When a repair shop replaces a part in a car, they remove the old one. It’s no longer of any use in its current state, and it certainly isn’t left in the vehicle, bolted up next to the new one. Due to some changes in the law a few years ago, real estate owners are able to more easily take a similar approach on their taxes for portions of their buildings they replace.
Under the old regime, if a building owner replaced a leaking roof or crumbling driveway, they were required to capitalize the replacement, but usually did nothing with the old roof or driveway, leaving it in service as part of the building they purchased. In order to treat a building as separate sub-components from the start, a real estate owner would need to obtain a cost segregation study. Not inexpensive, these reports prepared by building engineers formally designate which portions of a building are separate parts. They would allow a building owner to depreciate the various building components over shorter lives than 39 or 27.5 years, accelerating depreciation deductions. However, nearly as important, they would also allow replacements of major components, such as roofs, carpet, or pavement, to constitute a disposition of the old property.
While a cost segregation study is still the only way to achieve accelerated depreciation benefits (and is often worthwhile for a large investment), several regulations changed a few years ago allowing partial dispositions upon replacement of major components. Originally part of an effort to establish when the expenditures constituted repairs or capital improvements, they opened a back door for owners to dispose portions of a building being replaced, allowing owners a limited ability to chop up their buildings for tax purposes.
The tax advantages of this are twofold. First in the year of replacement, a loss may be taken for the un-depreciated portion of the disposed property; the value of which is determined based on the original purchase price for the building. Second, when the building is sold, the disposed portion isn’t contributing to the building’s depreciation recapture, allowing more of the gain to qualify as long term capital, taxed at a lower rate.
This treatment is available to a wide variety of building sub-components, including:
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The downside to this treatment is, in order to qualify, the new replacement property has to constitute a replacement, as opposed to a repair. As such, it must be capitalized and depreciated over time, in place of being immediately deducted.
If you own a rental property, or real estate as part of your business, and you would like to discuss utilizing these opportunities please feel free to contact us for a consultation.
Written by Damien Falato, CPA, MST, CGMA, Tax Director