Cost Segregation can be tricky. And what’s even trickier is the fact that there no single formula that is used to conduct a study. As a result, cost segregation studies can take various shapes, forms and sizes.Now, if you think it is a free for all, not so fast!
While there is no one clear way of conducting a cost segregation study, the IRS Cost Segregation Audit Technique Guide (ATG) was created in 2004 to help steer IRS Auditors, taxpayers and CPAs in the direction of what would constitute a “quality” cost segregation study.
To make it a little easier on you, chapter 3 of the ATG, outlines the six most commonly used approaches utilized for cost segregation studies. The approaches are listed in order of most methodical (accurate), to least. Oh, and just a heads up, here at Titan, we only use approaches one and two for our full cost segregation studies, as they are what the IRS considers as the methods that produce “quality” cost segregation reports.
The purpose of this post is to take a deeper dive into the six most commonly used approaches. If you haven’t done so already, check out the blog post Types of Cost Segregation Studies. It provides a “CliffNotes” version of this post.1. Detailed Engineering Approach from Actual Cost Records
The IRS considers this approach as the most methodical for the fact that it computes cost information from solid documentation, such as construction and accounting records. Typically this approach is possible with new construction, as these records are readily available.
According to chapter 3 of the A.T.G., construction documents typically used for determining unit costs include, “drawings, specifications, contracts, job reports, change orders, payment request, and vendor and supplier invoices.”
Although this approach allows for more accuracy, it is important to be able to classify the assets under the correct classification of property (section 1245).
As outlined in chapter 3 of the A.T.G, the detailed engineering approach from actual cost records typically includes the following activities:
- Identify the specific project and assets that will be analyzed in the cost segregation.
- Obtain information on all direct and indirect project costs. Substantiate the total project cost and reconcile the cost segregation to the total project cost.
- 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.
- 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.
- Review record drawings, specifications, contracts, bid documents, contractor pay requests, change order detail, and any other construction cost information or documentation that is available.
- 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).
- Prepare quantity take-offs for all assets and use contractor cost information to compute unit costs.
- 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.
- 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.
- 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.
2. Detailed Engineering Cost Estimate Approach
Similar to the above approach, the Detailed Engineering Cost Estimate Approach, is done when cost records are not available. This typically occurs when the the property was an acquisition from a previous owner.
This approach is a little trickier to execute without the documents. This is when a professional with construction experience comes in handy. This estimate approach relies on construction documents such as blueprints, contracts, invoices and alike. Then, costing data resources are utilized as a guide for estimating.
The same steps are utilized from Detailed Engineering Approach from Actual Cost Records, with the exception of step 7, since contractor cost information is not available.
It is important to note, that although contractor cost information is not available, if this approach is done correctly, cost allocations can be accurately calculated.
3. Survey or Letter Approach
This approach involves contacting the contractor who worked on the project, in order to get cost information for each asset that’s being segregated. The information is then plugged into one of the other approaches outlined in this list.
One of the drawbacks with this approach is that oftentimes, a contractor will provide data from similar projects, resulting in inaccurate information. If using this approach is it important to make sure that the contractor provides actual cost data. If not, there can be accuracy issues.
According to chapter 3 of the A.T.G., cost allocation using the survey approach involves the following steps:
- Complete Steps 1 – 6 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 if possible [either to an overall project 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.
4. Residual Estimation Approach
Considered to be the more simpler, but less accurate approach, this method adds up all short-lived assets costs (5 or 7 year property), then subtracts these numbers from the total project cost. The remaining cost is placed within the building or other long-term assets.
With this approach, the likelihood of miscalculation is very high, as project costs are not typically reconciled. For example, this method tends to place short lived assets in section 1245 property, when in reality, it is section 1250.
5. Sampling or Modeling Approach
In my opinion, this approach would be comparable to “conducting cost segregation studies in bulk.” Let’s say you own five gas stations. I would assume that all five properties have the same purpose, look identical and structurally similar. In this case, a single template can be utilized for all five properties. This approach is considered to be cost-effective and time-saving rather than doing separate studies for each property.
According to chapter 3 of the A.T.G., steps for this approach, typically include:
- 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 Step 2, 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.
It is important to note that are issues with this approach. If you do not follow the IRS’s valid statistic sampling methodology, sampling results can be inaccurate. If utilizing this method, the IRS may recommend that a Computer Audit Specialist reviews and evaluates the sampling, based on the complexity of the study.
6. "Rule of Thumb" Approach
This approach is utilized by someone who may have little to no experience in cost segregation. My recommendation is to avoid this method at all costs. Why? Because this approach has no hard data or documentation to support project costs. It is a big red flag to the IRS.
When researching cost segregation, it is beneficial to have an understanding of the various approaches and methods, especially how the IRS views them. Although there are no rules and regulations on how to conduct a cost segregation study, the best advice I can give is, the more hard cost documents and data you can provide, the more defensible you will be if you are audited.
Final words? It would be worth your while to utilize the Detailed Engineering Approach From Actual Cost Records or Detailed Engineering Cost Estimate Approach (the first and second approaches detailed in this post). Not only are these the approaches we use at Titan Echo, but you’ll sleep better at night knowing that you have a quality cost segregation study under your belt.
Ready to get started? It all begins with the Echo Learning Academy, a self-paced training knowledge base that teaches you how to do cost segregation, one step at a time - no experience required. Just for our readers, we’re giving away a sneak peek of what’s inside the Echo Learning Academy. Learn more by downloading: