The taxman has stepped in at the eleventh hour to modify a little-known tax law change that is (still) set to impact most businesses across the country.
A decade in the making, the new ‘Tangible Property Regulations’ (TPRs) are set to go into effect on April 15, effective for tax year 2014. But thanks to fierce opposition from CPAs and their trade association, the American Institute of CPAs, the IRS has relented and granted at least some relief to taxpayers.
The new TPRs are intended to provide accounting clarity as to whether taxpayers must add a physical item to their depreciation schedule or deduct it as a business expense. Much of existing determinations for what was depreciable versus what needed to be capitalized was the result of hard-fought court battles. A lot of that debate centered on whether or not changes were repairs, restoring function, or a replacement that added value.
The way the IRS saw it, replacements of say, a furnace or a window in a rental home, were capital improvements “because they are for betterments and/or restorations to the property.” Because of this, the IRS required taxpayers to depreciate their cost over their useful life – in this case, 27.5 years. Repairs, however, like painting a room or replacing roof shingles, aren’t considered replacements because they “do not improve the property but keep your property in an ordinarily efficient operating condition.”
Confused? Let’s recap. Replacing a window is depreciable and deducted over time. Replacing some shingles is immediately deductible. Unless, the IRS explained, “you make repairs as part of an extensive remodeling or restoration of your property and these repairs directly benefit or contribute to the restoration of your property, then the whole job is a capital improvement. “In this case,” the IRS commands, “you should capitalize and depreciate the repair costs in the restoration or remodeling project as the same class of property that you have restored or remodeled as discussed above.”
Apparently, not all replacements were repairs and not all repairs were replacements. Except when they were. Got that?
Writing in the Journal of Accountancy, Christian Wood summarized the confusion neatly:
Under the new, clarified regulations, a single window would be considered a repair, and not a replacement, and thus, could be deducted.
But the clarity that the new regulations brought came with a price: The now-modified regulations also required taxpayers to file a Form 3115 — an ‘Application for Change in Accounting Method’ — and a Section 481(a) form, on which a taxpayer documents the adjustments required to be made when changing accounting methods. The American Institute of Certified Public Accountants (AICPA) estimates that a fully prepared Form 3115 often takes 80 hours worth of work per client.
The regulations would affect every business owner with depreciable property and individuals who, say, own a rental property and currently depreciate things like a replacement window. Every business or individual with a rental home that depreciates or deducts business expenses would have had to “scrub” their depreciation schedule and make all items on their past tax filings still on the depreciation schedule complaint with the new regulations. Failure to comply would increase chances of an audit, and result in the loss of those deductions forever.
Accountants with mostly business clientele advised clients to prepare for extensions. Brenda McFadden, a CPA in Lawrence, Kansas, advised her clients to brace for the delays, saying, “it has become clear to us that it will not be humanly possible for us to get all the returns done by April 15 that we normally do,” and that, “some of your returns that were typically filed on time may have to be extended this year due to the complexity that the IRS has thrust upon all of us.”
Melanie Lauridsen, a technical manager in the tax division at the American Institute of Certified Public Accountants (AICPA) recalls her early meetings with the IRS on the now-modified change: “I remember in those first few conversations that I had with IRS, they were like ’This isn’t a big deal. This is just clarifying… this is actually helping [taxpayers].’ And we were like, ‘Uh, really?’”
“Had the regs been done prospectively,” Lauridsen adds, “you wouldn’t have had to file a Form 3115. I think that’s what is creating the huge problem. Because it’s retroactive and you have to look back [at past tax years].”
The AICPA largely got what it asked for. Now, the regulations allow small businesses — defined as those “with assets totaling less than $10 million or average annual gross receipts totaling $10 million or less” — to file prospectively, which is to say items currently being depreciated under the old rules get to stay that way, but new expenditures going forward have to comply with the new regulations.
Best of all, for those qualifying for relief, no onerous Form 3115 is required. (Though, not filing a Form 3115 means that previous tax filings don’t qualify for “safe harbor protection” and are still subject to audit.)
While this may seem like a relatively small-stakes case, it’s a cautionary tale for those hoping to enact significant tax reform in the near future. For those on Capitol Hill trying to reform the fragile egg basket that is the tax code, be careful what you wish for. That is, unless you’re ready to make some omelets.
