Bulletins

Reconsidering Those Desktop Purchase Price Allocations

Dear Clients and Friends:

When a taxpayer acquires real property consisting of multiple classes of depreciable and non-ciepreciable assets, the purchase price must be allocated in proportion to the fair market value of the assets acquired [IRS Publ. 225, Ch. 6]. Accordingly, when a taxpayer purchases something like a building, rental property, or farm, there is a need to allocate the purchase price to the non-depreciable land and to the depreciable buildings and other improvements, such as drainage tile or irrigation systems.

Typically, when these types of real estate change ownership, the sale price documents do not provide any allocation of the purchase price to the various depreciable and non-depreciable components. If a written allocation is provided, the Danielson line of court cases requires that the buyer and the seller are bound to this tax allocation for tax reporting purposes, absent the showing of duress or fraud. In the case of an asset acquisition that represents a business with going concern value, both the buyer and the seller must disclose the purchase price allocation on Form 8954 (Asset Acquisition Statement) within their tax returns [IRC Sec. 1060(b); Reg. 1.1060-1(e)(l)(ii)]. However, the purchase of real estate alone does not represent a going concern business, and the Form 8594 is not required.

The end result is that we are often presented with the purchase of real property with no allocation to the various components, and simply work out a reasonable allocation at the time of tax preparation or planning. That may not be such a good idea. Here's why.

The Accounting Method Rules

Applying the tax basis from the purchase of an asset to various depreciable components and non-depreciable land establishes an accounting method in terms of the resulting depreciation deductions. A change in a basis allocation that affects depreciation deductions becomes an accounting method change.

An accounting method change may only be made with the consent of the IRS [IRC Sec. 446(e); Reg. 1.446-1 (e)(2)]. Accounting method changes require the computation of a Section 481(a) adjustment, which represents the cumulative effect of the change as of the first day of the tax year for which the change is to occur. If a voluntary accounting method change results in an increase'to income, the taxpayer is allowed to spread that income equally over a four-year period commencing in the year of change. On the other hand, if the change results in a deduction, it is entirely claimed in the year ~f change [Rev. Proc. 2011-14, sec. 5.04].

Accounting method changes are not bound by the statute of limitations [Rev. Proc. 2011-14, sec. 2.05]. Rather. the cumulative timing effect of the change is measured at the first day of the year and corrected at that point in time, under the procedures highlighted in the prior paragraph. Voluntary accounting method changes initiated by the taxpayer are either automatic consent or advance consent changes. Correcting depreciable basis is an automatic consent change [Rev. Proc. 2011-14, Appendix sec.OI; Change No.7].

On the other hand, if the IRS initiates the accounting method change to depreciable items, the taxpayer does not get the benefit of a forward four-year income spread. Rather, the depreciable basis is increased to reflect the prior overstated depreciation, and the taxpayer must recognize immediate income (usually in the earliest open year under examination). Again, accounting method changes are not bound by the statute of limitations, meaning that either the taxpayer or the IRS may make a current correction to a prior accumulated depreciation amount.

Recent State Income Tax Examination Activity

Many states are becoming more aggressive in their income tax examination process by moving into areas that previously were addressed only by IRS agents. One of those cash-strapped states, Minnesota, has initiated an examination 'program that reviews the allocations made to the depreciable vs. non-depreciable components of farm real estate purchases.

The Minnesota Department of Revenue is identifying exam candidates presumably by reviewing transfers of real estate that are on record in the county courthouses, perhaps based on the Certificate of Real Estate Value that is filed for these transfers. In one of these e~ams, we learned that the state is scrutinizing land purchases as old as 15 years.

Lessons to Be Learned

It's a Two-way Street. Ever since the Hospital Corp. of America case, tax professionals have been filing Form 3115 (Accounting Method Changes) to more aggressively allocate commercial building costs to shorter-lived components. These corrections to prior depreciation schedules have been submitted without regard to any statute of I imitation constraint. We need to recognize that this capability cuts two ways, and that the IRS can correct overly-aggressive allocations to depreciable improvements vs. non-depreciable land. even where the allocation occurred in a closed tax year.

Improved File Documentation Is Warranted. With new real property acquisitions, it is clear from experience with examiners that allocations to depreciable components should be based on more than a client's verbal estimates. For example, county real estate assessor records will often contain valuations of both land and depreciable improvements. While the absolute dollars may be outdated, these records can provide evidence as to proportionality.

If drainage tile or other land improvement categories are involved, the county Farm Service Agency (FSA) office may have data that could provide better definition to an allocation. For example, there may be FSA tile maps available that could indicate linear feet and tile diameter in place, in order to assist in developing a reasonable estimate of current market value.

Where there is little other evidence of a proper allocation at the time of purchase, it may be worth securing an appraisal to justify the allocation. In some cases, it may make sense to discuss an allocation as part of the written sales documents, so that both buyer and seller are recording consistently and in a manner that is virtually bulletproof from the IRS. Written allocations of sales price between an unrelated buyer and seller who have adverse tax interests normally will be respected by the IRS.

Consider Voluntary Corrections. If this discussion brings to mind an overly-aggressive allocation that may have occurred in the past with a client, one solution is to consider taking preemptive action by filing a voluntary accounting method change via Form 3115. Under this approach, the taxpayer is protected from examination on that issue as of the filing of the Form 3115.

For example, if a file review indicates that a real property was purchased four years ago and an aggressive allocation was placed on buildings and other depreciable improvements, the taxpayer could be encouraged to file a Form 3115. In this manner, the excess depreciation as of the beginning of the year is restored to income over a four-year forward period, beginning with the year of change. This is certainly preferable to an IRS or state examination that reverses the excessive depreciation in the earliest open tax year and adds interest and penalties.

Conclusion

The slower summer months ahead would be an opportune time to review prior depreciation schedules and identify if you might benefit from a discussion regarding allocations that were made on a prior real estate purchase. There are no easy rules of thumb here; it is a "facts and circumstance" issue as to the appropriate allocation of a purchase price in each and every case. But obviously, the greater the portion of the purchase price allocated to depreciable improvements, the greater the likelihood of attracting IRS or state income tax examiner interest.

Daniel A. Kosmatka Donnelly , CPA, PFS, CFF
Dennis W. Donnelly, CPA, PFS
Michael R. Gohde, CPA, PFS

References:

IRC Secs. 446(e) and 1060(b). Rev. Proc. 2011-14, 2011-4 IRB 330.