The New Repair Regulations — Some Things To Consider
Dwight N. Mersereau and Corey M. Wise
Federal - 3/15/2012

All taxpayers that acquire, produce, or improve tangible property will need to evaluate whether to change their methods of accounting[1] to comply with income tax regulations that were recently issued by the Internal Revenue Service and the U.S. Department of the Treasury. Commonly referred to as “the repair regulations,” the new rules generally became effective on January 1, 2012.[2] The repair regulations are a marked departure from prior law (as well as earlier proposed regulations). In many respects, they require taxpayers to capitalize more costs than they were required to capitalize under prior law (and what they would have been required to capitalize under the earlier proposed regulations). In addition, the repair regulations provide several new, optional safe-harbor methods of accounting and elections for taxpayers to consider. This article discusses some of the changes in law the repair regulations make as well as some of the optional methods and elections that taxpayers need to consider.

Costs of Materials and Supplies

Under prior law, taxpayers generally were permitted to account for the costs of their materials and supplies as a deferred expense (i.e., not as inventory nor as depreciable property). Under the deferred expense method, taxpayers generally could deduct the cost of their non-incidental materials and supplies when they used and consumed them in operations, and could deduct the cost of their incidental materials and supplies when they purchased them, so long as they did not track their use of the materials and supplies and deducting them currently clearly reflected their income.[3]

The repair regulations retain that general framework. Additionally, the repair regulations define what are materials and supplies, provide an optional method of accounting for rotable and temporary spare parts, provide an optional election to account for materials and supplies under a de minimis rule, and provide an optional election to capitalize and depreciate the otherwise deductible cost of materials and supplies.

A. Materials and Supplies Defined

The repair regulations define materials and supplies as tangible property that is used or consumed in the taxpayer’s operations that is not inventory[4] and that:

  1. is a component acquired to maintain, repair, or improve a unit of tangible property5 owned, leased, or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property;
  2. consists of fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months or less, beginning when used in the taxpayer’s operations;
  3. is a unit of property that has an economic useful life of 12 months or less,6 beginning when the property is used or consumed in the taxpayer’s operations;
  4. is a unit of property that has an acquisition or production cost of $100 or less; or
  5. is identified in guidance published in the Federal Register or Internal Revenue Bulletin as materials and supplies for which treatment is permitted under Treas. Reg. §1.162-3.[7]

Property that is otherwise described above, but that a taxpayer acquires and uses to improve tangible property, is not a material and supply. Such property is instead subject to the capitalization rules under section 263(a), which are discussed below.[8]

B. Rotable and Temporary Spare Parts

Rotable spare parts are materials and supplies under number (1) in the foregoing list that a taxpayer acquires for installation on a unit of property with the intention to later remove them from that unit of property, repair or improve them, and then either reinstall them on the same or other property or stores them for later installation.[9]

Temporary spare parts are materials and supplies under number (1) that a taxpayer uses temporarily (until it can install new or repaired parts) and then removes and stores them for later emergency or temporary installation.[10]

Under the repair regulations, a taxpayer generally can consider its rotable and temporary spare parts as used or consumed in its operations — and thus, their cost deductible — only when it disposes of them. In some cases, this treatment is less favorable than capitalizing and depreciating the cost of the spare parts, particularly where the taxpayer will not dispose of the spare parts for many years.[11] In such cases, a taxpayer can elect to treat the spare parts as depreciable property.[12] This election, which is also available for other materials and supplies, is discussed below.

Alternatively, a taxpayer may use the “optional method for rotables” to account for its rotable and temporary spare parts, but only if the taxpayer uses the optional method for all of the rotable and temporary spare parts in its trade or business.[13] Under the optional method, the taxpayer deducts the cost of a rotable or temporary spare part when the taxpayer first installs it. When the taxpayer removes the spare part, however, the taxpayer must include its fair market value in income. That amount — together with the taxpayer’s costs of removing the spare part and any costs of maintaining, repairing, and improving it — will be the basis of the spare part. The taxpayer then can deduct the basis in the spare part, and any installation costs, when the taxpayer reinstalls it. When it disposes of a spare part, the taxpayer can deduct any remaining basis in the spare part.[14]

Finally a taxpayer can elect to deduct the cost of its rotable and temporary spare parts under the de minimis rule, which is discussed below.

To summarize, a taxpayer may account for the cost of rotable and temporary spare parts using the following methods:

  • Deduct the cost when the taxpayer disposes of them;
  • Capitalize and depreciate the cost over the applicable recovery period;
  • Elect the optional method for rotables; or
  • Deduct the cost under the de minimis rule.

If a taxpayer elects the optional method for rotables, it must use the method for all rotable and temporary spare parts within a trade or business, but it may selectively apply the de minimis rule. In contrast, if a taxpayer does not elect the optional method for rotables, it may use the deferral method, and selectively apply both the de minimis rule and the capitalization method.

C. The De Minimis Rule Election

Rather than deducting the cost of non-incidental materials and supplies when it uses or consumes them in the operations of the business, a taxpayer can elect to deduct the cost of non-incidental materials and supplies (including rotable and temporary spare parts) in the year in which it produces or acquires them, to the extent such a deduction qualifies under the de minimis rule of Temp. Reg. § 1.263(a)-2T(g).[15] Under the de minimis rule, a taxpayer can deduct the cost of non-incidental materials and supplies if the taxpayer (i) as of the beginning of the year, has a written accounting policy to expense property costing less than a certain threshold, and (ii) did in fact expense the cost of the property on its AFS[16] in accordance with that policy.[17] The total aggregate deduction under the de minimis rule, including deductions for the cost of property other than materials and supplies,[18] however, must be less than or equal to the greater of, (i) 0.1 percent of the taxpayer’s gross receipts for the year, or (ii) two percent of the taxpayer’s total financial accounting depreciation expense for the year.[19]

A taxpayer makes the election simply by deducting the cost of the materials and supplies in its timely-filed (including extensions) original federal income tax return for the year the taxpayer acquires or produces the materials and supplies.[20] A taxpayer may revoke the election only by showing good cause for the revocation.[21] A taxpayer may make the election with respect to each material and supply that it acquires or produces.[22] Thus, to maximize the benefit under the election, a taxpayer that is approaching the limit on the deduction can apply the de minimis rule to the materials and supplies that will be used or consumed over the longest period of time.

D. Election to Capitalize and Depreciate

Alternatively, a taxpayer can selectively elect to capitalize and depreciate the cost of any material and supply.[23] A taxpayer may choose to do so, for example, if the length of time it takes the taxpayer to use and consume the particular material and supply is significant compared to the recovery period. A taxpayer makes the election by capitalizing the cost of the materials and supplies subject to the election (i.e., by not deducting it) and beginning to depreciate it in the taxpayer’s timely-filed (including extensions), original federal income tax return for the year the taxpayer places the materials and supplies in service.[24] A taxpayer may revoke the election only by showing good cause for the revocation.[25] If it elects to use the optional method for rotables, a taxpayer cannot make the election to capitalize the cost of any rotable and temporary spare parts.[26]

Costs to Acquire or Produce Tangible Property

The repair regulations retain the longstanding rule that taxpayers must capitalize the costs of acquiring and producing tangible property.[27] Additionally, the repair regulations clarify both that taxpayers must capitalize transaction costs and when a taxpayer must account for moving and reinstallation costs of property that the taxpayer previously placed into service. The repair regulations also provide a de minimis rule. Each of these issues is now discussed.[28]

A. Transaction Costs

Just as the regulations with respect to intangible property require,[29] the repair regulations require taxpayers to capitalize the costs they incur to facilitate the acquisition or production of tangible property.[30] A taxpayer incurs a cost to facilitate the acquisition or production of property if, based on all the facts and circumstances, it incurs the cost “in the process of investigating or otherwise pursuing the acquisition.”[31] A taxpayer must always capitalize certain costs which are listed as “inherently facilitative,” [32] even if the taxpayer does not eventually acquire or produce the property.[33] Taxpayers may recover such costs under applicable provisions of the Code, such as §165 in the case of an abandoned transaction.[34]

An exception to the requirement that taxpayers must capitalize costs that facilitate an acquisition applies to the costs of acquiring (but not producing) real property.[35] Under this exception, a taxpayer is not required to capitalize costs it incurs in the process of determining whether to acquire real property and which real property to acquire.[36] The exception, however, does not apply to inherently facilitative costs.[37] Furthermore, because the exception is limited to acquisitions of real property, if a taxpayer acquires both real and personal property in a single transaction, the taxpayer must “reasonably” allocate the costs that facilitate the acquisition of the personal property.[38]

The repair regulations do not require taxpayers to capitalize employee compensation and overhead costs.[39] Taxpayers, however, may elect to capitalize such costs.[40] A taxpayer makes the election by capitalizing the costs on its timely-filed (including extensions), original federal income tax return for the year in which it incurred the costs.[41] A taxpayer may revoke the election only by showing good cause for the revocation.[42]

B. Moving and Reinstallation Costs

The repair regulations generally do not require a taxpayer to capitalize costs it incurs to move and reinstall property that it previously placed in service into a new location. The Preamble states that a taxpayer does not incur such costs to acquire or produce the property.[43] The repair regulations, however, contain an example that clarifies that, if the taxpayer incurs costs to move and reinstall property as part of a project to improve other property, the taxpayer must capitalize such costs under section 263A to the cost of the property improved.[44] The Preamble provides that, in such circumstances, while the moving and reinstallation costs are not acquisition costs, they are properly a portion of the costs the taxpayer incurred as part of improving other property.[45]

C. The De Minimis Rule Election

As explained in respect of materials and supplies, the repair regulations provide a de minimis rule.[46] The same requirements that apply to an election with respect to materials and supplies apply to other tangible property (i.e., the taxpayer must have a written accounting policy in place as of the beginning of the taxable year and expense the costs on its AFS), and the limitation on amounts subject to the rule applies in the aggregate to the costs of all tangible property to which the rule applies.[47] The de minimis rule does not apply to costs of inventory property or land.[48]

Unlike the case with respect to materials and supplies, a taxpayer must elect out of the de minimis rule if the taxpayer does not want to apply the rule to other tangible property, rather than elect in if the taxpayer does want to apply the rule.[49]

A taxpayer elects out (or, in the case of materials and supplies, elects in) on a property-by-property basis, so that a taxpayer can maximize the benefit of the election.[50] Thus, a taxpayer that is approaching the limit on the deduction can apply the de minimis rule to property that has the longest recovery period and to the materials and supplies that will be used or consumed over the longest period of time.[51]

The Preamble to the repair regulations states that the de minimis rule was not intended to prevent a taxpayer and its IRS examining agent from reaching an agreement that, based on risk analysis or materiality, the examining agent will not audit certain items, regardless of whether the items satisfy the de minimis rule.[52] Furthermore, the de minimis rule was not intended to have examining agents revise their materiality thresholds in accordance with the de minimis rule.[53]

As with materials and supplies, section 263A might require the taxpayer to capitalize as a cost of other property the otherwise deductible amount, if the cost of the tangible property is “incurred by reason of the production of the other property.”[54] The regulations provide as an example the cost of tooling and equipment that is allocable to property produced or property acquired for resale.[55] The repair regulations, however, specifically provide that taxpayers are not required to capitalize costs they properly deduct under the de minimis rule.[56]

Costs to Improve Tangible Property

The repair regulations generally require taxpayers to capitalize costs they incur to improve tangible property.[57] The repair regulations provide that a taxpayer improves tangible property if the taxpayer, after it places the property in service,[58] betters the property, restores the property, or adapts the property to a new or different use.59 In addition, the regulations provide: (i) a definition of “unit of property,” (ii) a routine maintenance safe harbor, (iii) an optional regulatory accounting method, and (iv) a casualty loss election. Finally, the repair regulations obsolete the plan of rehabilitation doctrine.

A. The Unit of Property

A taxpayer generally must make the determination whether it has improved property with respect to a “unit of property.” The larger the unit of property, the less likely the taxpayer will find that it has improved the property, and vice versa. Thus, as an initial matter, taxpayers will need to determine whether they are using the appropriate unit of property under the repair regulations, and if not, to consider changing to use the appropriate unit of property.[60]

The prior regulations under section 263(a) did not provide any guidance on determining the appropriate unit of property. Not surprisingly, taxpayers and the IRS frequently disagreed on the appropriate unit of property. Although some courts addressed the issue, their holdings were generally limited to their facts and did not provide rules of general applicability. The repair regulations define the “unit of property” for various classes of property.

1. In General

For most types of property, the “unit of property” is all functionally interdependent components (i.e., placing one component in service depends on placing the other component in service).61 Special rules, however, are provided for some types of property.

2. Buildings

With regard to buildings, the repair regulations define the unit of property as the building and its structural components.62 Taxpayers, however, must determine whether an expenditure improves the building by evaluating the expenditure with respect to a subset of the building. For purposes of determining whether an expenditure improves the building, the subsets are defined as:

• The building structure (the building and its structural components except for components specifically identified as building systems);
  • • The heating, ventilating, and air conditioning systems;
  • The plumbing systems;
  • The electrical systems;
  • All escalators;
  • All elevators;
  • The fire protection and alarm systems;
  • The security systems;
  • The gas distribution systems; and
  • Any other systems identified in published guidance.63

According to the IRS and Treasury, a taxpayer making the analysis with respect to a building under the repair regulations should reach a conclusion regarding capitalization similar to the conclusion it would have reached under existing case law.[64] For example, the Preamble to the repair regulations provides that a taxpayer that replaces an entire roof is required to capitalize the cost of replacing the roof, the result reached in Georgia Car & Locomotive Co., 2 B.T.A. 986 (1925) (holding that costs of a new roof on a building were capital expenditures).[65] The IRS and Treasury explained in the Preamble that some taxpayers had concluded that, under the prior proposed regulations, where such an expenditure could be compared to the entire building, the expenditure was a deductible repair.[66]

While a taxpayer must capitalize the expenditure for the new roof as an improvement, the taxpayer is permitted to deduct the remaining basis of the old roof. How the taxpayer can determine the remaining basis of the old roof, and whether the IRS will accept that determination, is unclear.

3. Condominiums and Cooperatives

The repair regulations define the unit of property with respect to condominiums as the individual unit owned by the taxpayer and the structural components that are part of the condominium unit.[67] Similarly, with respect to a cooperative housing corporation, the unit of property is the portion of the building in which the taxpayer has possessory rights and the structural components that are part of the portion of the building subject to the taxpayers possessory rights.[68]

As with buildings in general, taxpayers must determine whether an expenditure improves a condominium or cooperative unit by evaluating the expenditure with respect to a subset of the unit of property — the building structure that is part of the condominium or cooperative unit or to the part of any building system that is part of the condominium or cooperative unit.[69]

4. Leased Buildings

The repair regulations define the unit of property for leased buildings as 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.[70] Similar to condominiums, cooperatives, and general buildings, taxpayers must determine whether an expenditure improves a leased building or leased portion of the building by evaluating the expenditure with respect to a subset of the unit of property — the leased building structure (or the portion thereof subject to the lease) or any of the leased building systems (or the portion thereof subject to the lease).[71]

5. Plant Property

With respect to plant property, a taxpayer determines the unit of property by further dividing the functionally interdependent components into smaller units comprising the component (or group of components) that performs a discrete and major function within the functionally interdependent machinery or equipment.[72] While the repair regulations provide examples, there likely will be substantial controversy with the IRS over what is a discrete and major function.

6. Network Assets

The repair regulations define network assets as railroad track, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines owned or leased by taxpayers in those industries.[73] The repair regulations provide that the unit of property for network assets is determined by the taxpayer’s particular facts and circumstances, except as otherwise provided in published guidance.[74]In applying the facts and circumstances test, the functional interdependence standard used generally for other types of property is not determinative.[75]

The IRS and Treasury believe that the determination of the unit of property for network assets is best done on an industry-by-industry basis, and previously have requested taxpayers to submit requests for such determinations under the Industry Issue Resolution (IIR) program.[76] Through the IIR program, the IRS and Treasury have published guidance on the unit of property for electric utility transmission and distribution network assets,[77] wireless telecommunication network assets,[78] wireline telecommunication network assets,[79] Class II and III railroad network assets,80 and Class I railroad network assets.[81] Furthermore, the IRS and Treasury have accepted into the program requests from the cable, natural gas, and electric generation industries.[82]

7. Leased Property (Other than Buildings)

If a taxpayer is the lessee of real or tangible personal property other than a building, the unit of property is determined under the previously discussed general rules, except that, after applying those rules, the unit of property cannot be any larger than the property leased by the taxpayer.[83]

8. Improvements

Except for a lessee improvement, an improvement is not a separate unit of property from the property improved.[84] A lessee improvement is a separate unit of property from the leased property the lessee is improving.[85] If the lessee subsequently improves the lessee improvement, however, such improvements are not a separate unit of property from the lessee improvement.[86]

9. Depreciation Consistency Rule

A taxpayer is required to treat a component of a unit of property as a separate unit of property if, at the time the taxpayer initially places the unit of property in service, the taxpayer properly uses a different depreciation method or class life for the component than it uses for the rest of the unit of property of which the component is a part.[87]

Furthermore, if after the taxpayer initially places the unit of property in service, the Commissioner or the taxpayer changes the method of accounting or class life of the unit of property, the taxpayer must change the unit of property determination for that property to be consistent with the change in method of accounting.[88] For example, if, as a result of a cost segregation study, a taxpayer changes the class life of a component of a unit of property, the taxpayer must treat that component as a separate unit of property.[89]

B. Betterments

A taxpayer must capitalize the costs of maintaining property if the taxpayer’s maintenance results in a “betterment.”[90] The taxpayer’s maintenance will result in a betterment only if it:

(1) ameliorates a material condition or defect that either existed prior to the taxpayer’s acquisition of the property or arose during the production of the property,91 regardless of whether the taxpayer was aware of the condition or defect at the time it acquired or produced the property;92

(2) results in a material addition (including a physical enlargement, expansion, or extension) to the property; or

(3) results in a material increase of the capacity (including additional cubic or square space), productivity, efficiency, strength, or quality of the property or the output of the property.93

Taxpayers must make the determination whether the maintenance results in a betterment based on all the facts and circumstances, including the purpose of the expenditure, the physical nature of the work performed, the effect of the expenditure on the property, and the taxpayer’s treatment of the expenditure for financial reporting purposes.[94]

While they do not contain any bright-line tests, the regulations do provide some additional guidance. For example, the regulations provide that a taxpayer will not have to capitalize the cost of maintenance solely because the taxpayer, out of necessity, performed the maintenance with an improved, but comparable, replacement part.[95] In addition, consistent with prior case law, the regulations provide that the appropriate comparison in cases where a particular event necessitates the maintenance is the condition of the property after the maintenance with the condition of the property immediately prior to the event necessitating the maintenance. In the case of normal wear and tear, the appropriate comparison is the condition of the property after the maintenance with the condition of the property immediately after the last time the taxpayer performed maintenance for normal wear and tear (or if the taxpayer did not previously perform maintenance on the property for normal wear and tear, the condition of the property when the taxpayer placed the property in service).[96]

The regulations provide additional guidance on betterments in 19 examples covering a wide variety of situations.[97] For instance, examples 6 through 8 address whether a taxpayer must capitalize the costs it incurred to remodel its retail stores. The prior proposed regulations had a single example covering this situation,[98] which generated considerable controversy[99] Multiple commentators requested additional guidance on this situation,[100] and the additional examples should address many of the concerns.

Regrettably, in some cases the examples have assumptions that are unsupported by the facts, which reduces their effectiveness in providing guidance and might lead examining agents to assume that the conclusion reached in the example always applies, even when the assumptions do not apply. For instance, the repair regulations include an example to illustrate that section 263A may require a taxpayer to capitalize otherwise deductible costs if the taxpayer produces other property.[101] The example asks the reader to assume the same facts from an earlier example that discusses deductible costs to “refresh” stores and also to assume that “the work performed to refresh the stores directly benefits or was incurred by reason of a substantial remodel to X’s store buildings.”[102] The example, however, does not provide any additional facts supporting the assumption. In its conclusion, the example states that the taxpayer must capitalize the costs to refresh the stores because they “directly benefitted or were incurred by reason of the improvements to X’s store buildings,” which, of course, was simply the assumption the example posits.[103]

At best, the example provides no more guidance than if the regulation had simply said that a taxpayer must capitalize otherwise deductible costs if they directly benefit or are incurred by reason of a capital improvement. Because of the example, an IRS examining agent might incorrectly assume that the costs of a refresh always directly benefit or are incurred by reason of an improvement and, therefore, must be capitalized, if the refresh happens to occur at the same time as the improvement.

C. Restorations

A taxpayer must capitalize the costs of maintaining property if the taxpayer’s maintenance results in a “restoration” of the property. [104] The taxpayer’s maintenance will result in a restoration only if it:

  1. is for the replacement of a component of the property and the taxpayer properly has deducted a loss for that component (other than a casualty loss under Treas. Reg. § 1.165-7);
  2. is for a replacement of a component of the property and the taxpayer properly took into account the basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
  3. is for the repair of damage to the property for which the taxpayer properly 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;[105]
  4. 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. results in the rebuilding of the property to a like-new condition[106] after the end of its class life; or
  6. is for the replacement of a major component or a substantial structural part of the property.[107]

Generally, a taxpayer must make a determination with respect to a restoration based on all the facts and circumstances, and the regulations provide some guidance on what constitutes a major component or a substantial structural part of the property.[108] The regulations provide that a major component or substantial structural part includes a part or combination of parts that constitute a large portion of the physical structure of the property or that perform a discrete and critical function in the operation of the property.[109] The regulations clarify that a “minor component,” even if it affects the function of the property, generally is not, by itself, a major component or substantial structural part of the property.110 The regulations, however, do not otherwise define “minor component.”

As with betterments, the regulations rely on numerous examples to provide additional guidance, but in some cases the examples simply assume the conclusion. For instance, example 14 supports its conclusion that a taxpayer is not required to capitalize the cost of replacing a leaking roof membrane by simply stating, without more, that the roof membrane is not a major component or substantial structural part of the building.

D. Adaptations

The repair regulations contain the longstanding requirement that a taxpayer must capitalize costs it incurs to adapt property to a new or different use.[111] In general, a taxpayer has adapted property to a new or different use if the taxpayer’s new or different use of the property is inconsistent with the taxpayer’s intended ordinary use of the property at the time the taxpayer originally placed it in service.[112] A taxpayer has adapted a building to a new or different use if the taxpayer adapted the building or any of the specified building systems to a new or different use.[113] As with betterments and restorations, most of the guidance on adaptations is provided through examples.

E. Routine Maintenance Safe Harbor

The repair regulations provide a safe harbor under which costs a taxpayer incurs for routine maintenance on property (other than buildings and structural components of buildings) are deemed not to improve the property, and thus, the taxpayer does not need to capitalize them.[114] Routine maintenance is the recurring activities[115] that a taxpayer expects to perform as a result of the taxpayer’s use [116] of the property to keep it in its ordinarily efficient operating condition.[117]

The routine maintenance safe harbor generally does not apply where a taxpayer has already recovered (other than through depreciation or the de minimis rule) the remaining basis of the component on which it is performing routine maintenance. For example, the safe harbor does not apply to costs of replacing a component if the taxpayer either properly deducted a loss for the component or properly took into account the basis of the component in determining gain or loss on the sale or exchange of the component.[118] It also does not apply to the cost of repairing damage to a unit of property where 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.[119] Additionally, the safe harbor does not apply to the cost of repairs, maintenance, or improvements to rotable and temporary spare parts if the taxpayer elected the “optional method for retables.”[120]

Of course, a taxpayer may be required to capitalize the otherwise deductible maintenance costs under section 263A, to the extent that the costs are allocable to the production of inventory or self-constructed assets or property acquired for resale.

The routine maintenance safe harbor likely will reduce controversy, as IRS and Treasury undoubtedly intended for it to do.[121] Nonetheless, because the safe harbor applies to costs to keep the property in its ordinarily efficient operating condition but not to betterments,[122] some controversy is likely over whether the maintenance activities a taxpayer performs actually result in a betterment, particularly as the property ages and replacement parts have improved functionality.

F. Optional Regulatory Accounting Method

Regulated taxpayers[123] have the option of electing a simplified method of accounting to determine the costs of repairing, maintaining, and improving property that they must capitalize.[124] Under the optional method, a taxpayer simply follows for federal income tax purposes the regulatory accounting method of capitalization; if a taxpayer capitalizes a cost for regulatory accounting purposes, it must capitalize the cost for federal income tax purposes.[125] The election applies to all tangible property that is subject to the regulatory accounting rules.[126]

G. Casualty Loss Election

As previously discussed, taxpayers must capitalize an otherwise deductible repair cost if they repair property for which they claimed a basis adjustment as a result of a casualty loss under section165, or relating to a casualty event described in section 165.[127] This is one of the most controversial provisions in the repair regulations. As explained in the Preamble, several practitioners and industry groups had requested the IRS and Treasury to remove the proposed rule to the same effect and confirm that a taxpayer is entitled to claim both a casualty loss and a repair deduction.

They contended that claiming both the casualty loss and the repair deduction is not a “double deduction” for the same item because the casualty loss and the repair deduction arise out of separate tax events. In other words, the casualty loss compensates the taxpayer for the unexpected diminution in value of its property, and the repair deduction compensates the taxpayer for additional expenditures necessary to restore the property to working condition.[128]

The IRS and Treasury rejected these suggestions because they concluded that the costs to restore the property are analogous to the costs to acquire new property, and that the requirement to capitalize such costs is consistent with existing law.[129]

Nonetheless, the repair regulations permit a taxpayer electing to use a general asset account under Temp. Reg. §1.168(i)-1T to forgo recognizing the casualty loss (without reducing basis) and instead claim a deduction under section 162 for the cost of the replacement property, provided that the replacement cost is not otherwise required to be capitalized under a different provision of the repair regulations.[130] This election can be significant because the remaining basis of the destroyed property can be insignificant when compared to the cost of repairing it.

H. The Plan of Rehabilitation Doctrine

The repair regulations declare obsolete the judicial plan of rehabilitation doctrine, which had required taxpayers to capitalize otherwise deductible repair costs that they incurred as part of a general plan of rehabilitation, modernization, and improvement to the property.[131] Instead, taxpayers need only capitalize otherwise deductible repair costs that directly benefit or are incurred by reason of the taxpayer’s production of property or its production or purchase for resale of inventory.[132]

Rules for MACRS Property

Although taxpayers are required to capitalize improvements to buildings, including the cost of replacing structural components, under prior law taxpayers generally were not permitted to currently deduct as a loss the basis of the structural components that they replaced.[133] Instead, taxpayers had to continue to depreciate the basis of the replaced component. As a result, a taxpayer had to depreciate at the same time both the cost of the replaced component and the cost of the replacement component, even though only one of the components remained in service.

To provide relief from this inequity (and the inequity in other similar situations), the earlier proposed regulations provided rules that would more likely permit taxpayers to deduct the cost of the replacement component.[134] The repair regulations also provide relief from the inequities created under prior law, but instead of permitting taxpayers to deduct the cost of the replacement component, they generally provide taxpayers with a greater opportunity to deduct the cost of the replaced component.[135] To provide such relief, the repair regulations revise a number of the rules with respect to MACRS property.[136]

For example, the repair regulations expand the definition of dispositions with respect to MACRS property, and provide rules with respect to allocating basis to property that the taxpayer disposes of. The repair regulations also change the rules with respect to general asset accounts, increasing their flexibility. Moreover, the new accounting method change procedures permit taxpayers to make late general asset account elections.

A. Single and Multiple Assets Accounts

Taxpayers may account for an asset individually in a single asset account or with other, similar assets in multiple or general asset accounts. [137] Generally, taxpayers that dispose of an asset accounted for as either a single asset or in a multiple asset account are subject to the basic gain and loss recognition rules found elsewhere in the Code. Specifically, the typical gain or loss treatment applies to assets disposed of by sale, exchange, or involuntary conversion.[138] The repair regulations further clarify that, if it physically abandons its property, a taxpayer may recognize the loss to the extent of the adjusted depreciable basis of the asset at the time of the abandonment.[139] Furthermore, the repair regulations significantly expand the definition of disposition for MACRS property to include the retirement of a structural component of a building.[140] Thus, taxpayers now can recognize a loss on the disposition of such property, avoiding the inequity of depreciating both the replacement and replaced components.

In order to calculate the gain or loss from a disposal, the asset disposed of must be identified, and the basis of the identified asset must be determined. Generally, a taxpayer is required to use the specific identification method to identify which asset was disposed of and which year the asset was originally placed in service by the taxpayer.[141] As is often the case, a taxpayer that accounts for assets in multiple asset accounts may not be able to specifically identify which asset was disposed of. The repair regulations address this problem by allowing the taxpayer to identify the asset disposed of in one of four ways:

  • Under the first-in, first-out (FIFO) method, if the taxpayer cannot readily determine the unadjusted depreciable basis;[142]
  • Under the modified FIFO method, if the taxpayer can readily determine the unadjusted depreciable basis;[143]
  • Using a mortality dispersion table, if the asset disposed of is a mass asset;[144] or
  • Using any other method as the Secretary may designate; a last- in, first-out (LIFO) method of accounting, however, is not an available method.[145]

A taxpayer may also have difficulty in determining the basis of the asset disposed of. For example, a taxpayer is likely to have difficulty determining the basis allocable to the roof of a building. The repair regulations address this issue by permitting taxpayers to use any “reasonable” method to allocate basis.[146] The lack of more specific guidance in this area, however, is likely to lead to a significant amount of controversy between the IRS and taxpayers.

B. General Asset Account Elections

The repair regulations also make changes to the rules for general asset accounts, providing taxpayers with some flexibility in accounting for the costs of maintenance. Generally, a taxpayer does not recognize loss upon the disposition of property from a general asset account.[147] The taxpayer, however, does not actually remove the disposed of asset from the general asset account, and instead, continues to depreciate it.[148]

As revised by the repair regulations, these non-recognition rules are largely elective. A taxpayer has the option to terminate the general asset account and recover its basis in these assets if the taxpayer: (i) disposes of all assets; (ii) disposes of the last asset in the particular general asset account; or (iii) disposes of the asset in a qualifying disposition, which under the repair regulations, has been expanded to cover nearly all other dispositions.[149]

Thus, if a taxpayer accounts for an asset in a general asset account, the taxpayer generally has the option to not recognize a loss on a disposition, and instead, deduct the cost of the repair or replacement, while continuing to depreciate the basis of the replaced asset.[150] This may be preferable where, for example, an asset with little remaining basis is destroyed in a casualty.

Usually, a taxpayer must make a general asset account election in the year it places the asset in service.151 A taxpayer, however, may make a late general asset account election for property the taxpayer placed in service before January 1, 2012, by following the automatic consent procedures of Rev. Proc. 2011-14 for the taxpayer’s first or second taxable year beginning after December 31, 2011.[152]

Conclusion

All taxpayers that acquire, produce, or improve tangible property need to evaluate and, where necessary or appropriate, change their methods of accounting to comply with the repair regulations. The repair regulations markedly change existing law and contain numerous new, optional safe harbor methods and elections that taxpayers will need to consider. Therefore, taxpayers should begin to undertake the analysis immediately, even though they may change their methods of accounting in either their first or second taxable year beginning after December 31, 2011. Finally, although the repair regulations provide much-needed, additional guidance on capitalization issues, taxpayers seeking to comply with the repair regulations will find that there are many issues that the repair regulations do not resolve, and several new issues that they raise because of the largely facts-and-circumstances approach that they take.

Dwight N. Mersereau is a partner with the law firm of McDermott, Will & Emery LLP, based in the firm’s Washington, D.C. office. He received his J.D. degree from the University of New Mexico School of Law and his LL.M. degree in Taxation from the University of Florida’s Levin College of Law. Mr. Mersereau began his career as a trial and appellate lawyer with the U.S. Navy’s Office of the Judge Advocate General, and spent several years in the IRS’s Office of the Associate Chief Counsel (Income Tax & Accounting). Mr. Mersereau has taught Federal Tax Accounting as an Adjunct Professor of Law at the Georgetown University Law Center, and is a frequent writer and lecturer on tax accounting issues; he has articles published in The Tax Executive and other publications. He may be reached at dmersereau@mwe.com.

Corey M. Wise is an associate in the law firm of McDermott Will & Emery LLP and is based in the firm’s Chicago office. He received his J.D. degree from Northwestern University School of Law. While in law school, Corey was a summer law clerk for the Illinois Attorney General, Welfare Litigation Bureau. Before attending law school, Mr. Wise worked for a multinational accounting and consulting firm. Mr. Wise received his Master of Accountancy degree, with a specialization in tax, and his B.B.A. degree in Accounting from the University of Wisconsin, Madison. He is a certified public accountant, and may be reached at cwise@mwe.com.

The authors thank their colleagues, Jean A. Pawlow and Britt Haxton, for their invaluable insights and assistance.


1. Taxpayers may change their methods of accounting to comply with the new regulations using the “automatic consent” procedures of Rev. Proc. 2011-14, 2011-4 I.R.B. 330. The scope limitations (e.g., generally prohibiting a taxpayer from making a change in method of accounting while under IRS examination, from making the same change within five years, etc.) are waived for changes a taxpayer makes in its first and second taxable year beginning after December 31, 2011. Taxpayers generally must take into account a section 481(a) adjustment to prevent items of income or deduction from being duplicated or omitted solely as a result of the change in method of accounting. See Rev. Proc. 2012-19, 2012-14 I.R.B. 689 (March 7, 2012), and Rev. Proc. 2012- 20, 2012-14 I.R.B. 700 (March 7, 2012).
On March 15, 2012, the Commissioner of the Large Business & International Division issued a Directive (No. LB&I-4-0312-004) to Industry Directors, the Director, Field Specialists, and the Director, International Business Compliance, instructing IRS examiners to discontinue audit of issues in taxable years beginning before January 1, 2012, that are covered by the repair regulations. The “stand down” will give taxpayers an opportunity in their first or second taxable years beginning after December 31, 2011, to change their methods of accounting to comply with the repair regulations. Taxpayers changing to proper methods of accounting and taking into account correct section 481(a) adjustments with have “audit protection” with respect to all prior years. See § 7, Rev. Proc. 2011-14.
For a fuller discussion of accounting method change issues, see Dwight Mersereau, Navigating the Accounting Method Change Landscape — The New § 481 Regulations and Other Developments, Tax Management Memorandum, December 19, 2011, available at http://www.mwe. com/index.cfm/fuseaction/publications.list/bio_id/f476e65e-bc10- 4e94-accb-62b9dfe9fbf6.cfm.
2. T.D. 9564, 76 Fed. Reg. 81060 (December 27, 2011). The repair regulations, which address the application of sections 162(a) and 263(a), guide taxpayers in determining whether they must capitalize or instead may deduct the costs they incur to acquire, produce, or improve tangible property. See Temp. Reg. §§ 1.162-3T, -4T, -11T; 1.165- 2T; 1.167(a)-4T, -7T, -8T; 1.168(i)-1T, -7T, -8T; 1.263(a)-1T, -2T, -3T, -6T; 1.263A-1T; 1.1016-3T.
3. Treas. Reg. § 1.162-3. The dividing line between “incidental” and “non-incidental” materials and supplies is not entirely clear. The IRS previously has concluded that “incidental” materials and supplies are those that are “of minor importance such as pencils and stationery, but [not those that are] essential or necessary for the taxpayer’s manufacturing process.” TAM 7936014. If a taxpayer uses the materials and supplies in the production or resale of inventory or the production of self-constructed assets, section 263A generally requires the taxpayer to include in inventory or the basis of the self-constructed assets the otherwise deductible cost of the materials and supplies. Temp. Reg. § 1.263A-1. The new repair regulations do not change the treatment of the costs of materials and supplies under section 263A or any other Code section (except sections 162 and 212). Temp. Reg. § 1.162-3T(b).
4. Generally speaking, inventory is property held for sale to customers in the ordinary course of business. Andrew Crispo Gallery Inc. v. Commissioner, 86 F.3d 42 (2d Cir. 1996).
5. A “unit of property” is generally all the components of property that make up a unit that is used to determine whether the costs of maintenance of the unit of property is a capital improvement or a deductible repair. Units of property are discussed in the text that follows.
6. The economic useful life of the property is not its inherent useful life but rather the period over which the taxpayer reasonably expects it to be useful in the taxpayer’s business. Temp. Reg. § 1.162-3T(c)(3)(i). The taxpayer must consider factors such as wear and tear, climactic and other conditions, etc. Id.; Treas. Reg. § § 1.167(a)-1(b). For a taxpayer with an applicable financial statement (AFS), i.e., a statement filed with the Securities Exchange Commission, an audited financial statement, or a financial statement filed with a Federal or state government/ agency (other than the SEC or IRS), the economic useful life generally is the initial useful life used by the taxpayer to determine depreciation in its AFS (regardless of salvage value). Temp. Reg. § 1.162-3T(c)(3)(ii).
7. Smallwares (i.e., flatware, glassware, etc. used by a restaurant) are an example of materials and supplies that have been identified in published guidance as eligible for treatment under Treas. Reg. § 1.162-3. See Rev. Proc. 2002-12, 2002-1 C.B. 374.
8. Temp. Reg. § 1.263(a)-3T(c)(2).
9. Temp. Reg. § 1.162-3T(c)(2).
10. Id.
11. Temp. Reg. § 1.162-3T(a)(3).
12. Temp. Reg. § 1.162-3T(d)(1).
13. Temp. Reg. § 1.162-3T(e)(1). This method was included in the repair regulation at the suggestion of practitioners who noted that compliance with the deferral and capitalization methods — the only methods available under the earlier proposed regulations — would be burdensome to taxpayers who used the “optional method for rotables” for financial reporting purposes. 76 Fed. Reg. at 81062.
14. Temp. Reg. § 1.162-3T(e)(2).
15. Temp. Reg. § 1.162-3T(f)(1).
16. See note 6 for a definition of AFS. A taxpayer without an AFS cannot qualify for the de minimis rule. Temp. Reg. § 1.263(a)-2T(g)(1). Many small businesses may not have an AFS, and thus, this restriction will be significant to them. The IRS and Treasury are aware of this issue and are considering what, if anything, they can do to relieve this burden on small businesses.
17. Some taxpayers may not qualify for the election in the first effective year because they did not have a written policy in place as of the first day of that year. Nonetheless, the IRS and Treasury did not intend for the de minimis rule to prevent taxpayers and their examining agents from reaching agreement regarding risk analysis or materiality thresholds. 76 Fed. Reg. at 81064-81065. Thus, if a taxpayer and an examining agent have agreed that the deductions below a certain amount are immaterial and will not be examined, the IRS should continue to respect that agreement whether or not the deductions satisfy the requirements of the de minimis rule. Id. at 81065.
18. The applicability of the de minimis rule to other property is discussed in the text that follows.
19. Temp. Reg. § 1.263(a)-2T(g)(1). A taxpayer may elect out of the de minimis rule (or elect into the de minimis rule) for any unit of property (or any material and supply) during the tax year such that the taxpayer will not exceed these limitations. Temp. Reg. § 1.263(a)-2T(g)(4).
20. Temp. Reg. § 1.162-3T(f)(2).
21. Id.
22. Id.
23. Temp. Reg. § 1.162-3T(d)(1).
24. Temp. Reg. § 1.162-3T(d)(3). Presumably, the materials and supplies are “placed in service” when they are “available and ready for use,” even if the taxpayer has not actually started to use or consume them. Sears Oil Co. v. Commissioner, 359 F.2d 191 (2d Cir. 1966).
25. Temp. Reg. § 1.162-3T(d)(3).
26. Temp. Reg. § 1.162-3T(d)(2)(ii).
27. Temp. Reg. § 1.263(a)-2T(d).
28. In addition, the repair regulations clarify that costs a taxpayer incurs for work performed on the tangible property prior to placing it in service are a cost of acquiring the property, and therefore, the taxpayer must capitalize them. Temp. Reg. § 1.263(a)-2T(d)(1). See also, 76 Fed. Reg. at 81063. The repair regulations also clarify that costs a taxpayer incurs to defend or perfect its title to tangible property are costs to acquire or produce the property and, as such, the taxpayer must capitalize them. Temp. Reg. § 1.263(a)-2T(e)(1). 29. Treas. Reg. § 1.263(a)-4(e)(1).
30. Temp. Reg. § 1.263(a)-2T(f)(1).
31. Temp. Reg. § 1.263(a)-2T(f)(2)(i).
32. Temp. Reg. § 1.263(a)-2T(f)(2)(ii). Inherently facilitative costs include transportation costs, appraisal costs, negotiation costs, etc.
33. Temp. Reg. § 1.263(a)-2T(f)(3)(ii).
34. Id.
35. Temp. Reg. § 1.263(a)-2T(f)(2)(iii)(A).
36. Id.
37. Id.
38. Temp. Reg. § 1.263(A)-2T(f)(2)(iii)(B). Interestingly, the Preamble to the repair regulations states that the exception was not extended to the acquisition of tangible personal property because such a rule could generate controversy over unduly small amounts. 76 Fed. Reg. at 81064. It seems likely, however, that just as much controversy could be generated by the requirement to allocate unduly small amounts, particularly because the regulations provide no specific guidance on how taxpayers may make the allocation.
39. Temp. Reg. § 1.263(a)-2T(f)(2)(iv)(A). Taxpayers, however must apply section 263A, which might require them to capitalize employee compensation and other overhead costs to any property produced or acquired for resale. Id.
40. Temp. Reg. § 1.263(a)-2T(f)(2)(iv)(B). A taxpayer may make the election separately for each acquisition and separately for employee compensation and overhead.
41. Id.
42. Id.
43. 76 Fed. Reg. at 81063.
44. Temp. Reg. § 1.263(a)-3T(h)(4), ex. 10.
45. 76 Fed. Reg. at 81063.
46. Temp. Reg. § 1.263(a)-2T(g).
47. Temp. Reg. § 1.263(a)-2T(g)(1).
48. Temp. Reg. § 1.263(a)-2T(g)(2).
49. Temp. Reg. § 1.263(a)-2T(g)(4).
50. Id.
51. If a taxpayer exceeds the limit of the de minimis rule, the IRS should reasonably capitalize only the amount in excess of the limitation rather than disallowing the entire de minimis amount, especially since the de minimis rule applies unless a taxpayer makes an election not to apply the rule.
52. 76 Fed. Reg. at 81064-81065; see note 17 supra.
53. Id.
54. Temp. Reg. § 1.263(a)-2T(g)(3).
55. Id., citing Treas. Reg. § 1.263A-1(e)(3)(ii)(R).
56. Temp. Reg. § 1.263(a)-3T(c)(3).
57. Temp. Reg. § 1.263(a)-3T(d).
58. Costs a taxpayer incurs with respect to property prior to the time the taxpayer places the property in service generally are acquisition costs.
59. Temp. Reg. § 1.263(a)-3T(d).
60. A change from using one unit of property to using another unit of property is a change in method of accounting. Temp. Reg. § 1.263(a)- 3T(o); § 4.02(1), Rev. Proc. 2012-19, 2012-14 I.R.B. (March 7, 2012).
61. Temp. Reg. § 1.263(a)-3T(e)(3)(i).
62. Temp. Reg. § 1.263(a)-3T(e)(2)(i).
63. Temp. Reg. § 1.263(a)-3T(e)(2)(ii).
64. 76 Fed. Reg. at 81066.
65. Id.
66. Id. In the case of buildings, a taxpayer could be appropriately treating a building as the unit of property but still not properly determining whether it has improved the building by not making that determination with respect to a building system. In that situation, the taxpayer would not need to change the unit of property. Nonetheless, the IRS and Treasury have stated informally that such a taxpayer would need to change its method of accounting in order to begin making the proper determination whether it had improved the building. Furthermore, the IRS and Treasury have stated informally that a taxpayer can make such a change using the automatic change procedures of Rev. Proc. 2011-14, just as if the taxpayer were changing the unit of property.
67. Temp. Reg. § 1.263(a)-3T(e)(2)(iii)(A).
68. Temp. Reg. § 1.263(a)-3T(e)(2)(iv)(A).
69. Temp. Reg. §§ 1.263(a)-3T(e)(2)(iii)(B) and -3T(e)(2)(iv)(B).
70. Temp. Reg. § 1.263(a)-3T(e)(2)(v).
71. Temp. Reg. § 1.263(a)-3T(e)(2)(v)(B).
72. Temp. Reg. § 1.263(a)-3T(e)(3)(ii)(B). Plant property is functionally interdependent machinery and 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. Temp. Reg. § 1.263(a)- 3T(e)(3)(ii)(A).
73. Temp. Reg. § 1.263(a)-3T(e)(3)(iii)(A).
74. Temp. Reg. § 1.263(a)-3T(e)(3)(iii)(B).
75. Id.
76. 76 Fed. Reg. at 81067.
77. Rev. Proc. 2011-43, 2011-37 I.R.B. 326.
78. Rev. Proc. 2011-28, 2011-18 I.R.B. 743.
79. Rev. Proc. 2011-27, 2011-18 I.R.B. 740.
80. Rev. Proc. 2002-65, 2002-2 C.B. 700.
81. Rev. Proc. 2001-46, 2001-2 C.B. 263.
82. IRS Statement, available at http://www.irs.gov/newsroom/ article/0,,id=244226,00.html
83. Temp. Reg. § 1.263(a)-3T(e)(3)(iv).
84. Temp. Reg. § 1.263(a)-3T(e)(4).
85. Temp. Reg. § 1.263(a)-3T(f)(1)(ii)(B).
86. Id.
87. Temp. Reg. § 1.263(a)-3T(e)(5)(i).
88. Temp. Reg. § 1.263(a)-3T(e)(5)(ii).
89. Id.
90. Temp. Reg. § 1.263(a)-3T(h).
91. Although acknowledging concerns raised by commentators, the IRS and Treasury did not provide an exception from this rule for environmental remediation costs. Instead, a taxpayer that incurs costs for environmental remediation of newly acquired property must comply with section 198 to deduct costs that it must otherwise capitalize under section 263(a). Alternatively, if section 198 does not provide relief, the taxpayer can seek a private letter ruling from the IRS. 76 Fed. Reg. at 81072.
92. The IRS and Treasury noted that a rule requiring a determination of the taxpayer’s knowledge at the time of acquisition/production would be difficult to administer and contrary to existing case law. 76 Fed. Reg. at 81071.
93. Temp. Reg. § 1.263(a)-3T(h)(1). In the case of buildings, taxpayers must determine whether the maintenance resulted in a betterment to the specified building systems, and not to the unit of property, the building itself. Treas. Reg.§ 1.263(a)-3(h)(2).
94. Temp. Reg. § 1.263(a)-3T(h)(3)(i).
95. Temp. Reg. § 1.263(a)-3T(h)(3)(ii).
96. Temp. Reg. § 1.263(a)-3T(h)(3)(iii). This standard is consistent with Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333 (1962)(“The proper test is whether the expenditure materially enhances the value, use, life expectancy, strength, or capacity as compared with the status of the asset prior to the condition necessitating the expenditure.”).
97. Temp. Reg. § 1.263(a)-3T(h)(4).
98. Prior Prop. Reg. § 1.263(a)-3(f)(3), ex. 6.
99. 76 Fed. Reg. at 81072.
100. Id.
101. Temp. Reg. § 1.263(a)-3T(h)(4), ex. 8.
102. Id.
103. Id.
104. Temp. Reg. § 1.263(a)-3T(i).
105. This per se capitalization requirement is very controversial and is discussed in the text that follows.
106. A taxpayer will rebuild property to like-new condition if the taxpayer brings the property to the status of new, rebuilt, remanufactured, or similar status under the terms of any federal regulatory guideline or the manufacturer’s original specifications. Temp. Reg. § 1.263(a)-3T(i)(3).
107. Temp. Reg. § 1.263(a)-3T(i)(1). As with betterments, in the case of buildings, taxpayers must determine whether the maintenance restores a specified building system, not the unit of property, the building itself. Treas. Reg.§ 1.263(a)-3(i)(2).
108. Temp. Reg. § 1.263(a)-3T(i)(4).
109. Id. The repair regulations do not contain the “50% thresholds” that were in the 2008 proposed regulations. The Preamble explains that, while they provided an objective, bright-line test, the 50-percent thresholds likely would have permitted deductions inconsistent with existing case law. While the repair regulations, therefore, will likely require taxpayers to capitalize more costs to maintain buildings than they would have capitalized under the proposed regulations, the repair regulation also permit taxpayers to deduct the remaining basis of structural components of buildings that the taxpayer replaces, a change from prior law. This issue is discussed in the text that follows.
110. Id.
111. Temp. Reg. § 1.263(a)-3T(j)(1).
112. Id.
113. Temp. Reg. § 1.263(a)-3T(j)(2).
114. Temp. Reg. § 1.263(a)-3T(g).
115. Activities are recurring only if, at the time the taxpayer places the property in service, the taxpayer reasonably expects to perform the activities more than once during the class life (the recovery period under section 168(g)(2) and (3) for purposes of the alternative depreciation system) of the unit of property. Temp. Reg. § 1.263(a)-3T(g)(1). While the class life is relevant in determining whether activities are recurring, routine maintenance performed after the property’s class life are under the safe harbor. Temp. Reg. § 1.263(a)-3T(g)(5), ex. 2.
116. Work required because of a prior owner’s use of the property is a cost of acquiring/improving the property and is outside the safe harbor. See Temp. Reg. §§ 1.263(a)-2T(d)(1); -3T(h)(1). For a lessor, the lessor’s use of the property includes the lessee’s use of the property. Temp. Reg. § 1.263(a)-3T(g)(1).
117. Temp. Reg. § 1.263(a)-3T(g)(1). If the unit of property has deteriorated to a state of disrepair and is no longer functional for its intended use, the costs to return the property to its ordinarily efficient operating condition are a restoration of the property, and as such, are outside the safe harbor. Temp. Reg. § 1.263(a)-3T(g)(3)(iv). Similarly, if the maintenance betters the property, the costs of the maintenance are also outside the safe harbor. See Temp. Reg. § 1.263(a)-3T(g)(5), ex. 9.
118. Temp. Reg. §§ 1.263(a)-3T(g)(3)(i) and (ii).
119. Temp. Reg. § 1.263(a)-3T(g)(3)(iii).
120. Temp. Reg. § 1.263(a)-3T(g)(3)(v). Like the other exceptions, in the case of a taxpayer electing the optional method for rotables, the taxpayer deducted the basis of the rotable or temporary spare part when it installed it. If the taxpayer did not elect the optional method for rotables, the safe harbor does apply to routine maintenance on, and with regard to, rotable and temporary spare parts. Temp. Reg. §§ 1.263(a)- 3T(g)(2); -3T(g)(5), ex. 4.
121. 76 Fed. Reg. at 81070.
122. See Temp. Reg. § 1.263(a)-3T(g)(5), ex. 9.
123. A taxpayer is regulated if it is subject to the regulatory accounting rules of the Federal Energy Regulatory Commission, the Federal Communications Commission, or the Surface Transportation Board. Temp. Reg. § 1.263(a)-3T(k)(2).
124. Temp. Reg. § 1.263(a)-3T(k)(1). However, a taxpayer that does not need to capitalize a cost under the optional regulatory accounting method may still need to capitalize that otherwise deductible cost under section 263A. Id.
125. Temp. Reg. § 1.263(a)-3T(k)(2).
126. Id.
127. Temp. Reg. § 1.263(a)-3T(i)(1)(iii).
128. 76 Fed. Reg. at 81073.
129. Id.
130. 76 Fed. Reg. at 81074.
131. 76 Fed. Reg. at 81069, citing Moss v. Commissioner, 831 F.2d 833 (9th Cir. 1987); United States v. Wehrli, 400 F.2d 686 (10th Cir. 1968); and Norwest Corp. v. Commissioner, 108 T.C. 265 (1997).
132. Treas. Reg. § 1.263A-1(e).
133. See Prop. Reg. §§ 1.168-2(l)(1) and 1.168-6(b) of the proposed ACRS regulations, which the IRS generally has applied under MACRS; 76 Fed. Reg. at 81065.
134. For example, in the case of maintenance on buildings, the earlier proposed regulations permitted taxpayers to make the determination of whether the maintenance was an improvement with reference to the entire building. 76 Fed. Reg. at 81065. In the case of restorations of other tangible property, the earlier proposed regulations defined “major component or substantial structural part” as a part or combination of parts the costs of which constitute 50 percent or more of the replacement cost of the unit of property or the replacement of which comprises 50 percent or more of the physical structure of the unit of property. 76 Fed. Reg. at 81074.
135. 76 Fed. Reg. at 81075.
136. MACRS stands for modified accelerated cost recovery system, which applies to certain tangible property placed in service after 1986. Treas. Reg. § 1.168(a)-1(a).
137. Temp. Reg. §§ 1.168(i)-1T, -7T(a). Generally, a taxpayer can include assets in multiple or general asset accounts only if the assets have the same depreciation method, recovery period, and convention, and the taxpayer places them is service in the same taxable year. Temp. Reg. §§ 1.168(i)-1T(c)(2)(i); -7T(c)(2)(i). Additionally, a taxpayer cannot place an asset in a multiple or general asset account if the taxpayer uses the asset both in a trade or business and for personal activity or if the taxpayer places the asset in service and disposes of it in the same year. Temp. Reg. §§ 1.168(i)-1T(c)(1)(i); -7T(b).
138. Temp. Reg. § 1.168(i)-8T(d)(1).
139. Temp. Reg. § 1.168(i)-8T(d)(2). If the asset is subject to nonrecourse debt, the taxpayer must treat the disposition as if the taxpayer sold it. Id. If a taxpayer disposes of an asset by any other means, the taxpayer will only recognize loss on the disposition, and only to the extent that the adjusted depreciable basis of the asset exceeds the asset’s fair market value at the time of the disposition. Temp. Reg. § 1.168(i)-8T(d)(3).
140. Temp. Reg. § 1.168(i)-8T(b)(1).
141. Temp. Reg. § 1.168(i)-8T(f)(1).
142. Temp. Reg. § 1.168(i)-8T(f)(2)(i).
143. Temp. Reg. § 1.168(i)-8T(f)(2)(ii). Under the modified FIFO method, if it can readily determine the unadjusted depreciable basis, the taxpayer identifies the multiple asset account with the earliest placed-in-service year that has the same recovery 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.
144. Temp. Reg. § 1.168(i)-8T(f)(2)(iii).
145. Temp. Reg. § 1.168(i)-8T(f)(2)(iv).
146. Temp. Reg. § 1.168(i)-8T(e)(2).
147. Temp. Reg. § 1.168(i)-1T(e)(2)(i). Gain is still realized as ordinary income to the extent the sum of the unadjusted depreciable basis of the general asset account and any expensed cost for assets in the account exceeds any amounts previously recognized as ordinary income upon the disposition of other assets in the account. Temp. Reg. § 1.168(i)-1T(e)(2)(ii).
148. Temp. Reg. § 1.168(i)-1T(e)(2)(iii).
149. Temp. Reg. §§ 1.168(i)-1T(e)(3)(ii)(A), -1T(e)(3)(iii). A qualifying disposition is a disposition that does not involve all the assets, or the last assets, remaining in a general asset account, and that is not a specified transaction: (i) a tax-free transaction described in section 168(i) (7), (ii) a transaction subject to section 1031 or 1033, (iii) the technical termination of a partnership, or (iv) the anti-abuse rule of Temp. Reg. § 1.168(i)-1T(e)(3)(vii).
150. By not deducting the loss, the taxpayer will not restore the property solely as a result of recovering the basis of the replaced component. See Temp. Reg. §§ 1.263(a)-3T(i)(1)(i)-(iii). Of course, the repair or replacement must not otherwise be an improvement.
151. Temp. Reg. § 1.168(i)-1T(l)(1).
152. 2011-4 I.R.B. 330. See § 5.03(6), Rev. Proc. 2012-20, 2012-14 I.R.B. 700 (March 7, 2012).