IRS Relief for Form 3115: 2 Key Reasons to Seriously Consider Filing Anyway

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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.

Related: 5 Clever (& Legal) Tax Strategies to Save Real Estate Investors Money

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:

Example One

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.

Example Two

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.

Related: 6 Things Investors Can Do NOW for a Less Taxing Tax Season

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.

Conclusion

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!

Comments? Questions?

Let’s discuss in the comments section below!

About Author

Brandon Hall

Brandon Hall, owner of The Real Estate CPA, is an entrepreneur at heart who happens to be good at taxes. Brandon is a real estate investor and CPA specializing in providing business advice and creative tax strategies for real estate investors. Brandon's Big 4 and personal investing experiences allow him to provide unique advice to each of his clients. Sign up for my FREE NEWSLETTER to receive tips and updates related to business and taxes.

16 Comments

  1. Curt Smith

    Hi Brandon, If it wasn’t so complicated to file 3115 and none of the Tax prep folks support doing 3115 this is difficult to follow and a bit late at this point to elist any service/professional.

    Have you read about the de minimis safe harbor filing that either is suggested or required even if you are in the exemption for filling 3115, under $10M??

    http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Tangible-Property-Final-Regulations#Ademinimis

    – The election is made by attaching a statement to your income tax return for the taxable year.

    I can’t find the form being refered to?

    That IRS web page just goes in circles as I search for the form to file..

    For my own tax situation as a landlord, I’m ok with past filings re expenses vs deprciation. I’m depreciating alot of refrigerators… 🙁 I just want to file this darn additional doc.

    • Brandon Hall

      Hey Curt – It’s not too late to enlist professional help as you can always file an extension allowing you additional time to attack the issues addressed.

      In terms of the De Minimis election, there is no set form for it. You simply attach a statement that looks like this:

      Section 1.263(a)-1(f) De Minimis Safe Harbor Election
      Taxpayer Name:
      Taxpayer Address:
      Taxpayer Identification number:
      The taxpayer is hereby making the de minimis safe harbor election under
      section 1.263(a)-1(f).

      Hope that helps.

      • Curt Smith

        Wow can’t believe IRS didn’t create a form, even that short. Thanks alot Brandon.

        It’s all hard to parse but one source least I guessed meant one took this election PER HOUSE. Which I thought 3115 was per house so this guess made sense. Your view? tnx again.

        • Brandon Hall

          Hey Curt – my thoughts are the same in regards to not creating a simple form 🙂

          You take the election and file Form 3115 per BUSINESS. So if you have 20 houses in your name, you only need one 3115. If you have 20 houses in a LLC, you only need one 3115. If you have 20 houses in 20 separate LLCs, you need 20 3115s.

  2. Larisa G.

    Brandon, thanks for another great article! Could you please tell me your opinion. If a small landlord wants to adapt New IRS Regulations for previous years 2011-2013, can he re-do his accounting & taxes accordingly to New IRS Regs for all these years 2011, 2012, and 2013, and file amended tax returns for each of these years instead of filing form 3115 and 481(a) adjustments?
    And another question. You said that by filing form 3115 in 2014 the taxpayer gets audit protection for years 2012 and 2013. But what about year 2011- will he does not get audit protection, even though he adapted new Regs for 2011 and included 2011 numbers in form 3115 adjustment?
    Thank you

    • Brandon Hall

      Hey Larisa – thanks for reading. You can likely file amended returns but the 3115 is solid proof that you are adopting the new regs and the form will allow you to go back further in time. If you don’t have property older than what you can change on an amended return, then an amended return may be the way to go.

      I said you are granted audit protection in 2012 and 2013 because that statute of limitations for 2011 is about to expire in terms of auditability. It could be re-worded to say “all prior years.”

  3. Curt Smith

    Hi Brandon, Just heard about the 2% or $10k max expenses per year rule. Is this new with the 3115 reg or was this in place prior?

    I have alot of very low cost basis houses. $30k ish. $3k expenses would be the limit on expenses for that house…

  4. Curt Smith

    Wow thanks Brandon. Another great Tax article. You really help alot.

    I admit,,, this is the first year I’m feeling a bit overwhelmed with all the repair/improvement tax code additions. 🙁

    I see the IRSs point with clarifying how they want rentals filed on sched E, but it just seems like there could have been a simplier way than having 3 layered sections of code covering repair/maintenance/improvements… I’ll live through this and I still stick to my view that I’m smarter and better off having this deep tax code knowledge. I would never have realized I need to catagorize: repair (stuff that’s broke), maintenance (stuff that’;s not broke just needs up keep), improvements (adds value).

    A comical example I read in one of the IRS/nolo/BP articles was a paint job was classified as an improvment and depreciated. ($3k interior paint job). While encompassed in a rehab or remodel, sure. If a rental and a renter turn over situation, that’s typically maintenance in my view… And I need to mention specifically on Sched E which of the 3 catagories each cost is in: maint, repair, improvement (depreciated).

    Tnx Brandon for all your helps.

  5. Cheryl Lombardi on

    I am wondering if I am filing the 3115 correctly I do know there are only a few parts that are required due to I am under the 10 million rule. I really don’t believe I have any adjustments but want to file the form for audit protection. I have paid for 2 different books and am still confused!! Part 1 I am thinking I only complete B and was going to use “to comply with all regs 184-193” or should I use to change to automatic method change?

    I did list -0- for a 481 adjustment but am a little confused on line 8A which is asking if the applicant does not want audit protection for requestd change,, This should be marked NO??? Therefore meaning I am asking for audit protection. I do have a detailed listing of the current method and proposed method listed in the section that is needed as well as a statement listiing the property address (all individually owned -no entity.

    I have read through hundreds of pages and am getting alot of mixed information I have done 1 webinar and I am still confused. I would rather send in a correct 3115 than a wrong one!!! Thank you in advance for any help in regards to this. I am assuming that the date ont he 3115 should only be listed for the year of 2014 correct?

  6. Cheryl Lombardi

    I am wondering if I am filing the 3115 correctly I do know there are only a few parts that are required due to I am under the 10 million rule. I really don’t believe I have any adjustments but want to file the form for audit protection. I have paid for 2 different books and am still confused!! Part 1 I am thinking I only complete B and was going to use “to comply with all regs 184-193? or should I use to change to automatic method change?

    I did list -0- for a 481 adjustment but am a little confused on line 8A which is asking if the applicant does not want audit protection for requestd change,, This should be marked NO??? Therefore meaning I am asking for audit protection. I do have a detailed listing of the current method and proposed method listed in the section that is needed as well as a statement listiing the property address (all individually owned -no entity.

    I have read through hundreds of pages and am getting alot of mixed information I have done 1 webinar and I am still confused. I would rather send in a correct 3115 than a wrong one!!! Thank you in advance for any help in regards to this. I am assuming that the date ont he 3115 should only be listed for the year of 2014 correct?

  7. Hi Brandon

    Regarding a 481(a) deduction adjustment on real estate rentals- Does the deduction get shown as an ordinary loss or flow through on a form 4797 as a Sec 1231 loss

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