The goal of cost segregation is to reclassify a property’s components to accelerate depreciation of its shorter-lived assets.
Because a significant portion of your property’s valuation is land, how much you assign to land value greatly determines your depreciable basis. The allocated land value should be reasonable for the IRS to accept your other cost allocations.
In this post, we’ll explore how to determine land value for a cost segregation study and discuss how it can impact the cost segregation benefits.
Looking to determine your land’s value?
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Is Land Depreciable?
No, land is not a depreciable asset.
When you depreciate an asset for tax purposes, you recover its cost over its useful life. However, land has an indefinite useful life. It won’t wear out or become obsolete. Therefore, the IRS doesn’t allow including the land value in your depreciable basis.
That said, it’s essential to differentiate between land and land/site improvements. Land improvements, such as parking lots, sidewalks, and landscaping, are indeed depreciable.
The IRS expects these improvements to last 15 years. Therefore, you can subject them to accelerated depreciation after doing a cost segregation study.
How Land Value Impacts Your Cost Segregation Benefits
You do cost segregation to front-load depreciation on a significant portion of your property.
Therefore, it’s crucial to have an accurate assessment of your land value because there’s an inverse relationship between your potential depreciation benefits and the allocated land value.
For example, consider a property with the following details:
- Purchase: 1,000,000
- Improvements made: $50,000
- Land value: $150,000
To get the depreciable basis: Purchase + Improvements – Land.
The depreciable basis of the property is $900,000. ($1000,000 + $50,000 – $150,000). The higher the land value, the lower the depreciable basis.
Accordingly, to maximize your cost segregation benefits, you want to have a defensible but lower land value to have a higher depreciable portion.
IRS Requirements for Land Value Determination
Because the land value allocation determines a property’s depreciable basis, an unreasonable allocation is a major red flag. As such, you should avoid unsupported estimates or rule-of-thumb calculations as they significantly increase audit risk.
Here are the key requirements you must pay attention to:
- A supported allocation: The value determination should be based on real-world, accurate data and not unsupported estimates.
- Methodology: You must provide a detailed description of the methods used to arrive at the final allocation.
- Documentation: You must provide supporting documentation, such as tax assessments or appraisals, in the cost segregation report.
Methods to Determine Land Value
The IRS does not mandate a specific methodology for determining land value, but it expects your allocations to be reasonable and defensible.
That said, the IRS Cost Segregation Audit Technique Guide (ATG) acknowledges the following methodologies:
- Determination of the Fair Market Value (FMV) via an appraisal
- Doing a pro rata allocation based on a tax assessor’s records
Fair Market Value (FMV) via Appraisal
The FMV approach is a widely recognized asset valuation methodology that leverages the expertise of a professional appraiser.
The ATG explicitly states the following:
- Any opinion of value developed during a cost analysis should be reported in accordance with the relevant professional appraisal practice standards, such as the Uniform Standards of Professional Appraisal Practice (USPAP).
- The fair market value of land should be determined based on its highest and best use, as if it were vacant, regardless of the site improvements made to the land.
It’s noteworthy that the ATG considers it inappropriate to estimate land value by subtracting the cost of improvements from the total property price.
Pro Rata Allocation Based on Tax Assessor’s Records
In Nielsen v. Commissioner, the U.S. Tax Court upheld the use of the assessor’s records as a reliable method of valuation in some instances, especially when estimates provided by the taxpayer lack professional support.
This methodology first requires you to determine the land ratio (based on the local tax assessor’s records) and then apply that percentage to the property’s total purchase price.
- Land Ratio = Assessed Land Value ÷ Total Assessed Value
- Allocated Land Value = Land Ratio x Purchase Price
THE BOTTOM LINE:
Evidently, the superior method is to establish land value based on its fair market value by leveraging a professional appraisal. We prefer this approach.
You will:
- Treat the land as if it were vacant.
- Have a professional determine its fair market value by analyzing recent sales of comparable, vacant parcels of land in the same area.
While it’s the superior method, we understand that commissioning a new appraisal focused solely on the land’s fair market value can be expensive.
Where the cost of the appraisal outweighs the potential tax benefits, it makes sense to use pro rata allocation based on the tax assessor’s records.
Note: As mentioned above, this is not financial or tax advice. We highly recommend consulting your CPA or tax advisor before finalizing the best way to value your land.
Common Challenges and How to Overcome Them
Let’s explore the common challenges property investors face when determining land value for tax purposes:
- Inaccurate tax assessments: Relying on an assessor’s data may prove inadequate because the data may be incorrect or outdated. If you don’t trust the data, it’s best to use it only as a starting point and employ other methodologies as well.
- IRS scrutiny: If you submit an unsupported valuation, you risk further IRS scrutiny. It’s best to use an evidence-based, defensible land valuation method.
- Lack of comparable land: Some investors hold very unique properties, making it difficult to find sales of comparable parcels of land. To solve this problem, appraisers often use supplementary data, such as tax assessments and interviews with local builders, brokers, and other relevant professionals.
Working with Cost Segregation Professionals
Just as the IRS requires defensible land value allocations, you must also produce detailed, supported allocations for other property components for the purpose of accelerated depreciation.
Allocating costs accurately requires professional expertise. Working only with the best cost segregation companies allows you to:
- Maximize depreciation benefits: You want to aggressively, yet accurately (and defensibly) maximize the depreciable basis. A robust cost segregation tax strategy helps you allocate a significant portion of your property’s depreciable basis in shorter-lived asset classes, frontloading your deductions.
- Reduce audit risk: The IRS has strict guidelines that every cost-segregation study must follow. Relying on experienced professionals helps you avoid common pitfalls that could trigger an audit.
That said, cost segregation companies aren’t created equal. The IRS’s Cost Segregation Audit Technique Guide explicitly states that a cost segregation study done by someone with a construction or engineering background is more reliable.
As such, at Seneca Cost Segregation, we exclusively conduct detailed, engineering-based cost segregation studies.
Here’s what you get when you work with us:
- Ability to customize the studies to your specific needs.
- A detailed report supporting our findings.
- Post-study support to ensure you and your CPA can effectively implement our findings.
- Seneca AuditDefense Guarantee to help you defend the study in the unlikely event of an audit.
Ready to leverage our experience and specialized expertise to lower your tax bill with a cost segregation study? Request a free proposal.
Frequently Asked Questions (FAQs)
Let’s answer some of the common questions we get about how to determine land value for a cost segregation study:
What is the Difference Between Land Value and Land Improvements?
Land is not a depreciable asset. In contrast, land improvements (such as landscaping, sidewalks, and driveways) receive different tax treatment because they are considered depreciable assets.
Is Land Value Included in Purchase Price Allocation?
Yes, land value is included in the purchase price allocation.
When you buy a property, the price you pay is allocated to all the property components you’ve acquired.
Can Land Value Be Adjusted After a Cost Segregation Study?
If the recorded land value was incorrect, you can indeed adjust it. You can do so by filing for a change in accounting method using IRS Form 3115.
How Do Environmental Factors Influence Land Value?
Environmental factors will influence the desirability of the land and, hence, how much the market is willing to pay.
Positive factors, such as access to water and green space, lead to higher land values. Negative factors, such as air pollution and climate change risk, reduce land value.
Conclusion
Land is non-depreciable, yet an unsupported land value allocation puts your depreciable basis into question. It’s best to rely on professionals when allocating property costs to avoid an IRS audit.
Choosing the right professional partners includes working with the best cost segregation company. At Seneca Cost Segregation, we help you frontload a significant portion of your property’s depreciation with highly defensible, engineering-based cost allocations.
Moreover, each study is backed by Seneca AuditDefense, giving you the peace of mind that we’ll be there to help you defend the allocations in the unlikely event of an audit.
Contact us today to lower your tax bill with an IRS-compliant cost segregation study.
