Introduction
When purchasing real estate, the acquisition price often represents a single lumpsum amount that includes both the land and any improvements, such as buildings, parking lots, or other structures. Before depreciation can be calculated, the purchase price must be allocated between the non-depreciable land and the depreciable improvements.
This allocation should be the first step in determining allowable depreciation for the assets that have wear-and-tear. While buildings and certain site improvements generally qualify for depreciation because they deteriorate over time, land itself is not depreciable since it is considered to have an indefinite useful life since it does not “wear out, decays, gets used up, becomes obsolete, or loses its value from natural causes” (1).
Because the allocation between land and improvements directly affects depreciation deductions, it is often the first area of attention during IRS examinations, particularly when a cost segregation study is involved. An unsupported or arbitrary allocation can increase audit risk and potentially lead to adjustments that reduce depreciation deductions or result in additional tax liabilities.
Experienced cost segregation professionals understand the importance of using well-supported valuation methods. Simply assigning a standard percentage to land without supporting evidence is rarely appropriate and may not withstand IRS scrutiny. The IRS Cost Segregation Audit Technique Guide (2) emphasizes that a quality study should clearly explain how the purchase price was allocated among land, land improvements, buildings, and other assets. The guide also notes that land should generally be valued first based on its highest and best use.
The following are the most common methods used to establish land value, listed in order of reliability.
Formal Appraisal
A qualified appraisal is generally considered the strongest and most defensible method for establishing land value. When available, a licensed real estate appraiser can determine the fair market value of the land by considering factors such as local market conditions, zoning restrictions, comparable sales, and the property’s highest and best use.
Because an independent appraisal is supported by professional analysis and documentation, it is typically afforded the greatest credibility if the allocation is questioned by the IRS.
However, obtaining a formal appraisal may not be viable for every transaction, particularly for smaller investment properties where the property’s basis is low enough where the county assessor will provide a similar value.
County Assessor’s Pro Rata Allocation
When a formal appraisal is unavailable, many practitioners rely on the county assessor’s allocation between land and improvements. Rather than using the assessed dollar values directly, which often differ from current market values, the land-to-total-value ratio from the assessment is applied to the property’s actual purchase price.
For example, if the county assessment attributes 25% of the property’s total market value to land, then 25% of the purchase price would generally be allocated to land.
This approach is supported by judicial precedent. In Nielsen v. Commissioner (3), the Tax Court determined that a taxpayer could not simply assign an arbitrary allocation between land and improvements without adequate support. The court concluded that the county assessment allocation provided a more reliable basis than the taxpayer’s unsupported estimate.
Although assessed values rarely equal fair market value, using the assessor’s proportional allocation generally provides a reasonable and well-supported methodology.
Comparable Sales
When neither an appraisal nor assessment data is available, analyzing comparable land sales may provide a reasonable basis for estimating land value.
This approach involves identifying recent sales of vacant or undeveloped parcels that are similar to the subject property’s land. Factors such as location, zoning, size, topography, utility access, and development potential should all be considered when selecting comparable properties.
Commercial real estate brokers, appraisers, and valuation specialists can often assist in identifying appropriate comparable sales and interpreting the market data.
Because this method requires professional judgment, it is inherently more subjective than the previous approaches. As a result, taxpayers should maintain thorough documentation explaining the selection of comparable properties, the adjustments made, and the rationale supporting the final conclusion. Well-documented analyses are significantly more likely to withstand IRS review.
Wrapping Up
Establishing an accurate land value is a foundational step in calculating depreciation for real estate acquisitions. Since land cannot be depreciated, an appropriate allocation between land and depreciable improvements directly impacts the amount of depreciation a taxpayer may claim.
Whenever possible, taxpayers should rely on objective, well-supported valuation methods such as a qualified appraisal or the county assessor’s proportional allocation. When those methods are unavailable, a carefully documented comparable sales analysis may provide a reasonable alternative.
Working with an experienced cost segregation firm can help ensure the allocation is both technically supportable and optimized for tax purposes. A properly supported land valuation not only helps maximize allowable depreciation but also reduces the risk of adjustments if the allocation is examined by the IRS.
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