Under what conditions does a switch from MACRS to ADS require a Section 481(a) adjustment, and how does the RPTOB election impact this requirement?
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A switch from MACRS (Modified Accelerated Cost Recovery System) to ADS (Alternative Depreciation System) can occur in several contexts, but the requirement for a Section 481(a) adjustment depends on the reason for the switch and the timing of the change. The impact of the real property trade or business (RPTOB) election under Section 163(j) is particularly significant in this context.
1. General Rule: Change in Use vs. Change in Method of Accounting
Change in Use (No Section 481(a) Adjustment)
- When a taxpayer is required to switch from MACRS to ADS because of a change in use of the property (for example, due to making the RPTOB election under Section 163(j)), the regulations under Treas. Reg. § 1.168(i)-4(f) specify that this is not a change in method of accounting for purposes of Section 446(e). Therefore, no Section 481(a) adjustment is required at the time of the change. The taxpayer simply begins depreciating the property under ADS as of the year of change, using the adjusted basis and remaining recovery period as determined under the new method.
- This is supported by IRS guidance, which states that when a real property trade or business makes the RPTOB election and must switch to ADS for certain property (nonresidential real property, residential rental property, and qualified improvement property), the switch is treated as a change in use, not a change in method of accounting. Thus, no Form 3115 is required, and no Section 481(a) adjustment is made.
Change in Method of Accounting (Section 481(a) Adjustment Required)
- If a taxpayer fails to properly switch to ADS when required (for example, after making the RPTOB election), and continues to depreciate property under MACRS, the taxpayer is considered to have adopted an impermissible method of accounting. To correct this, the taxpayer must file Form 3115 to request a change to the permissible method (ADS). In this case, a Section 481(a) adjustment is required to prevent the omission or duplication of income or deductions.
- The Section 481(a) adjustment is calculated as the difference between the depreciation that was actually taken under the impermissible method (MACRS) and the depreciation that should have been taken under the permissible method (ADS), for all open and closed years prior to the year of change. The adjustment is then taken into account in the year of change (or spread over several years, depending on the size of the adjustment and other rules).
2. The RPTOB Election and Its Impact
- Under Section 163(j), a taxpayer engaged in a real property trade or business may make an irrevocable election to be excluded from the business interest expense limitation. However, as a condition of this election, the taxpayer must depreciate certain property (nonresidential real property, residential rental property, and qualified improvement property) using ADS rather than MACRS.
- When the RPTOB election is made, the switch to ADS for affected property is treated as a change in use under Treas. Reg. § 1.168(i)-4(d). As noted above, this does not require a Section 481(a) adjustment, nor does it require the filing of Form 3115.
- If the taxpayer does not properly implement the required switch to ADS after making the RPTOB election, and continues to use MACRS, the IRS considers this an impermissible method. The taxpayer must then file Form 3115 and make a Section 481(a) adjustment to correct the error.
3. Summary Table
4. Additional Nuances
- If the taxpayer is making the change as a result of a change in use (e.g., property is now used predominantly outside the U.S., or due to the RPTOB election), the switch is not a method change and no Section 481(a) adjustment is required.
- If the taxpayer is correcting an impermissible method (e.g., failed to switch to ADS when required), the change is a method change and a Section 481(a) adjustment is required.
5. Key Citations
- Treas. Reg. § 1.168(i)-4(f): Change in use is not a change in method of accounting.
- Rev. Proc. 2019-08: Guidance for electing real property trades or businesses.
- Rev. Proc. 2019-43, Section 6.05: Method change for depreciation due to change in use.
- Section 481(a): Adjustment required to prevent duplication or omission of income/deductions when changing methods of accounting.
In summary: A switch from MACRS to ADS due to a change in use (such as making the RPTOB election under Section 163(j)) does not require a Section 481(a) adjustment or Form 3115. However, if the taxpayer fails to make the required switch and later corrects the error, a Section 481(a) adjustment and Form 3115 are required to correct the impermissible method of accounting.
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