developer incidental rental income

Technical topics regarding tax preparation.
#1
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we got a developer client reporting some incidental rental income for tax year 2017 before its major construction starts in 2018. For depreciation purpose, shall we depreciate the old building based on new purchased price allocation in this case? The building does not have that much value comparing to the land FMV.
 

#2
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In the big picture, if the "old" structure is torn down, demolished, whatever, its basis gets added to the land, per IRC Section 280B, IIRC. It's almost not worth the effort to figure out whether more building basis for more depreciation deduction is better or not.
 

#3
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i located an online article regarding incidental income to real estate developer. It seems the correct treatment is to reduce capitalized cost basis instead of reporting it as rental income. I think it makes senses because most of expenses on developer's book are capitalized instead. In this case, shall we still report these incidental rental income at all?
 

#4
Nilodop  
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Harry, you do recall correctly. That section was added in 1976, but even back in 1960 there was reg. 1.165-3(a)(2)(i), which limited how much depreciation could be taken while renting pre-demolition.

OP describes client as a developer. Could be a demolition planned to make way to build houses, or a complete renovation of the building in order to rent or re-sell it. And I'm not sure, but maybe 263A applies so that the depreciation, if any, has to be capitalized.

And if there is to be a demolition, does the basis get reduced by the rental income? I see OP found something that says so while I was typing.

OP, does that article state an authority?
Last edited by Nilodop on 22-Aug-2018 3:35pm, edited 1 time in total.
 

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#6
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more facts. This building comes along with land purchase with existing tenant in it. Tenant will move out this year due to the completion of the contract and make way for developer to start the constructions.
 

#7
Nilodop  
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I think that's about accounting, as in GAAP. Is there a tax authority that you found? Or is that book about tax accounting?
 

#8
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no i have not found anything other this reference. Yes, I agree this GAAP basis, not sure if tax treatment will do differently. If rental income to be reported, I think we will need to dig into depreciation issue as well otherwise our client will need to pay income tax on this.
 

#9
Nilodop  
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I know of nothing that allows rental income not to be included in gross income. Maybe there's a case or ruling to that effect, but I'm not aware of it. One place I have not looked is 263A. Another is 263.

Expand on your facts. please. Is the building to be demolished or will it be renovated/reconstructed/sold?
 

#10
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the building will be demolished and rebuilt a brand new apartment buildings on the vacant land.
 

#11
Nilodop  
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Here's a thought. Allocate part of the purchase price of the property to the right to the rent income, and then credit the rent received to that asset. It would be more or less like what that 1.165-3 reg. is getting at.
 

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"Allocate part of the purchase price of the property to the right to the rent income, and then credit the rent received to that asset" is Nilodop's thought. But I thought there was a regulation somewhere that, in quite broad terms, prohibits us from splitting the cost of a real estate purchase up into such slices as goodwill, or tenants-in-place, or (as in this suggestion) rent-to-be-collected. Does anybody recognize what I'm talking about? Our client buys the real estate, and we divide that cost between land and building, and nobody ever mentions the existence of other arguably valuable assets that were bought in the bundle.... Am I hallucinating?
 

#13
sjrcpa  
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But if you buy with a tenant in place, the lease must have transferred or been addressed somehow in the acquisition.
 

#14
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I think that might violate section 167(c)(2).

The old section 165 reg is an interesting wrinkle.You could make the argument that section 280B overrides the old section 165 regulations in their entirety and so you just follow the normal purchase price allocation and depreciation rules. I don't like that argument because I tend to view section 280B as only settling the intent issue, and, given Treasury's many opportunities to repeal that part of section 1.165-3, the reg is still on the books. (Even if it is void, there may be very old case law that has the same result.)

Of course, by its terms, section 1.165-3 applies only to buildings. You could argue that the limitation on the purchase price allocation does not apply to tangible personal property and land improvements and have the old property cost segregated. This would create more deductions to offset the rental income.
-Brian

Director of Tax Accounting Methods & Credits
SourceAdvisors.com

Opinions my own.
 

#15
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got it. 1.165-3 a (2) has a good example. Thank you, Nil.
 

#16
Nilodop  
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But I thought there was a regulation somewhere that, in quite broad terms, prohibits us from splitting the cost of a real estate purchase up into such slices as goodwill, or tenants-in-place, or (as in this suggestion) rent-to-be-collected. Does anybody recognize what I'm talking about?. Yes, there is such a reg. I read it recently, and will try to find it again. But I'm with Brian Coddington.
 

#17
Nilodop  
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It's right there in the law, section 167(c)(2).
 

#18
Nilodop  
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Upon re-reading section 280B and reg. 1.280B-1, I think they don't even apply to OP's question, as they disallow
(A) any amount expended for such demolition, or
(B) any loss sustained on account of such demolition; and ...
. All the more reason why old reg. 1.165-3(a)(2)(i) still applies here.
 

#19
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Yes. Section 280B(1)(B) applies to the section 165 loss that would otherwise be allowable on the demolition. That's why I've never been comfortable with the idea that section 280B completely supersedes the old 165 regs. It just makes the intent-upon-acquisition question moot when the building is demolished.
-Brian

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#20
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I delved a little bit into the history of Sec. 280B. Originally Sec. 280B was enacted in 1976 to prevent deducting losses related to the demolition of "certain historic buildings", but it was amended in 1984 to apply to all buildings. Prior to 1976 (resp. 1984), apparently these demolition losses were allowed under Sec. 165(a). Reg. 1.165-3 was issued in 1960 to prevent people from deducting losses from buildings when they purchased the underlying land, intending to demolish the buildings. (In this case the buildings were actually just a nuisance realistically had zero or negative value.) Sec. 280B does not impliedly repeal Reg. 1.165-3, even though it was created to address a similar issue, so I think 1.165-3 is still good law.

Reg. 1.165-3 supersedes Reg. 1.167(a)-5. Reg. 1.167(a)-5 relates to the apportionment of basis between land and building. Reg. 1.165-3(a) says that none of the basis may be allocated to "nuisance" buildings (my own term). However, if some income is expected from the nuisance building, as much basis as represents (the PV of) the expected income is allowed to be allocated to the building. This depreciated over the same term as the income is expected to be received.

This seems "fair" because the developer, on net, only has income equal to the time-value of the rent received (barring other expenses).

Now adding my own wrinkle: The above was the state of the tax law before the creation of Sec. 168 in 1981. As far as I can tell, Sec. 168 makes MACRS (formerly ACRS) depreciation obligatory except in the case of depreciation which is not referenced by a term of years (e.g. unit-of-production), and some other cases which are not relevant here. MACRS depreciation requires buildings to be depreciated over 27.5 years, 30 years, 39 years, or 40 years -- no other options.
Specifically, the 3-year depreciation of the example under Reg. 1.165(a)(2) is not allowed under MACRS. Since statutes are of a higher authority than regulations, Sec. 168 "wins" in this conflict.

So, using the example from Reg. 1.165(a)(2), the developer would allocate $2,850 (the PV of the $3,600 expected rent) to the basis of the building, but would be required under Sec. 168 to depreciate that over 27.5 (or more) years, even though demolition is planned after the end of three years. The depreciation deduction would be about $300, and the remaining $2,550 would then be added to the basis of the land according to Sec. 280B.

This seems odd, but after digesting the relevant statutes and regulations, it seems to me correct according to the law.
 

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