Partial Asset Disposition (PAD)

By Jason Watson, CPA
Posted Monday, August 5 2024

Let’s say you purchase a rental property for $500,000 all-in. A portion of the real estate investment is considered land of course, but a portion of the value is tied up in the pool, the air conditioning system, the counters, and all kinds of other things. This is the crux of cost segregation that we discuss on page xx.

What’s the big deal? When you replace the air conditioning system, for example, you are replacing a part, albeit tiny, of the entire rental property. As such, and when accounting for depreciation, with a partial asset disposition (PAD) you might have a loss on the old system when you replace it. In nerdy accountant-speak, under the Tangible Property Regulations, a disposition of an asset occurs when ownership is transferred or the asset is permanently withdrawn from use. It includes-

• Sale

• Exchange

• Retirement

• Physical Abandonment

• Destruction (think Office Space printer)

Partial asset dispositions allow rental property owners to claim a loss on the disposition of a component (structural or otherwise) of an asset without having originally identified the component as an asset before the disposition.

Ok, so now what?

Can the New Asset Be Expensed?

The first step is to determine if the expenditure qualifies under one of the rental property safe harbors. Recall that there are three-

• De Minimis Safe Harbor Election

• Safe Harbor Election for Small Taxpayers (sounds a bit condescending)

• Safe Harbor for Routine Maintenance

We discussed these in fine detail in an earlier section on page xx. De minimis is the class favorite since it is quite simple and covers most purchases or situations. However, small taxpayers and routine maintenance have some teeth, but are commonly overlooked by even the most experienced tax professionals.

If you cannot immediately expense it, then it must be capitalized as a new asset and depreciated over time.

Problems With Only Adding A New Asset

There are a handful of problems with simply adding the new air conditioning system, let’s say, to your fixed asset listing, and firing up the depreciation calculator.

First, you are continuing to depreciate the previous asset that is tucked into the overall or primary asset. In our example above, the value of the building contains in part the value of the old air conditioning system. This means you could have phantom depreciation recapture on an asset that doesn’t exist upon sale. However, and depending on timing, you might have an artificially inflated cost basis to the rental property resulting in lower capital gains upon sale.

Second, if you double-down on depreciation between the original air conditioning system as part of the original purchase of the rental property and the new one, you might be missing out on some quick tax savings because of passive activity loss limits. For example, your rental has a loss mostly because of depreciation. Next, because you’re crushing it at your day job, none of your rental losses are deductible. By piling on more depreciation without a partial asset disposition, you are not getting an immediate tax benefit.

Sure, over the entire life of the rental property, you will end up in the same place. However, and this is the cornerstone to a cost segregation study as well, accelerating your cash flow is a good thing.

How To Compute The Unadjusted Basis Of The Replaced Asset

The IRS Publication 5712 Capitalization of Tangible Property Audit Technique Guide (ATG) define three methods for determining unadjusted basis, and therefore depreciation and possible tax benefit of a loss-

1. Discounting the cost of a replacement asset to its placed-in-service year cost using the Producer Price Index for Finished goods, the Producer Price Index (PPI) for Final Demand, or other index designated by guidance in the Internal Revenue Bulletin. This method can only be used if the replacement asset is a restoration as defined in § 1.263(a)-3(k); it cannot be used if the replacement is a betterment as defined in § 1.263(a)-3(j) or an adaption as defined in § 1.263(a)-3(l),

2. Pro rata allocation of the unadjusted depreciable basis of the MAA based on the replacement cost of the disposed asset and the replacement cost of all assets in the MAA (or pool), and

3. Study allocating the cost of the asset to its individual components.

What the heck is an MAA? Multiple Asset Accounts. Just think “entire rental property asset” for now. What are your thoughts on #3 above? Sounds like a cost segregation study doesn’t it? It does! Be weary of #1, since it is only available for restorations, and not betterments or adaptations (remember BRA or BAR, right)? This makes sense too from a theoretical perspective.

Example Using PPI Method

Here is an example of a rental building that was purchased for $500,000 (regardless of the value today), where the replacement air conditioning system cost $20,000.

Cost of New A/C System	20,000
Historical Building Cost	500,000
Historical Cost of A/C System (PPI Calc’d)	12,000
Building Cost After Removal of Old A/C	488,000
Total Accumulated Depreciation	125,000
Historical Building Cost	500,000
Depreciation Percentage	25%
Depreciation Percentage (a)	25%
Historical Cost of A/C System (b)	12,000
Accumulated Depreciation of Old A/C (c = a * b)	3,000
Loss From Sale of Business Property (b – c)	9,000

The historical cost of the air conditioning system is computed by taking the historical PPI divided by the replacement month PPI, and multiplying the cost of the new system by this value. Tilt! You can find purchase price index (PPI) commodity data from the U.S. Bureau of Labor Statistics. Drool.

The PPI method might produce unreasonable results when the existing rental property had several components near the end of their actual or economic life. Then again, take a swim in those gray waters!

The PPI method might produce unfavorable results when the purchase of the rental property was at a discount.

WCG CPAs & Advisors recommends and uses KBKG for various calculations and tools including PPI. According to their website-

The KBKG Partial Disposition Calculator is designed to make calculations as simple as possible while minimizing unnecessary work. By providing basic data, the calculator provides a PPI adjusted value while considering the condition of the respective component at the time it was acquired (accomplished by considering the component’s normal life, quality, and age).

CAUTION: Using a PPI discounting method to establish tax basis for a retired building component may grossly overstate the taxpayer’s retirement loss deduction.

See IRS T.D. 9689 Guidance Regarding Dispositions of Tangible Depreciable Property for more riveting information.

Pro Rata Allocation

This one is not written about often. Can you take the replacement cost of the air conditioning system and divide by the fair market value of the rental property, and then apply that to the accumulated depreciation? Not really. An MAA, or multiple asset accounts, is made up of a group of assets that are similar.

Cost Segregation Study

If you had a cost segregation study prepared at the time or close to the time of purchase, you can use that report to determine the historical cost of each component, and in this case, the cost of the air conditioning system. You might still have to do some of the mental gymnastics above to determine the accumulated depreciation specific to the old air conditioning system. Alternatively, you can kick it to your tax professional.

Election Required

Treasure Regulations Section 1.168(i)-8(d)(2)(ii)(A) reads that a partial-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.

The Cost Segregation Audit Technique Guide (ATG) reads that the engineering-based approach used in a cost segregation study is “the most methodical and accurate approach… and generally provides the most accurate cost allocations.”

In 2019 the IRS announced a partial asset disposition election compliance initiative, explaining that they will be training agents in a 5-step process to review partial asset disposition (PAD) elections by-

1. Determining if a partial disposition of a building occurred,

2. Identifying the disposed portion of the building,

3. Identifying the partially disposed asset and its placed-in-service date,

4. Determining the disposed portion’s adjusted basis, and

5. Reducing the adjusted basis of the asset.

Don’t let that dissuade you. Rather it should encourage you to understand the mechanics, line up your facts and data, and use partial asset disposition as a nice tax deduction.

Casualty Loss

If your rental property experiences a casualty loss through fire or flood, partial asset dispositions are handy for harvesting tax losses when insurance falls short. Technically, a casualty loss is the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual.