An IRS Hot Button – What Is Really The Cost? Part II

Jim Marshall, real estate, cost basis

Previously, I discussed keeping documented support for the basis of real estate. The easy part was the purchase and direct capital expenditures. But consider some of the other factors that directly impact your basis. Sale of an easement or eminent domain transfer, is it a sale, what is the allocated basis, does it diminish the remaining property value and if so how much?

Do you account for the property on the segment basis in which each item is costed out and depreciated separately? This is easy if you are building the property and have contracts for the segments but what about the finished building that is 10 years old. What are your costs of the a/c units (used), the doors, the driveways, the windows, the structural components, and a thousand other identifiable items.  Is it worth the cost of a detailed replacement appraisal to value each item.  If you are talking about an asset life of 37.5 years (commercial) or 29.5 years (residential) on a straight line basis versus a composite that may cut the life substantially increase the deprecation rate to an accelerated method this would increase depreciation per year while reducing taxable income it may be worth it. It would depend on the owners/investors objectives, intended holding periods, tax positions of the collective owner/investors, any covenants of borrowings as to the “value” of the asset being financed, and a myriad of other combinations to be considered. Are the objectives of the general partner/managing member the same as the limited partners/members. This can often be a significant point of contention and conflict of interest, especially if the controlling documents are not done precisely.

For the developer, consider the purchase of 10 acres to build 20 homes of different values, lot sizes and allocated infrastructure costs (grading, water, sewers, electric, media, roads, power transformers, traffic lights, curbs, waste management, permit fees, inspections, tap fees, city and county fees to subsidize development of schools and other public infrastructures and all the other incidentals to bringing the sites on line). What is the finished lot cost?

Let’s talk about the average independent individual taxpayer that owns a couple of residential rental properties. He has a substantial mortgage on each, property taxes and the usual operating costs that produce a sizable loss from the rentals each year. Any number of things:

1) Several years ago I met with a client making $80,000 a year but had substantial cash and credit. He asked if real estate was a good option to offset income and build value. I told him as long as his income was below $150K the rental losses would be deductible up to $25K per year. The next year he comes in with $40K of rental losses and $275K of earned income. He got none of the $40K in deductions they were all deferred since he was not a “real estate professional” as defined by the IRS. The $40K was a basis adjustment that carries forward until it is used to offset gains or the property is sold and the basis is adjusted for the deferred losses. Needless to say he didn’t heed the income and loss limitations and was not very happy.

2) The taxpayer is a “real estate professional” (not a subject to this discussion) but does not materially participate in the rentals, he still doesn’t get the deductions and the result is the same a 1) above.

3) These annual adjustments have to be tracked through the cost analysis worksheets and adjusted as changes occur to determine the “cost basis”.

Allocation of “cost” in a basket purchase is subject to review and IRS interpretation. Many years ago I was involved in the sale of approximately 15,000 tax parcels of land in California from a single sale. On behalf of the buyers we allocated the aggregate cost to each property based on the business plan for the use/operating properties/development/sale/and utility plans. The IRS sent 4 of their top corporate tax people to California to audit our allocations based on present values, development plans, CA’s agriculture preserves. After 2 and ½ years they closed the audit with no significant change. Obviously the audit fees to achieve this were substantial but the client believed were well worth the cost since it rightly deferred substantial taxable income to future periods.

As I said in Part I, if you were to sell the property this afternoon, would you be able to track and prove (to IRS satisfaction) the remaining cost basis to calculate your gain for tax purposes.

The key is to retain the records and worksheet or other record tacking the basis that is kept current.

We have only scratched the surface on the topic as I will cover a number of related and continuing issues in Part III.

Jim Marshall

Jim Marshall brings years of experience in tax and audit in a wide range of public and private companies large, medium and small. His experience includes responsibilities for major land acquisitions and dispositions and their structuring including publicly-held banks, savings and loan associations, mortgage bankers, real estate developers, insurance companies, builders and contractors. In addition to a strong background in all phases of tax and audit, Jim is a proven innovator and solution developer on both traditional and nontraditional alternatives.

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1 comment on “An IRS Hot Button – What Is Really The Cost? Part II”

  • Do you have standard worksheet you use to keep track of the cost basis? If so, maybe you could share that in your next blog.

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