In September, 2013, the Treasury issued two sets of tax regulations which will have a critical impact on the taxation of all owners of commercial or rental real estate. The first set, effective beginning in 2014, provides new standards as to when costs incurred in connection with buildings can be currently deducted as a repair, or must be capitalized as an improvement and deducted over the useful life of the building, either 39 years for non-residential real estate or 27.5 years for residential real estate. The second set of regulations, which is still proposed and is expected to go final some time during 2014, relates to the rules concerning depreciation of real estate assets, and contains a new rule which potentially provides a significant benefit for building owners—the so called “partial disposition election”.
It is this new provision, which reverses a long-standing policy of the Internal Revenue Service (IRS) which is the focus of this article. A recent IRS pronouncement allows owners, for a limited time, to make this election retroactively, so quick action is needed to take advantage of this tax-saving opportunity.
Prior to these new regulations, the law provided that an owner of a building who disposed of or replaced a component of the building could not take a loss for the remaining undepreciated cost of the asset replaced unless the entire building was sold. For example, assume a building owner replaced the roof on a building in 1990 at a cost of $400,000. Under the depreciation rules, the owner would recover this cost over the useful life of the building. If we assume, for simplicity, that the useful life is 40 years and straight-line depreciation was being used, this means that the owner would take a $10,000 tax deduction each year against his income. Now assume that, due to normal wear and tear, in 2010 the same owner had to tear out the roof installed in 1990 and replace it with a new roof at a cost of $500,000. Again, this cost would be depreciated straight line over 40 years, so the owner would take a tax deduction of $12,500 each year. In 2010, one half, or $200,000, of the cost of the 1990 roof has yet to be depreciated. Under prior law, the building owner was required to continue depreciating this $200,000 over the remaining 20 years of the original useful life ($10,000 per year). In effect, the owner had two roofs on its books for one building, and had to depreciate both.
If the second roof replacement had occurred in 2014 or later, the new regulations would now allow the owner to recognize the loss on the replacement of the old roof in the year of replacement, to the extent that there remain costs that have not yet been depreciated. This is accomplished by making a “partial disposition” election on a timely filed return, including extensions. In our example, this election would allow the owner to write off in full the remaining basis attributable to the first (1990) roof in the year it was disposed. If the owner does not have accurate records to determine this amount, for example where the owner purchased the building and did not separately allocate a portion of the purchase price to the replaced component, the new regulations allow taxpayers to use any reasonable method to determine the undepreciated cost, and give two examples of what would constitute a reasonable method. First, the owner could hire an engineer to do a “cost segregation” study to estimate the cost attributable to the disposed asset. Second, the taxpayer can take the replacement cost of the new asset (in our case, the second roof) and discount it back to the year the disposed asset was first placed in service (1990 in our example) using the consumer price index. The resulting amount would then be adjusted for any depreciation actually claimed on the disposed asset to determine the deductible loss.
The partial disposition election is also available to a landlord who renovates space for a tenant. To the extent that portions of the leased space are replaced or removed, the landlord may write-off remaining costs. While prior law allowed a landlord to take this loss upon the termination of an existing lease, the new partial disposition election will have a broader application.
The result of this rule is a potentially significant acceleration of deductions, which is a valuable tax benefit. And there is some icing on this cake; the new repair regulations provide that, if the partial disposition election is made, the cost of removing the old asset may also be deducted in the year of disposition. Under prior law, if the replacement costs were required to be capitalized, these demolition costs also were capitalized. So the “partial disposition” election can be doubly beneficial to the owner—the immediate deduction of the remaining cost of the replaced asset and the immediate deduction of the costs to remove that asset.
If the election is made, the replacement costs for the new asset must be capitalized. In most cases, such costs are required to be capitalized even if the election were not made, so this not a sacrifice. However, there could be situations where the replacement costs (as well as the removal costs incurred as part of the replacement) might be deductible as a repair; in these cases, the taxpayer will have to measure the benefits of the immediate deduction allowed by the partial disposition election against the benefit of taking an immediate deduction for the replacement costs but continuing to depreciate the cost of the replaced asset.
As noted above, the regulations providing for the election are expected to be finalized in 2014, and will be effective going forward. In addition, the Internal Revenue Service has published a Revenue Procedure allowing a limited window to make a late partial disposition election for dispositions in earlier years. Real estate owners who have not already consulted their tax advisors should do so now, since the time to take advantage of this considerable additional benefit is short, and gathering the necessary information should begin immediately.
Marc Ausfresser is a Berdon LLP principal with more than 20 years of experience in tax planning, research, and consulting. He has expertise in planning the organization of business entities, including real estate organizations, to minimize taxes and maximize financial return. Berdon LLP is a full service CPA and advisory firm, ranked among the nation’s largest, with offices in New York City and Jericho, Long Island.
This article was updated on September 2, 2014 from the version published on August 20, 2014.
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