Deducting the Costs of a Partial Disposition & Disposal Costs

Disposal Costs

The cost of disposing of a Unit of Property (UOP) or component of a UOP must be depreciated if the cost was incurred due to an improvement.

If the cost was incurred due to a repair, the disposal cost can be currently deducted.

Taxpayers can write off the adjusted basis of the UOP or component that was disposed of.

To do so, however, you must know the adjusted basis of the UOP or component, meaning you need to have a cost segregation study performed or you must have replaced that property at some earlier point.

Units of Property

To determine whether an expense is an improvement or repair, you must consider the Unit of Property (UOP) that is affected.

For larger UOPs, work performed on the component will likely result in being classified as a repair versus an improvement. In order to be classified as an improvement, the work must be significant in scope and cost as it relates to the affected UOP.

There are nine defined UOPs by the IRS:

1. The building structure: consists of the building and all structural components other than those UOPs listed below (IRS Reg. § 1.263(a)-3(e)(2)(ii))
2. Heating, ventilation, and air conditioning system
3. Plumbing systems
4. Electrical systems
5. Escalators
6. Elevators
7. Fire protection and alarm system
8. Security system
9. Gas distribution system

Partial Dispositions of Assets

While deducting disposal costs relates to deducting the cost when an entire component or Unit of Property (UOP) is replaced, partial dispositions of assets allow for significant tax deductions as well.

IRS Regs. Sec. 1.168(i)-8(f)(3) explains 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 of 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 of 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 the historical cost of a replaced asset. Applying the PPI can be difficult, as shown in the example below.

Making the Election

IRS Regs. Sec. 1.168(i)-8(d)(2)(ii)(A) says 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.

IRS Regs. Sec. 1.168(i)-8(d)(2)(ii)(B) says that to make the election, a taxpayer reports the gain, loss, or other deduction on the taxpayer’s timely filed original return for the year the partial disposition is made and classifies 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.

Real estate tax deductions can be complex.

Avoid common errors.