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On January 1, 2014, the partial disposition regulations of IRC § 168 went into effect allowing taxpayers to recognize gain or loss on the partial disposition of tangible depreciable property. Claiming this election to recognize a loss on a partial disposition of a portion of a building or its structural components has become an extremely valuable tax strategy. However, the IRS, in an effort to assure taxpayer compliance with the regulations, recently issued an updated Process Unit for the examination of a taxpayer who has made the election. This article discusses the recently released Process Unit and considers how cost segregation can help with compliance with these new guidelines.
A Common Situation Avoided by Partial Dispositions
A taxpayer constructs a commercial building in 2000, records the building as 39-year real property, and subsequently replaces the HVAC system in 2019. The replacement HVAC system is added to the taxpayer’s fixed asset register. Since the original 2000 building includes HVAC components, the taxpayer is in effect depreciating two sets of HVAC systems. A partial disposition allows the taxpayer to take an immediate loss on the disposed HVAC components rather than continuing to depreciate them over the remaining 20 years. The partial disposition accelerates the timing of tax deductions and improves cash flow. This is a common situation with lighting systems, windows, and roofs as they are often replaced before the end of their 39-year tax life due to obsolescence or deterioration.
The Basics of Partial Dispositions
Treas. Reg. 1.168(i)-8(d)(2) allows taxpayers to make an election to recognize the gain or loss on a partial disposition of MACRS property. This property includes a portion of a building and its structural components that are used in a taxpayer’s trade or business or in an income-producing activity. For example, when a taxpayer replaces and capitalizes a new roof on business property, the taxpayer may recognize a loss when the old roof is disposed of and replaced. A partial disposition election must be made on a timely filed tax return in the year that the disposition occurs. Generally, a partial disposition is considered to have occurred when the asset is sold or permanently removed from use.
In determining the unadjusted basis for an asset in a partial disposition, the regulations allow the taxpayer to use “any reasonable method.” The Process Unit discusses three options: (1) Discounting the cost of the replacement portion of the asset to its Placed in Service (PIS) year cost using the Producer Price Index (PPI), (2) Pro rata allocation of the unadjusted depreciable basis of the asset based on the replacement cost of the disposed portion of the asset and the replacement cost of the asset, and (3) conducting a cost segregation study.
New Audit Guidelines on Partial Dispositions
The new Process Unit establishes a five-step process for the examiner to follow once it has been determined that there is a risk of noncompliance with the partial disposition regulations. The five steps are:
- Determine Whether a Partial Disposition of a Building Occurred
- Identify the Disposed Portion of the Building
- Identify Which Asset is Partially Disposed of and Its Placed-in-Service (PIS) Date
- Determine the Adjusted Basis of the Disposed Portion of the Asset
- Account for the Disposed Portion (i.e., Reduce the Adjusted Basis of the Asset by the Disposed Portion)
In applying step 1, the Process Unit instructs the examiner to review and understand the taxpayer’s record-keeping requirements, dispositions in general, the connection the disposition regulations have with the Tangible Property Regulations (TPR), and instances when a partial disposition is required.
In applying step 2, the Process Unit instructs the examiner that this step relies on a facts-and-circumstances determination for each disposition and that the taxpayer must be able to substantiate the identity of the disposed portion of the building or its structural component.
In applying step 3, the Process Unit instructs the examiner to begin with the taxpayer’s books and records, however, as with Step 2, facts-and-circumstances may also be considered when depreciation schedules, or the description field on the fixed asset listings, cannot be relied upon.
In applying step 4, the Process Unit instructs the examiner to begin with the unadjusted basis of the entire asset, which is generally its cost. Further, the Process Unit instructs that the regulations allow the taxpayer to use reasonable methods to calculate unadjusted basis if the asset is contained in a Multiple Asset Account (MAA) or the disposition is of a portion of an asset and it is impracticable from the taxpayer’s records to determine the unadjusted depreciable basis of the disposed asset or portion of an asset.
In applying step 5, the Process Unit instructs the examiner how a partial disposition should be accounted for in a taxpayer’s books and records and for tax purposes and to adjust accordingly. On the first day of the taxable year of disposition: (i) the unadjusted depreciable basis of the disposed portion of the asset is moved into a Single Asset Account (SAA), (ii) the unadjusted depreciable basis of the asset is reduced by the unadjusted depreciable basis of the disposed portion, and (iii) there are now two asset accounts on the books and records – one for the disposed portion and one for the remaining asset. The taxpayer will also need to adjust the depreciation reserve on the remaining asset for prior depreciation associated with the disposed portion.
The Basics of Cost Segregation
Residential rental property is depreciated over a lengthy 27.5 years whereas commercial real estate is depreciated even longer over 39 years. IRS rules allow non-building components such as personal property and land improvements to be segregated from buildings and depreciated more rapidly, generally over 5, 7, and 15 years. This type of analysis, called a Cost Segregation, drastically improves cash flow by accelerating tax depreciation deductions that net against taxable income.
Using Cost Segregation to Establish the Unadjusted Basis for a Partial Disposition Election
While the partial disposition regulations state that any reasonable method may be used by a taxpayer in order to establish the basis of the asset in a partial disposition, under the new Process Unit guidelines, utilizing a cost segregation study may be the most robust option. In reclassifying a portion of a building or structural component for depreciation purposes, the cost segregation study is inherently establishing and utilizing a record of unadjusted basis, PIS and SAAs as described in the Process Unit that should be requested and examined by the examiner.
In preforming a proper cost segregation analysis, the taxpayer is identifying a portion of a building or a structural component thereof (step 2), establishing and having records of correct PIS dates (step 3), creating the proper record-keeping necessary to correctly enable an accurate adjusted basis of the asset (step 4), and have established SAAs for the segregated assets (step 5).
For example, in a HVAC replacement on a commercial building, a cost segregation analysis would segregate the HVAC into components such as compressors, air handlers, vents, ducts and more. Having a record-keeping of these structural components with values assigned should provide an examining agent with the necessary substantiation in order to ultimately confirm the partial disposition election was made in compliance with the regulations.
The newly issued Process Unit discussed in this article essentially places specific and more extensive requirements on taxpayers who wish to utilize the partial disposition election. This not to say that the election should be avoided in future tax years. The taxpayer and practitioners need to make themselves aware of this Process Unit and the scrutiny of the records kept related to the partial disposition election. Finally, taxpayers and practitioners should become familiar with available tax strategies, such as cost segregation, that can be utilized in anticipation of a partial disposition that inherently capture a significant number of these new requirements.