In order to calculate depreciation for Federal income tax purposes, taxpayers must use the correct method and proper recovery period for each asset or property owned. Property often consists of numerous asset types with different recovery periods, which must be separated into individual components or asset groups having the same recovery periods and placed-in-service dates. When the actual cost of each individual component is available, this is a rather simple procedure. However, when only lump-sum costs are available, cost estimating techniques may be required to ?segregate? or ?allocate? costs to individual components of property (e.g., land, land improvements, buildings, equipment, furniture and fixtures, etc.). This type of analysis is generally called a ?cost segregation study,? ?cost segregation analysis,? or ?cost allocation study.? Significant tax benefits may be derived from utilizing shorter recovery periods. The issues for Internal Revenue Service Examiners (Service Examiners) are 1) the rationale used to segregate property into its various components, and 2) the methods used to allocate the total project costs among these components. The most common situation is the allocation or reallocation of building costs to tangible personal property. A building, termed "section (§) 1250 property", is generally 39-year property eligible for straight-line depreciation. Equipment, furniture and fixtures, termed "section (§) 1245 property", are tangible personal property. Tangible personal property has a short recovery period, thus, a faster depreciation write-off (and tax benefit). Property allocations and reallocations are typically based on criteria established under the Investment Tax Credit (ITC). In a recent landmark decision, the Tax Court ruled that, to the extent tangible personal property is included in an acquisition or in overall costs, it should be treated as such for depreciation purposes. The court also decided that the rules for determining whether property qualifies as tangible personal property for purposes of ITC (under pre-1981 tax law) are also applicable to determining depreciation under current law. [See Hospital Corporation of America, 109 T.C. 21 (1997)] The Service acquiesced to the use of ITC rules for distinguishing § 1245 property from § 1250 property.

OVERVIEW

It is important to review the relevant legal history and the motivations of taxpayers to allocate costs to personal property. The legislative and judicial history of depreciation, depreciation recapture, and Investment Tax Credit (ITC) are closely related. The Internal Revenue Code (IRC) has historically authorized depreciation as an allowance for the exhaustion, wear and tear, and obsolescence of property used in a trade or business or for the production of income (IRC Sec. 167 and the regulations thereunder.)

BULLETIN F

For example, IRS Publication Number 173 (also known as "Bulletin F") was published in 1942 and provided a useful life guide for various types of property based on the nature of a taxpayer's business or industry. Bulletin F identified over 5,000 assets used in 57 different industries and activities and described two procedures for computing depreciation for buildings: Composite Method: A depreciation chart provided a composite rate for buildings, including all installed building equipment. Component Method: Taxpayers could elect to depreciate the building equipment separately from the structure itself.

COMPONENT DEPRECIATION

In 1959, the Tax Court recognized the right of taxpayers to calculate depreciation using a component method for newly constructed property [Shainberg vs. Commissioner, 33 T.C. 241 (1959)]. Revenue Procedure 62-21, 1962-2 C.B. 418, superceded Bulletin F and provided safe harbor useful lives based on industry-specific asset classes for taxpayers that met the reserve ratio test (a complex provision). Revenue Ruling 66-111, 1966-1 C.B. 46 (subsequently modified by Revenue Ruling 73-410, 1973-2 C.B. 53), addressed the use of component depreciation for used real property, in light of the decision in Shainberg. The ruling concluded that ?When a used building is acquired for a lump sum consideration, separate components are not bought; a unified structure is purchased? Accordingly, an overall useful life for the building must be determined on the basis of the building as a whole.? Revenue Ruling 68-4,1968-1 C.B. 77, concluded that the asset guideline classes outlined in Revenue Procedure 62-21 ??may only be used where all the assets of the guideline class (building shell and its components) are included in the same guideline class for which one overall composite life is used for computing depreciation.?

ASSET DEPRECIATION RANGE (ADR)

The elective ADR system, implemented by Revenue Procedure 72-10, 1972-1 C. B. 721, was developed for tangible assets placed in service after 1970. All tangible assets were placed in one of the more than 100 asset guideline classes (which generally corresponded to those set out in Rev. Proc. 62-21). The classes of assets were based on the business and industry of the taxpayer. In addition, each class of assets other than land improvements and buildings was given a range of years (called "asset depreciation range") that was about 20 percent above and below the class life. If the taxpayer did not elect the ADR system, Revenue Ruling 73-410, 1973-2 C.B. 53, clarified that a taxpayer may utilize the component method of depreciating used property if a qualified appraiser "?properly allocates the costs between non-depreciable land and depreciable building components as of the date of purchase."

ACCELERATED COST RECOVERY SYSTEM (ACRS)

Congress enacted IRC Sec. 168 I 1981. The ACRS was intended to provide a less complicated method for computing depreciation (known as ?cost recovery? by eliminating salvage value and specifying recovery periods of various classes of assets. In contrast to the elective ADR system, ACRS was mandatory and provided only five (later six) recovery periods. ACRS also allowed for a faster write-off of assets than had been allowed under previous rules.

MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS)

Significant modifications, generally less favorable to taxpayers, were made to ACRS by the Tax Reform ACT of 1986 (effective for property placed in service after December 31, 1986). Under the Modified Accelerated Cost Recovery System, the recovery period for buildings and structural components increased dramatically. Revenue Procedure 87-56, 1987-2 C.B. 674, provides the class lives and recovery periods for most MACRS assets. These determinations are based on the specific industry of a taxpayer and the specific activity for which the assets are used.

EXPENSING PROVISIONS AND BONUS DEPRECIATION

Another incentive for allocating costs to shorter-lived property is the expensing provision of IRC Sec. 179. By maximizing the costs allocable to tangible personal property, the taxpayer can not only get an immediate write-off under § 179, but also qualifies for a shorter recovery period under § 168. Also, the 30-percent additional first year bonus depreciation allowance pursuant to § 168(k), enacted by the Job Creation and Worker Assistance Act of 2002 (Public Law 107-147), provides even further incentive for taxpayers to segregate property into shorter recovery periods. The Jobs and Growth Reconciliation Tax Act of 2003 recently increased the bonus depreciation under § 168(k) to 50 percent for certain qualifying property acquired after May 5, 2003, and placed in service before January 1, 2006. Section 1400L provides special rules for qualifying property used by a business in the New York Liberty Zone.

INVESTMENT TAX CREDIT - IRC § 48

In order to stimulate the economy, Congress enacted Code § 48 in 1962. The ITC was designed to encourage the modernization and expansion of productive facilities through the purchase of certain new or used assets for use in a t

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