If you’re a CPA, how can a land valuation benefit your client’s cost segregation study before a real estate purchase?
Land is a non-depreciable asset. When your client purchases real estate, for tax capitalization purposes, they’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 their building will depreciate for tax purposes, or lose value, the value of their land won’t change for tax purposes.
That’s why when clients come to my company for a cost segregation study before a real estate purchase, the first thing I ask them is: “Has any land value has been assigned yet?” Because if it hasn’t, the best way for them to maximize their depreciation is by managing their land value and seeking an appropriate valuation for the building and the land.
At that point, I have to inform my clients that the IRS forbids cost segregation companies like mine from providing a land value; the client must provide it. As a result, we guide our clients to where they can obtain a land appraisal.
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 your client paid for the property. Let’s say your client bought a property for $1 million but sold it for $3 million. Since your client’s cost basis for the property was $1 million (the price they paid for it), their capital gains are $2 million.
But they must also add to their cost basis any depreciation they took on the property. Let’s say they’ve owned the property for a couple of years; because it’s a rental, they might have to add back in a $1 million dollars in depreciation. Since they’ve already realized a $3 million gain—their $2 million in capital gains plus $1 million in depreciation—the $3 million cost basis of their property has been already used up.
Their cost basis is the critical component here, because when they go to sell the property and commission a cost segregation study to break out the value of the land and the improvements, they’ll be reporting these assets being sold on their 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 a 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 they’re receiving a property by inheritance or by gift; it’s transferred to them. Imagine they inherited a rental property from their parents. Because their parents consistently depreciated it down, the basis decreased every year, and then before they died, they gifted it to your client. If your client’s parents bought it for a million and depreciated it down by a million dollars, their basis is zero.
When Does Your Client Plan to Sell?
If your client plans to sell the property in the short term, they might want a high value on their land, so they’d have less on the improvement side of their investment to depreciate, with a smaller capital gain when they sell the property. If, on the other hand, they intend to keep this property forever, they might want a larger allocation to depreciation because they’re never going to sell it. Since they’re not going to trigger a gain, they don’t need more basis in the land.
A popular strategy is the 1031 property exchange, where your client would swap one investment property for another to defer capital gains. Since their 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 their total cost basis over time. Because land value doesn’t depreciate, they’ll have a larger total cost basis when they undertake their 1031 swap, which would enable them 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 is a fact that might surprise you and your clients. If your client demolishes the existing building on their property, under Section 280B and General Asset Account (GAA) account rules, they add the demolition costs to the land’s value (since the demolished building can no longer be considered an improvement), so strangely enough, if they knock down their building, the value of their 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, your client can deduct the loss they sustained if they disposed of a portion of their building. Let’s say they replaced their roof. They can deduct the undepreciated cost of the old roof after they’ve replaced it. They write off the old non-existent roof as a deduction and simply depreciate the cost of the new existing roof.
Whether your client takes the partial asset disposition or not will impact the value of your client’s building. As a result, it will also tilt the ratio of their building value versus their land value, a fact they should consider. The more they’re going to allocate to the building portion, the larger their partial asset disposition. If they’re taking a smaller land allocation and a larger building allocation, their partial asset disposition will be bigger too, because it’s a percentage of the building.
Who Should Appraise Your Client’s Land?
Before your client undertakes a cost segregation study, the best place to start is with your client’s county tax assessor. They can consult what’s called a tax card, which is the tax assessor’s record, and it assigns a dollar value to your client’s 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 your client to hire a valuation professional and have the land value appraised at the time of their 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 a 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. Your client looks for comparable real estate sales for undeveloped land (not built out) in their area to get an idea of an accurate value.
When Should Your Client Get a Land Appraisal?
In this case, your client’s land valuation is intended to support their cost segregation study. As I mentioned before, your client must arrive at their land value before they purchase their property and undertake their cost segregation study.
As the great American humorist Will Rogers said, “Don’t wait to buy real estate. Buy real estate and wait.”