I have always struggled with basis. In the 1990’s I rented out a 1-Bedroom condo. When my 1995 return was picked up for audit, a kindly revenue agent pointed out that one needs to exclude the proportionate value of land from depreciation, even for a condo. Who knew? The excess depreciation I had taken in the audited year was disallowed, resulting in increased gross income. But the agent did not make me recapture in the audit year the excess depreciation I had taken in prior years, some of which were closed. I would account for that, the agent explained, when I sold the condo. I looked up §1016 and, sure enough, one must adjust basis by the greater of depreciation allowed (actually taken) or allowable (what you shudda taken). Lesson learned.
The unhappy taxpayers in Gary Pinkston and Janice Pinkston, T.C. Memo. 2020-44 (April 13, 2020)(Judge Lauber) learned a harsher lesson: they may have to recapture over $1.1 million of prior years’ excess depreciation as gross income in the year of audit. That is because §481 sometimes forces taxpayers to recapture income in the audit year that was improperly omitted in prior years. You can find the sad details on how that works below the fold.
Law: Methods of Accounting and Changes Thereto
Section 441(a) requires taxpayer to compute their income on a yearly basis. It creates the concept of tax year, which for most individuals is the calendar year. Section 6012(a)(1)(A) requires taxpayers to report the income on an annual return. And §6501 requires the IRS to assess the resulting tax “within 3 years after the return was filed.” Years that are barred by the §6501 assessment limitations period are called closed years. And oh boy are they closed! Section 6501 acts as a statute of repose. It does not just block a particular remedy (administrative assessment) like a statute of limitations. Oh no. It also extinguishes any unassessed liabilities for those closed years. At least that’s what I figured out in Camp, Tax Return Preparer Fraud and the Assessment Limitation Period, 116 Tax Notes 687 (August 20, 2007)(yes, I’ve been writing a long time).
That is why we say every tax year stands alone. Exceptions are few and generally explicitly stated in statutes. For example, §165(i) allows taxpayers to take casualty losses from certain disasters in the tax year preceding the disaster. So if a tornado hits in March, taxpayers can take the casualty loss on the return for the previous year that they file in April.
Taxpayers can generally choose their method of reporting that yearly income, but §446(b) warns that “if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.” Similarly, once a taxpayer starts using a method of accounting, the taxpayer must get permission from the IRS to change it. §446(e). Treasury has put out extensive regulations under §446 to further define what constitutes a change of accounting method.
The problem for the IRS is that sometimes a taxpayer’s erroneous accounting method has affected closed years. Thus Congress has given the IRS a tool to deal with that: §481.
Section 481 provides that if a taxpayer’s method of accounting changes in a given year---whether the change is made by the taxpayer or the IRS---then “there shall be taken into account [in the year of the change] those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted.” As Judge Lauber explains in today's opinion, what constitutes a “change in accounting method” for §481 purposes is the same as what constitutes such a change for §446(b) purposes.
Section 481 applies even when the IRS simply changes a “material item” of accounting and not the taxpayer’s entire method. Treas. Reg. 1.446-1(e)2)(ii)(a) provides that a material item is “any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.” Notice again the connection to the big idea of proper matching of cost to income. One sees how this bites in inventory accounting cases. I commend Huffman v. Commissioner, 126 T.C. 322 (2006), to you, an excellent opinion by Judge Halpern dealing with whether a single error in the taxpayer’s inventory accounting triggered §481. Spoiler alert: it did.
Quoting from Suzy’s Zoo v. Commissioner, 273 F.3d 875, 883 (9th Cir. 2001) Judge Lauber tells us that “The purpose of § 481 is to prevent either a distortion of taxable income or a windfall to the taxpayer arising from a change in accounting method when the statute of limitations bars reopening of the taxpayer’s earlier returns.” Op. at 8. Notice that the provision does not re-open a closed year. Nor does it change the liability for the closed year. The closed year remains closed. What the provision does instead is force the taxpayer to account for errors made in the closed years in the year of audit, thus changing the tax liability for the year of audit.
When I teach depreciation, I emphasize to my students that §167 contains the big idea and §168 contains the nitty-gritty.
The big idea is matching cost to income. Section 167(a) allows a deduction of a “reasonable allowance for the exhaustion, wear and tear” of property used in a trade or business or held for the production of income. This language recognizes that property can produce income over many different years and the idea of depreciation is to spread out the cost of that property to match the income it produces over those years. Otherwise, income in the year the property is acquired is distorted downwards and income in the out years is distorted upwards.
That’s the idea: you want income to properly reflect the costs of producing it. Don’t get me started on the fun-house mirrors of §168(k) or §179.
In contrast, §168 provides no independent authorization for a deduction. It just sets out rules for how one computes the “reasonable allowance” authorized by §167. And those rules are a complex waltz of three steps. Taxpayers must (1) find the applicable depreciation method for the property they want to depreciate; (2) find the applicable recovery period; and (3) apply the applicable start/stop convention. Make any misstep and you will either take too much depreciation or too little.
Many of the depreciation rules are easy to mess up, especially for folks renting out real estate, like me and my 1-bedroom condo in 1995. Because I do not want my students to make my error, I really hammer on them that land is not depreciable. That is because the law deems land not subject to exhaustion, wear and tear, even though any West Texas farmer can tell you otherwise.
Since land is not deductible, how does one know how much to allocate? I tell my students to use local property appraisals and use either the straight dollar amount the local appraisers allocate to land or else the percentage of value as applied to the actual purchase price, whichever is more favorable. I think either approach is defensible.
In today’s case, the IRS determined that the taxpayers had massively screwed up their depreciation deductions which, by definition, means they did not properly reflect income in the years of screw-up. When the IRS caught them, it adjusted their method of depreciation and said §481 forces the taxpayers to account for those prior screw-ups in the audited year. Let’s take a look.
Facts of The Case
This case involves the taxpayers’ 2012 return. On that return they reported rental income of $64,321 from a beach house in Kahuku, Hawaii. They had bought the beach house in 2003 for $1.6 million. They also reported rental income of $99,200 from a condo in Honolulu. They had bought the condo in 2010 for a cool $2.7 million.
The taxpayers made two depreciation errors. First, while they allocated part of each purchase to non-depreciable land, their allocation choices were questionable. As to the beach house, they allocated only $400k of the beach house cost to land. The IRS said nope, you should have allocated $1.4 million of the $1.6 purchase price to the beach. As to the condo, it appears that the taxpayers simply took their $28,000 closing costs and called that the value of the land. That’s just sloppy. The IRS said nope, the proper allocation is $292,000.
Second, the taxpayers choices about their recovery periods were questionable, mostly for the condo where they decided they could recover $2 million of their purchase using a 5-year recovery period for “Distributive trade and services.” Apparently, they rented their condo to a business. The IRS reclassified the bulk of the cost to “Nonresidential real property” which has a 39-year recovery period.
As a result of these changes, the IRS proposed to assess the taxpayers not only the increased income from the audit year of 2012, but also proposed to assess “additional adjustments to income for 2012 equal to the difference between the amounts of depreciation petitioners had previously claimed on the two rental properties and the amounts that the IRS would have allowed consistent with its reallocations for 2012.” Op. at 6. Here, that amounted to an additional $1.1 million in additional gross income for 2012.
That is the §481 issue. The taxpayers moved for partial summary judgment on that issue, arguing that §481 did not apply because those depreciation adjustments were just “corrections” and were not a “change in the method of accounting” for §481 purposes. Judge Lauber disagreed.
Lesson: Change in Depreciation Method Triggers §481
This is a great opinion that really helps readers see the difference between the question of “whether” taxpayers have items of income and “when” they do. Judge Lauber gives an excellent review of §481, which is a pretty confusing statute. Treasury regulations really help clarify its application and Judge Lauber does a great job explaining and applying those regulations, including their very helpful illustrations. Judge Lauber also refers reader to extensive case law on §481. In short, this is a great opinion to get a sense of §481 fundamentals.
The lesson here is that the IRS’s two changes to the taxpayers’ depreciation choices----the reallocation of cost to non-depreciable land, and the reclassification of cost to a much longer recovery period---constituted a change in accounting method that triggered §481. That is because both adjustments affected the proper matching of cost to income. By taking an excessive depreciation deductions from 2003 to 2012 for the beach house and from 2010-2012 for the condo, these taxpayers omitted income for those year that they would have reported had they done depreciation correctly. Even though many of those years were closed in 2012, §481 requires taxpayers to undo the distortion by reporting and paying tax in 2012 on the underreported income from the prior years.
It’s the effect on timing that makes the IRS adjustment trigger §481 recapture. If the IRS simply disallows a deduction by re-characterizing it from a type of expense that is deductible to a type of expense that is not deductible, that is not usually a change in accounting method. See Pelton & Gunther v. Commissioner, T.C. Memo 1999-339 (IRS disallowed deduction for litigation costs because they were reimbursable by clients and costs were like loans but that disallowance did not trigger §481).
Thus it does not matter that the §1016 basis adjustment makes it all come out right eventually. Notice that if the taxpayers had, for example, sold the beach house in 2012, they would have had a larger gain to report because §1016 would force them to reduce basis by their allowed depreciation deductions, which were much greater than their allowable. I do not believe that §481 would have then applied as to the beach house. I will accept correction on this if readers think I’m wrong.
Coda 1: This is a limited opinion on the taxpayer’s motion for partial summary judgment on the §481 issue. It leaves at least two questions unanswered. First, we have yet to see whether the Tax Court will sustain the corrections made in the NOD. Honestly, however, I cannot see how the taxpayer’s made a reasonable allocation to the beach house land of only $400,000 of their $1.6 million purchase price. C’mon, it’s a beach. In Hawaii. You could put a frigging tent on the property and sell it for close to the purchase price. Second, we do not know how the IRS or the Court will apply the limitations in §481(b) which is titled “Limitation on tax where adjustments are substantial.”
Coda 2: Notice that if the taxpayer ultimately lose this case, they will be able to adjust their basis upwards by the amount on which they had to pay tax. That's tax cost basis, which is also a fun concept to teach.
Coda 3: I continue to be bad at basis. In 2019 my wife and I sold a home we had converted to a rental in 2010. In preparing our return I discovered I had actually taken less depreciation than was allowable (because I had failed to account for some capital improvement costs prior to conversion that increased my basis). That sucked because it meant I had reported and paid tax on more income than I should have between 2010 and 2019. Worse, because of the §1016 rules, I could not fix that distortion when accounting for the sale of the rental property. That is just part of the heads-I-win, tails-you-lose structure of the Tax Code.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites you to visit TaxProf Blog every Monday for a new Lesson From the Tax Court.