Tax planning for land preparation costs.

• Author: Kelley, Claudia L.

EXECUTIVE SUMMARY

* Land preparation costs with a limited useful life can be depreciated, provided they are not inextricably associated with the land.

* Because cost-segregation studies often misclassify or overlook land improvements, taxpayers should keep documentation identifying and segregating depreciable land improvements.

* Tax advisers can review prior-year returns and documentation to determine if land improvements were correctly classified, and if bonus depreciation is available.

**********

Identifying depreciable land preparation costs can provide significant tax savings for clients.

This article discusses land improvements that may be depreciable, and how to take advantage of the available tax savings.

Tax advisers recognize the tax savings available from reclassifying building components as personal property with shorter useful lives than the building itself. Similar savings are also possible by identifying land costs that can be classified as depreciable property. However, the increased depreciation deductions available by classifying land preparation costs as land improvements or other depreciable property are often overlooked in cost-segregation studies. Even greater tax savings may be available by claiming bonus depreciation on pre-2005 land improvements: For every $1,000 classified as a land improvement, rather than land, taxpayers save $289 in taxes. (1)

Identifying and segregating the costs of land from those associated with depreciable improvements has often been controversial. This article analyzes land preparation costs and provides suggestions as to how taxpayers can increase the costs eligible for depreciation.

Land vs. Improvements

Land preparation costs can be classified as land, land improvements or as part of another depreciable asset. According to Regs. Sec. 1.167(a)-2, land, apart from improvements or other physical developments added to it, is not depreciable. Land improvements are generally considered 15-year recovery property and include parking lots, canals, fences, sidewalks and driveways. (2)

Distinguishing between land and improvements is not always clear. The question whether land preparation costs are more closely associated with the land or depreciable assets has been examined in various IRS rulings. If a cost is "inextricably associated with land," it increases the land's value and will continue to be useful when the property on it is replaced or rebuilt. The Service has repeatedly concluded that the costs of grading, excavating and removing earth in leveling land for general purposes is inextricably associated with the land. (3) The courts have upheld this view. In Eastwood Mall, Inc. (4) a district court ruled that reshaping and leveling mountainous land into a flat earthen plateau were permanent land improvements, because the costs would not have to be incurred again if the mall were replaced.

In contrast, if land preparation activities will be destroyed by putting property to a different use, the costs are not considered inextricably associated with the land and are depreciable improvements. For example, the clearing, grading, terracing and landscaping of a mobile home park were held to be depreciable improvements with a 15-year life, because any other use of the property would require reshaping of the land. (5)

Limited Life

To be deemed depreciable improvements, land preparation costs must have a limited life. According to the IRS and courts, this is found when the improvements:

* Will be abandoned at the end of the useful life of a related depreciable asset;

* Will be physically destroyed or rebuilt when a related depreciable asset is replaced or retired; or

* Are subject to wear, tear or exhaustion.

Abandonment of related property: Land preparation costs may derive their useful life from a closely related depreciable asset if abandoning the asset will result in abandoning the land preparations. For example, the Service allowed (6) a taxpayer constructing a processing and storage complex to depreciate land grading and removal of soil to construct roadways. The...