I have always been using a 85% building and 15% land value for calculating my depreciation basis. Now my accountant is saying I have to use the tax basis and the county is assessing most properties in my county at 50% or more land value and these are B or C condition properties on small 50 x 150 lots. Using this rule does not give you much to deprecate. I was talking with a large CPA firm that charges $1000+ to do a simple return and they were saying that they have been using the 85 15 rule and never had a problem. My current accountant is saying that the irs may come after me on it because I am starting to have a lot of properties and the amount is starting to get significant. I was thinking about going back to the seller and seeing about amending the purchase agreement to say 85 15 as that was one of the items that was mentioned on the irs info on the deprecation. I am wondering what other investiors are doing in this area of deprecation.
"I have always been using a 85% building and 15% land value for calculating my depreciation basis."
Don't just use a standard improvement ratio like 85/15 or 60/40 or something like that. If the IRS audits you, you have nothing to back up your ratio.
"Now my accountant is saying I have to use the tax basis and the county is assessing most properties in my county at 50% or more land value and these are B or C condition properties on small 50 x 150 lots."
Yes, using the assessor's ratio is the most common method, but by no means is it required to use the assessor's ratio. If you have documentation of the replacement value of the building (such as from an appraisal, your insurance company, or construction records), that would strengthen your case in the event of an audit. Say you buy a building for $200,000, and the replacement value of the building is $170,000. You have good support for an 85/15 building/land ratio. Also, don't forget that you can carve out personal property from your basis, which will accelerated your depreciation deductions somewhat.
"I was thinking about going back to the seller and seeing about amending the purchase agreement to say 85 15 as that was one of the items that was mentioned on the irs info on the deprecation."
Note that simply having the seller agree to such-and-such an allocation won't necessarily save you. As the IRS states in Publication 551, "This agreement is binding on both parties unless the IRS determines the amounts are not appropriate." It is very possible in the case of an audit tha the IRS will determine that whatever was stated in the agreement is not appropriate.
Now, I am a CPA, not an attorney, so I am not qualified to speak to the applicability of a particular court case to your specific situation, but please see below the reasoning of a Tax Court judge in Nicholson v. Commissioner of Internal Revenue, TC Memo 1993-183. Again, I am not saying whether or not this case applies to your situation. I have simply posted this for informational purposes only.
b. The Allocation
With respect to both properties, petitioners allocated 20 percent to the land and 80 percent to the building. In support of this allocation, petitioner argues (1) that the amended escrow instructions with respect to his purchase of the Fresno property so provide, and (2) that such allocation has been held to be reasonable, citing Meiers v. Commissioner [Dec. 38,766(M)], T.C. Memo. 1982-51. We reject both arguments.
The amended escrow instructions (in connection with petitioner's purchase of the Fresno property) provide in pertinent part as follows:
THE FOLLOWING IS INSERTED IN THE ABOVE CAPTIONED ESCROW AT THE REQUEST OF THE BUYER, WITH WHICH UNITED CALIFORNIA BANK HAS NO RESPONSIBILITY, OR DUTY IN CONNECTION THEREWITH, AND IS FOR INFORMATION PURPOSES ONLY: 80% of the Real Estate value is attributed to the Building and 20% to land.
This statement sets forth no basis for the allocation and we perceive none, except perhaps petitioner's foresight in seeking to substantiate depreciation deductions in connection with the Fresno property. We give no weight to that statement.
Further, Meiers does not support petitioners' position. Meiers does not stand for the unlikely proposition that an 80-percent allocation to buildings always or generally is reasonable, as petitioners suggest. Meiers merely held that the taxpayer's investigation regarding estimated replacement costs was sufficiently probative as to make reasonable the allocation, in that case, of 80 percent to the buildings. Moreover, Meiers explicitly stated that "The question [of what allocation is appropriate] is purely a factual one". Meiers v. Commissioner, supra, therefore is inapposite.
Petitioners make no other arguments, and have produced no evidence, in support of their proposed allocation. We are therefore unable to find their proposed allocation to be appropriate. Respondent, however, also has failed to offer any meaningful alternative, arguing that, inasmuch as petitioners' allocation is incorrect, no depreciation is allowable on the San Leandro and Fresno properties. Because we think it clear that some allocation to the buildings is appropriate, zero, a fortiori, is the wrong answer. Accordingly, we will estimate the proper allocation, bearing heavily upon petitioners who have the burden of proof on this issue. Cohan v. Commissioner [2 USTC ¶ 489], 39 F.2d 540 (2d Cir. 1930); Rule 142(a). Based upon the facts before us, we find that, with respect to both properties, 10 percent is allocable to the buildings and 90 percent is allocable to the land.
Great reply thanks for the info. I do have a appraisals on a few of my properties. I don't know if they said a land and building value My insurance is saying replacement cost would be above purchase price on most of my properties. What formulas are people using to calculate the land and building value?
If the vacant lot next door costs almost as much as your lot, even though yours has a big building on it, why shouldn't the IRS expect you to reverse the usual percentages? [Not tax advice]...
Nathan, I have the same questions as you...the appraisal does not split out land and replacement cost are all above the purchase price. Logan, what's the solution then?
I use lot sale values and then will use replacement cost from insurance policies as additional evidence of lot sale values being conservative if it is ever questioned. Not sure if that's proper.
@Mike Dymski , shouldn't "replacement cost" only factor after replacement occurs? I would think that the reason why vacant lots can cost as much lots with buildings on them is because those buildings have already been depreciated - on on books, and in real life!? [Not tax advice]...
@Brent Coombs , the insurance policy covers the replacement cost of the building in the event of a full loss regardless of the land value. Not sure if that is what you are asking.
Originally posted by @Mike Dymski :
@Brent Coombs, the insurance policy covers the replacement cost of the building in the event of a full loss regardless of the land value. Not sure if that is what you are asking.
I don't think the OP asked about insurance value, but rather: IRS/depreciation implications!
Agreed. Logan A, CPA, suggested using replacement value from the insurance policy.
I use lot sale values for IRS/depreciation implications (and have not had a property where the lot value exceeded the total value to cause issues). Not sure if my method is proper.
My question would be how well would a insurance valuation stand up against the tax valuation? Some of the appraisals I have give a replacement cost as well as a useful life. How well would a land sale of a lot near by stand up to a tax valuation?
There is no hard-and-fast rule here. All the government says is that your allocation between land and building has to be reasonable, but of course they don't give much specifics as to what "reasonable" is. Using the assessor's split is a reasonable method. Looking at replacement cost is a reasonable method. Looking at how much an undeveloped parcel of land similar to yours and in the same geographic reason recently sold for and comparing it to your purchase price is a reasonable method. You just want to make sure that there is logic to your methodology that could withstand in an audit.
Mike great link back to the three methods.
The insurance replacement cost may not be what your looking for. I asking my agent why the replacement cost in my policies are higher than my purchase costs in most cases, knowing it's not just buying right <Grin>. The insurance replacement assumes a fire or some other reason requiring replacement. So the replacement cost includes the demolition and associated environmental clean up and the rebuild.
Great reply Logan. I see a lot of people using 80 20 and not getting audited but that doesn't mean it is correct. It is common though very common. I would not go by the property website either because it is generally too much land allocated.
Just try and be reasonable