Note: Each chapter in this Audit Techniques Guide (ATG) can be printed individually. Please follow the links at the beginning or end of this chapter to either return to the Table of Contents or proceed to the next chapter.
Chapter 1 – INTRODUCTION
This Audit Techniques Guide (ATG) has been developed to assist Internal Revenue Service (Service) Examiners in the review and examination of cost segregation studies. The primary goals are to provide examiners with an understanding of:
- Why cost segregation studies are performed for Federal income tax purposes;
- How cost segregation studies are prepared;
- What to look for in the review and examination of these studies; and,
- When certain issues identified in the cost segregation study need further examination.
The ATG was originally developed by a cross-functional team of Service Engineers and Revenue Agents. It was updated by members of the Deductible & Capital Expenditures Practice Network (DCE PN) and is not intended as an official IRS pronouncement. Accordingly, it may not be cited as authority.
In order to calculate depreciation for Federal income tax purposes, taxpayers must use the correct method and proper recovery period for each asset or property owned. Property, whether acquired or constructed, often consists of numerous asset types with different recovery periods. Thus, property is typically separated into individual components or asset groups having the same recovery periods and placed-in-service dates to properly compute depreciation. When the actual cost of each individual component is available, this is a rather simple procedure. However, when only lump-sum costs are available, cost estimating techniques may be required to "segregate" or "allocate" costs to individual components of property (e.g., land, land improvements, buildings, equipment, furniture and fixtures, etc.). This type of analysis is generally called a "cost segregation study," "cost segregation analysis," or "cost allocation study."
In recent years, an increasing number of taxpayers have submitted either original tax returns or claims for refund with depreciation deductions based on cost segregation studies. The underlying incentive for preparing these studies for Federal income tax purposes is the significant tax benefits derived from utilizing shorter recovery periods and accelerated depreciation methods (including bonus depreciation and Internal Revenue Code (IRC) § 179 deduction) for computing depreciation deductions. The prevailing issues for Service examiners include obtaining an understanding of the rationale used to segregate property into its various components, and the methods used to allocate the total project costs among these components.
Cost segregation studies are most commonly prepared for the allocation or reallocation of building costs to tangible personal property. A building, termed "§ 1250 property", is generally non-residential real property (39-year) or residential rental property (27.5-year) property eligible for straight-line depreciation. Equipment, furniture and fixtures, termed "§ 1245 property", are tangible personal property. Tangible personal property has a shorter recovery period (e.g., 5 or 7 years) and is also eligible for accelerated depreciation (e.g., double declining balance, bonus depreciation and § 179 deduction). Therefore, a faster depreciation write-off (and tax benefit) can be obtained by allocating property costs to § 1245 property.
The following example illustrates the tax benefits of a cost segregation study. In general, a turnkey construction project includes elements of tangible personal property (e.g., phone system, computer system, process piping, storage tanks, etc.). It is relatively easy to identify these items as § 1245 property and allocate a portion of the total project costs to them. However, a cost segregation study may also report certain building occupancy items (e.g., carpeting, wall coverings, partitions, millwork, lighting fixtures) as § 1245 property that would have likely been classified or grouped under § 1250 property without the completion of a cost segregation study. These items may or may not constitute as qualifying § 1245 property depending on the particular facts and circumstances for which the project was designed.
This next example illustrates the complexity of cost segregation issues. In addition to identifying specific project components that qualify as § 1245 property, cost segregation studies may treat portions of building components as § 1245 property. For example, some items of the building’s electrical system support § 1245 property and § 1250 property. The Study will typically identify the costs of the branch circuits feeding the § 1245 property and classify according to the recovery period of the § 1245 property (i.e. 5 or 7 year recovery). It may also identify that, for example, 15 percent of a building’s electrical distribution system (EDS) directly supports § 1245 property, such as specialized kitchen equipment. Based on that conclusion, the study will then treat 15 percent of the EDS cost as § 1245 property along with the identified § 1245 branch circuits. See Chapter 8.1 - Functional Allocation of a Buildings Electrical Distribution System for further details. The allocation of building components to § 1245 property is often a contentious issue.
Property allocations and reallocations are typically based on criteria established under the Investment Tax Credit (ITC) laws under § 48. As a result from numerous legislative acts, court decisions and Service rulings relating to property qualifying for ITC and a lack of bright-line tests; complex and often conflicting guidance have impacted the ease in determining § 1245 property from § 1250 property. Related issues, such as the capitalization of interest and production costs under IRC § 263A and changes in accounting method, add to the complexity of this issue. For additional guidance on court rulings refer to Chapter 6.4 - Relevant Court Cases included in this ATG.
In a landmark decision, the Tax Court ruled that, to the extent tangible personal property is included in an acquisition or in overall costs, it should be treated as such for depreciation purposes. The court also decided that the rules for determining whether property qualifies as tangible personal property for purposes of ITC (under pre-1981 tax law) are also applicable to determining depreciation under current law. [See Hospital Corporation of America, 109 T.C. 21 (1997)] The Service acquiesced to the use of ITC rules for distinguishing § 1245 property from § 1250 property.
This ATG provides technical information, audit techniques and examples of proper cost segregation studies to focus the efforts of examiners. The use of cost segregation studies will likely continue to increase, and there are currently no standards regarding the preparation of these studies. These studies vary widely in terms of the methodology, documentation, depth, format, and expertise of the study’s preparer. This lack of consistency, coupled with the complexity of the law in this area, often results in an examination that can be controversial and burdensome for all parties.
Examiners reviewing cost segregation studies must determine the proper classification and correct costs of property. In some cases (e.g., small projects) examiners may be able to evaluate a study without assistance. However, other studies may require specialists with expertise, industry experience and specialized training (e.g., Engineers, Computer Audit Specialists and/or DCE PN Senior Revenue Agents). Examiners should perform a risk analysis as early as possible to determine the depth of an examination and the need for additional assistance.
Technical and/or procedural cost segregation questions may be submitted to the Deductible & Capital Expenditures Practice Network.
Depreciation issues involving cost segregation studies cross all LB&I industry lines and impact SB/SE taxpayers as well. The lack of consistency in cost segregation studies and the absence of bright-line tests for distinguishing property contribute to the difficulties of this issue. The purpose of this ATG is to provide the foundation to a better understanding of cost segregation studies and to provide the examination steps that will facilitate the audit process and minimize burden on taxpayers, practitioners and Service examiners alike.