This case is about the distinction between Land (non-depreciable) and Building / Land Improvements (depreciable) costs associated with the development of a shopping mall on a site that has significant changes in elevation.
Revised: 5/27/2015
Originally Issued: 5/18/15
Prepared by the ASCSP Education Committee
Issue, Ruling and Key Factors
Issue
Depreciable improvements versus non depreciable land: Is the cost to level a sloped plot of land, prior to construction, depreciable?
Ruling
The cost to “level a mountain” in order to permit a sloped parcel of land to be developed is a land cost and not subject to depreciation.
Key Factors
The activities undertaken to level the site would not need to be repeated if the building was destroyed, rebuilt or replaced, and are therefore, a permanent improvement inextricably linked to the Land. The leveled plateau will last indefinitely and is not subject to exhaustion, wear or obsolescence.
Background
Eastwood Mall Inc. (Plaintiff), a developer of a retail mall, known as the Meadowbrook Mall, developed a site in West Virginia on a highly-sloped parcel of land of approximately 100 Acres. Prior to building construction it was necessary to “cut and fill” the terrain to render it level. The cost of this process was $9,647,743, which the Plaintiff claimed as a 15-year land improvement on their tax return. Under audit, the IRS denied this depreciation and notified the Plaintiffs of adjustments to their return due to their opinion that these costs were non-depreciable.
The Plaintiffs filed a petition in the District Court of the Northern District of Ohio to overturn the Service’s request for the Adjustment. The Court essentially agreed with the IRS and entered a judgment, although they did not make any findings of fact, or conclusions of law.
Subsequently, the Plaintiffs appealed to the 6th Circuit Court, which vacated the lower court’s ruling and remanded to the District Court for the limited purposes of entering findings of fact and conclusions of law. The District Court held a conference wherein they denied a retrial and allowed the parties to submit amended proposed findings of fact and conclusions of law. The court considered the amended proposed findings of fact and conclusions of law from Plaintiffs and US (Defendant), and subsequently entered their findings of fact and conclusions of law in accordance with the limited remand of the Court of Appeals.
Findings of Fact
The Carfaro Company was involved in planning and development of a shopping mall in Bridgeport, West Virginia. Development began in 1980, and was completed in early 1983. In June of 1982, Carfaro sold its interest in the project to Meadowbrook Mall Company, but continued as the General Contractor. The property on which the mall was built consisted of 100-acres of “mountainous terrain with sharply contrasting elevations”. A Carfaro architect testified that the property in this condition could not be used as a site for the mall, but had to be leveled by a process known as “balanced cut and fill”.
Prior to this process the land underwent “clearing and grubbing” to remove vegetation. Following this, the rocky higher north side was required to be cut , blasted, and dug down and the lower side of the property be filled. The material removed from the north side was ported to the lower side and carefully spread in layers, resulting in the north side being lowered and the south side being built up to the “subgrade” level.
The costs for clearing, blasting, cutting and filing and necessary grading to level the site totaled $9,674,743. This was part of the total construction cost of $43MM. The total construction costs also included separate depreciable costs “not in dispute” for sewers, water lines, sprinklers, pipes, gas lines, electric and phone lines, catch basins, storm pipes, bridges, parking lots & lighting, roadways, curbs, islands, landscaping, and foundation trenches.
After the land was reshaped, construction of the mall began, which included trenches for the building’s foundations and utilities, including backfill of trenches, and preparation of sub-base for the concrete slab-on-grade. Additionally, an asphalt parking lot was installed on top of a compacted aggregate layer, and topsoil was placed on the embankment of the south side, and grass and other vegetation was planted to prevent erosion. These depreciable costs are not in dispute.
Meadowbrook Mall, on partnership returns for 1985 and 1986, reported a total of $43MM in depreciable costs for the building – including the $9.6MM for clearing, blasting and moving earth to level the site.
The IRS timely issued final notices of adjustment for 1985 and 1986, asserting that Meadowbrook Mall was not entitled to claim depreciation deductions with respect to the $9,674,743 in costs incurred for reshaping the unusable land into a plateau.
Based on evidence produced at trial, the District Court concluded that these costs are for a permanent improvement inextricably linked with the land, that such costs would not be reincurred if the mall building was replaced, and consequently is a non-depreciable capital asset separate and distinct from the mall building and its parking lot, and ruled in the IRS’s favor.
Conclusions in Law
Section 167(a) of the Internal Revenue Code allows as a depreciation deduction a reasonable allowance for exhaustion, wear and tear, and obsolescence of property – cut & fill does not meet this criteria.
The depreciation deduction does not apply to land. Likewise, the depreciation deduction does not apply to improvements that are inextricably associated with the land, including expenses incurred in creating usable land where no usable land previously existed. Since the Land does not lose value through wear and tear and the passage of time, the taxpayer’s cost basis is recoverable by him upon resale.
In Revenue Ruling 65-265, 1965-2 C.B. 52, the Commissioner addressed whether certain costs incurred in connection with the construction of an industrial complex were subject to an allowance for depreciation. The Commissioner held that “the costs attributable to general grading of the land are capital expenditures and become part of the cost basis of the land which is not subject to depreciation allowances.” The Commissioner further held, however, that
the “costs attributable to excavation, grading and removing soil necessary for the proper setting of the buildings and paving of the roadways are part of the cost of those assets and should be included in the depreciable base for those buildings and roadways.” 1965-2 C.B. at 53.
These costs, the Commissioner explained, “directly associated with the construction of buildings and the paved roadways, are not ‘inextricably associated with the land’ itself.”
The costs in question are for improvements “inextricably associated with the land,” and, hence, are non-depreciable. See Algernon Blair, Inc., 29 T.C. at 1221; Aurora Village Shopping Center, Inc., 29 T.C.M. (CCH) at 128-129; see also, United States v. Hill, ___ U.S. ___, 113 S. Ct. 941, 950 (1993).
Government’s treatment of the land preparation costs incurred in this case is wholly consistent with Revenue Ruling 65-265, and is supported by the Tax Court’s decision in Aurora Village Shopping Center, Inc. v. Commissioner, 29 T.C.M. (CCH) 126, 128 (1970), and further supported by Revenue Ruling 80-93, 1980-1 C.B. 50.
The key test for determining whether costs are non-depreciable Land costs is whether these costs would be reincurred if the building were to be replaced. Improvement costs that will continue to be useful when the existing building is replaced or rebuilt, are considered inextricably associated with land, and therefore, non-depreciable. However, land preparation costs so closely associated with a particular building that they necessarily will be retired, abandoned, or replaced contemporaneously with the building add to the taxpayer’s cost of the building and are depreciable. (Natural Gas Co. v. United States, 412 F.2d 1222, 1231 (Ct. Cl. 1969); Rev. Rul. 74-265, 1974-1 C.B. 56; see also, A. Duda & Sons, Inc. v. United States, 560 F.2d 669, 679 & n.15 (5th Cir. 1977); Rudolph Investment Corp. v. Commissioner, 31 T.C.M. (CCH) 573, 578 (1972); 1 B. Bittker & L. Lokken, Federal Taxation of Income, Estates and Gifts, paragraph 23.2.5 at 23-34 (2d ed. 1989)).
Applying this test to the current situation, because the evidence in the record plainly establishes that the land preparation costs in issue will be unaffected by the replacement of the shopping mall, these costs are for permanent improvements “inextricably associated with the land” and, hence, are non-depreciable. Cf. Spartanburg Terminal Co. v. Commissioner, 66 T.C. 916, 931-932 (1976).
Process Flow
Tax return with claimed depreciation filed by Eastwood Mall Partners
Tax return reviewed by IRS, which determined that the associated leveling costs should be considered land costs, and requested that Eastwood Mall Partners amend the return to reflect the change to non-depreciable costs.
Eastwood Mall Partners appeal the ruling.
The case goes to the District Court, which enters a judgment agreeing with the IRS, but does not make findings of fact or conclusions of law.
Eastwood Mall appeals to the Sixth Circuit Court of Appeals in an attempt to have the District Court over-ruled. The Sixth Court vacated the District Court’s ruling and remanded for entry of findings of fact and conclusions of law.
The District Court re-reviewed the case, denied any retrial, and in accordance with the Sixth Circuit Court’s ruling entered the findings of fact and conclusions of law after these were submitted by both parties. The initial ruling that the costs were non-depreciable remained.
Terminology
Vacated: Normally means the court disagreed with the decision and “nullified” the decision. However, in this case the court did so but on a limited basis, not disagreeing with the lower court’s ruling, but instructing the lower court to render a complete decision accompanied by findings of fact and conclusions of law.
Remanded: Sent the case back to the lower court for further consideration (in this case with accompanying specific requests).
Education Committee Discussion Points
Contradictory Positions
We were unable to locate legal precedents that are contradictory with the ruling in this case.
Examples of similar applications
This case is a somewhat extreme example of reshaping a site due to the specific topography of the site. It is uncommon to encounter a project where more than 22% of the costs were attributable to site preparation, as they were in this case, however similar issues can frequently be encountered on a smaller scale.
Retaining walls are one example of assets commonly encountered in cost segregation studies where these concepts may come into play. Retaining walls can range from small walls for landscaping purposes to large complex engineered walls created in conjunction with reshaping the land on a large portion of the site.
According to the IRS ATG for Cost Segregation “clearing, grading, excavating and removal costs directly associated with the construction of sidewalks, parking areas, roadways and other depreciable land improvements are part of the cost of construction of the improvements and depreciated over the life of the associated asset.”
The material used to create the wall typically has a finite life and is therefore eligible to be recovered. Sitework associated with the retaining wall will also be eligible for recovery however cost detail provided by a client may not provide an adequate allocation of the sitework costs to site shaping, depreciable land improvements such as retaining walls, or building foundations. The cost segregation practitioner should carefully analyze the sitework costs for proper classification, keeping in mind the facts discussed in this case.
Supporting Code, Rulings and Case Law
Code
Section 167(a) of the Internal Revenue Code
26 U.S.C. section 167
Rulings
Rev. Rul. 65-265, 1965-2 C.B. 52-55
Rev. Rul. 74-265, 1974-1 C.B. 56
Rev. Rul. 77-270, 1977-2 C.B. 79-80
Rev. Rul. 80- 93, 1980-1 C.B. 50-51
Case Law
Duda & Sons, Inc. v. United States, 560 F.2d 669, 678 (5th Cir. 1977)
Algernon Blair, Inc. v. United States, 29 T.C. 1205, 1221 (1958), acq. 1958-2 C.B. 4
Aurora Village Shopping Center, Inc. v. Commissioner, 29 T.C.M. (CCH) 126, 128 (1970)
Bittker & L. Lokken, Federal Taxation of Income, Estates and Gifts, paragraph 23.2.5 at 23-34 (2d ed. 1989)
Bender v. United States, 383 F.2d 656, 659 (6th Cir. 1967), cert. denied, 390 U.S. 958 (1968) (“[l]and, of course, is a non-depreciable asset”)
Houston Chronicle Publishing Co. v. United States, 481 F.2d 1241, 1245 (5th Cir. 1973), cert. denied, 414 U.S. 1129 (1974)
Massay Motors v. United States, 364 U.S. 92 (1960)
Shainberg v. Commissioner, 33 T.C. 241, 252 (1959)
Snyder v. Commissioner, 47 T.C.M. (CCH) 355, 377 (1983)
Southern Natural Gas Co. v. United States, 412 F.2d 1222, 1231 (Ct. Cl. 1969
Spartanburg Terminal Co. v. Commissioner, 66 T.C. 916, 931-932 (1976)
Trailmont Park, Inc. v. Commissioner, 30 T.C.M. (CCH) 871, 872-873 (1971)
Tunnell v. United States, 512 F.2d 1192, 1194 (3rd Cir. 1975), cert. denied, 423 U.S. 893 (1976)
United States v. Ludey, 274 U.S. 295, 300-01 (1926)
Urbanek v. United States, 2 Cl. Ct. 574, 578 (1983), aff’d, 731 F.2d 870 (Fed. Cir.), cert. denied, 469 U.S. 1034 (1984)
This document provides a summary of facts for the subject case, as well as commentary from the ASCSP Education Committee regarding cost segregation specific issues. This document is provided for general information and educational purposes only, and is not intended to be, and should not be relied upon as legal or tax advice.