New IRS guidance on ADS recovery period of residential rental property
TAX ALERT |
The IRS released guidance (Rev. Proc. 2021-28) instructing taxpayers on how to implement retroactive legislative changes in the recovery period of residential rental property. The new procedures apply to residential rental property not previously subject to Alternative Depreciation System (ADS) if owned by an electing real property trade or business.
The Tax Cuts and Jobs Act (TCJA) set the ADS recovery period for residential rental property at 30-years for property placed in service after Dec. 31, 2017. However, the IRS concluded in Rev. Proc. 2019-8 that any property the taxpayer placed in service prior to Jan. 1, 2018 retained a 40-year ADS recovery period.
Under TCJA, when a taxpayer elects under section 163(j)(7)(B) to become an electing real property trade or business, the taxpayer must depreciate certain real property using ADS. Later guidance specified that taxpayers must use ADS not only for such property placed in service during the election year and subsequent years, but also for property placed in service in years prior to the election year. The requirement to use ADS for certain real property upon making the election causes a change in use to occur for property previously placed in service by a taxpayer. When a change in use results in a longer recovery period, a taxpayer determines the depreciation allowance in the year of the change in use as if the taxpayer had used the longer recovery period when the taxpayer originally placed in service the property. For example, if a taxpayer made the election in 2018, the taxpayer’s change in use related to its previously placed in service residential rental property (recovered using GDS 27.5 years) required the taxpayer to determine depreciation as if it had always used a 40 year recovery period.
Recently, in the Taxpayer Certainty and Disaster Tax Relief Act of 2020 (Relief Act) Congress changed the law and retroactively provided a 30-year ADS recovery period for residential rental property placed in service before Jan. 1, 2018. This only applies if the taxpayer is an electing real property trade or business and this is the first time ADS applies to the property. Prior to Rev. Proc. 2021-28 taxpayers lacked the procedural rules to implement the retroactive change made by the Relief Act.
Changing methods under Rev. Proc. 2021-28
Revenue Procedure 2021-28 applies to taxpayers with residential rental property that meets three requirements:
(1) The taxpayer (or transferor in a section 168(i)(7) transaction (e.g. section 721 or section 351)) placed the property in service before Jan. 1, 2018;
(2) The taxpayer that holds the property is an electing real property trade or business; and
(3) The property was not subject to ADS prior to Jan. 1, 2018, in the hands of the taxpayer (or the transferor in a section 168(i)(7) transaction).
The Rev. Proc. excludes taxpayers who make a section 163(j)(7)(B) election on a return for tax years ending after Dec. 27, 2020, or make a late election with a filing after Dec. 27, 2020, using the procedures set forth in Rev. Proc. 2020-22. Revenue Procedure 2021-28 also excludes taxpayers that withdraw an election under section 163(j)(7)(B) pursuant to Rev. Proc. 2020-22.
The 30-year recovery period is mandatory for any electing real property trade or business to whom Rev. Proc. 2021-28 applies. A change in use occurs under section 168(i)(5) and Reg. section 1.168(i)-4(d) for the election year, and all affected taxpayers must use the 30-year recovery period beginning in that year. The method for changing, however, can vary.
- For any affected taxpayer that established a method other than a 30-year recovery period (i.e. a taxpayer that made the election more than one taxable year prior to the year of change), the taxpayer adopted an impermissible method of accounting for the property and must change its method. The taxpayer may change by:
1. Filing a Form 3115. A qualifying taxpayer may file an automatic change under section 6.05 of Rev. Proc. 2019-43 or any successor.
2. Filing an amended tax return or AAR, as applicable, for the election year. The taxpayer must file the amended return or AAR by April 15, 2022 to qualify, and must take the collateral changes into account on returns for subsequent years, whether through original filings, amended returns or AARs. Special rules apply to BBA partnerships.
- For any affected taxpayer that did not yet establish a method for the property (i.e. a taxpayer that made the election for the taxable year immediately preceding the year of change), the taxpayer may change by:
1. Filing a Form 3115. A qualifying taxpayer may file an automatic change under section 6.05 of Rev. Proc. 2019-43 or any successor, or
2. Filing an amended tax return or AAR, as applicable, for the election year (but this filing must precede the tax return for the subsequent tax year).
The guidance provides procedural rules for taxpayers that hold the residential rental property in a general asset account. The IRS also provided a separate revenue procedure with special rules to help BBA partnerships that want to implement these methods without a Form 3115. Refer to our tax alert on Rev. Proc. 2021-29 for more information on BBA partnerships.
Note that not every state necessarily follows these methods and procedures, so taxpayers should consult a state and local tax specialist to determine any state-level impacts.
Revenue Procedure 2021-28 provides guidance and options for affected taxpayers and affirms the fact that the 30-year recovery period is the only permissible method for the property in question. Taxpayers must change their depreciation methods to comply with the Relief Act. If filing an amended return or AAR, time is of the essence, as the guidance closes this window of opportunity after April 15, 2022. The guidance, however, does not limit the ability to file a Form 3115.