Electing Out of Interest Deduction Limit and Switching to ADS Is Not an Accounting Method Change

A taxpayer that elects out of the  business interest deduction limits won’t need to file an accounting method change when switching to the MACRS alternative depreciation system (ADS), according to the IRS.

During recent informal remarks, the IRS said it plans to allow electing farmers and real estate businesses to make the required switch to ADS under “change in use” regulations. The changes described in these regulations are not accounting method changes.  This means electing taxpayers wont’t have to:

  • file Form 3115, Application for Change in Accounting Method, or
  • include a Code Sec. 481(a) adjustment in income.

The IRS discussed its plans at the Capital Recovery and Leasing Section at the 2018 ABA Mid-Year Meeting.

Electing Farming and Real Property Trade or Businesses Must Use ADS

The Tax Cuts and Jobs Act generally limits the business interest deduction for taxpayers with more than $25 million in average annual gross receipts to the sum of:

  • business interest income; and
  • 30% of adjusted taxable income.

A farming or real property trade or business, however, may make an irrevocable election out of I.R.C. §163(j).

The election, however, comes at a price. A farming business making the election must depreciate any MACRS property with a recovery period of 10 years or greater using ADS. An electing real property trade or business must use ADS to depreciate:

  • residential rental property;
  • nonresidential real property; and
  • qualified improvement property.

Under ADS, property is depreciated using the straight-line method over a depreciation period that is usually longer than the period that would otherwise apply.

Unfortunately, the effective date of the provision is for “tax years beginning after 2017” and not for “property placed in service after 2017.” This means that an electing taxpayer must also depreciate property placed in service before 2018 using ADS.

Accounting Method Change v. Change in Use

Generally, when a taxpayer changes its method of depreciating MACRS property, an accounting method change must be filed on Form 3115. In addition, a Code Sec. 481(a) adjustment is required. In the case of a taxpayer switching to ADS, the section 481(a) adjustment, which is included in income, is the difference between:

  • the depreciation previously claimed; and
  • the depreciation that would have been claimed if ADS applied when the asset was first placed in service.

Representatives from the Chief Counsel’s Office, however, unofficially indicated at the mid-year meeting that the IRS will likely issue guidance that allows a taxpayer to apply the change in use regulations. This means an electing taxpayer will recover the remaining undepreciated basis of pre-2018 assets using ADS over the ADS recovery period that remains at the beginning of 2018. Previously claimed depreciation in excess of ADS depreciation is not included in income. This change is not considered an accounting method change.

Example:  ABC, a calendar-year real property trade or business, placed 27.5 year residential rental property costing $100,000 in service in January 2010 and makes an irrevocable election out of the business interest deduction limitation in 2018. The ADS recovery period for residential rental property placed in service before 2018 is 40 years. As of December 31, 2017, the property has been depreciated for seven years and eleven and one-half months. Only eleven and one-half month’s depreciation was allowed in 2010 under the mid-month convention. Depreciation claimed through December 31, 2017 is $28,937. Under the change in use regulations, ABC will depreciate the remaining $71,063 basis using the straight-line method over the remaining ADS recovery period of 32 years and ½ month beginning on January 1, 2018.

In this example, no switch to ADS is required if the residential rental property is fully depreciated before 2018. In this situation there is no undepreciated basis to recover using ADS even though the 40 year ADS recovery period has not expired.

The IRS officials gave no definite time frame for issuing the expected guidance. However, it should be available for the 2019 filing season.

By Ray G. Suelzer, J.D., LL.M.

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CCHTaxGroup

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