When purchasing a building, an allocation of the purchase price between land and construction must be made. This allowance will be used to determine the annual depreciation expense of the building for tax purposes and financial statements. Although there is no single formula that can be used every time an assignment is made, you must be able to defend the assignment between land and construction in case the assignment is questioned by a tax agency.
- Check the documents closing the purchase of the building and land. The full purchase price must be assigned between the land, construction and closing costs. Closing costs consist of the shares of securities, registration fees and attorney fees associated with the purchase. The closing costs will be capitalized, recorded as an asset in the balance sheet and amortized over the useful life of the property. The portion of the purchase price assigned to the 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.
- Assigns the purchase price between the land and the building based on the fair market values of each component according to the date of purchase. This assignment is subject to professional judgment. A good approximation rule to use when assigning the purchase price between the land and the building is rule 20/80. The building is the largest asset, representing approximately 80% of the purchase price. The land is the smallest asset, representing approximately 20% of the purchase price.
- Determine an allocation ratio by reviewing property tax assessments. Property tax assessments will provide a total assessed value of property, land and building, as well as a value for the building itself and the land itself. Calculate the ratio of the land value to the total property valuation and the proportion of the building value to the total property valuation. For example, if the valuation of the property was US $ 500,000, the land was US $ 100,000 and the building was US $ 400,000, the land would be 20% of the appraised value and the building would be 80%.
- Test the ratio calculated to ensure good judgment. For example, if you bought an apartment building with a yard, the value attributable to the land would be greater than if you purchased a corporate building with parking lots and picnic area. Remember that all buildings are built above ground. Even in the case of a city building without recreational areas or parking, the building rests on land. There must be some portion of the purchase price assigned to the land.