Final Regs Remove Associated Property Rule from Interest Capitalization Regs

(Parker Tax Publishing October 2025)

The IRS issued final regulations that remove the associated property rule and similar rules from the interest capitalization requirements for improvements constituting designated property. The final regulations also modify the definition of "improvement" for purposes of applying the existing regulations. T.D. 10034.

Background

Code Sec. 263A(a) and (b) generally require the capitalization of direct and indirect costs of real or tangible personal property produced by the taxpayer. Under Code Sec. 263A(g)(1) and Reg. Sec. 1.263A-8(d)(3), the term "produce" includes "improve."

Code Sec. 263A(f) contains rules for capitalizing interest with respect to certain property produced by the taxpayer and for determining the amount of interest required to be capitalized. In general, Code Sec. 263A(f)(1) limits capitalization 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, referred to as "designated property" in the Code Sec. 263A regulations.

Under Code Sec. 263A(f)(2)(A), in determining the amount of interest required to be capitalized to any property, (1) interest on any indebtedness directly attributable to production expenditures with respect to the property is assigned to the property, and (2) interest on any other indebtedness is assigned to the property to the extent that the taxpayer's interest cost could have been reduced if production expenditures not attributable to indebtedness described in clause (1) had not been incurred (i.e., the avoided cost method).

Avoided Cost Method

Reg. Sec. 1.263A-8(a) provides that taxpayers must use the avoided cost method described in Reg. Sec. 1.263A-9 in determining the amount of interest required to be capitalized with respect to the production of designated property. Reg. Sec. 1.263A-9(a)(1) explains that, under the avoided cost method, any interest that the taxpayer theoretically would have avoided if accumulated production expenditures (as defined in Reg. Sec. 1.263A-11) (APEs) had been used to repay or reduce the taxpayer's outstanding debt must be capitalized. Under Reg. Sec. 1.263A-11(a), APEs generally mean the cumulative amount of direct and indirect costs described in Code Sec. 263A(a) that are required to be capitalized with respect to a unit of property.

Reg. Sec. 1.263A-9(c) provides that, to the extent a taxpayer's APEs exceed traced debt (that is, debt that is allocated to APEs with respect to the unit of property), the general formula for determining the amount of interest that must be capitalized is the average excess expenditures multiplied by the weighted average interest rate on the debt during the time the production occurs. A larger base of production expenditures leads to more interest capitalized.

Prior to being amended, Reg. Sec. 1.263A-11(e)(1)(i) provided that, if an improvement constitutes the production of designated property under Reg. Sec. 1.263A-8(d)(3), APEs with respect to the improvement consisted of all direct and indirect costs required to be capitalized with respect to the improvement. In the case of an improvement to a unit of real property qualifying as the production of designated property under Reg. Sec. 1.263A-8(d)(3), Reg. Sec. 1.263A-11(e)(1)(ii) provided 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 was incurred by reason of the associated property (i.e., the "associated property rule"). In the case of an improvement to a unit of tangible personal property qualifying as the production of designated property under Reg. Sec. 1.263A-8(d)(3), Reg. Sec. 1.263A-11(e)(1)(iii) provided that APEs include the adjusted basis of the asset being improved if that asset either is not placed in service or must be temporarily withdrawn from service to complete the improvement.

Dominion Resources, Inc.

In Dominion Resources, Inc. v. U.S., 2012 PTC 141 (Fed. Cir. 2012), the Federal Circuit invalidated the associated property rule of Reg. Sec. 1.263A-11(e)(1)(ii)(B) for property temporarily withdrawn from service. The court concluded that the regulation was not a reasonable interpretation of the avoided cost rule in Code Sec. 263A(f)(2)(A)(ii) because it "unreasonably links" the interest capitalized when a taxpayer makes an improvement to the adjusted basis of the property temporarily withdrawn from service to complete the improvement. The court reasoned that to implement the avoided cost principle, the interest to be capitalized is the amount that could have been avoided if funds had not been expended for the improvement. However, the adjusted basis of the temporarily withdrawn property does not represent an "avoided" amount. The court found that "[a] property owner does not expend funds in an amount equal to the adjusted basis [of the temporarily withdrawn property] when making the improvement. Instead, she expends funds in an amount equal to the cost of the improvement itself." Thus, the court concluded that the regulation contradicted the avoided cost rule.

Proposed Regulations

On May 15, 2024, the IRS published proposed regulations in REG-133850-13. The proposed regulations would remove the associated property rule and similar rules in Reg. Sec. 1.263A-11(e) from the interest capitalization requirements for improvements that constitute the production of designated property under Code Sec. 263A(f) and Reg. Sec. 1.263A-8(d)(3). In addition, the proposed regulations would modify the mid-production purchases rule of Reg. Sec. 1.263A-11(f) to clarify that the rule applies only to property purchased and further produced before it is placed in service. Finally, the proposed regulations would amend Reg. Sec. 1.263A-8(d)(3) to update the definition of "improvement" so that it is consistent with the definition of "improvement" in Reg. Sec. 1.263(a)-3, including the exceptions, safe harbors, and elections provided under Reg. Sec. 1.263(a)-3.

T.D. 10034

On October 2, the IRS published final regulations in T.D. 10034 that adopt the proposed regulations as final regulations with only minor, clarifying changes. Specifically, the final regulations make minor changes to Prop. Reg. Sec. 1.263A-8(d)(3)(i) 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. Sec. 1.263A-8.

The final regulations apply to tax years beginning after October 2, 2025. Under the final regulations, a change in a taxpayer's treatment of interest to a method consistent with the final regulations is a change in method of accounting to which Code Secs. 446 and 481 apply.

For a discussion of the interest capitalization requirement, see Parker Tax ¶242,485.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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