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February 7, 2019

How to Allocate Tax Basis for Real Estate

Federal Income Tax

Houston Tax Attorney

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If you sell real estate, you pay tax on the gain. Gain is the product of the sales price less tax basis. Tax basis in turn is the amount invested in the property. But how do you calculate and then prove tax basis for buildings located on the property when you sell some but keep others? The Estate of Andersen v. Commissioner, T.C. Memo. 2019-2, provides an opportunity to consider this question.

Facts & Procedural History

The taxpayer sold a motel and RV park and ranch in 2010.

Since he did not file an income tax return to report the gain from these sales and because the IRS became aware of the sales by searching the local real estate records, the IRS issued a notice of deficiency to the taxpayer for tax on the gain.

The IRS calculated the taxpayer’s gain on the sales without including any basis in the property. Thus, the gain was the sales price, which should have been reduced by the taxpayer’s basis in the property and the closing costs, and increased by any depreciation taken or allowable but not taken.

By omitting all of these other items and only counting the sales price, the IRS grossly overstated the taxpayer’s gain.

The taxpayer responded to the IRS notice by filing a late tax return, which included the basis, depreciation, etc. in computing the gain on the sales.

On audit, the IRS did not accept the taxpayer’s calculations and litigation ensued.

Tax Basis in Real Estate

A taxpayer’s tax basis in real estate is generally the cost to acquire the property plus any expenses that had to be capitalized rather than deducted. These capital costs include improvements that prolong the useful life of the property, adapt the property to a new use, or restore the property to new condition.

In this case, the taxpayer acquired the property in 2006. The property included land, fencing, RV park facilities, motel rooms, cabins, and a house.

The taxpayer sold part of the property–a little more than 35 acres, which included the fencing, motel, and RV park buildings. The dispute focused on the value of the various buildings located on the land that was sold.

The taxpayer argued that he was entitled to add $106,210 additional tax basis for “improvements,” consisting of $75,264 in contract-labor expenses and $30,946 in “restaurant building” expenses. But the taxpayer did not present any evidence to support these amounts.

Allocating Basis Between Property

So what could the taxpayer have done differently? The answer is that he could have presented additional evidence. This evidence might have included an expert opinion from a cost segregation engineer.

The cost segregation engineer may have consulted various construction cost documents and have been able to establish the tax basis with some certainty. This is what cost segregation engineers do for a living. They are experts in taking tax basis, identifying the units of property at a sub component level, and determining the basis to allocate to the components.

This in turn would have shifted the burden of production to the IRS. Then, presumably, the IRS would have to either agree or rebut the engineer’s conclusions by putting on its own expert.

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