Depreciation detailed: more highlights from the 2002 Tax Act. (Federal Tax).

May's California CPA, Page 33, discussed the new 30-percent additional first year depreciation deduction for qualified property generally acquired after Sept. 10, 2001 and before Sept. 11, 2004 and pointed out that "A taxpayer can elect out of this new deduction for any class of property for any tax year."

The 2001 IRS Form 4562 Instructions (Revised March 2002) direct an electing taxpayer to:

"Attach a statement to your return indicating the class of property for which you are electing not to claim the additional depreciation deduction."

The 2001 Form 2106 Instructions (Revised March 2002) are similar.

Also, Rev. Proc. 2002-33, IRB 200220, May 20, 2002 contains the following additional procedures.

Election Out: This election applies to all qualified property that is in the same class and placed in service in the same tax year. In addition, the depreciation adjustments under IRC Sec. 56 apply to that property for AMT purposes. Each qualified property owner (e.g., each consolidated group member, partnership or S corp.) makes this election separately.

"Class of property" means:

1. Except for the property discussed in (3) and (4) below, each class of property described in Sec. 168(e), such as five-year property;

2. Computer software depreciated under Sec. 167(0(1);

3. Qualified leasehold property (defined in new Sec. 168(k)(3) and depreciated under Sec. 168); and

4. Water utility property (defined in Sec. 168(e)(5) and depreciated under Sec. 168).

Generally, the election must be made by the due date, including extensions of the return for the year in which the taxpayer places qualified property in service as prescribed by Form 4562 Instructions. Special procedures apply for tax years beginning in 2000 or 2001.

An automatic extension of six months from the due date, excluding extensions, of the return for the qualified property's placed-in-service year is granted to make this election if that return is timely filed and the taxpayer satisfies the corrective action and procedural requirements in Regs. Sec. 300.9100-2(c) and (d), respectively.

If a taxpayer files a 2000 or 2001 return after May 31, 2002, the general procedures (described above) apply. However, the instructions for the 2001 Form 4562 (quoted above) must be followed. If such a return was filed before June 1, 2002, the special procedures explained below apply.

An election out is revocable only with the IRS' prior written consent, which must be sought by requesting a letter ruling and paying the applicable user fee [pursuant to Rev. Proc. 2002-1 (or any successor Rev. Proc.)].

If an election out is not made in accordance with Rev. Proc. 2002-33, the depreciation allowable for qualified property under secs. 167(0(1) or 168, as applicable, is determined for the placed-in-service year and all subsequent years by taking into account the 30-percent additional first year depreciation deduction. Thus, an election out cannot be made in any other manner (e.g., through a request to change the taxpayer's accounting method).

Special Procedures: If a taxpayer filed a 2000 or 2001 return before June 1, 2002 without claiming the new 30-percent depreciation for qualified property, this depreciation can be claimed by either:

* Filing an amended return by the due date, excluding extensions, of the return for the next succeeding tax year. The top of this return should have the following statement: Filed Pursuant to Rev. Proc. 2002-33"; or

* Filing Form 3115, Application for Change in Accounting Method, with the next succeeding year's return. This Form 3115 is filed under the automatic change rules in Rev. Proc 2002-9, as modified by Rev. Proc. 2002-19, and as modified and clarified by Ann. 2002-17. The scope limitations in Rev. Proc. 2002-9, Sec. 4.02, do not apply. The Form 3115 must include the statement "Automatic Change Filed Under Rev. Proc. 2002-33" legibly printed or typed on the appropriate line of this form.

However, these procedures cannot be used if the taxpayer has made either an affirmative or deemed election out.

A taxpayer that filed a 2000 or 2001 return before June 1, 2002 will have elected out if the taxpayer made this election within:

* The prescribed time and manner; or

* The time described above and included in that return an affirmative statement that the taxpayer is not deducting the additional first year depreciation for the class of property. This statement may be attached to, or written on, the return (e.g., "Not deducting 30 percent.").

If there is no affirmative election out, a taxpayer that filed a 2000 or 2001 return before June 1, 2002, also will be deemed to have made an election out for a class of qualified property placed in service after Sept. 10, 2001, if the taxpayer neither:

* Claims the additional first year depreciation for that property, but claims other depreciation, on that return; nor

* Files an amended return or Form 3115 within the time described above to claim such depreciation.

Other Extensions to Elect Out: If a taxpayer does not elect out as discussed above, a request for an extension of time to make this election must be filed under the rules set forth in Regs. Sec. 300.9100-3.

Such a request is a letter ruling request and should be submitted under the letter ruling request procedures and accompanied by the applicable user fee.

Mark-to-Market Election

Principal Residence: The new law's Technical Explanation prepared by the Congressional Joint Committee on Taxation's Staff, Page 44, states that the new law "clarifies that the gain to which the mark-to-market election applies is included in gross income. Thus, the exclusion of gain on the sale of a principal residence under Code Sec. 121 would not apply with respect to an asset for which the election to mark to market is made. The provision is consistent with the holding of Rev. Rul. 2001-57."

Passive Activities: The Technical Explanation, Page 44, further states that the new law "clarifies that the election to mark to market an interest in a passive activity does not result in the deduction of suspended losses by reason of section 469(g)(1)(A)." Also see IRS Notice 2002-29, IRB 2002-17, April 29, 2002, to this effect.

Insolvent S Corp. Shareholders

Under the new law, an S corp's debt discharge income--that is excluded from the corporation's gross income--is not taken into account as an income item by any shareholder and thus does not increase the basis of shareholder's stock in the corporation.

This new rule generally applies to debt discharges after Oct. 11, 2001. However, it does not apply to any debt discharge before Mar. 1, 2002 pursuant to a reorganization plan filed with a bankruptcy court before Oct. 12, 2001.

Accrual Method of Accounting

Previously, an accrual method taxpayer was not required to include in income amounts to be received for services which, based on experience, will not be collected--if the taxpayer does not charge interest or a penalty for failure to timely pay the amount charged.

Under the new law, for tax years ending after Mar. 9, 2002, this nonaccrual accounting method applies only to services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting--if the taxpayer does not charge interest or a penalty for failure to timely pay the amount charged. This method also applies to other services if the taxpayer's average annual gross receipts for all prior tax years does not exceed $5 million.

The IRS must prescribe regulations permitting a taxpayer to use computations or formulas if they accurately reflect, based on experience, uncollected year-end receivables. The IRS may consider regulatory safe harbors upon which taxpayers may rely. The IRS must permit taxpayers to adopt or change to such computations or formulas.

Any accounting method change caused by this new law is considered a voluntary taxpayer-initiated change with IRS consent. Any resulting adjustment is taken into account over the lesser of four tax years or the number of tax years the taxpayer used the nonaccrual experience accounting method.

Stuart R. Josephs, CPA, has a San Diego-based Tax Assistance Practice (TAP) that specializes in assisting practitioners in resolving their clients' tax problems. Josephs, chair of the Federal Subcommittee of CalCPA's Committee on Taxation, can be reached at [phone] or [e-mail].