When a building is purchased, an allocation of the purchase price between the land and building must be made. This allocation will be used to determine annual depreciation expense for the building for tax and financial statement purposes. While there is no single formula that can be used every time an allocation is made, you must be able to defend the allocation between land value vs. building value in the event the allocation is challenged by a tax agency.
While there are various methods for separating out the land value from the building value, a good rule of thumb is to allocate 20% of the purchase price to the land.
Review the closing documents from the purchase of the building and land. The entire purchase price must be allocated between land, building and closing costs. Closing costs consist of title fees, recording fees and attorney fees associated with the purchase. Closing costs will be capitalized, recorded as an asset on the balance sheet and amortized over the property's useful life.
The portion of the purchase price allocated to land will not be depreciated. The portion of the purchase price allocated to the building will be depreciated over a useful life of 39 years.
Allocate the purchase price between the land and the building based on the fair market values of each component as of the date of purchase. This allocation is subject to professional judgment.
When accounting for a land and building purchase, a good rule of thumb to use is the 20/80 rule. The building is the major asset, representing approximately 80% of the purchase price. The land is the minor asset, representing approximately 20% of the purchase price.
You may also consider hiring a professional appraiser to ascertain the value of the land and building. A professional appraisal will stand up to any challenges you may face from tax agencies regarding the allocation between depreciable and nondepreciable assets.
Determine an allocation ratio by reviewing property tax assessments. Property tax assessments will provide a total assessed value of the property, land and building, as well as a value for the building alone and the land alone.
Calculate the ratio of the land’s value to the total property assessment and the ratio of the building’s value to the total property assessment. For example, if the property assessment was $500,000, the land was $100,000 and the building was $400,000, the land would be 20% of the assessed value and the building would be 80% of the assessed value.
Test the ratio calculated for reasonableness. For example, if you purchased an apartment building with a courtyard, the value attributable to the land would be greater than if you purchased a corporate building with parking lots and a picnic area.
Remember that all buildings are constructed on top of land. Even in the case of a city building with no recreation or parking areas, the building rests on top of the land. There must be some portion of the purchase price allocated to the land.