While the IRS doesn't mandate a specific method for land allocations, blindly applying an arbitrary ratio like the 80/20 split can raise red flags; instead, using the ratio from the county tax assessor's valuation is considered a defendable approach based on reliable, independent data. The IRS Cost Segregation Audit Technique Guide suggests using a “reasonable method based on reliable data,” which aligns well with the county's valuation, as it typically breaks out land and improvements separately.
Engineered Tax Services (ETS) confirms that using the ratio from county assessments provides a strong, audit-ready basis for depreciation, avoiding arbitrary percentages and guesswork. In unique or highly complex cases where the county valuation seems inaccurate, a professional appraisal focusing specifically on the land value can provide airtight documentation, though this is a more costly option.
Land Allocation Methods: IRS Standards
- 80/20 Split: Blindly applying an arbitrary ratio like 80/20 can raise red flags if it doesn't reflect the property's reality.
- IRS Guidance: The IRS suggests using a “reasonable method based on reliable data.”
- Best Practice: The county tax assessor's valuation (which breaks out land and improvements) is a strong, defendable approach because it relies on independent, third-party data.
- Complex Cases: In unique or highly complex situations, a professional appraisal focusing on land value may be necessary for airtight documentation.
- ETS Method: Engineered Tax Services typically uses the ratio from county assessments to provide an audit-ready basis for land allocation.
Why the 80/20 Split is Dangerous
The 80/20 split (assigning 80% of the cost to the building and 20% to the land) is a common but dangerous assumption. While it may seem convenient, the IRS views any arbitrary split without an underlying justification as highly suspect.
- No IRS Authority: There is no specific IRS rule or regulation that permits the blanket use of an 80/20 ratio.
- Risk of Audit: Relying on an unfounded ratio can increase your risk of an audit, and if challenged, the deduction may be disallowed, leading to significant back taxes and penalties.
The true value of the land varies dramatically based on location. A building in a dense urban center, for example, might have a land value far exceeding 20%, whereas a similar building in a rural area might have a much lower land value.
The Limitations of County Tax Value
The county's tax assessor also assigns separate values to land and improvements, and while this data is readily available, it is often inaccurate for federal income tax purposes.
- Different Purpose: County tax values are primarily used to assess property tax, not to determine the fair market value (or tax basis) for federal depreciation. The assessment methods and valuation dates used by the county may not align with the property's purchase date or true value.
- Outdated Data: County assessments are often conducted infrequently, and the assessed values may be significantly outdated compared to the current market value at the time of purchase.
The Superior Method: Professional Allocation
To accurately establish the basis of land and the depreciable improvements, investors should use either a qualified appraisal or, more effectively, an engineering-based Cost Segregation study.
A Cost Segregation study performs an engineering analysis to break down the total cost into four categories: land, land improvements, personal property, and the building structure. This process correctly identifies all non-building costs, including land improvements depreciation items like paving, curbing, fences, and sidewalks (which have a 15-year life). By rigorously substantiating the split, Cost Segregation provides an audit-defensible and optimized allocation that maximizes your depreciation for land improvements and the building itself.
