How to Conduct a Quality Cost Segregation Study

In our last post, we explained what a cost segregation study is as well as the benefits a cost segregation can provide the taxpayer.

In this post, we’ll focus more on how to conduct a quality cost segregation study and the steps involved in the process.

Cost Segregation Study Methodology and Best Practices

Cost segregation studies do not significantly increase the likelihood a property will come  under audit; however, should they come under audit, and the study was conducted poorly or improperly, the taxpayer could be liable for penalties and recapture. The bottom line is that the segregation of property into Section 1245 and Section 1250 assets must not only be worth the time, effort, and money involved in the process but they also must be worth the risk. Sound Cost Segregation methodology can virtually eliminate this risk.

While there is no prescribed framework for conducting a cost segregation study, the following steps can help to ensure a quality cost segregation study:

1.  Cost/Benefit Analysis

Before you decide to conduct a study, sit with your CPA and crunch the numbers. Pour through your depreciation schedules, identify any gaps in your documentation, and evaluate the deprecation benefit against your future business plans to determine whether the investment is beneficial in the long term. For example, if your business involves the regular purchase and resale of real estate, your CPA can help you decide whether or not depreciation recapture will negate the benefits of cost segregation. That being said, even in the case of recapture, the present day cash value of the benefit as an interest-free loan from the government could easily be sufficient enough benefit to conduct a study.

A pre-study cost-benefit analysis can shed light on the pros and cons of conducting a cost segregation study on the property in question.

2.  Hire an Expert

Cost Segregation Studies require extensive engineering analysis of real estate assets. Detailed knowledge of various building types and their corresponding components is prerequisite for a quality Cost Segregation preparer. Studies conducted by a structural, construction, or any type of engineer really should be viewed as much more reliable than those conducted by a non-engineer. And if the preparer is also knowledgeable about tax law, cost estimation, and value allocation all the better. 

Preparers should be an expert in the field of cost segregation analysis and have the credentials and references to prove that expertise.

3.  Organize your Documentation

Quality Cost Segregation studies require a rigorous allocation of costs amongst the various asset categories to achieve optimal results. Preparers should know how to treat (or estimate in the case of used property) all direct and indirect costs associated with a property but should also be able to justify this treatment to all concerned parties, including the IRS in an audit. The preparer should have extensive access to all property-related documentation. Prepare all documentation for immediate reference before the preparer begins.

Helpful Documentation:
  • Official payment documentation such as Project Budgets and Contractor’s Applications for Payment with the underlying invoices from subcontractors for new construction projects
  • Construction drawings and documentation such as ALTA surveys and municipal permits for new construction projects
  • Closing statements, appraisals, existing drawings, ALTA surveys, and rent rolls are invaluable for acquisition projects

Sometimes, especially in the case of an acquisition, documents are missing or unavailable. In such cases, the taxpayer should do their best to furnish whatever documentation is available and answer all of the preparer’s questions as accurately as possible.

Comprehensive documentation helps the preparer in identifying/classifying assets and allocating costs accurately.

4.  Site Visit

The preparer should visit the property to truly understand and document the project design as well as to understand the purpose and uses of specific assets. A detailed study of specific asset uses will help determine if any particular asset should be classified as personal property, qualified improvement property, or if it should remain long life property. For instance, if a portion of the building’s electrical conduit and wiring is specifically run to power qualified equipment, for example office cubicles, then that portion of the electrical conduit and wiring can be classified as personal property. The preparer should then document the equipment, the cubicles in this case, and the electrical connections with notes and photos as evidence for why the conduit and wire associated with these electrical connections is considered personal property. The preparer will also review the structure’s conformity with construction drawings and other documents, as well as conduct interviews with ownership, contractors, or other vendors who may be on site.

In the case of acquired properties, the preparer should collect photographic evidence of all substantial property as well as any physical deterioration or functional obsolescence of assets and account for the same while estimating the value of these assets.

5.  Report Preparation

After the site visit, the Cost Segregation team will begin the process of preparing the Cost Segregation report. They will review all the documents extensively, verify the assets, compare them or estimate their value with quality cost data (e.g. RSMeans), and segregate assets according to their appropriate recovery periods.

The report should then be reviewed to ensure that it aligns well with the formulae laid out in the IRS Cost Segregation Audit Technique Guide [1]. Once the report has been reviewed and finalized, the CPA will extract the pertinent data and apply it to the client tax return. Depending on when the property was placed in service, there may be other considerations for the accounting professional, e.g. filing a change in accounting method (form 3115) for properties placed in service in prior years, step-up in basis due to inheritance or partial ownership changes, or 1031 exchanges, etc.

Cost Segregation Study – Best Practices

A successful Cost Segregation study should maximize tax savings and cash flow but also conform to best practices so that the benefit gained will be strongly protected in the case of an audit. The preparer should ensure that the cost segregation report is comprehensive and accurate and that it conforms to the highest standards set out in the IRS ATG.

  1. The IRS describes a quality Cost Segregation study [2] as having the following elements:
  2. Description of the study methodology and listing of the steps taken to classify assets and determine costs.
  3. Use of common nomenclature to describe individual property items and standard numbering system to facilitate property classification.
  4. A legal analysis, including relevant citations, to support Section 1245 property classifications.
  5. Documentation of unit costs determination methodology (Engineering “take-offs”)
  6. Asset grouping and identification and listing of assets reclassified as Section 1245 property
  7. Explanation of the Indirect Cost treatment, and reconciliation of total allocated costs to total actual costs, and
  8. Consideration of related issues such as Section 263A [3], changes in accounting methods, and sampling techniques.

[1] https://www.irs.gov/businesses/cost-segregation-audit-techniques-guide-chapter-1-introduction

[2] https://www.irs.gov/businesses/cost-segregation-audit-technique-guide-chapter-4-principal-elements-of-a-quality-cost-segregation-study-and-report

[3] https://www.irs.gov/pub/irs-drop/rr-05-53.pdf

What is a Cost Segregation Study?

Adding to the bottom line is the ultimate goal of every business. There are, of course, a multitude of methods a business can employ to achieve this goal. If you hold commercial real estate, a Cost Segregation Study might just be the method for you!

What exactly is a Cost Segregation Study?

Simply put, a Cost Segregation Study enables you to reallocate part of the cost basis of a purchased or newly constructed commercial property into multiple asset classes, allowing for accelerated depreciation of a percentage of the property’s cost basis. This depreciation results in a deduction under the tax code, lowering your tax bill and boosting cash flows. The IRS suggests the following asset categories into which the asset cost basis can be allocated:

  • Personal Property
  • Land Improvements
  • Building
  • Land

How does Cost Segregation help?

“A bird in hand is worth two in the bush”

Front-loading your depreciation benefit will let you take advantage of the time value of money. By identifying personal property and land improvement components that would have otherwise have been lumped in with the total cost of the asset, a Cost Segregation study helps businesses depreciate their assets at an accelerated rate and, in some cases, even expense the accelerated property immediately. 

Personal property such as furniture, fixtures, equipment, some flooring types, etc., have relatively short depreciable lives (five years). On the other hand, the normal depreciable life of buildings and other real estate assets is 27.5 years (for residential real estate) and 39 years (for commercial non-residential real estate). By treating components as personal property and land improvements, your commercial property assets will be eligible for much shorter life spans. The shorter the depreciable life of the asset, the greater your depreciation deductions and greater tax savings.

Cost Segregation also allows you to take advantage of bonus depreciation for qualified assets in the first year in which the asset is put in service. The 2018 Tax Cuts and Jobs Act (TCJA), for instance, has increased the bonus depreciation available for 5, 7, and 15-year assets to 100% of the depreciable basis. By segregating your cost basis, you can take advantage of the bonus depreciation deduction available for personal property and qualified improvement property.

Furthermore, the TCJA has also introduced the “new to the taxpayer” concept wherein a taxpayer can claim bonus depreciation for even previously used properties so long as the owner has not had a previous depreciable interest in the property. In other words, if you purchase commercial real estate property from a third party, you can claim bonus depreciation in the first year in which you place the asset in use for your business. Your real estate asset need not be a new asset for you to claim bonus depreciation.

Let’s illustrate the benefits of a Cost Aggregation Study through an example

Tim is the owner of a multi-unit apartment complex, which he purchased in 2020 for $1.5 Million. He wants to record the depreciation costs for the 2020 tax year for his property. Other details are as below:

  • Land Value included in the Purchase Price of the Building = $500,000.00
  • Depreciable life of the Asset (apart from the land and per tax laws) = 27.5 Years
  • Marginal Tax Rate = 40%
  • Applicable Bonus Depreciation for the year 2020 = 100%
  • Depreciation Method followed for Long Life Property = Straight Line Method

Tim’s CPA calculates the depreciation for his property as follows:

Building Value (A)$1,500,000
Less: Land Value (B)$500,000
 ———–
Depreciable Basis [C= (A-B)]$1,000,000
Depreciable Life of the property (D)
(Not Bonus Eligible!)
27.5
1st Year Depreciation Deduction [E= (C/D)] 
(Half-Year Convention for Convenience )
$36,364/2
$18,182
Marginal Tax Rate (F)40%
*1st Year Cash Flow due to depreciation [G=(E*F)]1 $7,273
Example without Cost Segregation

Tim wonders if there is a better way to increase his tax savings due to depreciation and, in turn, increase free cash flow. His CPA suggests that Tim should explore the option of undertaking a Cost Segregation Study to save on his tax bills and increase cash flow. He also informs Tim that by segregating his acquisition cost, he can qualify for Bonus Depreciation on personal property and qualifying land improvements. Tim’s interest is piqued, and he hires a team of experts to conduct the study.

The team conducts the Cost Segregation Study and segregates the asset cost of $ 1.5 Million into the following asset categories:

Building Value (A)$1,500,000
Less: Land Value (B)$500,000
 ———–
Depreciable Basis [C= (A-B)]$1,000,000
Personal Property / 5 Year Assets (D1)
12% of $1,000,000 (100% Bonus Eligible!)
$120,000
Land Improvements / 15 Year Assets (D2)
17% of $1,000,000 (100% Bonus Eligible!)
$170,000
Real Property (Building) / 27.5 Year Assets (D3)
71% of $1,000,000 (No Bonus & 1/2 Year Convention) 
$710,000/27.5
$25,818/2
$12,909
1st Year Depreciation Deduction [E= (D1+D2+D3)]$302,909
Marginal Tax Rate (F)40%
1st Year Cash Flow due to depreciation [G2=(E*F)]
With Cost Segregation
$121,164
*1st Year Cash Flow due to depreciation [G1=(E*F)]
Without Cost Segregation (from Example Above)
$7,273
1st Year Increased Cash Flow with Cost Segregation [GIncrease=G2-G1]$113,891
Example with Cost Segregation

Through the segregation of assets, the team found an increased depreciation deduction/tax savings of $302,909 and increased cash flow of $121,164 in the first year.

That’s an additional cash flow increase of $113,891 in the first year with a Cost Segregation!

Year5-Year Assets15- Year Assets27.5-Year AssetDepn Dedn
With Cost Seg
Depn Dedn
Without Cost Seg
Inc Depn DednInc Cash Flow @40%
1$120k$170k$12,909$302,909$18,182$284,727$113,891
200$25,818$25,818$36,364($10,545)($4,218)
300$25,818$25,818$36,364($10,545)($4,218)
400$25,818$25,818$36,364($10,545)($4,218)
500$25,818$25,818$36,364($10,545)($4,218)
First Five Years of Depreciation

Cost-Benefit Analysis

Many small businesses shy away from conducting Cost Segregation studies as they believe it to be cost prohibitive.  The simple truth is Cost Segregation Studies come at a cost but can be economical even for properties with a basis of as small as $300,000! You can even write off the cost of the study itself, that’s a win-win!

Another common reason for hesitation is the fear of depreciation recapture on the sale of assets. Though you may end up showing the recapture as ordinary income when you sell your asset at a profit, remember that this will be taxed at the capital gains rate. In contrast, if you had not used a Cost Seg study to offset your ordinary income in the present, that income would have been taxed at your marginal tax rate (which is certainly higher than the Capital Gains rate).