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.
Demolition Tax Basis
Prior to 1984, the demolition of a building resulted in a loss equal to the remaining tax basis (plus demolition, minus salvage value). However, if the property was acquired with the intent to demolish it immediately or at a later date, the entire purchase price must be allocated to the land and no loss resulted upon demolition. (See Treasury regulations, sections 1.165-3(a) and (b).)
In 1984, Congress enacted Internal Revenue Code Section 280B. This tax provision provided that the adjusted basis of the building and cost of demolition (less any salvage value) must be capitalized and added to the basis of the land. No loss deduction would be allowed for demolishing a building, unless the owner could prove that the building was demolished due to an unexpected event. The tax basis for the new building only includes the cost of the new construction.
However, building modifications are not subject to this rule; these costs are added to the basis of the old building, not the land. The tax rules provide that a building has been modified, not demolished, if at least 75 percent of “the existing external walls of the building are retained in place as internal or external walls” and at least 75 percent of “the existing internal structural framework of the building is retained in place.” (See Rev. Proc. 95-27, 1995-1 CB 704.)
Recently issued tangible property regulations may provide a way to avoid the impact of IRC section 280B when a building is demolished.
Under tangible property regulations, a taxpayer who anticipates demolishing a building may place the building into a general asset account. GAA elections typically lock in the basis of a property and keep a taxpayer from realizing losses on the disposition of assets until the GAA balance is zero. A single-asset GAA can be used to the taxpayer's advantage, depreciating the property after its demolition, where the building's basis otherwise would be rolled into the land. (See Treasury regulations, section 1.168(i)-1(e)(3)(ii)(A).)
It is important to note that the GAA election must be made in the year in which the property is acquired. Also, this election is not available for properties that are purchased and sold within the same year. (See Treasury regulations, section 1.168(i)-1(c)(1)(i).)
This new rule allowing owners to continue to depreciate demolished buildings could benefit taxpayers in the current marketplace. Given current valuations, property owners should plan ahead and look for opportunities to acquire “tired” buildings in prime locations, demolish and rebuild them, yielding two deductions - the demolished building currently in the GAA and the new building upon completion of its construction.
While this article provides a general overview of the tax benefits available under new regulations, consult your tax professional for specific advice pertaining to your situation.