How to Calculate Partial Dispositions of Assets for Tax Purposes

Partial Dispositions Can Save You Money in a Few Ways

A team of workers installing a new roof on a building.
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Andy Sacks / Getty Images

Certain improvements, restorations, or adaptations to property can provide you with a tax opportunity to do a partial disposition of the old property and capitalize the new property. There are many ways to assess the change in value of the property when this happens, and it is important to learn how to make this calculation so that you don't miss out on the many other tax advantages that may be available to you.

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.

One way the IRS uses to figure out the value of a piece of property is through its cost basis. This is the original amount you paid for the property, with adjustments factored in for depreciation or other gains or losses.

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:

  1. Measure the cost of the replacement property.
  2. Using this cost, work backward to measure the historical cost of the original property.
  3. Determine the rate of change.
  4. Discount the present-day cost back to its historical cost using the rate of change. 
  5. Segregate basis and depreciation.
  6. Dispose of the partial asset, and calculate gain or loss.
  7. Capitalize and begin depreciating the new asset.

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 asset
  • Doing a cost segregation study
  • Using 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.

You can't use the Producer Price Index discount method for improvements, betterments, or adaptations. It's only intended for restorations.

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)

Year Jan. Feb. Mar. Apr. May June
2016 109.7 109.6 109.7 110.0 111.2 110.8
2017 111.6 111.8 112.1 112.7 112.7 112.9
2018 114.5 114.9 115.4 115.7 116.2 116.6
2019 116.7 117.1 117.7 118.5 118.6 118.5
2020 119.0 118.4 118.1 116.7 117.3 117.7
2021 120.9 121.9 123.0 124.3 125.5 126.6
2022 132.6(P)
Year July Aug. Sept. Oct. Nov.  Dec.
2016 110.8 110.5 110.6 111.0 110.8 111.0
2017 113.0 113.2 113.5 114.1 114.1 113.8
2018 116.8 116.6 116.6 117.6 117.1 116.8
2019 118.7 118.8 118.3 118.8 118.3 118.4
2020 118.4 118.5 118.7 119.5 119.3 119.4
2021 127.8 128.8 129.1 130.1(P) 131.0(P) 131.1(P)

Table 2: Producer Price Index—Commodities Finished Goods (WPUSOP3000)

Year Jan. Feb. Mar. Apr. May June
2016 189.9 188.8 189.2 190.3 191.7 193.8
2017 195.4 196.0 196.3 198.0 197.0 197.8
2018 201.0 201.3 202.1 202.8 205.0 205.9
2019 201.8 202.4 204.9 207.1 207.6 206.9
2020 206.8 205.0 201.8 196.1 200.9 202.2
2021 207.6 210.1 213.8 215.1 218.4 221.8
2022 233.0(P)
Year July Aug. Sept. Oct. Nov. Dec.
2016 193.5 192.6 193.2 193.7 192.4 193.7
2017 197.6 198.4 199.6 199.4 200.4 199.9
2018 206.0 205.8 205.9 206.7 204.4 202.5
2019 207.4 206.4 205.7 206.3 206.4 206.0
2020 203.3 203.2 203.3 203.8 203.8 204.4
2021 223.5 225.0 227.2 230.0(P) 231.0(P) 229.2(P)

If you see (P) next to an index, it means it's "preliminary." All indexes are subject to revision four months after original publication.

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:

Index at placed-in-service date for the restoration 119.4 December 2020
Index at placed-in-service date for the original component 110.6 September 2016
Percentage change between the two indices 0.079566 = (119.4-110.6)/110.6
Express this as a percentage. 7.9566%  

Using the PPI-Commodities Final Demand, the rate of change (R) is equal to 6.96%.

Do the same thing with the PPI-Commodities Finished Goods (Table 2).

Index at placed-in-service date for the restoration. 204.4 December 2020
Index at placed-in-service date for the original component. 193.2 September 2016
Percentage change between the two indices. 0.0579710 = (204.4-193.2)/193.2
Express this as a percentage. 5.7971%  

Using the PPI-Commodities Finished Goods, the rate of change (R) is equal to 6.83%.

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) = $12,000
  • Rate 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%

Asset Unadjusted basis Prior depreciation
Original building $250,000 $20,833
After segregation:    
Building (less old roof) $238,885 $19,907
Old roof $11,115 $926
New roof $12,000 n/a

Segregating Basis and Depreciation if You Use RFG = 5.80%

Asset Unadjusted basis Prior depreciation
Original building $250,000 $20,833
After segregation:    
Building (less old roof) $238,658 $19,888
Old roof $11,342 $945
New roof $12,000 n/a

The basis and depreciation figures for the building, less the old roof plus the new roof, add up to the figures for the original building. $238,658 + $11,342 = $250,000 for the basis, and, similarly, $19,888 + $945 = $20,833 for the prior depreciation.

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:

Gross proceeds   -0- Materials were scrapped
Cost basis of component 11,115    
Less prior depreciation (926)    
Less current depreciation -0-   Assume zero
Adjusted basis  
$10,189
 
Gain or loss   ($10,189)  

And if if R = RFG = 11,342:

Gross proceeds   -0- Materials were scrapped
Cost basis of component 11,342    
Less prior depreciation (915)    
Less current depreciation -0-   Assume zero
Adjusted basis   $10,427  
Gain or loss   ($10,427)  

Look at the two results. Depending on which method you choose for the discount rate (R), you have a loss of either of $10,189, using the Final Demand index or of $10,427, using the Finished Goods index. The loss of $10,427 is marginally better. 

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.

Frequently Asked Questions

Partial disposition confuses me. Does the IRS offer resources to make the process easier?

When your tax situation calls for including depreciation of assets, calculations can become quite confusing, especially if you have multiple capital assets involved. If you need to calculate partial dispositions, it will be a part of a larger gain or loss you claim, and so the relevant IRS form will be the most useful way to tackle the issue. IRS Publication 523, for example, has worksheets to help you calculate the sale of your home, with sections to guide you through partial dispositions.

How does the IRS verify the figures I use to claim loss or depreciation on my property?

As you make improvements to your home, keep receipts and all records of work done. When filing your taxes, you will need to provide figures about the cost basis, and they can be backed-up by demonstrating all of the money you have invested into property. Depreciation is determined by outside factors, so you do not need to prove it. When you claim a loss, the amount of this loss will depend on how your cost basis has depreciated.

Article Sources

  1. Internal Revenue Service. "Publication 946, How to Depreciate Property."

  2. BLS Data Labs. "PPI Consumer Index - Commodity Data for Final Demand." Sort for 2016-2022, 1-month net change.

  3. BLS Data. "PPI Commodity Data for Final Demand - Finished Goods." Sort for 2016-2022, 1-month net change.