This document provides a comprehensive guide for IRS examiners on how to review cost segregation studies. Here is a summary of the key points:
Overview of Cost Segregation
Cost segregation is the process of identifying and reclassifying personal property assets in a building from real property to personal property. This allows for shorter depreciation recovery periods and accelerated depreciation deductions. The main goal is to identify building components that can be depreciated over 5, 7 or 15 years instead of the standard 39 years for commercial real estate or 27.5 years for residential rental properties.
Legal Framework
The legal basis for cost segregation stems from several key areas:
- Depreciation rules under IRC Section 168
- Definitions of Section 1245 and Section 1250 property
- Former Investment Tax Credit (ITC) rules
- Court cases e.g., Hospital Corporation of America
The classification of assets as Section 1245 (personal property) or Section 1250 (real property) is critical. There is no bright-line test, so it requires a fact-intensive analysis based on the nature and use of each asset.
Common Cost Segregation Approaches
The most common methodologies include:
- Detailed Engineering Approach from Actual Cost Records
- Detailed Engineering Cost Estimate Approach
- Survey or Letter Approach
- Residual Estimation Approach
- Sampling or Modeling Approach
- "Rule of Thumb" Approach
The detailed engineering approaches are generally the most accurate and reliable. The other methods may be less precise but can be appropriate in certain circumstances.
Elements of a Quality Cost Segregation Study:
- Preparation by qualified individuals with relevant expertise
- Detailed description of methodology
- Use of appropriate documentation
- Interviews with knowledgeable parties
- Common nomenclature and numbering system
- Explanation of legal analysis
- Determination of unit costs and engineering take-offs
- Organization of assets into appropriate groups
- Reconciliation of total allocated costs to actual costs
- Explanation of indirect cost treatment
- Identification of Section 1245 property
- Consideration of related issues like Section 263A
The accompanying report should have elements such as:
- An executive summary
- Narrative report
- Schedules of assets and costs
- Description of engineering procedures
- Relevant exhibits
Examination Steps
Initial Risk Analysis
- Review the cost segregation study report
- Verify cost basis and reconcile to depreciation records
- Conduct risk analysis to evaluate audit potential
Key risk factors include:
- Mixed asset types in the same group
- Misclassification of structural components as personal property
- Minimal allocation to land or building
- Use of creative or misleading asset descriptions
- Large look-back depreciation adjustments
Examination
- Review the study report in detail
- Interview the study preparer
- Inspect the property
- Review and verify asset classifications and recovery periods
- Address additional issues like:
- Section 263A capitalization
- Change in accounting method
- Sampling techniques
- Summarize findings
Resolution
- Discuss the findings with the taxpayer
- Consider hiring specialists if needed
- Prepare a final report
Key Examination Areas
Methodology
- Evaluate the overall methodology and approach used
- Determine how costs were allocated and estimated
- Review the qualifications of the preparers
Documentation
- Request and review contemporaneous documentation like construction records
- Verify cost basis and reconcile to fixed asset records
- Ensure proper substantiation for asset costs and classifications
Asset Classification
- Carefully review descriptions and classifications of assets
- Be alert for misclassification of structural components as personal property
- Verify appropriate recovery periods are used based on asset class lives
Property Inspection
- Conduct a thorough on-site inspection when possible
- View questionable assets to understand their nature and use
- Interview facility personnel about asset functions
Related Issues
- Consider uniform capitalization rules under Section 263A
- Determine if a change in accounting method was properly made
- Evaluate any sampling techniques used
Special Topics
The guide includes additional chapters on areas like:
- Electrical distribution systems
- Stand-alone parking structures
- Construction process overview
- Depreciation rules
- Relevant court cases
- Uniform capitalization under Section 263A
- Change in accounting method procedures
- Statistical sampling techniques
It also provides industry-specific guidance for sectors like retail, restaurants, casinos, auto dealerships, and others.
Key Considerations for Examiners
Some of the key points emphasized for examiners include:
- There is no standard format or requirements for cost segregation studies. The quality and accuracy can vary widely.
- The classification of assets is very fact-specific. There are no bright-line tests for distinguishing Section 1245 vs 1250 property.
- Contemporaneous documentation from the actual construction or acquisition is ideal for verifying costs and asset uses.
- Be alert for aggressive positions that try to classify too many structural components as personal property.
- The treatment of indirect costs and the potential for duplicating costs in multiple asset categories are important areas to scrutinize.
For acquired properties, ensure an appropriate amount is allocated to land before segregating building components.
- Consider whether the taxpayer properly changed their accounting method if they are claiming catch-up depreciation deductions.
- Evaluate whether sampling techniques, if used, are statistically valid.
- Specialists like engineers may be needed to properly examine complex studies.
Wrapping Up
Cost segregation studies can provide significant tax benefits to taxpayers but also present risks of improper reclassification of assets. This guide provides IRS examiners with a structured approach to thoroughly evaluate the methodology, documentation, and conclusions of these studies.
By focusing on key risk areas and following the recommended steps, examiners can effectively identify potential issues and ensure taxpayers are properly classifying and depreciating their property assets.
