How to Calculate Partial Dispositions of Assets for Tax Purposes

Partial dispositions can save you money in a few ways

Certain betterments, 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. An this can result in still other tax advantages. 

Dispose of the Old and Capitalize the New

Let's say that 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.

You paid one price for the property when you bought it, and that price was for the land and the building. The roof was definitely part of the building, so the cost of the old roof is included that cost and is being depreciated over 27.5 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 that old roof, and capitalize and begin depreciating the new one. 

What Are the Benefits? 

You've disposed of the old roof—it no longer exists—but are you selling it? No, so there are no gross proceeds from the sale. 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. And 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.

Accumulated Depreciation 

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.

You'll Have to Do Some Math

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

Let's say that you bought the property and rented it out on Sept. 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 Dec. 31, 2018.

Now you replace the roof. The new roof is placed in service—it's in place there on the building—on Nov. 1, 2019. The cost of the new roof was $12,000. 

Separate the Original Cost 

You can separate out 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. So what are reasonable methods? You have four options. 

  • Use the Producer Price Index discount method for restorations only. 
  • Allocate 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.
  • Do a cost segregation study.
  • Use your tax records.

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

Discounting is like compounding for interest, but in reverse. The discount 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 U.S. 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.

A third method is to hire a professional to conduct a cost segregation study.

Finally, a taxpayer who actually built the asset can use his own records to determine the cost of each component.

Using the Price Indexes 

This is how the two data sets apply to our example.

Table 1: Producer Price Index—Commodities Final Demand (WPUFD4)

Year Jan Feb Mar Apr May Jun
2016 103.4 104.2 105.2 105.9 106.1 106
2017 106.6 107.1 107.7 108 107.8 107.4
2018 108.3 108.8 109.1 109 108.8 109.2
2019 109.7 110.1 110.8 111 111.1 111.2
Year July Aug Sept Oct Nov  Dec
2016 106.3 106.4 106.6 106.3 106.4 106
2017 107.4 107.7 108.2 108.3 108.2 108
2018 109.5 109.5 109.4 109.7 109.4 109.3
2019 111.6 111.6 111.1 111.4 110.9(P) 110.5(P)

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

Year Jan Feb Mar Apr May Jun
2016 184.4 186.6 189.1 191.4 192.5 191.4
2017 192 192.9 194.4 194.9 193.7 192.8
2018 194.8 196.3 196.6 195.9 196.8 197.2
2019 198 198.8 200.3 202 201.8 202.8
Year July Aug Sept Oct Nov Dec
2016 192.2 191.7 192.6 191.8 191.7 191.1
2017 193.2 195.4 196.7 196.3 194.5 193.7
2018 197.2 197.9 197.3 196.9 196 196.5
2019 202.9 202.4 201.7 200.3 198.1(P) 195.6(P)

If you see (R) next to an index, it means the number has been revised. (P) 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 Sept. 1, 2016. The indices for that date appear in bold. 

The roof was placed in service on Nov. 1, 2019. 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 110.9 Nov. 2019
Index at placed-in-service date for the original component 106.6 Sept. 2016
Percentage change between the two indices 0.040337711 = (110.9-106.6)/106.6
Express this as a percentage. 4.0338%  

Using the PPI-Commodities Final Demand, the rate of change (R) is equal to 4.03%.

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

Index at placed-in-service date for the restoration 198.1 Nov. 2019
Index at placed-in-service date for the original component 192.6 Sept. 2016
Percentage change between the two indices 0.028556594 = (198.1-192.6)/192.6
Express this as a percentage. 2.85566%  

Using the PPI-Commodities Finished Goods, the rate of change (R) is equal to 2.86%.

The IRS allows you to use either method, so now you must figure out which is going to 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 = 4.03% or RFG = 2.86%

Out of the entire original cost of the building—$250,000—$11,535 or $11,666 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 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 = 4.03%

Asset Unadjusted basis Prior depreciation
Original building $250,000 $20,833
After segregation:    
Building (less old roof) $238,465 $19,872
Old roof $11,535 $961
New roof $12,000 n/a

Segregating Basis and Depreciation if You Use RFG = 2.86%

Asset Unadjusted basis Prior depreciation
Original building $250,000 $20,833
After segregation:    
Building (less old roof) $238,334 $19,861
Old roof $11,666 $972
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. $238,465 + $11,535 = $250,000 for the basis, and, similarly, $19,872 + $961 = $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 old roof and for the new roof.

Using the first method, you get $961.23 of depreciation attributed to the old roof. You get $961.24 of depreciation attributed to the old roof using the second. So they both resulted in the same answer: approximately $961. 

Calculate Gain or Loss on the Partial Disposition

Here are the results if R = RFD = 11,535:

Gross proceeds   -0- Materials were scrapped
Cost basis of component 11,535    
Less prior depreciation (961)    
Less current depreciation -0-   Assume zero
Adjusted basis  

$10,574

 
Gain or loss   ($10,574)  

And if if R = RFG = 11,666:

Gross proceeds   -0- Materials were scrapped
Cost basis of component 11,666    
Less prior depreciation (972)    
Less current depreciation -0-   Assume zero
Adjusted basis   $10,694  
Gain or loss   ($10,694)  

Look at the two results. Depending on which method you choose for the discount rate (R), you have a loss either of $10,574 using the Final Demand index or of $10,694 using the Finished Goods index. The loss of $10,694 is marginally better. 

Putting It All Altogether

Not only did you get a loss of $10,694 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. So this increased passive activity loss further reduced your income.

You can expect the tax savings from a partial disposition to be $10,694 x 24% = $2,566 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.