Overview
Cost segregation is the practice of identifying and segregating the costs associated with various components of real estate assets into the appropriate property classes and recovery periods. The primary purpose of a cost segregation study is to accelerate the depreciation deductions associated with the assets. This is accomplished by identifying the components of the assets which are eligible for shorter cost recovery periods, accelerated depreciation methods (declining balance instead of straight-line), and “bonus” depreciation. By accelerating depreciation deductions, taxpayers can reduce their current taxable income and defer Federal (and state) income taxes to future years.

Cost segregation approaches
There are many different approaches utilized for cost segregation studies. The approach used is dependent on a number of factors, including the experience and skill of the person preparing the study, the availability of supporting documentation (e.g., actual construction costs, construction drawings, etc.), whether the property was newly constructed or acquired, and the size and nature of the property. The different approaches range from a detailed engineering approach from actual cost records to a “rule of thumb” approach (not recommended). And often times, multiple approaches will be used together as part of the same cost segregation study.

It is useful to describe the most common cost segregation approaches in the context of newly constructed or acquired properties. Newly constructed property (includes ground up construction, renovations, and additions to existing properties) usually involves construction that was completed by or for the taxpayer and has occurred relatively recently. Acquired property involves existing properties that are purchased by the taxpayer. The property could have been constructed recently or far in the past.

For newly constructed properties, detailed documentation is typically available in the form of actual project costs (both direct and indirect) and project construction documents (both drawings and specifications). Additionally, it is sometimes possible for the individual performing the cost segregation study to have access to the parties responsible for the design and construction of the property (e.g., architects, engineers, contractors, etc.). In these situations, cost segregation professionals typically use a detailed engineering approach from actual cost records and estimates or surveys where necessary. The cost segregation study relies on actual project documentation when determining the costs of each component of segregated property. This typically means the cost comes from one of the following sources:

1. Actual project invoices for direct or indirect costs
2. Surveys issued to project participants in order to estimate the cost of certain components that were not segregated in the project invoices
3. Cost estimates performed by the cost segregation professional that are based on an engineering analysis of the project drawings and specifications

For acquired properties, there is typically little (or no) detailed documentation available for the project. In these situations, cost segregation professionals typically use a detailed engineering cost estimate or residual estimation approach. This means that the professional prepares engineering estimates to determine the cost of each component of segregated property. These estimates are prepared based on a combination of project drawings (if available) and an inspection of the property. The lack of detailed contemporaneous documentation for acquired properties requires the cost segregation professional to rely more heavily on cost estimating techniques then when performing a study for newly constructed properties.

How are cost segregation studies performed?
The procedures used to perform a cost segregation study are dependent on the approach being taken, but generally follow the high-level work steps described below.

1. Information gathering and initial review. The information request may include the following items: construction drawings, general contractor’s application for payment, summary of project costs, invoices, purchase and sale agreement, appraisal or inspection, tenant lease agreements, etc.
2. Perform an inspection of the property to determine the nature of the facility, its intended use, and to identify the specific assets located at the property. During the site inspection, the professional will also gather photographs and take measurements to support the analysis.
3. Identify the appropriate asset classifications for the components of the property based on the documentation provided and the information gathered during the site inspection.
4. Perform quantity take-offs for certain assets, which includes identifying the types of materials used and then estimating the quantity of each material.
5. Identify the direct costs associated with each component of the property previously identified. The source of the direct cost can be a combination of actual project costs and cost estimates.
6. Identify any indirect costs associated with the project (e.g., architect’s fees, engineering fees, contractor’s overhead and profit, etc.) and determine how to allocate such costs to the direct costs previously identified.
7. Finally, the cost segregation professional will prepare detailed schedules and a report to describe and document the cost segregation analysis

There are numerous possible variations of the procedures described above and many sub steps within each step that are not described in this blog post. But the above is a general explanation of how a cost segregation professional will typically complete a cost segregation study. For more information on cost segregation approaches, please see our blog post on the IRS Cost Segregation ATG.

Summary
Cost segregation can be an effective tax planning strategy for many different companies and individuals who have constructed or acquired real estate assets. And there are many possible approaches to completing a cost segregation study. The appropriate approach will be dependent on your specific situation and the availability of information related to the assets. However, it is important to consult a professional with expertise and experience in cost segregation. If you have any questions regarding cost segregation studies and how they may benefit you, please reach out to Andrew Kohrs at [email protected].