Depreciation planning for newly acquired commercial real estate.

Little satisfaction is gained from depreciating commercial real estate over 39 years; however, taxpayers acquiring such property may be able to get a greater tax advantage by depreciating some parts of their purchase over a much shorter period.

Land and Land Improvements A crucial determination in the depreciation of real estate is the allocation of basis to land. Because land is nondepreciable, it is often advantageous to allocate a higher portion of the total purchase price to the building and other depreciable assets. While some practitioners allocate a straight 5% or 10% of cost to land, the regulations set forth specific guidelines on how to make the allocation.

Regs. Sec. 1.167(a)-5 indicates that the basis for depreciation cannot exceed the ratio of the value of the depreciable property at the time of acquisition to the value of the entire property at that time. The burden of proof as to both basis and allocation falls on the taxpayer. Therefore, it would be wise to obtain an independent appraisal of both the value of the land and the allocation between the land and the building.

Certain land improvements are not depreciable; these improvements are considered an extension of the land itself. However, Rev. Rul. 74-265 allowed for depreciation of other land improvements, stating that a useful life may be determined for certain landscaping located immediately adjacent to a building. For example, it was concluded in Eastwood Mall Inc., DC Ohio, 1995, that the land improvements would be destroyed if the depreciable asset (a building, in this case) were replaced or rebuilt. Because any improvements would be lost if the building were repaired, rebuilt or torn down, the improvements were considered closely associated with the building and, therefore, depreciable over the building's life.

Structural Components Regs. Sec. 1.48-1 (e) (2) defines personal property in terms of structural components; if an item is a structural component related to the operation or maintenance of a budding, it is not personal property. Structural components include parts of a building, such as walls, partitions, floors, ceilings, paneling, tiling, windows, doors, cooling and heating system components, plumbing, electrical wiring, lighting fixtures, chimneys, stairs and fire escapes. In addition, swimming pools, paved parking areas, wharves and docks, bridges and fences are structural components (Pegs. Sec. 1.48-1 (c)).

Although the regulations list items as structural components, the courts have found some of these listed items to be personal property.

In Hospital Corporation of America (HCA), 109 TC No. 2 (1997), the taxpayer was an affiliated group of corporations under a common parent that owned, operated and managed hospitals. The group constructed a number of hospital facilities and classified certain items related to the facilities as tangible personal property depreciable over a five-year period. The Service disagreed and insisted that the facilities and their components be depreciated over a 39-year period.

The court concluded that the tests used to ascertain whether property constituted tangible personal property for purposes of the investment tax credit (ITC) are also applicable to decide whether the property constitutes tangible personal property for modified accelerated cost recovery system (MACRS) purposes. Therefore, to the extent that a disputed property item would qualify as tangible personal property for ITC, that property will also qualify as tangible personal property for purposes of accelerated depreciation.

To define tangible personal property, the court cited Whiteco Industries, Inc., 65 TC 664 (1975), which asked the following questions: [] Is the property capable of being moved, and has it in fact been moved? [] Is the property designed or constructed to remain permanently in place? [] Are there circumstances that tend to show the expected or intended length of affixation? [] How substantial a job is it to remove the property and how time-consuming? [] How much damage will the property sustain on its removal? [] What is the manner of affixation of the property to the land?

Movability in and of itself is not the controlling factor in deciding to which class of property an item belongs (Kramertoun Co., 488 F2d 728 (5th Cir. 1974)).

The HCA court looked at different types of property, including: Primary and secondary electrical distribution systems: Items included in this category were main panels, main motor control centers, transformers, secondary distribution panels, and related wiring and conduit. HCA argued that portions of the primary and secondary electrical distribution systems that carry electrical loads to particular items of business equipment were Sec. 1245 property because they did not relate to the operation or maintenance of a building.

In agreeing with HCA, the court cited Scott Paper Co., 74 TC 137 (1980): "[W]e concluded that the components of the taxpayer's primary electric system which supplied the electric needs of process machinery rather than contributing to the overall operation or maintenance of buildings, was not an inherently permanent structure and the taxpayers were entitled to the investment tax credit on these components." The court found that the electrical components used to supply electricity to hospital equipment were tangible personal property, not a structural component related to the building's operation and maintenance. Internal communications equipment: Such equipment includes wiring and conduit, junction boxes, outlets and sleeves necessary for the operation of the hospital intercom, dictation, paging and nurse call systems. These items were used only with certain systems, and hospital blueprints show that they were intended to be used only with these systems. The IRS argued that although the wiring and sleeves were personal property, the other items were structural components. The court disagreed; the items were necessary for the operation of telephones and internal communications equipment, were used directly with the equipment to which they related and were considered a part of that equipment. Carpeting: HCA installed carpet during construction with a general purpose latex adhesive so that it could be easily removed without damage to the underlying floor and reused somewhere else. The court agreed that this carpeting was personal property depreciable over a five-year period. HCA's carpet was similar to carpet fastened with hooks attached to wood strips that were nailed along each wall and found to be personal property (Rev. Rul. 67-349). The court found that HCA did not intend for the carpeting to be permanent and that much of the carpeting had already been removed. Further, the Service, in its argument, had relied on a case that predated the Senate Finance Committee Report to the Revenue Act of 1978 (which specifically identified carpet as tangible personal property). Vinyl wall coverings: Although Pegs. Sec. 1.48-1 lists walls and their permanent coverings as structural components, the vinyl wall coverings used by HCA were found to be personal property. HCA did not intend or design the coverings to be integral parts of the walls, but merely decoration; in fact, many of the coverings had been removed (due to change; in decor and heavy wear). In addition, the walls were prepared with glue sizing to permit easy removal and prevent, damage to the walls. Patient corridor handrails: These handrails, which were attached by bolts to the wall, were not related to the operation or maintenance of the buildin. They were not intended to function as wall protectors; rather, they were placed to aid patients who might need support. Since the handrails we're not related to the building's operation, they were personal property and depreciable over five years. Partitions: HCA installed accordion-style room dividers that were attached to the ceilings. They were used to provide space for conferences and other social functions. Removal of the partitions would not cause any destruction to the budding structure and one partition had already been removed. Although the regulations list partitions as structural components, the court found that these partitions were not a permanent part of the building because they provided no structural support to it. Because they had only an incidental relationship to the building, they were properly classified as personal property.

The HCA case provides instances in which items generally regarded to be structural components were determined e personal property after considering the context in which they were used. Other examples of property eligible for accelerated depreciation include false balconies and other exterior ornamentation that have no more than an incidental relation to the operation or maintenance of a building, identity symbols that relate to a retail establishment or restaurant, signs, movable and removable partitions, and large and small pictures attached to a wall or suspended from a ceiling.

Sec. 179 Expense Another frequently overlooked option is expensing property under Sec. 179. Sec. 179 lays out the following guidelines to determine qualified property: [] Tangible property depreciable under either MACRS- or ACRS. [] Property described as Sec. 1245 property (as defined in Sec. 1245(a)(3)). [] Property purchased by the taxpayer for use in an active trade or business. Sec. 179 property includes property that is an integral part of manufacturing, production or extraction, or of furnishing transportation, communications, electricity, gas or water. Items such as printing presses, movable trailers and equipment used to operate as wells have all been deemed qualifying, Sec. 179 property.

There I few notable exceptions to the Sec. 179 expensing rules. Permanent fixtures, such is buildings, are not considered Sec. 1245 property, and are therefore not qualifying Sec. 179 property. The courts have also barred the expensing of heating and air conditioning units, and property originally purchased for personal use and later converted to business property.

Conclusion

Practitioners must analyze pieces of a client's commercial property purchase to see what can be depreciated under an accelerated method and what piece is required to be depreciated over a 39-year period, Simply classifying the entire purchase as 39-year property without breaking out the components does a great disservice to the client and can easily be avoided.