Originally published on Forbes.com.
One of the little puzzles that you have when dealing with rental real estate is the problem of allocation between depreciable and non-depreciable property – land and building. In the more advanced classes, we can get into the allocation among the depreciable items such as building and land improvements. There is a mini-industry that does cost segregation studies to help you with that, but by my reckoning, you need a project in the $2 million and up neighborhood to make paying for a cost segregation study a worthwhile expenditure. A recent Tax Court summary decision (TCS 2017-31) sheds a little light on the basic land building issue.
What Land?
The taxpayers, who probably don’t need me to make them more famous, were disputing the IRS determination of the breakdown of land and building. The couple had paid $360,000 for one property in 2003 and $750,000 for another. In 2011, they purchased a third property for $520,000. On their 2012 return the claimed $69,238 in depreciation on the three properties. That is more than the total of the three acquisition prices divided by 27.5, but the Tax Court did not go that deep into the math commenting:
Petitioners claimed depreciation deductions with respect to the rental properties as though the depreciable basis of each property included both the value of the improvements and the land.
Maybe there were some post-acquisition improvements.
What Does The Assessor Know?
The IRS looked at it differently and brought in some additional data. In 2012 the Los Angeles County Office of the Assessor valued the first property at $435,324 ($189,032 improvement $236,292 land), the second at $795,000 ($305,800 improvements $489,200 land) and the third at $532,807 ($163,940 improvements $368,867 land). That gave improvement percentages on each of the three properties of 44.4%, 38% and 31% respectively cutting the depreciation deduction for he year by more than 50% for a deficiency of $5,297.
It could have been worse. If the IRS had pushed the adjustment through as an accounting method change, the excess depreciation deductions from prior years would have been an income pickup in 2012.
Being Too Aggressive
I suspected the couple might have fallen victim to Reilly’s Eleventh Law of Tax Planning – “Pigs get fed. Hogs get slaughtered.” That was one of our sayings as we worked most tax season nights till 10:30 at Joseph B Cohan and Associates during the Reagan and first Bush administrations. At least we had indoor parking and did not have to scrape ice from our car windows before heading home. Many of the other sayings would not pass muster under the contributor guidelines. There was not much in the way of agriculture in our practice, so we had no idea what the phrase literally meant, but we interpreted it to mean that you should be aggressive, but not too aggressive.
The 10% Club
Our rule of thumb on a rental building was 10% for land which is pretty aggressive (Note: The Tax Court would have called that 90% to improvements, which sounds even more aggressive), but not nearly as aggressive as the 0% adopted by the couple. Of course, there is nothing very scientific about the 10%, and its derivation is lost in the mists of time. My thinking at an emotional level is that if you are giving up 10%, you are giving up something.
I was surprised when I looked into this that the method we tended to use back in the day is still floating around out there. This is from the Bradford Tax Institute:
I own rental property and I just left my first IRS audit. The IRS auditor arrived at the audit with the county tax assessor’s land and building values assigned to my property tax bill. That was a surprise to my new CPA. He said he had not previously seen the IRS arrive at an audit with the tax assessor’s information in hand. Worse, the property tax bill shows land as 37 percent of the value, meaning that I have only 63 percent that I can depreciate. My original accountant allocated 10 percent to land, so I am facing a sizable adjustment. I spoke with my old accountant who said he always used 10 percent and never had any trouble, but he offered no help for my current mess
I talked to somebody I know who is pretty old school and asked him what he thought. He said he favored 10% until it got up to a million and then he would go with 20%. He admitted that he is playing the audit lottery, something which is forbidden by AICPA standards of tax practice, but who am I to judge?
Looks Like The Real Estate Bill Might Be An Effective Safe Harbor
Tax Court Summary decisions cannot be cited as precedent, but that doesn’t mean you can’t bring them up in an audit. What this decision tells me is that you can feel pretty confident about using an assessor’s breakdown, but if you don’t like the assessor’s breakdown, you better have some sort of narrative to support a different breakdown.
The practical problem that practitioners face when doing returns for people who own a couple of rental properties is that it is difficult to justify spending anything on an appraisal for rental properties in the sub million dollar category. Moving $100,000 from land to residential real estate will give you a bit over $3,600 in additional depreciation, which might save you a thousand bucks, unless, as often happens, your losses are suspended by the passive activity loss rules. Somebody selling cost segregation studies will make a presentation showing the future value of deprecation deductions, but it can be an uphill battle with skinflint real estate operators.
Guidance
I thought it would make sense for me to look at what guidance/authority there is on the subject. Sadly you will not find any authority for the 10% rule beloved by some practitioners. The governing regulation 1.167(a)-5 is not any help.
In the case of the acquisition on or after March 1, 1913, of a combination of depreciable and nondepreciable property for a lump sum, as for example, buildings and land, the basis for depreciation cannot exceed an amount which bears the same proportion to the lump sum as the value of the depreciable property at the time of acquisition bears to the value of the entire property at that time.
The regulation tells you, you have to do something, but doesn’t really help you in how to do it.
IRS Publication 946 – How To Depreciate Property has some really amusing guidance.
You bought a building and land for $120,000 and placed it in service on March 8. The sales contract showed that the building cost $100,000 and the land cost $20,000. It is nonresidential real property. The building’s unadjusted basis is its original cost, $100,000.
I have been in the game for closer to forty years than thirty and I have never seen a contract that broke down the price between land and building.
If you are playing in the bigger leagues you should check out Cost Segregation Audit Techniques Guide. Chapter 5 – Review and Examination of a Cost Segregation Study stake out a disturbing position.
The fair market value of land should be based on the highest and best use of the land as though vacant, even if the land has improvements. The land value may equal the value of the total real estate even if the real estate has substantial improvements, when such improvements do not contribute value to the property. Whereas land has value, improvements contribute value. The value of the total real estate, less the value of the land, results in the value of the improvements. Accordingly, it is inappropriate to estimate the value of the land by subtracting the estimated value of the improvements from the lump real estate price. Basis assigned to land in this residual fashion may result in understating the appropriate basis in the land and overstating the appropriate basis in the depreciable improvements. Examiners should also be wary if a cost segregation study relies solely on local assessed values rather than appropriately determining fair market values. (Emphasis added)
Thus if you bought a property in a place like Manhattan Beach in California or the actual Manhattan, the IRS might assert that the depreciable portion is negligible if the highest and best use is a tear down. The real estate bill allocation starts looking pretty good in a situation like that.
Other Coverage
Thomson Reuters has a piece on the decision with some valuable suggestions of other methods to approach the land problem.
Although the Tax Court didn’t discuss the alternate valuation methods suggested by the taxpayers beyond mentioning them, presumably the land sales method referred to arriving at a valuation of the depreciable portion of property by reviewing comparable sales of raw land (without any depreciable improvements), and the insurance method referred to arriving at a valuation of the depreciable portion of property based upon the replacement value of the improvements as determined by a various insurance companies.
Lew Taishoff, who covers the Tax Court more thoroughly than anyone, had From Coast To Coast as he noted that the Tax Court had been less willing to accept appraiser values in New Jersey in 2012. The difference may have been that in the New Jersey case it was absolute value of the property that was relevant rather than the land building breakdown.
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