New IRS Guidance for Depreciation Changes to Certain Residential Rental Property
June 25, 2021
By Michael Torhan
Owners of residential rental property that was placed into service before January 1, 2018 may be affected by new guidance from the IRS and should evaluate the required implementation of such guidance as it may produce favorable tax benefits. In Revenue Procedure (“Rev. Proc.”) 2021-28, the IRS provides guidance for such owners on how to change the method of accounting for depreciation for such property that was historically depreciated over 40 years but should now be depreciated over 30 years due to a recent change in relevant tax law. Taxpayers who previously elected to be treated as electing real property trades or businesses (made the “RPTOB Election”) are those directly affected by the new guidance.
Background on Affected Taxpayers
The 2017 Tax Cuts and Jobs Act (“TCJA”) created a limitation on the amount of business interest expense that may be deducted by taxpayers. However, certain taxpayers that are real property trades or businesses are eligible to make the RPTOB Election, which causes them to not be subject to the interest limitation. One byproduct of such election is that nonresidential, residential, and qualified improvement property all need to be depreciated under the Alternative Depreciation System (“ADS”) rather than the General Depreciation System (“GDS”). Depreciation recovery periods under the ADS are generally longer than those under the GDS.
Prior to enactment of the TCJA, the recovery period under the ADS was 40 years for residential rental property. The TCJA changed the recovery period of such property under the ADS to 30 years -- however, only with respect to property placed in service after December 31, 2017. Rev. Proc. 2019-08 provided that for the election year (the first taxable year for which a taxpayer makes the RPTOB Election), the electing real property trade or business must begin depreciating nonresidential real property, residential rental property, and qualified improvement property under the ADS. This rule applies to newly-acquired property and to existing property. For existing property, the guidance provided that a change in use occurs for such existing property, and depreciation of such property would as a result follow the change in use rules. If the new recovery period for a property is longer as a result of a change in use, such change in use rules generally provide that the remaining net basis of property is recovered over the remaining recovery period (as amended).
Changes to Recovery Period of Affected Property
As a result of the amendments made by Title II, Section 202 of the Consolidated Appropriations Act, 2021, the depreciation of residential rental property placed in service prior to January 1, 2018 by taxpayers subject to the RPTOB Election changed. Specifically, in the case of any residential rental property (i) that was placed in service before January 1, 2018, (ii) that is held by an electing real property trade or business, and (iii) for which ADS was not otherwise required to be used by such taxpayer under IRC Sec. 168(g)(1)(A) through (E), such residential rental property would be depreciated with a recovery period of 30 years.
IRS Guidance for Taxpayers Affected
Rev. Proc. 2021-28 allows taxpayers to file an amended federal income tax return or information return, administrative adjustment request under IRC Sec. 6227, or a Form 3115, Application for Change in Accounting Method, to change their method of computing depreciation of affected residential rental property held by an electing real property trade or business to use a 30-year ADS recovery period and, if such property is included in a general asset account, to change their general asset account treatment for such property to comply with Treas. Reg. Sec. 1.168(i)-1(h)(2).
In Rev. Proc. 2021-28, the Treasury Department and the IRS commented that they are aware that some taxpayers may have made the RPTOB Election for their 2019 taxable year, and thereby changed to a 40-year ADS recovery period for residential rental property placed in service before 2018 under the change in use rules for the 2019 taxable year. While changes in method of accounting for depreciation are available and can generally be effected through the filing of a Form 3115 (see Revisiting Tax Depreciation Through Changes in Accounting Methods), there has been uncertainty over the past several months in regard to how such accounting method change could be accomplished if a change in use resulted from the immediately preceding taxable year (i.e., considering 2020 as the current tax filing year).
An accounting method generally needs to be used for two consecutive tax years to have been considered adopted by such taxpayer. There is an exception for changes from impermissible to permissible methods of accounting for depreciation where a change of accounting method can be requested after just one year. However, historically such exception did not apply for changes in a method of accounting for depreciation due to a change in the use of property. Therefore, taxpayers with RPTOB elections made in 2018 would have been eligible to request a change of accounting method in 2020 for the new 30-year recovery period since both 2018 and 2019 would have included the incorrect recovery periods. On the other hand, taxpayers with RPTOB Elections made in 2019 would have not been able to request a change of accounting method prior to this new guidance.
The Treasury Department and IRS acknowledged this in Rev. Proc. 2021-28 and provided that the change to the 30-year recovery period for residential rental property could be made by filing a Form 3115 in lieu of an amended federal income tax return or information return, or an administrative adjustment relief. Rev. Proc. 2021-28 provides the requirements and procedures to change to a 30-year recovery period by filing a Form 3115.
It is recommended that taxpayers that own residential rental property and that previously made the RPTOB Election consider such new guidance. Since the change is from 40 years to 30 years, favorable tax deductions can be afforded to taxpayers due to the additional depreciation that is available.
As noted above, this guidance strictly applies to taxpayers that would not have been otherwise required to use the ADS under IRC Sec. 168(g)(1)(A) through (E). Therefore, residential rental property that is owned by an electing real property trade or business may not be eligible to use the new 30-year recovery period if it is (i) used predominantly outside the United States, (ii) considered tax-exempt use property, (iii) considered tax-exempt bond financed property, (iv) covered by an Executive Order relating to imported property from countries maintaining trade restrictions or engaging in discriminatory acts, or (v) subject to an election by a taxpayer to use the ADS. For example, REITs commonly make an election to depreciate property under the ADS. If a REIT made such election in the past, but then also make the RPTOB Election, such property would not be allowed the new 30-year recovery period. Since the taxpayer was otherwise subject to the ADS, the 40-year recovery period would still apply.
Concurrently with the release of Rev. Proc. 2021-28, the IRS also released Rev. Proc. 2021-29 which provides relief to certain partnerships that would otherwise not be able to file amended tax returns because they are subject to the Centralized Partnership Audit Regime. Under Rev. Proc. 2021-29, eligible partnerships have until October 15, 2021 to files amended partnership returns and amended Schedules K-1. (Please see also IRS Provides More Welcome Relief to Certain BBA Partnerships—but Only Until October 15, 2021.)