Are you ready to knock down a deteriorating investment property or business building and construct a new building in its place?
Strategy: Don't swing the wrecking ball quite yet. First, note this important tax quirk: If you tear down only part of the building, you can write off your demolition costs. But if you completely gut the place, you'll typically earn no current tax benefit for the demolition.
The IRS has said it won't challenge deductions claimed by building owners who follow a "safe harbor rule" for renovations. As long as you stay within the IRS-approved boundaries, you're in the clear.
Basically, you earn no deduction for demolition expenses if you completely flatten the building. Instead, you must add those costs to the basis of the underlying land. So, you won't realize any tax benefit until you sell the building, if ever.
Example: extreme building makeover
Suppose you buy property with land valued at $200,000. The building on the property desperately needs repairs. You agree to pay a contractor $1 million to tear down the old structure and put up a new one.
If the demolition work costs $150,000, you must add that amount to the $200,000 land cost, which creates a total basis of $350,000. You receive no tax benefit from the $150,000 in demolition costs until you sell the land under the building.
But if you keep most of the building intact, you don't need to allocate costs between the demolition work and other renovations. Instead, you simply claim depreciation deductions based on the entire $1 million payment to the contractor. In other words, you don't need to add anything to the basis of the land if you qualify. (IRS Revenue Procedure 95-27)
To claim depreciation deductions for a partial demolition, you must:
1. Retain 75 percent or more of the external walls as either external or internal walls in the renovated building.
2. Retain at least 75 percent of the existing internal structure of the building. The "internal structure" includes load-bearing internal walls and other internal supports essential to the building's stability.
Bottom line: If you knock down about 25 percent of the building, you can still write off your demolition costs. Huddle with your tax pro and a construction expert to see if you can pull it off.