June 12, 2018 by Charles Duncan
When taxpayers develop real estate for use in their trade or business, they frequently must construct improvements that allow customers to access their property. In some cases, taxpayers must acquire additional property or even easements from adjacent property owners to permit access to their property. In others, taxpayers must construct new improvements on-site or off-site and then dedicate the improvements to the state or local municipality. We will consider variations on these factual situations below.
Acquiring Additional Land and Constructing Improvements
Land is not a depreciable asset,1 so the acquisition of additional, unimproved land from adjacent property owners has no immediate effect on taxable income. General land preparation costs, such as rough grading, are also not depreciable.2 Land preparation costs directly associated with the construction of depreciable property, however, are depreciable. Land preparation costs such as soil removal or fine grading directly attributable to the construction of depreciable improvements, however, are depreciable.3 When a taxpayer acquires additional land from adjacent property owners to permit access to its property, the land cost is non-depreciable. Land preparation costs associated with depreciable assets such as roads are depreciable on the same basis as the depreciable assets, generally as 15-year property classified under asset class 00.3 of Rev. Proc. 87-56.
Frequently, taxpayers will acquire an easement from an adjoining property owner instead of purchasing the land need to construct access roads directly. The taxpayer will incur the cost to acquire the easement, (an intangible asset), clearing and grading costs, and construction costs for improvements on the easement, such as roads. In Revenue Ruling 72-403, the Service determined that electrical transmission easements have a limited useful life and that the associated clearing and grading costs were part of the construction cost of their associated electrical transmission lines.4 The Service ruled that both the easement and the clearing and grading costs were depreciable.5 When a taxpayer acquires an easement to construct a depreciable asset, such as a road, the easement and clearing and grading costs would thus be depreciable on the same basis as the depreciable asset.
Sometimes taxpayers must construct on-site or off-site improvements that will be transferred to the state or the local municipality, which will maintain the improvements for public use. In general, when a taxpayer
constructs improvements on real property owned by another party and the real property is expected to produce significant economic benefits for the taxpayer, the taxpayer must capitalize the cost of the improvements as an intangible.6 The same rule applies when the taxpayer pays for real property, transfers the property to a third party (except for a sale at fair market value) and the real property is reasonably expected to produce significant economic benefits for the taxpayer.7 These capitalized costs may be depreciated using a safe harbor 25-year life.8 When the other party is the government, however, these rules may not apply. If a taxpayer pays for real property or real property improvements that will benefit new or existing developments, immediately transfers the property to a State or local government for dedication to the general public use, and where the property is maintained by the State or local government, the taxpayer does not have to capitalize the cost of the real property or its improvements as an intangible.9 Instead, the taxpayer must capitalize these costs under the rules of Code section 263A.10
Code section 263A (“UNICAP”) was “enacted to provide a single, comprehensive set of rules to govern the capitalization of the costs of producing, acquiring, and holding property, subject to appropriate exceptions
where application of the rules might be unduly burdensome. These rules are designed to more accurately reflect income and prevent unwarranted deferral of taxes by properly matching income with related expenses. These rules are also intended to make the tax system more neutral by eliminating the differences in the former capitalization rules that created distortions in the allocation of economic resources and in the manner in which certain economic activity is organized. See S. Rep. No. 313, 99th Cong., 2d Sess. 140 (1986), 1986-3 C.B. (Vol.3), 140.”11 UNICAP requires taxpayers who produce real property to capitalize all direct costs and the allocable portion of indirect costs associated with the production activity.12 Indirect costs are “properly allocable to property produced… when the costs directly benefit or are incurred by reason of the performance of production… activities.”13 In Von-Lusk v. Commissioner, the Tax Court held that permitting fees used to construct city-owned, public improvements are “ancillary to actual physical work on the land and are as much a part of a development project as digging a foundation or completing a structure’s frame,” and thus are categorized as indirect costs under UNICAP.14 When a taxpayer constructs real property improvements that are transferred to a State or local government for dedicated public use, these improvements will generally be capitalized as indirect costs under UNICAP. That is, to borrow a phrase from cost segregation studies, these costs are capitalized as a project in
- 1 Treas. Reg. § 1.167(a)-2.
- Eastwood Mall Inc. v. United States, 95-1 USTC ¶ 50,236 (D.C. Oh. 1995), aff’d 59 F.3d 170 (6th Cir. 1995).
- Rev. Rul. 65-265, 1965-2 C.B. 52, Rev. Rul. 68-193, 1968-1 C.B. 79, Rev. Rul. 88-99, 1988-2 C.B. 33.
- 1972-2 C.B. 102.
- Treas. Reg. § 1.263(a)-4(d)(8)(i).
- Treas. Reg. § 1.167(a)-3(b)(1)(iv).
- Treas. Reg. § 1.263(a)-4(d)(8)(iv).
- JT.D. 8482, 58 F.R. 42198, 42199.
- 2 I.R.C. § 263A(e).
- Treas. Reg. § 1.263A-1(e)(3)(i)(A).
- 104 T.C. 207, 216 (T.C. 1995)