Purchase Price Allocation and Your Property Sale
Real estate transactions aren’t just about the property. Every purchase or sale has a financial impact – specifically when it comes to profits and taxes. And determining exactly how much money you’ll keep for yourself involves the use of purchase price allocation.
“When our clients call us and say, ‘Hey, I want to sell this,’ what they want to know is ‘How much net am I going to end up with in my pocket after I pay taxes?’” said Suzanne Forbes, managing partner and Real Estate Services Team leader at James Moore. “And sometimes we’re not in the position to answer it because we haven’t addressed this issue of how we’re going to allocate the purchase price and figure out the tax rate for your gain.”
What is purchase price allocation?
Purchase price allocation is a process in which the sale price of a property is allocated into different categories to determine which parts of the property can be depreciated. What you hope to achieve, however, can depend on whether you’re the buyer or the seller.
Land itself can’t be depreciated until it is sold. So a property’s buyer would want more of the purchase price allocated to the building, equipment or land improvements — all of which can be depreciated. The more a buyer can allocate to depreciable assets, the more annual depreciation the buyer can take as an ordinary income tax deduction on their tax return.
The seller, typically, would want more of the sale price allocated to the land and less to the building. This is especially true if the sale includes a building that has been depreciated and is subject to a 25% depreciation recapture, as well as equipment or land improvements that may have depreciation recaptured under ordinary income tax rates (which could be as high as 37%). Since land cannot be depreciated, the entire gain on land is considered a capital gain. And if the property has been held for at least a year, the profit is taxed at long-term capital gains rates, which is a maximum 20%.
What should I consider during purchase price allocation?
It often helps to have a cost segregation study to break out the components of a commercial property that can be depreciated sooner than the standard 39 years. For example, if you buy a commercial rental property, it will likely have office equipment, furniture and perhaps even kitchen appliances. These have a much shorter life (for example, five or seven years) than the property itself. External property features can also come into play; a parking lot, for example, is considered a land improvement. This means it’s depreciable over 15 years instead of nearly four decades.
A cost segregation study will help you find such components so you can depreciate them earlier — and save money sooner.
Also keep in mind the allocation used when you sell a piece of property doesn’t have to match the allocation from the purchase of the property a long time ago.
“You might have a piece of waterfront property,” said Kim Hardy, a director on James Moore’s Real Estate Services team. “And you purchased it, let’s say 20 years ago, when your area wasn’t really booming like it is now. The allocation you might have used 20 years ago might be very different than it would be now.” Perhaps the building is dilapidated but the value of the land may have increased substantially. In this example, your allocation can be completely different from when you purchased it.
The key is to use a reasonable method. This could involve an appraisal of the property to best determine the breakdown of its value, especially if it’s a large sale. A tax assessor’s allocation can also be useful, since it allocates separate values to the land, building, and any improvements. While the value on a tax assessor’s website is generally less than actual, you can use the ratio of values to figure out what part of the sale price goes toward the land itself.
Why do some people avoid purchase price allocation when negotiating a transaction?
This difference in allocation needs between buyers and sellers can sometimes result in conflict or even hold up a sale.
“I often talk to attorneys and get the closing statements and I’ll say, ‘Hey, did you guys discuss purchase price allocation?’ and they’ll say, ‘No, because we didn’t want to screw up the deal,” said Suzanne. “And the reason why is many times, what’s good for the seller is bad for the buyer (and vice versa) from a tax standpoint on the allocation.”
It’s generally recommended that the buyer and seller use the same allocation to decrease an adjustment in the event of an IRS audit. However, this is not a legal requirement if the transaction only consists of real estate.
Use of reasonable methods during your purchase price allocation (as mentioned earlier) will help you in the event that your return is audited. They key is to document how you allocated and why you made your choices. Doing so during the process instead of waiting until you’re actually audited is recommended.
As you can see, purchase price allocation plays a big role in your property transaction when it comes to your bottom line.
“If you’re selling, you want to know at what rate your gain will be taxed. If you’re buying it’s even more critical because it helps determine your future cash flow by improving what you’ll pay over a period of time in taxes,” said Suzanne. “That’s the takeaway for anybody out there.”
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