Enterprise Zone R&D Tax Credit in Colorado: A Deep Analysis of the Exclusion of Land and Land Improvements

I. Executive Summary and Foundational Principles

1.1 The Exclusion Defined

Costs associated with the acquisition of land or any permanent fixtures constructed upon it—known as Land or Land Improvements—are explicitly ineligible for inclusion in Qualified Research Expenditures (QREs) when calculating the Colorado Enterprise Zone R&D Tax Credit. This exclusion ensures that the credit incentivizes consumable materials and direct labor, not capital investments in real property assets.1

The exclusion of land and improvements to land is a critical compliance checkpoint for businesses seeking to maximize the Colorado Research and Development (R&D) Tax Credit. The state credit, authorized under the Colorado Revised Statutes (C.R.S. § 39-30-105.5), is designed to encourage increased spending on experimental activities within designated economically distressed regions known as Enterprise Zones (EZs).1

1.2 Overview of the Colorado Enterprise Zone R&D Tax Credit

The Colorado R&D Tax Credit operates as an incremental incentive. The calculation dictates that the credit equals 3% of the amount by which the taxpayer’s current-year Qualified Research Expenditures (QREs) within the Enterprise Zone exceed the average QREs from the preceding two tax years within the same EZ.3 This formula incentivizes year-over-year growth in research spending rather than simply rewarding absolute spending levels.

Businesses must comply with specific structural limitations imposed by the state. The credit is non-refundable, meaning it can only offset Colorado income tax liability.3 Furthermore, taxpayers are limited in their annual utilization: they may claim no more than 25% of the total calculated credit in the year the expenditure was made, plus any applicable carryover amount from a prior year, up to 25% of the original credit amount.3 If the credit exceeds the tax liability in any given year, the unused balance may be carried forward indefinitely until it is fully utilized.3

A prerequisite for claiming this state incentive is mandatory pre-certification from the local EZ Administrator.3 Taxpayers must apply for this certification using forms such as DR 0074, DR 0076, or DR 0077 prior to claiming the credit. This administrative step ensures the business’s activities and location align with the program’s legislative intent.3

A common area of misapplication involves conflating the rules for the R&D credit with other incentives offered within the Enterprise Zone program. Colorado’s EZ legislation offers various tax credits, including those for investment in business personal property or qualified job training programs.7 For instance, certain costs associated with real property improvements, leasehold improvements, and leased space are eligible expenses for the EZ Job Training Program Credit.8 However, the R&D tax credit (C.R.S. § 39-30-105.5) maintains a distinct and specific list of exclusions, which absolutely prohibits the inclusion of land or improvements to land.1 Therefore, tax teams must ensure that they apply the correct set of QRE exclusions specific to the R&D statute, avoiding the assumption that an expense eligible for one EZ credit is automatically eligible for all EZ credits.

II. The Legal Basis for the Exclusion: Federal and State Nexus

The exclusion of real property expenditures from the Colorado R&D credit base is rooted in the fundamental structure of federal tax law governing research incentives, which the Colorado statute aligns with.

2.1 Conformity to IRC Section 41 Standards

Colorado’s R&D tax credit eligibility criteria require that Qualified Research Activities (QRAs) align closely with the standards set forth in Internal Revenue Code (IRC) § 41.3 IRC § 41 defines three main categories of QREs: wages for research employees, certain supplies, and contract research expenses.10

The federal exclusion for land and improvements is specifically found within the definition of “supply” QREs. Under IRC § 41(b)(2)(C), the term “supply” means any tangible property, but it specifically excludes two categories of property: (1) land or improvements to land, and (2) property of a character subject to depreciation.2 Therefore, any item that constitutes real property or a depreciable capital asset is categorically prohibited from being claimed as a supply expense in the QRE calculation.

The foundation for these exclusions is further established by IRC § 174, which defines the universe of “Research and Experimental Expenditures” (R&E) that Colorado uses as its QRE base.8 Section 174 generally disallows costs related to the acquisition of land and depreciable property.13 The purpose of this strict prohibition is to prevent taxpayers from benefitting from two different tax incentives—the R&D income tax credit and the deduction for depreciation or amortization—on the same capital investment base. The Colorado statute mirrors this foundational federal principle.

2.2 Statutory Prohibitions Under Colorado Law

The Colorado Office of Economic Development and International Trade (OEDIT), which administers the EZ program, provides clear official guidance reiterating these federal constraints. OEDIT guidance explicitly lists several non-qualifying expenses for the R&D credit, which include: land or improvements to land, depreciable equipment, management surveys, costs to adapt a product to a particular customer’s needs, and research funded by any government entity.1

This statutory prohibition is absolute: the acquisition cost of land and the associated capitalized costs of improving that land cannot be included in the QRE base, even if the research activities themselves are performed directly on or within that improved property. The exclusion applies because the expenditure represents an investment in a long-term capital asset, not the consumption of materials or labor directly supporting the experimental process.

For businesses engaged in capital-intensive research, rigorous fixed asset screening is paramount. Every expenditure identified as a potential QRE must be verified as a consumable material or direct labor cost and must not meet the criteria for capitalization, either as real property or depreciable equipment, under generally accepted accounting principles (GAAP) or tax accounting standards. Any mischaracterization of capital expenditures as QREs creates a significant audit vulnerability, as the exclusion of depreciable property and real property is a central pillar of both federal and Colorado R&D credit statutes.

III. Distinguishing Real Property from Qualified Supplies

One of the most complex compliance challenges taxpayers face is accurately segregating costs when a facility is constructed, renovated, or outfitted for research purposes. A clear understanding of what constitutes “Improvements to Land” is essential for accurate QRE computation.

3.1 Defining “Improvements to Land” in Colorado

Colorado law provides a detailed framework for defining real property, ensuring that costs associated with permanent structures are accurately treated as capital investments and excluded from the R&D credit. C.R.S. § 39-1-102(14) defines real property as land and its “improvements”.14

The statute further clarifies the term “Improvements” in C.R.S. § 39-1-102(6.3), defining them as “all structures, buildings, fixtures, fences, and water rights erected on or affixed to land, whether or not title to such land has been acquired”.14 This definition utilizes the “fixture test” common in property law: any construction or item that is permanently or semi-permanently affixed to a building or land and materially increases its value or useful life is deemed an improvement.14 This encompasses major construction projects, permanent structural additions or alterations to existing facilities, capitalized leasehold improvements, and even specialized foundations required for heavy machinery.10

Furthermore, all preparatory costs associated with developing the site for the research facility are excluded. Expenditures such as excavation, grading, laying utility lines leading up to the building, or pouring a permanent concrete foundation are deemed improvements to the land and are explicitly excluded from QREs.10

3.2 Delineation from Tangible Personal Property (Supplies QRE)

In stark contrast to real property improvements, Qualified Supplies are defined as tangible personal property that is consumed during the research process or used in the creation of a prototype that is not itself a depreciable asset.2

Examples of eligible Supply QREs include raw materials, chemicals, specialized gases, glassware, and components integrated into a test article or pilot model.11 These items are fundamentally consumable and are expensed quickly, aligning with the intent of the R&D credit to reward current-period experimental spending. Items that fall outside this scope, such as office supplies, computer licenses, utilities, rent, and insurance, are non-qualifying expenses.11

A key area requiring careful segregation involves specialized utility infrastructure. R&D activities, especially in manufacturing or biotechnology, often require specialized electrical, cooling, or ventilation systems that are permanently affixed to the building. While the general cost of installing conduits and structural elements to support these systems is an excluded “improvement to land” 14, the actual energy consumed by the specialized research apparatus may partially qualify. Federal guidance acknowledges that utility consumption (electricity, gas, water) that is “Extraordinary”—meaning consumption significantly beyond standard facility operations and directly attributable to the pilot model or testing equipment—can potentially be included in the QRE calculation.17 However, this inclusion applies only to the consumed utility cost, not the capitalized infrastructure used to deliver the utility. An effective compliance strategy requires precise cost allocation to separate the capitalized cost of infrastructure (excluded) from the operational utility expense (potentially included as an extraordinary utility QRE).

The differences between excluded and included costs are summarized in the following table:

Real Property vs. Qualified Supplies: Statutory Distinction

IV. Colorado Revenue Office Guidance and Compliance Procedures

Compliance for the Colorado Enterprise Zone R&D credit is a joint effort between the Office of Economic Development and International Trade (OEDIT) and the Colorado Department of Revenue (CDOR), each fulfilling distinct roles.

4.1 OEDIT Guidelines on Exclusionary Categories

OEDIT is responsible for overseeing the EZ program and issuing guidance on eligibility. OEDIT consistently specifies the mandatory exclusions that must be applied when calculating the QRE base, including the prohibition against claiming land or improvements to land.1 This guidance serves as the authoritative interpretation of C.R.S. § 39-30-105.5.

Prior to claiming the credit, a taxpayer must obtain pre-certification from the local EZ Administrator.3 This initial administrative step verifies the business’s location and general eligibility, but it does not, in itself, validate the QRE calculation.

4.2 CDOR Reporting Requirements and Form DR 1366

The actual credit claim is submitted to the Colorado Department of Revenue (CDOR) via the taxpayer’s annual income tax return. This requires the completion and submission of the Enterprise Zone Credit and Carryforward Schedule (Form DR 1366), along with copies of the EZ Tax Credit Certificates.1 Pass-through entities, such as S corporations and partnerships, must also file the Pass-Through Entity Enterprise Zone Credit Distribution Report (DR 0078A) to properly allocate the credit to their owners.1

Form DR 1366 includes “Worksheet 3: Research and Experimental Activities Credit,” which serves as the mechanism for calculating the credit. Line A of this worksheet requires the entry of the “Current year qualified expenditures”.18 The calculation then follows the incremental method: current year QREs are compared against the average of the two prior years’ expenditures to determine the qualifying increment.3

A critical compliance detail is that the instructions for Form DR 1366 typically do not explicitly detail the definitions of qualified expenditures or reiterate the land/improvements exclusion list.18 The form presumes that the taxpayer has already applied the rigorous exclusion standards mandated by C.R.S. § 39-30-105.5 and OEDIT guidance before arriving at the figure entered on Line A. This lack of explicit instruction on the form creates a significant compliance vulnerability.

Because CDOR relies entirely on the taxpayer accurately defining and subtracting all non-qualifying costs before entering the figure on Form DR 1366, the burden of proof for proper exclusion falls entirely on the taxpayer’s internal documentation and accounting records. In an examination, state auditors will demand a robust cost segregation methodology that clearly differentiates eligible consumable supplies from capitalized real property costs.19 This requires more than just high-level ledger entries; taxpayers must maintain detailed construction invoices, general ledger account reviews, and records that defend the exclusion of costs related to land, improvements, and depreciable equipment. Comprehensive audit defense for the Colorado R&D credit, especially in instances of major capital investment within an EZ, depends on demonstrating the deliberate and defensible exclusion of these non-qualifying capital expenditures.

V. Practical Application and Detailed Example

The following case study illustrates the necessity of detailed cost segregation and allocation when a business invests heavily in facility expansion within a Colorado Enterprise Zone.

5.1 Case Study: Advanced Materials Testing Facility

Advanced Composites LLC, a manufacturing firm located in a Colorado Enterprise Zone, undertakes a $4.5 million project to build and equip a specialized testing facility for developing new aerospace materials. The project occurs entirely within the tax year 2025. The firm’s existing QREs (wages and non-capitalized supplies) total $1,500,000 for 2025, separate from the facility upgrade costs.

Detailed Analysis of Facility Upgrade Costs

The total $3,000,000 facility upgrade cost must be meticulously reviewed against the QRE exclusion criteria.

Note: In this case, $2,350,000 ($600K + $400K + $1.2M + $150K) of the facility upgrade cost is entirely excluded from the QRE calculation due to the land/improvements and depreciable equipment prohibitions.

5.2 Quantitative Example: Calculating the Adjusted Credit Increment

Assuming Advanced Composites LLC had incurred an average of $850,000 in qualifying R&D expenses in the two preceding years (2023 and 2024), the credit calculation proceeds as follows:

Table: Colorado R&D Credit Calculation Summary (DR 1366 Worksheet 3)

The example demonstrates that even a significant capital expenditure of $3,000,000 does not translate directly into QREs. The costs must be meticulously segmented, ensuring that only the consumable property and direct research labor are included.

In the event of an audit, the primary area of scrutiny would be the allocation of labor and the definition of the capitalized assets. The taxpayer must be able to prove that the $550,000 in engineer wages was related only to the performance of qualified research and not inadvertently mixed with the $150,000 paid to technicians installing the excluded depreciable equipment. Federal guidance requires the exclusion of wages related to the construction or acquisition of depreciable property.13 If the taxpayer failed to accurately exclude this installation labor from the QRE base, the credit claim would be challenged, risking the loss of the entire $36,000 credit amount.

VI. Conclusion and Recommendations

The Colorado Enterprise Zone R&D Tax Credit offers substantial tax savings, but its highly specific exclusions for real property and depreciable equipment necessitate advanced compliance strategies. The statutory requirement to exclude land or improvements to land (C.R.S. § 39-30-105.5, aligning with IRC § 41) is a non-negotiable principle designed to restrict the credit to operational research costs, not capital investments.

6.1 Strategic Importance of Accurate Cost Segregation

The distinction between excluded capital assets and included QREs is not merely theoretical; it dictates the integrity of the tax claim. The simultaneous existence of multiple Enterprise Zone credits, some of which incentivize real property investment, increases the risk of misclassification for the R&D credit. Therefore, businesses must maintain internal controls that prioritize the absolute separation of capital expenditures from research consumption costs.

6.2 Recommendations for Compliance and Documentation

To mitigate compliance risks associated with the land and improvements exclusion, especially when undertaking substantial capital projects within an Enterprise Zone, the following steps are highly recommended:

1. Mandatory Capital Expenditure Screening: Taxpayers should establish a rigorous, two-step review process for all R&D-related spending. First, all costs must be screened against the four-part test for qualified research activities. Second, the resulting expenditures must be cross-referenced against Colorado’s specific exclusions, focusing on the definition of improvements to land (C.R.S. § 39-1-102) and depreciable equipment.1
2. Detailed Labor Allocation: For projects involving construction or facility preparation, time tracking for employees must strictly differentiate between labor spent performing qualified research (included QRE) and labor spent constructing, installing, or supervising the installation of excluded real property improvements or depreciable equipment (excluded).13 The inclusion of wages related to capital asset construction is a common audit trap.
3. Specific Documentation of Supplies vs. Fixtures: When purchasing specialty equipment, costs should be segregated. Consumable materials and components integrated into a prototype should be documented with invoices proving their consumption. Conversely, any item that is capitalized or permanently affixed to the building must be recorded in the fixed asset ledger and explicitly excluded from the QRE base.11
4. Leverage Architectural and Engineering Studies: Cost segregation studies used for federal depreciation purposes can provide a valuable starting point, but they must be refined to defend the Colorado QRE base, ensuring all costs associated with land, improvements, and depreciable asset installation labor are zeroed out of the QRE calculation.10

Ensure Proper CDOR Filing: Compliance requires securing pre-certification from the EZ Administrator and ensuring that Form DR 1366 is filed accurately, reflecting the rigorous application of all state-mandated exclusions, particularly for large capital investments.3

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