Automatic Accounting Method Changes: Compliance and the Hidden Tax Opportunities for Real Estate Owners (article)
The release of IRS Rev. Proc. 2017-30 made significant changes to the automatic accounting method changes originally listed in Rev. Proc. 2016-29. The list of available accounting method changes is extensive, outlining various changes which apply to many industries, and due to its magnitude it easily can be overlooked. However, there are several accounting method changes that directly impact the commercial real estate industry and cannot be disregarded. These automatic accounting method changes (AAMC) work in line with the tangible property regulations and, beyond the steep penalties for noncompliance, possess substantial benefits for the real estate industry.
AAMC #7 – Impermissible to Permissible Depreciation
This automatic accounting method change is a required method change under the tangible property regulations and can be applied in multiple situations where an impermissible depreciation method was used in previous years. In applying AAMC #7, the depreciation expense on the assets that previously used an impermissible method is recalculated based on the correct method. The resulting difference between the correct depreciation expense and the expense previously taken over the asset’s life is then accounted for on the current year return as either a negative or positive Section 481(A) adjustment. It is important to carefully assess fixed asset schedules to identify any assets that have not been properly depreciated, including the omission or misuse of special depreciation methods, and to make this automatic accounting method change when needed. To be in compliance this accounting method change should be used even if it will result in a positive Section 481(A) adjustment, which is additional income, in the current year.
Despite the possibility of a positive Section 481(A) adjustment, the Impermissible to Permissible Depreciation accounting method change can hold tremendous value for the real estate sector and should be considered during tax planning. Negative Section 481(A) adjustments result in a current year ordinary deduction; this value can be tremendous when dealing with assets such as real estate. The most valuable application of this method change and the related Negative Section 481(A) adjustment is through its integration with cost segregation studies.
There is a common misconception that cost segregation studies need to be completed the year the building is placed in service. As a result of this accounting method change, entities are allowed to undergo “look back” cost segregation studies and “catch up” on any missed depreciation benefits not claimed in prior tax years via a negative Section 481(A) adjustment.
One of the biggest benefits of cost segregation studies, regardless of when they are performed, is the increase in cash flow they generate by maximizing depreciation deductions and deferring income taxes. By combining the inherent benefits of cost segregation with the “catch-up” section 481(A) adjustment generated via a “look back” study, the initial year deduction for a real estate owner can be remarkable. From a tax planning standpoint this is a tremendous tool, which should be considered for any real estate owners who have not previously had a cost segregation study completed, particularly if they are anticipating substantial income in the current year.
AAMC #184 – Change to Deducting Repairs and Maintenance Costs, Capitalizing Improvements and Unit of Property
This automatic accounting method change is a required method change under the tangible property regulations and contains several intertwined components that relate to real estate owners. The most important thing to remember in applying this method change, beside the fact the accounting method change is not optional, is that it is a “look back.” The determination to expense or capitalize must be based on the capitalization and improvement rules as they apply to the unit of property based on the Final Tangible Property Regulations §1.162-4 and §1.263(a)-3(p). In applying this method change it is important to reconsider assets and previous expenditures, based on the final tangible property regulations (TPRs) and the related unit of property, to determine whether any items that were previously expensed or capitalized need to be reclassified. Similar to AAMC #7, the difference between what was previously deducted and the recalculated deduction is accounted for as either a negative or positive Section 481(A) adjustment.
The application of this accounting method change requires a solid understanding of the final tangible property regulations and can be rather time consuming. However, compliance is not optional and the proper implementation of this accounting method change can result in a tremendous benefit to the real estate sector. Prior to the implementation of the tangible property regulations, it was very common to see an over capitalization of expenditures. When applied to commercial real estate, these capitalized items were often classified as 39-year assets. Under the tangible property regulations, to be capitalized an “improvement” must result in a betterment, restoration or adaptation to the Unit-of-Property as a whole. Under the TPRs, a building and all of its structural components are defined as a single Unit-of-Property, and when many of these previously capitalized assets are reassessed using the revised definitions outlined in the final TPRs, they often do not meet the criteria of a capitalized improvement asset. They should instead be reclassified and expensed as repairs.
By applying for this accounting method change, the remaining net book value of an asset that was previously capitalized but has been determined to be a repair under the TPR definitions would be a negative Section 481(A) adjustment. This would result in an immediate ordinary loss by disposing of the repair that was incorrectly treated as a capital asset on the current year return. When utilized correctly, the proper application of these theories through the implementation of AAMC #184 has the potential to provide significant tax-planning opportunities and savings.
Compliance and Other Considerations
When considering the applicability of these method changes, it is important to remember that both AAMC #7 and AAMC #184 are required accounting method changes. As a result, compliance is mandatory. That being said, because they are both “automatic” accounting method changes, there is no fee required for applying for the changes with Form 3115. These accounting method changes are related to the tangible property regulations, so the statute is governed by the “asset class life” rather than the standard three-year statute. For assets that were expensed but should have been capitalized (which can be corrected with the filing of a Form 3115 for AAMC #184) the class life that would have been assigned to that asset is used as the statute. If an audit is conducted and there is noncompliance with the TPRs and these accounting method changes, the IRS has the ability to disallow you from expensing or continuing to depreciate any items that it determines are noncompliant. In addition to the possibility of losing these future deductions, noncompliance in this area comes with significant taxpayer and preparer penalties that could be assessed if audited.
Due to the need for compliance and the potential benefits available, it is crucial that real estate owners start considering the applicability of the automatic accounting method changes #7 and #184. In implementing these accounting method changes, it is imperative that you have a solid understanding of the tangible property regulations and the proper procedures, including confirming that a safe harbor Form 3115 was previously filed, in preparing and filing Form 3115.
Copyright © 2017, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).