Land and building value are the most integral parts of forming the cost basis for a rental real estate property. Land is typically never depreciable, so it makes sense to allocate as much as possible to the actual building value for tax purposes. However, appropriate steps must be taken to ensure that the method of allocation is done properly and conforms with IRS regulations. Typical methods of establishing the land value include:
- Reviewing the purchase contract for the property. Some contracts will allocate a percentage of the sales price to the land and to the building. If so, these amounts should be used to form the depreciable basis for the property over 27.5 years (if the property was placed into service before 2017) or 30 years (if the property was placed into service in 2017 or after). If this information is given in the purchase contract, the cost basis for land and the building is already given and should be used for depreciation over future years. For example, if the sales price of the rental property was $400,000, and $75,000 was described as land and $365,000 for the building, the land and building basis are:
$75,000 land / $400,000 sales price = 18.75% land basis
$325,000 building / $400,000 sales price = 81.25% building basis
- Examine the most recent real estate tax assessment on the property. Real estate tax assessments will typically allocate a dollar value to land and the building. By applying the percentage associated with land to the sales price of the rental property, it is possible to establish a depreciable cost basis. For example, consider a rental home purchased for $250,000. The most recent real estate assessment placed the value of the property at $200,000, with $20,000 allocated to land and $180,000 to the building. Thus, the land value is:
$20,000 assessed value / $200,000 total assessment = 10% land basis
10% land basis x $250,000 purchase price = $25,000 land value
Similarly, the building value could be calculated as follows:
$180,000 assessed value / $200,000 total assessment = 90% building basis
90% building basis x $250,000 purchase price = $225,000 building value
- Consider similar land values in the area. It is also possible to establish a property’s land value by examining similar properties in the area. The investor can review details of comparable properties with a competent realtor to ensure that their basis is reasonable.
Typical land values fall within 10% to 25% of the sales price of a property. Closing costs of the sale, such as commissions, legal fees, title insurance and survey costs can be added to the building sales price and depreciated as part of the cost basis of the property.