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Cost Segregation and Land Value Considerations

By Eric Wallace, CPA Tangible Property Tax Methods

In order to calculate depreciation for income tax purposes, taxpayers must use the correct method (ex: straight-line, accelerated) and proper recovery period (i.e. depreciable life) for each asset or property owned. Real property, whether purchased or constructed, often consists of numerous IRS asset types with different depreciable lives. Real property is typically separated into individual components or asset groups having the same depreciable lives and placed-in-service dates to properly compute depreciation. When the actual cost of each individual component is available, this procedure is simple. When only lump-sum costs are available, however, cost estimating techniques may be required to "segregate" or "allocate" costs to individual components of property (e.g., land, land improvements, buildings, equipment, furniture, and fixtures, etc.). This type of analysis is called a "cost segregation study” or “cost study.”

How Do Class Lives Effect Depreciation To Reduce The Taxpayers's Taxable Income?

For IRS depreciation purposes a building purchase cost or value is depreciated over a 27.5-year or 39-year class lives, respectively for residential or commercial properties. In order to accelerate these class lives, the practice of cost segregation was developed. Cost segregation takes those buildings costs or values of a building and performs the required cost “take offs” or estimating accumulations to arrive at lesser depreciable class lives. This process enables the taxpayer to enjoy shorter class lives thereby reducing the taxpayer’s taxable income.

Examples of portions of buildings that qualify for shorter 5-year class lives include the following:

  • Secondary and/or special electrical distribution systems or wiring
  • TV, audio, or communication equipment and its related wiring
  • Carpeting
  • Vinyl wall or floor covering
  • Kitchen hoods, water piping, grease traps, and steam lines
  • Partitions or room dividers
  • Car wash facility plumbing or electrical systems
  • Decorative finishes, canopies, signs

Examples of building purchase or construction costs that qualify for 15-year class lives include:

  • Landscaping
  • Parking lots (gravel, asphalt, concrete, curb work, islands)
  • Footings for signs, light poles
  • Convenience store buildings where gas pumps are located
  • Fencing
  • Sidewalks

Note that cost segregation is applied to buildings and depreciable land improvements values or costs and not to the land under the building or land improvements. In a cost segregation land values must first be assigned or deducted when a building is purchased. In this situation land value is determined by “highest and best use”. The balance of the purchase price is then allocated to the building and to other assets (such as personal assets within the building) based on their value as of the date of purchase. If instead a building is constructed, typically the taxpayer paid for the land separately and that amount is known.

If a building is constructed by the taxpayer then only the building construction costs are subjected to the cost segregation techniques or procedures. This statement assumes that the land under the building was ready for construction. If the land was not ready for construction in that the land required general grading, site preparation, demolition, or other costs (such as clearing and grubbing or compaction to provide site) to make the building site suitable for construction then those other costs are also considered non-depreciable land costs. Non-depreciable land costs are added to the land cost basis.

If a lump sum was paid for real estate, then the taxpayer is required to apply appropriate appraisal practices and procedures to determine the fair market value of the land. The IRS requires that the land value be considered as vacant, even though it has a building on it. While land has value, improvements contribute value. The value of the total real estate purchased, less the value of the land, results in the value of the building and its improvements. Accordingly, it is inappropriate to estimate the value of the land by subtracting the estimated value of the improvements from the lump real estate price. The opposite must be done – land allocation first and then the remainder to the building and improvements.

Based upon these foundational rules, what is taxpayer required to do to be able to come up with the land value on a purchased building when the taxpayer wishes to have a cost segregation performed? Cost segregation engineers perform their class live determinations on buildings and their components. Those engineers are not appraisers. The IRS Cost Segregation Audit Technique Guide (ATG) of June 1, 2022, states that the IRS agent should request a copy of the appraisal that supports the fair market value of the land. When a taxpayer purchases a property often the bank requires a supporting property appraisal. That appraisal, however, rarely states the value of the land and instead provides an appraisal of the total real property, building, land improvements, and land. When a cost segregation engagement is requested of a cost segregation firm it is the responsibility of the taxpayer to provide to the firm the land value. Some cost segregation firms offer as an additional service/fee to have a qualified appraiser value the land.

For simple or lesser cost properties, such as single-family homes, the taxpayer or the taxpayer’s CPA may just rely on the county assessor’s value of land and building to arrive at the land value. For example, assume a taxpayer pays $500,000 for a house and the county assessor has on their web site the value of the land assessed at $100,000 and the building at $200,000 for a total assessed value of $300,000 for real estate tax purposes. If the taxpayer or his or her CPA then uses those assessor amounts to calculate the land value as one-third of the purchase price or $166,667 in this example, then the cost segregation basis to employ in the cost segregation study would then be $333,333. I have found that in these situations an IRS agent would accept such supporting calculations.

For more extensive or expensive properties supporting land values should be obtained and such evidence retained. The IRS ATG states that “land included in the purchase price is valued first”. The supporting land value can be obtained from a formal land valuation by a qualified appraiser or from comparable land sales. A guesstimate or estimates on land values are generally worthless in the event of an IRS audit. Let’s go through some example scenarios. Assume a taxpayer pays $20,000,000 for an apartment complex in Texas that was constructed and placed in service by the prior owner five years ago. If the taxpayer or his or her CPA can find comparable land sales from that time period (such as those found on county real estate websites), using those supporting facts to arrive at the land value of the purchased apartment complex would be reasonable and supportable in the event of an IRS inquiry. Alternatively, if we encounter a situation where that apartment complex was decades old and comparable land values are not able to be easily found, a land appraisal would be required before the cost segregation building and land improvement basis can be determined.

In conclusion when a taxpayer wishes to reduce his or her taxable income by the hiring of a cost segregation firm, the issue of land value must be discussed with the firm up front as who is responsible for determining that value and how it was determined. In large real estate purchases the golden ticket is typically a supporting appraisal of the land.

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