Property recovery begins by allocating the purchase price to the various assets acquired, although purchase price allocations aren’t always straightforward.
Accounting for land and buildings are the defining factors of most property transactions, but undervaluing land could lead to tax penalties with interest as a result of over-depreciating the property. On the other hand, over-allocation could result in a missed depreciation opportunity.
Purchase price allocation is required of taxpayers involved in real estate transactions. For example, a typical allocation of purchase price would include non-depreciable versus depreciable improvements.
Similarly, in transactions where an entire business is acquired, a taxpayer is required to allocate purchase price to business intangibles, as well as non-depreciable and depreciable improvements, although the methodologies may be different. The standard is to use fair market value (FMV) in these tax allocations.
What’s Fair Market Value (FMV)?
FMV refers to the price when property changes hands between a willing buyer and seller, provided that neither party is under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.
FMV also refers to a definitive amount paid in cash or its equivalent for a given property that stays the same regardless of the purpose for the appraisal.
Why Allocate Value to Land in a Real Estate Purchase?
Most real estate transactions involve land and improvement components. If such property is used in a trade or business, or if the property is held for producing income, the IRS allows for a depreciation deduction to account for a reasonable allowance of exhaustion, wear, and tear.
However, land itself doesn’t depreciate, considering that it doesn’t wear out, become obsolete, or get depleted. Therefore, the taxpayer must allocate the purchase price between non-depreciable land and depreciable property.
Since most real estate transactions and purchase agreements don’t always assign value to these components, the taxpayer should understand the options available to them in determining a reasonable allocation to both depreciable and non-depreciable property.
More importantly, a taxpayer should understand that the burden of proof in self-allocating value to land will fall on the taxpayer if they’re ever audited. Taxpayers must be objective.
How to Allocate Purchase Price to Land
Following are methods for determining tax purchase price allocations with a particular focus on allocations between land and building.
While each of these methods hold merit, all allocations must be determined by facts, circumstances, and applying the best information available.
The sales comparison approach is:
- Commonly carried out by a third-party appraiser
- Often the preferred method when hiring a professional
- Mostly favored by the IRS
The methodology includes valuing a parcel of land by identifying other properties capable of development similar to the highest and best use of the acquired property and deriving a FMV for the land in the transaction. The buyer then employs a residual calculation for the improvements, deducting land value from the total purchase price.
Finally, a buyer would estimate the depreciated value of the building and site improvements, or do a cost segregation study to estimate the improvements portion of the sale price.
Although the sales comparison approach might seem quite intuitive, the methodology requires a high level of expertise.
Considerations for the Sales Comparison Method
The appraiser should have a real estate license in the state where the property is located. The appraiser will have access to the comparable market sales data required for an assignment. They’ll also be trained in the proper application of adjustments to the comparable sales. They can typically complete the assignment from start to finish with limited client interaction and supervision.
Each property tends to be unique—zoning allowances or development requirements specific to a county variance, for example. The land is always valued at its highest and best use, unless a value in use technique is employed which will value the land based on its current use. This might include uses legacied into a legal, nonconforming variance, which could increase the land value due to its unique characteristics.
Not all properties will hold the same value in land since they can’t be developed with the same uses. The point to remember is that the comparable property must be very similar to the subject property.
A taxpayer-driven market approach provides procedures on estimating market values without hiring an expert. It follows the same methodology outlined above.
The land value is first estimated and deducted from the sales price, leaving the remaining allocation to improvements as the residual in the equation.
Challenges with this approach include identifying comparable sales, making appropriate adjustments to the comparable properties, and costs to access online sales data: subscription can cost several hundred dollars per month.
Revenue Procedure 79-24
The IRS addresses this approach in Revenue Procedure 79-24, 1979-1, which provides guidance necessary to properly utilize the market data approach in appraising unimproved real property for federal income tax purposes.
Buyer and Seller Written Agreement
The idea behind this approach is that the allocation of a purchase is agreed upon in the purchase and sale agreement. In a transaction, especially when purchasing an established business, a buyer and seller will enter into an agreement to determine how the purchase consideration shall be allocated to the transacted assets.
If the parties agree in writing to the allocation of any consideration, or to the FMV of any of the assets, such agreement is binding to both parties, unless deemed inappropriate by the IRS.
This type of buyer and seller agreement is common in business transactions that include significant tangible assets and established operations. Specifically, it’s often carried out in winery and viticulture transactions where the transaction includes operational equipment, such as tanks and bottling lines, as well as farmland and branding.
The concept is that the buyer and seller are generally deemed to both be aware of facts and represent opposing interests, which one could interpret as the definition of determining FMV.
Internal Revenue Code (IRC) Section 1060
The legal underpinning in this method is laid out in IRC Section 1060 and has been addressed in court cases, such as Peco Foods, Inc. & Subsidiaries v. Commissioner of Internal Revenue.
Here, the tax court concluded that the taxpayer couldn’t modify the purchase price allocations that were agreed to in connection with an asset acquisition.
Any allocation to vacant land in the purchase and sale agreement will be difficult to change after purchase for a more favorable allocation.
Tax Assessor Ratio Approach
The tax assessor ratio approach is the most commonly applied and understood. This method uses ratios of assessed values to allocate the purchase price between land and depreciable improvements.
All land parcels are annually assessed by the governing county for property tax purposes, but the county may not go through a valuation process for several years. The information is typically public knowledge and accessible online. However, this method can only be used when there are no other ways of accessing a FMV allocation.
A taxpayer may not allocate its purchase cost basis to land and buildings solely according to the assessed values of the land and buildings for real estate tax purposes when better evidence exists to determine the FMV of the components.
Private Letter Ruling (PLR) 9110001
This approach is discussed in PLR 9110001. Application of the tax assessor approach can be challenging without an understanding of the basic definitions of terms related to the property’s assessment jurisdiction.
For example, California and Oregon have both passed legislation to limit annual increases in assessed values to specific percentage amounts per year. Given these are government-imposed limits and not market-imposed, it’s important to use the most reasonable amounts for allocation of value purposes and rely on ratios of land and improvement values, rather than absolute values.
In Oregon, when a property’s values are fixed to a point in time, and growth is artificially limited, the ratio of land versus buildings is also fixed. Some taxpayers may leverage the assessor’s real market value for determining ratios, rather than the assessed value.
In California, where assessed values inflate 2% each year, but don’t reset to market until a market transaction occurs, some taxpayers may evaluate if the ratio of land value to building value provides a reasonable basis—especially if the property hasn’t transacted for a long period of time. California jurisdictions issue supplemental assessments following transactions, which provide updated values.
Determining an appropriate methodology to allocate purchase price can be challenging. The taxpayer must understand the options available to them in determining a reasonable allocation to both depreciable and non-depreciable property.
More importantly, a taxpayer should understand that the burden of proof in self-allocating value to non-depreciable land will fall on the taxpayer if they’re ever audited.
We’re Here to Help
For guidance in allocating purchase price or conducting a cost segregation study or land valuation, contact your Moss Adams professional.