One of the biggest tax advantages of owning a rental property is the depreciation you can take on the amount you paid for the property. Of course, the IRS understands that land does not wear out. So, only the portion of the purchase price related to the building and the contents is subject to the allowance for depreciation. This makes determining the building/land split a very important decision. Take for instance a $200,000 home. If you can justify 10% of the value is for land and 90% is for building, you can take a depreciation deduction of at least $6,545 per year. Compare that to the same $200,000 home with a land value of 30% and a building value of 70%. In this case, the depreciation deduction is only going to be $4,580 per year. The result is almost a $2,000 difference in tax deduction per year.

But how do you determine the value of the land and the building? There are a few options available. The first option is to check the county real estate tax bill for the property. Frequently, county assessors print the estimated land value and improvements value on the actual tax bill. These assessed values may be lower than the price of the property at the time of purchase. So, if you use this method, you should take the relative values of the land and the improvements to arrive at the ratio of land value to total value. Then, you can apply that ratio to your purchase price to determine the land value for your tax return.

A second option you can use is comparable sales values based on appraisals for similar properties in the area. You can speak to a real estate agent to find out what appraisers are using for land values in the area.

A third option to determine the split between building and land is to use an industry standard for the area. This standard could be anywhere from 80% building and 20% land in some areas, to 30% building and 70% land in other areas where land is at a premium - many areas in California and Hawaii come to mind. Although it is rare for the IRS to challenge an industry-standard split, in the event of an IRS challenge, you may be forced to go back to one of the first two methods.

We find industry standard splits to be the most common method of allocating the purchase price between land and building simply because they are so easy to apply. With recent escalations in the prices of real estate throughout the country, however, this may be an area the IRS chooses to examine. We recommend that the industry standard be viewed as a last resort and encourage everyone to at least explore the other options simply because they provide good support for the IRS and they may even provide you with a more advantageous allocation.

Be sure to review these options with your tax preparer before they begin preparing your tax return.