By Lindsey Ottum, Withum
Back in 2013, the IRS released the final tangible property regulations, which provided guidance on the application of 162(a) and 263(a) of the Internal Revenue Code. These regulations apply to any corporation, S corporation, partnership, LLC, or individual who files a Schedule C, E, or F and acquires, produces, or improves tangible real or personal property.
The regulations include a partial asset disposition election that allows and sometimes requires that a taxpayer partially dispose of a MACRS asset(post-1986) and report the gain, loss, or other deduction in the year of the disposition. MACRS stands for modified accelerated cost recovery system and is the depreciation system that is currently used in the United States for real and personal property. According to regulation section § 1.168(i)-8, if any of the following situations has occurred, a taxpayer is required to recognize a partial disposition:
• Sale of a portion of a MACRS asset
• Involuntary conversion of a portion of a MACRS asset
• Like-kind exchange of a portion of a MACRS asset
The good news is that this election most often results in a loss, and it is reported on Form 4797. This election is most commonly used for buildings, making it a common occurrence within the real estate industry.
The facts and circumstances of each situation must be examined in order to determine the asset portion disposed of. The structural components of a building, including buildings that contain multiple units, and are original to the building, are all considered to be one asset. After the original building is placed in service, any additional work, such as improvements or additions to the building, are considered to be separate assets. The first step is determining if the improvement work being done is significant to the unit of property. If so, a portion of the original building can be disposed of once the new asset is placed in service.
The next step is to determine the adjusted basis of the asset being disposed of. This requires the unadjusted basis of the entire asset, which is typically its original cost, but if the original cost is unknown, it can be determined by using any of the following methods:
• Cost-segregation study
• Using the producer price index (PPI)
• Pro rata allocation of the unadjusted depreciable basis based on the replacement cost of the disposed portion of the asset and the replacement cost of the asset
The unadjusted basis is then decreased by the greater of the depreciation allowed or allowable, resulting in the adjusted basis, which is the net book value of the portion of the original asset being disposed. There will now be two assets on the taxpayer’s books: the asset portion being disposed of and the asset portion remaining.
An example is as follows: Taxpayer purchases a property and places it in service. The purchase price of the asset is allocated between land and building, and no further delineation is done because the taxpayer did not elect to have a cost segregation study prepared to further allocate the assets. Three years later, the taxpayer replaces the entire roof, including shingles, sheathing, etc. This asset is required to be capitalized under the tangible property regulations. However, when the cost of the new roof is placed on the books, there are technically two of the same assets now on the books. The taxpayer should implement “the rule of one”, meaning that there should only be one roof on the books. Therefore, a partial asset disposition of the original building’s purchase price should be calculated using the producer price index, and a loss recorded. At this point, only one roof will remain on the books.
There may be many different situations in which a partial disposition can be beneficial or is required. When questioning whether this election applies to you, keep note of any restoration-related work. Examples of potentially capitalizable work include replacing an HVAC, repairing a roof, resurfacing a parking lot, replacing lighting, doors, or windows, and other renovations. Please consult with your tax adviser for more information regarding your specific situation and to find out more information about how you can take advantage of this election.
Lindsey Ottum is a Tax Supervisor in the Real Estate Industry at Withum.