Loss deduction for retirement of environmentally contaminated real estate.

Tax advisers struggling with the Service's capitalization policies regarding environmental costs should take note of a recent Tax Court decision upholding a loss deduction when commercial rental property was retired due to structural and environmental problems. While somewhat narrow in scope, De Cou, 103 TC No. 6 (1994), illustrates an opportunity to claim a loss when environmental problems force a sudden termination in a property's use.

In early 1984, Charles De Cou purchased two improved parcels of real property that adjoined seven parcels he already owned. Located on the new parcels was a three-building complex. De Cou allocated a portion of the purchase price to each building plus an amount for the land. Two buildings at either end of the land were leased, while the middle building was vacant. Shortly after the purchase, one of the leases expired, thereby leaving two buildings vacant.

De Cou acquired the buildings intending to renovate them. Before purchasing the new parcels, De Cou, his architect and real estate broker inspected all three buildings. No conditions or limitations were observed that would preclude the buildings' renovation, and the seller was unaware of any structural defects in these buildings.

During renovation, the construction company found major but hidden structural defects in the vacant buildings. Concerned that the leased building might have similar defects, De Cou notified the city inspectors of its potentially hazardous condition. The inspectors found serious building code violations and extensive defects that resulted in suspension of the building's health permit.

De Cou was advised by engineers that the cost to repair the building could be twice as much as the cost to construct a new building of the same size. After the lessee vacated the building, De Cou boarded up the building, intending that it would no longer be used.

De Cou was informed that the building could not be insured if left unoccupied, so he had it demolished rather than remain exposed to the uninsurable risk of continued ownership. The demolition cost was added to his tax basis in the land.

On his 1985 Federal income tax return, De Cou claimed an ordinary loss due to the property's abandonment or retirement equal to the building's adjusted basis. The IRS disallowed that loss, claiming that Sec. 280B specifically prohibits the deduction of losses "on account of" the demolition of business property. De Cou argued that, under Secs. 165(a) and 167, he was entitled to an ordinary loss deduction because the building suddenly lost its usefulness and became obsolete before it was demolished.

In its analysis, the Tax Court noted that no regulations or published court opinions have interpreted Sec. 280B. However, Notice 90-21 states that "Section 280B of the Code does not disallow casualty losses allowable under section 165 .... if a casualty damages or destroys a structure, and the structure is then demolished, the basis of the structure must be reduced by the casualty loss allowable under section 165 before the loss sustained on account of' the demolition is determined." Thus, the court concluded that Sec. 280B did not prevent De Cou's loss deduction if the requirements of Sec. 165 were otherwise met.

Regs. Sec. 1.165-2(c) refers to Regs. Sec. 1.167(a)-8 for the rules governing the deduction of such a loss. Regs. Sec. 1.167(a)-8(b) defines "normal" and "abnormal" retirements as follows:

... the determination of whether a retirement is normal or abnormal shall be made in the light of all the facts and circumstances. In general, a retirement shall be considered a normal retirement unless the taxpayer can show that the withdrawal of the asset was due to a cause not contemplated in setting the applicable depreciation rate. For example, a retirement is considered normal if made within the range years taken into consideration in fixing the depreciation rate and if the asset has reached a condition at which, in the normal course of events, the taxpayer customarily retires similar assets from use in h business. On the other hand, a retirement may be abnormal if the asset is withdrawn at an earlier time or under other circumstances, as, for example, when the asset has been damaged by casualty or has lost its usefulness suddenly as the result extraordinary obsolescence.

To claim a loss from an abnormal retirement, a taxpayer must permanently withdraw the ass from use in a trade or busines (such is by disposition, abandonment or other withdrawal from productive use, such as transfering the asset to a scrap or supplies account (Regs. Sec. 1.167(a) 8(a))). Thus, no disposition of the asset is necessary to claim a loss Instead, the taxpayer must show that - the asset was prematurely an permanently withdrawn from business use; and - the withdrawal was due to: 1. damage to the asset by casualty, or 2. the asset's sudden loss of usefulness as the result of extraordinary obsolescence. (See also Coors Porcelain Co., 52 TC 682 (1969), aff'd, 429 F2d I (10th Cir. 1970).)

The loss allowable under Regs. Sec. 1.167(a)-8(a)(3)(i) is the excess of the asset's adjusted basis over its estimated salvage or fair market value (FMV).

The Tax Court agreed with De Cou. Although the building's extensive deterioration may have occurred over the course of several years, its usefulness suddenly and unexpectedly terminated when the deterioration and defects were first discovered and its health permit was suspended. The building's withdrawal from business use constituted an abnormal retirement caused by unexpected and extraordinary obsolescence.

It is easy to see how enviromentally contaminated real property could fall under similar fact If a taxpayer discovers that property is contaminated and cost of repairing the property prohibitive, the taxpayer may able to claim abnormal retirement losses to the extent of the excess of the adjusted basis over the estimated salvage or FMV Under Regs. Sec. 1.167(a)-8, the taxpayer must establish that the claimed loss arose from the sudden, unexpected termination the property's usefulness and that the property was permanently withdrawn from business us However, any effort to find alternative use for the property might indicate that it was neither use less nor withdrawn from use. (See Coors Porcelain, supra.) Observation: Since the building were acquired in 1984, they were accelerated Cost recovery system property. Consequently, Prop. Regs. Sec. 1.168-6, released Feb 16, 1984, should have applied This proposed regulation reads as follows:

(a) General rule. Except as provided in $S 1.168-2(h) relating to mass assets), where recovery property is disposed of during a taxable year, the following rules shall apply: (1) If the asset is disposed of by sale or exchange, gain or loss shall be recognized as Provided under the applicable provisions of the Code. (2) if the asset is disposed of by physical abandonment, loss shall be recognized in the amount of the adjusted basis of the asset at the time of the abandonment. For a loss to qualify for recognition under this subparagraph (2), the taxpayer must intend to discard the! asset irrevocably so that he will neither use the asset again, nor retrieve it for sale, exchange, or other disposition. (3) if the asset is disposed of other than by sale pr exchange or physical abandonment (as, for example, where the asset is transferred to a supplies or scrap account), gain shall not be recognized. Loss shall be' recognized in the amount of the excess of the adjusted basis of the asset over its fair market value at the time of the disposition. No loss shall be recognized upon the conversion of property to personal use. (b) Definitions. (1) See $S 1.168-2(l)(1) for the definition of "disposition ... (Emphasis added.)

In turn, Prop. Regs. Sec. 1.168-2(l)(1) states:

The term "disposition" means the permanent withdrawal of property from use in the taxpayer's trade or business or use for the production of income. Withdrawal may be made in several ways, including sale, exchange, retirement, abandonment, or destruction. ... The manner of disposition (e.g., ordinary retirement, abnormal retirement) is not a consideration .... (Emphasis added.)

Presumably, the Tax Court did not consider these proposed regulations because they were not invoked by either DeCou or the IRS.