Suppose you're tearing down a commercial building and replacing it with a new one. Unfortunately, you get no current tax write-offs for demolishing the existing building. For tax purposes, the demolition costs are simply added to the cost of the underlying land. In other words, you won't realize any tax benefit until you sell the land -- if ever.
For example: You buy land in a nearby business district for $150,000 and pay a contractor $1 million to raze the existing structure and put up a new building. Let's assume that the demolition cost comes to $100,000. While you can write off the remaining $900,000 of the cost through depreciation deductions, you must add the $100,000 demolition cost to your $150,000 basis in the land. Therefore, your basis for determining any future profit is $250,000.
On the other hand, there may be a "partial" solution to this problem. If you renovate the building instead of tearing it completely down, you may be able to write off part of the cost. Under a special "safe harbor" rule (IRS Revenue Ruling 95-27), you can claim annual depreciation deductions for the renovation -- including the cost attributable to the demolition -- if certain conditions are met.
To qualify, the conditions are:
If you stay within these two tax boundaries, you're on firm ground to withstand a possible challenge from the IRS. However, you may forfeit tax breaks for the renovation if you exceed the safe harbor limits. The key: It is important for your construction consultant and your attorney to work together as a team to secure the tax benefits.
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