Recent IRS Announcements: Parking Structures & Qualified Leasehold Improvements
Parking Structures
Recently there has been much discussion regarding the IRS General Counsel Memorandum # 20125201F. The memorandum pertains to the recommended assessment of a §6662 penalty on a taxpayer who took the position that an open air parking structure was a 15-year land improvement versus a building with a 39-year life. The taxpayer was penalized 20% of the underpayment of tax caused by this position.
The IRS rejected the taxpayer’s assertion that the cost segregation study and its accompanying memorandum on the parking structure justified their position. Because neither the study nor the memo contained specifics regarding the particular parking structure, and the taxpayer only discussed open air parking structures in general, the IRS decided it was not reasonable for the taxpayer to assume the position they did.
The IRS issued a Coordinated Issue Paper (CIP) on Parking Structures in 2009. While the CIP could not be cited as authority, the document did give taxpayers a good sense of how the IRS would look at parking structure depreciation treatment upon audit and that taxpayers could be cited for a §6662 penalty if there was no substantiation for their position.
Given the specific results associated with this particular taxpayer issue, the outcome should come as no surprise to anyone. The IRS ended its 2009 CIP by clearly stating that assessing underpayment penalties was an option they would pursue where they deemed appropriate.
It should be noted that the taxpayer had previous experience with the denial of 15-year treatment of a similar parking structure in a prior audit. In that case, the taxpayer fought the audit adjustment, but later settled at Appeals. The fact that the taxpayer was a repeat offender made it easy for the IRS to recommend assessing the penalty.
When discussing whether any structure is a building, one first has to look at the ‘Appearance and Function Test’ as set forth in Regulations §1.48-1(e). The Regulations state, in part, “The term ‘building’ generally means any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space.” The first part of the test is simply whether the building looks like a building, i.e. whether its appearance is that of a building.
Various court cases have illustrated how important this test is when evaluating whether a structure is a building. In some circuit courts, a structure must meet both tests to be considered a building; in other circuits, the function test is given the greater weight. In some cases, the appearance test is not met and its importance depends on location and what rationale the court applies to determining whether the structure is a building.
While the facts and circumstances regarding other parking structures could possibly warrant a 15-year treatment in some cases, the CIP essentially served notice to all taxpayers and their advisors that it would be a difficult position to defend upon audit. As such, Bedford began advising clients to assign 39-year lives to parking structures following the issuance of the CIP in 2009.
HVAC and Leasehold Improvements
The IRS recently issued Chief Counsel Advice (CCA) 201310028 in which they concluded that heating, ventilation, and air-conditioning (HVAC) outside of a building or on the roof cannot be considered Qualified Leasehold Improvements (QLI) and, therefore, cannot be depreciated over 15-years and are not eligible for bonus depreciation. In order for HVAC units to be eligible for QLI, the units must be installed inside the building.
MACRS specifies in §168(b)(3)(A) that nonresidential real property is written off over 39-years using the straight-line method of depreciation. The exception, under §168(e)(3)(E)(iv), is where QLI is depreciated over a 15-year life using the straight-line method of depreciation. QLI is also eligible for bonus depreciation under §168(k). It is also in §168(k) that we look for a definition of QLI. Under §168(k)(3)(3), QLI means any improvement to an interior portion of a building which is nonresidential real property if:
- the improvement is made under or pursuant to a lease by the lessee (or sublessee), or by the lessor, of that portion;
- that portion is to be occupied exclusively by the lessee (or any sublessee) of the portion; and
- the improvement is placed in service more than three years after the date the building was first placed in service.
QLI does not include any improvement for which the expense is attributable to the enlargement of the building, any elevator or escalator, any structural component benefiting a common area, or the internal structural framework of the building. Regulation §1.168(k)-1(c), explains the statutory QLI requirements in more detail, however neither the regs, Code, or the legislative history explain a central QLI requirement; namely that the improvement be made “to an interior portion” of a building.
In the CCA, the IRS states that a plain reading of the Code is adequate to determine what is meant by the term “interior portion” of a building. They go on to say that the use of the word “interior” in §168(e)(6), is clear and unambiguous. Based on the plain reading of the word “interior,” §168(e)(6) requires that a qualifying improvement be made to the inside or inner portion of the building.
The CCA adds that while the replacement HVAC units installed on the roof of the building and on concrete slabs adjacent to the building are structural components of the building, these improvements are to the exterior of the building and not to the interior portion of the building. Since the improvements are not to an interior portion of a building, they are not treated as QLI. Qualified retail improvement property (QRIP) has the same language in its definition as QLI so it too must be an interior improvement.
In contrast, this does not apply to qualified restaurant property (QRP) as QRP goes by a different definition. Under §168(e)(7)(A), QRP is any §1250 property which is a building or an improvement to a building, if more than 50% of the building’s square footage is devoted to preparation of, and seating for on-premises consumption of, prepared meals. There is no requirement that the property be an improvement to the interior of a building. Note that QRP is not eligible for bonus depreciation unless it also qualifies as QLI.
Despite the reliance on a ‘simple’ definition by the IRS, the Bedford team finds this to be too simplistic. The HVAC system functions as a unit with one goal and that is to heat and/or cool the inside of the leased space that is subject to QLI. To say that a part of the system has a longer life than the portions inside the building is not realistic – especially since the units mentioned are the most commonly replaced; often before the interior portions.
It is important to note that CCA is not the law. The law is the content of the current statute governing the definition of QLI and the specific assets that are allowed and disallowed. Currently, the law is silent on the issue of special treatment for specific portions of an HVAC system. As such, we suspect there will be further commentary and clarification on this particular matter in the future.
Is Your Company Benefiting from the Research Credit?
Although billions of dollars in research tax credits are generated each year, the credit still retains elements of complexity and misunderstanding. Companies often view the efforts of developing new products, improving legacy products, or enhancing outdated and costly processes as merely the cost of doing business. As a result, many businesses may be overlooking a potential tax benefit.
The research tax credit is in addition to the tax deduction for research expenses and results in a dollar-for-dollar reduction of income tax liability.
What is the research tax credit?
The credit was enacted as a provision of the Economic Recovery Tax Act of 1981 as a key component of a multifaceted tax reduction package to ensure future economic growth. The credit offered a financial incentive to profitable U.S. companies of all sizes that were engaged in certain types of product development and process engineering activities. Unfortunately, because of confusion on what qualified research is and how the credit computed, many small and medium size companies have distanced themselves from the credit, and resulting benefit.
What is qualified research?
Claims for the research credit rely on two factors – the definition of qualified research and the expenses eligible for the credit. Qualified research must:
- Involve activities aimed at the development of a new or improved product or process. This includes all technical activities such as analysis, design technical requirements, developing, coding, testing, etc. undertaken from initial design, proof of concept, planning and definition, architecture and detailed design, and development testing.
- Be intended to discover information that is “technical in nature” and useful in the development of a new or improved business product, process, computer software, technique, formula or invention.
- Rely upon a process of experimentation whose ultimate aim is the development of a business component with a “new or improved function, performance or reliability or quality.” These activities generally involve the evaluation of alternatives, trial and error, failures, or other testing methodologies.
Examples of qualifying activities include developing new and improved legacy products, designing and testing pre-production prototypes and models, and developing software applications. By contrast, research conducted outside of the United States, research related to the social sciences, or research funded by the Federal government or a corporate entity is ineligible for the credit.
What expenses are eligible for the credit?
In-house salaries and wages of employees engaged in qualified research, as well as the costs of materials, supplies, and certain time-sharing costs for computer use in qualified research are the only qualified research expenses (“QREs”) included in the credit computation. Additionally, 65% of amounts paid to third-party contractors for conducting qualified research are eligible for the credit.
It is important to understand that certain related research and development (“R&D”) expenses are ineligible for the credit. For example, amounts expended on depreciable property used in qualified research, such as buildings and equipment, are ineligible for the credit. Also, overhead expenses such as utility expenses, rent, and employee benefits are ineligible for the credit.
How is the research credit computed?
For the 2012 tax year, companies have the opportunity to elect one of the two formulas used to compute the research credit: 1) the traditional credit and 2) the alternative simplified credit (“ASC”).
Under the traditional method, businesses receive a 20% tax credit for QREs in excess of a computed base amount. The base amount for any given tax year is determined using the business’ history of QREs and gross receipts (i.e., 1984 – 1988). This methodology is beneficial for companies that have maintained its historical records and whose R&D spending has grown consistently with, or faster than, its revenues.
The ASC is a simplified computation that provides a 14% rate on current year QREs in excess of 50% of a company’s prior three-year average of QREs. The ASC is computed without reference to gross receipts, and utilizes a more current view of a company’s R&D expenses. If a company has no QREs in any of the preceding three years, the credit is equal to 6% of the QREs for the current tax year.
Do the states offer a research credit?
In addition to the federal research credit, approximately 35 states have enacted some form of research credit. R&D activities may also enable a company to qualify for other incentives, such as investment credits, jobs credits, and sales and use tax exemptions. Below is a sample of states that offer a research credit. To learn more about R&D, and whether your state offers a research credit, please contact Fred Lesser at (215) 885-7510 or flesser@bedfordteam.com.
Connecticut offers two general research credits:
- Incremental Research Credit. The Incremental Research Credit is equal to 20% of the increase in research expenditures (including both direct and indirect research expenditures compared to the preceding year.)
- Non-Incremental Research Credit. A Non-Incremental Research Credit is also provided to a qualified small business (i.e., $100 million or less in gross revenue) equal to 6% of the current year’s research expenditures.
The Connecticut credit includes all costs incidental to the development or improvement of a product, including any pilot model, process, formula, invention, technique, patent, or similar property. However, overhead and other expenses, such as general and administrative expenses that do contribute directly to the research and development effort do not qualify. In addition, Connecticut allows companies without a current tax liability to monetize their credit at a discounted selling price.
Massachusetts provides a research credit equal to 10% of the excess of qualified research expenses over a base amount. Qualifying research expenditures are similar to research expenditures that qualify for the federal research credit. The base amount computation is similar to the federal methodology.
New Jersey has a comprehensive package of tax incentives for research, including a research credit, an investment credit, a jobs credit, and a sales and use tax exemption. Additionally, certain technology and biotechnology companies may be able to transfer their unused research tax credits and net operating loss carryovers to other New Jersey taxpayers.
Pennsylvania offers a non-refundable incremental research credit of 10% for research activities conducted within the state. The credit is based on the rules set forth in IRS Code section 41. Companies must apply for the credit by September 15 and are notified by December 15 of the approved amount.
How should the credit be documented?
Documentation is essential for receiving and supporting the research credit. It is vital to be able to clearly and completely demonstrate to the Internal Revenue Service (“IRS”), as well as state jurisdictions, that the project work was indeed qualified research. It is also required that QREs be identified by qualified activity. Accordingly, if upon examination an examiner is unable to connect specific research projects and the underlying activities to the qualified expenses, the credit claim will not be sustained.
Contemporaneous books and records are the basis for research credit examinations. In addition, computational work papers, along with the following types of qualitative support, would be helpful:
- Materials explaining the research activities, including the difficulties encountered during the course of the project;
- Project summaries and/or progress reports indicating the issues encountered during the course of the research;
- Minutes of meetings that discuss research activities, including the resolution of uncertainties;
- Complete copies of contracts for research performed by outside contractors.
Is your company a candidate for the research credit?
Any firm with leading edge technology is likely to have qualified research and eligible costs. Companies in the chemical, electronics, manufacturing, medical technology, pharmaceutical, and software industry sectors are candidates for the credit.
President Obama Signs Bill that Averts Fiscal Cliff
The Senate passed H.R. 8, the “American Taxpayer Relief Act”, in the very early morning hours of Jan. 1, 2013. The House subsequently passed the bill later that day. Late last night President Obama signed the bill into law. The following is a brief overview of the key provisions within the Act.
Depreciation Provisions
- The 15-year straight-line cost recovery for qualified leasehold improvements (QLI), qualified restaurant buildings and improvements (QRI), and qualified retail improvements has been extended from January 1, 2012 through December 31, 2013 for property placed in service after December 31, 2011. Only QLI retains bonus depreciation.
- The 7-year recovery period for motorsports entertainment complexes was extended for 2012 through December 31, 2013 for property placed in service after December 31, 2011.
- The use of accelerated depreciation for business property on an Indian reservation was extended through December 31, 2013 for property placed in service after December 31, 2011. Section 168(j) allows for 5-year property to be depreciated over 3 years; 15-year property to be depreciated over 9 years; and nonresidential real property to be depreciated over 22 years (rather than 39 years).
- The increased expensing limitations and treatment of certain real property as Code Sec. 179 property were extended through December 31, 2013 for property placed in service after December 31, 2011.
- The Act also extends and modifies the bonus depreciation provisions with respect to property placed in service after December 31, 2012 but before January 1, 2014, in tax years ending after December 31, 2012. We are still using the 50% rate to determine first year bonus depreciation. The modifications are mainly to the election to accelerate the AMT credit rather than using bonus depreciation.
Business Credits
- The Code Sec. 41 research (R&D) credit is modified and retroactively extended for two years through 2013. It is now effective for 2012 and 2013.
- The temporary minimum low-income tax credit rate for non-federally subsidized new buildings under Code Sec. 42(b)(2)(A) is extended to apply to housing credit dollar amount allocations made before Jan. 1, 2014.
Energy Credits
- The credit for energy-efficient new homes under Code Sec. 45L is retroactively extended for two years through 2013.
For more details on the Act, and how the provisions effect you and your business, contact us today.
Update on the Repair Regulations (Notice 2012-73)
On Tuesday, November 20, 2012, the IRS issued Notice 2012-73 relating to the temporary regulations for the deduction and capitalization of expenses relating to the acquisition, renovation, or improvement of real estate.
Notice 2012-73 informs us that the IRS will be issuing permanent rules at some point during 2013. Additionally, the IRS is anticipating the permanent regulations will have an effective date of January 2014, which will replace the January 2012 effective date of the temporary regulations (issued at the end of 2011). We expect the final regulations will include further clarification on several items and finally provide some conclusive guidance as to whether an expense is deductible as a repair or must be capitalized as an improvement.
Taxpayers can choose to apply the temporary rules as they stand now or wait to analyze the new rules and decide the best way to implement. However, it is important to note that although the IRS identified three areas that may be revised in the final regulations – De Minimis Rule §1.263(a)-2Tg; Dispositions §1.168(i)-1T and -8T; and Safe Harbor for Routine Maintenance §1.263(a)-3Tg – until the rules are finalized anything issued in these sections of the temporary regulations may be subject to change. Therefore, any changes in accounting method made in accordance with the temporary regulations might not be the same after the permanent rules are finalized. The Notice does state the IRS will provide for accounting method changes after the new regulations are issued, but gave no indication as to what that might entail.
Until last week, many accounting firms were aggressively promoting the need to implement accounting method changes for General Asset Accounts. Given the released Notice, the urgency has essentially disappeared. However, the temporary regulations do suggest how assets should be classified in order to enable taxpayers and their advisors to make informed decisions regarding Repair vs. Capital items. A ReCap℠ study performed by Bedford will provide you with the appropriate level of detail regardless of whether you choose to take advantage of the regulations as they stand now, or when they are released next year.
Please contact us for more details.
End of Third Quarter Tax Planning
As we get ready to wrap-up the third quarter of 2012, it is a great time to explore the potential benefits of the various engineering-based tax solutions available today. Tax tools such as cost segregation, EPAct/Section 179D, and now the temporary regulations for Repair vs. Capital, are great sources for generating cash flow for owners of commercial real estate.
A unique feature of the 2012 tax season preparation is the host of traditional tax tools that are set to expire at the end of the calendar year. Currently, both bonus depreciation and all qualified leasehold improvement legislation are set to expire on December 31, 2012. While we can point to past instances where these programs were reinstated at the closing of the year, current financial and political climates do not ensure we can count on these benefits being available for the near future.
The Bedford team is strongly encouraging those that have the opportunity to place projects into service before the end of the year to do so. As always, our goal is to ensure our clients achieve the best economic benefit while maintaining a defensible position.
New HVAC Hotel & Apartment Technology Obtains Large EPAct Tax Incentives
Written by Charles R. Goulding, Andrea Albanese, and Jacob Goldman; Energy Tax Savers Inc., The EPAct 179D Experts.
New HVAC technology called VRV (Variable Refrigerant Volume system), also known as VRF (Variable Refrigerant Flow), is substantially reducing hotel and apartment building energy expenses.
This new technology began to mainstream into the US market after the enactment of the Energy Policy Act and is now being widely recommended by the architecture, engineering, and HVAC industries.
The EPAct Section 179D Tax Opportunities
Pursuant to Energy Policy Act (EPAct) Section 179D, VRV building owners making qualifying energy-reducing investments in their new or existing locations can obtain immediate tax deductions of up to $1.80 per square foot.
If the building project doesn’t qualify for the maximum EPAct Section 179D $1.80 per square foot immediate tax deduction, there are tax deductions of up to $0.60 per square foot for each of the three major building subsystems: lighting, HVAC (heating, ventilating, and air conditioning), and the building envelope. The building envelope is every item on the building’s exterior perimeter that touches the outside world including roof, walls, insulation, doors, windows and foundation.
VRV Technology Description
VRF/VRV is an air conditioning system most efficient for commercial buildings because of the ability to individualize control for different zones/rooms, whereas conventional systems condition a building as a whole. The system is very beneficial for buildings with varying cooling needs and different zones.
In particular, hotels, apartments, schools, and office buildings would get the most benefit from this system as individuals want to be able to control the temperature in their area. Individual control in VRF/VRV systems creates energy efficiency and allows for flexibility in building design.
The Japanese Manufacturers
First utilized in Japan over 20 years ago, VRF/VRV units are now marketed in the US by two large Japanese manufacturers, namely Mitsubishi and Daikin McQuay. As new entrants, both companies chose to locate thier US headquarters in two major warmer temperature markets, utilizing large amounts of cooling, namely Dalls, Texas and Atlanta, Georgia.
Apartment HVAC Replacement
With apartments it is the tenant that bears the utility costs related to HVAC. New benchmarking rules in major apartment markets, including California, New York City, Washington, D.C., Austin, and Seattle, will soon provide large amounts of data related to current apartment energy costs(1).
Presumably the Atlanta and Dallas markets where the two US VRF/VRV sellers are headquartered will quickly become aware of the magnitude of energy savings.
Hotel HVAC Tax Savings
The timing for this cost saving technology is excellent for the hotel category since the industry is in the midst of a rapid economic recovery. THe hotel industry was decimated during the economic downturn and has since reorganized.
During the economic downturn necessary HVAC replacements wer defined and are now being addressed. Often hotel investment groups own multiple properties so if they are pleased with VRF/VRV technology incentives, they will replicate it across their hotel portfolio.
Substantial Energy Cost Savings
For both hotels and apartments building HVAC is the largest energy cost item. VRF/VRV’s will annually reduce total energy costs for these two markets by at least 20% and may reduce current building energy costs by as much as 40%.
Many hotels and apartment buildings are currently installing LED and other energy efficient light technoilogies and the total energy cost savings from both measures can often exceed 50%.
Conclusion
VRV HVAC technology is rapidly being introduced into the US market with the help of large EPAct tax incentives. An EPAct technology that reduces apartment tennat cost is welcome on the market and the recovering hotel market is perfectly suitable for this opportunity.
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Charles R. Goulding, Attorney/CPA is the President of Energy Tax Savers Inc., The EPAct 179D Experts, an interdisciplinary tax and engineering firm that specializes in the energy-efficient aspects of buildings.
Andrea Albanese is an Analyst at Energy Tax Savers Inc., The EPAct 179D Experts.
Jacob Goldman, LEED AP, is an Engineer and Tax Consultant at Energy Tax Savers Inc., The EPAct 179D Experts.
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(1) See Goulding, Charles, Goldman, Jacob, & Most, Joseph. “Using EPAct Incentives to Enhance New Mandatory Building Energy Disclosure Requirements.” Corporate Business Taxation Monthly. October 2010. Page 11-14.
LED Lighting Can Play a Key Role in Securing EPAct Tax Benefits
Written by Charles R. Goulding, Raymond Kumar, and Jennifer Pariante; Energy Tax Savers Inc., The EPAct 179D Experts.
At the IMARK 2011 Energy Summit held on November 16-17 in Chicago, Illinois, a panel of senior lighting executives from Acuity Brands, GE Lighting, Hubbell Lighting, OSRAM SYLVANIA and Philips Lighting agreed that the fastest growing market segments for the adaption of LED lighting applications are:
1) Office buildings
2) Hospitality industry (hotels and restaurants)
3) Retail stores
The article explains how to optimize the Energy Policy Act (EPAct) tax opportunities related to these three important vertical market categories.
The EPAct Section 179D Tax Opportunities
Pursuant to Energy Policy Act (EPAct) Section 179D, facility owners making qualifying energy-reducing investments in their new or existing locations can obtain immediate tax deductions of up to $1.80 per square foot. If the building project doesn’t qualify for the maximum EPAct Section 179D $1.80 per square foot immediate tax deduction, there are tax deductions of up to $0.60 per square foot for each of the three major building subsystems: lighting, HVAC (heating, ventilating and air conditioning) and the building envelope. The building envelope is every item on the building’s exterior perimeter that touches the outside world including roof, walls, insulation, doors, windows and foundation.
EPAct Tax Deduction Wattage Targets for the Three Major Market Segments
The following table presents the EPAct wattage targets for office buildings, the hospitality categories of hotels and restaurants, and retail. Tax deductions start wattages at 25 percent more efficient than ASHRAE 90.1.2001 and the full deduction is achieved at 40 percent or better.
Office Buildings
Office buildings are excellent EPAct tax deduction candidates since the 0.78 watts per square maximum tax deduction wattage target is challenging for offices to meet with any lighting technology other than low-wattage LEDs. The country’s largest office buildings tend to be in major cities, many of which have recently enacted public benchmarking laws. These laws, generally applicable for buildings exceeding 50,000 square feet, compare building energy use by building category and assign a percentile. Landlords in the jurisdictions with benchmarking laws including California, New York City, Washington D.C., Austin, and Seattle, are moving quickly to make certain that they are not in the bottom 50 percentile. One of the easiest ways to measurably improve one’s rating is to install energy-efficient lighting, particularly LEDs. Office buildings with very energy-efficient HVAC and LEED certification may be platformed for larger EPAct tax deductions which can be used to offset the high cost of LED lighting.
Hospitality/Hotels
Hotels obtain special privileges under the EPAct tax provisions in that guest rooms are not subject to the tax bi-level switching rule and centralized HVAC is favored over individual room HVAC units. The hotel industry has reorganized after the economic downturn, and new owners are moving quickly to renovate hotels that, in many cases, have long deferred retrofit needs. LED lighting is particularly suitable for hotel guest room interior packages, which typically involve bathrooms, desk lamps, free-standing lamps and bed lighting. Historically, many of these applications used incandescent lamps which are now being phased out by law for the period of 2012 through 2014.
Restaurants
Like hotels, restaurants were adversely impacted by the economic downtrend. Many independent restaurants went out of business and the national and regional chains have gained market share. The large chains are cost containment experts and they standardize lighting design applications. Powerful low-wattage LED lighting is particularly suitable for restaurant design themes. LED lighting enables a much smaller lightweight lighting fixture, which saves these restaurants interior ceiling costs and expands ceiling design options.
Retail
Facing the ever-growing onslaught of nimble competitors and the Internet, retailers must reduce operating costs and in many cases seek to become centers of attraction. LED lighting greatly reduces ongoing operating costs and focused beams of LED lighting are ideal for emphasizing specific merchandise offerings.
Conclusion
LED lighting is now mainstreaming into the major building categories including the three major building categories described above. Informed tax advisors can help their property owners get a better economic return and accelerate these cost savings and business enhancement opportunities.
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Charles R. Goulding, Attorney/CPA is the President of Energy Tax Savers Inc., The EPAct 179D Experts, an interdisciplinary tax and engineering firm that specializes in the energy-efficient aspects of buildings.
Raymond Kumar, CPA is an Analyst at Energy Tax Savers Inc., The EPAct 179D Experts.
Jennifer Pariante is an Analyst at Energy Tax Savers Inc., The EPAct 179D Experts.
This article originally appeared in the February 2012 issue of IMARK Now.
ASCSP Comments on AmeriSouth XXXII., Tax Court Memo 2012-67
Contributing Authors: Gian Pazzia, CCSP; John Hoffman, CCSP; Jeffrey Shilling, CCSP
Summary
In the recently released AmeriSouth XXXII., Tax Court Memo 2012-67, the IRS makes its first meaningful strike in its attempt to marginalize the benefits of cost segregation studies for residential rental property. For many taxpayers and CPAs, this is a complete surprise. However, ASCSP members have known for over a year that this was likely to happen. The IRS seems to have made a coordinated national effort with regards to the classification of assets in residential rental property. Although there are currently numerous IRS exams underway involving depreciation of apartments, the IRS had yet to establish formal case law directly on point with its position on apartments. Further, the IRS warned cost segregation professionals of this position at an ASCSP National Conference and indicated they were going to release a Cost Segregation Industry Directive specific to the residential rental industry. This Directive has yet to be published. ASCSP believes that, much like early case law from the Investment Tax Credit era, just because this specific Tax Court Memo was unfavorable, it does not mean future tax court rulings on the same issues will be consistent. ASCSP provides its opinions below on several items disputed in this case. Further, this case emphasizes the importance of using a Certified or Senior Member of the American Society of Cost Segregation Professionals to ensure the taxpayer is aware of all current industry developments.
Facts
AmeriSouth XXXII, Ltd. acquired an apartment complex in 2003 for $10.25 million. The property was originally built in 1970. As soon as AmeriSouth bought the property, it began a $2 million renovation of the apartments that included replacing cabinets and countertops, dishwashers, garbage disposals, vent hoods, and kitchen sinks. The cost segregation study results were reported on the originally filed tax return for 2003. Roughly 33% of the property was reclassified into categories with 5 or 15 year tax lives. The components at issue include:
- site prepartion and earthwork
- water-distribution system
- sanitary-sewer system
- gas line
- site electric
- special HVAC
- special plumbing
- finish carpentry
- millwork
- interior windows and mirrors
- special painting
AmeriSouth sold the property about the time the case was tried, and stopped responding to communications from the Court, the Commissioner, and even its own counsel. Because of AmeriSouth’s lack of responsiveness, their lawyers withdrew from the case and left the taxpayer representing itself. The case could have been dismissed entirely, but because AmeriSouth didn’t file a post trial brief, the Court deemed any factual matters not otherwise contested to be conceded.
ASCSP Commentary
ASCSP understands that some of positions taken in this cost segregation study are considered somewhat aggressive by most experts. Based on the TC Memo, it also appears there was poor reference material available to substantiate the asset classifications used. A critical factor in this case was that the taxpayer had no interest in defending themselves, effectively giving the IRS a free pass to present their position on many issues without being challenged. In essence, this is the perfect storm for the multi-family industry caused in part by a taxpayer who didn’t resolve the issues at appeals and then essentially gave up when the case went to tax court. It is important to note that this was a Tax Court Memo, and is technically not authority, but that will not prevent the IRS from referencing this during future exams of a cost segregation studies.
We believe one of the most significant issues contested and considered by the Court relates to the appropriate comparison benchmark for an apartment. Should the Court look to see if the items in question relate to the operation and maintenance of a typical apartment building, or to the operation and maintenance of a generic shell building? The Court rationalized that the type of building does matter. ASCSP does not agree with the Court in this critical decision. While it is true that residential rental property enjoys a 27.5 year life versus 39 years for non-residential real property, the leap from building to apartment building seems to be a stretch and we are not convinced that the commissioner would have been successful if the argument had been opposed. We note if this principle is applied to a 15 year service station (asset class 57.1), it would conflict with existing case law that supports personal property classification in service stations. The same can be said for 20 year farm buildings and 15 year restaurant property. Nonetheless, if this argument holds up in future cases, it could have widespread consequences. Below are ASCSP’s comments specific to items held to be real property by the Court.
Site Utilities – Denied as 15 year property. Site utilities are outlined in several previously issued IRS Directives as 1250 Real Property when they relate to a typical building, and we agree. While ASCSP understands methodical allocations of site utilities may be appropriate in some cases, it is hard to argue an apartment building’s gas, water, sewer, and electric service does not relate to the overall operation and maintenance of a building as described in the definition of a structural component found in §1.48-1(e)(2).
Special HVAC – Partially denied as 5 year property. The venting connected to the stove hoods was not allowed because the Court was not convinced that they serve only the stoves. They rationalized that the stove hoods can also serve to remove odors and heat from beyond the stovetop. ASCSP disagrees and believes that if proper case law was referenced, the Court would have allowed these items as 5 year property. Serving as ventilation for the building is merely incidental to its primary function of servicing the stove. Venting serving the dryer was allowed as personal property.
Special Plumbing – Denied as 5 year property. Interestingly, the tax Court considered that AmeriSouth did not intend to periodically replace or plan to replace sinks after the 2003 renovation. While the intent to replace an item is relevant for purposes of determining Repair vs. Capitalization, it generally is not considered when determining the appropriate tax life of an asset. ASCSP also notes that the Court cited the accessory test early in this case but failed to apply such test to any of the items in question. One can argue that kitchen sinks and plumbing are accessory to and necessary for the business of renting apartments.
Ceiling fans and Lights – Denied as 5 year property. ASCSP believes this would have been ruled 5 year tangible personal property if AmeriSouth argued that the lighting provided by these combination light-fans serves to provide ambiance and only incidentally serves as general lighting. The fans are not structural components to the property.
Wiring – Denied as 5 year property. ASCSP believes this also would have been ruled 5 year tangible personal property if AmeriSouth showed that the wiring supplied power for the appliances. The Court stated there was no evidence showing such.
Electric Panels – Denied as 5 year property. Quite simply, if a proper electrical load calculation was conducted and documented between specific equipment and the overall requirements of the building, ASCSP believes this item would have been ruled 5 year tangible personal property. This has been proven in the Scott Paper case.
Millwork and Finish Carpentry – Denied as 5 year property. The Court stated that the proper classification of the cabinetry is strictly an issue of their permanence and implied the same for the finish carpentry. ASCSP has obtained information from unpublished resources that the general contractor who testified was not prepared to explain the steps required to remove these items and not prepared to address the six Whiteco Factors. ASCSP believes the Court would have a different opinion if the permanence of these items was explained by the taxpayer in the context of the Whiteco Case. The vast majority of all kitchen cabinetry in modern apartments is easily removable and reusable.
Mirrors – Denied as 5 year property. ASCSP believes if proper case law was referenced, the Court would have allowed these items as tangible personal property. The Court did not dispute that the mirrors are removable. However, when AmeriSouth’s former attorney called for testimony that the mirrors were decorative, their own witness stated the dining-room mirrors had “no function,” which actually supports the IRS position. I wonder if the judge scratched his head at this point in confusion and wondered which side this witness was arguing for.
Closing
The story of this case is that poor preparation and documentation allowed the IRS to get their positions on the record with circumstances that favored them before the case even started. Unfortunately, according to our inside member resources this case will not be appealed as the taxpayer has no interest in the property anymore. This case emphasizes the risks of not using a Certified or Senior member of ASCSP to conduct these studies. Before choosing one provider over another, check their credentials at
http://www.ascsp.org/
.
A fellow ASCSP member is in the process of assisting another tax payer/apartment owner that expects to be taking the same issues to tax court. We believe the outcome of that case will be much more relevant to the issues at hand. We will be closely monitoring developments in this area. If you are a taxpayer/owner of apartments and would like to discuss these issues further, please contact a member of the ASCSP. ASCSP is committed to supporting taxpayers that are willing to bring this issue to tax court.
“No-Show” Taxpayer Loses in Tax Court
While the title of this article probably invokes a response from the reader such as “well – that’s a no-brainer”, that is exactly what happened in the case of AmeriSouth XXXII, Ltd v. Commissioner of Internal Revenue. The recently released T.C. Memo 2012-67 has caused quite a stir within the accounting and cost segregation community.
Background
AmeriSouth acquired an apartment complex in 2003 for $10.25 million. Immediately following acquisition, AmeriSouth proceeded to renovate the property, incurring costs in the area of $2.0 million. AmeriSouth engaged the services of a cost segregation firm that took the position that $3.4 million could be classified in 5 and 15-year lives for depreciation purposes. The IRS disagreed with the taxpayer’s position and the taxpayer filed a petition to challenge the Commissioner’s adjustments.
Shortly thereafter, AmeriSouth sold the property and stopped communicating with the court as well as its own attorneys. The situation became so bad that the court permitted the AmeriSouth attorneys to withdraw from the case. When asked to file a post trial brief, AmeriSouth ignored the request. Perhaps they assumed that everything would just “go away”. Unfortunately for AmeriSouth, that would not be the case and the process went on without them.
Court’s Observations
On the surface, it would appear as if the cost segregation consultant made some serious errors and was overly aggressive with some of their interpretations in conducting the cost segregation study. Further, according to the Court, the consultant did not demonstrate sufficient evaluation, validation or substantiation of many assets they called “special use”. The Court also considered the IRS expert witness as being more reliable than the taxpayer’s consultant in recreating costs using the consultant’s own work papers (which strangely were not entered into evidence) citing that it was an attempt to undermine the Commissioner’s characterization of what they held.
The Details
The consultant missed the mark on many assets and did not provide the appropriate level of detail upon which to provide a convincing argument to the Tax Court. Some items include the following:
- Water Distribution Systems
- Sanitary Sewers
- Site Electric
- “Special HVAC and Plumbing”
- Interior Millwork
- “Special Painting”
Bedford’s Observation and Commentary
In several instances, the cost segregation consultant made some serious errors with their interpretation of relevant tax law, court cases and Revenue Procedures in preparing their study and assigned incorrect recovery periods to certain assets. Other than these errors, this case underscores the importance of engineering-based studies conducted and written by the same qualified individual. Cost segregation scope and methodology is critical – especially on acquired properties, as was the case in AmeriSouth.
Additional documentation supporting the consultant’s position regarding “special electrical” might have included actual photographs of electrical panels, and devices with actual load-based electrical calculations might have provided a more defensible position. Similarly, photographic documentation and specific delineation of appliance connections could have supported those assets having 5-year lives. Concise and accurate descriptions of these assets are always beneficial. Simply labeling something as being “special” has no relevance whatsoever.
While it is difficult to determine the credentials of the person who conducted the on-site evaluation and ensuing engineering analyses (if any), it is safe to assume that the report did not stand up to IRS scrutiny as written. Given the taxpayer’s unwillingness to follow procedures, coupled with a series of events that lead up to this decision, it is no wonder that the IRS got exactly what they wanted. The good news is that a comprehensive cost segregation study conducted by a qualified individual will be able to withstand any scrutiny by the IRS. Of course, when challenged by the IRS, the taxpayer and their consultant should actually have an opportunity for their day in court. The results could have been different on a number of items had AmeriSouth actually shown up.
IRS Modifies Energy Reduction Thresholds for 179D Deductions
On February 24, 2012, the IRS issued Notice 2012-22 which modifies the thresholds for various building component energy efficiencies in support of the § 179D deduction pursuant to EPAct 2005.
By way of reference, tax payers may be entitled to a deduction of up to $1.80 per square foot if certain energy savings are realized. The calculations for the deductions are based on lighting, HVAC and building envelope performance standards with the related deductions available for newly constructed or renovated properties. While these incentives have been around since 2005, there have been a couple of modifications over the years.
Traditionally, it has been relatively easy to meet the standards for lighting. It has been more difficult now however, to meet the qualifying thresholds for HVAC and building envelope. IRS Notice 2012-22 now reduces the thresholds for HVAC and building envelope, making it perhaps a bit easier to qualify for deductions associated with these elements. While the adjustment in the thresholds requires for lighting to “pick up the slack”, we feel that ongoing advancements in lighting technology will easily enable taxpayers to still meet the lighting thresholds and create a better chance of meeting the other two thresholds.
As with everything in the tax world, the actual strategy and ensuing results will be based on “facts and circumstances”. If you or your clients have recently constructed or renovated a facility, it may make sense to determine if you could benefit from a study to enable you to take advantage of this valuable tax deduction.
For more information, please contact your local Bedford representative.
