To maximize tax deductions through depreciation, accurately calculating the value of land and buildings on a rental property is essential. The IRS allows depreciation on assets that deteriorate over time, like a building, not the underlying land. Given that most real estate purchase agreements lack specific value allocations for land and buildings, a taxpayer needs to be knowledgeable about methods for determining a proper allocation between these categories.
If a land valuation wasn't part of the purchase appraisal, rental owners must distinguish the value of non-depreciable land from depreciable buildings and site improvements. Here are a few methods to calculating the value of land and buildings on a rental property
- Use the county tax assessor’s allocation: Taxpayers can examine their county tax assessor's property valuation, typically detailing the assessed values for land and improvements according to county standards. This breakdown is usually available on the latest property tax bill or the county assessor's website. While these values might differ from the total purchase price, the ratio between the land and improvement values can be used to allocate the final purchase price for income tax purposes.
This land allocation method is frequently used and generally accepted by the IRS. However, it may not always accurately reflect fair market value. Taxpayers who believe the land allocation is excessively high can explore alternative valuation methods. - Get a full-scope land appraisal: A full-scope land appraisal, conducted by a qualified professional following Uniform Standards of Professional Appraisal Practice guidelines, offers the most accurate land valuation and is least likely to be disputed by the IRS. This comprehensive analysis includes sales comparisons, highest and best use, market conditions, and income generation. However, it is also the most expensive option and can take several weeks to complete.complete the process.
- Limited-scope land appraisal: A real estate professional can perform a limited-scope land appraisal by analyzing sales comparisons or other limited data. This analysis, similar to a broker's opinion of value, is less detailed and may not adhere to USPAP guidelines.
- 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.
- Rule of thumb method:
Many taxpayers allocate a fixed percentage to improvements versus land for s rental (e.g., 80/20 or 70/30). Most tax professionals do not advise their clients to utilize this approach and it may raise concerns under IRS examination. This concern was reinforced by U.S. Tax Court Summary Opinion 2017-31 (May 2017), which found a county assessor's land and improvement valuation more dependable than the taxpayer's valuation on the rental. The Tax Court stated that there's no basis to suggest a taxpayer is qualified to independently allocate property value between land and improvements.
When a rental property is bought for a single price, tax professionals should counsel clients on different cost allocation methods for tax depreciation. Using a property tax assessment for this purpose might lead to missed deductions. If the county tax assessor's land valuation is too high, alternative approaches should be explored.
Speak to a tax professional at Digb to get further clarification.
This article is provided for illustrative purposes only; it does not provide personalized tax, legal, financial, or other professional advice. Your situation may be different; consult a professional for information concerning your individual tax, financial, or legal situation before taking any action.
