A few weeks ago, the small business world rejoiced at the IRS’s release of relief on the Final Tangible Property regulations. In case you missed it, I’ll briefly fill you in.
Toward the end of 2013, the IRS enacted the Final Tangible Property Regulations, which made major changes to the way property owners determine which costs should be currently deducted as repair expenses or capitalized and depreciated over many years. The Final Regulations also introduced three safe harbors, defined Unit of Property (UOP) systems, added the benefit of claiming a partial disposition, and made it harder (or in certain cases easier) to classify various expenses as currently deductible repairs. To comply with and adopt the Final Regulations, every small business owner needed to file Form 3115 – a form which takes on average 80 hours to prepare and file.
Naturally, many small business owners, landlords, and professional organizations (like the AICPA) cried foul. They banded together, formed a coalition, and stormed the IRS’s gates (figuratively obviously). The pushback was successful, and a few weeks ago the IRS relieved taxpayers of the requirement to file Form 3115 if a taxpayer’s business generates, on average of the last three years, less than $10MM in gross revenue OR has less than $10MM in gross assets. This test is applied separately to each business owned by the tax payer.
The relief is going to help some small business owners, but it likely won’t help landlords and property owners much at all. The key area where the relief will help is eliminating what has been coined as the “use it or lose it” rule where the IRS, as a result of an audit, can deny your ability to expense an item and at the same time forbid you to continue to depreciate it if you do not follow the new regulations.
Just because the relief was issued does not mean you as a property owner should ignore Form 3115 entirely. You need to determine whether or not you should file the form as you could be missing out on large tax breaks and audit protection for years prior to 2014.
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Pre-2014 Improvements Give Way to Large 2014 Tax Deductions
The final repair regulations outline stringent guidelines that property owners must follow in determining whether an item should be classified as a currently deductible repair or capitalized and depreciated as an improvement. Prior to the Final Regulations, the rules basically stated that if the taxpayer purchased an asset with a life of greater than one year, the cost of the purchase must be capitalized and depreciated over the useful life. Additionally, the cost of repairs that increase the value of an asset or extend the useful life of an asset must be capitalized. If you hired an aggressive tax preparer, you may have found yourself writing off the cost to replace an entire roof, which in certain cases could have been substantiated based on the old regulations.
The IRS recognized these abuses and as a result issued the Final Regulations. If you have been conservatively capitalizing costs in the past, you may be able to take substantial deductions this year by applying the “BAR” test, understanding partial dispositions, and filing Form 3115.
The BAR Test
When a taxpayer cannot utilize one of the three safe harbors provided by the Final Regulations, the taxpayer is supposed to apply the BAR test to expenditures as it will help in determining whether the expenditures are repairs or improvements. Essentially, the taxpayer must decide whether the cost represented a Betterment, Adaptation for new use, or Restoration. I’m not going to dive into the weeds of the BAR test (that will be for another post), but I will give you two BAR test examples:
You own a 10-unit building and in 2012, you replaced two out of ten HVAC units (20%). You appropriately capitalized and depreciated the two HVAC units. Under the new rules, you can actually currently deduct the expense of those HVAC units. The entire HVAC system (made up of ten HVAC units) is its own UOP and since you replaced only 20% of this UOP, you did not replace a significant portion of the UOP and the expenditure would not be classified as a betterment, adaptation, or restoration. You can file Form 3115 and currently deduct the remaining amount of the HVAC units’ basis to be depreciated.
You own a 10-unit building and in 2012 you repaired the roof. It cost you $5,000, which you capitalized and depreciated, but the repairs only made up 20% of the entire roof. The portion of the BAR test that will be most applicable here is “Restoration.” The roof is evaluated separately because it performs a discrete and critical function of the building structure itself. Since you are only replacing 10% of the roof, you are not replacing a “major component” or a “significant portion” of the roof, and as such, the costs are not required to be capitalized. You can file Form 3115 and currently deduct the remaining amount of the roof’s basis to be depreciated.
As a taxpayer, you need (or should require your tax preparer) to review your depreciation schedule and apply the BAR test to each item listed on the schedule. This could mean going back many years depending on the items you are still depreciating; however, the potential write-offs can make the process worthwhile.
The Partial Disposition Election
Under Section 1.168-8, the Final Regulations provide a means for electing to make a partial disposition when replacing a substantial part or the entirety of an asset. In years past when an asset was replaced, the taxpayer was required to capitalize the repair as an improvement and continue to depreciate the replaced component as they had been.
The Final Regulations allow the taxpayer to determine what the basis of the replaced asset would have been at the time it was replaced (using a present value calculation), and write off the remaining basis being depreciated. Let’s assume that in “Example 2” above, you actually replaced 80% of the roof. The basis of the old roof was $5,000 and is still being depreciated today. By filing Form 3115, you can currently deduct the remaining basis ($5,000) of the replaced asset.
The Partial Disposition Election is only allowed for the tax year 2014. If you do not file Form 3115 and claim partial dispositions on the assets you replaced, you will never be able to claim a partial disposition on those assets again. This basically means you will be depreciated two assets (roofs in our example) at one time which translates to you leaving money on the table. You will have to wait until the replaced asset is fully depreciated to realize the full benefit of the deduction, which could take many years.
Form 3115 Grants Audit Protection
By filing Form 3115 you are basically reviewing your depreciation schedule, identifying past expenditures, and asking how the Final Regulations apply to these expenditures. Because you are applying the rules retrospectively, you are granting yourself audit protection for years 2012 and 2013.
Let’s put this in perspective. Say the IRS audits you and finds that you didn’t file Form 3115 and you have pre-2014 expenditures that are incorrectly classified as repairs rather than improvements, improvements that are being depreciated over a shorter life than they should be, or you incorrectly took bonus depreciation. The IRS can hit you with a large adjustment, which may require you paying the IRS a substantial sum of money. If you had filed the Form 3115, you may have been able apply the BAR test and deduct currently the assets under question. Unfortunately, once an audit commences, it is too late to apply the BAR test and claim that the assets should have been deducted. Instead you will be stuck with the IRS adjustment going forward.
It’s important to note that if you choose not to file Form 3115 and you do get audited that you are not losing your depreciation deduction under the “use it or lose it” rule as the relief will provide taxpayers protection from that rule. You are, however, forfeiting your right to take a full deduction currently on expenditures that can really benefit your current tax position.
Do not assume that just because the IRS issued relief for filing Form 3115 that you can wipe your hands, kick back and relax. You really need to analyze your pre-2014 expenditures to determine whether or not the cost of filing Form 3115 is worth the benefits. Filling out Form 3115 will force you to check your major improvements for deduction opportunities, analyze the potential to take partial dispositions, and provide you with pre-2014 audit protection. When real money is on the line, ignorance isn’t an excuse. Get to work in analyzing your pre-2014 expenditures my fellow investors!
Let’s discuss in the comments section below!