Cost segregation studies are conducted for a variety of reasons (e.g., financial accounting, insurance purposes, property tax and income tax). After a number of years the IRS seemingly paid little attention to component depreciation developed as a result of cost segregation studies—as more and more taxpayers had the work performed the reductions in taxes paid became significant, finally, the IRS is now puts more eyes for cost segregation study review.
The IRS now has numbers of engineering agents who specialize in reviewing cost segregation studies. The IRS has developed a detailed audit guide for cost segregation that is to be used by regular revenue agents, not just engineering agents. It is not necessary for you to go through the entire audit guide. It is worthwhile to note that the IRS is starting to take cost segregation seriously and is challenging taxpayers’ claims if they are not based on sound and approved methodology.
Other than to have the cost segregation work performed in the first place, this is not a suitable topic for a ‘Do-It-Yourself’ approach. While it sounds simple on the surface to break out the costs of the relative components, in practice there are a lot of grey areas that the specialist understands and has had experience in how to handle. At the end of this post I show a small excerpt of the IRS audit guide, for a start purpose only (the full text is accessible in the IRS website.)
The IRS audit guide for cost segregation, however, would help a tax professional who is considering having a cost segregation study performed by one of the firms that specialize in this service. Reviewing it would give one an idea of the activities that must be performed and how the IRS reviews it. Inasmuch as cost segregation studies in this country are solely for tax purposes it really is up to the company’s tax advisors, and the cost segregation specialist, to make sure that the work conforms to IRS requirements.
Before answering the question whether cost segregation lower property tax expense, let’s have talk about cost segregation study for new construction.
Cost Segregation Study For New Construction
Cost segregation studies should be initiated as early in the construction or acquisition process as possible to obtain maximum savings. Consider these three points:
1. Get a cost segregation professional and have he/she shows the architect how to make a larger percentage of the building’s components qualify for short-term depreciation thereby increasing the tax savings to the building owner.
2. Special-order building components could have a higher invoiced cost than can be substantiated from cost estimating guides. There must be proof of these costs in order to report the higher value to the IRS. If granted access to the construction chief before the project breaks ground, a cost segregation specialist will request that five to ten items’ costs be set aside for separate reporting. It is often more difficult to track down cost documents further along in the construction process.
3. If a cost segregation study can be performed before the acquisition of a building, personal property can be separated from the building costs. The two costs can then be broken out in the sales agreement and the real property transfer tax basis can be reduced.
Note that the final tax savings may well be the same, but the effort to obtain the information, and hence the cost, will be reduced in terms of the cost segregation study.
In some localities there is a property transfer tax. There are potential savings on such property transfer taxes if one separates out personal property from real property, but this is possible only if the analysis is completed prior to the closing so the appropriate amounts can be filed on a timely basis. The same analysis, which will help reduce transfer taxes will also be used in the cost segregation study, so this really gives great incentive for buyers of real estate to build this directly into the internal procedures and reviews for real estate acquisitions.
Will Cost Segregation Lower Property Tax Expense?
This is question of most people who attempt to use segregation report. For assets already owned, I would suggest you to not use the cost segregation report to try and lower property taxes. They are two separate processes.
If someone, somewhere, sometimes, tells you that cost segregation study will lower your real and/or personal property taxes, make sure he/she will be covering the cost of appeals on the assessed valuations if the report is provided to the local assessors.
Yes, you can always appeal the assessments to ensure the property is taxed fairly and accurately. But bear in mind that most often individual states do not follow the same rules as federal income tax on what is real estate vs. personal property—therefore, a cost segregation analysis should never be provided to an assessor for use on local property tax assessment purposes.
IRS Cost Segregation Audit Guide (An Excerpt)
Cost segregation studies are conducted for a variety of reasons (e.g., income tax, financial accounting, insurance purposes, property tax). For income tax purposes, a cost segregation study involves the allocation (or reallocation) of the total cost (or value) of property into the appropriate property classes in order to compute depreciation deductions. The results of a study are typically summarized in an accompanying report, although there is no standard format for either the study or the report.
The methodology utilized in allocating total project costs to various assets is critical to achieving an accurate cost segregation study. Some of the more common methodologies, and their potential drawbacks, are summarized in this chapter. This discussion should assist the examiner in evaluating the accuracy of a particular study and in performing a risk analysis with respect to the depreciation deductions based on that study.
What are the most common methodologies utilized for cost segregation studies? Various methodologies are utilized in preparing cost segregation studies, including the following six:
1. Detailed Engineering Approach from Actual Cost Records
2. Detailed Engineering Cost Estimate Approach
3. Survey or Letter Approach
4. Residual Estimation Approach
5. Sampling or Modeling Approach
6. ‘‘Rule of Thumb’’ Approach
Examiners should not necessarily expect to see these terms mentioned in a study or in a report. Methodologies will also be described in varying detail in different reports. However, based on this information, an examiner should be able to recognize the attributes of a given study and identify the methods or approaches used (and also identify the potential drawbacks). It should also be noted that other methodologies may be used, although most are merely derivatives of those enumerated above.
What are the attributes of various cost segregation methodologies? The following discussion takes a closer look at the main components and attributes of each of the methodologies listed above. Keep in mind that these are the steps normally taken in the preparation of a cost segregation study. The examiner’s responsibility is to review the steps taken and evaluate the accuracy of the study.
Detailed Engineering Approach From Actual Cost Records
The detailed engineering approach from actual cost records, or ‘‘detailed cost approach,’’ uses costs from contemporaneous construction and accounting records. In general, it is the most methodical and accurate approach, relying on solid documentation and minimal estimation. Construction-based documentation, such as blueprints, specifications, contracts, job reports, change orders, payment requests, and invoices, are used to determine unit costs. The use of actual cost records contributes to the overall accuracy of cost allocations, although issues may still arise as to the classification of specific assets.
This approach is generally applied only to new construction, where detailed cost records are available. For used or acquired property and for new projects where original construction documents are not available, an alternative approach (e.g., the ‘‘detailed engineering cost estimate approach’’) may be more appropriate.
The detailed cost approach typically includes the following ten activities:
1. Identify the specific project/assets that will be analyzed.
2. Obtain a complete listing of all project costs and substantiate the total project costs.
3. Inspect the facility to determine the nature of the project and its intended use.
4. Photograph specific property items for reference. Request previous site photographs that illustrate the construction progress as well as the condition of the property before the project began.
5. Review ‘‘as-built’’ blueprints, specifications, contracts, bid documents, contractor pay requests, and other construction documentation.
6. Identify and assign specific project items to property classes (e.g., land, land improvements, building, equipment, furniture and fixtures, and other items of tangible personal property).
7. Prepare quantitative ‘‘take-offs’’ for all materials and use payment records to compute unit costs.
8. Apply unit costs to each project component to determine its total cost. Reconcile total costs obtained from quantitative take-offs to total actual costs.
9. Allocate indirect costs, such as architectural fees, engineering fees, and permits, to appropriate assets.
10. Group project items with similar class lives and placed-in-service dates to compute depreciation.
The detailed cost approach is the most time-consuming method and generally provides the most accurate cost allocations. However, the examiner should recognize that the proper classification and costs of § 1245 property could still be an issue with this method.