What are the potential tax consequences if the IRS reclassifies a metal steel building from non-structural to structural during an audit?

If the IRS reclassifies a metal steel building from non-structural (typically treated as tangible personal property, § 1245 property) to structural (typically treated as real property, § 1250 property) during an audit, several significant tax consequences may result. The core issues are the applicable recovery period, depreciation method, eligibility for bonus depreciation and Section 179 expensing, and potential recapture or adjustment of prior deductions. Here’s a detailed analysis based on the sources:

1. Change in Recovery Period and Depreciation Method

Non-structural (Personal Property, § 1245):- Typically classified as 5-, 7-, or 15-year property under MACRS, depending on the asset class and use (e.g., asset class 57.0 for distributive trades and services, or asset class 00.3 for land improvements).- Eligible for accelerated depreciation methods (200% or 150% declining balance).- May be eligible for Section 179 expensing and bonus depreciation.

Structural (Real Property, § 1250):- Classified as nonresidential real property (39-year recovery period under GDS, straight-line method).- Not eligible for accelerated depreciation (must use straight-line).- Not eligible for Section 179 expensing (except for certain qualified improvement property).- Not eligible for bonus depreciation unless it is qualified improvement property or meets other specific requirements.

Result: If reclassified as structural, the building’s remaining basis must be depreciated over 39 years using the straight-line method, and any prior deductions using shorter lives or accelerated methods may be disallowed or recaptured.

2. Recapture or Adjustment of Prior Depreciation Deductions

• If the taxpayer previously depreciated the building as personal property (e.g., 5- or 7-year property) and the IRS determines it is structural (39-year property), the taxpayer will have claimed excess depreciation.
• The IRS will require a correction, which is generally treated as a change in accounting method. The taxpayer must file Form 3115 to request a change in method, and a Section 481(a) adjustment is required to correct the cumulative depreciation.
• The adjustment is the difference between the depreciation actually claimed and the amount that would have been allowed using the correct (longer) recovery period and method.
• If the taxpayer does not file Form 3115, the IRS may disallow the excess deductions on audit and assess additional tax, interest, and possibly penalties.

3. Loss of Eligibility for Section 179 and Bonus Depreciation

• Section 179 expensing is generally not available for buildings or structural components, except for certain qualified improvement property and specific improvements to nonresidential real property (e.g., HVAC, roofs, fire protection, and security systems).
• Bonus depreciation is only available for property with a recovery period of 20 years or less, so reclassification to 39-year property generally eliminates eligibility.
• Any Section 179 or bonus depreciation previously claimed on the building would be disallowed and subject to recapture.

4. Potential Penalties

• If the IRS determines that the taxpayer’s position lacked reasonable basis or was negligent, accuracy-related penalties under IRC § 6662 may apply.
• Penalties may be assessed for substantial understatement of income tax or for negligence/disregard of rules and regulations.

5. Impact on Cost Segregation Studies

• The IRS Cost Segregation Audit Technique Guide emphasizes that the classification of property as § 1245 (personal) or § 1250 (real) is a fact-intensive determination, and misclassification can result in audit adjustments.
• If a cost segregation study was used to classify the building as non-structural and the IRS disagrees, the study’s allocations may be challenged, and the taxpayer may need to substantiate the basis for each asset’s classification.

6. Recapture on Disposition

• If the building is sold, the recapture rules differ for § 1245 and § 1250 property. If the IRS reclassifies the property as § 1250, the recapture of depreciation as ordinary income is generally limited to the amount of additional depreciation (i.e., depreciation in excess of straight-line), but if the property was misclassified as § 1245, more of the gain may be recaptured as ordinary income.

7. Uniform Capitalization (UNICAP) and Interest Capitalization

• The reclassification may also affect the amount of indirect costs and interest that must be capitalized under § 263A, as the rules differ for real and personal property.

8. Summary Table of Key Tax Consequences:

9. Legal Authority and Precedent

• The IRS and courts have consistently held that the classification of property as structural or non-structural is a fact-intensive inquiry, guided by the definitions in Treas. Reg. § 1.48-1(e) and the Whiteco factors.
• The IRS Cost Segregation Audit Technique Guide and relevant case law (e.g., Hospital Corp. of America v. Commissioner, 109 T.C. 21 (1997)) confirm that misclassification can result in audit adjustments, recapture, and penalties.

In summary: If the IRS reclassifies a metal steel building from non-structural to structural, the taxpayer will lose the benefit of accelerated depreciation, Section 179, and bonus depreciation, and will be required to correct prior depreciation deductions, potentially pay additional tax, interest, and penalties, and may face recapture of excess depreciation. The building’s remaining basis must be depreciated over 39 years using the straight-line method, and the taxpayer must file Form 3115 to change the accounting method and compute a Section 481(a) adjustment.