Importance of purchase price allocation in real estate transactions.

• Author: Ray, Jennifer M.

The bright pink house for sale was an eye-catcher. Built in the 1960s, this not-reallyupdated two-bedroom, one-bath house was purchased in 2001 for $100,000. In 2019, the asking price was $300,000, but it did not sell. Fast forward to 2021, and during a pandemic, the same house sold for $400,000. Could this little gem of construction really have increased so much in value in a couple of years? Or possibly was it the fact that it was on an extra-wide waterfront lot?

Suppose that this pink house was an income-producing property for the seller. When the property was originally acquired, the purchase price would have been allocated between the land and the building so that the building could be depreciated. Typically, in this situation the owner wants to be able to allocate as much purchase price as possible to the building so that the cost can be recouped (albeit ever so slowly) by depreciation. Often, this allocation is an afterthought and is done using the 20/80 rule of thumb (20% of the purchase price to the land and 80% of the purchase price to the building).

To calculate the gain on a sale, the same principle applies--the sales price needs to be allocated between the land and the building. Again, this allocation is typically done as an afterthought and, quite frankly, at the time the return is being prepared, potentially more than 11/2 years after the sale. Here is where tax practitioners have a responsibility to advise their clients as to the significance of the land/building value allocation and what it means to the client's tax bill.

Depreciable real estate, whether residential or commercial, that is used in a trade or business is Sec. 1231 property. The sale of Sec. 1231 property results in taxation at capital gain rates if there is a gain and ordinary income rates if there is a loss. Property owners are typically aware of the favorable tax rates they are allowed upon sale, but just like the rules of grammar, there is usually an exception to the rule. For depreciable real estate, the exception is in Sec. 1250, which provides that to the extent of depreciation taken (or allowed), the gain on the real estate sale is taxed at ordinary rates up to 25%. Depreciable real property is taxed at 25% up to the amount of depreciation taken and then taxed at capital gain rates. On the other hand, land is also Sec. 1231 property, but because it is not eligible for depreciation, it is not Sec. 1250 property.

To return to the little pink house on the...