The tax code is ever-changing, and for all landlords, 2015 has proven to be one of the most difficult and downright thorny years to date. The IRS implemented Form 3115, Application for Change in Accounting Method, on January 1st, 2014, which sent property owners into a tailspin and the phones at every accounting firm ringing.
What is Form 3115, exactly? As the saying goes, “It’s complicated.” Distilled down to the simplest of terms, the IRS wants to know if an incurred expense on a property is an improvement or a repair. Why is this important? Because repairs can be deducted in a single year, while residential property can be depreciated over 27.5 years.
To add insult to injury, the IRS made Form 3115 retroactive. As of January 1st, 2014, the IRS repair regulations went into effect for any years prior to 2014. The U.S. taxpayer must apply all new regulations to existing long-term assets, as well as any new long-term assets, acquired here forward. Large businesses, through a retroactive filing, are required to apply the regulations to anything before 2013. This includes all taxpayers with (1) assets over $10 million (as of the first day of the tax year) or (2) over $10 million in annual gross receipts for each distinct business they own.
Making this election is not only tedious, but extremely time consuming, especially for the individuals who must file the election retroactively. The taxpayer must review their depreciation schedules and make sure that the method of depreciation chosen matches the new regulations for allowable depreciable deductions. Clearly, any taxpayer who is not aware of these new regulations should seek help from a professional tax advisor.
Aside from the changes made through this election, there may be adjustments to your return that cause a recapture of the depreciation taken in prior years. This recapture of depreciation could trigger a tax liability for the taxpayer on a return filed in a previous year. These kinds of changes are called “Section 481(a) adjustments.” Generally, if this is the case and you owe money to the IRS, you have 4 years to pay it in full. Along with these changes, you must still file the election to change accounting method (Form 3115).
If a property owner did not make many or any repairs or improvements to personal business property prior to 2014, the changes may be minimal. If the election to Section 179 the deductions were taken, there may be very little depreciation carrying forward. This may result in even lower adjustments.
To give credit where credit is due, landlords cried foul, and the IRS listened and responded. As of February 2014, Form 3115 is optional. Therefore, if your business property does not fall into the $10 million plus category, the IRS gives the option of applying the regulations retroactively to years prior to 2014, or only prospectively to years 2014 and later. (IRS Revenue Procedure 2015-20.)
Once the IRS made the filing optional, landlords coast-to-coast breathed a collective sigh of relief. However, there are several benefits to filing Form 3115, and they should be known. If in previous years a taxpayer did own substantial business property and is still depreciating certain expenditures, it may be to their advantage to apply the repair regulations to those years. Some taxpayers choose a conservative route by classifying expenditures as improvements rather than repairs. There may be many expenses in previous years that the taxpayer chose to depreciate instead of taking fully as a write-off in the current year. This may allow for an immediate deduction in 2014 for such items, and may even result in a substantial tax savings in 2014. The taxpayer must weigh their options to see if filing Form 3115 will be of benefit.
One of the most valuable parts of Form 3115 is the section that allows a property owner to take an immediate loss when a building’s structural component has been replaced, such as roof trusses or floor panels or HVAC system. The caveat is that you must file Form 3115 in 2014; otherwise the option to take the partial disposition for any years prior is lost in perpetuity. This is one of many reasons to discuss this filing with a tax professional immediately.
Another benefit is that by filing this election, you are essentially obtaining audit protection through Form 3115, because the IRS is unlikely to audit and change the way you have classified repairs and improvements on prior year tax filings. Without Form 3115, you have no protection against the IRS and the sizeable adjustments they can make to your business property deductions.
- Form 3115 as a whole:
- As of 2015 (for 2014 tax filing period), any individual, LLC, S-Corp, C-Corp with rental property investment income is required to file for a change in accounting method.
- Change in accounting method is to show the IRS that capital improvements can be deducted against income in a current year vs. depreciating the expenses over the life of the asset.
- What is form 3115?
- Form 3115 is a request to change current year accounting method.
- Form 3115 stipulates investor information, accounting year, and cash or accrual method.
- Who is required to file 3115?
- Any individual, LLC, S-Corp, C-Corp with rental property investment income.
- Are there risks in not filing 3115?
- As of February 2015, the IRS is not requiring the filing of Form 3315 but still recommends for individuals and businesses to file a change in accounting method.
- How to file 3115:
- Even though federal and state tax returns are required to be e-filed, a paper Form 3115 still needs to be filed with the IRS separately.
- Form 3115 is complicated and very detailed. If the election is made incorrectly, the IRS has the option of limiting all deductions used to offset business property income.
- The verbiage used to file on Form 3115 cites specific internal revenue code that allows property owners to take current year deductions fully, as opposed to limiting deductions that are not structural or capital improvements.
- Form 3115 is not filed with or at the normal IRS agencies but instead filed with a specific division at the IRS.
While Form 3115 has caused monumental panic for property owners throughout the U.S., take heart. The truth is, with a brief look at your tax return, any accountant can help you decide what makes financial sense for you.
If you still have questions, Robert Hall & Associates offers to all AOA members a complimentary 30 minute consultation, either in person or over the phone. We are a full-service tax consulting firm, specializing in real estate investors since 1971. Call 818-242-4888 and we’ll be happy to help you.