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17SEPTEMBER/OCTOBER 2015 CONSTRUCTION ACCOUNTING AND TAXATION

Dur ing the las t few years ,downward pressure on caprates, historically low inter-est rates, and readily avail-able debt have caused the

commercial real estate market as a wholeto appreciate substantially. While lower-tier markets may not have reached theirpre-recession price levels, some may saythat first-tier markets are showing earlysigns of overheating.Given the cap rates for Class A prop-

er t ies in top-t ier markets , rea l es tateprofessionals have begun to look at build-ings that may be a l i t t le “ long in thetooth” and in need of significant improve-ments, if not complete demolition. Giventhe r ight c i rcumstances , th is t ype ofinvestment may provide superior returnscompared to investing in a building thatis closer to the beginning of its life cycle.When acquiring a property that even-

tual ly may be demolished, there are sig-nificant tax consequences to consider.

Allocation of purchase priceWhen land and a building are purchasedtogether for a lump sum, it is necessaryto apportion part of the purchase pricebetween the land and the building. Gen-

eral ly, the total purchase price is al lo-cated between the land and the buildingbased on their relative fair market values.1

Buyers and sel lers may have dif fer ingopinions on how much of the purchase priceto allocate between land and building.Sellers may want to allocate more purchaseprice to land because land is not depre-ciable, and any gain on the land shouldbe subject to a lower capital gains rate.2

The sale of a building, which is subjectto depreciation, would be subject to highertax rates under certain “recapture” rules.3

A buyer, on the other hand, wil l wantto al locate more to the building becausebuildings generate depreciat ion deduc-t ions that w i l l reduce future t axableincome. In addit ion, a buyer may wantto have a cost segregation study (or “costseg”) to fur ther a l locate the purchaseprice for the building among its varioussubcomponents. Many subcomponentshave shorter depreciable l ives, result ingin increased depreciat ion deduct ionsearly on. While a third-party appraisalof the land and the building is the safestbet to withstand a chal lenge by the IRS,a careful and reasonable al locat ion ofthe purchase price may be accepted pro-vided the parties can show the allocationwas based on arm’s-length negotiations.

SAVING DEPRECIABLETAX BASIS FROM

DEMOLITIONLAURA JACKSON AND SCOTT DRAGO

LAURA JACKSON is a managing director in the tax practice of the Real Estate & Infrastructure Solutions industry group atFTI Consulting, Inc. She can be reached at laura.jackson@fticonsult ing.com .

SCOT T DRAGO is a senior director in the tax practice of the Real Estate & Infrastructure Solutions industry group at FTIConsulting, Inc. Contact him via email at scott.drago@fticonsult ing.com .

Purchase pr ice al location may be less signif icant i f a

bui lding is ult imately demolished, unless rules issued

recently can be taken advantage of by the new owner.

18 CONSTRUCTION ACCOUNTING AND TAXATION SEPTEMBER/OCTOBER 2015 DEMOLITION TAX CONSEQUENCES

In addit ion, what if the buyer intendsto demolish the building? What is a rea-sonable amount of the purchase price toal locate to the building? If the buildingis no longer in service, then it may be dif-ficult to argue that any significant amountof the purchase pr ice should be a l lo-cated to the building. On the other hand,if the building is operat ing in the nor-mal course, then the buyer’s intent toeventual ly demolish the bui lding maynot have as much of an impact on the pur-chase price al location between land andbui lding . This w i l l depend on a l l thefac ts and c ircumstances . However, asdiscussed in the fol lowing paragraph,the purchase price allocation may be lesssignificant if the building is ult imatelydemolished, unless rules issued recentlycan be taken advantage of by the newowner.

Demolition and tax basisPrior to 1984, the demolit ion of a build-ing typical ly resulted in a loss deduc-tion for the owner equal to the remaining

basis in the building (plus costs ofdemolition, less any salvage value).4

As mentioned previously, this rulewas subject to a major exception.If the property was acquired withthe intent to demol i sh i t e i therimmediately or at a later date, thenthe entire purchase price was al lo-cated to the land and no loss wouldresult upon demolit ion. 5 Treasury

Regulations look to al l the facts and cir-cumstances sur rounding the buyer ’sintentions for the building to determinewhether the purchase pr ice should beal located solely to the land. 6

Internal Revenue Code Section 280BThe subject ive test used to determine abuyer’s intended use (or lack of use) ofa building was perceived as difficult toapply in the real world and often resultedin tax l it igat ion. As a result, Congressenacted IRC Sect ion 280B. 7 Under thatsect ion, when a building is demolished,the adjusted basis of the building (andthe cost of demolit ion) less any salvagevalue must be capitalized and added to

the basis of the land. The basis of thenew building only includes the cost of newconstruct ion.However, amounts spent modify ing a

bui lding are not subject to Code Sec-t ion 280B. Any modificat ions are addedto the basis of the old building and notto the land. For purposes of this excep-t ion to Code Sect ion 280B, a buildinghas been modified (as opposed to demol-ished) if (1) at least 75 percent of “theexist ing external walls of the buildingare retained in place as internal or exter-nal walls” and (2) at least 75 percent of“the exist ing internal structural frame-work of the building is retained in place.”8

This is an important except ion to thebr ight - l ine ru le under Code Sec t ion280B.

Case law exceptions to Code Section280BIt is important to keep in mind that CodeSect ion 280B does not prevent a tax-payer from taking a loss deduction on abuilding that results from an unexpectedret irement of the building prior to anydecision to demolish it. In the De Coucase, the taxpayer purchased real prop-erty in 1984 with the intention of reno-vat ing two of the buildings and leasinga third. 9 Serious defects in one of the build-ings were discovered in 1985 and cer-t a in permit s were revoked . It wasdetermined that the bui lding was notcommercially v iable without significantrepairs (which would cost twice as muchas construct ing a new bui lding). As aresult, the taxpayer decided to ret ire theproperty, but no efforts to sel l the prop-erty were made. The same year in whichthe defects were discovered and the build-ing was taken out of ser v ice, the tax-payer had the building demolished. Onthe taxpayer’s 1985 tax return, an ordi-nar y abandonment or ret irement losswas taken, which the IRS disal lowed.The Tax Court sided with the taxpayer

and al lowed the loss deduction. In find-ing for the taxpayer, the Tax Court notedthat the unexpected revocat ion of thebuilding’s permit and withdrawing thebuilding from use due to the discoveryof severe structural issues was the cause

WHEN A BUILDING ISDEMOLISHED, THE

ADJUSTED BASIS OFTHE BUILDING (AND

THE COST OFDEMOLITION) LESS

ANY SALVAGE VALUEMUST BE CAPITALIZED

AND ADDED TO THEBASIS OF THE LAND.

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of the loss , not the demolit ion of thebuilding. Therefore, the deduction wasnot barred by Code Section 280B. The keyto the Tax Court’s decision was the factthat the property was withdrawn from useand there were no efforts to sell the prop-erty.On the other hand, the 3 rd Circuit in

Gates, Linden v. U.S. found that a taxpayerwas not entit led to a loss deduction ona building that was subsequently demol-ished. 10 In Gates, the taxpayer acquireda building in 1984 with the intent to ren-ovate and lease it . In 1988, asbestos wasdiscovered and extensive damage fromvandal ism occurred. The renovat ionswere never made, and the building wasmarketed for lease or sale unti l 1989. In1991, the building was demolished. Indenying the taxpayer’s loss deduction, the3 rd Circu i t emphas i zed that the lo s s(asbestos and vandalism) occurred in1988, but the deduction was claimed in1991. As impor tant , the bui lding wasnever abandoned, as the taxpayer con-t inued to market i t for lease or sa le .Therefore, a taxpayer intending to claima loss deduction for a demolished build-ing must identify and document the eventthat created the loss, claim the loss in theappropriate tax year, and discontinue allmarket ing of the proper ty. The Ga tescase shows that, while hindsight may be20/20, it doesn’t help with a loss deduc-tion when a building is demolished. Fore-sight is the key.

Tangible property regulationsThe recently finalized tangible propertyregulations (or TPRs) are one of the mostsignificant (if not the most significant)tax developments affecting the real estateindustr y s ince the Tax Reform Act of1986. The TPRs touch on almost everyaspec t of owning and operat ing rea lproperty. While the TPRs are intendedto prov ide taxpayers cer tainty on theproper tax treatment of materials, sup-plies, repairs, and disposit ions of realproperty, they have also provided manyopportunit ies for tax planning.One such oppor tunity prov ides the

potential to avoid rol ling over a demol-ished bui lding’s remaining bas is into

land under Code Sect ion 280B. 11 Pur-suant to the TPRs, a taxpayer that antic-ipates demolishing a building may placethe building into a single-asset generalasset account (GAA) and cont inue todepreciate the bui lding even af ter thebuilding is demolished instead of rollingover the remaining adjusted basis of thebu i ld ing into the l and a s o therw iserequired by Code Sect ion 280B. 12

According to the TPRs, a taxpayer isnot required to terminate the GAA upondemolition of the building. Therefore, evenafter the building is demolished, a tax-payer would continue to depreciate theremaining adjusted tax basis as i f thebuilding was st i l l standing.GAA elect ions are relat ively uncom-

mon because they typical ly lock in thebasis of a property and keep a taxpayerfrom realizing losses on the disposit ionof assets. Disposit ion of an asset that ispart of a GAA general ly does not resultin a tax loss to the taxpayer. It contin-ues to be depreciated as part of the GAAuntil the GAA balance is $0. However, asingle-asset GAA can be used to a tax-payer’s advantage when it is desirable tocontinue depreciating the property evenafter its disposit ion, such as a demoli-t ion where the bui lding’s basis wouldotherwise be rol led into the land.It should be noted that the elect ion

to place a bui lding into a s ingle assetGAA is only avai lable for current andfuture years in wh ich a proper t y i sacquired.13 Further, the election to placea building into a GAA is not available forbuildings that are acquired and disposedof w ithin the same year. 14 As with thecases discussed prev iously, a taxpayermust plan ahead and keep the proverbialeye on the wrecking ball in order to makea t imely GAA elect ion.This new rule allowing for the continued

depreciat ion of a demolished buildingwould benefit taxpayers in the currentmarketplace. Given current real estatevaluations, commercial real estate own-ers may begin to look for opportunit iesto acquire “t ired” buildings that are inprime locat ions, demolish the exist ingstructure, and rebuild. Placing the oldbuilding in a GAA would al low the tax-payer to continue to depreciate the old

19DEMOLITION TAX CONSEQUENCES SEPTEMBER/OCTOBER 2015 CONSTRUCTION ACCOUNTING AND TAXATION

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

bui ld ing af ter demol i t ion, ins tead ofrol ling the building’s adjusted tax basisinto land only to real ize a tax benefitfrom the increased basis in the land upondisposit ion. The TPRs essential ly al lowa taxpayer to deduct two buildings (thedemolished bui lding now in the GAAand the new building once constructionis complete). n

NOTES1 Treasury Regulat ion § § 1.61-6(a) and 1.167(a)-5. 2 This assumes the sel ler is not in the trade or busi-ness of sel l ing property and has held the propertyfor investment purposes.

3 “Recapture” is a bit of a misnomer in that the gainis not re-characterized as ordinary income (assum-ing straight- l ine depreciat ion has been taken), butthe amount of gain equal to prior depreciation takenwould be subject to a higher 25 percent capita lgains rate. However, any accelerated depreciat iontaken on components of a bui lding may cause gainal located to those components to be treated asordinary income.

4 Treasury Regulation § 1.165-3(b)(1). However, underTreasury Regulation § 1.165-3(b)(2), demolition of abuilding subject to a lease requires the remaining taxbasis in the building to be added to the lease costand amortized over the remaining term of the lease.

5 Treasury Regulat ion § 1.165-3(a). 6 Treasury Regulat ion § 1.165-3(c)(1) and (2) set outa long l ist of factors to be considered.

7 All references to the “Code” herein are to the Inter-nal Revenue Code of 1986, as amended; Staff of JointComm. on Tax’n, 98th Cong., 2d Sess. , GeneralExplanation of the Revenue Provisions of the DeficitReduction Act of 1984, at 1178 (Comm. Print 1984).

8 Rev. Proc. 95-27, 1995-1 CB 704. 9 103 TC 80 (1994).10Gates, Linden v. U.S., 82 AFTR 2d 98-6909 (168 F.3d478), Code Sec(s) 165; 167; 280B, (CA3), 10/09/1998.

11 This assumes that a loss on demolit ion is not avai l -able under the case law discussed previously.

12Treasury Regulat ion § 1.168(i ) -1(e)(3)( i i ) (A).13This is because the period for f i l ing late account-ing method changes for previously acquired prop-erty under the TPRs has closed. For example, ataxpayer that acquired a property in 2011 and is aboutto begin demolit ion would not be entit led to makean elect ion to place that property into a GAA andcontinue depreciat ion.

14Treasury Regulat ion § 1.168(i ) -1(c)(1)( i ) .

20 CONSTRUCTION ACCOUNTING AND TAXATION SEPTEMBER/OCTOBER 2015 DEMOLITION TAX CONSEQUENCES