IRS Explains How to Change Depreciation Method to Comply with Recent Law Change

(Parker Tax Publishing June 2021)

The IRS issued a revenue procedure which provides guidance on a change made in the Taxpayer Certainty and Disaster Tax Relief Act of 2020 (TCDTRA) which retroactively provides a recovery period of 30 years under the alternative depreciation system (ADS) for certain residential rental property placed in service before January 1, 2018, held by an electing real property trade or business, and not previously subject to the ADS. The revenue procedure explains how a taxpayer changes its method of computing depreciation for such property to comply with TCDTRA. Rev. Proc. 2021-28.

Background

Before amendment by the Tax Cuts and Jobs Act of 2017 (TCJA), Code Sec. 168(g)(1) provided that the depreciation deduction under Code Sec. 167(a) was determined under the alternative depreciation system (ADS) for: (1) any tangible property that during the tax year is used predominantly outside the United States; (2) any tax-exempt use property; (3) any tax-exempt bond financed property; (4) any imported property covered by an Executive order under Code Sec. 168(g)(6); and (5) any property to which an election under Code Sec. 168(g)(7) applied.

TCJA amended Code Sec. 168(g)(1) to require that the depreciation deduction provided by Code Sec. 167(a) be determined under the ADS for nonresidential real property, residential rental property, and qualified improvement property held by an electing real property trade or business as defined in Code Sec. 163(j)(7)(B), as well as any property with a recovery period of 10 years or more that is held by an electing farming business as defined in Code Sec. 163(j)(7)(C). These amendments apply to tax years beginning after December 31, 2017, without regard to when the property is or was placed in service.

TCJA also amended the table of recovery periods under Code Sec. 168(g)(2)(C) to provide that the ADS recovery period is 30 years for residential rental property, where previously it had been 40 years. This amendment to the ADS recovery period applied only to property placed in service after December 31, 2017. In 2019, the IRS issued Rev. Proc. 2019-8 to provide guidance, in part, on the recovery period under the ADS for residential rental property placed in service before 2018 and on how taxpayers can change their computation of depreciation to the ADS for certain properties held by electing real property trades or businesses. Rev. Proc. 2019-8 provides that the recovery period under the table in Code Sec. 168(g)(2)(C) of the Code is 30 years for residential rental property placed in service by the taxpayer after December 31, 2017, and 40 years for residential rental property placed in service by the taxpayer before January 1, 2018. Pursuant to Rev. Proc. 2019-08, a change in use occurs under Code Sec. 168(i)(5) and Reg. Sec. 1.168(i)-4(d) for existing property as a result of an election under Code Sec. 163(j)(7)(B). Therefore, depreciation for such property is determined in accordance with the rules under Reg. Sec. 1.168(i)-4(d).

Subsequently, the Taxpayer Certainty and Disaster Tax Relief Act of 2020 (TCDTRA), which was enacted as part of the Consolidated Appropriations Act, 2021 (Pub. L. 116-260), retroactively provided a recovery period of 30 years under ADS for certain residential rental property placed in service before January 1, 2018, held by an electing real property trade or business, and not previously subject to the ADS. As a result of the enactment of this provision in the TCDTRA, the IRS issued Rev. Proc. 2021-28 to address the retroactive effective date of this provision for taxpayers affected by the provision.

Rev. Proc. 2021-28

Rev. Proc. 2021-28 permits taxpayers to file an amended federal income tax return or information return, administrative adjustment request under Code Sec. 6227, or a Form 3115, Application for Change in Accounting Method, to change their method of computing depreciation of certain residential rental property held by an electing real property trade or business to use a 30-year ADS recovery period and, if such property is included in a general asset account, to change their general asset account treatment for such property to comply

with the change in use rules in Reg. Sec. 1.168(i)-1(h)(2).

The IRS noted that some taxpayers may have elected to be an electing real property trade or business for their tax year beginning in 2019 (2019 tax year), and thereby changed to a 40-year ADS recovery period for residential rental property placed in service before 2018 under the change in use rules for the 2019 tax year. The IRS said it is also aware that some of those taxpayers may not have made the adjustments to general asset accounts under the change in use rules in Reg. Sec. 1.168(i)-1(h)(2) for the 2019 tax year. To the extent those taxpayers have not yet filed their federal income tax return or Form 1065, U.S. Return of Partnership Income, for the tax year beginning in 2020, the IRS advises in Rev. Proc. 2021-28 that the change to the 30-year recovery period for residential rental property to comply with the TCDTRA or to the method of accounting provided in Reg. Sec. 1.168(i)-1(h)(2) should be made on an amended federal income tax return or information return, or an AAR, as applicable. However, Rev. Proc. 2021-28 also provides these taxpayers with the option of changing to a 30-year recovery period or to the method of accounting provided in Reg. Sec. 1.168(i)-1(h)(2) by filing a Form 3115 in lieu of an amended federal income tax return or information return, or an AAR.

Example: In January 2016, Bob purchased and placed in service a residential rental property at a cost of $1,000,000. Bob depreciates the residential rental property under the general depreciation system of Code Sec. 168(a) (GDS) by using the straight-line method, a 27.5-year recovery period, and the mid-month convention. In January 2018, Bob and Donna form an equal partnership, BD. Donna contributes cash to BD, and Bob contributes the residential rental property to BD. The contribution of the residential rental property by Bob to BD is a Code Sec. 721 transaction. At the time of the contribution, Bob's adjusted basis in the residential rental property was $928,790. Pursuant to Code Sec. 723, BD's basis in the residential rental property contributed by Bob is $928,790. On its Form 1065 for the 2019 tax year, BD makes an election under Code Sec. 163(j)(7)(B) to be an electing real property trade or business. Because the contribution of the residential rental property by Bob to BD is a transaction described in Code Sec. 168(i)(7)(B), Code Sec. 168(i)(7)(A) and Rev. Proc. 2021-28 apply. To the extent of BD's basis of $928,790 in the residential rental property, BD is treated as placing in service such property in January 2016 and as depreciating such property under the GDS before January 1, 2018. Accordingly, this residential rental property is within the scope of Rev. Proc. 2021-28 and is subject to the 30-year recovery period under the ADS beginning in the 2019 tax year, which is the election year.

Example: Assume the same facts as the above example, except Bob made an election under Code Sec. 168(g)(7) on his timely filed 2016 federal income tax return to depreciate the residential rental property under the ADS by using the straight-line method, a 40-year recovery period, and the mid-month convention. As a result, Bob's adjusted basis in the residential rental property was $951,040 at the time of the contribution and BD's basis in the residential rental property contributed by Bob is $951,040. Because the contribution of the residential rental property by Bob to BD is a transaction described in Code Sec. 168(i)(7)(B), Code Sec. 168(i)(7)(A) and Rev. Proc. 2021-28 apply. To the extent of BD's basis of $951,040 in the residential rental property, BD is treated as placing in service such property in January 2016 and such property is treated as being subject to Code Sec. 168(g)(1)(E) in the hands of BD before January 1, 2018. Accordingly, this residential rental property is not within the scope of Rev. Proc. 2021-28 and continues to be subject to the 40-year recovery period under the ADS.

In Section 4 of Rev. Proc. 2021-28, the IRS describes the permissible methods of accounting for residential rental property that falls within the scope of Rev. Proc. 2021-28 and how the electing real property trade or business can change to such permissible methods for determining depreciation. Rev. Proc. 2021-28 provides that a taxpayer can file a Form 3115 under the automatic change procedures or non-automatic change procedures, as applicable. Another method of making the change is by filing of an amended federal income tax return or amended Form 1065 for the election year on or before April 15, 2022, but in no event later than the applicable period of limitations on assessment for the tax year for which the amended return is being filed. There is an exception to this timing rule for certain partnerships affected by Rev. Proc. 2021-29.

For a discussion of ADS and real property trades or businesses, see Parker Tax. ¶94,330.

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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