You may already know how imperative it is to ensure you execute a quality cost segregation study for say a $2 million property. But it is important to keep in mind that quality does not need to suffer, the lesser the value of the property is. After all, audits can happen to anyone. If there is one takeaway from this post you should definitely remember it is - quality.
Where am I going with this?
As a real estate investor, there’s a good chance you own at least one piece of property that financially it wouldn’t make sense to do a full-blown cost segregation on. This usually entails properties under $500,000 in basis. Instead, you find an economical approach, like a software solution. Great news! Upfront cash flow here you come! Not so fast though!
Remember when I said, audits can happen to anyone? Yes, even your $400,000 vacation bungalow that you rent out in Florida can be audited. You can be subject to significant penalties, if the cost segregation study is not done right.
Let’s break it down.
Remember that blog post I wrote? The Types of Cost Segregation Studies. It highlights the most methodological approaches for cost segregation studies according to the IRS Cost Segregation Audit Technique Guide (ATG). I highly recommend reading that post as gives you a greater insight on the most common approaches in cost segregation studies and how they are viewed by the IRS.
If you are looking for a cost segregation solution for a property under $500,000 in basis, it is important to do your due diligence. Ensure that the software you choose, utilizes an approach that is reliable, accurate and data driven. Because here’s the thing, these “economical” solutions on the market, are not substitutes for full cost segregation studies, nor do they meet all of the requirements in the ATG.
It is important to note that these software solutions utilize the residual estimation approach. Chapter 3 of the ATG states that this approach is, “less accurate.” This approach cuts corners. Simple as that.
The residual estimation approach works by adding together short-lived asset costs and then subtracting those costs from the total depreciated basis cost (after land is carved out). Then that remaining cost is applied to the building.
Let’s put this into perspective.
If the software you’re using only asks you to input specific items, but doesn’t account for ALL items, then this is mostly likely because the basis is being applied to those specific items and whatever is left over is assumed to be the structure.
The problem with that is, if the value of all the items added up is more than what you paid for the property, then the value applied to those specific items is overstated. This is fundamentally why residual estimating is not defensible.
Here’s another example. Let’s say the software only asks about the type of flooring in each room (ie. vinyl, carpet, laminate, etc), but doesn't ask for square footage. How can you accurately defend the basis of the flooring type without the actual size of the room?
Lastly, if the final report gives you a basis for cabinets, but never asked for the quantity of cabinets - how will you defend yourself in front of an IRS Auditor?
The takeaway here is to remember that, any attempt to break down property into components without underlying engineering details is indefensible. After all, you wouldn’t want a “less accurate” cost segregation study for a $2 million property. Why should you do the same in this case?
If you’re audited and you can’t defend your study, the IRS has the authority to disallow it. You’ll dig yourself a hole as you will have to pay significant penalties and interest on top of that.
As we like to sum it up, it is expensive to do it cost segregation wrong.
So, how do you do it right?
According to the ATG, the engineering approach is considered to be the most reliable, as it focuses on cost data from construction-based documents such as blueprints, contract estimates, or estimate guides, whichever the taxpayer has on hand.
At the end of the day, the ATG says, “substantiating the cost basis of each asset and reconciling total allocated costs to total actual costs, is what makes a defensible cost segregation study.”
Our Echo Lite Segregator is a do-it-yourself cost segregation software solution, specifically for buildings with a basis of less than $500,000. It is an empirical modeling tool, founded on a database of full-blown quality cost segregation studies.
The engineering approach will always be more defensible than residual estimating.
How does Echo Lite Segregator ensure an accurate report?
Echo Lite Segregator determines an accelerated depreciation model that utilizes a database of engineered-based cost segregation studies.
If you have an asset where the land’s value is already carved out, the building basis is less than $500,000, and you haven’t capitalized any improvements yet, Echo Lite can predict the benefit of a full-blown cost segregation study based on your property’s “Meta Data.”
Meta Data is information about your property such as, footprint gross square foot, total gross square foot and area of lot, just to name a few.
Based off of the Meta Data inputted, Echo Lite extrapolates our extensive database of cost segregation studies to predict the amount of personal property that you would be able to re class, if you did a full-blown engineer based cost segregation study.
If you have a building under $500,000 in basis (after land has been carved out). Be sure to check out the Echo Lite Segregator. We can model a quality cost segregation benefit for $400 per project.
What do you have to lose, besides an interest-free loan from the government?
Need an extra resource? Download the below eBook: IRS Cost Segregation Audit Techniques Guide - Simplified.