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Whenever assets constituting a functioning enterprise are transferred in a taxable transaction, Section 1060 of the Internal Revenue Code requires the seller and buyer to allocate the purchase price among the transferred assets. Treasury Regulations require sellers and buyers to allocate the purchase price to and among seven classes of assets according to the relative fair market values of each class, and the relative fair market values of the assets in each class.
- Class I assets are cash and bank deposits.
- Class II assets are certificates of deposit, foreign currency, and actively traded personal property.
- Class III assets are assets marketed-to-market at least annually for tax purposes.
- Class IV assets are stock in trade, inventory, and other property ordinarily sold to customers.
- Class V assets include real property and personal property not covered by any other class.
- Class VI assets are Section 197 intangibles.
- Class VII assets are going concern value and goodwill.
The buyer and seller may agree on the purchase price allocation. The agreement is binding on them, but not on the IRS if it finds that the allocation is based on inappropriate valuations. Thus, sellers and buyers should get a professional appraisal for big ticket items like real property.
The purchase price allocation is an important deal point. The allocation will determine the amount of gain or loss realized by the seller, and the character of such gain or loss. For individuals, capital gain is subject to a preferential tax rate; while ordinary gain and depreciation recapture are subject to the much higher income tax rates. Thus, the allocation will have an immediate tax consequences for the seller.
The allocation will also determine the buyer’s cost basis in the acquired assets, and the schedule over which the buyer recovers its cost basis through depreciation. Thus, the allocation will impact the buyer’s future taxable income, and the amount of gain realized on a subsequent asset disposition.
Naturally, sellers will want to allocate as much of the purchase price as reasonably possible to assets that result in a loss, no gain, or capital gain. Buyers in turn will want to allocate the purchase price to assets that depreciate quickly. Both will want to consider the present value of various tax consequences when negotiating the purchase price allocation.
For those in the real property space, it’s important to remember that real property is a collective noun: it’s inclusive of both “land” and any “permanent fixtures” affixed to the land. Land does not depreciate for tax purposes, but permanent fixtures do. So, a savvy seller will want to allocate more of the purchase price to land (thus realizing capital gain), and less to permanent fixtures (thus avoiding ordinary income through depreciation recapture).
The most common example of a permanent fixture is a building. Sounds simple enough, but not everything commonly thought of as part of a building is actually part of the “building” for tax purposes. Things like the HVAC system, P.A. system, and lighting fixtures are not necessarily part of the building. Non-permanent fixtures often have shorter depreciation schedules than do the walls, floor, and ceiling in which they are enclosed. So, even when allocating the purchase price among Class IV assets there is much room for negotiation.
Sellers and buyers have competing interests when allocating the purchase price to the seven asset classes, and among the assets in each class. The allocation will impact the seller’s net income in the current period, and the buyer’s net income in future periods. Since real money is on the line, sellers and buyers should pay close attention to how they allocate the purchase price, enlisting the help of a commercial real estate attorney, tax attorney or other tax professional.