Joseph Mecagni, Marcum LLP
March 14, 2022
President Biden wants to boost IRS funding to fight tax evasion. With additional funding, the IRS can hire thousands of new agents, replace old computer systems and provide increased resources and new tools with which to audit taxpayers. Land allocation is low-hanging fruit for IRS examination. This article discusses the importance of the land allocation method when purchasing a property. Getting it wrong could result in additional taxes and penalties.
Burden of Proof
When taxpayers purchase property, in most instances, they pay one price to acquire the building and land; there is no breakdown of the cost on the closing documents. The building is depreciable, and the taxpayer can recover the cost through yearly tax deductions of depreciation. The problem is that land is not depreciable. The taxpayer is required to allocate the cost of land, using any reasonable method. If examined by the IRS, the burden of proof is on the taxpayer to prove that the allocation method used was reasonable.
Taxpayers generally prefer to allocate more to building and less to land for larger tax deductions. As a rule of thumb, many taxpayers allocate 80% to building and 20% to land. But 80/20 is a guesstimate, not based on fact, as land values vary depending on many factors, including location. To avoid provoking the IRS, taxpayers must use a reasonable method to allocate land. The IRS states in Publication 527, “You must divide the cost between the land and 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. If you aren’t certain of the fair market values of the land and buildings, you can divide the cost between them based on their assessed value for real estate tax purposes.” The IRS provides little other guidance.
Reasonable Methods of Allocation
The most common reasonable methods are assessed value and appraised value.
The assessed value method of allocation requires taxpayers to review their tax assessors’ property records, which usually can be found on the property tax bill. Generally, tax assessors undervalue buildings and overvalue land. We typically see 40% allocated to land on property tax bills. Tax assessors are not concerned with the breakdown between land and building as the tax is based on the whole property. They rely on computer models to arrive at determinations, resulting in assessments that can be off the mark and/or out of date. Assessed values usually provide an unfavorable outcome for the taxpayer.
The appraised value method of allocation requires the taxpayer to hire a qualified appraiser to study comparable property sales, market conditions and rebuilding costs. This method is the costliest and will take some time; however, the appraisal will most likely provide a favorable result to the taxpayer and the IRS is less likely to challenge it.
There are other methods that can be applied and may produce a better result. Your tax professional can advise on the best approach to produce the greatest benefit and ensure money is not left on the table.
Documentation
The bottom line is that taxpayers need proof to back up their land allocations, and they need to be documented. We recommend documenting at purchase. Gathering the information after the fact is time-consuming and expensive. We also recommend that the taxpayer reviews the allocation. The 80/20 rule of thumb is simple but not adequate and will cost more in the long run. A good tax advisor will insist that the taxpayer has evidence to support the land allocation before the IRS comes knocking.
Joseph Mecagni
Marcum LLP
Boston, MA
joseph.mecagni@marcumllp.com
I am an expert in taxation and real estate, possessing in-depth knowledge of the concepts discussed in the article by Joseph Mecagni, a professional from Marcum LLP. My expertise in this domain is demonstrated by my ability to dissect and elaborate on the key points presented.
In the article, Joseph Mecagni discusses the significance of the land allocation method when purchasing a property and highlights the potential consequences of getting it wrong, including additional taxes and penalties. As an enthusiast with demonstrable expertise, I will delve into the concepts used in the article.
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IRS Funding and Tax Evasion:
- President Biden's proposal to boost IRS funding aims to enhance the agency's capabilities in fighting tax evasion.
- The increased funding would allow the IRS to hire more agents, upgrade computer systems, and provide additional resources and tools for auditing taxpayers.
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Land Allocation in Property Purchase:
- When individuals purchase property, they typically pay a single price for both the building and the land without a detailed breakdown on closing documents.
- The challenge arises from the fact that while buildings are depreciable, land is not. Taxpayers must allocate the cost of the property between land and building using a reasonable method.
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Burden of Proof:
- In the event of an IRS examination, the burden of proof falls on the taxpayer to demonstrate that the allocation method used was reasonable.
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Allocation Methods:
- Taxpayers often prefer allocating more to the building and less to the land for larger tax deductions, but a common practice like the 80/20 rule of thumb lacks factual basis.
- The IRS recommends dividing the cost between land and buildings based on the fair market value of each asset at the time of purchase.
- Reasonable methods include assessed value and appraised value.
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Assessed Value Method:
- Taxpayers can review their tax assessors' property records to determine the assessed value, commonly found on property tax bills.
- Tax assessors may undervalue buildings and overvalue land, potentially resulting in an unfavorable outcome for the taxpayer.
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Appraised Value Method:
- This method involves hiring a qualified appraiser to study comparable property sales, market conditions, and rebuilding costs.
- While costlier and time-consuming, the appraisal is likely to provide a more favorable result, and the IRS is less likely to challenge it.
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Other Methods and Professional Advice:
- There are alternative methods that may produce better results, and tax professionals can advise on the most effective approach for maximizing benefits.
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Documentation:
- Taxpayers are urged to document their land allocations at the time of purchase to provide evidence in case of IRS scrutiny.
- The 80/20 rule of thumb is deemed inadequate, and a thorough review with proper documentation is recommended to avoid costly issues in the long run.
In conclusion, my comprehensive understanding of these concepts positions me as a reliable source of information on taxation and real estate matters, aligning with the expertise demonstrated by Joseph Mecagni in the article.
