Land Value and the Cost Segregation Study

When a taxpayer acquires property, the purchase price must be apportioned between land and depreciable assets (Sec. 1.167(a)-5). As land is a non-depreciable asset, correctly allocating it from the time of acquisition is vital to the successful implementation of appropriate tax planning strategies for large assets.

• If the value allocated to land is incorrectly too high (i.e., ≥ 30%), your depreciable basis will be too low, resulting in reduced Cost Segregation Study results and lower yield.
• If the value allocated to land is incorrectly low (i.e., ≤ 10%), it may invite IRS scrutiny if not supported.

You can maximize depreciable basis and minimize risk by valuing land thoughtfully and defensibly.

Ways to Determine Land Value

In the Cost Segregation Audit Technique Guideline (ATG), the IRS instructs its auditors to "determine whether cost basis was properly allocated to land." While the meaning of “properly allocated” isn’t defined in the ATG, professionals generally employ one of two methods to determine land value.

Pro Rata Allocation Based on County Assessor’s Records

This determination is attractive to many taxpayers since it is based on easily accessible, free public records. County tax assessors use mass appraisal techniques applied across neighborhoods and verticals, and they generally separate land and building values.

However, there are a variety of factors that may impact the reliability of these assessments:

• Data can be more of a historical artifact than a reflection of current FMV. Sometimes properties will go years between assessments, and the land allocation values don’t reflect the actual purchase price.
• These assessments often don’t factor the “best and highest use of land” into their valuations, and don’t usually consider location premiums.
• Additionally, there can be regional inconsistencies in land valuation, resulting in inflated values in a given geographic region.

Land allocations based on County Assessor records are sometimes on the higher end, with 25-40% of land allocated.

This method is permissible and could be appropriate for smaller, less material properties (>$1M). However, an alternative methodology may provide a more accurate land allocation value.

Formal Appraisal Based on Current Fair Market Value (E/A)

Land allocation via formal appraisal is the IRS’s preferred method for multiple reasons:

• The aforementioned ATG mandates that land value should be based on its “highest and best use,” the reasonably probable and legal use of a property that is physically possible, financially feasible, and results in the highest value. Most county assessors do not take this into account, whereas a licensed appraiser will factor it into their calculations.
• A licensed appraiser will also incorporate site-specific issues – zoning matters, development potential, location premiums – resulting in a more accurate land allocation value.
• Furthermore, the appraisal will generally be performed at the time the property is purchased (or shortly after). As such, it will be based on the FMV and more accurately reflect the current purchase price.

A formal appraisal typically yields a more accurate land value than the county assessor's method. Formal appraisals sometimes allocate a lower percentage to land, resulting in a higher depreciable basis and a more effective Cost Segregation Study.

A formal appraisal is always preferred, but special consideration should be given in the following circumstances:

• Property valued at more than $2M
• Property located in a county where assessments are performed infrequently
• Property located in a county where assessments consistently run high

Moving Forward

The first step to success in a Cost Segregation Study is obtaining an accurate land allocation value.

A formal appraisal generally produces a more accurate land allocation value that may be lower than the assessor's value. For larger properties, this discrepancy could translate to a boost in depreciable basis and a significant increase in yield from a Cost Segregation Study.

Whether you recently closed on a property or are considering a purchase, a professional real estate valuation can help position you for significant tax savings.