Rental Property, Often Missed: Add New Roof, Deduct the Old One

Owning a rental property comes with upkeep headaches. Roofs, HVAC units, lighting systems—they all break down and require replacement eventually.

And then you have the IRS.

Yep, and you are not happy at that thought, but you are going to thank the IRS for what you learn in this article.

Before the IRS got into this area, getting a new roof or replacing an elevator did little for your taxes. For example, once you replaced, say, a roof, you were stuck capitalizing and depreciating the new roof—and you continued to depreciate the old one.

But thanks to the IRS, if today you’re thinking about replacing a roof (or other structural component in a building), you can claim a tax deduction equal to the remaining basis (undepreciated cost) of that roof you replaced.

That alone is a big deal. And, sadly, it’s often overlooked.

If you overlook the write-off of the old roof, you also pay taxes on the depreciation you claimed on the old roof. So, by not taking advantage of the IRS rule on writing off the old roof, you shoot yourself in the foot twice.

Let’s examine the benefits of getting this correct.

Benefit #1: Writing Off the Old Roof

As we mentioned, before the IRS stepped in, you couldn’t write off the remaining basis of replaced components when you renovated a building.

So even though your old roof was in a dump somewhere, it stayed on your books for tax purposes. You had to keep depreciating it as part of the cost of the building.

Think of it as a ghost roof—it’s physically gone, but it haunts you because it continues to sit on your books and you have to continue to depreciate it. We called this the “ugly two-roof problem.”

All that changed when the IRS published its final tangible property regulations.1 The new regulations allow you to elect to apply the property disposition rules to just a portion of a building, such as a roof.

Making the election on your tax return to write off the old roof allows you to say goodbye to that ghost roof and deduct the remaining undepreciated cost now.

The new regulations break your building into building structures, such as the roof, walls, and floors, and nine building systems, such as HVAC, electrical, and elevators. So now you can eliminate lots of ghosts.

Example. Let’s say you own a building with four elevators and you replace one of them. Here’s how you say goodbye to the ghost elevator if you make the partial disposition election:

·       You stop depreciation on that one elevator when you replace it.

·       You then write off the remaining undepreciated basis as a loss.

Key point. You need to make the partial disposition election in your tax return. If you don’t make the partial disposition election, you can’t take an immediate loss deduction for the adjusted basis of the old elevator. Instead, your replaced elevator continues on your books as a ghost elevator and you continue to depreciate it as part of the cost of the building.

When Not to Elect Partial Disposition.

You don’t want to make the partial disposition election when you can get a bigger write-off without making the election. Another thanks to the IRS for this.

The IRS rules for partial fixes and replacements of building structures and building systems let you deduct the cost of replacing certain non-major building components as expenses, as long as you don’t claim a gain or loss on the old component.

Example. The IRS gives you the following as one of its examples of how this works: The HVAC system at your office building contains 10 roof-mounted units, and you replace three of them. The IRS concludes that the three units are not a major component, and thus you can deduct the cost of the three new units as a repair cost, if you don’t claim a loss deduction on the three old units.

Duh! Clearly, when you can, you want to write off the cost of the new, more expensive units. Further, with the new units, you have no trouble identifying the cost, whereas identifying the cost of the old units is likely an inconvenience.

Benefit #2: Savings When You Sell.

When you sell your building for a profit, to the extent that the profit is from your prior building depreciation, you pay a special capital gains recapture tax of up to 25 percent (this is known technically as “unrecaptured Section 1250 gain”).

If in the sale of the building you separately sell Section 1245 property such as refrigerators, stoves, and fixtures, your depreciation recapture is taxed at your ordinary income rates of up to 37 percent.

Key point. When you use the partial disposition election or expense a repair as we did with the three HVAC units, you have no accumulated depreciation on your books for those assets. With no depreciation, you have no depreciation recapture tax.

Cost of Poor Planning.

Here’s an example of just how much of a windfall this approach can bring you. In this example, we ignore the cost, value, and selling price of the land because land is not depreciable and it’s not relevant for this example.

You buy a commercial building for $3 million and do a $1 million renovation in Year 7 (bringing the depreciable basis to $4 million), but you don’t make the election to write off the parts replaced. Years later, you sell the building for $5 million.

At the point of sale, say your adjusted basis on the building is zero—you claimed all $4 million of the depreciation. You sold the building for $5 million, so your gain on the sale is $5 million ($5 million – 0).

In your tax bracket, the law taxes the first $4 million of your gain at the depreciation recapture rate of 25 percent, and taxes the $1 million capital gain (gain in excess of cost) at the regular capital gains rate of 20 percent, for a total tax of $1.2 million.

Good Planning Benefit.

But let’s see how you benefit if you use the IRS rule for expensing the replaced components in the year of the renovations.

You first find the basis of each replaced component (more on this below). If, for example, you identify $800,000 as the component’s original basis and $140,000 in prior depreciation, you write off the adjusted basis of $660,000 in Year 7.

That leaves the building with a remaining cost basis of $3.2 million ($4 million – $800,000). On a gain of $5 million, the law taxes $3.2 million at 25 percent and $1.8 million at 20 percent, for a total tax of $1.16 million.

Here’s what happened with the replacement:

You deducted $660,000 in Year 7 and that put, say, 40 percent after taxes in your pocket, for a total of $264,000.

 In the year of sale, you saved another $40,000 ($1.2 million – $1.16 million).

• Without considering the time value of money, you have a $304,000 cash windfall by making the election.

Professional Help.

It’s unlikely that you have your buildings broken down into the various categories that can qualify for the partial disposition election.

But no worries, the IRS gives you solutions. It enables you to backtrack with specific calculations so you can identify the amount to write off for the replaced roof or elevator. Here are three methods that the IRS deems reasonable for making the backtracking calculation:

·       Producer Price Index (PPI). You can use the PPI to discount the replacement cost to what it would have been when the original component was placed in service. You can’t use this method in every situation, though.

·       Pro rata allocation. Using the cost to replace the entire building, you can make a pro rata allocation of the original cost of the building to the replaced part.

·       Cost segregation study. You can engage specialists to conduct a study that allocates the cost of the building to its individual components.

Most building owners need a tax professional to help with these calculations. With a cost segregation study, you’ll likely need engineering help, too. Of course, the savings you achieve should more than offset any fees you incur. 

Making the Election Is So Simple