When you buy business or investment real property, such as an apartment building, you usually pay one lump sum for land, buildings, and other improvements. There’s no cost breakdown. You can’t depreciate land because it doesn’t wear out. So, as far as depreciation goes, the land is useless.
What you need is a way to take that lump sum and allocate it to land, buildings, improvements, and equipment. Allocating costs to land and buildings for tax purposes is a factual determination initially performed by you, the property owner.
Problem: We are seeing IRS challenging more rental depreciation deductions based on county tax assessor’s land and building values. Many times the percentage of land to improvements are either way off from true fair market or way out of date.
Allocation Methods
The IRS provides little guidance on how land and building values should be allocated. It simply says that “you must divide the cost between the land and the buildings to figure the basis for depreciation of the buildings. The part of the cost that you allocate to each asset is the ratio of the fair market value of that asset to the fair market value of the whole property at the time you buy it.”
There are many ways to perform this allocation, including the contract terms and cost segregation. You are not required to use any particular method—just a reasonable method. The two most popular methods are assessed value and appraised value.
Assessed Value
We are going to use examples to show how the two methods work. For the examples, let’s say you purchase a rental home for $200,000.
You check the county tax assessor’s records for the property. It was last assessed 10 years ago. The assessor’s records show that at that time the entire property was valued at $100,000. The land was valued at $37,000 (37 percent) and the building at $63,000 (63 percent). This gives you your ratio of building to land. You multiply the $200,000 purchase price by 63 percent, resulting
in a $126,000 depreciable basis in the building and a $74,000 land value.
Appraised Value
Here, you hire a qualified appraiser who studies comparable property sales in the area and concludes in a written report (which you place in your tax file) that the land is worth only 10 percent of the total purchase price. This results in a $180,000 depreciable basis in the building and a $20,000 land value.
In this example, the appraisal gives you $54,000 of additional depreciation. In most cases, the appraisal gives you a good result, and it has high credibility with the IRS.
Why Assessed Values Are Usually Bad For Investors
Rental property owners often use assessed values for allocations to land and building, for the following reasons:
- They did not take the time to get an appraisal.
- They did not know what proof to collect.
- The assessor’s statement is readily available.
- The assessor’s statement costs nothing.
But assessors’ statements are notoriously inaccurate. County tax assessors aren’t greatly concerned about arriving at an accurate breakdown of the relative values of your land and improvements, because it has no effect on your property tax bill—your tax is based on the total assessed value of your property.
Often, county assessors apply a standard percentage to all property in the area—for example, 80 percent. Or they may use out-of-date sales data from previous years.
As a general rule, tax assessors tend to undervalue buildings and overvalue land, resulting in smaller depreciation deductions than can be obtained using other methods
Takeaways
Had you looked at the assessor’s statement, you would have noticed the high allocation of cost to the building. That may have triggered questions and perhaps an appraisal or cost segregation study.
The rule of thumb is simple: you need proof, and you generally need that proof on a timely basis. After-the-fact gathering-the-proof activity is seldom effective and often expensive.
With a lack of documentation, you may put yourself at the mercy of the IRS—and when is the last time you saw the word “mercy” used sympathetically in the same sentence as the IRS? Let’s face it: you are unlikely to find mercy in your dealings with the IRS.
If you have questions on allocating costs, please don’t hesitate to call me on my direct line at 509-543-7600 or send a request HERE.
June 2021
This blog does not provide legal, financial, accounting, or tax advice. This blog provides practical information on the subject matter. The content on this blog is “as is” and carries no warranties. TaxMedics does not warrant or guarantee the accuracy, reliability, and completeness of the content on this blog. Please contact us directly to discuss how this information may be used based on your actual facts and circumstances.