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How Tax Savings Can Pay for Renovations

How Tax Savings Can Pay for Renovations
Photo Courtesy: Kevin Jerry

The Tangible Property Regulations (TPRs), mandated in 2014, represent significant tax law changes for real estate owners since 1986. Despite many CPAs taking an online course on these regulations (§263a 1-3) in 2015, a considerable number are still not leveraging the TPRs to benefit their clients, finding them too complex and risky.

The TPRs outline how expenditures, after an asset is put into service, should be treated: should they be depreciated over 27.5 or 39 years, or can they be expensed immediately? According to the regulations, if an expenditure does not enhance the asset (such as a building) or does not impact a substantial portion of similar components (less than 40% of windows, compressors, flooring, fixtures, parking lots, etc.), it must be expensed regardless of the cost.

One of the overlooked yet beneficial aspects of the TPRs is the partial asset disposition (PAD) election. This allows taxpayers to expense the portion of an asset that has been retired, with building renovations being the common example. Commercial property owners who renovate their properties are prime candidates for the PAD election. As long as the renovation is subject to depreciation, the PAD election permits a one-time expense of the value of each building component that is discarded during the renovation. The amount that can be expensed is the original cost of the disposed component minus the depreciation already taken.

This process eliminates “ghost assets,” which are assets no longer in use (or in a landfill) but still being depreciated. A critical rule to remember is that the taxpayer must make the PAD election by the tax filing due date (including extensions) for the year in which the assets were retired.

Why Are Tax Practitioners Overlooking This Opportunity?

  • Complexity in Determining Adjusted Basis: Determining the adjusted basis of the building component can be complex and often requires engineering calculations.
  • Depreciation Timing: The components may be fully depreciated in the near future or were eligible for bonus depreciation and are already fully depreciated.
  • Perceived Minimal Gain or Loss: The perceived gain or loss might not seem worth the effort and time.

Many taxpayers are missing out on the long-term benefits of making a partial asset disposition election. Even if the immediate tax savings are minimal, the long-term tax savings can be substantial. By making a PAD election, taxpayers can not only expense the adjusted basis of the asset but also eliminate future §1245 or §1250 recapture.

Recapture Rules

  • §1250 Assets: These are structural and require the taxpayer to recapture depreciation when a gain is recognized on the sale of the building, with recapture taxed at 25%.
  • §1245 Recapture: This can be as high as 37%.

Thus, the PAD election helps taxpayers reduce recapture.

Simplified Example

Consider a taxpayer who purchases a $3 million building and invests $2 million in building improvements. According to §1.168, the taxpayer identifies $1 million worth of building components that were retired and elects to use a PAD. This results in a $1 million reduction in income, and with a 35% effective tax rate (ETR), the tax savings in the year of the renovation amount to $350,000. This is a clear financial advantage. When the building is eventually sold, there will be a reduced basis of $1 million (since this amount was expensed). While the taxpayer will pay more in long-term capital gains tax (at 20%) in the year of the sale, they will have had a significant expense to offset ordinary income (at 37%) in the year the components were retired.

In summary, the partial asset disposition election is a strategic tax planning tool that can yield significant tax savings and should be considered by all eligible taxpayers.

How Tax Savings Can Pay for Renovations

Kevin Jerry, Owner of KAJMST / Photo Courtesy: Kevin Jerry

Kevin Jerry is the owner of KAJMST. He’s a nationally recognized expert in Tax Method Changes. He specializes in Cost Segregation, Tangible Property Regulations, and revenue recognition changes.

Disclaimer: “The content in this article is provided for general knowledge. It does not constitute legal advice, and readers should seek advice from qualified legal professionals regarding particular cases or situations.”

 

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