Final regulations on disposition of tangible depreciable property: Indepth discussion of key issues

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1 from Washington National Tax Services Final regulations on disposition of tangible depreciable property: Indepth discussion of key issues September 12, 2014 In brief The IRS on August 14 released final regulations regarding disposition of tangible depreciable property (final disposition regulations, final regulations, or disposition regulations). (See PwC Insight, IRS issues final regulations regarding dispositions of tangible depreciable property, August 14, 2014.) The final disposition regulations generally retain all the provisions of the proposed disposition regulations (2013 proposed regulations), but also clarify the 2013 proposed regulations on the following topics: Determination of the unadjusted depreciable basis of a disposed asset in a general asset account (GAA) or multiple asset account (MAA); Determination of the unadjusted depreciable basis of a disposed portion of an asset; and The manner of making certain disposition elections for assets included in a GAA when Section 280B (demolition of structures) applies. The disposition regulations remove the temporary regulations issued on December 23, 2011 (the 2011 temporary regulations). The final disposition regulations apply to tax years beginning on or after January 1, As with the final regulations under Sections 162(a) and 263(a) on the deduction and capitalization of expenditures related to tangible property (the final repair regulations), the final disposition regulations allow taxpayers to apply the final regulations to tax years beginning on or after January 1, 2012, and before January 1, 2014 (i.e., 2012 and 2013 tax years). In detail The final disposition regulations address disposition of property under Section 168 Modified Accelerated Cost Recovery System (MACRS) property. The disposition regulations provide rules to account for an asset (or portion thereof) disposed of when such asset is in a GAA, MAA, or single asset account (SAA). More specifically, the final regulations discuss the asset disposed of, the methods used to identify the asset disposed of, the basis of the asset, any gain or loss from the disposition, and any effects on depreciation due to the asset s disposition. The final disposition regulations require a change in method of accounting unless an annual election such as a GAA election is permitted. Dispositions The final regulations generally retain the definition of dispositions from the 2013 proposed regulations.

2 A disposition occurs when the ownership of an asset is transferred or the asset is permanently withdrawn from use. A disposition of an asset includes a sale, exchange, retirement, physical abandonment, destruction, or transfer to a supplies, scrap, or similar account. The 2013 proposed regulations introduced the partial disposition election. The final regulations continue to allow taxpayers to make a partial disposition election for portions of assets that are disposed of. Asset disposed of For dispositions of buildings, the asset is defined as each building and its structural components. If a building has two or more condominium or cooperative units, each condominium or cooperative unit, including its structural components, is considered an asset. With the exception of a category that includes buildings or structural components, for items included in asset classes of Rev. Proc (guidance on the appropriate class lives and recovery periods for MACRS property) or items properly classified in a category under Section 168(e)(3) which provides the types of property that fall within 3-year, 5- year, 7-year, 10-year, 15-year, and 20- year property each item is considered a separate asset. An exception to these general rules relates to improvements. For an improvement or addition to an asset placed in service after the taxpayer placed the asset in service, the improvement or addition (and its structural components) is treated as a separate asset. Observation: The provision of the final regulations under which a disposition of a building includes its structural components represents a change from the 2011 temporary regulations, under which a disposition of a building did not include its structural components because the building and its structural components were treated as separate assets. For tax years beginning on or after January 1, 2014, taxpayers should be aware of this change for dispositions of buildings. For example, a disposition of only structural components is treated under the final regulations not as a full disposition but rather as a partial disposition (discussed below). The taxpayer therefore need not recognize the gain or loss associated with such disposition unless such disposition falls within the required partial disposition election categories (discussed below). Partial disposition As noted above, the final disposition regulations provide rules for a disposition of a portion of an asset. A partial disposition is a disposition of a portion of an asset. The final regulations provide certain situations in which a partial disposition must be recognized for tax purposes even if the taxpayer does not make the election under Reg. sec (i)-8(d)(2)(i). The mandatory categories for partial disposition treatment include: a disposition as a result of a casualty event (Section 165); a disposition of a portion of an asset for which Section 1031 or 1033 applies (like-kind exchanges and involuntary conversions); a transfer of a portion of an asset in a nonrecognition transaction (Section 168(i)(7)(B)); and a sale of a portion of an asset. If a disposition does not fall within one of the mandatory categories, then the partial disposition election is optional and is valid only if the election is made by the due date (including extensions) for the original federal return for the tax year in which the portion of an asset is disposed of by the taxpayer. The final disposition regulations also provide taxpayers with the ability to make a late partial disposition election for 2012 and 2013 returns by either an amended return (2013 returns only) or an accounting method change. Observation: A partial disposition election affords the taxpayer the flexibility to choose whether to recognize the gain or loss associated with the partial disposition of an asset. Unless a disposition is included in one of the mandatory categories in the final disposition regulations, the taxpayer may determine if it is more advantageous to make an election to recognize a partial disposition or continue to depreciate the disposed-of portion. Observation for 2013 calendaryear taxpayers: A 2013 calendaryear taxpayer that would like to make a late partial disposition election without filing an amended return can do so by filing an accounting method change under Rev. Proc on or before September 15, Assets included in a GAA Except for the clarifying language for property subject to Section 280B and Reg. sec B-1 (discussed below), the final regulations generally retain the provisions of the 2013 proposed regulations with regard to GAAs. Under the final disposition regulations, MACRS property including assets subject to the alternative depreciation system under Section 168(g) may be accounted for in one or more GAAs. A GAA may contain one or more assets. However, if a taxpayer wishes to include more than one asset in a GAA, the assets must have the same applicable depreciation method (e.g., 200% 2 pwc

3 declining balance method), same applicable recovery period (e.g., fiveyear property), and same applicable convention (e.g., half-year convention), and must be placed in service by the taxpayer in the same tax year. When assets included in a GAA are disposed of, a taxpayer may choose to continue to depreciate the disposed assets (or portions thereof) while currently recognizing the ordinary income to the extent of the proceeds received. The final regulations provide taxpayers with two additional options when assets in a GAA are disposed of: to make a qualifying disposition election or to terminate the GAA. However, these options can be applied only in limited circumstances. Thus, given the restrictive nature of the definition of qualifying dispositions and the fact that all assets in a GAA must be disposed of before the GAA can be terminated, the general rule most likely will apply and depreciation will continue for the assets (or portion thereof) disposed of. For a qualifying disposition, the final disposition regulations retain the 2013 proposed regulations restrictive definition of a qualifying disposition. A qualifying disposition is a disposition that does not involve all the assets, the last asset, or the remaining portion of the last asset in a GAA and that is: A direct result of a fire, storm, shipwreck, or other casualty, or from theft; A charitable contribution for which a deduction is allowable under Section 170; A direct result of a cessation, termination, or disposition of a business manufacturing or other income-producing process, operation, facility, plant, or other unit, other than by transfer to a supplies, scrap, or similar account; or Generally a transaction to which a nonrecognition section of the Code applies. Thus, a taxpayer cannot make a qualifying disposition election unless one of the above categories applies. To terminate a GAA, all the assets, the last asset, or the remaining portion of the last asset in a GAA must be disposed of. If not, the taxpayer cannot elect to terminate the GAA and must continue to depreciate the disposed-of asset (or portion thereof). Observation: A taxpayer with assets in a GAA or GAAs that plans to make partial dispositions and would like to recognize the gain or loss associated with those partial dispositions should file an accounting method change to revoke the related GAA elections. Rev. Proc provides taxpayers with the ability to make such change for any tax year beginning before January 1, Although the revenue procedures to implement the final disposition regulations have not been released, government officials have indicated that taxpayers may make the late partial disposition election under the final regulations for the 2014 tax year. Assets subject to Section 280B and Reg. sec B-1 included in a GAA The final disposition regulations clarify the manner of making dispositions from a GAA for property subject to Section 280B and Reg. sec B-1. The treatment of a demolished structure in a GAA mirrors the treatment of all other assets in a GAA that are disposed of. That is, a taxpayer must continue to depreciate the demolished structure unless the taxpayer elects to make a qualifying disposition election or terminate the GAA. However, those options are available to the taxpayer only if one of the limited circumstances for making a qualifying disposition or terminating a GAA discussed above apply. Under both options, the election is made by ending depreciation for the demolished structure at the time of disposition and reporting the depreciation amount for that structure on the taxpayer s tax return. Moreover, when making the election a taxpayer must apply Section 280B and Reg. sec B-1 to determine whether and to what extent gain or loss is recognized. If a loss is sustained due to the demolition of a structure, that loss is capitalized to the land on which the demolished structure was located. Observation: Although the final regulations provide a more restrictive qualifying disposition definition, a GAA can be advantageous for taxpayers expecting to demolish a structure. Because the termination of the GAA is optional under the final regulations, a taxpayer that demolishes a building may continue to depreciate the building and not apply Section 280B and Reg. sec B-1 in determining whether and to what extent gain or loss is recognized. Thus, if a taxpayer owns a building that is expected to be demolished in the future, the taxpayer could file an accounting method change to make a late GAA election to place the building in a GAA for any tax year beginning on or after January 1, 2012, and before January 1, The late GAA election will allow the taxpayer to continue to depreciate the demolished structure rather than capitalizing the remaining basis into the land under Section 280B. However, due to the restrictive definition of qualifying dispositions, a taxpayer will not be able to make a partial disposition election for dispositions of portions or structural components of assets in a GAA. Thus, taxpayers should analyze 3 pwc

4 the benefits and costs of placing a building in a GAA. Observation for 2013 calendaryear taxpayers: If a taxpayer expects to demolish a building in the future and wants to avoid the requirement under Section 280B to capitalize the remaining basis into the land, the taxpayer should file a late GAA election accounting method change for such building (must be owned by the taxpayer at the beginning of the 2013 tax year) on or before the date on which the taxpayer files its 2013 tax return. Identification of asset disposed of The final regulations provide that taxpayers must use the specific identification method of accounting to identify the placed-in-service date for the asset disposed of. The final regulations provide that if it is impracticable for a taxpayer to determine the tax year in which the asset was placed in service including situations in which the partial disposition rule applies the taxpayer may use any of the following reasonable methods to identify the placed-in-service year: First-in, first out (FIFO); A modified FIFO method; A mortality dispersion table if the asset disposed of is a mass asset grouped in a GAA with other mass assets; or Any method designated by the IRS. For assets included in a GAA, taxpayers do not have to use the specific identification method as a first choice and may use any of the reasonable methods (including the specific identification method) listed above in identifying the placed-inservice year. Determination of basis of asset The final regulations retain the rule in the 2013 proposed regulations for determining the basis of a disposed asset. Under that rule, a taxpayer may use any reasonable, consistent method in situations in which determination of the unadjusted depreciable basis of an asset may be impracticable because the asset is in a GAA, is in a MAA, or is a component of a larger asset. The final regulations retain the nonexclusive examples of what constitutes a reasonable method provided in the 2013 proposed regulations, with the exception of the Consumer Price Index method. The preamble to the final disposition regulations provides that the IRS has determined that the Producer Price Index (PPI) for Finished Goods (and its successor, the PPI for Final Demand) more accurately reflects inflation of capital expenditures. The use of the PPI is considered a reasonable method only if the replacement asset is a restoration under Reg. sec (a)-3(k) and is not a betterment (Reg. sec (a)- 3(j)) or an adaptation to a new or different use (Reg. sec (a)-3(l)). Examples of reasonable methods included in the final regulations include the following: Discounting the cost of the replacement asset to its placed-inservice year cost using the PPI for Finished Goods (and its successor, the PPI for Final Demand); A pro rata allocation of the unadjusted basis of the GAA or MAA, as applicable, based on the replacement cost of the disposed asset and the replacement cost of all the assets in the GAA or MAA, as applicable; and A study allocating the cost of the asset to its individual components. The above examples also apply to situations in which the partial disposition rules apply. That is, taxpayers could use any reasonable method for determining the unadjusted depreciable basis of the disposed-of portion of the asset or of each disposed-of portion of the same asset (disposals of more than one portion of the same asset). The takeaway As expected, the final disposition regulations retain many provisions of the 2013 proposed regulations. However, the final regulations provide clarifications for determining the basis of an asset (or portions thereof) disposed of and the treatment of property subject to Section 280B and Reg. sec B-1 in a GAA that is disposed of. The final regulations also provide that taxpayers are not required to terminate a GAA for a demolished structure; this rule provides flexibility for application of Section 280B and Reg. sec B-1. The final disposition regulations apply to tax years beginning on or after January 1, 2014, with the option for taxpayers to early adopt the regulations for tax years beginning on or after January 1, However, because the revenue procedures to implement the final disposition regulations have not yet been released, taxpayers currently do not have proper guidance to make accounting method changes under the final regulations. Calendar-year taxpayers that have not filed their 2013 tax return and would like to early adopt the final regulations should review the 2013 proposed regulations. If the treatment of the disposition of the assets (or portion thereof) mirrors the treatment under the final regulations, then a change in method of accounting filed under the 2013 proposed regulations procedural guidance should constitute a permissible method under the final 4 pwc

5 disposition regulations. Thus, the taxpayer should not have to make an additional change under the final regulations for dispositions. Let s talk For a deeper discussion of how this might affect your business, please contact: Federal Tax Services George Manousos, Washington, DC (202) george.manousos@us.pwc.com Jennifer Kennedy, Washington, DC (202) jennifer.kennedy@us.pwc.com Tax Projects Delivery Group Bob Love, Milwaukee (414) robert.love.@us.pwc.com Annette Smith, Washington, DC (202) annette.smith@us.pwc.com Dennis Tingey, Phoenix (602) dennis.l.tingey@us.pwc.com Nina O'Connor, McLean (703) nina.oconnor@us.pwc.com Christine Turgeon, New York (646) christine.turgeon@us.pwc.com 2014 PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers (a Delaware limited liability partnership), which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. SOLICITATION This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. 5 pwc