Partial Asset Disposition

May 10, 2024

Introduction  

Welcome to the fourth and final post in our exclusive series on navigating the Tangible Property Regulations. If you’re ready to jump right in, read on.  

If you need a brief refresher, take a moment to review posts on expensing options, the BAR Test, and Materiality and UoP.   

When someone makes an improvement to real estate, incurring a certain expenditure, the TPRs are the guide that determine how the expenditure should be treated. Ask the following crucial questions, in the following critical order, using our TPR Flowchart for reference:  

    • Can this be expensed under one of the three safe harbor elections established under the TPRs?

If it can, end of story.   

If the expenditure CANNOT be expensed under a safe harbor… 

    • Is this expenditure considered an improvement under the BAR Test? 

If this expenditure is indeed a Betterment OR an Adaptation, OR a Restoration, it must be capitalized.   

If the expenditure is NOT considered a Betterment, Adaptation or Restoration… 

    • Is the value of the expenditure material to its Unit of Property or material at the discrete function level?  

If the expenditure is not material to its UoP, it may be expensed. If it is material to its UoP, it must be capitalized. 

Partial Asset Disposition 

Let’s say you’ve followed the Flowchart, you’ve asked the questions, and it turns out your expenditure must be capitalized. Is that it?  Game over?   

The TPRs offer a method to get additional value out of this very scenario.  There’s no getting around capitalization of the new asset, but you can do something about the asset that was replaced. Partial Asset Disposition (PAD) Elections permit the immediate write-off of the remaining depreciable basis of an asset that was replaced or removed from service. You don’t have to keep retired or replaced assets on your books for years, watching the clock tick down. By using a PAD election in the year the asset was removed, you can take it off the books immediately.   

Consider the classic roof example. If you replaced a roof before the TPRs, you would capitalize the cost of the new roof and then depreciate it over the usual class life (39-year for commercial property.)  Most taxpayers would also continue depreciating the old roof which had been replaced. It wasn’t unusual to see two roofs on the books simultaneously.  

However, under the TPRs, the taxpayer can immediately write-off the remaining depreciable basis of the old roof, recognizing a loss in that amount. This results in benefits now and later:    

    • Lowers total income, taxable income, and tax burden immediately.  
    • Removes accumulated depreciation from the fixed asset schedule, reducing the amount of recapture in the event of a future sale. By reducing amounts to be recaptured, the disposition election in essence establishes a tax rate arbitrage, allowing taxpayers to use normal capital gains treatment under Sec. 1250. 

An additional bonus of the PAD election comes in the form of deductible removal costs. It costs money to remove all those old shingles and any bad wood.  The TPRs allow for the deduction of these costs on top of the deduction of the remaining depreciable basis of the old roof. (Note that removal costs related to demolition are covered under Sec. 280B and are addressed differently.) 

Determining the Basis of Disposed Assets

PAD Elections have tremendous implications for tax savings. Writing off the remaining depreciable basis of that old rotting roof would be great. But there’s one big question – how do you know how much to write-off?  What quantifiable value remains in that old roof?    

The IRS’ Audit Technique Guide on Tangible Property defines three acceptable methods by which the unadjusted basis of the replaced asset may be determined:   

  1. Pro-Rata Allocation based on the replacement cost of the disposed asset and the replacement costs of all assets in the pool.
  1. Producer Price Index (PPI) Method: The Producer Price Index for Finished Goods (or Producer Price Index Final Demand) can be used to discount the cost of a replacement asset to its placed-in-service year cost. 
  1. Cost Segregation: A thorough high-quality study will break out all components of the property – including those that will be replaced.  All assets will be assigned an accurate cost – including those that will be replaced. Determining the remaining depreciable basis left on that replaced roof is then a straightforward calculation based on the number of years the asset has been in service. 

Note the importance of performing a study before assets are removed, to document their presence on site, and support the PAD election later.    

The Role of Cost Segregation  

In the Cost Segregation Audit Technique Guideline, the IRS says that the engineering-based approach used in a cost segregation study is “the most methodical and accurate approach… and generally provides the most accurate cost allocations.”     

With their unique focus on breaking out costs, cost segregation studies are the ideal way to generate the data required to justify PAD elections. Every time an improvement is capitalized, there is potential for additional disposition. A properly performed study is crucial for taxpayers who want to see as much benefit from the TPRs as possible. 

In 2019 the IRS announced a PAD Election Compliance Initiative, explaining that they will be training agents in a 5-step process to review PAD Elections. Auditors will be:   

    • Determining if a partial disposition of a building occurred, 
    • Identifying the disposed portion of the building, 
    • Identifying the partially disposed asset and its placed-in-service date, 
    • Determining the disposed portion’s adjusted basis, and 
    • Reducing the adjusted basis of the asset 

The IRS will be looking at PAD Elections closely. This is yet another reason to ensure that your cost segregation study is performed by a quality third-party provider.  

_______________  

It’s crucial to consider all potential strategies to fully maximize tax savings. The Capstan team is here to help you develop a comprehensive plan that incorporates strategies old and new. Let’s make the most of all the opportunities the TPRs offer – together.  

Safe Harbors in a Storm TPR Expensing Options

When someone makes an improvement to real estate, incurring a certain expenditure, the TPRs are the guide that determine how the expenditure should be treated.

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