Cost classification studies: using federal tax law to subsidize building costs.

• Author: Jorgensen, Dean

Taxpayers, particularly manufacturers, can cut costs on the construction of new facilities through a special study that classifies costs into the most advantageous categories for tax purposes. These studies, known as cost classification studies, use the Federal tax law to reclassify as much as possible of the costs incurred from the real estate category into the personal property category. By doing this, taxpayers can recover the reclassified costs over a five- to 20-year period instead of a 39-year period.

The savings from the accelerated recovery can be quite significant. For example, if $1 million of costs are reclassified from the 39-year real estate category to a 15-year category, the taxpayer can save (based on reasonable assumptions) $120,000 in taxes on a present value basis. If the depreciable life is cut from 39 years to five years, the savings are $220,000 per $1 million.

Additional savings may also result, since fewer of the property costs are classified as real estate, which, in turn, may lessen state and local real estate taxes. Even if the property is located in a jurisdiction that also imposes a tax on personal property, taxpayers still generally come out ahead by reclassifying construction costs.

When the Federal tax law provided for investment tax credits (ITC) for investing in tangible personal property, taxpayers were motivated to reclassify costs as relating to personal property instead of real property to generate the ITCs. As a result, a significant amount of case law has developed that provided taxpayers with guidance to potentially make this reclassification.

With taxpayers now being motivated to reclassify costs as relating to personal property to avoid the 39-year real property recovery period, the ITC case law was being used by taxpayers to make this reclassification. However, it was never certain that the ITC case law could be applied to determine if property qualified as tangible personal property for purposes of the accelerated cost recovery system (ACRS) and the modified accelerated cost recovery system (MACRS).

In a case of first impression, the Tax Court, in Hospital Corp. of America (HCA), 109 TC 21 (1997), held that property qualified as tangible personal property for purposes of ACRS and MACRS if the property would have qualified as tangible personal property for ITC purposes. As a result, taxpayers can use the extensive ITC case law with confidence to reclassify construction costs from real property to...