What is involved in a cost segregation study?

5 Minute Read
Posted by Randy Eickhoff on Mar 3, 2015 1:38:00 PM

What is involved in a cost segregation study?  

Cost segregation is a valuable tax strategy for commercial real estate owners seeking to identify assets and costs to classify them properly for federal taxes, insurance, property taxes or financial accounting. This process assists the real estate owners in reallocating their real property into personal property, which will accelerate depreciation methods while providing a shorter depreciable tax life. 
To better understand this process, consider these common cost segregation questions:

What is a cost segregation study?

A cost segregation is an engineering analysis that examines the costs previously classified as subject to a 39-year depreciable life cycle. When computing depreciation deductions, the study reallocates the current allocation and construction costs or value of the property into classes of tangible property, personal property, real property or land improvements.
This type of study provides precise segregated property information to meet IRS requirements and regulations. The study includes the analysis of the components of the building properly to allocate associated costs and assign recovery periods. When completed, it provides owners with tax advantages. By segregating the costs, ten to thirty percent of the purchase price of the building depreciation can be reallocated over a shorter period. A cost study addresses all depreciable costs, not just the costs that qualify for the residual method.

What’s identified during a cost segregation study?

The study conducts a thorough analysis of cost data, lease agreements, and building plans. When completed, it identifies the building components that are eligible for reclassification into short-lived asset classes, such as mechanical components, finishes, plumbing and electrical installations.

What are the benefits of a cost segregation study?

The process of cost segregation is based on the Time Value of Money (TVM) concept, where tax deductions today are worth more than tax deductions tomorrow. The impact of a cost study can be significant and has a number of benefits including:
        Postponed tax payments
        Prior year missed depreciation deductions may be reclaimed  (retroactive benefits)
        Tax liability reductions
        An increase in cash flow
Cost segregation studies are permitted on new construction, renovations/expansion projects, the purchase of an existing property, leasehold improvements, look-back properties, and real property stepped-up through an estate. While most studies occur once a building has been acquired or constructed, owners may complete these studies of buildings already sold.

What are the qualifying factors in getting a cost segregation study completed?

Someone doing a study must have knowledge of the tax law involving property classifications, construction, engineering and accounting processes.
To qualify for a cost segregation study, the legal entity structure of the organization has to be a pass-through entity. These entities include partnerships, LPs, LLPs, S corps, LLCs and certain trusts. C-Corps and REITs also qualify in this area.
Another qualifier for this type of study is the motivation of the taxpayer in terms of recapturing the depreciation to determine whether they will hold the property or plan to sell eventually. Any size and type of commercial property qualifies for a cost segregation study if the property was in service after December 31, 1986.

When should a cost segregation study be conducted?
A cost segregation should occur when the property is in service through the current taxpayer. It is beneficial to maximize any depreciation deductions during the first year of service.

What is the methodology for a cost segregation study?

There are a number of methodologies used in a cost study. 

Some of the most commonly used methodologies are:

Survey or Letter
A survey or letter estimates costs through information provided by contractors and subcontractors.

“Rule of Thumb.”

Based on the experience of the preparer and uses little, if any, documentation.

 Detailed Engineering from actual cost records
Primarily used for new construction using real costs associated with the project.

 Residual Estimation
This method only determines short-lived asset costs.

 Sampling or Modeling
Uses models to analyze structures that are similar in appearance, use and construction, but has issues with the accuracy and validity of the information.

Detailed Engineering Cost Estimate

Similar to the detailed estimate approach but estimates costs instead of using real costs.
All of these varied methods are used based on the preparer’s preference and the availability of information to complete the studies.
New Call-to-action
Randy Eickhoff

Randy Eickhoff

Acena Consulting President Randy Eickhoff, licensed CPA, has partnered with more than 200 companies during more than 20 years of experience securing tax credits and other government incentives. His corporate partners range from multinational technology firms to smaller, privately held manufacturing, sports, and technology enterprises.