Tax Law and Business Organization Strategy
Tax Court Rejects Cost Segregation Study of Apartment Complex
A new Tax Court case deals with a taxpayer's claims that numerous assets in a rental apartment complex were depreciable as short-lived personal property rather than as residential rental property written off over 27.5 years. Amerisouth, TC Memo 2012-67. The Court disallowed most of the deductions, which were based on an overaggressive cost segregation study.
Residential rental property (a building or structure for which 80% or more of the gross rental income is from dwelling units), is depreciated over 27.5 years via straight line. (Code Sec. 168(c)) Code Sec. 1250 property that is a non-residential building generally is depreciated over a 39-year recovery period using the straight-line method. Under MACRS, taxpayers cannot depreciate a building via component depreciation—that is, for depreciation purposes, they can't break up a building into components and write off each separately. (Code Sec. 168(i)(6)) Some types of land improvements are, however, recoverable over a 15-year MACRS period. Additionally, most types of Code Sec. 1245 property are eligible for fast depreciation (e.g., over 5 or 7 years).
In the depreciation context, there is no stand-alone definition of “personal property.” Instead, the regs say the term is defined the same way as “tangible personal property” is defined under Reg. § 1.48-1(c), which deals with property eligible for the repealed investment tax credit (ITC). (Reg. § 1.1245-3(b)(1))
In recent years, taxpayers have hired firms to conduct what are called cost segregation studies. Capitalizing on some taxpayer-favorable court decisions, these studies make detailed inventories of individual assets in order to distinguish items of short-recovery-period Code Sec. 1245 from long-recovery-period realty (buildings and their structural components). The leading case on the issue is Hospital Corp of America & Subsidiaries, (1997) 109 TC 21, in which the Tax Court held that realty-related property is rapidly depreciable tangible personal property for MACRS purposes (rather than slowly recoverable commercial realty) if it would have been classified by the courts as tangible property for purposes of the repealed investment tax credit (ITC).
Hospital Corp. of America generally stands for the following propositions:
- If property would have qualified as tangible personal property for ITC purposes under pre-'81 case law, it will also qualify as tangible personal property for MACRS purposes.
- The following factors must be tested to determine whether an asset is an inherently permanent structural component or personal property (i.e., section 1245 property): Can the property be 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 removable” and how much damage would it sustain if moved? How is the property affixed to the land?
- An item may be section 1245 property if it does not relate to the operation and maintenance of the building.
The Tax Court concluded that the taxpayer in Hospital Corp. could depreciate over five years that percentage of the electrical systems, measured by electrical load, allocable to hospital equipment as opposed to building operation or maintenance. Also eligible for a quick writeoff were branch electrical wiring, connections, and special electrical equipment relating to special items of hospital equipment, to the extent they furnished electrical power for a function or equipment that did not relate to the operation or maintenance of the building (e.g., branch systems relating to operating rooms, kitchen, computer-room air conditioners). The fact that the equipment was permanently installed did not matter. The Tax Court OK'd quick writeoffs for a wide variety of other assets, such as certain carpeting, vinyl wall coverings, and accordion-style room partitions.
IRS acquiesced in the Hospital Corp. holding that the tests developed under the ITC are applicable in determining whether an asset is a structural component for purposes of ACRS and MACRS depreciation. IRS nonacquiesced, however, to the way in which the Tax Court applied this principle to specific items. (Acq and nonacq 1999-35 IRB 314, as corrected by Ann. 99-116, 1999-52 IRB 763) In recent years, IRS has bought into the concept of clearly documented cost segregation studies to identify section 1245 assets in buildings.
In 2003, AmeriSouth, LLC, bought and renovated a large apartment complex with numerous 2-story apartment buildings, a storehouse for mechanical equipment, and a leased office building. A consultant hired by AmeriSouth did a cost segregation study that broke down the cost of the complex into over 1,000 parts, including items such as sinks, outlets, paint, and electrical wiring connected to garbage disposal units. AmeriSouth claimed depreciation deductions for 2003 through 2005 based on the consultant's recommendations, but IRS denied a substantial portion of the deductions.
The Tax Court was highly critical of AmeriSouth's aggressive application of the cost segregation principle and sided with IRS on most of the contested items. Following is a sample of the numerous items discussed in the case:
- AmeriSouth submitted an exhibit that claimed $65,381 of depreciable basis related to “land improvements for excavating, grading, stone bases and compaction needed to construct sidewalks,” but could provide no allocation to these assets, so its claim was denied.
- AmeriSouth claimed the water distribution system was tangible personal property with a recovery period of 15 years, but the Tax Court said it was clear that the system was an integral part of the building's plumbing and air-conditioning systems and also served the building by providing potable water. As a result, the water system's components had to be depreciated over the life of the apartment buildings.
- AmeriSouth's property had units with washer and dryer connections for tenant use and seven common laundry rooms. The venting connected to clothes dryers in the apartments, and the venting connected to stove hoods in the units, were called “special HVAC” by AmeriSouth and depreciated over a short recovery period (the decision doesn't explain what the claimed recovery period was). The Tax Court held that the clothes-dryer vents serve specific equipment—the dryers. They expelled hot air and carbon monoxide, reduced humidity, extended directly from the dryers to the outside of the building, and had no connection to the apartments' general ventilation system. As a result, the Tax Court agreed the cost allocated to the venting was entitled to a shorter writeoff period than the building. However, the Tax Court was not convinced that the vent hoods above stoves in the units were tangible personal property. Although they served equipment—the kitchen ovens-–the Court was not convinced that they served only the stoves. AmeriSouth did little to rebut IRS's contention that the vents remove both heat and smells that can come from beyond the stovetop, so the Court held that the hoods were structural components of the buildings and had to be depreciated over 27.5 years.
- AmeriSouth argued that its sinks (in apartment units and the office building) were personal property because they were easy to remove, using its 2003 renovation effort as an example. However, the Tax Court pointed out that under the ITC regs (Reg. § 1.48-1(e)(2)), structural components include plumbing fixtures such as sinks and bathtubs, and denied AmeriSouth's claim.
- The Court agreed with IRS that kitchen countertop outlets and the outlets that a treadmill, copier, and cycle might plug into are structural components. The fact alone that a copier, treadmill, toaster, or other item of personal property happens to be plugged into a specific outlet in no way indicated that the outlet is for that specific use rather than the general operation or maintenance of the building. By contrast, the Court found that duplex outlets in rental units that are four feet above the ground in kitchen areas clearly accommodated refrigerators, which are personal property. The same was true for the 220-volt outlets in kitchen areas that were used solely for powering stoves and the outlets in laundry areas for washers and dryers. Thus, the duplex outlets for refrigerators and the 220-volt outlets could be depreciated as personal property.
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