The IRS on October 2 published final regulations (TD 10034) removing the “associated property rule” and related rules from the regulations on interest capitalization requirements for improvements to “designated property.” The new regulations follow the rationale of a Federal Circuit Court decision that invalidated the previous regulations.
The final regulations also modify the definition of “improvement” for purposes of these regulations under Reg. §1.263A-8(d)(3) so that it is consistent with the definition provided in the tangible property regulations under Reg. §1.263(a)-3.
The final rules adopt with minor changes proposed regulations issued in May 2024. While the final regulations apply to tax years beginning after October 2, 2025, taxpayers could apply the proposed regulations for tax years beginning after May 15, 2024.
Capitalization Requirements and Associated Property Rule
Section 263A generally requires the capitalization of direct and indirect costs of real or tangible personal property produced or improved by a taxpayer. Section 263A(f) provides rules for capitalizing interest for these purposes and for determining the amount of interest required to be capitalized. The requirement to capitalize interest is limited to interest that is paid or incurred during the production period and that is allocable to real property or certain tangible personal property produced by the taxpayer (designated property).
The regulations under Section 263A specify that taxpayers must use the “avoided cost method” to determine the amount of interest required to be capitalized with respect to the production of designated property. Under the avoided cost method, the taxpayer must capitalize any interest that the taxpayer would have avoided if accumulated production expenditures (APEs) had been used to repay or reduce the taxpayer’s outstanding debt.
In the case of an improvement to real property qualifying as the production of designated property, the previous regulations included an “associated property rule,” which stated that APEs include:
- An allocable portion of the cost of land, and
- For any measurement period, the adjusted basis of any existing structure, common feature, or other property that is not placed in service, or must be temporarily withdrawn from service to complete the improvement (associated property), during any part of the measurement period if the associated property directly benefits the property being improved, the associated property directly benefits from the improvement, or the improvement is incurred by reason of the associated property.
In Dominion Resources, Inc. v. U.S., 681 F.3d 1313 (Fed. Cir. 2012), the Federal Circuit invalidated the associated property rule under the previous regulations for property temporarily withdrawn from service. The court held that the regulation was not a reasonable interpretation of the avoided cost method and violated the requirement that the IRS provide a reasoned explanation for adopting a regulation.
Final Regulations
Following Dominion Resources, the final regulations remove the associated property rule for property temporarily withdrawn from service. The final regulations also remove the associated property rule for improvements to property “not placed in service.”
Under the changes – which remove from APEs the adjusted basis of associated real property, the adjusted basis of associated tangible personal property, and an allocable portion of the cost of the land when the taxpayer makes an improvement – a taxpayer is required to include in APEs only the direct and indirect costs of the improvement itself.
The IRS noted in the preamble to the final rules that it made only minor changes to the proposed rules to clarify the scope of improvements that constitute the “production of property” for purposes of determining whether any such improvement is designated property under Reg. § 1.263A-8. Specifically, the proposed rules had stated that “[a]ny improvement to property owned by the taxpayer that is treated as an improvement under § 1.263(a)-3 constitutes the production of property.” The final rules clarify that “[a]ny improvement to real or tangible personal property under § 1.263(a)-3, or any improvement to tangible personal property as defined in § 1.263A-2(a)(2)(ii), constitutes the production of property.”
Additionally, the final regulations retain the substantive rules in Reg. §1.263A-11(f), but they clarify that the rule only relates to the cost of property purchased for further production prior to being placed in service.
BDO Insights
Effective in 2025 for calendar-year taxpayers (under the proposed rules) and in 2026 for calendar-year taxpayers (under the final rules), taxpayers are no longer required to include associated property in the taxpayer’s APEs for property temporarily withdrawn from service or include associated land costs when making improvements to property. Only the direct and indirect costs of the improvements are required to be included in APEs – significantly reducing APEs and, therefore, interest capitalization in situations where the “associated property rule” would have applied.
Note that a change in a taxpayer’s treatment of interest to a method consistent with the proposed regulations is a change in method of accounting to which Sections 446 and 481 apply.
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