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Often Missed Rental Property Tax Savings

Owning a rental property comes with its share of maintenance challenges. Roofs, HVAC units, lighting systems—they all eventually require replacement. But there’s a silver lining: the IRS offers a valuable tax break for these necessary upgrades that many property owners overlook. Before you grit your teeth at the thought of the IRS, let’s dive into why you might actually thank them for this one.

The IRS and Your New Roof

Previously, when you replaced a structural component such as a roof, the old roof’s remaining depreciation continued on your books. Essentially, you were stuck with a “ghost roof” on your books, haunting you even after it was physically gone.

However, now IRS allows property owners to elect a “partial disposition” deduction. Using this election means when you replace an old roof, you can deduct the undepreciated basis of the old roof rather than continue depreciating it. This simple yet significant change can lead to substantial tax savings.

In some cases, you might achieve greater tax benefits without making the partial disposition election. The new IRS rules allow you to deduct the cost of replacing certain non-major building components as expenses, provided you don’t claim a loss on the old component.

For instance, if you replace a few units in a large HVAC system, the IRS might consider these replacements minor components. In such cases, you can deduct the cost of the new units as a repair expense without dealing with the old units’ depreciation.

Advantages of the Partial Disposition Election

The beauty of this new partial disposition election is twofold.

⦁ Immediate deduction. With the election, you claim an immediate tax deduction for the undepreciated basis of the old component.
⦁ Beat the recapture tax. When you eliminate the old component, you avoid the capital gains recapture tax of up to 25 percent (technically known as “unrecaptured Section 1250 gain”) when you sell the property.

The Cost of Poor Planning

Consider this scenario: You buy a commercial building for $3 million and do a $1 million renovation in Year 7 but don’t elect to write off the replaced components. Years later, you sell the building for $5 million. If you didn’t write off the replaced components, your adjusted basis is zero, and your gain is $5 million, resulting in a $1.2 million tax bill. Ouch!

The Benefit of Good Planning

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

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 (800,000 – 140,000) 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 of adjusted basis in Year 7 and that put about 40 percent after taxes in your pocket, for a total of $264,000.

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

Without considering the time value of money, you have a $304,000 (264,000 + 40,000) cash windfall by making the election.

Takeaways

Replacing a structural component in your building can bring double savings: an immediate deduction for the old component and reduced recapture taxes upon sale. To seize these benefits, you need to identify the remaining depreciable basis of the replaced asset and consult with your tax professional to use the IRS solutions. By making the partial disposition election, you write off the remaining basis of the old component and begin depreciating the new one, maximizing your tax advantages.

If you would like help with embracing tax benefits in your business, contact Saunders Tax & Accounting at www.SaundersTax.com or call us at 301-714-2071. Open Monday – Thursday 9 am to 5 pm. Awarded the Hagerstown Chamber of Commerce “2023 Small Business of the Year” and Hagerstown Hotlist 2024, we have been providing a Less Taxing Life and More Prosperous Solutions for 40 years!

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