Tax Considerations When Drafting your Purchase and Sale Agreement

“Language is a tool adequate to provide any degree of precision relevant to a particular situation.”  Kenneth L. Pike

When purchasing real estate, how important is it to allocate your purchase price to various components of your real estate purchase?  Very much if you would like to take specific deductions that will hold up in an audit.  Consider the recent Tax Court Decision in Norman vs C.I.R. TC Memo 2012-360.  

In Norman, the taxpayer borrowed $1.8 million to purchase a new residence and an adjoining parcel of property that he intended to develop by subdividing it into seven lots.  For tax purposes, Mr. Norman allocated $800,000 to the purchase of the adjoining property and $1 million to his residence.

From a tax standpoint, this allocation made perfect sense because the I.R.C. limits the deductibility of qualified residence interest to $1 million in acquisition indebtedness.  In turn, interest paid in the acquisition of an investment, i.e., the adjoining lot, is deductible as investment interest expense.  

During the audit, the IRS disagreed with Mr. Norman’s allocation and the Court agreed by denying Norman's $17,951 investment interest deduction, finding that he failed to show an adequate evidentiary basis to support his claimed allocation. More specifically, nothing in the purchase and sale agreement referenced such an allocation or intended use.  

Customarily, when a purchase and sale agreement is entered into with a seller, the recital typically contains the all encompassing term “real property,” when in reality much more is being purchased beyond the land, buildings and things physically attached to the buildings, i.e., fixtures.

In residential sales, it is customary for most free-standing appliances, carpeting, decorative lighting, sidewalks, fences, docks, certain landscaping, and window treatments in the property to convey to the buyer, even though they are generally personal property items or land improvements and not specifically listed as such in the purchase and sale agreement. Sometimes, specific pieces of furniture are also included in the sale. In a commercial context, the list is greatly expanded to include certain wiring and related property, special plumbing, or machinery.

For some investors this is an overlooked opportunity to increase their cash flow by taking advantage of faster depreciation deductions.  Assets allocated into the land improvement or personal property categories can be depreciated faster under an accelerated depreciation schedule (over 5 or 7 years) versus the straight-line approach adopted by most CPAs that allocates 80% to building and 20% to land and depreciates over 27 ½ or 39 years.

This is an opportunity not to be overlooked when purchasing real estate.  However, to avoid a result like Norman, you may want to consider including more specificity into your real estate purchase and sale agreements and assigning agreed upon values to certain aspects of the real estate you are purchasing.  This added specificity would buttress any position taken by your CPA with respect to accelerated allocations.