of the proposed regulations on the Accelerated Cost Recovery System of former section 168 (ACRS) (which generally have been applied to MACRS property). If an asset is disposed of by sale, exchange, or involuntary conversion, gain or loss is recognized under the applicable


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provisions of the Code. If an asset is disposed of by physical abandonment, loss is recognized in the amount of the asset’s adjusted depreciable basis at the time of the abandonment, unless an abandoned asset is subject to nonrecourse indebtedness in which case the asset is treated in the same manner as an asset disposed of by sale. Finally, if an asset is disposed of other than by sale, exchange, involuntary conversion, physical abandonment, or conversion to personal use (for example, when the asset is transferred to a supplies or scrap account), gain is not recognized but loss is recognized in the amount of the excess of the asset’s adjusted depreciable basis over its fair market value at the time of disposition. The same rules apply when the partial disposition rule applies to a disposition of a portion of an asset.

E. Determination of Basis of Disposed Asset

The final regulations retain the rule in the 2013 proposed regulations on determining the unadjusted depreciable basis of a disposed asset if that asset is in a multiple asset account and it is impracticable from the taxpayer’s records to determine the unadjusted depreciable basis of the disposed asset. In such a situation, the final regulations provide that the taxpayer may use any reasonable method that is consistently applied to all assets in the same multiple asset account. The IRS and the Treasury Department expect that reasonable methods are available that use information readily available or known to the taxpayer and do not necessitate undertaking an expensive study.

These final regulations also provide nonexclusive examples of reasonable methods. These examples are the same examples in the 2013 proposed regulations, except that the final regulations do not include discounting the cost of the replacement asset by the Consumer Price Index as an example of a reasonable method. After further review, the IRS and the Treasury Department have determined that the Producer Price Index for Finished Goods (and its successor, the Producer Price Index for Final Demand) more accurately reflects inflation for capital expenditures. The final regulations also clarify that discounting the cost of the replacement asset using the Producer Price Index for Finished Goods is a reasonable method only if the replacement asset is a restoration under § 1.263(a)–3(k) and is not a betterment under § 1.263(a)–3(j) or is not an adaptation to a new or different use under § 1.263(a)–3(l). The examples in

the final regulations include the following: (1) Discounting the cost of the replacement asset to its placed-in- service year cost using the Producer Price Index for Finished Goods (or its successor, the Producer Price Index for Final Demand, or any other index designated by guidance in the Internal Revenue Bulletin (see § 601.601(d)(2) of the chapter) for purposes of the final regulations) where the replacement asset is a restoration under § 1.263(a)– 3(k) and is not a betterment under § 1.263(a)–3(j) or is not an adaptation to a new or different use under § 1.263(a)– 3(l); (2) a pro rata allocation of the unadjusted depreciable basis of the multiple asset account based on the replacement cost of the disposed asset and the replacement cost of all of the assets in the multiple asset account; and (3) a study allocating the cost of the asset to its individual components.

The final regulations also provide rules to determine the unadjusted depreciable basis of the disposed portion of an asset when the partial disposition rule applies. While these rules retain most of the rules in the 2013 proposed regulations, the final regulations were changed to clarify when a taxpayer may use a reasonable method for determining the unadjusted depreciable basis of a disposed portion of an asset. The IRS and the Treasury Department intended to allow taxpayers to use a reasonable method under the same circumstances as described above for determining the unadjusted depreciable basis of a disposed asset in a multiple asset account. However, the 2013 proposed regulations did not reflect this intent. Consequently, the final regulations clarify that a taxpayer may use any reasonable method for determining the unadjusted depreciable basis of the disposed portion of the asset only if it is impracticable from the taxpayer’s records to determine such unadjusted depreciable basis. If a taxpayer disposes of more than one portion of the same asset and it is impracticable from the taxpayer’s records to determine the unadjusted depreciable basis of the first disposed portion of the asset, the reasonable method used by the taxpayer must be consistently applied to all portions of the same asset for purposes of determining the unadjusted depreciable basis of each disposed portion of the asset. If the asset, a portion of which is disposed of, is in a multiple asset account, the reasonable method used by the taxpayer must be consistently applied to all assets and portions of assets in the same multiple asset account. Finally, the final regulations

provide nonexclusive examples of reasonable methods that are similar to those discussed in the preceding paragraph.

F. Identification of Disposed Asset The final regulations retain the rules

in the 2013 proposed regulations for determining the placed-in-service year of a disposed asset. In general, a taxpayer must use the specific identification method. Under this method, the taxpayer can determine when the asset disposed of was placed in service. If an asset is in a multiple asset account and it is impracticable from the taxpayer’s records to determine the particular year in which the asset was placed in service by the taxpayer, the final regulations allow the taxpayer to identify the asset by using the following: A first-in, first-out (FIFO) method, a modified FIFO method, a mortality dispersion table if the asset is a mass asset, or any other method designated by the Secretary in published guidance. A last-in, first-out (LIFO) method is not permitted. These rules also apply when the partial disposition rule applies to a disposition of a portion of an asset and it is impracticable from the taxpayer’s records to determine the particular taxable year in which the asset was placed in service by the taxpayer. The final regulations provide an additional example of the LIFO method, which is impermissible.

III. General Asset Accounts Under § 1.168(i)–1

Section 168(i)(4) provides that, under regulations, a taxpayer may maintain one or more general asset accounts for any MACRS property. Except as provided in regulations, all proceeds realized on any disposition of property in a general asset account shall be included in income as ordinary income.

The final regulations generally retain all of the provisions in the 2013 proposed regulations for general asset accounts. The final regulations apply only to assets for which the taxpayer has made an election to account for the assets in general asset accounts. Each general asset account effectively is treated as the asset.

A. Establishing General Asset Accounts The final regulations retain the rules

in the 2013 proposed regulations for establishing general asset accounts. The final regulations provide that assets may be grouped into one or more general asset accounts. In general, each general asset account must include assets that have the same depreciation method, recovery period, and convention, and


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are placed in service in the same taxable year. However and as provided in the 2013 proposed regulations, the final regulations provide special rules in certain circumstances for establishing general asset accounts. For example, assets eligible for the additional first year depreciation deduction cannot be grouped with assets ineligible for the additional first year depreciation deduction. Also, assets eligible for the additional first year depreciation deduction may be grouped only with assets eligible for the same percentage of the additional first year depreciation.

B. Depreciation of a General Asset Account

The final regulations retain the rules in the 2013 proposed regulations for determining depreciation for each general asset account. The final regulations explain how to determine depreciation for a general asset account when all the assets in the account are eligible for the additional first year depreciation deduction and when all the assets in the account are not eligible for that deduction.

C. Disposition of an Asset From a General Asset Account

1. Disposition Definition The final regulations retain the

definition of ‘‘disposition’’ that is set forth in the 2013 proposed regulations. This definition is the same as the definition of ‘‘disposition’’ that was previously discussed under the disposition rules for MACRS property under § 1.168(i)–8. That is, a disposition occurs when ownership of the asset is transferred or when the asset is permanently withdrawn from use either in the taxpayer’s trade or business or in the production of income. A disposition includes the sale, exchange, retirement, physical abandonment, or destruction of an asset. A disposition also includes the retirement of a structural component (or a portion thereof) of a building only if the partial disposition rule (discussed in III.C.4) applies to such structural component (or a portion thereof). Finally, the manner of disposition (for example, abnormal retirement or normal retirement) is not taken into consideration in determining whether a disposition occurs or gain or loss is recognized.

2. Determining the Appropriate Disposed Asset

The final regulations also retain the rules in the 2013 proposed regulations for determining the disposed asset included in a general asset account for tax disposition purposes. These rules

are the same as those previously discussed for determining the disposed asset for purposes of § 1.168(i)–8.

In general, the facts and circumstances of each disposition are considered in determining the appropriate disposed asset included in a general asset account. However, the asset for tax disposition purposes may not consist of items placed in service by the taxpayer on different dates (without taking into account the applicable convention under section 168(d)). Further, the unit of property as determined under § 1.263(a)–3(e) or in published guidance in the Internal Revenue Bulletin under section 263(a) does not apply for purposes of determining what is the appropriate disposed asset.

In addition to these general rules, the final regulations retain the special rules in the 2013 proposed regulations for certain types of properties. These special rules are the same as the previously discussed special rules for determining the appropriate disposed asset under § 1.168(i)–8. The final regulations provide special rules for determining the appropriate disposed asset that is included in a general asset account and that is: (a) A building (including its structural components); (b) a building that includes two or more condominium or cooperative units; (c) an item properly included in one of the asset classes 00.11 through 00.4 of Rev. Proc. 87–56 (1987–2 CB 674) or classified in one of the categories under section 168(e)(3) (other than a category that includes buildings or structural components; for example, retail motor fuels outlet and qualified leasehold improvement property); or (d) an improvement or addition to an existing asset.

3. Disposition Rules The final regulations retain the

disposition rules in the 2013 proposed regulations. Immediately before any disposition of an asset (or a portion thereof) in a general asset account, the final regulations provide that the asset (or a portion thereof) is treated as having an adjusted depreciable basis of zero for purposes of section 1011. Therefore, no loss is realized upon the disposition of the asset (or a portion thereof). The final regulations also provide that any amount realized on a disposition generally is recognized as ordinary income. Further, the final regulations provide that the unadjusted depreciable basis and depreciation reserve of the general asset account are not affected by the disposition. Accordingly, a taxpayer continues to depreciate the general asset account, including the disposed asset

(or a portion thereof), as though no disposition occurred.

The final regulations also allow a taxpayer to terminate general asset account treatment upon certain dispositions. Under the final regulations, a taxpayer may elect to recognize gain or loss for a general asset account when the taxpayer disposes of all of the assets, the last asset, or the remaining portion of the last asset in the account.

The final regulations further allow a taxpayer to elect to terminate general asset account treatment for an asset in a general asset account when the taxpayer disposes of the asset in a qualifying disposition. A qualifying disposition is a disposition that does not involve all the assets, the last asset, or the remaining portion of the last asset, remaining in a general asset account and that is: (1) A direct result of a fire, storm, shipwreck, or other casualty, or from theft; (2) a charitable contribution for which a deduction is allowable under section 170; (3) a direct result of a cessation, termination, or disposition of a business, manufacturing, or other income producing process, operation, facility, plant, or other unit (other than by transfer to a supplies, scrap, or similar account); or (4) generally a transaction to which a nonrecognition section of the Code applies. If a taxpayer elects to terminate general asset account treatment for an asset disposed of in a qualifying disposition, the taxpayer must remove the disposed asset from the general asset account and adjust the unadjusted depreciable basis and depreciation reserve of the account.

The final regulations retain the rules in the 2013 proposed regulations on the manner of making (1) the election to terminate the general asset account upon the disposition of all of the assets, the last asset, or the remaining portion of the last asset in that general asset account, or (2) the qualifying disposition election. The final regulations provide that a taxpayer making either of these elections must apply section 280B and § 1.280B–1 to determine whether and to what extent gain or loss is recognized. Generally, a taxpayer makes these elections by reporting the gain, loss, or other deduction on the taxpayer’s timely filed original Federal tax return (including extensions) for the taxable year in which the disposition occurs.

In the case of a loss sustained on account of the demolition of a structure to which section 280B and § 1.280B–1 apply, however, the loss is capitalized to the land on which the demolished structure was located, and no gain or loss is reported at the time of


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demolition. Nevertheless, a taxpayer generally will report a depreciation deduction for the demolished structure for the taxable year in which the demolition occurs. Accordingly, the final regulations clarify that a taxpayer makes the election to terminate the general asset account or the qualifying disposition election by ending depreciation for the demolished structure at the time of disposition (taking into account the applicable convention) and reporting the depreciation amount for that structure for the taxable year in which the disposition occurs on the taxpayer’s timely filed original Federal tax return (including extensions) for that taxable year.

For assets in general asset accounts, the final regulations also require a taxpayer to terminate general asset account treatment for an asset that is disposed of in a transaction subject to section 167(i)(7)(B), section 1031, or section 1033, disposed of in an abusive transaction described under the final regulations, or used for any personal use. In such a case, the taxpayer must remove the disposed asset from the general asset account and adjust the unadjusted depreciable basis and depreciation reserve of the account.

In addition, the final regulations require a partnership to terminate its general asset accounts upon the technical termination of the partnership under section 708(b)(1)(B). If there is a redetermination of basis of an asset in a general asset account (for example, due to contingent purchase price or discharge of indebtedness), the final regulations provide that the general asset account election for the asset also applies to the increase or decrease in basis and require the taxpayer to establish a new general asset account for that increase or decrease in basis.

4. Partial Dispositions The final regulations retain the partial

disposition rule in the 2013 proposed regulations. Similar to the partial disposition rule under § 1.168(i)–8 that was previously discussed, the disposition rules in § 1.168(i)–1 apply to a partial disposition of an asset included in a general asset account. Consequently, a disposition includes a disposition of a portion of an asset as a result of a casualty event described in section 165, a disposition of a portion of an asset for which gain (determined without regard to section 1245 or 1250) is not recognized in whole or in part under section 1031 or 1033, a transfer of a portion of an asset in a transaction described in section 168(i)(7)(B), a sale of a portion of an asset, or a disposition

of a portion of an asset in a transaction described under the anti-abuse rules applicable to general asset accounts. For other transactions, a disposition includes a disposition of a portion of an asset only if the taxpayer makes the election to terminate the general asset account upon the disposition of all of the assets, the last asset, or the remaining portion of the last asset in that general asset account or makes the qualifying disposition election for that disposed portion. A separate partial disposition election is not provided for assets in a general asset account because a taxpayer can claim a loss upon the disposition of an asset (or a portion thereof) in a general asset account only when the taxpayer makes either one of these two elections.

D. Determination of Basis of Disposed Asset

The final regulations generally retain the rules in the 2013 proposed regulations on determining the unadjusted depreciable basis of an asset for which general asset account treatment is terminated. Because the general asset account is the asset, the final regulations provide that a taxpayer may use any reasonable method that is consistently applied to all assets in the same general asset account to determine the unadjusted depreciable basis of a disposed asset in that account if it is impracticable from the taxpayer’s records to determine the unadjusted depreciable basis of that asset. This rule also applies when the partial disposition rule applies to a disposition of a portion of an asset included in a general asset account. The IRS and the Treasury Department expect that reasonable methods are available that use information readily available or known to the taxpayer and do not necessitate undertaking an expensive study.

These final regulations also provide nonexclusive examples of reasonable methods. These examples are the same examples in the 2013 proposed regulations, except the final regulations do not include the Consumer Price Index as an example of a reasonable method for the reason previously discussed in II.E. Similar to the rules for determining the unadjusted depreciable basis of a disposed asset under § 1.168(i)–8, the final regulations clarify that, when discounting the cost of the replacement asset, using the Producer Price Index for Finished Goods (or its successor, the Producer Price Index for Final Demand) is a reasonable method. The examples in the final regulations include the following: (1) Discounting the cost of the replacement asset to its

placed-in-service year cost using the Producer Price Index for Finished Goods (or its successor, the Producer Price Index for Final Demand, or any other index designated by guidance in the Internal Revenue Bulletin (see § 601.601(d)(2) of the chapter) only if the replacement asset is a restoration under § 1.263(a)–3(k) and is not a betterment under § 1.263(a)–3(j) or is not an adaptation to a new or different use under § 1.263(a)–3(l); (2) a pro rata allocation of the unadjusted depreciable basis of the general asset account based on the replacement cost of the disposed asset and the replacement cost of all of the assets in the general asset account; and (3) a study allocating the cost of the asset to its individual components.

E. Identification of Disposed Asset

The final regulations retain the rules in the 2013 proposed regulations for determining the placed-in-service year of an asset for which general asset account treatment is terminated. These rules are the same as those previously discussed for identifying the placed-in- service year of the disposed asset for purposes of § 1.168(i)–8: The specific identification method, the FIFO method, the modified FIFO method, a mortality dispersion table if the asset is a mass asset, or any other method designated by the Secretary in published guidance. A LIFO method is not permitted. These rules also apply when the partial disposition rule applies to a disposition of a portion of an asset included in a general asset account. The final regulations provide an additional example of the LIFO method, which is impermissible.

IV. Accounting for MACRS Property Under § 1.168(i)–7

The final regulations retain the rule in the 2013 proposed regulations regarding how to account for a disposed portion of an asset. The final regulations under § 1.168(i)–8 provide that if a taxpayer disposes of a portion of an asset and the partial disposition rule applies to that disposition, the taxpayer must account for the disposed portion in a single asset account beginning in the taxable year in which the disposition occurs. This rule also is provided in the final regulations under § 1.168(i)–7.

V. Conforming Changes

The final regulations also amend §§ 1.165–2, 1.168(i)–7, 1.263(a)–3, and 1.1016–3 to replace references to the temporary regulations and the 2013 proposed regulations with references to these final regulations.


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VI. Applicability Dates

The final regulations apply to taxable years beginning on or after January 1, 2014. Alternatively, a taxpayer may choose to apply the final regulations to taxable years beginning on or after January 1, 2012.

A taxpayer also may choose to rely on the provisions of the 2013 proposed regulations for taxable years beginning on or after January 1, 2012, and beginning before January 1, 2014. Finally, a taxpayer may choose to apply the temporary regulations to taxable years beginning on or after January 1, 2012, and beginning before January 1, 2014.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because these regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the 2013 proposed regulations preceding this regulation were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business, and no comments were received.

Statement of Availability for IRS Document

For copies of recently issued Revenue Procedures, Revenue Rulings, notices, and other guidance published in the Internal Revenue Bulletin please visit the IRS Web site at http://www.irs.gov or the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

Drafting Information

The principal author of these regulations is Kathleen Reed, Office of the Associate Chief Counsel (Income Tax and Accounting). However, other personnel from the IRS and the Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR Part 1 is amended as follows:

PART 1—INCOME TAXES

■ Paragraph 1. The authority citation for part 1 is revised by adding an entry for § 1.168(i)–1 to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.168(i)–1 also issued under 26

U.S.C. 168(i)(4).

■ Par. 2. Section 1.165–2 is amended by revising the first sentence in paragraph (c) to read as follows:

§ 1.165–2 Obsolescence of nondepreciable property. * * * * *

(c) Cross references. For the allowance under section 165(a) of losses arising from the permanent withdrawal of depreciable property from use in the trade or business or in the production of income, see § 1.167(a)–8, § 1.168(i)–1, or § 1.168(i)–8, as applicable. * * * * * * * * ■ Par. 3. Section 1.168(i)-0 is amended by: ■ a. Redesignating the entries for paragraphs (b)(4), (5), and (6) as paragraphs (b)(5), (6), and (7), respectively, and revising newly redesignated paragraphs (b)(6) and (7). ■ b. Adding entries for paragraphs (b)(4), (b)(8), and (b)(9). ■ c. Revising entries for paragraphs (c)(3), (d)(2), (d)(3), (e), (e)(1), (e)(2)(v) through (viii), (e)(3)(vi), (h)(1), (i), and (m). ■ d. Adding entries for paragraphs (e)(1)(i) and (ii). ■ e. Removing the entry for paragraph (h)(2) and redesignating the entry for paragraph (h)(3) as paragraph (h)(2).

The additions and revisions read as follows: § 1.168(i)–0 Table of contents for the

general asset account rules. * * * * * § 1.168(i)–1 General asset accounts. * * * * *

(b) * * * (4) Building.

* * * * * (6) Mass assets. (7) Portion of an asset. (8) Remaining adjusted depreciable

basis of the general asset account. (9) Structural component. (c) * * * (3) Examples.

* * * * * (d) * * * (2) Assets in general asset account are

eligible for additional first year

depreciation deduction. (3) No assets in general asset account

are eligible for additional first year depreciation deduction.

* * * * * (e) Dispositions from a general asset

account. (1) Scope and definition. (i) In general. (ii) Disposition of a portion of an

asset. (2) * * * (v) Manner of disposition. (vi) Disposition by transfer to a

supplies account. (vii) Leasehold improvements. (viii) Determination of asset disposed

of. * * * * *

(3) * * * (vi) Technical termination of a

partnership. * * * * *

(h) * * * (1) Conversion to any personal use.

* * * * * (i) Redetermination of basis.

* * * * * (m) Effective/applicability dates.

§ 1.168(i)–0T [Removed]

■ Par. 4. Section 1.168(i)–0T is removed. ■ Par. 5. Section 1.168(i)–1 is amended by revising paragraphs (a) through (l)(1), and (m) to read as follows:

§ 1.168(i)–1 General asset accounts. (a) Scope. This section provides rules

for general asset accounts under section 168(i)(4). The provisions of this section apply only to assets for which an election has been made under paragraph (l) of this section.


(1) Unadjusted depreciable basis has the same meaning given such term in § 1.168(b)–1(a)(3).

(2) Unadjusted depreciable basis of the general asset account is the sum of the unadjusted depreciable bases of all assets included in the general asset account.

(3) Adjusted depreciable basis of the general asset account is the unadjusted depreciable basis of the general asset account less the adjustments to basis described in section 1016(a)(2) and (3).

(4) Building has the same meaning as that term is defined in § 1.48–1(e)(1).

(5) Expensed cost is the amount of any allowable credit or deduction treated as a deduction allowable for depreciation or amortization for purposes of section 1245 (for example, a credit allowable under section 30 or a deduction allowable under section 179,


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section 179A, or section 190). Expensed cost does not include any additional first year depreciation deduction.

(6) Mass assets is a mass or group of individual items of depreciable assets—

(i) That are not necessarily homogenous;

(ii) Each of which is minor in value relative to the total value of the mass or group;

(iii) Numerous in quantity; (iv) Usually accounted for only on a

total dollar or quantity basis; (v) With respect to which separate

identification is impracticable; and (vi) Placed in service in the same

taxable year. (7) Portion of an asset is any part of

an asset that is less than the entire asset as determined under paragraph (e)(2)(viii) of this section.

(8) Remaining adjusted depreciable basis of the general asset account is the unadjusted depreciable basis of the general asset account less the amount of the additional first year depreciation deduction allowed or allowable, whichever is greater, for the general asset account.

(9) Structural component has the same meaning as that term is defined in § 1.48–1(e)(2).

(c) Establishment of general asset accounts—(1) Assets eligible for general asset accounts—(i) General rules. Assets that are subject to either the general depreciation system of section 168(a) or the alternative depreciation system of section 168(g) may be accounted for in one or more general asset accounts. An asset is included in a general asset account only to the extent of the asset’s unadjusted depreciable basis. However, an asset is not to be included in a general asset account if the asset is used both in a trade or business or for the production of income and in a personal activity at any time during the taxable year in which the asset is placed in service by the taxpayer or if the asset is placed in service and disposed of during the same taxable year.

(ii) Special rules for assets generating foreign source income. (A) Assets that generate foreign source income, both United States and foreign source income, or combined gross income of a foreign sales corporation (as defined in former section 922), domestic international sales corporation (as defined in section 992(a)), or possession corporation (as defined in section 936) and its related supplier may be included in a general asset account if the requirements of paragraph (c)(2)(i) of this section are satisfied. If, however, the inclusion of these assets in a general asset account results in a substantial distortion of income, the Commissioner

may disregard the general asset account election and make any reallocations of income or expense necessary to clearly reflect income.

(B) A general asset account shall be treated as a single asset for purposes of applying the rules in § 1.861–9T(g)(3) (relating to allocation and apportionment of interest expense under the asset method). A general asset account that generates income in more than one grouping of income (statutory and residual) is a multiple category asset (as defined in § 1.861–9T(g)(3)(ii)), and the income yield from the general asset account must be determined by applying the rules for multiple category assets as if the general asset account were a single asset.

(2) Grouping assets in general asset accounts—(i) General rules. If a taxpayer makes the election under paragraph (l) of this section, assets that are subject to the election are grouped into one or more general asset accounts. Assets that are eligible to be grouped into a single general asset account may be divided into more than one general asset account. Each general asset account must include only assets that—

(A) Have the same applicable depreciation method;

(B) Have the same applicable recovery period;

(C) Have the same applicable convention; and

(D) Are placed in service by the taxpayer in the same taxable year.

(ii) Special rules. In addition to the general rules in paragraph (c)(2)(i) of this section, the following rules apply when establishing general asset accounts—

(A) Assets subject to the mid-quarter convention may only be grouped into a general asset account with assets that are placed in service in the same quarter of the taxable year;

(B) Assets subject to the mid-month convention may only be grouped into a general asset account with assets that are placed in service in the same month of the taxable year;

(C) Passenger automobiles for which the depreciation allowance is limited under section 280F(a) must be grouped into a separate general asset account;

(D) Assets not eligible for any additional first year depreciation deduction (including assets for which the taxpayer elected not to deduct the additional first year depreciation) provided by, for example, section 168(k), section 168(l), section 168(m), section 168(n), section 1400L(b), or section 1400N(d), must be grouped into a separate general asset account;

(E) Assets eligible for the additional first year depreciation deduction may

only be grouped into a general asset account with assets for which the taxpayer claimed the same percentage of the additional first year depreciation (for example, 30 percent, 50 percent, or 100 percent);

(F) Except for passenger automobiles described in paragraph (c)(2)(ii)(C) of this section, listed property (as defined in section 280F(d)(4)) must be grouped into a separate general asset account;

(G) Assets for which the depreciation allowance for the placed-in-service year is not determined by using an optional depreciation table (for further guidance, see section 8 of Rev. Proc. 87–57, 1987– 2 CB 687, 693 (see § 601.601(d)(2) of this chapter)) must be grouped into a separate general asset account;

(H) Mass assets that are or will be subject to paragraph (j)(2)(i)(D) of this section (disposed of or converted mass asset is identified by a mortality dispersion table) must be grouped into a separate general asset account; and

(I) Assets subject to paragraph (h)(2)(iii)(A) of this section (change in use results in a shorter recovery period or a more accelerated depreciation method) for which the depreciation allowance for the year of change (as defined in § 1.168(i)–4(a)) is not determined by using an optional depreciation table must be grouped into a separate general asset account.

(3) Examples. The following examples illustrate the application of this paragraph (c):

Example 1. In 2014, J, a proprietorship with a calendar year-end, purchases and places in service one item of equipment that costs $550,000. This equipment is section 179 property and also is 5-year property under section 168(e). On its Federal tax return for 2014, J makes an election under section 179 to expense $25,000 of the equipment’s cost and makes an election under paragraph (l) of this section to include the equipment in a general asset account. As a result, the unadjusted depreciable basis of the equipment is $525,000. In accordance with paragraph (c)(1) of this section, J must include only $525,000 of the equipment’s cost in the general asset account.

Example 2. In 2014, K, a proprietorship with a calendar year-end, purchases and places in service 100 items of equipment. All of these items are 5-year property under section 168(e), are not listed property, and are not eligible for any additional first year depreciation deduction. On its Federal tax return for 2014, K does not make an election under section 179 to expense the cost of any of the 100 items of equipment and does make an election under paragraph (l) of this section to include the 100 items of equipment in a general asset account. K depreciates its 5-year property placed in service in 2014 using the optional depreciation table that corresponds with the general depreciation system, the 200-percent declining balance method, a 5- year recovery period, and the half-year


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convention. In accordance with paragraph (c)(2) of this section, K includes all of the 100 items of equipment in one general asset account.

Example 3. The facts are the same as in Example 2, except that K decides not to include all of the 100 items of equipment in one general asset account. Instead and in accordance with paragraph (c)(2) of this section, K establishes 100 general asset accounts and includes one item of equipment in each general asset account.

Example 4. L, a calendar-year corporation, is a wholesale distributer. In 2014, L places in service the following properties for use in its wholesale distribution business: Computers, automobiles, and forklifts. On its Federal tax return for 2014, L does not make an election under section 179 to expense the cost of any of these items of equipment and does make an election under paragraph (l) of this section to include all of these items of equipment in a general asset account. All of these items are 5-year property under section 168(e) and are not eligible for any additional first year depreciation deduction. The computers are listed property, and the automobiles are listed property and are subject to section 280F(a). L depreciates its 5-year property placed in service in 2014 using the optional depreciation table that corresponds with the general depreciation system, the 200-percent declining balance method, a 5-year recovery period, and the half-year convention. Although the computers, automobiles, and forklifts are 5- year property, L cannot include all of them in one general asset account because the computers and automobiles are listed property. Further, even though the computers and automobiles are listed property, L cannot include them in one general asset account because the automobiles also are subject to section 280F(a). In accordance with paragraph (c)(2) of this section, L establishes three general asset accounts: One for the computers, one for the automobiles, and one for the forklifts.

Example 5. M, a fiscal-year corporation with a taxable year ending June 30, purchases and places in service ten items of new equipment in October 2014, and purchases and places in service five other items of new equipment in February 2015. On its Federal tax return for the taxable year ending June 30, 2015, M does not make an election under section 179 to expense the cost of any of these items of equipment and does make an election under paragraph (l) of this section to include all of these items of equipment in a general asset account. All of these items of equipment are 7-year property under section 168(e), are not listed property, and are property described in section 168(k)(2)(B). All of the ten items of equipment placed in service in October 2014 are eligible for the 50-percent additional first year depreciation deduction provided by section 168(k)(1). All of the five items of equipment placed in service in February 2015 are not eligible for any additional first year depreciation deduction. M depreciates its 7-year property placed in service for the taxable year ending June 30, 2015, using the optional depreciation table that corresponds with the general depreciation system, the 200-percent

declining balance method, a 7-year recovery period, and the half-year convention. Although the 15 items of equipment are depreciated using the same depreciation method, recovery period, and convention, M cannot include all of them in one general asset account because some of items of equipment are not eligible for any additional first year depreciation deduction. In accordance with paragraph (c)(2) of this section, M establishes two general asset accounts: one for the ten items of equipment eligible for the 50-percent additional first year depreciation deduction and one for the five items of equipment not eligible for any additional first year depreciation deduction.

(d) Determination of depreciation allowance—(1) In general. Depreciation allowances are determined for each general asset account. The depreciation allowances must be recorded in a depreciation reserve account for each general asset account. The allowance for depreciation under this section constitutes the amount of depreciation allowable under section 167(a).

(2) Assets in general asset account are eligible for additional first year depreciation deduction. If all the assets in a general asset account are eligible for the additional first year depreciation deduction, the taxpayer first must determine the allowable additional first year depreciation deduction for the general asset account for the placed-in- service year and then must determine the amount otherwise allowable as a depreciation deduction for the general asset account for the placed-in-service year and any subsequent taxable year. The allowable additional first year depreciation deduction for the general asset account for the placed-in-service year is determined by multiplying the unadjusted depreciable basis of the general asset account by the additional first year depreciation deduction percentage applicable to the assets in the account (for example, 30 percent, 50 percent, or 100 percent). The remaining adjusted depreciable basis of the general asset account then is depreciated using the applicable depreciation method, recovery period, and convention for the assets in the account.

(3) No assets in general asset account are eligible for additional first year depreciation deduction. If none of the assets in a general asset account are eligible for the additional first year depreciation deduction, the taxpayer must determine the allowable depreciation deduction for the general asset account for the placed-in-service year and any subsequent taxable year by using the applicable depreciation method, recovery period, and convention for the assets in the account.

(4) Special rule for passenger automobiles. For purposes of applying

section 280F(a), the depreciation allowance for a general asset account established for passenger automobiles is limited for each taxable year to the amount prescribed in section 280F(a) multiplied by the excess of the number of automobiles originally included in the account over the number of automobiles disposed of during the taxable year or in any prior taxable year in a transaction described in paragraph (e)(3)(iii) (disposition of an asset in a qualifying disposition), paragraph (e)(3)(iv) (transactions subject to section 168(i)(7)), paragraph (e)(3)(v) (transactions subject to section 1031 or section 1033), paragraph (e)(3)(vi) (technical termination of a partnership), paragraph (e)(3)(vii) (anti-abuse rule), paragraph (g) (assets subject to recapture), or paragraph (h)(1) (conversion to any personal use) of this section.

(e) Dispositions from a general asset account—(1) Scope and definition—(i) In general. This paragraph (e) provides rules applicable to dispositions of assets included in a general asset account. For purposes of this paragraph (e), an asset in a general asset account is disposed of when ownership of the asset is transferred or when the asset is permanently withdrawn from use either in the taxpayer’s trade or business or in the production of income. A disposition includes the sale, exchange, retirement, physical abandonment, or destruction of an asset. A disposition also occurs when an asset is transferred to a supplies, scrap, or similar account, or when a portion of an asset is disposed of as described in paragraph (e)(1)(ii) of this section. If a structural component, or a portion thereof, of a building is disposed of in a disposition described in paragraph (e)(1)(ii) of this section, a disposition also includes the disposition of such structural component or such portion thereof.

(ii) Disposition of a portion of an asset. For purposes of applying paragraph (e) of this section, a disposition includes a disposition of a portion of an asset in a general asset account as a result of a casualty event described in section 165, a disposition of a portion of an asset in a general asset account for which gain, determined without regard to section 1245 or section 1250, is not recognized in whole or in part under section 1031 or section 1033, a transfer of a portion of an asset in a general asset account in a transaction described in section 168(i)(7)(B), a sale of a portion of an asset in a general asset account, or a disposition of a portion of an asset in a general asset account in a transaction described in paragraph (e)(3)(vii)(B) of


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this section. For other transactions, a disposition includes a disposition of a portion of an asset in a general asset account only if the taxpayer makes the election under paragraph (e)(3)(ii) of this section to terminate the general asset account in which that disposed portion is included or makes the election under paragraph (e)(3)(iii) of this section for that disposed portion.

(2) General rules for a disposition—(i) No immediate recovery of basis. Except as provided in paragraph (e)(3) of this section, immediately before a disposition of any asset in a general asset account or a disposition of a portion of such asset as described in paragraph (e)(1)(ii) of this section, the asset or the portion of the asset, as applicable, is treated as having an adjusted depreciable basis (as defined in § 1.168(b)–1(a)(4)) of zero for purposes of section 1011. Therefore, no loss is realized upon the disposition of an asset from the general asset account or upon the disposition of a portion of such asset as described in paragraph (e)(1)(ii) of this section. Similarly, where an asset or a portion of an asset, as applicable, is disposed of by transfer to a supplies, scrap, or similar account, the basis of the asset or the portion of the asset, as applicable, in the supplies, scrap, or similar account will be zero.

(ii) Treatment of amount realized. Any amount realized on a disposition is recognized as ordinary income, notwithstanding any other provision of subtitle A of the Internal Revenue Code (Code), to the extent the sum of the unadjusted depreciable basis of the general asset account and any expensed cost (as defined in paragraph (b)(5) of this section) for assets in the account exceeds any amounts previously recognized as ordinary income upon the disposition of other assets in the account or upon the disposition of portions of such assets as described in paragraph (e)(1)(ii) of this section. The recognition and character of any excess amount realized are determined under other applicable provisions of the Code other than sections 1245 and 1250 or provisions of the Code that treat gain on a disposition as subject to section 1245 or section 1250.

(iii) Effect of disposition on a general asset account. Except as provided in paragraph (e)(3) of this section, the unadjusted depreciable basis and the depreciation reserve of the general asset account are not affected as a result of a disposition of an asset from the general asset account or of a disposition of a portion of such asset as described in paragraph (e)(1)(ii) of this section.

(iv) Coordination with nonrecognition provisions. For purposes of determining

the basis of an asset or a portion of an asset, as applicable, acquired in a transaction, other than a transaction described in paragraph (e)(3)(iv) (pertaining to transactions subject to section 168(i)(7)), paragraph (e)(3)(v) (pertaining to transactions subject to section 1031 or section 1033), and paragraph (e)(3)(vi) (pertaining to technical terminations of partnerships) of this section, to which a nonrecognition section of the Code applies, determined without regard to this section, the amount of ordinary income recognized under this paragraph (e)(2) is treated as the amount of gain recognized on the disposition.

(v) Manner of disposition. The manner of disposition (for example, normal retirement, abnormal retirement, ordinary retirement, or extraordinary retirement) is not taken into account in determining whether a disposition occurs or gain or loss is recognized.

(vi) Disposition by transfer to a supplies account. If a taxpayer made an election under § 1.162–3(d) to treat the cost of any rotable spare part, temporary spare part, or standby emergency spare part (as defined in § 1.162–3(c)) as a capital expenditure subject to the allowance for depreciation and also made an election under paragraph (l) of this section to include that rotable, temporary, or standby emergency spare part in a general asset account, the taxpayer can dispose of the rotable, temporary, or standby emergency spare part by transferring it to a supplies account only if the taxpayer has obtained the consent of the Commissioner to revoke the § 1.162– 3(d) election. If a taxpayer made an election under § 1.162–3T(d) to treat the cost of any material and supply (as defined in § 1.162–3T(c)(1)) as a capital expenditure subject to the allowance for depreciation and also made an election under paragraph (l) of this section to include that material and supply in a general asset account, the taxpayer can dispose of the material and supply by transferring it to a supplies account only if the taxpayer has obtained the consent of the Commissioner to revoke the § 1.162–3T(d) election. See § 1.162– 3(d)(3) for the procedures for revoking a § 1.162–3(d) or a § 1.162–3T(d) election.

(vii) Leasehold improvements. The rules of paragraph (e) of this section also apply to—

(A) A lessor of leased property that made an improvement to that property for the lessee of the property, has a depreciable basis in the improvement, made an election under paragraph (l) of this section to include the improvement in a general asset account, and disposes of the improvement, or disposes of a

portion of the improvement as described in paragraph (e)(1)(ii) of this section, before or upon the termination of the lease with the lessee. See section 168(i)(8)(B); and

(B) A lessee of leased property that made an improvement to that property, has a depreciable basis in the improvement, made an election under paragraph (l) of this section to include the improvement in a general asset account, and disposes of the improvement, or disposes of a portion of the improvement as described in paragraph (e)(1)(ii) of this section, before or upon the termination of the lease.

(viii) Determination of asset disposed of—(A) General rules. For purposes of applying paragraph (e) of this section to the disposition of an asset in a general asset account, instead of the disposition of the general asset account, the facts and circumstances of each disposition are considered in determining what is the appropriate asset disposed of. The asset for disposition purposes may not consist of items placed in service by the taxpayer on different dates, without taking into account the applicable convention. For purposes of determining what is the appropriate asset disposed of, the unit of property determination under § 1.263(a)–3(e) or in published guidance in the Internal Revenue Bulletin under section 263(a) (see § 601.601(d)(2) of this chapter) does not apply.

(B) Special rules. In addition to the general rules in paragraph (e)(2)(viii)(A) of this section, the following rules apply for purposes of applying paragraph (e) of this section to the disposition of an asset in a general asset account instead of the disposition of the general asset account:

(1) Each building, including its structural components, is the asset, except as provided in § 1.1250– 1(a)(2)(ii) or in paragraph (e)(2)(viii)(B)(2) or (4) of this section.

(2) If a building has two or more condominium or cooperative units, each condominium or cooperative unit, including its structural components, is the asset, except as provided in § 1.1250–1(a)(2)(ii) or in paragraph (e)(2)(viii)(B)(4) of this section.

(3) If a taxpayer properly includes an item in one of the asset classes 00.11 through 00.4 of Rev. Proc. 87–56 (1987– 2 CB 674) (see § 601.601(d)(2) of this chapter) or properly classifies an item in one of the categories under section 168(e)(3), except for a category that includes buildings or structural components (for example, retail motor fuels outlet, qualified leasehold improvement property, qualified


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restaurant property, and qualified retail improvement property), each item is the asset, provided that paragraph (e)(2)(viii)(B)(4) of this section does not apply to the item. For example, each desk is the asset, each computer is the asset, and each qualified smart electric meter is the asset.

(4) If the taxpayer places in service an improvement or addition to an asset after the taxpayer placed the asset in service, the improvement or addition and, if applicable, its structural components are a separate asset.

(ix) Examples. The following examples illustrate the application of this paragraph (e)(2):

Example 1. A, a calendar-year partnership, maintains one general asset account for one office building that cost $10 million. A discovers a leak in the roof of the building and decides to replace the entire roof. The roof is a structural component of the building. In accordance with paragraph (e)(2)(viii)(B)(1) of this section, the office building, including its structural components, is the asset for disposition purposes. The retirement of the replaced roof is not a disposition of a portion of an asset as described in paragraph (e)(1)(ii) of this section. Thus, the retirement of the replaced roof is not a disposition under paragraph (e)(1) of this section. As a result, A continues to depreciate the $10 million cost of the general asset account. If A must capitalize the amount paid for the replacement roof pursuant to § 1.263(a)–3, the replacement roof is a separate asset for disposition purposes pursuant to paragraph (e)(2)(viii)(B)(4) of this section and for depreciation purposes pursuant to section 168(i)(6).

Example 2. B, a calendar-year commercial airline company, maintains one general asset account for five aircraft that cost a total of $500 million. These aircraft are described in asset class 45.0 of Rev. Proc. 87–56. B replaces the existing engines on one of the aircraft with new engines. Assume each aircraft is a unit of property as determined under § 1.263(a)–3(e)(3) and each engine of an aircraft is a major component or substantial structural part of the aircraft as determined under § 1.263(a)–3(k)(6). Assume also that B treats each aircraft as the asset for disposition purposes in accordance with paragraph (e)(2)(viii) of this section. The retirement of the replaced engines is not a disposition of a portion of an asset as described in paragraph (e)(1)(ii) of this section. Thus, the retirement of the replaced engines is not a disposition under paragraph (e)(1) of this section. As a result, B continues to depreciate the $500 million cost of the general asset account. If B must capitalize the amount paid for the replacement engines pursuant to § 1.263(a)–3, the replacement engines are a separate asset for disposition purposes pursuant to paragraph (e)(2)(viii)(B)(4) of this section and for depreciation purposes pursuant to section 168(i)(6).

Example 3. (i) R, a calendar-year corporation, maintains one general asset

account for ten machines. The machines cost a total of $10,000 and are placed in service in June 2014. Of the ten machines, one machine costs $8,200 and nine machines cost a total of $1,800. Assume R depreciates this general asset account using the optional depreciation table that corresponds with the general depreciation system, the 200-percent declining balance method, a 5-year recovery period, and a half-year convention. R does not make a section 179 election for any of the machines, and all of the machines are not eligible for any additional first year depreciation deduction. As of January 1, 2015, the depreciation reserve of the account is $2,000 ($10,000 × 20%).

(ii) On February 8, 2015, R sells the machine that cost $8,200 to an unrelated party for $9,000. Under paragraph (e)(2)(i) of this section, this machine has an adjusted depreciable basis of zero.

(iii) On its 2015 tax return, R recognizes the amount realized of $9,000 as ordinary income because such amount does not exceed the unadjusted depreciable basis of the general asset account ($10,000), plus any expensed cost for assets in the account ($0), less amounts previously recognized as ordinary income ($0). Moreover, the unadjusted depreciable basis and depreciation reserve of the account are not affected by the disposition of the machine. Thus, the depreciation allowance for the account in 2015 is $3,200 ($10,000 × 32%).

Example 4. (i) The facts are the same as in Example 3. In addition, on June 4, 2016, R sells seven machines to an unrelated party for a total of $1,100. In accordance with paragraph (e)(2)(i) of this section, these machines have an adjusted depreciable basis of zero.

(ii) On its 2016 tax return, R recognizes $1,000 as ordinary income (the unadjusted depreciable basis of $10,000, plus the expensed cost of $0, less the amount of $9,000 previously recognized as ordinary income). The recognition and character of the excess amount realized of $100 ($1,100¥$1,000) are determined under applicable provisions of the Code other than section 1245 (such as section 1231). Moreover, the unadjusted depreciable basis and depreciation reserve of the account are not affected by the disposition of the machines. Thus, the depreciation allowance for the account in 2016 is $1,920 ($10,000 × 19.2%).

(3) Special rules—(i) In general. This paragraph (e)(3) provides the rules for terminating general asset account treatment upon certain dispositions. While the rules under paragraphs (e)(3)(ii) and (iii) of this section are optional rules, the rules under paragraphs (e)(3)(iv), (v), (vi), and (vii) of this section are mandatory rules. A taxpayer elects to apply paragraph (e)(3)(ii) or (iii) of this section by reporting the gain, loss, or other deduction on the taxpayer’s timely filed original Federal tax return, including extensions, for the taxable year in which the disposition occurs. However, if the loss is on account of the demolition of

a structure to which section 280B and § 1.280B–1 apply, a taxpayer elects to apply paragraph (e)(3)(ii) or (iii) of this section by ending depreciation for the structure at the time of the disposition of the structure, taking into account the convention applicable to the general asset account in which the demolished structure was included, and reporting the amount of depreciation for that structure for the taxable year in which the disposition occurs on the taxpayer’s timely filed original Federal tax return, including extensions, for that taxable year. A taxpayer may revoke the election to apply paragraph (e)(3)(ii) or (iii) of this section only by filing a request for a private letter ruling and obtaining the Commissioner’s consent to revoke the election. The Commissioner may grant a request to revoke this election if the taxpayer acted reasonably and in good faith, and the revocation will not prejudice the interests of the Government. See generally § 301.9100– 3 of this chapter. The election to apply paragraph (e)(3)(ii) or (iii) of this section may not be made or revoked through the filing of an application for change in accounting method. For purposes of applying paragraphs (e)(3)(iii) through (vii) of this section, see paragraph (j) of this section for identifying an asset disposed of and its unadjusted depreciable basis. Solely for purposes of applying paragraphs (e)(3)(iii), (e)(3)(iv)(C), (e)(3)(v)(B), and (e)(3)(vii) of this section, the term asset is:

(A) The asset as determined under paragraph (e)(2)(viii) of this section; or

(B) The portion of such asset that is disposed of in a disposition described in paragraph (e)(1)(ii) of this section.

(ii) Disposition of all assets remaining in a general asset account—(A) Optional termination of a general asset account. Upon the disposition of all of the assets, the last asset, or the remaining portion of the last asset in a general asset account, a taxpayer may apply this paragraph (e)(3)(ii) to recover the adjusted depreciable basis of the general asset account rather than having paragraph (e)(2) of this section apply. Under this paragraph (e)(3)(ii), the general asset account terminates and the amount of gain or loss for the general asset account is determined under section 1001(a) by taking into account the adjusted depreciable basis of the general asset account at the time of the disposition, as determined under the applicable convention for the general asset account. Whether and to what extent gain or loss is recognized is determined under other applicable provisions of the Code, including section 280B and § 1.280B–1. The character of the gain or loss is


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determined under other applicable provisions of the Code, except that the amount of gain subject to section 1245 is limited to the excess of the depreciation allowed or allowable for the general asset account, including any expensed cost, over any amounts previously recognized as ordinary income under paragraph (e)(2) of this section, and the amount of gain subject to section 1250 is limited to the excess of the additional depreciation allowed or allowable for the general asset account, over any amounts previously recognized as ordinary income under paragraph (e)(2) of this section.

(B) Examples. The following examples illustrate the application of this paragraph (e)(3)(ii):

Example 1. (i) T, a calendar-year corporation, maintains a general asset account for 1,000 calculators. The calculators cost a total of $60,000 and are placed in service in 2014. Assume T depreciates this general asset account using the optional depreciation table that corresponds with the general depreciation system, the 200-percent declining balance method, a 5-year recovery period, and a half-year convention. T does not make a section 179 election for any of the calculators, and all of the calculators are not eligible for any additional first year depreciation deduction. In 2015, T sells 200 of the calculators to an unrelated party for a total of $10,000 and recognizes the $10,000 as ordinary income in accordance with paragraph (e)(2) of this section.

(ii) On March 26, 2016, T sells the remaining calculators in the general asset account to an unrelated party for $35,000. T elects to apply paragraph (e)(3)(ii) of this section. As a result, the account terminates and gain or loss is determined for the account.

(iii) On the date of disposition, the adjusted depreciable basis of the account is $23,040 (unadjusted depreciable basis of $60,000 less the depreciation allowed or allowable of $36,960). Thus, in 2016, T recognizes gain of $11,960 (amount realized of $35,000 less the adjusted depreciable basis of $23,040). The gain of $11,960 is subject to section 1245 to the extent of the depreciation allowed or allowable for the account, plus the expensed cost for assets in the account, less the amounts previously recognized as ordinary income ($36,960 + $0 ¥ $10,000 = $26,960). As a result, the entire gain of $11,960 is subject to section 1245.

Example 2. (i) J, a calendar-year corporation, maintains a general asset account for one item of equipment. This equipment costs $2,000 and is placed in service in 2014. Assume J depreciates this general asset account using the optional depreciation table that corresponds with the general depreciation system, the 200-percent declining balance method, a 5-year recovery period, and a half-year convention. J does not make a section 179 election for the equipment, and it is not eligible for any additional first year depreciation deduction. In June 2016, J sells the equipment to an unrelated party for $1,000. J elects to apply

paragraph (e)(3)(ii) of this section. As a result, the account terminates and gain or loss is determined for the account.

(ii) On the date of disposition, the adjusted depreciable basis of the account is $768 (unadjusted depreciable basis of $2,000 less the depreciation allowed or allowable of $1,232). Thus, in 2016, J recognizes gain of $232 (amount realized of $1,000 less the adjusted depreciable basis of $768). The gain of $232 is subject to section 1245 to the extent of the depreciation allowed or allowable for the account (plus the expensed cost for assets in the account) less the amounts previously recognized as ordinary income ($1,232 + $0 ¥ $0 = $1,232). As a result, the entire gain of $232 is subject to section 1245.

(iii) Disposition of an asset in a qualifying disposition—(A) Optional determination of the amount of gain, loss, or other deduction. In the case of a qualifying disposition (described in paragraph (e)(3)(iii)(B) of this section) of an asset, a taxpayer may elect to apply this paragraph (e)(3)(iii) rather than having paragraph (e)(2) of this section apply. Under this paragraph (e)(3)(iii), general asset account treatment for the asset terminates as of the first day of the taxable year in which the qualifying disposition occurs, and the amount of gain, loss, or other deduction for the asset is determined under § 1.168(i)–8 by taking into account the asset’s adjusted depreciable basis at the time of the disposition. The adjusted depreciable basis of the asset at the time of the disposition, as determined under the applicable convention for the general asset account in which the asset was included, equals the unadjusted depreciable basis of the asset less the depreciation allowed or allowable for the asset, computed by using the depreciation method, recovery period, and convention applicable to the general asset account in which the asset was included and by including the portion of the additional first year depreciation deduction claimed for the general asset account that is attributable to the asset disposed of. Whether and to what extent gain, loss, or other deduction is recognized is determined under other applicable provisions of the Code, including section 280B and § 1.280B–1. The character of the gain, loss, or other deduction is determined under other applicable provisions of the Code, except that the amount of gain subject to section 1245 or section 1250 is limited to the lesser of—

(1) The depreciation allowed or allowable for the asset, including any expensed cost or, in the case of section 1250 property, the additional depreciation allowed or allowable for the asset; or

(2) The excess of—

(i) The original unadjusted depreciable basis of the general asset account plus, in the case of section 1245 property originally included in the general asset account, any expensed cost; over

(ii) The cumulative amounts of gain previously recognized as ordinary income under either paragraph (e)(2) of this section or section 1245 or section 1250.

(B) Qualifying dispositions. A qualifying disposition is a disposition that does not involve all the assets, the last asset, or the remaining portion of the last asset remaining in a general asset account and that is—

(1) A direct result of a fire, storm, shipwreck, or other casualty, or from theft;

(2) A charitable contribution for which a deduction is allowable under section 170;

(3) A direct result of a cessation, termination, or disposition of a business, manufacturing or other income producing process, operation, facility, plant, or other unit, other than by transfer to a supplies, scrap, or similar account; or

(4) A transaction, other than a transaction described in paragraph (e)(3)(iv) (pertaining to transactions subject to section 168(i)(7)), paragraph (e)(3)(v) (pertaining to transactions subject to section 1031 or section 1033), paragraph (e)(3)(vi) (pertaining to technical terminations of partnerships), or paragraph (e)(3)(vii) (anti-abuse rule) of this section, to which a nonrecognition section of the Internal Revenue Code applies (determined without regard to this section).

(C) Effect of a qualifying disposition on a general asset account. If the taxpayer elects to apply this paragraph (e)(3)(iii) to a qualifying disposition of an asset, then—

(1) The asset is removed from the general asset account as of the first day of the taxable year in which the qualifying disposition occurs. For that taxable year, the taxpayer accounts for the asset in a single asset account in accordance with the rules under § 1.168(i)–7(b);

(2) The unadjusted depreciable basis of the general asset account is reduced by the unadjusted depreciable basis of the asset as of the first day of the taxable year in which the disposition occurs;

(3) The depreciation reserve of the general asset account is reduced by the depreciation allowed or allowable for the asset as of the end of the taxable year immediately preceding the year of disposition, computed by using the depreciation method, recovery period, and convention applicable to the


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general asset account in which the asset was included and by including the portion of the additional first year depreciation deduction claimed for the general asset account that is attributable to the asset disposed of; and

(4) For purposes of determining the amount of gain realized on subsequent dispositions that is subject to ordinary income treatment under paragraph (e)(2)(ii) of this section, the amount of any expensed cost with respect to the asset is disregarded.

(D) Examples. The following examples illustrate the application of this paragraph (e)(3)(iii):

Example 1. (i) Z, a calendar-year corporation, maintains one general asset account for 12 machines. Each machine costs $15,000 and is placed in service in 2014. Of the 12 machines, nine machines that cost a total of $135,000 are used in Z’s Kentucky plant, and three machines that cost a total of $45,000 are used in Z’s Ohio plant. Assume Z depreciates this general asset account using the optional depreciation table that corresponds with the general depreciation system, the 200-percent declining balance method, a 5-year recovery period, and the half-year convention. Z does not make a section 179 election for any of the machines, and all of the machines are not eligible for any additional first year depreciation deduction. As of December 31, 2015, the depreciation reserve for the account is $93,600.

(ii) On May 27, 2016, Z sells its entire manufacturing plant in Ohio to an unrelated party. The sales proceeds allocated to each of the three machines at the Ohio plant is $5,000. This transaction is a qualifying disposition under paragraph (e)(3)(iii)(B)(3) of this section, and Z elects to apply paragraph (e)(3)(iii) of this section.

(iii) For Z’s 2016 return, the depreciation allowance for the account is computed as follows. As of December 31, 2015, the depreciation allowed or allowable for the three machines at the Ohio plant is $23,400. Thus, as of January 1, 2016, the unadjusted depreciable basis of the account is reduced from $180,000 to $135,000 ($180,000 less the unadjusted depreciable basis of $45,000 for the three machines), and, as of December 31, 2015, the depreciation reserve of the account is decreased from $93,600 to $70,200 ($93,600 less the depreciation allowed or allowable of $23,400 for the three machines as of December 31, 2015). Consequently, the depreciation allowance for the account in 2016 is $25,920 ($135,000 × 19.2%).

(iv) For Z’s 2016 return, gain or loss for each of the three machines at the Ohio plant is determined as follows. The depreciation allowed or allowable in 2016 for each machine is $1,440 (($15,000 × 19.2%)/2). Thus, the adjusted depreciable basis of each machine under section 1011 is $5,760 (the adjusted depreciable basis of $7,200 removed from the account less the depreciation allowed or allowable of $1,440 in 2016). As a result, the loss recognized in 2016 for each machine is $760 ($5,000 ¥ $5,760), which is subject to section 1231.

Example 2. (i) A, a calendar-year partnership, maintains one general asset account for one office building that cost $20 million and was placed in service in July 2011. A depreciates this general asset account using the optional depreciation table that corresponds with the general depreciation system, the straight-line method, a 39-year recovery period, and the mid-month convention. As of January 1, 2014, the depreciation reserve for the account is $1,261,000.

(ii) In May 2014, a tornado occurs where the building is located and damages the roof of the building. A decides to replace the entire roof. The roof is replaced in June 2014. The roof is a structural component of the building. Because the roof was damaged as a result of a casualty event described in section 165, the partial disposition rule provided under paragraph (e)(1)(ii) of this section applies to the roof. Although the office building, including its structural components, is the asset for disposition purposes, the partial disposition rule provides that the retirement of the replaced roof is a disposition under paragraph (e)(1) of this section. This retirement is a qualifying disposition under paragraph (e)(3)(iii)(B)(1) of this section, and A elects to apply paragraph (e)(3)(iii) of this section for the retirement of the damaged roof.

(iii) Of the $20 million cost of the office building, assume $1 million is the cost of the retired roof.

(iv) For A’s 2014 return, the depreciation allowance for the account is computed as follows. As of December 31, 2013, the depreciation allowed or allowable for the retired roof is $63,050. Thus, as of January 1, 2014, the unadjusted depreciable basis of the account is reduced from $20,000,000 to $19,000,000 ($20,000,000 less the unadjusted depreciable basis of $1,000,000 for the retired roof), and the depreciation reserve of the account is decreased from $1,261,000 to $1,197,950 ($1,261,000 less the depreciation allowed or allowable of $63,050 for the retired roof as of December 31, 2013). Consequently, the depreciation allowance for the account in 2014 is $487,160 ($19,000,000 × 2.564%).

(v) For A’s 2014 return, gain or loss for the retired roof is determined as follows. The depreciation allowed or allowable in 2014 for the retired roof is $11,752 (($1,000,000 × 2.564%) × 5.5/12). Thus, the adjusted depreciable basis of the retired roof under section 1011 is $925,198 (the adjusted depreciable basis of $936,950 removed from the account less the depreciation allowed or allowable of $11,752 in 2014). As a result, the loss recognized in 2014 for the retired roof is $925,198, which is subject to section 1231.

(vi) If A must capitalize the amount paid for the replacement roof under § 1.263(a)–3, the replacement roof is a separate asset for depreciation purposes pursuant to section 168(i)(6). If A includes the replacement roof in a general asset account, the replacement roof is a separate asset for disposition purposes pursuant to paragraph (e)(2)(viii)(B)(4) of this section. If A includes the replacement roof in a single asset account or a multiple asset account under § 1.168(i)– 7, the replacement roof is a separate asset for

disposition purposes pursuant to § 1.168(i)– 8(c)(4)(ii)(D).

(iv) Transactions subject to section 168(i)(7)—(A) In general. If a taxpayer transfers one or more assets, or a portion of such asset, in a general asset account in a transaction described in section 168(i)(7)(B) (pertaining to treatment of transferees in certain nonrecognition transactions), the taxpayer (the transferor) and the transferee must apply this paragraph (e)(3)(iv) to the asset or the portion of such asset, instead of applying paragraph (e)(2), (e)(3)(ii), or (e)(3)(iii) of this section. The transferee is bound by the transferor’s election under paragraph (l) of this section for the portion of the transferee’s basis in the asset or the portion of such asset that does not exceed the transferor’s adjusted depreciable basis of the general asset account or the asset or the portion of such asset, as applicable, as determined under paragraph (e)(3)(iv)(B)(2) or (C)(2) of this section, as applicable.

(B) All assets remaining in general asset account are transferred. If a taxpayer transfers all the assets, the last asset, or the remaining portion of the last asset in a general asset account in a transaction described in section 168(i)(7)(B)—

(1) The taxpayer (the transferor) must terminate the general asset account on the date of the transfer. The allowable depreciation deduction for the general asset account for the transferor’s taxable year in which the section 168(i)(7)(B) transaction occurs is computed by using the depreciation method, recovery period, and convention applicable to the general asset account. This allowable depreciation deduction is allocated between the transferor and the transferee on a monthly basis. This allocation is made in accordance with the rules in § 1.168(d)–1(b)(7)(ii) for allocating the depreciation deduction between the transferor and the transferee;

(2) The transferee must establish a new general asset account for all the assets, the last asset, or the remaining portion of the last asset, in the taxable year in which the section 168(i)(7)(B) transaction occurs for the portion of its basis in the assets that does not exceed the transferor’s adjusted depreciable basis of the general asset account in which all the assets, the last asset, or the remaining portion of the last asset, were included. The transferor’s adjusted depreciable basis of this general asset account is equal to the adjusted depreciable basis of that account as of the beginning of the transferor’s taxable year in which the transaction occurs,


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decreased by the amount of depreciation allocable to the transferor for the year of the transfer, as determined under paragraph (e)(3)(iv)(B)(1) of this section. The transferee is treated as the transferor for purposes of computing the allowable depreciation deduction for the new general asset account under section 168. The new general asset account must be established in accordance with the rules in paragraph (c) of this section, except that the unadjusted depreciable bases of all the assets, the last asset, or the remaining portion of the last asset, and the greater of the depreciation allowed or allowable for all the assets, the last asset, or the remaining portion of the last asset, including the amount of depreciation for the transferred assets that is allocable to the transferor for the year of the transfer, are included in the newly established general asset account. Consequently, this general asset account in the year of the transfer will have a beginning balance for both the unadjusted depreciable basis and the depreciation reserve of the general asset account; and

(3) For purposes of section 168 and this section, the transferee treats the portion of its basis in the assets that exceeds the transferor’s adjusted depreciable basis of the general asset account in which all the assets, the last asset, or the remaining portion of the last asset, were included, as determined under paragraph (e)(3)(iv)(B)(2) of this section, as a separate asset that the transferee placed in service on the date of the transfer. The transferee accounts for this asset under § 1.168(i)–7 or may make an election under paragraph (l) of this section to include the asset in a general asset account.

(C) Not all assets remaining in general asset account are transferred. If a taxpayer transfers an asset in a general asset account in a transaction described in section 168(i)(7)(B) and if paragraph (e)(3)(iv)(B) of this section does not apply to this asset—

(1) The taxpayer (the transferor) must remove the transferred asset from the general asset account in which the asset is included, as of the first day of the taxable year in which the section 168(i)(7)(B) transaction occurs. In addition, the adjustments to the general asset account described in paragraphs (e)(3)(iii)(C)(2) through (4) of this section must be made. The allowable depreciation deduction for the asset for the transferor’s taxable year in which the section 168(i)(7)(B) transaction occurs is computed by using the depreciation method, recovery period, and convention applicable to the general asset account in which the asset

was included. This allowable depreciation deduction is allocated between the transferor and the transferee on a monthly basis. This allocation is made in accordance with the rules in § 1.168(d)–1(b)(7)(ii) for allocating the depreciation deduction between the transferor and the transferee;

(2) The transferee must establish a new general asset account for the asset in the taxable year in which the section 168(i)(7)(B) transaction occurs for the portion of its basis in the asset that does not exceed the transferor’s adjusted depreciable basis of the asset. The transferor’s adjusted depreciable basis of this asset is equal to the adjusted depreciable basis of the asset as of the beginning of the transferor’s taxable year in which the transaction occurs, decreased by the amount of depreciation allocable to the transferor for the year of the transfer, as determined under paragraph (e)(3)(iv)(C)(1) of this section. The transferee is treated as the transferor for purposes of computing the allowable depreciation deduction for the new general asset account under section 168. The new general asset account must be established in accordance with the rules in paragraph (c) of this section, except that the unadjusted depreciable basis of the asset, and the greater of the depreciation allowed or allowable for the asset, including the amount of depreciation for the transferred asset that is allocable to the transferor for the year of the transfer, are included in the newly established general asset account. Consequently, this general asset account in the year of the transfer will have a beginning balance for both the unadjusted depreciable basis and the depreciation reserve of the general asset account; and

(3) For purposes of section 168 and this section, the transferee treats the portion of its basis in the asset that exceeds the transferor’s adjusted depreciable basis of the asset, as determined under paragraph (e)(3)(iv)(C)(2) of this section, as a separate asset that the transferee placed in service on the date of the transfer. The transferee accounts for this asset under § 1.168(i)–7 or may make an election under paragraph (l) of this section to include the asset in a general asset account.

(v) Transactions subject to section 1031 or section 1033—(A) Like-kind exchange or involuntary conversion of all assets remaining in a general asset account. If all the assets, the last asset, or the remaining portion of the last asset in a general asset account are transferred by a taxpayer in a like-kind exchange (as

defined under § 1.168–6(b)(11)) or in an involuntary conversion (as defined under § 1.168–6(b)(12)), the taxpayer must apply this paragraph (e)(3)(v)(A) instead of applying paragraph (e)(2), (e)(3)(ii), or (e)(3)(iii) of this section. Under this paragraph (e)(3)(v)(A), the general asset account terminates as of the first day of the year of disposition (as defined in § 1.168(i)–6(b)(5)) and—

(1) The amount of gain or loss for the general asset account is determined under section 1001(a) by taking into account the adjusted depreciable basis of the general asset account at the time of disposition (as defined in § 1.168(i)– 6(b)(3)). The depreciation allowance for the general asset account in the year of disposition is determined in the same manner as the depreciation allowance for the relinquished MACRS property (as defined in § 1.168(i)–6(b)(2)) in the year of disposition is determined under § 1.168(i)–6. The recognition and character of gain or loss are determined in accordance with paragraph (e)(3)(ii)(A) of this section, notwithstanding that paragraph (e)(3)(ii) of this section is an optional rule; and

(2) The adjusted depreciable basis of the general asset account at the time of disposition is treated as the adjusted depreciable basis of the relinquished MACRS property.

(B) Like-kind exchange or involuntary conversion of less than all assets remaining in a general asset account. If an asset in a general asset account is transferred by a taxpayer in a like-kind exchange or in an involuntary conversion and if paragraph (e)(3)(v)(A) of this section does not apply to this asset, the taxpayer must apply this paragraph (e)(3)(v)(B) instead of applying paragraph (e)(2), (e)(3)(ii), or (e)(3)(iii) of this section. Under this paragraph (e)(3)(v)(B), general asset account treatment for the asset terminates as of the first day of the year of disposition (as defined in § 1.168(i)– 6(b)(5)), and—

(1) The amount of gain or loss for the asset is determined by taking into account the asset’s adjusted depreciable basis at the time of disposition (as defined in § 1.168(i)–6(b)(3)). The adjusted depreciable basis of the asset at the time of disposition equals the unadjusted depreciable basis of the asset less the depreciation allowed or allowable for the asset, computed by using the depreciation method, recovery period, and convention applicable to the general asset account in which the asset was included and by including the portion of the additional first year depreciation deduction claimed for the general asset account that is attributable to the relinquished asset. The


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depreciation allowance for the asset in the year of disposition is determined in the same manner as the depreciation allowance for the relinquished MACRS property (as defined in § 1.168(i)– 6(b)(2)) in the year of disposition is determined under § 1.168(i)–6. The recognition and character of the gain or loss are determined in accordance with paragraph (e)(3)(iii)(A) of this section, notwithstanding that paragraph (e)(3)(iii) of this section is an optional rule; and

(2) As of the first day of the year of disposition, the taxpayer must remove the relinquished asset from the general asset account and make the adjustments to the general asset account described in paragraphs (e)(3)(iii)(C)(2) through (4) of this section.

(vi) Technical termination of a partnership. In the case of a technical termination of a partnership under section 708(b)(1)(B), the terminated partnership must apply this paragraph (e)(3)(vi) instead of applying paragraph (e)(2), (e)(3)(ii), or (e)(3)(iii) of this section. Under this paragraph (e)(3)(vi), all of the terminated partnership’s general asset accounts terminate as of the date of its termination under section 708(b)(1)(B). The terminated partnership computes the allowable depreciation deduction for each of its general asset accounts for the taxable year in which the technical termination occurs by using the depreciation method, recovery period, and convention applicable to the general asset account. The new partnership is not bound by the terminated partnership’s election under paragraph (l) of this section.

(vii) Anti-abuse rule—(A) In general. If an asset in a general asset account is disposed of by a taxpayer in a transaction described in paragraph (e)(3)(vii)(B) of this section, general asset account treatment for the asset terminates as of the first day of the taxable year in which the disposition occurs. Consequently, the taxpayer must determine the amount of gain, loss, or other deduction attributable to the disposition in the manner described in paragraph (e)(3)(iii)(A) of this section, notwithstanding that paragraph (e)(3)(iii)(A) of this section is an optional rule, and must make the adjustments to the general asset account

described in paragraphs (e)(3)(iii)(C)(1) through (4) of this section.

(B) Abusive transactions. A transaction is described in this paragraph (e)(3)(vii)(B) if the transaction is not described in paragraph (e)(3)(iv), (e)(3)(v), or (e)(3)(vi) of this section, and if the transaction is entered into, or made, with a principal purpose of achieving a tax benefit or result that would not be available absent an election under this section. Examples of these types of transactions include—

(1) A transaction entered into with a principal purpose of shifting income or deductions among taxpayers in a manner that would not be possible absent an election under this section to take advantage of differing effective tax rates among the taxpayers; or

(2) An election made under this section with a principal purpose of disposing of an asset from a general asset account to utilize an expiring net operating loss or credit if the transaction is not a bona fide disposition. The fact that a taxpayer with a net operating loss carryover or a credit carryover transfers an asset to a related person or transfers an asset pursuant to an arrangement where the asset continues to be used or is available for use by the taxpayer pursuant to a lease or otherwise indicates, absent strong evidence to the contrary, that the transaction is described in this paragraph (e)(3)(vii)(B).

(f) Assets generating foreign source income—(1) In general. This paragraph (f) provides the rules for determining the source of any income, gain, or loss recognized, and the appropriate section 904(d) separate limitation category or categories for any foreign source income, gain, or loss recognized on a disposition (within the meaning of paragraph (e)(1) of this section) of an asset in a general asset account that consists of assets generating both United States and foreign source income. These rules apply only to a disposition to which paragraph (e)(2) (general disposition rules), paragraph (e)(3)(ii) (disposition of all assets remaining in a general asset account), paragraph (e)(3)(iii) (disposition of an asset in a qualifying disposition), paragraph (e)(3)(v) (transactions subject to section 1031 or section 1033), or paragraph (e)(3)(vii) (anti-abuse rule) of this

section applies. Solely for purposes of applying this paragraph (f), the term asset is:

(i) The asset as determined under paragraph (e)(2)(viii) of this section; or

(ii) The portion of such asset that is disposed of in a disposition described in paragraph (e)(1)(ii) of this section.

(2) Source of ordinary income, gain, or loss—(i) Source determined by allocation and apportionment of depreciation allowed. The amount of any ordinary income, gain, or loss that is recognized on the disposition of an asset in a general asset account must be apportioned between United States and foreign sources based on the allocation and apportionment of the—

(A) Depreciation allowed for the general asset account as of the end of the taxable year in which the disposition occurs if paragraph (e)(2) of this section applies to the disposition;

(B) Depreciation allowed for the general asset account as of the time of disposition if the taxpayer applies paragraph (e)(3)(ii) of this section to the disposition of all assets, the last asset, or the remaining portion of the last asset, in the general asset account, or if all the assets, the last asset, or the remaining portion of the last asset, in the general asset account are disposed of in a transaction described in paragraph (e)(3)(v)(A) of this section; or

(C) Depreciation allowed for the asset disposed of for only the taxable year in which the disposition occurs if the taxpayer applies paragraph (e)(3)(iii) of this section to the disposition of the asset in a qualifying disposition, if the asset is disposed of in a transaction described in paragraph (e)(3)(v)(B) of this section (like-kind exchange or involuntary conversion), or if the asset is disposed of in a transaction described in paragraph (e)(3)(vii) of this section (anti-abuse rule).

(ii) Formula for determining foreign source income, gain, or loss. The amount of ordinary income, gain, or loss recognized on the disposition that shall be treated as foreign source income, gain, or loss must be determined under the formula in this paragraph (f)(2)(ii). For purposes of this formula, the allowed depreciation deductions are determined for the applicable time period provided in paragraph (f)(2)(i) of this section. The formula is:

Foreign Source In-come, Gain, or Loss from The Disposition of an Asset.

= Total Ordinary Income, Gain, or Loss from the Disposition of an Asset.

X Allowed Depreciation Deductions Allocated and Apportioned to Foreign Source In-come/Total Allowed Depreciation Deduc-tions for the General Asset Account or for the Asset Disposed of (as applicable).


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(3) Section 904(d) separate categories. If the assets in the general asset account generate foreign source income in more than one separate category under section 904(d)(1) or another section of the Code (for example, income treated as foreign source income under section 904(g)(10)), or under a United States

income tax treaty that requires the foreign tax credit limitation to be determined separately for specified types of income, the amount of foreign source income, gain, or loss from the disposition of an asset, as determined under the formula in paragraph (f)(2)(ii) of this section, must be allocated and

apportioned to the applicable separate category or categories under the formula in this paragraph (f)(3). For purposes of this formula, the allowed depreciation deductions are determined for the applicable time period provided in paragraph (f)(2)(i) of this section. The formula is:

Foreign Source In-come, Gain, or Loss in a Separate Cat-egory.

= Foreign Source Income, Gain, or Loss from The Disposition of an Asset.

X Allowed Depreciation Deductions Allocated and Apportioned to a Separate Category Total/Allowed Depreciation Deductions and Apportioned to Foreign Source In-come.

(g) Assets subject to recapture. If the basis of an asset in a general asset account is increased as a result of the recapture of any allowable credit or deduction (for example, the basis adjustment for the recapture amount under section 30(e)(5), 50(c)(2), 168(l)(6), 168(n)(4), 179(d)(10), 179A(e)(4), or 1400N(d)(5)), general asset account treatment for the asset terminates as of the first day of the taxable year in which the recapture event occurs. Consequently, the taxpayer must remove the asset from the general asset account as of that day and must make the adjustments to the general asset account described in paragraphs (e)(3)(iii)(C)(2) through (4) of this section.

(h) Changes in use—(1) Conversion to any personal use. An asset in a general asset account becomes ineligible for general asset account treatment if a taxpayer uses the asset in any personal activity during a taxable year. Upon a conversion to any personal use, the taxpayer must remove the asset from the general asset account as of the first day of the taxable year in which the change in use occurs (the year of change) and must make the adjustments to the general asset account described in paragraphs (e)(3)(iii)(C)(2) through (4) of this section.

(2) Change in use results in a different recovery period and/or depreciation method—(i) No effect on general asset account election. A change in the use described in § 1.168(i)–4(d) (change in use results in a different recovery period or depreciation method) of an asset in a general asset account shall not cause or permit the revocation of the election made under this section.

(ii) Asset is removed from the general asset account. Upon a change in the use described in § 1.168(i)–4(d), the taxpayer must remove the asset from the general asset account as of the first day of the year of change (as defined in § 1.168(i)–4(a)) and must make the adjustments to the general asset account described in paragraphs (e)(3)(iii)(C)(2) through (4) of this section. If, however,

the result of the change in use is described in § 1.168(i)–4(d)(3) (change in use results in a shorter recovery period or a more accelerated depreciation method) and the taxpayer elects to treat the asset as though the change in use had not occurred pursuant to § 1.168(i)–4(d)(3)(ii), no adjustment is made to the general asset account upon the change in use.

(iii) New general asset account is established—(A) Change in use results in a shorter recovery period or a more accelerated depreciation method. If the result of the change in use is described in § 1.168(i)–4(d)(3) (change in use results in a shorter recovery period or a more accelerated depreciation method) and adjustments to the general asset account are made pursuant to paragraph (h)(2)(ii) of this section, the taxpayer must establish a new general asset account for the asset in the year of change in accordance with the rules in paragraph (c) of this section, except that the adjusted depreciable basis of the asset as of the first day of the year of change is included in the general asset account. For purposes of paragraph (c)(2) of this section, the applicable depreciation method, recovery period, and convention are determined under § 1.168(i)–4(d)(3)(i).

(B) Change in use results in a longer recovery period or a slower depreciation method. If the result of the change in use is described in § 1.168(i)–4(d)(4) (change in use results in a longer recovery period or a slower depreciation method), the taxpayer must establish a separate general asset account for the asset in the year of change in accordance with the rules in paragraph (c) of this section, except that the unadjusted depreciable basis of the asset, and the greater of the depreciation of the asset allowed or allowable in accordance with section 1016(a)(2), as of the first day of the year of change are included in the newly established general asset account. Consequently, this general asset account as of the first day of the year of change will have a

beginning balance for both the unadjusted depreciable basis and the depreciation reserve of the general asset account. For purposes of paragraph (c)(2) of this section, the applicable depreciation method, recovery period, and convention are determined under § 1.168(i)–4(d)(4)(ii).

(i) Redetermination of basis. If, after the placed-in-service year, the unadjusted depreciable basis of an asset in a general asset account is redetermined due to a transaction other than that described in paragraph (g) of this section (for example, due to contingent purchase price or discharge of indebtedness), the taxpayer’s election under paragraph (l) of this section for the asset also applies to the increase or decrease in basis resulting from the redetermination. For the taxable year in which the increase or decrease in basis occurs, the taxpayer must establish a new general asset account for the amount of the increase or decrease in basis in accordance with the rules in paragraph (c) of this section. For purposes of paragraph (c)(2) of this section, the applicable recovery period for the increase or decrease in basis is the recovery period of the asset remaining as of the beginning of the taxable year in which the increase or decrease in basis occurs, the applicable depreciation method and applicable convention for the increase or decrease in basis are the same depreciation method and convention applicable to the asset that applies for the taxable year in which the increase or decrease in basis occurs, and the increase or decrease in basis is deemed to be placed in service in the same taxable year as the asset.

(j) Identification of disposed or converted asset—(1) In general. The rules of this paragraph (j) apply when an asset in a general asset account is disposed of or converted in a transaction described in paragraph (e)(3)(iii) (disposition of an asset in a qualifying disposition), paragraph (e)(3)(iv)(B) (transactions subject to


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section 168(i)(7)), paragraph (e)(3)(v)(B) (transactions subject to section 1031 or section 1033), paragraph (e)(3)(vii) (anti- abuse rule), paragraph (g) (assets subject to recapture), or paragraph (h)(1) (conversion to any personal use) of this section.

(2) Identifying which asset is disposed of or converted—(i) In general. For purposes of identifying which asset in a general asset account is disposed of or converted, a taxpayer must identify the disposed of or converted asset by using—

(A) The specific identification method of accounting. Under this method of accounting, the taxpayer can determine the particular taxable year in which the disposed of or converted asset was placed in service by the taxpayer;

(B) A first-in, first-out method of accounting if the taxpayer can readily determine from its records the total dispositions of assets with the same recovery period during the taxable year but the taxpayer cannot readily determine from its records the unadjusted depreciable basis of the disposed of or converted asset. Under this method of accounting, the taxpayer identifies the general asset account with the earliest placed-in-service year that has the same recovery period as the disposed of or converted asset and that has assets at the beginning of the taxable year of the disposition or conversion, and the taxpayer treats the disposed of or converted asset as being from that general asset account. To determine which general asset account has assets at the beginning of the taxable year of the disposition or conversion, the taxpayer reduces the number of assets originally included in the account by the number of assets disposed of or converted in any prior taxable year in a transaction to which this paragraph (j) applies;

(C) A modified first-in, first-out method of accounting if the taxpayer can readily determine from its records the total dispositions of assets with the same recovery period during the taxable year and the unadjusted depreciable basis of the disposed of or converted asset. Under this method of accounting, the taxpayer identifies the general asset account with the earliest placed-in- service year that has the same recovery period as the disposed of or converted asset and that has assets at the beginning of the taxable year of the disposition or conversion with the same unadjusted depreciable basis as the disposed of or converted asset, and the taxpayer treats the disposed of or converted asset as being from that general asset account. To determine which general asset account has assets

at the beginning of the taxable year of the disposition or conversion, the taxpayer reduces the number of assets originally included in the account by the number of assets disposed of or converted in any prior taxable year in a transaction to which this paragraph (j) applies;

(D) A mortality dispersion table if the asset is a mass asset accounted for in a separate general asset account in accordance with paragraph (c)(2)(ii)(H) of this section and if the taxpayer can readily determine from its records the total dispositions of assets with the same recovery period during the taxable year. The mortality dispersion table must be based upon an acceptable sampling of the taxpayer’s actual disposition and conversion experience for mass assets or other acceptable statistical or engineering techniques. To use a mortality dispersion table, the taxpayer must adopt recordkeeping practices consistent with the taxpayer’s prior practices and consonant with good accounting and engineering practices; or

(E) Any other method as the Secretary may designate by publication in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter) on or after September 19, 2013. See paragraph (j)(2)(iii) of this section regarding the last-in, first-out method of accounting.

(ii) Disposition of a portion of an asset. If a taxpayer disposes of a portion of an asset and paragraph (e)(1)(ii) of this section applies to that disposition, the taxpayer may identify the asset by using any applicable method provided in paragraph (j)(2)(i) of this section, after taking into account paragraph (j)(2)(iii) of this section.

(iii) Last-in, first-out method of accounting. For purposes of paragraph (j)(2) of this section, a last-in, first-out method of accounting may not be used. Examples of a last-in, first-out method of accounting include the taxpayer identifying the general asset account with the most recent placed-in-service year that has the same recovery period as the disposed of or converted asset and that has assets at the beginning of the taxable year of the disposition or conversion, and the taxpayer treating the disposed of or converted asset as being from that general asset account, or the taxpayer treating the disposed portion of an asset as being from the general asset account with the most recent placed-in-service year that has assets that are the same as the asset of which the disposed portion is a part.

(3) Basis of disposed of or converted asset. (i) Solely for purposes of this paragraph (j)(3), the term asset is the asset as determined under paragraph

(e)(2)(viii) of this section or the portion of such asset that is disposed of in a disposition described in paragraph (e)(1)(ii) of this section. After identifying which asset in a general asset account is disposed of or converted, the taxpayer must determine the unadjusted depreciable basis of, and the depreciation allowed or allowable for, the disposed of or converted asset. If it is impracticable from the taxpayer’s records to determine the unadjusted depreciable basis of the disposed of or converted asset, the taxpayer may use any reasonable method that is consistently applied to all assets in the same general asset account for purposes of determining the unadjusted depreciable basis of the disposed of or converted asset in that general asset account. Examples of a reasonable method include, but are not limited to, the following:

(A) If the replacement asset is a restoration (as defined in § 1.263(a)– 3(k)), and is not a betterment (as defined in § 1.263(a)–3(j)) or an adaptation to a new or different use (as defined in § 1.263(a)–3(l)), discounting the cost of the replacement asset to its placed-in- service year cost using the Producer Price Index for Finished Goods or its successor, the Producer Price Index for Final Demand, or any other index designated by guidance in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter) for purposes of this paragraph (j)(3);

(B) A pro rata allocation of the unadjusted depreciable basis of the general asset account based on the replacement cost of the disposed asset and the replacement cost of all of the assets in the general asset account; and

(C) A study allocating the cost of the asset to its individual components.

(ii) The depreciation allowed or allowable for the disposed of or converted asset is computed by using the depreciation method, recovery period, and convention applicable to the general asset account in which the disposed of or converted asset was included and by including the additional first year depreciation deduction claimed for the disposed of or converted asset.

(k) Effect of adjustments on prior dispositions. The adjustments to a general asset account under paragraph (e)(3)(iii), (e)(3)(iv), (e)(3)(v), (e)(3)(vii), (g), or (h) of this section have no effect on the recognition and character of prior dispositions subject to paragraph (e)(2) of this section.

(l) Election—(1) Irrevocable election. If a taxpayer makes an election under this paragraph (l), the taxpayer consents to, and agrees to apply, all of the


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provisions of this section to the assets included in a general asset account. Except as provided in paragraph (c)(1)(ii)(A), (e)(3), (g), or (h) of this section or except as otherwise expressly provided by other guidance published in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter), an election made under this section is irrevocable and will be binding on the taxpayer for computing taxable income for the taxable year for which the election is made and for all subsequent taxable years. An election under this paragraph (l) is made separately by each person owning an asset to which this section applies (for example, by each member of a consolidated group, at the partnership level and not by the partner separately, or at the S corporation level and not by the shareholder separately). * * * * *

(m) Effective/applicability dates—(1) In general. This section applies to taxable years beginning on or after January 1, 2014. Except as provided in paragraphs (m)(2), (m)(3), and (m)(4) of this section, § 1.168(i)–1 as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014.


(3) Early application of regulation project REG–110732–13. A taxpayer may rely on the provisions of this section in regulation project REG–110732–13 (2013–43 IRB 404) (see § 601.601(d)(2) of this chapter) for taxable years beginning on or after January 1, 2012. However, a taxpayer may not rely on the provisions of this section in regulation project REG–110732–13 for taxable years beginning on or after January 1, 2014.

(4) Optional application of TD 9564. A taxpayer may choose to apply § 1.168(i)–1T as contained in TD 9564 (76 FR 81060) December 27, 2011, to taxable years beginning on or after January 1, 2012. However, a taxpayer may not apply § 1.168(i)–1T as contained in TD 9564 (76 FR 81060) December 27, 2011, to taxable years beginning on or after January 1, 2014.

(5) Change in method of accounting. A change to comply with this section for depreciable assets placed in service in a taxable year ending on or after December 30, 2003, is a change in method of accounting to which the provisions of section 446(e) and the regulations under section 446(e) apply. A taxpayer also may treat a change to comply with this section for depreciable

assets placed in service in a taxable year ending before December 30, 2003, as a change in method of accounting to which the provisions of section 446(e) and the regulations under section 446(e) apply. This paragraph (m)(5) does not apply to a change to comply with paragraph (e)(3)(ii), (e)(3)(iii), or (l) of this section, except as otherwise expressly provided by other guidance published in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter).

§ 1.168(i)–1T [Removed]

■ Par. 6. Section 1.168(i)–1T is removed. ■ Par. 7. Section 1.168(i)–7 is amended by revising the last sentence in paragraph (a) and revising paragraphs (b), (c)(2)(ii)(H), and (e) to read as follows:

§ 1.168(i)–7 Accounting for MACRS property.

(a) * * * For rules applicable to general asset accounts, see § 1.168(i)–1.

(b) Required use of single asset accounts. A taxpayer must account for an asset in a single asset account if the taxpayer uses the asset both in a trade or business or for the production of income and in a personal activity, or if the taxpayer places in service and disposes of the asset during the same taxable year. Also, if general asset account treatment for an asset terminates under § 1.168(i)– 1(c)(1)(ii)(A), (e)(3)(iii), (e)(3)(v), (e)(3)(vii), (g), or (h)(1), as applicable, the taxpayer must account for the asset in a single asset account beginning in the taxable year in which the general asset account treatment for the asset terminates. If a taxpayer accounts for an asset in a multiple asset account or a pool and the taxpayer disposes of the asset, the taxpayer must account for the asset in a single asset account beginning in the taxable year in which the disposition occurs. See § 1.168(i)– 8(h)(2)(i). If a taxpayer disposes of a portion of an asset and § 1.168(i)–8(d)(1) applies to that disposition, the taxpayer must account for the disposed portion in a single asset account beginning in the taxable year in which the disposition occurs. See § 1.168(i)– 8(h)(3)(i).

(c) * * * (2) * * * (ii) * * * (H) Mass assets (as defined in

§ 1.168(i)–8(b)(3)) that are or will be subject to § 1.168(i)–8(g)(2)(iii) (disposed of or converted mass asset is identified by a mortality dispersion

table) must be grouped into a separate multiple asset account or pool. * * * * *

(e) Effective/applicability dates—(1) In general. This section applies to taxable years beginning on or after January 1, 2014.



(4) Optional application of TD 9564. A taxpayer may choose to apply § 1.168(i)–7T as contained in TD 9564 (76 FR 81060) December 27, 2011, to taxable years beginning on or after January 1, 2012. However, a taxpayer may not apply § 1.168(i)–7T as contained in TD 9564 (76 FR 81060) December 27, 2011, to taxable years beginning on or after January 1, 2014.

(5) Change in method of accounting. A change to comply with this section for depreciable assets placed in service in a taxable year ending on or after December 30, 2003, is a change in method of accounting to which the provisions of section 446(e) and the regulations under section 446(e) apply. A taxpayer also may treat a change to comply with this section for depreciable assets placed in service in a taxable year ending before December 30, 2003, as a change in method of accounting to which the provisions of section 446(e) and the regulations under section 446(e) apply. ■ Par. 8. Section 1.168(i)–8 is added to read as follows:

§ 1.168(i)–8 Dispositions of MACRS property.

(a) Scope. This section provides rules applicable to dispositions of MACRS property (as defined in § 1.168(b)– 1(a)(2)) or to depreciable property (as defined in § 1.168(b)–1(a)(1)) that would be MACRS property but for an election made by the taxpayer either to expense all or some of the property’s cost under section 179, section 179A, section 179B, section 179C, section 179D, or section 1400I(a)(1), or any similar provision, or to amortize all or some of the property’s cost under section 1400I(a)(2) or any similar provision. This section also


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applies to dispositions described in paragraph (d)(1) of this section of a portion of such property. Except as provided in § 1.168(i)–1(e)(3), this section does not apply to dispositions of assets included in a general asset account. For rules applicable to dispositions of assets included in a general asset account, see § 1.168(i)– 1(e).

(b) Definitions. For purposes of this section—

(1) Building has the same meaning as that term is defined in § 1.48–1(e)(1).

(2) Disposition occurs when ownership of the asset is transferred or when the asset is permanently withdrawn from use either in the taxpayer’s trade or business or in the production of income. A disposition includes the sale, exchange, retirement, physical abandonment, or destruction of an asset. A disposition also occurs when an asset is transferred to a supplies, scrap, or similar account, or when a portion of an asset is disposed of as described in paragraph (d)(1) of this section. If a structural component, or a portion thereof, of a building is disposed of in a disposition described in paragraph (d)(1) of this section, a disposition also includes the disposition of such structural component or such portion thereof.

(3) Mass assets is a mass or group of individual items of depreciable assets—

(i) That are not necessarily homogenous;

(ii) Each of which is minor in value relative to the total value of the mass or group;

(iii) Numerous in quantity; (iv) Usually accounted for only on a

total dollar or quantity basis; (v) With respect to which separate

identification is impracticable; and (vi) Placed in service in the same

taxable year. (4) Portion of an asset is any part of

an asset that is less than the entire asset as determined under paragraph (c)(4) of this section.

(5) Structural component has the same meaning as that term is defined in § 1.48–1(e)(2).

(6) Unadjusted depreciable basis of the multiple asset account or pool is the sum of the unadjusted depreciable bases (as defined in § 1.168(b)–1(a)(3)) of all assets included in the multiple asset account or pool.

(c) Special rules—(1) Manner of disposition. The manner of disposition (for example, normal retirement, abnormal retirement, ordinary retirement, or extraordinary retirement) is not taken into account in determining whether a disposition occurs or gain or loss is recognized.

(2) Disposition by transfer to a supplies account. If a taxpayer made an election under § 1.162–3(d) to treat the cost of any rotable spare part, temporary spare part, or standby emergency spare part (as defined in § 1.162–3(c)) as a capital expenditure subject to the allowance for depreciation, the taxpayer can dispose of the rotable, temporary, or standby emergency spare part by transferring it to a supplies account only if the taxpayer has obtained the consent of the Commissioner to revoke the § 1.162–3(d) election. If a taxpayer made an election under § 1.162–3T(d) to treat the cost of any material and supply (as defined in § 1.162–3T(c)(1)) as a capital expenditure subject to the allowance for depreciation, the taxpayer can dispose of the material and supply by transferring it to a supplies account only if the taxpayer has obtained the consent of the Commissioner to revoke the § 1.162–3T(d) election. See § 1.162– 3(d)(3) for the procedures for revoking a § 1.162–3(d) or a § 1.162–3T(d) election.

(3) Leasehold improvements. This section also applies to—

(i) A lessor of leased property that made an improvement to that property for the lessee of the property, has a depreciable basis in the improvement, and disposes of the improvement, or disposes of a portion of the improvement under paragraph (d)(1) of this section, before or upon the termination of the lease with the lessee. See section 168(i)(8)(B); and

(ii) A lessee of leased property that made an improvement to that property, has a depreciable basis in the improvement, and disposes of the improvement, or disposes of a portion of the improvement under paragraph (d)(1) of this section, before or upon the termination of the lease.

(4) Determination of asset disposed of—(i) General rules. For purposes of applying this section, the facts and circumstances of each disposition are considered in determining what is the appropriate asset disposed of. The asset for disposition purposes may not consist of items placed in service by the taxpayer on different dates, without taking into account the applicable convention. For purposes of determining what is the appropriate asset disposed of, the unit of property determination under § 1.263(a)–3(e) or in published guidance in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter) under section 263(a) does not apply.

(ii) Special rules. In addition to the general rules in paragraph (c)(4)(i) of this section, the following rules apply for purposes of applying this section:

(A) Each building, including its structural components, is the asset, except as provided in § 1.1250– 1(a)(2)(ii) or in paragraph (c)(4)(ii)(B) or (D) of this section.

(B) If a building has two or more condominium or cooperative units, each condominium or cooperative unit, including its structural components, is the asset, except as provided in § 1.1250–1(a)(2)(ii) or in paragraph (c)(4)(ii)(D) of this section.

(C) If a taxpayer properly includes an item in one of the asset classes 00.11 through 00.4 of Rev. Proc. 87–56 (1987– 2 CB 674) (see § 601.601(d)(2) of this chapter) or properly classifies an item in one of the categories under section 168(e)(3), except for a category that includes buildings or structural components (for example, retail motor fuels outlet, qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property), each item is the asset provided paragraph (c)(4)(ii)(D) of this section does not apply to the item. For example, each desk is the asset, each computer is the asset, and each qualified smart electric meter is the asset.

(D) If the taxpayer places in service an improvement or addition to an asset after the taxpayer placed the asset in service, the improvement or addition and, if applicable, its structural components are a separate asset.

(d) Disposition of a portion of an asset—(1) In general. For purposes of applying this section, a disposition includes a disposition of a portion of an asset as a result of a casualty event described in section 165, a disposition of a portion of an asset for which gain, determined without regard to section 1245 or section 1250, is not recognized in whole or in part under section 1031 or section 1033, a transfer of a portion of an asset in a transaction described in section 168(i)(7)(B), or a sale of a portion of an asset, even if the taxpayer does not make the election under paragraph (d)(2)(i) of this section for that disposed portion. For other transactions, a disposition includes a disposition of a portion of an asset only if the taxpayer makes the election under paragraph (d)(2)(i) of this section for that disposed portion.

(2) Partial disposition election—(i) In general. A taxpayer may make an election under this paragraph (d)(2) to apply this section to a disposition of a portion of an asset. If the asset is properly included in one of the asset classes 00.11 through 00.4 of Rev. Proc. 87–56, a taxpayer may make an election under this paragraph (d)(2) to apply this section to a disposition of a portion of


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such asset only if the taxpayer classifies the replacement portion of the asset under the same asset class as the disposed portion of the asset.

(ii) Time and manner for making election—(A) Time for making election. Except as provided in paragraph (d)(2)(iii) or (iv) of this section, a taxpayer must make the election specified in paragraph (d)(2)(i) of this section by the due date, including extensions, of the original Federal tax return for the taxable year in which the portion of an asset is disposed of by the taxpayer.

(B) Manner of making election. Except as provided in paragraph (d)(2)(iii) or (iv) of this section, a taxpayer must make the election specified in paragraph (d)(2)(i) of this section by applying the provisions of this section for the taxable year in which the portion of an asset is disposed of by the taxpayer, by reporting the gain, loss, or other deduction on the taxpayer’s timely filed, including extensions, original Federal tax return for that taxable year, and, if the asset is properly included in one of the asset classes 00.11 through 00.4 of Rev. Proc. 87–56, by classifying the replacement portion of such asset under the same asset class as the disposed portion of the asset in the taxable year in which the replacement portion is placed in service by the taxpayer. Except as provided in paragraph (d)(2)(iii) or (iv)(B) of this section or except as otherwise expressly provided by other guidance published in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter), the election specified in paragraph (d)(2)(i) of this section may not be made through the filing of an application for change in accounting method.

(iii) Special rule for subsequent Internal Revenue Service adjustment. This paragraph (d)(2)(iii) applies when a taxpayer deducted the amount paid or incurred for the replacement of a portion of an asset as a repair under § 1.162–4, the taxpayer did not make the election specified in paragraph (d)(2)(i) of this section for the disposed portion of that asset within the time and in the manner under paragraph (d)(2)(ii) or (iv) of this section, and as a result of an examination of the taxpayer’s Federal tax return, the Internal Revenue Service disallows the taxpayer’s repair deduction for the amount paid or incurred for the replacement of the portion of that asset and instead capitalizes such amount under § 1.263(a)–2 or § 1.263(a)–3. If this paragraph (d)(2)(iii) applies, the taxpayer may make the election specified in paragraph (d)(2)(i) of this section for the disposition of the portion

of the asset to which the Internal Revenue Service’s adjustment pertains by filing an application for change in accounting method, provided the asset of which the disposed portion was a part is owned by the taxpayer at the beginning of the year of change (as defined for purposes of section 446(e)).

(iv) Special rules for 2012 or 2013 returns. If, under paragraph (j)(2) of this section, a taxpayer chooses to apply the provisions of this section to a taxable year beginning on or after January 1, 2012, and ending on or before September 19, 2013 (applicable taxable year), and the taxpayer did not make the election specified in paragraph (d)(2)(i) of this section on its timely filed original Federal tax return for the applicable taxable year, including extensions, the taxpayer must make the election specified in paragraph (d)(2)(i) of this section for the applicable taxable year by filing either—

(A) An amended Federal tax return for the applicable taxable year on or before 180 days from the due date including extensions of the taxpayer’s Federal tax return for the applicable taxable year, notwithstanding that the taxpayer may not have extended the due date; or

(B) An application for change in accounting method with the taxpayer’s timely filed original Federal tax return for the first or second taxable year succeeding the applicable taxable year.

(v) Revocation. A taxpayer may revoke the election specified in paragraph (d)(2)(i) of this section only by filing a request for a private letter ruling and obtaining the Commissioner’s consent to revoke the election. The Commissioner may grant a request to revoke this election if the taxpayer acted reasonably and in good faith, and the revocation will not prejudice the interests of the Government. See generally § 301.9100– 3 of this chapter. The election specified in paragraph (d)(2)(i) of this section may not be revoked through the filing of an application for change in accounting method.

(e) Gain or loss on dispositions. Solely for purposes of this paragraph (e), the term asset is an asset within the scope of this section or the portion of such asset that is disposed of in a disposition described in paragraph (d)(1) of this section. Except as provided by section 280B and § 1.280B–1, the following rules apply when an asset is disposed of during a taxable year:

(1) If an asset is disposed of by sale, exchange, or involuntary conversion, gain or loss must be recognized under the applicable provisions of the Internal Revenue Code.

(2) If an asset is disposed of by physical abandonment, loss must be recognized in the amount of the adjusted depreciable basis (as defined in § 1.168(b)–1(a)(4)) of the asset at the time of the abandonment, taking into account the applicable convention. However, if the abandoned asset is subject to nonrecourse indebtedness, paragraph (e)(1) of this section applies to the asset instead of this paragraph (e)(2). For a loss from physical abandonment to qualify for recognition under this paragraph (e)(2), the taxpayer must intend to discard the asset irrevocably so that the taxpayer will neither use the asset again nor retrieve it for sale, exchange, or other disposition.

(3) If an asset is disposed of other than by sale, exchange, involuntary conversion, physical abandonment, or conversion to personal use (as, for example, when the asset is transferred to a supplies or scrap account), gain is not recognized. Loss must be recognized in the amount of the excess of the adjusted depreciable basis of the asset at the time of the disposition, taking into account the applicable convention, over the asset’s fair market value at the time of the disposition, taking into account the applicable convention.

(f) Basis of asset disposed of—(1) In general. The adjusted basis of an asset disposed of for computing gain or loss is its adjusted depreciable basis at the time of the asset’s disposition, as determined under the applicable convention for the asset.

(2) Assets disposed of are in multiple asset accounts. (i) If the taxpayer accounts for the asset disposed of in a multiple asset account or pool and it is impracticable from the taxpayer’s records to determine the unadjusted depreciable basis (as defined in § 1.168(b)–1(a)(3)) of the asset disposed of, the taxpayer may use any reasonable method that is consistently applied to all assets in the same multiple asset account or pool for purposes of determining the unadjusted depreciable basis of assets disposed of. Examples of a reasonable method include, but are not limited to, the following:

(A) If the replacement asset is a restoration (as defined in § 1.263(a)– 3(k)), and is not a betterment (as defined in § 1.263(a)–3(j)) or an adaptation to a new or different use (as defined in § 1.263(a)–3(l)), discounting the cost of the replacement asset to its placed-in- service year cost using the Producer Price Index for Finished Goods or its successor, the Producer Price Index for Final Demand, or any other index designated by guidance in the Internal Revenue Bulletin (see § 601.601(d)(2) of


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this chapter) for purposes of this paragraph (f)(2);

(B) A pro rata allocation of the unadjusted depreciable basis of the multiple asset account or pool based on the replacement cost of the disposed asset and the replacement cost of all of the assets in the multiple asset account or pool; and


(ii) To determine the adjusted depreciable basis of an asset disposed of in a multiple asset account or pool, the depreciation allowed or allowable for the asset disposed of is computed by using the depreciation method, recovery period, and convention applicable to the multiple asset account or pool in which the asset disposed of was included and by including the additional first year depreciation deduction claimed for the asset disposed of.

(3) Disposition of a portion of an asset. (i) This paragraph (f)(3) applies only when a taxpayer disposes of a portion of an asset and paragraph (d)(1) of this section applies to that disposition. For computing gain or loss, the adjusted basis of the disposed portion of the asset is the adjusted depreciable basis of that disposed portion at the time of its disposition, as determined under the applicable convention for the asset. If it is impracticable from the taxpayer’s records to determine the unadjusted depreciable basis (as defined in § 1.168(b)–1(a)(3)) of the disposed portion of the asset, the taxpayer may use any reasonable method for purposes of determining the unadjusted depreciable basis (as defined in § 1.168(b)–1(a)(3)) of the disposed portion of the asset. If a taxpayer disposes of more than one portion of the same asset and it is impracticable from the taxpayer’s records to determine the unadjusted depreciable basis (as defined in § 1.168(b)–1(a)(3)) of the first disposed portion of the asset, the reasonable method used by the taxpayer must be consistently applied to all portions of the same asset for purposes of determining the unadjusted depreciable basis of each disposed portion of the asset. If the asset, a portion of which is disposed of, is in a multiple asset account or pool and it is impracticable from the taxpayer’s records to determine the unadjusted depreciable basis (as defined in § 1.168(b)–1(a)(3)) of the disposed portion of the asset, the reasonable method used by the taxpayer must be consistently applied to all assets in the same multiple asset account or pool for purposes of determining the unadjusted depreciable basis of assets disposed of

or any disposed portion of the assets. Examples of a reasonable method include, but are not limited to, the following:

(A) If the replacement portion is a restoration (as defined in § 1.263(a)– 3(k)), and is not a betterment (as defined in § 1.263(a)–3(j)) or an adaptation to a new or different use (as defined in § 1.263(a)–3(l)), discounting the cost of the replacement portion of the asset to its placed-in-service year cost using the Producer Price Index for Finished Goods or its successor, the Producer Price Index for Final Demand, or any other index designated by guidance in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter) for purposes of this paragraph (f)(3);

(B) A pro rata allocation of the unadjusted depreciable basis of the asset based on the replacement cost of the disposed portion of the asset and the replacement cost of the asset; and


(ii) To determine the adjusted depreciable basis of the disposed portion of the asset, the depreciation allowed or allowable for the disposed portion is computed by using the depreciation method, recovery period, and convention applicable to the asset in which the disposed portion was included and by including the portion of the additional first year depreciation deduction claimed for the asset that is attributable to the disposed portion.

(g) Identification of asset disposed of—(1) In general. Except as provided in paragraph (g)(2) or (3) of this section, a taxpayer must use the specific identification method of accounting to identify which asset is disposed of by the taxpayer. Under this method of accounting, the taxpayer can determine the particular taxable year in which the asset disposed of was placed in service by the taxpayer.

(2) Asset disposed of is in a multiple asset account. If a taxpayer accounts for the asset disposed of in a multiple asset account or pool and the total dispositions of assets with the same recovery period during the taxable year are readily determined from the taxpayer’s records, but it is impracticable from the taxpayer’s records to determine the particular taxable year in which the asset disposed of was placed in service by the taxpayer, the taxpayer must identify the asset disposed of by using—

(i) A first-in, first-out method of accounting if the unadjusted depreciable basis of the asset disposed of cannot be readily determined from the taxpayer’s records. Under this method of accounting, the taxpayer

identifies the multiple asset account or pool with the earliest placed-in-service year that has the same recovery period as the asset disposed of and that has assets at the beginning of the taxable year of the disposition, and the taxpayer treats the asset disposed of as being from that multiple asset account or pool;

(ii) A modified first-in, first-out method of accounting if the unadjusted depreciable basis of the asset disposed of can be readily determined from the taxpayer’s records. Under this method of accounting, the taxpayer identifies the multiple asset account or pool with the earliest placed-in-service year that has the same recovery period as the asset disposed of and that has assets at the beginning of the taxable year of the disposition with the same unadjusted depreciable basis as the asset disposed of, and the taxpayer treats the asset disposed of as being from that multiple asset account or pool;

(iii) A mortality dispersion table if the asset disposed of is a mass asset. The mortality dispersion table must be based upon an acceptable sampling of the taxpayer’s actual disposition experience for mass assets or other acceptable statistical or engineering techniques. To use a mortality dispersion table, the taxpayer must adopt recordkeeping practices consistent with the taxpayer’s prior practices and consonant with good accounting and engineering practices; or

(iv) Any other method as the Secretary may designate by publication in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter) on or after September 19, 2013. See paragraph (g)(4) of this section regarding the last-in, first-out method of accounting.

(3) Disposition of a portion of an asset. If a taxpayer disposes of a portion of an asset and paragraph (d)(1) of this section applies to that disposition, but it is impracticable from the taxpayer’s records to determine the particular taxable year in which the asset was placed in service, the taxpayer must identify the asset by using any applicable method provided in paragraph (g)(2) of this section, after taking into account paragraph (g)(4) of this section.

(4) Last-in, first-out method of accounting. For purposes of this paragraph (g), a last-in, first-out method of accounting may not be used. Examples of a last-in, first-out method of accounting include the taxpayer identifying the multiple asset account or pool with the most recent placed-in- service year that has the same recovery period as the asset disposed of and that has assets at the beginning of the taxable year of the disposition, and the taxpayer


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treating the asset disposed of as being from that multiple asset account or pool, or the taxpayer treating the disposed portion of an asset as being from an asset with the most recent placed-in- service year that is the same as the asset of which the disposed portion is a part.

(h) Accounting for asset disposed of— (1) Depreciation ends. Depreciation ends for an asset at the time of the asset’s disposition, as determined under the applicable convention for the asset. See § 1.167(a)–10(b). If the asset disposed of is in a single asset account initially or as a result of § 1.168(i)– 8(h)(2)(i), § 1.168(i)–8(h)(3)(i), or general asset account treatment for the asset terminated under § 1.168(i)– 1(c)(1)(ii)(A), (e)(3)(iii), (e)(3)(v), (e)(3)(vii), (g), or (h)(1), as applicable, the single asset account terminates at the time of the asset’s disposition, as determined under the applicable convention for the asset. If a taxpayer disposes of a portion of an asset and paragraph (d)(1) of this section applies to that disposition, depreciation ends for that disposed portion of the asset at the time of the disposition of the disposed portion, as determined under the applicable convention for the asset.

(2) Asset disposed of in a multiple asset account or pool. If the taxpayer accounts for the asset disposed of in a multiple asset account or pool, then—

(i) As of the first day of the taxable year in which the disposition occurs, the asset disposed of is removed from the multiple asset account or pool and is placed into a single asset account. See § 1.168(i)–7(b);

(ii) The unadjusted depreciable basis of the multiple asset account or pool must be reduced by the unadjusted depreciable basis of the asset disposed of as of the first day of the taxable year in which the disposition occurs. See paragraph (f)(2)(i) of this section for determining the unadjusted depreciable basis of the asset disposed of;

(iii) The depreciation reserve of the multiple asset account or pool must be reduced by the depreciation allowed or allowable for the asset disposed of as of the end of the taxable year immediately preceding the year of disposition, computed by using the depreciation method, recovery period, and convention applicable to the multiple asset account or pool in which the asset disposed of was included and by including the additional first year depreciation deduction claimed for the asset disposed of; and

(iv) In determining the adjusted depreciable basis of the asset disposed of at the time of disposition, taking into account the applicable convention, the depreciation allowed or allowable for

the asset disposed of is computed by using the depreciation method, recovery period, and convention applicable to the multiple asset account or pool in which the asset disposed of was included and by including the additional first year depreciation deduction claimed for the asset disposed of.

(3) Disposition of a portion of an asset. This paragraph (h)(3) applies only when a taxpayer disposes of a portion of an asset and paragraph (d)(1) of this section applies to that disposition. In this case—

(i) As of the first day of the taxable year in which the disposition occurs, the disposed portion is placed into a single asset account. See § 1.168(i)–7(b);

(ii) The unadjusted depreciable basis of the asset must be reduced by the unadjusted depreciable basis of the disposed portion as of the first day of the taxable year in which the disposition occurs. See paragraph (f)(3)(i) of this section for determining the unadjusted depreciable basis of the disposed portion;

(iii) The depreciation reserve of the asset must be reduced by the depreciation allowed or allowable for the disposed portion as of the end of the taxable year immediately preceding the year of disposition, computed by using the depreciation method, recovery period, and convention applicable to the asset in which the disposed portion was included and by including the portion of the additional first year depreciation deduction claimed for the asset that is attributable to the disposed portion; and

(iv) In determining the adjusted depreciable basis of the disposed portion at the time of disposition, taking into account the applicable convention, the depreciation allowed or allowable for the disposed portion is computed by using the depreciation method, recovery period, and convention applicable to the asset in which the disposed portion was included and by including the portion of the additional first year depreciation deduction claimed for the asset that is attributable to the disposed portion.

(i) Examples. The application of this section is illustrated by the following examples:

Example 1. A owns an office building with four elevators. A replaces one of the elevators. The elevator is a structural component of the office building. In accordance with paragraph (c)(4)(ii)(A) of this section, the office building, including its structural components, is the asset for disposition purposes. A does not make the partial disposition election provided under paragraph (d)(2) of this section for the elevator. Thus, the retirement of the replaced elevator is not a disposition. As a result, depreciation continues for the cost of the building, including the cost of the retired

elevator and the building’s other structural components, and A does not recognize a loss for this retired elevator. If A must capitalize the amount paid for the replacement elevator pursuant to § 1.263(a)–3, the replacement elevator is a separate asset for disposition purposes pursuant to paragraph (c)(4)(ii)(D) of this section and for depreciation purposes pursuant to section 168(i)(6).

Example 2. The facts are the same as in Example 1, except A accounts for each structural component of the office building as a separate asset in its fixed asset system. Although A treats each structural component as a separate asset in its records, the office building, including its structural components, is the asset for disposition purposes in accordance with paragraph (c)(4)(ii)(A) of this section. Accordingly, the result is the same as in Example 1.

Example 3. The facts are the same as in Example 1, except A makes the partial disposition election provided under paragraph (d)(2) of this section for the elevator. Although the office building, including its structural components, is the asset for disposition purposes, the result of A making the partial disposition election for the elevator is that the retirement of the replaced elevator is a disposition. Thus, depreciation for the retired elevator ceases at the time of its retirement, taking into account the applicable convention, and A recognizes a loss upon this retirement. Further, A must capitalize the amount paid for the replacement elevator pursuant to § 1.263(a)– 3(k)(1)(i), and the replacement elevator is a separate asset for disposition purposes pursuant to paragraph (c)(4)(ii)(D) of this section and for depreciation purposes pursuant to section 168(i)(6).

Example 4. B, a calendar-year commercial airline company, owns several aircraft that are used in the commercial carrying of passengers and described in asset class 45.0 of Rev. Proc. 87–56. B replaces the existing engines on one of the aircraft with new engines. Assume each aircraft is a unit of property as determined under § 1.263(a)– 3(e)(3) and each engine of an aircraft is a major component or substantial structural part of the aircraft as determined under § 1.263(a)–3(k)(6). Assume also that B treats each aircraft as the asset for disposition purposes in accordance with paragraph (c)(4) of this section. B makes the partial disposition election provided under paragraph (d)(2) of this section for the engines in the aircraft. Although the aircraft is the asset for disposition purposes, the result of B making the partial disposition election for the engines is that the retirement of the replaced engines is a disposition. Thus, depreciation for the retired engines ceases at the time of their retirement, taking into account the applicable convention, and B recognizes a loss upon this retirement. Further, B must capitalize the amount paid for the replacement engines pursuant to § 1.263(a)–3(k)(1)(i), and the replacement engines are a separate asset for disposition purposes pursuant to paragraph (c)(4)(ii)(D) of this section and for depreciation purposes pursuant to section 168(i)(6).

Example 5. The facts are the same as in Example 4, except B does not make the


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partial disposition election provided under paragraph (d)(2) of this section for the engines. Thus, the retirement of the replaced engines on one of the aircraft is not a disposition. As a result, depreciation continues for the cost of the aircraft, including the cost of the retired engines, and B does not recognize a loss for these retired engines. If B must capitalize the amount paid for the replacement engines pursuant to § 1.263(a)–3, the replacement engines are a separate asset for disposition purposes pursuant to paragraph (c)(4)(ii)(D) of this section and for depreciation purposes pursuant to section 168(i)(6).

Example 6. C, a corporation, owns several trucks that are used in its trade or business and described in asset class 00.241 of Rev. Proc. 87–56. C replaces the engine on one of the trucks with a new engine. Assume each truck is a unit of property as determined under § 1.263(a)–3(e)(3) and each engine is a major component or substantial structural part of the truck as determined under § 1.263(a)–3(k)(6). Because the trucks are described in asset class 00.241 of Rev. Proc. 87–56, C must treat each truck as the asset for disposition purposes. C does not make the partial disposition election provided under paragraph (d)(2) of this section for the engine. Thus, the retirement of the replaced engine on the truck is not a disposition. As a result, depreciation continues for the cost of the truck, including the cost of the retired engine, and C does not recognize a loss for this retired engine. If C must capitalize the amount paid for the replacement engine pursuant to § 1.263(a)–3, the replacement engine is a separate asset for disposition purposes pursuant to paragraph (c)(4)(ii)(D) of this section and for depreciation purposes pursuant to section 168(i)(6).

Example 7. D owns a retail building. D replaces 60% of the roof of this building. In accordance with paragraph (c)(4)(ii)(A) of this section, the retail building, including its structural components, is the asset for disposition purposes. Assume D must capitalize the costs incurred for replacing 60% of the roof pursuant to § 1.263(a)– 3(k)(1)(vi). D makes the partial disposition election provided under paragraph (d)(2) of this section for the 60% of the replaced roof. Thus, the retirement of 60% of the roof is a disposition. As a result, depreciation for 60% of the roof ceases at the time of its retirement, taking into account the applicable convention, and D recognizes a loss upon this retirement. Further, D must capitalize the amount paid for the 60% of the roof pursuant to § 1.263(a)–3(k)(1)(i) and (vi) and the replacement 60% of the roof is a separate asset for disposition purposes pursuant to paragraph (c)(4)(ii)(D) of this section and for depreciation purposes pursuant to section 168(i)(6).

Example 8. (i) The facts are the same as in Example 7. Ten years after replacing 60% of the roof, D replaces 55% of the roof of the building. In accordance with paragraph (c)(4)(ii)(A) and (D) of this section, for disposition purposes, the retail building, including its structural components, except the replacement 60% of the roof, is an asset and the replacement 60% of the roof is a separate asset. Assume D must capitalize the

costs incurred for replacing 55% of the roof pursuant to § 1.263(a)–3(k)(1)(vi). D makes the partial disposition election provided under paragraph (d)(2) of this section for the 55% of the replaced roof. Thus, the retirement of 55% of the roof is a disposition.

(ii) However, D cannot determine from its records whether the replaced 55% is part of the 60% of the roof replaced ten years ago or whether the replaced 55% includes part or all of the remaining 40% of the original roof. Pursuant to paragraph (g)(3) of this section, D identifies which asset it disposed of by using the first-in, first-out method of accounting. As a result, D disposed of the remaining 40% of the original roof and 25% of the 60% of the roof replaced ten years ago.

(iii) Thus, depreciation for the remaining 40% of the original roof ceases at the time of its retirement, taking into account the applicable convention, and D recognizes a loss upon this retirement. Further, depreciation for 25% of the 60% of the roof replaced ten years ago ceases at the time of its retirement, taking into account the applicable convention, and D recognizes a loss upon this retirement. Also, D must capitalize the amount paid for the 55% of the roof pursuant to § 1.263(a)–3(k)(1)(i) and (vi), and the replacement 55% of the roof is a separate asset for disposition purposes pursuant to paragraph (c)(4)(ii)(D) of this section and for depreciation purposes pursuant to section 168(i)(6).

Example 9. (i) On July 1, 2011, E, a calendar-year taxpayer, purchased and placed in service an existing multi-story office building that costs $20,000,000. The cost of each structural component of the building was not separately stated. E accounts for the building and its structural components in its tax and financial accounting records as a single asset with a cost of $20,000,000. E depreciates the building as nonresidential real property and uses the optional depreciation table that corresponds with the general depreciation system, the straight-line method, a 39-year recovery period, and the mid-month convention. As of January 1, 2014, the depreciation reserve for the building is $1,261,000.

(ii) On June 30, 2014, E replaces one of the two elevators in the office building. E did not dispose of any other structural components of this building in 2014 and prior years. E makes the partial disposition election provided under paragraph (d)(2) of this section for this elevator. Although the office building, including its structural components, is the asset for disposition purposes, the result of E making the partial disposition election for the elevator is that the retirement of the replaced elevator is a disposition. Assume the replacement elevator is a restoration under § 1.263(a)–3(k), and not a betterment under § 1.263(a)–3(j) or an adaptation to a new or different use under § 1.263(a)–3(l). Because E cannot identify the cost of the elevator from its records and the replacement elevator is a restoration under § 1.263(a)–3(k), E determines the cost of the disposed elevator by discounting the cost of the replacement elevator to its placed-in- service year cost using the Producer Price Index for Final Demand. Using this

reasonable method, E determines the cost of the retired elevator by discounting the cost of the replacement elevator to its cost in 2011 (the placed-in-service year) using the Producer Price Index for Final Demand, resulting in $150,000 of the $20,000,000 purchase price for the building to be the cost of the retired elevator. Using the optional depreciation table that corresponds with the general depreciation system, the straight-line method, a 39-year recovery period, and the mid-month convention, the depreciation allowed or allowable for the retired elevator as of December 31, 2013, is $9,458.

(iii) For E’s 2014 Federal tax return, the loss for the retired elevator is determined as follows. The depreciation allowed or allowable for 2014 for the retired elevator is $1,763 ((unadjusted depreciable basis of $150,000 × depreciation rate of 2.564% for 2014) × 5.5/12 months). Thus, the adjusted depreciable basis of the retired elevator is $138,779 (the adjusted depreciable basis of $140,542 removed from the building cost less the depreciation allowed or allowable of $1,763 for 2014). As a result, E recognizes a loss of $138,779 for the retired elevator in 2014.

(iv) For E’s 2014 Federal tax return, the depreciation allowance for the building is computed as follows. As of January 1, 2014, the unadjusted depreciable basis of the building is reduced from $20,000,000 to $19,850,000 ($20,000,000 less the unadjusted depreciable basis of $150,000 for the retired elevator), and the depreciation reserve of the building is reduced from $1,261,000 to $1,251,542 ($1,261,000 less the depreciation allowed or allowable of $9,458 for the retired elevator as of December 31, 2013). Consequently, the depreciation allowance for the building for 2014 is $508,954 ($19,850,000 × depreciation rate of 2.564% for 2014).

(v) E also must capitalize the amount paid for the replacement elevator pursuant to § 1.263(a)–3(k)(1). The replacement elevator is a separate asset for disposition purposes pursuant to paragraph (c)(4)(ii)(D) of this section and for depreciation purposes pursuant to section 168(i)(6).

Example 10. (i) Since 2005, F, a calendar year taxpayer, has accounted for items of MACRS property that are mass assets in pools. Each pool includes only the mass assets that have the same depreciation method, recovery period, and convention, and are placed in service by F in the same taxable year. None of the pools are general asset accounts under section 168(i)(4) and the regulations under section 168(i)(4). F identifies any dispositions of these mass assets by specific identification.

(ii) During 2014, F sells 10 items of mass assets with a 5-year recovery period each for $100. Under the specific identification method, F identifies these mass assets as being from the pool established by F in 2012 for mass assets with a 5-year recovery period. Assume F depreciates this pool using the optional depreciation table that corresponds with the general depreciation system, the 200-percent declining balance method, a 5- year recovery period, and the half-year convention. F elected not to deduct the additional first year depreciation provided by


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section 168(k) for 5-year property placed in service during 2012. As of January 1, 2014, this pool contains 100 similar items of mass assets with a total cost of $25,000 and a total depreciation reserve of $13,000. Because all the items of mass assets in the pool are similar, F allocates the cost and depreciation allowed or allowable for the pool ratably among each item in the pool. This allocation is a reasonable method because all the items of mass assets in the pool are similar. Using this reasonable method, F allocates a cost of $250 ($25,000 × (1/100)) to each disposed of mass asset and depreciation allowed or allowable of $130 ($13,000 × (1/100)) to each disposed of mass asset. The depreciation allowed or allowable in 2014 for each disposed of mass asset is $24 (($250 × 19.2%)/2). As a result, the adjusted depreciable basis of each disposed of mass asset under section 1011 is $96 ($250 ¥ $130 ¥ $24). Thus, F recognizes a gain of $4 for each disposed of mass asset in 2014, which is subject to section 1245.

(iii) Further, as of January 1, 2014, the unadjusted depreciable basis of the 2012 pool of mass assets with a 5-year recovery period is reduced from $25,000 to $22,500 ($25,000 less the unadjusted depreciable basis of $2,500 for the 10 disposed of items), and the depreciation reserve of this 2012 pool is reduced from $13,000 to $11,700 ($13,000 less the depreciation allowed or allowable of $1,300 for the 10 disposed of items as of December 31, 2013). Consequently, as of January 1, 2014, the 2012 pool of mass assets with a 5-year recovery period has 90 items with a total cost of $22,500 and a depreciation reserve of $11,700. Thus, the depreciation allowance for this pool for 2014 is $4,320 ($22,500 × 19.2%).

Example 11. (i) The facts are the same as in Example 10. Because of changes in F’s recordkeeping in 2015, it is impracticable for F to continue to identify disposed of mass assets using specific identification and to determine the unadjusted depreciable basis of the disposed of mass assets. As a result, F files a Form 3115, Application for Change in Accounting Method, to change to a first- in, first-out method beginning with the taxable year beginning on January 1, 2015, on a modified cut-off basis. See § 1.446– 1(e)(2)(ii)(d)(2)(vii). Under the first-in, first- out method, the mass assets disposed of in a taxable year are deemed to be from the pool with the earliest placed-in-service year that has assets as of the beginning of the taxable year of the disposition with the same recovery period as the asset disposed of. The Commissioner of Internal Revenue consents to this change in method of accounting.

(ii) During 2015, F sells 20 items of mass assets with a 5-year recovery period each for $50. As of January 1, 2015, the 2008 pool is the pool with the earliest placed-in-service year for mass assets with a 5-year recovery period, and this pool contains 25 items of mass assets with a total cost of $10,000 and a total depreciation reserve of $10,000. Thus, F allocates a cost of $400 ($10,000 × (1/25)) to each disposed of mass asset and depreciation allowed or allowable of $400 to each disposed of mass asset. As a result, the adjusted depreciable basis of each disposed of mass asset is $0. Thus, F recognizes a gain

of $50 for each disposed of mass asset in 2015, which is subject to section 1245.

(iii) Further, as of January 1, 2015, the unadjusted depreciable basis of the 2008 pool of mass assets with a 5-year recovery period is reduced from $10,000 to $2,000 ($10,000 less the unadjusted depreciable basis of $8,000 for the 20 disposed of items ($400 × 20)), and the depreciation reserve of this 2008 pool is reduced from $10,000 to $2,000 ($10,000 less the depreciation allowed or allowable of $8,000 for the 20 disposed of items as of December 31, 2014). Consequently, as of January 1, 2015, the 2008 pool of mass assets with a 5-year recovery period has 5 items with a total cost of $2,000 and a depreciation reserve of $2,000.

(j) Effective/applicability dates—(1) In general. This section applies to taxable years beginning on or after January 1, 2014.



(4) Optional application of TD 9564. A taxpayer may choose to apply § 1.168(i)–8T as contained in 26 CFR part 1 edition revised as of April 1, 2014, to taxable years beginning on or after January 1, 2012. However, a taxpayer may not apply § 1.168(i)–8T as contained in 26 CFR part 1 edition revised as of April 1, 2014, to taxable years beginning on or after January 1, 2014.

(5) Change in method of accounting. A change to comply with this section for depreciable assets placed in service in a taxable year ending on or after December 30, 2003, is a change in method of accounting to which the provisions of section 446(e) and the regulations under section 446(e) apply. A taxpayer also may treat a change to comply with this section for depreciable assets placed in service in a taxable year ending before December 30, 2003, as a change in method of accounting to which the provisions of section 446(e) and the regulations under section 446(e) apply. This paragraph (j)(5) does not apply to a change to comply with paragraph (d)(2) of this section, except as provided in paragraph (d)(2)(iii) or (iv)(B) of this section or otherwise provided by other guidance published

in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter).

§ 1.168(i)–8T [Removed]

■ Par. 9. Section 1.168(i)–8T is removed.

§ 1.263(a)–3 [Amended]

■ Par. 10. Section 1.263(a)–3 is amended by: ■ a. In paragraphs (g)(2)(i), (g)(2)(ii) Example 2, and (g)(2)(ii) Example 4, removing the language ‘‘Prop. Reg. § 1.168(i)–8(d) (September 19, 2013)’’ and adding the language ‘‘§ 1.168(i)– 8(d)’’ in its place. ■ b. In paragraph (g)(2)(i), removing the language ‘‘§ 1.168(i)–1T(e)(3) nor Prop. Reg. § 1.168(i)–1(e)(3) (September 19, 2013)’’ and adding the language ‘‘§ 1.168(i)–1(e)(3)’’ in its place, and removing the language ‘‘Prop. Reg. § 1.168(i)–1(e)(2)(ix) (September 19, 2013)’’ and adding the language ‘‘§ 1.168(i)–1(e)(1)(ii)’’ in its place. ■ c. In paragraphs (g)(2)(ii) and (g)(2)(ii) Example 1, removing the language ‘‘Prop. Reg. § 1.168(i)–1(e) (September 19, 2013), or Prop. Reg. § 1.168(i)–8 (September 19, 2013)’’ and adding the language ‘‘§ 1.168(i)–1(e) or § 1.168(i)– 8’’ in its place. ■ d. In paragraph (k)(7) Example 30, removing the language ‘‘Prop. Reg. § 1.168(i)–8’’ and adding the language ‘‘§ 1.168(i)–8’’ in its place, and removing the language ‘‘Prop. Reg. § 1.168(i)– 8(c)(4)(ii)(A) (September 19, 2013)’’ and adding the language ‘‘§ 1.168(i)– 8(c)(4)(ii)(A)’’ in its place. ■ e. In paragraph (k)(7) Example 30 and Example 31, removing the language ‘‘Prop. Reg. § 1.168(i)–8(d)(2) (September 19, 2013),’’ and adding the language ‘‘§ 1.168(i)–8(d)(2)’’ in its place. ■ f. In paragraph (k)(7) Example 31, removing the language ‘‘Prop. Reg. § 1.68(i)–8(c)(4)(ii)(D) (September 19, 2013)’’ and adding the language ‘‘§ 1.168(i)–8(c)(4)(ii)(D)’’ in its place.

■ Par. 11. Section 1.1016–3 is amended by revising the fourth sentence in paragraph (a)(1)(ii) to read as follows:

§ 1.1016–3 Exhaustion, wear and tear, obsolescence, amortization, and depletion for periods since February 13, 1913.

(a) * * * (1) * * * (ii) * * * For rules governing losses

on retirement or disposition of depreciable property, including rules for determining basis, see § 1.167(a)–8,


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1.168(i)–1(e), or 1.168(i)–8, as applicable. * * * * * * * *

John Dalrymple, Deputy Commissioner for Services and Enforcement.

Approved: July 11, 2014. Mark J. Mazur, Assistant Secretary of the Treasury (Tax Policy). [FR Doc. 2014–19403 Filed 8–14–14; 11:15 am] BILLING CODE 4830–01–P

DEPARTMENT OF HOMELAND SECURITY

Coast Guard

33 CFR Part 165

[Docket Number USCG–2014–0329]

RIN 1625–AA00

Safety Zones; Marine Events in Captain of the Port Long Island Zone

AGENCY: Coast Guard, DHS. ACTION: Temporary final rule.

SUMMARY: The Coast Guard is establishing three temporary safety zones for two fireworks events and one swim event within the Captain of the Port Long Island Sound Zone. This action is necessary to provide for the safety of life on navigable waters during these events. Entering into, transiting through, remaining, anchoring or mooring within these regulated areas would be prohibited unless authorized by the Captain of the Port Sector Long Island Sound. DATES: This rule is effective without actual notice from August 18, 2014 until August 30, 2014. For the purposes of enforcement, actual notice will be used from the date the rule was signed, July 31, 2014, until August 18, 2014. ADDRESSES: Documents mentioned in this preamble are part of docket [USCG– 2014–0329]. To view documents mentioned in this preamble as being available in the docket, go to http://www.regulations.gov, type the docket number in the ‘‘SEARCH’’ box and click ‘‘SEARCH.’’ Click on Open Docket

Folder on the line associated with this rulemaking. You may also visit the Docket Management Facility in Room W12–140 on the ground floor of the Department of Transportation West Building, 1200 New Jersey Avenue SE., Washington, DC 20590, between 9 a.m. and 5 p.m., Monday through Friday, except Federal holidays. FOR FURTHER INFORMATION CONTACT: If you have questions on this rule, call or email Petty Officer Scott Baumgartner, Prevention Department, Coast Guard Sector Long Island Sound, (203) 468– 4559, [email protected]. If you have questions on viewing or submitting material to the docket, call Cheryl Collins, Program Manager, Docket Operations, telephone (202) 366–9826. SUPPLEMENTARY INFORMATION:

Table of Acronyms COTP Captain of the Port DHS Department of Homeland Security FR Federal Register NPRM Notice of Proposed Rulemaking

A. Regulatory History and Information There are three separate marine

events addressed by this temporary regulation. On May 29, 2014 the Coast Guard published a NPRM entitled ‘‘Safety Zones; Marine Events in Captain of the Port Long Island Zone’’ in the Federal Register (79 FR 30783). No public comments were received on the proposed rule. No public meeting was requested and none was held.

The Village of Saltaire fireworks display and the Riverhead Rocks Triathlon were both held the previous year and had separate safety zones established by a temporary final rule entitled ‘‘Special Local Regulations and Safety Zones; Marine Events in Captain of the Port Long Island Sound Zone.’’ This rulemaking was published on July 10, 2013 in the Federal Register (78 FR 41300). The Baker Family Celebration fireworks display is a first time event with no other regulatory history.

Under 5 U.S.C. 553(d)(3), the Coast Guard finds that good cause exists for making this rule effective less than 30 days after publication in the Federal Register. The comment period for the NPRM associated with the Freeport

Chamber of Commerce Fireworks Display expired on June 30, 2014. The first event covered by this regulation occurred on August 2, 2014. Thus, there was insufficient time for a 30 day effective period before the need to enforce the earliest of three safety zones established by this rule on August 2, 2014.

Delaying the enforcement of this rule to allow a 30 day effective period will be impractical and contrary to the public interest because it would inhibit the Coast Guard’s ability to fulfill its mission to keep the ports and waterways safe.

B. Basis and Purpose

The legal basis for this temporary rule is 33 U.S.C. 1231; 46 U.S.C. Chapter 701, 3306, 3703; 50 U.S.C. 191, 195; 33 CFR 1.05–1, 6.04–1, 6.04–6, and 160.5; Public Law 107–295, 116 Stat. 2064; Department of Homeland Security Delegation No. 0170.1, which collectively authorize the Coast Guard to define regulatory safety zones.

This temporary rule is necessary to promote the safety of life on navigable waterways within the COTP Long Island Sound Zone during these events.

C. Discussion of Comments, Changes and the Final Rule

No comments were received and there has been one change made to the final rule as a result of the sponsor for the Brookhaven Memorial Hospital Fireworks cancelling their event. The proposed safety zone associated with their event is no longer necessary and has been removed from the final rule.

The Coast Guard is establishing three safety zones for two fireworks displays and one swim event to provide for the safety of life on navigable waters during these events. This rule will be effective from 8:30 p.m. on August 2, 2014 to 10:30 p.m. on August 30, 2014.

The events covered by this regulation will be enforced on the respective dates, times, and locations listed in the table below. If any of the events are cancelled due to inclement weather, then this regulation will be enforced on rain dates listed in the table below.

Fireworks Displays

1 Village of Saltaire Fireworks ............................................................... • Date: August 2, 2014. • Rain Date: August 30, 2014. • Time: 8:30 p.m. to 10:30 p.m. • Location: All waters of Saltaire Bay near Saltaire, NY within 600 feet

of the fireworks barge located in approximate position 40°38′37.72″ N, 073°11′58.52″ W (NAD 83).

2 Baker Family Celebration Fireworks ................................................... • Date: August 16, 2014. • Rain Date: August 17, 2014. • Time: 8:30 p.m. to 10:30 p.m.


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Form 3115(Rev. December 2009) Department of the Treasury Internal Revenue Service

Application for Change in Accounting Method OMB No. 1545-0152

Name of filer (name of parent corporation if a consolidated group) (see instructions) Identification number (see instructions)

Principal business activity code number (see instructions)

Number, street, and room or suite no. If a P.O. box, see the instructions. Tax year of change begins (MM/DD/YYYY)

Tax year of change ends (MM/DD/YYYY)

City or town, state, and ZIP code Name of contact person (see instructions)

Name of applicant(s) (if different than filer) and identification number(s) (see instructions) Contact person’s telephone number

If the applicant is a member of a consolidated group, check this box . . . . . . . . . . . . . . . . . !If Form 2848, Power of Attorney and Declaration of Representative, is attached (see instructions for when Form 2848 is required), check this box . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . !Check the box to indicate the type of applicant.

Individual Corporation Controlled foreign corporation (Sec. 957) 10/50 corporation (Sec. 904(d)(2)(E)) Qualified personal service corporation (Sec. 448(d)(2)) Exempt organization. Enter Code section !

Cooperative (Sec. 1381) Partnership S corporation Insurance co. (Sec. 816(a)) Insurance co. (Sec. 831) Other (specify) !

Check the appropriate box to indicate the type of accounting method change being requested. (see instructions)

Depreciation or Amortization Financial Products and/or Financial Activities of Financial Institutions Other (specify) !

Caution. To be eligible for approval of the requested change in method of accounting, the taxpayer must provide all information that is relevant to the taxpayer or to the taxpayer's requested change in method of accounting. This includes all information requested on this Form 3115 (including its instructions), as well as any other information that is not specifically requested.

The taxpayer must attach all applicable supplemental statements requested throughout this form.

Part I Information For Automatic Change Request1 Enter the applicable designated automatic accounting method change number for the requested automatic change. Enter

only one designated automatic accounting method change number, except as provided for in guidance published by the IRS. If the requested change has no designated automatic accounting method change number, check "Other," and provide both a description of the change and citation of the IRS guidance providing the automatic change. See instructions.

Yes No

! (a) Change No. (b) Other Description !2 Do any of the scope limitations described in section 4.02 of Rev. Proc. 2008-52 cause automatic consent to be

unavailable for the applicant's requested change? If "Yes," attach an explanation. . . . . . . . . . . .Note. Complete Part II below and then Part IV, and also Schedules A through E of this form (if applicable). Part II Information For All Requests Yes No

3 Did or will the applicant cease to engage in the trade or business to which the requested change relates, or terminate its existence, in the tax year of change (see instructions)? . . . . . . . . . . . . . . . . . . .If “Yes,” the applicant is not eligible to make the change under automatic change request procedures.

4 a Does the applicant (or any present or former consolidated group in which the applicant was a member during theapplicable tax year(s)) have any Federal income tax return(s) under examination (see instructions)? . . . . . If “No,” go to line 5.

b Is the method of accounting the applicant is requesting to change an issue (with respect to either the applicant or any present or former consolidated group in which the applicant was a member during the applicable tax year(s)) either (i) under consideration or (ii) placed in suspense (see instructions)? . . . . . . . . . . . . . .

Signature (see instructions) Under penalties of perjury, I declare that I have examined this application, including accompanying schedules and statements, and to the best of my knowledge and belief, the application contains all the relevant facts relating to the application, and it is true, correct, and complete. Declaration of preparer (other than applicant) is based on all information of which preparer has any knowledge.

Filer Preparer (other than filer/applicant)

Signature and date

Name and title (print or type)

Signature of individual preparing the application and date

Name of individual preparing the application (print or type)

Name of firm preparing the application

For Privacy Act and Paperwork Reduction Act Notice, see the instructions. Cat. No. 19280E Form 3115 (Rev. 12-2009)


Form 3115 (Rev. 12-2009) Page 2 Part II Information For All Requests (continued) Yes No

4 c Is the method of accounting the applicant is requesting to change an issue pending (with respect to either the applicant or any present or former consolidated group in which the applicant was a member during the applicable tax year(s)) for any tax year under examination (see instructions)? . . . . . . . . . . . . . . . .

d Is the request to change the method of accounting being filed under the procedures requiring that the operating division director consent to the filing of the request (see instructions)? . . . . . . . . . . . . . . .If “Yes,” attach the consent statement from the director.

e Is the request to change the method of accounting being filed under the 90-day or 120-day window period? . .If “Yes,” check the box for the applicable window period and attach the required statement (see instructions).

90 day 120 day: Date examination ended !

f

Name ! Telephone number ! Tax year(s) !

If you answered “Yes” to line 4a, enter the name and telephone number of the examining agent and the tax year(s) under examination.

g Has a copy of this Form 3115 been provided to the examining agent identified on line 4f? . . . . . . . .5 a Does the applicant (or any present or former consolidated group in which the applicant was a member during the

applicable tax year(s)) have any Federal income tax return(s) before Appeals and/or a Federal court? . . . .If “Yes,” enter the name of the (check the box) Appeals officer and/or counsel for the government, telephone number, and the tax year(s) before Appeals and/or a Federal court. Name ! Telephone number ! Tax year(s) !

b Has a copy of this Form 3115 been provided to the Appeals officer and/or counsel for the government identified on line 5a? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

c Is the method of accounting the applicant is requesting to change an issue under consideration by Appeals and/or a Federal court (for either the applicant or any present or former consolidated group in which the applicant was a member for the tax year(s) the applicant was a member) (see instructions)? . . . . . . . . . . . . .If “Yes,” attach an explanation.

6 If the applicant answered “Yes” to line 4a and/or 5a with respect to any present or former consolidated group,attach a statement that provides each parent corporation’s (a) name, (b) identification number, (c) address, and (d) tax year(s) during which the applicant was a member that is under examination, before an Appeals office, and/or before a Federal court.

7 If, for federal income tax purposes, the applicant is either an entity (including a limited liability company) treated as a partnership or an S corporation, is it requesting a change from a method of accounting that is an issue under consideration in an examination, before Appeals, or before a Federal court, with respect to a Federal income tax return of a partner, member, or shareholder of that entity? . . . . . . . . . . . . . . . . . . .

If “Yes,” the applicant is not eligible to make the change. 8a Does the applicable revenue procedure (advance consent or automatic consent) state that the applicant does not

receive audit protection for the requested change (see instructions)? . . . . . . . . . . . . . . .b If “Yes,” attach an explanation.

9a Has the applicant, its predecessor, or a related party requested or made (under either an automatic change procedure or a procedure requiring advance consent) a change in method of accounting within the past 5 years (including the year of the requested change)? . . . . . . . . . . . . . . . . . . . . . . .

b If "Yes," for each trade or business, attach a description of each requested change in method of accounting (including the tax year of change) and state whether the applicant received consent.

c If any application was withdrawn, not perfected, or denied, or if a Consent Agreement granting a change was not signed and returned to the IRS, or the change was not made or not made in the requested year of change, attachan explanation.

10 a Does the applicant, its predecessor, or a related party currently have pending any request (including any concurrently filed request) for a private letter ruling, change in method of accounting, or technical advice? . . .

b If “Yes,” for each request attach a statement providing the name(s) of the taxpayer, identification number(s), the type of request (private letter ruling, change in method of accounting, or technical advice), and the specific issue(s) in the request(s).

11 Is the applicant requesting to change its overall method of accounting? . . . . . . . . . . . . .If “Yes,” check the appropriate boxes below to indicate the applicant’s present and proposed methods of accounting. Also, complete Schedule A on page 4 of this form.

Present method: Cash Accrual Hybrid (attach description)

Proposed method: Cash Accrual Hybrid (attach description) Form 3115 (Rev. 12-2009)


Form 3115 (Rev. 12-2009) Page 3 Part II Information For All Requests (continued) Yes No

12 If the applicant is either (i) not changing its overall method of accounting, or (ii) is changing its overall method ofaccounting and also changing to a special method of accounting for one or more items, attach a detailed and complete description for each of the following:

a The item(s) being changed. b The applicant’s present method for the item(s) being changed. c The applicant’s proposed method for the item(s) being changed. d The applicant’s present overall method of accounting (cash, accrual, or hybrid).

13 Attach a detailed and complete description of the applicant’s trade(s) or business(es), and the principal businessactivity code for each. If the applicant has more than one trade or business as defined in Regulations section1.446-1(d), describe: whether each trade or business is accounted for separately; the goods and services provided by each trade or business and any other types of activities engaged in that generate gross income; theoverall method of accounting for each trade or business; and which trade or business is requesting to change its accounting method as part of this application or a separate application.

14 Will the proposed method of accounting be used for the applicant’s books and records and financial statements? For insurance companies, see the instructions . . . . . . . . . . . . . . . . . . . . . .If “No,” attach an explanation.

15a Has the applicant engaged, or will it engage, in a transaction to which section 381(a) applies (e.g., a reorganization, merger, or liquidation) during the proposed tax year of change determined without regard to anypotential closing of the year under section 381(b)(1)? . . . . . . . . . . . . . . . . . . . .

b If “Yes,” for the items of income and expense that are the subject of this application, attach a statement identifying the methods of accounting used by the parties to the section 381(a) transaction immediately before the date of distribution or transfer and the method(s) that would be required by section 381(c)(4) or (c)(5) absent consent to the change(s) requested in this application.

16 Does the applicant request a conference with the IRS National Office if the IRS proposes an adverse response? 17 If the applicant is changing to either the overall cash method, an overall accrual method, or is changing its method

of accounting for any property subject to section 263A, any long-term contract subject to section 460, or inventories subject to section 474, enter the applicant's gross receipts for the 3 tax years preceding the tax year ofchange.

1st preceding year ended: mo. yr.

2nd preceding year ended: mo. yr.

3rd preceding year ended: mo. yr.

$ $ $ Part III Information For Advance Consent Request Yes No18 Is the applicant’s requested change described in any revenue procedure, revenue ruling, notice, regulation, or

other published guidance as an automatic change request? . . . . . . . . . . . . . . . . . .If “Yes,” attach an explanation describing why the applicant is submitting its request under advance consent request procedures.

19 Attach a full explanation of the legal basis supporting the proposed method for the item being changed. Include a detailed and complete description of the facts that explains how the law specifically applies to the applicant’s situation and that demonstrates that the applicant is authorized to use the proposed method. Include all authority (statutes, regulations, published rulings, court cases, etc.) supporting the proposed method. Also, include either a discussion of the contrary authorities or a statement that no contrary authority exists.

20 Attach a copy of all documents related to the proposed change (see instructions). 21 Attach a statement of the applicant’s reasons for the proposed change. 22 If the applicant is a member of a consolidated group for the year of change, do all other members of the

consolidated group use the proposed method of accounting for the item being changed? . . . . . . . .If “No,” attach an explanation.

23 a Enter the amount of user fee attached to this application (see instructions). ! $

b If the applicant qualifies for a reduced user fee, attach the required information or certification (see instructions). Part IV Section 481(a) Adjustment Yes No24 Does the applicable revenue procedure, revenue ruling, notice, regulation, or other published guidance require the applicant to

implement the requested change in method of accounting on a cut-off basis rather than a section 481(a) adjustment? . . . If “Yes,” do not complete lines 25, 26, and 27 below.

25 Enter the section 481(a) adjustment. Indicate whether the adjustment is an increase (+) or a decrease (-) in income. ! Attach a summary of the computation and an explanation of the methodology used to determine the section 481(a) adjustment. If it is based on more than one component, show thecomputation for each component. If more than one applicant is applying for the method change on the same application, attach a list of the name, identification number, principal business activity code (see instructions), and the amount of the section 481(a) adjustment attributable to each applicant.

$

Form 3115 (Rev. 12-2009)


Form 3115 (Rev. 12-2009) Page 4 Part IV Section 481(a) Adjustment (continued) Yes No26 If the section 481(a) adjustment is an increase to income of less than $25,000, does the applicant elect to take the

entire amount of the adjustment into account in the year of change? . . . . . . . . . . . . . . .27 Is any part of the section 481(a) adjustment attributable to transactions between members of an affiliated group, a

consolidated group, a controlled group, or other related parties? . . . . . . . . . . . . . . . .If “Yes,” attach an explanation.

Schedule A—Change in Overall Method of Accounting (If Schedule A applies, Part I below must be completed.)

Part I Change in Overall Method (see instructions) 1 Enter the following amounts as of the close of the tax year preceding the year of change. If none, state “None.” Also, attach a

statement providing a breakdown of the amounts entered on lines 1a through 1g. Amount

a Income accrued but not received (such as accounts receivable) . . . . . . . . . . . . . . $

b Income received or reported before it was earned (such as advanced payments). Attach a description ofthe income and the legal basis for the proposed method . . . . . . . . . . . . . . . .

c Expenses accrued but not paid (such as accounts payable) . . . . . . . . . . . . . . .d Prepaid expenses previously deducted . . . . . . . . . . . . . . . . . . . . . .e Supplies on hand previously deducted and/or not previously reported . . . . . . . . . . . .f Inventory on hand previously deducted and/or not previously reported. Complete Schedule D, Part II .g Other amounts (specify). Attach a description of the item and the legal basis for its inclusion in the

calculation of the section 481(a) adjustment. !h Net section 481(a) adjustment (Combine lines 1a–1g.) Indicate whether the adjustment is an increase (+)

or decrease (-) in income. Also enter the net amount of this section 481(a) adjustment amount on Part IV, line 25. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $

2 Is the applicant also requesting the recurring item exception under section 461(h)(3)? . . . . . . . Yes No3 Attach copies of the profit and loss statement (Schedule F (Form 1040) for farmers) and the balance sheet, if applicable, as of

the close of the tax year preceding the year of change. Also attach a statement specifying the accounting method used when preparing the balance sheet. If books of account are not kept, attach a copy of the business schedules submitted with the Federal income tax return or other return (e.g., tax-exempt organization returns) for that period. If the amounts in Part I, lines1a through 1g, do not agree with those shown on both the profit and loss statement and the balance sheet, attach a statement explaining the differences.

Part II Change to the Cash Method For Advance Consent Request (see instructions) Applicants requesting a change to the cash method must attach the following information:

1 A description of inventory items (items whose production, purchase, or sale is an income-producing factor) and materials and supplies used in carrying out the business.

2 An explanation as to whether the applicant is required to use the accrual method under any section of the Code or regulations.

Schedule B—Change to the Deferral Method for Advance Payments (see instructions)

1 If the applicant is requesting to change to the Deferral Method for advance payments described in section 5.02 of Rev. Proc. 2004-34, 2004-1 C.B. 991, attach the following information:

a A statement explaining how the advance payments meet the definition in section 4.01 of Rev. Proc. 2004-34.b If the applicant is filing under the automatic change procedures of Rev. Proc. 2008-52, the information required by section

8.02(3)(a)-(c) of Rev. Proc. 2004-34.c If the applicant is filing under the advance consent provisions of Rev. Proc. 97-27, the information required by section

8.03(2)(a)-(f) of Rev. Proc. 2004-34.2 If the applicant is requesting to change to the deferral method for advance payments described in Regulations section

1.451-5(b)(1)(ii), attach the following.a A statement explaining how the advance payments meet the definition in Regulations section 1.451-5(a)(1).b A statement explaining what portions of the advance payments, if any, are attributable to services, whether such services are

integral to the provisions of goods or items, and whether any portions of the advance payments that are attributable tonon-integral services are less than five percent of the total contract prices. See Regulations sections 1.451-5(a)(2)(i) and (3).

c A statement explaining that the advance payments will be included in income no later than when included in gross receipts for purposes of the applicant's financial reports. See Regulations section 1.451-5(b)(1)(ii).

d A statement explaining whether the inventoriable goods exception of Regulations section 1.451-5(c) applies and if so, when substantial advance payments will be received under the contracts, and how the exception will limit the deferral of income.

Form 3115 (Rev. 12-2009)


Form 3115 (Rev. 12-2009) Page 5

Schedule C—Changes Within the LIFO Inventory Method (see instructions)

Part I General LIFO Information Complete this section if the requested change involves changes within the LIFO inventory method. Also, attach a copy of all Forms 970, Application To Use LIFO Inventory Method, filed to adopt or expand the use of the LIFO method.

1 Attach a description of the applicant’s present and proposed LIFO methods and submethods for each of the following items:

a Valuing inventory (e.g., unit method or dollar-value method). b Pooling (e.g., by line or type or class of goods, natural business unit, multiple pools, raw material content, simplified dollar-

value method, inventory price index computation (IPIC) pools, vehicle-pool method, etc.). c Pricing dollar-value pools (e.g., double-extension, index, link-chain, link-chain index, IPIC method, etc.). d Determining the current-year cost of goods in the ending inventory (i.e., most recent acquisitions, earliest acquisitions during

the current year, average cost of current-year acquisitions, or other permitted method). 2 If any present method or submethod used by the applicant is not the same as indicated on Form(s) 970 filed to adopt or

expand the use of the method, attach an explanation. 3 If the proposed change is not requested for all the LIFO inventory, attach a statement specifying the inventory to which the

change is and is not applicable. 4 If the proposed change is not requested for all of the LIFO pools, attach a statement specifying the LIFO pool(s) to which the

change is applicable.

5 Attach a statement addressing whether the applicant values any of its LIFO inventory on a method other than cost. For example, if the applicant values some of its LIFO inventory at retail and the remainder at cost, identify which inventory itemsare valued under each method.

6 If changing to the IPIC method, attach a completed Form 970.

Part II Change in Pooling Inventories 1 If the applicant is proposing to change its pooling method or the number of pools, attach a description of the contents of, and

state the base year for, each dollar-value pool the applicant presently uses and proposes to use. 2 If the applicant is proposing to use natural business unit (NBU) pools or requesting to change the number of NBU pools,

attach the following information (to the extent not already provided) in sufficient detail to show that each proposed NBU was determined under Regulations section 1.472-8(b)(1) and (2):

a A description of the types of products produced by the applicant. If possible, attach a brochure. b A description of the types of processes and raw materials used to produce the products in each proposed pool. c If all of the products to be included in the proposed NBU pool(s) are not produced at one facility, state the reasons for the

separate facilities, the location of each facility, and a description of the products each facility produces. d A description of the natural business divisions adopted by the taxpayer. State whether separate cost centers are maintained

and if separate profit and loss statements are prepared. e A statement addressing whether the applicant has inventories of items purchased and held for resale that are not further

processed by the applicant, including whether such items, if any, will be included in any proposed NBU pool. f A statement addressing whether all items including raw materials, goods-in-process, and finished goods entering into the

entire inventory investment for each proposed NBU pool are presently valued under the LIFO method. Describe any items that are not presently valued under the LIFO method that are to be included in each proposed pool.

g A statement addressing whether, within the proposed NBU pool(s), there are items both sold to unrelated parties and transferred to a different unit of the applicant to be used as a component part of another product prior to final processing.

3 If the applicant is engaged in manufacturing and is proposing to use the multiple pooling method or raw material content pools, attach information to show that each proposed pool will consist of a group of items that are substantially similar. See Regulations section 1.472-8(b)(3).

4 If the applicant is engaged in the wholesaling or retailing of goods and is requesting to change the number of pools used, attach information to show that each of the proposed pools is based on customary business classifications of the applicant’s trade or business. See Regulations section 1.472-8(c).

Form 3115 (Rev. 12-2009)


Form 3115 (Rev. 12-2009) Page 6 Schedule D—Change in the Treatment of Long-Term Contracts Under Section 460, Inventories, or Other Section 263A Assets (see instructions)

Part I Change in Reporting Income From Long-Term Contracts (Also complete Part III on pages 7 and 8.) 1 To the extent not already provided, attach a description of the applicant’s present and proposed methods for reporting income

and expenses from long-term contracts. Also, attach a representative actual contract (without any deletion) for the requestedchange. If the applicant is a construction contractor, attach a detailed description of its construction activities. Are the applicant’s contracts long-term contracts as defined in section 460(f)(1) (see instructions)? . . Yes No2aIf “Yes,” do all the contracts qualify for the exception under section 460(e) (see instructions)? . . . . Yes Nob If line 2b is “No,” attach an explanation.

c If line 2b is “Yes,” is the applicant requesting to use the percentage-of-completion method using cost-to-cost under Regulations section 1.460-4(b)? . . . . . . . . . . . . . . . . . . . . Yes No

d If line 2c is “No,” is the applicant requesting to use the exempt-contract percentage-of-completionmethod under Regulations section 1.460-4(c)(2)? . . . . . . . . . . . . . . . . . . . Yes NoIf line 2d is “Yes,” attach an explanation of what cost comparison the applicant will use to determine a contract’s completion factor. If line 2d is “No,” attach an explanation of what method the applicant is using and the authority for its use.

3a Does the applicant have long-term manufacturing contracts as defined in section 460(f)(2)? . . . . . Yes Nob If “Yes,” attach an explanation of the applicant’s present and proposed method(s) of accounting for long-

term manufacturing contracts. c Attach a description of the applicant’s manufacturing activities, including any required installation of manufactured goods.

4 To determine a contract’s completion factor using the percentage-of-completion method: a Will the applicant use the cost-to-cost method in Regulations section 1.460-4(b)? . . . . . . . . Yes Nob If line 4a is “No,” is the applicant electing the simplified cost-to-cost method (see section 460(b)(3) and

Regulations section 1.460-5(c))? . . . . . . . . . . . . . . . . . . . . . . . . Yes No5 Attach a statement indicating whether any of the applicant’s contracts are either cost-plus long-term

contracts or Federal long-term contracts. Part II Change in Valuing Inventories Including Cost Allocation Changes (Also complete Part III on pages 7 and 8.) 1 Attach a description of the inventory goods being changed. 2 Attach a description of the inventory goods (if any) NOT being changed. 3 a Is the applicant subject to section 263A? If "No," go to line 4a . . . . . . . . . . . . . . Yes Nob Is the applicant's present inventory valuation method in compliance with section 263A (see instructions)?

If "No," attach a detailed explanation . . . . . . . . . . . . . . . . . . . . . . . Yes No

4 a Check the appropriate boxes below. Identification methods:

Inventory Being Changed Inventory Not Being Changed

Present method Proposed method Present method

Specific identification . . . . . . . . . . . . . . . .FIFO . . . . . . . . . . . . . . . . . . . . .LIFO . . . . . . . . . . . . . . . . . . . . .Other (attach explanation) . . . . . . . . . . . . . .

Valuation methods: Cost . . . . . . . . . . . . . . . . . . . . .Cost or market, whichever is lower . . . . . . . . . . .Retail cost . . . . . . . . . . . . . . . . . . .Retail, lower of cost or market . . . . . . . . . . . . .Other (attach explanation) . . . . . . . . . . . . . .

b Enter the value at the end of the tax year preceding the year of change 5 If the applicant is changing from the LIFO inventory method to a non-LIFO method, attach the following information (see

instructions). a Copies of Form(s) 970 filed to adopt or expand the use of the method. b Only for applicants requesting advance consent. A statement describing whether the applicant is changing to the method

required by Regulations section 1.472-6(a) or (b), or whether the applicant is proposing a different method. c Only for applicants requesting an automatic change. The statement required by section 22.01(5) of the Appendix of Rev.

Proc. 2008-52 (or its successor). Form 3115 (Rev. 12-2009)


Form 3115 (Rev. 12-2009) Page 7 Part III Method of Cost Allocation (Complete this part if the requested change involves either property subject

to section 263A or long-term contracts as described in section 460 (see instructions)). Section A—Allocation and Capitalization Methods Attach a description (including sample computations) of the present and proposed method(s) the applicant uses to capitalize direct and indirect costs properly allocable to real or tangible personal property produced and property acquired for resale, or to allocate and, where appropriate, capitalize direct and indirect costs properly allocable to long-term contracts. Include a description of the method(s) used for allocating indirect costs to intermediate cost objectives such as departments or activities prior to the allocation of such costs to long-term contracts, real or tangible personal property produced, and property acquired for resale. The description must include the following:

1 The method of allocating direct and indirect costs (i.e., specific identification, burden rate, standard cost, or other reasonable allocation method).

2 The method of allocating mixed service costs (i.e., direct reallocation, step-allocation, simplified service cost using the labor-based allocation ratio, simplified service cost using the production cost allocation ratio, or other reasonable allocation method).

3 The method of capitalizing additional section 263A costs (i.e., simplified production with or without the historic absorption ratio election, simplified resale with or without the historic absorption ratio election including permissible variations, the U.S. ratio, or other reasonable allocation method).

Section B—Direct and Indirect Costs Required To Be Allocated Check the appropriate boxes showing the costs that are or will be fully included, to the extent required, in the cost of real or tangible personal property produced or property acquired for resale under section 263A or allocated to long-term contracts under section 460. Mark “N/A” in a box if those costs are not incurred by the applicant. If a box is not checked, it is assumed that those costs are not fully included to the extent required. Attach an explanation for boxes that are not checked.

Present method Proposed method

1 Direct material . . . . . . . . . . . . . . . . . . . . . . . . .2 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . .3 Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . .4 Officers’ compensation (not including selling activities) . . . . . . . . . . . .5 Pension and other related costs . . . . . . . . . . . . . . . . . . .6 Employee benefits . . . . . . . . . . . . . . . . . . . . . . . .7 Indirect materials and supplies . . . . . . . . . . . . . . . . . . . .8 Purchasing costs . . . . . . . . . . . . . . . . . . . . . . . .9 Handling, processing, assembly, and repackaging costs . . . . . . . . . . .

10 Offsite storage and warehousing costs . . . . . . . . . . . . . . . . .11 Depreciation, amortization, and cost recovery allowance for equipment and facilities

placed in service and not temporarily idle . . . . . . . . . . . . . . . .12 Depletion . . . . . . . . . . . . . . . . . . . . . . . . . . .13 Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . .14 Taxes other than state, local, and foreign income taxes . . . . . . . . . . . .15 Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . .16 Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . .17 Maintenance and repairs that relate to a production, resale, or long-term contract activity 18 Engineering and design costs (not including section 174 research and experimental

expenses) . . . . . . . . . . . . . . . . . . . . . . . . . .19 Rework labor, scrap, and spoilage . . . . . . . . . . . . . . . . . .20 Tools and equipment . . . . . . . . . . . . . . . . . . . . . . .21 Quality control and inspection . . . . . . . . . . . . . . . . . . . .22 Bidding expenses incurred in the solicitation of contracts awarded to the applicant . .23 Licensing and franchise costs . . . . . . . . . . . . . . . . . . . .24 Capitalizable service costs (including mixed service costs) . . . . . . . . . .25 Administrative costs (not including any costs of selling or any return on capital) . . . .26 Research and experimental expenses attributable to long-term contracts . . . . . .27 Interest . . . . . . . . . . . . . . . . . . . . . . . . . . .28 Other costs (Attach a list of these costs.) . . . . . . . . . . . . . . . .

Form 3115 (Rev. 12-2009)


Form 3115 (Rev. 12-2009) Page 8 Part III Method of Cost Allocation (see instructions) (continued)

Section C—Other Costs Not Required To Be Allocated (Complete Section C only if the applicant is requesting to change its method for these costs.)

Present method Proposed method

1 Marketing, selling, advertising, and distribution expenses . . . . . . . . . . .2 Research and experimental expenses not included in Section B, line 26 . . . . . .3 Bidding expenses not included in Section B, line 22 . . . . . . . . . . . .4 General and administrative costs not included in Section B . . . . . . . . . .5 Income taxes . . . . . . . . . . . . . . . . . . . . . . . . .6 Cost of strikes . . . . . . . . . . . . . . . . . . . . . . . . .7 Warranty and product liability costs . . . . . . . . . . . . . . . . . .8 Section 179 costs . . . . . . . . . . . . . . . . . . . . . . . .9 On-site storage . . . . . . . . . . . . . . . . . . . . . . . . .

10 Depreciation, amortization, and cost recovery allowance not included in Section B, line 11 . . . . . . . . . . . . . . . . . . . . . . . . . . .

11 Other costs (Attach a list of these costs.) . . . . . . . . . . . . . . . .

Schedule E—Change in Depreciation or Amortization (see instructions)

Applicants requesting approval to change their method of accounting for depreciation or amortization complete this section. Applicants must provide this information for each item or class of property for which a change is requested. Note. See the List of Automatic Accounting Method Changes in the instructions for information regarding automatic changes under sections 56, 167, 168, 197, 1400I, 1400L, or former section 168. Do not file Form 3115 with respect to certain late elections and election revocations (see instructions).

1 Is depreciation for the property determined under Regulations section 1.167(a)-11 (CLADR)? . . . . Yes NoIf “Yes,” the only changes permitted are under Regulations section 1.167(a)-11(c)(1)(iii).

2 Is any of the depreciation or amortization required to be capitalized under any Code section (e.g., section 263A)? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yes NoIf “Yes,” enter the applicable section !

3 Has a depreciation, amortization, or expense election been made for the property (e.g., the election under sections 168(f)(1), 179, or 179C)? . . . . . . . . . . . . . . . . . . . . . . . . Yes NoIf “Yes,” state the election made !

4 a To the extent not already provided, attach a statement describing the property being changed. Include in the description the type of property, the year the property was placed in service, and the property’s use in the applicant’s trade or business or income-producing activity.

b If the property is residential rental property, did the applicant live in the property before renting it? . . Yes Noc Is the property public utility property? . . . . . . . . . . . . . . . . . . . . . . Yes No

5 To the extent not already provided in the applicant’s description of its present method, attach a statement explaining how theproperty is treated under the applicant’s present method (e.g., depreciable property, inventory property, supplies under Regulations section 1.162-3, nondepreciable section 263(a) property, property deductible as a current expense, etc.).

6 If the property is not currently treated as depreciable or amortizable property, attach a statement of the facts supporting theproposed change to depreciate or amortize the property.

7 If the property is currently treated and/or will be treated as depreciable or amortizable property, provide the following information for both the present (if applicable) and proposed methods:

a The Code section under which the property is or will be depreciated or amortized (e.g., section 168(g)).

b The applicable asset class from Rev. Proc. 87-56, 1987-2 C.B. 674, for each asset depreciated under section 168 (MACRS) or under section 1400L; the applicable asset class from Rev. Proc. 83-35, 1983-1 C.B. 745, for each asset depreciated under former section 168 (ACRS); an explanation why no asset class is identified for each asset for which an asset class has not been identified by the applicant.

c The facts to support the asset class for the proposed method. d The depreciation or amortization method of the property, including the applicable Code section (e.g., 200% declining balance

method under section 168(b)(1)). e The useful life, recovery period, or amortization period of the property. f The applicable convention of the property. g A statement of whether or not the additional first-year special depreciation allowance (for example, as provided by section

168(k), 168(l), 168(m), 168(n), 1400L(b), or 1400N(d)) was or will be claimed for the property. If not, also provide an explanationas to why no special depreciation allowance was or will be claimed.

Form 3115 (Rev. 12-2009)


Userid: NEDICK00 schema instrx Leadpct: 0% Pt. size: 9 ❏ Draft ❏ Ok to Print

PAGER/XML Fileid: ...\Documents\2011 Corporate Products\Form 3115 instr\I3115-mark.xml (Init. & date)

Page 1 of 20 Instructions for Form 3115 10:42 - 22-MAR-2012

The type and rule above prints on all proofs including departmental reproduction proofs. MUST be removed before printing.

Department of the TreasuryInternal Revenue ServiceInstructions for Form 3115

(Rev. March 2012)(Use with the December 2009 revision of Form 3115)Application for Change in Accounting Method

Request Scope Limitations, later. If the requested change isSection references are to the Internal Revenue Code unlessapproved, the filer will receive a letter ruling on the requestedotherwise noted.change. File a separate Form 3115 for each unrelated item or

All references to Rev. Proc. 97-27 are to Rev. Proc. 97-27, submethod. A user fee is required. See the instructions for1997-1 C.B. 680 (as modified and amplified by Rev. Proc. Part III later for more information.2002-19, 2002-1 C.B. 696, as amplified and clarified by Rev.

For general rules on changing an accounting method under:Proc. 2002-54, 2002-2 C.B. 432), as modified by Rev. Proc.2007-67, 2007-2 C.B. 1072), as clarified and modified by Rev.

Automatic change See generally Rev. Proc. 2011-14.Proc. 2009-39, 2009-2 C.B. 371 and as clarified and modifiedrequest procedures . . .by Rev. Proc. 2011-14, 2011-4 I.R.B. 330, or its successor.

All references to Rev. Proc. 2011-14 are to Rev. Proc. Advance consent See Rev. Proc. 97-27, as amplified,2011-14, 2011-4 I.R.B. 330, or its successor. (Note. Rev. Proc. request procedures . . . clarified and modified by Rev. Proc.2011-14 amplified, clarified, modified, and, in part, superceded 2002-19, Rev. Proc. 2002-54, Rev. Proc.Rev. Proc. 2008-52, 2008-36 I.R.B. 587.) 2007-67, Rev. Proc. 2009-39, and Rev.

Proc. 2011-14.All references to Rev. Proc. 2012-1 are to Rev. Proc.2012-1, 2012-1 I.R.B. 1, or its successor (updated annually). For more information, see Rev. Proc. 2012-1 (or its successor),

particularly section 9.General Instructions

When filing Form 3115, you must determine if the IRSWhat’s New has published any new revenue procedure, revenueruling, notice, regulation, or other published guidanceCAUTION

!Future developments. The IRS has created a page on

relating to the specific method the applicant is requesting toIRS.gov for information about Form 3115 at www.irs.gov/change. This guidance is published in the Internal Revenueform3115. Information about any future developments affectingBulletin. For the latest information, visit IRS.gov.Form 3115 (such as legislation enacted after we release it) will

be posted to that page. Who Must FilePurpose of Form The entity or person required to file Form 3115, whether on its

own behalf or on behalf of another entity, is the filer. The entity,File Form 3115 to request a change in either an overall methodtrade or business, or person on whose behalf the change inof accounting or the accounting treatment of any item.method of accounting is being requested is the applicant. ForTwo procedures exist under which an applicant may request example, the common parent corporation of a consolidateda change in method of accounting. group is the filer when requesting a change in method of

Automatic change request procedures. Unless otherwise accounting for another member of that consolidated group (or aprovided in published guidance, you must file under the separate and distinct trade or business of that member), andautomatic change request procedures if (a) the change in the other member (or trade or business) on whose behalf themethod of accounting is included in those procedures for the Form 3115 is filed is the applicant. For information on therequested year of change, and (b) you are within the scope of difference between a filer and an applicant, see Name(s) andthose procedures for the requested year of change. See Signature(s), later.Automatic Change Request Scope Limitations, later. A Form An applicant is an entity or a person, or a separate and3115 filed under these procedures may be reviewed by the IRS distinct trade or business of an entity or a person (for purposesand you will be notified if information in addition to that of Regulations section 1.446-1(d)), whose method ofrequested on Form 3115 is required or if your request is denied. accounting is being changed.No user fee is required. An applicant that timely files and

For a consolidated group of corporations, the commoncomplies with an automatic change request procedure isparent corporation must file Form 3115 for a change in methodgranted consent to change its accounting method, subject toof accounting for itself or any member of the consolidatedreview by the IRS National Office and operating divisiongroup.director. See the instructions for Part I and the List of Automatic

Accounting Method Changes, later. For a CFC or 10/50 corporation without a U.S. trade orbusiness, Form 3115 must be filed by the designatedOrdinarily, a taxpayer is required to file a separate Form(controlling domestic) shareholder who retains the jointly3115 for each change in method of accounting. However, inexecuted consent described in Regulations sectionsome cases you are required or permitted to file a single Form1.964-1(c)(3)(ii). If the controlling domestic shareholder is a3115 for particular concurrent changes in method of accounting.member of a consolidated group, the common parentFurther, in some cases you are required or permitted to file acorporation must file Form 3115 for the controlling domesticstatement in lieu of a Form 3115 for particular changes inshareholder on behalf of the foreign corporation. For anmethod of accounting. See section 6.02(1)(a) and (b) of Rev.automatic change, the controlling domestic shareholder(s) (orProc. 2011-14 for more information.its common parent) must attach a copy of the Form 3115 to itsAdvance consent request procedures. If you are not withinincome tax return for its tax year with or within which the CFCsthe scope of any automatic change request procedures for theor 10/50 corporation’s year of change tax year ends.requested year of change or the accounting method change

you are requesting is not included in those procedures for the Generally, a filer must file a separate Form 3115 for eachrequested year of change, you may be able to file under the applicant seeking consent to change a method of accounting.advance consent request procedures. See Advance Consent For example, a filer must file a separate Form 3115 for each

Cat. No. 63215HMar 22, 2012


of 20 Instructions for Form 3115 10:42 - 22-MAR-2012


File Form 3115 at the applicable IRS address listed below.

For applicants (other than exempt organizations) filing . . .

An advance consent request The National Office copy of an automatic Ogden, Utah copychange request

Delivery by Internal Revenue Service Internal Revenue Service Internal Revenue Service mail Attn: CC:PA:LPD:DRU Automatic Rulings Branch 1973 North Rulon White Blvd.

P.O. Box 7604 P.O. Box 7604 Mail Stop 4917 Benjamin Franklin Station Benjamin Franklin Station Ogden, UT 84404Washington, DC 20044 Washington, DC 20044

Delivery by Internal Revenue Service Internal Revenue Service Internal Revenue Service private Attn: CC:PA:LPD:DRU Automatic Rulings Branch 1973 North Rulon White Blvd. delivery Room 5336 Room 5336 Mail Stop 4917 service 1111 Constitution Ave., NW 1111 Constitution Ave., NW Ogden, UT 84404

Washington, DC 20224 Washington, DC 20224

For exempt organizations filing an advance consent request or the National Office Ogden, Utah copycopy of an automatic change request

By mail Internal Revenue Service Internal Revenue Service Tax Exempt & Government Entities 1973 North Rulon White Blvd. P.O. Box 2508 Mail Stop 4917 Cincinnati, OH 45201 Ogden, UT 84404

By private delivery service Internal Revenue Service Internal Revenue Service Tax Exempt & Government Entities 1973 North Rulon White Blvd. 550 Main Street, Room 4024 Mail Stop 4917 Cincinnati, OH 45202 Ogden, UT 84404

corporation (with a single trade or business) that is part of a When and Where To Filerelated group of corporations. A filer also must file a separate

Automatic change requests. Except as otherwise specificallyForm 3115 for each separate and distinct trade or businessprovided, you must file a Form 3115 under the automatic(including a QSub or single-member LLC) of each corporationchange request procedures in duplicate as follows.or other entity, even if the requested change in method of• Attach the original to the filer’s timely filed (includingaccounting will be used by all separate and distinct trades orextensions) federal income tax return for the year of change.businesses of an entity.• Attach an original filed on behalf of a CFC or 10/50Each partnership entity must file on its own behalf even if corporation to the filer’s timely filed federal income tax return formultiple related or tiered partnership entities are filing for the tax year of the filer with or within which the CFCs or 10/50identical changes in method of accounting. corporation’s year of change tax year ends.

There are three limited exceptions to the requirement to file File a copy of the Form 3115 with the IRS National Office,a separate Form 3115 for each applicant seeking consent to unless the Appendix of Rev. Proc. 2011-14 or other publishedchange a method of accounting. The filer may file a single Form guidance requires you to file the copy with the IRS office in3115 for multiple applicants in each of the 3 following situations Ogden, UT, instead of the IRS National Office. File the copy no(separately, but not in any combination): earlier than the first day of the year of change and no later than• A common parent of a consolidated group or other entity the date the original is filed with the federal income tax returnrequesting an identical change in method of accounting for two for the year of change (or if applicable, for the tax year in whichor more (a) members of that consolidated group, or (b) separate the CFCs or 10/50 corporation’s year of change tax year ends).and distinct trades or businesses (for purposes of RegulationsIf you are making more than one change in method ofsection 1.446-1(d)) of that entity or members of the

accounting on the same Form 3115 (when permitted) and (1)consolidated group, including a QSub or single-member LLC.one method change requires you to file a copy of the Form• A common parent of a consolidated group requesting an3115 with the IRS Office in Ogden, UT, and (2) the otheridentical change in method of accounting on behalf of two ormethod change(s) being requested requires you to file a copy ofmore controlled foreign corporations (CFCs) or noncontrolledForm 3115 with the IRS National Office, file only one copy ofsection 902 corporations (10/50 corporations), or separate andthe Form 3115 with the IRS Office in Ogden, UT. However, ifdistinct trades or businesses of a CFC or 10/50 corporation,Rev. Proc. 2011-14 or other published guidance describing thethat do not engage in a trade or business within the Unitedrequested change in method of accounting specifically requiresStates where all controlling U.S. shareholders of the CFC andyou to file a copy of the Form 3115 with both the IRS Nationalall majority domestic corporate shareholders of the 10/50Office and the IRS office in Ogden, UT, you must file a copycorporations are members of the consolidated group.with each office. See section 3.06 of the Appendix of Rev. Proc.• A taxpayer requesting an identical change in method of2011-14 for an example of when published guidanceaccounting on behalf of two or more CFCs or 10/50specifically requires you to file a copy with both offices.corporations, or separate and distinct trades or businesses of a

Example: You are requesting consent for a change inCFC or 10/50 corporation, that do not engage in a trade ormethod of accounting described in section 6.01 of the Appendixbusiness within the United States for which the taxpayer is theof Rev. Proc. 2011-14 and for a concurrent change to asole controlling U.S. shareholder of the CFCs or the soleUNICAP method, as permitted in section 6.01(7)(b) of thedomestic corporate shareholder of the 10/50 corporation (or anyAppendix of Rev. Proc. 2011-14. File the copy of the Form 3115separate and distinct trade or businesses of any such CFC orwith the IRS office in Ogden, UT.10/50 corporation).

For information on what is an identical change in method of In specified circumstances you are required to sendaccounting, see section 15.07(4) of Rev. Proc. 2012-1. additional copies of the Form 3115 to another IRS address.

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For example, you must file additional copies if the applicant is is filed for multiple applicants in a consolidated group ofunder examination, before an Appeals office, and/or before corporations, multiple CFCs, or multiple separate and distinctFederal Court. See section 6.03(c) of Rev. Proc. 2011-14 for trades or businesses of a taxpayer (including QSubs, ormore information. See also Late Application below, and, if the single-member LLCs), attach a schedule listing each applicantapplicant is under examination for purposes of Rev. Proc. and its identification number (where applicable). This schedule2011-14, the instructions for Part II, lines 4d and 4e. may be combined with the information requested for Part III,

line 23a (regarding the user fee) and Part IV (section 481(a)Advance consent requests. You must file Form 3115 underadjustment). If multiple names and signatures are required (forthe advance consent request procedures during the tax year forexample, in the case of CFCs—see instructions below), attachwhich the change is requested, unless otherwise provided bya schedule labeled “SIGNATURE ATTACHMENT” to the Formother published guidance. For example, see Regulations3115, signed under penalties of perjury using the samesection 1.381(c)(4)-1(d)(2)(iii) and 1.381(c)(5)-1(d)(2)(iii), whichlanguage as in the declaration on page 1 of Form 3115.provide different deadlines for filing a Form 3115 in the year ofReceivers, trustees, or assignees must sign any Form 3115a section 381 transaction. If the tax year for which the change isthey are required to file.requested is a short period, file Form 3115 by the last day of the

short period unless other published guidance provides another Individuals. If Form 3115 is filed for a husband and wife whodeadline. File the Form 3115 with the IRS National Office (see file a joint income tax return, enter the names of both spousesbelow). File Form 3115 as early as possible during the year of on the first line and the signatures of both spouses on thechange to provide adequate time for the IRS to respond prior to signature line.the due date of the filer’s return for the year of change (or if Partnerships. Enter the name of the partnership on the firstapplicable, for the tax year of the filer in which the CFCs or 10/ line of Form 3115. In the signature section, enter the signature50 corporation’s year of change tax year ends). See Late of one of the general partners or limited liability companyApplication below and, if the applicant is under examination for members who has personal knowledge of the facts and who ispurposes of Rev. Proc. 97-27, as modified by Rev. Proc. authorized to sign. Enter that person’s name and title below the2009-39, and Rev. Proc. 2011-14, and the instructions for signature. If the authorized partner is a member of aPart II, lines 4d and 4e. consolidated group, then an authorized officer of the common

The IRS normally sends an acknowledgment of receipt parent corporation with personal knowledge of the facts mustwithin 60 days after receiving a Form 3115 filed under the sign.advance consent request procedures of Rev. Proc. 97-27. If the Non-consolidated corporations, personal servicefiler does not receive an acknowledgment of receipt for an corporations, S corporations, cooperatives, and insuranceadvance request within 60 days, the filer can inquire to: companies. Enter the name of the filer on the first line of Form Internal Revenue Service, Control Clerk, CC:IT&A, Room 3115. In the signature section, enter the signature of the officer4516, 1111 Constitution Ave., NW, Washington, DC 20224. who has personal knowledge of the facts and authority to bindNote: The IRS does not send acknowledgments of receipt for the filer in the matter. Enter that officer’s name and official titleautomatic change requests. below the signature.

Consolidated group of corporations. Enter the name of theLate Application common parent corporation on the first line of Form 3115. AlsoIn general, a taxpayer that fails to timely file a Form 3115 will enter the name(s) of the applicant(s) on the fourth line if anot be granted an extension of time to file except in unusual member of the consolidated group other than, or in addition to,and compelling circumstances. See Regulations section the parent corporation is requesting a change in method of301.9100-3 for the standards that must be met. For information accounting. In the signature section, enter the signature of theon the period of limitations, see section 5.03(2) of Rev. Proc. officer of the common parent corporation who has personal2012-1. knowledge of the facts and authority to bind the common parent

However, a limited 6-month extension of time to file Form corporation in the matter, and that officer’s name and official3115 may be available for automatic change requests. For title below the signature.details, see section 6.02(3)(d) of Rev. Proc. 2011-14 and Separate and distinct trade or business of an entity. EnterRegulations section 301.9100-2. the name of the entity (or common parent corporation if the

A taxpayer submitting a ruling request for an extension of entity is a member of a consolidated group) on the first line oftime to file Form 3115 must pay a user fee for its extension Form 3115. Also enter the name of the separate and distinctrequest and, in the case of an advance consent request, also a trade or business requesting a change in method of accountingseparate user fee for its accounting method change request. on the fourth line. In the signature section, enter the signatureFor the schedule of user fees, see (A)(3)(b), (A)(4), and of the individual who has personal knowledge of the facts and(A)(5)(d) in Appendix A of Rev. Proc. 2012-1. authority to bind the separate and distinct trade or business of

the entity in the matter, and that person’s name and official titlebelow the signature.CFC or 10/50 Corporation. For a CFC or 10/50 corporationSpecific Instructionswith a U.S. trade or business, follow the same rules as for othercorporations. For a CFC or 10/50 corporation that does notName(s) and Signature(s) have a U.S. trade or business, the Form 3115 filed on behalf of

Enter the name of the filer on the first line of page 1 of Form its controlling domestic shareholder(s) (or common parent)3115. For an automatic change request, the filer must send a must be signed by an authorized officer of the designatedsigned and dated copy of the Form 3115 to the IRS National (controlling domestic) shareholder that retains the jointlyOffice and/or Ogden, UT, office and, in some cases, to an executed consent as provided for in Regulations sectionadditional IRS office. For each of these copies, submit either 1.964-1(c)(3)(ii). If there is more than one shareholder, thethe copy with an original signature or a photocopy of the original statement described in Regulations section 1.964-1(c)(3)(ii)signed Form 3115. The Form 3115 attached to the income tax must be attached to the application. Also, the controllingreturn (including any additional statements) does not need to be domestic shareholder(s) must provide the written noticesigned. The name and signature requirements are discussed required by Regulations section 1.964-1(c)(3)(iii). If thebelow. designated (controlling domestic) shareholder is a member of a

consolidated group, then an authorized officer of the commonIn general, the filer of the Form 3115 is the applicant.parent corporation must sign.However, in circumstances where the Form 3115 is filed on

behalf of the applicant, enter the filer’s name and identification Estates or trusts. Enter the name of the estate or trust on thenumber on the first line of Form 3115 and enter the applicant’s first line of Form 3115. In the signature section, enter thename and identification number on the fourth line. If Form 3115 signature of the fiduciary, personal representative, executor,

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administrator, etc., who has personal knowledge of the facts act(s), must be properly reflected on Form 2848. For furtherand legal authority to bind the estate or trust in the matter, and details for an authorized representative and a power ofthat person’s official title below the signature. attorney, see sections 9.03(8) and (9) of Rev. Proc. 2012-1.

Exempt organizations. Enter the name of the organization on A Form 2848 must be attached to Form 3115 in order for thethe first line of Form 3115. In the signature section, enter the Service to discuss a Form 3115 with a taxpayer’ssignature of a principal officer or other person who has personal representative, even if the taxpayer’s representative preparedknowledge of the facts and authority to bind the exempt and/or signed the Form 3115.organization in the matter, and that person’s name and officialtitle below the signature. Option to Receive Correspondence by Fax

A filer that wants to receive, or wants its authorizedPreparer (other than filer/applicant). If the individualpreparing the Form 3115 is not the filer or applicant, the representative to receive, correspondence regarding its Formpreparer also must sign. However, for an automatic change 3115 (for example, additional information letters or the letterrequest, the preparer need not sign the original Form 3115 ruling) by fax must attach to the Form 3115 a statementattached to the income tax return. requesting this service. The attachment must also list the

authorized name(s) and fax number(s) of the person(s) who areto receive the fax. The listed person(s) must be eitherIdentification Number authorized to sign Form 3115, or an authorized representativeEnter the filer’s taxpayer identification number on the first line of of the filer that is included on Form 2848. For further details onForm 3115 as follows. the fax procedures, see section 9.04(3) of Rev. Proc. 2012-1.• Individuals enter their social security number (SSN) (or

individual taxpayer identification number (ITIN) for a resident ornonresident alien). If the Form 3115 is for a husband and wife Type of Accounting Method Changewho file a joint return, enter the identification numbers of both. Requested• All others, enter the employer identification number (EIN).

Check the appropriate box described below indicating the type• If the filer is the common parent corporation of a consolidatedof change being requested.group of corporations, enter the EIN of the common parent on

the first line of Form 3115. Enter the EIN of the applicant on the • Depreciation or amortization. Check this box for a changefourth line if a member of the consolidated group other than, or in (a) depreciation or amortization (for example, thein addition to, the common parent is requesting the change in depreciation method or recovery period), (b) the treatment ofmethod of accounting. salvage proceeds or costs of removal, (c) the method of• If the common parent is filing the Form 3115 on behalf of accounting for retirements of depreciable property, or (d) themultiple applicants in a consolidated group of corporations, treatment of depreciable property from a single asset account tomultiple CFCs or 10/50 corporations, or multiple and distinct a multiple asset account (pooling), or vice versa).trades or businesses of a member (including QSubs, or • Financial products and/or financial activities of financialsingle-member LLCs), attach a schedule listing each applicant institutions. Check this box for a change in the treatment of aand its identification number (if applicable). financial product (for example, accounting for debt instruments,• If the applicant is a foreign entity that is not otherwise derivatives, mark-to-market accounting, etc.), or in the financialrequired to have or obtain an EIN, enter “Not applicable” in the activities of a financial institution (for example, a lendingspace provided for the identifying number. institution, a regulated investment company, a real estate

investment trust, a real estate mortgage investment conduit,etc.)).Principal Business Activity Code• Other. For advance consent requests, check this box ifIf the filer is a business, enter the six-digit principal businessneither of the above boxes applies to the requested change. Inactivity (PBA) code of the filer. The principal business activity ofthe space provided, enter a short description of the change andthe filer is the activity generating the largest percentage of its

total receipts. See the instructions for the filer’s income tax the most specific applicable Code section(s) for the requestedreturn for the filer’s PBA code and definition of total receipts. change (for example, change within section 263A costs;

deduction of warranty expenses, section 461; change to theNote. An applicant requesting to change its accounting completed contract method for long-term contracts, section 460;method under designated automatic accounting method change etc.). For automatic change requests, this informationalnumbers 33 and/or 51 in the List of Automatic Accounting requirement is satisfied by properly completing Part I, line 1 ofMethod Changes must also attach to Form 3115 the detailed Form 3115.NAICS code for the applicant’s principal business activity. SeeRev. Proc. 2002-28, 2002-1 C.B. 815, for further guidance. You must follow the instructions below to correctly

complete Form 3115. Address CAUTION

!Include the suite, room, or other unit number after the street • Applicants requesting a change in method of accountingaddress. If the Post Office does not deliver mail to the street using the automatic change request procedures must completeaddress and the filer has a P.O. box, show the box number Parts I, II, and IV.instead of the street address. • Applicants requesting a change in method of accounting

using the advance consent request procedures must completeParts II, III, and IV.Contact Person• All applicants must complete Schedules A, B, C, D, and E, asThe contact person must be an individual authorized to signapplicable, for the requested change in method of accounting.Form 3115, or the filer’s authorized representative. If this• If more room is needed to respond to any line, attach aperson is someone other than an individual authorized to signschedule providing the applicable information and label it withForm 3115, you must attach Form 2848, Power of Attorney andthe line number.Declaration of Representative.• Attachments submitted with Form 3115 must show the filer’s

Form 2848, Power of Attorney and Declaration name and identification number. Also, indicate that theinformation is an attachment to Form 3115.of Representative• Report amounts in U.S. dollars, and if applicable, in theAuthorization to represent the filer before the IRS, to receive afunctional currency with a statement of exchange rates used.copy of the requested letter ruling, or to perform any other

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published guidance specifically states that one or more scopelimitation(s) do not apply to the requested change.Part I—Information For Automatic

If any of the scope limitations apply to the requested changeChange Requestin method of accounting and apply to the applicant, automaticconsent is not available to the applicant for the requestedAutomatic Change Request Scope Limitationsaccounting method change. However, the applicant may beAn applicant is not eligible to use the automatic change request eligible to request its change under the advance consentprocedures of Rev. Proc. 2011-14 (either in the Appendix or request procedures. See Part III—Information For Advanceincluded by reference in other published guidance) if any of theConsent Request, later in these instructions to determine iffollowing six scope limitations (section 4.02 of Rev. Proc. these procedures apply to the applicant.2011-14) apply, unless the applicable section of the Appendix

of Rev. Proc. 2011-14 or other published guidance states thatPart II—Information For All Requeststhe particular scope limitation does not apply to the applicant’s

requested change. The scope limitations (unless waived) apply Line 3. Ordinarily, the IRS will not consent to a request for aat the time the copy of Form 3115 would be filed with the IRS change in method of accounting for the applicant’s final taxNational Office or Ogden, UT. year. If the applicant ceases to engage in the trade or business1. The applicant is under examination, except as provided in to which the desired change in accounting method relates or

section 4.02(1) of Rev. Proc. 2011-14. If the applicant is a CFC terminates its existence in the year of change, the applicant isor 10/50 corporation that is not required to file a federal income ordinarily not eligible to make the change under automatictax return, the applicant is under examination if any of its change request procedures unless the applicable section of thecontrolling domestic shareholders is under examination for a Appendix of Rev. Proc. 2011-14 or other applicable publishedtaxable year(s) in which it was a U.S. shareholder of the CFC or guidance states that section 4.02(5) of Rev. Proc. 2011-14 does10/50 corporation, except as provided in section 4.02(1) of Rev. not apply to the requested change in method of accounting. IfProc. 2011-14. the change is requested under the advance consent

2. The applicant is (or was formerly) a member of a procedures, the IRS National Office will consider the reasonsconsolidated group that is under examination for a tax year(s) for the change in the applicant’s final year (see Part III, line 21)the applicant was a member of the group. For more information, in determining whether to approve the requested change.see section 4.02(2) of Rev. Proc. 2011-14.

Note: For lines 4a, 4b, 4c, 5a, 5c, and 6, the reference to3. The applicant is an entity treated as a partnership or S“applicant” includes the applicant and any present or formercorporation and the accounting method to be changed is anconsolidated group in which the applicant was a member duringissue under consideration in an examination with respect to athe applicable tax year(s). A reference to “applicable tax years”partner, member, or shareholder of the applicant. For moreincludes any tax years for which the applicant’s present orinformation, see section 4.02(3) of Rev. Proc. 2011-14.former consolidated group is under examination, before an4. The applicant engages in a transaction to which sectionAppeals office, and/or before a federal court if the applicant was381(a) applies within the proposed tax year of change. Fora member of the group in those tax years. For each of themore information, including exceptions to this limitation, seeapplicable lines (4a, 4b, 4c, 5a, 5c, and/or 6), attach to Formsection 4.02(4) of Rev. Proc. 2011-14.3115 a list of the beginning and ending dates of the tax year(s)5. The applicant is in the final tax year of its trade orthat the applicant (including its present and former consolidatedbusiness as described in sections 4.02(5) and 5.04(3)(c) ofgroup) is under examination, before an Appeals office, and/orRev. Proc. 2011-14.before a Federal court. If the method of accounting the6. The applicant made or applied to make a change inapplicant is requesting to change is an issue either undermethod of accounting for the same item (or for its overallconsideration, placed in suspense, or pending for any tax yearmethod) within the last 5 tax years, including the year ofunder examination, or if the method of accounting the applicantchange. For more information, see section 4.02(6) and 4.02(7)is requesting to change is an issue under consideration by anof Rev. Proc. 2011-14.Appeals office or by a Federal court, indicate the applicable taxyear(s).Line 1. Enter the designated automatic accounting method

change number on line 1(a). These numbers may be found in Line 4a. The applicant is under examination if it has a federalthe List of Automatic Accounting Method Changes, or in income tax return under examination (including while thesubsequently published guidance. Also see the Appendix of taxpayer has a refund or credit under review by the JointRev. Proc. 2011-14. In general, enter a number for only one Committee on Taxation, and while the taxpayer participates inchange. However, the numbers for two or more changes may the Compliance Assurance Process) on the date the Form 3115be entered on line 1(a) if specifically permitted in applicable is (or would be) filed. For more information, see sections 3.07published guidance. See section 6.02(1)(b) of Rev. Proc. and 4.02(2) of Rev. Proc. 97-27, as modified by Rev. Proc.2011-14. 2002-19, Rev. Proc. 2009-39, and Rev. Proc. 2011-14; orsections 3.08 and 4.02(1) of Rev. Proc. 2011-14, as applicable.Do not enter an Internal Revenue Code section on line

1(a). Enter the applicable change number listed in the Line 4b. The applicant’s method of accounting is an issueinstructions or other applicable published guidance.CAUTION

!under consideration if the examining agent has given theapplicant (or filer) written notification specifically citing theIf the accounting method change is not included in the List of treatment of the item as an issue under consideration (or for aAutomatic Accounting Method Changes or assigned a number CFC or 10/50 corporation, if any controlling domesticin the published guidance providing the automatic accounting shareholder receives notification that the treatment of amethod change, check the box for line 1(b) and identify the distribution or deemed distribution from the foreign corporation,revenue procedure or other published guidance under which or the amount of its earnings and profits or foreign taxesthe automatic accounting method change is being requested. deemed paid is an issue under consideration). For further

Line 2. Review the applicable accounting method change details, see section 3.08 of Rev. Proc. 97-27, as modified bysection in the Appendix of Rev. Proc. 2011-14 (rather than Rev. Rev. Proc. 2009-39, and Rev. Proc. 2011-14 , or section 3.09 ofProc. 2008–52 as indicated on line 2 of Form 3115), or the Rev. Proc. 2011-14, as applicable. The applicant’s method ofprocedures in other published guidance, if applicable, to accounting is an issue placed in suspense if the examiningdetermine whether the scope limitations of section 4.02 of Rev. agent has given the applicant (or filer) written notification thatProc. 2011-14, apply to the specific change in accounting the issue is placed in suspense. Answering Line 4b satisfies themethod requested. In general, the scope limitations of section requirement in section 6.01(2)(b) or 6.01(3)(b) of Rev. Proc.4.02 of Rev. Proc. 2011-14 apply to the requested change 97-27, as modified by Rev. Proc. 2009-39, if applicable, tounless the Appendix of Rev. Proc. 2011-14 or other applicable attach a separate statement.

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Line 4c. The applicant’s method of accounting is an issue 2002-19, Rev. Proc. 2009-39, and Rev. Proc. 2011-14 orpending if the IRS has given the applicant (or filer, or in the sections 6.04 and 6.05 of Rev. Proc. 2011-14, as applicable.case of a CFC or 10/50 corporation, any controlling domestic Line 6. The information requested on line 6 may be providedshareholders of a CFC or 10/50 corporation) written notification in an attachment that includes the information requested on lineindicating that an adjustment is being made or will be proposed 4f and/or line 5a, as applicable.with respect to the applicant’s method of accounting for the tax

Line 7. If yes is answered to the question on line 7, attach anyear(s) under examination. See section 6.03(6) of Rev. Proc.explanation. The applicant may not be eligible to make the2011-14. Attach a copy of this written notification to Form 3115.change (for example, if the issue is under consideration for aFor further details, see section 6.01(5) of Rev. Proc. 97-27, astax year under examination). If eligible to make the change, themodified by Rev. Proc. 2002-19, and Rev. Proc. 2009-39, orapplicant may not receive audit protection with the change (forsection 6.03(6) of Rev. Proc. 2011-14, as applicable.example, if the issue is under consideration for a tax yearLine 4d. A filer may request to change a method of accounting before either an Appeals office or a Federal court). Seefor an applicant that is under examination if the director sections 4.02(6), 6.01, 6.02, and 6.03 of Rev. Proc. 97-27, asconsents to the filing of Form 3115. (See section 1.01(3) of modified by Rev. Proc. 2002-19 and Rev. Proc. 2011-14, orRev. Proc. 2012-1 for the definition of director.) The director will sections 6.03, 6.04 and 6.05 of Rev. Proc. 2011-14, asconsent to the filing of Form 3115 unless, in the opinion of the applicable.director, the method of accounting to be changed wouldLine 8. A taxpayer does not receive audit protection underordinarily be included as an item of adjustment in the year(s) forcertain circumstances described in sections 6.01(5), 6.02, 6.03,which the applicant is under examination. Submit a request foror 9.02 of Rev. Proc. 97-27, as modified by Rev. Proc. 2002-19,the consent of the director to the examining agent. If theRev. Proc. 2009-39, Rev. Proc. 2011-14 or in sectionsdirector consents to the filing of Form 3115, attach the consent4.02(7)(b), 6.03(5), 6.03(6), 6.04, 6.05, or 7.02 of Rev. Proc.to the Form 3115 filed with the IRS National Office or the2011-14. If filing under the automatic change requestOgden, UT office. Also, submit the director copy of Form 3115procedures, also review the applicable accounting methodto the examining agent no later than the date the Form 3115 ischange section in the Appendix of Rev. Proc. 2011-14, or thefiled with the IRS National Office or the Ogden, UT office. Whenprocedures in other IRS published guidance, if applicable, tofiling under the automatic change request procedures, attach todetermine if the applicable section of the Appendix of Rev.the original Form 3115 (which is attached to the filer’s incomeProc. 2011-14 or other available IRS published guidance statestax return) a written statement certifying that (a) the writtenthat the applicant does not receive audit protection with theconsent was obtained from the director and (b) the applicant willrequested change. If “Yes” is answered to the question on lineretain a copy of the consent for inspection by the IRS. For8, attach an explanation, including the applicable provision offurther details, see section 6.01(4) of Rev. Proc. 97-27, asRev. Proc. 97-27, as modified by Rev. Proc. 2002-19, Rev.modified by Rev. Proc. 2009-39, or section 6.03(4) of Rev.Proc. 2009-39 and Rev. Proc. 2011-14, or Rev. Proc. 2011-14,Proc. 2011-14, as applicable.that prevents audit protection.Line 4e. The following exceptions apply to the underLine 9. For further details, see section 9.03(6)(a) of Rev. Proc.examination scope limitations:2012-1, and either section 8.05 of Rev. Proc. 97-27 or sections• 90-day window period. A Form 3115 may be filed under4.02(6) and 4.02(7) of Rev. Proc. 2011-14, as applicable.Rev. Proc. 97-27 or Rev. Proc. 2011-14 for an applicant under

examination during the first 90 days of any tax year if the Line 10. For further details, see section 9.03(6)(b) of Rev.applicant has been under examination for at least 12 Proc. 2012-1.consecutive months as of the first day of the tax year. The

Line 12. A special method of accounting for an item is a90-day window period does not apply if the method themethod of accounting, other than the cash method or anapplicant is requesting to change is an issue underaccrual method, expressly permitted by the Code, regulations,consideration or placed in suspense by the examining agent.or guidance published in the IRB that deviates from the rules ofFor further details, including special rules for CFCs and 10/50sections 451 and 461 (and the regulations thereunder) that iscorporations, see section 6.01(2) of Rev. Proc. 97-27, asapplicable to the taxpayer’s overall method of accountingmodified by Rev. Proc. 2009-39, or section 6.03(2) of Rev.(proposed overall method if being changed). For example, theProc. 2011-14, as applicable.installment method of accounting under section 453 is a special• 120-day window period. A Form 3115 may be filed undermethod of accounting. See section 14.01(3)(e) of the AppendixRev. Proc. 97-27 or Rev. Proc. 2011-14 for an applicant underof Rev. Proc. 2011-14 for additional examples of specialexamination during the 120-day period following the date anmethods.examination ends regardless of whether a subsequent

examination has commenced. For the definition of when an If the applicant prepared a Schedule M-3 with its last filed taxexamination ends, see section 3.07 of Rev. Proc. 97-27, as return or expects to file a Schedule M-3 with its next tax return,modified by Rev. Proc. 2009-39 and Rev. Proc. 2011-14, or please state whether applicant’s proposed change in method ofsection 3.08 of Rev. Proc. 2011-14, as applicable. The 120-day accounting for federal income tax purposes is related to thewindow period does not apply if the method the applicant is applicant’s adoption of the International Financial Reportingrequesting to change is an issue under consideration or placed Standards (“IFRS”) for financial statement purposes. (Note:in suspense by the examining agent. Enter the ending date of There is a box on Schedule M-3, Part I, line 4, to indicate thethe examination that qualifies the applicant to file under the accounting standard used for financial reporting.)120-day window. For further details, including special rules for Line 13. For each applicant, including each member of aCFCs and 10/50 corporations, see section 6.01(3) of Rev. Proc. consolidated group, each separate and distinct trade or97-27, as modified by Rev. Proc. 2009-39, or sections 6.03(3) business of each member of a consolidated group or otherand 3.08(1)(c) of Rev. Proc. 2011-14, as applicable. entity (even if the change is for all of a member’s or otherLine 5a. If the applicant has any federal income tax return entity’s trades or businesses), and each eligible CFC or 10/50before an Appeals office and/or a Federal court, refer to corporation filing a single Form 3115 requesting the identicalsections 6.02 and 6.03 of Rev. Proc. 97-27, as modified by Rev. accounting method change, attach (i) a schedule describing itsProc. 2002-19, Rev. Proc. 2009-39 and Rev. Proc. 2011-14, or trade(s) or business(es) for each separate and distinct trade orsections 6.04 and 6.05 of Rev. Proc. 2011-14, as applicable. business, including any QSub or single-member LLC, and (ii)Line 5c. Except as otherwise provided in IRS published the Principal Business Activity code. For guidance on what is aguidance, an applicant that is requesting to change a method of separate and distinct trade or business, see Regulationsaccounting that is an issue under consideration by an Appeals section 1.446-1(d). For each trade or business, use the mostoffice and/or a Federal court does not receive audit protection specific Principal Business Activity code listed in thefor the requested change. For further details, see sections 6.02 instructions for the applicant’s federal tax return (or the filer’sand 6.03 of Rev. Proc. 97-27, as modified by Rev. Proc. federal tax return, if applicable).

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Line 14. Insurance companies must also state whether the • The filer is permitted to file a single Form 3115 for multipleproposed method of accounting will be used for annual applicants. See Who Must File, earlier. The filer must pay astatement accounting purposes. separate user fee for each applicant. For each Form 3115

requesting an identical change in method of accounting, the filerLine 16. For details on requesting and scheduling apays the regular user fee in section (A)(3)(b) (or the reducedconference, see sections 9.04(4) and 10 of Rev. Proc. 2012-1.user fee in section (A)(4), if applicable) of Appendix A of Rev.Proc. 2012-1 for the first applicant and the lesser user fee inPart III—Information For Advance section (A)(5)(b) of Appendix A of Rev. Proc. 2012-1 for eachadditional applicant.Consent Request

Example 1. The filer is the common parent of aAdvance Consent Request Scope Limitations consolidated group of corporations. The parent is filing a FormAn applicant may not use the advance consent request 3115 on behalf of itself and 3 other members of theprocedures if any of the following four scope limitations apply at consolidated group. The parent is engaged in one trade orthe time the Form 3115 would be filed with the IRS National business. The 3 other included member corporations areOffice. See Rev. Proc. 97-27, as modified by Rev. Proc. engaged in one trade or business each. All the trades or2002-19, Rev. Proc. 2009-39, and Rev. Proc. 2011-14. businesses are requesting an identical change in method of

accounting. There are 4 applicants for the Form 3115. The filer1. The change in accounting method is required to be mademust submit the regular user fee in section (A)(3)(b) (or theaccording to a published automatic change procedure, such asreduced fee in section (A)(4), if applicable) of Appendix A ofRev. Proc. 2011-14. For more information, see section 4.02(1)Rev. Proc. 2012-1 for the first applicant (that is, the commonof Rev. Proc. 97-27.parent) and the lesser user fee in section (A)(5)(b) of Appendix2. The applicant is under examination, except as provided inA of Rev. Proc. 2012-1 for each of the other 3 applicants (thatsection 4.02(2) of Rev. Proc. 97-27, as modified by Rev. Proc.is, the 3 other members of the consolidated group).2002-19, Rev. Proc. 2009-39, and Rev. Proc. 2011-14.

3. The applicant is (or was formerly) a member of a Example 2. The filer is the common parent of aconsolidated group that is under examination, or before an consolidated group of corporations. The parent is filing a FormAppeals office, or before a Federal court for the tax year(s) the 3115 on behalf of itself and 3 other members of theapplicant was a member of the group. For more information, consolidated group. The parent is engaged in one trade orsee section 4.02(5) of Rev. Proc. 97-27, as modified by Rev. business. Each of the 3 other included member corporationsProc. 2009-39. are engaged in two trades or businesses. All of the trades or

4. In the case of a partnership or S corporation, the businesses are requesting an identical change in method ofaccounting method the applicant is requesting to change is an accounting. There are 7 applicants for the Form 3115. The filerissue under consideration in an examination, or by an Appeals must submit the regular user fee in section (A)(3)(b) (or theoffice, or before a Federal court with respect to a partner, reduced fee in section (A)(4), if applicable) of Appendix A ofmember, or shareholder of the applicant. For more information, Rev. Proc. 2012-1 for the first applicant (that is, the parent’ssee section 4.02(6) of Rev. Proc. 97-27, as modified by Rev. trade or business) and the lesser user fee in section (A)(5)(b) ofProc. 2009-39. Appendix A of Rev. Proc. 2012-1 for each of the 6 applicants

(that is the other 6 trades or businesses of the 3 otherLine 18. If the requested change is covered by an automatic consolidated group members).change request procedure, and that procedure applies to the Example 3. The filer is the common parent of aapplicant for the requested year of change, the applicant is not consolidated group of corporations. Another member of theeligible to file an advance consent request. If the requested consolidated group is the controlling domestic shareholder of achange is covered by an automatic change request procedure, CFC that does not engage in a trade or business within theattach an explanation describing why the applicant is eligible to United States. The CFC has 4 separate and distinct trades orfile a request under advance consent request procedures. businesses, all requesting an identical change in method ofLine 19. For further details on what is to be included in the accounting. The filer is the common parent of the consolidatedattachment, see sections 9.03(1) (facts and other information), group. There are 4 applicants for the Form 3115. The filer must9.03(4) (analysis of material facts), 7.01(8) and 9.03(1) submit the regular user fee in section (A)(3)(b) (or the reduced(statement of supporting authorities), 9.03(2) (statement of fee in section (A)(4), if applicable) of Appendix A of Rev. Proc.contrary authorities), and 9.03(7) (statement identifying pending 2012-1 for the first applicant (that is, the first trade or businesslegislation) of Rev. Proc. 2012-1. of the CFC) and the lesser user fee in section (A)(5)(b) of

Appendix A of Rev. Proc. 2012-1 for each of the 3 otherLine 20. Attach true copies of all contracts, agreements, andapplicants (that is, the other 3 trades or businesses of theother documents directly related to the proposed change inCFC). Note. Because the filer is not changing its accountingmethod of accounting. See section 9.03(3) of Rev. Proc.method, it does not pay a fee on the account of itself.2012-1.

For information on user fees for tax-exempt organizations,Line 21. For further details on what is to be included in thesee Rev. Proc. 2012-8, 2012-1 I.R.B. 235 (or its successor).attachment, see section 7.01(1)(d) and 9.03(1) of Rev. Proc.

2012-1. The user fee (check or money order payable to the InternalRevenue Service) must be attached to any Form 3115 filedLine 23. Taxpayers filing under the advance consent requestunder Rev. Proc. 97-27 that is filed with the IRS National Office.procedures must pay a user fee for each Form 3115 and for

each applicant, if applicable. See section 15 and Appendix A ofPart IV—Section 481(a) AdjustmentRev. Proc. 2012-1.

Note: Taxpayers filing under an automatic change request Line 24. Ordinarily, an adjustment under section 481(a) isprocedure do not pay a user fee. required for changes in method of accounting. However, for

certain changes in method of accounting, the taxpayer mustThe applicable user fee must accompany each Form 3115make the change on a cut-off basis. In those cases, there is nofiled with the National Office under Rev. Proc. 97-27. The usersection 481(a) adjustment.fee for a Form 3115 is the regular user fee provided in section

(A)(3)(b) of Appendix A of Rev. Proc. 2012-1, unless one (or If the accounting method change is an automatic accountingboth) of the following exceptions apply: method change in functional currency under section 985 (see• The filer qualifies for a reduced user fee provided in section section 29.01 of the Appendix to Rev. Proc. 2011-14), the(A)(4) of Appendix A of Rev. Proc. 2012-1 because the filer has adjustments required under Regulations section 1.985-5 mustgross income less than the specified amount. For the definition be made on the last day of the taxable year ending before theof gross income, see sections (B)(2), (3), and (4) in Appendix A year of change. Any gain or loss that is not required to beof Rev. Proc. 2012-1. recognized under Regulations section 1.985-5 is not subject to

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section 481. Attach a schedule showing the adjustment Schedule A—Change in Overall Methodrequired under Regulations section 1.985-5. The schedule of Accountingshould include the amount of the adjustment required pursuantto Regulations section 1.985-5, a summary of the computation

Part I—Change in Overall Methodof such adjustment, and an explanation of any otheradjustments required by Regulations section 1.985-5. All applicants filing to change their overall method of accounting

must complete Schedule A, Part I, including applicants filingLine 25. In computing the net section 481(a) adjustment, a under designated automatic accounting method changetaxpayer must take into account all relevant accounts. For some numbers 32, 33, 34, 122, 123, 126, 127, and 128 in the List ofchanges (for example, a change that effects multiple accounts), Automatic Accounting Method Changes.the section 481(a) adjustment is a net section 481(a)

Lines 1a through 1g. Enter the amounts requested on linesadjustment. See example 2, below, and the example in1a through 1g, even though the calculation of some amountsSchedule A, Part 1, line 1h, later.may not have been required in determining taxable income dueto the applicant’s present method of accounting.Attach a schedule showing the (net) section 481(a)

adjustment for each change in method of accounting for eachNote: Do not include amounts that are not attributable to theapplicant included in the Form 3115. Include a summary of how change in method of accounting, such as amounts that correctthe (net) section 481(a) adjustment was computed and an a math or posting error or errors in calculating tax liability. Inexplanation of the methodology used to determine it. The addition, for a bank changing to an overall cash/hybrid methodsummary of computation and explanation must be sufficient to of accounting, do not include any amounts attributable to ademonstrate that the (net) section 481(a) adjustment is special method of accounting (as described in sectioncomputed correctly. If the applicant is a CFC or 10/50 14.12(2)(b) of the Appendix of Rev. Proc. 2011-14—automaticcorporation, or a trade or business of a CFC or 10/50 change number 127).corporation, and if its functional currency is not the U.S. dollar,

state the (net) section 481(a) adjustment in that functional Line 1b. Enter amounts received or reported as income in acurrency. This schedule may be combined with the information prior year that were not earned as of the beginning of the yearrequested on the fourth line on page 1 (list of applicants and of change. For example, an advance payment received in atheir identification numbers) and on line 23 (user fee). prior year for goods that were not delivered by the beginning of

the year of change may be reported upon delivery if theExample 1. Under its present method, XYZ Corporation is taxpayer qualifies under Regulations section 1.451-5. If anydeducting certain costs that are required to be capitalized into amounts entered on line 1b are for advance payments,inventory under section 263A. XYZ Corporation is proposing to complete Schedule B.change its method of accounting to properly capitalize suchcosts. The computation of the section 481(a) adjustment with Line 1h. Enter the net amount, which is the net section 481(a)respect to the change in method of accounting is demonstrated adjustment, on line 1h. Also, enter the net section 481(a)as follows: adjustment on page 3, Part IV, line 25.

The following example illustrates how an applicant calculatesBeginning inventory for year of change underproposed method . . . . . . . . . . . . . . . . . . . . . . . $120,000 the section 481(a) adjustment when changing to an accrual

Beginning inventory for year of change under method, a nonaccrual-experience method, and the recurringpresent method . . . . . . . . . . . . . . . . . . . . . . . . 100,000 item exception.

Section 481(a) adjustment (positive) . . . . . . . . . . . . $ 20,000Example. ABC Corporation, a calendar year taxpayer usingthe cash method of accounting, has the following items ofExample 2. WXY Corporation, a calendar year taxpayer, is unreported income and expense on December 31, 2010.a producer and capitalizes costs that are required to be

capitalized into inventory under section 263A. Each February, Accrued income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $250,000WXY Corporation pays a salary bonus to each employee who Uncollectible amounts based onremains in its employment as of January 31 for the employee’s the nonaccrual-experience method . . . . . . . . . . . . . 50,000services provided in the prior calendar year. Under its present Accrued amounts properly method, WXY Corporation treats these salary bonuses as deductible (economic performance has occurred) . . . . 75,000incurred in the tax year the employee provides the related Expenses eligible for recurring item services. For 2011, WXY Corporation proposes to change its exception . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000method of accounting to treat salary bonuses as incurred in thetax year in which all events have occurred that establish the fact ABC Corporation changes to an overall accrual method, aof the liability to pay the salary bonuses and the amount of the nonaccrual-experience method, and the recurring itemliability can be determined with reasonable accuracy, pursuant exception for calendar year 2011. The section 481(a)to section 19.01(2) of the Appendix of Rev. Proc. 2011-14. The adjustment is calculated as of January 1, 2011, as follows.computation of WXY Corporation’s net section 481(a)adjustment for the change in method of accounting for salary Accrued income . . . . . . . . . . . . . . . . . . . . . . . $250,000bonuses is demonstrated as follows:

Less:

Salary bonuses treated as incurred under the Uncollectible amount . . . . . . . . . . . . . . . . . . . 50,000present method, but not incurred under the

Net income accrued but not received . . . . . . . . . $200,000proposed method . . . . . . . . . . . . . . . . . . . . . $40,000Beginning inventory as of Jan. 1, 2011, with Less:

capitalized salary bonuses computed under the Accrued expenses . . . . . . . . . . . . . . . . . . . . . 75,000present method . . . . . . . . . . . . . . . . . . . . . . $100,000

Beginning inventory as of Jan. 1, 2011, with Expenses deducted as recurring item . . . . . . . . 5,000capitalized salary bonuses, computed under the

Total expenses accrued but not paid . . . . . . . . . 80,000proposed method . . . . . . . . . . . . . . . . . . . . . . . 92,000Decrease in beginning inventory as of Jan. 1, 2011 (8,000) Section 481(a) adjustment . . . . . . . . . . . . . . . $120,000Net section 481(a) adjustment (positive) . . . . . . . $32,000

Line 2. If an applicant is requesting to use the recurring itemLine 26. See section 7.03(1) of Rev. Proc. 97-27, as modified exception (section 461(h)(3)), the section 481(a) adjustmentby Rev. Proc. 2002-19, or section 5.04(3)(a) of Rev. Proc. must include the amount of the additional deduction that results2011-14, as applicable. from using the recurring item exception.

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Part II—Change to the Cash Method For Schedule D—Change in the Treatment ofAdvance Consent Request Long-Term Contracts Under Section 460,Limits on cash method use. Except as provided below, C Inventories, or Other Section 263Acorporations and partnerships with a C corporation as a partnermay not use the cash method of accounting. Tax shelters, also, Assetsare precluded from using the cash method. For this purpose, atrust subject to tax on unrelated business income under section Part I—Change in Reporting Income 511(b) is treated as a C corporation with respect to its unrelated From Long-Term Contractstrade or business activities.

Line 2a. Under section 460(f), the term long-term contractThe limit on the use of the cash method under section 448 means any contract for the manufacture, building, installation,

does not apply to: or construction of property that is not completed in the tax yearin which it is entered into. However, a manufacturing contract1. Farming businesses as defined in section 448(d)(1).will not qualify as long-term unless the contract involves the2. Qualified personal service corporations as defined inmanufacture of (a) a unique item not normally included insection 448(d)(2).finished goods inventory or (b) any item that normally requires3. C corporations and partnerships with a C corporation as more than 12 calendar months to complete.a partner if the corporation or partnership has gross receipts of

Generally, long-term contracts that do not meet the$5 million or less. See section 448(b)(3) and (c) to determine ifexceptions under section 460(e) must be accounted for usingthe applicant qualifies for this exception.the percentage of completion method. See section 460 and therelated regulations.For farming corporations and partnerships with a C

corporation as a partner, see section 447 for limits on the use of Line 2b. To qualify for the contract exceptions under sectionthe cash method. 460(e), the contract must be:

1. A home construction contract as defined in sectionUse of the cash method is also limited under Regulations460(e)(6)(A), orsections 1.471-1 and 1.446-1(c)(2)(i) if the applicant purchases,

2. Any other construction contract entered into by theproduces, or sells merchandise that is an income-producingapplicant if, at the time the contract is entered into, it isfactor in its business. However, for exceptions to this limitation,expected to be completed within 2 years and the applicant’ssee section 14.03 in the Appendix of Rev. Proc. 2011-14.average annual gross receipts determined under section460(e)(2) for the 3-year period preceding the tax year theSchedule B—Change to the Deferral contract was entered into did not exceed $10 million.

Method for Advance Payments Line 4b. Under the simplified cost-to-cost method, only certainIn general, advance payments must be included in gross costs are used in determining both (a) costs allocated to theincome in the tax year of receipt for federal income tax contract and incurred before the close of the tax year andpurposes. However, an applicant may be entitled to defer the (b) estimated contract costs. These costs are: (1) direct materialinclusion in income of certain advance payments, as defined in costs; (2) direct labor costs; and (3) allowable deductions forsection 4.01 of Rev. Proc. 2004-34, 2004-1 C.B. 991, or in depreciation, amortization, and cost recovery allowances onRegulations section 1.451-5(a)(1). equipment and facilities directly used to construct or produce

the subject matter of the long-term contract. See RegulationsLine 1. Rev. Proc. 2004-34, as modified by Rev. Proc.section 1.460-5(c).2011-18, 2011-5 I.R.B. 443 allows applicants using an accrual

method, in certain circumstances, to defer the inclusion in Part II—Change in Valuing Inventories Includingincome of advance payments to the next tax year. Applicants Cost Allocation Changesrequesting to change to the Deferral Method for allocableIf the applicant is currently using a LIFO inventory method orpayments described in section 5.02(4)(a) of Rev. Proc. 2004-34submethod and is changing to another LIFO inventory method(other than allocable payments described in section 5.02(4)(c)or submethod, Schedule D, Part II is not applicable. Useof Rev. Proc. 2004-34) or for payments for which a methodSchedule C, Changes Within the LIFO Inventory Method.under section 5.02(3)(b)(i) or (iii) of Rev. Proc. 2004-34 applies,

must file under the advance consent procedures of Rev. Proc. Line 3. If an applicant is subject to, but not in compliance with,97-27. All other applicants generally must file under the section 263A, generally on the same Form 3115 the applicantautomatic change procedures of Rev. Proc. 2011-14 (rather must first comply with section 263A before changing anthan Rev. Proc. 2008-52, as indicated on line 1b of Form 3115). inventory valuation method. The applicant must complete

Schedule D, Part III, Method of Cost Allocation. For exceptions,Line 2. Regulations section 1.451-5 allows applicants using an see Regulations section 1.263A-7(b)(2).accrual method, in certain circumstances, to defer the inclusionLine 5a. If the applicant properly elected the LIFO inventoryin income of advance payments for goods or items inmethod but is unable to furnish a copy of Form(s) 970,accordance with the applicant’s financial reports.Application to Use a LIFO Inventory Method, attach thefollowing statement to Form 3115:Schedule C—Changes Within the LIFO

“I certify that to the best of my knowledge and belief (nameInventory Method of applicant) properly elected the LIFO inventory method byUse this schedule to request a change from one LIFO inventory filing Form 970 with its return for the tax year(s) ended (insertmethod or submethod to another LIFO inventory method or date(s)) and otherwise complied with the provisions of sectionsubmethod. All applicants changing within the LIFO inventory 472(d) and Regulations section 1.472-3.”method or submethods must complete Part I. Complete Part II Line 5c. Attach the two statements required by sectiononly if applicable. 22.01(5) in the Appendix of Rev. Proc. 2011-14 (rather than

Rev. Proc. 2008-52, as indicated on line 5c of Form 3115).Part I—General LIFO InformationPart III—Method of Cost AllocationLine 6. Applicants changing to the IPIC method must use this

method for all LIFO inventories. This includes applicants Applicants requesting to change their method of accounting forrequesting designated automatic accounting method change any property (produced or acquired for resale) subject tonumbers 61 or 62 in the List of Automatic Accounting Method section 263A or any long-term contracts as described in sectionChanges, later. 460 must complete this schedule.

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If the change is for noninventory property that is subject to 6. To change a useful life under section 167 (except for asection 263A, attach a detailed description of the types of change to or from a useful life, recovery period, or amortizationproperty involved. period that is specifically assigned by the Code, the regulations,

or other published guidance).There are several methods available for allocating andcapitalizing costs under section 263A, and for allocating and,where appropriate, capitalizing costs properly allocable tolong-term contracts. A change to or from any of these methods List of Automatic Accounting Methodis a change in accounting method that requires IRS consent. ChangesUsing the applicable regulations and notice listed below, the

Listed below are automatic accounting method changesapplicant should verify which methods are presently being usedproviding for the filing of Form 3115. This list includesand the proposed methods that will be used before completingregulatory automatic changes, changes provided for in theSchedule D, Part III. These methods are as follows:Appendix of Rev. Proc. 2011-14, and automatic changes

1. Allocating Direct and Indirect Costs provided for in other guidance. These automatic changes maybe modified or supplemented with additional automatic changes• Specific identification method—Regulations sectionsby subsequently published guidance.1.263A-1(f)(2) and 1.460-5.

• Burden rate method—Regulations sections 1.263A-1(f)(3)(i) The list provides a brief description of the automatic changesand 1.460-5. in method of accounting made using Form 3115. A • Standard cost method—Regulations sections filer/applicant may not rely on the list or the descriptions of1.263A-1(f)(3)(ii) and 1.460-5. accounting method changes in the list as authority for making• Any other reasonable allocation method—Regulations an accounting method change. A filer/applicant that is within thesections 1.263A-1(f)(4) and 1.460-5. scope of, and complies with, all the applicable provisions of the

published guidance that authorizes each listed change may rely2. Allocating Mixed Service Costs on the applicable published guidance as authority for its• Direct reallocation method—Regulations section automatic accounting method change. If any information in the1.263A-1(g)(4)(iii)(A). list conflicts with published guidance, the published guidance• Step-allocation method—Regulations section applies. Each automatic method change described in the1.263A-1(g)(4)(iii)(B). Appendix of Rev. Proc. 2011-14, as modified, contains a• Simplified service cost method: contact person you may call if you need additional information

concerning the change (not a toll-free call).Using the labor-based allocation ratio—Regulations section1.263A-1(h)(4). Each item in the list below:Using the production cost allocation ratio—Regulations • Designates an automatic accounting method change numbersection 1.263A-1(h)(5). for each change for entry on line 1a of Form 3115.

• Any other reasonable allocation method—Regulations • Briefly describes the accounting method change and itssection 1.263A-1(f)(4). primary Code section(s).

• Indicates in some cases which schedules of Form 3115 to3. Capitalizing Additional Section 263A Costs complete.• Simplified production method: • Provides a reference to the basic published guidance (for

example, revenue procedure) that provides for the automaticWithout historic absorption ratio election—Regulationschange, which filers should review prior to completing Part I,section 1.263A-2(b)(3).Information For Automatic Change Request, on page 1 of With historic absorption ratio election—Regulations sectionForm 3115.1.263A-2(b)(4).

• Simplified resale method: 1. Commodity Credit Corporation loans (section77)— for loans received from the Commodity CreditWithout historic absorption ratio election—RegulationsCorporation, from including the loan amount in gross incomesection 1.263A-3(d)(3).for the tax year in which the loan is received to treating the loanWith historic absorption ratio election—Regulations sectionamount as a loan. See section 2.01 in the Appendix of Rev.1.263A-3(d)(4).Proc. 2011-14.• U.S. ratio method—Notice 88-104, 1988-2 C.B. 443.

2. Lawyers handling cases on a contingent fee basis• Any other reasonable allocation method—Regulations(section 162)—from treating advances of money to theirsection 1.263A-1(f)(4) (including the methods listed aboveclients for litigation costs as deductible business expenses tounder Allocating Direct and Indirect Costs).treating those advances as loans. See section 3.01 in theAppendix of Rev. Proc. 2011-14.Schedule E—Change in Depreciation or 3. ISO 9000 costs (section 162)—to treating the costs as

Amortization deductible, except to the extent they result in the creation oracquisition of an asset having a useful life substantially beyondAll applicants requesting to change their method of depreciationthe tax year. See section 3.02 in the Appendix of Rev. Proc.or amortization must complete Schedule E of Form 3115.2011-14.Applicants changing their method of accounting for depreciation

4. Restaurant smallwares costs (section 162)—to theor amortization under the automatic change request proceduressmallwares method described in Rev. Proc. 2002-12, 2002-1should see the depreciation changes in the List of AutomaticC.B. 374 (that is, as materials and supplies that are notAccounting Method Changes below.incidental under Regulations section 1.162-3). See section 3.03

Do not file Form 3115: in the Appendix of Rev. Proc. 2011-14.1. To make an election under sections 167, 168, 179, 1400I, 5. Bad debts (section 166)— for an applicant other than a

1400L(b), 1400L(c), or 1400N(d), or former section 168; bank, from accounting for bad debts using a reserve or other2. To revoke an election made under one of those sections; improper method to a specific charge-off method that complies3. To make or revoke an election under section 13261(g)(2) with section 166. See section 4.01 in the Appendix of Rev.

or (3) of the Revenue Reconciliation Act of 1993 (relating to Proc. 2011-14.section 197 intangibles); 6. Bad debt conformity for banks (section 166)— for

4. To change the placed-in-service date; banks other than new banks, to the method that conforms to5. To change the salvage value (except for a change in Regulations section 1.166-2(d)(3) for the first time the bank

salvage value to zero when the salvage value is expressly makes this change, or to involuntarily revoke this method. Thistreated as zero by the Code, the regulations, or other published change does not fall under the procedures of Rev. Proc.guidance); or 2011-14. Instead, see Regulations section 1.166-2(d)(3).

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7. Depreciation or amortization (impermissible) acquired computer software), or to deductible expenses under(sections 56, 167, 168, 197, 1400I, 1400L, 1400N, and former Regulations section 1.162-11 (for leased or licensed computersection 168)—from an impermissible method to a permissible software). Complete Schedule E of Form 3115 for changesmethod for changes allowed under Regulations section relating to acquired computer software or developed computer1.446-1(e)(2)(ii)(d), and for depreciable property owned at the software if the change is to capital expenditures andbeginning of the year of change. Complete Schedule E of Form amortization. See section 9.01 in the Appendix of Rev. Proc.3115. An applicant changing its method of accounting for 2011-14.depreciation because of a change described in designated 19. Package design costs (section 263)—to theautomatic accounting method change number 10 (sale or lease capitalization method, to the design-by-design capitalizationtransactions) must file Form 3115 according to the designated and 60-month amortization method, or to the pool-of-costautomatic accounting method change number 10. See section capitalization and 48-month amortization method. See section6.01 in the Appendix of Rev. Proc. 2011-14. 10.01 in the Appendix of Rev. Proc. 2011-14.

8. Depreciation (permissible) (sections 56 and 20. Line pack gas or cushion gas costs (section 263)—to167)—from a permissible method to another permissible treating the costs as capital expenditures, the costs ofmethod listed in section 6.02 in the Appendix of Rev. Proc. recoverable amounts as not depreciable, and the costs of2011-14. Complete Schedule E of Form 3115. See section 6.02 unrecoverable amounts as depreciable. A taxpayer thatin the Appendix of Rev. Proc. 2011-14. changes its method for the costs of unrecoverable amounts

9. Obsolete. also must change to a permissible method of depreciation forthose costs. Complete Schedule E of Form 3115 for changes10. Sale, lease or financing transactions (sections 61,relating to the costs of unrecoverable amounts. See section162, 167, 168, and 1012)—from treating property as sold,10.02 in the Appendix of Rev. Proc. 2011-14.leased or, financed to another permissible method described in

section 6.03 in the Appendix of Rev. Proc. 2011-14. See 21. Removal costs (section 263)— for certain costssection 6.03 in the Appendix of Rev. Proc. 2011-14. incurred in the retirement and removal of depreciable assets, to

a method that conforms with Rev. Rul. 2000-7, 2000-1 C.B.11. Modern golf course greens (sections 167, 168, and712. See section 10.03 in the Appendix of Rev. Proc. 2011-14.former section 168)—either to capitalization of land

preparation costs undertaken in the construction of modern golf 22. Certain uniform capitalization methods used bycourse greens that are closely associated with depreciable resellers and reseller-producers (section 263A)— forassets or to the addition to basis of land for earth moving costs qualifying applicants, to a qualifying method or methods.inextricably associated with the land. Complete Schedule E of Complete Schedule D, Parts II and III, of Form 3115. SeeForm 3115. See Rev. Rul. 2001-60, 2001-2 C.B. 587, and section 11.01 in the Appendix of Rev. Proc. 2011-14.section 6.04 in the Appendix of Rev. Proc. 2011-14. 23. Certain uniform capitalization methods used by

12. Original and replacement tire costs (section 168)— for producers and reseller-producers (section 263A)— forqualifying vehicles, to the original tire capitalization method qualifying applicants, to a qualifying method or methods.provided in Rev. Proc. 2002-27, 2002-1 C.B. 802. Complete Complete Schedule D, Parts II and III, of Form 3115. SeeSchedule E of Form 3115. See section 6.05 in the Appendix of section 11.02 in the Appendix of Rev. Proc. 2011-14.Rev. Proc. 2011-14. 24. Research and experimental expenditures under

13. Depreciation of gas pump canopies (sections 167, uniform capitalization methods (section 263A)—from168, and former section 168)— for depreciation of certain capitalizing research and experimental expenditures tostand-alone gasoline pump canopies and their supporting inventory to no longer capitalizing these costs to inventory.concrete footings, to classifying the gasoline pump canopies in Complete Schedule D, Part II, of Form 3115, as applicable. Seeasset class 57.1 of Rev. Proc. 87-56, 1987-2 C.B. 674, and to section 11.03 in the Appendix of Rev. Proc. 2011-14.classifying the supporting concrete footings in asset class 57.1 25. Impact fees (section 263A)— for impact fees incurred inof Rev. Proc. 87-56. Complete Schedule E of Form 3115. See connection with the new construction or expansion of asection 6.06 in the Appendix of Rev. Proc. 2011-14. residential building, to treating the costs as capital expenditures

14. Depreciation of utility assets (sections 167, 168, and allocable to the building. Complete Schedule E of Form 3115 ifformer section 168)— for depreciation of assets owned by a the building is depreciable. See section 11.04 in the Appendixutility used in general business operations, to classifying assets of Rev. Proc. 2011-14.under Rev. Proc. 87-56,1987-2 C.B. 674, to conform with Rev. 26. Related party transactions (section 267)— for losses,Rul. 2003-81, 2003-2 C.B. 126. Complete Schedule E of Form expenses, and qualified stated interest incurred in transactions3115. See section 6.07 in the Appendix of Rev. Proc. 2011-14. between related parties, to disallowing or deferring certain

15. Depreciation of cable TV fiber optics (sections 167 deductions attributable to such transactions in accordance withand 168)— for depreciation of fiber optic node and trunk line of section 267. See section 12.01 in the Appendix of Rev. Proc.a cable television distribution system, to the safe harbor 2011-14.method in Rev. Proc. 2003-63, 2003-2 C.B. 304, for classifying 27. Deferred compensation determination (sectionthe unit of property either as providing one-way communication 404)— for determining whether an item of compensation isservices or two-way communication services. Complete deferred compensation or when the item is paid, from makingSchedule E of Form 3115. See section 6.08 in the Appendix of the determination by reference to when the item is secured toRev. Proc. 2011-14. making the determination by reference to when the item is

16. Amortizable bond premium (section 171)—from actually received. See section 13.01 in the Appendix of Rev.amortizing bond premium to not amortizing the premium Proc. 2011-14.(revoking the section 171(c) election). See section 5.01 in the 28. Bonus or vacation pay deferred compensationAppendix of Rev. Proc. 2011-14. (section 404)— for bonuses that are deferred compensation,

17. Research and experimental expenditures (section from treating as deductible or capitalizable when accrued, to174)—from the capitalization method to another permissible treating as deductible or capitalizable in the year in whichmethod, from the expense method to another permissible includible in the employee’s income, and for vacation pay that ismethod, from the deferred expense method to another deferred compensation, from treating as deductible orpermissible method, or from the current period of amortization capitalizable when accrued to treating as deductible orto a different period of amortization under the deferred expense capitalizable in the year in which paid to the employee. Seemethod. See section 7.01 in the Appendix of Rev. Proc. section 13.02 in the Appendix of Rev. Proc. 2011-14.2011-14. 29. Grace period contributions (section 404)— for

18. Computer software expenditures (sections 162 and contributions made to a section 401(k) qualified cash or167)— for costs of developed, acquired, leased or licensed deferred arrangement or matching contributions under sectioncomputer software, to deductible expenses or capital 401(m), from treating contributions made after the end of theexpenditures and amortization (for developed software), to tax year but before the due date of the tax return as being oncapital expenditures and depreciation or amortization (for account of the tax year without regard to when the underlying

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compensation is earned to treating such contributions as not 2002-1 C.B. 993) made by vehicle lessees, to the method thatbeing on account of the tax year if they are attributable to excludes these payments from the applicant’s gross incomecompensation earned after the end of that tax year. See section and from the applicant’s bases in the purchased vehicles. See13.03 in the Appendix of Rev. Proc. 2011-14. section 15.04 in the Appendix of Rev. Proc. 2011-14.

30. Obsolete. 40. Exclusion for certain returned magazines,paperbacks, or records (section 458)— for an accrual31. Multi-year insurance policies for multi-year servicemethod applicant electing to exclude from gross income somewarranty contracts (section 446)— for a manufacturer,or all of the income attributable to qualified sales during the taxwholesaler, or retailer of motor vehicles or other durableyear of magazines, paperbacks, or records that are returnedconsumer goods accounting for multi-year insurance policies forbefore the close of the applicable merchandise return period formulti-year service warranty contracts, to capitalizing andthat tax year. The applicant’s Form 3115 need contain only theamortizing the costs. See section 14.02 in the Appendix of Rev.information listed in Regulations section 1.458-2(d). ThisProc. 2011-14.election does not fall under the procedures of Rev. Proc.32. Overall cash method ($1 million) (section 446)— for2011-14. Instead, see Regulations section 1.458-2.qualifying applicants changing to the overall cash method.

41. Percentage-of-completion (section 460)— for anComplete Schedule A, Part I, of Form 3115. Also, completeapplicant not required by section 460 to use theSchedule D, Parts II and III, as applicable. See section 14.03 inpercentage-of-completion method to account for its long-termthe Appendix of Rev. Proc. 2011-14.contracts, from an exempt-contract method properly applied to33. Overall cash method ($10 million) (section 446)— forthe percentage-of-completion method. Complete Schedule D,qualifying applicants changing to the overall cash method.Parts I and III, of Form 3115. See section 18.01 in the AppendixComplete Schedule A, Part I, of Form 3115. Also, completeof Rev. Proc. 2011-14.Schedule D, Parts II and III, as applicable. See section 14.03 in

42. Timing of incurring employee medical benefitsthe Appendix of Rev. Proc. 2011-14.liabilities (section 461)— for an applicant with an obligation to34. Overall accrual method (section 448)— for an applicantpay an employee’s medical expenses (including medicalrequired by section 448 to change from the cash method for itsexpenses for retirees and employees who filed claims under afirst section 448 year to an overall accrual method that does notworkers’ compensation act) that is neither insured nor paid frommeet the scope requirements of Rev. Proc. 2011-14. Completea welfare benefit fund, to treatment as a liability incurred in theSchedule A, Part I, of Form 3115. Also, complete Schedule D,tax year in which the applicant’s employee files the claim withParts II and III, as applicable. This change does not fall underthe applicant; or, if the applicant has a liability to pay a thirdthe procedures of Rev. Proc. 2011-14. Instead, see Regulationsparty for medical services to its employees, to treatment as asection 1.448-1. (See automatic method change 123 forliability as incurred in the tax year in which the services aretaxpayers within the scope of Rev. Proc. 2011-14).provided. See section 19.01(1) in the Appendix of Rev. Proc.35. Nonaccrual-experience method (section 448)— for an2011-14.applicant changing: to a safe harbor method provided in section

43. Timing of incurring real property taxes, personal1.448-2(f)(1) (the revenue-based moving average method),property taxes, state income taxes, and state franchise(f)(2) (the actual experience method), (f)(3) (the modified Blacktaxes (section 461)— for a qualifying applicant, to treatingMotor method), (f)(4) (the modified moving average method), ofthese taxes as incurred in the tax year in which the taxes are(f)(5) (the alternative nonaccrual-experience method); to apaid, or to account for these taxes under the recurring itemperiodic system; from a NAE method to a specific charge-offexception to the economic performance rules, or to revoke themethod; from a sub-method of its current NAE methodratable accrual election under section 461(c). See section 19.02provided in section 1.448-2 regarding applicable periods toin the Appendix of Rev. Proc. 2011-14.another sub-method regarding applicable periods that is

44. Timing of incurring workers’ compensation act, tort,permitted under section 1.448-2, other than a change tobreach of contract, or violation of law liabilities (sectionexclude tax years from an applicable period under section461)— for a qualifying applicant accounting for self-insured1.448-2(d)(6); from a sub-method of its current NAE methodliabilities arising under any workers’ compensation act or out ofprovided in section 1.448-2 regarding tracing of recoveries toany tort, breach of contract, or violation of law, to treating theanother sub-method regarding tracing of recoveries permittedliability as incurred in the tax year in which (a) all the eventsunder section 1.448-2(f)(2)(iii); or, to the NAE book safe harborhave occurred establishing the fact of the liability, (b) themethod described in section 5.01 of Rev. Proc. 2011-46,amount of the liability can be determined with reasonable2011-42 I.R.B. 518. Note: an applicant using the NAE book safeaccuracy, and (c) payment is made to the person to which theharbor method that wants to make certain changes within theliability is owed. See section 19.03 in the Appendix of Rev.NAE book safe harbor method (as described in sections 5.02Proc. 2011-14.and 5.03 of Rev. Proc. 2011-46) must attach a statement to its

Federal income tax return in lieu of filing a Form 3115. See 45. Timing of incurring certain payroll tax liabilitiesRev. Proc. 2011-46, section 14.04 in the Appendix of Rev. (section 461)— for FICA and FUTA taxes, state unemploymentProc. 2011-14, and Rev. Proc. 2006-56, 2006-2 C.B. 1169. taxes, and railroad retirement taxes, to the method under which

36. Interest accrual on non-performing loans (section the applicant may deduct in Year 1 its otherwise deductible451)— for an accrual method bank accounting for qualified FICA and FUTA taxes, state unemployment taxes, and railroadstated interest on non-performing loans, to the method whereby retirement taxes imposed with respect to year-end wagesinterest is accrued until either the loan is worthless under properly accrued in Year 1, but paid in Year 2, if thesection 166 and is charged off as a bad debt or the interest is requirements of the recurring item exception are met; or, fordetermined to be uncollectible. See section 15.01 in the state unemployment taxes and railroad retirement taxes, to theAppendix of Rev. Proc. 2011-14. method stated above where the applicant already uses that

method of accounting for FICA and FUTA taxes; or for FICA37. Advance rentals (section 451)— for advance rentalsand FUTA taxes to the safe harbor method provided in Rev.other than advance rentals subject to section 467, to inclusionProc. 2008-25, 2008-1 C.B. 686. See section 19.04 in thein gross income in the tax year received. See section 15.02 inAppendix of Rev. Proc. 2011-14.the Appendix of Rev. Proc. 2011-14.

38. State or local income or franchise tax refunds 46. Cooperative advertising (section 461)—to incurring a(section 451)— for an accrual method applicant with state or liability in the tax year in which these services are performed,local income or franchise tax refunds, to accrue these items in provided the manufacturer is able to reasonably estimate thisthe tax year the applicant receives payments or notice of liability even though the retailer does not submit the requiredapproval of its refund claim (whichever is earlier), according to claim form until the following year. See section 19.05 in theRev. Rul. 2003-3, 2003-1 C.B. 252. See section 15.03 in the Appendix of Rev. Proc. 2011-14.Appendix of Rev. Proc. 2011-14. 47. Distributor commissions (section 263)—from

39. Capital cost reduction (CCR) payments (section deducting distributor commissions to capitalizing and451)— for CCR payments (as defined in Rev. Proc. 2002-36, amortizing distributor commissions using the distribution fee

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period method, the 5-year method, or the useful life method. applicable. See section 21.06 in the Appendix of Rev. Proc.Complete Schedule E of Form 3115. See section 10.04 in the 2011-14.Appendix of Rev. Proc. 2011-14. 56. Change from LIFO inventory method (section

48. Cash discounts (section 471)— for cash discounts 472)— for an applicant changing from the LIFO inventorygranted for timely payment, when such discounts approximate a method for its entire LIFO inventory, or for one or morefair interest rate, from a method of consistently including the dollar-value pools within its LIFO inventory, to the permittedprice of the goods before discount in the cost of the goods and method as described in section 22.01(1)(b) in the Appendix ofincluding in gross income any discounts taken to a method of Rev. Proc. 2011-14. Complete Schedule D, Parts II and III, ofreducing the cost of the goods by the cash discounts and Form 3115, as applicable. See section 22.01 in the Appendix ofdeducting as an expense any discounts not taken, or vice Rev. Proc. 2011-14.versa. Complete Schedule D, Parts II and III, of Form 3115, as 57. Determining current-year cost under the LIFOapplicable. See section 21.01 in the Appendix of Rev. Proc. inventory method (section 472)— for an applicant changing2011-14. its method of determining current-year cost: to: (a) the actual

49. Estimating inventory shrinkage (section 471)—from cost of the goods most recently purchased or producedthe present method of estimating inventory shrinkage in (most-recent acquisitions method); (b) the actual cost of thecomputing ending inventory to the retail safe harbor method in goods purchased or produced during the tax year in the order ofsection 4 of Rev. Proc. 98-29, 1998-1 C.B. 857, or to a method acquisition (earliest-acquisitions method); (c) the average unitother than the retail safe harbor method, provided cost equal to the aggregate actual cost of all the goods(a) the applicant’s present method of accounting does not purchased or produced throughout the tax year divided by theestimate inventory shrinkage and (b) the applicant’s new total number of units so purchased or produced; (d) the specificmethod of accounting (that estimates inventory shrinkage) identification method; or (e) a rolling-average method if theclearly reflects income under section 446(b). Complete applicant uses that rolling-average method in accordance withSchedule D, Parts II and III, of Form 3115, as applicable. See Rev. Proc. 2008-43, 2008-30 I.R.B. 186, as modified by Rev.section 21.02 in the Appendix of Rev. Proc. 2011-14. Proc. 2008-52, 2008-2 C.B. 587. Complete Schedule C, Part I,

of Form 3115. See section 22.02 in the Appendix of Rev. Proc.50. Small taxpayer ($1 million) inventory exception2011-14.(section 471)— for a qualifying applicant with average annual

gross receipts of $1,000,000 or less (see Rev. Proc. 2001-10, 58. Alternative LIFO inventory method (section 472)— for2001-1 C.B. 272), from the present method of accounting for a qualifying applicant that sells new automobiles or newinventoriable items (including, if applicable, the method of light-duty trucks, to the Alternative LIFO Method described incapitalizing costs under section 263A) to treating inventoriable Rev. Proc. 97-36, 1997-2 C.B. 450, as modified by Rev. Proc.items in the same manner as materials and supplies that are 2008-23, 2008-1 C.B. 664. Complete Schedule C of Form 3115,not incidental under Regulations section 1.162-3. Complete as applicable. See section 22.03 in the Appendix of Rev. Proc.Schedule A, Part I, and Schedule D, Parts II and III, of Form 2011-14.3115, as applicable. See section 21.03 in the Appendix of Rev. 59. Used vehicle alternative LIFO method (sectionProc. 2011-14. 472)— for a qualifying applicant that sells used automobiles and

51. Small taxpayer ($10 million) inventory exception used light-duty trucks, to the Used Vehicle Alternative LIFO(section 471)— for a qualifying applicant with average annual Method, as described in Rev. Proc. 2001-23, 2001-1 C.B. 784,gross receipts of $10,000,000 or less (see Rev. Proc. 2002-28, as modified by Announcement 2004-16, 2004-1 C.B. 668 and2002-1 C.B. 815), from the present method of accounting for Rev. Proc. 2008-23, 2008-1 C.B. 664. Complete Schedule C,inventoriable items (including, if applicable, the method of Part I, of Form 3115. See section 22.04 in the Appendix of Rev.capitalizing costs under section 263A) to treating inventoriable Proc. 2011-14.items in the same manner as materials and supplies that are 60. Determining the cost of used vehicles purchased ornot incidental under Regulations section 1.162-3. Complete taken as a trade-in (section 472)— for a qualifying applicant,Schedule D, Parts II and III, of Form 3115, as applicable. See to a method of (a) determining the cost of used vehiclessection 21.03 in the Appendix of Rev. Proc. 2011-14. acquired by trade-in using the average wholesale price listed by

52. Obsolete. a consistently used official used car guide on the date of thetrade-in; (b) using a different official used vehicle guide for53. Qualifying volume-related trade discounts (sectiondetermining the cost of used vehicles acquired by trade-in; (c)471)—to treating qualifying volume-related trade discounts asdetermining the cost of used vehicles purchased for cash usinga reduction in the cost of merchandise purchased at the timethe actual purchase price of the vehicle; or (d) reconstructingthe discount is recognized in accordance with Regulationsthe beginning-of-the-year cost of used vehicles purchased forsection 1.471-3(b). Complete Schedule D, Parts II and III, ofcash using values computed by national auto auctionForm 3115, as applicable. See section 21.04 in the Appendix ofcompanies based on vehicles purchased for cash, where theRev. Proc. 2011-14.national auto auction company selected is consistently used.54. Impermissible methods of inventory identificationComplete Schedule C, Part I, of Form 3115. See section 22.05and valuation (section 471)—from an impermissible methodin the Appendix of Rev. Proc. 2011-14.described in Regulations sections 1.471-2(f)(1) through (5),

61. Change to IPIC inventory method (section 472)— for aincluding a LIFO taxpayer restoring a write down of inventoryqualifying applicant, from a non-inventory price indexbelow cost or discontinuing maintaining an inventory reserve;computation (IPIC) LIFO inventory method to the IPIC methodfrom a gross profit method; or from a method of determiningin accordance with all relevant provisions of Regulations sectionmarket that is not in accordance with section 1.471-4; or1.472-8(e)(3); or, from the IPIC method as described in T.D.changing from a method that is not in accordance with section7814, 1982-1 C.B. 84 (the old IPIC method) to the IPIC method1.471-2(c) for determining the value of “subnormal goods;” to aas described in T.D. 8976, 2002-1 C.B. 421 (the new IPICpermitted inventory method (identification or valuation, or both).method), which includes the following required changes (ifComplete Schedule D, Parts II and III, of Form 3115, asapplicable): from using 80% of the inventory price index (IPI) toapplicable. See section 21.05 in the Appendix of Rev. Proc.using 100% of the IPI to determine the base-year cost and2011-14.dollar-value of a LIFO pool(s); from using a weighted arithmetic55. Core Alternative Valuation Method formean to using a weighted harmonic mean to compute an IPI forremanufactured and rebuilt motor vehicle parts (sectiona dollar-value pool(s); and from using a components-of-cost471)— for remanufacturers and rebuilders of motor vehiclemethod to define inventory items to using a total-product-costparts and resellers of remanufactured and rebuilt motor vehiclemethod to define inventory items. Complete Schedule C ofparts that use the lower of cost or market method to value theirForm 3115, as applicable. See section 22.06 in the Appendix ofinventory of cores, to the safe harbor method of accounting (theRev. Proc. 2011-14.Core Alternative Valuation method) to value inventories of cores

as provided for in Rev. Proc. 2003-20, 2003-1 C.B. 445. 62. Changes within IPIC inventory method (sectionComplete Schedule D, Parts II and III, of Form 3115, as 472)— for one or more of the following changes within IPIC:

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(a) from the double-extension IPIC method to the link-chain 73. Market discount bonds (section 1278)—fromIPIC method, or vice versa; (b) to or from the 10 percent including market discount currently in income for the tax year tomethod; (c) to a pooling method described in Regulations which the discount is attributable to including market discount insection 1.472-8(b)(4) or Regulations section 1.472-8(c)(2), income for the tax year of disposition or partial principalincluding a change to begin or discontinue applying one or both payment (revoking the section 1278(b) election). See sectionof the 5 percent pooling rules; (d) combine or separate pools as 32.01 in the Appendix of Rev. Proc. 2011-14.a result of the application of a 5 percent pooling rule described 74. Interest income on short-term obligations (sectionin Regulations section 1.472-8(b)(4) or Regulations section 1281)—to currently including accrued interest and discount in1.472-8(c)(2); (e) change the selection of BLS tables from income (to comply with section 1281). See section 33.01 in theTable 3 (Consumer Price Index for All Urban Consumers Appendix of Rev. Proc. 2011-14.(CPI-U): U.S. city average, detailed expenditure categories) of 75. Stated interest on short-term loans (sectionthe monthly CPI Detailed Report to Table 6 (Producer price 1281)— for a bank using the cash receipts and disbursementsindexes and percent changes for commodity groupings and method of accounting, from accruing stated interest onindividual items, not seasonally adjusted) of the monthly PPI short-term loans made in the ordinary course of business toDetailed Report, or vice versa; (f) change the assignment of using the cash method to report such interest. See sectionone or more inventory items to BLS categories under either 33.02 in the Appendix of Rev. Proc. 2011-14.Table 3 of the monthly CPI Detailed Report or Table 6 of the 76. Sales of mortgage loans (section 1286)— formonthly PPI Detailed Report; (g) change the representative accounting for certain sales of mortgage loans in which themonth when necessitated because of a change in tax year or a seller also enters into a contract to service the mortgages inchange in method of determining current-year cost made consideration for amounts received from interest payments,pursuant to section 22.02 in the Appendix of Rev. Proc. from a method that is inconsistent with Rev. Rul. 91-46, 1991-22011-14; or (h) change from using preliminary BLS price C.B. 358, to a method that is consistent with Rev. Rul. 91-46.indexes to using final BLS price indexes to compute an However, the change is only an automatic accounting methodinventory price index, or vice versa. Complete Schedule C of change for certain taxpayers who are under examination. ThisForm 3115, as applicable. See section 22.07 in the Appendix of change does not fall under the procedures of Rev. Proc.Rev. Proc. 2011-14. 2011-14. Instead, see Rev. Proc. 91-51, 1991-2 C.B. 779.

63. Replacement cost method for automobile dealers’ 77. Environmental remediation costs (section 263A)— forparts inventory (sections 471 and 472)—to the replacement costs incurred to clean up land that a taxpayer contaminatedcost method for automobile dealers’ parts inventory described with hazardous waste from the taxpayer’s manufacturingin Rev. Proc. 2002-17, 2002-1 C.B. 676. Complete Schedule D, operations, to capitalizing such costs in inventory costs underParts II and III, of Form 3115, as applicable. See section 21.07 section 263A. See section 11.05 in the Appendix of Rev. Proc.in the Appendix of Rev. Proc. 2011-14. 2011-14.64. Mark-to-market (section 475)— for accounting for 78. Costs of intangibles and certain transactions (sectionsecurities or commodities by commodities dealers, securities 263(a))— for amounts paid or incurred to acquire or createtraders, and commodities traders, to the mark-to-market intangibles, or to facilitate an acquisition of a trade or business,method under section 475(e) or (f). An election statement must a change in the capital structure of a business entity, andbe filed earlier than the due date of Form 3115. See Rev. Proc. certain other transactions, to a method of accounting provided99-17, 1999-1 C.B. 503, for rules relating to this statement. See in Regulations sections 1.263(a)-4, 1.263(a)-5, andsection 23.01 in the Appendix of Rev. Proc. 2011-14. 1.167(a)-3(b). Complete Schedule E of Form 3115 for changes65. Dealer status changes (section 475)— for an applicant to a method of accounting provided in Regulations sectionelecting out of certain exemptions from securities dealer status, 1.167(a)-3(b). See Rev. Proc. 2006-12, 2006-1 C.B. 310, asto the mark-to-market method. This change does not fall under modified by Rev. Proc. 2006-37, 2006-2 C.B. 499, and sectionthe procedures of Rev. Proc. 2011-14. Instead, see Rev. Proc. 10.05 in the Appendix of Rev. Proc. 2011-14.97-43, 1997-2 C.B. 494. 79. REMIC inducement fees (sections 860A-860G)— for66. Bank reserves for bad debts (section 585)— for a bank an inducement fee received in connection with becoming the(as defined in section 581, including a bank for which a qualified holder of a noneconomic residual interest in a REMIC, to a safesubchapter S subsidiary (QSub) election is filed) to change harbor method provided under Regulations sectionfrom the section 585 reserve method to the section 166 1.446-6(e)(1) or (e)(2). See Rev. Proc. 2004-30, 2004-1 C.B.specific charge-off method. See section 24.01 in the Appendix 950, and section 27.01 in the Appendix of Rev. Proc. 2011-14.to Rev. Proc. 2011-14.

80. All events test method for credit card annual fees67. Insurance company premium acquisition expenses(section 451)—to a method that satisfies the all events test in(section 832)— for certain insurance companies, to a safeaccordance with Rev. Rul. 2004-52, 2004-1 C.B. 973. Seeharbor method of accounting for premium acquisition expensessection 15.05 in the Appendix of Rev. Proc. 2011-14.set forth in Rev. Proc. 2002-46, 2002-2 C.B. 105. See section

81. Ratable inclusion method for credit card annual fees25.01 in the Appendix of Rev. Proc. 2011-14.(section 446)—to the ratable inclusion method for credit card68. Discounted unpaid losses (section 846)— forannual fees. See section 15.05 in the Appendix of Rev. Proc.insurance companies other than life insurance companies2011-14.computing discounted unpaid losses, to the composite method

82. Credit card late fees (section 451)—to a method thator to alternative methods set forth in Notice 88-100, 1988-2treats credit card late fees as interest income that creates orC.B. 439, and Rev. Proc. 2002-74, 2002-2 C.B. 980. Seeincreases OID on the pool of credit card loans to which the feessection 26.01 in the Appendix of Rev. Proc. 2011-14.relate. See section 15.06 in the Appendix of Rev. Proc.69. Obsolete.2011-14.70. Functional currency (section 985)—to the use of

83. Full inclusion method for certain advance paymentsanother functional currency for the applicant or its qualified(section 451)—to the full inclusion method as described inbusiness unit (QBU), other than a QBU described in Regulationsection 5.01 of Rev. Proc. 2004-34, 2004-1 C.B. 991. Thesection 1.985-1(b)(1)(iii). See section 29.01 in the Appendix ofapplicant must be using, or changing to, an overall accrualRev. Proc. 2011-14.method of accounting. See section 15.07 in the Appendix of71. Rule of 78s (section 1272)— for stated interest onRev. Proc. 2011-14.certain short-term consumer loans, from the Rule of 78s

method to the constant yield method. See section 14.05 in the 84. Deferral method for certain advance paymentsAppendix of Rev. Proc. 2011-14. (section 451)—to the deferral method as described in section

72. Original issue discount (sections 1272 and 1273)—to 5.02 of Rev. Proc. 2004-34, 2004-1 C.B. 991 (except asthe principal-reduction method for de minimis original issue provided in section 8.03 and 8.04(2) of Rev. Proc. 2004-34).discount (OID). See section 31.01 in the Appendix of Rev. Proc. The applicant must be using, or changing to, an overall accrual2011-14. method of accounting. See section 15.07 in the Appendix of

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Rev. Proc. 2011-14, Rev. Proc. 2004-34, as modified and commercial revitalization expenditure allocation. Completeclarified by Rev. Proc. 2011-18, 2011-5 I.R.B. 443. Schedule E of Form 3115. See section 6.12 in the Appendix of

Rev. Proc. 2011-14.85. Film producer’s treatment of certain creative property98. Insurance contracts acquired in an assumptioncosts (section 446)—to account for creative property costs

reinsurance transaction (section 197)— for an applicant’sunder the safe harbor method provided in Rev. Proc. 2004-36,first tax year ending after April 10, 2006, for certain insurance2004-1 C.B. 1063. See section 14.06 in the Appendix of Rev.contracts acquired in an assumption reinsurance transaction, toProc. 2011-14.comply with Regulations section 1.197-2(g)(5). See Regulations86. Timber fertilization costs (section 162)— for costssection 1.197-2(g)(5) and section 6.13 in the Appendix or Rev.incurred by a timber grower for the post-establishmentProc. 2011-14.fertilization of an established timber stand, to treat such costs

99. Obsolete.as ordinary and necessary business expenses deductible under100. Obsolete.section 162. See section 3.04 in the Appendix of Rev. Proc.

2011-14. 101. Obsolete.87. Change in general asset account treatment due to a 102. Obsolete.

change in the use of MACRS property (section 168)—to the 103. Obsolete.method of accounting provided in Regulations sections 104. Obsolete.1.168(i)-1(c)(2)(ii)(E) and 1.168(i)-1(h)(2) (as in effect before 105. Obsolete.January 1, 2012). Complete Schedule E of Form 3115. See 106. Timing of incurring certain liabilities for services orRegulations section 1.168(i)-1(l)(2)(ii) (as in effect before insurance (section 461)— for an applicant that is currentlyJanuary 1, 2012) and section 6.09 in the Appendix of Rev. treating the mere execution of a contract for services orProc. 2011-14. insurance as establishing the fact of the liability under section

88. Change in method of accounting for depreciation due 461 and wants to change from that method for liabilities forto a change in the use of MACRS property (section services or insurance to comply with Rev. Rul. 2007-3, 2007-1168)—to the method of accounting provided in Regulations C.B. 350. See section 19.06 in the Appendix of Rev. Proc.section 1.168(i)-4 or to revoke the election provided in 2011-14.Regulations section 1.168(i)-4(d)(3)(ii) to disregard a change in 107. Impermissible to permissible method of accountinguse of MACRS property. Complete Schedule E of Form 3115. for depreciation or amortization for disposed depreciableSee Regulations section 1.168(i)-4(g)(2) and section 6.10 in the or amortizable property (sections 167, 168, 197, 1400I,Appendix of Rev. Proc. 2011-14. 1400L(b), 1400L(c), or 1400N(d) or former 168)— for an item

89. Depreciation of qualified non-personal use vans and of certain depreciable or amortizable property that has beenlight trucks (section 280F)— for certain vehicles placed in disposed of by the applicant and for which the applicant did notservice before July 7, 2003, to a method of accounting in take into account any depreciation allowance or did take intoaccordance with Regulations section 1.280F-6(f)(2)(iv). account some depreciation but less than the depreciationComplete Schedule E of Form 3115. See Regulations section allowable, from using an impermissible method of accounting1.280F-6(f)(2)(iv) and section 6.11 in the Appendix of Rev. for depreciation to using a permissible method of accounting forProc. 2011-14. depreciation. Complete Schedule E of Form 3115. See section

90. Insurance companies’ incentive payments to health 6.17 in the Appendix of Rev. Proc. 2011-14.care providers (section 446)— for deducting provider 108. Change by bank for uncollected interest (sectionincentive payments, to the method of including those payments 446)— for a bank (as defined in Regulation sectionin discounted unpaid losses without regard to section 404. See 1.166-2(d)(4)(i)) that uses an accrual method of accounting; issection 14.07 in the Appendix of Rev. Proc. 2011-14. subject to supervision by Federal authorities, or by state

91. Up-front network upgrade payments received by authorities maintaining substantially equivalent standards; andutilities (section 61)—to a safe harbor method provided in has six or more years of collection experience to change to theRev. Proc. 2005-35, 2005-2 C.B. 76. See section 1.01 in the safe harbor method of accounting for uncollected interest (otherAppendix of Rev. Proc. 2011-14. than interest described in Regulation section 1.446–2(a)(2)) set

92. Allocation of environmental remediation costs to forth in section 4 of Rev. Proc. 2007-33, 2007-1 C.B. 1289. Seeproduction (section 263A)—to a method that allocates under section 14.08 in the Appendix of Rev. Proc. 2011-14.section 263A environmental remediation costs to the inventory 109. Rotable spare parts (section 263(a))— for an applicantproduced during the tax year such costs are incurred. See Rev. that maintains a pool or pools of rotable spare parts that areRul. 2005-42, 2005-2 C.B. 67, and section 11.06 in the primarily used to repair customer-owned (or customer-leased)Appendix of Rev. Proc. 2011-14. equipment under warranty or maintenance agreements to the

93. Obsolete. safe harbor method provided in Rev. Proc. 2007-48, 2007-294. Credit card cash advance fees (section 451)—to a C.B. 110. Complete Schedule E of Form 3115. See section

method that treats credit card cash advance fees as creating or 10.06 in the Appendix of Rev. Proc. 2011-14.increasing original issue discount (OID) on a pool of credit card 110. Rotable spare parts (section 471)—from the safeloans that includes the cash advances that give rise to the fees. harbor method (or a similar method) of treating rotable spareSee section 15.08 in the Appendix of Rev. Proc. 2011-14. parts as depreciable assets, in accordance with Rev. Proc.

95. Obsolete. 2007-48, 2007-2 C.B. 110, to treating rotable spare parts asinventoriable items. See section 21.09 in the Appendix to Rev.96. Replacement cost method for heavy equipmentProc. 2011-14.dealers’ parts inventory (sections 471 and 472)—to the

replacement cost method for heavy equipment dealers’ parts 111. Advance trade discount method (section 471)— for aninventory described in Rev. Proc. 2006-14, 2006-1 C.B. 350. accrual method applicant required to use an inventory methodComplete Schedule D, Parts II and III, of Form 3115, as of accounting and maintaining inventories, as provided inapplicable. See section 21.08 in the Appendix of Rev. Proc. section 471, that receives advance trade discounts to the2011-14. Advance Trade Discount Method described in Rev. Proc.

2007-53, 2007-2 C.B. 233. See section 21.10 in the Appendix97. Depreciation of qualified revitalization building in theto Rev. Proc. 2011-14.expanded area of a renewal community (section 1400I)— for

a qualified revitalization building that is placed in service by the 112. Changes to the Vehicle-Pool Method (sectionapplicant after December 31, 2001, in the area of a renewal 472)— for a retail dealer or wholesaler distributor (reseller) ofcommunity that was expanded by the U.S. Department of cars and light-duty trucks to the Vehicle-Pool Method asHousing and Urban Development and for which the applicant described in Rev. Proc. 2008-23, 2008-1 C.B. 664. See sectionreceives a retroactive commercial revitalization expenditure 22.08 in the Appendix to Rev. Proc. 2011-14.allocation. This change applies only if the applicant filed the 113. Payroll tax liabilities (section 461)— for an accrualfederal tax return for the placed-in-service year of that building method applicant that wants to change its method for FICA andon or before the date the applicant received the retroactive FUTA taxes to the safe harbor method provided in Rev. Proc.

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2008-25, 2008-1 C.B. 686, which provides that, solely for the 121. Repairable and reusable spare parts (sectionpurposes of the recurring item exception, an applicant will be 263(a))—to treat certain repairable and reusable spare partstreated as satisfying the requirement in Regulation section as depreciable property in accordance with the holding in Rev.1.461-5(b)(1)(i) for its payroll tax liability in the same tax year in Rul. 69-200, 1969-1 C.B. 60, or Rev. Rul. 69-201, 1969-1 C.B.which all events have occurred that establish the fact of the 60. Complete Schedule E of Form 3115. See section 10.07 inrelated compensation liability and the amount of the related the Appendix of Rev. Proc. 2011-14, as modified by sectioncompensation liability can be determined with reasonable 4.02(15) of Rev. Proc. 2012-19. This change is only availableaccuracy. See section 19.04 in the Appendix to Rev. Proc. for spare parts that have been placed in service by the taxpayer2011-14. in taxable years beginning before January 1, 2012.

122. Overall accrual method other than for the first114. Rolling-average method of accounting for inventoriessection 448 year (section 446)— for a qualifying applicant for(sections 471 and 472)— for an applicant required to accountother than its first section 448 year, from the overall cashfor inventories under section 471 and that uses areceipts and disbursements method to an overall accrualrolling-average method to value inventories for financialmethod, or to an overall accrual method in conjunction with theaccounting purposes to the same rolling-average method torecurring item exception under 461(h)(3). Complete Schedulevalue inventories for federal income tax purposes, inA, Part I, of Form 3115. Also complete Schedule D, Parts II andaccordance with Rev. Proc. 2008-43, 2008-30 I.R.B.186. SeeIII, as applicable. See section 14.01 in the Appendix of Rev.section 21.14 in the Appendix to Rev. Proc. 2011-14.Proc. 2011-14.115. Kansas additional first year depreciation— for123. Change in overall method from the cash method toqualified Recovery Assistance property placed in service by the

an accrual method for the first section 448 year (sectionapplicant on or after May 5, 2007, during the tax year that446)— for an applicant that is required by section 448 toincludes May 5, 2007, to claim the Kansas additional first yearchange from the overall cash method to an overall accrualdepreciation deduction for a class of property for which themethod and the applicant qualifies to make the change undertaxpayer did not claim the Kansas additional first yearthe automatic consent procedures of Regulation sectionsdepreciation deduction on the taxpayer’s timely filed federal tax1.448-1(g) and (h)(2) as well as Rev. Proc. 2011-14 for a yearreturn for the tax year that includes May 5, 2007, provided theof change that is the applicant’s first section 448 year. Seetaxpayer did not make an election not to deduct the KansasRegulation sections 1.448-1(g) and (h)(2), and section 14.01 inadditional first year depreciation for the class of property.the Appendix to Rev. Proc. 2011-14.Complete Schedule E of Form 3115. See section 6.22 in the

Appendix to Rev. Proc. 2011-14. 124. Change from the cash method to an accrual methodfor specific items (section 446)— for a qualifying applicant116. Depreciation of MACRS property acquired in ausing an overall accrual method and accounting for one or morelike-kind exchange or as a result of an involuntaryidentified specific items of income and expense on the cashconversion (section 168)—to apply the provisions ofmethod to an accrual method of accounting for the identifiedRegulations section 1.168(i)-6 or rely on prior guidance by thespecific item or items. See section 14.09 in the Appendix toService for determining the depreciation deductions ofRev. Proc. 2011-14.replacement MACRS property and relinquished MACRS

property, for a like-kind exchange or an involuntary conversion 125. Multi-year service warranty contracts (sectionof MACRS property for which the time of disposition, the time of 446)— for an eligible accrual method manufacturer, wholesaler,replacement, or both occur on or before February 27, 2004 or, or retailer of motor vehicles or other durable consumer goodsto apply Regulations section 1.168(i)-6(i)(2) to the relinquished that wants to change to the service warranty income methodproperty and the replacement property for which the time of described in section 5 of Rev. Proc. 97-38, 1997-2 C.B. 479.disposition, the time of replacement, or both occur on or before See Rev. Proc. 97-38 and section 14.10 in the Appendix toFebruary 26, 2007, if the replacement property replaces Rev. Proc. 2011-14.relinquished property for which the taxpayer made a valid 126. Overall cash method for specified transportationelection under section 168(f)(1) to exclude it from the industry taxpayers (section 446)— for “specifiedapplication of section 168. Complete Schedule E of Form 3115. transportation industry taxpayers,” as defined in sectionSee Regulations sections 1.168(i)-6 and 1.168(i)-6(i)(2), and 14.11(2) of Rev. Proc. 2011-14, with average annual grosssection 6.18 in the Appendix of Rev. Proc. 2011-14. receipts of more than $10,000,000 and not in excess of117. Lessor improvements abandoned at termination of $50,000,000 to the overall cash receipts and disbursements

lease (section 168)— for an applicant that is a lessor, from method. See section 14.11 in the Appendix to Rev. Proc.depreciating under section 168 an improvement described in 2011-14.section 168(i)(8)(B)(i) and (ii) after the improvement was 127. Change to overall cash/hybrid method for certainirrevocably disposed of or abandoned by the lessor at the banks (section 446)— for an eligible bank, as defined intermination of the applicable lease by the lessee to complying section 14.12(2)(a) in the Appendix to Rev. Proc. 2011-14, towith section 168(i)(8)(B) by recognizing gain or loss upon an overall cash/hybrid method described in section 14.12(2)(b)disposition or abandonment of the improvement. See section in the Appendix to Rev. Proc. 2011-14. See section 14.12 in the168(i)(8)(B), and section 6.19 in the Appendix of Rev. Proc. Appendix to Rev. Proc. 2011-14.2011-14. 128. Change to overall cash method for farmers (section118. Repairable and reusable spare parts (section 446)— for a qualifying applicant engaged in the trade or

168)— for repairable and reusable spare parts, from item business of farming to the overall cash receipts andaccounting to multiple asset accounting (pooling) in accordance disbursements method. See section 14.13 in the Appendix towith section 6.20(2) in the Appendix of Rev. Proc. 2011-14, or Rev. Proc. 2011-14.to using a permissible method of identifying disposed repairable 129. Nonshareholder contributions to capital underand reusable spare parts, as described in section 6.20(3) in the section 118 (section 446)—from excluding from gross incomeAppendix of Rev. Proc. 2011-14. Complete Schedule E of Form under section 61 certain payments or the fair market value of3115. See section 6.20 in the Appendix of Rev. Proc. 2011-14, property received (including customer connection fees receivedas modified by section 4.02(14) of Rev. Proc. 2012-19. This by a regulated public utility described in section 118(c)), bychange is only available for spare parts that have been placed characterizing the payments or the fair market value of propertyin service by the taxpayer after 1986 and before taxable years as nontaxable contributions to capital under section 118(a), tobeginning after December 31, 2011. including the payments or the fair market value of property in119. Land (sections 167 and 168)—from depreciating land gross income under section 61. This change also applies to a

to not depreciating land, or from depreciating a nondepreciable regulated public utility described in section 118(c) that changesland improvement to not depreciating a nondepreciable land from including in gross income under section 61 payments orimprovement. See section 6.21 in the Appendix of Rev. Proc. fair market value of property received that are contributions in2011-14. aid of construction under section 118(c) and Regulation section120. Obsolete. 1.118-2 and that meet the requirements of sections 118(c)(1)(B)

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and 118(c)(1)(C) to excluding from income the payments or the engaged in the trade or business of retail sales of newfair market value of the property as nontaxable contributions to automobiles or new light-duty trucks (dealership) fromcapital under sections 118(a). See section 14.14 in the capitalizing certain advertising costs as acquisition costs underAppendix to Rev. Proc. 2011-14. Regulation section 1.471-3(b) to deducting the advertising

costs under section 162 as the advertising services are130. Retainages (section 451)— for an accrual methodprovided to the dealership. See Regulation sectionapplicant’s retainages under section 451 to a method1.461-4(d)(2)(i), and section 21.13 in the Appendix to Rev.consistent with the holding in Rev. Rul. 69-314, 1969-1 C.B.Proc. 2011-14.139. This change does not apply to retainages under long-term

contracts as defined in section 460(f). An applicant changing its 140. Changes within the Used Vehicle Alternative LIFOmethod of accounting under this section must treat all Method (section 472)— for a taxpayer using the Used Vehicleretainages (receivables and payables) in the same manner. Alternative LIFO Method, as described in Rev. Proc. 2001-23,See section 15.10 in the Appendix to Rev. Proc. 2011-14. 2001-1 C.B. 784, as modified by Announcement 2004-16,131. Series E, EE, or I U.S. savings bonds (section 2004-1 C.B. 668, and Rev. Proc. 2008-23, 2008-1 C.B. 664, to

454)— for a cash method taxpayer changing the taxpayer’s use a different “official used vehicle guide” in conjunction withmethod of accounting for interest income on Series E, EE, or I the Used Vehicle Alternative LIFO Method, or to a differentU.S. savings bonds from reporting as interest income the precise manner of using an official used vehicle guide (forincrease in redemption price on a bond occurring in a tax year example, a change in the specific guide category that anto reporting this income in the tax year in which the bond is applicant uses to represent vehicles of average condition forredeemed, disposed of, or finally matures, whichever is earliest. purposes of section 4.02(5)(a) of Rev. Proc. 2001-23). SeeA statement in lieu of a Form 3115 is authorized for this section 22.09 in the Appendix to Rev. Proc. 2011-14.change. See section 16.01 in the Appendix to Rev. Proc. 141. Changes to dollar-value pools of manufacturers2011-14. (section 472)— for a manufacturer that purchases goods for132. Prepaid subscription income (section 455)— for an resale (resale goods) and thus must reassign resale goods from

accrual method applicant changing its method of accounting for the pool(s) it maintains for the goods it manufactures to one orprepaid subscription income to the method described in section more resale pools, and the manufacturer wants to change from455 and the related regulations, including an eligible applicant using multiple pools described in Regulation sectionthat wants to make the “within 12 months” election under 1.472-8(b)(3) to using natural business unit (NBU) poolsRegulations section 1.455-2. A statement in lieu of a Form 3115 described in Regulation section1.472-8(b)(1), or vice versa; oris authorized for this change. See section 17.01 in the Appendix wants to reassign items in NBU pools described in Regulationto Rev. Proc. 2011-14. section 1.472-8(b)(1) into the same number or a greater133. Timing of incurring liabilities for bonuses (section number of NBU pools. See section 22.10 in the Appendix to

461)—to treat bonuses as incurred in the tax year in which all Rev. Proc. 2011-14.events have occurred that establish the fact of the liability to 142. Obsolete.pay a bonus and the amount of the liability can be determined 143. Materials and supplies (section 162)— for an applicantwith reasonable accuracy. See section 19.01(2) in the Appendix changing to the method of accounting described in Regulationsto Rev. Proc. 2011-14. section 1.162-3 (reserved) to treat materials and supplies as a134. Timing of incurring liabilities for vacation pay deferred expense to be taken into account in the taxable year in(section 461)—to treat vacation pay as incurred in the tax year which they are actually consumed and used in operation. Seein which all events have occurred that establish the fact of the section 3.05 in the Appendix to Rev. Proc. 2011-14, asliability to pay vacation pay, and the amount of the liability can reserved by section 4.01(1) of Rev. Proc. 2012-19. This changebe determined with reasonable accuracy. The applicant may is only available for amounts paid or incurred in taxable yearsmake this change if the vacation pay vests in that tax year and beginning before January 1, 2012.the vacation pay is received by the employee by the 15th day of

144. Repair and maintenance costs (section 162)— for anthe 3rd calendar month after the end of that tax year. Seeapplicant changing from capitalizing under section 263(a) costssection 19.01(3) in the Appendix to Rev. Proc. 2011-14.paid or incurred to repair and maintain tangible property135. Rebates and allowances (section 461)— for an accrual(including network assets) to treating the repair andmethod applicant’s liability for rebates and allowances to themaintenance costs as ordinary and necessary businessrecurring item exception method under section 461(h)(3) andexpenses under section 162 and Regulations section 1.162-4.Regulation section 1.461-5. See section 19.07 in the AppendixSee section 3.06 in the Appendix to Rev. Proc. 2011-14, asto Rev. Proc. 2011-14.reserved by section 4.01(1) of Rev. Proc. 2012-19. This change136. Change from an improper method of inclusion ofapplies only to taxable years beginning before January 1, 2012.rental income or expense to inclusion in accordance with145. Tenant construction allowances (section 168)— for anthe rent allocation (section 467)— for an applicant that is a

applicant changing from improperly treating the applicant asparty to a section 467 rental agreement; and is changing itshaving a depreciable interest in the property subject to themethod for its fixed rent to the rent allocation method providedtenant construction allowances for federal income tax purposesin Regulation section 1.467-1(d)(2)(iii). See section 20.01 in theto properly treating the applicant as not having a depreciableAppendix to Rev. Proc. 2011-14.interest in such property for federal income tax purposes; or137. Permissible methods of inventory identification andfrom improperly treating the applicant as not having avaluation (section 471)— for an applicant changing from onedepreciable interest in the property subject to the tenantpermissible method of identifying and valuing inventories toconstruction allowances for federal income tax purposes toanother permissible method of identifying and valuingproperly treating the applicant as having a depreciable interestinventories that is not a change described in another section inin such property for federal income tax purposes. See sectionthe Appendix to Rev. Proc. 2011-14 or in other guidance6.23 in the Appendix to Rev. Proc. 2011-14.published in the IRB. See section 21.11 in the Appendix to Rev.

Proc. 2011-14. 146. Dispositions of structural components of a building138. Change in the official used vehicle guide utilized in (section 168)— for an applicant changing to a unit of property

valuing used vehicles (section 471)— for a used vehicle that is permissible under applicable legal authority fordealer from not using an official used vehicle guide for valuing determining when the applicant has disposed of a building andused vehicles to using an official used vehicle guide for valuing its structural components for depreciation purposes. Thisused vehicles; or from using an official used vehicle guide for change will also affect the determination of gain or loss from thevaluing used vehicles to using a different official used vehicle disposition of the building (including its structural components).guide for valuing used vehicles. See section 21.12 in the See section 6.24 in the Appendix to Rev. Proc. 2011-14.Appendix to Rev. Proc. 2011-14. Obsolete for tax years beginning on or after January 1, 2012.139. Invoiced advertising association costs for new For taxable years beginning on or after January 1, 2012, see

vehicle retail dealerships (section 471)— for an applicant change number 177.

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147. Dispositions of tangible depreciable assets (other card in the amount of the gift card, as provided in Rev. Proc.than a building or its structural components) (section 2011-17, 2011-5 I.R.B. 441. See section 19.10 in the Appendix168)— for an applicant changing to a unit of property that is of Rev. Proc. 2011-14.permissible under applicable legal authority for determining 157. Classification of wireless telecommunications assetswhen the applicant has disposed of a section 1245 property a used by wireless telecommunications carriers (sectionsdepreciable land improvement for depreciation purposes. This 167 and 168)— for applicants that have a depreciable interestchange will also affect the determination of gain or loss from the in wireless telecommunication assets (as defined in Rev. Proc.disposition of the section 1245 property or the depreciable land 2011-22, 2011-8 I.R.B. 737) used primarily to provide wirelessimprovement. See section 6.25 in the Appendix to Rev. Proc. telecommunications or broadband services by mobile phones2011-14. Obsolete for taxable years beginning on or after that are changing to the method described in Rev. Proc.January 1, 2012. For taxable years beginning on or after 2011-22 to determine the recovery periods for depreciation ofJanuary 1, 2012, see change 178. certain tangible assets used by wireless telecommunications148. Debt issuance costs (section 446)— for an applicant carriers. See Rev. Proc. 2011-22, adding section 6.26 to the

changing its method of accounting to comply with Regulation Appendix of Rev. Proc. 2011-14.section 1.446-5, which provides rules for allocating the costs 158. Wireline network property (section 263(a))— forover the term of the debt. See section 14.15 in the Appendix to certain applicants that have depreciable interest in wirelineRev. Proc. 2011-14. network assets (as described in section 4 of Rev. Proc.149. Ratable accrual of real property taxes (section 2011-27, 2011-8 I.R.B. 740) used primarily to provide wireline

461)— for an accrual method applicant for real property taxes telecommunication or broadband services that are changing tothat relate to a definite period of time to the method described (a) the wireline network assets maintenance allowance methodin section 461(c) and section 1.461-1(c)(1) (ratable accrual described in section 5 of Rev. Proc. 2011-27, or (b) theelection) for a taxable year other than the applicant’s first adoption of all, or some, of the units of property described intaxable year in which real property taxes are incurred. See section 6 of Rev. Proc. 2011-27, to determine whethersection 19.08 in the Appendix to Rev. Proc. 2011-14. expenditures to maintain, replace, or improve wireline network

assets must be capitalized under section 263(a). See Rev.150. Retail sales facility safe harbor for a motor vehicleProc. 2011-27, adding section 3.07 to the Appendix of Rev.dealership (section 263A)— for a motor vehicle dealership toProc. 2011-14.treat its sales facility as a retail sales facility as described in

section 5.01 of Rev. Proc. 2010-44, 2010-49 I.R.B. 811. See 159. Wireless network property (section 263(a))— forsection 11.07 in the Appendix of Rev. Proc. 2011-14. certain applicants that have a depreciable interest in wireless

network assets (as described in section 4 of Rev. Proc.151. Reseller without production activities safe harbor for2011-28, 2011-8 I.R.B. 743) used primarily to provide wirelessa motor vehicle dealership (section 263A)— for a motortelecommunications or broadband services by mobile phonesvehicle dealership to be treated as a reseller without productionthat are changing to (a) the wireless network assetactivities as described in section 5.02 of Rev. Proc. 2010-44,maintenance allowance method described in section 5 of Rev.2010-49 I.R.B. 811. See section 11.07 in the Appendix of Rev.Proc. 2011-28, or (b) the adoption of all, or some, of the units ofProc. 2011-14.property described in section 6 of Rev. Proc. 2011-28, to152. Deduction for energy efficient commercial buildingsdetermine whether expenditures to maintain, replace or improve(section 179D)— for an applicant changing to deduct underwireless network assets must be capitalized under sectionsection 179D amounts paid or incurred for the installation of263(a). See Rev. Proc. 2011-28, adding section 3.08 to theenergy efficient commercial building property, subject to theAppendix of Rev. Proc. 2011-14.limits of section 179D(b), in the year the property is placed in160. Electric transmission and distribution propertyservice. See section 8.04 in the Appendix of Rev. Proc.

(section 263(a))— for certain applicants that have a2011-14.depreciable interest in electric transmission or distribution153. Advance payments—change in applicable financialproperty (as described in section 4 of Rev. Proc. 2011-43,statements (Rev. Proc. 2004-34)— for an applicant using the2011-37 I.R.B. 326) used primarily to transport, deliver, or selldeferral method for including advance payments in grosselectricity that are changing to the method described in Rev.income in accordance with its applicable financial statementProc. 2011-43, to determine whether expenditures incurred to(AFS) to change its method to recognize advance payments inmaintain, replace, or improve transmission and distributiongross income under Rev. Proc. 2004-34 consistent with aproperty are deductible repairs under section 162 orchanged manner for recognizing advance payments for its AFS.capitalizable improvements under section 263(a). See Rev.Although the requirement to file a copy of the application withProc. 2011-43, adding section 3.09 to the Appendix of Rev.the IRS National Office is waived for this application, a taxpayerProc. 2011-14.may nevertheless file a copy of the application with the IRS161. Timing of incurring liabilities under the recurring itemNational Office, for example, under the 90-day or 120-day

exception to the economic performance rules (sectionwindow in section 6.03(2) or 6.03(3) of Rev. Proc. 2011-14. In461(h)(3))— for an applicant changing to a method ofall cases, the requirement in section 6.02(3)(c) of Rev. Proc.accounting to conform to any of the holdings in Rev. Rul.2001-14 to provide an additional copy of the application to the2012-1, 2012-2 I.R.B. 255, which addresses the “not material”examining agent(s), appeals officer(s) and counsel to theand “better matching” requirements of the recurring itemgovernment, if applicable, applies to this application. Seeexception and distinguishes contracts for the provision ofsection 15.11 in the Appendix of Rev. Proc. 2011-14.services from insurance and warranty contracts.154. California franchise taxes (Rev. Rul. 2003-90)— for an

accrual method applicant changing to recognizing its California 162. Deducting repair and maintenance costs (sectionfranchise tax liability in the tax year following the tax year in 162)— for an applicant changing from capitalizing underwhich the tax is incurred under the Cal. Rev. & Tax Code. See section 263(a) amounts paid or incurred for tangible property tosection 19.09 in the Appendix of Rev. Proc. 2011-14. deducting these amounts as repair and maintenance costs

under section 162 and Regulations section 1.162-4T and for an155. Unearned premiums (section 833)— for a Blue Crossapplicant changing its units of property under Regulationsor Blue Shield organization within the meaning of sectionsection 1.263(a)-3T(e) solely for purposes of determining833(c)(2) or an organization described in section 833(c)(3)whether amounts paid or incurred improve a unit of propertyrequired to change its method of accounting for unearnedunder Regulations section 1.263(a)-3T. See section 4.02(1) ofpremiums because it fails to meet the MLR requirements ofRev. Proc. 2012-19, adding section 3.10 to the Appendix ofsection 833(c)(5). See section 25.02 in the Appendix of Rev.Rev. Proc. 2011-14.Proc. 2011-14.

156. Gift cards issued as a refund (Rev. Proc. 163. Change to the regulatory accounting method (section2011-17)— for an accrual method applicant who issues gift 162)— for a regulated applicant changing its method ofcards as a refund for returned goods changing to treat the accounting for amounts paid or incurred to repair or maintaintransaction as the payment of a cash refund and sale of a gift tangible property to follow its method of accounting for

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regulatory accounting purposes to determine whether an to amounts paid or incurred in taxable years beginning on oramount paid or incurred improves property under Regulations after January 1, 2012.section 1.263(a)-3T, consistent with Regulations section 171. Change to the safe harbor routine maintenance on1.263(a)-3T(k). See section 4.02(2) of Rev. Proc. 2012-19, property other than buildings (section 162)— for anadding section 3.11 to the Appendix of Rev. Proc. 2011-14. applicant changing its method of accounting for amounts paid

or incurred for routine maintenance performed on a unit of164. Deducting non-incidental materials and suppliesproperty to the method of treating such amounts as amountswhen used or consumed (section 162)— for an applicantthat do not improve the unit or property, consistent withchanging its method of accounting for non-incidental materialsRegulations section 1.263(a)-3T(g). See section 4.01(10) ofand supplies to the method of deducting such amounts in theRev. Proc. 2012-19, adding section 3.19 to the Appendix oftaxable year in which they are actually used or consumed,Rev. Proc. 2011-14.consistent with Regulations section 1.162-3T. See section172. Non-dealer expense to facilitate the sale of property4.02(3) of Rev. Proc. 2012-19, adding section 3.12 to the

(section 162)— for an applicant that is not a dealer in propertyAppendix of Rev. Proc. 2011-14. This change applies only tochanging its method of accounting for commissions and otherthe amounts paid or incurred in taxable years beginning on orcosts paid or incurred to facilitate the sale of property to theafter January 1, 2012.method of capitalizing such costs, consistent with Regulations165. Deducting incidental materials and supplies whensection 1.263(a)-1T(d)(1). See section 4.01(11) of Rev. Proc.paid or incurred (section 162)— for an applicant that wants to2012-19, adding section 10.08 to the Appendix of Rev. Proc.change its method of accounting for incidental materials and2011-14.supplies to the method of deducting such amounts in the173. Capitalizing acquisition or production costs (sectiontaxable year in which they are paid or incurred, consistent with

263(a))— for an applicant changing its method of accounting toRegulations section 1.162-3T. See section 4.02(4) of Rev. Proc.capitalizing amounts paid or incurred to acquire or produce2012-19, adding section 3.13 to the Appendix of Rev. Proc.property under Regulations section 1.263(a)-2T and, if2011-14. This change applies only to amounts paid or incurreddepreciable, to depreciating such property under section 168.in taxable years beginning on or after January 1, 2012.See section 4.01(12) of Rev. Proc. 2012-19, adding section166. Deducting non-incidental rotable and temporary 10.09 to the Appendix of Rev. Proc. 2011-14.spare parts when disposed (section 162)— for an applicant 174. Capitalizing improvements to tangible propertychanging its method of accounting for costs to acquire or (section 263(a))— for an applicant changing its method ofproduce non-incidental rotable and temporary spare parts to accounting to capitalizing amounts paid or incurred forthe method of deducting such costs in the taxable year in which improvements to units of property consistent with Regulationsthe taxpayer disposes of the parts, consistent with Regulations sections 1.263(a)-1T and 1.263(a)-3T and, if depreciable, tosection 1.162-3T. See section 4.02(5) of Rev. Proc. 2012-19, depreciating such improvements under section 168. Seeadding section 3.14 to the Appendix of Rev. Proc. 2011-14. section 4.01(13) of Rev. Proc. 2012-19, adding section 10.10 toThis change applies only to amounts paid or incurred in taxable the Appendix of Rev. Proc. 2011-14.years beginning on or after January 1, 2012. 175. Depreciation of leasehold improvements (sections167. Change to the optional method for rotable and 167, 168, and 197)— for leasehold improvements in which thetemporary spare parts (section 162)— for an applicant applicant has a depreciable interest at the beginning of the yearchanging its method of accounting for rotable and temporary of change, from improperly depreciating or amortizing thesespare parts to the optional method of accounting for rotable and leasehold improvements over the term of the lease (includingtemporary spare parts (described in Regulations section renewals, if applicable) to properly depreciating or amortizing1.162-3T(e)), consistent with Regulations section 1.162-3T. See these leasehold improvements under section 167(f)(1), 168, orsection 4.02(6) of Rev. Proc. 2012-19, adding section 3.15 to 197, as applicable. This change applies only to taxable yearsthe Appendix of Rev. Proc. 2011-14. beginning on or after January 1, 2012. Complete Schedule E of

168. Deducting dealer expenses that facilitate the sale of Form 3115. See section 6.27 in the Appendix to Rev. Proc.property (section 162)— for an applicant that is a dealer in 2011-14, as modified by section 5.03(1) of Rev. Proc. 2012-20property changing its method of accounting for commissions (creating new section 6.27).and other costs paid or incurred to facilitate the sale of tangible 176. Depreciation of MACRS property (permissible)property to the method of treating such costs as ordinary and (section 168)— for MACRS property, from a permissiblenecessary business expenses, consistent with Regulations method to another permissible method listed in section 6.28(3)section 1.263(a)-1T(d)(1). See section 4.02(7) of Rev. Proc. in the Appendix of Rev. Proc. 2011-14. This change applies2012-19, adding section 3.16 to the Appendix of Rev. Proc. only to taxable years beginning on or after January 1, 2012.2011-14. Complete Schedule E of Form 3115. See section 6.28 in the169. Deducting de minimis amounts (section 263(a))— for Appendix to Rev. Proc. 2011-14, as modified by section 5.03(2)

an applicant changing its method of accounting for amounts of Rev. Proc. 2012-20 (creating new section 6.28).paid or incurred to acquire or produce (including any amounts 177. Dispositions of a building or a structural componentpaid or incurred to facilitate the acquisition and production of) a (section 168)— for an applicant changing to an asset that isunit of property to the method of applying the de minimis rule permissible under Regulations section 1.168(i)-8T(c)(4) forunder Regulations sections 1.263(a)-2T(g) and determining what building, condominium unit, cooperative unit,1.263A-1T(b)(14) to such amounts, consistent with Regulations or structural components has been disposed of by the applicantsection 1.263(a)-2T. See section 4.02(8) of Rev. Proc. 2012-19, for depreciation purposes; or from a method not specified inadding section 3.17 to the Appendix of Rev. Proc. 2011-14. Regulations section 1.168(i)-8T(f)(1), (f)(2)(i), (f)(2)(ii), orThis change applies only to amounts paid or incurred in taxable (f)(2)(iii) to a method specified in Regulations sectionyears beginning on or after January 1, 2012. 1.168(i)-8T(f)(1), (f)(2)(i), (f)(2)(ii), or (f)(2)(iii), as applicable, for170. Deducting certain costs for investigating or pursuing identifying which buildings, condominium units, cooperative

the acquisition of property (section 162)— for an applicant units, or structural components in multiple asset accounts havechanging its method of accounting from capitalizing to been disposed of by the applicant. This change also will affectdeducting amounts paid or incurred in the process of the determination of gain or loss from the disposition of theinvestigating or otherwise pursuing the acquisition of real building, condominium unit, cooperative unit, or the structuralproperty if the amounts meet the requirements of Regulations component and may affect whether the applicant mustsection 1.263(a)-2T(f)(2)(iii) or the acquisition of real or capitalize amounts paid to restore a unit of property underpersonal property if the amounts are for employee Regulations section 1.263(a)-3T(i). This change applies only tocompensation or overhead costs under Regulations section taxable years beginning on or after January 1, 2012. See1.263(a)-2T(f)(2)(iv), consistent with section 1.263(a)-2T. See section 6.29 in the Appendix to Rev. Proc. 2011-14, as modifiedsection 4.04(9) of Rev. Proc. 2012-19, adding section 3.18 to by section 5.03(3) of Rev. Proc. 2012-20 (creating new sectionthe Appendix of Rev. Proc. 2011-14. This change applies only 6.29).

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178. Dispositions of tangible assets (other than a building by the applicant. This change also may affect the determinationor its structural components) (section 168)— for an of gain or loss from the disposition of the asset and may affectapplicant changing to an asset that is permissible under whether the applicant must capitalize amounts paid to restore aRegulations section 1.168(i)-8T(c)(4) for determining what unit of property under Regulations section 1.263(a)-3T(i). Thissection 1245 property or depreciable land improvement has change applies only to taxable years beginning on or afterbeen disposed of by the applicant for depreciation purposes; or January 1, 2012. See section 6.31 in the Appendix to Rev.from a method not specified in Regulations section Proc. 2011-14, as modified by section 5.03(5) of Rev. Proc.1.168(i)-8T(f)(1), (f)(2)(i), (f)(2)(ii), or (f)(2)(iii) to a method 2012-20 (creating new section 6.31).specified in Regulations section 1.168(i)-8T(f)(1), (f)(2)(i), 180. General asset account elections (section 168)— for an(f)(2)(ii), or (f)(2)(iii), as applicable, for identifying which section applicant making a late general asset account election under1245 property or depreciable land improvements in multiple

section 168(i)(4) and Regulations sections 1.168(i)-1 andasset accounts have been disposed of by the applicant. This1.168(i)-1T for MACRS property placed in service by thechange also will affect the determination of gain or loss from theapplicant in a taxable year beginning before January 1, 2012;disposition of the section 1245 property or the depreciable landor a late election to recognize gain or loss upon the dispositionimprovement and may affect whether the taxpayer mustof all the assets, or the last asset, in a general asset account incapitalize amounts paid to restore a unit of property under theaccordance with Regulation section 1.168(i)-1T(3)(ii); or for anRegulations section 1.263(a)-3T(i). This change applies only toitem of MACRS property for which the applicant made a validtaxable years beginning on or after January 1, 2012. See

section 6.30 in the Appendix to Rev. Proc. 2011-14, as modified general asset account election, a late election to recognize gainby section 5.03(4) of Rev. Proc. 2012-20 (creating new section or loss upon the disposition of that item in a qualifying6.30). disposition in accordance with Regulations section179. Dispositions of tangible depreciable assets in a 1.168(i)-1T(e)(3)(iii). This change also may affect the

general account (section 168)— for MACRS property for determination of gain or loss from the disposition of the assetwhich the applicant made a valid general asset election, and may affect whether the applicant must capitalize amountschanging to an asset that is permissible under Regulations paid to restore a unit of property under Regulations sectionsection 1.168(i)-1T(e)(2)(viii) for determining what asset has 1.263(a)-3T(i). This change applies only to the applicant’s firstbeen disposed of by the applicant for depreciation purposes; or or second taxable year beginning after December 31, 2011.from a method not specified in Regulations section See section 6.32 in the Appendix to Rev. Proc. 2011-14, as1.168(i)-1T(j)(2)(i), (ii), (iii), or (iv) to a method specified in modified by section 5.03(6) of Rev. Proc. 2012-20 (creating newRegulations section 1.168(i)-1T(j)(2)(i), (ii), (iii), or (iv), as section 6.32).applicable, for identifying which assets have been disposed of

Privacy Act and Paperwork Reduction Act Notice. We ask for the information on this form to carry out the Internal Revenue lawsof the United States. Section 446(e) says that you must obtain IRS approval before you change your method of accounting, exceptwhere otherwise provided. To obtain this approval, you are required to provide the information requested on this form. Thisinformation will be used to ensure that you are complying with the applicable laws, and to figure and collect the right amount of tax.Failure to provide all of the information requested may delay or prevent processing of this form. Providing false information maysubject you to penalties. Routine uses of this information include giving it to the Department of Justice for civil and criminal litigation,and to cities, states, the District of Columbia, and to U.S. commonwealths and possessions for use in the administration of their taxlaws. We may also disclose this information to other countries under a tax treaty, to Federal and state agencies to enforce Federalnon-tax criminal laws, or to federal law enforcement and intelligence agencies to combat terrorism.

You are not required to provide the information requested on a form that is subject to the Paperwork Reduction Act unless theform displays a valid OMB control number. Books or records relating to a form or its instructions must be retained as long as theircontents may become material in the administration of any Internal Revenue law. Generally, tax returns and return information areconfidential, as required by section 6103.

The time needed to complete and file this form will vary depending on individual circumstances. The estimated burden forindividual taxpayers filing this form is approved under OMB control number 1545-0074 and is included in the estimates shown in theinstructions for their individual income tax return. The estimated burden for all other taxpayers who file this form is shown below.

Learning about the law Preparing and sendingForm Recordkeeping or the form the form to the IRS

3115 38 hr., 29 min. 19 hr., 54 min. 23 hr., 48 min.Sch. A 3 hr., 21 min. 1 hr., 51 min. 3 hr., 11 min.Sch. B 1 hr., 25 min. 30 min. 33 min.Sch. C 5 hr., 1 min. 45 min. 2 hr., 4 min.Sch. D 27 hr., 30 min. 1 hr., 59 min. 2 hr., 31 min.Sch. E 3 hr., 49 min. 1 hr., 59 min. 2 hr., 8 min.

If you have comments concerning the accuracy of these time estimates or suggestions for making this form simpler, we would behappy to hear from you. You can write to the Internal Revenue Service, Tax Products Coordinating Committee,SE:W:CAR:MP:T:T:SP, 1111 Constitution Ave. NW, IR-6406, Washington, DC 20224. Do not send the tax form to this office.Instead, see When and Where To File earlier.

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