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Cost recovery issues involving the acquisition of open-air and prefabricated structures.

Over time, some taxpayers might encounter cost recovery issues involving the acquisition of certain types of structures. In most situations, the acquisition of open-air or prefabricated structures occurs pursuant to the acquisition of nonresidential real property. When acquiring a depreciable structure, a taxpayer's goal is typically to "shorten" the time period during which cost recovery will occur for some or all of the total acquisition cost involved. The difference in depreciation expense in each of the early years of such a structure's useful life can, in many situations, provide a taxpayer with a significant deferral of tax liability.

Depreciation of Nonresidential Real Property

Nonresidential real property is defined as Internal Revenue Code (IRC) section 1250 property, other than 1) residential rental property, or 2) property with a class life less than 27.5 years [IRC section 168(eX2)(B)]. Class lives are contained in Revenue Procedure 87-56. Under the modified accelerated cost recovery system (MACRS), depreciable nonresidential real property placed into service after May 12, 1993, is generally subject to a 39year cost recovery period, using the straight-line method and midmonth convention [IRC section 168(c)].

Real Property under IRC Section 1250

Treasury Regulations section 1.12501(e)(3) defines "real property" by a process of exclusion. Real property is any property that is not personal property under Treasury Regulations section 1.1245-3(b). This regulation then refers to the definition of property qualifying for the investment tax credit under the old investment tax credit rules. Basically, personal property is tangible property other than land and improvements thereto.

Accordingly, buildings and other socalled "inherently permanent" structures, along with their related structural components, will typically be treated as IRC section 1250 property. In addition, an inherently permanent structure or its components qualifying as a land improvement will typically be treated as IRC section 1250 property. In a few situations, however, real property can qualify as "IRC section 1245 real property."

For example, certain single-purpose agricultural or horticultural structures are treated as section 1245 real property.

Depreciating Structures and Buildings

Typically, if a structure is a nonresidential building, it will be depreciated over 39 years. (Under MACRS, a residential building will typically be depreciated over 27.5 years using the straight-line method and midmonth convention.) Sometimes, tax professionals might question when a structure is a building. In general, it will be classified as a building for depreciation purposes if it meets both the inherently permanent and appearance and function tests (discussed later).

If the structure is not a building, then it will usually be either a land improvement or IRC section 1245 personal property. When a taxpayer acquires in a "basket purchase" a building and a structure that is not a building, the services of an appraiser should be procured in order to determine the fair market value of each depreciable asset acquired. The total acquisition cost will then be allocated, using the relative fair market value method, between the building and structure that is not a building.

If an asset is considered to be a land improvement not specifically included in another asset class and is otherwise depreciable, it will typically be depreciable over 15 years. (See Revenue Procedure 87-56; such land improvements are categorized as Asset Class 00.3.) Under MACRS, the depreciation of a land improvement is generally taken pursuant to the 150% declining-balance method. Examples of land improvements under Revenue Procedure 87-56 include "sidewalks, roads, canals, waterways, drainage facilities, sewers (not including municipal sewers in class 51), wharves and docks, bridges, fences, landscaping, shrubbery, or radio and television transmitting towers"; however, examples of such assets do not include "land improvements that are explicitly included in any other class, and buildings and structural components as defined in section 1.48-1(e) of the regulations." In a few situations, Revenue Procedure 87-56 will assign the land improvement to a different asset class requiring a shorter recovery period; thus, the business activity in which the taxpayer is engaged may have an effect upon the depreciable life of the improvement for the purposes of applying Revenue Procedure 87-56.

Where an asset is classified as a land improvement rather than as depreciable real property, the difference in depreciation expense in each of the early years of such asset's life can be significant. For example, consider a taxpayer who bought an existing property consisting of a real estate lot (nondepreciable property), a commercial office building (nonresidential real property), and a parking lot (land improvement) for a total of $1.36 million. A qualified appraiser, using the relative fair market value method to allocate cost, determined the cost of the land to be $200,000; office building, $1.1 million; and parking lot, $60,000.

The taxpayer placed the office building in service on April 29, 2013. The taxpayer placed no other depreciable assets in service during 2013. The depreciation for 2013 (Year 1) would be as follows:

* Land Improvement: $3,000 (Land improvement will be treated as 15-year property using MACRS table depreciation with half-year convention. Depreciation: $60,000 x 5% = $3,000.)

* Commercial Office: $19,979 [Commercial real estate will be treated as 39-year property using MACRS, straight-line method, and midmonth convention. Depreciation: ($1,100,000 - 39) x (8.5 - 12) = $19,979],

The depreciation for 2014 (Year 2) would be as follows:

* Land Improvement: $5,700 (Depreciation: $60,000 x 9.5% = $5,700)

* Commercial Office: $28,205 (Depreciation: $1,100,000 + 39 = $28,205).

The above example illustrates the notion that, in the early years of an asset's life, a land improvement is depreciated at a faster rate than the nonresidential real property. In Year 1, taking into account the half-year convention, 5% of the land improvement cost will be recovered; the recovery percentage for the nonresidential depreciable real property will be approximately 1.8162%. In Year 2, 9.5% of the land improvement cost will be recovered; the recovery percentage for the nonresidential depreciable real property will be approximately 2.564%. The increase in tax expense by depreciating the cost of a land improvement over a shorter life than the cost of real estate will work to decrease the taxpayer's taxable income in the early years of the land improvement's depreciable life. It will also defer the taxpayer's tax liability until a later year (or years) and, using the principles of time value of money, may ultimately result in significant tax savings.

Against this backdrop, a basket purchase of nonresidential real property that contains open-air or prefabricated structures can pose a number of thorny cost recovery issues. In many situations, the issue involves the question of whether the structure is a building.

Open-Air Structures

Open-air structures are used in a variety of trades and businesses. The steel industry, for example, features structures that house interior, overhead magnetic cranes for purposes of moving slabs of steel. Typically, the structure itself is large, rectangular, and "covered with metal or other relatively cheap siding, but having large doors, roof ventilators, and other openings" [Field Service Advice (FSA) Memo 0536, IRS, Aug. 6, 1992], Typically, the cranes "consist of two steel rails mounted atop steel columns along the sides of the structure and running the length of the structure. A steel bridge spanning the width of the structure is attached to steel wheels that sit on the rails so that the bridge can move up and down the length of the structure" (IRS 1992).

In Lukens Inc. v. Comm V (TC Memo 1987-464) and Barrenechea v. Comm 'r (TC Memo 199IM-71), the Tax Court held that the structures that housed the cranes at issue constituted personal property qualifying for the investment tax credit under prior law. In these two decisions, the Tax Court classified the open-air structures as personal property and not as buildings. In addition, the IRS announced in FSA Memo 0536 that it would not litigate this issue again in the context of structures that house overhead traveling cranes.

Another type of open-air structure that has attracted IRS scrutiny is the stand-alone parking garage. In a 2009 Coordinated Issue Paper (CIP), the IRS adopted the position that a stand-alone open-air parking structure constitutes depreciable real property (see LMSB4-0709-029). Unlike land improvements, which are associated with the ground but nothing more (e.g., fences, sidewalks, roads, landscaping), buildings or structures meet distinct function and appearance tests. According to the CIP, the appearance test under Treasury Regulations section 1.481 (e)( 1) requires that the property be a "structure or edifice enclosing a space within its walls, and usually covered by a roof'-- in other words, the property must look like a building. Moreover, the function test requires the property "to provide shelter or housing, or to provide working office, parking, display or sales space."

The CIP refutes two arguments often made by taxpayers when asserting that an open-air structure is a land improvement: 1) open-air structures do not provide workspace or shelter and, as a result, do not pass the function test, and 2) in any event, open-air structures do not pass the appearance test. With regard to the latter, taxpayers contend that stand-alone open-air parking structures do not contain walls or a roof for the specific purpose of sheltering people or vehicles, remain open to the elements, and do not have many of the structural components of a building (or do not share structural supporting elements with a building).

Citing Treasury Regulations section 1.48-1(e), the IRS asserted that "working, office, parking, display or sales space" is sufficient to meet the function test and that the provision of parking space meets such standard. With respect to the appearance test, the CIP noted the following:

* Each parking level (other than the top level) acts as both a ceiling and floor. By this, it is meant that each parking level is a ceiling for the floor beneath it and a floor for the level above it. The top level functions as a roof.

* There are walls for each parking level.

* The presence of walls and floors means that each level is not totally vulnerable to the elements. It is not critical for a structure to have a mechanical means of heating and cooling.

* The structure has elevators, fire extinguishers, and sprinkler systems, along with wiring and lighting fixtures. Each of these items is associated with a structure.

? The longevity of such a parking structure is comparable to those of other structures or buildings--that is, in the range of 25-40 years.

"For depreciation purposes, the term building is given its commonly accepted meaning," according to Treasury Regulations section 1.48-1(e)(1). "The term includes, for example, structures such as apartment houses, factories and office buildings, warehouses, bams, garages, railway or bus stations, and stores." In the IRS's opinion, no reasonable argument can be made for the proposition that a garage is not a building. Taxpayers asserting such an argument may be subject to a negligence penalty pursuant to IRC section 6662. The CIP indicates that the mere fact the taxpayer may have consulted a tax professional for advice, and such professional supported the alleged position taken by the taxpayer, is not, by itself, sufficient to show reasonable cause and good faith to defend against a negligence penalty.

Prefabricated Structures

The phrase "prefabricated structure" can mean many things. To some, it means "made in a factory." A mobile home used as a temporary office building is an example of a prefabricated structure. Some factories produce airplane hangars, storage facilities, and other structures. Often, prefabricated structures take days or even weeks of on-site assembly prior to being placed in service; some of these are moveable, whereas others are not. To further complicate matters, some moveable structures are either never moved or cannot be moved without incurring substantial additional costs.

If the prefabricated structure is moveable, then it is probably not inherently permanent in nature. Such property typically will be treated as IRC section 1245 property. In Fox Photo Inc. v. Comm 'r (TC Memo 1990-348), the taxpayer attached prefabricated one-hour photo labs to concrete pads on commercial lots. If necessary, the prefabricated structures could be removed and relocated by using a flatbed truck over the course of two to three days. The taxpayer did move some of the prefabricated structures from their existing locations and relocated them to new sites; it cost the taxpayer less money to remove and relocate these existing structures than to buy new ones. Given these facts, the Tax Court held the prefabricated structures to be IRC section 1245 property.

Film N'Photos Inc. v. Comm V (TC Memo 1978-162) involved a movable, prefabricated photo-processing hut and the concrete base to which it was attached. The property at issue in Film N'Photos was smaller than the property at issue in Fox Photo. The process of loading the photo-processing hut and attached concrete base onto a trailer could occur in less than one hour and did not require the unit's disassembly. Accordingly, the Tax Court classified the entire unit as personal property.

The fact that a prefabricated structure can be moved does not necessarily preclude it from being inherently permanent for purposes of satisfying the tests for being classified as a building. In L.L. Bean Inc. v. Comm 'r [TC Memo 1997-175, aff'd 145 F.3d 53 (1st Cir., 1998)], the taxpayer built a storage warehouse measuring, 500' by 190' by 57'. L.L. Bean presented evidence at trial that another taxpayer in the book-printing industry had, in fact, moved a similar structure.

The court noted that L.L. Bean had specially designed its storage warehouse to be an addition to its existing distribution center, and, given "improbability and expense" of the storage structure's relocation, found it to be inherently permanent in nature and subject to being depreciated as nonresidential real property.

J. McManus v. Comm V involved a prefabricated airplane hangar that the taxpayer claimed could be disassembled and reassembled by four workers in less than two weeks [863 F.2d 491 (CA7); JFM Inc., TC Memo 1994-239 (1994)]. The court found the structure to be inherently permanent. The court also held that the structure had both the appearance and function of a building. Although most courts require the structure involved to satisfy both the inherently permanent test and the appearance and function test to be classified as a building, the court in J. McManus apparently did not find this necessary.

Sometimes the structure involved is not a building, but the depreciable life of the structure itself is in dispute. This might occur because the cost recovery rules contained in the various sources of the tax law are many and varied. At times, they do not appear to work well together. By way of example, although an improvement is typically depreciated over 15 years, if a prefabricated structure is in the nature of IRC section 1245 property, then it will typically be treated as IRC section 1245 property; however, Revenue Procedure 87-56 also contains mles that list how certain items are to be treated in situations involving taxpayers engaged in certain activities.

In PDV America v. Comm'r (TC Memo 2004-118), the taxpayer placed steel petroleum storage tanks in service. The taxpayer categorized the storage tanks under Asset Class 57.0 as IRC section 1245 property used to market petroleum and petroleum products. The IRS took the position that the storage containers should have been categorized under Asset Class 57.1 as land improvements. This category specifically includes land improvements used in marketing petroleum and petroleum products. The Tax Court held that the storage tanks, although large and heavy, were not inherently permanent, precluding IRC section 1245 status. Accordingly, the Tax Court ruled in favor of the taxpayer.

Practical Advice

Tax professionals sometimes find it difficult to classify certain assets for purposes of calculating depreciation. Whenever a structure is acquired in connection with the acquisition of nonresidential real property, an analysis of the facts and circumstances of the acquisition, along with the relevant sources of the tax law, is highly advisable.

To the uninitiated, it might seem a bit odd that a parking lot owned and placed in service by a taxpayer will typically be depreciated over a 15-year period, whereas an open-air, multilevel parking garage owned and placed in service by that same taxpayer will typically be depreciated over a 39-year period. Accordingly, when it comes to open-air or prefabricated structures, a taxpayer is well advised to obtain a favorable ruling from the IRS before proceeding to depreciate such property.

Mark A. Segal, JD, LLM, CPA, is a professor of accounting in the Mitchell College of Business & Management Studies, University of South Alabama, Mobile, Ala. Bruce M. Bird, JD, MST, CPA, is a professor of accounting in the Richards College of Business, University of West Georgia, Carrollton, Ga.
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Title Annotation:Taxation: tax planning
Author:Segal, Mark A.; Bird, Bruce M.
Publication:The CPA Journal
Geographic Code:1USA
Date:Jul 1, 2014
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