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The new Tangible Property Regulations (TPRs) (which are summarized in the article published in our latest Real Estate Report), are required to be adopted by all affected taxpayers starting with their 2014 tax return.
While it is not unusual for Treasury to write regulations to interpret and administer the tax laws, it is uncommon for them to write them in a way that requires their adoption as an “Accounting Method Change.” As such, in order to be in compliance with the new regulations, you will be required to file (at least one) IRS Form 3115.
If you have not previously filed for an accounting method change, this form may be unfamiliar to you, hence the reason for this letter. Generally, changes in accounting methods require permission from the IRS which is requested using Form 3115. Fortunately, the IRS has issued procedures which allow the permission to be “automatic” if certain procedures are followed. One of those procedures requires the filing of an abbreviated copy of the form.
What happens if I don’t file Form 3115?
Without filing the form, it will be unclear to the IRS that you properly adopted the TPRs and therefore you may be denied its beneficial provisions (e.g. routine maintenance safe harbor) on audit. However, see important note at the end of this letter. For the most part, the provisions of the TPRs are favorable, so adoption is not only required but recommended. In addition, failure to follow the adoption procedures could expose you to audit adjustments in the future or require you to change your method of accounting at a time which might not be beneficial. Also, as a licensed professional, we may not be allowed to sign your return if it is not in compliance with these rules.
In addition to completing Form 3115, what else needs to be done to ensure compliance?
In addition to completing and filing the form, your accounting policies and procedures related to accounting for tangible property need to be reviewed for alignment with the final regulations. This includes reviewing your depreciation schedules for assets that either shouldn’t be there (e.g. a repair that was improperly capitalized and depreciated) or ones that should be there and aren’t (e.g. improvements that were improperly expensed as a repair). Adjustments to your 2014 return will need to be made (either positive or negative) for items which were not treated properly.
In most cases, we will not be able to review your depreciation schedules and make this determination on our own. Therefore, we will need your assistance.
How have the TPRs changed the definition of an “Improvement”?
In general, the rules have not changed. If an expenditure results in an improvement to the property, it has always been required to be capitalized. What the TPRs do is attempt to help define what an improvement is by, in essence “codifying” various court cases and rulings that have evolved over the years. As a result, the regulations “define” an improvement as a “Restoration, Adaptation, or Betterment” (the RAB test). If an expenditure fails all three of these tests, it is deducted.
We have prepared an Improvement Flowchart to aid you with your analysis.
I generally expense everything below a certain dollar amount for book purposes. Can’t I just do that for tax purposes?
Yes, within certain limits. If your financial statements are audited by a CPA or you provide your financial statements to a Government Agency (other than the IRS) you may make an annual De Minimis Safe Harbor election to adopt this method for tax purposes. However, the maximum amount under the safe harbor is $5,000 per item. If you don’t have audited financial statements nor provide them to a Government Agency, the limit is $500 per item.
In most cases, we recommend you make this election.
Will preparing this form increase my tax preparation fees or delay the filing of my return?
This depends on the number of properties you own, your current capitalization policies, and the number of items on your depreciation schedules. At a minimum, your RINA representative will need to discuss these rules with you to determine the scope and complexities of implementing them. If you own one or two rental properties, it is likely that these rules will have a minimal impact on the cost and timing of your return preparation.
At the time this letter went to press, the IRS published guidance that will allow certain small businesses to adopt these rules prospectively for years beginning in 2014 without the need to file a Form 3115. However, taxpayers electing this option will not receive audit protection for taxable years beginning prior to January 1, 2014. Therefore, you should discuss this with your RINA representative prior to selecting this option.
We understand these requirements may be confusing and that each client situation is different. Please be assured that we are doing everything possible to reduce the complexity and potential cost associated with implementing these new rules.
As always, if you have any questions on this or other aspects of your income tax situation, please don’t hesitate to contact your RINA representative.