By this point, you are aware that land is not subject to depreciation. Accordingly, when doing a cost segregation study or even just allocating a purchase price between land and building, you get the most bang for the buck if you have a low land valuation. But how do you justify it?
First, by identifying and allocating the depreciable components first, and land last, is a way to arrive at the leftover (“residual”) land value. But then you should confirm that the approach was reasonable.
Allocations toward depreciable land improvements reduce the amount allocated to non-depreciable land. Use the building basis valuation method that gives you a higher building value and lower land value, yet without taking away from the allocations to personal property and 15-year land improvements associated with the land. The building improvement ratio method proved to be very effective for accomplishing this.
Special valuation factors (such as highest & best use) – In Platt (75-1USTC) a low allocation to land was upheld where it was indicated that the highest & best use of the property was for residential purposes even though it was zoned for industrial use. The rental property was in an area where there was a housing shortage. Such a housing shortage would make houses (i.e. buildings) more valuable, land less valuable. This is consistent with the aforementioned arguments supporting large building allocations.
With condominiums the owner does not have a direct fee simple interest in the common elements which include land. Accordingly there is a lower-than-usual land value, even zero.
The argument of low land valuation for condos is substantial. This argument has been supported by the condo documentation which indicated very low allocations toward the common elements (which includes land). In fact, we have seen IRS agents accept arguments of no land value. Yes, no land value, despite being a properties at beach locations where land values are generally considered higher than usual.
Generally do not use comparable sales.They sometimes can artificially inflate land values.
Another method used to determine such allocations toward land is “comparable sales”. Here, you value the land portion of a property based on what adjacent or nearby vacant lots have recently sold for. This method is frequently used for investment properties in high-priced resort areas.
Problem with using comparable sales = high distorted land value with the loss of depreciation deductions. The problem with this method is that it often provides a very high (and distorted) land value, which is obviously unfavorable to the investor. For example, you buy a resort-area property for $1,000,000. A nearby lot has sold for $600,000. Under this method your allocation toward land is $600,000 or a whopping 60% of the total cost of $1,000,000. (I say no way!). The higher the land value the less toward the other depreciable components, less deductions = less savings.
No one method is necessarily the right one. This is supported in Nail (1972) 59 TC 187 (A). Here, the court concluded that use of comparative sales is not an exclusive method of valuation and may have to be considered in conjunction with other methods, such as capitalization of income. The appellate court in Douglas Hotel Co. V. Comm’r supports this by stating comparative sales is, of course, not the only evidence which may be considered.
Comparable sales have been considered not totally reliable for the following reasons:
- Where there was an absence of truly comparable properties within a reasonable time surrounding the valuation date, Andrews (1930, CA 2) 38 F2d 55(e); Jacobs, (1930) 20 BTA 529 (i).
- There must at least be a reasonable degree of comparability between properties.
- Where there is a sudden boom in land values, Wilson (1926) 5 BTA 615 (A) (e). In this situation, many times properties quickly become artificially inflated because of speculation or euphoric optimism. Such a quick and sudden increase could cause a distortion in fair market value.
- Where the sales price of the property was not indicative of fair market value. For example the property may have been bought or sold under compulsion or distress giving either the seller or to the buyer an opportunity to exploit an unusual situation, Ireland, TC Memo 5/8/51.For example, an overly anxious and emotional buyer will pay more than fair market value.
- Where the sales price is inflated because the terms of the sale were liberal, such as little or no money down, or a low interest rate as part of “creative financing”, Kaplan vs. U.S. (1967), DC Ariz. (279F Supp 709).
Such comparable land sales can distort a property’s total valuation; more value is in the building. For the reasons previously discussed, much of the property value should be in the building. Once a building is placed on land, then the overall valuation picture changes with more value toward the building.
Also, a substantial portion of what we call “non-depreciable land” is really depreciable as land improvements. In effect, allocations toward these depreciable land improvements reduce the amount allocated to nondepreciable land.