On November 6, 2019, the IRS released a process unit to train and educate its agents on partial asset dispositions of a building. The release of this educational material to its employees may indicate IRS intent to target these deductions for examination, which are common in the real estate industry. Before we address this development, we'll first give you a refresher and explain the information your tax preparer needs to determine if you may benefit from the deduction. Finally, we'll address risk mitigation, given the recent IRS pronouncement.
What is a Partial Asset Disposition?
As part of the Tangible Property Regulations (TPR) released in 2013 that overhauled how businesses decide to expense or capitalize property improvements and purchases, IRS created the partial asset disposition (PAD) deduction. This deduction allows property owners to recognize a loss on the disposition of a portion of a building, which generally occurs when significant improvements are made to the building that include the replacement or "ripping-out" of existing building components.
For example, a commercial building owner replaces a portion of the building's roof after 10 years. Before the TPR, the building owner had to capitalize and depreciate the entire cost of the roof replacement over the life of the building. Since the original cost of the building presumably included some cost related to the old roof, the owner was left depreciating both the new roof and the old roof, which no longer exists or has value. To remedy this seemingly inequitable result, the PAD deduction allows the owner to elect to deduct the undepreciated cost of the old roof once it has been replaced. Here, the owner writes-off the old non-existent roof as a deduction and simply depreciates the cost of the new existing roof.
What Does Your CPA Need to Know to Calculate a PAD Deduction?
To determine if you qualify for a PAD deduction, your CPA needs to know specific details about the type of improvements done to a building. Not all work done to a building's systems or structural components qualify as a PAD and there are complex and nuanced rules beyond the scope of this article. Accordingly, it is advisable to provide a threshold level of improvement or capital expenditure detail to your CPA when sending your tax information so they can determine if you qualify for a PAD deduction.
Often, a single line-item on your trial balance for "building improvements" is not enough to make this determination. Breaking down building improvements into different categories, such as electrical, plumbing, facade, roof, HVAC, elevator, etc., can help your CPA focus on areas where a PAD may be applicable. A brief description or narrative of the improvements done to the building can also be a valuable guide, especially if you can draw distinctions between improvements that entailed the replacement or ripping-out of existing building components vs. building expansions, additions, or significant system upgrades. Contractor invoices and AIA reports for larger projects can be a great starting point.
While this information can help your CPA determine if there is an opportunity for a PAD deduction, the final determination cannot be made by simply looking at accounting records or other documents. Ultimately, you should have a conversation with your CPA to navigate the nuances of the law together to ensure you qualify for a PAD deduction.
Expect to hear questions like, 'Is the new HVAC system significantly more efficient than the old HVAC system,' and 'Did you replace the entire roof or a certain section? The whole roof system or just the roof membrane?' Sometimes it may be necessary for your CPA to speak directly with your contractor to take this deep dive.
PAD Risk Mitigation
Since eligibility of a PAD deduction hangs on key details regarding the physical work done to a property, which cannot be captured in traditional accounting records, retaining substantiation for a PAD deduction is more challenging. The recently released IRS PAD process unit lays out a five-step examination process as follows:
- Determining if a partial disposition of a building occurred,
- Identifying the disposed portion of the building,
- Identifying the partially disposed asset and its placed-in-service date,
- Determining the disposed portion’s adjusted basis, and
- Reducing the adjusted basis of the asset
Numbers 1, 2 and 3 are the soft ones that can be supported by AIA reports, contractor invoices, your narrative and your CPA's "deep-dive" notes from your conversation.
However, number 4 may be the most difficult, as the PAD rules allow for two (2) methods for determining the adjusted basis of the disposed of portion of the asset (i.e. the undepreciated cost of the old roof in our previous example). The first and best way to make this determination is to have a cost segregation study done on the building/improvements by a qualified professional. This entails a walk-through of the building, generally conducted by an engineer specifically educated on PAD deductions, to specifically identify the assets disposed of and issue a formal report used to substantiate the deduction with the IRS. The alternative method entails discounting the cost of the replacement assets to the date the building was first placed in service to estimate the cost of the replaced assets. However, this method is not always allowed and ultimately needs to be reviewed for reasonableness. For this reason, it carries additional IRS exam risk.
While PAD deductions present a significant opportunity for building owners to accelerate deductions, the calculations can quickly become overwhelming and complicated. Additional prudence should be taken when electing to take a PAD deduction and care should be taken to retain substantiation, given the recent process unit issued by the IRS. As always, you can call on The Tax Warriors® at Drucker & Scaccetti for help with this or any other tax-related matter.
Topics: Tax Deductions, Real Estate Ownership, Tangible property regulations, PAD, Partial Asset Disposition Deductions, AIA, Building Improvement, Risk Mitigation, IRS Process Unit, Capitalize or Depreciate