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Asset Allocation Rules
Written by: Steve Beaucaire, MST, CCSP
Director of Tax | Bedford Cost Segregation, LLC
Many questions have been raised about the asset allocation rules when purchasing or selling assets, whether it be buildings with land, a business or any other asset. In general the asset allocation rules are the same for all the above. The trouble is, asking the questions after the transaction is done could mean opportunity lost, whereas understanding the rules and regulations can yield vastly improved benefits if coupled with a cost segregation study (CSS). In order to lay claim to those advantages, we need to examine the issues in a purchase and sale agreement that impact depreciation.
First, the savvy buyer or advisor needs to know what not to do. If you remember nothing else, do not restrict yourself with the wording of the purchase and sale, and here's why. If the purchase and sale sets forth the detail of the assets down to the asset class level, i.e. 5, 15 and 39 year property, the IRS will consider this binding on both parties and nothing can be done later by either taxpayer to change it. That means the owner is locked into the asset class lives. The IRS takes the position that the wording in the P & S will govern the asset life and they will throw out any CSS. Most sellers want everything to be land or 39-year assets (to maximize capital gain) and the purchaser wants everything to be short lived assets (to maximize return of capital).
As background to the above, § 1060 states in part that the assets' basis is allocated according to § 338(b)(5) and that any of the allocation of the assets as part of the written agreement will be binding on all parties, the seller and buyer.(1) The transactions are reported on Form 8883 where you must identify both the buyer and seller of the property, the Target Corporation (relevant only if that was the purchased item), and on page two a listing of the assets by class. This form is filed by both the buyer and seller so of course it should match. Of the many forms seen, almost all put the assets into Class V unless a real premium is paid, which would generate goodwill in Class VII (asset classes are identified below). Otherwise you must break it down according to the definitions of the classes below.
Now let's talk about what to do. In general, asset allocation rules apply to all large purchases where the basis is determined by the consideration paid for them (2) , i.e. if you paid a million dollars for a property or a business, then your basis will be a million dollars. The important point is that you get to capitalize what you paid for the assets, but remember that the allocation itself is based on the fair market value of each asset. What the IRS prefers to see is a valuation study, but if it is not done, the value of land had better be close to the local tax assessor's valuation since the IRS always looks at the value of land. The other assets' value should be determined by reference to a valuation study or some other verifiable manner of determining the basis of each asset as a percentage of the total consideration paid.
The regulations describe seven classes of assets of Form 8883; Class I assets are cash and general deposit accounts other than certificates of deposit; Class II assets are actively traded personal property; Class III assets are generally debt instruments; Class IV assets are inventory items; Class V assets are all assets other than Class I, II, III, IV, VI, and VII assets; Class VI assets are all section 197 intangibles; Class VII assets are goodwill and going concern value. It is to the purchaser's advantage to classify as much as possible under the rules into Class V. And here's the silver lining: Class V assets can be segregated into personal vs. real property via a cost segregation study.
Bedford Cost Segregation has seen both sides of the coin, some where high percentages have been allocated to shorter lives and others where the allocation was locked in by the P & S. The taxpayer must manage the allocation or the allocation will mange him.
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