Cost segregation studies (CSS) are conducted by cost segregation services for a host of reasons for example for financial accounting, income tax, property tax, and insurance purposes.
Specific for income tax purposes, a cost segregation study entails the allotment (or re-allotment) of the total value (or cost) of the property into the correct property class or classes to compute depreciation exclusions.
Cost segregation studies are typically summarized by cost segregation services in a complimentary report. There is no standard format for both the study and the report.
The methodology employed by cost segregation services in assigning total project costs to various assets is key to obtain an accurate cost segregation study.
Principal Elements of CSS Done by Cost Segregation Services
As there is no standard format for studies and reports on cost segregation. An individual or business entity employing the expertise of cost segregation services must note principal elements that should always be present in a CSS to identify a quality study.
Regardless of the length or methodology used in the study, a CSS and report should have:
- Classified assets into property classes like land, building, furniture, fixtures, equipment, and land improvements;
- Explained the rationale including legal bases for classification of assets as either Section 1245 or Section 1250 property; and,
- Substantiated the basis of cost for each asset and reconciled the total allotted costs to total actual costs.
Key Elements of a Quality Cost Segregation Services Study
A cost segregation services firm provides a “quality” cost segregation study when they provide both an acute and well-documented study about the 3 principles above. Quality studies will expedite the IRS’s review, thus the audit burden is kept to a minimum on all parties. A “quality” study by cost segregation services possesses several characteristics and is detailed below.
Prepared By an Expert and Experienced Service Firm
Preparing a cost segregation study requires know-how of both the construction aspect and the tax law which involves property classifications for purposes of depreciation. A cost segregation services’ credentials and expertise level will have a pull on the study’s overall accuracy and quality.
Generally, a study done by a construction engineer is more dependable than the one conducted by an individual with no construction or engineering background. The possession of specific is not the only requirement, however. Vast experience of cost segregation services preparers in cost estimate and allocations, as well as applicable tax law knowledge are also crucial.
Detailed Description of Methodology Employed
Quality cost segregation services must discuss the approaches and methodologies used in the preparation of cost segregation studies. In actuality, a study may be based upon a variable or combination of methods and also not identify by name the used methods, rather, it described the methodology and details the steps taken to classify assets and identify costs.
Appropriate Documentation Use
Quality studies of cost segregations services use the best available form of documentation in classifying assets and determining costs. Documentations utilized to support a study may vary depending on the age of the property or if original construction documents are accessible. Contemporaneous or coexistent type of documentation is most preferred and trustworthy.
Conducts Interviews with Appropriate Contingents
In determining the specific use of a property and the construction processes entailed, interviewing contractors and subcontractors along with taxpayers and managers of properties are valuable inputs. The cost segregation services firm documents all the interviews done with appropriate parties, thereby adding depth and accuracy in its credible study.
Uses Common Nomenclature
A quality study by cost segregation services does away with using creative or misleading nomenclatures to describe property elements. Rather, It makes use of common and plainly understood terms. Using common nomenclature rather than a creative description does not disguise the true characters of an asset. Quality studies also use terminologies that are consistent throughout project documents.
Uses Standard Numbering Systems
Using a standard numbering system is convenient for IRS auditors. An example of this standard numbering system is the Construction Specification Institute (CSI) Master Format Division. The number of assets in a quality study must be consistent with bidding documents and pay requests. Utilizing a standard numbering system facilitates the property classification for depreciation computation.
Other typical asset groupings may include land, furniture and fixture, plumbing and electrical systems, equipment, land improvements, etc. The CSI comes in a format that categorizes unit costs by specific construction systems or components like concrete, metals, woods, carpentry, electrical, and lighting.
Legal Analysis Explanation
A thorough legal analysis including valid stipulations to support its Section 1245 classification of property is a key element of a quality study by cost segregation services firms. Legal discussions in quality cost segregation study recognize conflicts in inconsistencies in judicial decisions and try to reconcile these to specific circumstances and facts of the property in question.
Unit Costs And Engineering “Take-Offs” Determination
Having done the identification and assignment of property classifications, determining respective costs is next by cost segregation services. To determine the cost for each class or unit in a project, the total project cost must inherently be broken down. This process of breaking down project costs is known as engineering “take-offs” – which must be documented carefully to show derived costs per unit. Cost of property items can generally be taken from actual costs records when available. Otherwise, costs are estimated.
Assets are Organized into Lists or Groups
To facilitate the review of the IRS, quality studies done by cost segregation services firms organize listed assets and ties them to a taxpayer client’s fixed asset ledger.
Total Allocated Cost Reconciles to Total Actual Costs
Estimating techniques are used throughout all the items to reconciling purchase prices, project costs, or specific property costs for consistency. When different methods are used in the cost segregation services, cost distortion may happen.
Treatment of Indirect Costs Explained
Cost segregation services must list all the costs associated with a particular project whether direct or indirect and explain treatments of indirect costs. Direct costs are said to be the labor and costs of material for specific assets. Indirect costs are intangible costs that arise in the construction of a facility. Indirect costs must be proportionately allocated to a specific asset where they relate. Cost segregations services study must accurately reflect and explain treatments of indirect costs to avoid this frequent area of controversy.
Section 1245 Property Identification and Listing
Quality studies by cost segregation services must list Section 1245 properties including their corresponding amounts and show properties classified originally as Section 1250 that was reclassified to Section 1245 properties.
Addressing Related Issues (such as Section 263A)
Cost segregations services study considers related issues like the Section 263A “Change in Accounting Method, and Sampling Techniques”. Uniform capitalization or UNICAP rules of 263A require the capitalization of direct costs and specific indirect costs that can be allocated to the taxpayer’s real property and tangible properties.
A high-quality cost segregation study and report must reflect accurate methodologies and conclusions. The amount of detail reported by a cost segregation services firm may vary considerably on its experience and expertise as there are no prescribed or standard formats.