The Principal Elements of a Quality Cost Segregation Study

• August 14, 2023
• Carey M. Heyman, CPA

In June 2022, the Internal Revenue Service (IRS) released their Cost Segregation Audit Technique Guide, which included tax law updates for the Protecting Americans from Tax Hikes (PATH) Act, Tax Cuts and Jobs Act (TCJA), the Coronavirus Aid, Relief, and Economic Security (CARES) Act and the Taxpayer Certainty and Disaster Tax Relief Act of 2020. The Cost Segregation Audit Technique Guide commits a lot of its 268 pages to the concept of “quality.” And while cost segregation studies aren’t likely joining the IRS’ “Dirty Dozen” tax scams list anytime soon, the emphasis on “quality” appears to be a strong acknowledgment of bad actors in the space. The principal elements of a quality cost segregation study, as outlined by the Cost Segregation Audit Technique Guide, include:

1. Preparation by an individual with expertise and experience. There are no prescribed qualifications for cost segregation preparers. But, a preparer’s credentials and level of expertise, which should include knowledge of the construction process and tax law involving property classifications for depreciation purposes, may have a bearing on the overall accuracy and quality of a cost segregation study.
2. Detailed description of the methodology used.
3. Use of appropriate documentation. A quality study will use the best available documentation to classify assets and determine costs, will explain the treatment of land and land development costs, and will include a visit to the property.
4. Interviews conducted with appropriate parties, including the taxpayer, property manager, contractors and sub-contractors. These interviews will add credibility to the depth and accuracy of the cost segregation study.
5. Use of a common nomenclature. Terminology that is consistent with property blueprints and other project documents should be used.
6. Use of a standard numbering system, such as the Construction Specification Institute (CSI) Master Format Division.
7. Explanation of relevant legal analysis. A quality study will include a thorough legal analysis, providing relevant citations, to support asset classifications. The legal discussion should acknowledge prior court decisions and/or unclear IRS positions and attempt to reconcile them to the specific facts and circumstances of the property being examined.
8. Determination of unit costs and engineering “take-offs.” A quality study should minimize any controversy by clearly explaining and documenting the methodology used to assign costs to each asset class.
9. Organization of assets into lists or groups that reconcile to the taxpayer’s fixed asset ledger.
10. Reconciliation of total allocated costs to total actual costs. It is important for the same estimating technique to be used on all of the items that reconcile to a purchase price, a project cost, or to a particular property cost.
11. Explanation of the treatment of indirect costs. Indirect costs, commonly referred to as “allocables,” are intangible costs that are related to the construction of a property. Indirect costs must be allocated proportionately to the basis of the specific assets to which they relate. A quality study will list all the costs associated with a particular project, including both direct and indirect costs, and explain the treatment and allocation of the indirect costs.
12. Identification and listing of Section 1245 property and any property originally classified as Section 1250 property that is being reclassified to Section 1245 property.
13. Consideration of related issues, such as the uniform capitalization (UNICAP) rules of Section 263A, change in accounting method, and sampling techniques. A quality study will address these related audit issues and comment on the treatment of these items for tax purposes, especially where amounts are to be restated for prior tax years.

Thanks to Agatha Li, Mona Stocki and Alison Smidt for their assistance with this blog post. I have worked with each of them over the past couple of years and found them to be exceptional resources for cost segregation study (and fixed asset study) questions and opportunities.

Tags: Cost Segregation Study, Depreciation, Fixed Asset Study, Real Estate, Federal and state taxation, including proposed regulations, Industry best practices, Industry trends/analysis, Year-end tax planning | Comments Off on The Principal Elements of a Quality Cost Segregation Study