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The new rules are in effect for the 2012 tax year and for some clients, will require as many as 19 different automatic accounting method changes to comply with them. Most clients who own real estate will need on average four to six accounting method changes.
One of the biggest concessions the IRS made was finally agreeing that taxpayers should take a retirement loss when a building’s structural component is removed (i.e., demolished during a remodeling).
While this can provide opportunities for claiming unrealized retirement losses from prior years, it’s important to understand the unintended implications of this rule. An offset to this provision is that when you claim a retirement loss on a building component, the cost of the replacement component will always be considered a restoration and therefore must be capitalized (under Temp. Reg. Section 1.263(a)-3T(i)).
As the rules are written, a taxpayer is required to take a retirement loss when a component is removed even if the new expenditure would otherwise satisfy the criteria of a repair expense (under Temp. Reg. Section 1.168(i)-8T). This can produce an unfavorable result since a retirement loss deduction will generally be less than the alternative repair cost of the new component.
To clarify, let’s assume that a taxpayer owned a building for 15 years and spends $75,000 to replace their old roof shingles with similar but new shingles. The new roof shingles are the same type and strength, so they are not considered a betterment. The cost of the old roof shingles were determined to be $50,000 and after 15 years, the remaining tax basis is $30,769. Generally, under the new regulations, replacing roof shingles is not considered an improvement. However, in this case, the taxpayer is required to take the $30,769 retirement loss and then capitalize the $75,000 new roof shingles (which would otherwise be deductible).
Your client could be stuck with similar treatment for all future replacement repairs unless they make an election to use General Asset Accounting rules for their property. The newly modified GAA rules in the recent repair vs. capitalization regulations provide the option to continue depreciating any asset that is disposed. Going back to our example above, if the building and original roof shingles were in a GAA, you could choose to continue depreciating the old roof shingles and take a repair deduction on the new roof shingles (a difference of $44,231 of additional deductions).
For those not familiar with GAA rules, they stipulate that only assets depreciated the same way can be in the same GAA (i.e. assets with the same MACRS tax life, recovery method, convention, and effective placed in service date). The GAA election is simply made by checking a box on the Form 4562, and taxpayers will need to keep records of which assets are in which GAA. Further, a GAA election must be made on a timely filed tax return (including extensions) for the year the asset was placed in service.
In light of these changes, the IRS is allowing two years for taxpayers to file retroactive GAA elections for assets placed in service before 2012 using the Form 3115, Automatic Change of Accounting Method form. If that window is missed, your client might be stuck indefinitely with the adverse consequences mentioned above so it’s critical that you address this issue.
Gian Pazzia, CCSP, is a principal with KBKG and its National Practice Leader for Cost Segregation and Repair v Capitalization issues. He currently serves on the board of directors for the American Society of Cost Segregation Professionals and is chair of their Technical Issues Committee.