The goal of a cost segregation report is to break out property that would otherwise be classified as building (using a 27.5 or 39 year life). So in this post, we are going to discuss the IRS requirements for personal property. We will also provide a couple strategies for maximizing the personal property allocations.
But before we dive in, I want to apologize upfront. The goal of this post is to provide a comprehensive discussion, so I thought it would be necessary to look at some of the relevant IRS court cases and rulings. This will provide you the ability to research the related topics as you take a look at personal property allocations for your property.
Background on personal property under Section 1245
The issue of personal vs. real property goes back to the 1960’s when we had the Investment Tax Credit (“ITC”) for personal property used in a trade or business, such as machinery, equipment and office furniture (also referred to as “Section 1245” property).
If you purchased such personal property you would be entitled to a tax credit (ITC) of 10% of the cost of the property. For example, a $30,000 purchase would result in a $3,000 credit directly against your tax liability. In effect, you paid $27,000 for the assets. This became an important tax strategy at the time.
The ITC was obviously valuable and taxpayers started to become creative & aggressive in reclassifying what appeared to be non-qualifying real property into qualifying personal property.
This creative approach begins with Regulation 1.48-1(c) which states “Local law shall not be controlling for purposes of determining whether property is or is not personal. Property may be personal property even if under local law the property is considered a fixture and therefore real property”.
Thus, the tax law is more liberal than state or local real estate law in classifying a property item as personal, as opposed to real. The result of all this has led to a multitude of cases and rulings on this issue, many of which have been in the favor of the taxpayer. The ITC was repealed in January, 1986.
Consequently, many forgot about this still important issue. The distinction between real property (single family homes, office buildings, etc) and personal property is still the significant difference of writing an asset over 5 years versus of 27-1/2 or 39 years, IRC 168(c). With Section 179 and bonus depreciation, certain personal property may qualify for a large write-off all in one year.
There have been three important guidelines that have been used in distinguishing between real and personal property. We will take a detailed look at these three characteristics.
Moveability is the primary requisite in classifying an item as tangible personal property. This is consistent with RR 65-79 (the IRS’s first ruling on this issue) which states that if property is movable and its removal will not impair the function of the building as a building, the property is tangible personal property.
This is further supported by the principal case in applying the test of moveability, Whiteco Industries, Inc., 65 T.C. 664 (1975). Faced with the question of whether outdoor advertising signs constituted personal property (which they are), the Court asked the following six questions:
It should be pointed out that in no part of the Whiteco opinion does the Court suggest that all six tests must be met in every case. These tests are overall guidelines to help provide judgment in this area. However, they should be taken into consideration with the other criteria discussed in this post.
2. Accessory to the operation of a business
Assets that are accessory to the operation of a business generally are personal property even though such assets may be fixtures under local law.
The “accessorial” concept is basically from the language of the Technical Explanation (858), i.e., “assets accessory to the operation of a business, such as machinery, printing presses, transportation or office equipment, refrigerators, individual air-conditioning units, grocery counters, etc.
These assets generally constitute tangible personal property, even though such assets may be termed fixtures under local law”. In contrast the Regulations simply state, “Tangible personal property includes all property (other than structural components) which is contained in or attached to a building.“
Thus, such property as production machinery, printing presses, transportation and office equipment, refrigerators, grocery counters, testing equipment, display racks & shelves, and neon and other signs, which is contained in or attached to a building constitute tangible personal property”, Regulation 1.48-1(c).
The same reasoning was used in Revenue Ruling 69-170, when it considered seats in a baseball stadium (which is a building) to be tangible personal property, because the seats were “neither essential parts of the building, nor are they items that relate to the operation or maintenance of the building”. Instead they related to the operation of the taxpayer’s business.
There are certain property components that would be in a building regardless of the type of business and thus such property should be classified as structural components, and accordingly, non-qualifying. However, there are those assets that are in a building only because they are related (i.e., “accessorial”) to a particular business. That is, if the particular business did not exist, then the related or accessorial assets would also not exist.
For example, the business of a retail store may contain certain assets such as counters, racks, shelves, signs, display cases, etc. While these assets may be considered real property fixtures under local law, for tax purposes they are tangible personal property, because under the “accessorial concept”, they are directly related to the operation of this business.
If you take away the business of the retail store, then there would be no need for the above mentioned assets. In Revenue Ruling 6579, the IRS considered walk-up and drive-up teller windows to be tangible personal property, because they were accessorial to the taxpayer’s business of banking.
3. Functions as equipment
If it functions as machinery or equipment, a structural component can be personal property even if permanently attached. This is considered the “function test”. This very much relates to the above accessorial concept. The function characteristic is best illustrated through the following examples:
Greenhouse. Even though a greenhouse appeared to be a building, it was personal property because it functioned like machinery in that it provided a controlled environment for growing flowers and employee activity was only incidental to that function. The court of appeals rejected the IRS’ “appearance” test that the greenhouse looked like a building, Arnie Thirup, TC 122 (‘72), rev’d 508. F.2d 915 (CA ‘75). It also helped that a “building” permit was not required for the greenhouse.
Storage Facilities. These will qualify as personal property provided that it is solely for storage and does not contain any space for workers, Hart, TC Memo 1999-236. Here, the storage facility functions as equipment. On the other hand, truck-docking facilities were buildings because of the substantial, essential daily human activity of the dock’s workers, Consolidated Freightways, Inc., 74 TC 768 (1980), 620 F2d 862 (Ct. Cl. 1980). The same conclusion would apply to a warehouse, which is real property.
Bank Windows. In Revenue Ruling 65-79, the IRS considered walk-up and drive-up teller windows to be tangible personal property, because they must be “equipment” (personal property), instead of real property “structural components”.
Towers. Ski lift support towers and the associated machinery were in the nature of machinery (personal property), regardless of their permanency, Joseph B. Weirick, 62 TC 446 (1974). A similar conclusion was reached for steel towers that were part of a ride in an amusement park, Marineland of the Pacific, Inc. 34 TCM 1250 (1975).
Other. Gasoline pumps, hydraulic car lifts, and automatic vending machines, although annexed to the ground, are considered tangible to be personal property, Regulation 1.48-1(c)]. Also, gasoline storage tanks qualify, RR 74-602. They all function as machinery.
So there you have it. We have taken a close look at the three conditions to be classified as personal property: movability, accessory and function. All three are critical to understanding how to properly classify personal property.