Tag Archives: Cost Segregation

Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

Taxpayers often own a property that they would like to trade for another, but they do not want to be taxed on the exchange. Fortunately, only three years after Congress enacted the first modern income tax law, Congress added a provision that allowed taxpayers to defer gain recognition on the exchange of properties.  These enormously complex §1031 rules can be distilled into one simple rule: Taxpayers can defer the recognition of gain (paying taxes) on the simultaneous or delayed exchange of one property for another.

This simple rule obscures the complexity of this law. To qualify for deferring gain recognition, the exchange must be of properties held for productive use in a trade or business or for investment. The property cannot be held for personal use. Further, stocks, bonds, inventory, and certain other properties do not qualify. The §1031 exchanged properties must be “like kind”, which means of the same nature or character even though they may differ in quality. Domestic and foreign properties are not like-kind. Though real estate is generally like kind to other real estate, even if one is improved and the other unimproved, personal property has an additional requirement to be of like class. Even when properties are like kind, there are additional hurdles before an exchange will qualify for gain deferral.

These additional hurdles include significant timing rules and rules related to taking cash out of the transaction. Originally, like kind exchanges had to be simultaneous. For example, a farmer might want to swap one pasture for one owned by an adjacent farmer. In the seminal Starker decision, the Ninth Circuit Court of Appeals expanded the concept to deferred exchanges. In a deferred exchange, a taxpayer can sell a property, deposit the proceeds with a qualified intermediary, and identify a replacement property within 45 days that is then acquired within 180 days. This concept was further enlarged to include a reverse like-kind exchange where the replacement property is acquired before the original property is sold, and a build-to-suit like kind exchange where the replacement property is improved and the improvements count as part of the replacement. Even with these substantially liberalized rules, taxpayers can still recognize gain in an exchange.

Recognizing gain on an exchange is called receiving boot. “Boot” is cash received in the exchange, which is taxed at normal capital gains rates. “Boot” also includes situations where the liabilities assumed by the buyer exceed those of the seller. If a taxpayer continually trades up, that is, acquires property worth more than the relinquished property, he or she can generally avoid boot.

§1031 like kind exchanges, though complicated, are an effective strategy to defer the recognition of gain from selling properties. They require that the taxpayer remain invested in like kind property, but otherwise permit flexibility in changing asset types, (e.g. residential real estate to commercial real estate).

Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

Though cost segregation is a very popular tax savings strategy, some aspects are seldom encountered in practice. One rarely encountered situation is the proper reclassification of what looks like a building to tangible personal property. From a tax perspective, reclassifying an apparent building to short-life tangible personal property has substantial, immediate cash tax benefits. These opportunities are most commonly found at heavy manufacturing facilities and typically depend on a building-like structure functioning as large piece of machinery or equipment.

Most manufacturing industries are assigned a seven-year tax recovery period for their tangible personal property. For each million dollars of basis, reclassifying a structure from 39-year nonresidential real estate to seven-year tangible personal property results in additional first-year tax deductions of approximately $550,000 after taking into account 50% bonus depreciation and the much shorter recovery period. Assuming a 40% tax rate, this means first year cash savings of approximately $220,000. To understand how it is possible to reclassify an entire “building” to tangible personal property, an understanding of the former Investment Tax Credit is necessary.

The former Investment Tax Credit (“ITC”) was a tax credit for the construction or acquisition of most tangible personal property and certain other tangible property, not including buildings and their structural components, used as an integral part of certain industries, such as manufacturing. (The former ITC rules still govern MACRS property classifications to a large extent.) The meaning of the former ITC regulations and rules were very frequently litigated. Over the course of many years, the courts developed many tests to determine whether a structure was a building, other tangible property, or tangible personal property.

The two primary tests to identify a building were: 1) the appearance test and, 2) the function test. In practice, the courts primarily looked to the function test. This test looked to whether human activity in a structure was minimal or incidental to the functioning of the structure as part of the manufacturing process. For example, an automated, deep freeze storage warehouse may have minimal human activity relative to the primary function of freezing food products. In such cases, human activity may be limited to only routine maintenance. In the manufacturing context, the Tax Court expanded this logic to facilities such as heavy craneway structures in the Lukens case in 1987.

In Lukens, the Tax Court held that a steel foundry’s craneway structures were essentially an item of machinery or equipment. A craneway structure consists of elevated rails along which a crane moves. The cranes transport heavy materials through a production process. In Lukens, the craneways had roof coverings and siding that functioned as walls for the cranes. The structures had no offices, restrooms, heating or air conditioning for employee comfort. The structures were designed to support the cranes as well as the rudimentary roof. Another way of looking at Lukens is that the structure of the crane also, incidentally, supported the roof and siding and that the roof and siding were necessary to protect the cranes and only incidentally protected the workers. Since all human activity was incidental to the production process and the structures functioned as a giant piece of machinery, the Tax Court held that they were not buildings, but rather tangible personal property. This was so even though they looked like buildings with roofs and some walls.

The facts and circumstances for applying Lukens are very specific and may easily be misinterpreted. Certain types of structures, such as parking garages, are specifically defined as buildings though some taxpayers have unsuccessfully attempted to argue otherwise. If you or your clients have heavy manufacturing facilities or automated facilities with minimal worker accommodations, please contact us to discuss a cost segregation study to determine whether the entire facility qualifies as short-life property.

Full Lukens Case Document

For more than 30 years, SourceHOV | Tax has helped companies properly identify and sustain tax incentive strategies including R&D tax credits, cost segregation studies, 179D tax deductions and LIFO inventory accounting.  For more information, please call 800.806.7626 or visit www.sourcehovtax.com.

Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

Over the last two years, the new temporary and proposed reliance tangible property capitalization regulations have brought to light previously overlooked tax compliance opportunities. One of the more well-publicized opportunities involves permitting taxpayers to write off the remaining adjusted basis of retired building structural components. This new opportunity has a significant exception: Taxpayers cannot take a loss on the demolition of an entire building.

Historically, taxpayers were permitted to take a loss on the demolition of a building as long as they did not intend to demolish it upon purchase. If a taxpayer intended to demolish a newly acquired building, the taxpayer had to capitalize any basis allocable to the building to a non-depreciable land account. This harsh result led to frequent litigation between the Service and taxpayers. After decades of disputes, Congress enacted Code section 280B in 1984 to settle this area of contention. This Code section requires taxpayers to capitalize to non-depreciable land accounts the remaining adjusted basis of a demolished building plus the costs of demolition. Code section 280B itself has no exceptions for when or how the building was acquired or why it was demolished.

For many years afterwards, section 280B remained on the books with little explanation. In 1994, the Tax Court held in De Cou v. Comm’r, 103 T.C. 80 that a taxpayer could take a loss on a building abandoned due to unforeseen and extraordinary obsolescence even though it was later demolished. This permitted some taxpayers to take a loss on a building. In 1995, the Service provided a safe harbor in Revenue Procedure 95-27 for section 280B: a refurbished building will not be considered demolished as long as both: 1) 75 percent or more of the existing external walls are retained as internal or external walls, and 2) 75 percent of more of the existing internal structural framework is retained in place. Without looking at other statutory provisions, this safe harbor allowed taxpayers to demolish significant portions of a building, recognize a loss, and not capitalize those portions’ adjusted bases and demolition costs to land.

Even though the section 280B safe harbor did not prevent taxpayers from writing off retired structural components, for many years the Service took the position that retired structural components could not be written off under the MACRS rule that prohibits the component depreciation of buildings. When Treasury released temporary regulations on the disposition of tangible assets, this long-standing policy was reversed. According to the temporary and proposed reliance regulations, with proper substantiation and making the proper elections, taxpayers can now write off the adjusted bases of retired building structural components unless section 280B applies.

Based on the safe harbor of Revenue Procedure 95-27, taxpayers can write off the adjusted bases and demolition costs of retired structural components as long as the two safe harbor requirements are met. Tax practitioners should consider this major limitation of the new disposition regulations when advising their clients of the tax consequences of substantially renovating a newly acquired building.

Attempt to Subdivide Component Assets Identified by Cost Segregation Study Deemed “Immaterial”

A number of our clients have expressed concern about a recent tax court case where the court disallowed reclassification of assets identified by a cost segregation study. After careful review, we concluded that the decision is a narrow one and will likely not apply beyond the facts in this case. We believe that the decision will not readily apply to all purchase price allocations.

In Peco Foods, Inc. & Subsidiaries, Petitioner v. Commissioner of Internal Revenue, Respondent ( T.C. Memo 2012-18) the tax court upheld the decision of the Internal Revenue Service precluding Peco Foods from modifying purchase price allocations of two processing plants it purchased in 1995 and 1998. The court upheld the terms of the respective asset purchase agreements, which the buyer and seller had agreed to at the time of the purchases.

The purchase agreements contained provisions in both allocation schedules stating that “the parties would use these values for all purposes including tax and financial reporting,” making the contracts binding unless Peco could prove they were unenforceable. The court determined that Peco’s decision to allocate the purchase price among machinery, equipment, and furniture showed that it was aware of the specific component assets but chose not to allocate additional purchase price to those assets. Therefore the court determined that Peco intended the asset described as “Processing Plant Building” to be treated as a single asset.

The court also found that Peco believed the term “Processing Plant Building” was ambiguous only after it perceived a benefit could be realized by subdividing the building into component assets. Therefore, the court ruled that there was no ambiguity in the term.

Peco agreed to allocate the purchase price of the plant among three assets: Real Property: Land, Real Property: Improvements,” and “Machinery, Equipment, Furnitures and Fixtures.”

The court determined that the decision to allocate the purchase price separately among these various assets showed that Peco was aware of the existence of subcomponent assets but chose not to allocate additional purchase price to them. The court also determined that had Peco intended to allocate purchase price to subcomponent assets, it would have done so by allocating additional purchase price to the asset described as “Machinery, Equipment, Furnitures and Fixtures.”

In addition, the appraisal for the second plant was dated prior to the date on which Peco entered into the agreement, suggesting that Peco could have adopted a more detailed allocation schedule into the agreement but chose not to.

The second agreement contained a merger clause providing that the contract, accompanying exhibits, and closing documents “constitute the entire agreement between the Parties.” The court determined that this clause creates a presumption that the writing represents a “final and complete agreement of the parties.”

The court never reached the issue of cost segregation when it ruled that the agreements were not ambiguous and that whether the acquired assets may be subdivided into component assets was immaterial because Peco may not deviate from its characterization of those assets as stated in the original allocation schedules.

Because Peco Foods attached a statement to Form 8594 allocating specific amounts of the Purchase Price to Processing Plant Buildings and Real Property Improvements, they cast the allocations in stone. The tax court found that the agreements were enforceable, the terms were unambiguous, and all relevant assets were covered. Peco claimed that it could reallocate the useful lives of assets under Code Sec. 338(b)(5), the “residual method,” which applies when the parties do not agree in writing as to the allocation of any part of the consideration. However, since all assets were covered by the agreements, and the agreements were enforceable, the residual method did not apply.

Because the original documents went into the level of detail of identification they are bound to stay within those allocations. In our experience, agreements containing such specificity are rare. Therefore, we don’t expect any significant impact from this ruling nor do we anticipate an appeal.

From Federal Tax Updates Checkpoint Newsstand May 31, 2011

Businesses that trade in machinery or equipment for which they claimed bonus depreciation under Code Sec. 168(k) may qualify for another bonus depreciation deduction on the remaining depreciable basis if they swap for like-kind property that also is eligible under Code Sec. 168(k). In effect, the business gets two bonus depreciation deductions for its expenditure on the traded-in property. What’s more, this result is explicitly OK’d by the regs.

Background. Bonus first-year depreciation deductions are available for a property if: (1) it is property to which the modified accelerated cost recovery system (MACRS) rules apply with a recovery period of 20 years or less, computer software other than computer software covered by Code Sec. 197, qualified leasehold improvement property, or certain water utility property); (2) its original use commences with the taxpayer; and (3) it is timely bought and placed in service by the taxpayer.

The bonus first-year depreciation allowance is:

• 50% of the cost of qualified property acquired and placed in service after Dec. 31, 2007, and before Sept. 9, 2010;
• 100% of the cost of qualified property acquired and placed in service after Sept. 8, 2010 and before Jan. 1, 2012 (before Jan. 1, 2013 for certain longer-lived and transportation property); and
• 50% of the cost of qualified property acquired and placed in service after Dec. 31, 2011 and before Jan. 1, 2013 (after Dec. 31, 2012 and before Jan. 1, 2014 for certain longer-lived and transportation property). (Code Sec. 168(k)(2), Code Sec. 168(k)(5))

Note that 50% bonus depreciation also applied for certain qualified property acquired after May 5, 2003 and before Jan. 1, 2005, and 30% bonus depreciation applied for certain qualified property acquired after Sept. 10, 2001, and before May 6, 2003.

MACRS property may be acquired (1) in exchange for MACRS property in a Code Sec. 1031 like-kind property exchange, or (2) to replace involuntarily converted MACRS property in a Code Sec. 1033 involuntary conversion. (Reg. § 1.168(i)-6(c)(1)) The replacement property is for depreciation purposes divided into the depreciable exchanged basis (i.e., remaining basis of the relinquished property carried over to the replacement property), and the depreciable excess basis (i.e., additional consideration to acquire the replacement property). Where the properties share the same recovery class and depreciation method, the depreciable exchanged basis is written off over what’s left of the relinquished property’s recovery period; and the depreciable excess basis is in effect treated as a separate property with a recovery period that begins anew. (Reg. § 1.168(i)-6(c)(3)(ii))

Double helping on bonus depreciation. When otherwise eligible MACRS property or computer software is acquired via a Code Sec. 1031 like-kind exchange or as a result of a Code Sec. 1033 involuntary conversion, both the carryover basis and the excess basis, if any, of the acquired property are eligible for bonus depreciation. (Reg. § 1.168(k)-1(f)(5)(iii)(A)) What’s more, it doesn’t matter if bonus depreciation was claimed on the old property. (Reg. § 1.168(k)-1(f)(5)(vi), Ex. 3)

RIA illustration: In January of 2010, ABX Corp. bought a new refrigerator truck (5-year MACRS property) for $100,000 and placed it in service that year. In 2011, ABX acquires another new, higher-capacity refrigerator truck in exchange for the truck bought in 2010 by trading in that truck and paying $50,000 cash. ABX uses the optional rate tables to compute depreciation and is subject to the half-year convention in 2010 and 2011.

For 2010, ABX claimed 50% bonus first-year depreciation for the truck bought and placed in service that year. As a result, its 2010 depreciation deduction for the truck was $50,000 of bonus depreciation (.50 × $100,000) plus $10,000 of regular first-year depreciation allowance (.20 recovery year one table percentage for 5-year property × [$100,000 − $50,000 bonus depreciation]), for a total of $60,000.

For 2011, ABX claims an $8,000 depreciation deduction (.32 recovery year two table percentage for 5-year property × [$100,000 − $50,000 bonus depreciation] × 6/12 [half-year convention applies]) for the relinquished truck.

ABX may claim a 100% bonus first-year depreciation deduction for the $32,000 remaining depreciable basis of the relinquished truck, i.e., the depreciable exchanged basis ($100,000 cost − $60,000 − $8,000). ABX also may claim a 100% bonus first-year depreciation deduction for the $50,000 in cash that it pays to acquire the upgraded refrigerator truck.

RIA observation: In essence, for bonus depreciation purposes, the regs treat a taxpayer like ABX as if it had sold the old truck for its remaining depreciable basis and then used the proceeds, along with additional cash, to purchase a new one.

RIA caution: This won’t work if the older-model truck was acquired in January of this year and the newer model in December. Under Reg. § 1.168(k)-1(f)(5)(iii)(B), bonus depreciation isn’t allowable for the exchanged (or involuntarily converted) MACRS property if the exchanged (or involuntarily converted property) is placed in service and disposed of in a like-kind exchange or involuntary conversion in the same tax year.

If you plan to expand your business, 2011 is a great time to invest in new equipment or building assets and benefit from newly expanded tax incentives. In his state of the union speech, President Obama highlighted the recently passed Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 signed into law December 17, 2010. As he said “Thanks to the tax cuts we passed, Americans’ paychecks are a little bigger today. Every business can write off the full cost of new investments they make this year.”

For businesses with projects that qualify for tax incentives such as cost segregation, the benefits for 2011 will be substantial. A taxpayer must meet specific requirements to utilize this tax deduction. Qualifying property generally includes: depreciable property with a recovery period of 20 years or less; water utility property; computer software; and qualified leasehold improvements. A cost segregation analysis is a method of identifying the maximum amount of qualifying property (property with a recovery period of 20 years or less) and separating those costs from the real property assets associated with a new building or expansion project.

Also, included in the tax relief act is a two-year extension of the 50 percent, first-year additional bonus depreciation allowance which applies to qualifying property acquired by a taxpayer from January 1, 2008 through December 31, 2012, and placed in service before January 1, 2013. The bonus depreciation rate increases from 50 percent to 100 percent in the case of qualifying property acquired after September 8, 2010, but before January 1, 2012, and placed in service before January 1, 2012.

When I first began working in the area of cost segregation, people would ask, “What do you do for a living?” I would respond, “I explain to people what I do for a living, because no one has ever heard of it.” At the time only the large accounting firms provided this service.

Over the past decade, however, the cost segregation market has spread to small and medium sized investors and businesses. Despite the rapid growth of service providers nationwide, there are still underserved businesses and markets.

Building owners who acquired or built commercial buildings in prior years are often overlooked. There is a common misconception that only new construction qualifies for the benefit of cost segregation. However, anytime a building is built or changes hands, depreciation starts over, and a study can be performed. Cost segregation front-end loads that depreciation, so the owner recoups money faster.

When looking at buildings placed in service in prior years, the missed depreciation gets caught up on the tax return in the year of the study via a change in method of accounting (Form 3115) and a §481(a) adjustment.

For example, if you purchased a building in 2000 for $5 million and put it on the books as 39-year property, the straight-line depreciation would yield an annual deduction of $128,000. Through a cost segregation study, we reclassify 12% in 5-year and 8% in 15-year property. Because of the §481(a) adjustment, the additional current year deduction (above and beyond the depreciation already taken) would be $624,500, which would result in a current year cash flow increase of $218,575. The net present value over the entire tax life of the building is $149,110.

Due to the Tax Reform Act of 1986, we can conduct a cost segregation study for any commercial or rental building, constructed or acquired, since January 1, 1987. Ideal properties are those built or acquired in the last 15 years, but many good opportunities exist back to 1987.

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