PLR 200852013: A buyer of a term interest in an apartment complex may depreciate the land

Plain-English summary

Land does not wear out, so nobody depreciates it. That is one of the first rules anyone learns about real estate tax. This ruling is about the exception hiding behind it.

Three sellers owned an apartment and retail complex in one city: several residential buildings, a parking structure, a surface parking lot, and the land under all of it. They split the ownership in two by time. One buyer bought the remainder interest, meaning everything after a fixed number of years. A different, unrelated buyer bought the estate for years, meaning full use of the property until that date arrives. The second buyer, the taxpayer here, wanted to know how to write off what it paid.

The answer turns on a distinction between the property and the interest in the property. An estate for years is not land. It is a wasting asset with a known expiration date, so the cost of buying one is recovered over its term even where the underlying asset would never be depreciable in someone's hands outright. The courts settled this in Lomas Santa Fe and Gordon. So the portion of the purchase price allocable to the land is treated as an intangible asset and written off ratably across the term of the interest.

The buildings and the parking lot work differently, and the mechanism is a little indirect. Section 167(e)(4)(B) says that if a depreciation deduction would be allowable on a term interest, the principles of section 167(d) apply, and section 167(d) tells a life tenant to compute depreciation as if it were the absolute owner. So the taxpayer steps into the shoes of an owner for the depreciable property and applies section 168 in the ordinary way, on the regular recovery periods, rather than over the term of its interest.

Running through both rulings is a condition the letter repeats every single time it states a conclusion: no depreciation is allowable at all, under section 167 or 168 or anything else, for any period during which the remainder interest is held directly or indirectly by a related person. That is section 167(e)(1), and it is the anti-abuse rule that keeps this structure from being a way to manufacture deductions out of land by carving it up within a family or an affiliated group. Lomas Santa Fe itself makes the related point that a taxpayer who splits its own interest without new investment and keeps the term interest gets nothing.

The taxpayer represented that everyone involved is unrelated within the meaning of section 267, that neither the sellers nor the remainderman funded its purchase, and that it will use the interest in an active rental business. The letter calls these material facts, then declines to rule on any of them. It also expressly withholds any opinion on whether the taxpayer is the owner of the property for federal tax purposes during the term, on whether the interest is in fact used in a trade or business, and on how the lump purchase price is allocated among the assets.

That set of caveats is most of the practical risk in the deal. The ruling answers the mechanics cleanly and leaves the facts that drive them to examination.

This is a clean digital release rather than a scan, so no OCR correction was needed. The letter states its two rulings twice, verbatim, once under rulings requested and again under conclusions; both appear as released.

Ruling snapshot

• Question: How does a purchaser of an estate for years in improved real property recover its cost, and does any of it get depreciated even though part of the price buys land?
• Outcome: approved. If the interest is used in a trade or business or held for the production of income, the portion of basis allocable to the land is depreciated ratably over the term of the interest under section 167(a), and the portion allocable to the buildings, parking structure and surface parking lot is depreciated under section 168. No deduction is allowable for any period during which the remainder interest is held, directly or indirectly, by a related person under section 267(b) or (e).
• Key authorities: Code sections 167(a), 167(d), 167(e)(1), 167(e)(4)(B), 167(e)(5)(A), 167(e)(5)(B), 168, 267(b), 267(e), 1001(e)(2); Treas. Reg. sections 1.167(a)-1, 1.167(a)-3(a), 1.167(a)-5, 1.167(h)-1(a); Gordon v. Commissioner, 85 T.C. 309 (1985); Lomas Santa Fe, Inc. v. Commissioner, 74 T.C. 662 (1980), aff'd, 693 F.2d 71 (9th Cir. 1982).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 200852013 Third Party Communication: None
Release Date: 12/26/2008 Date of Communication: Not Applicable Index Number: 167.17-00 Person To Contact:
------------------------------------------------------------ -----------------, ID No. -------------
--------------------------------------------- Telephone Number:

--------------------------- Refer Reply To:
--------------------------------------- CC:ITA:7
PLR-116187-08
Date:
September 24, 2008

Re: Request for rulings under sections 167 and 168

Taxpayer = ------------------------------------------------------- S1 = --------------------------------------------------------------------- S2 = -----------------------------------------------------------------------
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S3 = -----------------------------------------------------------------------
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A = -------------------------------------
City = -----------
StateX = --------
N1 =
N2 =
N3 =
Remainderman = ------------------------------------------------------------ N4 = --------------- N5 = ---- N6 = ---------------

Dear -----------------------------:

This letter responds to a letter dated April 3, 2008 submitted by Taxpayer requesting rulings under sections 167 and 168 of the Internal Revenue Code regarding the purchase of a term interest in certain property by Taxpayer.

FACTS

Taxpayer represents that the facts are as follows:

S1, S2, and S3 (collectively, the “Sellers”) own A and the land underlying A, which are located in City, StateX (collectively, the “Property”). A consists of N1 buildings as well as a parking structure and a surface parking lot. S1 owns N2 of the buildings, all of which contain residential rental apartments. S2 owns N3 of the buildings, all of which contain residential rental apartments and commercial retail space, and also owns the parking structure. S3 owns the surface parking lot.

S1, S2, and S3 each owns its interest in the Property through a StateX land trust. Further, S1, S2, and S3 each represents that it is properly treated as the owner of the Property for Federal income tax purposes.

S1, S2, and S3 each have entered into an Agreement of Purchase and Sale (Remainder Interest) (the “Remainder Interest Purchase Agreements”) with Remainderman and an Agreement of Purchase and Sale (Estate for Years) (the “Lead Interest Purchase Agreements”) with Taxpayer.

The Remainder Interest Purchase Agreements provide for the purchase of a remainder interest in the Property (the “Remainder Interest”) by Remainderman for a total of $N4. Remainderman’s purchase of the Remainder Interest will neither directly nor indirectly be funded by Sellers or Taxpayer. Remainderman intends to hold the Remainder Interest as a long-term investment. Pursuant to the Remainder Interest Purchase Agreements, Remainderman will have the unrestricted right to sell, assign, encumber, or otherwise dispose of, all its rights in the Remainder Interest.

Upon the closing of the Remainder Interest Purchase Agreements, Sellers will convey the Remainder Interest to Remainderman and will retain an estate for years in the Property for N5 years.

The Lead Interest Purchase Agreements provide for the purchase of Sellers’ N5- year estate for years in the Property (as well as in any fixtures, equipment, and personalty owned by Sellers that are located on the Property and used in conjunction with the Property, and in the leases for the residential and commercial spaces of the Property) (the “Lead Interest”) by Taxpayer for a total of $N6 immediately after the sale of the Remainder Interest by Sellers to Remainderman. Taxpayer’s purchase of the Lead Interest will neither directly nor indirectly be funded by Sellers or Remainderman. Taxpayer intends to use the Lead Interest in its active business of renting commercial and residential property.

Pursuant to the Lead Interest Purchase Agreements, all of the benefits and burdens of ownership in the Property during the term of the Lead Interest will be transferred to Taxpayer. Taxpayer will have the unrestricted right to sell, assign, encumber, or otherwise dispose of, all of its rights in the Lead Interest. Further, Taxpayer will pay all of the carrying costs associated with the Lead Interest.

Each direct and indirect owner of Sellers is unrelated (within the meaning of section 267 of the Internal Revenue Code) to each direct and indirect owner of both Taxpayer and Remainderman. Each direct and indirect owner of Taxpayer is unrelated (within the meaning of section 267) to each direct and indirect owner of Remainderman. RULINGS REQUESTED

1. If the Lead Interest is used in a trade or business or held for the production of
   income by Taxpayer, Taxpayer is entitled to depreciate the portion of Taxpayer’s basis in the Lead Interest allocable to the land ratably over the term of the Lead Interest under section 167(a). However, no depreciation deduction is allowable under section 167 or any other provision of the Code to Taxpayer for the Lead Interest for any period during which the Remainder Interest is held (directly or indirectly) by a related person (within the meaning of section 267(b) or (e)).

2. If the Lead Interest is used in a trade or business or held for the production of
   income by Taxpayer, Taxpayer is entitled to depreciate the portion of Taxpayer’s basis in the Lead Interest allocable to the buildings (including the parking structure) and the surface parking lot in accordance with section 168. However, no depreciation deduction is allowable under section 167, section 168, or any other provision of the Code to Taxpayer for the Lead Interest for any period during which the Remainder Interest is held (directly or indirectly) by a related person (within the meaning of section 267(b) or (e)).

LAW AND ANALYSIS

Section 167(a) provides that there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) of property used in a trade or business or held for the production of income.

Section 167(d) provides that, in the case of property held by one person for life with remainder to another person, the depreciation deduction shall be computed as if the life tenant were the absolute owner of the property and shall be allowed to the life tenant. See also section 1.167(h)-1(a) of the Income Tax Regulations.

Section 167(e)(1) provides that no depreciation deduction shall be allowed under section 167 (and no depreciation or amortization deduction shall be allowed under any other provisions of the Code) to the taxpayer for any term interest in property for any period during which the remainder interest in such property is held (directly or indirectly) by a related person.

Section 167(e)(4)(B) provides that if, but for section 167(e), a depreciation or amortization deduction would be allowable to any person with respect to any term interest in property, the principles of section 167(d) shall apply to such person with respect to such term interest.

Section 167(e)(5)(A) provides that, for purposes of section 167(e), the term “term interest in property” has the meaning given such term by section 1001(e)(2). Section 1001(e)(2) provides that the term “term interest in property” means a life interest in property, an interest in property for a term of years, or an income interest in a trust.

Section 167(e)(5)(B) provides that, for purposes of section 167(e), the term “related person” means any person bearing a relationship to the taxpayer described in section 267(b) or (e).

Section 1.167(a)-1(a) provides that the allowance for depreciation is the amount that should be set aside for the taxable year in accordance with a reasonably consistent plan (not necessarily at a uniform rate), so that the aggregate of the amounts set aside, plus the salvage value, will, at the end of the estimated useful life of the depreciable property, equal the cost or other basis of the property.

Section 1.167(a)-1(b) provides that, for purposes of section 167, the estimated useful life of an asset is not necessarily the useful life inherent in the asset but is the period over which the asset may reasonably be expected to be useful to the taxpayer in the taxpayer’s trade or business or in the production of his income.

Section 1.167(a)-3(a) provides that if an intangible asset is known from experience or other factors to be of use in the business or in the production of income for only a limited period, the length of which can be estimated with reasonable accuracy, such an intangible asset may be the subject of a depreciation allowance.

Section 1.167(a)-5 provides that when depreciable and nondepreciable property are acquired together for a lump sum, the acquisition cost must be allocated between the depreciable property and nondepreciable property on the basis of the respective values of the depreciable property and the nondepreciable property.

Generally, a taxpayer who purchases a term interest is entitled to deduct the cost of that interest over its expected life. Gordon v. Commissioner, 85 T.C. 309, 322-323 (1985); Lomas Santa Fe, Inc. v. Commissioner, 74 T.C. 662, 683 (1980), affd. 693 F.2d 71 (9th Cir. 1982). This principle applies even though the property underlying the term interest is not depreciable. Lomas Santa Fe, Inc., 693 F.2d at 72-73 n.2; Gordon, supra at 323. However, if a taxpayer, without additional investment, splits its interest in nondepreciable property into a term interest and a remainder interest and the taxpayer retains the term interest, depreciation deductions are not allowable under section 167(a) for that term interest. Lomas Santa Fe, Inc. Further, pursuant to section 167(e)(1) and (e)(5)(B), depreciation deductions are not allowable under the Code for any term interest in property for any period during which the remainder interest in that property is held (directly or indirectly) by a related person within the meaning of section 267(b) or (e).

Taxpayer has represented that each direct and indirect owner of Sellers is unrelated (within the meaning of section 267) to each direct and indirect owner of both Taxpayer and Remainderman, and that each direct and indirect owner of Taxpayer is unrelated (within the meaning of section 267) to each direct and indirect owner of Remainderman. Taxpayer also has represented that Taxpayer’s purchase of the Lead Interest will neither directly nor indirectly be funded by Sellers or Remainderman. Further, Taxpayer has represented that it intends to use the Lead Interest in its active business of renting commercial and residential property. These representations are material facts. Accordingly, the only issue for our consideration is how Taxpayer may depreciate its Lead Interest under section 167(a).

While the Lead Interest may include depreciable tangible personal property or depreciable land improvements other than the surface parking lot, Taxpayer has not requested a ruling on such property. Accordingly, we will address only how to depreciate the portion of Taxpayer’s basis in the Lead Interest that is allocable to the land, buildings (including the parking structure), and surface parking lot (a land improvement for depreciation purposes).

If the Lead Interest is used in a trade or business or held for the production of income by Taxpayer, the portion of Taxpayer’s basis in the Lead Interest allocable to the land, buildings (including the parking structure), and surface parking lot are subject to the allowance for depreciation under section 167(a). In such a case, the portion of Taxpayer’s basis in the Lead Interest allocable to the land is an intangible asset and, as a result, Taxpayer will depreciate such asset ratably over the term of the Lead Interest. Further, pursuant to sections 167(e)(4)(B) and 167(d), Taxpayer is treated as though it owned the buildings (including the parking structure) and surface parking lot for depreciation purposes and, therefore, Taxpayer will determine the depreciation for the portion of its basis in the Lead Interest allocable to such buildings (including the parking structure) and surface parking lot in accordance with section 168. However, no depreciation deduction is allowable under section 167, section 168, or any other provision of the Code to Taxpayer for the Lead Interest for any period during which the Remainder Interest is held (directly or indirectly) by a related person (within the meaning of section 267(b) or (e)).

CONCLUSIONS

Based solely on the facts and representations submitted and the relevant law as set forth above, we conclude that:

1. If the Lead Interest is used in a trade or business or held for the production of
   income by Taxpayer, Taxpayer is entitled to depreciate the portion of Taxpayer’s basis in the Lead Interest allocable to the land ratably over the term of the Lead Interest under section 167(a). However, no depreciation deduction is allowable under section 167 or any other provision of the Code to Taxpayer for the Lead Interest for any period during which the Remainder Interest is held (directly or indirectly) by a related person (within the meaning of section 267(b) or (e)).

2. If the Lead Interest is used in a trade or business or held for the production of
   income by Taxpayer, Taxpayer is entitled to depreciate the portion of Taxpayer’s basis in the Lead Interest allocable to the buildings (including the parking structure) and the surface parking lot in accordance with section 168. However, no depreciation deduction is allowable under section 167, section 168, or any other provision of the Code to Taxpayer for the Lead Interest for any period during which the Remainder Interest is held (directly or indirectly) by a related person (within the meaning of section 267(b) or (e)).

Except as specifically set forth above, we express no opinion concerning the federal income tax consequences of the facts described above under any other provisions of the Code. Specifically, no opinion is expressed or implied on: (i) whether each direct and indirect owner of Sellers is unrelated (within the meaning of section 267) to each direct and indirect owner of both Taxpayer and Remainderman, (ii) whether each direct and indirect owner of Taxpayer is unrelated (within the meaning of section 267) to each direct and indirect owner of Remainderman, (iii) whether Taxpayer is the owner of the Property during the term of the Lead Interest for Federal income tax purposes, (iv) whether the Lead Interest is used in a trade or business or held for the production of income by Taxpayer, or (v) whether the total purchase price of $N6 is properly allocated by Taxpayer between the various assets comprising the Lead Interest.

In accordance with the power of attorney, we are sending a copy of this letter ruling to Taxpayer’s authorized representative. We are also sending a copy of the letter ruling to the appropriate operating division director.

Sincerely,

Kathleen Reed

Kathleen Reed
Chief, Branch 7
Office of Associate Chief Counsel
(Income Tax and Accounting)

Enclosures:
Copy of this letter
Copy for section 6110 purposes