When Is A Building Not a Building

After Hospital Corp. of America, 109 TC 21 (1997), tax practitioners have been looking for ways to reclassify building components as assets with much shorter useful lives than the building itself. Generally, they try to classify nonstructural components of the building as either tangible personal property or other tangible property that is an integral part of the manufacturing or production process. In many cases, the line between asset classes is not clear. The majority of the case law on classifying assets involves an investment tax credit (ITC). If an asset was classified as tangible personal property or other tangible property, it would have been eligible for the credit. Today, the ITC is gone, but the case law is the best guidance for classifying assets into their respective class lives for depreciation purposes.

"Freezer" Burn

In Munford, Inc., 849 F2d 1398 (11th Cir. 1988), Munford was in the business of distributing frozen foods. Munford constructed an addition to its building that would store frozen foods and maintain the inside temperature at or below freezing. When Munford filed its Federal return, it claimed an ITC on the full cost of constructing the addition. It argued that the addition was essentially a giant freezer, and was therefore "property in the nature of machinery." Also, Munford depreciated the remaining basis over an eight-year life (which was acceptable at that time for tangible personal property). The IRS took one look at the addition and denied the ITC, asserting that the addition had to be a building. The Service allowed Munford to take the ITC only for the actual refrigeration units and related equipment.

For property to qualify for the ITC, it must qualify as "Sec. 38 property," defined in Sec. 48(a)(1) as:

1. Tangible personal property or

2. Other tangible property (not including a building or its structural components), but only if such property "is used as an integral part of manufacturing, production, or extraction, or of furnishing transportation, communications, electrical energy, gas, water, or sewage disposal services."

The regulations under Sec. 48 further define tangible personal property to include "all property which is in the nature of machinery (other than structural components of a building or other inheritantly permanent structure)."

To solve the dispute, the Tax Court had to decide first if the addition was a building. Buildings and their structural components are defined in Regs. Sec. 1.48-1(e)(1) as "any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space." The examples also include warehouses in the definition of building. The courts have interpreted the regulation as establishing a two-part test, considering both appearance and function to determine if a structure is a building.

The court looked at the photographs of the addition and agreed with the IRS that it looked like a building. However, it felt that the function test was a more important consideration. The court concluded:

[t]he principal purpose or function of the refrigerated area is not to furnish working space for petitioner's employees, but rather to provide an area in which frozen foods may be stored at low temperatures...the refrigerated area of the Addition is maintained at a temperature which limits, rather than promotes, human activity. Due to the cold temperature, the activities of petitioner's employees are limited in both scope and duration...the structure itself serves the principal function of low temperature storage of products, and the activities of petitioner's employees are merely supportive of and ancillary to this function. Accordingly, we conclude that the refrigerated portion of the addition is not a building under the functional test.

Although the court agreed with the Service that the addition served as a warehouse, it decided that the refrigeration element distinguished the addition from "a conventional building used for general storage purposes." The specialized refrigeration feature caused it not to be classified as a building.

What Is It (for Depreciation Purposes)?

The Tax Court then went on to rule that the addition did not qualify as tangible personal property or other tangible property. Munford was not eligible to use the eight-year life it had originally used. The court's ruling was upheld on appeal. However, for depreciation class-life purposes, if it is not a building and is not personal property, then what is it? While the court in Munford was not concerned with this question, it is reasonable to conclude that the addition would be considered a land improvement, reducing the depreciable life of the addition from 39 years to 15.

Conclusion

In the years after the ITC, the major advantage in creatively classifying depreciable assets is in reducing the asset's depreciation period. Classifying an asset as a land improvement rather than as a building will have a tremendous impact on a taxpayer's tax liability. In most situations, taking a second look at asset classification pays when a client is purchasing or has recently purchased something that looks like a building.

From Henry F. Gingerich, CPA, MT, Cohen & Company Ltd., Cleveland, OH