Rev. Rul. 70-165

Advice has been requested whether, under the circumstances described below, a taxpayer (a railroad company) must, for Federal income tax purposes, continue to credit depreciation reserve with the amount of the salvage proceeds realized from its normal retirement sales of freight train cars depreciated in an average rate multiple asset account (that is 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, one of which was depreciated under the straight line method using a rate based upon the average estimated useful life of the assets in the account (average rate multiple asset account). The assets in the account had not been depreciated to estimated salvage value (that is, the account was not fully depreciated). During the taxable year 1968 the taxpayer retired by sale from this account 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 the account by crediting the depreciation reserve with the amount of such proceeds. This practice 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 average rate 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 the depreciation reserve is used (the practice of the taxpayer prior to 1968), the reserve is credited with the salvage proceeds realized on the sale of the normally retired assets, and gains or losses are not recognized on such retirements.

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 and 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 the depreciation reserve 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 average rate multiple asset account in accordance with its method of accounting by crediting the depreciation reserve with the amount of the salvage proceeds realized so long as that practice clearly reflects income. If in the future the taxpayer wishes to change its accounting method from crediting the depreciation reserve with salvage proceeds 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, page 46.