Landlord Loses on Improvement vs. Land Value Allocation

A Tax Court case, Nielsen v. Commissioner (TC Summary Opinion 2017-31) gives landlords insight into how the IRS will audit land vs. improvement values.

The taxpayer owned property in Las Angeles and claimed depreciation deductions on the full purchase price of the property which included the land and buildings. The IRS found this error during audit and because the IRS and taxpayer could not agree on the adjustment, the case ended up in Tax Court.

Ultimately, the taxpayer lost the battle. Let’s explore the case and what went wrong.

Allocating Value to Land

When a landlord purchases a rental property, the landlord is really purchasing the land and the improvements (i.e. the building). The purchase price must be allocated between the land and improvements, and because land cannot be depreciated, the resulting annual depreciation exepense should be based solely on the value allocated to improvements.

How do you determine land values? Unfortunately, the Tax Code does not provide much in the way of clarity.

The depreciation allowance in the case of tangible property applies only to that part of the property which is subject to wear and tear, to decay or decline from natural causes, to exhaustion, and to obsolescence.

Treas. Reg. Sec. 1.167(a)-5

This regulation indicates that you cannot depreciation land.

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.

Treas. Reg. Sec. 1.167(a)-5

This regulation tells landlords that they must make an allocation to land, but it does not tell them how to do it. Ultimately, you can use any reasonable method to allocate value between land and improvements.

The three most common ways to allocate value between land and improvements is the sales contract, the appraised value, and the assessed value.

An IRS Publication sheds further light:

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.

IRS Publication 946 – How To Depreciation Property

Rarely will real estate contracts break down the land and improvement values of the property being transacted. So this may not be very helpful unless you are involved with larger transactions.

What about the appraised value? If you hire a qualified appraiser, or a cost segregation engineer, to provide a report based on comparable sales, the IRS will accept this as better evidence than the assessed value (PLR 911001).

But you can also use the ratio between the land and improvements as determined by the property assessor. Though the IRS prefers that you use this method only when there is not better evidence of valuation, such as through a sales contract or an appraisal, this is a reasonable basis to determine valuation.

Using Assessed Value

Most states and counties provide public, online access, to the property assessor database. Through this database, landlords are able to find their own property and determine a ratio between land and improvements. They can then apply that ratio to the purchase price to determine land and improvement values.

For example, assume a landlord buys a rental for $200,000. The landlord discovers that the property assessor values the land at $30,000 and the improvements at $70,000. The landlord then has reasonable basis to allocate 30% of the purchase price to land and 70% to improvements.

Using 10% or 15%

Many tax practitioners will apply an arbitrary ratio of 10% or 15% to land, meaning if the landlord buys a $100,000 property, $10,000 or $15,000 will be allocated to land. Practitioners use this method because it’s quick and it’s “what they’ve always done” and they’ve never had audit problems.

There are several issues with this approach.

First, there is no reasonable basis for using this random ratio to allocate value between land and improvements. It is not scientific nor is it supported by fact.

Second, you need evidence to support any ratio you come up with to support a value allocation. The burden of proof is on the taxpayer.

Third, because there is no reasonable basis for using an arbitrary ratio, and because you have no evidence to support it, if the IRS challenged you, they’d win.

Back to the Case

In Nielsen, the taxpayer allocated 100% of the value to improvements, which is obviously not correct.

On exam, the IRS found that the 2012 LA County Office of the Assessor valued improvements at 44.4%, 38%, and 31% for each of the properties at issue.

The Tax Court determined that the allocation from the Assessor was more reliable than any of the evidence presented by the taxpayer and ultimately sided with the IRS. The Court found no authority suggesting that a taxpayer is qualified to allocate the value of property between land and improvements without supporting evidence.

Takeaways

The taxpayer in this case lost and faced an adjustment to their annual depreciation expense. They failed to present evidence that their value allocation of 100% to improvements was reasonable.

More importantly, this case confirmed that it’s reasonable for taxpayers to use the Assessor ratio of land vs. improvements to determine how to allocate value. Landlords should use the Assessor’s ratio absent better evidence.

If you or your tax practitioner are using a random ratio to apply to land that is not supported by fact, know that you could land yourself in hot water. If you are audited, you’ll have no evidence to support your position and you’ll be facing an adjustment, plus potential penalties and interest.