Time to Revisit HCA

It has been over four years since the controversial Tax Court decision in Hospital Corporation of America, 109 TC 21 (1997) (HCA), in which the taxpayer successfully argued that certain items included in a hospital building should be depreciated as personal property.

Cost Segregation

In the pre-accelerated cost recovery system (ACRS) days, the Service allowed component depreciation, which was the practice of segregating the components of a building and depreciating the various components over a life shorter than the life for the shell. ACRS and the modified ACRS (MACRS) do not permit component depreciation; however, there is still a distinction between real property and personal property. The purpose of a cost-segregation study is to identify and classify personal property, thus taking advantage of its shorter depreciable life. The key to the cost segregation is determining what is real property and what is personal property. In HCA, the courts held (and the IRS acquiesced) that items in a building that qualify as tangible personal property under the investment tax credit (ITC) rules in effect prior to 1981 may be separately depreciated as personal property; see Regs. Sec. 1.48-1(c).

The IRS initially argued that cases involving the years prior to 1981, when component depreciation was allowed, were of limited application in determining what constitutes a structural component. The Tax Court rejected this argument, stating that Congress did not intend to redefine Sec. 1250 property to include property that, prior to the enactment of ACRS, had been Sec. 1245 property for ITC purposes. The Service also argued in HCA that the items in question were structural components under an ITC analysis and, consequently, were Sec. 1250 property within the meaning of Regs. Sec. 1.48-1(e)(2). Regs. Sec. 1.48-1(e)(2) defines "structural component" by way of example rather than by definition. The court summarized the regulation, stating "an item constitutes a structural component of a building if the item relates to the operation and maintenance of the building."

Common Types of Personal Property

The regulations cited in HCA provide a fairly good representation of what a taxpayer can include in personal property. First, it is necessary to determine whether an item is a structural component of a building. In general, if an item is movable rather than permanent, it is personal property. Even if an item is attached to a building, it may still be considered personal property. Under Regs. Sec. 1.48-1(e)(2), structural components include:

1. Walls, partitions, floors and ceilings, as well as any permanent coverings (such as paneling or tiling);

2. Windows and doors;

3. All components (whether in, on or adjacent to the building) of a central air conditioning or heating system (including motors, compressors, pipes and ducts);

4. Plumbing and plumbing fixtures (such as sinks and bathtubs);

5. Electric wiring and lighting fixtures;

6. Chimneys;

7. Stairs, escalators and elevators (including all components thereof);

8. Sprinkler systems, fire escapes and other components relating to the operation or maintenance of a building.

Although this may appear to be a fairly comprehensive list with little room for interpretation, exceptions exist for many of these items. The items listed in Regs. Sec. 1.48-1(e)(2) presumably relate to the operation or maintenance of a building. They do not include items necessary for (and relating to) the operation of specific tangible personal property. For example, specialty wiring to run restaurant equipment or manufacturing machinery, cabinets and counters, and specialty lighting (e.g., directional spot lights in an office), are necessary for (or relate to) the operations of specific tangible personal property. Exhibit 1 presents specific examples of common types of personal property.

IRS Thoughts on Cost Segregation

Although the IRS agreed in HCA that tests developed under the ITC prior to the 1981 adoption of the cost-recovery system are applicable in determining a structural component for ACRS and MACRS purposes, it did not acquiesce that certain items in HCA were properly treated as tangible personal property and depreciated over a five-year recovery period. The Service argued that certain items should have been considered structural components of the buildings to which they relate, which must be depreciated, under Sec. 168, over the same recovery period as the buildings.

In April 1999, Chief Counsel Advice (CCA) 9921045 discussed the response examiners should take in light of the Tax Court's decision in HCA. The CCA stated that the determination of whether an item is a structural component of a building or tangible personal property is still a highly factual one, with no bright-line tests, and directs examiners to "closely scrutinize" cost-segregation studies in the field. The CCA also notes, "[a]n accurate cost-segregation study may not be based on noncontemporaneous records, reconstructed data, or taxpayer's estimates or assumptions that have no supporting records."

What does this mean for taxpayers? The ability to document and support an allocation of personal property is essential to a cost-segregation analysis. For this reason, it is advisable to seek the assistance of professionals who deal specifically in this area and who, if necessary, can enlist assistance from engineering firms that perform cost-segregation studies. Cost engineers are often better suited to perform a detailed cost-segregation analysis, as a result of their knowledge of how a facility is constructed and their cost-estimating experience. In addition, a cost engineer can perform a cost-segregation study on an existing building as well as a newly constructed one.

Potential Savings from Cost Segregation

To accurately compute the savings from a cost-segregation analysis, it is necessary to analyze the net present value of the tax savings, in essence determining the time value of money on the tax dollars being saved today and in the future. Although generally focused on the reclassification of personal property, a cost-segregation study also results in a reclassification of costs to land improvements, which are eligible for a 15-year depreciable life instead of a 39-year or 27.5-year life. With a proper, well-documented cost-segregation analysis, it is not unreasonable to reclassify five percent to 15% of the cost to personal property and 10% to 20% of the cost to land improvements.

How much can a taxpayer expect to save?

Example: R builds an office building for $3,000,000, not including the cost of the land. If all the costs are allocated to 39-year real property, he can expect approximately $76,900 of depreciation per year. R performs a cost-segregation analysis. As a result, he can reclassify eight percent of the cost to personal property with a depreciable life of five years and 15% of the cost to land improvements. The net present value of the tax savings, discounted at eight percent, resulting from the cost-segregation study, is in excess of $150,000.

Conclusion

It has been over four years since HCA and now may be a good time for advisers to revisit the opportunities of cost segregation. The Service has issued a CCA directing the examiners to "closely scrutinize" cost-segregation studies in the field. Taxpayers wishing to capitalize on this opportunity should diligently document their analysis of personal property. It is recommended that a taxpayer use the services of professionals trained in the area of cost segregation, including cost engineers.

From R.J. McArthur, CPA, Ehrhardt Keefe Steiner & Hottman, PC, Denver, CO