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Demolition of a building.

At one time, a taxpayer's intentions when he purchased a building dictated whether he was entitled to a loss on the demolition of the building or whether the undepreciated cost of the building at demolition would have to be capitalized as part of the cost of the land (Regs. Sec. 1.165-3). The determination of the taxpayer's intentions was a source of much disagreement and litigation between taxpayers and the IRS. With the addition of Sec. 280B, it is clear that the cost of demolition and undepreciated costs must be capitalized as part of the basis in workpaper, and the various components making up the three factors horizontally across the top of the workpaper. This way it can be readily seen whether the totals by factor agree in the books.

Once the information has been gathered and organized for the three factors, the information can be used to determine whether a return for a given state in required to be filed. If the property factor or the payroll factor applies, the business will most certainly have some filing obligation. If only the sales factor applies, it is possible the business may be exempt from filing a return under PL 86-272. Basically, this law states that if a business solicits sales within a state and the sales orders are filled from inventory located in another state and the business has no property, payroll or leased property, it is exempt from any income tax filing requirements.

In order to do business in most states, a company is encouraged to apply for a certificate of authority to do business. This certificate gives the right to pursue litigation within the state, such as the collection of bad debts. If the business has the certificate in a state in which it is not required to file an income tax return, it may still be liable for a license fee or a franchise tax in order to maintain an active certificate. Of course, even if the applicable factors indicate an obligation to file but the business has no Federal taxable income, there probably will still be a state tax due for a license or franchise fee.

A tax preparer should always consult the instructions to the applicable state form. In addition, there are several state tax guides, and within them are sections on the "Doing Business Requirements" within the states. It is important to realize that each state has its own law governing nexus, and by reading the state form instructions and consulting a state the land. However, there is no mention in Sec. 280B (and no regulations have been issued to date) of what treatment a taxpayer is allowed when a building is purchased with the intention of demolishing it, but prior to the demolition the taxpayer rents the building or uses it for the production of income.

Regs. Sec. 1.165-3 was originally proposed in 1956 and, after being withdrawn and reproposed, was finally adopted in 1960. Amendments were made in 1976; since then, no changes have been proposed.

As originally enacted in 1976, Sec. 280B provided that in the case of the demolition of a certified historic structure, no deduction would be allowed for any amount expended for the demolition or any loss sustained on account of the demolition. Instead, the demolition costs and any loss sustained on the demolition would be added to the cost of the land on which the demolished structure was located. On July 18, 1984, the Deficit Reduction Act of 1984 amended Sec. 280B and deleted all references to certified historic structures. Therefore, Sec. 280B now deals with the demolition of any structure.

It would seem that Regs. Sec. 1.165-3 has been superseded by Sec. 280B. However, Sec. 280B contains no counterpart to Regs. Sec. 1.165-3(a)(2)(i), which provides for an allocation of a portion of the basis of the total property to the building if the building will be used for the production of income or rented prior to demolition. The portion of the purchase price to be allocated to the building is determined from the present value of the right to receive rentals from the building over the period of intended use. With the passage of Sec. 280B, there is a question as to whether this allocation is still allowed.

Sec. 280B comes into play on the demolition of a structure. This section makes no reference as to how the structure should be treated between the time it is acquired and the time it is demolished. Regs. Sec. 1.165-3, on the other hand, looks to the purchaser's intent when property is originally acquired. Sec. 280B really differs from Regs. Sec. 1.165-3 in the situation in which property is acquired with a bona fide intent to rent the property or to use the property in a trade or business, but such decision is later changed and the property is demolished. Regs. Sec. 1.165-3 allows a current deduction of the resulting loss on the demolition; Sec. 280B does not.

Regs. Sec. 1.165-3(a)(1) prohibits the deduction of any loss if the intention at the time of purchase is to demolish; the entire basis of the property is allocated to the land. Regs. Sec. 1.165-3(a)(2)(i) contemplates a period of business use prior to the demolition and makes provision for an allocation of the basis of the property to the building and deduction of this allocated costs during the period of business use. This particular situation is not addressed in Sec. 280B but appears quite logical and is not inconsistent with Sec. 280B. Regs. Sec. 1.165-3(a)(2)(ii) provides that, if any portion of the purchase price is allocated to the building, and demolition takes place prior to the end of the rental period, a loss is allowable for the unrecovered allocated costs. While this portion of the regulation is totally inconsistent with Sec. 280B, Regs. Sec. 1.165-3(a)(1) and (2)(i) may still be valid despite the enactment of Sec. 280B.

Having made the decision that Regs. Sec. 1.165-3(a)(2)(i) is still valid, the taxpayer must now determine the proper method of computing the "present value of the right to receive rentals from the buildings over the period of their intended use." Rev. Rul. 67-445 held that the "portion of the purchase price which may be allocated to the buildings, to be depreciated over the rental period, may not exceed the present value of the difference between the gross rentals to be received during the rental period and so-called |variable' expenses applicable to the rental period." In this case, variable expenses were considered to include utilities, insurance, janitorial, maintenance, waste disposal and real estate taxes to the extent that they would not have been incurred had the building been demolished on acquisition. After deducting the variable expenses from the gross rentals, the present value of the resulting income should be computed taking into account appropriate interest and time factors.

In 1973, the Tax Court decided the case of Nash, 60 TC 503 (1973), holding that depreciation in a situation such as contemplated here is allowed only to the extent of net rental income. In Nash, small amounts of rent were collected and there was little or no net rental income prior to taking a depreciation deduction.

The particular method of computing the portion of the purchase price allocable to the building would depend on the particular facts and circumstances of each case. The important point is that justification for allocation of a portion of the purchase price still exists even after the enactment of Sec. 280B.
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Title Annotation:allocation of demolition costs
Author:Edwards, Ray
Publication:The Tax Adviser
Date:Sep 1, 1992
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