Applying Large-Company Asset Practices to a Rental Portfolio
Applying Large-Company Asset Practices to a Rental Portfolio
Five roof replacements resulted in a $9,102 tax deduction, and it had nothing to do with the new roofs.
Over several years, we replaced roofs on five of our rental properties.
The accounting for the new roofs was straight forward. They were capital improvements, so the costs were capitalized and depreciated.
But that left another question:
What happened to the old roofs?
Physically, they were gone.
From an accounting perspective, however, part of their original cost was still embedded in the tax basis of each building and continuing to be depreciated.
Applying a Large-Company Asset Practice
This question came naturally from my engineering background.
In a large company, capital assets are not always treated as one permanent block of cost. When a significant component is replaced, there is often a second question beyond how to account for the new asset:
What should happen to the value associated with the component that was removed?
I applied that same thought process to our rental portfolio.
The new roof clearly became a new capital asset.
But if the old roof no longer existed, should we really continue depreciating its remaining cost for years?
I discussed the issue with my business tax accountant, and we agreed it was appropriate to remove the remaining basis associated with the old roofs.
The harder part was determining that basis.
The Roof Wasn't a Separate Asset
When we originally purchased the properties, there was no separate line on the depreciation schedule labeled "roof."
The roof was simply one component of the building.
That meant there was no convenient number to write off when the roof was replaced.
I needed a reasonable method to estimate how much of the building's remaining basis represented the old roof.
I started with our own portfolio data. I compared the actual cost of the five roof replacements with the insured replacement cost of the buildings. The roof replacements averaged approximately 5.5% of building replacement value.
I also compared that result with published residential construction-cost data as an external reasonableness check. The industry data did not provide a perfect apples-to-apples comparison, new construction separates roofing, framing, trusses, sheathing, and other components differently than a roof replacement, but it gave me another reference point for evaluating whether our portfolio-derived percentage was reasonable.
Using the portfolio data as the basis for the estimate, the remaining cost associated with the old roofs was removed from the buildings' tax basis. The final tax return reported a combined $9,102 loss on Form 4797.
How This Differs from Cost Segregation
Rental property owners hear a great deal about cost segregation.
Cost segregation generally works by identifying portions of a building that can appropriately be depreciated over shorter recovery periods rather than leaving the entire cost in the building's 27.5-year residential rental property depreciation schedule.
What I was dealing with was different.
I was not trying to accelerate depreciation on an asset we still owned.
I was asking whether we were continuing to depreciate a component that had already been removed from service.
That is a fundamentally different question.
Cost segregation asks:
Can part of this property's cost be depreciated faster?
A partial-disposition analysis asks:
Should I still be depreciating this component at all?
For our roofs, the answer to the second question was no.
Roofs May Not Be the Only Candidates
That experience also changed how I think about other major capital projects.
A rental building is technically one depreciable asset in many owners' records, but operationally it is made up of many components.
That raises similar questions when a major component is completely replaced.
Potential examples might include:
A complete HVAC system replacement
A whole-house window replacement
Other major building components that were originally included within the building's depreciable basis
Not every repair or replacement will qualify for the same treatment, and determining the remaining basis of an old component can become difficult when the original records do not separately identify it.
But the question is still worth asking.
If a component was capitalized as part of the building and is being depreciated over 27.5 years, replacing it does not necessarily mean the remaining basis should automatically stay buried in the building's depreciation schedule.
A Different Way to Look at Capital Improvements
Most discussions about capital improvements focus on the new expenditure:
How much did the roof cost?
Does it need to be capitalized?
What is the depreciation period?
Those are important questions.
But there can also be an accounting consequence attached to the asset being removed.
For me, the useful discipline was the same one I had seen applied to much larger capital asset systems:
Account for what went in, but also account for what came out.
That led to a $9,102 deduction across five roof replacements.
More importantly, it gave me another framework for reviewing capital projects throughout the portfolio.
Whenever we completely replace a major building component, I now think there are two questions worth asking:
How should I account for the new asset?
And:
Am I still depreciating something I no longer own?
This article describes an example from my own rental portfolio and is not tax advice. The tax treatment of building components, partial dispositions, basis allocation, and depreciation depends on the individual facts and applicable tax rules. Rental property owners should review their specific circumstances with a qualified tax professional.
