The IRS has finalized regulations that affect how business owners can deduct repairs and improvements to business property. (IRS Reg. §1.168(i)-8.) Under the new rules, when building owners dispose of a building's structural components, such as a roof, HVAC unit, or windows, they can choose between two different methods of depreciation: They can either continue to depreciate the cost of the replaced component, or they can fully deduct the unrecovered cost of the component in the year it is replaced. (IRS Reg. §1.168(i)-8.)
Under the old rules, if you replaced a component, such as an old roof with a new roof, you would depreciate the cost of the new roof. But, you also had to go on depreciating the building components you replaced along with the rest of the original structure. This meant that, in effect, you could end up depreciating two or more roofs at the same time!
Taxpayers have the option to apply the new rules to tax years before 2014 by filing IRS Form 3115, Application for Change in Accounting Methodno later than the due date (with extensions) for the 2014 tax return. You’ll likely need the aid of a tax professional to do this.
The building owner need to do nothing to select option 1. The component continues to be depreciated along with the rest of the building.
Option 2 is chosen by making a “partial disposition election” on the owner’s tax return. In this event, the adjusted basis (original basis minus depreciation taken) of the retired component is deducted that tax year. In addition, the building owner must depreciate the cost of the replacement component, even if it might have otherwise been currently deductible as a repair under the IRS’s repair regulations. This election must be made on a timely filed return including extensions in the taxable year in which the disposition occurs. No formal election statement is required. The taxpayer simply reports the loss on the disposed portion of the asset on his or her return.
Example: Alice has owned an apartment building for ten years. She replaces the roof, which is a structural component. Alice may not recognize a loss and must continue to depreciate the retired old roof unless she elects to treat the roof retirement as a partial disposition of the building. If she decides not to make this election, she separately depreciates the cost of the new roof and continues to include the cost of the old roof in the amount she depreciates for the building as a whole. If she does make the election, depreciation on the old roof ceases at the time of its retirement. Alice recognizes a loss upon the retirement equal to the remaining undepreciated basis of the roof.
When such an election is made, it is necessary to allocate a portion of the original cost (depreciable basis) of the whole building to the replaced component. For example, the cost of the replaced roof in Alice’s building would have to be determined since depreciation was not separately claimed on the original roof. Any reasonable method may be used to determine the adjusted basis of the old replaced component at the time of its replacement, including:
Example: Alice elects to use the CPI index method to determine the basis of the old roof, which was placed in service ten years ago. She spent $10,000 to replace the roof this year. The CPI has risen by 24.7% over the last 10 years, so the old roof’s placed-in-service year cost is valued at $7,530. Over ten years, Alice took a total of $3,115 in depreciation deductions for the roof, leaving her with a $4,415 adjusted basis she may deduct in full.
There are some exceptions to the rule that a building owner is not required to recognize a loss (or gain) on a disposition of a building component. The regulations make such recognition mandatory if the disposition is the result of casualty event, sale of a portion of an asset, like kind exchange, or involuntary conversion.