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Oct 2014
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October 20, 2014

Appeals Court Distinguishes Supreme Court Precedent, Allows Deductions on Real Estate Acquisitions


In a recent case, the U.S. Court of Appeals for the Sixth Circuit ruled that a company could deduct part of the purchase price of a building it leased. The deduction of lease termination payments is not novel; however, there have been many cases where costs incurred by a taxpayer when purchasing real estate were required to be capitalized, including a decision handed down by the U.S. Supreme Court.

In ABC Beverage Corporation, 756 F.3d 438 (6th Cir.), the Court of Appeals was able to distinguish Supreme Court precedent and also a prior decision against a taxpayer on very similar facts. The decision will allow taxpayers who purchase  property they lease and occupy to deduct the portion of the purchase price allocable to the termination of the lease.

ABC Beverage leased a facility under a 40-year term. The lease included rent that was above the fair market rate, according to an appraisal that ABC commissioned. The company/taxpayer had an option to purchase the property and determined that it was in its best interest to buy it rather than continue to be a tenant paying above fair market rent. ABC exercised its option and, after negotiations over the proper calculation of the purchase price, purchased the property for $11 million.

ABC did something that was critical for purposes of providing evidence on the allocation of the purchase price. It obtained three independent appraisals prior to purchasing the property, which set the value at $2.75 million with the lease. The tax return reflected a capitalized cost for the facility of $2.75 million and a business expense deduction for the difference between the purchase price of $11 million and the capitalized cost. The Internal Revenue Service disallowed the deduction and assessed an income tax deficiency.

It is well established that, if ABC Beverage had paid $6.25 million to terminate the lease and vacated the premises, the amount would have been a deductible expense. Furthermore, it is well established that if a third party had purchased the property subject to the lease for $11 million, the purchaser would have been required to capitalize $11 million as the cost of the facility because the purchaser would have benefited from the continuing lease.

The IRS had victories in the Supreme Court requiring the capitalization of costs incurred in the acquisition of property, but none of those cases included the cost of terminating a lease. The Court went to lengths to state that it's not simply the character of the payment, but the overall facts and circumstances. The Court finally held that the Supreme Court cases did not overturn the precedent set in 1948 by Cleveland Allerton Hotel, Inc. v. Comm’r, 166 F.2d 805 (6th Cir. 1948).

The ABC Beverage case provides us with some guidance whenever a tenant is exercising its purchase option during the term of a lease:
  • First, the purchase must be made by the tenant of the property. The case did not discuss if a related party or a party controlled by the taxpayer purchased the building, so  there is no assurance that this decision would be extended to such circumstances.
  • Second, the taxpayer obtained independent appraisals prior to purchasing the property. It was not clear whether appraisals obtained after the purchase, but before filing a tax return, would have sufficed. However, if a tenant is committed to purchasing the property, it should commit to spending the money to obtain the appraisals.
  • Third, it was clear that the purchase price, less the appraised value of the property, determined the value of the leaseholder interest. That  seems logical, but someone could have argued that the value of the lease was different;  there were also other costs associated with the acquisition which could have led to a different result.
If contemplating the purchase of real estate you lease, you should carefully analyze whether the acquisition price would exceed the fair market value of the property. This would reduce the net after-tax costs of the purchase of the real estate, if your circumstances are in line with the ABC Beverage case.
 

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