Requirement to Change to ADS for Depreciation When Electing out of Section 163(j): A Change in Use, Not a Change in Accounting Method
On December 21, 2018, the IRS released Revenue Procedure (“Rev. Proc.”) 2019-8, which provides guidance to real property trades or businesses and farming businesses that have the ability to elect out of Section 163(j) interest limitations, without the requirement to file an accounting method change when changing to the alternative depreciation system (“ADS”) as required. This new guidance is extremely taxpayer friendly as it applies to applicable property placed in service before the election year, during the election year, and in subsequent taxable years.
The TCJA limits the business interest deduction for taxpayers with more than $25 million in average annual gross receipts to the sum of their business interest income and 30% of their adjusted taxable income. However, certain taxpayers are provided a great opportunity to elect out of these limitations in Section 163(j)(7). In order for an electing real property trade or business to elect out of Section 163(j), all nonresidential real property, residential rental property, and qualified improvement property must be depreciated using ADS; similarly an electing farming business must depreciate all property with a recovery period of 10 years or more using ADS if electing out of Section 163(j).
In a surprising but favorable clarification, Rev. Proc. 2019-8 states that the change in computing depreciation for the election year for existing property is NOT a change in method of accounting, but rather a “change in use.” As a result, electing taxpayers will simply adjust the remaining depreciable period as if the property had always been depreciated using the ADS recovery period. If any of the property was eligible for bonus depreciation under Section 168(k), the additional depreciation deduction allowable for that property is not re-determined; however, no current year or subsequent year acquired property would qualify for the Section 168(k) bonus depreciation.
Another taxpayer favorable change is the ADS recovery period for residential rental property, which has been reduced from 40 years to 30 years for residential rental property placed in service after December 31, 2017. Residential rental property placed in service prior to January 1, 2018 will still be depreciated using the 40-year ADS recovery life.
If the electing real property trade or business or electing farming business elects out of Section 163(j), but continues to depreciate applicable property over the GDS recovery periods and method and not ADS, then the taxpayer will be determined to have elected an impermissible method of accounting which can then only be changed through the filing of a Form 3115, Application for Change in Accounting Method.
You should be reviewing if it is applicable for you to elect out of the Section 163(j) limitations, as you may qualify as an electing real property trade or business or an electing farming business. As discussed, an election out the Section 163(j) limitations will require a change to ADS for applicable property. Now is a great time to reach out to your trusted Cherry Bekaert tax advisor and the Cherry Bekaert C/AM team who can assist in reviewing your situation and evaluating if you are able to take advantage of this beneficial opportunity.