IRS has issued a Practice Unit focused on identifying when taxpayers elect a partial disposition of a building or its structural components. he Practice Unit instructs IRS examiners that the identification process should occur through a review of taxpayer documents and tax return information during an IRS examination. After a positive identification, an IRS examiner can determine if there is a risk of noncompliance in recognizing the partial disposition.
Background. Reg § 1.168(i)-8 provides rules for recognizing gain or loss on the disposition of Modified Accelerated Cost Recovery System (MACRS) property. Under Reg § 1.168(i)-8(d)(2), taxpayers are allowed to elect to recognize partial dispositions of MACRS property, including the disposition of a portion of a building or its structural components. The partial disposition election is an annual election for tax years beginning on or after Jan. 1, 2014.
These Code Sec. 168 regs only apply to MACRS property. If the books and records show that the partially disposed asset was depreciated under a pre-MACRS method, a loss cannot be recognized on the partial disposition. Prior to these regs, recognizing a loss on a disposed portion of an asset was generally prohibited, requiring taxpayers to continue depreciating the basis associated with the disposed portion. For example, a loss could not be recognized when an old roof was disposed and replaced with a new roof.
Partial disposition election. The Practice Unit notes that identifying that a taxpayer elected to take a partial disposition of a building is the first step in determining whether it is compliant with the Code Sec. 168 disposition regs. The election is made by reporting the gain or loss on a timely-filed original tax return, including extensions, for the tax year in which the portion of the building is disposed. No specific form or election statement is required to be attached to the return. The election may be made by any taxpayer having a depreciable interest in a building or its structural components. Electing a partial disposition of a building will often result in a loss recognized on the tax return.
Since no specific form is filed in making the election, IRS identification of a partial disposition election for a building, including its structural components, occurs through a review of documents and tax return information during an IRS examination. As explained in greater detail below, examiners need to: (1) review annual reports and Forms 10-K; (2) review the depreciation tax asset detail schedules; and (3) review the tax return for specific forms filed related to asset dispositions.
The Practice Alert notes that instances where taxpayers are required to recognize a partial disposition include:
…A casualty event under Code Sec. 165;
…Transfers of a portion of an asset in a “step-in-the-shoes” transaction described in Code Sec. 168(i)(7)(B); or
…Sales of a portion of an asset.
IRS instructions to its examiners. The Practice Unit instructs IRS examiners to perform the following steps:
Step 1. Review Annual Report or Form 10-K for dispositions. In general, reviewing the taxpayer’s annual report or its Form 10-K can provide an examiner with a framework of what occurred in the taxpayer’s business during the tax year. These documents may provide sections regarding challenges or opportunities that the taxpayer encountered. The disclosures can assist the examiner in determining if the taxpayer had opportunities to make the election or was required to recognize the disposition of assets or portions of assets. For example, these disclosures might include a casualty event, an involuntary conversion, or projects such as remodels or improvements.
Reg § 1.263(a)-3 provides rules for improvements to buildings, including their structural components. Reg § 1.263(a)-3 and the disposition regs under Reg § 1.168(i)-8 interact with each other. In some cases, capitalization of the replacement costs is required on the partial disposition of an asset or portion of an asset. A review of the annual report or 10-K may help determine if there was a partial disposition of a building or its structural components that required the taxpayer to capitalize the replacement of the disposed portion of the asset. Reg § 1.263(a)-3(k) requires capitalization when a part, or a combination of parts, that comprise a major component or substantial structural part of a Unit of Property (UOP), is replaced. Replacement costs must be capitalized regardless of the size or importance if: (a) the taxpayer has properly deducted a loss for that component; (b) the taxpayer has properly considered the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component; or (c) a UOP is restored following a casualty loss/event under Code Sec. 165.
Certain partial dispositions are required to be recognized. Examiners should review the annual report or 10-K for statements regarding casualty events or involuntary conversions such as a flood, hurricane, fire or other disaster; or the exchange of property in a like-kind exchange.
Step 2. Review the tax asset depreciation detail schedules for dispositions and capitalization. Examiners should review the tax asset depreciation detail schedules for dispositions, partial dispositions and capitalized improvements. The tax depreciation schedules can provide information as to assets capitalized in the current year and assets or portions of assets disposed in the current year. If any of the descriptions appear to be related to a building or its structural components, the taxpayer may have elected to recognize a partial disposition. For example, examiners are instructed to look for descriptions of portions of a building removed or added during the year such as heating, ventilation, and air-conditioning (HVAC), roof, plumbing, walls, floors, or windows.
Generally, a Form 3115 (Application for Change of Accounting Method), would be filed by a Large Business and International (LB&I) taxpayer to comply with Reg § 1.263(a)-3‘s tangible property regs. The examiner should determine if the taxpayer has implemented the Code Sec. 263(a) regs, as required for tax years beginning on or after Jan. 1, 2014.
If the taxpayer has a depreciable interest in a leasehold improvement, it can recognize a partial disposition of that leasehold improvement. The examiner should consider the taxpayer’s line of business and its depreciable interest in its fixed assets—which may depend on whether the taxpayer is the owner, lessor, or lessee.
The Practice Unit notes that a partial disposition may not occur if the taxpayer merely adds or expands the building, such as the addition of new rooms or walls in a formerly open area. A taxpayer must actually dispose of a structural component of a building or a portion of a component to make a partial disposition election.
Generally, a taxpayer’s fixed asset detail schedule will have additional schedules that will report gains/losses on specific tax return forms, such as Forms 4797, 8824, 8949. The examiner should determine if the tax asset depreciation schedule show a gain or loss on a disposed asset or portion of an asset calculated with sale proceeds or through a like-kind exchange or an involuntary conversion, or if there a physical abandonment that shows a loss without any sale proceeds.
Step 3. Review tax return for partial dispositions of buildings, including its structural components. Examiners should determine whether the tax return has forms filed that indicate a partial disposition of a building or its structural components. Although such descriptions are not required to be stated on the forms, look for descriptions of portions of a building such as HVAC, roof, plumbing, walls, and windows.
Form 4797 (Sales of Business Property) reports the gain or loss on the partial disposition of a building or its structural components used in a taxpayer’s trade or business. While taxpayers may not report the partial disposition under the correct parts of Form 4797, the examiner should review the following areas for partial disposition of a building or its structural components, including involuntary conversions: Part I (reported as Code Sec. 1231property; Part II (reported as ordinary income property); Part III (used to compute ordinary income recapture).
Form 8949 (Sales and Other Dispositions of Capital Assets), used with Schedule D, can be used to report the gain or loss on the partial disposition of a building or its structural components, including involuntary conversions, held for investment purposes: Part I (held for one year or less, i.e., short-term); Part II (held for longer than a year, i.e., long-term).
Form 8824 (Like-Kind Exchanges) reports an exchange of business or investment property for property of a like kind. A taxpayer may be exchanging a portion of a building or its structural components and replacing through a like-kind exchange transaction. A taxpayer is required to recognize the partial disposition in this situation.
Forms 4797 and 8824 may be the initial form calculating gain or loss on the disposition of property held for investment purposes, with the result being transferred to Form 8949.