An acquisition of an income-producing property is often an investment in much more than land and improvements. Tangible and intangible personal property can combine with the land and buildings or improvement to produce the income stream valued by investors. Because intangible property is exempt from property tax, identifying the presence of intangible personal property and appropriately allocating values to these components offers savvy investors the opportunity to save money both in the acquisition and, in some cases, for years thereafter.
A purchase price allocation agreement offers a powerful tool to achieve these goals. But before attempting to draft such a document, investors should have a firm grasp of what constitutes intangible property.
It is a truism that an investor in an income-producing property is purchasing the real and potential income stream and not the land and buildings alone. Land, improvements, tangible personal property, and intangible personal property—the proverbial bundle of rights—all may contribute to the income stream.
Dealing with this bundle of rights involves two distinct steps. First, the taxpayer or appraiser must determine if tangible or intangible personal property is involved in creating the income. Second, they must quantify the value of each component.
In many transactions, there is little argument that these separate components exist. The Appraisal Institute, Internal Revenue Service, Securities and Exchange Commission, the International Association of Assessing Officers, Financial Accounting Standards Board and America Institute of Certified Public Accountants all agree that a property’s value often includes an intangible value component.
Intangible and tangible personal property contribute in varying degrees to the income streams of hotels, health-care facilities such as hospitals, nursing homes and ambulatory surgical centers), restaurants, nightclubs and recreational facilities such as theme parks, theaters, sports venues and golf courses. On the other hand, multi-family projects, office buildings and retail shopping centers generally involve little, if any, personal property. Some property types such as self-storage lie somewhere in the middle.
Most investors and assessors recognize that hotels involve various types of personal property that can include operating licenses, an assembled workforce, furniture, brand, copyright and goodwill. The argument usually arises over the how the assessor or appraiser quantifies that value. In fact, that argument has been ongoing for many years.
Similarly, most investors and assessors recognize that seniors housing facilities include varying types and amounts of tangible and intangible personal property. These include independent living, assisted living, memory care and skilled nursing facilities, as well as continuing care retirement communities. The value of the intangible assets differs with each type, usually increasing as the level of care increases. Assessors and investors often struggle to quantify the intangible personal property’s value.
The presence and amount of tangible and intangible personal property in the transaction can impact the property owner’s cost in a variety of ways. Typical closing costs such as transfer taxes and title insurance premiums are generally based on the value of the land and improvements—not the value of the personal property. If the purchase price allocated to real estate in a transaction is too small and the buyer’s title insurance policy covers less than the real value of land and improvements, the title insurer may assert that the buyer or lender has assumed a portion of the title risk equal to the percentage of which the property was under-insured.
Calculation of income tax often requires separation of tangible and intangible components, and each of these generally involves a different depreciation schedule.
Ad valorem taxes are a third and perhaps more important area where the individual values of the components matter. Some jurisdictions tax tangible personal property at different rates than they do real property. More importantly, most jurisdictions exclude intangible personal property from property tax. By appropriately allocating among these components, property owners can save substantial amounts on property taxes.
Allocation agreements between buyers and sellers show whether the parties to the transaction itself agree that intangible personal property was present and how the parties valued that property. Part of the allocation agreement’s usefulness is in showing the agreement between two parties. Without an agreement, buyers and sellers may report different numbers in their income tax reporting and invite an audit.
Allocation agreements can become particularly important in bulk sales where the seller and buyer are transferring multiple pieces of real estate in a single transaction. These properties are often located in multiple states. Local assessors are statutorily bound to value the individual properties, and allocation agreements offer a guide for doing so.
The applicability of allocation agreements on local assessors varies by state. For example, Ohio law generally states that the best evidence of the fair market value of real property for tax purposes is the proper allocation of a recent arm’s-length purchase price, and not an appraisal. In South Carolina, allocation agreements are suggestive, but not binding, on local assessors. Some other states require assessors by statute to accept the full purchase price in an arm’s-length transaction as the value for purposes of ad valorem assessment.
There are several ways to structure allocation agreements. These include allocation specifically in the sales contract or negotiating a separate agreement after the execution of the purchase contract but prior to closing. Alternatively, the parties may incorporate various “agreements to agree” on allocations after the transaction has closed, which is usually a bad idea. Or they may establish a dispute resolution mechanism to address the issue after closing.
Real estate dealmakers generally focus on the income streams generated by the going concerns that are being sold in today’s marketplace. However, separating and valuing the components that contribute to the income stream is often critical to reducing the costs that will weigh on net revenues for years to come. A carefully considered allocation agreement between the parties to the transaction can be a valuable tool in mitigating tax liability for years to come.
Morris Ellison, Esq., is a partner in the Charleston, S.C., office of law firm Womble Bond Dickinson (US) LLP.