The IRS on October 1, 2025, released final regulations (TD 10034) that remove certain rules from the interest capitalization requirements for improvements to designated property. The final regulations make only minor changes to the May 2024 proposed regulations that were issued in response to the Federal Circuit decision in Dominion Resources, Inc. v. United States, 681 F.3d 1313 (Fed. Cir. 2012), in which the court invalidated the IRS's "associated property" rule. The final regulations also modify the definition of "improvement" and other rules due to the removal of certain rules. The final regulations are effective October 2, 2025.

The final regulations make only minor changes to Prop. Reg. Section 1.263A-8(d)(3)(i) to clarify the scope of improvements that constitute the "production of property" for purposes of determining if such improvement is designated property under Treas. Reg. Section 1.263A-8.

Background

In Dominion, the Federal Circuit found that Treas. Reg. Section 1.263A-11(e)(1)(ii)(B) "unreasonably links" the interest capitalized when a taxpayer makes an improvement to the adjusted bases of the property temporarily removed from service to complete the improvement. The court observed that when implementing 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." Additionally, the court pointed out that the adjusted basis of the temporarily withdrawn property is not an "avoided" amount. The court also determined that a property owner expends funds in the amount equal to the cost of the improvement, not the amount equal to the adjusted basis of the temporarily withdrawn property. Therefore, the court ruled Treas. Reg. Section 1.263A-11(e)(1)(ii)(B) contradicts the avoided-cost rule.

The Treasury and the IRS issued proposed regulations on May 15, 2024, to conform to the court holding that invalidated the IRS's "associated property" rule and similar rules in Treas. Reg. Section 1.263A-11(e) (See Tax Alert 2024-1010). Treasury and the IRS published a correction to the proposed regulations on July 24, 2024, to amend citation errors in the preamble to the proposed regulations. No public hearing was requested or conducted on the proposed regulations. Treasury and the IRS received only two comments on the proposed regulations, only one of which they said addressed the proposed regulations directly.

Final regulations

Because Treasury and the IRS agreed with the Federal Circuit's opinion, the final regulations remove the associated property rule for improvements to real property (Treas. Reg. Section 1.263A-11(e)(1)(ii)(B)) and tangible personal property (Treas. Reg. Section 1.263A-11(e)(1)(iii)) for property temporarily withdrawn from service. The final regulations also remove Treas. Reg. Section 1.263A-11(e)(1)(ii)(A) related to accumulated production expenditures (APEs) for an improvement to real property that includes an allocable portion of the land cost.

Additionally, the final regulations remove the associated property rule in Treas. Reg. Sections 1.263A-11(e)(1)(ii)(B) and 1.263A-11(e)(1)(iii) for improvements to property not placed in service because Treas. Reg. Section 1.263(a)-3(d) limits the definition of "improvement" to amounts paid for activities conducted after the property is placed in service. In the preamble to the proposed regulations, Treasury and the IRS pointed out that amounts "paid for activities performed prior to the date that property is placed in service are characterized as acquisition or production costs (rather than improvement costs) and are generally capitalized under [Treas. Reg. Section] 1.263(a)-2 and [IRC S]ection 263A."

With the removal of the associated property rule under Treas. Reg. Section 1.263A-11(e)(1)(ii)(B), the de minimis rule under Treas. Reg. Section 1.263A-11(e)(2) is no longer relevant. Therefore, the final regulations also remove the de minimis rule. The removal of all these rules now requires taxpayers to include in APEs only the direct and indirect costs of the improvements.

The final regulations retain the substantive rules in Treas. Reg. Section 263A-11(f) but clarify that the rules only apply to situations in which property is purchased and further produced before it is placed in service. The final regulations also include a cross-reference to Treas. Reg. Section 1.263A-12(d)(1) "to emphasize that taxpayers must comply with the rules of that section when determining whether the production period has ended and therefore whether the taxpayer's production activities constitute an improvement."

In addition, the final regulations update the definition of "improvement" to make it consistent with the definition of "improvement," including the exceptions, safe harbors and elections under Treas. Reg. Section 1.263(a)-3.

Implications

The elimination of the associated property rule in Treas. Reg. 1.263A-11(e), which previously included the value of certain related property (e.g., land or existing structures) in APEs, is a welcome change that could reduce the amount of interest required to be capitalized for taxpayers that improve property. The final regulations also harmonize the definition of improvement with Treas. Reg. Section 1.263(a)-3, which governs the improvements to tangible property.

Taxpayers should consider reviewing ongoing improvement projects to assess the impact of the final regulations and determine if and when an accounting method change should be filed to comply with the final regulations.