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Purchase price allocation may be less significant if a building is ultimately demolished, unless rules issued recently can be taken advantage of by the new owner.
During the last few years, downward pressure on cap rates, historically low interest rates, and readily available debt have caused the commercial real estate market as a whole to appreciate substantially. While lowertier markets may not have reached their pre-recession price levels, some may say that first-tier markets are showing early signs of overheating.
Given the cap rates for Class A properties in top-tier markets, real estate professionals have begun to look at buildings that may be a little "long in the tooth" and in need of significant improvements, if not complete demolition. Given the right circumstances, this type of investment may provide superior returns compared to investing in a building that is closer to the beginning of its life cycle.
When acquiring a property that eventually may be demolished, there are significant tax consequences to consider.
Allocation of purchase price
When land and a building are purchased together for a lump sum, it is necessary to apportion part of the purchase price between the land and the building. Generally, the total purchase price is allocated between the land and the building based on their relative fair market values.1 Buyers and sellers may have differing opinions on how much of the purchase price to allocate between land and building. Sellers may want to allocate more purchase price to land because land is not depreciable, and any gain on the land should be subject to a lower capital gains rate.2 The sale of a building, which is subject to depreciation, would be subject to higher tax rates under certain "recapture" rules.3
A buyer, on the other hand, will want to allocate more to the building because buildings generate depreciation deductions that w ill reduce future taxable income. In addition, a buyer may want to have a cost segregation study (or "cost seg") to further allocate the purchase price for the building among its various subcomponents. Many subcomponents have shorter depreciable lives, resulting in increased depreciation deductions early on. While a third-party appraisal of the land and the building is the safest bet to withstand a challenge by the...