An In-Depth Look: IRS Finalizes Regs on Dispositions of Tangible Depreciable Property.
(Parker Tax Publishing September 8, 2014)

Almost every business must account for gains or losses on property dispositions. The method used for determining such gains or losses is a method of accounting and must meet certain criteria. Over the past few years, the IRS has been revising the tax rules for acquiring, producing, and improving tangible property, including the acceptable methods for computing gain or loss on dispositions. While most of the rules were finalized last year, the property disposal rules took a little longer. On August 18, the IRS issued the final regulations on dispositions of tangible depreciable property subject to Modified Accelerated Cost Recovery System (MACRS) depreciation. The final regulations not only provide rules for determining gain or loss upon the disposition of MACRS property, but also provide rules for identifying the asset disposed of and accounting for partial dispositions of MACRS property.

Practice Tip: While taxpayers had several options for accounting for property dispositions before these final regulations were issued, all taxpayers are expected to comply with the final regulations, effective for tax years beginning on or after January 1, 2014. Thus, practitioners need to review the current fixed asset accounting policies of their clients to see if they are in compliance with the final regulations. Those who are not will need to file for an accounting method change with the IRS.

The final regulations, which issued under Reg. Secs. 1.168(i)-1, 1.168(i)-7, and 1.168(i)-8, generally retain all the provisions in the proposed regulations. However, some provisions were modified, including the rules for determining the unadjusted depreciable basis of a disposed asset, or portion of an asset, in a general or multiple asset account, and the manner of making certain disposition elections for assets included in a general asset account (GAA) when Code Sec. 280B (relating to demolition of structures) applies.

Compliance Tip: As noted above, the final regulations apply to tax years beginning on or after January 1, 2014. With respect to tax years beginning on or after January 1, 2012, and before January 1, 2014, taxpayers have three choices as to the rules they can apply: (1) the rules under the final regulations; (2) the rules under the 2013 proposed regulations; or (3) the rules under the temporary regulations.

Background

In December of 2011, the IRS issued temporary regulations (T.D. 9564 (12/17/11)) on the accounting for, and dispositions of, property subject to depreciation under Code Sec. 168 (i.e,, MACRS property). The temporary regulations also amended the general asset account (GAA) regulations under Reg. Sec. 1.168(i)-1. At the same time, the IRS issued proposed regulations (REG-168745-03 (12/17/11)), which cross-referenced the temporary regulations (2011 proposed regulations).

The temporary regulations initially applied to tax years beginning on or after January 1, 2012. However, the IRS subsequently issued Notice 2012-73, announcing that, to help taxpayers transition to the final regulations, the temporary regulations would not apply until tax years beginning on or after January 1, 2014. Notice 2012-73 gave taxpayers the option of choosing to apply the temporary regulations to tax years beginning on or after January 1, 2012, and before the applicable date of the final regulations. Notice 2012-73 also alerted taxpayers that the IRS intended to publish final regulations in 2013 and expected the final regulations to apply to tax years beginning on or after January 1, 2014; additionally, final regulations would allow taxpayers the option of applying the final regulations to tax years beginning on or after January 1, 2012. On December 17, 2012, the IRS amended the applicability date of the temporary regulations to tax years beginning on or after January 1, 2014, while allowing taxpayers to choose to apply the temporary regulations to tax years beginning on or after January 1, 2012, and before the applicability date of the final regulations.

Notice 2012-73 also alerted taxpayers that the IRS intended to revise the disposition rules in the temporary regulations and, in September of 2013, the IRS withdrew the 2011 proposed regulations under Reg. Sec. 1.168(i)-1 and Reg. Sec. 1.168(i)-8 and issued another set of proposed regulations under Reg. Secs. 1.168(i)-1, 1.168(i)-7, and 1.168(i)-8 (2013 proposed regulations). The 2011 proposed regulations under Reg. Sec. 1.168(i)-1 and Reg. Sec. 1.168(i)-8 had amended the existing regulations on GAAs and provided rules for dispositions of MACRS property, respectively. The IRS did not withdraw or remove the temporary regulations under Reg. Sec. 1.168(i)-1T and Reg. Sec. 1.168(i)-8T, and taxpayers continued to have the option of applying those temporary regulations to tax years beginning on or after January 1, 2012, and before the applicable date of the final regulations.

Dispositions of Assets Not in a General Asset Account

The final regulations under Reg. Sec. 1.168(i)-8 provide the basic rules for dispositions of MACRS property that is not included in a GAA. Under the final regulations, a disposition occurs when ownership of the asset is transferred or when the asset is permanently withdrawn from use either in the taxpayer's trade or business or in the production of income. A disposition includes the sale, exchange, retirement, physical abandonment, or destruction of an asset. A disposition also includes the retirement of a structural component (or a portion thereof) of a building only if the partial disposition rule (discussed below) applies to that structural component (or a portion thereof). The manner of disposition (for example, abnormal retirement or normal retirement) is not taken into consideration in determining whether a disposition occurs or gain or loss is recognized.

In general, the facts and circumstances of each disposition are considered in determining the appropriate disposed asset. However, the asset for tax disposition purposes may not consist of items placed in service by the taxpayer on different dates (without taking into account the applicable convention). Further, the unit of property as determined under Reg. Sec. 1.263(a)-3(e) or in published guidance under Code Sec. 263(a) does not apply for purposes of determining what is the appropriate disposed asset.

Special disposition rules apply for certain types of properties. For example, each building (including its structural components) is the asset for tax disposition purposes, unless (1) more than one building (including its structural components) is treated as the asset, (2) there is an improvement or addition to an existing building (including its structural components), or (3) the building includes two or more condominium or cooperative units. If there is an improvement or addition to an existing building (including its structural components), the improvement or addition is the asset. If a building includes two or more condominium or cooperative units, each condominium or cooperative unit (including its structural components) is the asset.

Example: ABC owns an office building with four elevators. ABC replaces one of the elevators. The elevator is a structural component of the office building. The office building, including its structural components, is the asset for disposition purposes. ABC does not make a partial disposition election for the elevator. Thus, the retirement of the replaced elevator is not a disposition. As a result, depreciation continues for the cost of the building, including the cost of the retired elevator and the building's other structural components, and ABC does not recognize a loss for the retired elevator. If ABC must capitalize the amount paid for the replacement elevator under the capitalization rules, the replacement elevator is a separate asset for disposition purposes and for depreciation purposes.

The final regulations also provide that if a taxpayer includes an item in one of the asset classes 00.11 through 00.4 of Rev. Proc. 87-56 or classifies an item in one of the categories under Code Sec. 168(e)(3) (other than a category that includes buildings or structural components; for example, retail motor fuels outlet and qualified leasehold improvement property), each item is the asset, provided it is not an improvement or addition to an existing asset.

Partial Dispositions of Assets Not in a General Asset Account

The final regulations retain the partial disposition rule in the 2013 proposed regulations. Consequently, the disposition rules in the final regulations apply to a partial disposition of an asset (for example, the disposition of a roof (or a portion of a roof)). The partial disposition rule allows taxpayers to claim a loss upon the disposition of a structural component (or a portion thereof) of a building or upon the disposition of a component (or a portion thereof) of any other asset without identifying the component as an asset before the disposition event. The partial disposition rule also minimizes circumstances in which an original part and any subsequent replacements of the same part are required to be capitalized and depreciated simultaneously.

In many cases, the partial disposition rule is elective. However, consistent with the 2013 proposed regulations and the operation of Code Secs. 165, 168(i)(7), 1031, and 1033, and because sales of a portion of an asset are common, the partial disposition rule is required to be applied to (1) a disposition of a portion of an asset as a result of a casualty event described in Code Sec. 165, (2) a disposition of a portion of an asset for which gain is not recognized in whole or in part under Code Sec. 1031 or 1033, (3) a transfer of a portion of an asset in a step-in-the-shoes transaction described in Code Sec. 168(i)(7)(B), or (4) a sale of a portion of an asset. Consequently, a disposition includes a disposition of a portion of an asset under these circumstances, even if the taxpayer does not make the partial disposition election for that disposed portion. For other transactions, a disposition includes a disposition of a portion of an asset only if the taxpayer makes the partial disposition election for that disposed portion.

Compliance Tip: The partial disposition election is made on the taxpayer's timely filed original federal tax return, including extensions, for the tax year in which the portion of the asset is disposed of by the taxpayer. This election cannot be made or revoked by the filing of a Form 3115, Application for Change in Accounting Method. A taxpayer may revoke a partial disposition election by filing a request for a letter ruling and obtaining IRS consent to revoke the election.

Calculating Gain or Loss on Dispositions of MACRS Property Not in a General Asset Account

If an asset is disposed of by sale, exchange, or involuntary conversion, gain or loss is recognized under the applicable provisions of the Code (Code Sec. 1231 for a disposition of an asset used in a trade or business, Code Sec. 1231 for a like-kind exchange, etc.). If an asset is disposed of by physical abandonment, loss is recognized in the amount of the asset's adjusted depreciable basis at the time of the abandonment. If an abandoned asset is subject to nonrecourse indebtedness, the asset is treated in the same manner as an asset disposed of by sale. If an asset is disposed of other than by sale, exchange, involuntary conversion, physical abandonment, or conversion to personal use (for example, when the asset is transferred to a supplies or scrap account), gain is not recognized but loss is recognized in the amount of the excess of the asset's adjusted depreciable basis over its fair market value at the time of disposition. The same rules apply when the partial disposition rule applies to a disposition of a portion of an asset.

Determining the Basis of a Disposed Assets Not in a General Asset Account

The final regulations retain the rule in the 2013 proposed regulations for determining the unadjusted depreciable basis of a disposed asset where that asset is in a multiple asset account and it is impracticable from the taxpayer's records to determine the unadjusted depreciable basis of the disposed asset. In such cases, the taxpayer may use any reasonable method that is consistently applied to all assets in the same multiple asset account.

OBSERVATION: In a change from the proposed regulations, the final rules do not include discounting the cost of the replacement asset by the Consumer Price Index as an example of a reasonable method. According to the IRS, the Producer Price Index for Finished Goods (and its successor, the Producer Price Index for Final Demand) more accurately reflects inflation for capital expenditures. The final regulations also clarify that discounting the cost of the replacement asset using the Producer Price Index for Finished Goods is a reasonable method only if the replacement asset is a restoration under Reg. Sec. 1.263(a)-3(k) and is not (1) a betterment under Reg. Sec. 1.263(a)-3(j), or (2) an adaptation to a new or different use under Reg. Sec. 1.263(a)-3(l).

The final regulations also provide rules to determine the unadjusted depreciable basis of the disposed portion of an asset when the partial disposition rule applies. While these rules retain most of the rules in the 2013 proposed regulations, the final regulations clarify when a taxpayer may use a reasonable method for determining the unadjusted depreciable basis of a disposed portion of an asset. A taxpayer may use any reasonable method for determining the unadjusted depreciable basis of the disposed portion of the asset only if it is impracticable from the taxpayer's records to determine the unadjusted depreciable basis. If a taxpayer disposes of more than one portion of the same asset and it is impracticable from the taxpayer's records to determine the unadjusted depreciable basis of the first disposed portion of the asset, the reasonable method used by the taxpayer must be consistently applied to all portions of the same asset for purposes of determining the unadjusted depreciable basis of each disposed portion of the asset. If the asset, a portion of which is disposed of, is in a multiple asset account, the reasonable method used by the taxpayer must be consistently applied to all assets and portions of assets in the same multiple asset account.

In general, a taxpayer must use the specific identification method to determine when an asset disposed of was placed in service. If an asset is in a multiple asset account and it is impracticable from the taxpayer's records to determine the particular year in which the asset was placed in service by the taxpayer, the final regulations allow the taxpayer to identify the asset by using the following: a first-in, first-out (FIFO) method, a modified FIFO method, a mortality dispersion table if the asset is a mass asset, or any other method designated by the Secretary in published guidance. A last-in, first-out (LIFO) method is not permitted. These rules also apply when the partial disposition rule applies to a disposition of a portion of an asset and it is impracticable from the taxpayer's records to determine the particular tax year in which the asset was placed in service by the taxpayer. The final regulations provide an additional example of the LIFO method, which is impermissible.

Dispositions of MACRS Property in GAAs

Under Code Sec. 168(i)(4), a taxpayer can elect to maintain one or more general asset accounts (GAAs) for any MACRS property. An asset cannot be included in a GAA if it is used both in a trade or business or for the production of income and in a personal activity at any time during the tax year in which the asset is placed in service by the taxpayer or if the asset is placed in service and disposed of during the same tax year. The final regulations generally retain all of the provisions in the 2013 proposed regulations for GAAs. Each GAA effectively is treated as the asset.

Compliance Tip: The election to use GAAs is made under Reg. Sec. 1.168(i)-1(l) and is irrevocable and binding on the taxpayer for the year of the election and all subsequent tax years. The election is made separately by each person owning an asset to which the election is made. Thus, it is made at the partnership level or the S corporation level and not by the partner or S shareholder.

In general, each GAA must include assets that have the same depreciation method, recovery period, and convention, and are placed in service in the same tax year. However, the final regulations provide special rules in certain circumstances for establishing GAAs. For example, assets eligible for the additional first year depreciation deduction cannot be grouped with assets ineligible for the additional first year depreciation deduction. Also, assets eligible for the additional first year depreciation deduction may be grouped only with assets eligible for the same percentage of the additional first year depreciation.

The definition of what constitutes the disposition of an asset in a GAA is the same as for dispositions of a non-GAA asset. Reg. Sec. 1.168(i)-1(e)(2) provides that the asset (or a portion thereof) is treated as having an adjusted depreciable basis of zero for purposes of Code Sec. 1011 immediately before any disposition of an asset (or a portion thereof) in a GAA. Therefore, no loss is realized upon the disposition of the asset (or a portion thereof). The final regulations also provide that any amount realized on a disposition generally is recognized as ordinary income. Further, the final regulations provide that the unadjusted depreciable basis and depreciation reserve of the GAA are not affected by the disposition. Accordingly, a taxpayer continues to depreciate the GAA, including the disposed asset (or a portion thereof), as though no disposition occurred.

Example: ABC is a calendar year corporation and it maintains one GAA for 10 machines. The machines cost a total of $10,000 and are placed in service in June 2014. Of the 10 machines, one machine costs $8,200 and nine machines cost a total of $1,800. ABC depreciates this GAA using the optional depreciation table that corresponds with the general depreciation system, the 200-percent declining balance method, a five-year recovery period, and a half-year convention. ABC does not make a Code Sec. 179 election for any of the machines, and none of the machines are eligible for any additional first year depreciation deduction. As of January 1, 2015, the depreciation reserve of the account is $2,000 ($10,000 20%). On February 8, 2015, ABC sells the machine that cost $8,200 to an unrelated party for $9,000. The machine is treated as having an adjusted depreciable basis of zero. On its 2015 tax return, ABC recognizes the amount realized of $9,000 as ordinary income because the amount does not exceed the unadjusted depreciable basis of the GAA ($10,000), plus any expensed cost for assets in the account ($0), less amounts previously recognized as ordinary income ($0). Moreover, the unadjusted depreciable basis and depreciation reserve of the account are not affected by the disposition of the machine. Thus, the depreciation allowance for the account in 2015 is $3,200 ($10,000 32%).

Termination of GAA Treatment

The final regulations allow a taxpayer to terminate GAA treatment upon certain dispositions. Under Reg. Sec. 1.168(i)-1(e)(3), a taxpayer may elect to recognize gain or loss for a GAA when the taxpayer disposes of all of the assets, the last asset, or the remaining portion of the last asset in the account. The final regulations also allow a taxpayer to elect to terminate GAA treatment for an asset in a GAA when the taxpayer disposes of the asset in a qualifying disposition. If a taxpayer elects to terminate GAA treatment for an asset disposed of in a qualifying disposition, the taxpayer must remove the disposed asset from the GAA and adjust the unadjusted depreciable basis and depreciation reserve of the account. The taxpayer is required to terminate GAA treatment for an asset that is disposed of in a transaction subject to Code Sec. 167(i)(7)(B), Code Sec. 1031, or Code Sec. 1033, disposed of in an abusive transaction, or used for any personal use. In such a case, the taxpayer must remove the disposed asset from the GAA and adjust the unadjusted depreciable basis and depreciation reserve of the account. In addition, the final regulations require a partnership to terminate its GAAs upon the technical termination of the partnership under Code Sec. 708(b)(1)(B). (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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