Summary Regulatory History of Cost Segregation
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Summary of the Regulatory History of Cost Segregation
This summary provides an overview of the regulatory history of cost segregation, compiled by O’Connor & Associates from the IRS Cost Segregation Audit Techniques Guide.
Background
To determine depreciation for federal income tax, taxpayers must accurately apply the appropriate methods and recovery periods for each property. Properties often consist of various asset types with distinct recovery periods, necessitating separation into individual components. When individual component costs are unknown, cost estimating techniques are necessary for accurate segregation.
Cost segregation studies can lead to significant tax benefits through shorter recovery periods. Key issues for IRS examiners include the justification for property segregation and methods of allocating project costs among components. Typically, this involves reallocating building costs to tangible personal property, which benefits from faster depreciation.
A landmark Tax Court decision clarified that tangible personal property included in a purchase should be treated as such for depreciation, applying rules similar to those for the pre-1981 Investment Tax Credit (ITC). The IRS agrees with using ITC rules to differentiate property types.
Overview
Understanding the legal background and taxpayer motivations for cost allocations is essential. The legislative and judicial history of depreciation and the ITC are interconnected. The Internal Revenue Code authorizes depreciation allowances for property used in business or income production.
Historical Developments
Bulletin F
In 1942, IRS Bulletin F provided a guide on useful life for various properties, introducing methods like the Composite and Component Methods for depreciation.
Component Depreciation
Tax courts recognized the component method for calculating depreciation on new properties in 1959. Subsequent rulings established guidelines for handling used property by considering it as a unified structure rather than separate components.
Asset Depreciation Range (ADR)
Implemented in 1972, ADR was an elective system categorizing assets by industry and providing a range of years for depreciation.
Accelerated Cost Recovery System (ACRS) and MACRS
Implemented in 1981, ACRS simplified depreciation methods, allowing faster asset write-offs. Modified by the Tax Reform Act of 1986, MACRS extended recovery periods for buildings.
Tax Incentives and Legislative Changes
Expensing Provisions and Bonus Depreciation
IRC Sec. 179 allows immediate write-offs for tangible personal property, offering additional depreciation incentives. Bonus depreciation provisions have periodically been adjusted to encourage investment.
Investment Tax Credit (ITC)
Enacted in 1962 to stimulate economic growth, ITC encouraged the purchase of new or used business assets. It has undergone various modifications, including its eventual repeal in 1986.
Property Classifications
Section 1245 and Section 1250 Property
Determining the appropriate classification of assets under sections 1245 and 1250 is central in cost segregation studies. ITC rules play a crucial role in this classification process.
Inherent Permanency Test
The Whiteco Factors were developed to assess whether an asset qualifies as tangible personal property, influencing classification decisions.
Repeal and Judicial Developments
Repeal of ITC and Component Depreciation
The use of component depreciation became problematic and was prohibited in the 1981 Economic Recovery Tax Act. However, the 1997 Hospital Corporation of America decision revived a form of component depreciation, allowing cost segregation for specific building support systems.
Method of Accounting Guidance
Changes in depreciation methods require consent from the IRS and are seen as accounting method changes. A taxpayer must file Form 3115 for such changes, which adjustments to income pursuant to IRC 481(a).
Current Position and Look-Back Studies
To change accounting methods, taxpayers must file Form 3115. Numerous court cases have addressed property classification without establishing clear distinctions.
In summary, the regulation of cost segregation has evolved through legislative changes, court decisions, and IRS rulings, providing a complex but beneficial framework for taxpayers seeking to optimize depreciation strategies.
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