SECTION 9. AFSI — Internal Revenue Bulletin 2023-40

FOR SECTION 168 PROPERTY

.01 Purpose . The Treasury Department and the IRS intend to propose rules in forthcoming proposed regulations consistent with the interim guidance provided in this section 9, which provides Taxpayers with additional clarity in determining AFSI adjustments for Section 168 Property (as defined in section 4.02(5) of Notice 2023-7) prior to forthcoming proposed regulations.

.02 Modifications and clarifications to Notice 2023-7. This section 9.02 modifies and clarifies certain provisions in section 4 of Notice 2023-7. Taxpayers that choose to rely on the interim guidance in section 4 of Notice 2023-7 on or after September 12, 2023, must apply the guidance in section 4 of Notice 2023-7, as modified and clarified by this notice.

(1) Adjustments for accounting method changes . If a Taxpayer changes its method of accounting for depreciation for any item of Section 168 Property for Regular Tax purposes, the Taxpayer must adjust AFSI to reflect the adjustment required under § 481(a) for such change to prevent depreciation from being duplicated or omitted under § 56A(c)(13). Section 9.02(5) and (6) of this notice modifies and clarifies sections 4.02 and 4.03 of Notice 2023-7 to take into account this § 481(a) adjustment. Section 9.02(8) of this notice modifies and clarifies section 4.08 of Notice 2023-7 to provide an example of this rule.

(2) Adjustments for Tax Depreciation capitalized and subsequently deducted . If a Taxpayer capitalizes Tax Depreciation, as defined in section 4.02(7) of Notice 2023-7, and recovers the amount capitalized through one or more deductions allowed in computing taxable income, AFSI is reduced by such deductions, even if such deductions are allowed under a provision of the Code other than § 167. For example, if a Taxpayer capitalizes and amortizes Tax Depreciation under § 174(a)(2), AFSI is reduced by the amortization deductions allowed under § 174 in computing taxable income. Section 9.02(5) and (6) of this notice modifies and clarifies sections 4.02 and 4.03 of Notice 2023-7 to take into account the deductions described in this section 9.02(2).

(3) Adjustments for Tax Depreciation capitalized to non-inventory property held for sale . If a Taxpayer capitalizes Tax Depreciation to property described in § 1221(a)(1) that is not inventory and recovers the amount capitalized as part of the computation of gain or loss from the sale or exchange of such property in computing taxable income, AFSI is reduced by such amount. Section 9.02(5) and (6) of this notice modifies and clarifies sections 4.02 and 4.03 of Notice 2023-7 to take into account the amounts described in this section 9.02(3).

(4) Adjustments related to disposi- tions of Section 168 Property that occur for AFS purposes before they occur for Regular Tax purposes . If a Taxpayer takes a disposition loss, including an abandonment loss, into account in its FSI with respect to Section 168 Property for a taxable year that is earlier than the taxable year in which the disposition event occurs for Regular Tax purposes, the Taxpayer must adjust AFSI for such earlier taxable year to disregard the disposition loss included in its FSI for that taxable year. The Taxpayer must wait until the taxable year in which the disposition event occurs for Regular Tax purposes to take the disposition loss (as redetermined under section 4.07 of Notice 2023-7, as modified by this notice) into account for AFSI purposes. Section 9.02(5) and (6) of this notice modifies and clarifies sections 4.02 and 4.03 of Notice 2023-7 to reflect this adjustment. Additionally, section 9.02(7) of this notice modifies section 4.07 of Notice 2023-7 to clarify that the rules in such section apply in the taxable year in which Section 168 Property is disposed of for Regular Tax purposes. Section 9.02(7) of this notice also modifies and clarifies section 4.07 of Notice 2023-7 to provide additional rules regarding adjustments to the AFS basis of Section 168 Property for purposes of redetermining the FSI gain or loss from the disposition of such property. Finally, section 9.02(8) of this notice modifies and clarifies the example in section 4.08 of Notice 2023-7 to illustrate these rules.

(5) Modifications to section 4.02 of Notice 2023-7 . In accordance with sections 9.02(1) through (4) of this notice, section 4.02 of Notice 2023-7 is modified and clarified to read as follows:

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.02 Defined Terms . For purposes of this section 4:

(1) Covered Book COGS Depreciation . The term Covered Book COGS Depreciation means depreciation expense, disposition loss (including from an abandonment) that occurs prior to the taxable year in which the disposition occurs for regular tax purposes, impairment loss, or impairment loss reversal that is taken into account as cost of goods sold (or as part of the computation of gain or loss from the sale or exchange of other property held for sale) in the net income or loss set forth on the taxpayer’s AFS with respect to Section 168 Property (as defined in section 4.02(5) of this notice).

(2) Covered Book Depreciation Expense . The term Covered Book Depreciation Expense means depreciation expense, disposition loss (including from an abandonment) that occurs prior to the taxable year in which the disposition occurs for regular tax purposes, impairment loss, or impairment loss reversal other than Covered Book COGS Depreciation that is taken into account in the net income or loss set forth on the taxpayer’s AFS with respect to Section 168 Property.

(3) Covered Book Expense . The term Covered Book Expense means an amount, other than Covered Book COGS Depreciation and Covered Book Depreciation Expense, that is- (a) recognized as an expense or loss in the net income or loss set forth on the taxpayer’s AFS, and

(b) reflected in the unadjusted depreciable basis, as defined in § 1.168(b)-1(a) (3), of Section 168 Property for purposes of the regular tax liability, as defined in § 26(b) (Regular Tax). (4) Deductible Tax Depreciation . The term Deductible Tax Depreciation means Tax Depreciation (as defined in section 4.02(7) of this notice) that is allowed as a deduction in computing taxable income, including Tax Depreciation that is capitalized and subsequently allowed as a deduction in computing taxable income (even if such deduction is allowed under a provision of the Code other than § 167).

(5) Section 168 Property . The term Section 168 Property means property to which § 168 applies, as described in section 4.04 of this notice.

(6) Tax COGS Depreciation . The term Tax COGS Depreciation means Tax Depreciation that is capitalized to inventory under § 263A and recovered as part of cost of goods sold in computing gross income, and Tax Depreciation that is capitalized to property described in § 1221(a) (1) that is not inventory and recovered as part of the computation of gain or loss from the sale or exchange of such property in computing taxable income.

(7) Tax Depreciation . The term Tax Depreciation means depreciation deductions allowed under § 167, with respect to Section 168 Property.

(8) Tax Depreciation Section 481(a) Adjustment . The term Tax Depreciation Section 481(a) Adjustment means those adjustments that are required under § 481(a) for a change in method of accounting for depreciation for any item of Section 168 Property.

(6) Modifications to section 4.03 of Notice 2023-7 . In accordance with section 9.02(1) through (4) of this notice, section 4.03 of Notice 2023-7 is modified and clarified to read as follows:

.03 Adjustments for Depreciation (Including Depreciation Capitalized to Inventory) . For purposes of § 56A(c)(13), AFSI is- (1) reduced by Tax COGS Depreciation, but only to the extent of the amount recovered: (a) as part of cost of goods sold in computing taxable income for the taxable year, or (b) as part of the computation of gain or loss from the sale or exchange of non-inventory property described in § 1221(a)(1) that is included in taxable income, or deducted in computing taxable income, respectively, for the taxable year, as applicable,

(2) reduced by Deductible Tax Depreciation, but only to the extent of the amount allowed as a deduction in computing taxable income for the taxable year,

(3) adjusted to disregard Covered Book COGS Depreciation, Covered Book Depreciation Expense, and Covered Book Expense,

(4) reduced by any Tax Depreciation Section 481(a) Adjustment that is negative, but only to the extent of the amount of such Tax Depreciation Section 481(a) Adjustment that is taken into account in computing taxable income for the taxable year,

(5) increased by any Tax Depreciation Section 481(a) Adjustment that is positive, but only to the extent of the amount of such Tax Depreciation Section 481(a) Adjustment that is taken into account in computing taxable income for the taxable year, and

(6) adjusted for other items as provided in regulations or other guidance.

(7) Modifications to section 4.07 of Notice 2023-7 . In accordance with section 9.02(1) and (4) through (6) of this notice, section 4.07 of Notice 2023-7 is modified and clarified to read as follows:

.07 AFSI adjustments for dispositions . If a taxpayer disposes of Section 168 Property for Regular Tax purposes, the taxpayer must adjust AFSI for the taxable year in which such disposition occurs to redetermine any gain or loss taken into account in the net income or loss set forth on the taxpayer’s AFS with respect to such disposition for such year (including a gain or loss of zero) by adjusting the remaining AFS basis of such property by the amounts described in sections 4.07(1) through (4) of this notice with respect to such property, including those amounts attributable to taxable years prior to the effective date of the CAMT. For purposes of the preceding sentence, the remaining AFS basis of such property is- (1) decreased by the full amount of Tax Depreciation with respect to such property (regardless of whether any amount of such Tax Depreciation was capitalized and not yet taken into account as a reduction to AFSI through an adjustment described in sections 4.03(1) or (2) of this notice),

(2) increased by the cumulative adjustments described in section 4.03(3) of this notice with respect to such property,

(3) increased by the full amount of any Tax Depreciation Section 481(a) Adjustment with respect to such property that is positive and decreased by the full amount of any Tax Depreciation Section 481(a) Adjustment with respect to such property that is negative (regardless of whether any portion of such Tax Depreciation Section 481(a) Adjustment has yet to be taken into account in AFSI through an adjustment described in sections 4.03(4) or (5) of this notice), and

(4) increased or decreased, as appropriate, by any other adjustments to AFS basis required under § 56A, regulations,

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or other guidance with respect to such property (for example, AFS basis adjustments required under section 3.03(2) of this notice).

(8) Modifications to section 4.08 of Notice 2023-7 . In accordance with section 9.02(1) and (4) through (6) of this notice, section 4.08 of Notice 2023-7 is modified and clarified to read as follows:

.08 Examples . The following examples illustrate certain rules set forth in section 4 of this notice. (1) Example 1 – Section 481(a) adjustment . (a) Facts . X is an Applicable Corporation for the calendar year ending December 31, 2023. X timely files a Form 3115, Application for Change in Accounting Method, under Rev. Proc. 201513, 2015-5 I.R.B. 419, for the calendar year ending December 31, 2023, to change its method of accounting for depreciation for an item of Section 168 Property, and the Secretary consents to the change. The adjustment required under § 481(a) to implement such change is positive because the total amount of depreciation taken by X with respect to the Section 168 Property under its present method was $1,000x greater than the total amount of depreciation allowable under the new method of accounting. X takes the $1,000x net positive § 481(a) adjustment into account in computing taxable income ratably over the § 481(a) adjustment period of 4 taxable years, beginning with the year of change (2023 through 2026).

(b) Analysis for taxable years 2023 through 2026 . Pursuant to section 9.02(1) of this notice, X must take the $1,000x net positive Tax Depreciation Section 481(a) Adjustment into account in determining AFSI under § 56A(c)(13) for taxable years 2023 through 2026. Because the adjustment is positive, X would increase AFSI by $250x each year.

(2) Example 2 – Property placed in service prior to 2023 and disposition adjustments .

(a) Facts . Taxpayer is an Applicable Corporation for the calendar year ending December 31, 2023. On January 1, 2018, Taxpayer purchased and placed in service Property A, which is Section 168 Property, at a cost of $1,000x. Property A qualified for, and Taxpayer claimed, the 100-percent additional first year depreciation deduction allowable under § 168(k) for its taxable year ending December 31, 2018. For AFS purposes, Taxpayer depreciates Property A over 40 years on a straight-line method and recognizes $25x ($1,000x cost / 40 years) of Covered Book Depreciation Expense in 2018 and each year thereafter until it sells Property A (a disposition for Regular Tax and AFS purposes) on January 1, 2024, for $900x. For 2024, Taxpayer takes into account $50x of net gain for the sale of Property A in the net income or loss set forth on its AFS ($900x proceeds - $850x of AFS basis ($1,000x cost - $150x accumulated Covered Book Depreciation Expense as of January 1, 2024)).

(b) Analysis for taxable year 2023 . In determining AFSI for the taxable year ending December 31, 2023, Taxpayer does not have any Deductible Tax Depreciation or Tax COGS Depreciation in computing taxable income with respect to Property

A, and thus, the adjustments under section 4.03(1) and (2) of this notice would be zero. In addition, Taxpayer would adjust AFSI under section 4.03(3) of this notice to disregard the $25x of Covered Book Depreciation Expense with respect to Property A.

(c) Analysis for taxable year 2024 . To determine the AFSI adjustment for the gain or loss from the sale of Property A under section 4.07 of this notice, Taxpayer must adjust the remaining AFS basis of such property by the amounts described in section 4.07(1) through (4) of this notice with respect to such property, including those amounts attributable to taxable years prior to the effective date of the CAMT. Accordingly, the redetermined basis of Property A for AFSI purposes is zero ($850x remaining AFS basis + $150x accumulated Covered Book Depreciation Expense - $1,000x of accumulated Tax Depreciation). Thus, the redetermined gain on the sale of Property A for AFSI purposes is $900x ($900x proceeds - $0 redetermined AFSI basis), and a positive adjustment to AFSI of $850x ($900x redetermined gain - $50x net gain set forth on the AFS) is made to reflect the redetermined gain.

.03 Other AFSI rules for Section 168 Property .

(1) Section 56A(c)(13) does not apply to property not depreciated under §§ 167 and 168 . If a Taxpayer owns property that is not subject to depreciation under §§ 167 and 168 for Regular Tax purposes (for example, because the Taxpayer is not subject to U.S. taxation), then AFSI of that Taxpayer is not adjusted under § 56A(c)(13) with respect to such property. Further, the rules for determining Applicable Corporation status of members of a FPMG in § 59(k)(2)(A), including the rule that disregards the AFSI adjustment described in § 56A(c)(4), do not change this result.

(2) Amounts recognized in FSI for the disposition of Section 168 Property . Section 5.02(3)(b) of this notice provides that except as otherwise provided in § 56A or § 59(k) (as applicable), regulations, or other guidance, AFSI includes all items of income, expense, gain, and loss reflected in the Taxpayer’s FSI regardless of whether such amounts are realized, recognized, or otherwise taken into account for Regular Tax purposes. Section 56A(c)(13) does not provide for an adjustment to AFSI to apply nonrecognition or gain deferral provisions that apply to certain dispositions of Section 168 Property for Regular Tax purposes (for example, like-kind exchanges under § 1031 or installment sales under § 453). However, other provisions under § 56A or guidance issued by the Treasury Department and the IRS may provide for such an adjustment in certain

situations (for example, see section 3 of Notice 2023-7, which provides an adjustment to AFSI if Section 168 Property was disposed of in a Covered Nonrecognition Transaction). Accordingly, except as otherwise provided in other provisions under § 56A, regulations, or other guidance, if a Taxpayer disposes of Section 168 Property for Regular Tax purposes and recognizes gain or loss from the disposition in its FSI, such gain or loss (as redetermined under section 4.07 of Notice 2023-7, as modified and clarified by this notice) is recognized for AFSI purposes, regardless of whether any gain or loss with respect to such disposition is realized, recognized, or otherwise taken into account for Regular Tax purposes.

(3) Examples . The following examples illustrate the rules set forth in sections 5.02(3)(b) and 9.03(2) of this notice and the application of § 56A(c)(13) in taxable years following a transaction described in section 9.03(2) of this notice.

(a) Example of installment sale under § 453 . (i) Facts . X is a calendar year Taxpayer and also issues its AFS on a calendar year basis. On January 1, 2018, X purchased for $550x and placed in service residential rental property (Real Property A), which is Section 168 Property. For Regular Tax purposes, X depreciates Real Property A under the general depreciation system by using the straight-line method and a 27.5-year recovery period. X becomes an Applicable Corporation for the calendar year ending December 31, 2024. On January 1, 2024, X sells Real Property A to Y, an unrelated Taxpayer, for $1,000x with the following payment structure: $100x payable at closing and the remainder payable in equal annual installments over the next 9 years, together with adequate stated interest. As of the date of the installment sale, X’s adjusted basis for Regular Tax purposes, remaining AFS basis, and redetermined basis for AFSI purposes (as determined under section 4.07 of Notice 2023-7, as modified and clarified by this notice) for Real Property A is $430x. X does not elect out of the installment method under § 453. The gross profit to be realized on the sale is $570x ($1,000x selling price - $430x basis). The gross profit percentage is 57% (gross profit of $570x / $1,000x contract price). No provision in § 56A, regulations, or other guidance provides for an adjustment to AFSI to apply the gain deferral rules under § 453.

(ii) Analysis . For taxable year 2024, X realizes $570x ($1,000x selling price - $430x basis) of gain for both Regular Tax and FSI purposes from the disposition of Real Property A in the installment sale. X recognizes $570x of the gain in FSI, but for Regular Tax purposes, X recognizes only $57x (57% of $100x) of the gain and the remaining $513x of gain will be recognized as payments are received under the installment method. Pursuant to section 9.03(2) of this notice, the gain deferral provisions in § 453 do not apply for purposes of determining the AFSI gain or loss on the disposition of Real Property A.

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Accordingly, X must recognize the entire $570x gain in AFSI, notwithstanding that $513x was deferred under § 453 for Regular Tax purposes.

(b) Example of like-kind exchange under § 1031 . (i) Facts . The facts are the same as section 9.03(3)(a)(i) of this notice, except that on January 1, 2024, X transfers Real Property A to Y in exchange for Real Property B with a fair market value of $440x and $20x in cash. The exchange qualifies as an exchange of real property held for productive use or investment under § 1031. As of the date of the exchange, X’s adjusted basis for Regular Tax purposes, remaining AFS basis, and redetermined basis for AFSI purposes (as determined under section 4.07 of Notice 2023-7, as modified and clarified by this notice) for Real Property A is $430x. No provision in § 56A, regulations, or other guidance provides for an adjustment to AFSI to apply the nonrecognition rules under § 1031.

(ii) Analysis . For taxable year 2024, X realizes $30x of gain under § 1001(a) (amount realized of $460x [$440x fair market value of replacement Real Property B plus $20x cash], less $430x adjusted Regular Tax basis of relinquished property). Of the realized gain, only $20x is recognized by X under § 1031(b) for Regular Tax purposes, as this is the amount of non-like-kind consideration (cash of $20x). For AFS purposes, X recognizes $30x of gain in its FSI (amount realized of $460x [$440x fair market value of Real Property B plus $20x cash], less $430x remaining AFS basis of Real Property A). Pursuant to section 9.03(2) of this notice, the nonrecognition rules in § 1031 do not apply for purposes of determining the AFSI gain or loss on the disposition of Real Property A. Accordingly, for AFSI purposes, X must recognize the entire redetermined gain of $30x ($460x amount realized less $430x of redetermined AFSI basis under section 4.07 of Notice 2023-7, as modified and clarified by this notice) for purposes of computing AFSI, notwithstanding that X recognized only $20x of the $30x gain realized for Regular Tax purposes.

(i) Facts . The facts are the same as section 9.03(3)(b)(i) of this notice. In addition, X’s Regular Tax exchanged basis in the replacement Real Property B as of the date of the exchange is $430x ($430x adjusted Regular Tax basis of relinquished Real Property A, less $20x cash, plus $20x gain realized). X’s AFS basis of Real Property B as of the date of the exchange is $440x , which is the fair market value of Real Property B as of the date of the exchange. The recovery period, depreciation method, and convention prescribed under § 168 for Real Property B are the same as Real Property A. Under § 1.168(i)-6(c)(3)(ii) and (c)(4)(v)(A), X depreciates Real Property B over the remaining recovery period of, and using the same depreciation method and convention as that of, Real Property A for Regular Tax purposes. Except for taxable year 2024 and the taxable year in which Real Property B is disposed of, Tax Depreciation with respect to Real Property B is $20x ($430x / 21.5) for each year, which X deducts in computing taxable income. Under the mid-month convention, Real Property B is deemed placed in service on January 15, 2024. Therefore, in 2024, Tax Depreciation for

Real Property B is $19x ($20x multiplied by [11.5 / 12]), which X deducts in computing taxable income. For AFS purposes, X depreciates Real Property B using the straight-line method and a 27.5-year recovery period and recognizes $16x ($440x / 27.5) of Covered Book Depreciation Expense each year. On January 1, 2032, X sold Real Property B with a Regular Tax adjusted exchanged basis of $270x ($430x exchange basis - $160x accumulated Tax Depreciation [8 years multiplied by ($430x cost / 21.5 recovery period), which includes $20x multiplied by (11.5 / 12) of depreciation for 2024 or $19x and (0.5 / 12) of depreciation for 2032 or $1x]) and a remaining AFS basis of $312x ($440x cost

$128x accumulated book depreciation [8 years multiplied by ($440x cost / 27.5 recovery period)]) to Z for $500x in cash.

(ii) Analysis for taxable year 2032 . For Regular Tax purposes, X recognizes a gain on the sale of Real Property B of $230x (amount realized of $500x

$270x Regular Tax adjusted exchanged basis). For AFS purposes, X recognizes a gain of $188x in its FSI (amount realized of $500x - $312x remaining AFS basis). Pursuant to section 4.07 of Notice 2023-7 (as modified and clarified by this notice), X must adjust AFSI for taxable year 2032 to redetermine the AFS gain or loss of $188x from the disposition of Real Property B by adjusting the remaining AFS basis of Real Property B to take into account the amounts described in section 4.07(1) through (4) of Notice 2023-7 (as modified and clarified by this notice) with respect to such property, including those amounts attributable to taxable years prior to the effective date of the CAMT. Accordingly, the redetermined basis of Real Property B for AFSI purposes is $280x ($312x AFS basis + $128x accumulated Covered Book Depreciation Expense - $160x of accumulated Tax Depreciation). Thus, the redetermined gain on the sale of Real Property B for AFSI purposes is $220x ($500x proceeds - $280x redetermined AFSI basis).