A pair of opportunities in the recently issued modified accelerated cost recovery system (MACRS) disposition regulations and tangible property regulations present a significant new benefit for taxpayers. When a taxpayer makes a capital expenditure that results in an improvement to a unit of property, the related project often includes demolishing or removing a portion of the asset being improved. The new MACRS disposition regulations allow a taxpayer to take a loss in this situation by making an election to partially dispose of the asset (Regs. Sec. 1.168(i)-8(d)(2)). A complementary provision in the tangible property regulations gives a taxpayer who has made this election an option to also deduct the removal costs associated with the partial disposition instead of capitalizing the costs as unitary with the improvement (Regs. Sec. 1.263(a)-3(g)(2)).
Far from an afterthought, the deduction for removal costs often exceeds the loss on the partial disposition. With this in mind, this item discusses how a taxpayer may have both of these benefits limited or lost entirely if it fails to consider them and to perform the required compliance in a timely manner.
Renovation or remodeling projects that give rise to significant partial-disposition losses and removal cost deductions often are multimonth or even multiyear projects, and demolition of the existing property generally is completed early or at the very beginning of the project. This can lead to situations in which a taxpayer performs the removal of the old property in year 1, while the project is not completed and the improvement is not placed into service until year 2 or later. Historically, taxpayers had no compelling reason to consider the proper accounting for such initial costs at the time they were incurred. Prior to the issuance of the regulations, no provision allowed the current deduction of removal costs when a partial disposition occurred. In this situation, removal costs were capitalized to the asset being improved, and the proper classification of the removal costs for tax depreciation purposes was not of consequence until the tax year in which the improved property was placed into service.
Due to the intersection of these timing issues, however, a taxpayer cannot wait until the improvement is placed into service to act if it wishes to take advantage of these new opportunities. If a taxpayer removes portions of an asset in an improvement project during year 1 and fails to make the partial-disposition election on the year 1 tax return, it will lose both the opportunity to claim the loss on the partial disposition and the opportunity to deduct the removal costs in year 1. Regs. Sec. 1.263(a)-3(g)(2) states:
If a taxpayer disposes of a depreciable asset, including a partial disposition under [Regs. Sec.] 1.168(i)-1(e)(1)(ii), or [Regs. Sec.] 1.168(i)-8(d), for Federal income tax purposes and has taken into account the adjusted basis of the asset or component of the asset in realizing gain or loss, then the costs of removing the asset or component are not required to be capitalized under this section.
This makes the partial-disposition election a prerequisite for taking the removal cost deduction. The partial-disposition election is made by taking the loss on the tax return for the year the disposition occurred. Some taxpayers who are not familiar with the new rules related to dispositions and removal costs may fail to claim the loss on a partial disposition and not deduct the related removal costs.
For taxpayers who have missed these opportunities, retroactively capturing the losses is uncertain and may take multiple steps. The only option for making a partial-disposition election after the pertinent return has been filed is through the relief provisions of Regs. Sec. 301.9100-2 or 301.9100-3. Under Regs. Sec. 301.9100-2, a taxpayer who has timely filed its return for the year the election should have been made is granted an automatic six-month extension from the original due date of the return (not including extensions) to make the election. Requests for extensions to make a late election that do not meet the requirements of Regs. Sec. 301.9100-2 (such as when the six-month extension period of Regs. Sec. 301.9100-2 has passed) must be made under the nonautomatic relief provisions of Regs. Sec. 301.9100-3. According to Regs. Sec. 301.9100-3, the taxpayer must, among other requirements, provide evidence that it acted reasonably and in good faith and show that the granting of relief will not prejudice the interests of the government. Furthermore, a request under this section is considered a request for a private letter ruling. The private letter ruling request should be filed under the guidance of Rev. Proc. 2016-1 and submitted with the applicable user fee. Under both the automatic and nonautomatic provisions, if granted, the late election is effectuated via an amended return.
If a taxpayer is granted relief to make the late partial-disposition election, it will also have an opportunity to deduct the related removal costs. Unlike the partial-disposition loss taken via the election, the optional deduction of removal costs is considered a tax accounting method. Taxpayers who previously have adopted this method will capture the deductions on the amended return filed to make the late partial-disposition election under Regs. Sec. 301.9100-2 or 301.9100-3.
Taxpayers who previously have not adopted this method must file an application for a change in accounting method. Generally, this method change is automatic and covered under Rev. Proc. 2016-29, Section 11.03, which outlines the change to accounting for removal costs under Regs. Sec. 1.263(a)-3(g)(2) as change No. 21 (see also Rev. Proc. 2015-13, §5, for exceptions to being able to file under the automatic accounting method procedures). The change to the optional deduction of removal costs is not effectuated via the cutoff basis. Therefore, an applicant will take the cumulative difference of not deducting to deducting removal costs into taxable income in the year of change under Sec. 481(a).
The new partial-disposition loss and related removal cost deduction regime presents taxpayers with additional opportunities for accelerated deductions in the context of renovation projects. However, the regime also forces an acceleration of the time in which the taxpayer must address the proper accounting for these projects to get those benefits. Taxpayers planning capital improvement projects that will include partial dispositions of existing assets need to consider the proper accounting for these costs and their impact on the existing property at the onset of the project, even though the improvement may not be placed into service until a future tax year. Taxpayers who fail to take the appropriate action in the year the costs are incurred and who wish to retroactively pursue the benefits will be faced with an uncertain and possibly costly process.
Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.