What is Cost Segregation?

Cost Segregation is the practice of identifying assets and their costs,
and classifying those assets for federal tax purposes. It is an IRS
defined and sanctioned approach that requires skills and expertise in
Construction Engineering and Taxes.

The process allows Commercial Property owners to REDUCE
FEDERAL TAXES by accelerating the depreciation on their
properties. In a cost segregation study, certain costs previously
classified as subject to 39-year depreciable life, can instead be
classified as personal property or land improvements, with a 5, 7, or
15-year rate of depreciation using accelerated methods. An
"engineering-based" study allows a building owner to depreciate a
new or existing structure in the shortest amount of time permissible
under current tax laws.

The benefits of a cost segregation study include:
• An immediate increase in cash flow
• A reduction in current tax liability
• The deferral of taxes
• The ability to reclaim "missed" depreciation deductions from prior
years (without having to amend tax returns)

COST SEGREGATION DEFINED

“Engineering-based” cost segregation enables commercial real estate
owners to reallocate real property (under Code Sec. 1250) to
personal property (under Code Sec. 1245). This results in a
substantially shorter depreciable tax life and accelerated
depreciation methods.

WHY A SPECIALIST IS NEEDED

For both new and existing properties, the IRS requires that
engineering-based cost segregation studies be performed in order to
realize the maximum depreciation benefits. Engineering-based cost
segregation studies provide more precisely segregated property
information, giving CPAs the information and detailed supporting
documentation they need to meet with strict IRS regulations and
requirements for audit defense.

In the IRS Cost Segregation Audit Techniques Guide (ATG), Chapter
4, the prime attribute of a high-quality cost segregation study is
“preparation by an individual with expertise and experience.” The
Audit Techniques Guide adds: “Preparation of cost segregation
studies requires knowledge of both the construction process and the
tax law involving property classifications for depreciation purposes.
In general, a study by a construction engineer is more reliable than
one conducted by someone with no engineering or construction
background. Experience in cost estimating and allocation, as well as
knowledge of the applicable tax law, are other important criteria.”

WHAT TYPES OF ITEMS ARE IDENTIFIED?

Through an engineering-based cost segregation study, a wide range
of building components, such as electrical installations, plumbing,
mechanical components, and finishes can be identified and
reclassified into shorter-lived asset classes. This adds up to
substantial savings to the client.

WHAT ROLE DOES “TIME VALUE OF MONEY” (TVM) PLAY?

Cost segregation is based on the fundamental principle that “a dollar
today is worth more than a dollar tomorrow”. The same logic applies
to the statement: “a tax deduction today is worth more than a tax
deduction tomorrow”. By accelerating a buildings’ depreciation,
property owners can lower their tax liability and thus realize a
significant increase in cash flow. This larger cash flow—resulting
from postponing tax payments—is available for other investments.

"The major advantage of cost segregation is not necessarily that it will produce
more depreciation deductions. Instead, due to the time value of money, the
advantage of these front-loaded deductions will be quantifiably greater than had
the deductions been spread over longer periods of time using slower depreciation
methods."

Journal of Accountancy
© 2005 by the AICPA

THE IRS’s AUDIT TECHNIQUES GUIDE (ATG)

In late 2004, the IRS released the guidelines their agents must follow
for audits of cost segregation studies. This guide reviews the
methodologies recognized by the IRS for asset allocation. It examines
the various characteristics of a quality study. Referring to the
"detailed engineering approach," the guidelines state: "In general, it
is the most methodical and accurate approach, relying on solid
documentation and minimal estimation."

THE BOTTOM LINE

Cost segregation studies are one of the most valuable tax strategies
available to owners of commercial real estate today. This
increasingly popular phenomenon, offers facility owners the
opportunity to defer taxes, reduce their overall current tax burden,
and free up capital by improving their current cash flow. Virtually
every taxpayer who owns, constructs, renovates, or acquires a
commercial real estate structure stands to benefit from a cost
segregation study. By engaging the expertise of Walker Bryce &
Associates, property owners can be assured that their study will
stand up to the strictest scrutiny of IRS auditors. Walker Bryce has
been performing cost segregation studies since 1996 and has vast
experience defending cost segregation studies during IRS inquiries
and audits.


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