A purchase price allocation in real estate splits the total price of a commercial property into separate asset categories so each piece gets its own tax treatment. Land, the building, parking lots and landscaping, movable equipment, and intangibles like favorable leases all depreciate on different schedules, and some don’t depreciate at all. The split you choose controls how much you can deduct each year, how large your tax hit will be when you eventually sell, and whether the IRS accepts your return without question. Both buyer and seller have to report the same numbers, and Section 1060 of the Internal Revenue Code lays out exactly how to do it.
When the Allocation Rules Apply
A formal purchase price allocation under Section 1060 is required when the deal is an “applicable asset acquisition.” Two conditions have to be true at once: the assets being transferred constitute a trade or business, and the buyer’s tax basis in those assets is determined entirely by what was paid.1Office of the Law Revision Counsel. 26 U.S. Code 1060 – Special Allocation Rules for Certain Asset Acquisitions
Most commercial real estate purchases hit that threshold. If you’re buying a tenant-occupied building along with leases, service contracts, and operating systems, the IRS treats the transfer as involving a trade or business because goodwill or going concern value could attach.2Internal Revenue Service. Instructions for Form 8594 – Asset Acquisition Statement Under Section 1060
Buying raw land or an empty building with no tenants, no leases, and no operating history is a different story. Section 1060 likely doesn’t apply, and Form 8594 isn’t required. You still have to divide the price between land and improvements for depreciation purposes, but the seven-class residual method and the IRS reporting obligations below won’t be triggered.
How Each Asset Category Is Taxed
The whole reason to break the price apart is that each category writes off at a different speed. Faster write-offs are worth more; dollars stuck in slow categories or non-depreciable categories cost you.
Land
Land never depreciates. The IRS treats it as having an indefinite useful life, so every dollar allocated to the dirt itself is a dollar you cannot deduct until you sell. Buyers push for a lower land number; sellers often push the other way.
Building and Structural Components
The building shell and its structural systems (roof, walls, foundation, plumbing, electrical, standard HVAC) are real property. Nonresidential real property depreciates straight-line over 39 years; residential rental over 27.5 years.3Office of the Law Revision Counsel. 26 U.S. Code 168 – Accelerated Cost Recovery System Thirty-nine years is a long payback, which is why so much of the planning around an allocation is about pulling components out of this bucket.
Land Improvements
Parking lots, sidewalks, fencing, landscaping, drainage, and exterior lighting are 15-year property under MACRS. That’s less than half the building’s recovery period, so dollars shifted here produce deductions more than twice as fast.
Personal Property
Items not permanently attached to the building (specialized equipment, removable furniture, certain fixtures, decorative finishes) have five- or seven-year recovery periods. These are the most tax-efficient dollars in the deal: they qualify for accelerated depreciation, and often for immediate expensing under Section 179 or bonus depreciation.
Intangibles and Goodwill
Favorable leases, customer relationships, workforce in place, and non-compete agreements are Section 197 intangibles. They amortize ratably over 15 years from the month of acquisition.4Office of the Law Revision Counsel. 26 U.S. Code 197 – Amortization of Goodwill and Certain Other Intangibles In real estate deals, favorable below-market leases are often the most significant intangible. Goodwill and going concern value, the residual above the fair market value of everything else, also amortize over 15 years.5Internal Revenue Service. Intangibles
Why Buyers and Sellers Pull in Opposite Directions
The two sides want different splits, and that tension drives the negotiation.
Buyers want value loaded onto short-lived assets. A dollar shifted from a 39-year building to a five-year personal property category generates deductions roughly eight times faster. The ideal buyer allocation front-loads depreciation and keeps the non-depreciable land number as low as fair market value allows.
Sellers want the reverse because of depreciation recapture. Gain on personal property (Section 1245 property) is recaptured as ordinary income up to the total depreciation previously taken, meaning it can be taxed at the seller’s full marginal rate.6Office of the Law Revision Counsel. 26 U.S. Code 1245 – Gain From Dispositions of Certain Depreciable Property Gain attributable to depreciation on the building (Section 1250 property) gets friendlier treatment: unrecaptured Section 1250 gain is capped at a 25% rate rather than ordinary rates that can exceed 37%.7Internal Revenue Service. Topic No. 409, Capital Gains and Losses Any remaining gain qualifies for long-term capital gains rates. The seller therefore prefers more weight on building and land.
This isn’t academic. It’s the central allocation issue in most deals and the reason the IRS requires a written methodology.
The Seven-Class Residual Method
Section 1060 requires you to allocate the purchase price using the residual method, distributing the total consideration across seven classes in a fixed sequence. You fill each class up to the fair market value of the assets it contains, then push whatever is left into the next class.
- Class I: cash and general deposit accounts.
- Class II: actively traded securities and certificates of deposit.
- Class III: debt instruments and accounts receivable.
- Class IV: inventory and stock in trade.
- Class V: all other tangible assets, including land, buildings, land improvements, personal property, furniture, fixtures, vehicles, and equipment.
- Class VI: all Section 197 intangibles except goodwill and going concern value, including non-compete agreements, favorable leases, customer-based intangibles, and government licenses.
- Class VII: goodwill and going concern value, which absorbs anything left after Classes I through VI are filled.
In a typical commercial real estate deal, Classes I through IV are small or zero. The real work is inside Class V, where the allocated amount has to be divided among land, building, land improvements, and personal property based on their relative fair market values. That’s where an appraisal and a cost segregation study earn their keep.
Getting the Allocation in Writing
Section 1060 provides that if the buyer and seller agree in writing on the allocation of any consideration, or on the fair market value of any asset, that agreement binds both parties for tax purposes unless the IRS determines the allocation is inappropriate. The allocation is usually attached as an exhibit to the purchase and sale agreement or handled through a separate side letter before closing.
Two reasons to insist on it. First, a written agreement keeps the other party from filing a conflicting Form 8594, which would flag both returns. Second, an allocation backed by a signed agreement and a professional appraisal is far harder for the IRS to disturb than one the buyer simply asserted on their return.
Without an agreement, each side files its own numbers and should expect the mismatch to draw attention. The IRS defaults to fair market value, the price a willing buyer and willing seller would agree to with no pressure on either side.
Appraisals and Cost Segregation Studies
You can’t credibly defend an allocation without professional valuations behind it.
A standard commercial appraisal establishes the fair market value of the land versus the improvements. County assessor ratios are sometimes used as a shortcut, but they’re unreliable for this purpose; assessors use mass-appraisal techniques that don’t reflect the specific characteristics of your property. A qualified appraisal from a licensed commercial appraiser is far more defensible, and typically runs a few thousand dollars for straightforward properties.
A cost segregation study is a detailed engineering analysis that reclassifies building components into shorter-lived asset categories. It walks the property piece by piece, identifying items that qualify as five-year, seven-year, or 15-year property rather than the default 39-year building classification. The IRS’s Cost Segregation Audit Techniques Guide notes that a study prepared by someone with construction engineering expertise is more reliable than one prepared by someone without that background.8Internal Revenue Service. Cost Segregation Audit Technique Guide (Publication 5653)
The best time to run a cost segregation study is right after closing, when the property is placed in service. The IRS also allows look-back studies that recover missed depreciation from prior years through a change in accounting method. Study fees vary with property size and complexity, but on a commercial building the tax savings almost always dwarf the cost.
Bonus Depreciation and Section 179
The payoff from a careful allocation shows up in two accelerated write-off rules.
Bonus depreciation under Section 168(k) gives an additional first-year deduction on qualifying property beyond the normal MACRS amount. The One Big Beautiful Bill Act, signed into law in 2025, permanently restored 100% bonus depreciation for qualifying property acquired and placed in service after January 19, 2025. For 2026, eligible assets such as personal property, land improvements, and qualified improvement property can be written off in full in the first year. The earlier phase-down schedule that was dropping the percentage by 20 points per year has been eliminated.
That changes the math on cost segregation. Every dollar a study reclassifies out of the 39-year building and into a bonus-eligible category can be deducted immediately. On a $10 million acquisition where $2 million gets reclassified, that’s $2 million of first-year deductions instead of amounts spread across nearly four decades.
Section 179 lets you expense qualifying property in the year it’s placed in service rather than depreciating it. For the 2025 tax year, the maximum deduction is $2,500,000, with a phase-out beginning when total qualifying property placed in service exceeds $4,000,000.9Internal Revenue Service. Publication 946 – How To Depreciate Property These limits are adjusted annually for inflation, and the 2026 limits are expected to be slightly higher. Section 179 covers tangible personal property and certain qualifying real property improvements, which overlaps heavily with what a cost segregation study pulls out.
One catch: Section 179 deductions can’t exceed your taxable income from active trades or businesses for the year, with any excess carried forward. Bonus depreciation has no such income cap, which is why it tends to be the heavier tool on large acquisitions.
Reporting on Form 8594
Both the buyer and seller must file IRS Form 8594, Asset Acquisition Statement Under Section 1060, when the transferred assets make up a trade or business and goodwill or going concern value could attach.10Internal Revenue Service. Instructions for Form 8594
Form 8594 is attached to your income tax return for the year the sale closed. That means Form 1040 for individuals, Form 1065 for partnerships, and Form 1120 or 1120-S for corporations. If the total consideration later changes because of earnout payments, contingent consideration, or purchase price adjustments, a supplemental Form 8594 is required for the year the change is taken into account.
Part I collects identifying information: the other party’s name, address, and taxpayer ID, plus the sale date and total consideration. Part II is where the allocation itself lives, broken down by each of the seven classes with both the fair market value and the allocated amount for each.
The IRS cross-references the two forms. If the buyer’s numbers and the seller’s numbers don’t match, both returns get flagged. That is the single most common trigger for an allocation audit, and it is entirely avoidable with a written agreement signed at or before closing.
Form 8594 is an information return. Failing to file it, or filing it with incorrect information, exposes you to a penalty of $250 per return, capped at $3,000,000 per calendar year across all information returns.11eCFR. 26 CFR 301.6721-1 – Failure to File Correct Information Returns The bigger cost is usually the audit exposure a missing or inconsistent form invites.