Is your client's leased property depreciable? The IRS may not think so.

• Author: Sawyer, Edward E.

A recently released Internal Revenue Service pronouncement has raised concerns over whether or under what circumstances depreciation of property which is leased is allowable if the taxpayer is engaged in the dual businesses of selling property and leasing or renting the same type of property.(1) This issue is commonly described by reference to the property involved as the "dual purpose property" issue. The controversy in these cases generally arises when the IRS seeks to treat leased property as inventory held for sale, and thus not depreciable. Taxpayers that hold dual purpose property should be aware that their depreciation of leased property may be called into question and they need to understand the factors which may be relevant in that determination.

Field Service Advice 1999-1948

Field Service Advice 1999-1948 (the FSA) involves a field auditor's request for National Office advice on whether a taxpayer's dual purpose property should be held in inventory or depreciated. The taxpayer maintained an inventory for its new and used property and depreciated the property which was leased. The FSA concludes that depreciation of the leased property is allowable while the property is out on lease but should be discontinued when the property comes off lease and is once again available for either sale or lease.

The FSA is based on IRC [sections] 1231 authority which does not support the conclusion with respect to depreciation set forth in the FSA. The FSA also implies that its conclusion with respect to the treatment of off-lease dual purpose property is supported by an authoritative treatise.(2) However, the cited portion of the treatise refers to the applicability of IRC [sections] 1231 on a disposition of dual purpose property, not the depreciability of dual purpose property under IRC [sections] 167.3. Furthermore, the position set forth in the FSA conflicts with Revenue Ruling 80-374 which is directly on point and states with respect to dual purpose property that "the leased asset does not cease to be depreciable property until the year of sale." These authorities and the factors which are relevant in dual purpose property cases are analyzed in this article.

Depreciation Generally

The Internal Revenue Code provides that "[t]here shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear ... of property used in a trade or business."(5) The related Treasury Regulations provide that depreciation deductions are not allowed with respect to inventory.(6) Neither the IRC nor the Treasury Regulations address how a taxpayer that is both a seller and lessor of the same type of property should determine when such property is used in the taxpayer's trade or business or when such property is inventory.

It is clear that a taxpayer can simultaneously engage in the separate and distinct businesses of selling and leasing the same type of property.(7) When a taxpayer simultaneously engages in the trade or business of selling property and the trade or business of leasing the same type of property, the taxpayer's "primary purpose" with respect to each individual asset determines whether that asset is properly classified as an asset used in the taxpayer's trade or business of leasing and, therefore, subject to depreciation under IRC [sections] 167 or as inventory and, therefore, not subject to depreciation under IRC [sections] 167.

The Primary Purpose Test

Whether a taxpayer's primary purpose is to sell or lease an asset is a question of fact. As noted, there are no statutory or regulatory standards for dual purpose property. This has lead to a case-by-case approach to the resolution of the issue. Numerous cases have discussed the "primary purpose" test; however, none of these cases has specifically addressed whether or under what circumstances the taxpayer's leased property is depreciable when the taxpayer also sells the same type of property from its inventory.(8) Four private letter rulings(9) (PLRs) have applied the primary purpose test to the specific facts of certain taxpayers engaged in the dual businesses of selling and leasing similar property in order to determine if depreciation was allowable. Interestingly, none of these PLRs reach the "off lease" conclusion contained in the FSA.

In the cases where the dual purpose property issue has been litigated, the substantive issue has been whether gain recognized on the sale of previously leased property was eligible for IRC [sections] 1231 treatment when the taxpayer was also engaged...