Real property purchased by a business may have two components: land and buildings. For purchasers that are not in the business of actively purchasing or investing in real property as their primary function, these two components receive very different accounting treatment so the costs of each must be separately identified. Separating these is necessary for both tax and financial purposes so it is important the valuation of each piece is accurate. From an accounting perspective the most notable difference between the treatments of each of these two components is depreciation. Land is not depreciated, buildings and structures are.
While not all real property comes with parking lots, green space, or other open land areas, all structures are built on land. The value of the land itself is included in the value of the entire property. In the absence of buildings or structures, the land would still have value and is considered to have an unlimited useful life. For this reason the cost of the land associated with the purchase of a property is not depreciated and therefore will not affect a company’s profit or loss until it is sold, at which time a gain or loss will be recognized.
Buildings and structures, on the other hand, should be depreciated. Unlike land, buildings have finite lives. They are typically depreciated over 30 to 40 years for financial purposes, depending on the condition, use and company’s policy. For tax purposes, a building is depreciated over 39 years. Significant building improvements may enhance a property’s value as a whole, but should be allocated to the depreciable building portion. If those improvements extend the useful life of the building, the depreciable period may be adjusted.
The allocation of a property’s purchase price between land and building is different from one type of property to another. In the absence of specific valuations, a general rule of thumb for real property is 80% to buildings and 20% to land. However, every commercial property is likely to be unique. A good method of determining the split between land and buildings is to review public records, especially county property tax assessment records. Although the assessed value is not necessarily the same as the purchase price of the property, the assessment’s allocation of value between land and structures can be applied on a pro rata basis to the purchase price. For example, if a property’s total appraised value on the county assessment records is $750,000, and is split $150,000 to land and $600,000 to building, the cost split should be 20/80. If that same property is purchased by a business for $900,000, the purchase price would be allocated as $180,000 to land (20%) and $720,000 to buildings (80%).
For most businesses the proper treatment of land and buildings has significant implications on the company’s value, profitability, and potentially its tax liability. Contact the managerial accounting professionals at TGG Accounting for additional information and more ideas on how to improve your company’s bottom line.Written by: Ashley Peth TGG Accounting