Of all the questions that I’ve received so far this tax season, the most popular is “What do I do about the new tangible property regulations and this form 3115?”
Federal form 3115, Application for Change in Accounting Method, is the form used to request a change in a method of accounting or the tax treatment of certain items. New IRS rules means that it may apply to the way we record certain kinds of tax breaks, like materials, supplies, repairs and maintenance, and purchases of equipment and other assets like real estate.
SO WHAT ARE THE REPAIR REGS?
Effective January 1, 2014 (and retroactive to January 1, 2012), the IRS issued final regulations that completely revamp the way a taxpayer must evaluate certain expenses to determine if the costs are a deductible repair or a capital improvement that has to be depreciated over time (perhaps a very long time!). In addition, regulations were also issued for new guidance on when a taxpayer can deduct “materials and supplies”.
WHY IS THIS AN ISSUE?
Because tax advisers like me are greedy, greedy people! It has been significantly less clear (a gray area if you will) how to treat certain costs paid for by taxpayers. As a general rule, when the IRS leaves a gap in guidance on a specific topic, aggressive tax advisers like myself tend to abuse the hell out of the opportunity for our business and tax clients and deduct everything under the sun. The IRS has grown weary of the abuses and audit negotiations are are issuing permanent guidelines that everyone must follow. At any rate, it appears the IRS is trying to get things straightened out by issuing these formal regulations.
HIDDEN BENEFITS FOR REAL ESTATE INVESTORS?
The regulations basically allow us to keep accounting for tax as normal with a few extra bonuses for real estate investors. Under the prior deduction tests for real estate investors, a lot of expenses that would have been capitalized and depreciated in the past would no longer have to be depreciated over 39.5 years.
Consider a taxpayer who in 2011 spent $10,000 on an HVAC unit, one of ten in that particular building. Under the new regs you would expense that $10,000 immediately. That’s cool. And maybe it would be worth getting a write-off of about $10,000 in 2014 rather than $256 per year for the next 39.5 years.
Another great example is a client with a tenant that requires the taxpayer spend $25,000 getting the property ready to meet the new tenant’s needs. In the past these costs had to be capitalized and depreciated. Under the new regs we can potentially expense the costs immediately! This was never possible in the past.
SO DO YOU FILE THE FORM OR NOT?
The IRS has stated we can make the change for materials and supplies related expenses as of now and not file the form 3115. Nothing is free and the cost is taxpayers will not get retroactive coverage of the rules back to prior years like they would if they file the form 3115.
The tax community is split on the issue. Since the user fees have been waived for filing the form 3115 for this year and virtually no risk in filing, I tend to agree on the side of protecting taxpayers from the IRS and recommend filing the form to get the automatic consent and protection.
Filing the form has some benefits beyond peace of mind.
First, you can avoid the potential loss of deductions and tax breaks for the prior periods. Without the form 3115 the IRS could later disallow those changes. That means that any related tax deductions would be disallowed.
It also potentially affords the taxpayer some audit protection for previous years. Filing form 3115 is our way of telling the IRS that we previously complied with the IRS regulations. In return, the IRS agrees not to impose any penalties and interest on any tax underpayments as a result of the inconsistent deductions for materials, supplies, repairs and maintenance.
And lastly, the regulations could result in huge tax breaks for some taxpayers, particularly when the taxpayer is a lessor making tenant improvements as discussed above.
You don’t have to file the form 3115. But remember, the three safe harbors for de minimus materials and supplies, small building, and routine repairs and maintenance exceptions are all annual elections that apply only on a go forward basis. These still must be attached to all returns.
The form 3115 is extraordinarily complex. The issues surrounding the new real estate requirements are complex. I don’t have all the answers. This is the first year that taxpayers have had to deal with many of these changes and the IRS hasn’t had to deal with the confused taxpayers over the issues either.
My advice is to be proactive and file the protective form 3115. It won’t hurt and could really help cut your taxes a lot! I know we are taking care of our clients by filing the elections!!!