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The IRS issued final regulations (TD 10034) that remove the associated property rule from the existing regulations governing interest capitalization requirements for improvements to designated property under Section 263A(f).
The final regulations adopt the proposed regulations published on May 15, 2024, (see our prior story) with slight changes, including clarification regarding the scope of improvements that constitute the production of property for purposes of determining whether an improvement is designated property.
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 accumulated production expenses (APEs) for purposes of determining interest capitalization associated with the improvements. Any improvement to real or tangible personal property under Treas. Reg. Section 1.263(a)-3, or any improvement to intellectual or creative property that is tangible property as defined in Treas. Reg. Section 1.263A-2(a)(2)(ii), constitutes the production of property. The final regulations apply to tax years beginning after Oct. 2, 2025 (i.e., 2026 tax years).
The final regulations remove the associated property rule for improvements to real property and tangible personal property for property temporarily withdrawn from service and remove the requirement to include an allocable portion of the cost of land as APEs. They also remove the associated property rule for improvements to property not placed in service because, in accordance with Treas. Reg. Section 1.263(a)-3(d), an improvement is limited to amounts paid for activities performed after the property is placed in service. In addition, the final regulations modify certain other rules to align with the removal of the associated property rule.
The final regulations generally conform to the Federal Circuit decision, Dominion Resources, Inc. v. United States, 681 F.3d 1313 (Fed. Cir. 2012), which invalidated the associated property rule in the prior regulations.
Grant Thornton Insight:
The One Big Beautiful Bill Act (OBBBA) introduced changes to the Section 163(j) limitation on business interest expense (see prior coverage) that, together with the final regulations, affect tax planning flexibility for interest deductions. For tax years beginning after Dec. 31, 2025, the Section 163(j) interest limitation applies to business interest expense without regard to whether the taxpayer would otherwise deduct that interest or capitalize it under an interest capitalization provision. However, this rule does not apply to interest required to be capitalized under Section 263A(f) (construction of designated property).
For calendar-year taxpayers, the new rules under the OBBBA take effect for the 2026 tax year, aligning with the effective date of the final regulations. Taxpayers that have capitalized additional interest by applying the associated property rule as part of a broader tax planning strategy (e.g., limitation provisions of Section 163(j)) may choose to continue this approach for the 2025 tax year. Beginning in 2026, however, taxpayers will no longer have the option to apply the associated property rule when determining interest required to be capitalized under Section 263A(f).
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