Court rejects taxpayer’s land vs. building allocation

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A recent Tax Court opinion favored a Los Angeles County tax assessor’s valuation of rental property improvements over the property owner’s own appraisal.

On May 8, 2017, the U.S. Tax Court released Summary Opinion 2017-31, in the case of Nielsen v. Commissioner, concluding that the county assessor’s allocation to land and improvement values were more reliable than the taxpayer’s proposed values. The Tax Court noted it could not find any authority that suggests a taxpayer is qualified to allocate the value of property between land and improvements.

The taxpayer contended the county assessor’s data was “extraordinarily inaccurate,” but the Tax Court did not agree. While the Tax Court acknowledged a taxpayer is qualified to testify as to the value of their entire property, it found no authority suggesting a taxpayer is qualified to allocate the value of property between land and improvements.

When land and a building are purchased for one price, the case highlights the importance of substantiating the values used for tax depreciation purposes.

In many cases, a real estate appraisal is performed for financing purposes but does not include a value for land. In these instances, where the purchase price is significant, it may be prudent to contact the same appraiser to commission a land appraisal. For income tax purposes, every dollar shifted from land value to improvement value yields permanent tax benefits.

When purchasing real estate, taxpayers are required to separately identify the value of non-depreciable land from the depreciable improvements (such as buildings and site work) for tax capitalization purposes. If an appraisal was not conducted at the time of purchase, and the taxpayer feels the county assessor’s allocation to land value is excessive, taxpayers may consider the following options:

1. Rely on the county tax assessor’s allocation: The property tax assessor provides a value of land and improvements based on the municipality’s guidelines. While this may not reconcile with the acquisition cost, the ratio between the land and improvement values can be applied to the acquisition cost to provide corresponding values for federal income tax purposes.

2. Commission a full scope land appraisal: A qualified professional (such as an MAI, a member of the Appraisal Institute) following Uniform Standards of Professional Appraisal Practice guidelines will generate a comprehensive analysis considering factors such as sales comparisons, the highest and best use, market conditions, replacement cost, and the amount of income generated. While this is the most accurate approach, it can be costly and require several weeks to complete.

3. Limited scope land appraisal: A real estate professional, who may not follow USPAP guidelines, simply provides an analysis of sales comparisons.

4. RTD method: In the "roll the dice" method, also known as the “rule of thumb” approach, a taxpayer uses a predetermined allocation (i.e., 80%/20% or 70%/30%) for land and improvements. Many CPAs are not comfortable with this approach and it may raise concerns under IRS examination.

A higher depreciable basis in the building improvement category, coupled with a cost segregation study, generates greater accelerated deductions as relative building component values also increase.

When land and building are purchased for one price, tax preparers must advise their clients on the pros and cons of using various approaches to allocate the cost for tax depreciation purposes. Relying on a property tax assessment for this information may result in leaving deductions on the table. In situations where the county tax assessor’s land value is excessive, considering other options can yield significant permanent tax benefits that can be further enhanced by a cost segregation study.

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