Application of Partial Asset Dispositions and the De Minimis Safe Harbor

Editor: Valrie Chambers, Ph.D., CPA

The initial adoption of the tangible property regulations has now passed, and practitioners have implemented them for clients. Two important matters that practitioners should continue to monitor are partial asset dispositions and de minimis safe-harbor elections. The partial-asset-disposition election may provide taxpayers with significant tax deductions. The de minimis safe-harbor election allows taxpayers to use the increased deduction thresholds for the purchase or improvement of tangible property.

Partial Asset Disposition

According to Regs. Sec. 1.168(i)-8(d)(2)(ii)(A), apartial-asset-disposal election must be made by the due date (including extensions) of the original federal tax return for the year in which the taxpayer disposes of the portion of the asset. Regs. Sec. 1.168(i)-8(d)(2)(ii)(B)explains the manner of making the election is by reporting the gain, loss, or other deduction on the taxpayer’s timely filed original return for the year the partial disposition is made and by classifying the replacement portion of the asset under the same asset class as the disposed portion of the asset in the year the replacement asset is placed in service by the taxpayer. Under Regs. Sec. 1.168(i)-8(d), the taxpayer must classifythe replacement asset(s) in the same asset class of which the replaced part is a component: modified accelerated cost recovery system (MACRS) asset classes 00.11 through 00.4 of Rev. Proc. 87-56.

Regs. Sec. 1.168(i)-8(f)(3) clarifies that if it is impractical to determine the unadjusted depreciable basis from the taxpayer’s records, a reasonable method may be used to determine the unadjusted depreciable basis of the disposed portion, including the following:

1. The producer price index (PPI) for finished goods or final demand: discounting the cost of the replacement asset to its placed-in-service year cost using the PPI for finished goods or final demand.
2. A pro rata allocation of the unadjusted depreciable basis of the asset based on the replacement cost of the disposed portion of the asset and the replacement cost of the asset.
3. A cost-segregation study.

A taxpayer can use the PPI only if the replacement is a restoration; also, the consumer price index is no longer a reasonable method to calculate historical cost of a replaced asset. Applying the PPI can be difficult, as shown in the example below.

Example: Taxpayer purchases a $150,000 air conditioner in June 2015. Taxpayer owns a building with an original cost basis of $750,000, which it placed in service in June 2005 and has accumulated depreciation of $306,664 as of June 2015. The taxpayer wants to calculate the disposal value of the original air conditioner using the PPI method. To do that, the taxpayer will need to apply the PPI table using several steps, as shown in the exhibit below. According to the U.S. Department of Labor’s Bureau of Labor Statistics, the June 2005 PPI was 154.2; the June 2015 PPI was 197.7. The PPI for finished goods and PPI for final demand are available at data.bls.gov.

The new air conditioner is depreciated separately as 39-year real property beginning in June 2015, and the removal costs may be deducted or included in the basis of the new air conditioner.

The regulations require that the disposed asset be placed in a separate account as of the first day of the tax year of disposition and that the unadjusted depreciable basis of the building be reduced by the unadjusted depreciable basis of the original asset (as shown in Step 2 of the exhibit).

Potential issues and limitations with the PPI method include:

• The PPI can be used only when the replaced asset is a restoration; because a betterment or adaptation generally involves replacing an existing asset with a newer, more expensive, and/or dissimilar asset, in those situations the PPI would offer an unfair comparison.
• A PPI index rollback may produce unreasonable results where a taxpayer has purchased an existing building with particular components near the end of their economic life; without further adjustment, the PPI will overstate the retirement loss. A taxpayer may counter this issue by applying discount factors such as the economic life discount.
• The PPI may also produce unfavorable results if a taxpayer purchases a new or existing building at a discount. The PPI may calculate a historical cost that might be equal to or greater than the total adjusted cost.

In summary, the PPI is one of the methods available to determine the historical cost of replaced assets and can help in determining the loss on disposal as well as remaining basis in the original asset. The PPI method has limitations: A taxpayer may use it only for restorations, and it may provide unreliable or unfavorable results if assets are at the end of their life or if original assets are purchased at discounts, which may skew the resultant historical cost.

De Minimis Safe Harbor

The tangible property regulations also allow taxpayers that pay or incur amounts to acquire, produce, or improve tangible or personal property to elect to apply a de minimis safe-harbor expensing for amounts that they also expense for financial accounting purposes. The amounts allowable under the de minimis safe harbor are $2,500 or $5,000, depending on whether the taxpayer has an applicable financial statement (AFS). Taxpayers with an AFS may use this safe harbor to deduct amounts paid for purchases and/or improvements of tangible property for up to $5,000 per invoice or item, provided that this accounting procedure is in writing. Non-AFS taxpayers may use the safe harbor to deduct up to $2,500 per invoice or item. Non-AFS taxpayers are not required to have written accounting procedures, but they must expense amounts on books and records in accordance with accounting procedures existing at the beginning of the tax year.

If a taxpayer’s policy is to expense items above the $2,500 threshold for non-AFS taxpayers, it should still elect the de minimis safe harbor on the federal return because this will ensure that the IRS will not question the deduction of the items costing $2,500 or less.

Taxpayers must apply their applicable threshold to their books and records to benefit from this election and eliminate any book-to-tax differences when deducting assets or improvements that fall under their applicable threshold.

To elect the de minimis safe harbor, the taxpayer should attach a statement titled “Section 1.263(a)-1(f) de minimis safe harbor election” to the timely filed federal tax return including extensions for the tax year in which the de minimis amounts are actually paid. The annual election does not require the filing of Form 3115, Application for Change in Accounting Method.