Can Land be Depreciated?
A common question we receive from our real estate investor clients at Midwest CPA is “Can land be depreciated?”. The short answer is no, but the topic is more complex than it seems.
Once it’s established that land cannot be depreciated, the next question arises: “How much of the property purchase price should be allocated to the land versus the building?” Allocating a higher amount to the building is in the investor’s best interest, as the building is depreciable. The greater the allocation to the building’s basis, the higher the depreciation expense the real estate investor can utilize to reduce taxes.
However, selecting any percentage arbitrarily is not allowed by the IRS. This is a common mistake made by generalist CPAs, who often allocate 10-15% to land for every property they prepare a return for. Such a percentage may not hold up under scrutiny during an audit, potentially leading to additional taxes and penalties. Conversely, an excessively high percentage could result in overpaying taxes. This is why it’s essential to work with a specialized real estate CPA.
The goal should be to find the most reasonable and accurate method for determining land versus building cost allocation. In this article, we will explore five methods to achieve this goal.
1. Tax Assessor's Allocation
This is the most used method and is generally well accepted by the IRS.
Each year, the local tax assessor provides property value assessments used to calculate the property tax bill.
For instance, if the land value is assessed at $63,000 and the building value at $387,000, with a total property value of $450,000, the land value percentage would be 14% ($63,000/$450,000).
If the property was purchased for $600,000, $84,000 (14% x $600,000) would be allocated to the land value, while the remaining $516,000 would be allocated to the building value for depreciation purposes.
2. Replacement Cost
Under this method, the taxpayer estimates a reasonable cost to construct a new structure similar to the one on the property. Often the property insurance policy will outline an expected cost to replace the building, and this can be used to estimate the replacement cost.
Subtracting the estimated replacement cost from the purchase price helps determine the value attributable to the land.
3. Full Scope-Land Appraisal
This method involves a qualified professional appraiser analyzing the property to determine the land value. The appraiser considers comparison sales, the property’s highest and best use, overall market conditions, and income generated by the property. Following the guidelines of the Uniform Standards of Professional Appraisal Practice (USPAP), this method offers high accuracy and support. However, it can be time-consuming and costly, making it more suitable for expensive real estate.
4. Real Estate Professional Appraisal
This appraisal is much more limited in scope than the one above and will not follow USPAP guidelines. Further, this analysis does not require a professional appraiser as it can be performed by a real estate professional instead. Their analysis will likely rely mostly on an analysis of comparative sales.
At Midwest CPA we recommend that this method be used only in rare circumstances.
5. Rule of Thumb
Finally, there is the rule of thumb method that is used by a lot of generalist tax professionals due to its ease and speed to calculate. A percentage of anywhere from 10-30% will be selected and used across all properties.
This method leaves you as a taxpayer with the lowest level of protection in an audit since there is very little support for your position.
By understanding these methods and their implications, real estate investors can make informed decisions about land versus building cost allocation. This way you can ensure you remain in compliance with the IRS while still working to optimize tax planning strategies.
Work With a Real Estate CPA Firm
Real Estate taxation is complicated. That is why partnering with a specialized CPA firm can make a significant difference in your financial success. A real estate CPA firm, like Midwest CPA, possesses in-depth knowledge and expertise in the intricacies of real estate taxation, ensuring that you navigate the tax landscape with confidence.
While we’ve got you here, why not take a look at our real estate CPA services.
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.