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Allocating an investment property’s purchase price between land and depreciable improvements directly affects the deductions available to the owner. Land cannot be depreciated, while buildings and qualifying site improvements may be depreciated over their applicable recovery periods. Purchase agreements often specify a single purchase price, requiring taxpayers to make a reasonable, well-documented allocation based on the property’s values at the time of acquisition.
Key Takeaways
- Land is non–depreciable, so a supportable allocation determines how much of the purchase price may generate depreciation deductions.
- County assessor ratios are a common starting point, although appraisals and other valuation approaches may better reflect fair market value.
- After establishing the land allocation, a cost segregation study may accelerate deductions for qualifying building components and site improvements
KBKG Insight
A county assessor’s ratio may be convenient, but convenience alone does not establish that the allocation reflects market conditions at acquisition. For significant purchases, taxpayers should compare available appraisal information, assessor data, and property-specific facts before deciding whether to obtain a separate land valuation that provides stronger support for the depreciable basis.
Five Methods to Allocate Land vs. Building Value
Taxpayers are required to separately identify the value of non-depreciable items (i.e., land) from the depreciable building and site improvements. If a full-scope appraisal showing the land value was not completed during the purchase process, taxpayers may consider the following options:
Method 1: County Tax Assessor’s Allocation
A taxpayer can review their county tax assessor’s property allocation, which usually provides an assessment of land and improvements based on the county’s guidelines. This allocation can be found on the most recent property tax bill or on the county assessor’s website. The values listed may not match the total acquisition cost, but the proportionate ratio between the land and improvement values can be applied to the final purchase price for income tax purposes.
Formula:
Assessed Land Value ÷ Total Assessed Value = Land Percentage
Purchase Price × Land Percentage = Land Basis
Example: A property is purchased for $500,000. The county assessor shows a land value of $50,000 and an improvement value of $150,000, for a total assessed value of $200,000. The land percentage is 25% ($50,000 ÷ $200,000). Applied to the purchase price: $500,000 × 25% = $125,000 allocated to land and $375,000 allocated to the building.
Additional insights on IRS approval of this methodology can be found here.
KBKG Insight:
While the property tax allocation method is most commonly used and generally accepted by the IRS, it’s not always the best indication of fair market value. Other methods can be considered should the taxpayer think the allocation to land is disproportionately high.
Method 2: Full-Scope Land Appraisal
Another option is to commission a full-scope land appraisal. A qualified professional appraiser will generate a comprehensive analysis considering factors such as sales comparisons, highest and best use, market conditions, and income generated following Uniform Standards of Professional Appraisal Practice guidelines. While this option is the most accurate land valuation approach and least likely to be challenged by the IRS, it is also the most costly and can require several weeks to complete the process.
Method 3: Limited-Scope Land Appraisal
A limited-scope land appraisal can be completed by a real estate professional who provides an analysis of sales comparisons or other limited metrics. Similar to a broker’s opinion of value, this analysis is less detailed and may not follow USPAP guidelines.
Method 4: Replacement Cost Method
This methodology is supported by a 1982 tax court case, Meiers v Commissioner (T.C. Memo 1982-51), where the taxpayer successfully argued against the property tax “assessed value” allocation. In this approach, the taxpayer calculated that the cost to construct a new building (say, $300 per square foot at 2,000 square feet, totaling $600,000) should be allocated to building and the remaining balance of the acquisition should be allocated to land.
KBKG Insight:
Whatever value is used must still be reasonable and in line with market conditions. The tax court in the Meiers case felt the tax assessor’s allocation did not show any evidence to “comport with reality” and the taxpayers estimate was “much closer to the mark.” This property was acquired in 1977 when real estate values were not inflated to the level we see today. If a property sells for significantly higher than the replacement cost of the building and land value, this strategy is not optimal.
Method 5: Rule of Thumb Method
Some taxpayers use a predetermined percentage (such as 80/20 percent, 70/30 percent, etc.) for improvements and land. Most tax professionals do not advise their clients to utilize this approach and it may raise concerns under IRS examination. This was highlighted when the U.S. Tax Court released Summary Opinion 2017-31 in May 2017, concluding that a county assessor’s allocation to land and improvement values was more reliable than the taxpayer’s proposed values. The Tax Court noted it could not find any authority that suggests a taxpayer is qualified to allocate the value of property between land and improvements. This guidance remains current and continues to inform IRS examination practices.
KBKG Insight:
If a client owns multiple properties similar to the one in question, in the same geographic region with established land values, some taxpayers have successfully utilized an average of the building and land allocation percentages to apply to the newly purchased property.
How Allocation Affects You When You Sell
The land vs. building allocation matters beyond the purchase, it directly affects your tax liability when you sell.
Under Section 1250 of the Internal Revenue Code, depreciation previously taken on the building portion is subject to recapture at a rate of up to 25% upon sale. This means the tax benefit you received from building depreciation during the holding period is partially recaptured as ordinary income when you dispose of the property.
Land, on the other hand, is not depreciated, so there is no recapture exposure. Gain on the land portion is taxed at long-term capital gains rates, which for most taxpayers are lower than the 25% recapture rate.
Example: You sell a property at a $200,000 gain. Of that, $80,000 is attributable to depreciation taken on the building — taxed at up to 25% ($20,000). The remaining $120,000 in land-related gain is taxed at the capital gains rate of 15% or 20% ($18,000–$24,000). A well-supported allocation can reduce total tax on disposition by thousands of dollars.
How Cost Segregation Extends Your Tax Benefits
Once the land vs. building split is established, a cost segregation study can unlock additional savings. The study identifies specific building components, electrical systems, flooring, cabinetry, site work, that qualify for accelerated 5-, 7-, or 15-year depreciation schedules. This front-loads deductions into the early years of ownership, improving cash flow when it matters most.
Example: On a $500,000 building allocation, a cost segregation study might reclassify 20–40% of costs to shorter-lived categories. That shift could accelerate $100,000–$200,000 in deductions into the first few years of ownership.
Use the KBKG Cost Segregation Savings Calculator to estimate the potential benefit for a specific property.
If you or your CPA have specific questions or would like to begin your study, contact a KBKG cost segregation specialist for a free, no-obligation consultation.
Frequently Asked Questions
No. Land does not wear out or lose value through use, so the IRS excludes it from depreciation. Only the building and site improvements are depreciable.
The most common method uses the county tax assessor’s ratio. Divide the assessed land value by the total assessed value to get the land percentage, then multiply your purchase price by that percentage. See Method 1 above for a step-by-step example.
Land is the raw ground beneath a property and cannot be depreciated. Land improvements, such as parking lots, sidewalks, and drainage systems, are separate assets eligible for 15-year MACRS depreciation.