How purchase value is divided up between land and buildings impacts the depreciation tax benefits you get as a real estate owner. Here’s what you need to know.
Depreciation for residential and commercial properties
A tax benefit of real estate investing is the tax shelter provided by depreciation. Depreciation is an IRS acknowledgment that assets deteriorate over time. The IRS provides specific depreciable lives for residential and commercial property of 27.5 and 39 years, respectively. Unlike other expenses, the depreciation deduction is a paper deduction. You do not have to spend money to be entitled to an annual deduction.
Allocations favorable to taxpayers
When acquiring real estate, a taxpayer is acquiring non-depreciable land and depreciable improvements (excluding raw land, land leases, etc. for this discussion). In transactions that result in a transfer of depreciable property and non-depreciable property such as land and building purchased for a lump sum, the cost must be apportioned between the land and the building (improvements).
Land can never be depreciated. Since land provides no current tax benefit through depreciation deductions, a higher allocation to building is taxpayer-favorable. This results in the common query of how a taxpayer should allocate the purchase price between land and building. The Tax Court has repeatedly ruled that use of the tax assessor’s value to compute a ratio of the value of the land to the building is an acceptable way to allocate the cost.
For example, a taxpayer purchases a property for $1,000,000. The tax assessor’s ratios are 35/65 land to building. Using the tax assessor’s allocation the taxpayer would allocate the purchase price $350,000 and $650,000 to land and building, respectively.
Other acceptable methods used as basis for allocation include a qualified appraisal, insurance coverage on the structure (building), comparable sales of land and site coverage ratio.
Assessor’s allocation vs. taxpayer proposed values
In the recent U.S. Tax Court case, Nielsen v. Commissioner, the court concluded the county assessor’s allocation between land and improvements were more reliable than the taxpayer’s proposed values. Nielsen (the “petitioners”) incorrectly included their entire purchase price as depreciable basis, with no allocation between the improvements and the land.
When the petitioners were challenged they acquiesced and agreed the land should not have been included in their calculation of the depreciable basis. However, the petitioners challenged the accuracy of the Los Angeles County Office of the Assessor’s assessment as being inaccurate and inconsistent. Petitioners relied on alternative methods of valuation, which included the land sales method and the insurance method. The Tax Court ruled the county assessor’s allocation between land and improvement values was more reliable than the taxpayer’s proposed values.
We’ve got your back
In Nielsen vs. Commissioner, the Tax Court chose the assessor’s allocation over those provided by the taxpayers. However, facts and circumstances may not support the assessor’s allocation in all cases. It is important for a taxpayer to have reliable support and documentation to defend an allocation if it should be challenged.
Limited Liability Company
In my practice as an accountant and trusted advisor I often receive inquiries from clients and their advisors because real estate is an important element of a diversified portfolio. Until recently, opportunities to invest in real estate were limited to acquiring a rental property directly, participating in a real estate investment group, flipping properties or a joining a real estate investment trust (REIT).
Making charitable contributions is a great way to reduce your taxable income. The most common type of donation is a monetary contribution. Taxpayers are allowed to make tax deductible monetary contributions to qualified organizations in amounts up to 50% of adjusted gross income.
Hint: it’s about deferring taxes
Property gifted during a taxpayer’s lifetime receives a carryover basis, that is, the gift recipient takes the same basis as that of the donor. This means the recipient of the gift takes the same tax basis in the property as it had when owned by the decedent. Consequently, the increase in value of the property that occurred during the decedent’s lifetime is subject to federal and state taxes when the property is sold.
Under the installment method, each year the portion of the gain received via installment payments is included in the seller’s income. Fundamentally, interest should be charged on an installment sale. If the interest charged is less than the