Depreciating Post-1986 MACRS Property on a Change in Use

In July 2003, the IRS issued Sec. 168(i)(5) proposed regulations on computing depreciation on post-1986 modified accelerated cost recovery system (MACRS) property when there is a change in use. These changes include conversion to business or personal use and changes in the MACRS recovery period.

These types of situations are not new; taxpayers may have already developed a way to handle them. The proposed regulations provide additional guidance. Taxpayers facing this issue for the first time may wish to adopt these rules. Taxpayers who have already developed a method to handle these situations can either continue to use their old method (as long as it is reasonable and consistently applied) or shift to the proposed method. When final regulations are issued, they will control the tax treatment.

Conversion from or to Personal Use

Conversion to business use: Under Prop. Regs. Sec. 1.168(i)-4(b), personal-use property converted to business or income-producing use is deemed MACRS property placed in service on the date of conversion. The converted property is subject to the MACRS depreciation methods, recovery periods and placed-in-service conventions applicable in the change year. Prop. Regs. Sec. 1.168(i)-4(b)(1) states that the depreciable basis in the change year is the lesser of the fair market value (FMV) or the adjusted depreciable basis at the time of conversion.

Example 1: A personal residence is converted to rental property. If its original cost were $70,000 and its FMV at the time of conversion were $120,000, the MACRS depreciable basis would be $70,000.

Conversion to personal use: Under Prop. Regs. Sec. 1.168(i)-4(c), business or income-producing property converted to personal use is treated as a disposition; however, the taxpayer recognizes no gain, loss or depreciation recapture on the conversion. Depreciation in the change year hinges on the particular propertys MACRS rules. There may also be depreciation recapture if the property is subsequently sold.

Example 2: The facts are the same as in Example 1; in addition, the former residence had been depreciated. Its adjusted basis at the time of the conversion back to business or income-producing use was $60,000. The $10,000 depreciation is not recaptured on conversion. However, the $10,000 depreciation might be subject to recapture if the property were subsequently sold; see Rev. Rul. 69-487.

Change in Use

Prop. Regs. Sec. 1.168(i)-4(d) discusses changes in the use of MACRS property that remains MACRS property after the change. These changes occur when the propertys primary use changes, when the property becomes used or ceases being used predominately outside the U.S., or there are changes to or from its classification as exempt-use property. For example, commercial real estate with a 39-year MACRS useful life could be converted to residential rental property with a 27.5-year MACRS useful life. The tax treatment depends in part on whether the change in use occurs in the initial year the property was placed in service or in a later year.

After the initial year: Under Prop. Regs. Sec. 1.168(i)-4(d), a change occurring after the initial year the property is placed in service is depreciated as if the change occurred on the first day of the change year. However, the IRS invited comments on an alternative approach that would treat a change in use as occurring on the first day of the month in which the use changes, and would allocate the MACRS depreciation allowance for the change year based on the number of full months of old use and of new use during that year.

If the new MACRS recovery period is shorter than the remaining old MACRS period, under Prop. Regs. Sec. 1.168(i)-4(d)(3)(i), taxpayers take the adjusted basis at the beginning of the change year and depreciate the property over the shorter period. Thus, in Example 1 above, if the commercial real estate were converted in year 2 to rental property, its adjusted basis at the beginning of that year would be depreciated over 27.5 years.

What if the conversion occurred in year 20?  Would the taxpayer be forced to depreciate the adjusted basis of the property in year 20 over another 27.5 years?  Fortunately, Prop. Regs. Sec. 1.168(i)-4(d)(3)(ii) allows taxpayers to elect to continue using their former recovery period as if the change had not occurred.

If the new MACRS recovery period is longer than the original one, the taxpayer depreciates the adjusted basis at the beginning of the change year over the remaining portion of the longer recovery period, according to Prop. Regs. Sec. 1.168(i)-4(d)(4).

Taxpayers who used the optional MACRS depreciation tables set out in Rev. Proc. 87-57 when the property was initially placed in service, can continue to use those tables or modify their depreciation calculations; see Prop. Regs. Sec. 1.168-4(d)(5).

In the initial year: If the change occurs in the initial year the property was placed in service, Prop. Regs. Sec. 1.168(i)-4(e) states that depreciation is determined by the primary use of the property during the initial tax year. The primary use can be determined using any reasonable method consistently applied. Predominate use (rather than primary use) is the test for property used within or without the U.S. during the initial year. For exempt property or imported property covered by an executive order, the propertys use at the end of the initial tax year controls. Finally, if an exempt bond for the MACRS property is issued during the initial year, the property is depreciable as MACRS exempt-bond-financed property in the initial year.

General Asset Accounts

Finally, any property formerly in a general asset account with a change in use will be removed from the account and placed in a separate general asset account. This action will not affect assets remaining in the original general asset account; see Prop. Regs. Sec.  1.168(i)-1(h)(2). The IRS is considering a proposal to leave these assets as is, except for a conversion to personal use.

Conclusion

The IRS has requested public comments on these proposed regulations, which will be effective in tax years ending on or after the date final regulations are published in the Federal Register. However, before the final regulations are issued, the IRS will allow any reasonable method of depreciating the property to be used in the change year  and subsequent tax years, as long as the method is consistently applied. In the meantime, these proposed regulations should provide guidance for taxpayers computing depreciation for post-1986 MACRS property that changes use.

From Elizabeth Higgins, CPA, PKF New York, New York, NY