Componentization of depreciable assets and new procedures for changing depreciation methods.

The automatic change in accounting method provisions contained in Rev. Proc. 98-60 make it easier for taxpayers that have incorrectly reported depreciation or depreciable lives or both to change the method or life. As a result of Hospital Corporation of America, 109 TC 21 (1997), taxpayers can now review the components of their real property additions to determine if they should be more properly classified as personal property. Carefully scrutinizing components of real estate could lead to shorter depreciable lives and accelerated depreciation deductions. Once it has been determined that there has been a misclassification of property, a taxpayer can receive an automatic change in accounting method for depreciation under Rev. Proc. 98-60.

Hospital Corporation of America

In Hospital Corporation of America, certain hospital facility-related items were classified as personal property and depreciated over a five-year life, rather than as real property and depreciated over 39 years. The IRS disputed this treatment.

Looking at the statutory language and legislative history of the accelerated depreciation systems, the Tax Court concluded that Congress intended to retain prior law tests related to the investment tax credit (ITC) to distinguish between components that were Sec. 1250 property and Sec. 1245 property. Under prior law, tests were developed to determine if property was tangible personal property qualifying for the ITC. These same tests would be used to determine if the hospital facility-related items were tangible personal property and, thus, would qualify for shorter depreciable lives. The court used certain factors to determine whether the hospital facility-related items were tangible personal property:

1. Could the property be moved and has it been moved?

2. Was the property designed or constructed to remain permanently in place?

3. Were there circumstances showing that the property might (or would have to) be moved?

4. Was the property readily movable?

5. How much damage would the property sustain if removed?

6. How was the property affixed to the land?

Based on the foregoing information, if the property were easily moved or removed, it is likely to be classified as personal property.

Items generally classified as real property may be considered personal property when the manner in which the property is used by the taxpayer is considered. In Hospital Corporation of America, the taxpayer was able to prove the following:

1. Electrical distribution systems and wiring related to hospital equipment, televisions and communications equipment were not essential to the building operation and maintenance, but to the operation of the related equipment.

2. The carpeting and vinyl wall and floor coverings were not permanent, but easily removable without significant damage to the building.

3. Kitchen hood and exhaust systems were in place solely to regulate the temperature and humidity so that the kitchen equipment could operate properly.

4. Handrails were intended to assist patients walking in the hallways, not to protect the walls.

5. The partitions were incidental to the structure of the building; they did not provide support for the ceilings or walls, but were used to subdivide the cafeteria and conference room into smaller eating or meeting spaces.

In light of this case, a taxpayer's components of real property additions should be reviewed to determine if any items normally classified as structural components of real property can be reclassified as personal property based on the taxpayer's use of the item.

Change in Accounting Method

If a taxpayer determines there has been a misclassification of property, it can file Form 3115, Application for Change in Accounting Method, to apply for a change in accounting method relating to depreciation. The taxpayer can then deduct the underreported depreciation from prior periods and use the remaining shorter life going forward. Because the accounting method change would be considered automatic, there is no user fee. The original Form 3115 must be attached to the taxpayer's timely fried tax return for the change year (including extensions); a copy of the application must be filed with the IRS National Office no earlier than the first day of the change year and no later than when the original is filed with the Federal income tax return for the change year. The Sec. 481(a) adjustment will be taken into account over four years unless it qualifies for the de minimis exception (i.e., less than $25,000), in which case the adjustment can be taken in the change year. Rev. Proc. 98-60 superceded Rev. Proc. 96-31, which originally applied to changing depreciation methods. Unlike Rev. Proc. 9860, Rev. Proc. 96-31 allowed all the underreported depreciation to be taken into account in the change year, regardless of the amount.

An accounting method needs to be established to use Rev. Proc. 98-60. According to the definitions in Rev. Proc. 98-60, a method must be used for at least two years immediately preceding the change year to constitute an accounting method. If the depreciation method was used for only one year, the taxpayer should not use Rev. Proc. 98-60 to correct the depreciable life, but should file an amended return instead.

As a result of Hospital Corporation of America, many opportunities may exist to review the depreciable lives on certain property, and taxpayers should closely scrutinize their property additions. In addition, Rev. Proc. 98-60 allows taxpayers to automatically correct the depreciable lives of misclassified property.

LISA M. LOYCHIK, CPA, MT, COHEN & COMPANY, CPAs, YOUNGSTOWN, OH