Reallocation of Basis Is Change in Accounting Method

2. Whether a change in depreciation method, recovery period, and convention for the basis of depreciable property resulting from a re- allocation of basis from section 1245 property to section 1250 property is a change in method of accounting?

3. How is the depreciable basis of the property computed at the beginning of the year of change.

2. A change in depreciation method, recovery period, and convention for the basis of depreciable property resulting from a re- allocation of basis from section 1245 property to section 1250 property is a change in method of accounting.

3. As a result of the change in method of accounting, the depreciable basis of the property at the beginning of the year of change is equal to that property's unadjusted basis as redetermined ("redetermined unadjusted basis") less the depreciation deductions that would have been allowable for the property in the taxable years before the year of change determined as though the redetermined unadjusted basis had been used since the placed-in-service date of the property.

[5] A calendar-year taxpayer ("Taxpayer") constructs a factory in 1990 and places it in service in 1991. The total cost of the factory (including the land) is $10,000,000. During the examination of Taxpayer's tax return for 1993, the examining agent redetermined the allocation of the factory's cost of $10,000,000 and Taxpayer agrees with the agent's determination. The allocation as originally determined by Taxpayer on its 1991 tax return and the allocation as determined by the examining agent during the examination of Taxpayer's 1993 tax return are as follows:

                          Unadjusted         Unadjusted

[7] The re-allocation of basis affects the computation of Taxpayer's deductions for the cost of the property in two ways. First, the re-allocation of $250,000 of the cost of the property from depreciable building and machinery to nondepreciable land results in a change from deducting $250,000 of the cost of the property through depreciation in each year of a certain recovery period to deducting such cost at the time of the property's disposition. Second, the re- allocation of $1,250,000 of the cost of the depreciable property from machinery (7-year property) to building (nonresidential real property) results in a change in depreciation method, recovery period, and convention for such cost.

[8] Because of these effects of the re-allocation of basis, the examining agent made two adjustments to Taxpayer's taxable income for 1993. First, the agent concluded that the change from deducting $250,000 of the cost of the property through depreciation over a certain recovery period to deducting such cost at the time of the property's disposition and the change in depreciation method, recovery period, and convention with respect to $1,250,000 of the cost of the depreciable property are a change in method of accounting subject to sections 446(e) and 481(a). As a result, the agent computed a net positive section 481(a) adjustment (an increase to taxable income) of $520,512 to disallow the net excess depreciation claimed by Taxpayer for the property in the taxable years before 1993, which are closed under the period of limitation for assessment. Second, because a change in method of accounting occurs, the agent recomputed the depreciation deduction for 1993 based on the redetermined unadjusted basis of the depreciable property less the depreciation deductions that would have been allowable for that property in the taxable years before 1993 determined as though the redetermined unadjusted basis had been used since the property's placed in service date. Consequently, Taxpayer's taxable income for 1993 is increased by $222,612 to disallow the net excess depreciation deducted on Taxpayer's tax return for 1993. Thus, the total amount of the increase to Taxpayer's taxable income for 1993 is $743,124.

[9] Taxpayer disagrees with the agent's conclusion that a change in method of accounting occurs. Instead, Taxpayer argues that the issue of whether the cost is depreciable property or nondepreciable property, or is 7-year property or nonresidential real property, is one of "characterization" and not a change in method of accounting issue. Taxpayer also argues that the re-allocation of basis among depreciable property and nondepreciable property, or among section 1245 property and section 1250 property, is similar to a purchase price adjustment and, thus, is not a change in method of accounting. Moreover, with respect to the change from 7-year property to nonresidential real property, Taxpayer argues that a change in recovery period is not a change in method of accounting.

[10] Taxpayer also disagrees with the agent's recomputation of depreciation for 1993. While Taxpayer agrees that the depreciation deduction for 1993 is based on the property's adjusted basis at the beginning of 1993, Taxpayer argues that such adjusted basis equals the redetermined unadjusted basis of the depreciable property less the depreciation actually claimed by Taxpayer on its tax returns for 1991 and 1992 with respect to that property. Under Taxpayer's position, the total amount of the increase to Taxpayer's taxable income for 1993 is $549,214.

[11] In the present case, the re-allocation of basis results in two changes that affect the timing of deductions. The first change is a change in the treatment of a portion of the cost of the property from depreciable property (that is, building and machinery) to non- depreciable property (that is, land) resulting in a change from deducting such cost through depreciation over a certain recovery per period to deducting the cost at the time of the property's disposition. The second change is a change in the depreciation method, recovery period, and convention for the cost of the depreciable property that is reclassified under section 168(e) from 7-year property (that is, machinery) to nonresidential real property (that is, building). The question is whether these changes are a change in method of accounting or a correction of an error.

[12] In determining whether a change in method of accounting or a correction of an error occurs, the key factor is timing. Pursuant to section 1.446-1(e)(2)(ii)(a) of the Income Tax Regulations, a change in method of accounting includes a change in the treatment of any material item. The term "material item" is defined in section 1.446-1(e)(2)(ii)(a) as meaning any item that involves the proper time for the inclusion of the item in income or the taking of the item as a deduction. In determining whether a taxpayer's practice for an item involves timing, section 2.01(l) of Rev. Proc. 97-27, 1997-1 C.B. 680, 681, provides that the relevant question generally is whether the practice permanently changes the amount of taxpayer's lifetime income. If the practice does not permanently affect the taxpayer's lifetime income, but does or could change the taxable year in which income is reported, the practice involves timing and, thus, is a method of accounting.

[13] Although a method of accounting may exist under this definition without the necessity of a pattern of consistent treatment of an item, section 1.446-1(e)(2)(ii)(a) further provides that in most instances a method of accounting is not established for an item without consistent treatment. For purposes of this regulation, the erroneous treatment of a material item in the same way in two or more consecutively filed tax returns represents consistent treatment of that item. See Rev. Rul. 90-38, 1990-1 C.B. 57; section 2.01(2) of Rev. Proc. 97-27, 1997-1 C.B. at 681.

[14] Pursuant to section 2.01(3) of Rev. Proc. 97-27, a change in the characterization of an item may also constitute a change in method of accounting if the change has the effect of shifting income from one period to another. For example, a change from treating an item as income to treating the item as a deposit is a change in method of accounting. See Rev. Proc. 91-31, 1991-1 C.B. 566.

[15] Section 1.446-1(e)(2)(ii)(b) provides that a change in method of accounting does not include adjustment of any item of income or deduction that does not involve the proper time for the inclusion of the item of income or the taking of a deduction. According to the regulation, examples of these adjustments include corrections of items that are deducted as interest or salary but which are in fact payments of dividends, and of items that are deducted as business expenses but which are in fact personal expenses.

[16] Section 1.446-1(e)(2)(ii)(b) further provides that a change in method of accounting does not include correction of mathematical or posting errors, or a change in treatment resulting from a change in underlying facts.

[18] In the present case, one of the changes resulting from the re-allocation of basis is a change from treating a portion of the cost of the property as depreciable building and machinery to treating it as nondepreciable land. Taxpayer's treatment of the cost of this property as depreciable, property on its original returns affects when, not whether, Taxpayer's cost of that property will be deducted. By treating the property as depreciable property, Taxpayer was deducting the cost of the property through depreciation over a certain recovery period. If Taxpayer had treated the property as nondepreciable land, Taxpayer would have deducted its cost at the time of disposition. Under either treatment, Taxpayer is entitled to the same amount of deductions. Consequently, Taxpayer's incorrect treatment of the cost of the property as depreciable property on its original returns affects the timing of deductions. Thus, the change in the timing of the deduction for the cost of the property resulting from the re-allocation of such cost from depreciable property to nondepreciable property is a change in method of accounting.

[19] Further, the court in Diebold held that a change from nondepreciable inventory to depreciable property is a change in method of accounting. If a change from nondepreciable property to depreciable property is a change in method of accounting, then a change in the other direction is also a change in method of accounting.

[20] Moreover, in the present case none of the exceptions under section 1.446-1(e)(2)(ii)(b) apply. The change in treatment from depreciable to nondepreciable property is not due to a change in underlying facts, or a correction of mathematical or posting errors.

[22] Section 1.167(e)-1 provides, that any change in the method of computing the depreciation allowances with respect to a particular account is a change in method of accounting. See also section 2.01(1)(b) of the APPENDIX of Rev. Proc. 97-37, 1997-33 I.R.B. 18, 30 (formerly section 2.01 of Rev. Proc. 96-31, 1996-1 C.B. 714).

[23] With respect to a change in depreciation method, the legislative history underlying the statutory language of section 446(e) and former section 167(e) clearly supports the Service's position that a change in depreciation method is a change in method of accounting. The legislative history of section 446(e) provides that a change in method of accounting includes "a change in the treatment of a material item such as . . . a change in the method of depreciating any property." S. Rep. No. 1622, 83d Cong., 2d Sess. (1954), reprinted in 1954 U.S.C.C.A.N. 4621, 4940. Further, the legislative history of former section 167(e) also provides that "[a]ll changes in depreciation method are changes in accounting method under section 446(e) and, therefore, will require the consent of the Secretary or his delegate." S. Rep. No. 1622, 83d Cong., 2d Sess. (1954), reprinted in 1954 U.S.C.C.A.N. at 4842.

[24] Further, in Standard Oil Co. (Indiana) v. Commissioner, 77 T.C. 349 (1981) (Issue 3), the taxpayer had treated signs and lights as section 1250 property and depreciated such property by using the depreciation methods permitted for section 1250 property (that is, 150-percent declining balance method for the new signs and lights and the straight-line method for the used signs and lights). In Standard Oil, the taxpayer successfully obtained reclassification of certain of those signs and lights as section 1245 property and, as a result, sought to recompute the depreciation for those reclassified assets by using the more accelerated depreciation methods permitted for section 1245 property (that is, the sum-of-the-years-digits method for the new signs and lights and the 150-percent declining balance method for the used signs and lights). The Tax Court held that the change in depreciation methods is a change in method of accounting. The court cited to sections 1.167(e)-1 and 1.446-1(e)(2)(ii)(a), and explained: "It is unquestioned that a change in the method of computing depreciation is a change in the method of accounting." 77 T.C. at 410.

[25] However, if a taxpayer has not adopted a depreciation method for the property, a change from that depreciation method to another depreciation method is not a change in method of accounting. The two situations specified in Rev. Rul. 72-491, 1972-2 C.B. 104, are examples of a taxpayer not adopting an erroneous depreciation method. Specifically, a change from an erroneous depreciation method to a proper depreciation method is not a change in method of accounting if: (1) the Internal Revenue Service disallows the use of the erroneous depreciation method for the first taxable year for which the taxpayer used the method; or (2) a taxpayer uses an erroneous depreciation method in the property's placed-in-service year and before filing the tax return for the succeeding taxable year, the taxpayer files an amended return for the placed-in-service year using a proper depreciation method.

[26] With respect to a change in recovery period or convention, the Service's position that such a change is a change in method of accounting is supported by section 1.446-1(e)(2)(ii)(a). The recovery period determines the period of time over which the basis of depreciable property is recovered. The convention determines the portion of the taxable year for which depreciation is allowable and determines how much of the applicable recovery period remains as of the beginning of the taxable year following the placed-in-service year. Section 5.01 of Rev. Proc. 87-57, 1987-2 C.B. 687, 690. A change in recovery period or convention of depreciable property affects when, not whether, the cost of that property will be deducted. Consequently a change in recovery period or convention affects the timing of deductions and, thus, is a change in method of accounting. See also section 2.01(2)(b)(vii) of the APPENDIX of Rev. Proc. 97-37, 1997-33 I.R.B. at 30 ( Rev. Proc. 97-37, which provides the procedures for taxpayers to obtain the automatic consent of the Commissioner of Internal Revenue to change certain methods of accounting, generally applies to a change in the recovery period of property for which depreciation is determined under section 168 or former section 168).

[27] In the present case, the depreciation method, recovery period, and convention are changed for the cost of the depreciable property that is reclassified under section 168(e) from 7-year property (section 1245 property) to nonresidential real property (section 1250 property). Taxpayer's method of computing depreciation for this property on its original returns affects when, not whether, the cost of the property will be deducted By treating the property as 7-year property, Taxpayer was computing depreciation for the property by using the 200-percent declining balance method, a 7-year recovery period, and a half-year convention. If Taxpayer had treated the property as nonresidential real property, Taxpayer would have computed the depreciation by using the straight-line method, a 31.5- year recovery period, and a mid-month convention. Under either method of computing depreciation, Taxpayer is entitled to the same amount of depreciation deductions. Consequently, Taxpayer's computation of depreciation for the cost of the property that is incorrectly treated as 7-year property on Taxpayer's original returns affects the timing of deductions. Thus, the change in depreciation method, recovery period, and convention for the cost of the property resulting from the re-allocation of such cost from 7-year property to nonresidential real property is a change in method of accounting.

[28] Moreover, in this case, none of the exceptions in Rev. Rul. 72-491 or under section 1.446-1(e)(2)(ii)(b) apply. The change in depreciation method, recovery period, and convention is not made by the Service in the first taxable year for which Taxpayer used such methods of accounting for depreciation and is not due to a change in underlying facts.

[29] Taxpayer makes two arguments in support of its position that the re-allocation of basis is not a change in method of accounting. First, Taxpayer argues that the issue is whether the property is depreciable property or nondepreciable property, or whether the property is 7-year property or nonresidential real property under section 168(e), instead of when the basis of such property should be recovered. Thus, the issue is one of "characterization" and not a method of accounting issue. Taxpayer cites Coulter Electronics, Inc. v. Commissioner, T.C. Memo. 1990-186 (59 TCM (CCH) 350), aff'd without published opinion 943 F.2d 1318 (11th Cir. 1991), and Saline Sewer Co. v. Commissioner, T.C. Memo. 1992-236 (63 TCM (CCH) 2832).

[30] In Coulter, the taxpayer supplied equipment to customers and treated the transactions as sales on its original returns. The taxpayer also transferred the receivables arising from those transactions to a bank and treated the transfers on its original returns as sales of the receivables. Subsequently, the taxpayer took the position that the transactions with its customers were leases and that the transfers to the bank were pledges of the leases to the bank as security for loans. The Service contested the recharacterization of the transfers to the bank and argued that the taxpayer had thereby made an unauthorized change in method of accounting. The court rejected the Service's position stating:

[31] The court further explained that "[a]lthough there is a timing consequence to the outcome of the characterization, it is automatically determined by the characterization and no change of accounting within the meaning of section 446 is involved." Id. at 365.

[32] In Saline Sewer, the taxpayer received fees from its customers during the years 1976 through 1983 and treated them as nontaxable contributions to capital under section 118. In the notice of final S corporation administrative adjustment for taxable years 1984 and 1985, the Service recharacterized the fees as taxable customer connection fees. The Service argued that the recharacterization of the fees is a change in method of accounting because taxpayer reported the fees as a reduction to the depreciable basis of assets thereby reducing the taxpayer's depreciation expense over the life of the underlying assets and increasing the taxpayer's taxable income dollar-for-dollar by the amount at issue. The court rejected the Service's position on the rationale that the issue is whether the fees are taxable income instead of when the fees are included in taxable income. 63 TCM (CCH) at 2834.

[33] The Service, however, has rejected the argument that the accounting method provisions, including section 446(e), are inoperative whenever an issue involves characterization. Section 2.01(3) of Rev. Proc. 97-27 states that a change in the characterization of an item may constitute a change in method of accounting if the change has the effect of shifting income from one period to another. Thus, a change in characterization that does not permanently affect net income but only its timing is a change in method of accounting.

[34] The Service's position in Rev. Proc. 97-27 is supported by the regulations and case law under section 446(e). Section 1.446- 1(e)(2)(ii)(b) excludes from the accounting method rules only those characterization issues that permanently affect net income. As examples of these issues, the regulations mention: (1) whether payments are deductible interest or salary rather than nondeductible dividends; and (2) whether payments are deductible business expenses rather than nondeductible personal expenses. Moreover, the case law confirms that a change in characterization that does not permanently affect net income but only its timing is a change in accounting method. See Diebold, Inc. v. United States, 891 F.2d 1579, 1583 (Fed.Cir. 1989), cert. denied, 498 U.S. 823 (1990) (a change from nondepreciable inventory to depreciable property is a change in method of accounting); Pacific Enterprises v. Commissioner, 101 T.C. 1 (1993) (a change from "working gas" (inventory) to "cushion gas" (capital asset) is a change in method of accounting); Standard Oil Co. (Indiana) v. Commissioner, 77 T.C. 349 (1981) (Issue 3) (a change in depreciation method resulting from a change from section 1250 property to section 1245 property is a change in method of accounting).

[35] Finally, Taxpayer argues that the re-allocation of basis among depreciable and nondepreciable assets, or among section 1245 property and section 1250 property, is similar to a purchase price adjustment and, thus, is not a change in method of accounting. Taxpayer cites Spencer v. Commission, 110 T.C. 62 (1998), and section 1.168-2(d)(3) of the proposed regulations under former section 168. ("proposed ACRS regulations").

[36] In Spencer, the Service and the taxpayer agreed to re- allocate the purchase price of contract rights acquired in 1987 and 1990 from amortizable property to nonamortizable property but they disagreed as to how to compute the allowable amortization deduction under section 167 for taxable years after 1990. The Service argued that the amortizable basis is the redetermined unadjusted basis of the property less the amortization actually claimed by the taxpayer before 1991, and the taxpayer argued that the amortizable basis is the redetermined unadjusted basis of the property without reduction for amortization claimed before 1991. The court accepted the Service's position by holding that when the original amortizable basis is redetermined, the redetermined unrecovered cost reduced by the greater of amortization previously allowed or allowable, less salvage value (if any), should be spread over the remaining useful life to arrive at the correct annual amortization allowance for subsequent years. The court explained that "[t]his reallocation, and the resulting corrected amortizable bases, is similar to a purchase price reduction that will affect the calculation of the amount of amortization to be deducted in subsequent taxable years." 110 T.C. at 90. The court further concluded that the method of computing depreciation when the useful life of depreciable property is changed "should apply where a property's basis for amortization is redetermined." 110 T.C. at 92. Because a change in useful life is not a change in method of accounting pursuant to section 1.446- 1(e)(2)(ii)(b) (see discussion below under "Change in Recovery Period"), Taxpayer concludes that a re-allocation of basis also is not a change in method of accounting.

[37] Spencer does not support Taxpayer's position. The court did not address the issue of whether the re-allocation of basis among amortizable and nonamortizable assets poses an accounting method issue. Further, the Service did not raise that issue.

[38] Taxpayer also argues that section 1.168-2(d)(3) of the proposed ACRS regulations supports the position that a re-allocation of basis is not a change in method of accounting. We disagree. These proposed ACRS regulations describe how to compute depreciation under former section 168 (ACRS) for the taxable year (and subsequent taxable years) in which the unadjusted basis of depreciable property is redetermined. The proposed ACRS regulations do not address the issue of whether a change in method of accounting occurs when there is a re-allocation of basis among tangible assets. Further, the examples in the proposed ACRS regulations indicate that these regulations, if adopted, were intended to apply to a situation in which the basis of depreciable property is correct in the first year under the facts existing at the end of that year but is subsequently adjusted due to a change in the underlying facts. This situation is not the one in this case. Here, the examining agent determined, and Taxpayer agreed, that the original allocation of basis was incorrect.

[40] Section 1.446-1(e)(2)(ii)(b) does not support Taxpayer's position. These regulations do not address the issue of whether a change in recovery period is a change in method of accounting. While both "recovery period" and "useful life" are used to determine the period of time over which the basis of depreciable property is recovered, "recovery period" and "useful life" are not synonymous terms. Pursuant to section 1.167(a)-1(b), the estimated useful life of property is the period over which the property may reasonably expected to be useful to a taxpayer in its trade or business or in the production of its income. In contrast, the recovery period of property is a prescribed period that is assigned to each class of property under section 168(e) and, consequently, may or may not reflect the period over which the property may be useful to the taxpayer in its trade or business or in the production of income.

[41] As previously stated, a change in recovery period affects the timing of the depreciation deductions. As originally allocated, the basis of the property was to be recovered over 7 years. The re- allocation results in the recovery of the basis of the property over 31.5 years. Under either treatment, Taxpayer is entitled to the same amount of depreciation deductions. Thus, a change in recovery period is a change in method of accounting.

[42] Even if a court held that the useful life provision in section 1.446-1(e)(2)(ii)(b) applies to a change in recovery period, the change in computing depreciation for the cost of the property that is incorrectly treated as 7-year property on Taxpayer's original returns does not result in only a change in recovery period. Instead, this change results in a change in depreciation method and a change in convention in addition to a change in recovery period. As previously stated, a change in depreciation method or convention is a change in method of accounting. Moreover, under section 446(e) (and former section 167(e)) and section 1.446-1(e)(2)(ii)(b), a taxpayer who changes, at the same time, the depreciation method and useful life of property for which depreciation is determined under section 167 is still required to obtain the consent of the Commissioner before changing the depreciation method.

ISSUE #3: COMPUTATION OF DEPRECIABLE BASIS

[43] The remaining issue is how to compute the depreciable basis of the property as of the beginning of the year of change (January 1, 1993). The service argues that because a change in method of accounting occurs in the present case, the depreciable basis of the property at the beginning of the year of change is the property's redetermined unadjusted basis less the depreciation deductions that would have been allowable for the property in the taxable years before the year of change determined as though the redetermined unadjusted basis had been used since the placed-in-service date of the property. Taxpayer argues that the depreciable basis of the property at the beginning of the year of change is the property's redetermined unadjusted basis less the depreciation actually claimed by Taxpayer for the property in the taxable years before 1993. The resolution of this issue depends upon the effect of the section 481(a) adjustment on the computation of depreciable basis.

[44] Section 167(c) determines the depreciable basis of property for which depreciation is determined under section 168. Section 167(c)(1) provides that in general, the basis on which depreciation is allowed in respect of any property is the adjusted basis provided in section 1011, for the purpose of determining the gain on the sale or other disposition of this property. Pursuant to section 1011(a), the adjusted basis for determining the gain or loss from the sale or other disposition of property generally is the basis determined under section 1012 (cost) adjusted as provided in section 1016. Section 1016(a)(2) provides that the basis of property is adjusted by the amount of depreciation, amortization, and depletion allowed as deductions in computing taxable income and resulting in a reduction for any taxable year of the taxpayer's taxes, but not less than the amount allowable for the property. Accordingly, the depreciable basis of property at the beginning of any taxable year generally is its cost reduced by the greater of depreciation previously allowed or allowable. See sections 6.03, 6.04, and 6.05 of Rev. Proc. 87-57, 1987-2 C.B. at 692.

[45] When a change in method of accounting occurs, the new method of accounting is treated as though it had been always used and not merely used prospectively. See section 2.05(1) of Rev. Proc. 97-27, 1997-1 C.B. at 682; GCM 36234 (April 7, 1975. Also, section 481(a) applies Section 481(a) requires the taxpayer to take into account those adjustments necessary solely by reason of the method change to prevent the duplication or omission of deductions in any prior taxable year, regardless whether open or closed under the statute of limitations. See Graff Chevrolet Co. v. Campbell, 343 F.2d 568 (5th Cir. 1965).

[46] If there is a change in method of accounting for depreciation involving property for which a taxpayer claimed less than or more than the depreciation allowable for taxable years before the year of change, the omitted depreciation or excess depreciation from such taxable years is taken into account through a section 481(a) adjustment. Section 2.01(3)(b) of the APPENDIX of Rev. Proc. 97-37, 1997-33 I.R.B. at 31. The section 481(a) adjustment, in effect, adjusts the amount of the depreciation previously allowed thereby resulting in a depreciable basis of the property at the beginning of the year of change equal to the adjusted basis that the property would have had if that property had been accounted for in accordance with the new method since its placed-in-service date. See Rev. Rul. 67-379, 1967-2 C.B. 127; Rev. Rul. 70-318, 1970-1 C.B. 113.

[47] For example, assume that in 1998, the Service re-allocates the purchase price of property that was placed-in-service in 1994 among depreciable and nondepreciable assets and, as a result, the basis of the depreciable asset is changed from $10x to $8x. Based on the $10x basis, the taxpayer deducted depreciation of $4x for the 1904-1997. taxable years. If the basis had been $8x, the depreciation deductions for such years would have been $3x. The net positive section 481(a) adjustment (an increase to taxable income) as of January 1, 1998, is $1x ($4x depreciation allowed less $3x depreciation allowable). This adjustment, in effect, reduces the $4x depreciation allowed to the $3x depreciation allowable and, consequently, the depreciable basis of the property as of January 1, 1998, is $5x ($8x redetermined unadjusted basis less ($4x depreciation allowed before 1998 less $1x section 481(a) adjustment)).

[48] In the present case, we have concluded that a change in method of accounting occurs. Further, in the taxable years before the year of change (1993), Taxpayer deducted more than the depreciation allowable for the building and machinery. Thus, an adjustment under 481(a) is necessary to prevent the duplication of depreciation for these assets under the new method. The net 481(a) adjustment will equal the difference between (1) the total amount of depreciation that would have been allowable for the property for the taxable years before the year of change had the redetermined unadjusted basis been used since the placed-in-service date of the property, and (2) the total amount of depreciation actually deducted for the property on Taxpayer's returns for the taxable years before the year of change. This 481(a) adjustment also will adjust the depreciable basis of the property as of the beginning of the year of change so that the depreciable basis is equal to the adjusted basis that the property would have had as though that property had been accounted for in accordance with the new method since the placed-in-service date of the property.

[50] As previously stated, the court in Spencer accepted the Service's position by holding that when the original amortizable basis is redetermined, the redetermined unrecovered cost reduced by the greater of amortization previously allowed or allowable, less salvage value (if any), should be spread over the remaining useful life to arrive at the correct annual amortization allowance for subsequent years. See Computing & Software, Inc. v. Commissioner, 65 T.C. 1153 (1976) (on a re-allocation of basis from amortizable to nonamortizable property, the redetermined unadjusted cost of the amortizable property is reduced by the greater of amortization allowed or allowable). The court reached this holding by applying the method of computing depreciation when the useful life of depreciable property is changed to a situation in which a property's basis for amortization is redetermined. 110 T.C. at 92. A change in useful life does not modify depreciation claimed in prior years but is corrected by adjustments in the current and future years. See section 1.446-1 (e)(2)(ii)(b); Kilgroe v. United States, 664 F.2d 1168 (10th Cir. 1981); Cohn v. United States, 259 F.2d 371, 377-378 (6th Cir. 1958). Similarly, when the basis of depreciable property is redetermined, depreciation for the year of redetermination is computed under section 1.168-2(d)(3) of the proposed ACRS regulations based on the redetermined unadjusted basis reduced by the greater of depreciation previously allowed or allowable without modifying the depreciation previously allowed. Consequently, under Spencer and section 1.168- 2(d)(3) of the proposed ACRS regulations, the redetermined unadjusted basis is used only prospectively and is not treated as though it had been always used since the property's placed-in-service date and, thus, the depreciable basis of the property at the beginning of the year of the re-allocation is the property's redetermined unadjusted basis reduced by the greater of depreciation allowed or allowable in prior taxable years without modifying such allowed depreciation.

[51] Although Taxpayer's argument is the same one made by the Service in Spencer, Spencer and section 1.168-2(d)(3) of the proposed ACRS regulations do not support Taxpayer"s position for the same reasons previously stated. Neither the court in Spencer nor these proposed ACRS regulations address the issue of whether the re- allocation of basis among depreciable (amortizable) property and nondepreciable (nonamortizable) property, or among section 1245 property and section 1250 property, poses an accounting method issue and, thus, the effect of the section 481(a) adjustment on the depreciable basis of the property. Further, the Service did not raise that issue in Spencer. Moreover, the examples in section 1.168- 2(d)(3) of the proposed ACRS regulations indicate that these regulations, if adopted, were intended to apply to a situation in which the basis of depreciable property is correct in the first year under the facts existing at the end of that year but is subsequently adjusted due to a change in the underlying facts, which is not the situation in this case.

[52] Taxpayer also argues that if a change in method of accounting occurs in the present case, section 1.167(e)-l(b) and (d), and section 2.02(4)(a) and (5) of the APPENDIX of Rev. Proc. 97-37, support its position that the depreciable basis of the Property is its redetermined unadjusted basis less the depreciation previously claimed by Taxpayer. Section 1.167(e)-l(b) and (d) provide that the unrecovered cost or other basis is recovered over the remaining estimated useful life when a change from a declining balance method to the straight line method is made. Similarly, section 2.02(4)(a) and (5) of the APPENDIX of Rev. Proc. 97-37 provide that there is not any section 481(a) adjustment for a change in method of accounting for depreciation under section 167 because the depreciable basis of the property at the beginning of the year of change is the property's adjusted basis, as determined under section 1011, at the end of the year immediately preceding the year of change. Accordingly, Taxpayer concludes that it is the Service's long-standing position not to impose a section 481(a) adjustment for a change in method of accounting for depreciation but to determine the depreciable basis of the property as of the beginning of the year of change as equal to its redetermined unadjusted basis less the depreciation previously claimed.

[53] We disagree. Section 1.167(e)-1(b) and (d), and section 2.02 of the APPENDIX of Rev. Proc. 97-37, do not apply in the present case. Section 1.167(e)-1(b) and section 2.02 of the APPENDIX of Rev. Proc. 97-37 apply when a taxpayer is changing from a permissible method to another permissible method of accounting for depreciation. This situation is not the one in the present case. Here, Taxpayer is changing from an impermissible method of computing depreciation (200- percent declining balance method, 7-year recovery period, and a half- year convention) to a permissible method of computing depreciation (straight-line method, 31.5 year recovery period, and a mid-month convention), for the portion of the cost of the depreciable property that is reclassified to nonresidential real property. Further, section 1.167(e)-1(d) does not apply in the present case because the period prescribed by such regulation for making the election to change from a declining-balance method to the straight-line method for section 1250 property has expired. Moreover, for changes in methods of accounting from an impermissible to a permissible method of accounting for depreciation, we have exercised our discretion under section 446(e) to impose a section 481(a) adjustment. See section 2.01(3)(b) of APPENDIX of Rev. Proc. 97-37, 1997-33 I.R.B.at 31.

[57] If you have any questions on this matter, please call Kathy Reed at (202) 622-3040.