Partial Dispositions:

Are You Paying Tax on Assets that Don’t Exist?

Building owners who engage in demolitions and renovations without considering partial dispositions of assets are making an expensive mistake.A typical long-term hold property owner has the opportunity to retire 30% or more of a building’s component costs over the life of the property. Why pay taxes on assets that don’t exist? By removing disposed building components, you reduce your tax basis by reducing the property’s book value.

How to spot these assets

When might a partial disposition come into play? Imagine you’re renovating an existing space to upgrade the lighting,replacing or repairing portions of the roof, and/orinstalling a more efficient HVAC system. Without a methodology in place that allows you to accurately value the disposed-of assets being replaced, you willlikely experience at least one of three outcomes (none of them good!):

(1) you’ll miss the partial disposition opportunityaltogether

(2) you’ll fail to maximize the tax benefit by undervaluing the disposed asset

(3) you’ll inadequately substantiate the write-off, making you vulnerable under audit

How big is the benefit of getting it right? Well, consider this:

The owner of a 400,000 square foot multi-tenant office building engaged in a number of renovations. There was HVAC work as retail space was converted to restaurant use. The owner also made roof repairs, improvements to lighting, and plumbing upgrades.
This property owner thought ahead and consulted with Meridian, enabling them to get the right methodology in place before the projects started.

The result?

A detailed engineering cost segregation study positioned the owner to realize $1.4 million in dispositions/tax write-offs over a three-year period. Additionally, by using Meridian as an ongoing resource over the life of the property as improvements are made or tenants change, the client has an easy, cost-free way to efficiently account for fixed asset retirements.

Imagine another case

A property owner purchases a 100-year-old warehouse in an up and coming neighborhood. After several years of warehouse use, the property’s location and architectural qualities make it a perfect fit for transition to residential/rental and retail use, but the features of the older structure make it far from energy efficient.

Replacing the existing HVAC system, windows, and other elements can bring the building up to contemporary energy efficiency standards. And, for the owner, a detailed accounting of the assets to be replaced before the work begins sets the stage for successfully realizing tax write-offs through partial dispositions. Additionally, the owner was able to further increase their tax benefits by accelerating the depreciation of the improvements via a cost segregation analysis and 179D energy tax deduction

• Regular refreshing of spaces in hotels, office buildings, residential rental buildings, retail properties, restaurants, and multi-tenant properties
• Production line changes or expansion of manufacturing properties
• Lighting upgrades to meet the needs of a new tenant or to cut energy use

Getting It Right with the IRS

How can a property owner make sure the partial depreciation will pass IRS muster? Well, the IRS has indicated it will accept any reasonable partial dispositions methodology, but it’s up to the taxpayer to show that the methodology is indeed reasonable. Since these rules are vague, the IRS has the upper hand under audit. For this reason, it’scritical that the methodology is comprehensive and performed in the context of a construction format that documents the overall building, versus simply cherry picking disposed assets.

The IRS has been targeting unsubstantiated disposition elections in their LB&I audit strategy to deter abuse. Meridian’s methodology takes the burden of proof off the Taxpayer and CPA by providing details for the entire building in a construction format that’s easy for the IRS agents/engineers to follow under audit.

Defend yourself

The key word in successfully navigating an IRS audit is “defensible.”

Defensible fixed-asset classifications are a must for property owners seeking to benefit from a partial dispositions strategy. Many firms only recently started to incorporate partial dispositions as a result of disposition regulations finalized in 2014.

Unlike those firms new to the practice, Meridian Financial Solutions’ cost segregation team has been helping real estate investors, public companies, and institutional clients successfully defend fixed asset classifications for depreciation and future write-offs since the late 1980s – more than 30 years ago.

In fact, we’ve been told that the IRS referred to our methodology as the authority when they wrote the engineering methodology in their Audit Techniques Guide.

The Importance of Expert Assistance

There’s no underestimating the value of the right expertise in realizing the tax benefits of partial dispositions. Property owners whodon’tkeep good records or fail to consult an expert prior to demolitions risk losing the opportunity to get ghost assets off their books. On the other hand, making sure your books reflect what you actually own can lower income taxes and, potentially, property taxes (depending on the municipality).

Select candidates

Who can benefit from partial dispositions? Multi-tenant real estate owners, property owners planning to hold properties for long periods of time, or those who plan on making significant upgrades or ongoing improvements during the ownership period stand to gain the most from a well-organized fixed asset strategy.

Meridian’s studies and retirement guidance have withstood scrutiny from thousands of Revenue Agent Reviews (RARs) and full audits on completed projects.

Property owners engaging in demolitions and renovations can realize significant tax benefits through partial disposition of assets. But realizing those benefits requires understanding these opportunities.Engaging experts provides the substantiation to maximize eligible benefits early onresulting in a solid basis for depreciations and future tax write-offs that withstand IRS scrutiny.