How to Allocate Land vs. Building Values for Investment Property

[Malik Javed]

How to Allocate Land vs. Building Values for Investment Property

When buying a residential property, one important yet often overlooked task is determining how to divide the property's value between the land and the building for depreciation purposes. The allocation can affect property taxes and legal responsibilities. Different portions of land and building might be subject to different tax rates or legal considerations.

Calculating land and building values for tax purposes is a critical step toward maximizing your available tax deductions from depreciation. This is because the law says you can only depreciate items that wear down over time (i.e., the building and not the land). Since most real estate purchase agreements do not assign value to each category, taxpayers must understand what options are available to determine the appropriate allocation to land and building.

Taxpayers are required to separately identify the value of non-depreciable items (i.e., land) from the depreciable building and site improvements. If a full scope appraisal showing the land value was not completed during the purchase process, taxpayers may consider the following options:

1. Rely on the county tax assessor’s allocation: A taxpayer can review their county tax assessor’s property allocation, which usually provides an assessment of land and improvements based on the county’s guidelines. This allocation can be found on the most recent property tax bill or on the county assessor’s website. The values listed may not match the total acquisition cost, but the proportionate ratio between the land and improvement values can be applied to the final purchase price for income tax purposes.
2. Commission a full-scope land appraisal: Another option is to commission a full-scope land appraisal. A qualified professional appraiser will generate a comprehensive analysis considering factors such as sales comparisons, highest and best use, market conditions, and income generated following Uniform Standards of Professional Appraisal Practice guidelines. While this option is the most accurate land valuation approach and least likely to be challenged by the IRS, it is also the most costly and can require several weeks to complete the process.
3. Limited-scope land appraisal: A limited-scope land appraisal can be completed by a real estate professional who provides an analysis of sales comparisons or other limited metrics. Similar to a broker's opinion of value, this analysis is less detailed and may not follow USPAP guidelines.
4. Replacement cost method: This methodology is supported by a 1982 tax court case, Meiers v Commissioner (T.C. Memo 1982-51), where the taxpayer successfully argued against the property tax “assessed value” allocation. In this approach, the taxpayer calculated that the cost to construct a new building (say, $300 per square foot at 2,000 square feet, totaling $600,000) should be allocated to building and the remaining balance of the acquisition should be allocated to land.
5. Rule of thumb method: Some taxpayers use a predetermined percentage (such as 80/20 percent, 70/30 percent, etc.) for improvements and land. Most tax professionals do not advise their clients to utilize this approach and it may raise concerns under IRS examination. This was highlighted when the U.S. Tax Court released Summary Opinion 2017-31 in May 2017, concluding that a county assessor’s allocation to land and improvement values was more reliable than the taxpayer’s proposed values. The Tax Court noted it could not find any authority that suggests a taxpayer is qualified to allocate the value of property between land and improvements.

When land and buildings are purchased for one price, taxpayers should be aware of the pros and cons of using various approaches to allocating the cost for tax depreciation purposes. Relying on a property tax assessment for this information may result in leaving deductions on the table. In situations where the county tax assessor’s land value is excessive, considering other options can yield significant permanent tax benefits that can be further enhanced by a cost segregation study.

If you'd like to discuss this topic further, feel free to comment or DM.

[Malik Javed]

Quote from @Vicki Karpovich:

Thank you for reviewing these options so clearly.  What if the county (or city in my case) has a very low percentage for land compared to the total.  It's about 6%.  I did review other similar properties in the area (recently sold and not recently sold) and other properties throughout the entire city.  It ranged from 3-9% with the majority being around 5-6%.  While completing a Cost Seg study, they were very resistent to me using 6% and because of time-sensitivity, I decided to default to the "rule of thumb" method that you mentioned and used 80/20.  That impacts me negatively now (compared to 6%), but supposedly was to prevent IRS questioning/audit in the future.  At this point, I feel like both were wrong and I should just get a land appraisal. I'm not sure if it's too late to go back and change it now or not, but would you recommend land appraisal it at this point, or do I have enough supporting evidence to use 6%?  It was for 2022 purchase filed in 2023 taxes (although we're going to have to file an amendment anyway, so maybe it's not too late??)

In the absence of an appraisal, when purchasing buildings that include the cost of the underlying land, you must allocate the total purchase price between the land and the buildings to determine the depreciation basis for the buildings. To do this, divide the cost based on the ratio of the fair market value (FMV) of each asset to the total FMV of the entire property at the time of purchase.

If you are uncertain about the FMVs of the land and the buildings, you can alternatively allocate the cost based on their assessed values for property tax purposes.

Source: IRS Publication 527 (Residential Rental Property)