Cost Segregation Analysis
For commercial properties, a Cost Segregation Study (CSS) is normally conducted by an engineering consultant in cooperation with the client’s accountant or tax CPA. The purpose is to provide a defensible document to support accelerated depreciation of real estate. That is, to reclassify 39 year assets to more tax-favorable asset class lives such as 5 or 7 years.
When to Use
A CSS can be used as part of a pre-purchase due diligence study on existing commercial, apartment, or industrial property. It can also be used on new construction and property that had been purchased in the past.
By converting eligible “brick & mortar” assets (depreciated in a straight-line method over 39 years) into personal property assets (depreciated on a double-declining basis over 5 years), the buyer receives earlier tax depreciation expenses thus improving the deal’s cash flow. The advantage of this can be measured in the reduction of the overall purchase price to the buyer and tax savings for future, early-year capital needs. These savings can be further enhanced for newly purchased personal property by taking advantage of the 50% bonus depreciation rules passed under the Jobs Growth Reconciliation Act of 2003. CSS benefits are best measured in terms of Net Present Value (NPV) savings.
After an initial consultation a proposal is prepared for client’s consideration. The CSS can be conducted in parallel with a Building Evaluation, Environmental Site Assessment (Phase I), or done independently. An engineering team reviews available site plans, construction drawings, purchase documents, and other information to assign values and classifications of assets purchased. Through site visits and document reviews a determination of the value of the land and building is made. The engineering team then ‘dissects’ the property to identify all personal property in the purchase to reclassify the assets and develop engineering estimates of their value. This includes estimating building systems that are not visible such as buried utility systems and those hidden behind walls, floors, and ceilings. Purchase soft-costs, that are capitalized, are also considered in the reclassification analysis. All personal property assets are categorized as needed and tabulated into summary statements for the client’s CPA tax filing.
The CSS’ results are incorporated into the client’s federal and state tax filings by the client’s CPA in the tax year of the purchase for new purchases per Rev. Proc. 2002-19. For prior year purchases there is no need to amend prior year returns or K-1’s. The CPA files an ‘automatic’ Form 3115 to advise IRS of the method change.
Tax Law History
CSS began in earnest in 1996 following the IRS issuance of Rev. Proc. 96-31 which allowed taxpayers to correct mistakes in depreciation of their assets. After several major tax court cases being found in favor of taxpayers using CSS methods, IRS has accepted this procedure. What gives the true strength in the taxpayer’s position is the tax courts have ruled the case law created for Investment Tax Credit, before the ITC’s demise in 1986, is applicable to CSS methods. As a result, CPA’s have felt comfortable with the estimating and asset life reclassification that occurs in a CSS report.