Businesses face increasing challenges from ever-expanding tax regulation complexities. It’s exciting, then, when tax professionals like us can dig deep within such challenges and uncover money-saving opportunities for our clients. One opportunity in particular has recently emerged, and we at Skoda Minotti think it merits serious consideration by real estate businesses of nearly any size.
This opportunity emanates from the recent introduction of the tangible property regulations (aka, “repair regs.”) These regs represent one of the most profound tax law changes in the past 30 years, and one area in particular that deserves special attention is the partial asset disposition election. We believe this election can save many companies and individuals substantial tax dollars when it comes time for filing tax returns for building owners.
The New Partial Asset Disposition Rules
Under the old rule, building components would continue to be depreciated, even after the components were replaced. But since 2014, the IRS allows taxpayers to write off parts of their buildings as they are replaced or remodeled. For example, this could include tearing off a roof or renovating a building—but only with approved documentation detailing the cost basis of those replaced components.
Specifically, Reg. Sec. 1.168(i)-8(d)(2) allows a taxpayer to elect to write off the portion of a building component that has been disposed or replaced. The regulation states that the taxpayer must make the election by the due date – including extensions – in the year in which the portion of an asset is disposed.
Implications of the New Rules
Making a partial asset disposition election brings about two things: First, the taxpayer making the election writes off the remaining depreciable basis of that portion of the building component. This new tax write-off can be significant and save building owners material income tax dollars. Second, the taxpayer also writes off future Sec. 1245 or 1250 gain.
It’s important to note that Sec. 1250 requires a taxpayer to recapture accumulated depreciation when that taxpayer recognizes gain on the sale of these assets defined under Sec. 1245 or 1250. In particular, Sec. 1250 applies a special capital gains rate of 25%, and the maximum tax rate for normal capital gains is 20%. Accordingly, the partial asset disposition election establishes a tax rate arbitrage; it does this by allowing taxpayers to reduce recapture amounts and use normal capital gains treatment.
As a result, taxpayers who reside in the 25% ordinary bracket, as well as those further up the chain, will realize a tax savings of at least five percentage points on the disposed accumulated depreciation. This can represent a significant savings for many people.
The Problem with Partial Asset Disposition—and the Solution
Unfortunately, the partial asset disposition election may be getting ignored by practitioners and their clients, primarily because determining the adjusted cost basis of the replaced building components has been viewed as too complex.
The solution: A cost segregation study. Cost segregation is the process of separating the costs of tangible personal property, other tangible property, indirect costs and land improvements from building and improvement costs for income tax purposes. Segregated costs are generally deducted over a five-year, seven-year and 15-year recovery period, instead of a 27- or 39-year recovery period. Personal property assets found in a cost segregation study generally include items that are affixed to the building but do not relate to the overall operation and maintenance of the building—specifically, a building’s non-structural elements, exterior land improvements and indirect construction costs.
The cost segregation approach is an engineering based approach. To quote the IRS, an engineering based approach “… is the most methodical and accurate approach…and generally provides the most accurate cost allocations.”
In essence, a cost segregation study allows a taxpayer to write off building components more quickly and realize tax benefits more quickly. Therefore, a cost segregation study, prepared by a qualified practitioner and its engineers, can provide an immediate increase in cash flow, and it can deliver concrete value for years – even decades into the future – by supporting the write-off of the remaining cost basis of the replaced building component.
If you’d like to discuss the partial asset disposition or cost segregation studies in more detail, please contact Roger Gingerich, CPA, ABV, CVA, CCA at 440-449-6800 or firstname.lastname@example.org. Discover how our Real Estate and Construction group can help you your real estate business save on taxes.