The proposed regulations under section 263(a) of the Code set forth the general statutory principles of capitalization and provide that capital expenditures generally include amounts paid to sell, acquire, produce, or improve tangible property. The proposed regulations, if promulgated as final regulations, would replace current §§1.263(a)-1, 1.263(a)-2, and 1.263(a)-3 of the Income Tax Regulations. The treatment of amounts paid to acquire or create intangibles was addressed with the publication of §§1.263(a)-4 and 1.263(a)-5 in the Federal Register on January 5, 2004 (T.D. 9107, 2004-1 C.B. 447 [69 FR 436]).

Certain sections of the current regulations under section 263(a) are proposed to be removed entirely and are not restated in the proposed regulations. Section 1.263(a)-1(c) of the current regulations lists several Code and regulation sections to which the capitalization provisions do not apply. Section 1.263(a)-3 (election to deduct or capitalize certain expenditures) lists several Code sections under which a taxpayer may elect to treat certain capital expenditures as either deductible or deferred expenses, or to treat deductible expenses as capital expenditures. These two sections have not been carried over to the proposed regulations because the lists of items in these sections are outdated. This language is intended to have the same general effect as current §§1.263(a)-1(c) and 1.263(a)-3, without citing to specific Code and regulation sections that may have been repealed and without omitting specific Code and regulation sections that may have been added.

Certain portions of §1.263(a)-2 of the current regulations (examples of capital expenditures) also are not restated in the proposed regulations, or are incorporated into other sections of the proposed regulations. Section 1.263(a)-2(a) of the current regulations (the cost of acquisition of property with a useful life substantially beyond the taxable year) is incorporated into and expanded upon in §1.263(a)-2 of the proposed regulations (amounts paid to acquire or produce tangible property). Section 1.263(a)-2(b) of the current regulations (amounts expended for securing a copyright and plates) is proposed to be removed because these amounts are now addressed by §1.263(a)-4(d)(5) and section 263A. The rules in §1.263(a)-2(c) of the current regulations (the cost of defending or perfecting title to property) are addressed in §1.263(a)-4(d)(9) of the current regulations with regard to intangibles and in §1.263(a)-2(d)(2) of the proposed regulations with regard to tangible property. Section 1.263(a)-2(d) of the current regulations (amounts expended for architect’s services) is proposed to be removed because those amounts are now included in section 263A. The rules in §1.263(a)-2(f) and (g) of the current regulations (relating to certain capital contributions) essentially are restated in §1.263(a)-1(b) of the proposed regulations. Finally, §1.263(a)-2(h) of the current regulations (the cost of goodwill in connection with the acquisition of the assets of a going concern) is proposed to be removed because this cost is now addressed by §1.263(a)-4(c)(1)(x).

Taking into account the provisions that are proposed to be removed and other modifications to the current regulations noted above, the remaining guidance in the current regulations is contained in §1.263(a)-1(a) and (b) of the proposed regulations. Section 1.263(a)-1(a) of the current regulations restates the statutory rules from section 263(a), which are carried over in §1.263(a)-1(a) of the proposed regulations. The rules in §1.263(a)-1(b) of the current regulations address amounts paid to add to the value, or substantially prolong the useful life, of property owned by the taxpayer, and amounts paid to adapt property to a new or different use. They also address the treatment of those capitalized expenditures, for example, as a charge to capital account or basis. These rules are incorporated into and expanded upon in §1.263(a)-3 of the proposed regulations. The proposed regulations also revise §1.162-4 of the current regulations (allowing a deduction for the cost of incidental repairs) to provide rules consistent with §1.263(a)-3 of the proposed regulations (requiring capitalization of amounts paid to improve property).

The proposed regulations do not address amounts paid to acquire or create intangible interests in land, such as easements, life estates, mineral interests, timber rights, zoning variances, or other intangible interests in land. The IRS and Treasury Department request comments on whether these and similar amounts, or certain of these amounts, should be addressed in the final regulations and, if so, what rules should be provided. The proposed regulations also do not address the treatment of software development costs.

The proposed regulations require capitalization of amounts paid to acquire, produce, or improve tangible real and personal property, including amounts paid to facilitate the acquisition of tangible property. The proposed regulations do not address amounts paid to facilitate an acquisition of a trade or business because those amounts are addressed in §1.263(a)-5 of the current regulations.

The proposed regulations clarify that they do not change the treatment of any amount that is specifically provided for under any provision of the Code or regulations other than section 162(a) or section 212 and the regulations under those sections. This rule applies regardless of whether that specific provision is more or less favorable to the taxpayer than the treatment in the proposed regulations. Thus, where another section of the Code or regulations prescribes a specific treatment of an amount, the provisions of that section apply and not the rules contained in the proposed regulations. This rule is the same as that contained in §§1.263(a)-4(b)(4) and 1.263(a)-5(j) of the current regulations. The proposed regulations, for example, do not preclude taxpayers from deducting the cost of certain depreciable business assets under section 179. On the other hand, the proposed regulations do not exempt taxpayers from applying the uniform capitalization rules under section 263A when applicable, nor do they exempt taxpayers from complying with the timing rules regarding incurring a liability under section 461 (including economic performance).

The rule clarifying that the proposed regulations do not change the treatment of any other amount that is specifically provided for under any other provision of the Code or regulations provides an exception for the treatment of any amount that is specifically provided for under section 162(a) or section 212 or the regulations under those sections. Thus, the proposed regulations override any conflicting provisions in the regulations under sections 162(a) and 212. For this reason, the proposed regulations amend the current rule for deductible repairs under §1.162-4 to provide that amounts paid for repairs and maintenance to tangible property are deductible if the amounts paid are not required to be capitalized under §1.263(a)-3 of the proposed regulations. The proposed regulations, however, do not amend or remove any other provisions of the current regulations under section 162(a), including §§1.162-6 (regarding professional expenses) and 1.162-12 (regarding certain expenses of farmers). Section 1.162-6 permits a deduction for amounts paid for books, furniture, and professional instruments and equipment, the useful life of which is short, while §1.162-12 permits a deduction for the cost of ordinary tools of short life or small cost. The rules in current §§1.162-6 and 1.162-12 are consistent with the rules in the proposed regulations and are not revised.

The proposed regulations provide that, except in the case of dealers in property, commissions and other transaction costs paid to facilitate the sale of property generally must be capitalized and treated as a reduction in the amount realized. Dealers in property include taxpayers that maintain and sell inventories and taxpayers that produce property for sale in the ordinary course of business, for example, the home construction business. The language in this section is slightly broader than the current language of §1.263(a)-2(e), which refers only to commissions paid in selling securities. However, the language in the proposed regulations is consistent with case law that generally treats all transaction costs paid in connection with the sale of any property as capitalized and offset against the amount realized. See, Wilson v. Commissioner, 49 T.C. 406, 414 (1968); rev’d on other grounds, 412 F.2d 314 (6^th Cir. 1969) (“The rule is thoroughly engrained that commissions and similar charges must be treated as capital expenditures which reduce the selling price when gain or loss is computed on the transaction”); Frick v. Commissioner, T.C. Memo 1983-733, aff’d without opinion, 774 F.2d 1168 (7^th Cir. 1985) (“Fees paid in connection with the disposition of real property are capital expenditures and are deductible from the selling price in determining gain or loss on the ultimate disposition”); Hindes v. United States, 246 F. Supp. 147, 150 (W.D. Tex. 1965); affd. in part, revd. in part on other grounds, 371 F.2d 650 (5^th Cir. 1967) (“Fees and expenses paid in connection with the acquisition or disposition of property, real or personal, are capital expenditures, and, in the case of a taxpayer not engaged in the business of buying and selling real estate, are deductible from the selling price in determining gain or loss on the ultimate disposition”). The sales cost rule in the proposed regulations, however, applies only to transaction costs and does not include other amounts that might be paid for the purpose of selling property, such as amounts paid to repair or improve the property in preparation for a sale. The treatment of those amounts is governed by the general rules under §1.263(a)-3 of the proposed regulations relating to improvements.

The current regulations under section 263(a) require capitalization of amounts paid for the acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year. See §1.263(a)-2(a) of the current regulations. The proposed regulations are consistent with this rule, but treat amounts paid to construct or erect property as production costs. Specifically, the proposed regulations require capitalization of amounts paid for property having a useful life substantially beyond the taxable year, including land and land improvements, buildings, machinery and equipment, and furniture and fixtures, and a unit of property (as determined under §1.263(a)-3(d)(2)), having a useful life substantially beyond the taxable year. See §1.263(a)-2(d) of the proposed regulations. Thus, §1.263(a)-2 of the proposed regulations requires capitalization of amounts paid for property that is not itself a unit of property, such as property (not treated as a material or supply under §1.162-3) that is intended to be used as a component in the repair or improvement of a unit of property. Additionally, the current regulations at §1.263(a)-1(b) list inventory costs as capital expenditures under §1.263(a)-1(a). Therefore, §1.263(a)-2 of the proposed regulations also requires capitalization of amounts paid to acquire real or personal property for resale and to produce real or personal property for sale.

The proposed regulations provide that the terms amounts paid and payment mean, in the case of a taxpayer using an accrual method of accounting, a liability incurred (within the meaning of §1.446-1(c)(1)(ii)). The definitions of real and tangible personal property are intended to be the same as the definitions used for depreciation purposes as derived from the language in the regulations at §1.48-1. Thus, for purposes of the proposed regulations, tangible personal property means any tangible property except land and improvements thereto, such as buildings or other inherently permanent structures (including items that are structural components of buildings or structures). See, Whiteco Indus., Inc. v. Commissioner, 65 T.C. 664 (1975) (applying six factors in determining whether property is an inherently permanent structure). Under the proposed regulations, the definitions of building and structural components are the definitions provided in §1.48-1(e). The IRS and Treasury Department considered other definitions of real and tangible personal property, including the definitions in the regulations under section 263A(f), but believe that the definitions used for depreciation purposes are the definitions most consistent with the purposes of the proposed regulations.

The definition of produce in §1.263(a)-2(b)(4) of the proposed regulations is intended to be the same as the definition used for purposes of section 263A(g)(1) and §1.263A-2(a)(1)(i), except that improvements are separately defined in §1.263(a)-3 of the proposed regulations. The costs that are required to be capitalized to property produced or to any improvement are the costs that must be capitalized under section 263A. Thus, for example, all direct materials and direct labor, and all indirect costs that directly benefit or are incurred by reason of production/improvement activities are required to be capitalized to the property being produced or improved.

The proposed regulations require taxpayers to capitalize an amount paid to defend or perfect title to tangible property. This rule is consistent with the current regulations at §1.263(a)-2(c) and parallels the rule in §1.263(a)-4(d)(9) with regard to intangible property. The proposed regulations also require capitalization of amounts paid to facilitate the acquisition of real or personal property. The IRS and Treasury Department request comments on whether any specific guidance is needed with regard to employee compensation and overhead costs that facilitate the acquisition of tangible property and, if so, what that guidance should provide. The proposed regulations do not address transaction costs related to the production or improvement of tangible property because those costs are subject to capitalization under section 263A.

As noted in section II.A. above, the proposed regulations generally do not change the treatment of any amount that is specifically provided for under any provision of the Code or regulations other than section 162(a) or section 212 and the regulations under those sections. However, with regard to section 162(a), the proposed regulations provide an exception for amounts paid for materials and supplies that are properly treated as deductions or deferred expenses, as appropriate, under §1.162-3. Thus, the proposed regulations do not change the treatment of materials and supplies under §1.162-3, including property that is treated as a material and supply that is not incidental under Rev. Proc. 2002-28, 2002-1 C.B. 815 (regarding the use of the cash method by certain qualifying small business taxpayers), Rev. Proc. 2002-12, 2002-1 C.B. 374 (regarding smallwares), and Rev. Proc. 2001-10, 2001-1 C.B 272 (regarding inventory of certain qualifying taxpayers).

The current regulations under sections 263(a), 446, and 461 require taxpayers to capitalize amounts paid to acquire property having a useful life substantially beyond the taxable year. See §§1.263(a)-2(a), 1.446-1(c)(1)(ii), and 1.461-1(a)(2)(i) of the current regulations. Section 1.263(a)-2(d) of the proposed regulations retains this general rule. Some courts have adopted a 12-month rule for determining whether property has a useful life substantially beyond the taxable year. See Mennuto v. Commissioner, 56 T.C. 910 (1971), acq. (1973-2 C.B. 2); Zelco, Inc. v. Commissioner, 331 F.2d 418 (1^st Cir. 1964); International Shoe Co. v. Commissioner, 38 B.T.A. 81 (1938). Under the 12-month rule adopted by some courts, a taxpayer may deduct currently an amount paid for a benefit or paid for property having a useful life that does not extend beyond one year. This rule was adopted in the regulations relating to intangibles. See §1.263(a)-4(f). The proposed regulations provide a similar 12-month rule for amounts paid to acquire or produce certain tangible property.

The proposed regulations generally provide that an amount (including transaction costs) paid for the acquisition or production of a unit of property with an economic useful life of 12 months or less is not a capital expenditure. The unit of property and economic useful life determinations are made under the rules described in §1.263(a)-3 for improved property. The 12-month rule generally applies unless the taxpayer elects not to apply the 12-month rule, which election may be made with regard to each unit of property that the taxpayer acquires or produces. An election not to apply the 12-month rule may not be revoked. Taxpayers that have elected to use the original tire capitalization method of accounting for the cost of certain tires under Rev. Proc. 2002-27, 2002-1 C.B. 802, must use that method for the original and replacement tires of all their qualifying vehicles. See section 5.01 of Rev. Proc. 2002-27. Therefore, taxpayers that use that method cannot use the 12-month rule provided under the proposed regulations to deduct amounts paid to acquire original or replacement tires.

The proposed regulations clarify the interaction of the 12-month rule with the timing rules contained in section 461 of the Code. Nothing in the proposed regulations is intended to change the application of section 461, including the application of the economic performance rules in section 461(h). This coordination rule is the same as that provided in the regulations under section 263(a) relating to intangibles. See §1.263(a)-4(f). In the case of a taxpayer using an accrual method of accounting, section 461 requires that an item be incurred before it is taken into account through capitalization or deduction. For example, under §1.461-1(a)(2), a liability generally is not incurred until the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. Thus, the 12-month rule provided by the proposed regulations does not permit an accrual method taxpayer to deduct an amount paid for tangible property if the amount has not been incurred under section 461 (for example, if the taxpayer does not have a fixed liability to acquire the property). The proposed regulations contain examples illustrating the interaction of the 12-month rule with section 461.

The proposed regulations provide that, upon a sale or other disposition, property to which a taxpayer applies the 12-month rule is not treated as a capital asset under section 1221 or as property used in the trade or business under section 1231. Thus, 12-month property is not of a character subject to depreciation and any amount realized upon disposition of 12-month property is ordinary income to the taxpayer.

The IRS and Treasury Department do not believe that it is appropriate to apply the 12-month rule to certain types of property. Thus, the proposed regulations provide that the 12-month rule does not apply to property that is or will be included in property produced for sale or property acquired for resale, improvements to a unit of property, land, or a component of a unit of property.

In Notice 2004-6, the IRS and Treasury Department requested comments on whether the regulations should provide a de minimis rule. Because the notice refers to the application of section 263(a) to amounts paid to repair, improve, or rehabilitate tangible property, most commentators focused on a de minimis rule for the cost of repairs rather than the cost to acquire property. However, one commentator requested that the regulations specifically provide a de minimis rule for acquisition costs, but allow taxpayers to continue to use their current method if they have reached a working agreement with their IRS examining agent regarding a de minimis rule.

The IRS and Treasury Department recognize that for regulatory or financial accounting purposes, taxpayers often have a policy for deducting an amount paid below a certain dollar threshold for the acquisition of tangible property (de minimis rule). For Federal income tax purposes, the taxpayer generally would be required to capitalize the amount paid if the property has a useful life substantially beyond the taxable year. However, in this context some courts have permitted the use of a de minimis rule for Federal income tax purposes. See Union Pacific R.R. Co. v. United States, 524 F.2d 1343 (Ct. Cl. 1975) (permitting the use of the taxpayer’s $500 de minimis rule, which was in accordance with the Interstate Commerce Commission (ICC) minimum rule and generally accepted accounting principles); Cincinnati, N.O. & Tex. Pac. Ry. v. United States, 424 F.2d 563 (Ct. Cl. 1970) (same). But see Alacare Home Health Services, Inc. v. Commissioner, T.C. Memo 2001-149 (disallowing the taxpayer’s use of a $500 de minimis rule because it distorted income).

The proposed regulations do not include a de minimis rule for acquisition costs. However, the IRS and Treasury Department recognize that taxpayers often reach an agreement with IRS examining agents that, as an administrative matter, based on risk analysis and/or materiality, the IRS examining agents do not select certain items for review such as the acquisition of tangible assets with a small cost. This often is referred to by taxpayers and IRS examining agents as a de minimis rule. The absence of a de minimis rule in the proposed regulations is not intended to change this practice.

The IRS and Treasury Department considered including a de minimis rule in the proposed regulations. The de minimis rule considered would have provided that taxpayers are not required to capitalize certain de minimis amounts paid for the acquisition or production of a unit of property. Under the rule considered, if a taxpayer had written accounting procedures in place treating as an expense on its applicable financial statement (AFS) amounts paid for property costing less than a certain dollar amount, and treated the amounts paid during the taxable year as an expense on its AFS in accordance with those written accounting procedures, the taxpayer would not have been required to capitalize those amounts if they did not exceed a certain dollar threshold. A taxpayer that did not meet these criteria (for example, a taxpayer that did not have an AFS) would not have been required to capitalize amounts paid for a unit of property that did not exceed the established dollar threshold. Because taxpayers without an AFS generally are smaller than taxpayers with an AFS, the dollar threshold for the de minimis rule that would have applied to them would have been lower than the threshold for taxpayers with an AFS (although the de minimis rule for taxpayers with an AFS also would have been limited to the amount treated as an expense on their AFS). The de minimis rule considered by the IRS and Treasury Department would not have applied to inventory property, improvements, land, or a component of a unit of property.

The de minimis rule considered also would have provided that property to which a taxpayer applies the de minimis rule is treated upon sale or disposition similar to section 179 property. Thus, de minimis property would have been property of a character subject to depreciation and amounts paid that were not capitalized under the de minimis rule would have been treated as amortization subject to recapture under section 1245. Thus, gain on disposition of the property would have been ordinary income to the taxpayer to the extent of the amount treated as amortization for purposes of section 1245.

The IRS and Treasury Department decided to not include a de minimis rule in the proposed regulations but instead to request comments on whether such a rule should be included in the final regulations or whether to continue to rely on the current administrative practice of IRS examining agents. Therefore, the IRS and Treasury Department request comments on whether a de minimis rule for acquisition costs should be included in the final regulations, and, if so, whether the de minimis rule should be the rule described above and what dollar thresholds are appropriate.

The IRS and Treasury Department also request comments on the scope of costs that should be included in a de minimis rule if one is provided in the final regulations and on the character of de minimis rule property. For example, the de minimis rule considered by the IRS and Treasury Department would have applied to the aggregate of amounts paid for the acquisition or production (including any amounts paid to facilitate the acquisition or production) of a unit of property and including amounts paid for improvements prior to the unit of property being placed in service. If a de minimis rule should be provided in the final regulations, the IRS and Treasury Department request comments on what, if any, type of rule should be provided to prevent a distortion of income when taxpayers acquire a large number of assets, each of which individually is within the de minimis rule (for example, the purchase by a taxpayer of 2,000 personal computers).

If a de minimis rule for acquisition costs should be provided in the final regulations, the IRS and Treasury Department request comments on whether the rule should permit IRS examining agents and taxpayers to agree to the use of higher de minimis thresholds on the basis of materiality and risk analysis and, if so, under what circumstances a higher threshold should be allowed. The IRS and Treasury Department also request comments on whether, if a de minimis rule should be provided in the final regulations, changes to begin using a de minimis rule or changes to a higher dollar amount within a de minimis rule should be treated as changes in a method of accounting.

As noted in section III.A. of this preamble, §1.263(a)-2 of the proposed regulations generally requires capitalization of amounts paid for the acquisition or production of property having a useful life substantially beyond the taxable year. Thus, §1.263(a)-2(d) of the proposed regulations applies to property that is not itself a unit of property, such as property (not treated as a material or supply under §1.162-3) that is intended to be used as a component in the repair or improvement of a unit of property. It must be determined whether the subsequent use of the component property results in an improvement to the unit of property under §1.263(a)-3 or an otherwise deductible repair or maintenance cost under §1.162-4. Even if the subsequent use of the component is an otherwise deductible expense under §1.162-4, the amount paid nonetheless may be required to be capitalized. For example, it must be determined whether the amount paid for the component property is required to be capitalized under section 263A as an indirect cost that directly benefits or is incurred by reason of property produced or acquired for resale. The proposed regulations illustrate this concept in an example of a manufacturer that replaces one window in a building. The taxpayer initially must capitalize under §1.263(a)-2(d) amounts paid to acquire the window. The replacement of the window subsequently is determined to be a repair to the building rather than an improvement. Amounts paid for the repair (or an allocable portion thereof) must then be capitalized under section 263A to the inventory that the taxpayer produces to the extent that the repair directly benefits or is incurred by reason of the taxpayer’s production activities.

In response to Notice 2004-6, the IRS and Treasury Department received several comments on the issues that should be addressed in the proposed regulations to provide guidance on amounts paid to repair, improve, and rehabilitate tangible property. These comments have been taken into account in drafting §1.263(a)-3 of the proposed regulations. That section addresses amounts paid to improve tangible property and includes the following provisions: (1) rules for determining the appropriate unit of property to which the improvement provisions apply; (2) general rules for improvements; (3) rules for determining whether an amount paid materially increases the value of the unit of property; (4) rules for determining whether an amount paid restores the unit of property; and (5) an optional repair allowance method.

A threshold issue in applying the improvement rules under §1.263(a)-3 of the proposed regulations is determining the appropriate unit of property to which the rules should be applied. For example, to determine whether an amount paid materially increases the value of property, it is necessary to know what property is at issue. The smaller the unit of property, the more likely it is that amounts paid in connection with that unit of property will materially increase the value of, or restore, the property. Taxpayers and the IRS frequently disagree on the unit of property to which the capitalization rules should be applied. Thus, the unit of property rules in the proposed regulations are intended to provide guidance in determining whether an amount paid improves the unit of property under §1.263(a)-3. The unit of property rules also apply for purposes of §1.263(a)-1 of the proposed regulations (which references the rules in §§1.263(a)-2 and 1.263(a)-3 of the proposed regulations) and §1.263(a)-2 of the proposed regulations (for example, with regard to the 12-month rule). The unit of property rules in the proposed regulations apply only for purposes of section 263(a) and §§1.263(a)-1, 1.263(a)-2, and 1.263(a)-3 of the proposed regulations, and not any other Code or regulation section. For example, no inference is intended that these unit of property rules have any application for section 263A(f) interest capitalization purposes.

The current regulations under section 263(a) do not provide any guidance on determining the appropriate unit of property. Some courts have addressed the unit of property issue under section 263(a), but their holdings are based on the particular facts of each case and do not contain rules that are generally applicable for purposes of section 263(a). See, FedEx Corp. v. United States, 291 F. Supp. 2d 699 (W.D. Tenn. 2003), aff’d, 412 F.3d 617 (6^th Cir. 2005) (concluding that an aircraft, and not the aircraft engine, was the appropriate unit of property); Smith v. Commissioner, 300 F.3d 1023 (9^th Cir. 2002) (concluding that an aluminum reduction cell, rather than entire cell line, was the appropriate unit of property); Ingram Industries, Inc. v. Commissioner, T.C. Memo 2000-323 (concluding that a towboat, and not the towboat engine, was the appropriate unit of property); LaSalle Trucking Co. v. Commissioner, T.C. Memo 1963-274 (concluding that truck engines, tanks, and cabs were each separate units of property).

In FedEx, the court ruled on whether an aircraft engine or the entire aircraft was the appropriate unit of property for determining whether the costs of engine shop visits (ESVs) must be treated as capital expenditures. Relying on the opinions in Ingram and Smith, the court concluded that the following four factors were relevant in determining the appropriate unit of property: (1) whether the taxpayer and the industry treat the component part as a part of a larger unit of property for regulatory, market, management, or accounting purposes; (2) whether the economic useful life of the component part is coextensive with the economic useful life of the larger unit of property; (3) whether the larger unit of property and the smaller unit of property can function without each other; and (4) whether the component part can be and is maintained while affixed to the larger unit of property. Applying these factors to aircraft engines, the court concluded that the engines should not be considered a unit of property separate and apart from the airplane.

In Notice 2004-6, the IRS and Treasury Department requested comments on the relevance of various unit of property factors derived from FedEx and other cases that addressed the unit of property issue. The factors listed in Notice 2004-6 included: (1) whether the property is manufactured, marketed, or purchased separately; (2) whether the property is treated as a separate unit by a regulatory agency, in industry practice, or by the taxpayer in its books and records; (3) whether the property is designed to be easily removed from a larger assembly, is regularly or periodically replaced, or is one of a fungible set of interchangeable or rotable assets; (4) whether the property must be removed from a larger assembly to be fixed or improved; (5) whether the property has a different economic life than the larger assembly; (6) whether the property is subject to a separate warranty; (7) whether the property serves a discrete purpose or functions independently from a larger assembly; or (8) whether the property serves a dual purpose function.

The IRS and Treasury Department received nine comments on the unit of property issue, four of which specifically recommended that the proposed regulations adopt the factors used by the court in FedEx. These factors essentially are contained in factors 1, 2, 4, 5, and 7 of Notice 2004-6. Several of the factors listed in Notice 2004-6 have been incorporated into the proposed regulations. However, the IRS and Treasury Department determined that some factors were not relevant for certain types of property. For example, the factors listed in Notice 2004-6 primarily derive from case law that addresses tangible personal property; therefore, the factors were not as helpful in determining the appropriate unit of property for real property, such as land. Further, some types of property lend themselves to specific unit of property rules, such as buildings and property owned by taxpayers in a regulated industry. The IRS and Treasury Department believe that the administrative burden associated with determining the appropriate unit of property can be reduced for both the IRS and taxpayers by identifying specific rules reflecting an approach appropriate for the taxpayer’s industry and the type of property at issue. Therefore, the proposed regulations provide different unit of property rules for four categories of property, rather than prescribing one rule for all types of property.

The unit of property rules in the proposed regulations apply to all real and personal property other than network assets. For purposes of the unit of property rules, network assets means railroad track, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines that are owned or leased by taxpayers in each of those respective industries. Network assets include, for example, trunk and feeder lines, pole lines, and buried conduit. They do not include property that would be included as a structural component of a building under §1.263(a)-3(d)(2)(iv) of the proposed regulations, nor do they include separate property that is adjacent to, but not part of a network asset, such as bridges, culverts, or tunnels. The proposed regulations do not affect current guidance that addresses the unit of property or capitalization rules for network assets, such as Rev. Proc. 2001-46, 2001-2 C.B. 263 (track maintenance allowance method for Class I railroads); Rev. Proc. 2002-65, 2002-2 C.B. 700 (track maintenance allowance method for Class II and III railroads); and Rev. Proc. 2003-63, 2003-2 C.B. 304 (safe harbor unit of property rule for cable television distribution systems). The IRS and Treasury Department request comments on the relevant rules for determining the appropriate unit of property for network assets. Additionally, the IRS and Treasury Department request comments on whether to include rules for network assets in final regulations, or whether to develop for network assets industry-specific guidance that is similar to the above referenced revenue procedures.

With the exception of network assets, the four categories of property in the proposed regulations are intended to cover all real and personal property. In addition to the four categories of property, the unit of property rules provide for an initial unit of property determination, which, except with regard to buildings and structural components, is made prior to categorizing the property. The initial unit of property determination is based on the functional interdependence test in §1.263A-10(a)(2), relating to the capitalization of interest. The initial unit of property determination is intended to be a common-sense approach to defining the largest possible unit of property as a starting point for analyzing the rules under one of the four relevant unit of property categories. After the initial unit of property is determined, the additional unit of property rules are intended to result in a determination that either confirms the initial unit of property as the unit of property, or that separates one or more components of the initial unit of property into separate units of property.

Some commentators suggested that the functional interdependence test under §1.263A-10(a)(2) regarding interest capitalization should be the sole test for determining the appropriate unit of property. The IRS and Treasury Department believe that the functional interdependence test is a relevant, but not dispositive factor. The purpose of that test under §1.263A-10(a)(2) is to calculate the appropriate unit of property for determining the accumulated production expenditures at the beginning and end of the production period. The preamble that accompanied the promulgation of §1.263A-10 discusses the reasoning for adopting a broad formulation of the unit of property definition and states that “this concept of single property may differ from the concept of single or separate property that taxpayers use for other purposes (e.g., for computing amounts of depreciation deductions or separately tracking the bases of assets).” T.D. 8584, 1995-1 C.B. 20, 25; [59 FR 67, 187] Dec. 29, 1994).

In contrast to the unit of property rules in §1.263A-10(a)(2), the purpose of the unit of property rules under section 263(a) is to provide a starting point for determining whether an amount paid materially increases the value of, or restores, the unit of property. Thus, §1.263A-10(a)(2) has a different purpose than the proposed regulations under section 263(a). Further, in determining the appropriate unit of property for purposes of section 263(a), the functional interdependence test does not always produce appropriate results. For example, a taxpayer might argue that application of that test results in an entire complex of structures and machinery, such as an entire power plant, being treated as a single unit of property. The IRS and Treasury Department do not believe that result is correct for purposes of section 263(a).

After the initial unit of property determination is made, the unit of property analysis continues with determining the appropriate category of property and applying the rules in that category. The proposed regulations provide specific rules for four categories of property: (1) property owned by taxpayers in a regulated industry; (2) buildings and structural components; (3) other personal property; and (4) other real property. The unit of property determination made under the applicable category is then subject to an additional rule in §1.263(a)-3(d)(2)(vii) regarding treatment for other Federal income tax purposes. The rules for each of the four categories are explained below.

The first unit of property category in the proposed regulations is property owned by taxpayers in a regulated industry. The proposed regulations provide that if the taxpayer is in an industry for which a Federal regulator has a uniform system of accounts (USOA) identifying a particular unit of property, the taxpayer must use the same unit of property for Federal income tax purposes, regardless of whether the taxpayer is subject to the regulatory accounting rules of the Federal regulator and regardless of whether the property is particular to that industry. This rule derives from one of the factors cited by the court in FedEx for determining the appropriate unit of property — whether the taxpayer and the industry treat the component part as part of the larger unit of property for regulatory, market, management, or accounting purposes. Thus, this rule ties into the regulatory accounting element of the FedEx factor, as well as the general concept of industry practice. The IRS and Treasury Department are aware of three Federal regulators that provide a USOA: (1) the Federal Energy Regulatory Commission (FERC); (2) the Federal Communications Commission (FCC); and (3) the Surface Transportation Board (STB). Accordingly, this unit of property category applies to taxpayers such as power companies, telecommunications companies, and railroads.

The IRS and Treasury Department determined that the regulatory accounting rule should be applied similarly to all taxpayers in industries for which a Federal regulator provides a USOA, regardless of whether the taxpayer is subject to the regulatory accounting rules of the Federal regulator. This rule is consistent with the general standard of using industry practice to determine the appropriate unit of property. Further, it results in all taxpayers within a specific industry being treated the same for Federal income tax purposes, without regard to whether a particular taxpayer is subject to the accounting rules of the Federal regulator. The rule is limited to the regulator’s USOA and does not apply to other Federal regulatory rules, such as rules concerning safety or health. The proposed regulations apply only to USOA provided by Federal regulators and do not apply to USOA issued by any state or local agencies. Rules of state and local agencies may be different than Federal regulatory rules and can vary widely within an industry depending on the taxpayer’s location.

Four of the commentators on this aspect of Notice 2004-6 recommended adopting the four factors cited in FedEx, from which the regulated industry rule was derived. None of the commentators specifically objected to a regulatory accounting rule, although one commentator suggested that where cost recovery is determined for non-tax purposes by a Federal or state agency, the regulations should provide a special election that may be made on an annual basis under which the taxpayer may use the same unit of property for tax purposes as it must use for regulatory purposes. The IRS and Treasury Department believe the unit of property inquiry should result in one clear determination that will be used consistently by the taxpayer unless the underlying facts change and, therefore, do not believe an annual election is appropriate.

In general, a building and its structural components must be treated as one unit of property. This rule is based on the definitions of building and structural component in the regulations under section 48. The repair allowance regulations under the Class Life Asset Depreciation Range (CLADR) system also provide that a building and its structural components generally are a single unit of property. See §1.167(a)-11(d)(2)(vi). The IRS and Treasury Department believe that these definitions are useful in determining the appropriate unit of property for buildings and structural components. One commentator specifically requested that the proposed regulations use the definition of building under §1.48-1(e) to determine a unit of property. The proposed regulations rely on the definition of building under §1.48-1(e). Property located inside a building that is not a structural component of the building must be analyzed under one of the other three unit of property categories; for example, machinery and equipment inside a factory must be analyzed under Category III (the other personal property category).

This Category II is the only category to which the initial unit of property determination does not apply. Applying the functional interdependence test to a building would raise issues in cases where certain floors or portions of a building are placed in service independently of another. The IRS and Treasury Department believe that, unless the additional rule in §1.263(a)-3(d)(2)(vii) of the proposed regulations (regarding treatment for other Federal income tax purposes) applies to require a component of a building to be treated as a separate unit of property, the building and its structural components should be the unit of property. The IRS and Treasury Department recognize, however, that it is not always appropriate to treat the entire building as the unit of property. For example, a taxpayer who owns a unit in a condominium building, whether the unit is used for personal or investment purposes, should not treat the entire building as the unit of property. Therefore, the IRS and Treasury request comments on how the unit of property rules should apply to condominiums, cooperatives, and similar types of property.

The unit of property determination for personal property not included in Category I (taxpayers in a regulated industry) is a facts and circumstances test, based on four exclusive factors, none of which is dispositive or weighs more heavily than the others.

The first exclusive factor is whether the component is (1) marketed separately to or acquired or leased separately by the taxpayer (from a party other than the seller/lessor of the property of which the component is a part) at the time it is initially acquired or leased; (2) subject to a separate warranty contract (from a party other than the seller/lessor of the property of which the component is a part); (3) subject to a separate maintenance manual or written maintenance policy; (4) appraised separately; or (5) sold or leased separately by the taxpayer to another party. This factor contains a number of items intended to determine the treatment in the marketplace of the component as a separate unit of property.

Whether the component is acquired separately was a factor addressed by the courts in FedEx and Ingram, and is also part of the CLADR repair allowance regulations under section 167 and the unit of property determination for interest capitalization in §1.263A-10. In FedEx, the court discussed this issue in the context of whether the taxpayer and the industry treat the component part as part of the larger unit of property for regulatory, market, management, or accounting purposes. In finding that the aircraft engines were not purchased separately, the court relied on the fact that the engines and aircraft were designed to be compatible and were generally acquired by the taxpayer at the same time. The court disregarded the fact that the taxpayer purchased the engines and airframes from different sellers when the aircraft were initially acquired. The IRS and Treasury Department believe that the acquisition of a component from a different seller at the time the larger property is acquired should be a relevant factor, and that the same rule should apply if the taxpayer leases the component from a different party than the seller of the larger property.

The IRS and Treasury Department recognize that this factor may produce different results depending on whether the property is new or used. When a taxpayer acquires or leases used property, it is possible that items that were separate units of property when purchased new will be treated as one unit of property because the initial purchaser has assembled the units into one functional item that it sells or leases. The IRS and Treasury Department considered whether it was appropriate to have a factor that could treat new and used property differently, and decided that the difference reasonably reflects the substance of the transactions — where the taxpayer acquires or leases a component from a different party from whom it acquires or leases the larger property, the taxpayer typically is conducting different, but related, transactions with separately negotiated terms.

Whether the component is subject to a separate warranty contract, maintenance manual, or written maintenance policy was cited as a factor in FedEx and is adopted as part of the marketplace treatment factor in the proposed regulations. The warranty contract factor applies only to a warranty that is provided by a party other than the seller/lessor of the larger property. It is not intended to apply to a warranty provided by the sellor/lessor that may contain separate warranties (for example, for different time periods) on various components of the larger property. Whether the property is manufactured separately was a possible factor cited in Notice 2004-6. The proposed regulations do not specifically adopt this factor because components that are subject to a separate warranty or maintenance procedures also are likely to be manufactured separately. The FedEx case used as a factor whether the component was appraised or valued separately and the CLADR repair allowance regulations under section 167 addressed whether the component was sold separately to another party. The proposed regulations adopt these tests as part of the marketplace factor.

The IRS and Treasury Department believe that it is important that all the criteria in this factor be taken into account together when weighing this factor with the other three factors. Some criteria may be stronger indicators warranting treatment of the component as a separate unit of property than others. The IRS and Treasury Department acknowledge that several of the criteria within this factor do not work well for property produced by the taxpayer, and request comments regarding how and whether a marketplace factor should apply to self-constructed property.

The second exclusive factor in this Category III is whether the component is treated as a separate unit of property in industry practice or by the taxpayer in its books and records. This factor was cited by the court in FedEx. The IRS and Treasury Department believe that the taxpayer’s treatment of the component as separate in its books and records is a relevant factor in determining whether the component should be treated as a separate unit of property in the proposed regulations. In particular, if the taxpayer’s books and records assign different economic useful lives to the component and the larger property, this factor would weigh heavily toward treating the component as a separate unit of property.

The IRS and Treasury Department considered whether to use as a factor whether the component has a different economic useful life than the property of which it is a part. This factor was cited by the courts in Smith, Ingram, and FedEx. However, for this factor to be useful, the regulations would need to define economic useful life. The proposed regulations at §1.263(a)-3(f) (with regard to restoration of a unit of property) provide a definition of economic useful life, which has different meanings depending on whether a taxpayer has an AFS. If the unit of property rules adopted this definition, the economic useful life test under this factor would produce different results depending on whether the taxpayer has an AFS. These different results are not justified in this context. Further, a taxpayer’s treatment of the component in its books and records under this Factor 2 includes any useful life determinations of the component and the property of which the component is a part in the books and records. Therefore, the economic useful life factor was not specifically adopted as a separate factor.

The third exclusive factor in the other personal property category is whether the taxpayer treats the component as a rotable part. A rotable part is defined as a part that is removeable from property, repaired or improved, and either immediately reinstalled on other property or stored for later installation. This factor was cited by the courts in Smith and LaSalle. The court in FedEx ignored this factor, but considered as a separate concept whether the component can be and is maintained while affixed to the larger unit. The IRS and Treasury Department considered this separate concept as well, but believe that the rotable part factor incorporates this concept from FedEx. As the examples in the proposed regulations illustrate, this factor focuses on the particular taxpayer’s treatment of the property as a rotable part in determining whether the rotable is a separate unit of property. Therefore, for example, if the rotable part is a separate unit of property to the taxpayer and the taxpayer incorporates the rotable into other property for resale, the rotable part will not necessarily be a separate unit of property to the purchaser.

Two commentators stated that the treatment of a component as a rotable part is of limited or no relevance. While treatment of minor parts as rotable would not weigh heavily toward separate unit of property treatment, the IRS and Treasury Department believe that the treatment of major components as rotable is a relevant factor in determining whether a component is a separate unit of property, particularly when the economic useful life of the larger property is limited by the expected useful life of the rotable part. Many taxpayers do not maintain an inventory of rotable spares for their major components. Although it is understood that the purpose for maintaining an inventory of rotables is to minimize the time that the larger property is out of service, treatment of a major component as a rotable has consequences that tend to be indicative of a separate unit of property. For example, in the case of a taxpayer that does not maintain an inventory of rotable spare parts, if a major component of the larger property breaks down, then the entire larger property must be taken out of service while the major component is being repaired. This is indicative of the larger property and the component collectively being treated as one unit of property. Conversely, a taxpayer that does maintain an inventory of rotable spare parts for a major component is able to continue to use the larger property without regard to the time required to repair the broken down component. In this instance, the IRS and Treasury Department believe that continued use of the larger property is indicative of separate unit of property treatment for the rotable part. In addition, rotables being depreciated as rotable spare parts is indicative of separate treatment because the components are depreciated separately from the larger property.

In the request for comments, Notice 2004-6 combined several other factors with the rotables factor, including whether a component is designed to be easily removed from a larger assembly, is regularly or periodically replaced, or is one of a fungible set of interchangeable assets. These factors are broader than the rotables factor in the proposed regulations and would sweep in many minor components that rarely, if ever, would be appropriately considered a separate unit of property. Further, these factors are duplicative of the rotables part factor, because a rotable generally meets all of these factors. The IRS and Treasury Department believe that these factors are not more helpful in determining whether a component is a separate unit of property than the rotables factor described in the proposed regulations. Therefore, the proposed regulations do not include these other factors.

The fourth and final factor in Category III is whether the property of which the component is a part generally functions for its intended use without the component property. This factor was cited by the court in FedEx and is similar to the discrete purpose test under the CLADR repair allowance regulations. It is also similar to the functional interdependence test under §1.263A-10(a)(2) and the rules in these proposed regulations regarding the initial unit of property determination. As noted in the discussion of the initial unit of property determination, the IRS and Treasury Department agree with commentators that the functional interdependence test is a relevant, although not dispositive, factor in the unit of property analysis. Although the proposed regulations use the functional interdependence test to determine the initial unit of property, the functional interdependence test in that context is merely a starting point in determining the appropriate unit of property, rather than a specific factor to be considered. Providing this version of the functional interdependence test as a specific factor gives appropriate weight to that test in the unit of property analysis for other personal property.

The unit of property determination for real property not included in Category I or II is based on a facts and circumstances test. The property subject to this category is primarily land and land improvements owned or leased by taxpayers not in a regulated industry. This category does not list specific factors because land and land improvements are such unique assets that specific factors cannot uniformly provide appropriate results. Thus, the unit of property determination for property in this category may be based on some, all, or none of the factors listed in Category III for personal property, or may be based on other factors. The IRS and Treasury Department request comments on whether additional guidance is needed for this category of property and, if so, what unit of property guidance would be appropriate.

After determining the initial unit of property and applying the unit of property rules under the appropriate category, the additional rule in §1.263(a)-3(d)(2)(vii) must be applied. Under this rule, if a taxpayer properly treats a component as a separate unit of property for any Federal income tax purpose, the taxpayer must treat the component as a separate unit of property for purposes of §1.263(a)-3. The purpose of this rule is to prevent taxpayers from taking inconsistent positions by arguing that a component of property is a unit of property for one tax purpose and that it is not a separate unit of property for capitalization purposes. For example, if a taxpayer does a cost segregation study on a building and properly identifies separate section 1245 property, the taxpayer must treat that separate property as the unit of property for capitalization purposes.

As a further example, if a taxpayer properly recognizes a loss under section 165, or under another applicable provision, from a retirement of a component of property or from the worthlessness or abandonment of a component of property, the taxpayer must treat the component as a separate unit of property. A loss arising under another applicable provision in this context includes a loss arising under (1) §1.167(a)-8 or 1.167(a)-11, as applicable, from a retirement of a component of property if the component is not subject to section 168 (MACRS property) or former section 168 (ACRS property); (2) §1.167(a)-8(a) from a retirement of a component of property if the component is MACRS or ACRS property (applying §1.167(a)-8(a) as though the retirement is a normal retirement from a single asset account) unless the component is a structural component or the component is in a mass asset account (ACRS property) or a general asset account (MACRS property); or (3) §1.168(i)-1(e) from the disposition of a component of property if the component is MACRS property and in a general asset account. No inference is intended that this rule in the proposed regulations requires or allows taxpayers that are using a unit of property for purposes of the proposed regulations to use the same unit of property for purposes of any Code or regulation section other than section 263(a) and §§1.263(a)-1, 1.263(a)-2, and 1.263(a)-3 of the proposed regulations.

This rule is intended to prevent taxpayers from taking a loss deduction on a component of a unit of property, and then deducting the cost of the replaced component as a repair. The application of this rule results in the replacement component being treated as a separate unit of property, thus requiring capitalization under §1.263(a)-2 of amounts paid to acquire or produce the replacement component. The IRS and Treasury Department believe that taxpayers must be consistent in the treatment of a unit of property for capitalization (other than interest capitalization), depreciation, and loss deduction purposes. The IRS and Treasury Department recognize that the language of this consistency rule is very broad, and request comments regarding circumstances in which this rule should not apply.

Section 1.263(a)-1(b) of the current regulations provides that an amount must be capitalized if it (1) adds to the value, or substantially prolongs the useful life, of property owned by the taxpayer, or (2) adapts the property to a new or different use. Notice 2004-6 requested comments on what general principles of capitalization should apply to amounts paid to repair or improve tangible property. Commentators were almost unanimous in their suggestion that the current principles of value, useful life, and new or different use be retained. The IRS and Treasury Department agree with the commentators that the current guidelines generally are appropriate. However, the current regulations require a subjective inquiry into the application of the particular facts at issue, which often results in disagreements between taxpayers and the IRS. Accordingly, the proposed regulations attempt to clarify and expand the standards in the current regulations by setting forth rules to determine whether there has been a material increase in value (including adapting property to a new or different use) and to determine whether there has been a restoration of property (the useful life rules). In addition, the proposed regulations provide objective rules for improvements in an optional repair allowance method.

The proposed regulations generally provide that a taxpayer must capitalize the aggregate of related amounts paid that improve a unit of property, whether the improvements are made by the taxpayer or a third party. The aggregate of related amounts does not encompass otherwise deductible repair costs unless those costs directly benefit or are incurred by reason of a capital improvement. Instead, the aggregation language is intended to include amounts paid for an entire project, including removal costs and other project costs, regardless of whether amounts are paid to more than one party or whether the work spans more than one taxable year. The proposed regulations do not affect the treatment of amounts paid to retire and remove a unit of property in connection with the installation or production of a replacement asset. See Rev. Rul. 2000-7, 2000-1 C.B. 712.

Several commentators suggested that the proposed regulations provide that the relevant distinction between capital improvements and deductible repairs is whether the amounts were paid to put the property in ordinarily efficient operating condition or to keep the property in ordinarily efficient operating condition. See Estate of Walling v. Commissioner, 373 F.2d 190 (3d Cir. 1967); Illinois Merchants Trust Co. v. Commissioner, 4 B.T.A. 103 (1926), acq. (V-2 C.B. 2); Rev. Rul. 2001-4, 2001-1 C.B. 295. The improvement rules in the proposed regulations are consistent with the put versus keep standard, to the extent that standard is relevant. An amount paid may be a capital expenditure even if it does not put the property in ordinarily efficient operating condition because not all repair or improvement costs affect the functionality of the property. Thus, amounts paid that keep property in ordinarily efficient operating condition are not necessarily deductible repair costs, particularly if the useful life is extended. On the other hand, amounts that put property in ordinarily efficient operating condition are likely to be amounts paid prior to the property’s being placed in service or to ameliorate a pre-existing condition or defect. Amounts paid in these later situations would be capital expenditures under either the value rule or the restoration rule in the proposed regulations.

Some commentators suggested that the frequency of the expenditure should be considered, noting that an expenditure being regularly incurred on a cyclical basis should be a strong indication of deductible maintenance. The IRS and Treasury Department considered this comment but concluded that the frequency of the expenditure was too vague a standard to be administrable. Further, the IRS and Treasury Department believe that the proposed regulations provide appropriate guidance on cyclical maintenance by clarifying other rules, such as the appropriate comparison rule for adding value and the rules relating to prolonging economic useful life.

In accordance with several comments received in response to Notice 2004-6, the proposed regulations provide that a Federal, state, or local regulator’s requirement that a taxpayer perform certain repairs or maintenance is not relevant in determining whether the amount paid improves the unit of property. Several courts have held that amounts paid to bring property into compliance with government regulations were capital expenditures, in part because they made the taxpayer’s property more valuable for use in its trade or business. See, Swig Investment Co. v. United States, 98 F.3d 1359 (Fed. Cir. 1996) (replacing cornices and parapets on hotel to comply with city earthquake ordinance); Teitelbaum v. Commissioner, 294 F.2d 541 (7^th Cir. 1961) (converting electrical system from direct current to alternating current to comply with city ordinance); RKO Theatres, Inc. v. United States, 163 F. Supp. 598 (Ct. Cl. 1958) (installing fire-proof doors and fire escapes to comply with city code); Hotel Sulgrave, Inc. v. Commissioner, 21 T.C. 619 (1954) (installing sprinkler system to comply with city code). In each case, however, the court did not rely entirely on regulatory compliance as a basis for requiring capitalization. For example, in Hotel Sulgrave and RKO Theatres, both involving the installation of certain equipment to comply with city fire codes, the courts emphasized that the work involved the addition of property with a useful life extending beyond the taxable year. Moreover, both Swig and Teitelbaum involved expenditures for the replacement of major structural components of a building (parapets and cornices in Swig and an electrical system in Teitelbaum) with upgraded components. Thus, in all these cases, even without the legal compulsion to make these changes, the taxpayers’ amounts paid would have constituted capital expenditures.

In contrast to the cases discussed above, both the courts and the IRS have permitted a current deduction for some government mandated expenditures. For example, in Midland Empire Packing Co. v. Commissioner, 14 T.C. 635 (1950), acq. (1950-2 C.B. 3), the court allowed the taxpayer to deduct the costs of applying a concrete liner to its basement walls to satisfy Federal meat inspectors. Similarly, the IRS has permitted taxpayers to treat as otherwise deductible repairs amounts paid to remediate certain environmental contamination and to replace certain waste storage tanks to comply with applicable state and Federal regulations. See Rev. Rul. 94-38, 1994-1 C.B. 35; Rev. Rul. 98-25, 1998-1 C.B. 998. The IRS specifically recognized in Rev. Rul. 2001-4, 2001-1 C.B. 295 that the requirement of a regulatory authority to make certain repairs or to perform certain maintenance on an asset to continue operating the asset does not mean that the work performed must be capitalized. Thus, the proposed regulations reiterate that statement in Rev. Rul. 2001-4 and provide that a legal compulsion to repair or maintain tangible property is not a relevant factor in the repair versus improvement analysis. The IRS and Treasury Department further believe that a new government requirement for existing property that mandates certain expenditures with respect to the property does not create an inherent defect in the property.

In response to several comments, the proposed regulations provide that if a taxpayer needs to replace part of a unit of property that cannot practicably be replaced with the same type of part, the replacement of the part with an improved but comparable part does not, by itself, result in an improvement to the unit of property. This rule is intended to apply in cases where the same replacement part is no longer available, generally because of technological advancements or product enhancements. This rule, however, is not intended to apply if, instead of replacing an obsolete part with the most similar comparable part available, the taxpayer replaces the part with one of a better quality than what would have sufficed.

The proposed regulations do not prescribe a plan of rehabilitation doctrine as traditionally described in the case law. That judicially-created doctrine provides that a taxpayer must capitalize otherwise deductible repair costs if they are incurred as part of a general plan of rehabilitation to the property.