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New IRS Regulations Reduce Interest Capitalization Required for Property Improvements

The IRS has released new proposed regulations in response to a court decision it lost regarding interest capitalization. These regulations are more generous than what the court required, allowing taxpayers to take a larger current deduction. The regulations address the rule that requires a portion of interest to be capitalized rather than deducted when a taxpayer produces property or makes improvements to property.

Associated Property Rule Invalidated

The general rule under IRC Sec. 263A requires capitalization of direct and indirect costs (including interest) of real or tangible personal property produced or improved by the taxpayer—so called “designated property.” Interest paid or incurred during the production period must be capitalized.

Previously, the IRS used the “associated property rule” to determine the required amount of interest capitalization. Under this rule, the IRS looks at avoided costs and accumulated production expenditures to calculate the interest that must be capitalized. A larger base of production expenditures leads to more interest capitalized.

The associated property rule required that production expenditures include some of the land cost and the basis of property not put in service or temporarily withdrawn from service to complete the improvement. The effect of this rule was to require more interest to be capitalized on these projects.

In 2012, however, the Federal Circuit Court of Appeals invalidated the IRS’s associated property rule, in the case of Dominion Resources, Inc. v. U.S.. The Court said that property temporarily withdrawn from service should not be included in accumulated production expenditures. It was concluded that the earlier regulation was not a “reasonable interpretation” of the avoided cost rule and that it violated the requirement that the IRS provide a “reasoned explanation for adopting a regulation.”

New Regulations Embrace Change

Taxpayers have had the Dominion case to point to for the last 12 years to reduce their capitalized interest, but now they also have more certainty from the IRS on this issue. “The Treasury Department and the IRS have considered the Federal Circuit’s opinion in Dominion Resources and agree with its rationale.” The agency goes on to say that treating the basis of withdrawn property as a production expenditure contradicts the avoided cost rule because that basis does not represent an “avoided” amount.

The IRS takes it a step further by changing its former rule to also exclude an allocable portion of the cost of land associated with the improvement from accumulated production expenditures (The Dominion Court did not rule on this issue.).

In plain language, this means that only the direct and indirect costs of an improvement will be included in calculating accumulated production expenditures; associated property will not. This rule will allow taxpayers to deduct, rather than capitalize, more interest expense incurred in the production of property. The new rules also provide more certainty by aligning the IRS’s practices with the decision in the Federal Circuit. Predictability is a good thing when businesses make plans to produce new property or improvements to existing property, so the IRS’s action is a welcome change.

Effective Date

The new rules apply to taxable years beginning after the date that final regulations are published, but taxpayers may choose to apply them for taxable years beginning after May 15, 2024. Contact your Frazier & Deeter tax advisor to discuss how the proposed interest capitalization rules can benefit your business.

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