Calculating Land Value

Calculating land and building values is the first critical step you must take when you want to maximize your depreciation expense.

Tax law says you cannot depreciate land. Land, in theory, appreciates and does not lose value because of everyday wear and tear (petroleum rights aside). A taxpayer can only depreciate items that wear down or wear out over time, like the components within a building. Most real estate transactions do not assign a land value to the purchase, so CPAs and EAs must understand the myriad of available options. Assign a value for land that’s too high, and the depreciation expense drops too low. Assign a value for land that’s too low, and the IRS will question your decision and calculations.

Unfortunately, there is no “one size fits all” in valuing land. All real estate appraisers will agree it’s virtually impossible to reach 100% certainty for any property, and that’s doubly true for unimproved land.

What does the IRS say about this?

In Publication 527, “You must divide the cost between the land and buildings to figure the basis for depreciation of the buildings.” The IRS states that taxpayers may use any “reasonable” approach.

Here is a list of reasonable approaches from Publications 561 and 551.

1. Comparable Sales: The comparable sales method compares the property with several similar properties that have been sold. This would then indicate the estimated FMV of the property.
   1. If the comparable sales method is used to determine the value of unimproved real property, the following factors should be considered:
      1. Location, size, and zoning
      2. Accessibility and road frontage, and available utilities and water rights
      3. Riparian rights (water rights)
      4. Soil characteristics and mineral rights
   2. Sales having the least adjustments should be considered comparable.
2. Replacement cost: This method, used by itself, does not result in an accurate determination of FMV. Instead, it sets the upper limit of land valuation, especially in times when real estate is rising, because it assumes that no knowledgeable buyer will pay more for real estate than the price to reproduce a comparable property. The replacement cost of a building is generally calculated by adding materials, labor, or workmanship and the number of square feet in the building. This cost represents the total cost of labor and material, overhead, and a profit margin.
3. An appraisal: This option is the least likely to be challenged by the IRS, but it is the most costly, and you generally have to live with the results.
4. Rule of thumb method: Some taxpayers use a predetermined percentage, such as 80/20 percent for building and land. We do NOT advise clients to take this approach because it will raise concerns under an IRS examination. Tax Court rulings have stated they could not find any authority that implies a taxpayer is qualified to allot the value of the property between land and improvements.

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