How to Best Calculate the Improvement Ratio to Increase Annual Depreciation

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Ah, depreciation, the great phantom expense that shelters our rental income from the tax man every year. For those of you who do not know, depreciation is a reduction in the value of an asset with the passage of time due to wear and tear. To encourage investment, the IRS allows depreciation expense to be written off each year as a means to recover the cost of the investor’s initial investment.

It should be understood that depreciation isn’t an efficient means to recover the cost of your initial investment, mainly because you have to recover the cost over a number of many years. In fact, when my clients come to me with a “repairs vs. improvements” scenario, I try my best to classify items as repairs because we get to deduct the expense and subsequently recover the cost in the current year, rather than depreciate it over many years. A motto all CPAs should live by: “A dollar today is worth more than a dollar tomorrow.”

That being said, there are times you won’t have a choice but to depreciate certain costs, the largest of which will be the overall acquisition cost and the focus of this article from here on.

I’m not going to walk you through a HUD statement and tell you how to account for each line item (maybe a future article), but I will teach you the methodology I use to show the largest “improvement” value for a client after the purchase of a property. As you know, only the cost of improvements can be depreciated, as the IRS takes the stance that land does not deteriorate and lasts forever. Because of this, we must allocate the purchase price between land and improvements, with the goal of allocating as much of the value to improvements to increase our annual depreciation expense.

Related: Yes, You CAN Write Off Your Depreciation: Here’s How

An example to show you what costs can be depreciated:

You purchase a property for $100k. The property card says the land is valued at $25k, and that’s the value you decide to use. You determine your improvements are $75k, which is the amount you are allowed to depreciate over 27.5 years. The $25k of land is not able to be depreciated.

If the above example describes you, I suggest you bookmark this article and reference as needed. Most people don’t give their land value much thought at all. They simply list the land value on their property tax card and call it a day. But as I will discuss below, there are several methods you can use to yield a higher improvement value and subsequently much better depreciation results.

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Methods to Calculate Depreciation

You can utilize several different methods to calculate depreciation, and the IRS doesn’t indicate which they prefer you use. Ultimately, it’s up to you to decide how to allocate the purchase price between land and improvements, and as long as you can support your calculation, you will likely hold up during an audit. You always want to have the ability to support your decision making; otherwise, you may end up in a situation where the IRS doesn’t agree, causing you to pay back a portion of what has been written off over the years.

There are three methods I have used in the past to determine improvement vs. land value and subsequently depreciation for myself and my clients. While it is important to utilize all of these methods and use the one that gives you the best result, I have listed them below in order of level of effort and how well the method will support a calculation. After all, you don’t want to spend a lot of time using one method only to find out it doesn’t hold up in the event of an audit.

  1. Property Tax Card
  2. Buyer/Seller Appraisals
  3. Replacement Cost and Land Sale Comps

In each of these methods, I seek to find the best “improvement ratio.” An improvement ratio is the value of the improvements divided by the total value of the property (land + improvements). I then apply the best (largest) improvement ratio to the purchase price of the building, and that becomes the basis of the property which will be depreciated over 27.5 years (39 for commercial).

I’m going to walk you through each example using my most recent purchase and the numbers associated with it. My purchase price was $91,800.

Method One: Property Tax Card

This method requires the least amount of effort and is one of the best ways to substantiate your calculations. The property tax card for my property lists the land value at $27,500 and the improvement value at $105,000, for a total value of $132,500.

My improvement ratio = $105,000 / ($105,000 + 27,500) = 79.92%

An 80% ratio isn’t bad, but I’d want use the other methods to see if I can increase it. In my experience, I’m able to safely use roughly an 85% improvement ratio.

To calculate my depreciable basis, I apply the ratio of 79.92% to my purchase price of $91,800 and end up with a depreciable basis of $73,367 and a land value of $18,433. The depreciable basis will result in annual depreciation of $2,668.

Method Two: Buyer/Seller Appraisals

I list this as the second best method only because it takes more effort to pull off in that you likely have to pay for the appraisal to be done. This method will substantiate your calculations just as well as method one above.

The appraisal that I had completed on my property indicated that the value of the improvements are $147,816, and the value of the land is $20,000, for a total value of $167,816.

My improvement ratio = $147,816 / ($147,816 + $20,000) = 88.08%

To calculate my depreciable basis, I apply the ratio of 88.08% to my purchase price of $91,800 and end up with a depreciable basis of $80,859 and a land value of $10,941. The depreciable basis will result in annual depreciation of $2,940, which is an increase over method one of $272.

Method Three: Replacement Cost and Land Sale Comps

This method is listed last because it takes the most effort and is more questionable in terms of whether you can fully support your improvement ratio calculations.

Replacement cost is the cost to construct a brand new building substantially equal in size, shape, and style to the one you currently own. You can gather information about your replacement cost from a variety of sources, most commonly your appraisal report and insurance estimates. An appraisal report will likely be the safer option unless an insurance agent physically conducts his/her own appraisal or analyzes the appraisal report. For purposes of showing readers a variety of methods, I will assume the insurance agency sent their own agent to conduct an appraisal, and we will use their replacement cost of $255,000 in the quote they provided me.

Land Sale Comps can also be found from a variety of sources, including third party websites, county offices, and agents with access to the MLS. When I conducted my study, I found land sales comparable to my lot were about $30,000.

My improvement ratio = $255,000 / ($255,000 + $30,000) = 91.07%

To calculate my depreciable basis, I apply the ratio of 91.07% to my purchase price of $91,800 and end up with a depreciable basis of $83,602 and a land value of $8,198. The depreciable basis will result in annual depreciation of $3,040.

Related: 4 Depreciation Tax Mistakes Investors Need to Avoid

Now, I think that using an improvement ratio of 91% is too aggressive for the extra amount per year that I’d be able to write-off. In any decision making scenario, you need to fully analyze the costs vs. the benefits.

That being said, I also think the calculation from method one (80%) is too low. Like I said, I like to see around an 85% improvement ratio. In this situation, I averaged my three ratios of 79.92%, 88.08%, and 91.07% and received a final ratio of 86.36%. Applying this ratio to my purchase price of $91,800, I have a depreciable basis of $79,278, a land value of $12,522, and annual depreciation expense of $2,883. I’m comfortable with this calculation and confident that I can easily substantiate my basis in the event of an IRS audit. By averaging the results of the three methods, I actually provide more support for my calculation, and it is right where I want it to be.

Conclusion

Don’t overlook this relatively simply yet extremely important calculation. Calculating your improvement ratio to increase your annual depreciation expense is arguably one of the most important calculations you will make. And always remember to keep the documents you used to support your calculations.

Investors: How do you calculate your improvement ratio? Have any questions about the method I use?

Leave your comments below!

About Author

Brandon Hall

Brandon Hall, owner of The Real Estate CPA, is an entrepreneur at heart who happens to be good at taxes. Brandon is a real estate investor and CPA specializing in providing business advice and creative tax strategies for real estate investors. Brandon's Big 4 and personal investing experiences allow him to provide unique advice to each of his clients. Sign up for my FREE NEWSLETTER to receive tips and updates related to business and taxes.

29 Comments

  1. Daniel Ryu

    Thanks Brandon.
    As for hiring a CPA, do you think hiring a CPA virtually is worthwhile?
    Or should it always be someone local?
    I’ve yet to hire one but I was just wondering – since we can share files through dropbox, etc, does a virtual CPA make sense?
    Thanks.

    • Brandon Hall

      Hey Daniel – it really comes down to whether or not you can find a competent CPA locally and what your personal preference is. If you are comfortable using a non-local CPA and using the data share methods you described, it will be more beneficial for you because you will have a larger pool of CPAs to choose from and a better chance of ultimately finding one that fits your needs.

      I have clients all over the states, some of which my only interaction has been phone calls and emails and they have all been happy with the service (at least that’s what they tell me).

  2. John Barnette

    Does the IRS consider location of the property at all in an evaluation of the improvement ratio? I own several income properties in San Francisco. The same 1200 square foot two bedroom house in SF would be worth a million dollars whereas in Sacramento it could be worth $500,000. For easy numbers. The underlying depreciable structure is effectively equal in size, condition, use, etc. Thus the SF asset truly and honestly has a much lower ratio.
    I have been using the 75% ratio myself and CPA suggests that this will not cause undo alarm. Works for me.
    Good article and I like the logic. Would it be appropriate to “overlay” a location consideration?
    Thanks john

    • Brandon Hall

      Hey John,

      Your improvement ratio will vary from location to location. when I say I shoot for 85%, that is excluding the outliers like San Fran, DC, New York, etc.

      In DC, a typical improvement ration is around 70-80%. I don’t have clients in San Fran, so I can’t speak to what you may see.

      I would go through each of the methods I described above and see if you can improve the 75% ratio you are using. You may be surprised. Additionally, is your CPA helping you to calculate your improvement ratio? Or are they just using a flat 75%? The key question I’d pose to the CPA is: in the event of an audit, how will you defend my 75% improvement ratio. If they have no clue, find a better CPA.

      Thanks for reading! Feel free to ask any additional questions you may have.

  3. Jeff S.

    Hey Brandon, just went through this. Bought a property at auction for 144k plus 9k redemption cost. The tax appraisal is about 225k with land at over 50%. Consequently my improvement write-off is only 77k.

    The least I have heard of for land value is what we used to use years ago was 25%. Nowadays lots are worth 135-200k. When you pay less than lot value you lose a considerable write-off but the loss is well worth it.

  4. Andrea S.

    Hi Brandon
    I’m wondering about depreciation when inheriting a home. My father in-law passed away and we are taking over 2 rental properties. We are buying out my brother in law at 50% of the assessed value. Can we deprecate these properties? We wanted to use the tax assessment to save form having to do an appraisal.

    • Brandon Hall

      Hey Andrea – when you inherit a property, you receive a step-up basis which is usually the market value of the property at the time of inheritance. So if the property is worth $100k at the time of inheritance, your basis is $50k (50% due to splitting it with your sibling).

      Can you depreciate it? That depends on what you are using the property for.

      I’d suggest spending an hour or two on the phone with a real estate CPA. You may pay $200 but it will be well worth it.

  5. Sonny Smith

    Excellent article Brandon! I have only used the Property Tax Card up until this point, but will be at least running the numbers on the other methods on future properties. I have had people recommend depreciating cabinets and counter tops separately as a way of accelerating depreciation. What are your thoughts on this? Might warrant a separate blog post.

  6. Mike Moreken

    I would like to know the tax code or rulings, form/Pub etc. for those 3 methods. I have not found these 3 methods in my searches through IRS pubs and forms except in a dated 2003 RE book I recently read.

    Method One: Property Tax Card
    Method Two: Buyer/Seller Appraisals
    Method Three: Replacement Cost and Land Sale Comps

    My current CPA is not the best. I got this property in a foreclosure I initiated. So this CPA took the lawyer foreclosure costs (that I was going to write off on Sch C) and is keeping it to use as basis starting next year!

    I have been educating this CPA and he has me using my first extension.

    So according to CPA, basis:
    about $1,500 foreclosure costs
    about $6,000 new roof.

    So have $7.5K to depreciate according to him.

    Looking at my current today online property card assessments I see:
    $X property
    $Y land (Both numbers below $100,000) 🙂

    So using method one I ought to be able to use $X for my basis + the new roof.

    Thank you Brandon.

    • Brandon Hall

      Hey Mike – You should not be educating your CPA, he should be educating you. That’s why you pay him the big bucks. I can’t comment on the numbers you provided because they are too vague, but feel free to connect and we can discuss further if you’d like.

      The following information is from IRS Pub 527:

      “Separating cost of land and buildings. If you buy buildings and your cost includes the cost of the land on which they stand, you must divide the cost between the land and the buildings to figure the basis for depreciation of the buildings. The part of the cost that you allocate to each asset is the ratio of the fair market value of that asset to the fair market value of the whole property at the time you buy it.

      If you are not certain of the fair market values of the land and the buildings, you can divide the cost between them based on their assessed values for real estate tax purposes.

      Example: You buy a house and land for $200,000. The purchase contract does not specify how much of the purchase price is for the house and how much is for the land. The latest real estate tax assessment on the property was based on an assessed value of $160,000, of which $136,000 was for the house and $24,000 was for the land. You can allocate 85% ($136,000 ÷ $160,000) of the purchase price to the house and 15% ($24,000 ÷ $160,000) of the purchase price to the land.

      Your basis in the house is $170,000 (85% of $200,000) and your basis in the land is $30,000 (15% of $200,000).”

      • Mike Moreken

        The following information is from IRS Pub 527:

        “Separating cost of land and buildings. If you buy buildings and your cost includes the cost of the land on which they stand, you must divide t…

        TU found it in Line 18, Sch E too.

        http://tax1.co.monmouth.nj.us/cgi-bin/m4.cgi?district=1111&l02=111134402____00025_________M

        See the above link for my property.

        Educating my CPA. He puts wrong or misses info wrongly on form. Then have to educate him. Example Health insurance deduction on first page of 1040. He skipped it saying I needed proof it was in my business name, BULL, so sent him the verbiage from tax code.

        He puts postage as other on Sch C, and have 0 for office expenses! I found out the IRS described postage for office in 2008. Before that no instruction. So I know I normally have a couple hundred here and he has 0. Once again another error.

        Best Wishes.

  7. Mike Moreken

    Line 18 Sch E
    Separating cost of land and buildings. If you buy buildings and your cost includes the cost of the land on which they stand, you must divide the cost between the land and the buildings to figure the basis for depreciation of the buildings.

    “The part of the cost that you allocate to each asset is the ratio of the fair market value of that asset to the fair market value of the whole property at the time you buy it. ”

    If you are not certain of the fair market values of the land and the buildings, you can divide the cost between them based on their assessed values for real estate tax purposes.

    🙂 so that middle sentence should straighten me out since CPA is not doing Sch E this now past tax year.

  8. Mike Moreken

    When I saw his expense voucher. 🙂 I created a phantom one for him:

    Invoice APR-2015-124

    CPA Course 4-11-2015

    Education on Self employment health deduction $100

    Re-educated on Sch C postage $100

    Educated on PTC and APTC $250
    forms 8962 and 1095a

    Avoiding audit Exhibit A $500
    rebate NO CHARGE ($350)

    Educating form 8606 $100

    Reminder filing for *** LLC Sch C $25

    Total $725

  9. Emily S.

    Hi Brandon,
    Thanks so much for the details. Having read lots about depreciation, I had yet to find this thorough of a tutorial. One question: Owner-occupancy status is irrelevant, is that right? Buy and hold investors can take advantage of this on each and every property they own?

  10. Jesse T.

    The 3rd method seems like it would only be supportable for new construction. Say you have a house that would cost 200K to rebuild and is on a lot similar to lots selling for 35K. It would be 85% according to method 3. However if the house was 10 years old it would actually be worth closer to 145K(20/27.5) due to the depreciation from the first 10 years. The 35K may not be supportable if the lots need work to be build since the property lot is obviously buildable.
    In practice I don’t know that the IRS would dig this deep in the weeds, but if you are using dramatically different results from the first 2 methods, it could be risky.

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