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Tax Court Shoots Holes in Taxpayer’s Cost Segregation Study

Tax Court Shoots Holes in Taxpayer's Cost Segregation Study

As we’ve discussed previously, cost segregation studies are hotter than Hansel right now. Taxpayers with significant money invested in a building acquisition or substantial improvements look to get more depreciation bang for their buck via these studies, which reclassify a portion of the building’s basis to shorter-lived assets that “comprise” the building. In doing so, a taxpayer can convert 39-year (for nonresidential rental) or 27.5-year (for residential rental) property into 5, 7, or 15-year property, accelerating depreciation deductions.  

Today, however, the Tax Court struck another blow to the cost segregation movement, taking a match to the taxpayer’s expansive study and accelerated depreciation deductions in its decision in Amerisouth XXXII, LTD, v. Commissioner, T.C. Memo 2012-67.

In Amerisouth, a partnership purchased an apartment complex for $10.25 million before quickly pumping in another $2 million worth of improvements. Because of the 27.5-year depreciation life afforded nonresidental rental property by I.R.C. Section 168, Amerisouth was faced with the prospect of recovering its investment via a slow boat.

Hoping to accelerate depreciation deductions, Amerisouth engaged MS Consultants to perform a cost segregation study. The result was a monstrosity of a study; deconstructing the apartment complex into over 1,000 parts and giving rise to significant amounts of additional depreciation.

Before we dive into the Tax Court’s analysis, there is one mitigating factor to this decision worth noting: Amerisouth was forced to represent itself in these proceedings because it essentially stopped communicating with the court, the IRS, and even its own counsel. Had they taken a more cooperative approach with the government — or had proper counsel represent them at trial — perhaps the result would not have been so harsh.

While the Tax Court’s decision was certainly eye-opening, the lesson for taxpayers is the methodology employed by the court in attacking the cost segregation study. As expected, the court initially set the ground rule that any asset held to represent a “structural component” of the building must be depreciated over 27.5 years. After traversing through the statute, the Tax Court then arrived at Treas. Reg. 1.48-1(e), which defines a “structural component” of a building as:

…such parts of a building as walls, partitions, floors, and ceilings, as well as any permanent coverings therefor such as paneling or tiling; windows and doors; all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts; plumbing and plumbing fixtures, such as sinks and bathtubs; electric wiring and lighting fixtures; chimneys; stairs, escalators, and elevators, including all components thereof; sprinkler systems; fire escapes; and other components relating to the operation or maintenance of a building. [Emphasis added.]

The court looked at this final sentence and required specificity; in this case, for an asset to be a structural component, it must be essential to the operation or maintenance of a typical apartment building.

This produces a dramatically different result than if the court had simply chosen to base its determination on whether a component was essential to the operation of a generic, shell building. To illustrate the difference, a commercial building might have no use for a gas line. Thus, if the court were to evaluate the gas lines servicing the apartments based on how essential they were to the operation of any building, they would not be structural components since they are not required for the operation of all buildings. Gas lines are, however, essential to an apartment building. Thus, by requiring the analysis to be specific to an apartment building, gas lines and other assets were transformed from nonessential to essential, requiring them to be treated as structural components and depreciated over the life of the underlying building.

While this became the primary litmus test applied to each component in the cost segregation study, the court also took into consideration whether a component was permanent  — which would indicate it was part of the building — or merely decorative, in which case it would be eligible for a shorter life.

Below is a listing of each component delineated in the cost segregation study, the depreciable life used by the taxpayer, and the court’s ultimate findings. The court’s reasoning for each conclusion can be found in the endnotes:

Component Taxpayer Life Tax Court Life
Water lines leading from the municipal water main to the buildings

15

27.5[i]

Sewer lines from the buildings to the municipal sewer

15

27.5[ii]

Gas lines from the utility source to the buildings

15

27.5[iii]

Underground electric lines

15

27.5[iv]

Exterior lighting

15

27.5[v]

HVAC venting connected to stove hoods

5

27.5[vi]

HVAC venting connected to dryers

5

5[vii]

Sinks and drain pipes

5

27.5[viii]

Water and rough water piping for clothes washers

5

27.5[ix]

Gas lines from primary lines to clothes dryer

5

5[x]

Drains and waste lines in the laundry room

5

27.5[xi]

Recessed lights

5

27.5[xii]

Door bells

5

27.5[xiii]

Sliding gate components

15

15[xiv]

Ceiling fans and light fixtures

5

27.5[xv]

General Outlets

5

27.5[xvi]

Refrigerator outlets

5

5[xvii]

Cable, telephone, and data outlets

5

5[xviii]

Wiring from unit panel to outlets

5

27.5[xix]

Electric panels

5

27.5[xx]

Shelving, crown molding, paneling, chair rails, and base boards

5

27.5[xxi]

Cabinets and countertops, windows and mirrors.

5

27.5[xxii]

 
I’ll defer on commenting on the impact of Amerisouth until I’ve run it by the experts who do this sort of thing for a living. But this much I’m sure of: the decision today certainly got those experts’ attention, as the Tax Court’s willingness to examine each asset listed in the study and ask “how essential is this to the operation or maintenance of this specific type of building” could have cost segregation engineers reexamining their approach.

[i] The water system is an integral part of the building’s plumbing and air-conditioning systems and thus relates to the operation of the apartments.

[ii] The sewer system serves the building generally.

[iii] The gas lines are essential to the operation of an apartment building.

[iv] Treated the same as the other utilities; i.e., gas lines and water lines.

[v] The lighting was not specialized; it was for the general purpose of illuminating the exterior of the apartments.

[vi] The stove vents did not serve only the stoves; they also removed heat and smells from beyond the stovetop.

[vii] The clothes-dryer vents served specific equipment which was tangible personal property — the dryers. Thus, it was not a structural component.

[viii] Sinks are listed in the Section 48 regulations as structural components. Even though they are not “permanent” the Tax Court held that they are essential to the operation of an apartment building.

[ix] Amerisouth could not provide evidence that the clothes washers were connecting by these lines to the building’s plumbing lines.

[x] These lines supplied gas only to the dryers, not to the building generally.

[xi][xi] These are a permanent part of the building.

[xii] The lights did not serve a decorative or security purpose, so they serve the building generally.

[xiii] Permanent part of the building

[xiv] The IRS agreed the gate components were land improvements.

[xv] Even though ceiling fans are decorative and not permanent, the Tax Court found they were structural improvements because Amerisouth failed to provide evidence that they underwent systematic replacement.

[xvi] As you might imagine, the Court held that outlets serve the building in general.

[xvii] These are specifically for pieces of tangible personal property.

[xviii] Same as fridge outlets.

[xix] Wiring provided power to the apartments generally.

[xx] Amerisouth failed to provide evidence that the panels only provided power to certain pieces of tangible personal property

[xxi] Though these things are movable, there was no sign that Amerisouth planned or actually moved them. Paneling is also specifically mentioned in the Section 48 regulations as a structural component.

[xxii] To the court, this was strictly an issuance of permanence; Amerisouth failed to present evidence that they planned or actually removed any of these items.

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Cost Segregation

Cost segregation is a method that creates revenue in the form of reducing current taxes for real estate owners and developers. The process allocates the entire costs of a building or other property into components that cause an acceleration of tax deductions with a resulting deferral of federal and state taxes. While the study’s purpose is to reduce current taxes they are usually prepared by engineers.

Apr 24, 2019

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