What due diligence in determining cost basis for depreciation

Question

In reviewing my taxes for the upcoming year, I've been looking more closely at my Schedule E and reading more about depreciation and cost basis. I know that your cost basis needs to be accurate, a number the IRS agrees with you on, but what constitutes due diligence in choosing this number?

In my situation, most of my property's market value comes from the land, not the dwelling. Additionally, I have 2 recent appraisals showing different values as well as 2 years of tax statements where the tax assessor placed significantly different value on the dwelling. On top of this, I house hack so I only attribute a percentage of the dwelling as eligible for depreciation.

All that said, it seems I have a significant amount of room to choose my cost basis and provide evidence for each. What is the most proper approach in this situation and what would the IRS want to see in the event of an audit?

Steven Hamilton II · Answer

There is actually quite a bit of room here as you can review your appraisal, local land comps, your property tax assessment etc. The key point is for a reasonable amount of room. In my opinion. I will want the highest amount of depreciation possible and would select the most favorable.

Natalie Kolodij · Answer

Also just to clarify RECENT appraisals don't matter.

Assets like Rentals need to be recorded at historic value. This is their value when put into service. This can NOT be adjusted if they are worth more later.

So if you had appraisals done when you bought them/ first put them into service you're good- If a year later you fixed them up and did an appraisal for a refinacne. You can't use that at all.

Also any LATER adjustments by the assessor, don't matter at all.

You can look at several methods to value your land v. building- but it has to be at that set point in time for when it was placed into service. Not a later date or year .

Natalie Kolodij · Answer

This is spot on and what I do too.

Things I see way too often: Tax pros just apply 80/20 because they're lazy. That's not a real method.

And they only look at and just use the tax assessors allocation.

But there are like 7 methods the IRS has and could accept if you can back them well enough. Make sure you realize your risk for how aggressive of a stance you take but Appraisal and tax assessor are both super solid starting points to both look at.

Andrew Ashby · Answer

Property Value-Land value=Building (improvement) value. Building value / depreciation term (27.5 years for residential, 39 years for commercial) = annual depreciation

Steven Hamilton II · Answer

Actually it depends if it is inside your dwelling and not an accessory building it is considered all eligible except you will have gain from the depreciation taken.

If it is an accessory building you do not get the 121 exclusion on that portion.

Steven Hamilton II · Answer

The most important part is to be ready to back up your method. Nielsen V Commissioner.  https://ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=11211

In this case the taxpayer lost as they completely winged a method and then their numbers did not line up.

You want to document the method in which you allocated land value. The easy or safe methods are the appraisal or assessors value.

Wayne Brooks · Answer

@Brian Nel Just an observation.....on your back, unless you plan on it being a pure rental property before you sell....whatever portion you depreciate will not be eligible for for your 121 primary exclusion. And remember, depreciation write off saving are essentially an interest fee loan that you have to pay back if you sell....not as good as a cap gains exemption.

@Natalie Kolodij BTW, is a certain portion of your primary, that you house hack/rent out, subject to Required depreciation and recapture like a pure rental property?

Brian Nel · Answer

Thanks for the great discussion on this. It's amazing to me how cut and dry taxes usually are yet in this situation there's many different ways to come at it.

The county tax assessor has been attributing less and less value to my dwelling each year and more to the land as my area continues to appreciate yet my overall appraisal is lower since I won a tax appeal so using the original number when placed into service will be better for me anyhow.

Natalie Kolodij · Answer

I don't think I've seen the IRS allow OTHER properties land v. building splits as your basis

Because unless your house and it's value/ improvements/ overall condition is EXACTLY like that one- you can't say it's allocation to land v. building is comparable - I'd just be a little cautious with this one.

You can use recent land sales though- prove what your land value is based on comparable properties .

Boomer Philbrick · Answer

What the IRS asks is for you to be reasonable when it comes to land value. It's recommended to look at other similar properties in the area and see what value or % they are using for land. And you can also do what Jaysen recommended above and look at town property records. Again, it all comes back to is the value you designate for land reasonable relative to other properties around and if you get questioned, can you defend it.

What due diligence in determining cost basis for depreciation

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