Revenue Ruling 2008-18: A Breakdown

An official interpretation of tax law by the Internal Revenue Service (IRS) is known as a Revenue Ruling. These rulings provide guidance to taxpayers and tax professionals, clarifying the IRS’s position on a specific set of facts. For those involved in real estate, understanding these interpretations can have significant financial consequences in how property is valued and depreciated.

Before the tax law changes in 2017, a piece of IRS guidance addressed a common question for purchasers of commercial real estate. This guidance explored the tax uncertainty that existed and the ultimate conclusion that provided a clear path for property owners.

The Tax Question on Used Property Components

For many years, uncertainty surrounded the tax incentive known as bonus depreciation. Under the Internal Revenue Code at the time, a taxpayer could immediately deduct a large percentage of the cost of qualifying property in the year it was placed in service. A requirement to qualify for this accelerated deduction was the “original use” test, which stipulated that the property must be new, with its first use commencing with the taxpayer.

This created a dilemma for taxpayers purchasing existing buildings, as the building itself was clearly “used” property and therefore ineligible for bonus depreciation. Many taxpayers, however, engaged in a practice called a cost segregation study. This analysis involves identifying and separating the components of a building into different asset classes with shorter depreciation recovery periods than the building structure, which is depreciated over 39 years for non-residential property.

A cost segregation study might identify items like carpeting, decorative lighting, and dedicated electrical systems as 5-year property, and land improvements like parking lots and landscaping as 15-year property. While these components were part of a used building, the question arose: could the new owner be considered the first user of these specific, segregated components? If so, these assets could satisfy the original use test and qualify for bonus depreciation.

IRS Analysis and Clarification

An important piece of IRS guidance addressed the uncertainty by analyzing two distinct factual scenarios. The analysis in both situations hinged on the legal distinction between the building structure itself and the components within it.

The first scenario involved a taxpayer who purchased an existing commercial building. Shortly after the acquisition, the taxpayer commissioned a cost segregation study which identified various components that qualified as Section 1245 property, including tangible personal property like specialized plumbing and decorative fixtures. These items have shorter recovery periods under the tax code than the building structure, which is classified as Section 1250 property.

The IRS reasoned that the building and its structural components were indeed used property. However, the shorter-lived Section 1245 assets were considered separate from the building for depreciation purposes. The IRS concluded that the “original use” of these specific components began with the taxpayer who acquired the building, thereby satisfying the test.

The second scenario expanded on the first by adding a renovation element. In this situation, a taxpayer acquired an existing building and then incurred additional costs to improve it. Following the renovation, a cost segregation study allocated the total costs among the structure, pre-existing components, and newly installed components. The IRS analysis was consistent, affirming that the original building shell remained ineligible for bonus depreciation, but the components from the original acquisition and the renovation were both eligible.

The Conclusion on Bonus Depreciation Eligibility

The conclusion from the IRS provided a definitive answer. The official guidance was that components of a building qualifying as Section 1245 property could be treated as eligible for bonus depreciation, even when the building itself was acquired in a used condition. This eligibility was contingent on the components meeting all other requirements for bonus depreciation, most notably that their original use began with the taxpayer.

This holding endorsed the view that a building acquisition can be bifurcated for depreciation purposes. The building structure is one asset, and the various components identified through a cost segregation study are separate assets. The guidance clarified that the “placed-in-service” date for these components, for the purpose of the original use test, is when the new owner acquires the building and puts those components to use in their trade or business.

Practical Application and Modern Law

The direct consequence of this IRS guidance was an increase in the value of performing cost segregation studies on acquired properties. Before this clarification, the primary benefit of a study was accelerating deductions by moving assets from a 39-year recovery period to shorter 5, 7, or 15-year periods. The guidance added a new benefit: the ability to claim a large, upfront bonus depreciation deduction on those reclassified assets.

The Tax Cuts and Jobs Act of 2017 (TCJA) amended the law to allow bonus depreciation for used property, rendering the original use test moot for most real estate acquisitions after September 27, 2017. The primary requirement now is that the property was not previously used by the taxpayer.

While the TCJA’s changes have superseded the specific issue addressed in the earlier guidance, the underlying strategy remains important. The TCJA initially increased bonus depreciation to 100%, but this rate is now phasing down. For property placed in service in 2025, the bonus rate is 40%, and it will fall to 20% in 2026 before being eliminated. This makes a cost segregation study a fundamental tax planning tool to maximize upfront deductions on both newly acquired and renovated properties.