Purchase and sale agreements for a property consisting of both land and improvements commonly name a single price. When companies record the acquisition on their books, they need to determine how to reflect the purchase price on the trial balance.
One significant question is the land and building allocation; this determination is made at the time of purchase. Because land isn’t depreciable, and different methods and recovery periods apply to different types of improvements, the determination has significant implications for depreciation expense allowable for current and future years.
For tax reporting, the basis in property consisting of land and depreciable improvements is allocated among the land and improvements in proportion to their respective fair market values at the time they’re acquired. Fair market value (FMV) is the price at which property would change hands between a buyer and seller under ordinary market conditions, and with both parties having reasonable knowledge of all necessary facts.
Companies need to use a reasonable allocation method to arrive at this number. Some companies and practitioners use an arbitrary 85%/15% or 80%/20% building/land split across all their assets. This approach is simple and may result in favorable depreciation – but also may be challenging to substantiate under audit.
Investors are motivated to have a higher depreciable base, but in many cases (e.g., New York City real estate) the value of the land may be much closer to the value of improvements.
Determining an appropriate ratio
IRS Publication 551 (December 2018), Basis of Assets, provides guidance about allocating lump-sum purchases of building and land. Applying this approach requires purchasers to determine the independent FMV of the land without the improvements, which may not always be easy to determine.
At a basic level, the IRS recommends multiplying the lump sum by a fraction, calculated as follows:
- Numerator: FMV of asset (e.g., building)
- Denominator: FMV of entire property at the time of purchase
In practice, the following approaches are available:
- If you’re a US GAAP reporter that’s purchasing a building currently occupied by tenants, you’ll likely require an ASC 805 (business combinations) study for your financial reporting. In that case, you should look to that study for the allocations. As a best practice, tax reporting and GAAP reporting shouldn’t vary between land and improvements without good reason.
- Alternatively, if an appraisal was performed as part of the financing due diligence, you may use the ratio from the appraisal. Appraisers will usually isolate the land value using land comparable sales.
- Some companies may have the expertise and data in-house to perform a valuation. A company with many recent transactions within a market may be able to identify land comparable values and arrive at a reasonable allocation. In this case, it’s very important for the company to maintain good support for its files to leave an audit trail.
- If the above options aren’t available, you may use property tax assessor data. Many jurisdictions include a breakdown of land and building values within their assessments of value. The company will have access to its holdings’ records, but the information is usually available publicly. The tax assessment is often significantly lower than actual market value, but the key information to be utilized is the ratio of land to building.
- A cost segregation study is an important tool for allocating your improvements in a tax-favorable manner. However, the cost segregation specialists’ starting point for allocation is the total depreciable basis portion of the purchase price allocable to improvements, as they don’t provide the land allocation themselves.
- When a property is acquired with intent to demolish the existing structure (e.g., to construct a new ground-up development), the full purchase price will generally be allocated to land (along with demolition costs once incurred).
- Allocation based on the relative amounts at which the assets were carried on the seller's books isn’t permitted because book amounts aren’t necessarily indicative of FMV.
- Legal expenses and other acquisition costs must be allocated between land and improvements at the same ratio of the purchase price allocation.
It’s important to address questions regarding purchase price allocation early on, not after your accountant has started preparing your tax return or annual financial statements.
Contact your Mazars team today for appraisal services, ASC 805 studies, cost segregation, accounting assistance or tax guidance.
Katelyn Kogan, Senior Manager
Ian Ernst, Manager, Tax