Tax issues

Commercial Developers May Gain Basis Allocation Advantage

A recent U.S. Tax Court decision may provide commercial developers with another creative tax-planning tool, based upon a long-standing basis-allocation rule available to residential developers.

In a series of judicial decisions dating back to the 1950s, courts have ruled that real estate developers can allocate the basis of common improvements to the cost of individual lots to be sold. The operative theory, generally, has been that the improvements add value to the lots the developer is selling.

The courts’ conclusions in these decisions, commonly called the "developer line" of cases, have been directed toward residential real estate developers. These cases involve a two-part test: Has the developer constructed the facility in question for the basic purpose of inducing purchasers to buy lots, and has the developer parted with the constructed facility for the benefit of the subdivided lots? If the answers to those two questions are "yes," the seller may recover its cost of the common improvements as part of its cost of goods sold.

In a 1998 Tax Court case, Norwest Corp. v. Commissioner, the court may have charted a new course by expanding these decisions beyond residential developers. Although the taxpayer in Norwest was unable to convince the court of its position, the court did conclude that, given the appropriate circumstances, the allocation of basis of common improvements is available to commercial developers as well.

Case History
In this case, Norwest was the successor in interest to an affiliated group of corporations whose parent corporation was United Banks of Colorado, Inc. (UBC). During the years at issue, UBC and its subsidiaries owned two buildings on a prime commercial downtown block in Denver. To meet its office space needs, UBC planned to build a new office tower on land owned by one of its subsidiary corporations. The proposed site was on a downtown block directly east of the prime block, making it a less preferable location relative to the commercial downtown area at the time.

As part of the office tower project—and to combat its less-preferable location—UBC decided to connect the new tower to the better-located buildings with enclosed, elevated pedestrian walkways and a large central atrium. Despite the advice of outside consultants that the atrium itself would produce substantial yearly financial deficits, UBC proceeded with the project in hopes of generating increased rental rates in its two original buildings, thus positively boosting its image in the Rockies and counteracting any adverse perception generated by the location of the new tower.

Eventually, UBC divested itself of all three properties. The company allocated the basis of the atrium—which it viewed as a general common improvement to its three-building complex—to the basis of each of the three properties in the complex, ultimately helping it recover the cost of the atrium as the properties were sold.

The Norwest Decision
In Norwest, relying heavily on the developer line of cases and citing Internal Revenue Code (IRC) Section 1016(a)(1) (generally defining adjustments to basis), UBC argued that it was entitled to allocate the cost of the atrium assets to the bases of the properties that benefited from the atrium, stating that "[UBC] constructed the atrium for the purpose of creating an office building complex with the expectation that the buildings within the complex would increase in value."

On the other hand, the Internal Revenue Service (IRS) argued in citing IRC Section 1012 (governing basis), "the amount paid for a given asset becomes the asset’s cost basis and cannot be added to or combined with the basis of other assets." While the IRS acknowledged the existence of an exception to the general rule, as supported in the developer line of cases, it claimed that the present case was distinguishable from those cases and that the principles of those cases have "never been applied outside the narrow factual context in which those cases arose." In addition, the IRS argued that the case at issue failed to meet even the developer line of cases’ factual requirements. More specifically, it was determined that although UBC "constructed the atrium for the purpose of creating an office building complex with the expectation that the buildings within the complex would increase in value," that fact alone was insufficient without an intention to induce sales of the beneficial properties as established by the developer line of cases.

In its analysis, the Tax Court acknowledged that the developer line of cases "all involve real estate developers that seek to allocate the cost of certain common improvements to the bases of residential lots held for sale" and that the cases "address the basic problem of what constitutes a proper adjustment to the basis of property in the context of a common improvement that benefits lots in a residential subdivision."

In addition, citing the logic of similar cases including Estate of Collins v. Commissioner and Country Club Estates v. Commissioner, the court concluded that "when the basic purpose of property is the enhancement of other properties to induce their sale and such property does not have, in substance, an independent existence, total cost recovery for such property should be dependent on sale of the benefited properties."

Moreover, the court determined that the logic of the developer line of cases cannot only be applied to residential property, but can be applied to commercial property as well.

Commercial Real Estate Implications
The court ultimately ruled that, while the basis allocation exception outlined by the developer cases could be applied to commercial real estate, the nature of the atrium in the Norwest case did not meet the two tests established by those cases as cited above.

Although the commercial developer lost this case, the court’s logic in determining the case’s outcome has obvious positive implications for commercial developers in general. The implication is that given a better set of facts, commercial developers will be able to allocate the bases of common facilities, thus recovering their costs as the benefiting properties are sold. In doing so, commercial developers will be able to take advantage of a benefit seemingly limited to the realm of residential developers.

Steven M. Friedman and Samuel H. Hoppe

Steven M. Friedman is a tax partner and Samuel H. Hoppe is a tax professional in the McLean, Va., office of Ernst & Young. Contact them at (703) 747-1000 or and


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