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In 2014, there was a seismic shift in tax accounting commonly known to tax practitioners as the “tangible regulations.”
These regulations were finalized in 2013, after nine years of development, and redefine whether an expenditure should be capitalized or expensed. While this seems like a simple concept, it's not. The decision to expense or capitalize has been a highly litigated area of tax law, and the regulations attempt to add definition and structure to this decision.
The rollout of these regulations was unique. The IRS initially required all affected taxpayers to file multiple changes in accounting methods with some changes requiring retroactive application. The American Institute of Certified Public Accountants cried foul, and the IRS backed down from some of the administrative burdens that these regulations required.
Because of the complexity of the regulations and the compliance difficulty, the IRS allowed small taxpayers to adopt the new regulations without going through the accounting method change procedures.
Even if small taxpayers were not required to go through the process of an accounting method change, they are deemed to have made the change to the new accounting methods, as well as electing to use the cut-off method for the change and only apply the new law prospectively. All taxpayers are now subject to the new tangible regulations, and there are a couple of areas that could pose problems to unsuspecting taxpayers.
In the past, gain or loss could only be recognized for a complete disposition of an asset. Therefore, if you undertook a major remodel of a building, you could not dispose of the portion of the old building that was demolished because it was not a complete disposition. The new rules allow for partial dispositions.
A partial disposition is made by election. All you need to do is show the disposition on your tax return. Because the partial disposition is made by election, if you miss taking the loss on your tax return, you cannot file an amended return to correct the situation. If you discover the error within six months from the original due date of the return (not including extensions) there is a relief provision. But if it's outside of this window, you have to request a private letter ruling. For most taxpayers, this option would be cost prohibitive.
To further complicate matters, the new tangible regulations allow for the deduction of removal costs but only if the optional accounting method is adopted. Also, to take a deduction for removal costs, the taxpayer must have made the partial disposition election for that particular asset.
Now, fast forward to 2016. You have a major renovation project that is started toward the end of 2016 and will be finished in 2017. All costs will be captured in a “Construction in Process” account and when the project is completed in 2017, the asset will be placed in service. For example, the allocated cost of the demolished structure is $20,000 and demolition costs incurred for the project are $15,000. This gives you a current deduction of $35,000 if the partial disposition election is made and the optional removal cost accounting method is adopted.
The big problem is that in the past, there was no need to pay much attention to assets under construction because none of the related costs could be deducted until the asset was placed in service. Now under the new tangible rules, you can take a deduction for a partial disposition and deduct related removal costs. The deduction should be taken in the year of the disposition, which in our case is 2016. If the tax preparer is not specifically considering the new tangible property rules, there is a good chance the deduction will be missed on the 2016 tax return.
If the deduction is missed on the 2016 tax return and not considered until the asset is placed in service in 2017, the partial disposition election cannot be made without obtaining permission from the IRS. Without special permission, the $35,000 that could have been taken as a deduction will be required to be capitalized and depreciated over the life of the asset.
For a commercial building, the depreciable life is 39 years.
Through a simple oversight, a current $35,000 deduction is now a yearly $900 deduction for the next 39 years.
All taxpayers with renovation projects that straddle tax years should proactively pay attention to the timing of deductions. The rules are new, complex and a change from past practice.
Failure to catch the opportunity to deduct these costs cannot easily be corrected.
Pamela Schuneman, C.P.A., is a practicing tax accountant in Sarasota. She has 33 years of experience helping her clients navigate the vast federal tax system and has worked with businesses as varied as Fortune 500 companies to small sole-proprietors. Contact her at [email protected]
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