The 2015 tax filing season had been shaping up to be the most difficult and challenging for landlords in decades. The reason was the complex new IRS repair regulations that took effect in 2014 and must be adopted by all landlords. Because the IRS initially said the new regulations had to be applied retroactively by all landlords to years before 2014, landlords feared they would have to go through the nightmarish process of examining their rental property depreciation records for past years and make adjustments to their depreciation and/or repair deductions if they failed to follow the rules established by the new regs. They also had to file the complex IRS Form 3115, Application for Change In Accounting Method with their 2014 return.
However, in response to widespread complaints, the IRS has granted taxpayers a last minute reprieve: Applying the repair regulations retroactively, and the need to file Form 3115, is now optional for most landlords and other business owners.
The repair regulations (available at www.irs.gov/irb/2013-43_IRB/ar05.html) establish extremely detailed rules on how to determine whether an expense a business property owner like a landlord incurs is a repair or an improvement. This distinction is important because repairs can be deducted in a single year while improvements must be depreciated over many years—27.5 years for residential real property. The regulations also establish some helpful new deductions and safe harbors for business property owners (especially smaller landlords) that can allow them to currently deduct expenses that might otherwise have to be depreciated.
The repair regulations took full effect on January 1, 2014 and must be followed for that and all subsequent years. The IRS also made the regulations retroactive—that is, they had to be applied to expenses for repairs and improvements to rental property owned before 2014 as well as after.
Applying the regulations to years before 2014 can be a real headache. You’re supposed to review your depreciation schedules and other available documentation (such as invoices for repairs and improvements) for all rental property you are currently depreciating and figure out if there would have been any difference if you had applied the new regulations to the property before 2014.
If some (or many) of your pre-2014 decisions about which expenses to deduct and which to depreciate don’t jibe with the new rules, you may need to make adjustments to the deductions or depreciation you took in past years. “Adjustments” (also called “Section 481(a) adjustments”) mean either you owe the IRS money or the IRS owes you money.
As part of the process of applying the regulations retroactively, landlords were also required to complete and file with their 2014 returns IRS Form 3115, Application for Change in Accounting Method. This s an extraordinarily complex form that few landlords can file without the help of a knowledgeable tax professional. Many landlords with multiple properties could need to file more than one Form 3115. Depending on the nature of a landlord’s property, recordkeeping, and depreciation practices, completing and filing Form 3115 could cost anywhere from a few hundred to many thousands of dollars. The cost could easily exceed the cost of preparing the rest of a landlord’s tax return.
After receiving many complaints from landlords, businesses, and tax professionals, the IRS issued new regulations in mid-February 2014 (Revenue Procedure 2015-20). These provide most taxpayers with optional relief from the requirement that they apply the IRS repair regulations retroactively to years before 2014. Taxpayers who take advantage of this option need not file IRS Form 3115 with their 2014 tax return.
Landlords who choose the relief provided by Revenue Procedure 2015-20 need only apply the repair regulations prospectively—that is, starting on January 1, 2014. They need not go back to years before 2014 and make any changes in how they classified expenses as repairs or improvements or make any changes in their depreciation deductions.
The relief provided by Revenue Procedure 2015-20 is available only for “smaller” taxpayers. This includes all taxpayers with (1) assets under $10 million (as of the first day of the tax year) or (2) less than $10 million in annual gross receipts for each distinct business they own for the past three tax years. Obviously, the vast majority of landlords will qualify to use Revenue Procedure 2015-20. However, large landlords with assets and receipts over $10 million who are not eligible for the relief provided by Revenue Procedure 2015-20 must apply the repair regulations retroactively and file IRS Form 3115, Application for Change In Accounting Method.
To use the new regulations, you simply file your 2014 tax return as you normally do. There is no need to include any statement in your return that you’re adopting Revenue Procedure 2015-20. You don’t need to complete or include IRS Form 3115 with your return, which will result in a much simpler return.
You still need to include any required annual elections with your return—these are not affected by these new regulations. Such elections include the Safe Harbor Election for Small Taxpayers (see “Small Taxpayer Safe Harbor for Repairs and Improvements”), and the De Minimis Safe Harbor election (see “New IRS De Minimis Rule for Deducting Business Property”). With the routine maintenance safe harbor, there is no annual election or filing required, so taxpayers can simply start using the routine maintenance safe harbor and apply the IRS repair regulations prospectively, starting with tax year 2014 (see “Routine Maintenance Safe Harbor Under New IRS Repair Regulations.”) Landlords also can use the materials and supplies deduction starting in 2014 without filing Form 3115 or making any other filing (see “Materials and Supplies Deduction Under the IRS Repair Regulations”).
You must apply all the new IRS repair regulations starting on January 1, 2014. This means you must determine whether the building expenses you incurred during 2014 qualified for one of the safe harbors; and, if not, whether they should be classified as repairs or improvements under the new regulations.
The relief provided by Revenue Procedure 2015-20 is optional—meaning you don’t have to take it. You can still apply the repair regulations retroactively to years before 2014 and file Form 3115. If, like many smaller landlords, you were conservative about classifying past building expenses as improvements instead of repairs, there may be many pre-2014 expenses that you’ve mistakenly been depreciating for many years. You’ll be able to take an immediate deduction in 2014 for such items. This could result in a substantial tax savings in 2014, even a tax refund. The value of such favorable adjustments on your past years’ taxes could far outweigh the time and expense involved in examining your old depreciation schedules and completing Form 3115. This is something you should discuss with your tax professional.
Also, one of the most significant changes brought about by the new repair regulations is a new rule that allows building owners to take an immediate loss when a building structural component such as a roof or HVAC system is replaced. This is done by making a partial disposition election on your tax return and then deducting the adjusted basis (cost minus depreciation taken) of the component. Such losses have never been allowed before. (See “IRS Repair Regulations: How to Deduct Old Roofs and Other Building Components.”) If you file Form 3115 and apply the repair regulations retroactively, you have the option of making partial disposition elections for building components you replaced in years before 2014. This could result in a substantial tax deduction. If you don’t file Form 3115 in 2014, you lose forever the ability to make such a partial disposition election for years before 2014. Again, you and your tax pro should consider whether the value of such deductions makes it worthwhile to file Form 3115 in 2014.
Finally, if you file Form 3115 in 2014 you obtain audit protection for years before 2014. This limits the ability of the IRS to audit you and unilaterally change the way you’ve classified repairs and improvements in past years. You get no audit protection if you don’t file Form 3115 with your 2014 return.
If you do elect to apply the regulations retroactively, your completed Forms 3115 are due by the due date of your 2014 return—April 15, 2015, or October 15, 2015 if you file for an automatic extension of time to file your 2014 return. Your original completed Form 3115 must be filed with an IRS district office, and a copy must be attached to your return.