Legal Basis for Cost Segregation Difference between Section 1245 and Section 1250 property

Legal Basis for Cost Segregation: Differentiating Between

Section 1245 and Section 1250 Property

The IRS Regulations as Construed by the Tax Court

The essence of the Tax Court’s1997 ruling in the landmark case (landmark for cost segregation purposes) Hospital Corp. of America v. Commissioner (hereinafter “HCA”) is that the tests developed under pre-1986 law, to determine whether property constitutes tangible personal property for purposes of the investment tax credit, are equally applicable in deciding whether property constitutes tangible personal property for purposes of the current depreciation system (MACRS).

The Income Tax Regulations only generally address the question of how to differentiate between section 1245 and section 1250 property, defining tangible personal property to include “any tangible property except land and improvements thereto, such as buildings or other inherently permanent structures (including items which are structural components of such buildings or structures)”; and clarifying the term tangible personal property is not intended to be defined narrowly and includes assets accessory to the operation of a business.

Section 1.48-1(e)(2), Income Tax Regs., explains the meaning of “structural components” by way of example rather than by definition, as follows:

The term “structural components” includes 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. The term “structural components“ does not include machinery the sole justification for the installation of which is the fact that such machinery is required to meet temperature or humidity requirements which are essential for the operation of other machinery or the processing of materials or foodstuffs.

The above language from the regulation was construed (in HCA) to mean that an item constitutes a structural component of a building if the item relates to the operation and maintenance of the building; however, items on the above list are section 1245 property if they are accessories to the taxpayer’s business and do not relate to the operation or maintenance of the building.

These are the assets ruled on in HCA:

Asset	Ruling
Carpet, wall to wall	Sec 1245
Vinyl wall coverings	Sec 1245
Vinyl floor coverings	Sec 1245
Telephone & communications receptacles & wiring	Sec 1245
TV equipment receptacles & wiring	Sec 1245
Other equipment-related electrical wiring, receptacles & connections	Sec 1245
Kitchen water pipe & equipment plumbing connections	Sec 1245
Kitchen hoods & exhaust systems	Sec 1245
Partitions, accordion style	Sec 1245
Patient corridor handrails	Sec 1245
Acoustical tile ceilings	Sec 1250
Bathroom accessories	Sec 1250
Recessed fluorescent light fixtures	Sec 1250
Steam boilers	Sec 1250

Some assets, such as carpeting and vinyl wall, are not permanently attached to the structure of the building. Other assets that are more permanently attached, such as various electrical components serving end-using devices that are themselves 5-year property, are section 1245 property when they function as "assets accessorial to the taxpayer's business activity" rather than as a structural component of the building. The “accessory to the business” test was approved in HCA. This "accessory to the business activity" test is the main one used to support the classification of many electrical and plumbing components as section 1245.

Extrapolating From the Case Law – Practical Classification Guidelines

There is no bright line test for differentiating between section 1245 and section 1250 property. The existing regulations and case law appear to give two somewhat overlapping basic tests for determining whether an asset is section 1245 property:

· Manner of attachment

· Function

The analyst should consider the factors listed below before making a decision regarding classification. A “yes” or “no” answer to any one question will not be determinative. Ultimately, classification decisions must be based on the exercise of sound judgment. The analyst may be called upon to defend his decisions before the taxpayer the IRS or the taxpayer-client.

In making decisions about the classification of various types of property that are at least nominally attached to a building or site, the following facts should be considered:

A. Manner of Attachment:

Is the property permanent? This is determined by balancing the factors listed below, and the answers to the first six questions (from the Whiteco case) should be given somewhat more weight than the others:

· How is the property attached to the building or site?

· ls the property designed or constructed to re- main permanently in place?

· Is the property capable of being moved, and has it actually been moved?

· How much damage will the property sustain upon its removal?

· How substantial a job is removal of the property and how time-consuming is removal (i.e., is it readily removable)? Would the property remain in substantially the same condition after removal as it was before?

· Are there circumstances that indicate how long the property will remain attached? Is it likely that the property will be moved in the future?

· Is the property reusable in another location? Has it actually been removed and reused in another location, either within the original building or in another building? Is it reusable in its entirety or only partially reusable?

· How much damage will the property’s removal cause to the building--no damage, merely temporary damage, or more than temporary damage?

· Does the property owner intend for the property to remain in place indefinitely?

· Was the property incorporated into the building during the construction of the building shell, or was it installed in a separate phase of construction following the construction of the building shell?

· Is the property a load-bearing part of the building?

B. Function:

Does the properly relate to the operation or maintenance of the building, or, instead, is it an accessory to the taxpayer’s business? This determination is made by considering the following factors:

· ls the property an integral part of operating the taxpayer’s business?

· Is the property unique to a particular industry or business, or is it a standardized item commonly found in many different types of buildings?

· Will removal of the property significantly detract from the usefulness or continued operation of the building “as a building”?

· Does the item occur in an unusual circumstance and not in relation to the operation or maintenance of the building?

· Does the item serve primarily a decorative function and have no more than an incidental relationship to the operation or maintenance of the building?

C. For electrical or mechanical components:

If the property is an electrical or mechanical component, then, in addition to manner of attachment and function, an additional inquiry should be whether the electrical or mechanical component is closely related to machinery or equipment? ln making this determination, consider the following factors:

· Is the property necessary to and used directly with specific items of machinery or equipment?

· Is the property dedicated to an end-using device that is itself tangible personal property?

· Is the sole justification of the equipment to maintain temperature or humidity requirements essential for the operation of other equipment or the processing of materials or foodstuffs?

· Is the property inextricably linked to specific equipment, or is it reasonably adaptable to more general uses?