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E-DIRT
Fall 2000
(Volume I, Issue 4)
Newsletter
of the Real Property Probate and Trust Law Section
of the American Bar Association
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to Table of Contents
The Case for Accelerated Depreciation of Building
Components
by William E. Burris*
Thompson Coburn
LLP
One Firstar Plaza
Suite 3500
Saint Louis, Missouri
USA 63101
Telephone: 314-552-6330
Facsimile: 314-552-7330
Email: wburris@thompsoncoburn.com
Generally,
equipment, machinery, and fixtures attached to a building constitute real
property which must be depreciated over the life of the building. As such,
these items are typically depreciated over 39-years on a straight line
method. However, the Tax Court and the Internal Revenue Service ("IRS")
have held that these items may constitute "personal property"
under certain circumstances. As such, these items are eligible for accelerated
depreciation over shorter periods under the Accelerated Cost Recovery
System ("ACRS") or the Modified Accelerated Cost Recovery System
("MACRS") described in Section 168 of the Internal Revenue Code
of 1986, as amended (the "Code") and the regulations thereunder.
As such, taxpayers can achieve results comparable to component depreciation,
which can be financially significant in the real estate context.
Background
Component
depreciation generally refers to the practice of segregating the components
of a building at the time the building is placed in service and separately
depreciating each component for the purpose of obtaining a depreciation
period that is substantially shorter than the depreciation period for
the shell. Component depreciation is not permitted under the Code (Prop.
Regs. Section 1.168-2(e)(1). However, the Tax Court and the IRS have,
in effect, modified this prohibition.
Tax
Court & IRS Developments
Although
component depreciation is specifically disallowed by Code Section 168(i)(6)
and the regulations thereunder, the Tax Court has ruled that items in
a building which qualify as Code Section 1245 tangible personal property
under the investment tax credit ("ITC") rules in effect prior
to 1981, may be separately depreciated under ACRS and MACRS (Hosp.
Corp. of Am. and Subsidiaries v. Comm’r, 109 T.C. 21 (1997), acq.,
AOD 1999-008 (8/30/99). The Tax Court concluded that, though Congress
did prohibit the use of component depreciation in the Code, this was not
intended to automatically transform "Section 1245" personal
property located within a real property structure, into Code Section 1250
real property not permissibly depreciated under ACRS or MACRS.
Briefly,
Section 1245 property includes tangible personal property, which is eligible
under the Code and the regulations for depreciation under the ACRS or
MACRS, while Section 1250 property is real property not so eligible. Essentially,
the Tax Court in Hospital Corp. of America acknowledged that Congress
intended to prohibit ACRS or MACRS depreciation of Section 1250 real property
by prohibiting taxpayer’s from breaking out individual pieces of real
property (component depreciation). However, the Tax Court noted that if
a particular component is Section 1245 tangible personal property in-and-of
itself, Congress did not intend to reclassify the property as Section
1250 real property merely because it was placed in use within a building.
In response
to the Tax Court ruling in Hospital Corp. of America, the IRS issued
an internal legal memorandum (Ltr. Rul. 199921045, April 1, 1999)
advising field agents how to apply the decision. In this memorandum, the
IRS essentially adopted the Tax Court’s test for determining the character
of components for MACRS and ACRS depreciation. Though such a ruling is
not binding on the Service, it is a general indication of how the IRS
will react to future instances of component depreciation by taxpayers.
Following the April 1999 internal memorandum, the IRS publicly announced
its acquiescence in the Tax Court test and acknowledged that the term
"tangible personal property," as defined under a pre-1981 ITC
analysis, continues to be valid under MACRS and ACRS. AOD 1999-008
(8/30/99). The IRS initially acquiesced in result only, but later amended
its decision in Announcement 99-116, 1999-52 I.R.B. 763 to reflect its
unqualified acquiescence regarding the Tax Court test. However, the IRS
did not acquiesce regarding the Tax Court’s characterization of the particular
components analyzed in the case.
What
You Should Know
The IRS memorandum
and Tax Court ruling cite the following six factors as determinative of
whether an item is personal property or part of the building:
- Is the property capable
of being moved, and has it in fact been moved?
- Is the property designed
or constructed to remain permanently in place?
- Are there circumstances
which tend to show the expected or intended length of affixation i.e.,
are there circumstances which show that the property may or will have
to be moved?
- How substantial a job
is removal of the property and how time-consuming is it? Is it readily
movable?
- How much damage will
the property sustain upon its removal?
- What is the manner of
affixation of the property to the land?
The IRS memorandum
notes that "the determination of whether an asset is a structural
component or tangible personal property is a facts and circumstances assessment
. . . no bright line test exists." The Tax Court ruling and the IRS
memorandum specifically note that structural components (as defined by
Reg. §1.48-1(e)(2)) of a building are specifically excluded
from the definition of tangible personal property by the investment tax
credit regulations.
The IRS memorandum
further notes that a taxpayer bears the burden of determining the depreciable
basis of equipment or assets that are considered personal property. Specifically,
the memorandum outlines the following standards for cost segregation studies:
- An accurate cost segregation
study may not be based on non-contemporaneous records, reconstructed
data, or the taxpayer’s estimates or assumptions that have no supporting
records.
- Taxpayers who are constructing
buildings and plan to take advantage of this de facto exception
allowing component depreciation will need to maintain accurate records
(such as architectural and engineering reports) that establish the
items that constitute personal property and that properly allocate
costs to these depreciable items.
The IRS memorandum
also notes, with respect to buildings already in service, that a change
in depreciation periods is a change in method of accounting and requires
IRS consent. Thus, as a practical matter, separate depreciation of personal
property attached to a building will be available only at the time of
construction or acquisition of the building. Though the Tax Court ruling
and IRS memorandum only deal with newly constructed buildings, logic suggests
that separate depreciation of tangible personal property would also be
available upon the acquisition of an existing building, provided the appropriate
cost segregation is properly documented at that time.
The
Impact
The Tax Court
ruling and IRS memorandum may affect any structure containing equipment,
including retail stores, restaurants, hospitals, hotels and manufacturing
plants. For example, under the ruling and the memorandum, the portion
of a building’s electrical system that deals with a function other than
running the building itself (supplying electricity to a manufacturer’s
machines or to a restaurant’s kitchens, for example) can be depreciated
as personal property. In Hospital Corp. of America, the following
installed items also qualified for a five-year write-off:
- Carpeting attached to
the concrete floor with latex adhesive;
- Vinyl wall coverings
on many of the walls;
- The plumbing piping
and steam lines necessary for the proper operation of kitchen equipment;
- Corridor hand rails
that were designed for patient safety – not to protect the walls from
damage; and
- Floor-to-ceiling accordion-style
room dividers.
However,
items such as permanent partitions, floor (or wall) tiles, and acoustical
ceiling systems constitute structural components that are required to
be depreciated over the life of the building. Nonetheless, based on a
review of ITC cases and rulings, the following items are also likely to
qualify, in some instances, for a shorter write-off period, even though
affixed to real property.
- Office equipment;
- Refrigerators and central
refrigeration systems;
- Grocery counters;
- Testing equipment;
- Display racks and shelves;
- Neon and other signs;
- Gasoline pumps;
- Hydraulic lifts;
- Automatic vending machines;
- Movable office partitions;
- Floating boat docks;
and
- Emergency diesel generators
and related electrical, fuel tanks, and exhaust equipment.
Bottom
Line
Based on
the Tax Court ruling and the IRS responses thereto, taxpayers may significantly
improve the tax consequences resulting from some real estate investments
by carefully analyzing the components of any given building. If such an
analysis indicates treatment of components as tangible personal property,
taxpayers should thoroughly document the depreciable basis of the equipment
or assets with a cost segregation study.
*
William E. Burris is an
associate in the St. Louis, Missouri office of Thompson Coburn LLP, where
he practices in the Tax and Corporate Securities Departments. Mr. Burris
is a graduate of Washington University in St. Louis, Missouri, where he
earned a J.D. with honors, M.B.A., and LL.M. (in taxation). For
additional information about Mr. Burris visit the following web site:
http://www.thompsoncoburn.com/AttyResTemp/WEB25331.htm.
The views expressed herein are those of
the author only, and constitute neither the opinion of Thompson Coburn
LLP nor necessarily the position of Thompson Coburn LLP. The options discussed
herein are not appropriate in every situation, as each client’s situation
is unique. The tax analysis presented herein is not intended to be thorough
coverage but merely an attempt to raise some of the issues that apply
in many situations. The reader should not rely on this outline but rather
should do thorough independent research if the reader is a qualified professional,
otherwise the reader should consult a qualified professional.
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E-DIRT
Fall 2000
(Volume 1, Issue 4)
Newsletter of the Real Property Probate and Trust Law Section
of the American Bar Association
Back
to Table of Contents
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