Calculating the cost basis of a new rental property

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I am trying to determine the correct way to calculate the basis of a new rental property; specifically, the amount to depreciate. Although there are many (and sometimes varying) descriptions of how to do this online, words can be vague and I would love to have a simple formula. It’s no help here that I am a programmer and that's how my mind works. TurboTax of course does the calculation, but it does not seem intuitive to me.

Here is a very simple scenario. A property costs $100K, that total being 40% land and 60% building. Closing costs are $1k. Prior to being placed in service, $10K improvements are made to the building. Assume these values are assigned correctly.

TT calculates the basis as (property + closing + improvements) x building percent of total = (100K + 1k + 10K) x 60% = $66.6K.

To me the more logical answer would be building + closing + improvements = 100K*60% + 1K + 10K = $71K. This is because the improvements are only to the building, not the land, so it does not make sense the value of the land should affect them.

I’m no accountant and I completely realize that the tax code may not be logical and that I am wrong. Can somebody please confirm that TT is doing it correctly? Can anyone supply a reliable reference with a formula, ideally from an IRS publication, or at least an IRS publication with a detailed description?

Thank you in advance for your time and attention.

[KrisD15 · Accepted solution]

I would add the closing cost to the basis of both land and building. You would have paid closing costs if you were just buying the lot.

The program does not know what the improvements were, they could have been made to the lot and/or building.

If the work was only made to the building, I would increase the basis for the building only.  

Land 60,400

Building 70,600

Land is never depreciated and depreciation on the rental will most likely need to be recaptured when you sell. 

According to the IRS:

"Separating cost of land and buildings.

If you buy buildings and your cost includes the cost of the land on which they stand, you must divide the cost between the land and the buildings to figure the basis for depreciation of the buildings. The part of the cost that you allocate to each asset is the ratio of the fair market value of that asset to the fair market value of the whole property at the time you buy it.

If you aren’t certain of the fair market values of the land and the buildings, you can divide the cost between them based on their assessed values for real estate tax purposes."

"Additions or improvements.

Add to the basis of your property the amount an addition or improvement actually costs you, including any amount you borrowed to make the addition or improvement. This includes all direct costs, such as material and labor, but doesn’t include your own labor. It also includes all expenses related to the addition or improvement."

Pub 527

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@KrisD15 's methodology makes perfect sense & I completely agree with it. Thank you.

A warning to those who may be viewing this post - TurboTax seems to do it differently.

Although I would love to have a formula to use (to put into a spreadsheet) it dawned on me that such a formula probably doesn't exist, and that all the IRS provides is explanatory text. But, a specific formula may not be necessary anyway if all one needs is a reasonable method to demonstrate in the case of an audit.