When taxpayers acquire a building that may need to be demolished in the foreseeable future, they are often disappointed to learn from their tax preparer that they will lose all future tax depreciation deductions associated with the building. For many years, the Code has not been forgiving to property owners who invest in a building and then realize it may not be suitable for future use. In general, the basis of any demolished building must be capitalized to land, which cannot be depreciated.
However, the recently released tangible property regulations provide a potential opportunity to continue depreciating a building after demolition has occurred. To use this strategy, however, a taxpayer must elect to include the building in a General Asset Account (GAA) in the year the building is placed in service and comply with all the rules that apply to GAAs. The election must be made on an original, not amended, return. Thus, it is critical for tax preparers to identify this opportunity early in the process to properly assess this strategy. Furthermore, the benefit of electing a GAA should be weighed against the fact that partial dispositions are not allowed in a GAA.
Observation: There may be significant permanent tax savings realized by continuing to depreciate a demolished building. If the adjusted basis of the old building is capitalized and added to the basis in the land, the basis will not be recovered until the land is sold, which will result in a reduced capital gain. A taxpayer that continues to depreciate a demolished building in a GAA can use those deductions to reduce current taxes at higher ordinary income rates versus the lower rate under Sec. 1250 in the year of sale. Further, accelerating the deductions generates savings based on the time value of money.
Sec. 280B provides that “in the case of the demolition of any structure . . . any amount expended for such demolition, or . . . any loss sustained on account of such demolition . . . shall be treated as properly chargeable to capital account with respect to the land on which the demolished structure was located.” Regs. Sec. 1.280B-1(b) further explains that the term “structure” is a building, including its structural components, as defined in Regs. Sec. 1.48-1(e). Thus, any structures that are essentially items of machinery or equipment, such as oil and gas storage tanks, or blast furnaces, are not required to be capitalized to land when demolished.
Observation: Because Sec. 280B only applies to buildings and their structural components, a taxpayer may reduce the adjusted basis of the demolished building and the amount subject to capitalization by performing a cost segregation study to separately identify personal property such as carpet, cabinetry, process plumbing, and special electrical systems, etc. These items are considered tangible personal property and can be written off over a 5- or 7-year tax life. Also, because personal property can be retired when the building is demolished, a cost segregation study should be considered regardless of whether the building is put in a GAA.
For situations where only parts of a building structure are demolished, the IRS has provided a safe harbor for purposes of determining whether structural modifications to a building are considered a demolition (see Rev. Proc. 95-27). The safe harbor indicates that modifications will not be treated as a demolition for purposes of Sec. 280B if: (1) 75% or more of the existing external walls of the building are retained in place as internal or external walls; and (2) 75% or more of the existing internal structural framework of the building remains in place.
Changes under the tangible property regulations
Under the tangible property regulations, there is no requirement to terminate a GAA upon the disposition of a building. Therefore, a taxpayer that includes a building in a GAA may effectively choose whether to continue to depreciate the building when disposed of or capitalize the adjusted basis to land under Sec. 280B.
In general, the adjusted basis of any asset in a GAA (that is disposed of) is determined to be zero immediately prior to disposition. The basis associated with that asset remains in the GAA and continues to depreciate. (See Regs. Secs. 1.168(i)-1(e)(2)(i) and (iii).) Thus, the basis of a demolished building subject to capitalization under Sec. 280B is zero and the taxpayer continues to depreciate the basis in the GAA. Alternatively, when the last asset in a GAA is disposed of, a taxpayer may elect to terminate the GAA and the adjusted basis of the GAA is subject to all other provisions of the Internal Revenue Code, including Sec. 280B. (See Regs. Sec. 1.168(i)-1(e)(3)(ii).) If only one demolished building is in a GAA and the taxpayer elects to terminate the GAA, the adjusted basis of the building would effectively be capitalized under Sec. 280B.
Caution: This strategy does not work for any building acquired and demolished in the same tax year (Regs. Sec. 1.168(i)-1(c)(1)(i)). Additionally, the anti-abuse rules under Regs. Sec. 1.168(i)-1(e)(3)(vii)) are unclear on the extent to which taxpayers can use this strategy if there is clear intent to demolish the building at the time of acquisition.
A taxpayer acquires a multi-tenant shopping plaza in February of 2016 for $4 million. The property consists of three retail building structures with ample parking on a large parcel. The property is fully leased and each building is in relatively good operating condition. The lease for one of the single tenant buildings (Building A) is set to expire in 2017.
In November 2016, taxpayer is approached by a national restaurant chain that wants to build a new location on the property. To carry out its theme, the restaurant chain uses a unique building structure for each location, making it impractical to convert any of the existing buildings on site. If an agreement is reached, the taxpayer anticipates demolishing Building A at the end of the lease term and constructing a new restaurant facility to lease to the restaurant chain.
The taxpayer conducts a cost segregation study on the acquired property, which allocates $600,000 of value to the Building A structure (depreciated over 39 years) and an additional $90,000 of personal property fixtures within Building A (depreciated with a five-year life). On its 2016 return, the taxpayer elects to put only the Building A structure ($600,000) into a GAA and does not put tangible personal property ($90,000) into a GAA.
In 2017, an agreement is reached with the restaurant chain. Upon demolition of Building A, the taxpayer is not required under Sec. 280B to move Building A’s remaining tax basis to land, but the taxpayer continues to depreciate the building each year going forward. This generates a net present value of $72,000.* Further, the taxpayer claims a retirement loss deduction on the remaining basis from the $90,000 of five-year property, generating an additional net present value of $34,000.*
*Assumes a combined federal and state income tax rate of 40%, an 8% discount rate, and the property is never sold.
Compliance with GAA rules
While continuing to depreciate the basis of a demolished building may be favorable, a taxpayer that elects to include the building in a GAA must also apply all of the applicable GAA rules. Additional items to consider when deciding whether to make a GAA election include:
Timing. In general, a GAA election must be made on a timely filed return for the year the asset is placed in service. Thus, it is critical for tax preparers to identify this opportunity early in the process to appropriately consider all facts and circumstances.
How to make a GAA election. The election is made by checking the applicable box on Line 18 of Form 4562, Depreciation and Amortization, and by including a statement in the taxpayer’s records that identifies the assets included in each GAA. This statement does not need to be included with the tax return.
Partial dispositions are not available for assets included in a GAA. The GAA rules require a taxpayer to continue to depreciate the basis of the asset(s) included in the GAA until all assets in the GAA are disposed of. Thus, a taxpayer that replaces items, such as windows or lighting, may not claim a partial disposition loss. This limitation is one of the main reasons it is generally not appealing to make a GAA election for a building.
How many assets may be included in a GAA? In general, a taxpayer may include in a single GAA as many or as few assets as are placed in service at the same time and depreciated using the same recovery period, convention, method, bonus depreciation election, etc. (See Regs. Sec. 1.168(i)-1(c)(2) for additional requirements.)
Observation: Where multiple buildings are purchased on one property, consider making the GAA election only for the building that will be demolished. In this way, only the specified building is subject to the potentially unfavorable GAA rules. In addition, if a GAA election is desired for all building structures, the greatest flexibility is afforded when each structure is included in a separate GAA.
Subsequent additions may not be included in the original building’s GAA. Any additions to an asset included in a GAA may not be added to the original GAA. A taxpayer may make a separate GAA election for those assets or may choose to depreciate the addition separately without making a GAA election.
Losing the benefit of depreciation deductions, due to the demolition of the building, never feels good to a property owner. However, the recently released tangible property regulations provide a potential opportunity to preserve those deductions. In situations where a building is acquired that could potentially be demolished in the foreseeable future, the GAA election should be carefully considered in the year it is placed in service and before the original tax return is filed.
Gian Pazzia, CCSP, is a principal with KBKG and its national practice leader for cost segregation services, as well as a subject matter expert on repair vs. capitalization issues. He has served as president of the American Society of Cost Segregation Professionals and currently holds a seat on its board of directors.
James Liechty, CPA, has over 15 years of experience with PwC’s National Tax and McLean, Va., offices consulting on large and complicated federal income tax fixed-asset issues and change in accounting methods. He has consulted extensively on depreciation, cost segregation, and tangible property regulations issues for a broad range of clients across numerous industries.