Tangible Property Regulations Relief: What Does it Really Mean?

Real Estate

Tangible Property Regulations Relief: What Does it Really Mean?

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Late in the afternoon on Friday, February 13, 2015, the IRS issued what many saw as a ray of hope for accountants and taxpayers alike struggling to comply with the final tangible property regulations. Revenue Procedure 2015-20 provides broad relief that will obviate the need for many Form 3115s for qualifying small taxpayers. However, as we will see below, it should be used only when appropriate as many opportunities still exist for taxpayers under the final regulations.

By way of background, the final tangible property regulations (the “TPRs”) were issued September 13, 2013, and adopted new standards for evaluating when costs incurred to acquire or improve tangible property must be capitalized or whether those costs may be immediately deducted. In addition, the TPRs redefined things such as the unit of property for building property, provided guidance regarding the deductibility of materials and supplies and also provided taxpayers with many annual election opportunities. Finally, the new regulations gave taxpayers the opportunity to go back and dispose of portions of larger units of property replaced in prior tax years. This opportunity, known as a late partial disposition, is only available to taxpayers in 2014. Taxpayers had the option of applying the TPRs to tax years beginning after January 1, 2012, but were required to adopt the final regulations for tax years beginning on or after January 1, 2014.

Prior to the release of Rev. Prov. 2015-20, every taxpayer with: (1) materials and supplies; (2) repair and maintenance costs; or (3) assets being currently depreciated would have needed to file a Form 3115, Application for Change in Accounting Method, in order to evidence their adoption of the TPRs. Form 3115’s come in two types, advanced consent requests and automatic accounting method changes. Fortunately for taxpayers, the IRS has determined that the changes necessary to adopt the TPRs qualify as automatic method change requests. As a result, one copy of Form 3115 would need to be filed with the taxpayer’s income tax return for the year in which the change is effective (generally the 2014 tax return) and a second copy must be filed directly with the IRS office in Ogden, Utah. For those unfamiliar with the Form 3115, it is quite comprehensive and requires the taxpayer to answer a host of questions regarding business operations and the method(s) being changed.

In addition to filing Form 3115, taxpayers adopting the TPRs would be required to go back in time and “scrub” their depreciation schedules, analyzing assets that were previously capitalized to determine whether those same items would need to be capitalized under the tests outlined in the final regulations. While this sounds like quite a chore, it actually represents a significant opportunity for taxpayers to accelerate deductions that they would otherwise wait years to realize. There was concern in the industry that a taxpayer who failed to scrub depreciation schedules risked losing the potential deductions in the event of an IRS examination under the well-known “allowed or allowable” rule for depreciation. There was also concern about the time and effort required to complete this “scrubbing”. As more and more taxpayers and their accountants realized the amount of work that was going to be required to complete these Form 3115s and scrub their depreciation schedules, the drumbeat grew louder and louder demanding some kind of relief from the IRS.

In issuing Rev. Proc. 2015-20, the IRS removed much of the uncertainty and addressed many taxpayer concerns about the need to file Form 3115. Under the provisions of Rev. Proc. 2015-20, a qualifying taxpayer can avoid the requirement to go back and “scrub” old assets and can adopt the TPRs prospectively without filing a Form 3115. In order to qualify for relief, a taxpayer must have assets equaling $10,000,000 or less, OR average annual receipts of less than $10,000,000 (an averaging of the taxpayer’s gross receipts for the preceding three tax years). This test is applied to each of the separate trades or business of the taxpayer, so it is possible for a taxpayer with more than $10,000,000 of assets or more than $10,000,000 in average annual receipts in sum to qualify for this relief. Much rejoicing was heard throughout the industry, from accountants and taxpayers alike, when word of this relief came down. I’m sure there was many an accountant who turned in early for the week, excited that the previously overwhelming burden of complying with the TPRs was now gone.

Unfortunately, in many cases, adopting the TPRs prospectively causes the taxpayer to miss out on many of the opportunities for additional deductions available under the TPRs. As mentioned before, “scrubbing” the depreciation schedule of old, improperly capitalized assets may net taxpayers significant deductions in the 2014 tax year. Another benefit of “scrubbing”, which has no impact on the current year P&L, is to remove improperly capitalized assets that have been fully depreciated from the books. When assets that have been fully depreciated are sold, any gain realized that is attributable to prior depreciation deductions is taxable at higher rates. This is known as the recapture of prior depreciation. If assets improperly capitalized in prior years but fully depreciated are sold (think improvements to a building that should have been deducted as repairs or maintenance expenses), the gain would be subject to these depreciation recapture provisions. If a taxpayer takes advantage of the opportunity to “scrub” their depreciation schedules and remove these assets, there would be no depreciation recapture on a future sale.

In summary, Rev. Proc. 2015-20 does provide small taxpayers with relief from the obligation to file Form 3115s to simply adopt the new regulations, allowing those taxpayers to adopt the regulations prospectively. However, taxpayers cannot have it both ways. Prospective application of the TPRs means that those taxpayers are prohibited from going back and “scrubbing” their depreciation schedules. Taxpayers choosing not to file Form 3115 would also forego the opportunity to make late partial disposition elections. As a result, the ability to accelerate deductions, as described above, would not be available for those taxpayers.

Taking advantage of the available relief under Rev. Proc. 2015-20 makes sense in three scenarios: (1) when taxpayers would not benefit from “scrubbing” their depreciation schedules; (2) when taxpayers would not benefit from making late partial disposition elections; and (3) when taxpayers may be able to generate additional expenses from “scrubbing” or late partial disposition elections, but those additional deductions would not generate a tax benefit (due to NOLs, passive activity limitations, or similar provisions). Small taxpayers in these situations should welcome the relief provided. Other taxpayers should analyze the potential for generating additional expenses through adopting the TPRs and should plan to file one (or more) Forms 3115.

Brian Lovett, CPA, JD Brian Lovett, CPA, JD, Partner
732-828-1614
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Anthony Nitti, CPA, Partner Anthony Nitti, CPA, Partner
970-925-7382
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