What the guide says the IRS requires
Less than most people assume. In its own words, the IRS "has not established any requirements or standards for the preparation of cost segregation studies" (Chapter 3). What the guide does insist on is substantiation: the classification of property is "factually intensive and must be supported by corroborating evidence," and actual costs are more reliable than estimates. Where estimates are the only option, the methodology and the source of the cost data should be clearly documented.
Every study, whatever its length or method, should do three things (Chapter 4):
- Classify assets into property classes: land, land improvements, building, equipment, and furniture and fixtures.
- Explain the rationale, with legal citations, for classifying each asset as §1245 or §1250 property.
- Substantiate the cost basis of each asset and reconcile total allocated costs to total actual costs.
How the guide is organized
| Chapter | What it covers |
|---|---|
| 1. Introduction | Purpose of the guide and background on cost segregation. |
| 2. Legal framework | The history of depreciation, §1245 vs §1250 property, the tests courts use to tell them apart, and the Hospital Corporation of America case. |
| 3. Cost segregation approaches | The six common approaches and what the IRS requires of them (nothing prescribed). |
| 4. Principal elements of a quality study and report | The 13 elements of a quality study and the nine parts of a quality report. |
| 5. Review and examination of a study | How an examiner reads a study, verifies basis and decides what to look at. |
| 6. Special topics | Uniform capitalization, accounting method changes, depreciation basics, case-law tables, the inherently permanent standard, construction process, sample information document requests, §179, §179D and bonus depreciation. |
| 7. Industry-specific guidance | Asset classification matrices for retail, restaurants, pharmaceutical and biotech, casinos, auto dealerships, auto manufacturing and residential rental property. |
| 8. Issue-specific guidance | Electrical distribution systems and stand-alone open-air parking structures. |
For an owner, the most useful parts are Chapter 4 (what a quality study contains) and the Chapter 7 matrix for your property type.
The six study approaches
Chapter 3 describes the approaches examiners commonly see. It does not require any of them.
- Detailed engineering from actual cost records. Uses the actual construction cost records; generally the most methodical and accurate.
- Detailed engineering cost estimate. Estimates component costs when actual records are not available.
- Survey or letter. Relies on a contractor's or architect's letter or survey of costs.
- Residual estimation. Estimates certain components and assigns the remainder to the building.
- Sampling or modeling. Applies the results of studied properties to similar ones.
- "Rule of thumb". A fixed percentage from industry averages; the guide tells examiners to view it with caution.
The 13 principal elements of a quality study
The guide calls a study that is "both accurate and well-documented" a quality study, and lists 13 elements it contains (Chapter 4). They describe quality, not a pass/fail test, and they are a good checklist when you compare providers.
| # | Element | What the guide looks for | Question to ask |
|---|---|---|---|
| 1 | Preparation by an individual with expertise and experience | Knowledge of both construction and the tax law. The guide notes there are no prescribed qualifications, and says a quality study identifies the preparer and their credentials. | Who prepared the study, and does the report say so? |
| 2 | Detailed description of the methodology | The study describes the method used and the steps taken to classify assets and determine costs. | Does the report explain, step by step, how the numbers were produced? |
| 3 | Use of appropriate documentation | The best available documents. For a purchased building: the purchase agreement first, how the price was split between land, building and other assets (land determined first), deterioration and obsolescence, appraisals, and a site visit with photographs. | Which of my documents did the study use, and where does the land value come from? |
| 4 | Interviews conducted with appropriate parties | Interviews with contractors, owners and property managers about how the property is used, documented in the study. | Did anyone ask me how the property is actually used? |
| 5 | Use of a common nomenclature | Plain terms consistent with the project documents. The guide warns against "creative" names that disguise an asset, such as building water piping called "process piping." | Are the components named in plain language I recognize? |
| 6 | Use of a standard numbering system | A standard system such as the CSI MasterFormat divisions, consistent with bid documents and pay requests. | Is each line item organized by a recognized building-system code? |
| 7 | Explanation of the legal analysis | Legal citations supporting each §1245 classification, including where court decisions conflict, reconciled to the property's facts. | Does each reclassified item cite its asset class or authority? |
| 8 | Determination of unit costs and engineering "take-off" | Documented unit costs. When actual costs are not available they are estimated, and the guide says estimates are "always reconciled to an acquisition price or a total project cost." | Where do the component costs come from, and how were they estimated? |
| 9 | Organization of assets into lists or groups | Assets listed by recovery period, tying to the taxpayer's fixed asset ledger. | Can my CPA enter the schedule straight into the depreciation software? |
| 10 | Reconciliation of total allocated costs to total actual costs | One estimating technique applied to every item, total allocated costs reconciled to total actual costs, and separately bought furniture and equipment listed separately so nothing is counted twice. | Does the schedule add up to my depreciable basis, and is anything counted twice? |
| 11 | Explanation of the treatment of indirect costs | All direct and indirect costs listed, with indirect costs (permits, general conditions, overhead and profit) explained and allocated to the assets they relate to. | How were closing or indirect costs spread across the components? |
| 12 | Identification and listing of §1245 property | The §1245 property listed with amounts, showing what was reclassified from §1250. | Is there a clear list of the personal property and its cost? |
| 13 | Consideration of related aspects | Related issues such as uniform capitalization under §263A, a change in accounting method (Form 3115 for prior years), and sampling techniques for large portfolios. | If the property was placed in service in an earlier year, does the study address the catch-up? |
What a quality report contains
The guide separates the study (the work) from the report (what you receive). A quality report has nine parts: a summary letter or executive summary naming the preparer, date, taxpayer and property; a narrative explaining the property, the rationale and the supporting law; a schedule of assets that ties to your depreciation records; a schedule of direct and indirect costs; a schedule of property units and costs; the engineering procedures used; a statement of assumptions and limiting conditions; a certification; and exhibits such as photographs and drawings.
What an examiner checks first
Chapter 5 walks an examiner through the review. The first three steps:
- Read the report. Background on the property, the method, the assets and their recovery periods, and the authority for each classification.
- Verify the cost basis and reconcile depreciation records. The study should tie to the depreciation schedules on the return, and to prior-year schedules for a look-back study. Examiners check whether furniture and equipment listed elsewhere were counted again.
- Decide what to look at. A risk analysis of the property unit descriptions, the reclassified amounts and the method, to set the scope of the exam.
Chapter 6 includes the document requests an examiner may send, covering who prepared the study, the properties, drawings, the study itself and its computations.
Residential rental property
Chapter 7 includes a matrix for residential rental property (Exhibit A) with the recommended classification and recovery period for common rental assets: most §1245 property in a rental (such as appliances and carpeting) under asset class 57.0, five years; land improvements such as fencing, sidewalks and parking areas under asset class 00.3, 15 years; and the building itself at 27.5 years. The guide tells examiners that when a return is consistent with the matrix, they should not adjust the classification or recovery period. For a rental owner it is the single most useful table in the guide.
See also IRS Publication 946, explained for recovery periods, and the 15-year life of land improvements.