If you own an investment property, I’ve got good news for you. The IRS has a regulation called a partial disposition election. It allows you to immediately benefit from any undepreciated value when you replace a depreciable structural component on your office building or rental property. It also provides tax benefits when you sell the property.
Previously, when you replaced a structural component that you had only partly depreciated, you had to keep the old depreciation schedule and add a new depreciation schedule for the new asset. Now you don’t. Let’s say you installed a $75,000 roof fifteen years ago. Now, although you’ve only depreciated two-thirds of the value, you already need a new roof. In the past, you would have had to depreciate the remaining $25,000 based on the original depreciation schedule (even though that roof didn’t exist anymore). Now, you can immediately write off that $25,000 as a loss for tax purposes.
Before I go further, let me remind you that if you own investment property, I highly recommend cost segregation. I’ve written about this in the past, but as a refresher, cost segregation allows you to depreciate assets based on their remaining useful life as opposed to the standard IRS timetables (i.e., 27.5 years for residential properties or 39 years for commercial properties). For example, instead of depreciating all major assets in your office building over 39 years, you might depreciate the roof over its remaining life of 20 years, the carpet for 7 years, the electrical system for 15 years, and the heating and air conditioning system for 10 years, depending on what the cost-segregation study determines.
The earlier you write off depreciation with cost segregation, the higher your tax deductions will be in those early years. If you sell the property ten years after you buy it, for example, you would have fully depreciated the carpet and HVAC system, most of the electrical system, and half of the roof, allowing you to pay lower income taxes.
So, back to partial disposition election. In addition to writing off the depreciation on an asset when you replace it, the IRS now allows property owners to elect a partial disposition deduction when you sell the property. When you sell an investment property, two components combine to calculate your taxable gain: the property’s increased value (ordinary income capital gains) and the recapture of depreciation (unrecaptured Section 1250 gains).
The partial disposition deduction is good for two reasons. First, you can claim an immediate tax deduction for the undepreciated basis of the old asset. Second, you can pay the ordinary income capital gains tax (as opposed to the more expensive recapture tax rate) for the depreciated portion. Also, by taking the tax loss of these assets early, you benefit from the time value of money.
Obviously, any time you consider the tax benefits of buying or selling property, it must be done in context; that is, considering your whole financial picture. You’ll want to look at your tax burden for this year and your projected tax burden down the road. If your business lost money this year, now is not the time to do a segregated cost recovery program. Your tax burden is already low, so additional tax deductions won’t help you much.
If this was a great financial year with high taxable income—and you have reason to believe that you’ll have lower taxable income in future years (maybe you’re approaching retirement)—then you’ll want as many tax deductions as you can get this year. As always when making financial decisions, work with your tax professional and financial advisor to determine how best to manage your assets. I am not a CPA and every single person’s tax landscape is different and must be reviewed in the context of all other financial considerations.
If you have questions about property management or real estate, please contact me at rselzer@selzerrealty.com or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery.