EXPLAINED: Land allocation for depreciation and cost segregation

[Michael Plaks]

Everyone wants cost segregation today. We are one step away from offering cost segregation to dogs. After all, bowls and beds are not permanently attached to the dog house, so why not?

And every cost segregation starts with allocating a portion of the total property value to land. In fact, land allocation is required even without cost segregation.

We have debated land allocation on this forum for years. Of course, being in real estate, we never agree on anything. This post is one tax accountant's summary of the issues and one tax accountant's opinion on how to approach land allocation. I'm sure some colleagues of mine and some investors will disagree. I prepared some popcorn, just in case.

We start with basics and then proceed deeper into the woods.

1. Why land allocation matters.

Because of depreciation. And here is an introduction to depreciation if this term is new or confusing to you.

You buy a rental house for $300k. Simple slow depreciation of houses takes roughly 30 years, 27.5 to be exact. So this sounds like a $10k depreciation deduction per year. Wrong.

We have to subtract land value first, because land cannot be depreciated. If $100k of the $300k purchase price is the value of non-depreciable land, we have only $200k left for depreciation. Our annual depreciation deduction is now $200k / 27.5 years = $7,300 per year.

However, if the land is worth only $30k, we can depreciate the remaining $270k, which gives us a $10,000 depreciation deduction per year. This is better than $7,300, right?

With cost segregation, land allocation can influence your tax savings even more significantly. So yes, it matters.

2. The notorious 15/85 allocation.

I like simplicity. Pretty sure that you do, too. The national average of land value for residential real estate is 15%-20% of the total value. Why not just allocate 15% or 20% of any property to land and call it a day?

This proposition, known as 15/85 (or 20/80) allocation is very tempting. No work required, and most of the property remains eligible for depreciation. Some colleagues of mine have aggressively pushed this approach here on Bigger Pockets. I don't tell them what to do.

But somebody else might. Uncle Sam. And he is not as easy to brush away as me. You will have to deal with him.

Why does he care? Well, here is some shocking news for you. The IRS wants to give you as little depreciation as possible. The more value is allocated to land, the smaller is your depreciation deduction. If they could, they would allocate 100% to land. See the problem?

If the IRS does not check your tax return, anything flies. You could get away with 15%, 5% or 0% to land. As long as nobody is looking. Which is exactly the argument of 15/85 people: we have done it forever, and we never had a problem. Which is exactly how breaking the rules works. Anything goes when nobody is watching.

I'm not a preacher, I'm an accountant. Not telling you whether to respect the rules or ignore them. Your call.

3. So what are the rules, then?

Ha, this is where it gets interesting. There are no clear rules. The tax law allows any reasonable method of allocation, as long as it is based on fair market values. Here's more shocking news: what may be reasonable to you - say, 15/85 - is often not reasonable to the IRS. And who decides what exactly is a fair market value of anything?

When there are disagreements, there are negotiations. If taxpayers and the IRS cannot bridge their differences, it goes to court. Guess what? Courts decide it inconsistently. Fun, isn't it?

We have the IRS preferred approaches which are not really the law, per se. And we have to decide between aggressively claiming the maximum benefit, timidly taking a conservative minimum or something in between.

4. What does the IRS want?

Your money, of course.

Their position is published as an ATG - Audit Techniques Guide for Cost Segregation Studies aka Publication 5653. This is an internal training guide that the IRS auditors are supposed to go by when harassing you. You can download and read it if you have strong masochistic tendencies. Only 348 pages long, no cartoons. I did read it, but I had to.

Throughout the ATG, the IRS instructs its auditors to "determine whether cost basis was properly allocated to land," however they don't bother to define the meaning of properly allocated.

The only method the IRS will not challenge is a formal appraisal done at the time of purchase. If you have such an appraisal or are willing to pay to have one done, AND you are comfortable with its results - this is the safest method.

The reason why a formal appraisal is the most reliable method is because it is based on the actual total market value at the moment - which is likely very close to what you paid for the property. Everything else requires somewhat arbitrary adjustments.

The next best method, according to both the IRS and the courts, is a local tax assessment. The obvious problem with this method is that the total value of land plus improvements, per county assessor, is usually very different from what you actually paid.

5. How do you adjust for the difference in total value?

Let's illustrate the problem with an example first. You bought a property for $500k. Your county tax assessor website says that the property is $150k land and $450k improvements, for a $600k total.

Option A. You subtract $150k land from your $500k purchase total, and you have $350k left for depreciation.

Option B. You subtract $450k improvements from $500k, leaving $50k for non-depreciable land and $450k for depreciation.

Option C. You apply the county assessor's 25/75 ratio to your $500k purchase price. Now you get $125k for land and $375k for depreciable improvements.

Same data, but 3 very different results for depreciation. $350k, $375k and $450k. Which number is correct? It depends on whom you ask, of course.

Predictably, the IRS ATG tells you to subtract land first (Option A), which leaves the minimum value for depreciation. In at least one case, the US Tax Court allowed the taxpayer to do the exact opposite: subtract the full improvements first and leave the minimum for land (Option B).

Most CPAs and cost segregation firms believe that Option C - preserving the ratio - is the most accurate one. However, in one section of the ATG, the IRS appears to dismiss this approach. Decisions, decisions.

6. Any other methods?

Yes, however they are not listed in any legally binding guidance and not in the IRS ATG, either. They are the methods commonly used by CPAs and cost segregators and sometimes tested in litigation, albeit not specifically endorsed or dismissed by courts. They are in the typical grey area of "we will consider it, but we may or may not accept it."

A written opinion of land and improvements value by a licensed Realtor. In essence, this is an informal appraisal, based on analysis of comparable sales. This is a much faster and cheaper, possibly free, solution than a formal appraisal. It is also much less convincing to the IRS, should you have to defend it.

Valuations by insurance carriers. Your insurance policy typically assigns values to land and improvements. Insurance allocations are not binding outside the context of insurance. However, the IRS tends to accept them. The reason is simple: both the IRS and your insurance company are motivated to allocate as much as possible to land and as little as possible to improvements.

Investor's own research of comparable sales. After all, this is your business, and analyzing property values is something you do regularly. Courts have recognized that investors can testify as to the values of real estate they own, however such opinions are merely a consideration. It is weighted against other available data, and county appraisals typically win.

Replacement cost method. You take an estimated cost of rebuilding as the depreciable building value, and whatever is left is land. I personally consider this to be a risky method. That said, the Tax Court did allow this method in one old case. Surprisingly, it was even allowed to override the local tax assessor's valuations. However, the properties in question were condominiums, and it might have played a role. I would not count on it holding water if litigated again and for stand-alone buildings.

7. So, what do we do?

The dilemma is very typical when it comes to controversial tax decisions. Get aggressive and poke the IRS bear? Or be conservative and hope the IRS will bother someone else?

This is a very personal decision. Let me suggest some food for thought while you're pondering your course of action.

Will the IRS audit me if my land value is too low? This is not going to trigger an IRS audit by itself. Mostly because your tax return does not explicitly report your land allocation. Your land allocation can be guessed by somebody who is analyzing your tax return but not by the IRS computer. In other words, it very well can be challenged during your audit, but it will not be the reason why you are audited. At least not until the IRS figures out how to turn AI against you.

If I choose a conservative allocation, do I throw away money? Not necessarily. When you sell your property, all prior depreciation is recaptured (reversed). The less depreciation you claim, the less taxes you will owe when you sell. From this simplistic angle, it seems like there is no harm from under-claiming depreciation. In reality, there may be, for more than one reason. The biggest reason is that you can postpone your depreciation recapture indefinitely if you utilize 1031 exchanges instead of selling outright. And if you hold your properties until you die, recapture will die with you.

What is the worst case scenario if I undervalue my land? First, you will have to be picked for an audit. Next, you will have to be challenged on the land value you used. Then, you will have to lose the challenge. Finally, you will have to lose or forfeit your opportunities to appeal and litigate. At that point, you will owe the IRS extra taxes, plus interest and penalties that can more than double that amount.

What allocation percentage is safe? No such thing as a "safe" percentage. Land allocations vary between locations and types of properties. An old house in San Francisco may have 90% of its value in land. A newly built fancy cabin in rural Arizona may warrant only 5% allocated to land. Keep in mind, however, that when you order a cost segregation study, your cost seg firm has to be comfortable with the land allocation. Likewise, when your tax return is prepared and signed by a CPA, your CPA has to be on board.

Conclusion. 

Want to have a rock-solid allocation? Use a full appraisal. Everything else is some shade of grey.

[Aaron Zimmerman]

Great post! There's a lot of considerations with building vs land. I love how you talked about the 15/85 and 20/80 rules of thumb because they have no basis very common in the industry.

I appreciate you bringing mindfulness to this conversation as it is absolutely crucial to have some type of backup.