Category: Deductions & Credits; Tax Returns,
Examinations & IRS Procedure Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer purchased a commercial building on 5/31/90 for approximately $2.5 million. At the suggestion of a decorator, the taxpayer demolished or tore out $1 million worth of the original decor of the building and spent an additional $800 thousand on remodeling. On the taxpayer's return, the unrecovered cost of the improvements torn out was deducted. On examination, the IRS disallowed the deduction stating the current interpretation of the law requires improvements to remain on the taxpayer's books to be recovered through depreciation. The IRS claims the position stems from a change in the law at some unspecified point during the 1980's. The IRS has not cited any specific statute or other authority to support its position. It seems to me that absent some overriding authoritative principle to the contrary, the taxpayer in this instance should be able to claim the unrecovered cost of the improvements removed from the building as an abandonment loss. Abandonment of depreciable assets is covered by Regulation Section 1.167(a)-(8)(a)(4) which provides as follows. Where an asset is retired by actual physical abandonment (as, for example, in the case of a building condemned as unfit for further occupancy or other use), loss will be recognized measured by the amount of the adjusted basis of the asset abandoned at the time of such abandonment. In order to qualify for the recognition of loss from physical abandonment, the intent of the taxpayer must be irrevocably to discard the asset so that it will neither be used again by him nor retrieved by him for sale, exchange, or other disposition. The assets in question have clearly been retired from productive use in the taxpayer's business by virtue of their having been torn out of the building, and it is clear that there is no intention (indeed there is no possibility) to use the assets for any further purpose. It seems to me that this set of facts falls within the gambit of Regulation Section 1.167(a)-(8)(a)(4). This conclusion is supported by the case of Gerald R. Gorman v. Commr., 33 TCM 74. In Gorman, the taxpayer owned a series of buildings leased to a supermarket. The supermarket moved out, and in order to make the building suitable for a new tenant, the taxpayer partially demolished a wall on which the former tenant's commercial logo had been displayed. The taxpayer was allowed a loss for the undepreciated cost of the wall under §165(a) and Regulation Section 1.167(a)-(8)(a)(4). It is possible that the law change to which the IRS refers is §280B which was enacted in 1984 and provides that if a structure is demolished, the undepreciated cost of the structure plus the cost of demolition must be added to the basis of the underlying land. There are no regulations under this statute and no helpful case law. The legislative history of the statute offers no clue as to whether the statute is intended to cover only total demolition of a building or whether partial demolition is covered as well. Note that the IRS has stated that the unrecovered cost of the demolished improvements remains in place to be recovered by future depreciation deductions. They have not contended that the cost should be added to land basis. Prior to the enactment of §280B, the regulations at §1.165-3(a) addressed the issue of demolition of buildings. These regulations provided three rules. 1) No deduction was allowed if a building was acquired with the intent to demolish the structure. 2) The loss from any unrecovered basis of assets demolished plus the cost of demolition was required to be recovered over the remaining term of a lease if the demolition was required by the terms of the lease. 3) Unrecovered basis plus demolition costs not falling into categories 1) or 2) was deductible. Various commentators have indicated that the rules of §280B are intended to replace the rules of §1.165-3(a). There are cases decided under pre-1984 law to the effect that demolition of a portion of a structure falls under the rules of Regulation Section 1.165-3(a). Does it then follow from these cases that partial demolition should fall under the rules of §280B? To me, this seems to be a very large leap of faith. How a court would rule on this issue is totally unknowable. Clearly, §280B presents some level of risk, but the extent of that risk is not subject to precise measurement. Based on the foregoing, I suggest you consider the following strategy. 1. Go to the IRS and insist that they produce the "alleged" authority for their position. If they produce nothing, assert that the loss is allowable under §165(a), Regulation §1.167(a)-(8)(a)(4), and the Gorman decision. 2. If the IRS asserts §280B, strenuously argue that tearing out some walls, flooring, and paneling does not constitute demolition of the structure. Point out that there is no definition of the term "demolition of a structure". Point out that in the absence of a specific definition, words are deemed to have their ordinary meanings. Point out that what the taxpayer has done would not be considered demolition of a structure based on the ordinary meaning of those words. Be prepared to show a dictionary definition of the word demolition. 3. If the IRS asserts something else, it should be carefully analyzed before proceeding. |
