Cost reclassification on exam ruled method change

Tax Hot Topics newsletterThe Tax Court concluded in T.C. Memo 2020-44 that the IRS’s cost reclassification of taxpayers’ cost basis in their depreciable rental properties under Section 168 constitutes a change in the taxpayers’ method of accounting that results in an adjustment under Section 481.

The issue before the court was whether the IRS’s cost reclassification constituted a change in method of accounting. However, the taxpayers’ lack of documentation and substantiation of their original cost classification appears to have been a key factor in the original IRS exam and cost reclassification.

The taxpayers owned and rented two real estate properties in Hawaii. The first property is a beach house purchased in 2003, and the second property is a condominium purchased in 2010. For both, the taxpayers allocated their basis to nondepreciable land, and depreciable personal property and residential rental property. Upon examination in 2012, the IRS reclassified the taxpayers’ allocation for the beach house to increase land basis. The condo, however, was the major issue at hand, and was reallocated as shown in the chart below:

Asset class

The IRS appeared to have determined that the condo did not meet the definition of residential rental property under Section 168(e)(2)(A), likely because the rentals are on a short-term, transient basis, and changed the recovery period from 27.5 years to 39 years. The IRS also applied a “haircut” to the depreciable basis on the condo by 10%, because of estimated personal use.

The IRS concluded that the basis reallocation constituted a change in the taxpayers’ method of accounting that would necessitate a Section 481 adjustment. The taxpayers filed a motion for partial summary judgment, arguing that the IRS’s reallocation of the taxpayers’ basis in their assets should not result in an adjustment under Section 481 (in this case, an unfavorable one-year income pickup) in the year under exam, because such reallocation did not result in a change in the taxpayers’ method of accounting.

A change in method of accounting includes “a change in the treatment of any material item,” under Treas. Reg. Sec. 1.446-1(e)(2)(ii)(a). An erroneous treatment rises to the level of “method of accounting” only if it is employed consistently for two or more years. A “material item” is defined as “any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.”

The Tax Court concluded that the IRS’s change in recovery period under Section 168 was a change in treatment of a material item, and that because the taxpayers employed their depreciation method for more than two consecutive years, constituted a change in method of accounting. The court agreed with the IRS that the reclassification is not merely a recharacterization because the reclassification does not change the total amount that the taxpayers will eventually recover, but it did change the timing of the cost recovery deductions. Lastly, the court disagreed with the taxpayers’ argument that the reclassification was a change in fact, because the underlying relevant facts did not change, but again it was a reclassification of the taxpayer’s basis because of improper allocations as of the date of acquisition.

Sharon Kay
Partner, Washington National Tax Office
T +1 202 861 4140

Caleb Cordonnier
Washington National Tax Office
T +1 202 521 1555

Jason Seo
Senior Associate
Washington National Tax Office
T +1 202 521 1556

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