Your taxpayer client advises you that he "sold a building". As tax professionals, we recognize that the client has probably sold two distinguishable assets - land and improvements.
A common (default) presentation for reporting the sale of improved realty is to report the selling price on IRS Form 4797, Part III ("Gain ... under section ... 1250 ..." etc.). The resulting calculations of gain, by character, may often have produced a proper result in the past, even though THE UNDERLYING LAND IS NOT SEC. 1250 PROPERTY. Prior to 1997, if there was some accelerated depreciation, the combination of the historical increase in value of realty and the relatively minimal amount of depreciation exceeding straight line by the time the property is sold rarely resulted in gain from the improvements being a lesser amount than the Sec. 1250 recapture.
This all changed due to enactment in 1997 of a 25% capital gains tax rate for unrecaptured 1250 gains. When coupled with the changes made by the 2003 Tax Act, ALL depreciation can give rise to a higher rate of tax than the15% long-term gain rate, not merely the excess over straight line.
The amount subject to the higher (25% or ordinary) rates is limited to the gain on the Sec. 1250 property. If the gain is allocable primarily to the land, the rate of tax on the overall gain from sale of the realty may be brought back toward the lower15% long-term rate. The consequences could range from no benefit for buildings which have increased in value above their original acquisition basis, to significant benefit where a building is close to the point of being demolished, the principal value component being the land.
As an example, if accumulated depreciation (otherwise subject to "unrecaptured section 1250 gain" treatment) is $300, but analysis (as discussed in the following material) can reduce the gain attributable to the building at the date of sale to $200, then the federal income tax to a high bracket taxpayer on the $100 reduction is reduced from $25 to $15. $25 is a 66 2/3 percent increase over the $15 "correct" tax, and a needless penalty for the taxpayer to volunteer.
Certain nonresidential realty placed in service between 1981 and 1986 for which a straight line ACRS recovery election was not made exacerbates the problem by categorizing all depreciation as §1245 recapture, thus all at ordinary rates. A practitioner should be especially careful in such case to confirm that the improvements must be allocated a substantial enough portion of the sales price to equal or exceed the original basis - a reduced value would convert "ordinary" rates into long-term (15%) rate.
Section 1250 Regulations:
Reg. §1.1250-1(a)(6) states: "... the total amount realized ... shall be allocated between the section 1250 property and the other property in proportion to their respective fair market values ... in accordance with the principles set forth in ... (Reg. §1.1245-1(a)(5))". In turn, Reg. §1.1245-1(a)(5) states: "... the total amount realized ... shall be allocated ... in proportion to their respective fair market values. In general, if a buyer and seller have adverse interests as to the allocation ... any arm's length agreement ... will establish the allocation. In the absence of such an agreement, the allocation shall be made by taking into account the appropriate facts and circumstances. Some (facts and circumstances) ... include ... (i) original cost and reproduction cost ... (ii) the remaining economic useful life, (iii) state of obsolescence, and (iv) anticipated expenditures to maintain, renovate, or to modernize."
IRS Publication 544:
Gain limitation:
IRS Publication 544 (1997) at page 32 includes an example - calculating potential Sec. 1250 recognition in a tax-deferred exchange - and first allocates the value of the property between land and building, resulting in a gain limitation based on only the building's value. (The 1999 version changes the facts in the example, resulting in a larger gain on the building - thus, it no longer appears to illustrate this limitation.)
Other limitations:
Publication 544 (1999) at page 25 also illustrates two other limitations with respect to "recapture", which arguably apply to "unrecaptured section 1250 gain":
1) "The adjustments reflected in adjusted basis generally do not include deductions for depreciation on retired or demolished parts of section 1250 property unless these deductions are reflected in the basis of replacement property...". An example (dealing with low income housing - at page 26) illustrates by removing accumulated depreciation on a replaced roof.
2) Depreciation allowed or allowable - "If you can show that the deduction allowed ... was less than the amount allowable, the lesser figure will be the depreciation adjustment for figuring additional depreciation."
Case law:
Proper allocation of sales/purchase price between land and improvements has been the subject of substantial litigation. Although a review of these cases is beyond the scope of this newsletter, two points are worth noting:
1) The taxpayer's lack of an expert appraisal will lay heavily on the taxpayer - the government's subsequent appraisal will generally be accepted by the courts;
2) The courts have not infrequently accepted the taxpayer's well documented expert appraisal over a government appraisal of lesser quality.
(Note that the burden of proof may shift to the government if the taxpayer produces "credible evidence" - perhaps enhancing the value of a competent appraisal.)
(See, for example: duPont, 67-1 USTC ¶9237; Johnson, 49 T.C. 324 (1968); Little, 31 T.C. 607 (1958); Estate of Hagerman, 1998 U.S. Dist. LEXIS 8191)
Summary:
Obtaining a competent appraisal could be a significant investment by a taxpayer/seller. The practitioner should document that the client has been advised of the potential tax consequences with and without an appraisal. If circumstances are such that an "arm's length" agreement may be obtained, it is important that the client be advised early in the negotiation process.
The prior depreciation records should be reviewed to remove any portion attributable to retired or demolished property.
This material should be viewed only as a general summary of the tax law as of its indicated date, and not as a substitute for tax consultation in a particular case. Your questions and comments would be appreciated.
RICHARD A. LAVINE, CPA You DO have a
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