Dispose of the Old, and Capitalize the New
Suppose you’ve replaced the roof on your rental property. The old roof is no more, but the cost of that old roof was included in the cost of the whole building, and you’ve been depreciating for tax purposes since you first bought it. You paid one price for the property when you bought it, and that was for the land and the building. The roof was definitely part of the building, so the cost of the old roof is being depreciated over 27 1/2 years (if it’s residential property) or 39 years (if it’s commercial real estate). You must therefore extract the cost of the old roof from the cost of the building, dispose of it, and capitalize and begin depreciating the new one.
What Are the Benefits?
You’ve disposed of the old roof—it no longer exists—but since you aren’t selling it, there are no gross proceeds. The gain on the disposition will therefore be zero proceeds minus the remaining cost basis, which means you have a loss. That’s a negative income number that reduces your total income, adjusted gross income, and taxable income. When losses decrease income, they do so for purposes of measuring passive activity losses, the net investment income tax, the additional Medicare tax, the alternative minimum tax, and a whole range of other income-sensitive calculations. Then, there’s the accumulated depreciation. You remove both the cost and the accumulated depreciation from the original asset when you dispose of a partial asset. You get a currently deductible loss right now, and you have less depreciation to recapture if and when the property is sold in the future.
How to Calculate a Partial Distribution
The basic process of a partial distribution works out like this:
An Example
Suppose that you bought the property and rented it out on September 1, 2016. The cost of the building, not including the cost of the land, was $250,000. You would have realized $20,833 in depreciation by December 31, 2018. Now you replace the roof. The new roof is in place there on the building on December 1, 2020. The cost of the new roof was $12,000.
Separate the Original Cost
You can separate the original cost of the roof using “any reasonable method,” according to the IRS. The method must consistently apply to all portions of the same asset. Reasonable methods include:
Using the Producer Price Index discount method (for restorations only)Allocating the cost of the original asset based on a ratio of the replacement cost of the partial disposition to the replacement cost of the whole assetDoing a cost segregation studyUsing your tax records
The first method, discounting, is like compounding for interest but in reverse. The method is the most objective of the officially sanctioned methods outlined in Treasury Regulations. You can use either the Producer Price Index for Finished Goods or the Producer Price Index for Final Demand. Both can be found on the Bureau of Labor Statistics website. The second method is to take the replacement cost of the component and divide it by the replacement cost for the whole asset. This results in a ratio that is then multiplied by the original cost of the whole asset. The third method involves hiring a professional to conduct a cost-segregation study. The fourth method is for that ambitious taxpayer who actually built the asset and can use their own records to determine the cost of each component.
Using the Discount Method With Price Indexes
This is how the two data sets apply to our roof example from above. Table 1: Producer Price Index—Commodities Final Demand (WPUFD4)
Finding the Discount Rate
The rental house was originally placed in service on September 1, 2016. The indices for that date appear in bold. The roof was placed in service on December 1, 2020. Likewise, the indices for that date appear in bold. Now find the percentage change between the two indices starting with the PPI-Commodities Final Demand (Table 1). The math goes like this: Do the same thing with the PPI-Commodities Finished Goods (Table 2). The IRS allows you to use either method, so now you must figure out which would be most reasonable.
Using the Rate of Change
You can calculate the discount in either of two mathematically equivalent ways. Divide the replacement cost by 1+R, or multiply the replacement cost by the PPI for the month it was originally placed in service, then divide by the PPI for the months it was replaced. Both should result in the same answer. The first method works out like this:
Replacement cost (RC) = $12,000Rate of change (R) is either RFD = 7.96% or RFG = 5.80%
Out of the entire original cost of the building—$250,000—$11,115 or $11,342 of that is allocated to the original roof. We base this on taking the actual cost to replace the roof—$12,000—and discounting this cost back by using each of two measures of the Producer Price Index.
Segregate Basis and Depreciation
The goal here is to separate the original asset and its depreciation into two assets so you can dispose of one and keep the other. Segregating Basis and Depreciation if You Use RFD = 7.96% You haven’t lost any basis or any depreciation. You’ve merely split the original amount into two separate assets.
Depreciation Figures
You can find the depreciation figures in two ways as well. The first is:
Divide the historical cost of the old roof by the total original cost to get a percentage.Then, multiply that by the original depreciation figures to find the depreciation attributed to the replaced component.
The second simply involves calculating depreciation for the building, less the old roof, and for the new roof. Using the first method, you get $945.16 of depreciation attributed to the old roof. You get $945 of depreciation attributed to the old roof using the second. They both result in the same answer: approximately $945.
Calculate Gain or Loss on the Partial Disposition
Here are the results if R = RFD = 11,115:
Putting It All Altogether
Not only did you get a loss of $10,427 on your Form 1040, but this also reduced your income for the passive activity loss limitations, which increases how much of a passive loss you can deduct this year. Therefore, this increased passive activity loss further reduced your income. You can expect the tax savings from a partial disposition to be $10,427 x 24% = $2,502 if you’re in the 24% tax bracket, but because you lowered your income enough to take more passive activity losses, the actual tax savings would work out to be about $3,500.
