As a result of tax reform, cost segregation studies have become increasingly popular. For tax purposes, cost segregation reporting involves the allocation of the total cost basis of a property into the specific property classes and corresponding recovery periods. The goal is to accelerate depreciation deductions and accurately compute depreciation for the individual components.
Cost segregation results are generally summarized in a formal report that will detail the assets and depreciation schedules. Interestingly, there is no standard or prescribed format for either the cost segregation approach or the cost segregation report.
The approach and methodology used to allocate the total cost to the various assets is imperative to achieving a complete and accurate segregation study. The industry will use the words “methodology” and “approach” interchangeably when discussing cost segregation in general.
But in this article, we will try to summarize some of the most common methodologies in cost segregation. We will take a look at the advantages and disadvantages (pros and cons) of each approach.
The goal of this discussion is to understand how to evaluate the accuracy cost segregation reports and allow you to understand the resulting depreciation deductions provided in the report.
Cost segregation is typically performed for newly constructed buildings as well as acquired properties. Each situation may require a different overall approach.
Brand new construction, which will also include a significant remodel of existing properties along with property additions, usually entails construction that was completed relatively recently. A cost segregation is generally performed either when the construction project is completed or soon thereafter.
For newly constructed properties, direct cost data (from contractors, suppliers, vendors, , etc.) and indirect cost data (from engineers, architects, construction testing companies, government zoning and building departments, etc.) is typically readily available. In addition, construction invoices, reports and documents such as drawings, contracts, and specifications are readily available for the analysis.
Acquired property is when an existing property is purchased. This purchased property may have been recently constructed (the last couple years) or decades in the past. The cost and construction data might either not be available or may be so old that it is essentially irrelevant. The starting point would be what the buyer paid for the property.
When it is determined that construction cost data is not available, it must be “reconstructed” utilizing construction cost methods and techniques that are typically employed in real estate appraisal. This reconstructed cost will then be adjusted as a result of the current condition of the property at the time of acquisition. Then it is adjusted to match the acquisition price that was paid by the investor for the property.
The most common methodologies used in segregation studies
A variety of approaches can be utilized in cost segregation, including the following six:
The cost segregation studies themselves do not often document the approach utilized for the cost segregation study. Some cost segregation reports will mention and possibly describe what approach was used in great detail. But most will be silent as to the methodology.
However, you will typically be able to see the attributes of the cost segregation analysis and often be able to identify the approach that was used. This may also enable you to understand the pros and cons of the methodology. Please note that the report could utilize other approaches that are not mentioned here. But typically they are just derivatives of the approaches discussed herein.
Let’s take a close look at the various cost segregation approaches and examine the steps involved and the attributes of the methodologies listed above. Please realize that these are the normal steps taken when completing a cost segregation study.
1. Detailed Engineering Approach From Actual Cost Records
The detailed engineering approach uses actual cost records. It is also often called the “direct cost method” or the “detailed cost approach.” It will use cost information directly from the construction and accounting records. As a general rule, it is the most accurate and methodical approach because it relies on solid external documentation of the construction related costs with minimal cost estimation.
Construction drawings, contracts, specifications, change orders, job reports, payment requests, and invoices will be utilized to determine the specific component costs. The approach uses actual cost records, which contributes to the overall accuracy of the allocations. This approach has one specific drawback. It is generally only applicable to new construction, where the direct cost information from contractors and suppliers is readily available.
The following activities are typically completed under the detailed engineering approach from actual cost records:
- Identify the critical aspects of the specific project along with the assets that will be reviewed in the cost segregation.
- Obtain the supporting information for all direct and indirect project fees and costs. Review and substantiate the total building cost and complete a reconciliation of the cost segregation to the total project cost.
- Perform a site visit to physically inspect the property. Understand the nature and use of the property, and identify any specific assets that are located at the property.
- Photograph the specific assets for substantiation and reference. Request all relevant photographs that support the property condition before construction was commenced along with photographs that document construction progress.
- Review specifications, drawings, bids, contracts, and any other relevant construction data or supporting documentation.
- Assign the assets identified in the document analysis and site inspection to the corresponding property classes and depreciation recovery periods (i.e. building, land, equipment, land improvements, fixtures, and any other tangible personal property).
- Analyze quantity take-offs for all asset classes and utilize contractor data to compute unit costs.
- Apply final unit costs to the assets to determine the final cost basis. Reconcile the actual contractor costs to the total cost basis obtained from the quantity take-offs.
- Allocate all required indirect costs to the related assets. This allocation is typically completed on a pro rata basis for any indirect costs that are applicable to the entire real estate project and on a specific case by case basis for indirect costs applicable only to specific assets.
- Finally, group assets with similar depreciable lives, and in-service dates to properly complete depreciation calculations and the tracking of the assets for the tax preparation process.
Even though the detailed engineering approach from actual cost records will normally provide the most complete and accurate cost allocation, you need to ensure that you reflect the proper cost basis and recovery periods under the Internal Revenue Code (IRC). This is especially true for §1245 property.
2. Detailed Engineering Cost Estimate Approach
The detailed engineering cost estimate approach (often called the detailed estimate approach) is similar in process to the detailed cost approach. The main difference is that under the detailed estimate approach costs are only “estimates” and not actual costs. This methodology is often utilized when specified cost records are not actually available such as for the purchase of used property.
With an acquisition, care should be taken to determine reasonable values of the acquired assets, such as considering physical depreciation and even functional obsolescence of the property under the cost approach and considering other approaches to value that may be apparent.
The detailed estimate approach can be very methodical and rely on accurate documentation. It will often use construction-based documents such as job reports, blueprints, contracts and specifications. When an estimate is required to be calculated, it is based on specific costing information, either from contractors or from reliable external sources (i.e. R. S. Means or Marshall Valuation Service).
The sources of the estimation data is often referenced, including the identification of the volume, page and item number. In addition, the same estimation techniques and unit and quantity cost data sources are used for the entire asset pool that comprise the actual cost total.
In summary, the steps used under this approach are generally the same as those under the detailed cost approach, except for Step 7 above. The costs are the result of contractor estimates or the use of estimation guides. However, if the detailed cost estimates are properly analyzed, prepared methodically, and reconciled to actual costs, then reasonably accurate cost allocations are certainly possible under the approach.
A property inspection is helpful, whether it is for new or used properties. But if drawings and specifications are limited or non-existent, which is typically the case for used or acquired property, field inspection can be a critical step.
This inspection would likely document any physical specifications or details of the property, type of construction, materials that were used for the construction, the personal property contained in the building, the types and sizes of building systems (plumbing, HVAC, , alarm systems, fire protection, electrical, data and communications, etc.).
In addition, you would want to document any land improvements such as driveways, landscaping, decking, fencing, lighting, etc. that were included in the property acquisition and the condition of such property at the purchase date.
3. The Survey or “Letter” Approach
The survey (or simply called the letter) approach is an alternative method used for estimating costs for any newly constructed property. Under this approach, contractors and subcontractors are contacted via a survey or letter and asked to provide cost data on specific assets that they installed on the property. The fees and costs are then included in one of the engineering approaches or under the residual estimation approach (discussed shortly).
The cost allocation under the survey approach involves applying the following steps:
- Complete steps 1 through 6 of the detailed engineering approach from the actual cost records so that you can identify the property that requires cost estimates. Estimates should then be reconciled to actual cost if at all possible. The reconciliation can be to an overall project cost or to the specific system costs, like electrical and plumbing.
- Divide and separate the property items by the specified contractor or subcontractor.
- Request that contractors and subcontractors provide the required quantities and prices of the specified items.
- Utilize unit cost estimates that are obtained from the surveys or letters to determine and allocate property costs accordingly.
In a given situation when the contractor or subcontractor provides actual cost information, the allocations will generally be reasonable and reliable. But when the information is obtained from other projects or site work, the information may not be as reliable or comparable.
The quantity and quality of detail provided by a variety of contractors may also vary substantially. This vast disparity in cost estimation can indicate that you should be cautious to ensure that the total cost allocation does not exceed the total actual project cost.
4. Residual Estimation Approach
The residual estimation approach is more abbreviated than the previous methods. Under this method, only short-lived assets (i.e. 5, 7, or 15 year property) is determined. Short-lived asset costs are combined and then subtracted from the total actual project cost.
The result is a “residual” cost that is then assigned to the building and any other long-lived assets. This method is often simpler and less time consuming than the other engineering based approaches and it may be less accurate.
One point to note is that this approach will typically not reconcile project related costs. As a general rule, the residual building costs are not estimated or often examined for reasonableness. An accurate and “reasonable” residual cost should always be calculated and then added back to the total of the short-lived assets to very that the total project cost is properly reconciled.
Please note that different estimation techniques for short-lived assets can result in skewed costs in favor of § 1245 property.
5. Sampling Or Modeling Approach
The sampling or modeling approach will utilize a model or template to analyze multiple properties that are similar in construction, use and appearance (i.e., warehouses, single family homes, storage facilities, etc). The sampling approach minimizes resources and fees compared to conducting exhaustive studies of all properties.
Typical steps in the methodology are:
- Stratify the property types (i.e. mall location, free-standing facility, etc).
- Perform the required cost segregation study by sampling real properties within each specific stratum.
- Based on the results above in Step 2, you then develop a standard model for each property type.
- Apply the costs derived under the model to the population of items on a percentage basis. As an example, the statistical model may indicate that 12% of the project costs would be allocable to 5-year property and 4% to land improvements. This same allocation is applied to each property in the same stratum.
An issue with this approach can be the accuracy of the sampling results. In some situations, the method used may not be statistically valid. It may utilize a small population that could limit the accuracy of a sampling technique. As a result, a reasonable sampling error can be considered.
Also, despite the fact that property types within the same strata may appear at first glance to be very similar. But with variations in locations, building codes, and materials and labor costs may make it challenging to validate an appropriate model.
6. “Rule Of Thumb” Approach
The “rule of thumb” approach is the last and least accurate approach. As a general rule, this approach will use minimal to no documentation and is based on a person’s “experience” in a particular field or industry. For example, a tax preparer may estimate IRC § 1245 property as a fixed percentage of the total project cost by relying on “industry standards” or “industry averages” (i.e. 25% for a warehouse). This approach should be viewed with caution since it will typically lack reasonable documentation to support the specific allocation of total project costs.
So what approach is required by the IRS?
At the end of the day, any approach may be acceptable in the eyes of the IRS. Neither the IRS nor any trade group or association has established uniform standards or requirements for the preparation of cost segregation studies. The courts have specifically addressed component depreciation, but they have not specifically addressed the approach and methodologies of cost segregation studies.
The IRS has addressed the issue only briefly, i.e., Revenue Ruling 73-410, 1973-2 C.B. 53, also in Private Letter Ruling (PLR) 7941002 (June 25, 1979), and in Chief Counsel Advice Memorandum 199921045 (April 1, 1999). These rulings all specify that the determination of § 1245 property is factually intensive and should be adequately supported by corroborating evidence. Additionally, an underlying basic assumption is that the study should be performed by “qualified individuals” and “professional firms” that are competent in construction, design, auditing, and estimation procedures relating to property construction (PLR 7941002).
Despite minimal specific requirements for preparing segregation studies, real estate investors still are required to substantiate depreciation deductions and classifications of real and personal property. Any substantiation that uses actual costs is more complete and accurate than using an estimated approach.
However, many situations exist when estimation is simply the only option. In this case, the methodology and the source of cost inputs and related data should be clearly and carefully documented. Additionally, estimated costs should always be reconciled back to the actual costs or to acquisition price.
Cost Segregation IRS Summary
Cost segregation studies are often prepared for tax planning purposes and a variety of methodologies and procedures can be utilized. While neither the IRS nor any association specifies a required methodology, there are definitely certain approaches that will produce more accurate and reliable results. Despite using reliable methods, depreciation issues can still arise when it comes to accurate classification of IRC § 1245 property.
Any approach that yields accurate allocations will provide less audit risk to the real estate investor and expedite any IRS audit. An accurate and well documented study is considered a “quality” cost segregation study.