Cost Segregation Study Review

A. Introduction

(1) The preceding chapters described the legal framework for classifying assets (Chapter 2), common methodologies used to segregate costs (Chapter 3), and elements of a quality cost segregation study and report (Chapter 4). This chapter provides suggested audit steps for reviewing and examining a cost segregation study.

(2) The appropriate audit steps depend on the nature and size of the cost segregation project as well as on the overall quality of the study. Cost segregation is a factually intensive determination that is based on complex tax law and engineering analysis. While examiners may be able to evaluate the adequacy of some cost segregation studies, other studies may require specialists with expertise, industry or construction experience and specialized training.

(3) The Engineering Program in LB&I business unit of the IRS is the principal source of technical expertise for examining cost segregation studies. The Computer Audit Specialist (CAS) Program in LB&I is also available to provide assistance when a study is based on statistical sampling. Formal advice, using the referral process, should be solicited through the LB&I website and the Specialist Referral System (SRS). Informal advice through consultation is also available by contacting your engineering or computer audit specialist group. The Senior Revenue Agents in the Deductible and Capital Expenditures Practice Network (DCE PN) are also available to assist examiners with this issue.

(4) Preliminary steps in a cost segregation examination should include a risk analysis to determine the depth of the examination and the need for additional assistance. The steps should be tailored to the specific facts and circumstances and the quality of the study. This chapter provides general guidance for reviewing cost segregation studies and should be read in conjunction with other technical materials, such as Training 4650-003 “Cost Segregation Audit Techniques” and other resources available in the LB&I website.

B. Audit Steps for Reviewing and Examining Cost Segregation Studies

(1) The following steps represent a general framework for the examination of cost segregation studies. Not all steps may be necessary or applicable to every examination. The order of these steps may also be changed based on the facts and circumstances of the examination and the quality of the cost segregation study.

Step 1: Obtain and Review General Information About the Property and the Cost Segregation Study

(1) The examiner should obtain and review the cost segregation study, all supporting documentation, and any correspondence related to the cost segregation study. During this step, the examiner should identify:

The subject property and its physical characteristics;
The taxpayer’s basis in the property;
The date the property was placed in service;
The type of property (new construction, acquisition, etc.);
The total project or acquisition cost;
The preparer of the study and their qualifications;
The methodology used in the study;
The amounts allocated to the various property classes;
Any indication that the study may have been prepared on a contingency fee basis.

(2) The examiner should also determine if the taxpayer has previously had a cost segregation study performed on the same or similar property, or whether the same preparer was used for other cost segregation studies involving the taxpayer. This information may assist in identifying patterns or issues.

Step 2: Verify the Total Project Cost or Acquisition Price

(1) The examiner should verify that the total project cost or acquisition price used in the cost segregation study is accurate and supported by documentation. For new construction, this may involve reviewing:

Construction contracts;
Invoices and payment requests;
Closing statements;
Title insurance documents;
Other supporting documentation.

(2) For acquisitions, the examiner should verify the purchase price and allocate land value separately from the improvements and personal property.

Step 3: Review the Methodology Used in the Cost Segregation Study

(1) The examiner should evaluate the methodology used in the cost segregation study to determine whether it is appropriate for the facts and circumstances. Chapter 3 of this ATG describes the various methodologies that may be used. The examiner should consider:

Whether the methodology is adequately described in the cost segregation study or supporting documentation;
Whether actual costs or estimates were used;
Whether the methodology is consistent with industry standards;
Whether the methodology is supported by adequate documentation.

(2) Based on this review, the examiner should identify any methodologies that appear to be unreliable or unsupported.

Step 4: Review the Cost Segregation Study Report for Examination Purposes

(1) As discussed in Chapter 4, a quality cost segregation study should contain certain elements. The examiner should review the report to determine whether these elements are present and whether the report supports the conclusions reached in the study.

(2) The examiner should specifically consider whether:

The preparer’s credentials and experience are documented;
The methodology is clearly described;
Documentation supporting the classifications and cost allocations is referenced;
The legal analysis supporting the classifications is thorough and well-reasoned;
The treatment of indirect costs is explained;
Costs are properly reconciled to the total project cost or acquisition price;
The study identifies and explains any areas of concern or uncertainty;
Any contingency fee arrangement is disclosed.

(3) Contingency fee arrangements may create an incentive for the preparer to maximize the amount of § 1245 property. When a contingency fee arrangement is identified, the examiner should be alert to potential issues in the study.

Step 5: Identify the Specific Assets Claimed as § 1245 Property

(1) The examiner should identify all assets that the study claims are § 1245 property and all assets that were reclassified from § 1250 property to § 1245 property. This information should be documented and made available for use in subsequent examination steps.

(2) The examiner should consider preparing a summary or spreadsheet of the § 1245 property claims to facilitate the examination.

Step 6: Conduct a Site Inspection

(1) A site inspection of the property is an important part of the cost segregation examination. During the inspection, the examiner should:

Observe the physical characteristics of the property;
Verify that the property is as described in the cost segregation study;
Identify the specific assets that are claimed to be § 1245 property;
Determine whether the property appears to have been properly constructed and maintained;
Take photographs for the examination file;
Interview the taxpayer’s representative or building manager to obtain information about the property and its use.

(2) The examiner should compare the site observations to the statements made in the cost segregation study to determine whether the study is consistent with the physical characteristics of the property.

Step 7: Review and Verify the Asset Classes and Recovery Periods of Property

(1) The examiner should determine whether the asset classes and recovery periods assigned to the various property items are consistent with IRC § 168 and the applicable regulations. This requires a review of:

The appropriate asset classification under the MACRS rules;
The applicable recovery periods for each asset class;
Any applicable conventions.

(2) The examiner should consider consulting with specialists in the Engineering Program or the DCE PN if the asset classifications are complex or unusual.

Step 8: Review the Classification of Assets as § 1245 or § 1250 Property

(1) As discussed in Chapter 2 of this ATG, the classification of assets as § 1245 or § 1250 property is factually intensive and requires consideration of all relevant facts and circumstances. The examiner should review the cost segregation study’s analysis of this issue and determine whether:

The preparer has correctly identified all assets that may qualify as § 1245 property;
The analysis considers all applicable statutes, regulations, rulings, and case law;
The analysis is supported by adequate documentation;
The conclusions reached are reasonable given the facts and circumstances.

(2) The examiner should pay particular attention to:

The treatment of building components and structural systems;
The treatment of assets that may have characteristics of both § 1245 and § 1250 property;
The use of any special allocation methodologies (e.g., the functional allocation approach for electrical distribution systems);
Any reclassification of assets from § 1250 property to § 1245 property.

(3) The examiner should be prepared to challenge any asset classifications that appear to be unsupported or inconsistent with applicable law. No bright-line test exists for distinguishing § 1245 property from § 1250 property, so each case must be evaluated based on the specific facts and circumstances involved.

Step 9: Review the Determination of Unit Costs and Engineering Take-Offs

(1) The examiner should review the process used by the preparer to determine the costs of specific assets. This requires:

Reviewing the supporting documentation (blueprints, specifications, contracts, invoices, etc.);
Verifying that unit costs are properly derived from actual costs or industry estimates;
Determining whether the engineering take-offs are properly documented;
Verifying that the costs derived from the take-offs reconcile to the total project cost or acquisition price.

(2) The examiner should consider whether:

The costs appear reasonable given the nature and quality of the construction;
The estimation techniques used are consistent across different property items;
Any unusual cost allocations are adequately explained and supported.

Step 10: Evaluate the Treatment of Indirect Costs

(1) The examiner should review the preparer’s treatment of indirect costs, including:

The identification and quantification of all indirect costs;
The allocation methodology used;
The reasonableness of the allocations made.

(2) Common areas of concern include:

The allocation of contractor overhead and profit;
The allocation of architectural, engineering, and design fees;
The allocation of interest and finance charges;
The allocation of property taxes and insurance during construction.

(3) The examiner should verify that indirect costs have not been improperly allocated to § 1245 property or that different allocation methodologies have not been used for different property items, which could create cost distortions.

Step 11: Reconciliation of Total Allocated Costs

(1) The examiner should verify that the total costs allocated to all property classes (land, land improvements, building, and personal property) reconcile to the total project cost or acquisition price.

(2) If the allocated costs do not reconcile, the examiner should:

Require the preparer to explain the discrepancy;
Determine whether a pro-rata step-up factor was improperly used to force a reconciliation (which is not acceptable);
Recalculate the allocations based on the available information;
Make adjustments as necessary.

Step 12: Evaluate Statistical Sampling

(1) If the cost segregation study uses statistical sampling, the examiner should:

Evaluate the validity of the sampling methodology;
Determine whether the sampling method is appropriately documented;
Verify that the results are properly projected to the overall population;
Consider whether the results are reasonable and consistent with expectations.

(2) The examiner may need to consult with the Computer Audit Specialist (CAS) Program for assistance in this area.

Step 13: Consider Change in Accounting Method

(1) If the taxpayer is using the cost segregation study to reclassify property or reallocate costs (other than in the year the property is placed in service), a change in accounting method may be required. The use of a cost segregation study to reclassify property and reallocate costs generally constitutes a change in accounting method, which requires the consent of the Commissioner.

(2) The examiner should:

Determine whether a change in accounting method has occurred;
If so, consider whether the taxpayer has properly applied for and obtained consent to the change;
If consent has not been obtained, consider making an adjustment to disallow the change or require the filing of Form 3115, Application for Change in Accounting Method.

C. Summary and Conclusions

(1) This chapter provided a framework for the examination of cost segregation studies. The examination should be tailored to the specific facts and circumstances and the quality of the cost segregation study. The examiner should be aware that cost segregation is a complex area involving both tax law and engineering analysis, and specialist assistance should be sought when necessary.

(2) A thorough examination of the cost segregation study, including verification of the total project cost, evaluation of the methodology used, review of the asset classifications, verification of cost allocations, and consideration of any changes in accounting method, will assist the examiner in determining the proper treatment of the depreciation deductions claimed based on the cost segregation study.

(3) Quality cost segregation studies that are well-documented and supported by adequate evidence will facilitate the examination process and minimize the audit burden on all parties.