The IRS has turned up the heat on the use of cost segregation studies by building owners. Auditors have a special guide to help assist them in examining the returns of taxpayers who utilize cost segregation studies. Nevertheless, these tax-saving studies can still be used to provide faster write-offs for building components as long as they are supported by concrete evidence.
Background: A business can use a cost segregation study to write off the cost of certain building components. For instance, a company may be entitled to separate write-offs for electrical systems, plumbing systems or removable carpeting. It normally takes 39 years to fully depreciate the cost of nonresidential real estate, but the cost of these components may be recouped in less than a third of that time.
Typically, a cost segregation study may identify hundreds, or even thousands, of separately depreciable components in complex structures such as hospitals, restaurants, shopping centers, office buildings and factories. A study also allocates costs to these items, including amounts for material, labor, architect and engineering fees and impact and permit fees. For an existing building where records are not readily available, valuation experts often rely on standardized cost estimation manuals.
Audits of cost segregation studies are “controversial and burdensome for all parties,” according to the IRS. Reasons cited: There are no standards regarding the preparation of the studies; the relevant law is complex; court decisions and IRS rulings have sometimes produced conflicting guidance; and the studies vary widely in terms of methodology, documentation, depth and format.
To address these issues, the IRS released a 115-page Audit Techniques Guide to assist its examiners in reviewing cost segregation studies. The guide states the issues IRS examiners need to look at “are the rationale used to segregate property into its various components, and the methods used to allocate the total project costs among these components.”
The IRS guide explains why cost segregation studies are performed, how the studies are prepared and what agents should be examining. It is “must reading” for building owners interested in learning more about the complex subject of cost segregation studies. It is available to the public on the IRS website by clicking here.
The tax agency and the courts have given their approval to numerous cost segregation studies. The IRS audit guide makes it clear a properly-prepared study must classify property into the appropriate asset class with adequate documentation. Therefore, it is critical that a cost segregation study be performed by professionals who understand the strict IRS standards.
Guidance for IRS Auditors
“The most common situation is the allocation or reallocation of building costs to tangible personal property. A building, termed ‘Section 1250 property,’ is generally 39-year property eligible for straight-line depreciation. Equipment, furniture and fixtures, termed ‘Section 1245 property,’ are tangible personal property. Tangible personal property has a short recovery period (e.g., 5 or 7 years) and is also eligible for accelerated depreciation (e.g., double declining balance). Thus, a faster depreciation write-off (and tax benefit) can be obtained by allocating property costs to Section 1245 property, or by reallocating Section 1250 property costs to Section 1245 property.
A simple example illustrates the tax benefits of a cost segregation study. In general, a turnkey construction project includes elements of tangible personal property such as a phone system, computer system, process piping and storage tanks. It is relatively easy to identify these items as Section 1245 property and allocate a portion of the total project costs to them.
However, a cost segregation study may also report certain building occupancy items, such as carpeting, wall coverings, partitions, millwork, lighting fixtures, suspended ceilings, doors, as Section 1245 property. These items may or may not constitute qualifying Section 1245 property depending on particular facts and circumstances, such as the location of the assets and the specific activities for which the project was designed.”
— From the IRS Cost Segregation Audit Techniques Guide