Maximizing Tax Benefits Through Partial Asset Disposition
The Tangible Property Regulations (TPRs), made mandatory in 2014, represent one of the most significant changes in tax law since 1986. Despite many CPAs taking courses on these regulations in 2015, a large number still hesitate to utilize them due to their perceived complexity. These regulations have fundamentally changed how expenditures, post the initial service of an asset, are documented.
One aspect that remains unchanged and is often overlooked is the election for partial asset dispositions (PADs). This portion of the TPRs can be incredibly beneficial for many clients, yet it’s one of the least utilized. According to § 1.168(i)-8(d)(2), taxpayers have the option to expense the retired portion of an asset. Building renovations are a common example of PADs. Clients who own commercial properties and undertake renovations stand to gain significantly from making this election.
To take advantage of a partial asset disposition, the taxpayer must make the election by the due date, including extensions, for the year in which the asset portion is retired. Typically, a PAD results in an ordinary loss of the adjusted basis, which is the original cost minus depreciation. This loss would otherwise be depreciated over the remaining years of the asset’s depreciable life. However, many practitioners avoid this opportunity due to the complexity of determining the adjusted basis, the nearing full depreciation of the asset, or a perceived minimal gain or loss. Additionally, the regulation is not extensively covered in accounting education or on the CPA exam.
Taxpayers often fail to consider the long-term benefits of a partial asset disposition election. Even if the current-year tax savings are minimal, taxpayers can save thousands of dollars in taxes upon the sale of the asset. By making this election, the taxpayer not only expenses the adjusted basis of the asset but also eliminates future §1245 or §1250 recapture. For instance, §1250 requires recapture of depreciation at a rate of 25%, while normal capital gains are taxed at a maximum of 20%. The PAD election allows taxpayers to reduce recapture amounts and benefit from capital gains treatment.
Consider two simplified scenarios for better understanding:
- Without Partial Asset Disposition: A taxpayer sells a building with $1 million in depreciation on a $3 million building and $2 million in improvements, sold for $10 million. The $6 million gain results in $250,000 taxed at the §1250 rate (25%) and $1 million at the capital gains rate (20%), totaling $1,250,000 in tax due.
- With Partial Asset Disposition: The same taxpayer identifies and expenses $1 million of the $2 million renovation. This reduces income by $1 million, saving $350,000 in taxes at a 35% ETR. Upon sale, the taxpayer’s gain is $7 million, with $250,000 taxed at the Sec. 1250 rate of 25% and $1.2 million at the capital gains rate of 20%, resulting in $1,450,000 in tax due. Although the tax on the sale is $200,000 higher, the initial $350,000 tax savings and potential investment return make this a beneficial strategy.
In conclusion, while a partial asset disposition may result in higher taxes upon the sale of an asset, the upfront tax savings and subsequent investment opportunities present a compelling case for making this election. Taxpayers and practitioners should not overlook the significant long-term benefits that PADs can offer.