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