Real Estate Tax: When Filling Up A Hole Is Tax Deductible

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Bill Walker was a frequent visitor to 100 Middle Street in Portland, Maine, and the office of KPMG, a national accounting firm.  Bill was an entrepreneur, a business manager and friend of the wealthy in and out of Maine.  He was energetic, imaginative and well spoken.  His career had lots of chapters.  He had been the president of a large family real estate business, a shepherd of inventors, a fundraiser for politicians and a manager of venture capital.

He always had something interesting he was working on.  Early one Friday morning in December of 1989 he found his way off the elevator, passing the KPMG receptionist’s desk (she was not in yet) and found David Reed in his office knowing David was always at work early. Bill’s visits to KPMG were not always to see David, although several times a year this early morning entrance was repeated. David sometimes thought Bill assumed a visit before office hours had officially started was a non-billable event. 

This particular morning he had a gleam in his eye and asked if David had a few minutes to help with a tax problem. David knew that Bill had probably talked with other accountants and was just now coming to David as a last resort.

Bill was helping a family excavating company with the purchase of a parcel of real estate and said he just wanted to know what income tax benefits might be available to offset the $500,000 purchase price.  David knew there had to been something hidden in this situation as Bill was very knowledgeable about the tax benefits of owning real estate. 

However, David decided to bite anyway and asked, “Will the buyer be developing the property for sale so that the purchase price can be deducted as lots are sold?”  He got a negative answer. David then asked, “Are there any buildings on the property (thinking of depreciation deductions)?”  Getting a negative answer, David then asked how large a parcel of real estate is involved and got the answer –15 acres.   Is there any timber or minerals on the property, (thinking about depletion deductions)?  Another “No”.  

David was getting a little frustrated but kept on.  Will your clients be paying the sellers over time with an installment note?  Bill did not know but asked why. David then explained his theory of optional interest. For instance, here if the price still being negotiated looks to be $500,000 and the sellers were going to charge 5% interest on the note, the buyers might negotiate for a lower price of say $400,000 but pay a higher interest rate so that the seller would be in the same cash position but the buyers would gain deductible interest expense in place of non-deductible land.  

For this to work the buyer has to have the negotiating leverage in the transaction or for the seller this would have to be ordinary income property, as otherwise the seller would be substituting capital gain for ordinary income.

Bill kept shaking his head and smiling as he really enjoyed seeing David dig deep into his tax “tool box” for a way to find a tax benefit. 

David paused but then asked, “What is the buyer going to use the land for?”  Bill responded saying, “Oh, I should have told you before the land is an old gravel pit with no aggregate left to extract, which is ideal as the buyer is negotiating a contract with the local pulp and paper company to be the repository for paper making, non- toxic wastes.  The paper company otherwise has only very expensive alternatives. The buyer has passed most of the environmental requirements.  The key is to layer clay at the bottom of the pit to prevent seepage into the subsurface ground water.  The area is perfect and the preparation has passed the scrutiny of the Maine D.E.P. and only needs the approval of the local code enforcement officer.”

David was at a loss of how to gain any tax advantage here but would not give up so he said, “ Let me think about this over the weekend and I will call you on Monday morning.”  Bill, wanting to see David squirm on Monday, said, “Oh I will just drop by early Monday morning”.  Bill smiled and left.

David went to his office on Saturday morning, as he usually did with the approach of year-end and its usual rush of transactions needing to be completed before December 31.  He also had planned to do a little Christmas shopping but now realized that research on Bill’s “challenge” would replace the shopping.

Sometimes it is just luck that presents a favorable answer and that was the situation that Saturday morning.  Tax research in late 80’s was not as easy as today and relied on hard copy tax indexes and a library of hard copy research materials.   David’s initial index search for something relevant was fruitless.   When, however, he took a break seeking out his third cup of coffee he started to think more about the expected use of the property than about rules for amortization, depreciation or depletion. 

The use was predicated on having an empty hole large enough to accommodate millions of cubic feet of waste.  The $500,000 was to be spent on physical capacity not on something that could currently be described as personal or real property.  With a little excitement David re-directed his research and found a 1950’s tax court case matching his situation.  There the Court allowed depletion-like deduction as an ordinary and necessary business expense to be available as the “hole” was filled up.  SUCCESS!!!

It was a good morning and there was even some time left for shopping before going to his oldest son’s swim meet.

Bill arrived at 6:30 Monday morning and found David, again in his office.  David presented a perplexed facial expression and got what he wanted from Bill, as Bill said, “No luck?”   It was pure pleasure when David smiled and said the buyer should be able to deduct most of the purchase price as he fills up the pit. 

Bill could not hide his surprise and eagerly wanted to know how that was possible.

David told Bill about the favorable case and that the buyer of the empty gravel pit would need to:

  1. Obtain an appraisal of the property as real estate.
  2. Subtract the resulting value from the purchase price to derive the value of the empty space.
  3. Have an engineer determine the amount of cubic feet of useable empty space.
  4. Then, each year accumulate information on how many cubic feet of waste went into the pit and use that information to calculate that year’s proportion of the allocable cost of the empty space that was filled up.

Bill was delighted with the result but seemed to have wished he had stumped David.

He started to leave but asked, “what is the name of the case?”

David responded, “Who do I bill for my work?”

Bill smiled and said, “I will get back to you.”

This Post Has 2 Comments

  1. Leonard Washington

    Thanks for writing this! I own a cattle ranch and a small restaurant, these articles pertaining to tax practices really hit home. Look forward to future pieces by you.

    1. Ben Vincent

      Glad to hear it, Leonard!

      If you have any particular issues with your businesses that you’d like to see addressed, let us know and we can see if we can get an article up that can help you out.

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David Hawkes (aka David Reed) is a tax, financial planning, family & small business consulting expert. He has worked with thousands of clients and saved them millions of dollars in taxes over the course of his career. David is also a former minority shareholder of the Boston Red Sox.