Here is a common problem with rental property tax. You replace the roof in year four for $25,000. You start depreciating the new roof over 27.5 years. Meanwhile, the old roof is still sitting on your depreciation schedule, depreciating over the same 27.5 years. You are depreciating two roofs. Forever. That is dumb. The IRS knows it’s dumb and gave you a fix.
When you can use it
Any time you replace a portion of a depreciable asset and the replacement work is capitalized as an improvement. Roofs, HVAC, electrical systems, plumbing, parking lots, anything you have to capitalize. You make the election on the timely-filed return for the year you replaced the component. There is no separate form, just the election attached.
The math
You bought the building five years ago for $400,000. $80,000 was land, $320,000 was building. Five years of depreciation took your building basis from $320,000 down to about $262,000. You replace the roof this year for $25,000. The original roof represented (let’s say) 6% of the building’s basis, or $19,200. Five years of depreciation on that piece took it down to about $15,800. The partial disposition election writes off the $15,800 as a loss this year. The new $25,000 roof starts its own 27.5-year schedule.
Without the election: the $15,800 keeps depreciating at about $570 a year for the next 22.5 years, alongside the new roof. With the election: $15,800 of deduction lands now.
How to figure the basis of what you replaced
You have to come up with a defensible number for what the old component cost (its share of the original purchase price). The IRS allows several methods, including a percentage allocation based on construction costs at the time, an engineering estimate, or, easiest, the numbers from a cost segregation study if you have one.
A cost seg study breaks the building into pieces, so each piece has its own basis. When you replace one, the math is already done. That’s a big reason cost seg pairs well with active management of an older property.
What you cannot use it for
Repairs that you deducted (not capitalized) do not need the election. Improvements you made in the year you bought the property are part of acquisition cost and are typically capitalized as part of the building’s basis, not a separate component, so the partial disposition election is generally not in play for those.
It is an annual election, not a method
You can use it on one component this year, skip it on a different component next year. There is no consistency rule. You just need to make the election on a timely return (with extensions) for the year of the disposition. Missed it? See your tax pro: Rev. Proc. 2014-54 provides limited relief for late elections.