Cost Segregation & Land Costs: Why Site Prep Isn't Depreciable

In the world of real estate tax planning, cost segregation can be a powerful tool to accelerate depreciation deductions and reduce taxable income. However, not all property-related costs qualify for depreciation. A recent federal court ruling covered in Tax Notes reaffirmed a long-standing principle in tax law: land preparation costs, such as leveling a mountain, must be capitalized into the land basis and are not depreciable.

Core Highlights

• Expenses like grading, leveling and clearing land must be capitalized into the land’s basis under IRC §263 and are not eligible for depreciation since land has an indefinite useful life.
• Tax courts have repeatedly ruled that land preparation costs benefit the land itself, not any future depreciable structures, reinforcing the importance of properly classifying these costs.
• A detailed cost segregation study should separate non-depreciable land preparation costs from depreciable property improvements to maximize tax savings and ensure compliance with tax law.

Table of Content

• Core Highlights
• The General Rule: Land Is Not Depreciable
• Common Examples of Non-Depreciable Land Costs
• Why Courts Disallow Depreciation on Land Preparation
• Implications for Cost Segregation Studies
• Conclusion

The General Rule: Land Is Not Depreciable

Under the Internal Revenue Code (IRC) §263, expenditures that improve the value of land or prepare it for its intended use must generally be capitalized, not expensed or depreciated. Land, unlike buildings or equipment, is considered to have an indefinite useful life. Therefore, its cost including costs to prepare it for development is not subject to depreciation.

Common Examples of Non-Depreciable Land Costs

It is essential for real estate professionals to distinguish between depreciable improvements and non-depreciable land preparation. Here are some common examples of costs that must be capitalized into the land's basis:

• Clearing and Grubbing: The removal of trees, brush, and other natural obstacles.
• Excavation and Leveling: This includes significant earth-moving activities, even on a massive scale like removing a portion of a mountain to create a flat building pad.
• Filling and Grading: The process of adding or moving soil to create a stable and level surface.
• Demolition of Existing Structures: In many instances, the cost to remove old buildings to make way for new development is considered a land preparation cost.
• Environmental Remediation: The expense of cleaning up contaminated land to make it suitable for use.

Why Courts Disallow Depreciation on Land Preparation

In tax disputes, courts typically apply the principle that land preparation activities are for the benefit of the land itself, not for any depreciable structure that will eventually be built. The courts focus on the nature of the expenditure, not the taxpayer's intent to construct depreciable assets later.

The recent court case illustrates this principle. The taxpayer attempted to depreciate the costs of leveling mountainous terrain in preparation for construction. The court ruled that these costs improved the underlying land, not the future buildings or equipment. As a result, the costs had to be capitalized into the land basis making them non-depreciable.

This aligns with past rulings, such as:

• Mount Morris Drive-in Theatre Co. v. Commissioner, where grading costs were part of the land’s cost.
• IRS regulations and rulings, which consistently treat site preparation as a land cost unless it directly relates to installing a depreciable asset.

Implications for Cost Segregation Studies

When performing a cost segregation study, distinguishing between depreciable property (such as buildings, parking lots, and fencing) and non-depreciable land is critical.

• Depreciable items: Building structures, site utilities, paving, signage, and other assets with determinable useful lives.
• Non-depreciable land preparation: Leveling, grading, or excavation needed to make the land suitable for any use.

A well-conducted cost segregation study will exclude land preparation costs from the depreciable basis and allocate them to the land account. This ensures compliance with tax law and reduces the risk of audit adjustments.

Conclusion

If you’re improving raw land whether it’s filling a swamp, clearing trees, or even leveling a mountain the IRS and the courts view those costs as part of the land's permanent value. They cannot be depreciated, even if they are necessary to make the land usable for business. Builders, investors, and tax professionals should account for these rules when budgeting for depreciation deductions.