What is Cost Segregation?
Cost segregation is a highly beneficial and widely accepted tax compliance strategy utilized by commercial real estate owners and tenants to accelerate depreciation deductions, defer tax, and improve cash flow. Once used only by big-4 type accounting firms and the nation’s largest real estate owners, this practice has now become routine for commercial property owners of almost every size.
Cost segregation is considered one of the most effective tax strategies for real estate owners and investors and is one of the top niche services for accounting firms. You may be leaving serious tax benefits on the table by not using it. It’s not just for newly constructed or newly acquired assets and it can dramatically increase your cash flow.
When Should a Cost Segregation Study be Performed?
There are several situations where a cost segregation study should be performed. A cost segregation study should be performed immediately after construction or acquisition or following major capital improvements (including leasehold improvements). The study can also be performed after a change in ownership, including inherited property and change in partnership interest. And finally, a cost segregation study can be useful for buildings already in service. In this situation, a Look-back study would be performed.
The IRS permits taxpayers to use a cost segregation study to adjust depreciation on properties placed in service as far back as January 1, 1987. Many property owners and tax advisors share a common misconception that once the three-year statute to amend has expired, the taxpayer can no longer make a change. Fortunately, this is not the case. Upon completion of the study, the taxpayer is allowed to make an adjustment under IRC §481(a) to catch up on depreciation. The catch up, which is taken in a single year, is equal to the difference between what was depreciated and what could have been depreciated if a cost segregation study was performed on day one.
Expectedly, these benefits can be quite substantial. As an added bonus, the change can be made without filing an amended return. The taxpayer simply files Form 3115 (Change in Accounting Method) with the cost segregation study attached.
The Consequences of a Poor Cost Segregation Study
Per the IRS Audit Techniques Guide, studies being performed by unqualified individuals and those using an abbreviated methodology will receive higher scrutiny than the ones performed by qualified professionals who utilized the detailed engineering-based approach. Therefore, it is more important than ever to have your studies performed by an expert in the field.
Most Common Methods
One of the most common methods of cost segregation is a detailed engineering approach from actual cost records. This method is generally for new construction where detailed costs are available and it provides the most accurate cost allocations. This is the method that the IRS prefers. Another common method is the detailed engineering cost estimate approach. This method estimates costs when actual costs are not available. It uses costs determined by published sources and also uses consistently applied methodology to determine costs.
Another frequently used method is the survey or letter approach. With this approach, contractors and/or subcontractors are contracted to gather costs. The costs are used in conjunction with all methodologies. You may also see a method called the residual estimation approach. The residual estimation approach is an abbreviated study where only short-lived asset costs are determined. The residual costs are assigned to long-life assets and simpler and less accurate than an engineering approach.
The last two methods you might run into are the sampling or modeling approach and the “Rule of thumb” approach. The sampling or modeling approach analyzes multiple (similar) properties (fast food chains, etc.). The “rule of thumb” approach uses an estimate of the percentage generally moved to shorter-lived property, by industry and is highly suspect.
Required Methodologies
There are no required methodologies, but there are now industry standards developed by the ASCSP. The IRS position is that a “quality” study needs to be performed by “qualified” individuals. Qualified individuals are engineers or others competent in design, construction, and costing procedures relating to the building construction. The IRS prefers a cost segregation study performed by an engineer. They also take into account the amount of cost segregation experience and the resume of the individual or individuals performing the study should be included in the report. The engineering approach provides an analysis of electrical and mechanical systems and appropriate costing and reconciliation. It leaves you with a real defensible study/report.
What to Look for when Evaluating a Cost Segregation Provider
When evaluating a cost segregation provider, there are several things you should look for. First, you want to figure out how long the firm has been performing cost segregation studies and how many studies they have performed. Next, you want to figure it out if the firm employs degreed or professional engineers and tax experts with specific cost segregation experience. You should also ask the firm if they employ any ASCSP Certified Cost Segregation Professionals and if so, what role do they play.
When it comes to the study, ask the firm if they use a detailed engineering approach and if they comply with ASCSP standards. It’s also important to know if the firm subcontracts their cost segregation studies to a third party and if they carry professional liability insurance. And finally, you need to ask the firm how they defend their work in the event of an audit. You can also ask for references if you are still on the fence.
The Source Advisors Approach
Our approach to cost segregation follows these values. At Source Advisors, we don’t train our team on your dime. We only hire heavily experienced cost segregation specialists. We believe experience is critical to maximizing the benefits of cost segregation, and the majority of our team has spent between 10 and 20+ years managing cost segregation projects. Even our least experienced member has conducted more studies than many who manage projects at large firms.
We have a specialized in-house dedicated cost segregation team. Our team is composed of architects, professional engineers, CPAs, MBAs and LEED cost segregation specialists dedicated solely to cost segregation. Our management team is involved in every project we’re engaged to perform and often conduct the site visits themselves. And, with rare exceptions, we always conduct a site visit. The IRS expects it, and we believe it is the best way to accurately assess a property.
