Common depreciation missteps and misconceptions: Demolition of structures
In most cases, the demolition of a structure to facilitate construction of a new building increases the land value. Not only does the cost of demolition increase the value of the land, but also the remaining basis of the building must be added to the land value at the time of demolition.
There are limited exceptions to this. Under section 280B of the U.S. Code, an abandonment loss that is unrelated to demolition is allowed. If a property owned by a taxpayer is deemed condemned due to latent defects, it may be abandoned. The taxpayer could then abandon the property and take an abandonment loss to avoid increasing the land value.
However, if a taxpayer purchases a condemned building with the intent to demolish, the basis of the building and the demolition cost would be added to the land.
Under IRS tangible property regulations, portions of a building removed from service can be disposed of when they are removed and replaced with a new asset. This can include roof, heating, ventilation, air conditioning and lighting replacements. However, the law is clear that when the entire building is demolished, the basis of land is increased. The IRS confirms this position in its audit techniques guide for tangible property regulations.
All of this speaks to the importance of taxpayers tracking dispositions as they take place. If dispositions are not tracked accurately, the basis added to land upon demolition could be even higher.
Finally, it is critical to determine whether a modification amounts to a demolition. Under the previously mentioned audit techniques guide, the IRS brings up safe harbor under Revenue Procedure 95-27 stating that a modification does not amount to a section 280B demolition if both of the following are true: 75 percent of external walls remain in place (as internal or external walls) and 75 percent of the structural framework remains in place.
This test is only a safe harbor, but the IRS points out that there is no “bright line to determine when a demolition has occurred.” Taxpayers often “renovate” a property by tearing down large portions of the original structure, leaving just enough in place to comply with local zoning or other laws. In most cases, such renovation will be considered a demolition for federal tax purposes and may affect the land value.
The bottom line is large-scale renovations must be reviewed before demolition begins to determine if the renovation is truly a renovation for tax purposes.