The 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:
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.
Partner, Washington National Tax Office
+1 202 861 4140
Washington National Tax Office
+1 202 521 1555
Washington National Tax Office
+1 202 521 1556
Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.