Cost Segregation Approaches

Introduction

(1) Cost segregation studies are conducted for a variety of reasons (e.g., income tax, financial accounting, insurance purposes, and property tax). For income tax purposes, cost segregation studies involve the allocation (or reallocation) of the total cost (or value) of property into the appropriate property classes and recovery periods in order to properly compute depreciation deductions. The results of cost segregation studies are typically summarized in an accompanying cost segregation report. Currently, there is no standard format for either cost segregation studies or cost segregation reports.

(2) The methodology or approach utilized in allocating total project costs to various assets is critical to achieving an accurate cost segregation study. The terms “methodology” and “approach” are often used interchangeably in discussions of cost segregation; however, to simplify, the term “approach” is used in this ATG. Also, in this ATG, the term “cost segregation” refers to the process of performing cost segregation and the term “cost segregation study” refers to the written report that conveys the results of the cost segregation. This chapter summarizes some of the more common approaches to cost segregation and their potential drawbacks. This discussion should assist the examiner in evaluating the accuracy of the cost segregation and in performing a risk analysis with respect to the depreciation deductions based on the cost segregation.

(3) Cost segregation is generally performed for either newly constructed property or acquired property. Each of these situations requires a very different overall approach.

(4) Newly constructed property, which includes remodels of existing properties and additions to existing properties, usually involves construction that was completed for the taxpayer that has occurred relatively recently. The cost segregation is normally performed either at the completion of the construction project or soon after. At this point, direct cost information (from contractors, vendors, suppliers, etc.) and indirect cost information (from architects, engineers, construction testing firms, local government building departments, etc.) is generally readily available from the taxpayer. Also, construction documents that were used for the construction project (construction drawings, specifications, contract documents, etc.) are generally readily available as well.

(5) Acquired property typically includes a combination of land, buildings, land improvements, and personal property located on the land or in the buildings purchased by the taxpayer. The acquired property could have been constructed recently or far in the past. The available cost and construction information may range from as much as that available for a newly constructed property down to nothing more than the purchase price of the acquired property.

(6) When construction cost information for the acquired property is not available, it must be estimated using the construction cost data, methods, and techniques normally employed for a property appraisal. These estimated property costs (replacement cost new (RCN)), which include indirect costs, are then adjusted for the asset’s age and condition at the acquisition date, including physical depreciation, functional obsolescence, and economic obsolescence. These adjustments are generally expected to be different among the various items of acquired property (e.g., a building and its structural components, land improvements, and personal property), given that each of these items of property have varying expected useful lives, levels of use, and may have been constructed and/or installed on different dates. The total replacement cost new less depreciation (RCNLD) of the acquired items of property, along with the fair market value (FMV) of the land, should reasonably approximate the total purchase price of the acquired property.

What are the Most Common Approaches Utilized for Cost Segregation Studies?

(1) Various approaches may be used in completing cost segregation, including:

Detailed Engineering Approach from Actual Cost Records,
Detailed Engineering Cost Estimate Approach,
Survey or Letter Approach,
Residual Estimation Approach,
Sampling or Modeling Approach, and
“Rule of Thumb” Approach.

(2) Examiners should not necessarily expect to see the approach that was used for a cost segregation mentioned in a cost segregation report. Some cost segregation reports may describe the approach that was used for the cost segregation in great detail and some cost segregation reports may not mention the approach that was used at all. However, based on the information in this chapter, an examiner should be able to recognize the attributes of the cost segregation and identify the approach that was used (and also identify the potential drawbacks of the approach). Other approaches not mentioned here may be used, although most are merely derivatives of the approaches discussed in this chapter.

What are the Attributes of the Various Cost Segregation Approaches?

(1) The following discussion takes a closer look at the steps involved and the attributes of each of the approaches listed above. Keep in mind that these are the steps normally taken when completing cost segregation. The examiner’s responsibility is to review the steps taken in the cost segregation and to evaluate the accuracy of the cost segregation and, additionally, to evaluate the quality of the accompanying cost segregation report. Chapter 5 - Review and Examination of Cost Segregation Study provides guidance in how to review cost segregation and cost segregation reports.

Detailed Engineering Approach from Actual Cost Records

(1) The detailed engineering approach from actual cost records, also called the “detailed cost approach” or “direct cost method,” uses cost information from contemporaneous construction and accounting records. In general, it is the most methodical and accurate approach, relying on solid documentation of the construction costs and minimal cost estimating. Construction documentation, such as construction drawings, specifications, contracts, job reports, change orders, payment requests, and vendor and supplier invoices, are used to determine unit costs. The use of actual cost records in this approach contributes to the overall accuracy of cost allocations, although issues may still arise as to the proper cost classification of specific assets. Refer to Chapter 6.F. - Construction Process, for a discussion of a typical construction project and an explanation of the construction cost information and documentation mentioned above.

(2) The detailed engineering approach from actual cost records is generally applicable only to new construction, where detailed direct cost information (from contractors, vendors, suppliers, etc.) and indirect cost information (from consultants, testing firms, local government building departments, etc.) is readily available.

(3) The detailed engineering approach from actual cost records typically includes the following activities:

a. Identify the specific project and assets that will be analyzed in the cost segregation.

b. Obtain information on all direct and indirect project costs and substantiate the total project cost.

c. Conduct a site visit to inspect the facility. Determine the nature of the facility, its intended use, and identify the specific assets that are contained within the facility and on the facility site.

d. Photograph specific assets for reference. Request any available photographs that document the condition of the property prior to the start of construction as well as progress photographs that document the progress of the construction during the construction project.

e. Review record drawings, specifications, contracts, bid documents, contractor pay requests, change order detail, and any other construction cost information or documentation that is available.

f. Assign the specific assets identified in the document review and site visit to property classes and recovery periods (e.g., land, land improvements, building, equipment, furniture and fixtures, and other items of tangible personal property).

g. Prepare quantity take-offs for all assets and use contractor cost information to compute unit costs.

h. Apply unit costs to each asset to determine its total cost basis. Reconcile the total costs basis obtained from quantity take-offs to the total actual contractor costs.

i. Allocate indirect costs to the appropriate assets. This allocation is normally done on a pro rata basis for indirect costs applicable to the entire project and on a specific basis for indirect costs applicable only to specific assets.

j. Group assets with similar class lives, recovery periods, and placed-in-service dates to simplify depreciation computations and the entry of the assets into the taxpayer’s fixed assets system.

(4) Even though the detailed engineering approach from actual cost records generally provides the most accurate cost allocations for the assets, the examiner should recognize that the proper cost basis and recovery periods of the § 1245 property analyzed in the cost segregation could still be an issue even when this approach is used.

Detailed Engineering Cost Estimate Approach

(1) The detailed engineering cost estimate approach (or detailed estimate approach) is similar to the detailed cost approach. The difference is that the detailed estimate approach estimates costs, rather than using actual costs. This approach is used when cost records are not available such as for an acquisition of property comprised of land, existing buildings, land improvements, and personal property. In the context of an acquisition, additional steps must be taken to determine the values of the acquired assets, such as addressing physical depreciation and functional obsolescence in the detailed cost approach.

(2) The detailed estimate approach is methodical, relying on solid documentation and using construction-based documents such as blueprints, specifications, contracts, job reports, change orders, payment requests, invoices, appraisals, etc. When estimates are required, they are based on costing data, either from contractors or from reliable published sources (e.g., R. S. Means or Marshall Valuation Service). The sources of estimating data are clearly referenced, including identification of the specific volume, page, and item number. Further, consistent estimating techniques and unit cost data sources are used for all of the items that comprise the actual cost.

(3) In essence, the steps for this approach are the same as the detailed cost approach, except for Step C.1.g (in which costs come from contractor estimates or estimating guides). However, if detailed cost estimates are prepared methodically, then the total RCNLD of the buildings, land improvements, and personal property should reasonably approximate the total purchase price of the property less the FMV of the land.

(4) A field inspection is recommended for all quality studies, whether the studies are for new or used properties. When construction drawings and specifications are limited or are not available, which is often the case for used or acquired property, field inspection of the property is a critical step. This field inspection should document the physical details of the building, type of construction, materials used for construction, the assets contained in the building, the size, and types of building systems (HVAC, plumbing, fire protection, electrical, data and communications, etc.), and any land improvements (such as parking lots, sidewalks, site lighting, etc.) that were included in the purchase of the property and the condition of that property at the time of purchase. It is important that this field inspection be completed thoroughly and accurately as it forms the starting point for estimating the construction costs and depreciation for each item of property.

Survey or Letter Approach

(1) The survey or letter approach is an alternative method for estimating costs for newly constructed property. In this approach, contractors and subcontractors are contacted via a survey or letter to provide information on the cost of specific assets that they installed on a particular project. These costs are then used in one of the engineering approaches or in the residual estimation approach (discussed in the following section). Cost allocation using the survey approach involves the following steps:

Complete Steps C.1.a – 1.f of the detailed engineering approach from the actual cost records to identify the specific property items that require cost estimates. Estimates should be reconciled to an actual cost, either to a line-item cost or to an individual system cost (e.g., plumbing, electrical).
Divide property items by contractor and/or subcontractor.
Ask contractors and/or subcontractors to provide the quantities and prices of specific property items.
Use unit cost estimates obtained from the surveys to determine and allocate property costs.

(2) In situations where the contractor provides actual cost data, the allocations may be reasonably reliable. However, when contractor data is obtained from other sites or projects, the data may not be comparable or reliable. The amount of detail provided by different contractors may also vary. The wide disparity in cost estimation methods dictates the use of caution to ensure that the total allocated costs do not exceed the actual total project cost.

Residual Estimation Approach

(1) The residual estimation approach is an abbreviated method in which only short-lived asset costs (e.g., 5- or 7-year property) are determined. Short-lived asset costs are added together and then subtracted from the total project cost. The remaining or “residual” cost is then simply assigned to the building and/or other long-lived assets. Although this method is simpler and less time consuming than the engineering approaches, it can also be less accurate.

(2) It should be recognized that this method generally does not reconcile project costs. In general, residual costs are not estimated or checked for reasonableness. A proper and “reasonable” residual cost should always be determined and then added back to the total of all short-lived asset costs to check if the total project cost is reconciled.

(3) It should also be understood that different estimation techniques for short-lived assets can produce a skewed result in favor of § 1245 property (e.g., § 1245 property based on single-unit costs for high quality construction, while the building is based on gross square footage).

Sampling or Modeling Approach

(1) The sampling or modeling approach uses a created model (or template) to analyze multiple facilities that are nearly identical in construction, appearance, and use (e.g., fast food chains and retail outlets). The use of sampling minimizes resources and costs compared to conducting studies on all properties.

(2) Typical steps are:

Stratify properties by facility type (e.g., free-standing facility, mall location, leased or owned property, etc.).
Perform a cost segregation study by sampling properties within each stratum.
Based on the results in the prior step, develop a standard model for each type of facility.
Apply the costs derived from the model(s) to the population on a percentage basis. For example, the model may indicate that 10% of the project costs are allocable to 5-year property. This same percentage is then applied to each facility within the same stratum.

(3) A frequent issue is the accuracy of the sampling results. In some cases, the sampling method may not be statistically valid. In addition, a population less than 50 could limit the accuracy of a sampling technique, unless an appropriate sampling error is considered. Also, despite the fact that facilities within certain strata may appear to be very similar, variations in building codes, geographic location, and material and labor costs may make it difficult to determine an appropriate model. Statistical sampling is discussed in more detail in Chapter 5 - Review and Examination of a Cost Segregation Study.

”Rule of Thumb” Approach

(1) Some cost segregation studies are merely based on a “rule of thumb” approach. In general, this approach uses little or no documentation and is based on a preparer’s “experience” in a particular industry or with a particular type of property (e.g., residential rental property). For example, a preparer will estimate the amount of § 1245 property as a fixed percentage of project cost by relying on previously determined “industry averages” (e.g., 40% for a manufacturing facility). An examiner should view this approach with caution since it lacks sufficient documentation to support its allocation of project costs.

What Approach is Required by the IRS?

(1) The Internal Revenue Service (Service) has not established any requirements or standards for the preparation of cost segregation studies. The courts have addressed component depreciation but have not specifically addressed the methodologies of cost segregation studies.

(2) The Service has addressed this issue but only briefly, i.e., Revenue Ruling 73-410, 1973-2 C.B. 53, Technical Advice Memorandum (TAM) 7941002 (June 25, 1979), Chief Counsel Advice 199921045 (April 1, 1999). These documents all emphasize that the determination of § 1245 property is factually intensive and must be supported by corroborating evidence. In addition, an underlying assumption is that the study is performed by “qualified individuals” and “professional firms” that are competent in design, construction, auditing, and estimating procedures relating to building construction. See TAM 7941002.

(3) Despite the lack of specific requirements for preparing cost segregation studies, taxpayers still must substantiate their depreciation deductions and classifications of property. Substantiation using actual costs is more accurate than using estimates. However, in situations where estimation is the only option, the methodology and the source of any cost data should be clearly documented. If estimated properly, the total RCNLD of the improvements and personal property should reasonably approximate the difference between the total purchase price and the FMV of the land. It is not an appropriate cost estimation methodology to apply a pro-rata step-up factor to the individual costs estimated for the various improvements and personal property merely to reconcile to the total purchase price of the improvements and personal property, as established by reducing the property’s purchase price by the FMV of the land.

(4) For example, assume the total purchase price of an acquired warehouse property is $5 million and the FMV of the land is $1.88 million, which leaves $3.12 million as the purchase price of the improvements and personal property. A cost segregation study estimated the total RCNLD of the improvements at $2.6 million including $1.2 million for the building. The § 1245 property was estimated at $800,000 and the land improvements at $600,000 totaling $1,400,000. The study then multiplied the estimated costs of each of these items by a factor of 1.2 to step up the total estimated RCNLD of the items to the total purchase price of the improvements and personal property. The results of this step-up ($520,000) increased the RCNLD of the § 1245 property to $960,000 and the RCNLD of the land improvements to $720,000 totaling $1,680,000. The step-up also increased the RCNLD of the building by $240,000 to $1,440,000.

(5) This step-up should be scrutinized by the examiner because the sum of the RCNLD estimates ($2,600,000) does not tie to the total purchase price of the improvements and personal property ($3,120,000). This is indicative of inaccuracies in the cost segregation study. Taxpayers must substantiate their segregation of buildings, land improvements, and § 1245 property from the total purchase cost of the acquired property less the FMV of the land. Applying a pro-rata step-up factor to the improvements and personal property is not an acceptable method of establishing the depreciable basis of the acquired items. An analysis of the available data and methodology should be conducted to assess and determine the source of the difference (i.e., is the difference attributable to items of depreciable property or to land).

(6) Typical reasons for the estimated RCNLD of the items of depreciable property to be in error include:

Incorrect FMV of the land;
Failure to properly identify all the parcels of land, assets, building components, quantities, etc.;
Utilizing incorrect cost estimates and factors;
Utilizing incorrect depreciation/obsolescence factors; and
Failure to properly account for indirect costs.

Summary and Conclusions

(1) Cost segregation studies are prepared for a variety of reasons (e.g., income tax, financial accounting, insurance purposes, property tax), and many different methodologies and procedures are used. While the Service does not prescribe a specific methodology, there are certain approaches (e.g., studies based on actual costs or on proper estimation techniques) that produce more accurate and reliable allocations. Despite the use of one of these more reliable methods, issues may still arise with respect to the proper classification of § 1245 property.

(2) Approaches that yield accurate cost allocations expedite the Service’s review, saving time and resources for taxpayers, practitioners, and Service examiners alike. A study that is both accurate and well documented is considered (in this ATG) a “quality” cost segregation study. The specific characteristics that comprise a quality study are described in Chapter 4 - Principal Elements of a Quality Cost Segregation Study and Report.