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Cost classification studies: using federal tax law to subsidize building costs.

Taxpayers, particularly manufacturers, can cut costs on the construction of new facilities through a special study that classifies costs into the most advantageous categories for tax purposes. These studies, known as cost classification studies, use the Federal tax law to reclassify as much as possible of the costs incurred from the real estate category into the personal property category. By doing this, taxpayers can recover the reclassified costs over a five- to 20-year period instead of a 39-year period.

The savings from the accelerated recovery can be quite significant. For example, if $1 million of costs are reclassified from the 39-year real estate category to a 15-year category, the taxpayer can save (based on reasonable assumptions) $120,000 in taxes on a present value basis. If the depreciable life is cut from 39 years to five years, the savings are $220,000 per $1 million.

Additional savings may also result, since fewer of the property costs are classified as real estate, which, in turn, may lessen state and local real estate taxes. Even if the property is located in a jurisdiction that also imposes a tax on personal property, taxpayers still generally come out ahead by reclassifying construction costs.

When the Federal tax law provided for investment tax credits (ITC) for investing in tangible personal property, taxpayers were motivated to reclassify costs as relating to personal property instead of real property to generate the ITCs. As a result, a significant amount of case law has developed that provided taxpayers with guidance to potentially make this reclassification.

With taxpayers now being motivated to reclassify costs as relating to personal property to avoid the 39-year real property recovery period, the ITC case law was being used by taxpayers to make this reclassification. However, it was never certain that the ITC case law could be applied to determine if property qualified as tangible personal property for purposes of the accelerated cost recovery system (ACRS) and the modified accelerated cost recovery system (MACRS).

In a case of first impression, the Tax Court, in Hospital Corp. of America (HCA), 109 TC 21 (1997), held that property qualified as tangible personal property for purposes of ACRS and MACRS if the property would have qualified as tangible personal property for ITC purposes. As a result, taxpayers can use the extensive ITC case law with confidence to reclassify construction costs from real property to personal property by doing a cost classification study.

A cost classification study focuses on new construction projects, expansions, renovations, leasehold improvements and even purchases of existing buildings, to reclassify as much as possible of the related costs from real property to personal property. Owners of a wide variety of businesses, including manufacturing and industrial facilities, financial institutions, office buildings, hotels, shopping centers, restaurants and entertainment facilities, can benefit from these studies.

HCA specifically addressed the cost classification opportunities with hospitals. In its opinion, the court generally used the test of whether the costs related to (1) the operation or maintenance of the buildings or (2) a particular function or process, such as providing medical care or a particular piece of equipment. Costs associated with the former category are considered real property costs, while costs associated with the latter category are considered personal property costs.

Example: A hospital incurred branch electrical wiring costs consisting of conduit, wiring and electrical connections, which relate to particular items of hospital equipment (such as X-ray film processing equipment and hospital sterilization equipment). The wiring and connections are required for the operation and use of the equipment to which they relate and are used only with such equipment. Since the costs aid in the providing of healthcare services and do not relate to the operation or maintenance of the building, they are considered personal property costs. As the parties stipulated that assets used in the delivery of healthcare services have a five-year recovery period, the related costs are depreciated over five years.

Even though hospital-specific items were being addressed, the HCA opinion provides good insight relating to the principles underlying cost classification studies. While taxpayers can now clearly cite ITC case law to reclassify real estate costs as personal property costs for purposes of Federal tax depreciation, taxpayers should be aware that the IRS can still challenge taxpayers by citing opposing ITC case law.

Ideally, a cost classification study should be performed when planning and constructing a building, but it can also be performed after the fact. Even if the property was placed in service and has been depreciated in at least two tax years immediately preceding the year of change, taxpayers are allowed to claim the benefits of accelerated depreciation, as long as the property is still owned by the taxpayer at the beginning of the year in which the correction is made; see Rev. Proc. 97-37, particularly Section 2 of the Appendix.

From Dean Jorgensen, CPA Washington, D.C.
COPYRIGHT 1998 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1998, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Jorgensen, Dean
Publication:The Tax Adviser
Date:Feb 1, 1998
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