Everything and the Kitchen Sink: The AmeriSouth Cost Segregation Tax Court Case

Published by Jon E. Krabbenschmidt on Friday, June 1, 2012
Journal thumb June 2012

“The details of depreciation spur many to more interesting pastures ...” So begins the case discussion section of a recent Tax Court (TC) case on the topic in AmeriSouth v. Commissioner (TC Memo 2012-67) issued on March 12.

Rental real estate consists of a multitude of assets: land, building shell, doors, kitchen cabinets, appliances, plumbing, underground utilities, landscaping, etc. The allocation of these assets into appropriate asset classes for purposes of calculating depreciation expense is what is called “cost segregation.”

The basic concept of depreciation is to expense the wear and tear of property used in a trade or business for the production of income over the expected life of that property. The shorter the life (or recovery period) of an asset, the greater is the depreciation expense in the initial years of operation. A good cost segregation study identifies all of the shorter-life (five-, seven- and 15-year) personal property, such as furniture, fixtures and equipment, and land improvements, from the longer life 27.5-year residential building life and non-depreciable land. For the past few years taxpayers have even been eligible for 50 percent and 100 percent bonus depreciation on any newly placed-in-service personal property and land improvements, another reason to identify and segregate fixed asset carefully.

Industry standards for asset class allocations are supported by guidance from the Internal Revenue Service (IRS) in the form of numerous announcements, revenue procedures, regulations and TC cases. In AmeriSouth, however, the judge appears to blow out of the water and into longer-life asset classes many of the widely accepted asset class allocations. Judge Mark V. Holmes decided that many of the assets of the petitioner’s 40-building, 366-unit apartment complex in Texas should be reclassified from personal property to building.

Clearly, shorter depreciation periods benefit a taxpayer by accelerating the depreciation deductions. “We (the Tax Court) are tempted to say this is why AmeriSouth throws in everything but the kitchen sink to support its argument – except it actually throws in a few hundred kitchen sinks …” AmeriSouth purchased the $10.25 million market-rate apartment complex in 2003 and spent $2 million in renovations. They hired consultants to perform a cost segregation study that resulted in increased depreciation deductions of approximately $1,412,000 from 2003-2005. The IRS commissioner subsequently denied deductions of more than $1,000,000. AmeriSouth then filed its petition to challenge the commissioner.

A significant aspect of this case is that the court places the burden of proof on the taxpayer to provide support for why an asset should have a shorter depreciable life. Yet, the court decided the case without AmeriSouth’s counsel present during the trial. The petitioner sold the property in question prior to the case being tried and subsequently failed to participate in the post-trial briefings requested by the court. The court decided that it would “deem any factual matters not otherwise contested to be conceded” in favor of the IRS commissioner. The important factor to remember about AmeriSouth is that the taxpayer failed to introduce evidence to support many of its positions, so it is hard to place too much reliance on the case.

The meat of the AmeriSouth case is whether tangible property attached to a building can be claimed as shorter-life personal property and site improvements, separate from the building itself. The commissioner argued that the “components in question are integral to the apartments’ operation and maintenance and should thus be classified as structural components.” The case goes on to review 12 categories of assets, from site preparation and utility lines to finish carpentry and painting. Let’s examine a few of these in detail.

Underground Utilities
The court’s argument here hinges on whether the utilities (e.g. water, sewer, electrical lines) relate to the “operation and maintenance of the apartments.” Income Tax Regulation Section 1.48-1(e)(2) states that “structural components” are parts of the building, such as walls, floors, permanent coverings, ducts, plumbing and stairs, “relating to the operation or maintenance of a building.” The court further sited Scott Paper Co v. Commissioner (74 TC 137 (1980)): “Property can relate to the overall operation and maintenance of a building, even though it is not located within the building.” Even though underground utilities are not inside the building structure, they are an “integral part” of the building and a utility “system serves the building generally” by providing water, sanitation, gas or electricity to the building for general operational purposes.

In Trailmont Park Inc v. Commissioner (TC Memo 1971-212), the court sided with the taxpayer, agreeing that clearing, grading and underground utility connections for each mobile home pad on the trailer park property were site improvements depreciable over 15 years. In Trailmont, the commissioner had argued that these improvements were “‘inextricably associated’ with the land itself and thus … not depreciable.” In AmeriSouth, the commissioner and the court concluded that the underground utilities were part of the building, depreciable over 27.5 years. Whether a property’s underground utilities should be classified as site improvements or building depends on what the utility line is connected to and who owns the utility line(s) and is responsible for repairing and maintaining the line(s).

The first point is easy to address: what is the utility line connected to? The key difference between Trailmont and AmeriSouth is that the underground utility lines were connecting to the trailer home pads versus a building structure. The trailer pads are site improvements (no building exists – the pads are concrete slabs on which mobile homes are parked), while an apartment building is clearly a building. Alternatively, if there are electrical lines running to pathway lighting, or water lines running to a sprinkler system, the costs of those utility lines are depreciable over 15 years as site improvements because they service other site improvements (the light fixtures and landscape sprinklers). Again, the key is to determine the type of asset the water, sewer, gas or electrical line is principally supporting.

The second factor to consider is not as straightforward. If costs are incurred to install and maintain underground utilities on private land, AmeriSouth supports the industry standard that those are depreciable assets. On the other hand, if a utility company owns the utility line and is responsible for maintaining the line, then the asset is not depreciable even if it is located on private property. What if they are offsite utilities? It is not uncommon for a municipality to require a developer to construct or pay for offsite improvements as a condition of receiving services.

Offsite Improvements
AmeriSouth does not specifically address onsite or offsite improvements that the owner pays for but then dedicates to the utility company. Yet, they can be a significant expense to a developer and an important consideration in whether or not they are includable in an LIHTC project’s eligible basis.

In IRS Technical Advice Memorandum (TAM) 200017046, a developer built streets, sewer and water systems and storm drain improvements immediately around the developer’s commercial parcel. The developer entered into an acquisition and financing agreement with the local municipality in which these improvements were deeded to the city as public improvements and the city became responsible for their maintenance, repair and replacement. In exchange, the developer received bond financing from the city. The TAM outlines the IRS’ position that these assets do not constitute depreciable property to the developer. Instead, they are intangible assets. The offsite infrastructure provides public utilities and transportation access directly to the developer’s site, which is a “long-term direct business advantage” [emphasis added]. The city is responsible for the repair and maintenance of the offsite improvements for an indefinite period; therefore, the assets themselves have an indefinite life. The TAM says, “Under § 1.167(a)-3, an intangible asset, the useful life of which is not limited, is not subject to the allowance for depreciation. No allowance will be permitted merely because, in the unsupported opinion of the taxpayer, the intangible asset has a limited useful life.”

However, effective for costs incurred on or after December 31, 2003, and as discussed in IRS Private Letter Ruling (PLR) 200916007, IRS Reg. §1.263(a)-4(d)(8)(iv) provides that offsite infrastructure built by a “taxpayer where the real property or improvements benefit new development or expansion of existing development, are immediately transferred to a state or local government for dedication to the general public use, and are maintained by the state or local government” are “dedicated improvements.” Dedicated improvements are indirect, tangible assets and depreciable as part of the project’s other depreciable assets. This PLR specifically addressed the development of an LIHTC project and found that (similar to impact fees) “the costs directly benefit, or are incurred by reason of, the construction of the project. Therefore, the costs are indirect costs as defined in § 1.263A-1(e)(3)(i), and are capitalizable to the property produced in the project.” Additionally, because the scope of the required dedicated improvements would change depending on changes in the size of the project’s buildings, the costs were “properly allocable only to, and among, the project’s residential rental buildings.” The PLR also found that these costs are includable in the project’s eligible basis.

Finish Carpentry & Cabinets
As with typical apartment buildings, AmeriSouth’s “finish carpentry comprises the shelving in pantry closets and the living room wall recesses, the shelving in the office building, wood-base, crown molding, chair rails, wood paneling, and closet rods.” The case also looks at millwork consisting of cabinets and countertops. With these types of assets, the court focused on the assets’ permanence.

Whiteco Indus. Inc v. Commissioner (65 TC 664 (1975)), is the governing case for determining an asset’s permanence. In that case, the Tax Court Memo asks, “Nothing human lasts forever, moving us to ask how permanent must a component be to have ‘permanence’?” Whiteco provides six factors to consider, which, in summary, revolve around the ease of movability of an asset without damaging property to which it is attached, and the owner’s intent for permanency at the time of the asset’s construction or installation.

For a typical residential apartment building, many of these assets likely need to be replaced several times over the 27.5 year depreciable life of the building. The baseboards may need to be replaced when carpeting or tiles are replaced after some years. Cabinets and countertops may suffer heavy use and damage, requiring replacement. An apartment with a freshly renovated kitchen will certainly garner higher market rent (or greater demand if it is a restricted rent unit) than a comparable unit with kitchen cabinets, countertops and hardware that has seen 10 years of scrapes, stains and soiling from a dozen different tenants. Cabinetry and closet rods usually are removed easily; they can be unscrewed from the wall without inflicting any significant damage. But, at the time of installation, was the intent to replace them every 10 years? Or, was the thought that they would last the life of the building with just moderate repairs along the way?

In AmeriSouth, the court agreed with the commissioner that none of these assets are five-year personal property, but instead, structural components of the buildings, depreciable over 27.5 years. The court decided that wood moldings, baseboards and paneling were not purely decorative, but instead provided protection for other parts of the buildings (namely the floors, walls and ceilings) from damage, thereby making them an integral part of the building. And, because AmeriSouth did not present its case adequately, there was no evidence to indicate the non-permanence or frequency of replacement of these assets. Again, due to the lack of evidence, the court had to concede to the commissioner.

Whether or not an asset is primarily decorative is a second key factor (along with permanency) to consider when evaluating an asset’s depreciable life. In general, if an item is primarily decorative, such as accent lighting and false balconies, then it is five-year personal property. Arguably, crown molding serves a primarily decorative purpose, but is it ever intended to be replaced? Should the decorative aspect of property outweigh its permanence, or vice versa? The case does not establish a clear priority. It remains the taxpayer’s responsibility to support a position of primarily decorative or non-permanent.

…And the Kitchen Sink
In the AmeriSouth TC Memo, the court writes, “AmeriSouth concentrates most of its persuasive efforts on the permanence of the sinks. AmeriSouth argues that the sinks are easy to remove …” and classified them as five-year personal property. The judge did not focus on permanency here, but rather, whether or not the fixture has a special, singular purpose or use. Special equipment or appliances and the piping, outlets and vents that are singularly designed for that equipment or appliance, are indeed personal property. However, the judge disagreed with the petitioner and stated, “providing water for the kitchen is hardly unusual … and AmeriSouth fails to give any other evidence that it periodically replaced or even planned to replace sinks …” Once again, the court reclassified AmeriSouth’s personal property to structural components of the building.

The court did allow, however, five-year depreciable lives for vents that serviced dryers (personal property) in the laundry rooms and electrical outlets specifically for washers, dryers and refrigerators. The court reclassified to the building vents over kitchen stoves, arguing that these vents provide general ventilation of smoke, smells and steam from the kitchen, rather than directly functioning as part of the stove (personal property). Would the result change if the vent was connected directly to a free standing stove-oven?

Conclusion
According to Holmes in the TC Memo, “AmeriSouth’s wish list is long, but its supporting evidence is limited.” An owner has the responsibility to operate and maintain assets and, therefore, has the right to depreciate those assets over an asset class life that correlates to its practical, useful life. In order to support its allocation position upon examination by the IRS, an owner must prepare a cost segregation study. The AmeriSouth case provides guidance for these reports by focusing on: lack of permanency; property that serves a function specific to equipment (rather than the general operation of the building); and ornamentation. Perhaps the moral of the AmeriSouth story is this: if you can reasonably document your regular replacement of carpet, sinks, baseboards, etc., then they can be depreciated over a shorter life than the building shell. The other potential moral is: if you sue the IRS in court, you should plan on presenting adequate evidence during the trial.

For information on the cost segregation services that Novogradac & Company LLP can provide, please contact Jon Krabbenschmidt at [email protected] or Colette Alpen at [email protected].