Cost Segregation Study

What is a Cost Segregation Study?

The goal of a Cost Segregation Study is to identify building costs that have been traditionally depreciated 39 years and to re-allocate a significant portion of these costs to a shorter, accelerated method of depreciation.  Additionally, they can be used to identifying improvements that may qualify for the 50% bonus depreciation and allocating hard and soft costs to these improvements.

Construction-related costs, which may account for as much as 75 to 90 percent of the overall project cost, are usually lumped together as real property with a depreciable life of 39 years. When segregating the costs of a construction project, it is easy to properly identify costs of equipment, furniture and fixtures, and computer equipment that can be depreciated over 5 and 7 years for tax purposes.

Benefit vs. Costs

Reclassification of costs from real property to personal property may:

• Reduce tax lives from 39 years to 5 to 7 for assets such as such as removable carpeting attached with latex adhesives, signage, movable and removable partitions, cabinets and shelves, decorative millwork, window treatments, interior ornamentation, certain electrical and plumbing equipment necessary for the operation of specialized equipment such as computer rooms (rather than for overall building maintenance and operation) or lighting fixtures that are used for decoration or plant growth.
• Identify leasehold improvements that qualify for 50% bonus depreciation.  These are improvements that are not for the cost of building enlargements, elevators or escalators, structural components benefiting common areas, or a building’s internal structural framework.

Structural components for these purposes are defined as load-bearing internal walls and any other internal structural supports, including the columns, girders, beams, trusses, spandrels and all other materials that are essential to the stability of the building.

Generally 10%-25% of the total cost may qualify for reallocation of costs into shorter tax lives.  In most cases, tax saving for the first year will greatly exceed the cost of doing the study.

Candidates for Cost Segregation Studies

Includes:

• Commercial properties with construction cost or purchase price over $1million.

• New construction or remodels/ rehabilitations after 1986

• Lessees with leasehold improvements

• Improvements with special equipments such as a computer room, a technology demonstration room, or a special lab.

Properties with cost lower than $1million, or planned to be sold in 2 years are not good candidates for a cost segregation study.

Timing of Cost Segregation Study

The best time to have a study completed is for the year the building or improvements are placed in service.  During the process, considerable amounts of design or architect fees may be appropriately identified with certain equipments layout, non-structural improvements and be classified as properties of shorter lives rather than be lumped together and allocated to building.  Specific identification is important since the IRS does not allow a simple percentage method for breaking out construction costs.

The Process

A qualified professional such as an appraiser, engineer, architect or construction estimator should complete the cost segregation study using specific take off and historical unit cost information as a basis for reallocating costs. Although accountants are not qualified professionals, they can assist the engineer or architect in the determination of property that qualifies for shorter lives.

The process includes:

• Physical inspection of the property.

• Examination of architectural/engineering drawings and specifications for potential asset reclassification.

• Analysis of cost data, including the contractor’s application of payments, change orders, owner-incurred costs and indirect disbursements.

• Preparation of an itemized list of property qualifying for shorter-life classification based on relevant income tax authorities.

• Apportionment of direct labor, material components and indirect costs based on engineering drawings and specifications.

• Reconciliation of total costs per the engineering analysis to capitalized project costs.

• Documentation of methodology, procedure performed and conclusions to provide a clear and detailed audit trail. A report of the study generally includes a project cost reconciliation, cost detail and summary by appropriate IRS class lives, property definitions, study procedures, photos, and final results of facts to be used for income tax purposes.