A cost segregation study allows property owners to reclassify certain assets, accelerating depreciation and leading to significant tax savings. While there is no standard format, all cost segregation studies should aim to classify assets correctly, explain the reasoning behind their classifications, and provide accurate substantiation of costs. These key factors help ensure the study meets IRS guidelines and stands up to audit scrutiny.
A quality cost segregation study is well-documented, accurate, and comprehensive in detailing asset classifications and costs. The more thorough the study, the smoother the review process will be for all parties, minimizing audit risks. A high-quality study shares a number of key characteristics, outlined in the 13 principal elements below.
Typically, a study conducted by a construction engineer is considered more dependable than one performed by an individual lacking engineering experience or a construction background. Moreover, expertise in cost estimation and allocation, along with familiarity with relevant tax laws, are crucial qualifications.
A quality study always identifies the preparer and always references their credentials, experience, and expertise in the cost segregation area.
A quality study consistently outlines the methodology employed and specifies the steps undertaken to classify assets and ascertain costs.
A high-quality study relies on current documentation to categorize assets and establish costs. The supporting documentation may differ based on whether the property is new or pre-owned and whether original construction documents are accessible.
Conversations with contractors, subcontractors, taxpayers, and property managers play an essential role in understanding the property's specific use and the construction processes involved. A quality study meticulously records all these interviews with relevant parties, enhancing the study's depth and accuracy. However, it is important to note that obtaining details about subcontractor work can be challenging since taxpayers often have no direct interaction with them.
Using confusing or inventive terms to describe property items, instead of straightforward and well-understood terminology, diminishes the study's quality. Such descriptions might obscure the actual nature or function of an asset (for example, calling a building's sewage or water piping system "process piping" or labeling an emergency exit sign a "decorative placard").
A quality study consistently employs terminology that aligns with the blueprints and other project documents (such as contract specifications, payment requests, etc.).
Utilizing a standardized numbering system, like the Construction Specification Institute (CSI) Master Format Division, can be advantageous but is not obligatory. A well-prepared study aligns asset numbering with the contract bidding documents and payment requests. This systematic approach aids in property classification for depreciation calculations and streamlines the examination process by the Service.
A quality study includes a comprehensive legal analysis with pertinent citations to bolster its § 1245 property classifications. Although the treatment of certain items might be straightforward due to consistent judicial rulings, there are numerous cases where court decisions can seem conflicting or where the Service has not agreed. These apparent discrepancies typically highlight the factual complexities involved in accurately classifying property.
After identifying and categorizing property items or assets into classes such as building and personal property, it is essential to determine their individual costs. To ascertain the cost for each unit or property class within a project or component system, a detailed breakdown of total project costs or component system costs is typically required. This process is referred to as engineering "take-offs."
Cost estimates can significantly fluctuate based on the estimation guide used and whether the construction is categorized as "high" or "low" quality.
In a quality study, cost estimates are always reconciled to an acquisition price, a total project cost, or to a component system cost to ensure the accuracy of an allocation.
Typically, a study lists assets by recovery period (e.g., land, land improvements, furniture and fixtures, electrical systems, plumbing systems, equipment).
A quality study’s asset listings tie to a taxpayer's fixed asset ledger, which also facilitates the Service’s review.
It is important that the same estimating technique be used on all of the items that reconcile to a purchase price, a project cost, or to a particular component cost. If different methods or cost guides are used on different property items (e.g., one method for tangible personal property and a different method for the building), cost distortions arise.
A quality study always reconciles total allocated costs to total actual costs in order to ensure the accuracy of its allocations.
A quality study outlines all costs linked to a specific project, encompassing both direct and indirect expenses, and provides an explanation for the handling of any indirect costs. Direct costs pertain to the labor and materials required for particular items or assets. Indirect costs, also known as "allocables," are non-tangible expenses associated with the construction of a facility. These indirect costs must be proportionately allocated to the basis of the specific assets they pertain to.
The report specifically highlights assets classified under § 1245 (e.g., personal property), which benefit from accelerated depreciation.
The study addresses additional relevant aspects, including accounting methods, I.R.C. § 263A, and any necessary sampling techniques.
A quality cost segregation study ensures accurate asset classification, cost substantiation, and legal compliance. By following these 13 principal elements, property owners can confidently maximize their tax benefits while minimizing audit risks.
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Edited by Randy Eickhoff, CPA, Founder & Head Coach at Acena Consulting. Photo courtesy of EpicTop10.com on Flickr.