Debits & Credits
by Douglas Schultz & Marlene Smith
Q. My partner and I recently purchased an 18-unit apartment building in San Francisco. We paid over $10 million for the building and want to be sure we properly allocate our cost basis in the property between land and building. We know that we cannot depreciate the land. Accordingly, for tax purposes we would like to allocate as little as possible of our cost to land. What guidelines are there for determining how much of the cost of a property is allocable to land?
A. This is an astute question because in recent years the IRS has focused more attention on rental property owners who fail to adequately allocate the basis of their property between land and building for depreciation purposes.
The stakes can be high in determining how much to allocate between land and building because, as noted above, land is not depreciable, whereas the building is. Therefore, many building owners have an incentive to allocate a very high percentage of the property cost to the building and its components and a relatively small percentage to land. However, that allocation may not hold water under an IRS examination.
We have seen cases where property owners have assigned an arbitrarily low percentage to the allocation of land; often an allocation that may be considered unreasonable based on local market conditions. In these cases, the property owners face the risk that the IRS could reallocate the basis between land and building and reduce prior year depreciation deductions, thereby increasing taxes, along with interest and the potential for penalties.
The IRS gives the most credence to basis allocations determined by outside sources, including appraisals by qualified firms, local property tax assessments and the values set in the sales contract.
A starting point in allocating cost basis between land and building is to review the appraisal of the building performed in connection with obtaining financing for the purchase, or other appraisals that may have been performed in marketing the property. However, appraisals do not always break out the value of the land versus the building for this purpose. It may be necessary to request that the appraiser provide a percentage allocation of the land and building based on their experience and expertise.
A next step is to examine the land and building values determined by the local tax assessor for property taxes as evidence of the allocable basis for your land and building to calculate the annual depreciation expense. Again, caution is required because the IRS generally does not accept the determined tax--assessed values solely as evidence for basis allocation purposes when there are better resources available for determining the basis allocation. Indeed, it may be counterproductive to base your allocation on your property tax assessment.
In the Bay Area, property values have swelled, but much of the value is apparently in the land (in the assessors’ eyes). A review of a sample of property tax assessments in San Francisco reveals that land as a percentage of total property value ranges from 33% to 65% on apartment buildings. Properties that have changed ownership recently tend to have higher allocations to land than properties that have been under the same ownership for long periods of time. For example, in the case of a 24-unit apartment building that was purchased in the last three years in San Francisco, the land assessment was 56% of the total property value and the apartment building was 44%.
Based on the disparities that appear to exist among property tax assessments, it would be prudent to obtain other outside sources to support your allocation, including appraisals and comparable sales data provided by a real-estate agent around the time the real estate was purchased.
Inherited Property
If you inherit real estate, it is important that the trustee or executor of the estate of the decedent obtains an appraisal of the property from a qualified appraiser. The appraisal will be needed in the event an estate-tax return is required to support the valuation reflected on the return. The appraisal will also be used to establish your cost basis in the property. Generally, your basis in the inherited property is its fair market value as of the date of the decedent’s death. Again, it will be necessary to allocate the value of the property between land and building. The appraiser should be instructed to provide the land-to-building allocation as part of the appraisal.
Tenancy-in-Common Allocations
Tenancy-in-common (TIC) property ownership arrangements (where two or more people co-own a parcel of real estate) also require a careful analysis of the allocation of basis between land and the units in the building. An appraisal of the building should be performed at the time of purchase and should provide an allocation of the relative worth of each unit in the building. For example, a third-floor unit may be allocated a higher cost basis than the first or second floor units, even where the square footage is the same among the three units. The third-floor unit’s value may be higher because of the desirability of views and the lack of upstairs neighbor noise, among other reasons. This allocation generally works itself out based on the arms-length negotiations among the buyers of the building.
It is equally important for buyers of 3-4-unit buildings, who have a plan to sell off units as TIC interests, to get an up-front appraisal of each of the units in the building as well as an appraisal of the allocation to land. This is important for two reasons. First, the owner may decide to live in one of the units and rent the others. Therefore, an allocation of the cost to the personal use portion of the building will be required. This will be needed for establishing the basis for purposes of determining gain on the future sale of the personal residence unit. It also establishes the basis upon which depreciation deductions may be claimed on the rental portion of the building. Second, when the owner of the building decides to sell one or more of the remaining units in the building as TICs, the owner will need a cost basis allocable to that unit that consists of land and building (adjusted for any depreciation deductions claimed).
Cost Segregation Studies
Cost segregation studies can be performed to substantiate an allocation of a portion of a building’s cost to assets with a shorter depreciable life than generally assigned to real property. These studies are often performed by accounting firms with expertise in this area, in concert with an engineering firm. Without a study, apartment buildings are depreciated over 27.5 years using the straight-line depreciation method. A cost segregation study will identify significant portions of the building that qualify for 5-, 7- and 15-year lives with accelerated depreciation methods. A cost segregation study performed by a firm with valuation expertise can also provide support for your allocation between land and building.
In recent years, the dramatic appreciation of real-estate prices in the Bay Area means those property owners who use their property in a trade, business or residential rental could receive large deductions in depreciation expense. However, it is important to be able to adequately allocate the basis among all of the components of the property, including land, and to have support for that allocation. That way, if the IRS contacts you for an audit, you will be prepared.
The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of SFAA or San Francisco Apartment Magazine. Douglas Schultz is a CPA and partner in the tax-practice division of Burr, Pilger & Mayer, LLP, a San Francisco-based accounting and consulting firm. Marlene Smith is a senior accountant in the tax practice division at BPM. They can be reached at 415-421-5757. Copyright ©2006 by San Francisco Apartment Magazine. All rights reserved.