You Likely Need to File IRS Form 3115 This Year - And It's Costly

I discussed the IRS final regulations that were enacted Jan. 1, 2014 in this blog post. Readers had questions pertaining to the requirement to file IRS Form 3115 which I will be discussing in this post.

The IRS tends to make annual adjustments to tax regulations. Most times, these changes are simply minor tweaks intended to close loopholes that have been exploited. Occasionally however, the changes can be significant, costly, and affect a majority of taxpayers. Such is the case with the IRS final regulations.

If you own rental property and were in business prior to 2014, you are required by law to file IRS Form 3115 with your taxes this year. There are no exceptions or exemptions, regardless of how small of a landlord you are. As I highlighted in my previous blog post, the IRS final regulations include many updates. Most significantly is the new accounting treatment for repairs vs. improvements, specifically the Routine Maintenance Safe Harbor. Repairs that you previously deducted as an operating expense may be at risk of being capitalized, and expenses you previously capitalized, may be able to qualify as an operating expense. Regardless, you are tasked with analyzing all of your expenses prior to 2014 and documenting them via Form 3115.

What is IRS Form 3115?

IRS Form 3115 is an Application for Change in Accounting Method. The IRS final regulations essentially require every landlord owning rental property prior to 2014 to change their accounting treatment of classifying expenses for repairs or improvements. Changing the accounting treatment requires changing the accounting method, and hence we are brought to Form 3115.

The IRS is expecting many applications to come in this year and as such has streamlined the process for acceptance. When you file Form 3115, your application will be automatically approved without headache and questions from the IRS.  As previously stated, you will file Form 3115 with your timely prepared tax returns for this year, at the latest being October 15, 2015. 

You only need to file one 3115 for each legal entity owning properties prior to 2014. If you have many properties under one legal entity, you still only need to file one 3115. However, if you are one of those who took asset protection to the extreme and placed properties in separate entities, each entity will need to file Form 3115 which is going to be a costly headache. 

Benefits of Filing Form 3115

Aside from simply following the law, there are several benefits to filing Form 3115. They include: a chance to correctly classify expenses and receive deductions, a chance to correctly classify expenses and capture depreciation, audit protection, and a four-year payment period for adjustments. 

The first and probably most exciting benefit of filing a 3115, is that you will be allowed to currently deduct expenses previously capitalized if they are classified as deductible repairs under the new regulations. This benefit will likely be significant for those owning commercial properties. For instance, say four years ago you capitalized $39,000 of expenses related to an apartment building you own. You cannot file an adjustment since you are outside the time frame of 3 years, but you can file Form 3115. If those $39,000 of expenses are classified as deductible under the new regs, you can deduct the non-depreciated amount of $35,000 ([$39,000-($39,000/39*4)]) this year. You can look at your depreciation schedule to view your capital expenses and subsequently review them to determine whether or not they can be classified as currently deductible. 

Another benefit is that the 3115 gives you the chance to correctly capitalize expenses and capture depreciation. If you previously deducted a repair, but under the new regulations you should have capitalized it as an improvement and subsequently depreciate, the 3115 gives you the opportunity to classify the expense correctly and capture the past depreciation. This may not sound like a huge benefit, especially once you consider that this will likely cause you to owe the IRS money, however it is important to view this from an audit perspective. If an IRS auditor finds that you failed to file a 3115 and you have incorrectly deducted expenses rather than capitalize and depreciate them, the auditor may disallow the deduction in its entirety and you won't be able to reclassify the expense and capture the depreciation. 

Filing Form 3115 will grant you some audit protection for the previous three tax years, which are always open to IRS review. By filing form 3115, you are showing the IRS that your past business transactions comply with IRS regulations and as such, you will not be charged interest and penalties on any underpayments of tax you made due to deductions you took that were inconsistent with regulations. 

The final benefit to filing Form 3115 is related to the time period in which you can pay off adjustments that weren't in your favor. If, after analyzing previous deductions you find you owe the IRS money, you will be granted a four year pay back schedule which will help lessen the burden of a large tax bill. If however you fail to file a 3115 and are audited, you will be required to pay the adjustment in full within one year.

If you fail to file Form 3115, you will not receive any of these benefits and in the event of an audit, you may find yourself spending much more time and money that you would have had you simply filed a 3115.

Complexities Surrounding Form 3115 and How to be Prepared

The major downside with Form 3115 is that it is an extremely complex tax form and you will likely need to consult a tax professional and/or CPA. The form itself consists of eight detailed pages and the instructions are a solid 20 pages. As required by the Privacy Act and Paperwork Reduction Act, the instructions include an estimate on the amount of time it takes to understand the law surrounding the 3115 and then prepare and submit it to the IRS. So how long does it take? Approximately 82 hours. 

82 hours is of course a long time and a lot of hard work but remember, this is just an estimate. The estimate also includes about 20 hours of time to "learn about the law" which your tax pro shouldn't be charging you for. So in reality you may be stuck paying for approximately 62 hours of work. Even then, it's unlikely your tax pro will need to spend that much time preparing your 3115. The majority of BP members are smaller landlords and as such will not require as much time as say a larger business owner. 

Form 3115 is so complex because it requires you to look at many different aspects of your business and properties. It will require that you develop schedules showing adjustments for repairs, capital expenses, and depreciation. It will be in your best interest to read the items below and go to your tax pro with questions and appropriate documentation. Being well organized and providing the correct documentation will save your tax pro time, and you money.

The easiest place to start will be your pre-2014 depreciation schedules. You will want to review these schedules to determine what items you are still depreciating and whether any of these items can be classified as a currently deductible expenses under the new regulations. Do not analyze property you have fully depreciated as it is exempt from the new regulations. You will also need to determine if any previous expenses that you fully deducted should now be classified as a capital improvement and subsequently depreciated. If you find that you have adjustment and deductions, you will need to attach a schedule to your 3115 showing your work and how you found your way to the amount on the 3115. 

As discussed in my previous blog post are the new Unit of Property (UOP) changes and the Routine maintenance safe harbor. If you are using a UOP that is inconsistent with the final regulations, you will need to change it and include the change in your 3115. If you were in business prior to 2014, you may only utilize the safe harbor in 2014 and later if you file Form 3115 this year. When you file the 3115 and adopt the new method of accounting, you will have the option of applying the safe harbor to years prior to 2014 meaning you will be able to deduct any expenses you are currently depreciating as long as they fall within the safe harbor guidelines. 

By filing a timely Form 3115 will allow you to take advantage of the new rules regarding partial asset dispositions. Partial asset disposition rules are one of the major changes under the final regulations that I did not touch on in my previous blog post. In short, landlords may elect to recognize a loss when a structural component is replaced (i.e. a roof). In the past, the new cost would simply be added to the adjusted basis and you would continue depreciating the entire cost for many years. Now, you may deduct the adjusted basis when you replace the component. By filing your Form 3115, you may take these deductions for building components you replaced prior to 2014. This may result in substantial refunds if you replaced building components such as HVAC units, roofs, etc. 

The last item of significance is that filing Form 3115 will allow you to change your accounting method to utilize segmented depreciation if you hadn't previously. Segmented depreciation is the division of value and depreciation between the actual building, land improvements, and any personal property in the building. Utilizing segmented depreciation will allow you to depreciate items more quickly resulting in larger annual deductions. 

The Bottom Line

Get organized, educate yourself on the new regulations, review previous expenses, prepare the appropriate schedules, and utilize a tax professional. It will likely be expensive to prepare Form 3115, however it is a necessary evil as the law requires you to file a 3115. Being organized will decrease the time spent on the preparation which will save you money. And who knows, if you have been capitalizing most of your expenses, you may receive a hefty refund... which you can roll into your next acquisition. 

That wraps up this blog post. I'd love to see some comments and questions. I hope you enjoyed the read and I look forward to hearing your thoughts and opinions.