What Is Land Depreciation, and How Can You Take Advantage of it?

Jared Faltys

Financial planning, business tax planning, investment advisory services

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Many small business owners struggle with balancing their books. Yet, from mom and pop stores to the trendiest tech startups, getting the numbers right is what guarantees business survival. The Small Business Agency estimates that about 30 percent of small enterprise failures arise out of cash flow problems. However, with proper accounting practices, it is easy to avoid this pitfall. While it is easy to know your main numbers like sales figures and expenses, getting into details like taxes and depreciation can be more challenging.

One of the visions for many small business owners is to gain complete control of their fixed assets. Undeniably so, they will consume a considerable chunk of the capital investment. With good accounting practice, entrepreneurs can recover the expenses incurred in a few years. For example, provisions on land depreciation can help them improve business cash flows for the short-term.

What Is Depreciation?

Everything that helps you make money in your business is an asset. This can include stocks, inventory, raw materials, computers, printers, trucks, machinery, workstations, land, and buildings. The IRS allows businesses to allocate the depreciation cost over the life expectancy of an asset.

  • Tangible: Physical assets that you can see or touch.
  • Intangible: Assets whose value can only be quantified, like stocks held and goodwill.
  • Movable: Assets you can liquidate for cash in a short period, like your inventory, stocks held, or cash reserves.
  • Immovable: Also called fixed assets, they represent items that you hold on to for the longest time, and you use them for daily operations, like machinery, trucks, and buildings.

At some point, your fixed assets will have outlived their useful life. This point calls for their disposal, where you could sell them off or give them away.

Either way, the value you receive will be much less than your purchase price. Depreciation is the difference between the value at the start and the end of an asset’s useful life and counts as a cost to a business. When making annual accounts, a portion of this cost goes into business expenses and continues throughout the years in use. In doing this, your business enjoys tax savings. It is important to have a good understanding of tax laws and depreciation points of assets when accounting for depreciation.

When Does Land Depreciate?

Land does not have a defined useful life, making it nearly impossible to account for depreciation. Its value may either rise or fall over time, depending on different factors. For instance, a real estate boom can push up land prices, while an environmental catastrophe can decrease values. The assets on land, like buildings, qualify for depreciation.

Even though land cannot be depreciated, some improvements you make have a definite life and will count as depreciation items. Examples of land improvements include paving a driveway, fencing, outdoor lighting, or even filling a wasteland with soil to make it usable.

You may also write down the value when there is evidence of degradation by natural or unnatural causes. For example, an earthquake hits and devastates an area, or mining activity that completely exhausts resources.

What Is the Difference Between Land Improvement and Leasehold Improvement?

Leasehold improvements arise when you make permanent changes to rented property. An example is when you rent a building on a 10-year lease and construct partitions. All improvements will go back to the owner at the expiry of your lease agreement. In practice, the tenant can depreciate the expenses they incur on the improvements over the life of the lease.  

The Depletion Method

Depletion is a depreciation expense charged for the use of natural resources on the land. It is a common accounting practice in the mining industry. Since natural resources have a finite life, the company makes deductions to reflect the reduction of natural resources. The charge will include the costs incurred to acquire the mining resource, the exploratory, and development costs. Once the mining activities end, environmental regulations require the company to undertake restoration. Those costs can also be depreciated.

How to Account for Land Improvements

To properly account for land improvements, a business needs an account entry in the general asset ledger. Any improvements that you make will debit your expense account and credit the land improvements account. The depreciation forms part of the expenses charged on your income tax return, which reduces the company’s income tax liability.

The credit on your general asset ledger raises your balance sheet, which is an indicator of business growth.

Why Would I Want to Account for Land Depreciation?

Although land does not usually depreciate, there are some reasons you should claim depreciation when you can:

  • Depreciation counts as a non-cash expense on your income statement. Since it is tax-deductible, it lowers the amount of tax due on your profits.
  • It allows you to claim depreciation on an older property. A new owner who makes claimable improvements to the property previously owned by someone else can recoup the amounts spent in the long run.
  • As your business grows, it helps to display all the aspects causing the expansion. 

Many businesses have benefited by accounting for land depreciation. The substantial tax savings over the years can help to fuel growth when plowed back into the capital reserves. Being a complex area, it is always advisable to consult an accounting expert. You will also need to have a trusted quantity surveyor to help with the valuations.

Although land depreciation can be an extremely complex area, McMill CPAs & Advisors have the expertise you need to navigate the challenges ahead. We will help you balance your books better as you focus on increasing your business returns. For more information on how to take advantage of land depreciation, contact us today.