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Cost segregation is an important federal income tax tool that increases your near-term cash flow by utilizing shorter recovery periods to accelerate the return on capital from your investment in a property.

In today’s market, there is a vast proliferation of so-called cost segregation service providers. It is important to understand that many providers do not take the time and effort to perform a “quality study” as described by the IRS. POER believes that since the IRS is ultimately the final judge in the event of an audit, it is prudent to provide a document that thoroughly meets all IRS specifications.

Currently, there is not a nationally recognized governing body for cost segregation professionals and therefore, no certification process. Multiple start-up groups are hoping to change this but none have been validated by the professional community or the IRS.
 

The American Society of Cost Segregation Professionals (ASCSP) is one of the more promising organizations hoping to develop a certification process for the industry. It is presently trying to win acceptance and has opened its enrollment to the entire profession. Unfortunately, it is still too early to ascertain whether it will pick up the traction necessary to effect the much needed changes. This leaves the IRS's guidance as the only true means of measuring a cost segregation provider.

What Does the IRS Recommend?

The following is an excerpt from the IRS Cost Segregation Audit Techniques Guide, which outlines 12 principal elements of a quality cost segregation study.

A quality study is both accurate and well documented. It should include:

1. Preparation by an individual with expertise and experience

2. Detailed description of the methodology

3. Use of appropriate documentation

4. Interviews conducted with appropriate parties

5. Use of a common nomenclature

6. Use of a standard numbering system

7. Explanation of the legal analysis

8. Determination of unit costs and engineering “take offs”

9. Organization of assets into lists or groups

10. Reconciliation of total allocated costs to total actual costs

11. Explanation of the treatment of indirect costs

12. Consideration of related aspects

Preparation by an Individual with Expertise and Experience

A quality study identifies the preparer and always references
his/her credentials, experience and expertise in the cost segregation area.

The preparation of cost segregation studies requires knowledge of both the construction process and the tax law involving property classifications for depreciation purposes.

In general, a study by a construction engineer is more reliable than one conducted by someone with no engineering or construction background. Experience in cost estimating and allocation, as well as knowledge of the applicable law are important criteria that differentiate POER from other cost segregation service providers.

Detailed Description of the Methodology

A quality study always describes the methodology used
and the steps taken to classify assets and determine costs.

The most common methodologies used in preparing cost segregation studies are:

• Engineering approach from actual cost records

• Engineering cost estimate approach

• Survey or letter approach

• Sampling or modeling approach

• “Rule of thumb” approach

An actual study may be based upon a variation or combination of these methods.

Use of Appropriate Documentation

A quality study uses contemporaneous documentation
to classify assets and determine costs.

Documentation supporting a quality study will vary, depending on whether a property is new or used and whether original construction documents are available.

For new construction, the treatment of land and development costs such as roads, utility mains, storm drains and subdivision costs should be documented. A site visit along with before and after photographs should be used to establish land and site preparation costs. Blueprints, construction drawings and contract payments should be reviewed with actual or estimated costs cross-referenced to the supporting documentation.

For acquired or used properties, documentation will likely be based on estimates and/or reconstructed costs. This should include purchase price allocation of the land, land improvements, building and other assets. The lack of cost records and the age of a property can add to the uncertainty in determining its value or cost. In making this determination, the physical deterioration and functional obsolescence of the assets must be addressed. When original construction documents are not available, other corroborating evidence such as the purchase/lease agreement and appraisals are helpful. As for new construction, a site visit and photographic evidence can assist in identifying the assets and determining the allocation of value.

Interviews Conducted with Appropriate Parties

A quality study documents all interviews conducted with appropriate parties.

Interviews with contractors and subcontractors, as well as with taxpayers and property managers are valuable in ascertaining the specific use of a property and the construction process involved. However, work details can be difficult to obtain if general contractors are reticent to share information because of confidentiality (e.g., profit margins).

Use of a Common Nomenclature

A quality study always uses terminology consistent with
the blueprints and other project documents.

The use of creative or misleading nomenclature to describe property items, rather than common and clearly understood terms, detracts from the quality of a cost segregation study. “Creative” descriptions may be used to disguise the true nature or character of an asset (e.g., a building sewage system referred to as “process piping” or an emergency exit sign termed “decorative placard”).

Use of a Standard Numbering System

A quality study numbers assets consistent with
the contract bid documents and pay requests.

The use of a standard numbering system, such as the Construction Specification Institute (CSI) Master Format Division is helpful but not mandatory. The CSI format categorizes costs by specific building systems or components such as concrete, carpentry, metals, woods and plastics, mechanical, electrical and lighting. Other typical groupings of assets may include land, land improvements, furniture and fixtures, electrical systems, plumbing systems, equipment, etc.

Explanation of the Legal Analysis

A quality study contains a thorough legal analysis,
including relevant citations to support personal property classifications.

While the treatment of some items may be fairly clear based on consistent judicial decisions, there are many instances in which court decisions may appear to be contradictory or to which the IRS has not acquiesced. These apparent contradictions generally reflect the intensely factual basis that underlies the proper classification of property. As might be expected, the proper classification of property is the source of much audit controversy.

The legal discussion in a quality study recognizes these contradictions and attempts to reconcile them to the specific facts and circumstances of the property at issue. An accurate analysis of the statutes and judicial precedent adds to the overall quality of a study and facilitates an IRS review.

Determination of Unit Costs and Engineering “Take Offs”

A quality study carefully documents engineering take offs to show derived unit costs.
Individual property units are clearly identified or highlighted on the “as-built” blueprints.

Once property items or assets have been identified and assigned to property classes (e.g., building and personal property), their respective costs must be determined. In order to establish a cost for each unit or class of property in a project or component system, total costs must generally be broken down. This breakdown process is commonly known as engineering take offs.

For new construction, the cost of property items in an engineering take off can generally be obtained from actual cost records. However, when actual costs are unavailable, costs must be estimated.

Organization of Assets into Lists or Groups

A quality study’s asset listings tie to a taxpayer’s
fixed asset ledger in order to better facilitate an IRS review.

Typically, a cost segregation study lists assets by recovery period (e.g., land, land improvements, furniture and fixtures, electrical systems, plumbing systems, equipment).

Reconciliation of Total Allocated Costs to Total Actual Costs

A quality study always reconciles total allocated costs to
total actual costs in order to ensure the accuracy of its allocations.

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, cost distortions arise. Separately acquired personal property should be listed separately to prevent possible duplication.

Explanation of the Treatment of Indirect Costs

A quality study explains the purpose of each indirect cost, describes
its allocation, and explains any deviations from commonly accepted practice.

The treatment of indirect costs is an area of frequent controversy. Direct costs are the labor and material costs for specific items or assets. Indirect costs, also referred to as “allocables” are intangible costs that are supplemental to the construction of a facility.

Indirect costs must be allocated proportionately to the basis of the specific assets to which they relate. For instance, costs to survey and subdivide land, grade the land to prepare a building pad, and construct offsite improvements are generally allocable only to the land.

Consideration of Related Aspects

A quality study addresses related aspects such as a change in accounting method
and/or sampling techniques. It also comments on the treatment of these items for
tax purposes, especially when the amounts are restated for prior tax years.

The uniform capitalization rules require the capitalization of all direct costs and certain indirect costs allocable to real property and tangible personal property produced by the taxpayer. Self-constructed assets and property built under contract are treated as property "produced" by the taxpayer. It furthermore, requires the capitalization of certain interest expense incurred in connection with the production of property.

Although the courts have not uniformly agreed, it is the position of the IRS that a change in depreciation method, recovery period, or convention for depreciable property constitutes a change in accounting method. Therefore, the use of a cost segregation study to reclassify property and/or reallocate costs requires the consent of the Commissioner.