by George G. Jones and Mark A. Luscombe
Cost segregation has been a long-used technique to maximize depreciation deductions. Lately, however, more aggressive use of this strategy of dividing one asset into various components, some with short recovery periods, has met with greater resistance from the Internal Revenue Service.
In turn, the IRS has taken a number of steps to put some brakes on this trend. Fortunately, its reaction indicates that cost segregation is here to stay, although certain modifications in its use are advisable if a business taxpayer wants to keep the IRS at bay.
Three recent developments help guide a revision of cost segregation strategies. A new chief counsel’s notice offers a break for past actions while clarifying more stringent obligations going forward. Renewed debate has surfaced over how aggressive cost segregation might foreclose flexibility in the like-kind exchange area. And the IRS’s novel use of industry directives to provide safe-harbor recovery periods promises to make more conservative use of cost segregation virtually audit-proof.
Cost segregation
The identification and separate depreciation of personal property components and land improvements is referred to as “cost segregation” (called component depreciation in pre-ACRS days). Cost segregation generates significant tax savings by reducing the period over which depreciation deductions are claimed.
Cost segregation allows recovery of the personal property elements of a building over a five- or seven-year period (depending upon the taxpayer’s business activity) using the 200 percent declining balance method. The classification of building elements as personal property can also reduce state and local real estate taxes and take advantage of certain sales and use tax exemptions, such as for tangible personal property used in a manufacturing process or for research and development.
Cost segregation is not limited to newly constructed or purchased property. Rev. Proc. 2002-9 allows a taxpayer to reclassify building elements as personal property and claim a deduction for the depreciation that should have been claimed on those elements. For tax years ending on or after Dec. 31, 2001, those retroactive deductions may all be taken in the year of change.
Drawbacks
The reclassification of components as personal property can trigger an alternative minimum tax liability. Personal property with a five- or seven-year recovery period, which is depreciated using the 200 percent declining balance method, is subject to an AMT depreciation adjustment. For AMT purposes, this property must be depreciated using the 150 percent declining balance method. If a taxpayer changes its accounting method to reclassify assets as separately depreciable property, any Code Sec. 481(a) adjustment taken into account for regular tax purposes needs to be recomputed for AMT purposes.
Recapture does not apply to MACRS real property since it is depreciated using the straight-line method. Recapture does apply, however, to MACRS personal property. Under the Code Sec. 1245 recapture rules, the depreciation claimed on personal property components of a building is taxed as ordinary income to the extent of gain allocable from the sale of the building to the personal property (assuming the personal property has not been retired or replaced prior to the sale of the building).
Chief Counsel Notice 2004-7
The IRS recently announced a shift in its litigating position on accounting method changes for depreciable property. For changes for tax years ending before Dec. 30, 2003, the IRS will not assert that a change in computing depreciation for depreciable or amortizable property that is treated as a capital asset is a Code Sec. 446(e) change in accounting method.
For example, if, based on a cost segregation study, a taxpayer this year reclassifies MACRS property placed in service in 2001 from non-residential property to a 15-year property under Code Sec. 168(e), the IRS will not assert that the change in computing depreciation is a change in method of accounting under Code Sec. 446(e).
The IRS’s change in tactics signifies a realization that some courts have adopted contrary positions. In Brookshire Brothers Holding Inc. & Subsidiaries v. Commr., 320 F.3d 507 (2003), the Fifth Circuit found that a change in classification under MACRS is the functional equivalent of a change in useful life and is not a change in method of accounting. The Eighth Circuit concurred in O’Shaughnessy v. Commr., 332 F.3d 1125 (2003).
However, Reg §1.446-1T9(e) (2)(ii)(d), issued on Dec. 30, 2003, changes the equation, since the IRS believes that its regulatory authority now trumps past case law. Going forward, taxpayers should decide how to segregate costs before the property is placed in service, so that the change-in-accounting issue is avoided altogether.
Like-kind exchange problem
An emerging downside to cost segregation studies involves the question of how cost segregation impacts like-kind exchanges. If what is transferred in a like-kind exchange includes property that has been segregated as personal property of a certain class in a cost segregation study, will that personal property qualify for like-kind exchange treatment if there is not property of a similar class being transferred with the property being received in exchange?
Real property may qualify as like-kind to other real property regardless of how dissimilar the properties are as to grade or quality. For example, improved real estate may be exchanged for unimproved real estate. The rules on exchanges of personal property are more stringent. Property is of a like class to other depreciable tangible personal property if the exchanged properties are within either the same general asset class or within the same product class.
Depreciable tangible personal property is classified into one of 13 general asset classes. The classes are listed in the classification system established for determining depreciation deductions for ACRS and MACRS purposes. The general asset classes likely to be involved in cost segregation are: office furniture, fixtures and equipment; information systems; and data-handling equipment. Depreciable personal property that is not classified within any general asset class is classified into one of a series of product classes listed in a four-digit product class within Division D of the Standard Industrial Classification codes, set forth in the SIC Manual.
The question remains, however, whether a taxpayer can segregate “fixtures” for cost segregation depreciation purposes but still have that count as part of the real estate for like-kind exchange purposes. The argument for qualifying for like-kind exchange treatment is that the items become fixtures under state real property law when left behind for the exchange. Whether the IRS will accept that argument remains to be seen.
IRS field directive
The Internal Revenue Service has issued an industry directive to provide guidance on property type and class-life determinations for restaurant assets. The IRS solicited input from IRS examiners, the restaurant industry, and the practitioner community while drafting this industry directive.
Straightaway, the IRS admits that the difference in recovery periods has placed it and taxpayers in adversarial positions in determining whether an asset is Section 1245 or 1250 property. It also concedes that this situation causes an excessive expenditure of examination resources. As a solution, the director for the retailers, food, pharmaceuticals and health care industry chartered a group to find an efficient way to deal with the problem in the restaurant industry. The group has come up with a matrix that, if followed by taxpayers, instructs examiners not to make adjustments to categorization and lives.
Industry directives are not official pronouncements of the law or the IRS’s position, but the IRS suggests that the guidance should reduce the costs and burden for both taxpayers and the IRS, since the directive will help standardize the tax treatments of certain assets. Taxpayers in other industries should consider using this guide to help support certain cost segregation.
One surprise found in the new directive is how electrical light fixtures can be divided. Interior and exterior lighting relating to the operation or maintenance of the building is considered a building component, subject to a 39-year recovery period. However, decorative lighting fixtures that do not provide the only artificial illumination in the building, along walkways or otherwise related to the operation or maintenance of the building, are subject to a low five- year recovery period. With the sudden popularity of architectural lighting and indoor highlighting fixtures, this should be good news for many businesses.
Some other finds: a music or PA system not integral to a fire protection system has a five-year recovery period. Decorative millwork to enhance the overall theme of the business, as well as strippable wallpaper, also carry a five-year life.
Conclusion
The IRS is following a familiar recent pattern in dealing with aggressive tax tactics. It is conceding the gray areas and seeking to clearly define and focus enforcement efforts on what is impermissible.
For cost segregation strategies, this tactic means that the practitioner should become aware of cost segregation options before future assets are placed in service, try to live with segregation options presented by the IRS in field directives and elsewhere, and watch the back door for further developments on how cost segregation meshes with other tax rules, particularly in the like-kind exchange area.
George G. Jones, J.D., LL.M., is the managing editor of Federal and State Tax, and Mark A. Luscombe, J.D., LL.M., CPA, is the principal analyst of Federal and State Tax, at CCH Inc., in Riverwoods, Ill.
