On October 2, 2025, the Department of the Treasury and the Internal Revenue Service (IRS) issued final regulations (TD 10034) that significantly alter the interest capitalization rules under Internal Revenue Code (IRC) § 263A(f) for improvements to designated property. The regulations primarily focus on eliminating the complex "associated property rule," updating the definition of an "improvement," and clarifying the treatment of "mid-production purchases". This article provides a technical overview of these changes for tax practitioners.

Governing IRC Provisions and Regulatory Authority

The final regulations amend the existing regulations under IRC § 263A(f), which governs the capitalization of interest paid or incurred during the production period of certain property. The Treasury Department and the IRS issued these regulations under the express authority granted by IRC § 263A(j), which directs the Secretary to prescribe regulations necessary to carry out the purposes of § 263A. Further authority is derived from the general rulemaking power granted under IRC § 7805(a).

Key Changes in the Final Regulations

The final regulations introduce three principal changes to the interest capitalization landscape for taxpayers producing designated property through improvements.

Elimination of the Associated Property Rule: The most significant change is the removal of the "associated property rule" and similar provisions previously found in § 1.263A-11(e). Under the prior regulations, when a taxpayer made an improvement to real property, the "unit of property" subject to interest capitalization included not only the improvement itself but also the un-depreciated basis of the existing "associated property" that directly benefited from the improvement. This rule often dramatically increased the amount of accumulated production expenditures (APEs) and, consequently, the amount of capitalized interest. By removing this rule, the regulations simplify compliance and align the APE calculation more closely with the direct costs of the improvement project.
Revised Definition of an Improvement: The regulations amend § 1.263A-8(d)(3)(i) to update the definition of an "improvement". The revised definition now explicitly aligns with the framework established in § 1.263(a)-3, which details the rules for capitalizing amounts paid for the improvement of tangible property. This change incorporates the various exceptions, safe harbors, and elections available under § 1.263(a)-3 into the § 263A analysis. This harmonization provides greater consistency between the general tangible property regulations and the uniform capitalization (UNICAP) rules. It is important to note that repairs and maintenance, as described in § 1.162-4(a), are explicitly excluded from the definition of an improvement constituting production.
Clarification of the Mid-Production Purchases Rule: The final regulations modify the mid-production purchases rule in § 1.263A-11(f) to clarify its scope. The revised rule now explicitly states that it applies when a taxpayer purchases a unit of property for further production before the property is placed in service. In such cases, the taxpayer’s APEs include the full purchase price of the unit plus all additional direct and indirect costs capitalized during the subsequent production period.

The IRS’s Analysis

The final regulations were adopted after a notice and comment period, which began with the publication of proposed regulations on May 15, 2024. The Treasury Department and the IRS received only two public comments in response. One comment was not relevant to the proposed rules, while the other expressed full support for the proposed changes without suggesting any modifications. Given the straightforward and supportive public feedback, the final regulations adopt the proposed regulations with only minor clarifying changes to the language in § 1.263A-8(d)(3)(i).

Effective Date and Accounting Method Changes

The final regulations, specifically the changes to § 1.263A-8(d)(3) and § 1.263A-11(e) and (f), apply to taxable years beginning after October 2, 2025.

Crucially, taxpayers must recognize that a change in the treatment of interest to conform with these new rules is considered a change in method of accounting. As such, any taxpayer adopting these new provisions must do so in accordance with IRC §§ 446 and 481. This generally requires the filing of a Form 3115, Application for Change in Accounting Method. The reporting burden associated with this form will be reflected in the Paperwork Reduction Act submission for Form 3115.

These regulations are expected to primarily affect businesses with gross receipts exceeding the § 263A small business exemption threshold (currently $25 million, adjusted for inflation). The IRS estimates that of the roughly 30,000 taxpayers subject to § 263A, no more than 1%, or approximately 300 taxpayers, may file for a change in accounting method in any given year as a result of these final rules.

Prepared with assistance from NotebookLM.