How to Allocate the Purchase Price in Buying Farm Land
With the recent run-up in the price of farmland in recent months, the issue of allocation of the purchase price for depreciation purposes has taken on greater significance. With the improvements ranging from fairly new machinery storage facilities and grain bins all the way to older buildings bordering on obsolescence and fences of varying states of repair, it's not an easy task to figure out how much of the purchase price to assign to each. The same problem exists with tile lines, some of which may be fairly new and some 30 to 40 years old and built with different materials.
Here are the guidelines and what it takes to satisfy the Internal Revenue Service.
The General Rule
The IRS position is that allocation of the purchase price must be carried out on the basis of relative fair market values of the depreciable and non-depreciable components. The amount assigned to depreciable assets cannot exceed an amount which bears the same proportion to the total cost as the value of the depreciable property bears to the value of the entire property. That's easy to state but it's much more difficult to apply.
Let's say we have a 160-acre tract of farmland with only fences and tile lines. The farm sold for $800,000 in 2007 and the new owner wants to know how to allocate the $800,000 to the soil (which is not depreciable) and the tile lines and fences which are depreciable. A decade ago, the same farmland sold for $550,000 and nothing had been done to either the tile lines or the fences since the 1997 sale. If it was considered reasonable that the fences and tile lines in 1997 made up 10 percent of the selling price, or $55,000, does it follow that 10 percent of the $800,000 purchase price could be allocated to the fences and tile lines in 2007? That depends upon the relative fair market values for the soil on the one hand and the fences and tile lines on the other in 2007, not in 1997.
Or let's take a farm which sold for $400,000 in 2008 with the only depreciable property being a couple of miles of run down fence (which will likely be bulldozed and not replaced) and buildings that are slated for demolition.
Depreciable Property to Be Demolished
Before 1984, if the purchaser had an intent to demolish depreciable property on acquisition, no part of the purchase price could be allocated to those properties. That led to purchasers being very careful not to display their intent-until later. That's why the law was changed in 1984 to specify that no deduction is allowed to the owner of a structure for any costs of demolition or any loss arising from the item demolished.
That rule does not apply to fences or other properties that are not a "structure." But allocating to a fence and promptly demolishing it makes it difficult to argue that a generous allocation of the purchase price to the fence was reasonable.
Sources of Guidance
One way to determine fair market value, particularly for items not sold in a market, such as skid-mounted buildings, is to check what the replacement cost would be for the same item and then reduce that value for the age of the property in place. This is often the most convincing approach. Of course, unless the purchaser acquired well-documented tile maps, it may not be clear how much tile is in the land in question (and the size and condition of the tile) let alone when it was installed. Obviously, it is helpful to obtain as much information from the seller as possible, particularly if the seller installed the tile.
The Internal Revenue Service has recognized, although reluctantly, allocations based on assessed value for property tax purposes where that is the best available source of information. In a 1991 private letter ruling, IRS made it clear that allocations could not be made solely on the basis of real estate assessment figures if better evidence exists to determine the fair market values of properties.
Sometimes values used for insurance purposes have been offered in support of allocations made. Those values are more authoritative if the values have been adjusted regularly for inflation and are based on replacement values.
Certainly, in determining the amount to be allocated to bare land, it is important to check recent sales of comparable land in the locality.
A written agreement between the buyer and the seller concerning the allocation of the purchase price is often respected, particularly if between unrelated parties, unless there is mistake, undue influence, fraud or duress.
Remember. . .
The amount allocated to depreciable assets can be depreciated-7 years for grain bins and farm equipment, 10 years for confinement livestock facilities, 15 years for land improvements, 20 years for farm buildings. For machinery or equipment, fences, tile lines, feeding floors, confinement livestock facilities and grain bins, to mention the major items eligible for expense method depreciation, up to $125,000 can be deducted in 2007.
Dr. Neil E. Harl is a Charles F. Curtiss Distinguished Professor in Agriculture and Emeritus Professor of Economics, Iowa State University, Ames, Iowa. He is a member of the Iowa Bar. He can be reached at 515-294-6354.