Land is a non-depreciable asset. When purchasing real estate, for tax capitalization purposes, you’re required to identify the value of non-depreciable land separately from the depreciable improvements, such as buildings and site work. While, over time, the value of your building will depreciate for tax purposes, or lose value, the value of your land won’t change for tax purposes.
Tax Basis Rules
How is land valued in the first place? Its worth is determined by a methodology called cost basis, which is equivalent to the amount you paid for the property. Let’s say you bought a property for $1 million but sold it for $3 million. Since your cost basis for the property was $1 million (the price you paid for it), your capital gains are $2 million.
But you must also add to your cost basis any depreciation you took on the property. Let’s say you’ve owned the property for a couple of years; because it’s a rental, you might have to add back in $1 million dollars in depreciation. Because you’ve already realized a $3 million gain — your $2 million in capital gains plus $1 million in depreciation — the $3 million cost basis of your property has been already used up.
Your cost basis is the critical component here, because when you go to sell the property and commission a cost segregation study to break out the value of the land and the improvements, you’ll be reporting these assets being sold on your tax return. The land value divides up this basis, usually with a percentage of basis allocated to land and a percentage allocated to the building. Typically, it’s an 80%/20% or 70%/30% ratio for improvements and land, respectively.
However, there’s another kind of basis methodology for valuing real estate, called transfer basis, which entails you receiving a property by inheritance or by gift; it’s transferred to you. Imagine you inherited a rental property from your parents. Because they consistently depreciated it down, the basis decreased every year, and then before they died, they gifted it to you. If they bought it for $1 million and depreciated it down by $1 million, your basis is zero.
When Do You Plan to Sell?
If you plan to sell the property in the short term, you might want a high value on your land, so you’d have less on the improvement side of your investment to depreciate, with a smaller capital gain when you sell the property. If, on the other hand, you intend to keep this property forever, you might want a larger allocation to depreciation because you’re never going to sell it. Since you’re not going to trigger a gain, you don’t need more basis in the land.
A popular strategy is the 1031 property exchange, where you swap one investment property for another to defer capital gains. Since your capital gains are likely to increase (real estate tends to appreciate), it could be wiser to obtain a higher allocation to land, since depreciation is going to eat away at your total cost basis over time. Because land value doesn’t depreciate, you’ll have a larger total cost basis when you do your 1031 swap, which would enable you to get a bigger property (since real estate investors tend to trade up).
When the Value of the Land Isn’t Just the Land
Here’s a fact that might surprise you. If you demolish the existing building on your property, under Section 280B and General Asset Account (GAA) account rules, you add the demolition costs to the value of the land (since the demolished building can no longer be considered an improvement) so, strangely enough, if you knock down your building, the value of your land goes up.
Another anomaly: one real estate investor installed phenomenally expensive pylons to support his building. When it came time to sell the building, the pylons were considered part of the land, since they were sunk deep in the earth.
The issue of partial asset disposition can also influence land value. Using the partial asset disposition deduction, you can deduct the loss you sustained if you disposed of a portion of your building. Let’s say you replaced your roof. You can deduct the undepreciated cost of the old roof after you’ve replaced it. You write off the old non-existent roof as a deduction and simply depreciate the cost of the new existing roof.
Since whether you take the partial asset disposition or not will impact your building’s value, it will also tilt the ratio of your building value versus your land value, a fact you should consider. The more you’re going to allocate to the building portion, the larger your partial asset disposition. If you’re taking a smaller land allocation and a larger building allocation, your partial asset disposition will be bigger too, because it’s a percentage of the building.
Who Should Appraise Your Land?
Before you undertake a cost segregation study, the best place to start is with your county tax assessor. You can consult what’s called a tax card, which is the tax assessor’s record, and it assigns a dollar value to your land. In the Midwest, it may be that county tax assessors understate the value. However, in states where land is worth more, like California, the opposite might be true. Tax assessors might deliver extremely high estimated land values; in that case, taxpayers have recourse to property tax appeal companies (as do the denizens of other states).
Another approach would be for you to hire a valuation professional and have the land value appraised at the time of your purchase. This is considered the most defensible source, because it stems from a comprehensive appraisal that divides the land value and building value.
Some clients approach their CPA (not the one doing the cost seg study!) and ask for a suggested land value. Some CPAs apply what’s called “the rule of thumb” — they apply an estimated average allocation, such as an 80%/20% or 70%/30% ratio, for improvements and land, respectively. However, some CPAs are uncomfortable with the potential inaccuracy of this approach, fearful it may raise concerns under IRS examination. As a result, they prefer one of the other methods cited here.
An additional alternative method for land valuation is the comparable market analysis (or “comp sale”) approach. You look for comparable real estate sales for undeveloped land (not built out) in your area to get an idea of an accurate value.
When Should I Get a Land Appraisal?
In this case, your land valuation is intended to support your cost segregation study. As mentioned previously, you must arrive at your land value before you purchase your property and undertake your cost segregation study.
As the great American humorist Will Rogers said, “Don’t wait to buy real estate. Buy real estate and wait.”
