How to determine building value for depreciation

Question

I'm in a bit of a quandary at the moment. I purchased a property in pretty bad shape for about $1 million last year and spent about $500,000 on what ended up being a MAJOR rehab project. The city assessed the value of the property when I bought it at $1 million, but only $100,000 was assessed to the building, and $900,000 to the land.

So now my CPA tells me that the IRS goes by the city assessed values to determine the PERCENTAGE of land vs building value. So if you purchased at $1,000,000, and now the property is worth $1,500,000, the IRS will allow 10% of that $1,500,000 to be depreciated ($150,000), while the rest cannot since it goes to land value. Am I the only one that thinks this is ridiculous? The city and county of Honolulu is notorious for unfair land/building ratio valuations.

My view is that I should ignore my CPA, and go with the REPLACEMENT VALUE the insurance company assessed on the building. The insurance company put the replacement value of the building at $660,000.

Or, should I take the initial purchase price, somehow subtract a fair value for the building BEFORE the rehab (let's say $200,000), and then add the labor and material that went into the project (approx $500,000) giving me a building value of $700,000 to depreciate?

Then there is the appraisal (not sure if this can be used for depreciation because the appraiser never splits land and building values), which came out at $2,140,000. But how do I allocate the building value out of that?

As you can see, I have no idea how to determine my new basis going forward. I just completely disagree with my CPA that I should use the "ratio" the city and county uses to determine the building value.

Thanks in advance for any advice and help!

Account Closed · Answer

A good accountant will also review the HUD 1 for closing costs that can be legitimately written off currently as opposed to those costs that must be rolled up into the purchase price.

Bryan Hancock · Answer

This is addressed in Reed's, "Aggressive Tax Avoidance For Real Estate investors" book. I would err on the side of being aggressive in this case. Some of our resident board members seem to think that the IRS regs are clear. This is only one of ten billion instances where things are obviously not clear and constitutes a "grey area." BE AGGRESSIVE! Thanks for digging this thread up Charles!

Account Closed · Answer

This is an old post but worth resurrecting for those that might have a similiar question. First of all there is no hard and fast rule used by the IRS in allocating building, land or personal assets. A CPA is required to use good judgment and allocate on a reasonable basis. For tax purposes your basis starts with the original purchase. Generally an appraisal is done as part of the purchase this determines the initial allocation between land and building. The building can be further allocated into equipment, furnishings, etc example: Using the example above you purchased the building and land for 1 million. Sense you didn't provide an appraisal lets say the appraisal is 1,100,000 and allocate 850K to land and the remainder to the building. I would ignore the assessed value figures. Your initial 1 million should be allocated proportionately. This would mean 773K should be allocated to the land and 227K to the building. If you later rehab the building this should be treated as a separate group of assets. I would separate appliances, furnishings, landscape improvements, etc because these all have different class lives. None of which would change the original land basis.

Keith Barton · Answer

If it is something pretty straight forward, as described in IRS Publications, as an established industry practice, etc... then that's how you should do it. This is not that. Ultimately what matters is the value of the building - if you have enough to support/justify your treatment of the amount at issue - go with that. When it is something that is not a simple yes/no, the IRS will decide what they decide: sometimes it will be reasonable and sometimes it won't. Then you have to decide how much it means to you (i.e., is it enough to go to court over?) In any event, as Charles mentioned - improvements of the type the original post was about, oh so many years ago, would be depreciated separately from the original cost of the building....

Steve Luo · Answer

Thanks for the tip, Bryan. Just ordered this book directly from the publishing company. Have a good weekend.

Bill Gulley · Answer

Your appraisal is more than the cost. It also has the value of the land as well as the improvements. Use that vor the value of the land and depreciate the value of the improvements based on the cost + costs of acuistion as Charles pointed out. SInce you purchase probably didn't break out the costs, you can use that to justify land costs. Never heard of the IRS only accepting a municipal or county tax assessment, that's two different things! I think I'd find another CPA. Good luck, Bill

Tod R. · Answer

Never heard of this book, but from looking at the TOC online, it seems like a great tool to have.

Joe Wilson · Answer

Sorry, but I don't buy into the % ratio allocation method used for improvements. I use the dollar value allocation method where if it was set that $900K was allocated to land on the assessment, then $900K will be allocated to land and any other amount will be allocated to depreciable real or personal property. Make sure you have a detailed invoice of the rehab so there can be a proper allocation to the different lives. I would use the % ratio on the original purchase price only, ie. Let's say the tax assessment is $750K - $500K building & $250K land and you bought it for $900K. Then you could use the % allocation method to say the building was bought for $600K and the land was bought for $300K. Any additions after that would all be property updates. That is my opinion as a CPA. Joe

Tim Hawkins · Answer

The assessment procedure begins with establishing land value. Appraisal theory and state law require land to be valued as if vacant. This value is determined by analyzing sales of comparable bare land. Our next step is to study sales and market trends of improved (developed or built-on) properties in a selected area. This sales analysis is used to determine total market value based on square footage, year built and other characteristics of the property. From this total value, we subtract the amount determined for land. The balance is allocated to improvements. Real property valuations are made by our staff of accredited real estate appraisers. The total valuation represents 100% of fair market value. Market value is the amount of money a buyer, willing but not obligated to buy, would pay to a seller willing but not obligated to sell. For residential parcels, fair market value is determined by analyzing recent sales of comparable properties in the same area. Commercial properties also may be appraised using this method or by using the income or cost approach. The appraisal method used will be the one that offers the best evidence of market value. www$metrokc$gov/Assessor/RealProperty$htm replace $ with . ________________________________________ Comparable Sales The comparable sales method compares the donated property with several similar properties that have been sold. The selling prices, after adjustments for differences in date of sale, size, condition, and location, would then indicate the estimated FMV of the donated property. If the comparable sales method is used to determine the value of unimproved real property (land without significant buildings, structures, or any other improvements that add to its value), the appraiser should consider the following factors when comparing the potential comparable property and the donated property: 1. Location, size, and zoning or use restrictions, 2. Accessibility and road frontage, and available utilities and water rights, 3. Riparian rights (right of access to and use of the water by owners of land on the bank of a river) and existing easements, rights-of-way, leases, etc., 4. Soil characteristics, vegetative cover, and status of mineral rights, and 5. Other factors affecting value. For each comparable sale, the appraisal must include the names of the buyer and seller, the deed book and page number, the date of sale and selling price, a property description, the amount and terms of mortgages, property surveys, the assessed value, the tax rate, and the assessor's appraised FMV. The comparable selling prices must be adjusted to account for differences between the sale property and the donated property. Because differences of opinion may arise between appraisers as to the degree of comparability and the amount of the adjustment considered necessary for comparison purposes, an appraiser should document each item of adjustment. Only comparable sales having the least adjustments in terms of items and/or total dollar adjustments should be considered as comparable to the donated property. www$irs$gov/pub/irs-pdf/p561$pdf replace $ with . ________________________________________ Section 6. Real Property Valuation Guidelines (IRS instructions to their employees) 1. Approach to Value --- The Valuation Process. The valuator should determine which methodologies are to be utilized in developing the opinion of value of the subject property. The valuator should consider the appropriate valuation approaches, such as the market approach, the income approach and the cost approach. Professional judgment should be used to select the approach(es) ultimately used and the method(s) within such approach(es) that best indicate the value of the property. 2. In the Market or Sales Comparison Approach, properties similar to the subject properties sold close to the valuation date are compared to the subject property. Adjustments are made for financing, condition of sale, date of sale, physical characteristics and location to indicate the value of the subject. Care should be taken to consider the number of sales available, their relative comparability, the degree and rationale for adjustments to the sales and the relative correlation and reliability of the value indications from the sales. www$irs$ustreas$gov/irm/part4/ch42s06$html replace $ with . Read IRS pub 946 How to depreciate property. Read IRS pub 551 Basis of assets. Not where they say you "can" us the assessors numbers, they don't say you must. Note also where they say to use Fair Market Value. And, I believe the only way to get to fair market value when you buy and and improvments at the same time, is to check the MLS for comparible land in the area, and use that (based on area), to value your land, the remainder is the value of the improvments. this method saved us $24k in taxes first year (Go zone) for 4 houses in AL and MS + more on our rental in CA and our home office in CA. Also, be sure to do a Cost Segregation Study -- saved us a bunch of money. Regards, Tim

Frank Adams · Answer

I'm not sure if it's a hard and fast RULE about allocating between land and attachments to determine the the proportion to each. But, I do know that the amount you can depreciate is the LOWER, of COST, or MARKET. So, it's what you PAID in, not what the insurance company says to replace it. I've always broken my rehab costs into CAPITAL EXPENDITURES which must be capialized and depreciated, and REPAIR EXPENSES which can be expensed in the year you pay them. While and A/C, carpet and MAJOR APPLIANCES need to be capitalized I've never had a problem EXPENSING painting, sheetrock repairs, repairing (actually replacing) interior doors etc. I generally went with the $100 rule. If it was less than $100 for material it was expensed. EDIT: BTW, you're saying the building is $600K, the insurance company says replacement is $660K. Not a lot of difference there. $60K over 30 years is only $2K/year. all cash