Purchase Price Allocations
“The combined effect of extraordinary market demand for long-term leased properties to corporate high credit tenants, which already results in significant premiums being paid for these properties, coupled with the lease rates of these properties being inflated by components that do not relate to real estate value, results in values and lease rates that are inconsistent with the value premise of fee simple real estate for tax assessment purposes"
Allocations can yield significant income tax and property tax savings. Purchasers of restaurants tend to focus on the overall cash flow without attributing these cash flows to specific components of the business enterprise. However, accurate purchase price allocations can often avoid unintended increases in their property tax assessment, as well as providing significant income tax savings.
Potential areas of benefit include:
Real Estate Tax Assessments – Unfortunately, attorneys inexperienced with these property types often merely include the total consideration within contracts of sale and in the transfer deed, as is common with purchases of other property types, such as apartment buildings, retail properties or office buildings. However, failure to allocate the total purchase price between real estate, tangible personal property, including inventory and FF&E, and the business enterprise value allows local tax assessors to treat the sale in a manner they are only too willing to accept. The result can cripple the new owner with significantly inflated property taxes far above the fair market value of the real estate, exclusive of personal property and business enterprise value.
Allocations of the total assets on the recorded deed present strong evidence of at least an effort to separate the categories. When the allocation is done by an expert, this becomes even more compelling evidence of the real property contribution to the total price paid. Unfortunately, such allocations are frequently not completed. Although there may be various reasons for not allocating, the reality of the situation is that if the price has not been allocated, the assessor interprets that to mean the purchase price represents the value of the real property.
This can result in a nearly insurmountable obstacle to the resolution of a discrepancy between market value and the assessed value. Many assessors see any allocation done at the time of an appeal as only a 'tactic' to lower taxes. This perception is unfortunate because the failure of uninformed buyers and their advisors to properly allocate at the time of the transaction is far more common than it should be and is the result of failing to understand the importance of allocation and the consequences of failing to do so.
Similarly, A similar obstacle also frequently emerges when a loan has been underwritten based on an appraisal in which the value was not allocated. These appraisals are repeatedly discovered through the legal process as a case moves closer to litigation. In such appraisals, frequently the appraiser doing the appraisal lacks the necessary depth of understanding about the issues. In fact, in many instances the title describing these appraisals appears as 'An Estimate of the Market Value.'
This, by itself, is meaningless and must be accompanied by the answer to the question, market value of what? Is it the market value of the total assets or just the real property? Often, reports titled this way represent an estimate of the value of the total assets of the business. As such, it suffers the same drawbacks as trying to use the sales comparison approach to value, and is inapplicable to the value of the real property for all the same reasons.
Property tax appeals to correct this situation are time-consuming, often taking years to resolve - even in the case of successful tax appeals; are expensive to prosecute because they require the hiring of an attorney and a commercial real estate appraiser, and the case is also significantly hampered by the recorded deed which shows what was paid in the transaction. According to tax court rules in many states, the consideration or sales price stated within the deed or other instrument of conveyance shall be admitted as prima facie evidence of the true consideration or sales price of the said property.
Build-to-Suits, sale-leasebacks, turnkey leases and other tenant financing instruments, are another common situation which would significantly benefit from an accurate allocation. These financial transactions typically enable companies to access more capital than traditional financing methods. For example, sale leasebacks allow companies to receive 100% of the value created by a lease, in contrast to traditional financing which is limited by loan to value and debt coverage ratios. These financing instruments also effectively allow these companies to grow by improving their balance sheets and redeploying invested capital in real estate into business expansion efforts.
For the seller, the above benefits are reason enough to prefer this financing tool over traditional bank loans. However, in addition, the Single Tenant Net Leased (STNL) market has emerged over the past 10-20 years from a small fraction of total commercial real estate transactions to a $50+ Billion per year industry. The investor benefits of long-term leases to corporate tenants with excellent credit ratings, with virtually no management headaches and fair returns, coupled with a low-interest rate environment over the past decade that keeps bond yields at very low levels, has resulted in great demand by investors for these properties. In fact,
With this backdrop, developers have benefited greatly by working with retailers on build-to-suit arrangements. Corporate tenants enter into agreements with developers to construct their buildings all over the country. Their building designs in many cases are focused on branding and serving their specific needs, rather than on resale value of the building. Therefore, the value of the buildings on the open market to an alternate user is often much less than its cost to build.
Further, the developers custom fit the space out for the specific tenant. This includes all of the equipment and furniture with relatively short economic life. Thus, many costs that would otherwise be sunk costs for the tenant in opening up a business in the new location are effectively financed on a long-term basis by structuring the lease as a function of the developers cost plus profit.
As a result, the lease rate for these properties is not related to the market or based on an analysis of comparable leased properties within the market area; the lease rate is strictly based on a financing arrangement to cover cost plus profit.
The combined effect of extraordinary market demand for long-term leased properties to corporate high credit tenants, which already results in significant premiums being paid for these properties, coupled with the lease rates of these properties being inflated by components that do not relate to real estate value, results in values and lease rates that are inconsistent with the value premise of fee simple real estate for tax assessment purposes.
Failure to accurately allocate the total purchase price for these situations, and the resulting crushing property tax burdens on the property owners has become increasingly difficult to correct as courts have moved toward adopting a sale price as value, regardless of what other evidence may exist to demonstrate that the sale was not representative of the “true value” of the real estate.
In fact, the case law in some states make the recorded sale price binding on assessors for purposes of setting the property tax assessment. It is extremely important, however, that the allocations be reliable and supportable. Under-reporting of real estate value has its own set of problems: title insurance policies insuring the buyer or the buyer’s lender can assert that the buyer or lender has assumed a ratio of the title risk equal to the percentage of which the property was under-insured due to an understated real estate value.
Similarly, in most states which collect a state, local or county transfer tax, the under-reporting of transfer tax as a result of understating real estate value is often subject to challenge and could lead to interest and penalties.
Real Estate Transfer Taxes - The applicability of transfer taxes depends on the jurisdiction, however, the taxes are usually based on the “value” of the real estate being sold. Therefore, including the overall value of the business within the deed will lead to a higher transfer tax.
Allocation of basis for income tax purposes - Because basis of a property for federal income tax purposes is determined at the time of acquisition, allocating the purchase price should be done before closing. Additionally, different depreciation rates for real estate improvements versus different types of personal property provide an opportunity for preferential tax treatment and depreciation write-offs.
Real and personal property tax assessments and taxes -
Segregation of readily depreciable/amortizable assets from non-depreciable/ amortizable assetsValue allocation generally involves four components:
- Land (non-depreciable);
- Buildings/improvements (typically depreciable over lengthy time periods);
- Tangible personal property; and
- Business Enterprise Value, including intangible personal property and goodwill.
A going concern is an established and operating business with an indefinite future life. For certain types of properties (e.g., hotels and motels, restaurants, bowling alleys, manufacturing enterprises, athletic clubs, landfills), the physical real estate assets are integral parts of an ongoing business. The market value of such a property (including all the tangible and intangible assets of the going concern, as if sold in aggregate) is commonly referred to by laymen as business value or business enterprise value, but in reality it is market value of the going concern including real property, personal property, and the intangible assets of the business.
When analyzing the value of income producing real estate properties, the Appraisal Institute, Internal Revenue Service (“IRS”), Securities Exchange Commission (“SEC”) and Financial Accounting Standards Board pronouncements of the America Institute of Certified Public Accountants (“FASB”) all recognize that a property’s value includes an intangible value component. Similarly, component analysis is applied in ad valorem taxation where taxing authorities are generally charged with separately taxing (i) real property value, (ii) personal property value, and (iii) intangible value, often at different rates.
1. See Michael Allen, Price Allocation, Gain Tax Benefits by Allocating Price Before Closing Sale of Business, PRACTICAL TAX STRATEGIES, Aug. 25, 2008.
2. Appraisal Institute, Appraisal of Real Estate, p. 63 (14th Edition)
3. See, e.g., 2012 Internal Revenue Service Manual, Part 4, Chapter 48, Section 5; FASB Accounting Standards Codification ¶ 350-20-35-3 and 3A-3G