Cost Classification and Our Approach

Many businesses have significant investments in depreciable property.  The period over which this property is depreciated can have a significant impact on a business’s tax liabilities.  The depreciable life of various assets under the Internal Revenue Code varies dramatically based on the classification of property as real property or tangible personal property.  Real property is generally depreciated over lives as long as 39 years while many items of tangible personal property are depreciated over much shorter lives of 5 to 7 years.  Classifying or reclassifying assets from real property to tangible personal property can produce tax savings through acceleration of depreciation deductions.

The classification of property needs to be supported by a proper accounting analysis.  Such an analysis determines and explains the criteria used to properly assign depreciable lives to various assets.  The savings from the acceleration of depreciation deductions can be quite significant.  For example, if $1,000,000 of costs is reclassified from the 39-year real property category to a 15-year category, a taxpayer can save $120,000 on a present value basis (based on reasonable assumptions).  If the depreciable life is cut from 39 years to 5 years, the savings could be $200,000.  The amount of depreciation deductions claimed over the life of the assets is the same no matter what the useful life of the asset.  Claiming depreciation deductions faster and therefore reducing income taxes on an accelerated basis is what generates the savings detailed above.

A cost classification analysis focuses on new construction projects, expansions, renovations, leasehold improvements and even purchases of existing buildings, to classify as much as possible of the related costs from real property to tangible personal property.  Owners of a wide variety of businesses, including manufacturing and industrial facilities, financial institutions, office buildings, hotels, shopping centers, restaurants and entertainment facilities, can benefit from these analyses.  Much of the renewed focus on cost classification has resulted from the Tax Court’s ruling in Hospital Corporation of America (HCA).  HCA prevailed in its arguments that components of a hospital building used to support various items of medical equipment should not be classified as real property.  Rather, they asserted these items should be treated as tangible personal property like the equipment they supported.

Many of HCA’s arguments have existed in the tax law for sometime.  For example, electric service needed to operate a piece of manufacturing equipment, although constructed into a building, can be considered tangible personal property.  Such a classification is used since the electric service’s only purpose is the support and operation of an item of tangible personal property.  Since the electric service is considered tangible personal property, it is depreciated over much shorter lives than the balance of the building costs.  We believe that many of these opportunities to classify costs existed before HCA was decided.

Many public accounting firms view a cost segregation study as a “separate project” from the preparation of a client’s tax returns.  At DeJoy, Knauf & Blood, we believe when a client purchases new assets such an analysis is an integral part of our tax planning and tax return preparation.  The tax law has allowed taxpayers for many years to properly classify assets for purposes of computing depreciation.  HCA merely highlighted its renewed application.  Our approach to asset cost classification includes the following:

• Review of the overall scope of a building project including review of architectural drawings, consultation with engineering and other construction staff and “walk-through” of property.
• Review of overall costs incurred on the building project including budgeted costs and actual costs by phase of construction.
• Review of costs incurred on identified items of personal property that will be installed in the building.
• Preparation of preliminary accounting analyses to allocated costs among real property and personal property.
• Assignment of proper depreciation lives to the various items of real and personal property.
• Review of final cost classifications analyses with our client and communication of inherent tax risks.

This approach puts us in the position to maximize our clients’ depreciation deductions when preparing their tax returns.  Preparing a separate cost classification analysis after the fact would mean we did not do our job when preparing our clients’ tax returns.  It also allow us to properly advise our clients of the tax risks related to the classification of costs on a particular project.  Merely allocating costs to various property classifications without a reasonable basis for such allocation can result in additional tax risks.  Our approach to cost classification is focused on making sure our clients are not assuming unreasonable levels of risk.

Opportunities for Assets Previously Classified

Opportunities exist for taxpayers who have previously purchased assets and have not properly classified costs and determined tax depreciation lives.  Because you classified assets and computed depreciation incorrectly when initially purchasing property or completing construction, it does not mean that the past classifications cannot be corrected.  The IRS has issued rules that allow taxpayers who have incorrectly reported depreciation or depreciable lives to make corrections.  Businesses that have in the past misclassified property when computing depreciation can change accounting methods relating to depreciation.  A business can deduct the underreported depreciation from prior periods and use the newly determined asset life in the future.  Such a change in accounting method is considered by the IRS to be automatic.  Therefore, taxpayers do not need to ask the IRS for permission to change their methods of computing depreciation.  This is unlike many other accounting method changes where a taxpayer must request permission from the IRS to change a method of accounting. 

These procedures allow taxpayers to review their methods of computing depreciation and classifying costs.  Changes in these depreciation methods and cost classifications can result in increased depreciation deductions and significant tax savings.  These changes must be supported by a cost classification analysis that provides a detailed and balanced approach to the reclassification.  Consistent with our approach outlined above, we make sure that our clients do not assume unreasonable levels of risk when reclassifying asset purchase costs.  Many CPA firms make promises of tax savings greatly in excess of their professional fees charged to complete a study.  Promises like these should be viewed cautiously since the CPA firm may be inclined to take overly aggressive positions in order to justify their professional fees.

At DeJoy, Knauf & Blood, we can help you determine appropriate cost classifications and depreciation methods for assets.  Our services can result in significant tax savings for your business.  Our approach will make sure that you are properly advised of your tax risks associated with the cost classification of your real and personal property purchases.  Opportunities may exist for your business today to increase depreciation deductions and reduce your tax liabilities.  If you would like additional information on a cost classification analysis and its ability to reduce your tax liabilities, please call or reply to Mark Blood or Dennis Stein.  We welcome your questions.