Costs & benefits: what you need to know to comply with the repair regulations.
In September 201 3, the IRS released final regulations providing rules regarding the tax treatment of materials and supplies and the capitalization of costs of acquiring, maintaining and improving tangible property. These regulations are effective for tax years beginning on or after Jan. 1, 2014. Overall, the rules provide a significant benefit to many taxpayers, but the benefits came with a cost: Burdensome compliance.
Rev. Proc. 2014-16 (I.R.B. 2014-7, Jan. 24, 2014) and other related guidance led many to believe that every taxpayer who filed a depreciation schedule in their tax return would be required to file a Form 3115 (.Request for a Change of Accounting Method) with their 2014 tax returns to properly adopt these rules. Although Form 3115 itself is not that difficult, it does require computing a Sec. 481 adjustment, which effectively restates all prior years to reflect the change in accounting method. After an outpouring of requests for simplification, the IRS released Rev. Proc. 2015-20 (I.R.B. 2015-9, Feb. 13, 2015), which provides the taxpayer with an election that eliminates this requirement. As with any election, there are trade-offs. This article describes the election and its implications.
Qualifying for the Simplified Election
The IRS states in Rev. Proc. 2015-20 that the purpose behind the election is to make it easier for small business to comply with the final regulations. The revenue procedure applies to a taxpayer with one or more separate and distinct trade or business(es) that meet the following test:
* Total assets of less than $ 10 million on the first day of the tax year for which change in method of accounting is effective; or
* Average annual gross receipts of $ 10 million or less for the prior three taxable years.
Total assets are determined by the accounting method that the taxpayer uses in keeping the books and records of the trade or business at the end of the tax year. Gross receipts for each tax year are defined as the trade or business's receipts for the tax year that are recognized under the method of accounting used for federal tax purposes. This includes total sales (net of returns and allowances), receipts for services and income from investments.
Investment income is broader than just what is included in taxable income. It includes interest (including tax-exempt interest), dividends, rents, royalties and annuities, regardless of whether amounts are derived from the taxpayer's ordinary trade or business. Gross receipts from the sale of capital assets are reduced by the adjusted basis in the property sold [the IRS's Tangibk Property Final Regulations references Reg. Sec. 1,263(a)-3(h)(3)(iv) for the definition of gross receipts].
This is a taxpayer friendly provision, as it does not require aggregation of gross receipts of all entities owned by the taxpayer. Separate and distinct trade or business is defined as a business with "complete and separable books and records." [Rev. Proc. 2015-20, Sec. 4 references Reg. Sec. 1.446-1(d) for the definition of separate and distinct trades or businesses].
This means there are basically no related party rules to apply. The "separate trade or business" requirement means some of the entities under common ownership could qualify for this relief, while others do not. This may offer planning options to real estate investors who own multiple properties in different legal entities (with separate books and records).
In addition, the test is an "or" test, meaning, if the taxpayer meets either the asset or the gross receipts threshold, they qualify as a "small business" and can use the simplified procedure. This exception should eliminate the need for many taxpayers to file a Form 3115 and compute a Sec. 481 adjustment.
Relief Provided by Rev Proc. 2015-20
Rev. Proc. 2015-20 allows the taxpayer to change to certain methods of accounting by taking into account only amounts paid or incurred in taxable years beginning on or after Jan. 1, 2014.
Changes required by the final regulations will be made using the "cut-off" method, which means that qualifying taxpayers will have only to take into account amounts paid or incurred, as well as dispositions, in taxable years beginning on or after Jan. 1, 2014.
Although a change using the "cut-off" method is a change in method of accounting, Rev. Proc. 2015-20 allows taxpayers to make these changes without filing a Form 3115. A separate statement is not required in the 2014 tax return, but the IRS does note in its Q&A on this topic that if the taxpayer elects the simplified procedure, then inclusion of a separate statement indicating that the taxpayer is using this method might be appropriate to demonstrate compliance with the final repair regulations (Www.irs.gov/Businesses/Small-Businesses&-Self'-Employed/Tangible-Property-Final-Regulations).
What to Consider in Making the Election to Use the Simplified Procedure
If you make the election, you will not receive audit protection for the trade or business amounts paid or incurred in years prior to Jan. 1, 2014. So, IRS can go back and make a change on a prior year's tax return if an improper method of accounting was used. This is not a significant risk if the taxpayer has been in compliance with the law that applied in prior years.
What's of more concern to taxpayers is that they will not be able to take deductions related to prior years' expenditures that were capitalized (and now the final regulations clarify that such expenditures can be deducted). This issue commonly relates to replacement property where the replacement cost was capitalized and the adjusted basis of the old unit could not be determined. Therefore, the taxpayer simply kept depreciating the cost of the old unit and capitalized the cost of the new unit (and started depreciating that cost).
The final regulations provide acceptable procedures to estimate the basis of the partial disposition that allows taxpayers to write off the cost of the old unit.
Example: In 2008, Alex (your client) repaired the roof of a large industrial warehouse that he rented. About 25 percent of the roof was replaced, and the cost was capitalized and has depreciated ever since. Under the final repair regulations, the expenditure is categorized as a repair and deductible (as it's not substantial and does not qualify as an improvement/ betterment). Alex has the option of making an automatic accounting method change and taking the un-depreciated balance of the asset as a negative Sec. 481(a) adjustment in 2014. If Alex does not make a partial disposition election, then he keeps depreciating the cost of the old roof over its remaining useful life.
Alex has a lot to consider. He must determine whether he can utilize the additional deduction in his 2014 tax return. Since this is rental property, it's more likely a passive activity, and Alex's deductions are limited to passive income (or the rental income from this property if this is his only passive property). If Alex does not qualify to claim the $25,000 deduction for active participation, then the deduction for the old roof might very well be suspended.
Further, if Alex uses the simplified procedure, he will not receive audit protection for the trade or business amounts paid or incurred in years prior to Jan. 1,2014. This means the IRS can go back and make a change on a prior year's tax return if an improper method of accounting was used. This might not be a significant risk, if Alex has been in compliance with the law that applied in prior years. If Alex can use the deduction, then in addition to the benefit of an immediate write-off, Alex effectively reduces the accumulated depreciation that may be subject to Sec. 1250 depreciation recapture upon sale of the warehouse.
If Alex decides to take the prior year loss, he must compute the basis of the old roof and the related depreciation. The regulations now allow Alex to use a "reasonable method" to determine the original cost of the replaced roof. The regulations suggest three methods that are "reasonable:" discounting the cost of the replacement property using the producer price index (which measures the average change over time of prices received by domestic sellers of goods and services), pro rata allocation and a prior cost segregation study.
If the taxpayer elects to use the simplified procedure, then all changes made that are related to the final regulations must be made using the simplified procedure.
If, at some point after the first tax year beginning in 2014, the taxpayer decides to change their accounting method by filing a Form 3115 and computing a Sec. 481 adjustment, then the adjustment is calculated by taking into account only amounts paid or incurred in tax years beginning in 2014. In other words, the taxpayer cannot in a later year request a change of accounting related to the final regulations and make the change retroactively effective if the simplified method was used in 2014.
The FTB has been particularly generous in its interpretation of the state's conformity to these regulations. Although there were limited, if any, issues regarding conformity under the Personal Income Tax Law, the same could not be said for the Corporate Tax Law (CTL). Although the CTL does not directly conform to IRC Sec. 263, the statute does include a separate provision that reads the same as the comparable federal provision (California RTC 24422). In this case, prior case law and FTB administrative guidance indicate that the state will follow federal interpretations under IRC Sec. 263 unless the FTB advises to the contrary [Meanly v. McColgan (1942); FTB Technical Advice Memorandum 2002-0353; FTB Notice 2009-8].
There was more uncertainty with the new rules on partial dispositions, as California has never conformed to Modified Accelerated Cost Recovery System or Accelerated Cost Recovery System under the CTL. In its March issue of Tax News, the FTB stated it would conform to the repair regulations (including the partial disposition provisions and the simplified filing procedure ol Rev. Proc. 2015-20). It does caution that, although a partial disposition deduction will be allowed on the California tax return, the numbers will be different because of use of different depreciation methods.
For most small taxpayers who do not have potential deductions related to partial dispositions, the simplified procedure provided in Rev. Proc. 2015-20 considerably eases the compliance burden.
For taxpayers not eligible to use Rev. Proc. 2015-20, compliance simplification can be achieved by adopting the de minimis safe harbor for materials and supplies each year. In addition, taxpayers can annually elect a "book capitalization method," which may result in capitalization of otherwise deductible repairs if those amounts are capitalized in their books and records [Reg. 1.263(a)-3(n)]. Although these taxpayers will have to file Form 3115 to conform to various sections of the repair regulations, they may be able to avoid a Sec. 481 adjustment if they believe their book capitalization policies are compliant with final regulations.
Each client scenario must be reviewed and evaluated based on each situation. There is no one size fits all.
Kathleen Wright, CPA, MBA, JD, LLM is a professor at Golden Gate University and was recently appointed to the CBA. You can reach her at email@example.com.
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|Author:||Wright, Kathleen K.|
|Date:||Jun 1, 2015|
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