Can I change accounting methods to a Safe Harbor expense after taking depecriation for several years using form 3315?

[ehoffman1]

I have a rental property that was rented 50% and replaced the water heater 3 years ago. I started to depreciate the water heater each year. This year I changed the rental property to 100% rental and realized the lifetime depreciation for a water heater is 27.5 years (ugh).

Can I use Form 3115 - Application for Change in Accounting Method, to change from depreciation to taking a one-time Safe Harbor expense?

I have seen references to doing this but have not found an actual example or confirmation that this is true.

Form 3115 also indicates that if there is a change in use for the asset, you don't need to file 3115 for a change in Accounting Methods.

Or can you only elect Safe Harbor or De Minimis the year the expense was incurred?

[M-MTax]

You didn't use an impermissible method of accounting......for depreciation......so you can't use form 3115.

[ehoffman1]

My understanding is Form 3115 is used to Change the Accounting Method, including changes to both impermissible and permissible accounting methods depending on the Code used (see below).

You are correct that I used a permissible depreciation method, but I want to change the method from depreciation to an expense under Safe Harbor.

Can you only elect Safe Harbor in the year the expense was incurred (which would require refiling for those tax years), or can you change the method of accounting using Form 3115?

Why Use Form 3115?

There are two main reasons why you might need to use Form 3115. The first scenario involves correcting a mistake on your previous tax returns. If you discover that an incorrect accounting method was used, Form 3115 allows you to request permission from the IRS to fix the error and ensure your taxes are reported accurately.

The second scenario involves switching to a new accounting method. Perhaps you find a different method that better reflects your business's financial activities or offers a potential tax advantage. Because any change in accounting methods requires approval from the IRS, you can request this change in method through Form 3115.

• Changing from not taking depreciation to taking depreciation. (Because this is a change from an impermissible method to a permissible method use Code 7 on Form 3115)
• Changes in methods or conventions, (Because this is a change from 1 permitted method to another, use Code 8 or 200 if MACRS on Form 3115)
• Changes to or from a required life, (Because this is a change from 1 permitted method to another, use Code 8 on Form 3115)
• Correcting depreciation on leasehold improvements from using the incorrect life of the lease term to the correct life of the asset (generally 39 years). (Use Code 199 on Form 3115)

[ehoffman1]

M-MTax,

See my response below. I thought you could use Form 3315 for both permissible and impermissible accounting changes.

Thank You

[Mike9241]

(ii) Taxpayer without applicable financial statement. A taxpayer electing to apply the de minimis safe harbor may not capitalize under § 1.263(a)-2(d)(1) or § 1.263(a)-3(d) nor treat as a material or supply under § 1.162-3(a) any amount paid in the taxable year for property described in paragraph (f)(1) of this section if—

(A) The taxpayer does not have an applicable financial statement (as defined in paragraph (f)(4) of this section);

(B) The taxpayer has at the beginning of the taxable year accounting procedures treating as an expense for non-tax purposes—

(1) Amounts paid for property costing less than a specified dollar amount

since it would seem you did not have such an accounting policy in place, in my opinion you cannot retroactively elect safe harbor

Importantly, making the election is not considered a change in accounting method. No need to file a Form 3115 Application for Change in Method of Accounting, then. However, it is still important to maintain adequate records and to adhere to the accounting procedures necessary to account for the amounts incurred.

[Opus 17]

Let's start with what was possible, then you can decide if it is worth fixing.

Let me also say that when you place a property in service, everything in that property is depreciated over 27.5 years, as part of the adjusted cost basis of the property.  But if you replace items, they get listed as separate assets, and may have different depreciation schedules depending on their expected life.

So let's run an example.  You buy a duplex in 2020 and start renting unit 1 (unit 2 is your personal residence).  You should list unit 1 for depreciation with half your cost basis.  In 2021, you buy a hot water heater that serves both units.  For unit 1, you can take 50% of the cost as a safe harbor deduction, or you can list 50% of the cost of the hot water heater for depreciation.  But you probably should use 10 years, not 27.5 years, because that's the normal useful life.  The other 50% of the cost is added to the cost basis of unit 2, your personal home.  

Then in 2024, you convert unit 2 to a rental.  Your basis for depreciation is either your adjusted cost basis, or the fair market value, whichever is less.  And that adjusted cost basis includes 50% of the water heater, since it was a property improvement.  You can't take the safe harbor for it.  You can only depreciate it as included in the overall cost basis of the unit.  

Let's carry this forward to 2034, 10 years from now, and assume you don't change accounting methods.  The hot water heater fails and is replaced.  Because 50% of the hot water heater is a separate asset for unit 1, you can roll up the remaining depreciation and deduct it in 2034, which is what happens when you dispose of a worthless asset that still has depreciation left.  The 50% of the water heater that is included in the basis of unit 2 doesn't get any special treatment, you continue to depreciate unit 2 over 27.5 years from its original basis.  However, you then have the choice of expensing or depreciating the new water heater in 2034, depending on what the cost is (and whether the safe harbor limits get an inflation adjustment).

Since half the water heater must be depreciated over 27.5 years as part of the overall cost basis for unit 2, the most you can get back is half the cost that could have been a safe harbor deduction in 2021 (minus the depreciation you claimed that now gets reversed).  And even if you leave everything alone, you don't have to wait 24 years to get the cost of the water heater back, since you will get a roll-up of leftover depreciation when the water heater is next replaced (which will probably be sooner than 24 years.). So even if the water heater cost the full $5000 and was eligible for a full $2500 safe harbor, the most you will get back is a $2200 expense deduction, which would save you $450 of taxes, against the cost of preparing and filing the form.

[ehoffman1]

@Opus 17 @Mike9241 

I appreciate your responses and sounds like using Form 3115 is NOT what I should to do. Also, sounds like I missed the boat to take Safe Harbor / de Minimis expense.

For clarification, I rented out 50% of the property starting in 2016 and now in 2023 I am converting it to 100% rental use. I have seen some posts that TurboTax is a little difficult to make changes to the percentage of business use.

When I originally entered depreciation information, I used the full cost basis (100%) of the house but indicated it was used only 50% as rental, so depreciation was calculated at 50% of allowable per year over 27.5 years. Now, I am entering 100% rental in 2023 and the depreciation is calculated at 100% allowable per year.

I checked the depreciation calculations by subtracting the previous years depreciation and extrapolating out the new 100% depreciation per year for the remaining useful life and and they seem to be correct and add up to the total cost basis if taken over 27.5 years.

I have seen some posts that recommend taking the original asset out of service (placed in service in 2016 with 50% depreciation) and then entering a new asset (placed in service in 2023 with 100% depreciation), but I don't see how this changes the depreciation calculations.

Am I still missing something?

[Opus 17]

@ehoffman1 

I have not attempted to use Turbotax for rentals,

@Carl 

@Critter-3 

What I would have done is list unit 1 as an individual 100% property, rather than listing it as a 50% property.  That way, you could have added unit 2 as a separate property with its own basis.  To my way of thinking, the percentage method would be more appropriate for when you rent a room of your house, rather than a unit in a multi-unit building.    So I can't help with adjusting the percentage.

Form 3115 would be the correct way of correcting the HWH to take the the safe harbor (on 50% of the cost).  I just don't think it's cost-effective to do so at this point, especially if it is 8 years old already.  Whenever you replace it, you will be able to roll up the remaining depreciation.

"When I originally entered depreciation information, I used the full cost basis (100%) of the house"

Did you reduce that by the value of the land?  Because land doesn't depreciate.  Suppose the duplex cost $100,000 in 2016, but the fair market value of the land was $10,000 (that is something a real estate agent could tell you, or possibly the county tax assessor).  You would only list the home for depreciation at $90,000.  If you listed the duplex at full price including the land, that is a mistake that should be corrected with a form 3115 and it will be important to do so because you have been overstating your deduction and understating your income for the last 8 years and that is an audit issue if the IRS ever figures it out.

"I have seen some posts that recommend taking the original asset out of service..."

That addresses the problem of having a split asset.  By default, half the HWH is a separate asset, and the other half is incorporated into the overall basis of unit 2.  That means that when you next replace the HWH (2028, given an estimated 12 year life), you would "roll up" the remaining depreciation on half the HWH, but the depreciation that is built in to the cost basis of unit 2 never comes back to you until you fully depreciate unit 2 (27 years from now, 35 years after buying the duplex in 2016).   If you remove the HWH from unit 1 and then add it back to the whole duplex, you do have to start over at a new 27.5 year calendar (using the present FMV), but when you next replace it, you can roll up the remaining depreciation on the entire thing instead of half.   (I would also try and verify whether 27.5 years is correct.  A stand alone appliance like a washing machine would have a shorter lifespan.  Because the HWH is attached to the home, it may be correct to use 27.5, but I would double check.  And no matter the length of time, you get the roll-up whenever you replace it.)

[M-MTax]

Form 3115 would be the correct way of correcting the HWH to take the the safe harbor (on 50% of the cost). 

Would not. As Mike9241 said, that safe harbor can't be elected retroactively.