--- kind: "range" citation: "26 C.F.R. §§ 1.263A-8–1.263A-15" title: "26" from: "1.263A-8" to: "1.263A-15" count: 8 url: "https://uscodex.org/cfr/26/1.263A-8..1.263A-15" --- # §1.263A-8. Requirement to capitalize interest. - (a) **In general—** - (1) **General rule.** Capitalization of interest under the avoided cost method described in [§ 1.263A-9](/cfr/26/1.263A-9.md) is required with respect to the production of designated property described in [paragraph (b)](#b) of this section. However, a taxpayer, other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under [section 448(a)(3)](/cfr/26/448.md?p=a-3), that meets the gross receipts test of [section 448(c)](/cfr/26/448.md?p=c) for the taxable year is not required to capitalize costs, including interest, under [section 263A](/cfr/26/263A.md). See [§ 1.263A-1(j)](/cfr/26/1.263A-1.md?p=j). - (2) **Treatment of interest required to be capitalized.** In general, interest that is capitalized under this section is treated as a cost of the designated property and is recovered in accordance with [§ 1.263A-1(c)(4)](/cfr/26/1.263A-1.md?p=c-4). Interest capitalized by reason of assets used to produce designated property (within the meaning of [§ 1.263A-11(d)](/cfr/26/1.263A-11.md?p=d)) is added to the basis of the designated property rather than the bases of the assets used to produce the designated property. Interest capitalized with respect to designated property that includes both components subject to an allowance for depreciation or depletion and components not subject to an allowance for depreciation or depletion is ratably allocated among, and is treated as a cost of, components that are subject to an allowance for depreciation or depletion. - (3) **Methods of accounting under section 263A(f).** Except as otherwise provided, methods of accounting and other computations under [§§ 1.263A-8 through 1.263A-15](/cfr/26/1.263A-8..1.263A-15.md) are applied on a taxpayer, as opposed to a separate and distinct trade or business, basis. - (4) **Special definitions—** - (i) **Related person.** Except as otherwise provided, for purposes of [§§ 1.263A-8 through 1.263A-15](/cfr/26/1.263A-8..1.263A-15.md), a person is related to a taxpayer if their relationship is described in section [267(b)](/cfr/26/267.md?p=b) or [707(b)](/cfr/26/707.md?p=b). - (ii) **Placed in service.** For purposes of [§§ 1.263A-8 through 1.263A-15](/cfr/26/1.263A-8..1.263A-15.md), placed in service has the same meaning as set forth in [§ 1.46-3(d)](/cfr/26/1.46-3.md?p=d). - (b) **Designated property—** - (1) **In general.** Except as provided in paragraphs [(b)(3)](#b-3) and [(b)(4)](#b-4) of this section, designated property means any property that is produced and that is either: - (i) Real property; or - (ii) Tangible personal property (as defined in [§ 1.263A-2(a)(2)](/cfr/26/1.263A-2.md?p=a-2)) which meets any of the following criteria: - (A) Property with a class life of 20 years or more under [section 168](/cfr/26/168.md) (long-lived property), but only if the property is not property described in [section 1221(l)](/cfr/26/1221.md?p=l) in the hands of the taxpayer or a related person, - (B) Property with an estimated production period (as defined in [§ 1.263A-12](/cfr/26/1.263A-12.md)) exceeding 2 years (2-year property), or - (C) Property with an estimated production period exceeding 1 year and an estimated cost of production exceeding $1,000,000 (1-year property). - (2) **Special rules—** - (i) **Application of thresholds.** The thresholds described in paragraphs (b)(l)(ii)(A), (B), and (C) of this section are applied separately for each unit of property (as defined in [§ 1.263A-10](/cfr/26/1.263A-10.md)). - (ii) **Relevant activities and costs.** For purposes of determining whether property is designated property, all activities and costs are taken into account if they are performed or incurred by, or for, the taxpayer or any related persons and they directly benefit or are incurred by reason of the production of the property. - (iii) **Production period and cost of production.** For purposes of applying the classification thresholds under paragraphs (b)(l)(ii) (B) and (C) of this section to a unit of property, the taxpayer is required, at the beginning of the production period, to reasonably estimate the production period and the total cost of production for the unit of property. The taxpayer must maintain contemporaneous written records supporting the estimates and classification. If the estimates are reasonable based on the facts in existence at the beginning of the production period, the taxpayer's classification of the property is not modified in subsequent periods, even if the actual length of the production period or the actual cost of production differs from the estimates. To be considered reasonable, estimates of the production period and the total cost of production must include anticipated expense and time for delay, rework, change orders, and technological, design or other problems. To the extent that several distinct activities related to the production of the property are expected to occur simultaneously, the period during which these distinct activities occur is not counted more than once. The bases of assets used to produce a unit of property (within the meaning of [§ 1.263A-11(d)](/cfr/26/1.263A-11.md?p=d)) and any interest that would be required to be capitalized if a unit of property were designated property are disregarded in making estimates of the total cost of production for purposes of this [paragraph (b)(2)(iii)](#b-2-iii). - (3) **Excluded property.** Designated property does not include: - (i) Timber and evergreen trees that are more than 6 years old when severed from the roots, or - (ii) Property produced by the taxpayer for use by the taxpayer other than in a trade or business or an activity conducted for profit. - (4) **De minimis rule—** - (i) **In general.** Designated property does not include property for which— - (A) The production period does not exceed 90 days; and - (B) The total production expenditures do not exceed $1,000,000 divided by the number of days in the production period. - (ii) **Determination of total production expenditures.** For purposes of determining whether the condition of [paragraph (b)(4)(i)(B)](#b-4-i-B) of this section is met with respect to property, the cost of land, the adjusted basis of property used to produce property, and interest that would be capitalized with respect to property if it were designated property are excluded from total production expenditures. - (c) **Definition of real property—** - (1) **In general.** Real property includes land, unsevered natural products of land, buildings, and inherently permanent structures. Any interest in real property of a type described in this [paragraph (c)](#c), including fee ownership, co-ownership, a leasehold, an option, or a similar interest is real property under this section. Real property includes the structural components of both buildings and inherently permanent structures, such as walls, partitions, doors, wiring, plumbing, central air conditioning and heating systems, pipes and ducts, elevators and escalators, and other similar property. Tenant improvements to a building that are inherently permanent or otherwise classified as real property within the meaning of this [paragraph (c)(1)](#c-1) are real property under this section. However, property produced for sale that is not real property in the hands of the taxpayer or a related person, but that may be incorporated into real property by an unrelated buyer, is not treated as real property by the producing taxpayer (e.g., bricks, nails, paint, and windowpanes). - (2) **Unsevered natural products of land.** Unsevered natural products of land include growing crops and plants, mines, wells, and other natural deposits. Growing crops and plants, however, are real property only if the preproductive period of the crop or plant exceeds 2 years. - (3) **Inherently permanent structures.** Inherently permanent structures include property that is affixed to real property and that will ordinarily remain affixed for an indefinite period of time, such as swimming pools, roads, bridges, tunnels, paved parking areas and other pavements, special foundations, wharves and docks, fences, inherently permanent advertising displays, inherently permanent outdoor lighting facilities, railroad tracks and signals, telephone poles, power generation and transmission facilities, permanently installed telecommunications cables, broadcasting towers, oil and gas pipelines, derricks and storage equipment, grain storage bins and silos. For purposes of this section, affixation to real property may be accomplished by weight alone. Property may constitute an inherently permanent structure even though it is not classified as a building for purposes of former [section 48(a)(1)(B)](/cfr/26/48.md?p=a-1-B) and [§ 1.48-1](/cfr/26/1.48-1.md). Any property not othewise described in this [paragraph (c)(3)](#c-3) that constitutes other tangible property under the principles of former [section 48(a)(1)(B)](/cfr/26/48.md?p=a-1-B) and [§ 1.48-1(d)](/cfr/26/1.48-1.md?p=d) is treated for the purposes of this section as an inherently permanent structure. - (4) **Machinery—** - (i) **Treatment.** A structure that is property in the nature of machinery or is essentially an item of machinery or equipment is not an inherently permanent structure and is not real property. In the case, however, of a building or inherently permanent structure that includes property in the nature of machinery as a structural component, the property in the nature of machinery is real property. - (ii) **Certain factors not determinative.** A structure may be an inherently permanent structure, and not property in the nature of machinery or essentially an item of machinery, even if the structure is necessary to operate or use, supports, or is otherwise associated with, machinery. - (d) **Production—** - (1) **Definition of produce. Produce—** is defined as provided in [section 263A(g)](/cfr/26/263A.md?p=g) and [§ 1.263A-2(a)(1)(i)](/cfr/26/1.263A-2.md?p=a-1-i). - (2) **Property produced under a contract—** - (i) **Customer.** A taxpayer is treated as producing any property that is produced for the taxpayer (the customer) by another party (the contractor) under a contract with the taxpayer or an intermediary. Property produced under a contract is designated property to the customer if it is real property or tangible personal property that satisfies the classification thresholds described in [paragraph (b)(1)(ii)](#b-1-ii) of this section. If property produced under a contract will become part of a unit of designated property produced by the customer in the customer's hands, the property produced under the contract is designated property to the customer. - (ii) **Contractor.** Property produced under a contract is designated property to the contractor if it is real property, 2-year property, or 1-year property and the property produced under the contract is not excluded by reason of [paragraph (d)(2)(v)](#d-2-v) of this section. - (iii) **Definition of a contract.** For purposes of this [paragraph (d)(2)](#d-2), contract has the same meaning as under [§ 1.263A-2(a)(1)(ii)(B)(2)](/cfr/26/1.263A-2.md?p=a-1-ii-B-2). - (iv) **Determination of whether thresholds are satisfied.** In the case of tangible personal property produced under a contract, the customer and the contractor each determine under this [paragraph (d)(2)](#d-2), whether the property satisfies the classification thresholds described in [paragraph (b)(1)(ii)](#b-1-ii) of this section. Thus, tangible personal property may be designated property with respect to either, or both, the customer and the contractor. The provisions of [paragraph (b)(2)(iii)](#b-2-iii) of this section are modified as set forth in this [paragraph (d)(2)(iv)](#d-2-iv) for purposes of determining whether tangible personal property produced under a contract is 2-year property or 1-year property. - (A) **Customer.** In determining a customer's estimated cost of production, the customer takes into account costs and payments that are reasonably expected to be incurred by the customer, but does not take into account costs incurred (or to be incurred) by an unrelated contractor. In determining the customer's estimated length of the production period, the production period is treated as beginning on the earlier of the date the contract is executed or the date that the customer's accumulated production expenditures for the unit are at least 5 percent of the customer's total estimated production expenditures for the unit. The customer, however, may elect to treat the production period as beginning on the date the sum of the accumulated production expenditures of the contractor (or contractors if more than one contractor is producing components for the unit of property) and of the customer are at least 5 percent of the customer's estimated production expenditures for the unit. - (B) **Contractor.** In determining a contractor's estimated cost of production, the contractor takes into account only the costs that are reasonably expected to be incurred by the contractor, without any reduction for payments from the customer. In determining the contractor's estimated length of the production period, the production period is treated as beginning on the date the contractor's accumulated production expenditures (without any reduction for payments from the customer) are at least 5 percent of the contractor's total estimated accumulated production expenditures. - (v) **Exclusion for property subject to long-term contract rules.** Property described in [paragraph (b)](#b) of this section is designated property with respect to a contractor only if— - (A) The contract is not a long-term contract (within the meaning of [section 460(f)](/cfr/26/460.md?p=f)); or - (B) The contract is a home construction contract (within the meaning of [section 460(e)(6)(A)](/cfr/26/460.md?p=e-6-A)) with respect to which the requirements of [section 460(e)(1)(B)](/cfr/26/460.md?p=e-1-B) (i) and (ii) are not met. - (3) **Improvements to existing property—** - (i) **In general.** Any improvement to real or tangible personal property under [§ 1.263(a)-3](/cfr/26/1.263..3.md), or any improvement to tangible personal property as defined in [§ 1.263A-2(a)(2)(ii)](/cfr/26/1.263A-2.md?p=a-2-ii), constitutes the production of property. Generally, any improvement to designated property constitutes the production of designated property. An improvement is not treated as the production of designated property, however, if the de minimis exception described in [paragraph (b)(4)](#b-4) of this section applies to the improvement. [Paragraph (d)(3)(iii)](#d-3-iii) of this section provides an exception for certain improvements to tangible personal property. In addition, improvements to designated property under this [paragraph (d)(3)(i)](#d-3-i) do not include repairs and maintenance described in [§ 1.162-4(a)](/cfr/26/1.162-4.md?p=a). - (ii) **Real property.** The rehabilitation or preservation of a standing building, the clearing of raw land prior to sale, and the drilling of an oil well are activities constituting improvements to real property and, therefore, the production of designated property. Similarly, the demolition of a standing building generally constitutes an activity that is an improvement to real property and, therefore, the production of designated property. See the exceptions, however, in paragraphs [(b)(3)](#b-3) and [(b)(4)](#b-4) of this section. - (iii) **Tangible personal property.** If the taxpayer has treated a unit of tangible personal property as designated property under this section, an improvement to such property constitutes the production of designated property regardless of the remaining useful life of the improved property (or the improvement) and, except as provided in [paragraph (b)(4)](#b-4) of this section, regardless of the estimated length of the production period or the estimated cost of the improvement. If the taxpayer has not treated a unit of tangible personal property as designated property under this section, an improvement to such property constitutes the production of designated property only if the improvement independently meets the classification thresholds described in [paragraph (b)(1)(ii)](#b-1-ii) of this section. # §1.263A-9. The avoided cost method. - (a) **In general—** - (1) **Description.** The avoided cost method described in this section must be used to calculate the amount of interest required to be capitalized under [section 263A(f)](/cfr/26/263A.md?p=f). Generally, any interest that the taxpayer theoretically would have avoided if accumulated production expenditures (as defined in [§ 1.263A-11](/cfr/26/1.263A-11.md)) had been used to repay or reduce the taxpayer's outstanding debt must be capitalized under the avoided cost method. The application of the avoided cost method does not depend on whether the taxpayer actually would have used the amounts expended for production to repay or reduce debt. Instead, the avoided cost method is based on the assumption that debt of the taxpayer would have been repaid or reduced without regard to the taxpayer's subjective intentions or to restrictions (including legal, regulatory, contractual, or other restrictions) against repayment or use of the debt proceeds. - (2) **Overview—** - (i) **In general.** For each unit of designated property (within the meaning of [§ 1.263A-8(b)](/cfr/26/1.263A-8.md?p=b)), the avoided cost method requires the capitalization of— - (A) The traced debt amount under [paragraph (b)](#b) of this section, and - (B) **The excess expenditure amount under paragraph (c) of this section.** - (ii) **Rules that apply in determining amounts.** The traced debt and excess expenditure amounts are determined for each taxable year or shorter computation period that includes the production period (as defined in [§ 1.263A-12](/cfr/26/1.263A-12.md)) of a unit of designated property. [Paragraph (d)](#d) of this section provides an election not to trace debt to specific units of designated property. [Paragraph (f)](#f) of this section provides rules for selecting the computation period, for calculating averages, and for determining measurement dates within the computation period. Special rules are in [paragraph (g)](#g) of this section. - (3) **Definitions of interest and incurred.** Except as provided in the case of certain expenses that are treated as a substitute for interest under paragraphs [(c)(2)(iii)](#c-2-iii) and [(g)(2)(iv)](#g-2-iv) of this section, interest refers to all amounts that are characterized as interest expense under any provision of the Code, including, for example, sections [482](/cfr/26/482.md), [483](/cfr/26/483.md), [1272](/cfr/26/1272.md), [1274](/cfr/26/1274.md), and [7872](/cfr/26/7872.md). Incurred refers to the amount of interest that is properly accruable during the period of time in question determined by taking into account the loan agreement and any applicable provisions of the Internal Revenue laws and regulations such as [section 163](/cfr/26/163.md), [§ 1.446-2](/cfr/26/1.446-2.md), and [sections 1271 through 1275](/cfr/26/1271..1275.md). - (4) **Definition of eligible debt.** Except as provided in this [paragraph (a)(4)](#a-4), eligible debt includes all outstanding debt (as evidenced by a contract, bond, debenture, note, certificate, or other evidence of indebtedness). Eligible debt does not include— - (i) Debt (or the portion thereof) bearing interest that is disallowed under a provision described in [§ 1.163-8T(m)(7)(ii)](/cfr/26/1.163-8T.md?p=m-7-ii); - (ii) Debt, such as accounts payable and other accrued items, that bears no interest, except to the extent that such debt is traced debt (as defined in [paragraph (b)(2)](#b-2) of this section); - (iii) Debt that is borrowed directly or indirectly from a person related to the taxpayer and that bears a rate of interest that is less than the applicable Federal rate in effect under [section 1274(d)](/cfr/26/1274.md?p=d) on the date of issuance; - (iv) Debt (or the portion thereof) bearing personal interest within the meaning of [section 163(h)(2)](/cfr/26/163.md?p=h-2); - (v) Debt (or the portion thereof) bearing qualified residence interest within the meaning of [section 163(h)(3)](/cfr/26/163.md?p=h-3); - (vi) Debt incurred by an organization that is exempt from Federal income tax under [section 501(a)](/cfr/26/501.md?p=a), except to the extent interest on such debt is directly attributable to an unrelated trade or business of the organization within the meaning of [section 512](/cfr/26/512.md); - (vii) Reserves, deferred tax liabilities, and similar items that are not treated as debt for Federal income tax purposes, regardless of the extent to which the taxpayer's applicable financial accounting or other regulatory reporting principles require or support treating these items as debt; - (viii) Federal, State, and local income tax liabilities, deferred tax liabilities under [section 453A](/cfr/26/453A.md), and hypothetical tax liabilities under the look-back method of [section 460(b)](/cfr/26/460.md?p=b) or similar provisions; and - (ix) A purchase money obligation given by the lessor to the lessee (or a party that is related to the lessee) in a sale and leaseback transaction involving an agreement qualifying as a lease under [§ 5c.168(f)(8)-1](/cfr/26/5c.168..1.md) through [§ 5c.168(f)(8)-11](/cfr/26/5c.168..11.md) of this chapter. See [§ 5c.168(f)(8)-1(e)](/cfr/26/5c.168..1.md) Example (2) of this chapter. - (b) **Traced debt amount—** - (1) **General rule.** Interest must be capitalized with respect to a unit of designated property in an amount (the traced debt amount) equal to the total interest incurred on the traced debt during each measurement period (as defined in [paragraph (f)(2)(ii)](#f-2-ii) of this section) that ends on a measurement date described in [paragraph (f)(2)(iii)](#f-2-iii) of this section. See the example in [paragraph (b)(3)](#b-3) of this section. If any interest incurred on the traced debt is not taken into account for the taxable year that includes the measurement period because of a deferral provision, see [paragraph (g)(2)](#g-2) of this section for the time and manner for capitalizing and recovering that amount. This [paragraph (b)(1)](#b-1) does not apply if the taxpayer elects under [paragraph (d)](#d) of this section not to trace debt. - (2) **Identification and definition of traced debt.** On each measurement date described in [paragraph (f)(2)(iii)](#f-2-iii) of this section, the taxpayer must identify debt that is traced debt with respect to a unit of designated property. On each such date, traced debt with respect to a unit of designated property is the outstanding eligible debt (as defined in [paragraph (a)(4)](#a-4) of this section) that is allocated, on that date, to accumulated production expenditures with respect to the unit of designated property under the rules of [§ 1.163-8T](/cfr/26/1.163-8T.md). Traced debt also includes unpaid interest that has been capitalized with respect to such unit under [paragraph (b)(1)](#b-1) of this section and that is included in accumulated production expenditures on the measurement date. - (3) **Example.** The provisions of paragraphs [(b)(1)](#b-1) and [(b)(2)](#b-2) of this section are illustrated by the following example. - (c) **Excess expenditure amount—** - (1) **General rule.** If there are accumulated production expenditures in excess of traced debt with respect to a unit of designated property on any measurement date described in [paragraph (f)(2)(iii)](#f-2-iii) of this section, the taxpayer must, for the computation period that includes the measurement date, capitalize with respect to this unit the excess expenditure amount calculated under this [paragraph (c)(1)](#c-1). However, if the sum of the excess expenditure amounts for all units of designated property of a taxpayer exceeds the total interest described in [paragraph (c)(2)](#c-2) of this section, only a prorata amount (as determined under [paragraph (c)(7)](#c-7) of this section) of such interest must be capitalized with respect to each unit. For each unit of designated property, the excess expenditure amount for a computation period equals the product of— - (i) The average excess expenditures (as determined under [paragraph (c)(5)(ii)](#c-5-ii) of this section) for the unit of designated property for that period, and - (ii) The weighted average interest rate (as determined under [paragraph (c)(5)(iii)](#c-5-iii) of this section) for that period. - (2) **Interest required to be capitalized.** With respect to an excess expenditure amount, interest incurred during the computation period is capitalized from the following sources and in the following sequence but not in excess of the excess expenditure amount for all units of designated property: - (i) Interest incurred on nontraced debt (as defined in [paragraph (c)(5)(i)](#c-5-i) of this section); - (ii) Interest incurred on borrowings described in [paragraph (a)(4)(iii)](#a-4-iii) of this section (relating to certain borrowings from related persons); and - (iii) In the case of a partnership, guaranteed payments for the use of capital (within the meaning of [section 707(c)](/cfr/26/707.md?p=c)) that would be deductible by the partnership if [section 263A(f)](/cfr/26/263A.md?p=f) did not apply. - (3) **Example.** The provisions of paragraph [(c)(1)](#c-1) and [(2)](#c-2) of this section are illustrated by the following example. - (4) **Treatment of interest subject to a deferral provision.** If any interest described in [paragraph (c)(2)](#c-2) of this section is not taken into account for the taxable year that includes the computation period because of a deferral provision described in [paragraph (g)(1)(ii)](#g-1-ii) of this section, [paragraph (c)(2)](#c-2) of this section is first applied without regard to the amount of the deferred interest. After applying [paragraph (c)(2)](#c-2) without regard to the deferred interest, if the amount of interest capitalized with respect to all units of designated property for the computation period is less than the amount that would have been capitalized if a deferral provision did not apply, see [paragraph (g)(2)](#g-2) of this section for the time and manner for capitalizing and recovering the difference (the shortfall amount). - (5) **Definitions—** - (i) **Nontraced debt—** - (A) Defined. Nontraced debt means all eligible debt on a measurement date other than any debt that is treated as traced debt with respect to any unit of designated property on that measurement date. For example, nontraced debt includes eligible debt that is allocated to expenditures that are not capitalized under [section 263A(a)](/cfr/26/263A.md?p=a) (e.g., expenditures deductible under section [174(a)](/cfr/26/174.md?p=a) or [263(c)](/cfr/26/263.md?p=c)). Similarly, even if eligible debt is allocated to a production expenditure for a unit of designated property, the debt is included in nontraced debt on measurement dates before the first or after the last measurement date for that unit of designated property. Thus, nontraced debt may include debt that was previously treated as traced debt or that will be treated as traced debt on a future measurement date. - (B) **Example.** The provisions of [paragraph (c)(5)(i)(A)](#c-5-i-A) of this section are illustrated by the following example. - (ii) **Average excess expenditures—** - (A) **General rule.** The average excess expenditures for a unit of designated property for a computation period are computed by— (1) Determining the amount (if any) by which accumulated production expenditures exceed traced debt at each measurement date during the computation period; and (2) Dividing the sum of these amounts by the number of measurement dates during the computation period. - (B) **Example.** The provisions of [paragraph (c)(5)(ii)(A)](#c-5-ii-A) of this section are illustrated by the following example. - (iii) **Weighted average interest rate—** - (A) **Determination of rate.** The weighted average interest rate for a computation period is determined by dividing interest incurred on nontraced debt during the period by average nontraced debt for the period. - (B) **Interest incurred on nontraced debt.** Interest incurred on nontraced debt during the computation period is equal to the total amount of interest incurred during the computation period on all eligible debt minus the amount of interest incurred during the computation period on traced debt. Thus, all interest incurred on nontraced debt during the computation period is included in the numerator of the weighted average interest rate, even if the underlying nontraced debt is repaid before the end of a measurement period and excluded from nontraced debt outstanding for measurement dates after repayment, in determining the denominator of the weighted average interest rate. However, see [paragraph (g)(7)](#g-7) of this section for an election to treat eligible debt that is repaid within the 15-day period immediately preceding a quarterly measurement date as outstanding on that measurement date. See [paragraph (a)(3)](#a-3) of this section for the definitions of interest and incurred. - (C) **Average nontraced debt.** The average nontraced debt for a computation period is computed by— (1) Determining the amount of nontraced debt outstanding on each measurement date during the computation period; and (2) Dividing the sum of these amounts by the number of measurement dates during the computation period. - (D) **Special rules if taxpayer has no nontraced debt or rate is contingent.** If the taxpayer does not have nontraced debt outstanding during the computation period, the weighted average interest rate for purposes of applying paragraphs [(c)(1)](#c-1) and [(c)(2)](#c-2) of this section is the highest applicable Federal rate in effect under [section 1274(d)](/cfr/26/1274.md?p=d) during the computation period. If interest is incurred at a rate that is contingent at the time the return for the year that includes the computation period is filed, the amount of interest is determined using the higher of the fixed rate of interest (if any) on the underlying debt or the applicable Federal rate in effect under [section 1274(d)](/cfr/26/1274.md?p=d) on the date of issuance. - (6) **Examples.** The following examples illustrate the principles of this [paragraph (c)](#c): - (7) **Special rules where the excess expenditure amount exceeds incurred interest—** - (i) **Allocation of total incurred interest to units.** For a computation period in which the sum of the excess expenditure amounts under [paragraph (c)(1)](#c-1) of this section for all units of designated property exceeds the total amount of interest (including deferred interest) available for capitalization, as determined under [paragraph (c)(2)](#c-2) of this section, the amount of interest that is allocated to a unit of designated property is equal to the product of— - (A) The total amount of interest (including deferred interest) available for capitalization, as determined under [paragraph (c)(2)](#c-2) of this section; and - (B) A fraction, the numerator of which is the average excess expenditures for the unit of designated property and the denominator of which is the sum of the average excess expenditures for all units of designated property. - (ii) **Application of related person rules to average excess expenditure.** Certain excess expenditures must be taken into account by the persons (if any) required to capitalize interest with respect to production expenditures of the taxpayer under applicable related person rules. For each computation period, the amount of average excess expenditures that must be taken into account by such persons for each unit of the taxpayer's property is computed by— - (A) Determining, for the computation period, the amount (if any) by which the excess expenditure amount for the unit exceeds the amount of interest allocated to the unit under [paragraph (c)(7)(i)](#c-7-i) of this section; and - (B) **Dividing the excess by the weighted average interest rate for the period.** - (iii) **Special rule for corporations.** If a corporation is related to another person for the purposes of the applicable related party rules, the District Director upon examination may require that the corporation apply this [paragraph (c)(7)](#c-7) and other provisions of the regulations by excluding deferred interest from the total interest available for capitalization. - (d) **Election not to trace debt—** - (1) **General rule.** Taxpayers may elect not to trace debt. If the election is made, the average excess expenditures and weighted average interest rate under [paragraph (c)(5)](#c-5) of this section are determined by treating all eligible debt as nontraced debt. For this purpose, debt specified in [paragraph (a)(4)(ii)](#a-4-ii) of this section (e.g., accounts payable) may be included in eligible debt, provided it would be treated as traced debt but for an election under this [paragraph (d)](#d). The election not to trace debt is a method of accounting that applies to the determination of capitalized interest for all designated property of the taxpayer. The making or revocation of the election is a change in method of accounting requiring the consent of the Commissioner under [section 446(e)](/cfr/26/446.md?p=e) and [§ 1.446-1(e)](/cfr/26/1.446-1.md?p=e). - (2) **Example.** The provisions of [paragraph (d)(1)](#d-1) of this section are illustrated by the following example. - (e) **Election to use external rate—** - (1) **In general.** An eligible taxpayer may elect to use the highest applicable Federal rate (AFR) under [section 1274(d)](/cfr/26/1274.md?p=d) in effect during the computation period plus 3 percentage points (AFR plus 3) as a substitute for the weighted average interest rate determined under [paragraph (c)(5)(iii)](#c-5-iii) of this section. A taxpayer that makes this election may not trace debt. The use of the AFR plus 3 as provided under this [paragraph (e)(1)](#e-1) constitutes a method of accounting. A taxpayer makes the election to use the AFR plus 3 method by using the AFR plus 3 as the taxpayer's weighted average interest rate, and any change to the AFR plus 3 method by a taxpayer that has never previously used the method does not require the consent of the Commissioner. Any other change to or from the use of the AFR plus 3 method under this [paragraph (e)(1)](#e-1) (other than by reason of a taxpayer ceasing to be an eligible taxpayer) is a change in method of accounting requiring the consent of the Commissioner under [section 446(e)](/cfr/26/446.md?p=e) and [§ 1.446-1(e)](/cfr/26/1.446-1.md?p=e). All changes to or from the AFR plus 3 method are effected on a cut-off basis. - (2) **Eligible taxpayer.** A taxpayer is an eligible taxpayer for a taxable year for purposes of this [paragraph (e)](#e) if the average annual gross receipts of the taxpayer for the three previous taxable years do not exceed $10,000,000 (the $10,000,000 gross receipts test) and the taxpayer has met the $10,000 gross receipts for all prior taxable years beginning after December 31, 1994. For purposes of this [paragraph (e)(2)](#e-2), the principles of section [263A(b)(2)(B)](/cfr/26/263A.md?p=b-2-B) and [(C)](/cfr/26/263A.md?p=b-2-C) and [§ 1.263A-3(b)](/cfr/26/1.263A-3.md?p=b) apply in determining whether a taxpayer is an eligible taxpayer for a taxable year. A taxpayer is an eligible taxpayer for a taxable year for purposes of this [paragraph (e)](#e) if the taxpayer is a small business taxpayer, as defined in [§ 1.263A-1(j)](/cfr/26/1.263A-1.md?p=j). - (f) **Selection of computation period and measurement dates and application of averaging conventions—** - (1) **Computation period—** - (i) **In general.** A taxpayer may (but is not required to) make the avoided cost calculation on the basis of a full taxable year. If the taxpayer uses the taxable year as the computation period, a single avoided cost calculation is made for each unit of designated property for the entire taxable year. If the taxpayer uses a computation period that is shorter than the full taxable year, an avoided cost calculation is made for each unit of designated property for each shorter computation period within the taxable year. If the taxpayer uses a shorter computation period, the computation period may not include portions of more than one taxable year and, except as provided in the case of short taxable years, each computation period within a taxable year must be the same length. In the case of a short taxable year, a taxpayer may treat a period shorter than the taxpayer's regular computation period as the first or last computation period, or as the only computation period for the year if the year is shorter than the taxpayer's regular computation period. A taxpayer must use the same computation periods for all designated property produced during a single taxable year. - (ii) **Method of accounting.** The choice of a computation period is a method of accounting. Any change in the computation period is a change in method of accounting requiring the consent of the Commissioner under [section 446(e)](/cfr/26/446.md?p=e) and [§ 1.446-1(e)](/cfr/26/1.446-1.md?p=e). - (iii) **Production period beginning or ending during the computation period.** The avoided cost method applies to the production of a unit of designated property on the basis of a full computation period, regardless of whether the production period for the unit of designated property begins or ends during the computation period. - (2) **Measurement dates—** - (i) **In general.** If a taxpayer uses the taxable year as the computation period, measurement dates must occur at quarterly or more frequent regular intervals. If the taxpayer uses computation periods that are shorter than the taxable year, measurement dates must occur at least twice during each computation period and at least four times during the taxable year (or consecutive 12-month period in the case of a short taxable year). The taxpayer must use the same measurement dates for all designated property produced during a computation period. Except in the case of a computation period that differs from the taxpayer's regular computation period by reason of a short taxable year (see [paragraph (f)(1)(i)](#f-1-i) of this section), measurement dates must occur at equal intervals during each computation period that falls within a single taxable year. For any computation period that differs from the taxpayer's regular computation period by reason of a short taxable year, the measurement dates used by the taxpayer during that period must be consistent with the principles and purposes of [section 263A(f)](/cfr/26/263A.md?p=f). A taxpayer is permitted to modify the frequency of measurement dates from year to year. - (ii) **Measurement period.** For purposes of this section, measurement period means the period that begins on the first day following the preceding measurement date and that ends on the measurement date. - (iii) **Measurement dates on which accumulated production expenditures must be taken into account.** The first measurement date on which accumulated production expenditures must be taken into account with respect to a unit of designated property is the first measurement date following the beginning of the production period for the unit of designated property. The final measurement date on which accumulated production expenditures with respect to a unit of designated property must be taken into account is the first measurement date following the end of the production period for the unit of designated property. Accumulated production expenditures with respect to a unit of designated property must also be taken into account on all intervening measurement dates. See [§ 1.263A-12](/cfr/26/1.263A-12.md) to determine when the production period begins and ends. - (iv) **More frequent measurement dates.** When in the opinion of the District Director more frequent measurement dates are necessary to determine capitalized interest consistent with the principles and purposes of [section 263A(f)](/cfr/26/263A.md?p=f) for a particular computation period, the District Director may require the use of more frequent measurement dates. If a significant segment of the taxpayer's production activities (the first segment) requires more frequent measurement dates than another significant segment of the taxpayer's production activities, the taxpayer may request a ruling from the Internal Revenue Service permitting, for a taxable year and all subsequent taxable years, a segregation of the two segments and, notwithstanding [paragraph (f)(2)(i)](#f-2-i) of this section, the use of the more frequent measurement dates for only the first segment. The request for a ruling must be made in accordance with any applicable rules relating to submissions of ruling requests. The request must be filed on or before the due date (including extensions) of the original Federal income tax return for the first taxable year to which it will apply. - (3) **Examples.** The following examples illustrate the principles of this [paragraph (f)](#f): - (g) **Special rules—** - (1) **Ordering rules—** - (i) **Provisions preempted by section 263A(f).** Interest must be capitalized under [section 263A(f)](/cfr/26/263A.md?p=f) before the application of [section 163(d)](/cfr/26/163.md?p=d) (regarding the investment interest limitation), [section 163(j)](/cfr/26/163.md?p=j) (regarding the limitation on business interest expense), [section 266](/cfr/26/266.md) (regarding the election to capitalize carrying charges), [section 469](/cfr/26/469.md) (regarding the limitation on passive losses), and [section 861](/cfr/26/861.md) (regarding the allocation of interest to United States sources). Any interest that is capitalized under [section 263A(f)](/cfr/26/263A.md?p=f) is not taken into account as interest under those sections. However, in applying [section 263A(f)](/cfr/26/263A.md?p=f) with respect to the excess expenditure amount, the taxpayer must capitalize all interest that is neither investment interest under [section 163(d)](/cfr/26/163.md?p=d), business interest expense under [section 163(j)](/cfr/26/163.md?p=j), nor passive interest under [section 469](/cfr/26/469.md) before capitalizing any interest that is either investment interest, business interest expense, or passive interest. Any interest that is not required to be capitalized after the application of [section 263A(f)](/cfr/26/263A.md?p=f) is then taken into account as interest subject to sections [163(d)](/cfr/26/163.md?p=d), [163(j)](/cfr/26/163.md?p=j), [266](/cfr/26/266.md), [469](/cfr/26/469.md), and [861](/cfr/26/861.md). If, after the application of [section 263A(f)](/cfr/26/263A.md?p=f), interest is deferred under sections [163(d)](/cfr/26/163.md?p=d), [163(j)](/cfr/26/163.md?p=j), [266](/cfr/26/266.md), or [469](/cfr/26/469.md), that interest is not subject to capitalization under [section 263A(f)](/cfr/26/263A.md?p=f) in any subsequent taxable year. - (ii) **Deferral provisions applied before this section.** Interest (including contingent interest) that is subject to a deferral provision described in this [paragraph (g)(1)(ii)](#g-1-ii) is subject to capitalization under [section 263A(f)](/cfr/26/263A.md?p=f) only in the taxable year in which it would be deducted if [section 263A(f)](/cfr/26/263A.md?p=f) did not apply. Deferral provisions include sections [163(e)(3)](/cfr/26/163.md?p=e-3), [267](/cfr/26/267.md), [446](/cfr/26/446.md), and [461](/cfr/26/461.md), and all other deferral or limitation provisions that are not described in [paragraph (g)(1)(i)](#g-1-i) of this section. In contrast to the provisions of [paragraph (g)(1)(i)](#g-1-i) of this section, deferral provisions are applied before the application of [section 263A(f)](/cfr/26/263A.md?p=f). - (2) **Application of section 263A(f) to deferred interest—** - (i) **In general.** This [paragraph (g)(2)](#g-2) describes the time and manner of capitalizing and recovering the deferral amount. The deferral amount for any computation period equals the sum of— - (A) The amount of interest that is incurred on traced debt that is deferred during the computation period and is not deductible for the taxable year that includes the computation period because of a deferral provision described in [paragraph (g)(1)(ii)](#g-1-ii) of this section, and - (B) **The shortfall amount described in paragraph (c)(4) of this section.** - (ii) **Capitalization of deferral amount.** The rules described in [paragraph (g)(2)(iii)](#g-2-iii) of this section apply to the deferral amount unless the taxpayer elects under [paragraph (g)(2)(iv)](#g-2-iv) of this section to capitalize substitute costs. - (iii) **Deferred capitalization.** If the taxpayer does not elect under [paragraph (g)(2)(iv)](#g-2-iv) of this section to capitalize substitute costs, deferred interest to which the deferral amount is attributable (determined under any reasonable method) is capitalized in the year or years in which the deferred interest would have been deductible but for the application of [section 263A(f)](/cfr/26/263A.md?p=f) (the capitalization year). For this purpose, any interest that is deferred from a prior computation period is taken into account in subsequent capitalization years in the same order in which the interest was deferred. If a unit of designated property to which previously deferred interest relates is sold before the capitalization year, the deferred interest applicable to that unit of property is taken into account in the capitalization year and treated as if recovered from the sale of the property. If the taxpayer continues to hold, throughout the capitalization year, a unit of depreciable property to which previously deferred interest relates, the adjusted basis and applicable recovery percentages for the unit of property are redetermined for the capitalization year and subsequent years so that the increase in basis is accounted for over the remaining recovery periods beginning with the capitalization year. See Example 2 of [paragraph (g)(2)(v)](#g-2-v) of this section. - (iv) **Substitute capitalization—** - (A) **General rule.** In lieu of deferred capitalization under [paragraph (g)(2)(iii)](#g-2-iii) of this section, the taxpayer may elect the substitute capitalization method described in this [paragraph (g)(2)(iv)](#g-2-iv). Under this method, the taxpayer capitalizes for the computation period in which interest is incurred and deferred (the deferral period) costs that would be deducted but for this [paragraph (g)(2)(iv)](#g-2-iv) (substitute costs). The taxpayer must capitalize an amount of substitute costs equal to the deferral amount for each unit of designated property, or if less, a prorata amount (determined in accordance with the principles of [paragraph (c)(7)(i)](#c-7-i) of this section) of the total substitute costs that would be deducted but for this [paragraph (g)(2)(iv)](#g-2-iv) during the deferral period. If the entire deferral amount is capitalized pursuant to this [paragraph (g)(2)(iv)](#g-2-iv) in the deferral period, any interest incurred and deferred in the deferral period is neither capitalized nor deducted during the deferral period and, unless subsequently capitalized as a substitute cost under this [paragraph (g)(2)(iv)](#g-2-iv), is deductible in the appropriate subsequent period without regard to [section 263A(f)](/cfr/26/263A.md?p=f). - (B) **Capitalization of amount carried forward.** If the taxpayer has an insufficient amount of substitute costs in the deferral period, the amount by which substitute costs are insufficient with respect to each unit of designated property is a deferral amount carryforward to succeeding computation periods beginning with the next computation period. In any carryforward year, the taxpayer must capitalize an amount of substitute costs equal to the deferral amount carryforward or, if less, a prorata amount (determined in accordance with the principles of [paragraph (c)(7)(i)](#c-7-i) of this section) of the total substitute costs that would be deducted during the carryforward year or years (the carryforward capitalization year) but for this [paragraph (g)(2)(iv)](#g-2-iv) (after applying the substitute cost method of this [paragraph (g)(2)(iv)](#g-2-iv) to the production of designated property in the carryforward period). If a unit of designated property to which the deferral amount carryforward relates is sold prior to the carryforward capitalization year, substitute costs applicable to that unit of property are taken into account in the carryforward capitalization year and treated as if recovered from the sale of the property. If the taxpayer continues to hold, throughout the capitalization year, a unit of depreciable property to which a deferral amount carryforward relates, the adjusted basis and applicable recovery percentages for the unit of property are redetermined for the carryforward capitalization year and subsequent years so that the increase in basis is accounted for over the remaining recovery periods beginning with the carryforward capitalization year. See Example 2 of [paragraph (g)(2)(v)](#g-2-v) of this section. - (C) **Method of accounting.** The substitute capitalization method under this [paragraph (g)(2)(iv)](#g-2-iv) is a method of accounting that applies to all designated property of the taxpayer. A change to or from the substitute capitalization method is a change in method of accounting requiring the consent of the Commissioner under [section 446(e)](/cfr/26/446.md?p=e) and [§ 1.446-1(e)](/cfr/26/1.446-1.md?p=e). - (v) **Examples.** The following examples illustrate the application of the avoided cost method when interest is subject to a deferral provision: - (3) **Simplified inventory method—** - (i) **In general.** This [paragraph (g)(3)](#g-3) provides a simplified method of capitalizing interest expense with respect to designated property that is inventory. Under this method, the taxpayer determines beginning and ending inventory and cost of goods sold applying all other capitalization provisions, including, for example, the simplified production method of [§ 1.263A-2(b)](/cfr/26/1.263A-2.md?p=b), but without regard to the capitalization of interest with respect to inventory. The taxpayer must establish a separate capital asset, however, in an amount equal to the aggregate interest capitalization amount (as defined in [paragraph (g)(3)(iii)(C)](#g-3-iii-C) of this section). Under the simplified inventory method, increases in the aggregate interest capitalization amount from one year to the next generally are treated as reductions in interest expense, and decreases in the aggregate interest capitalization amount from one year to the next are treated as increases to cost of goods sold. - (ii) **Segmentation of inventory—** - (A) **General rule.** Under the simplified inventory method, the taxpayer first separates its total ending inventory value into segments that are equal to the total ending inventory value divided by the inverse inventory turnover rate. Each inventory segment is then assigned an age starting with one year and increasing by one year for each additional segment. The inverse inventory turnover rate is determined by finding the average of beginning and ending inventory, dividing the average by the cost of goods sold for the year, and rounding the result to the nearest whole number. Beginning and ending inventory amounts are determined using total current cost of inventory for the year (rather than carrying value). Cost of goods sold, however, may be determined using either total current cost or the taxpayer's inventory method. In addition, for purposes of this [paragraph (g)(3)(ii)](#g-3-ii), current costs for a year (and, if applicable, the cost of goods sold for the year under the taxpayer's inventory method) are determined without regard to the capitalization of interest with respect to inventory. - (B) **Example.** The provisions of [paragraph (g)(3)(ii)(A)](#g-3-ii-A) of this section are illustrated by the following example. - (iii) **Aggregate interest capitalization amount—** - (A) **Computation period and weighted average interest rate.** If a taxpayer elects the simplified inventory method, the taxpayer must use the taxable year as its computation period and use the weighted average interest rate determined under this [paragraph (g)(3)(iii)(A)](#g-3-iii-A) in determining the aggregate interest capitalization amount defined in [paragraph (g)(3)(iii)(C)](#g-3-iii-C) of this section and in determining the amount of interest capitalized with respect to any designated property that is not inventory. Under the simplified inventory method, the taxpayer determines the weighted average interest rate in accordance with [paragraph (c)(5)(iii)](#c-5-iii) of this section, treating all eligible debt (other than debt traced to noninventory property in the case of a taxpayer tracing debt) as nontraced debt (i.e., without tracing debt to inventory). A taxpayer that has elected under [paragraph (e)](#e) of this section to use an external rate as a substitute for the weighted average interest rate determined under [paragraph (c)(5)(iii)](#c-5-iii) of this section uses the rate described in [paragraph (e)(1)](#e-1) as the weighted average interest rate. - (B) **Computation of the tentative aggregate interest capitalization amount.** The weighted average interest rate is compounded annually by the number of years assigned to a particular inventory segment to produce an interest factor (applicable interest factor) for that segment. The amounts determined by multiplying the value of each inventory segment by its applicable interest factor are then combined to produce a tentative aggregate interest capitalization amount. - (C) **Coordination with other interest capitalization computations—** (1) In general. If the tentative aggregate interest capitalization amount for a year exceeds the aggregate interest capitalization amount (defined in [paragraph (g)(3)(iii)(D)](#g-3-iii-D) of this section) as of the close of the preceding year, then, for purposes of applying the rules of [paragraph (c)(7)](#c-7) of this section, the excess is treated as an excess expenditure amount and the inventory to which the simplified inventory method of this [paragraph (g)(3)](#g-3) applies is treated as a single unit of designated property. If, after these modifications, no [paragraph (c)(7)](#c-7) interest allocation is necessary (i.e., the excess expenditure amounts for all units of designated property do not exceed the total amount of interest (including deferred interest) available for capitalization), the aggregate interest capitalization amount generally equals the tentative aggregate interest capitalization amount. If, on the other hand, a [paragraph (c)(7)](#c-7) allocation is necessary, the tentative aggregate interest capitalization amount is generally adjusted to reflect the results of that allocation (i.e., the increase in the aggregate interest capitalization amount is limited to the amount of interest allocated to inventory, reduced, however, by any substitute costs that are capitalized with respect to inventory under applicable related party rules). (2) Deferred interest. In determining the aggregate interest capitalization amount, the tentative aggregate interest capitalization amount is adjusted (after the application of [paragraph (c)(7)](#c-7) of this section) as appropriate to reflect the deferred interest rules of [paragraph (g)(2)](#g-2) of this section. The tentative aggregate interest capitalization amount would be reduced, for example, by the amount of a taxpayer's deferred interest for a taxable year unless the taxpayer has elected the substitute capitalization method under [paragraph (g)(2)(iv)](#g-2-iv). (3) Other coordinating provisions. The Commissioner may prescribe, by revenue ruling or revenue procedure, additional provisions to coordinate the election and use of the simplified inventory method with other interest capitalization requirements and methods. See [§ 601.601(d)(2)(ii)(b)](/cfr/26/601.601.md?p=d-2-ii-b) of this chapter. - (D) **Treatment of increases or decreases in the aggregate interest capitalization amount.** Except as otherwise provided in this [paragraph (g)(3)(iii)(D)](#g-3-iii-D), increases in the aggregate interest capitalization amount from one year to the next are treated as reductions in interest expense, and decreases in the aggregate interest capitalization amount from one year to the next are treated as increases to cost of goods sold. To the extent a taxpayer capitalizes substitute costs under either applicable related party rules or the deferred interest rules in [paragraph (g)(2)](#g-2) of this section, increases in the aggregate interest capitalization amount are treated as reductions in applicable substitute costs, rather than interest expense. - (E) **Example.** The provisions of this [paragraph (g)(3)(iii)](#g-3-iii) are illustrated by the following example. - (iv) **Method of accounting.** The simplified inventory method is a method of accounting that must be elected for and applied to all inventory within a single trade or business of the taxpayer (within the meaning of [section 446(d)](/cfr/26/446.md?p=d) and [§ 1.446-1(d)](/cfr/26/1.446-1.md?p=d)). This method may be elected only if the inventory in that trade or business consists only of designated property and only if the taxpayer's inverse inventory turnover rate for that trade or business (as defined in [paragraph (g)(3)(ii)(A)](#g-3-ii-A) of this section) is greater than or equal to one. A change from or to the simplified inventory method is a change in method of accounting requiring the consent of the Commissioner under [section 446(e)](/cfr/26/446.md?p=e) and [§ 1.446-(1)(e)](/cfr/26/1.446-.md?p=1-e). - (4) **Financial accounting method disregarded.** The avoided cost method is applied under this section without regard to any financial or regulatory accounting principles for the capitalization of interest. For example, this section determines the amount of interest that must be capitalized without regard to Financial Accounting Standards Board (FASB) Statement Nos. 34, 71, and 90, issued by the Financial Accounting Standards Board, Norwalk, CT 06856-5116. Similarly, taxpayers are not permitted to net interest income and interest expense in determining the amount of interest that must be capitalized under this section with respect to certain restricted tax-exempt borrowings even though netting is permitted under FASB Statement No. 62. - (5) **Treatment of intercompany transactions—** - (i) **General rule.** If interest capitalized under [section 263A(f)](/cfr/26/263A.md?p=f) by a member of a consolidated group (within the meaning of [§ 1.1502-1(h)](/cfr/26/1.1502-1.md?p=h)) with respect to a unit of designated property is attributable to a loan from another member of the group (the lending member), the intercompany transaction provisions of the consolidated return regulations do not apply to the lending member's interest income with respect to that loan, except as provided in [paragraph (g)(5)(ii)](#g-5-ii) of this section. For this purpose, the capitalized interest expense that is attributable to a loan from another member is determined under any method that reasonably reflects the principles of the avoided cost method, including the traced and nontraced concepts. For purposes of this [paragraph (g)(5)(i)](#g-5-i) and [paragraph (g)(5)(ii)](#g-5-ii) of this section, in order for a method to be considered reasonable it must be consistently applied. - (ii) **Special rule for consolidated group with limited outside borrowing.** If, for any year, the aggregate amount of interest income described in [paragraph (g)(5)(i)](#g-5-i) of this section for all members of the group with respect to all units of designated property exceeds the total amount of interest that is deductible for that year by all members of the group with respect to debt of a member owed to nonmembers (group deductible interest) after applying [section 263A(f)](/cfr/26/263A.md?p=f), the intercompany transaction provisions of the consolidated return regulations are applied to the excess, and the amount of interest income that must be taken into account by the group under [paragraph (g)(5)(i)](#g-5-i) of this section is limited to the amount of the group deductible interest. The amount to which the intercompany transaction provisions of the consolidated return regulations apply by reason of this [paragraph (g)(5)(ii)](#g-5-ii) is allocated among the lending members under any method that reasonably reflects each member's share of interest income described in [paragraph (g)(5)(i)](#g-5-i) of this section. If a lending member has interest income that is attributable to more than one unit of designated property, the amount to which the intercompany transaction provisions of the consolidated return regulations apply by reason of this [paragraph (g)(5)(ii)](#g-5-ii) with respect to the member is allocated among the units in accordance with the principles of [paragraph (c)(7)(i)](#c-7-i) of this section. - (iii) **Example.** The provisions of [paragraph (g)(5)(ii)](#g-5-ii) of this section are illustrated by the following example. - (6) **Notional principal contracts and other derivatives.** [Reserved] - (7) **15-day repayment rule.** A taxpayer may elect to treat any eligible debt that is repaid within the 15-day period immediately preceding a quarterly measurement date as outstanding as of that measurement date for purposes of determining traced debt, average nontraced debt, and the weighted average interest rate. This election may be made or discontinued for any computation period and is not a method of accounting. # §1.263A-10. Unit of property. - (a) **In general.** The unit of property as defined in this section is used as the basis to determine accumulated production expenditures under [§ 1.263A-11](/cfr/26/1.263A-11.md) and the beginning and end of the production period under [§ 1.263A-12](/cfr/26/1.263A-12.md). Whether property is 1-year or 2-year property under [§ 1.263A-8(b)(1)(ii)](/cfr/26/1.263A-8.md?p=b-1-ii) is also determined separately with respect to each unit of property as defined in this section. - (b) **Units of real property—** - (1) **In general.** A unit of real property includes any components of real property owned by the taxpayer or a related person that are functionally interdependent and an allocable share of any common feature owned by the taxpayer or a related person that is real property even though the common feature does not meet the functional interdependence test. When the production period begins with respect to any functionally interdependent component or any common feature of the unit of real property, the production period has begun for the entire unit of real property. See, however, [paragraph (b)(5)](#b-5) of this section for rules under which the costs of a common feature or benefitted property are excluded from accumulated production expenditures for one or more measurement dates. The portion of land included in a unit of real property includes land on which real property (including a common feature) included in the unit is situated, land subject to setback restrictions with respect to such property, and any other contiguous portion of the tract of land other than land that the taxpayer holds for a purpose unrelated to the unit being produced (e.g., investment purposes, personal use purposes, or specified future development as a separate unit of real property). - (2) **Functional interdependence.** Components of real property produced by, or for, the taxpayer, for use by the taxpayer or a related person are functionally interdependent if the placing in service of one component is dependent on the placing in service of the other component by the taxpayer or a related person. In the case of property produced for sale, components of real property are functionally interdependent if they are customarily sold as a single unit. For example, the real property components of a single-family house (e.g., the land, foundation, and walls) are functionally interdependent. In contrast, components of real property that are expected to be separately placed in service or held for resale are not functionally interdependent. Thus, dwelling units within a multi-unit building that are separately placed in service or sold (within the meaning of [§ 1.263A-12(d)(1)](/cfr/26/1.263A-12.md?p=d-1)) are treated as functionally independent of any other units, even though the units are located in the same building. - (3) **Common features.** For purposes of this section, a common feature generally includes any real property (as defined in [§ 1.263A-8(c)](/cfr/26/1.263A-8.md?p=c)) that benefits real property produced by, or for, the taxpayer or a related person, and that is not separately held for the production of income. A common feature need not be physically contiguous to the real property that it benefits. Examples of common features include streets, sidewalks, playgrounds, clubhouses, tennis courts, sewer lines, and cables that are not held for the production of income separately from the units of real property that they benefit. - (4) **Allocation of costs to unit.** Except as provided in [paragraph (b)(5)](#b-5) of this section, the accumulated production expenditures for a unit of real property include, in all cases, the costs that directly benefit, or are incurred by reason of the production of, the unit of real property. Accumulated production expenditures also include the adjusted basis of property used to produce the unit of real property. The accumulated costs of a common feature or land that benefits more than one unit of real property, or that benefits designated property and property other than designated property, is apportioned among the units of designated property, or among the designated property and property other than designated property, in determining accumulated production expenditures. The apportionment of the accumulated costs of the common feature (allocable share) or land (attributable land costs) generally may be made using any method that is applied on a consistent basis and that reasonably reflects the benefits provided. For example, an apportionment based on relative costs to be incurred, relative space to be occupied, or relative fair market values may be reasonable. - (5) **Treatment of costs when a common feature is included in a unit of real property—** - (i) **General rule.** Except as provided in this [paragraph (b)(5)](#b-5), the accumulated production expenditures of a unit of real property include the costs of functionally interdependent components (benefitted property) and an allocable share of the cost of common features throughout the entire production period of the unit. See [§ 1.263A-12](/cfr/26/1.263A-12.md), relating to the production period of a unit of property. - (ii) **Production activity not undertaken on benefitted property—** - (A) **Direct production activity not undertaken—(1) In general.** The costs of land attributable to a benefitted property may be treated as not included in accumulated production expenditures for a unit of real property for measurement dates prior to the first date a production activity (direct production activity), including the clearing and grading of land, has been undertaken with respect to the land attributable to the benefitted property. Thus, the costs of land attributable to a benefitted property (as opposed to land attributable to the common features) with respect to which no direct production activities have been undertaken may be treated as not included in the accumulated production expenditures of a unit of real property even though a production activity has begun on a common feature allocable to the unit. (2) Land attributable to a benefitted property. For purposes of this [paragraph (b)(5)(ii)](#b-5-ii), land attributable to a benefitted property includes all land in the unit of real property that includes the benefitted property other than land for a common feature. (Thus, land attributable to a benefitted property does not include land attributable to a common feature.) - (B) **Suspension of direct production activity after clearing and grading undertaken—(1) General rule.** This [paragraph (b)(5)(ii)(B)](#b-5-ii-B) may be used to determine the accumulated production expenditures for a unit of real property, if the only production activity with respect to a benefitted property has been clearing and grading and no further direct production activity is undertaken with respect to the benefitted property for at least 120 consecutive days (i.e., direct production activity has ceased). Under this [paragraph (b)(5)(ii)(B)](#b-5-ii-B), the accumulated production expenditures attributable to a benefitted property qualifying under this [paragraph (b)(5)(ii)(B)](#b-5-ii-B) may be excluded from the accumulated production expenditures of the unit of real property even though production continues on a common feature allocable to the unit. For purposes of this [paragraph (b)(5)(ii)(B)](#b-5-ii-B), production activity is considered to occur during any time which would not qualify as a cessation of production activities under the suspension period rules of [§ 1.263A-12(g)](/cfr/26/1.263A-12.md?p=g). (2) Accumulated production expenditures. If this [paragraph (b)(5)(ii)(B)](#b-5-ii-B) applies, accumulated production expenditures attributable to the benefitted property of the unit of real property may be treated as not included in the accumulated production expenditures for the unit starting with the first measurement period beginning after the first day of the 120 consecutive day period, but must be included in the accumulated production expenditures for the unit beginning in the measurement period in which direct production activity has resumed on the benefitted property. Accumulated production expenditures with respect to common features allocable to the unit of real property may not be excluded under this [paragraph (b)(5)(ii)(B)](#b-5-ii-B). - (iii) **Common feature placed in service before the end of production of a benefitted property.** To the extent that a common feature with respect to which all production activities to be undertaken by, or for, a taxpayer or a related person are completed is placed in service before the end of the production period of a unit that includes an allocable share of the costs of the common feature, the costs of the common feature are not treated as included in accumulated production expenditures of the unit for measurement periods beginning after the date the common feature is placed in service. - (iv) **Benefitted property sold before production completed on common feature.** If a unit of real property is sold before common features included in the unit are completed, the production period of the unit ends on the date of sale. Thus, common feature costs actually incurred and properly allocable to the unit as of the date of sale are excluded from accumulated production expenditures for measurement periods beginning after the date of sale. Common feature costs properly allocable to the unit and actually incurred after the sale are not taken into account in determining accumulated production expenditures. - (v) **Benefitted property placed in service before production completed on common feature.** Where production activities remain to be undertaken on a common feature allocable to a unit of real property that includes benefitted property, the costs of the benefitted property are not treated as included in the accumulated production expenditures for the unit for measurement periods beginning after the date the benefitted property is placed in service and all production activities reasonably expected to be undertaken by, or for, the taxpayer or a related person with respect to the benefitted property are completed. - (6) **Examples.** The principles of [paragraph (b)](#b) of this section are illustrated by the following examples: - (c) **Units of tangible personal property.** Components of tangible personal property are a single unit of property if the components are functionally interdependent. Components of tangible personal property that are produced by, or for, the taxpayer, for use by the taxpayer or a related person, are functionally interdependent if the placing in service of one component is dependent on the placing in service of the other component by the taxpayer or a related person. In the case of tangible personal property produced for sale, components of tangible personal property are functionally interdependent if they are customarily sold as a single unit. For example, if an aircraft manufacturer customarily sells completely assembled aircraft, the unit of property includes all components of a completely assembled aircraft. If the manufacturer also customarily sells aircraft engines separately, any engines that are reasonably expected to be sold separately are treated as single units of property. - (d) **Treatment of installations.** If the taxpayer produces or is treated as producing any property that is installed on or in other property, the production activity and installation activity relating to each unit of property generally are not aggregated for purposes of this section. However, if the taxpayer is treated as producing and installing any property for use by the taxpayer or a related person or if the taxpayer enters into a contract requiring the taxpayer to install property for use by a customer, the production activity and installation activity are aggregated for purposes of this section. # §1.263A-11. Accumulated production expenditures. - (a) **General rule. Accumulated production expenditures—** generally means the cumulative amount of direct and indirect costs described in [section 263A(a)](/cfr/26/263A.md?p=a) that are required to be capitalized with respect to the unit of property (as defined in [§ 1.263A-10](/cfr/26/1.263A-10.md)), including interest capitalized in prior computation periods, plus the adjusted bases of any assets described in [paragraph (d)](#d) of this section that are used to produce the unit of property during the period of their use. Accumulated production expenditures may also include the basis of any property received by the taxpayer in a nontaxable transaction. - (b) **When costs are first taken into account—** - (1) **In general.** Except as provided in [paragraph (c)(1)](#c-1) of this section, costs are taken into account in the computation of accumulated production expenditures at the time and to the extent they would otherwise be taken into account under the taxpayer's method of accounting (e.g., after applying the requirements of [section 461](/cfr/26/461.md), including the economic performance requirement of [section 461(h)](/cfr/26/461.md?p=h)). Costs that have been incurred and capitalized with respect to a unit of property prior to the beginning of the production period are taken into account as accumulated production expenditures beginning on the date on which the production period of the property begins (as defined in [§ 1.263A-12(c)](/cfr/26/1.263A-12.md?p=c)). Thus, for example, the cost of raw land acquired for development, the cost of a leasehold in mineral properties acquired for development, and the capitalized cost of planning and design activities are taken into account as accumulated production expenditures beginning on the first day of the production period. For purposes of determining accumulated production expenditures on any measurement date during a computation period, the interest required to be capitalized for the computation period is deemed to be capitalized on the day immediately following the end of the computation period. For any subsequent measurement dates and computation periods, that interest is included in accumulated production expenditures. If the cost of land or common features is allocated among planned units of property that are completed in phases, any portion of the cost properly allocated to completed units is not reallocated to any incomplete units of property. - (2) **Dedication rule for materials and supplies.** The costs of raw materials, supplies, or similar items are taken into account as accumulated production expenditures when they are incurred and dedicated to production of a unit of property. Dedicated means the first date on which the raw materials, supplies, or similar items are specifically associated with the production of any unit of property, including by record, assignment to the specific job site, or physical incorporation. In contrast, in the case of a component or subassembly that is reasonably expected to be become a part of (e.g., be incorporated into) any unit of property, costs incurred (including dedicated raw materials) for the component or subassembly are taken into account as accumulated production expenditures during the production of any portion of the component or subassembly and prior to its connection with (e.g., incorporation into) any specific unit of property. For purposes of the preceding sentence, components and subassemblies must be aggregated at each measurement date in a reasonable manner that is consistent with the purposes of [section 263A(f)](/cfr/26/263A.md?p=f). - (c) **Property produced under a contract—** - (1) **Customer.** If a unit of property produced under a contract is designated property under [§ 1.263A-8(d)(2)(i)](/cfr/26/1.263A-8.md?p=d-2-i) with respect to the customer, the customer's accumulated production expenditures include any payments under the contract that represent part of the purchase price of the unit of designated property or, to the extent costs are incurred earlier than payments are made (determined on a cumulative basis for each unit of designated property), any part of such price for which the requirements of [section 461](/cfr/26/461.md) have been satisfied. The customer has made a payment under this section if the transaction would be considered a payment by a taxpayer using the cash receipts and disbursements method of accounting. The customer's accumulated production expenditures also include any other costs incurred by the customer, such as interest, or any other direct or indirect costs that are required to be capitalized under [section 263A(a)](/cfr/26/263A.md?p=a) and the regulations thereunder with respect to the production of the unit of designated property. - (2) **Contractor.** If a unit of property produced under a contract is designated property under [§ 1.263A-8(d)(2)(ii)](/cfr/26/1.263A-8.md?p=d-2-ii) with respect to the contractor, the contractor must treat the cumulative amount of payments made by the customer under the contract attributable to the unit of property as a reduction in the contractor's accumulated production expenditures. The customer has made a payment under this section if the transaction would be considered a payment by a taxpayer using the cash receipts and disbursements method of accounting. - (d) **Property used to produce designated property—** - (1) **In general.** Accumulated production expenditures include the adjusted bases (or portion thereof) of any equipment, facilities, or other similar assets, used in a reasonably proximate manner for the production of a unit of designated property during any measurement period in which the asset is so used. Examples of assets used in a reasonably proximate manner include machinery and equipment used directly or indirectly in the production process, such as assembly-line structures, cranes, bulldozers, and buildings. A taxpayer apportions the adjusted basis of an asset used in the production of more than one unit of designated property in a measurement period among such units of designated property using reasonable criteria corresponding to the use of the asset, such as machine hours, mileage, or units of production. If an asset used in a reasonably proximate manner for the production of a unit of designated property is temporarily idle (within the meaning of [§ 1.263A-1(e)(3)(iii)(E)](/cfr/26/1.263A-1.md?p=e-3-iii-E)) for an entire measurement period, the adjusted basis of the asset is excluded from the accumulated production expenditures for the unit during that measurement period. Notwithstanding this [paragraph (d)(1)](#d-1), the portion of the depreciation allowance for equipment, facilities, or any other asset that is capitalized with respect to a unit of designated property in accordance with [§ 1.263A-1(e)(3)(ii)(I)](/cfr/26/1.263A-1.md?p=e-3-ii-I) is included in accumulated production expenditures without regard to the extent of use under this [paragraph (d)(1)](#d-1) (i.e., without regard to whether the asset is used in a reasonably proximate manner for the production of the unit of designated property). - (2) **Example.** The following example illustrates how the basis of an asset is allocated on the basis of time: - (3) **Excluded equipment and facilities.** The adjusted bases of equipment, facilities, or other assets that are not used in a reasonably proximate manner to produce a unit of property are not included in the computation of accumulated production expenditures. For example, the adjusted bases of equipment and facilities, including buildings and other structures, used in service departments performing administrative, purchasing, personnel, legal, accounting, or similar functions, are excluded from the computation of accumulated production expenditures under this [paragraph (d)(3)](#d-3). - (e) **Improvements.** If an improvement constitutes the production of designated property under [§ 1.263A-8(d)(3)](/cfr/26/1.263A-8.md?p=d-3), accumulated production expenditures with respect to the improvement consist of all direct and indirect costs required to be capitalized with respect to the improvement. See [§ 1.263A-12(d)(1)](/cfr/26/1.263A-12.md?p=d-1) to determine when the production period for a unit of property has ended. - (f) **Mid-production purchases.** If a taxpayer purchases a unit of property for further production before the purchased unit of property is placed in service, the taxpayer's accumulated production expenditures include the full purchase price of the purchased unit of property plus all the additional direct and indirect production costs incurred by the taxpayer that are required to be capitalized with respect to the purchased unit of property. - (g) **Related person costs.** The activities of a related person are taken into account in applying the classification thresholds under § [1.263A-8(b)(1)(ii)(B)](/cfr/26/1.263A-8.md?p=b-1-ii-B) and [(C)](/cfr/26/1.263A-8.md?p=b-1-ii-C), and in determining the production period of a unit of designated property under [§ 1.263A-12](/cfr/26/1.263A-12.md). However, only those costs incurred by the taxpayer are taken into account in the taxpayer's accumulated production expenditures under this section because the related person includes its own capitalized costs in the related person's accumulated production expenditures with respect to any unit of designated property upon which the parties engage in mutual production activities. For purposes of the preceding sentence, the accumulated production expenditures of any property transferred to a taxpayer in a nontaxable transaction are treated as accumulated production expenditures incurred by the taxpayer. - (h) **Installation.** If the taxpayer installs property that is purchased by the taxpayer, accumulated production expenditures include the cost of the property that is installed in addition to the direct and indirect costs of installation. # §1.263A-12. Production period. - (a) **In general.** Capitalization of interest is required under [§ 1.263A-9](/cfr/26/1.263A-9.md) for computation periods (within the meaning of [§ 1.263A-9(f)(1)](/cfr/26/1.263A-9.md?p=f-1)) that include the production period of a unit of designated property. In contrast, [section 263A(a)](/cfr/26/263A.md?p=a) requires the capitalization of all other direct or indirect costs, such as insurance, taxes, and storage, that directly benefit or are incurred by reason of the production of property without regard to whether they are incurred during a period in which production activity occurs. - (b) **Related person activities.** Activities performed and costs incurred by a person related to the taxpayer that directly benefit or are incurred by reason of the taxpayer's production of designated property are taken into account in determining the taxpayer's production period (regardless of whether the related person is performing only a service or is producing a subassembly or component that the related person is required to treat as an item of designated property). These activities and the related person's costs are also taken into account in determining whether tangible personal property produced by the taxpayer is 1-year or 2-year property under [§ 1.263A-8(b)(1)(ii)](/cfr/26/1.263A-8.md?p=b-1-ii) (B) and (C). - (c) **Beginning of production period—** - (1) **In general.** A separate production period is determined for each unit of property defined in [§ 1.263A-10](/cfr/26/1.263A-10.md). The production period begins on the date that production of the unit of property begins. - (2) **Real property.** The production period of a unit of real property begins on the first date that any physical production activity (as defined in [paragraph (e)](#e) of this section) is performed with respect to a unit of real property. See [§ 1.263A-10(b)(1)](/cfr/26/1.263A-10.md?p=b-1). The production period of a unit of real property produced under a contract begins for the contractor on the date the contractor begins physical production activity on the property. The production period of a unit of real property produced under a contract begins for the customer on the date either the customer or the contractor begins physical production activity on the property. - (3) **Tangible personal property.** The production period of a unit of tangible personal property begins on the first date by which the taxpayer's accumulated production expenditures, including planning and design expenditures, are at least 5 percent of the taxpayer's total estimated accumulated production expenditures for the property unit. Thus, the beginning of the production period is determined without regard to whether physical production activity has commenced. The production period of a unit of tangible personal property produced under a contract begins for the contractor when the contractor's accumulated production expenditures, without any reduction for payments from the customer, are at least 5 percent of the contractor's total estimated accumulated production expenditures. The production period for a unit of tangible personal property produced under a contract begins for the customer when the customer's accumulated production expenditures are at least 5 percent of the customer's total estimated accumulated production expenditures. - (d) **End of production period—** - (1) **In general.** The production period for a unit of property produced for self use ends on the date that the unit is placed in service and all production activities reasonably expected to be undertaken by, or for, the taxpayer or a related person are completed. The production period for a unit of property produced for sale ends on the date that the unit is ready to be held for sale and all production activities reasonably expected to be undertaken by, or for, the taxpayer or a related person are completed. See, however, [§ 1.263A-10(b)(5)(iv)](/cfr/26/1.263A-10.md?p=b-5-iv) providing an exception for common features in the case of a benefitted property that is sold. In the case of a unit of property produced under a contract, the production period for the customer ends when the property is placed in service by the customer and all production activities reasonably expected to be undertaken are complete (i.e., generally, no earlier than when the customer takes delivery). In the case of property that is customarily aged (such as tobacco, wine, or whiskey) before it is sold, the production period includes the aging period. - (2) **Special rules.** The production period does not end for a unit of property prior to the completion of physical production activities by the taxpayer even though the property is held for sale or lease, since all production activities reasonably expected to be undertaken by the taxpayer with respect to such property have not in fact been completed. See, however, [§ 1.263A-10(b)(5)](/cfr/26/1.263A-10.md?p=b-5) regarding separation of certain common features. - (3) **Sequential production or delivery.** The production period ends with respect to each unit of property (as defined in [§ 1.263A-10](/cfr/26/1.263A-10.md)) and its associated accumulated production expenditures as the unit of property is completed within the meaning of [paragraph (d)(1)](#d-1) of this section, without regard to the production activities or costs of any other units of property. Thus, for example, in the case of separate apartments in a multi-unit building, each of which is a separate unit of property within the meaning of [§ 1.263A-10](/cfr/26/1.263A-10.md), the production period ends for each separate apartment when it is ready to be held for sale or placed in service within the meaning of [paragraph (d)(1)](#d-1) of this section. In the case of a single unit of property that merely undergoes separate and distinct stages of production, the production period ends at the same time (i.e., when all separate stages of production are completed with respect to the entire amount of accumulated production expenditures for the property). - (4) **Examples.** The provisions of [paragraph (d)](#d) of this section are illustrated by the following examples: - (e) **Physical production activities—** - (1) **In general.** The term physical production activities includes any physical activity that constitutes production within the meaning of [§ 1.263A-8(d)(1)](/cfr/26/1.263A-8.md?p=d-1). The production period begins and interest must be capitalized with respect to real property if any physical production activities are undertaken, whether alone or in preparation for the construction of buildings or other structures, or with respect to the improvement of existing structures. For example, the clearing of raw land constitutes the production of designated property, even if only cleared prior to resale. - (2) **Illustrations.** The following is a partial list of activities any one of which constitutes a physical production activity with respect to the production of real property: - (i) Clearing, grading, or excavating of raw land; - (ii) Demolishing a building or gutting a standing building; - (iii) Engaging in the construction of infrastructure, such as roads, sewers, sidewalks, cables, and wiring; - (iv) Undertaking structural, mechanical, or electrical activities with respect to a building or other structure; or - (v) **Engaging in landscaping activities.** - (f) **Activities not considered physical production.** The activities described in paragraphs [(f)(1)](#f-1) and [(f)(2)](#f-2) of this section are not considered physical production activities: - (1) **Planning and design.** Soil testing, preparing architectural blueprints or models, or obtaining building permits. - (2) **Incidental repairs.** Physical activities of an incidental nature that may be treated as repairs under [§ 1.162-4](/cfr/26/1.162-4.md). - (g) **Suspension of production period—** - (1) **In general.** If production activities related to the production of a unit of designated property cease for at least 120 consecutive days (cessation period), a taxpayer may suspend the capitalization of interest with respect to the unit of designated property starting with the first measurement period that begins after the first day in which production ceases. The taxpayer must resume the capitalization of interest with respect to a unit beginning with the measurement period during which production activities resume. In addition, production activities are not considered to have ceased if they cease because of circumstances inherent in the production process, such as normal adverse weather conditions, scheduled plant shutdowns, or delays due to design or construction flaws, the obtaining of a permit or license, or the settlement of groundfill to construct property. Interest incurred on debt that is traced debt with respect to a unit of designated property during the suspension period is subject to capitalization with respect to the production of other units of designated property as interest on nontraced debt. See [§ 1.263A-9(c)(5)(i)](/cfr/26/1.263A-9.md?p=c-5-i) of this section. For applications of the avoided cost method after the end of the suspension period, the accumulated production expenditures for the unit include the balance of accumulated production expenditures as of the beginning of the suspension period, plus any additional capitalized costs incurred during the suspension period. No further suspension of interest capitalization may occur unless the requirements for a new suspension period are satisfied. - (2) **Special rule.** If a cessation period spans more than one taxable year, the taxpayer may suspend the capitalization of interest with respect to a unit beginning with the first measurement period of the taxable year in which the 120-day period is satisfied. - (3) **Method of accounting.** An election to suspend interest capitalization under [paragraph (g)(1)](#g-1) of this section is a method of accounting that must be consistently applied to all units that satisfy the requirements of [paragraph (g)(1)](#g-1) of this section. However, the special rule in [paragraph (g)(2)](#g-2) of this section is applied on an annual basis to all units of an electing taxpayer that satisfy the requirements of [paragraph (g)(2)](#g-2) of this section. - (4) **Example.** The provisions of [paragraph (g)(1)](#g-1) of this section are illustrated by the following example. # §1.263A-13. Oil and gas activities. - (a) **In general.** This section provides rules that are to be applied in tandem with §§ [1.263A-8 through 1.263A-12](/cfr/26/1.263A-8..1.263A-12.md), [1.263A-14](/cfr/26/1.263A-14.md), and [1.263A-15](/cfr/26/1.263A-15.md) in capitalizing interest with respect to the development (within the meaning of [section 263A(g)](/cfr/26/263A.md?p=g)) of oil or gas property. For this purpose, oil or gas property consists of each separate operating mineral interest in oil or gas as defined in [section 614(a)](/cfr/26/614.md?p=a), or, if a taxpayer makes an election under [section 614(b)](/cfr/26/614.md?p=b), the aggregate of two or more separate operating mineral interests in oil or gas as described in [section 614(b)](/cfr/26/614.md?p=b) ([section 614](/cfr/26/614.md) property). Thus, an oil or gas property is designated property unless the de minimis rule applies. A taxpayer must apply the rules in [paragraph (c)](#c) of this section if the taxpayer cannot establish, at the beginning of the production period of the first well drilled on the property, a definite plan that identifies the number and location of other wells planned with respect to the property. If a taxpayer can establish such a plan at the beginning of the production period of the first well drilled on the property, the taxpayer may either apply the rules of [paragraph (c)](#c) of this section or treat each of the planned wells as a separate unit and partition the leasehold acquisition costs and costs of common features based on the number of planned well units. - (b) **Generally applicable rules—** - (1) **Beginning of production period—** - (i) **Onshore activities.** In the case of onshore oil or gas development activities, the production period for a unit begins on the first date physical site preparation activities (such as building an access road, leveling a site for a drilling rig, or excavating a mud pit) are undertaken with respect to the unit. - (ii) **Offshore activities.** In the case of offshore development activities, the production period for a unit begins on the first date physical site preparation activities, other than activities undertaken with respect to expendable wells, are undertaken with respect to the unit. For purposes of the preceding sentence, the first physical site preparation activity undertaken with respect to a [section 614](/cfr/26/614.md) property is generally the first activity undertaken with respect to the anchoring of a platform (e.g., drilling to drive the piles). For purposes of this section, an expendable well is a well drilled solely to determine the location and delineation of offshore hydrocarbon deposits. - (2) **End of production period.** The production period ends for a productive well unit on the date the well is placed in service and all production activities reasonably expected to be undertaken by, or for, the taxpayer or a related person are completed. See [§ 1.263A-12(d)](/cfr/26/1.263A-12.md?p=d). - (3) **Accumulated production expenditures—** - (i) **Costs included.** Accumulated production expenditures for a well unit include the following costs (to the extent they are not intangible drilling and development costs allowable as a deduction under section [263(c)](/cfr/26/263.md?p=c), [263(i)](/cfr/26/263.md?p=i), or [291(b)(2)](/cfr/26/291.md?p=b-2)): the costs of acquiring the [section 614](/cfr/26/614.md) leasehold and the costs of taxes and similar items that are required to be capitalized under [section 263A(a)](/cfr/26/263A.md?p=a) with respect to the [section 614](/cfr/26/614.md) leasehold; the cost of real property associated with developing the [section 614](/cfr/26/614.md) property (e.g., casing); the basis of real property that constitutes a common feature within the meaning of [§ 1.263A-10(b)(3)](/cfr/26/1.263A-10.md?p=b-3); and the adjusted basis of property used to produce property (such as a mobile rig, drilling ship, or an offshore drilling platform). - (ii) **Improvement unit.** To the extent [section 614](/cfr/26/614.md) costs are allocated to a well unit, the undepleted portion of those [section 614](/cfr/26/614.md) costs must also be included in the accumulated production expenditures for any improvement unit (within the meaning of [§ 1.263A-8(d)(3)](/cfr/26/1.263A-8.md?p=d-3)) with respect to that well unit. - (c) **Special rules when definite plan not established—** - (1) **In general.** The special rules of this [paragraph (c)](#c) must be applied by a taxpayer that cannot establish, at the beginning of the production period of the first well drilled on the property, a definite plan that identifies the number and location of the wells planned with respect to the property. A taxpayer than can establish such a plan is permitted, but not required, to apply the rules of this [paragraph (c)](#c), provided the rules of this [paragraph (c)](#c) are consistently applied for all the taxpayer's oil or gas properties for which a definite plan can be established. - (2) **Oil and gas units—** - (i) **First productive well unit.** Until the first productive well is placed in service and all production activities reasonably expected to be undertaken by, or for, the taxpayer or a related person are completed, a first productive well unit includes the [section 614](/cfr/26/614.md) property and all real property associated with the development of the [section 614](/cfr/26/614.md) property. Thus, for example, a first productive well unit includes the [section 614](/cfr/26/614.md) property and real property associated with any nonproductive well drilled on the [section 614](/cfr/26/614.md) property on or before the date the first productive well is placed in service and all production activities reasonably expected to be undertaken by, or for, the taxpayer or a related person are completed. For purposes of this section, a productive well is a well that produces in commercial quantities. See [paragraph (c)(5)](#c-5) of this section, which provides a special rule whereby the costs of a [section 614](/cfr/26/614.md) property and common feature costs for a [section 614](/cfr/26/614.md) property generally are included only in the accumulated production expenditures for the first productive well unit. - (ii) **Subsequent units.** Generally, real property associated with each productive or nonproductive well with respect to which production activities begin after the date the first productive well is placed in service and all production activities reasonably expected to be undertaken by, or for, the taxpayer or a related person are completed, constitutes a unit of real property. Additionally, a productive or nonproductive well that is included in a first productive well unit and for which development continues after the date the first productive well is placed in service and all production activities reasonably expected to be undertaken by, or for, the taxpayer or a related person are completed, generally is treated as a separate unit of property after that date. See, however, [paragraph (c)(5)](#c-5) of this section, which provides rules for the treatment of costs included in the accumulated production expenditures of a first productive well unit. - (3) **Beginning of production period—** - (i) **First productive well unit.** The beginning of the production period of the first productive well unit is determined as provided in [paragraph (b)](#b) of this section. - (ii) **Subsequent wells.** In applying [paragraph (b)](#b) of this section to subsequent well units (as described in [paragraph (c)(2)(ii)](#c-2-ii) of this section), any activities occurring prior to the date the production period ends for the first productive well unit are not taken into account in determining the beginning of the production period for the subsequent well units. - (4) **End of production period.** The end of the production period for both the first productive well unit and subsequent productive well units is determined as provided in [paragraph (b)(2)](#b-2) of this section. See [§ 1.263A-12(d)](/cfr/26/1.263A-12.md?p=d). Nonproductive wells included in the first productive well unit need not be plugged and abandoned for the production period to end for a first productive well unit. - (5) **Accumulated production expenditures—** - (i) **First productive well unit.** The accumulated production expenditures for a first productive well unit include all costs incurred with respect to the [section 614](/cfr/26/614.md) property and associated real property at any time through the end of the production period for the first productive well unit. Thus, the costs of acquiring the [section 614](/cfr/26/614.md) property, the costs of taxes and similar items that are required to be capitalized under [section 263A(a)](/cfr/26/263A.md?p=a) with respect to the [section 614](/cfr/26/614.md) property, and the costs of common features, that are incurred at any time through the end of the production period of the first productive well unit ([section 614](/cfr/26/614.md) costs) are included in the accumulated production expenditures for the first productive well unit. - (ii) **Subsequent well unit.** The accumulated production expenditures for a subsequent well do not include any costs included in the accumulated production expenditures for a first productive well unit. In the event that [section 614](/cfr/26/614.md) costs or common feature costs with respect to a [section 614](/cfr/26/614.md) property are incurred subsequent to the end of the production period of the first productive well unit, those common feature costs and undepleted [section 614](/cfr/26/614.md) costs are allocated among the accumulated production expenditures of wells being drilled as of the date such costs are incurred. - (6) **Allocation of interest capitalized with respect to first productive well unit.** Interest attributable to any productive or nonproductive well included in the first productive well unit (within the meaning of [paragraph (c)(2)(ii)](#c-2-ii) of this section) is allocated among and capitalized to the basis of the property associated with the first productive well unit. See [§ 1.263A-8(a)(2)](/cfr/26/1.263A-8.md?p=a-2). - (7) **Example.** The provisions of this [paragraph (c)](#c) are illustrated by the following example. # §1.263A-14. Rules for related persons. Taxpayers must account for average excess expenditures allocated to related persons under applicable administrative pronouncements interpreting [section 263A(f)](/cfr/26/263A.md?p=f). See [§ 601.601(d)(2)(ii)(b)](/cfr/26/601.601.md?p=d-2-ii-b) of this chapter. # §1.263A-15. Effective dates, transitional rules, and anti-abuse rule. - (a) **Effective dates—** - (1) [Sections 1.263A-8 through 1.263A-15](/cfr/26/1.263A-8..1.263A-15.md) generally apply to interest incurred in taxable years beginning on or after January 1, 1995. In the case of property that is inventory in the hands of the taxpayer, however, these sections are effective for taxable years beginning on or after January 1, 1995. Changes in methods of accounting necessary as a result of the rules in [§§ 1.263A-8 through 1.263A-15](/cfr/26/1.263A-8..1.263A-15.md) must be made under the terms and conditions prescribed by the Commissioner. Under these terms and conditions, the principles of [§ 1.263A-7](/cfr/26/1.263A-7.md) must be applied in revaluing inventory property. - (2) For taxable years beginning before January 1, 1995, taxpayers must take reasonable positions on their federal income tax returns when applying [section 263A(f)](/cfr/26/263A.md?p=f). For purposes of this [paragraph (a)(2)](#a-2), a reasonable position is a position consistent with the temporary regulations, revenue rulings, revenue procedures, notices, and announcements concerning [section 263A](/cfr/26/263A.md) applicable in taxable years beginning before January 1, 1995. See [§ 601.601(d)(2)(ii)(b)](/cfr/26/601.601.md?p=d-2-ii-b) of this chapter. For this purpose, Notice 88-99, 1988-2 C.B. 422, applies to taxable years beginning after August 17, 1988, in the case of inventory, and to interest incurred in taxable years beginning after August 17, 1988, in all other cases. Finally, under administrative procedures issued by the Commissioner, taxpayers may elect early application of [§§ 1.263A-8 through 1.263A-15](/cfr/26/1.263A-8..1.263A-15.md) to taxable years beginning on or after January 1, 1994, in the case of inventory property, and to interest incurred in taxable years beginning on or after January 1, 1994, in the case of property that is not inventory in the hands of the taxpayer. - (3) [Section 1.263A-9(a)(4)(ix)](/cfr/26/1.263A-9.md?p=a-4-ix) generally applies to interest incurred in taxable years beginning on or after May 20, 2004. In the case of property that is inventory in the hands of the taxpayer, [§ 1.263A-9(a)(4)(ix)](/cfr/26/1.263A-9.md?p=a-4-ix) applies to taxable years beginning on or after May 20, 2004. Taxpayers may elect to apply [§ 1.263A-9(a)(4)(ix)](/cfr/26/1.263A-9.md?p=a-4-ix) to interest incurred in taxable years beginning on or after January 1, 1995, or, in the case of property that is inventory in the hands of the taxpayer, to taxable years beginning on or after January 1, 1995. A change in a taxpayer's treatment of interest to a method consistent with [§ 1.263A-9(a)(4)(ix)](/cfr/26/1.263A-9.md?p=a-4-ix) is a change in method of accounting to which sections [446](/cfr/26/446.md) and [481](/cfr/26/481.md) apply. - (4) [Section 1.263A-9(g)(1)(i)](/cfr/26/1.263A-9.md?p=g-1-i) applies to taxable years beginning on or after November 13, 2020. However, taxpayers and their related parties, within the meaning of sections [267(b)](/cfr/26/267.md?p=b) and [707(b)(1)](/cfr/26/707.md?p=b-1), may choose to apply the rules of that section to a taxable year beginning after December 31, 2017, so long as the taxpayers and their related parties consistently apply the rules of the [section 163(j)](/cfr/26/163.md?p=j) regulations (as defined in [§ 1.163(j)-1(b)(37)](/cfr/26/1.163..1.md)), and, if applicable, §§ [1.381(c)(20)-1](/cfr/26/1.381..1.md), [1.382-1](/cfr/26/1.382-1.md), [1.382-2](/cfr/26/1.382-2.md), [1.382-5](/cfr/26/1.382-5.md), [1.382-6](/cfr/26/1.382-6.md), [1.382-7](/cfr/26/1.382-7.md), [1.383-0](/cfr/26/1.383-0.md), [1.383-1](/cfr/26/1.383-1.md), [1.469-9](/cfr/26/1.469-9.md), [1.469-11](/cfr/26/1.469-11.md), [1.704-1](/cfr/26/1.704-1.md), [1.882-5](/cfr/26/1.882-5.md), [1.1362-3](/cfr/26/1.1362-3.md), [1.1368-1](/cfr/26/1.1368-1.md), [1.1377-1](/cfr/26/1.1377-1.md), [1.1502-13](/cfr/26/1.1502-13.md), [1.1502-21](/cfr/26/1.1502-21.md), [1.1502-36](/cfr/26/1.1502-36.md), [1.1502-79](/cfr/26/1.1502-79.md), [1.1502-91 through 1.1502-99](/cfr/26/1.1502-91..1.1502-99.md) (to the extent they effectuate the rules of §§ [1.382-2](/cfr/26/1.382-2.md), [1.382-5](/cfr/26/1.382-5.md), [1.382-6](/cfr/26/1.382-6.md), and [1.383-1](/cfr/26/1.383-1.md)), and 1.1504-4, to that taxable year. - (5) The last sentence of each of [§ 1.263A-8(a)(1)](/cfr/26/1.263A-8.md?p=a-1) and [§ 1.263A-9(e)(2)](/cfr/26/1.263A-9.md?p=e-2) apply to taxable years beginning on or after January 5, 2021. However, for a taxable year beginning after December 31, 2017, and before January 5, 2021, a taxpayer may apply the last sentence of each of [§ 1.263A-8(a)(1)](/cfr/26/1.263A-8.md?p=a-1) and [§ 1.263A-9(e)(2)](/cfr/26/1.263A-9.md?p=e-2), provided that the taxpayer follows all the applicable rules contained in the regulations under [section 263A](/cfr/26/263A.md) for such taxable year and all subsequent taxable years. - (6) Sections [1.263A-8(d)(3)](/cfr/26/1.263A-8.md?p=d-3) and [1.263A-11(e)](/cfr/26/1.263A-11.md?p=e) and [(f)](/cfr/26/1.263A-11.md?p=f) apply to taxable years beginning after October 2, 2025. A change in a taxpayer's treatment of interest to a method consistent with §§ [1.263A-8(d)(3)](/cfr/26/1.263A-8.md?p=d-3) and [1.263A-11(e)](/cfr/26/1.263A-11.md?p=e) and [(f)](/cfr/26/1.263A-11.md?p=f), as applicable, is a change in method of accounting to which sections 446 and 481 of the Internal Revenue Code apply. - (b) **Transitional rule for accumulated production expenditures—** - (1) **In general.** Except as provided in [paragraph (b)(2)](#b-2) of this section, costs incurred before the effective date of [section 263A](/cfr/26/263A.md) are included in accumulated production expenditures (within the meaning of [§ 1.263A-11](/cfr/26/1.263A-11.md)) with respect to noninventory property only to the extent those costs were required to be capitalized under [section 263](/cfr/26/263.md) when incurred and would have been taken into account in determining the amount of interest required to be capitalized under former [section 189](/cfr/26/189.md) (relating to the capitalization of real property interest and taxes) or pursuant to an election that was in effect under [section 266](/cfr/26/266.md) (relating to the election to capitalize certain carrying charges). - (2) **Property used to produce designated property.** The basis of property acquired prior to 1987 and used to produce designated noninventory property after December 31, 1986, is included in accumulated production expenditures in accordance with [§ 1.263A-11(d)](/cfr/26/1.263A-11.md?p=d) without regard to whether the basis would have been taken into account under former [section 189](/cfr/26/189.md) or [section 266](/cfr/26/266.md). - (c) **Anti-abuse rule.** The interest capitalization rules contained in [§§ 1.263A-8 through 1.263A-15](/cfr/26/1.263A-8..1.263A-15.md) must be applied by the taxpayer in a manner that is consistent with and reasonably carries out the purposes of [section 263A(f)](/cfr/26/263A.md?p=f). For example, in applying [§ 1.263A-10](/cfr/26/1.263A-10.md), regarding the definition of a unit of property, taxpayers may not divide a single unit of property to avoid property classifying the property as designated property. Similarly, taxpayers may not use loans in lieu of advance payments, tax-exempt parties, loan restructurings at measurement dates, or obligations bearing an unreasonably low rate of interest (even if such rate equals or exceeds the applicable Federal rate under [section 1274(d)](/cfr/26/1274.md?p=d)) to avoid the purposes of [section 263A(f)](/cfr/26/263A.md?p=f). For purposes of this [paragraph (c)](#c), the presence of back-to-back loans with different rates of interest, and other uses of related parties to facilitate an avoidance of interest capitalization, evidences abuse. In such cases, the District Director may, based upon all the facts and circumstances, determine the amount of interest that must be capitalized in a manner that is consistent with and reasonably carries out the purposes of [section 263A(f)](/cfr/26/263A.md?p=f).