How to allocate cost basis when splitting a lot from an investment property

[RaineB]

I bought a house in 2023 that had an extra lot that could be split off and sold separately. Both the extra lot and the lot the house sits on are the same size. 

I sold the extra lot in 2024, after owning it for a year. I hope to sell the house soon. I've never lived in the house.

Say the cost of the entire property was $900,000, and I sold the extra lot for $400,000.  

How do I distribute the cost basis of $900,000 between the house and extra lot? They were previously taxed together, so I don't have separate assessments. I can see two ways:

1. Use the ratio of the sales prices. If I sell the house for, say, $800,000 and I got $400,000 for the extra lot, then I split the $900,000 initial cost at the same ratio: two thirds for the house and a third for the lot. So $600,000 would be the basis in the house and $300,000 would be the basis for the extra lot.

2. Look at how the assessment when I bought the property split the cost of the land and improvements. Say the assessment was $250,000 for the land and $750,000 for the house -- so 25 percent of the total price was for the land. I sold half the land; that would be $125,000 or 12.5 percent of the total assessed value. So I take 12.5 percent of what I paid ($900,000), which is $112,500, and use that as the cost basis for the extra lot.

This is quite a difference -- $300,000 vs $112,500. Is there an accepted way to do this, or is it a situation where you can use any method that you are prepared to justify? If I sell the house this year, is it a moot point, as I could then just add the sales prices together and treat it as a single sale?

Thank you. 

[Loretta P]

Hello RaineB,

You can check with your county tax assessment, many times they will break out the difference between land and buildings.  That ratio or percentage can be used against the original purchase price to determine the amount of all the land involved in the sale.  If the two lots were equal in size, then you would allocate half the land value to the lot with the building and half the land value to the vacant lot.

For example:

If the tax records report of the $900,000 purchase price, $250,000 is for the land and both lots are the same size, then each lot is $125,000 as the cost.  You sold the extra lot for $400,000 so the gain on the sale would be $275,000.  

[RaineB]

I suggested in my initial question exactly what you propose. I included the breakout of the cost of the land and house, as provided by the county assessor, in my first scenario, and divided it by two to get a value of $125,000 for the lot, just as you did. What about the second scenario I asked about? Assessments are always guesses. But if I sell the house this year, I will have real-life data on the relative value of the house and the lot. That's why I asked if that ratio could be used to determine basis. 

I'm also still interested in knowing if I could handle both sales as a single transaction, if the house sells this year, too.

Thanks.

[K M W]

Hi, RaineB!  Let me try to provide some clarity, as I agree the results you show below are vastly different depending on which of the two methods you use to value the house and the extra lot.  The reason the results are vastly different is due to trying to compare apples and oranges, and that essentially either allocation method you chose to use is just that - an allocation method, that can be right or wrong, and can be wrong in an insignificant way or in a significant way.

First, let me give the best technical answer:  The absolute correct response is that, when you purchased the house and the second lot, you should have had an independent appraisal performed to determine the FMV of the lot at that point of time and the FMV of the house and it's lot at that point of time. Then, you would have allocated your original purchase price based on this ratio: i.e. if you paid $900,000 for both lots and house, and the appraisal when you purchased said the standalone lot was worth $400,000 and the house/lot was worth $600,000, you would allocate your $900,000 purchase price as 40% to the lot and 60% to the house/lot.

That would be the answer in a perfect world. The reality is that we don't live in a perfect world, and so we have to figure out the next best way to estimate what the relative values were between the two properties when you purchased them, using the information available now.

So, how should you allocate your original purchase price, if you did not get an appraisal when you purchased the lot? Again, best answer, you should hire an expert now (real estate agent, appraiser, etc) to determine what the relative values would have been back when you purchased.

If you did not have an appraisal performed, you should use a reasonable method to allocate your purchase price. But your question is which method to use, then they give drastically different answers?  And why do they give drastically different answers?

First, let's take the county assessor's numbers.  Do you know for sure how the assessor allocated between house and land?  Does the assessor calculate those numbers based on your specific lots owned, or does the county come up with an overall ratio for houses in the county, and then applies that ratio to all properties?  If the county assessor does not provide the allocation based on  your specific lots, then I would discount the assessor's ratio.  As an example, the ratio in the general area may be a 25%/75% ratio, but what if your lot is the only property that is lakefront, and your actual land may be worth more than other properties in the general area?  If the county assessor's 25%/75% split is NOT based on a review of your specific house and lots, but is rather the "average" of other properties in the area, I would tend to avoid using that assessment.

As for using the sales prices you get this year and applying that ratio to your purchase price - that may work, but also has it's limitations. For example, you may have put substantial improvements into the house since you owned it, so the value of the house may have increased more in proportion to the increase in the value of the land.  Or, vacant land prices may have risen significantly in the time that you have owned the properties, to where now vacant land is worth more than it was when you purchased your property.  

Ultimately, the best source for determining the respective values is to have a valid appraisal performed. Absent that, you can use any reasonable method as a basis for allocating - but you need to make sure that the method you are using is, indeed reasonable. And, know that in any case, using an allocation method can be reviewed  and disallowed by the IRS, so you want to make sure you keep adequate documentation and notes justifying your position. I would recommend you review the methods you propose, and then pick the one that best represents what the ratios would be for your lots and your house.  Honestly, given you purchased the lots and house in 2023 and are selling in 2024, unless you made substantial improvements to one or the other, the relative sales prices in 2024 would seem to be a more supportable position to me.

As for aggregating the two transactions if they both close in the same year, the answer is no, you cannot.  Sales of assets must be reported based on the sales date - so even the sale of two identical assets but a month apart in time must be reported separately.

The next logical question next would be: does it matter on my tax return if they are both sold in this year?  As long as they both meet the same holding period and are both capital gain transactions .i.e .they are both considered short-term capital gains or they are both considered long-term capital gains, and no other special tax rules apply (i.e. like one being a primary home that may meet Section 121 gain exclusion rules), then theoretically it becomes irrelevant, as both generate short-term or both generate long-term gains.  But if the first one sold was held for under a year, and the second one sold was held for over a year, then you will have a different result based on short term and long term capital gains being taxed at different tax rates.

I hope that helped to clarify the situation for you!