In times of economic expansion, business owners often look for ways to defer paying their taxes or eliminate their tax burden by maximizing deductions under current tax rules. One method that will allow a taxpayer to take advantage of current tax deductions is a cost segregation study.
A cost segregation study is a strategic tax saving tool that allows companies or individuals to increase their cash-flow by accelerating depreciation expense and deferring their federal and state income taxes. In general, for real estate, the value of the building and its components are limited to depreciation over a 27.5-year period for residential rental property (i.e. apartment buildings, nursing homes, assisted living facilities, etc.) or a 39-year period for nonresidential real property (i.e. office buildings, car dealerships, hotels, retail centers, etc.).
“Significant real estate projects will often have millions of dollars invested in 27.5-year property or 39-year property, which significantly defers the return of the invested capital.”
A cost segregation study can be applied to purchased, renovated or newly constructed properties. A taxpayer can reclassify certain building components over shorter tax lives that will allow for faster cost recovery/depreciation, rather than using 27.5 years or 39 years for the entire project. The cost segregation process is far from simple and faces considerable scrutiny from the Internal Revenue Service (IRS) when not done properly, thus the importance of using a seasoned cost segregation firm.
To better understand cost segregation, an examination of the IRS’ Cost Segregation Audit Technique Guide (“the Guide”) discusses a quality cost segregation study, principal elements of a cost segregation study and the necessary approaches needed to perform cost segregation.
A quality cost segregation study requires:
- classifying assets into property classes (e.g., land, land improvements, building, equipment, furniture and fixtures);
- explaining the rationale (including legal citations) for classifying assets as either § 1245 or
1250 property (i.e. shorter-lived property); and, - substantiating the cost basis of each asset and reconciling total allocated costs to total actual costs.
The principal elements of a quality cost segregation study are:
- Preparation by an individual with expertise and experience
- Detailed description of the methodology
- Use of appropriate documentation
- Interviews conducted with appropriate parties
- Use of a common nomenclature
- Use of a standard numbering system
- Explanation of the legal analysis
- Determination of unit costs and engineering “take-offs”
- Organization of assets into lists or groups
- Reconciliation of total allocated costs to total actual costs
- Explanation of the treatment of indirect costs
- Identification and listing of § 1245 property
- Consideration of related aspects (e.g. IRC § 263A, Change in accounting method and sampling techniques)
Acceptable approaches to a cost segregation study:
- Detailed Engineering Approach From Actual Cost Records – In general, it is the most methodical and accurate approach, relying on solid documentation of the construction costs and minimal cost estimating for newly constructed properties. Original documents such as construction drawings, engineering specifications, contracts, job cost reports, change orders, payment requests, and vendor invoices are used to determine which costs can be reclassified to shorter lives under MACRS depreciation.
- Detailed Engineering Cost Estimate Approach – This approach is similar to the detailed engineering approach above. The difference is that the detailed estimate approach estimates costs, rather than using actual This approach is used when costs records are not available such as for an acquisition of used property. When estimates are required, they are based on costing data, either from contractors or from reliable published sources (e.g., R. S. Means or Marshall Valuation Service).
- Survey or Letter Approach – Under this approach, the preparer of the study will collect cost data by surveying contractors and subcontractors. The results of this survey will be used in the unit cost estimate to determine how to properly allocate cost in the entire project to each segregated component.
- Residual Estimation Approach – Shorter lived assets (5-, 7-, or 15-year property) are determined and summed together. This cost is then subtracted from the total cost of the property and this residual value is attributed to longer lived assets (27.5-year or 39-year property).
- “Rule of Thumb” Approach – This approach is often based on the preparer’s experience in either a particular industry or with the real property in question. Often, industry averages are used to assign costs to shorter lives. For example, a manufacturing facility may have, on average, 40% of the real property cost allocated to shorter lives, while a hotel may only have 25%.
Cost segregation has been addressed by the courts and the methodology, report quality, and preparer reputation are all factors that will affect not only the result of the study performed, but also the success of the cost segregation study holding up to any potential IRS challenge.
An engineering-backed approach will provide the most rigorous and accurate results in overcoming IRS scrutiny rather than the other less methodical and structured approaches presented above.
Not all cost segregation studies are the same. A taxpayer should be aware of what areas the IRS will consider key factors in a cost segregation study and be sure to use a reputable cost segregation firm.