IRS Releases Procedural Guidance on Changing ADS Method of Accounting for Electing Real Property Trade or Business
IRS Releases Procedural Guidance on Changing ADS Method of Accounting for Electing Real Property Trade or Business
On June 17, 2021, the IRS released an advance copy of Rev. Proc. 2021-28, providing guidance for taxpayers on how to change their method of computing depreciation to a 30-year recovery period under the alternative depreciation system (ADS) for certain residential rental property placed in service before 2018 and held by an electing real property trade or business (RPTOB). The IRS also released Rev. Proc. 2021-29, which permits an eligible partnership to file an amended Form 1065, U.S. Return of Partnership Income, as an alternative to filing an administrative adjustment request (AAR) or a Form 3115 to change to this depreciation method. Rev. Proc. 2021-28 modifies guidance for automatic accounting method changes previously issued under Rev. Proc. 2019-08 and Rev. Proc. 2019-43.
Rev. Proc. 2021-28 is effective June 17, 2021. Rev. Proc. 2021-29 applies to partnership taxable years that began in 2018, 2019, or 2020.
The revenue procedures expand the scope of the relevant automatic accounting method change procedures to apply to taxpayers that made a RPTOB election in 2019 as well as taxpayers that made the RPTOB election in 2018. The revenue procedures also permit taxpayers to make an accounting method change by filing Form 3115 or by filing an amended return, and permit eligible partnerships to file amended Forms 1065 in lieu of filing an AAR.
The 2017 Tax Cuts and Jobs Act (TCJA) permits qualified taxpayers to make a RPTOB election in order to be exempt from the interest expense limitation under Section 163(j) of the Internal Revenue Code. As an offset, Section 168(g)(8) requires electing RPTOBs to depreciate nonresidential real property, residential rental property and qualified improvement property under the ADS. Prior to the TCJA, the recovery period under the ADS for residential rental property was 40 years. The TCJA modified this recovery period to 30 years for property placed in service after December 31, 2017. An electing RPTOB that owned residential rental property placed in service prior to December 31, 2017 was required to follow the change in use rules under Section 168(i)(5) and Reg. §1.168(i)-4(d) and depreciate such property over 40 years.
The Consolidated Appropriations Act, 2021 (CCA 2021), enacted on December 27, 2020, retroactively expanded the 30-year recovery period for RPTOB taxpayers to include certain residential rental property placed in service before January 1, 2018. This change makes the recovery period 30 years for residential rental property held by an electing RPTOB, regardless of when the property was placed in service.
Rev. Proc. 2019-08 provides guidance for an electing RPTOB on changing the depreciation method for its existing property (property placed in service before its RPTOB election year) to the ADS in the year it makes the RPTOB election. Rev. Proc. 2019-08 also provides that if an electing RPTOB fails to change its existing property to the required ADS for its election year or the subsequent taxable year, it will be considered to have adopted an impermissible method of accounting for that property and must then change the accounting method to a permissible method. If a taxpayer is eligible, it may make the method change by filing Form 3115 using designated automatic accounting method change number (DCN) 88, as provided under Section 6.05 of Rev. Proc. 2019-43. DCN 88 provides an automatic change in method of accounting for depreciation due to a change in the use of MACRS property.
Rev. Proc. 2021-28 applies to residential rental property meeting all the following criteria:
- The property was placed in service by the taxpayer before January 1, 2018, or was placed in service by the transferor of the residential rental property before January 1, 2018 if the acquisition of such property by the transferee-taxpayer is subject to Section 168(i)(7) (this section provides “step-in-the shoes” treatment for certain depreciable property in certain types of transactions—Section 3.04 of Rev. Proc. 2021-28 provides some examples of the application of this rule);
- The property is held by an electing RPTOB; and
- The property was not subject to the ADS depreciation method prior to January 1, 2018 in the hands of the taxpayer or the transferor if the acquisition of such property by the transferee-taxpayer is subject to Section 168(i)(7).
Rev. Proc. 2021-28 applies only to RPTOB elections made on or before December 27, 2020 (the date of enactment of the CCA 2021). It does not apply to a taxpayer making a late RPTOB election under Section 4 of Rev. Proc. 2020-22, or a taxpayer withdrawing a RPTOB election under Section 5 of Rev. Proc. 2020-22.
Rev. Proc. 2021-28 permits an electing RPTOB to file an amended federal income tax return or information return, an AAR under section 6227 or a Form 3115, Application for Change in Accounting Method, to change its method of computing depreciation for certain existing residential rental property to use a 30-year ADS recovery period. If such property is included in a general asset account (GAA), Rev. Proc. 2021-28 also provides procedures to change a taxpayer’s GAA treatment for such property.
Rev. Proc. 2021-28 expands the availability of the relevant automatic changes as follows:
- Generally, a taxpayer that improperly depreciates an item on only one federal tax return has not established a tax accounting method and, to correct the error, would be required to amend that return. However, once the impermissible treatment has been used on two consecutive federal tax returns, the taxpayer has established the method of accounting and would need to change to a permissible method by filing Form 3115. Rev. Proc. 2021-28 expands the application of the automatic method changes under DCN 88 (see above) and DCN 87 (which applies to a change in GAA treatment due to a change in the use of MACRS property), to permit a taxpayer that has only filed one federal tax return using an impermissible method to change to a permissible method by filing Form 3115 instead of an amended return.
- A taxpayer now may use the automatic changes even if the year of change is the final year of the taxpayer’s trade or business.
- A taxpayer now may use the automatic changes even if it has made or requested a change for the same residential rental property during any of the five taxable years ending with the year of change for taxable years of change beginning in 2019, 2020, 2021, or 2022.
- For property not included in a GAA, the taxpayer must own the property at the beginning of the year of change to use DCN 88.
- A taxpayer may include changes for both DCN 87 and DCN 88, from permissible to permissible methods of accounting for depreciation under a GAA election under Section 6.12(3)(b) of Rev. Proc. 2019-43, and for dispositions of depreciable assets in a GAA, on the same Form 3115.
If a taxpayer filed an accounting method change under Section 6.01 (impermissible to permissible method of accounting for depreciation or amortization) of Rev. Proc. 2019-43 before June 17, 2021, and the change was made either on a modified cut-off basis (if the property is in a GAA) or with a Section 481(a) adjustment (if the property is not in a GAA), the taxpayer does not have to file another accounting method change under Rev. Proc. 2021-28.
Partnership Options in Lieu of Filing Form 3115
Rev. Proc. 2021-29 allows certain BBA partnerships (a partnership subject to the centralized partnership audit regime enacted as part of the Bipartisan Budget Act of 2015) to file amended returns for tax years beginning in 2018, 2019 or 2020 instead of AARs. By granting this relief, taxpayers may generally receive an acceleration of refunds related to depreciation changes. To take advantage of the relief, a partnership must have filed initial partnership returns and schedules before June 17, 2021 and the amended returns and Schedules K-1 must be filed on or before October 15, 2021. Rev. Proc. 2021-29 applies only if the BBA partnership and the residential rental property are within the scope of Rev. Proc. 2021-28. Note however, if a partnership is eligible to file an amended return under Rev. Proc. 2021-29, the partnership may also make changes on its amended return in addition to the retroactive ADS change for residential rental property.
Limited Time to File Amended Return or AAR
Rev. Proc. 2021-28 provides that a taxpayer, including a non-BBA partnership, may file an amended federal income tax return or amended Form 1065 for its RPTOB election year on or before April 15, 2022, but in no event later than the applicable period of limitations on assessment for the taxable year for which the amended return is being filed. A BBA partnership that does not file an amended return may file an AAR for the election year on or before April 15, 2022, but in no event later than the applicable period of limitations on making adjustments under Section 6235 for the reviewed year. Collateral adjustments to taxable income or to tax liability must be made on the amended return or amended Form 1065, or AAR, and such adjustments also must be made on original or amended federal income tax returns or Forms 1065, or AARs, for any affected succeeding taxable years. For residential rental property in a GAA, the taxpayer must make the adjustments in Reg. §1.168(i)-1(h)(2)(ii) and (iii)(B).
Note that this guidance does not provide any relief in the form of being able to make an automatic accounting method change for taxpayers that are, or plan on, performing a cost segregation study after making a RPTOB election. These taxpayers may not be able to file an automatic accounting method change to reclassify any personal property that has been treated as longer-lived property to shorter depreciation recovery periods due to the order in which the RPTOB election and cost segregation study are implemented and the current accounting method change guidance.
In short, if a taxpayer has changed the depreciation of personal property to the ADS when making the RPTOB election (because the assets have not been properly reviewed and classified as personal property instead of residential rental property or non-residential real property), the taxpayer likely has made an unauthorized accounting method change for the personal property. If a taxpayer subsequently performs a cost segregation study to properly classify the personal property, the current procedural guidance will prohibit filing an automatic accounting method change within five years of a prior accounting method change (including an unauthorized change). A taxpayer that inadvertently misclassified some assets in its fixed asset system and does not discover the misclassification until after the RPTOB election is made may also be prohibited from filing an automatic accounting method change. A taxpayer may file a non-automatic accounting method change—which may only be requested for the current tax year, requires the Form 3115 to be filed with and reviewed by the IRS national office and requires the payment of an IRS user fee. Alternatively, a taxpayer could wait for the five-year period to pass before filing an automatic accounting method change.
BDO’s Tax Accounting Methods group has extensive experience assisting taxpayers of all industries and sizes with their accounting method issues and filing accounting method change requests with the IRS.