Cost Segregation FAQs
How is depreciation impacted under the Alternative Minimum Tax (AMT) system?
Generally, for improvements placed in service after 1998, personal property identified in a Cost Segregation Study will require depreciation to be calculated using a 150% declining balance method as opposed to the 200% declining balance method. Although the acceleration of depreciation is slower under the 150% declining balance, the benefits of a Cost Segregation Study are not impacted significantly since the recovery periods remain the same. For improvements placed in service before 1998, the calculations are more complex and benefits from a Cost Segregation Study are likely to be somewhat lower than originally anticipated.
I have just constructed a building and the general contractor’s invoice already breaks down the costs. Can’t my CPA conduct the Study?
In September of 2004, the IRS released the first iteration of the Cost Segregation Audit Techniques Guide, in an effort to make clear what they are looking for in a Study. Of the 13 essential elements, the very first item the IRS lists is “Preparation By An Individual With Expertise And Experience.” They further explain the following:
“The preparation of cost segregation studies requires knowledge of both the construction process and the tax law involving property classifications for depreciation purposes.”
“… a study by a construction engineer is more reliable than one conducted by someone with no engineering or construction background. However, the possession of specific construction knowledge is not the only criterion. Experience in cost estimating and allocation, as well as knowledge of the applicable law, are other important criteria.”
“A quality study identifies the preparer and always references his/her credentials, experience, and expertise in the cost segregation area.”
The reason the IRS stresses experience and expertise as being so important is because they recognize that there are no set rules that you can use to determine if property is eligible. For example, a light fixture in one room may qualify as 1245 property (property eligible for a shorter accelerated depreciable life) while the exact same light fixture in the very next room may not qualify because of various facts and circumstances on how and why it’s being used. This applies to every asset in the building, and the onus (to prove and substantiate that each asset qualifies) is on the taxpayer. This is done by understanding each asset’s characteristics and knowing the circumstances for which legal authority can support your position on each asset. Because this is both a time consuming and confusing task, it is the exact reason why all the major accounting firms in the country have specially trained non-CPA professionals performing these studies. Below are citations from the IRS on this issue.
“The determination of whether an asset is a structural component or tangible personal property is a facts-and-circumstances assessment, and as such, no bright line test exists.” CCA 199921045; 5/28/1999
“A plethora of legislative acts, court decisions and Service rulings have produced complex and often conflicting guidance with respect to property qualifying” ATG; Section 1
“It cannot be overemphasized that the classification of assets is a factually intensive determination.” ATG; Section 2
Taxpayers or CPAs that attempt to perform a study are very likely to misclassify assets resulting in lower tax benefits and/or much more exposure during an audit. Additionally, an engineer can provide significantly greater tax benefits by breaking down construction costs even further through an analysis of the blueprints, a thorough facility inspection, and the use of proprietary software and tools.
Finally, another area of difficulty for a non-qualified professional is the allocation of construction “soft costs”. These “soft costs” also known as “indirect costs” are intangible costs that are incident to the construction of a facility. Indirect costs must be allocated proportionately to the basis of the specific assets to which they relate. For instance, a cost for HVAC design work must be allocated on a pro-rata basis to very specific HVAC “hard costs” (tangible costs). Because of the intermixing of services from various vendors within a construction project, it’s extremely difficult to determine the appropriate allocation and then to correctly apply those calculations without a software program designed specifically for that purpose.
The IRS has been involved in reviewing these types of studies for various tax purposes since the 1950’s. They have concluded (and stated on record) that this type of analysis is simply too complex for a non-qualified professional to perform. Below are just some of the many additional citations where the IRS states that a study should be performed by a third party qualified professional.
“Therefore, it is proper for the taxpayer to use a third party cost analysis to allocate costs to a building’s structural components” Private Letter Ruling 7941002, 6/25/1979
“The use of cost segregation studies must be specifically applied by the taxpayer” CCA 199921045; 5/28/1999
What’s the benefit of addressing abandonment issues in a Cost Segregation Study?
By quantifying all property including “structural components” by suite, our analysis will allow for the identification of costs that can be written off for future tenant abandonments. For a fully improved property acquired after 1996 with no cost documentation on those improvements, it’s impossible to take advantage of these benefits without a Cost Segregation Study. Although this is beyond the scope of the normal Study, it is standard in our product and it can significantly increase total tax benefits by as much as three times!
I did a 1031 exchange into my property. Will a Cost Segregation Study still save me money?
Nearly half of the Cost Segregation Studies conducted at KBKG involve properties in a 1031 exchange. However, there are situations where a 1031 exchange will negate the benefits of a Cost Segregation Study. Our CPAs have an in-depth knowledge of how a study interacts with an exchange, and will let you know how using both tax strategies will affect your cash flow.
I plan on selling my property very soon. Does Cost Segregation make sense for me?
If you conduct a Study on a property you plan to sell in a taxable transaction, you may have to recapture your accelerated depreciation deductions. However, this depends on when the property was acquired and what the value of the accelerated depreciation property is upon disposition (i.e. you may be able to create a large deduction and only have a smaller amount of recapture). Better still, if you intend to enter into a like kind exchange (a non-taxable transfer of your property for another property) you will not have depreciation recapture issues until you sell the replacement property. In this situation, a Cost Segregation Study could be extremely beneficial. In addition, conducting a Study in the year of an exchange could give you the opportunity to pull out some cash (taxable boot) without creating any tax liability. Our tax experts will work with you or your CPA to assess your specific situation and inform you on what your options are.
How long do I need to hold on to the property for Cost Segregation to make sense?
If the intention is to sell for cash, we generally recommend Cost Segregation for clients that will hold a property for a minimum of 3-5 years. We can calculate the exact “break even” point to determine the benefits of a Cost Segregation Study based on how long you plan on holding the property.
I have several partners in this property. There’s no way they will all agree to amend their returns to take advantage of the study. Is there another way?
Yes. An amended return is no longer necessary to fix depreciation in the prior year. The IRS has recently issued Revenue Ruling 2004-11, which allows a taxpayer to file a form 3115 Automatic Change in Accounting in lieu of an amended return. This allows the taxpayer to take any missed deductions in the current year. The same form is also used to fix depreciation on assets acquired as far back as 1987.
Will a Cost Segregation Study increase my chances of getting audited?
Not if you are taking depreciation you are allowed to, as identified by the IRS. In fact the IRS has:
- Issued revenue procedures specifically outlining how Cost Segregation can be used
- Identified appropriate asset class lives that can be taken
- Specified guidelines on how the accountant should file for an automatic change in accounting method to account for missed depreciation
Why has my accountant not performed a Study already?
The IRS recognizes that a Study requires engineering expertise. While an accountant may have knowledge in taxation, an engineer is needed to interpret blueprints, assess construction methods, inspect the building, and estimate components. Additionally, since the same asset can qualify in one building and not in another, knowledge of numerous IRS rulings is needed to ensure assets are being depreciated correctly for a specific situation.
How much can be saved?
Every building is different. Savings depend on many factors including: purchase price, building use, construction methods used, design, and year acquired.
An estimate of savings can easily be obtained through our Savings Calculator. For a more accurate estimate, you can Request a Free Analysis and Proposal. Generally, the savings is roughly 25 to 35 times the cost of the Study.
A Study is generally beneficial if the property is not operating at a loss and is generally applicable unless the property is for a non-profit organization.
Do You Qualify for a Cost Segregation?
KBKG can help you identify if you are an ideal candidate for this and other lucrative studies.
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