We will use the following example to illustrate how to divide the cost of real estate into the cost of the land and the cost of the building. Assume that the entire cost of a real estate purchase is $220,000. The appraisal made at the time of the purchase indicates that the land has a market value of $50,000 and the building has a market value of $200,000...for a total market value of $250,000.
We can use the appraisal amounts for dividing the actual cost of $220,000 into the cost of the land and the cost of the building. There are two related techniques which will have the same results.
- Since the appraisal report indicated that the land's value is $50,000 out of the $250,000 of total appraised value, we can assign 20% (50/250) of the total cost of $220,000 to the land, or $44,000. The building's appraised value is $200,000 out of the $250,000 total appraised value. Therefore we can assign 80% (200/250) of the total cost of $220,000 to the building, or $176,000.
- The real estate's total cost of $220,000 is 88% of the total appraised value of $250,000. We can multiply the land's appraised value of $50,000 times 88% in order to get the cost of the land at $44,000. The building's appraised value of $200,000 times the 88% cost ratio equals the cost of land at $176,000.
A self-check of both calculations indicates the same costs: land at $44,000 plus the building at $176,000 equals the total actual cost of $220,000.
We did not deviate from the cost principle. We merely used the appraised market values as a logical way to divide up the actual cost between the land and building. This assignment or allocation is necessary because the cost of the building used in a business will be depreciated, while the cost of the land is not depreciated.
