Partial Dispositions

A team of workers installing a new roof on a building.
Replaced a roof or made other substantial repairs? Think of it as an opportunity for a partial disposition. Andy Sacks / Getty Images

So you or your client replaced the roof on a rental property.

Or made some sort of repair that was a betterment, restoration or adaptation in which a significant part of the property or equipment was torn down and replaced.

What we have here is an opportunity to do a partial disposition of the old property and capitalize the new property.

We're going to tell you about the idea and the math behind partial dispositions, and give you one example to work with.

The Idea: If We Have to Replace It, We Can Dispose the Old and Capitalize the New Property

Imagine a roof. (Yes, that's one of the examples the IRS gives in its final regulations, plus it's easy for us to imagine, so that's the example we're going to stick with here.) FYI for the full text of these regulations, see T.D. 9689, Guidance Regarding Dispositions of Tangible Depreciable Property. (So far, this is the only place online to find the full text of 26 CFR 1.168(i)-8.)

So we have a client who has a rental property. The client replaces the roof. The old roof comes off and the materials are recycled or discarded. The old roof is no more, yet the cost of the roof is included in the cost of the whole building. Back when the client purchased the property, the client paid one price, and that price was for the land and building, and the roof was definitely part of the building. So the cost of the old roof is in the cost of the building, which is being carried on the client's tax return and depreciated over 27.5 or 39 years (for residential or commercial rental properties, respectively).

A partial disposition means we 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 roof. Make sense?

There's Going to Be a Lot of Math Involved

"I don't have time for math," one CPA told me at the beginning of April. Understandable.

Let's focus on the good this does our client. Are we disposing of the old roof? Yes. And are we selling that? No. So there are no gross proceeds from the sale. So the gain on the disposition will have zero proceeds minus the remaining cost basis, which means we have a loss. That's a negative income number that gets carried to the front of the 1040. And negative income numbers do what? They lower total income, lower adjusted gross income, lower taxable income, and decrease tax.

But wait there's more. Losses decrease income, and this means decreases income for the purposes of measuring passive activity losses and measuring things like the net investment income tax, the additional Medicare tax, the alternative minimum tax, and a whole range of other income-sensitive calculations. So if you don't have time to do the math, extend and do the math when you have some brain time. It will benefit the client now and in the future.

Will it benefit the client in the future? Yes, because look at the accumulated depreciation. When we dispose of a partial asset, we remove both the cost and the accumulated depreciation from the original asset. We get a currently deductible loss now. And by reducing the amount of accumulated depreciation, we have less depreciation to recapture if and when the property is sold in the future.

Never pass up an opportunity to save money twice.

The Steps in a Nutshell

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

Example

A taxpayer has a residential rental property. Here are the pertinent facts:

Taxpayer buys the house and rents it out

Placed in service date for the house:

09/01/2011

Cost of the building (not land):

$250,000

Prior depreciation (through end of 2013):

$20,833

Taxpayer replaces the roof

Roof is placed in service on

11/1/2014

Cost of the new roof:

$12,000

Step 1: Measure the Cost of the Replacement Property

This is the $12,000 for the new roof, in the example above. Where does this number come from? The client gave me all the proof of payment  and invoices for the roofers. We added up the expenses. (Now, of course, expenses rarely add up to a round figure, such as the twelve thousand above. I'm keeping my example easy to grasp.)

Step 2: Measure the Historical Cost of the Original Property

To separate out the original cost of the roof (or any other component of the building for which we want to make a partial disposition), the IRS says we can use "any reasonable method" to determine the original cost as long as the method is "consistently applied to all portions of the same asset" (Treasury Regulations 1.168(i)-8(f)(3)).

So what are reasonable methods?

  1. For restorations only, use the Producer Price Index discount method.
  2. 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.
  3. Cost segregation study.
  4. Taxpayer's records.

"Typically most commonly we see the Producer Price Index rollback method," said Phil Zaman, a certified public accountant who directs the learning programs at CBIZ & Mayer Hoffman McCann P.C.

The Producer Price Index discount method works "only for restorations," Zaman cautioned. We "cannot use it for improvements/betterments or adaptations."

"Discounting is like compounding for interest, but in reverse," Zaman explained. He also said that the discount method is the "most objective of the officially sanctioned" methods outlined in Treasury Regulations section 1.168(i)-8.

A second method, Zaman said, is to take the replacement cost of the component and divide 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 professionals to conduct a cost segregation study, which taxpayers "can do at any time," Zaman said.

Finally, taxpayers who actually built the asset can use their own records to determine the cost of each component.

Step 2A: Finding the Discount Rate Using the Producer Price Index

First, we can use either the Producer Price Index for Finished Goods or its successor, the Producer Price Index for Final Demand.

  • These indices can be found on the Bureau of Labor Statistics data web site.
  • http://www.bls.gov/data/
  • Then scroll down to where it says Prices – Producer.
  • Then under that section see where it says Commodity Data including "headline" FD-ID indexes.
  • Now look to the right and click Top Picks (the icon with the star).
  • This gives us different indices from which to pick.
  • "Generally you use either final demand or finished goods (neither seasonally adjusted)," says Zaman.
  • So either choose Final demand - WPUFD4.
  • Or choose Finished goods - WPUSOP3000.
  • The final demand index starts from November 2009 and goes forward.
  • "Finished Goods (WPUSOP3000) goes back to 1947," says Zaman.
  • "You can adjust the years that are displayed at the top of the page," Zaman points out.
  • Zaman further cautions that you might want to work with just one set of indices.

Copy the relevant PPI data and paste it into a spreadsheet.

For reference, here are the two data sets with which we need to work for our example.

Table 1. Producer Price Index – Commodities Final Demand (WPUFD4)

Year

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

2011

103.4

104.2

105.2

105.9

106.1

106

106.3

106.4

106.6

106.3

106.4

106

2012

106.6

107.1

107.7

108

107.8

107.4

107.4

107.7

108.2

108.3

108.2

108

2013

108.3

108.8

109.1

109

108.8

109.2

109.5

109.5

109.4

109.7

109.4

109.3

2014

109.7

110.1

110.8

111

111.1

111.2

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

Jul

Aug

Sep

Oct

Nov

Dec

2011

184.4

186.6

189.1

191.4

192.5

191.4

192.2

191.7

192.6

191.8

191.7

191.1

2012

192

192.9

194.4

194.9

193.7

192.8

193.2

195.4

196.7

196.3

194.5

193.7

2013

194.8

196.3

196.6

195.9

196.8

197.2

197.2

197.9

197.3

196.9

196

196.5

2014

198

198.8

200.3

202

201.8

202.8

202.9

202.4

201.7

200.3

198.1(P)

195.6(P)

Footnotes: If you see (R) next to an index, it means the number has been Revised. (P) means Preliminary. "All indexes are subject to revision four months after original publication," the BLS says.

Now we're going to find the discount rate.

The rental house was originally placed in service on September 1, 2011. We highlight in bold (above) the indices for that date.

The roof was placed in service on November 1, 2014. Likewise, we highlight in bold the indices for that date.

Here's the math part. We find the percentage change between the two indices. Let's start 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 2014

Index at placed-in-service date for the original component

106.6

Sept 2011

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, I have a rate of change (RFD) equal to 4.03%.

Let's do the same thing, this time for the PPI-Commodities Finished Goods (Table 2).

Index at placed-in-service date for the restoration

198.1

Nov 2014

Index at placed-in-service date for the original component

192.6

Sept 2011

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, I have a rate of change (RFG) equal to 2.86%.

We have now found two different discount rates (RFD and RFG). Since the IRS allows us to use any reasonable method, I need to find out which method is going to be most reasonable for my client. (We will do that in step 4, below.) Once we decide on which index to use, we'll make a note of that in the client's permanent file so that we will remember to use this same method when doing any further partial dispositions on this same rental property.

We are now done with step 2A.

Step 2B: Using the Rate of Change, Discount the Present-Day Cost Back to Its Historical Cost

There are two mathematically equivalent ways of calculating the discount.

  1. Divide the replacement cost by 1+R; or
  2. Multiply the replacement cost by the PPI for the month originally placed in service and divide by the PPI for the months it was replaced.

Both should result in the same answer. For brevity, I will show you only the first method only.

Replacement cost (RC) = $12,000

Rate of change (R) is either RFD = 4.03% or RFG = 2.86%

 

If R = RFD = 4.03%

If R = RFG = 2.86%

RC/(1+R)

12,000 / (1 + 4.03%)

12,000 / (1 + 2.86%)

 

12,000 / (104.03%)

12,000 / (102.86%)

 

11,535.1341

11666.3426

Historical cost of the original roof is

$11,535

$11,666

So what are we saying here? Out of the entire cost of the building (originally 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 one of two measures of the Producer Price Index. Which method will be better for our client? We'll figure that out in step 4.

Step 3: Segregate Basis and Depreciation

The goals here are to separate the original asset and its depreciation into two assets. That way we can dispose of one and keep the other.

I'll show you the results first, and then we'll talk through how to do it.

Segregating Basis and Depreciation if We Use RFD = 4.03%

Asset

Unadjusted basis

Prior depreciation (through end of 2013)

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 We Use RFG = 2.86%

Asset

Unadjusted basis

Prior depreciation (through end of 2013)

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

Notice: the basis and depreciation figures for the building (less old roof) plus the old roof add up the figures for the original building. (That is, 238,465 + 11,535 = 250,000 for the basis; and similarly 19,872 + 961 = 20,833 for the prior depreciation, in the chart using RFD above.)  We haven't lost any basis or any depreciation. We have merely split the original amount into two separate assets.

Why is prior depreciation through the end of 2013? Because our tax software will calculate the depreciation for 2014 once we put in the assets correctly.

How to get these numbers? The first line, relating to the original building, that comes from our tax software or from the client's depreciation schedules in their return for last year.

The basis figure for the old roof: we need that math up above. Notice the 11,535 figure for the old roof. This is RFD from above. We could also use RFG.

The basis figure for the building less roof: we took the original basis and subtracted the old roof.

The depreciation figures for the building less old roof and for the old roof: there are two methods for finding this out. There is William's method. And there is Phil Zaman's method. William's method goes like this:

  • 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.

And Zaman's method? Calculate depreciation for the building less old roof and for the old roof.

I calculated it both ways. Using my method, I got $961.23 of depreciation attributed to the old roof. Using Zaman's method, I got $961.24 of depreciation attributed to the old roof. So, after rounding, these both resulted in the same answer: $961. While my method works well because we can do the math in a spreadsheet, I do think Zaman's method is technically the accurate way to do this.

Step 4: Calculate Gain or Loss on the Partial Disposition

Here are the results, and then we'll dig into the details.

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-

 

Let's assume zero for now

Adjusted basis

 

10,574

 

Gain or loss

 

(10,574)

 

 

 

 

 

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-

 

Let's assume zero for now

Adjusted basis

 

10,694

 

Gain or loss

 

(10,694)

 

 

 

 

 

Note: I'm ignoring depreciation for the current year. Why? For our immediate purpose right now, we need to figure out which discount method will work better for our client. And this we can do in a spreadsheet program. When doing the actual gain/loss calculation, our tax software will calculate current year depreciation and put it in the right places.

Look at the two results. Depending on which method we choose for the discount rate (R), we have a loss either of $10,574 (using the Final Demand index) or of $10,694 (using the Finished Goods index). Which is going to be better for this particular client? The loss of $10,694.

I make a note in the client's file that we chose to use the PPI-Commodities Finished Goods for calculating partial dispositions on this rental property. And I now transfer the appropriate calculations (using RFG) to the tax software.

Now, let's think about what's going on. The Finished Goods Index resulted in a better outcome for this particular client. Is there a way I could have sped up the decision-making process so I didn't have to do so much math? I notice that (RFD) is 4.03% and (RFG) is 2.86%, over the relevant time frame in this example. The finished goods index, which had a lower rate of change, resulted in a larger historical basis and a larger loss. I hypothesize that whichever rate of change is lower will result in a larger historical basis, and thus a larger loss. I will continue to run the calculations both ways until I figure out if this is a true statement or not.

Let's Put This Altogether

Our client replaced the roof on his rental property. It cost $12,000 to put on that new roof. We calculated that the cost of the old roof was $11,666 by discounting the replacement cost by the Producer Price Index. In this scenario, the PPI for Finished Goods worked out to be the most advantageous discount rate. Using the historical cost, we separate out the basis and depreciation related to the old roof from the building. We keep the rest of the building on the books and depreciating as normal. We dispose of the old roof, resulting in a loss of $10,694. We add the new roof to the fixed asset section of our tax software and begin depreciating it.

How did this work out for our client? Not only did our client get a loss of $10,694 onto page one of the Form 1040, but this also reduced his income for the passive activity loss limitations, which in turn increased how much of a passive loss was deducted this year. This increased passive activity loss further reduced his income. For a client in the 28% tax bracket, we might expect the tax savings from a partial disposition to be 10,694 x 28% = $2,994. But because we lowered income enough to take more passive activity losses, the actual tax savings worked out to be about $4,000.

So if you are thinking, boy, this sure is a lot of math. Maybe putting an extra money in your client's pocket will motivate you to fire up your spreadsheet and crunch some numbers.

Further Reading on the Topics of Deducting Repairs, Partial Dispositions, and the new "Repair Regs":