The GAA Advantage for Demolished Buildings

Depreciate A Demolished Building Using a General Asset Account but Only if the Election is Done in the Year of Purchase 

In general, the basis of demolished buildings must be reclassified into the land cost, which cannot be depreciated. There is a way around this general rule if a proper general asset account (GAA) election is done in the year the property is purchased. When taxpayers acquire a building that may need to be demolished in the foreseeable future, they are often disappointed to learn from their tax preparer that they will lose all future tax depreciation deductions associated with the building. For many years, the Code has been “mean” to property owners who invest in a building and then realize later that it needs to be torn down.

The issuance of the tangible property regulations (TPRs) in 2014 provided an avenue to continue to depreciate a building after it has been demolished. In order to take advantage of this opportunity, however, the taxpayer must make an election in the year of purchase, or when placed in service, to include the building in a General Asset Account (GAA). In addition, the taxpayer must comply with all the rules that apply to GAAs. The election must be made on an originally filed return and cannot be made on an amended return. The election is a simple process of checking a box on the IRS Form 4562. Tax return preparers should discuss the issue with the taxpayer in order to identify this opportunity.

There are significant permanent tax savings realized by continuing to depreciate a demolished building. If the adjusted basis of the demolished building is capitalized into the basis of the land, the building basis will not be recovered until the land is sold. At that time the sale will result in a reduced capital gain. On the other hand, a taxpayer that continues to depreciate a demolished building in a GAA can use those annual deductions to reduce current taxes. Those current taxes are paid at higher ordinary income rates versus the lower rate under IRS Code Sec. 1250 in the year of sale. In addition, accelerating the deductions generates savings based on the time value of money.

IRS Code and Background

IRS Code Sec. 280B states that “in the case of the demolition of any structure . . . any amount expended for such demolition, or . . . any loss sustained on account of such demolition . . . shall be treated as properly chargeable to capital account with respect to the land on which the demolished structure was located.” Sec. 1.280B-1(b) states that the term “structure” is a building, including its structural components. Due to this definition any tangible property that are not building components or structures, such as items of machinery or equipment, and land improvements are not required to be capitalized into the land basis when the building is demolished.

We note that because 280B only applies to buildings and their structural components, a taxpayer may reduce the adjusted basis of the demolished building and the amount subject to capitalization by performing a cost segregation study to separately identify tangible personal

property such as carpet, cabinetry, process plumbing, and special electrical systems, etc. These items are considered tangible personal property and can be written off over a 5- or 7-year tax life. Also, because personal property can be retired when the building is demolished, a cost segregation study should be considered regardless of whether the building is put in a GAA.

For situations where only a section or part of a building structure is demolished, the IRS provides a safe harbor for the purpose of determining whether structural modifications to a building are considered a demolition (Rev. Proc. 95-27). The safe harbor outlines that modifications will not be treated as a demolition for purposes of 280B if: (i) 75% or more of the existing external walls of the building are retained in place as internal or external walls; and (ii) 75% or more of the existing internal structural framework of the building remains in place.

The Opportunity Provided by the TPRs

Per the TPRs, there is no requirement to terminate a GAA upon the disposition, demolition, of a building. Therefore, a taxpayer that includes a building in a GAA may effectively choose whether to continue to depreciate the building when disposed of or capitalize the adjusted basis to land under 280B.

In accordance with the GAA rules, the adjusted basis of any asset in a GAA (that is disposed of) is determined to be zero immediately prior to disposition. The basis associated with that asset remains in the GAA and continues to depreciate. (1.168(i)-1(e)(2)(i) and (iii).) As such, the basis of a demolished building in a GAA subject to capitalization under 280B is zero. The taxpayer may continue to depreciate the building basis in the GAA. When the last asset in a GAA is disposed of, a taxpayer may elect to terminate the GAA. Then the adjusted basis of the GAA is subject to all other provisions of the Code, including 280B. (1.168(i)-1(e)(3)(ii).) If only one demolished building is in a GAA and the taxpayer elects to terminate the GAA, the adjusted basis of the building would effectively be capitalized into the land under 280B.

Taxpayers and their preparers should note that this tax strategy may not work for any building acquired and demolished in the same tax year (1.168(i)-1(c)(1)(i)). In addition, the anti-abuse rules under 1.168(i)-1(e)(3)(vii)) are unclear on the extent to which taxpayers can use this strategy if there is clear intent to demolish the building at the time it was placed in service. A recommendation is to place the building into service for a time period prior to demolition.

Case study

A taxpayer acquires a shopping plaza in early 2022 for $5 million. The property consists of two retail buildings, one large, building A, and the other is an outparcel structure, building B. The property has numerous parking spaces on its large parcel. The property is fully leased to multiple tenants. Each building is in good operating condition. The lease for building B with one large tenant is set to expire in 2023.

In late 2022, the taxpayer hears from a national restaurant chain that wants to build a new location on the property. Typically, the restaurant chain uses a unique building structure for each of its locations, making it impractical to convert building B to its needs. If the landlord can come to terms it anticipates demolishing building B at the end of the lease term and permitting the restaurant to construct a new restaurant building in place of building B.

The taxpayer conducts a cost segregation study on the acquired buildings. In its 2022 return, the taxpayer elects to put building B into a GAA but does not put its tangible personal property resulting from the cost segregation into a GAA.

If in tax year 2023 an agreement is reached with the restaurant chain the taxpayer, upon demolition of building B, is not required under 280B to move building B’s remaining tax basis to the land. The taxpayer will be able to continue to depreciate the building each year going forward. In addition, the taxpayer will be able to report a retirement loss deduction on the remaining basis of its five and fifteen-year property, that resulted from the cost segregation.

Complying with the GAA Rules

While continuing to depreciate the basis of a demolished building may be favorable, a taxpayer that elects to include the building in a GAA must also apply all of the applicable GAA rules. Additional items to consider when deciding whether to make a GAA election include:

• Timing. A GAA election must be made on a timely filed return for the year the asset is placed in service. Thus, it is key for tax preparers to identify this TPR opportunity to appropriately consider all facts and circumstances.

• How to make a GAA election. The election is made by checking the applicable box on Line 18 of Form 4562, Depreciation and Amortization, and by including a statement in the taxpayer’s records that identifies the assets included in each GAA. This statement does not need to be included with the tax return.

• Partial dispositions are not available for assets included in a GAA. The GAA rules require a taxpayer to continue to depreciate the basis of the asset(s) included in the GAA until all assets in the GAA are disposed of. Thus, a taxpayer that replaces items, such as windows or lighting, may not claim a partial disposition loss. This limitation is one of the main reasons it is generally not appealing to make a GAA election for a building.

In general, a taxpayer may include in a single GAA as many or as few assets as are placed in service at the same time and depreciated using the same recovery period, convention, method, bonus depreciation election, etc. (1.168(i)-1(c)(2)

Planning Tool Consideration: Where multiple buildings are purchased on one parcel, consider making the GAA election only for the building that will/may be demolished. In this manner, only the one building is subject to the potentially unfavorable GAA rules. In addition, if a GAA election is desired for all buildings, the greatest flexibility is afforded when each building is included in its own separate GAA.

Subsequent additions may not be included in the original building’s GAA. Any additions to an asset included in a GAA may not be added to the original GAA. A taxpayer may make a separate GAA election for those assets or may choose to depreciate the addition separately without making a GAA election.

Conclusion

The loss of depreciation due to the 280B rules is not a good tax result for taxpayers. Nonetheless the opportunity provided by the TPRs enables a to preserve those depreciation deductions. In situations where a building is acquired that could potentially be demolished in the foreseeable future, the GAA election should be carefully considered in the year it is placed in service and before the original tax return is filed.

Eric P. Wallace CPA 1-20-23