The Final Repair Regulations clarified the rules related to whether a building expenditure is a capital improvement or can be a repair expense. However, one of the most significant rules that has changed under these Regs is in regards to the disposition of structural components of buildings. In the past, when a taxpayer renovated an existing building, they were not allowed to write off the remaining basis of the structural components being abandoned or "ripped out". This might include things like the old roof, HVAC units that were replaced, old lighting and so forth.
Under the new rules, you can now assign a value to the old 39 year components that are replaced and write off the remaining tax basis! This is a brand new opportunity that all CPAs should be aware of for all clients. Even though a cost segregation might have already been done on the new renovations, most CPAs did not write off the building components that were gutted or replaced. If a taxpayer made renovations over the last 15 years, you can now use form 3115 to go back and write off the components that were ripped out.
Example: Taxpayer acquired $5M building in 2007
- 2010 they spent $1M to remodel portion of 2nd floor (ceilings, walls, lighting, plumbing, ducting, electrical wiring, etc.)
- Cost Segregation was already performed in prior year for the 2007 purchase and the 2010 improvements.
- KBKG “Retirement Study” determines the original cost basis of demolished components is $470K (from the original $5M building)
- Recognize a loss of $404K in 2013 tax year by filing Form 3115. (original cost basis less depreciation already taken)
Retirements Convert Recapture tax into Capital Gains
If you incorrectly continue to depreciate 1245 & 1250 property that was removed from a building, you pay recapture tax upon sale
- 1245 recapture is at ordinary rates (35%-41%);
- 1250 recaptured at 25%
- Capital Gains are typically taxed at 20%
Example Above Continued: $5M building with $470K of retirements.
In the example above, if they continue to depreciate the $470k, they recapture all of it upon sale
- Let’s say $370k of that was 39 year & $100k was 7 year property
- Recapture Tax = $127,500 ($370k X 25% + $100k X 35%)
Alternatively, if they do a Retirement Study:
- Recapture tax on the $470K = 0
- Capital gain tax = $94,000 ($470K X 20%)
Permanent tax savings of $33,500 upon sale
Author: Gian Pazzia, CCSP