Loss deduction for retirement of environmentally contaminated real estate.

• Author: Mannik, Thomas L.

Tax advisers struggling with the Service's capitalization policies regarding environmental costs should take note of a recent Tax Court decision upholding a loss deduction when commercial rental property was retired due to structural and environmental problems. While somewhat narrow in scope, De Cou, 103 TC No. 6 (1994), illustrates an opportunity to claim a loss when environmental problems force a sudden termination in a property's use.

In early 1984, Charles De Cou purchased two improved parcels of real property that adjoined seven parcels he already owned. Located on the new parcels was a three-building complex. De Cou allocated a portion of the purchase price to each building plus an amount for the land. Two buildings at either end of the land were leased, while the middle building was vacant. Shortly after the purchase, one of the leases expired, thereby leaving two buildings vacant.

De Cou acquired the buildings intending to renovate them. Before purchasing the new parcels, De Cou, his architect and real estate broker inspected all three buildings. No conditions or limitations were observed that would preclude the buildings' renovation, and the seller was unaware of any structural defects in these buildings.

During renovation, the construction company found major but hidden structural defects in the vacant buildings. Concerned that the leased building might have similar defects, De Cou notified the city inspectors of its potentially hazardous condition. The inspectors found serious building code violations and extensive defects that resulted in suspension of the building's health permit.

De Cou was advised by engineers that the cost to repair the building could be twice as much as the cost to construct a new building of the same size. After the lessee vacated the building, De Cou boarded up the building, intending that it would no longer be used.

De Cou was informed that the building could not be insured if left unoccupied, so he had it demolished rather than remain exposed to the uninsurable risk of continued ownership. The demolition cost was added to his tax basis in the land.

On his 1985 Federal income tax return, De Cou claimed an ordinary loss due to the property's abandonment or retirement equal to the building's adjusted basis. The IRS disallowed that loss, claiming that Sec. 280B specifically prohibits the deduction of losses "on account of" the demolition of business property. De Cou argued that, under Secs. 165(a) and 167...