Rev. Rul. 70-166

Advice has been requested whether, under the circumstances described below, a taxpayer (a railroad company) must, for Federal income tax purposes, continue to (1) credit ordinary income with the amount of the salvage proceeds realized for one account, and (2) credit estimated salvage value, or actual salvage proceeds if less than estimated salvage value, to the depreciation reserve, with any excess of salvage proceeds over estimated salvage value credited to ordinary income for a second account (from its normal retirement sales of freight train cars depreciated in its two average rate multiple asset accounts, that are not fully depreciated), or whether it can recognize gains and losses under the provisions of section 1231 of the Code, for such sales in 1968.

The taxpayer accounted for its freight train cars in several multiple asset depreciation accounts, two of which were depreciated under the straight line method using rates based upon the average estimated useful life of the assets in the accounts (average rate multiple asset accounts). The assets in these two accounts had not been depreciated to estimated salvage value (that is, the accounts were not fully depreciated). During the taxable year 1968 the taxpayer retired by sale from these two accounts many of its freight train cars that had been held for more than six months. Some of the retirements were normal and some were abnormal within the meaning of section 1.167(a)-8(b) of the Income Tax Regulations. Prior to 1968, the taxpayer accounted for the salvage proceeds realized from its normal retirements from one of the two accounts by crediting ordinary income with the amount of such proceeds. For the second of these two accounts, the taxpayer credited the estimated salvage value (that used in determining the depreciation deductions), or actual salvage proceeds if less than estimated salvage value, to the depreciation reserve, with any excess of actual salvage proceeds over estimated salvage value credited to ordinary income. These two practices clearly reflected the taxpayer's income. Gains and losses were determined and recognized on abnormal retirements. However, in 1968, the taxpayer determined and recognized gains and losses on its normal retirement sales, claiming that such gains and losses were subject to the provisions of section 1231 of the Internal Revenue Code of 1954.

Section 1.167(a)-7(b) and section 1.167(a)-8 of the regulations provide the general accounting rules for normal retirement sales of depreciable property from multiple asset accounts. In general the asset account is credited with the full cost of the asset retired and the depreciation reserve is charged with the same amount. The regulations provide three accounting practices that may be used to account for the salvage proceeds realized from such a normal retirement sale. These are: (1) crediting the depreciation reserve (see section 1.167(a)-7(b) and section 1.167(a)-8(e)(2) of the regulations), (2) recognizing gain or loss (see section 1.167(a)-8(a)(1) and section 1.167(a)-8(c)(1) of the regulations), and (3) crediting ordinary income (see section 1.167(a)-8(e)(2) of the regulations).

Where the practice of crediting ordinary income is used, ordinary income is credited with the salvage proceeds realized on the sale of the normally retired assets, and gains and losses are not recognized on such retirements. Prior to 1968 the taxpayer used this practice for one of the two accounts, but for the second account a practice was used that combined the provisions of section 1.167(a)-8(c)(1) and section 1.167(a)-8(e)(2) of the regulations. Under this latter practice, estimated salvage value (that used in determining the depreciation deductions), or actual salvage proceeds if less than estimated salvage value, was credited to the depreciation reserve with any excess of actual salvage proceeds over estimated salvage value credited to ordinary income.

Under the practice where gains and losses are recognized, the depreciation reserve is credited with the estimated salvage value of the assets retired (that used in determining the depreciation deductions), and gains or losses are determined by computing the difference between such estimated salvage value (as the adjusted basis) and the salvage proceeds realized on the sale of the normally retired assets.

Section 1.167(a)-8(a)(1) of the regulations provides that where an asset is retired by sale, recognition of gain or loss will be subject to, among other provisions, section 1231 of the Code. Section 1231(a) of the Code provides that if, during the taxable year, the recognized gains on sales or exchanges of property used in the trade or business, plus the recognized gains from the involuntary conversion of property used in the trade or business and capital assets held for more than six months, exceed the recognized losses from such sales, exchanges, and involuntary conversions, such gains and losses shall be considered as long-term capital gains and losses. If such gains do not exceed such losses, such gains and losses shall be considered as ordinary gains and losses.

The provisions of section 1231 of the Code are applicable to normal retirements from multiple asset accounts where gains and losses are recognized. However, gain on such a retirement is not treated under the provisions of section 1231 of the Code to the extent that the provisions of section 1245 of the Code are applicable.

The accounting treatment of retirements is a method of accounting within the meaning of section 446 of the Code. See section 446(c)(3) of the Code. Thus, as in this case, a change from the practice of crediting ordinary income (including the combination method of crediting the depreciation reserve with estimated salvage value, or actual salvage proceeds if less, with any excess of salvage proceeds over estimated salvage value credited to ordinary income) with the salvage proceeds realized on normal retirement sales to the practice of computing and recognizing gains and losses on such sales, is a change in method of accounting requiring the consent of the Commissioner. Section 446(e) of the Code and section 1.446-1(e)(2)(i) of the regulations.

Accordingly it is held that, in the instant case, the taxpayer must continue to account for its normal retirements of freight train cars from its two average rate multiple asset accounts in accordance with its method of accounting by (1) crediting ordinary income with the amount of the salvage proceeds realized for the one account, and (2) crediting estimated salvage value, or actual salvage proceeds if less than estimated salvage value, to the depreciation reserve, with any excess of salvage proceeds over estimated salvage value credited to ordinary income for the second account, so long as these practices clearly reflect income. If in the future the taxpayer wishes to change its accounting method to that of recognizing gains and losses, it may make such change by complying with the requirements of Revenue Procedure 67-40, C.B. 1967-2, 674, which provides an administrative procedure for expeditiously obtaining consent to change, among other things, the accounting treatment of salvage proceeds from normal retirements. If such a change is made, gains and losses on normal retirements would be governed by the provisions of section 1231 of the Code except to the extent that the provisions of section 1245 of the Code are applicable to the gains on such retirements.

The accounting and income tax treatment of abnormal retirements from an average rate multiple asset account is described in Revenue Ruling 70-167, below.