Bought a rental property and planning a cost segregation study? But can you do your own study? In this post, we look at the pros and cons of the DIY cost segregation.
If you want to do it yourself you may be in luck. But there are a few pitfalls so let’s get started.
There are professionals (typically known as cost segregation consultants or engineers) who will do the work for you. Their fees can be high and they will only do it for larger properties. They will tell you it is not worth on smaller properties.
Personal property assets that are combined with the whole property can include any items that are not directly attached to the building. These items do not directly relate to the building’s maintenance or operations.
For the sake of cost segregation studies, the definition of personal property can include many of the building’s non-structural components and exterior improvements to the land. They can also include indirect costs of construction. The idea is to find all of these construction related costs so that they can be depreciated over a shorter life span than the depreciation of the property as a whole.
This shorter depreciation rate is usually between 5 and 7 years but it can be as high as 15 years. Commercial properties will have construction related cost depreciation lives of 39 years.
DIY Background
Independent appraisal may have its place for larger projects. However it may be too expensive for many real estate investors (although not necessarily for commercial investors). Moreover, while independent appraisal can be permitted (Pittsburg Plate Glass Co.TCM 1965-159), it has been disallowed if it is determined that the appraiser is not qualified, Meeker, TC Memo, 1981-215.
The IRS is no authority either. In a number of cases on valuation the courts have either disregarded the IRS’s expert testimony, or refused to let an IRS employee to testify at all, because they had little or no familiarity with local real estate market conditions, Garstin vs. US, 1965, CtCl, 352 F2d, 537 (I); Brown, TC Memo 1966-92(g); Knoell, Exr. vs. US, 1964, DC, Pa., 236 F Supp 299(e).
The IRS, in the Cost Segregation Audit Techniques Guide (ATG), states that the preparation of a cost segregation study requires knowledge of both construction process and tax law. However, the IRS acknowledges in the ATG that there are currently no prescribed qualifications for the cost segregation practitioner.
Moreover, the ATG was developed by a crossfunctional team of Service engineers and agents and is not intended as an official IRS pronouncement. Accordingly, it may not be cited as authority. This essentially means that any fairly knowledgeable real estate investor may be able to do it.
DIY Cost Segregation: The Pitfalls
Because of the huge deductions and substantial tax savings with larger commercial property, it may pay the commercial investor to hire an experienced cost segregation consultant or engineering professional to help with the component breakdown.
There seems to be a misconception that the valuation of the different components must be exact for a competent study. One can determine the cost of the components from professional appraisal books, such as Marshall & Swift’s or contact an appraiser.
However, it is not required that you do either. Independent appraisal may have its place for larger projects. But it may be too expensive for many real estate investors. Moreover, while independent appraisal can be permitted (Pittsburg Plate Glass Co.TCM 1965-159), it has been disallowed if it is determined that the appraiser is not qualified, Meeker, TC Memo, 1981-215.
The IRS is no authority either. In a number of cases on valuation the courts have either disregarded the IRS’s expert testimony, or refused to let an IRS employee to testify at all, because they had little or no familiarity with local real estate market conditions, Garstin vs. US, 1965, CtCl, 352 F2d, 537 (I); Brown, TC Memo 1966-92(g).
Valuation is quite arbitrary. The “value” of an item is also not always clear. In his book, Contesting IRS Penalties, IRS expert, Holmes F. Couch He states that the general IRS viewpoint on such valuation issues is that it is very controversial and therefore very difficult to dispute because there is much comparative analysis involved. This strengthens the case for DIY cost segregation.
Thus, there is a much wider tolerance for error. In fact, there is the following statement from an IRS training manual titled, IRS Valuation Training For Appeals Officers, Coursebook # 6126-002, “As appeals officers, we should always strive to settle cases. This is especially true with respect to valuation cases because of the judicial distaste for such issues.”
In one case, the tax court stated that ….”We are convinced that the valuation issue is capable of resolution by the parties themselves, thereby saving the expenditure of time, effort and money by the parties and the Court — a process not likely to produce a better result”, Buffalo Tool & Die, 74TC 441 (1980). Self appraisal, based on experience, has held up, Offshore
IRS Penalties
Under IRC Section 6662(a) there is a penalty for overvaluation. But this provision gives you so much leeway that even if you deliberately tried to incur the penalty, you probably still could not do it.
If you overvalue a property component, the IRS may impose a penalty of 20% of the portion of any underpayment of tax from a “substantial valuation overstatement.”. However, the law gives you a lot of leeway. For the penalty to apply the value of the property must be 200% (double) or more than the amount determined to be the correct amount. Moreover, the overvaluation must also result in a substantial misstatement of taxes exceeding $5,000 ($10,000 in the case of a C-corp). Even further, the IRS may waive the penalty if you can show reasonable cause and you acted in good faith on a DIY cost segregation.
ABecause the law gives you a significant amount of leeway, it is highly unlikely that you will incur any penalty. This is especially so if you follow the instructions for using the Multi-Component/Land-Residual Method.
However, beware of “new kids on the block” who are jumping on the cost segregation band wagon which is just starting to get popular (it’s only been around for over 40 years). When hiring a professional carefully check their experience and credentials. Get their fees in writing, upfront.