Allocation of Costs to Land When Purchasing Real Estate
All real estate professionals have been there. It is the end of the year, and a rookie staff accountant from your CPA firm asks you, "How much of the purchase price should be allocated to land?" The quick response is 20%. This enables the entity to depreciate 80% of the purchase price. Now, you may wonder where the classic 80/20 came from. My best guess is that it came from an old intermediate accounting book which anyone who has ever taken accounting has seen.
However, the 80/20 rule is probably not accurate. In recent IRS audits of real estate entities, the service has been questioning the ratio split. This is especially true in parts of the country where the land is much more valuable than the structure on top of it.
The service's FAQ on depreciation states: "Land can never be depreciated. Since land cannot be depreciated, you need to allocate the original purchase price between land and building. You can use the property tax assessor's value to compute a ratio of the value of the land to the building."
The Tax Court has repeatedly ruled that this is accurate and has also ruled that mortgage appraisals may be used as an acceptable way to ratio the cost. The IRS has countered and said, "A taxpayer cannot allocate his cost basis in land and buildings solely according to their assessed values for property tax purposes when better evidence, such as an engineering report, exists to establish fair market value."
The one thing that the service is guaranteed to frown upon is to not have a basis for the ratio. Professional experience or an old intermediate accounting book are not considered acceptable appraisal standards.
We have recently seen tax assessor ratios of 40/60 building to land, which are not taxpayer friendly. This has caused us to search out alternative ways to arrive at an acceptable method on which to base our allocation. Acceptable methods include the following:
- The Gold Standard is the appraisal by a qualified independent appraiser. As a matter of due diligence, we have been asking our clients to request a breakout in all appraisals.
- Comparable sales of land in the local geographic area to arrive at a per-acre price.
- Insurance coverage on the structure.
- Site Coverage Ratio: The ratio of the ground surface occupied by a structure to the total surface of the land.
- Using the tax assessor's value for the land and the actual acquisition cost for the value of the entire purchase.
There is no single formula that can be used every time in every situation. Of primary importance is your ability to defend your allocation in the event of an audit. Proper documentation done at the time of purchase will support your position that the ratio has not been determined haphazardly.
This allocation, while crucial for tax purposes, is also important for financial statement purposes. A 10% swing in the allocation ratio could very easily cause a material misstatement in the financial statements.