The purpose of a Cost Segregation Study is to separate the items that can be classified as personal property from the building itself. Not all items qualify, so it is important to understand how an asset (or item) can be classified as personal property versus part of the building. This process has been clarified and refined over time through landmark court cases to provide guidance and support for taxpayers. In this blog, you will learn more about which items can be depreciated over shorter class lives and the reasoning behind it.
Depreciation Over 5 Years: Personal Property
Items that qualify for a 5-year depreciation schedule are typically personal property—those that are tangible and can be easily removed from the building without damaging the structure. Personal property includes equipment, furniture, and certain components that are not permanently attached to the building.
Examples of items that can be depreciated over 5 years include:
- Carpet and Flooring (Non-permanent): Carpeting, vinyl tiles, and certain flooring materials that can be easily replaced are eligible for 5-year depreciation. The IRS has ruled that such materials are distinct from structural elements, and thus they can be classified as personal property.
- Specialized Equipment and Machinery: This includes equipment used for specific business purposes not part of the building’s essential infrastructure. Printers, copiers, and restaurant kitchen equipment often qualify for shorter depreciation schedules.
- Interior Fixtures: Wall coverings, cabinetry, and decorative lighting fixtures can often qualify for 5-year depreciation if they are not integral to the building structure. However, their eligibility depends on the extent to which they are fixed or removable.
- Certain Building Systems: Items such as specialized plumbing or wiring dedicated to non-structural systems (like a security system) can fall under 5-year depreciation if they don’t support the building's overall infrastructure.
Relevant Court Cases:
- Hospital Corporation of America v. Commissioner (1987): In this case, the court ruled that specific interior improvements, including carpets, tile, and non-permanent partitions, qualify for 5-year depreciation as personal property rather than structural elements.
- Black & Decker (1992): The court ruled that specific factory equipment was eligible for 5-year depreciation because it was used in manufacturing and could be considered personal property.
These rulings reinforced the IRS’s view that items not permanently affixed to the building or used in the daily function of the structure itself can be depreciated over a shorter period.
Depreciation Over 15 Years: Land Improvements
Land improvements refer to enhancements made to the land itself that are not part of the building’s structure but provide utility to the property. These can be depreciated over a 15-year period, significantly reducing tax liabilities in the first few years after purchase. Unlike personal property, land improvements are considered to have a long, useful life, but they are not permanent fixtures.
Examples of land improvements include:
- Parking Lots: The construction of a parking lot, whether paved with asphalt or concrete, is considered a land improvement that qualifies for a 15-year depreciation schedule.
- Sidewalks and Driveways: Similar to parking lots, sidewalks and driveways are improvements to the land that are necessary for the building's operation but are not part of the building structure itself.
- Landscaping: Trees, shrubs, and other types of landscaping are typically depreciated over 15 years. However, it is essential to distinguish between landscaping that is integral to the operation of the property (like trees that are part of a stormwater system) and decorative landscaping, which may have different depreciation classifications.
- Fencing and Outdoor Lighting: Fencing, as well as outdoor lighting systems, are land improvements that are not permanently affixed to the building but still add value to the property.
Relevant Court Cases:
- CIR v. Taylor (1985): This case helped establish guidelines for land improvements by affirming that landscaping (including trees, shrubs, and lawns) could be depreciated over 15 years as a land improvement.
- TIF (Tax Increment Financing) Decision (2001): In this case, the court affirmed that parking lot improvements and driveways are land improvements that should be depreciated over 15 years. It emphasized the distinction between real property and land improvements in relation to building structures.
Testing the Determination of Items in a Cost Segregation Study
The classification of items for cost segregation purposes is determined through a series of tests based on IRS guidance and case law. The primary tests involve assessing whether the asset is:
- Personal Property vs. Real Property: Personal property includes items that are moveable or not essential to the structure, while real property includes permanent, fixed, structural components of a building.
- Permanence: The IRS guidelines look at whether an item is permanently affixed to the building. If an item can be removed without damaging the structure, it may be eligible for shorter depreciation.
- Functional Use: This involves evaluating whether an asset is integral to the building’s function. It may qualify for accelerated depreciation if it serves a specialized function distinct from the building.
- Industry Standards: Cost segregation studies classify items based on industry practices and IRS rules. Engineers and tax professionals often conduct site visits to gather data and determine how assets should be classified based on their physical characteristics and operational function.
Conclusion
Cost segregation studies are powerful tools for accelerating depreciation and optimizing tax benefits. Property owners can save significant taxes by identifying items that qualify for 5-year- and 15-year depreciation. Personal property and land improvements are common components that benefit from shorter depreciation schedules, and court decisions have solidified the classifications over the years. Understanding how to properly classify and test these items is critical, and working with professionals who specialize in cost segregation ensures that the correct depreciation schedules are applied.
By staying informed and proactive, real estate owners can maximize their deductions, optimize cash flow, and ensure compliance with IRS rules.
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Edited by Randy Eickhoff, CPA, Founder & Head Coach at Acena Consulting. Photo courtesy of EpicTop10.com on Flickr.