Tangible Property Regs
Avoid demolishing your depreciable tax basis
Having climbed back from the lows of the Great Recession, the commercial real estate market has rebounded in recent years; some would say there are signs that top-tier markets are overheating. In response, commercial real estate professionals are beginning to look at older properties with buildings needing significant improvements, if not complete demolition. The return on investment may be worth the risk. But are there tax consequences to consider?
A property’s purchase price is allocated between land and buildings based on their relative fair market values, with sellers and buyers often taking different points of view on how such allocation should be calculated. (See Treasury regulations, sections 1.61-6(a) and 1.167(a)-5.)
Sellers may want to allocate the purchase price to land, which is not depreciable and subject to lower capital gains, assuming the seller has held the property for investment purposes. A building that has been depreciated is subject to higher tax rates under certain IRS recapture rules. (See www.irs.gov/publications/p544/ch03.html.)
Buyers favor a higher allocation to buildings since potential depreciation would reduce future taxable income. They even may want cost segregation studies to designate a portion of the purchase price among various subcomponents with shorter depreciable lives and faster deductions.
While third-party appraisals of land and buildings are the best safeguard to potential IRS challenges to a purchase price allocation, a reasonable allocation of the purchase price may be accepted if it’s based on arm’s length negotiations between the parties.
But what if the buyer intends to demolish the building? If the building is no longer in service, it may be difficult to argue that any significant portion of the purchase price should be allocated to the structure. If it is currently in use, the buyer’s intent to demolish the building sometime in the future should have no impact on the allocation. As discussed below, the purchase price allocation to a building may be less significant if the building is ultimately demolished, unless the new owner takes advantage of recently issued Treasury regulations.