When Overvaluing Land Can Cost You Thousands of Dollars (and maybe more!)
When commercial real estate owners acquire a property, one of the most important tax decisions they make is allocating the purchase price between land and building value. While this allocation may seem like a routine accounting exercise, assigning too much value to the land component can have significant and long-lasting tax consequences.
Because land is not depreciable, every dollar allocated to land is a dollar that cannot generate depreciation deductions. Overvaluing land can therefore result in missed tax savings, reduced cash flow, and lower after-tax returns on investment.
Understanding the Land Allocation Issue
For tax purposes, the purchase price of a commercial property must be divided between land and improvements (the building and other depreciable assets). The building portion can generally be depreciated over 39 years for commercial properties (and 27.5 years for residential rentals), while certain building components identified through a cost segregation study may qualify for even shorter recovery periods.
Land, however, does not wear out, deteriorate, or become obsolete in the eyes of the IRS. As a result, land cannot be depreciated.
If a taxpayer allocates 30% of a property's value to land when a more supportable allocation might be 20%, that additional 10% is effectively removed from the depreciation calculations. Depending on the property's value, this could represent hundreds of thousands of dollars in lost depreciation deductions over time.
The Impact on Cash Flow
Depreciation is one of the most valuable tax benefits available to commercial property owners. By reducing taxable income, depreciation lowers current tax liability and helps preserve cash flow that can be reinvested into the business or additional real estate acquisitions.
An excessive land allocation reduces annual depreciation expense and increases taxable income. The result is often higher tax payments and less cash available for growth opportunities.
For investors focused on maximizing returns, this can be a costly mistake.
A Common Cause of Overvaluation
Many property owners rely solely on arbitrary percentages or estimates without obtaining professional support, increasing the risk of inaccurate allocation. While this short-cut method may be useful as a starting point, it’s important to consult a professional to arrive at a fair and supportable land value for your final allocation.
Supportable Allocations Matter
I’m not saying to minimize land value at all costs. Instead, property owners should establish a reasonable and defensible allocation based on market data, appraisal methodologies, and the specific characteristics of the property.
A properly prepared allocation analysis can help ensure that land, building, and land improvement values are appropriately identified and documented. This not only maximizes available depreciation deductions but also provides support in the event of an IRS examination.
What’s in Your Depreciation Schedule?
Whenever I receive a request to conduct a cost segregation study on a property that has been owned for more than a year, I always ask to see the owner’s depreciation schedule. I want to check on the land value used and see if it’s reasonable. I can’t tell you how many times I’ve uncovered dramatically overvalued land! This typically occurs without the property owner even being aware of it!
The most recent occurrence was an overstatement of over $800,000! To be sure we were correct, I consulted with a local property value expert and he agreed that the booked land value was grossly overvalued. Using the Change of Accounting Method form (IRS Form 3115), as part of the cost segregation study, we reallocated the dollars into the building category which more than doubled the depreciable cost basis of the building!
Don't Leave Tax Savings on the Table!
Overvaluing land may seem like a small accounting decision, but its impact can last for decades.
By carefully analyzing purchase price allocations and ensuring that land values are properly supported, commercial property owners can maximize depreciation benefits, improve cash flow, and capture tax savings that might otherwise be lost for the life of the property!
Let’s Look At Your Schedule Together!
If you have doubts or just want a quick review of what’s REALLY on your depreciation schedule, send me an email (Tom.Brodie@CSSIServices.com) and attach a copy of your last tax year’s depreciation schedule. (You’ll probably have to get your schedule from your CPA or tax preparer. The schedule is not normally attached to a tax return.)
I’ll take a quick look to determine the “health” of your schedule and if there are areas that require attention. No Cost, No Obligation, just peace of mind!
Cost Segregation Services (CSSI) is the nation's premier engineering-based consulting firm, specializing in tax law surrounding commercial buildings. With over 23 years of experience and more than 60,000 studies completed, we’ve maintained unmatched service standards and a perfect record: Zero IRS audits triggered. Our mission is to unlock tax solutions, maximize benefits, and increase cash flow for our clients.
