IRS removes associated-property rule from interest capitalization regulations

Editor: Greg A. Fairbanks, J.D., LL.M.

The IRS issued final regulations (T.D. 10034) that remove the associated–property rule from the interest capitalization requirements for improvements to designated property. These final regulations apply to tax years beginning after Oct. 2, 2025, (i.e., 2026 tax years for calendar–year filers) and generally align with the Federal Circuit’s decision in Dominion Resources, Inc., 681 F.3d 1313 (Fed. Cir. 2012). As a result, taxpayers now have less flexibility in tax planning for interest capitalization.

Interest capitalization and the associated-property rule

Sec. 263A(f) and the regulations thereunder contain rules for capitalizing interest with respect to certain property produced by the taxpayer, generally limiting capitalization to designated property. Regs. Sec. 1.263A–8(b)(1) defines designated property as property that is produced that is either (1) real property or (2) tangible personal property that is long–lived (i.e., with a class life of 20 years or more under Sec. 168), has an estimated production period greater than two years, or has an estimated production period greater than one year and an estimated cost of production exceeding $1 million. Regs. Sec. 1.263A–8(d)(3) also provides that any improvement to designated property constitutes the production of designated property.

In accordance with Regs. Sec. 1.263A–8(a), taxpayers are generally required to capitalize interest to designated property using the avoided–cost method. Under this method, interest that a taxpayer theoretically would have avoided if those production expenditures had been used to repay or reduce the taxpayer’s outstanding debt must be capitalized. Under Regs. Sec. 1.263A–11(e)(1), before it was removed by T.D. 10034, production expenditures for improvements to designated property included:

• All direct and indirect costs required to be capitalized with respect to the improvement,
• In the case of real property:
  • An allocable portion of the cost of land, and
  • 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basis of any existing structure, common feature, or other property that is not placed in service or must be temporarily withdrawn from service to complete the improvement (associated property), and
• In the case of tangible personal property, the adjusted basis of the asset being improved if the asset either is not placed in service or must be temporarily withdrawn from service to complete the improvement.

Including the basis of associated property in production expenditures results in the capitalization of more interest to improvements to designated property under Sec. 263A(f), as the adjusted basis increases the base of production expenditures for calculating the amount of interest that must be capitalized.

Overview of the final regulations

Under the final regulations, taxpayers making improvements to real or tangible personal property that constitute the production of designated property are required to include only the direct and indirect costs of the improvements as production expenditures for purposes of determining interest capitalization associated with improvements. Adopting the previously issued proposed regulations with slight changes, the final regulations:

• Remove the adjusted basis of any associated property (e.g., property not placed in service or temporarily withdrawn from service) from production expenditures;
• Remove an allocable portion of the cost of land from production expenditures; and
• Clarify the scope of improvements that constitute the production of property for purposes of determining whether such an improvement is designated property.

The final regulations amend Regs. Sec. 1.263A–8(d)(3) to update the definition of an improvement to be consistent with the definition in Regs. Sec. 1.263(a)-3. Therefore, any improvement to real or tangible personal property does not include repairs as described in Regs. Sec. 1.162–4(a). A change in the treatment of interest to implement the final regulations is a change in method of accounting subject to Secs. 446 and 481.

Dominion Resources decision

In Dominion Resources, the Federal Circuit invalidated the associated–property rule, finding that it was not a reasonable interpretation of the avoided–cost method because the rule unreasonably linked the interest capitalized when making an improvement to the adjusted basis of the property temporarily withdrawn from service to complete the improvement.

The taxpayer in Dominion Resources was a public utility that replaced coal burners in two of its electricity–generating plants. During the improvement, the taxpayer temporarily removed the two electricity–generating plants from service and deducted a portion of interest expense that it incurred. The IRS disagreed with the taxpayer’s computations and challenged the amount of interest that the taxpayer deducted, citing the associated–property rule under Regs. Sec. 1.263A–11(e)(1)(ii)(B). The IRS argued that the associated–property rule required the taxpayer to include the adjusted basis of the electricity–generating plants temporarily withdrawn from service as production expenditures.

The Court of Federal Claims denied the taxpayer’s subsequent claim for refund and granted summary judgment in favor of the government (Dominion Resources, Inc., 97 Fed. Cl. 239 (Fed. Cl. 2011)). However, on appeal, the Federal Circuit overturned the lower court’s ruling. The Federal Circuit analyzed the validity of the associated–property regulation and found that the regulation directly contradicted the avoided–cost rule that Congress intended the statute to implement, reasoning that an amount equal to the adjusted basis of property temporarily drawn from service would not have been available to pay down the debt had the improvement not been made, as those funds were expended prior to the decision to make the improvement.

Additionally, the Federal Circuit stated that the associated–property rule violated the requirement that Treasury provide a reasoned explanation for adopting a regulation, as established by the Supreme Court ruling in Motor Vehicles Mfrs. Ass’n of the United States, Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983). The Federal Circuit examined prior IRS guidance interpreting the interest–capitalization requirements, including Notice 88–99 and proposed regulations, finding no explanation for the way that use of an adjusted basis implements the avoided–cost rule.

Takeaways

The final regulations are a significant development for taxpayers making improvements to designated property. Under prior law and the ruling in Dominion Resources that invalidated the associated–property rule, taxpayers had flexibility in applying the regulatory or judicial interpretation to calculate the amount of interest required to be capitalized to improvements to designated property. While many taxpayers relied on Dominion Resources to reduce the amount of interest required to be capitalized, taxpayers wanting to capitalize additional interest as part of a broader tax planning strategy may have applied the associated–property rule in prior regulations.

Taxpayers have less flexibility in tax planning under the final regulations, which now align with the ruling in Dominion Resources. As taxpayers begin planning for their 2026 tax years, they will need to evaluate how these regulations fit into their broader tax strategy. This includes considering the impact that the change in method of accounting may have on interest capitalization strategies that have been implemented in prior years and strategies that will be implemented in future years.

Editor

Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Fairbanks at greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.