IMPROVEMENT vs LAND VALUE FOR DEPRECIATION

When you buy a rental property, you get to depreciate the acquisition cost, less the land, over 27.5 years. Depreciation is an annual deduction meant to track the deterioration of your property and it helps shelter your ongoing cash flow.

Here’s an example:

• I buy a property for $100k. I allocate $10k to land, so $90k is allocated to Improvements (the building).
• I depreciate the $90k over 27.5 years (39 years for non-residential property).
• This yields $3,273 in annual depreciation.

I get to claim that amount against my rental income every year as an expense. I do not have to spend any additional money in order to claim the $3,273… think of it as a “thank you” from our government for investing in U.S. housing.

But how, exactly, did I determine that I should allocate $10k to land. Why not $5k? Why not $60k?

Many CPAs use a “rule of thumb” method of 20-25%. This means that regardless of where you purchase your property, they will allocate 20-25% of the purchase price to land.

While that may be okay in some cases, you should understand that if you use the rule of thumb method, and you are later challenged under audit, you’re probably going to lose on the allocation because you have no actual support to substantiate your allocation of the value to land.

The BEST way to allocate between land and improvements, and the best way to substantiate the allocation under audit or Tax Court, is to use the property assessor’s allocation.

In my example, the property assessor may have shown a $45k improvement value and a $5k land value.

This means land is 10% of the total value. I apply that 10% to MY purchase price to get MY land value allocation.

So in my example where I purchased a property for $100k, I get a land value allocation of $10k… the remainder of $90k is allocated to improvements.

For our Tax Smart Investors who are in CA, AZ, NYC, NJ, and other high-cost areas, you may find that the property assessor shows a land value allocation of 50-80%!

Think about that.

I buy a property for $1MM and I have to allocate $800k to land, which cannot be depreciated, and only $200k is allocated to improvements.

My annual depreciation, in this case, would be only $7,273.

But if instead I purchased a $1MM property in an area with a 20% land allocation and an 80% improvement allocation, I’d be depreciating $800k of improvements over 27.5 years… or $29,090 per year.

Do you see why allocating more value to improvements is better? It gets you a higher annual derpeciation deduction!

But… BE CAREFUL.

In the Tax Court case Nielsen v. Commissioner, T.C. Summary Opinion 2017-31, the taxpayer lived in Los Angeles and didn’t like the property assessor’s land value allocation so they came up with their own.

The taxpayer contended the county assessor’s data was “extraordinarily inaccurate,” but the Tax Court did not agree and held that the LA assessor valuation was the correct allocation to use.

While the Tax Court acknowledged a taxpayer is qualified to testify as to the value of their entire property, it found no authority suggesting a taxpayer is qualified to allocate the value of property between land and improvements.

So if you work with a CPA, tax preparer, or cost seg firm that tells you to use 20-25%, just know that you may be challenged one day and you may lose.

Especially if you’re in an area where land comes at a premium.

Example: 15400 E 48th St, Kansas City, MO 64136-1181, Jackson County

Land $5,634 + Improvements $62,007 = $67,641

$5,634/$67,641 = 8.33% 

Purchase Price $550,000 

550,000 x 8.33% = $45,815

$45,815 is the land value on $550,000 purchase price