The introduction of the tangible property regulations, or the "repair regs.," is one of the most fundamental tax law changes since the 1986 Code went into effect. Many practitioners have gone through a crash course of information overload trying to comprehend the new capitalization standards, determine what are materials and supplies, etc. An area of the new regulations that, operationally, remains largely unchanged from prior law is that regarding dispositions, with the exception of the new partial asset disposition election. This part of the regulations has largely been ignored or underappreciated by practitioners. Yet the partial asset disposition election might be one of the most, if not the most, beneficial tools for many clients in year-end tax planning.
Regs. Sec. 1.168(i)-8(d)(2) allows a taxpayer to elect to dispose of a portion of an asset for certain disposition transactions that include retirement of the portion. The taxpayer must make the election by the due date, including extensions, in the year in which the portion of an asset is disposed. There is no requirement to attach a statement with the return on which the election is made. The taxpayer simply needs to record the disposition as such. The taxpayer then may recognize any gain or loss upon the disposal of the portion of the asset. Generally, a partial asset disposition will result in an ordinary loss.This disposal accelerates depreciation via the abandonment of adjusted basis that otherwise would have had to be recognized over the remaining years of the asset's depreciable life.
Tax Rate Arbitrage on Sale of Asset
Many practitioners, however, are ignoring this valuable election for one or more of the following reasons:
- Determining the adjusted basis is too complex;
- The asset will be fully depreciated in the next few years; or
- The gain or loss is not worth the time and effort to figure.
Many taxpayers are failing to look at the long-term benefit that results from making a partial asset disposition election. Even if the current-yearwrite-off is minimal in tax savings, taxpayers can, upon the sale of the asset, save thousands of dollars in taxes. By making a partial asset disposition election, the taxpayer not only writes off the remaining depreciable basis of that portion of the asset; it also writes off future Sec. 1245 or 1250 gain, depending on the asset type, because the asset's accumulated depreciation is also reduced by the amount of accumulated depreciation attributable to the portion of the asset disposed.
Sec. 1250 requires the taxpayer to recapture accumulated depreciation when the taxpayer recognizes gain on the sale of assets defined under these sections. Sec. 1250 applies a special capital gains rate of 25%. The maximum tax rate for normal capital gains is 20%. Therefore, the partial asset disposition election has built in a tax rate arbitrage by allowing taxpayers to reduce recapture amounts and use normal capital gains treatment. Taxpayers in the 25% ordinary bracket and up will see a tax savings of at least 5 percentage points on the disposed accumulated depreciation.
Example: Taxpayer T is involved in investing in and developing commercial buildings. T purchased and placed in service a commercial office building in the beginning of year 1 for $3 million. The interiors of two of the five floors of the office building needed complete renovation, as they were in disrepair from years of neglect. The contractor estimated the renovation would cost $1 million. The renovation was completed and placed in service at the end of year 7. T expects to sell the building at the end of year 40 for $5 million to one of the tenants.
Sale without a partial asset disposition: Assume the taxpayer had taken depreciation of $4 million on the building and building improvements at the time of sale. The adjusted basis would be zero. Also assume the taxpayer is subject to the 20% maximum capital gains rate. The sale of the building would result in a $5 million gain. The first $4 million of this gain is taxed at the Sec. 1250 rate of 25%, and the remaining $1 million is taxed at the regular capital gains rate of 20%. This results in tax due of $1.2 million on the sale of the asset.
Sale with a partial asset disposition: Assume the same facts as above, except the taxpayer partially disposes of the building when the renovation is placed in service. Following the guidance in Regs. Sec. 1.168(i)-8, T identifies that $800,000 of the $3 million cost basis of the building should be the amount disposed. At this point, $140,000 of depreciation had been taken on this portion of the building being disposed and would be written off, along with the $800,000 cost basis. A $660,000 ordinary loss would result in the year of disposition.
Now, fast forward to the year of sale. The taxpayer has taken $3.2 million of depreciation on the remaining cost basis on the original building and building improvements. The adjusted basis at the time of sale would be zero. The sale of the building would result in a gain of $5 million. The first $3.2 million of this gain is taxed at the Sec. 1250 rate of 25%, and the remaining $1.8 million is taxed at the regular capital gains rate of 20%. This results in tax due of $1,160,000 on the sale.
Analysis: The partial asset disposition election reduced the basis and accumulated depreciation in the building. The building was fully depreciated in year 40, the year of the sale. So regardless of the partial asset disposition election, the gain on the sale of the building was the same. Eliminating $800,000 of eventual accumulated depreciation via the partial asset disposition election saved T $40,000 in taxes in the year of the sale, as making the election reduced the amount subject to Sec. 1250.
A taxpayer can also increase the net tax savings by selling the building earlier. In this case, the taxpayer will see that it pays more tax in the year of sale when it elects a partial asset disposition versus not electing a partial asset disposition. Although this is true, the taxpayer must also look at the tax savings generated from electing the partial asset disposition. Comparing the net tax cost over the life of owning and operating a building, the ordinary rates received from the accelerated write-off at the 39.6% rate are much more beneficial than maintaining a higher cost basis with more built-in Sec. 1250 gain.
It would behoove practitioners to use this new election for long-term tax savings. Taxpayers with appreciating Sec. 1250 property will be able to use this tax rate arbitrage to its full potential. This is just another aspect of the partial asset disposition election to consider, on top of its immediate benefit of accelerating depreciation in the election year through a partial disposal. It is unclear whether this was part of the intention of the inclusion of the partial asset disposition election in the disposition regulations, but the result will greatly benefit taxpayers looking to sell improved property.
Michael Koppel is with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or email@example.com.
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