I own rental property, and I just left my first IRS audit. The IRS auditor arrived at the audit with the county tax assessor’s land and building values assigned to my property tax bill.
That was a surprise to my new CPA, who has been around the block more than once. He said he had not previously seen the IRS arrive at an audit with the tax assessor’s information in hand.
Worse, the property tax bill shows the land as 37 percent of the value, meaning that I have only 63 percent that I can depreciate. My original accountant allocated 10 percent to land, so I am facing a sizable adjustment.
I spoke with my old accountant, who said he always used 10 percent and never had any trouble, but he offered no help for my current mess. So, with this background, here is my question: Can the IRS require that I use the county tax assessor valuations to allocate the cost of my property to land and buildings for depreciation purposes?
No. You can use any reasonable method to determine the value of land and buildings for depreciation purposes. Assessed values are commonly used, but the IRS can’t require that they be used if you have something better.
Your immediate problem is that you have nothing better, in fact, you have nothing at all, really. It sounds like the old accountant used the finger-in-the-wind approach (meaning he made a guess). That’s wrong. You need evidence. The burden of proof is on you.
Further, from what we know, the IRS’s use of the tax assessor’s statement in an audit is not uncommon on recent audits, thanks to the internet.
When you buy business or investment real property, such as an apartment building, you usually pay one lump sum for land, buildings, and other improvements. There’s no cost breakdown.
You can’t depreciate land, because it doesn’t wear out. So, as far as depreciation goes, land is useless.
What you need is a way to take that lump sum and allocate it to land, buildings, improvements, and equipment.
Allocating costs to land and buildings for tax purposes is a factual determination initially performed by you, the property owner. But as you are learning, the IRS is not bound by your allocations and may re-examine them.
See Make the Closing Statement Work for You When Buying Rental Property for how the allocation process starts with the closing statement and then continues with allocations to the assets purchased.
The IRS provides little guidance on how land and building values should be allocated. It simply says that “you must divide the cost between the land and the buildings to figure the basis for depreciation of the buildings. The part of the cost that you allocate to each asset is the ratio of the fair market value of that asset to the fair market value of the whole property at the time you buy it”.
There are many ways to perform this allocation. You are not required to use any particular method 00 just a reasonable method. The two most popular and common methods are assessed value and appraised value.
We are going to use examples to show how the two methods work. For the examples, let’s say you purchase a rental home for $200,000.
Here, we are taking a page from your IRS auditor’s initial confrontation with you and your CPA.
You check the county tax assessor’s records for the property. It was last assessed 10 years ago. The assessor’s records show that at that time the entire property was valued at $100,000. The land was valued at $37,000 (37 percent) and the building at $63,000 (63 percent).
This gives you your ratio of building to land. You multiply the $200,000 purchase price by 63 percent, resulting in a $126,000 depreciable basis in the building and a $74,000 land value.
Here, you hire a qualified appraiser who studies comparable property sales in the area and concludes in a written report (which you place in your tax file) that the land is worth only 10 percent of the total purchase price. This results in a $180,000 depreciable basis in the building and a $20,000 land value.
In this example, the appraisal gives you $54,000 of additional depreciation. In most cases, the appraisal gives you a good result, and it has high credibility with the IRS.
Drilling Down on Assessed Values
Rental property owners often use assessed values for allocations to land and building, for the following reasons:
- They did not take the time to gen an appraisal.
- They did not know what proof to collect.
- The assessor’s statement is readily available.
- The assessor’s statement costs nothing.
But assessor’s statements are notoriously inaccurate.
County tax assessors aren’t greatly concerned about arriving at an accurate breakdown of the relative values of your land and improvements, because it has no effect on your property tax bill — your tax is based on the total assessed value of your property.
Often, county assessors apply a standard percentage to all property in the area — for example, 80 percent. Or they use out-of-date sales data from previous years.
As a general rule, tax assessors tend to undervalue buildings and overvalue land, resulting in smaller depreciation deductions than can be obtained using other methods.
Obviously, you think the assessed value that the IRS wants you to use for your building is too low. Ask the IRS examiner if he will allow an after-the-fact appraisal.
You could point out to the auditor that while the IRS has said that assessor valuations can be used, no IRS regulation or publication requires that they be used.
In fact, the IRS has made clear that assessed values should be relied on only if nothing better is available.
For example, in Private Letter Ruling 9110001, the IRS told the property owner that he could not rely on assessed values where an IRS engineer had conducted an appraisal resulting in a less favorable allocation. The IRS ruled that land and building allocations cannot be made “solely according to the assessed values… when better evidence exists to determine the fair market values of the properties.”
In Meiers, the IRS attempted to force a property owner to use assessed values for depreciation purposes. Steven Meiers bought two condominiums for a total of $111,000. After investigating the replacement costs for the buildings, he allocated 80 percent of the cost to the buildings and 20 percent to the land.
The IRS contended that the buildings and land should be valued according to their assessed values. This would create cost allocations of 55 percent building for the first condo and 49 percent building for the second condo.
The Tax Court sided with Mr. Meiers’s allocations because there was no evidence that “the assessor’s allocations of value between land and building comport with reality”. Rather, the court accepted Mr. Meiers’s valuations as reasonable.
You failed the burden-of-proof test, and that puts you in hot water. Your previous accountant should have insisted that you come up with evidence for the allocation.
Had you looked at the assessor’s statement, you would have noticed the high allocations of cost to the building. That may have triggered questions and perhaps an appraisal or cost segregation study.
The rule of thumb is simple: you need proof, and you generally need that proof on a timely basis. After-the-fact gathering-the-proof activity is seldom effective and often expensive.
With your lack of documentation, you have put yourself at the mercy of the IRS — and when is the last time you saw the word “mercy” used sympathetically in the same sentence as the IRS? Let’s face it: you are unlikely to find mercy in your dealings with the IRS.