Did you know there are various ways to conduct a cost segregation study? The types of cost segregation studies range from detailed engineering methodologies to approaches that utilize pure estimating and no documentation. As you can tell, the level of effort varies drastically.Chapter 3 of the IRS Cost Segregation Audit Technique Guide, details the six most commonly used approaches in cost segregation studies, in order of most “defensible” to least. Whenever I talk to clients and prospects, I always make it a point to let them know that the further you go down the list, the higher your chances are of dis-allowance, if you’re audited. In other words, it is safer to stay at the top.
Is the risk worth it to you? Keep reading to find out.
One thing to keep in mind is that, a cost segregation study is performed differently for newly constructed property versus acquired property.
Newly constructed property includes, new buildings and existing buildings that were remodeled or expanded. Acquired property includes, existing properties purchased by the taxpayer.
With newly constructed property, cost segregation study is done typically during or after construction. With that said, construction drawings, invoices and payments from contractors, suppliers and vendors are easily accessible.
With an acquired property, this information may not be as easily accessible. According to chapter 3 of the IRS Cost Segregation Audit Technique Guide, “when construction cost information for a property is not available, it must be reconstructed using the construction cost data, methods, and techniques normally employed for property appraisal. The reconstructed cost is then adjusted for the current physical condition of the property at the time of acquisition and finally adjusted to match the actual amount paid by the taxpayer for the property.”
Most common approaches in cost segregation studies:
- Detailed Engineering Approach from Actual Cost Records - considered to be the most accurate approach, as it relies on hard documentation for cost allocating.
- Titan Echo’s opinion: this approach is golden in the eyes of an IRS auditor. You have the ammunition (cost records) for the most accurate cost allocation, therefore significantly reducing the need to estimate. We use this approach for all newly constructed property, when this data is available.
- Detailed Engineering Cost Estimate Approach - similar to the approach #1 (above), the only difference is that it estimates costs, versus actual costs. This is common with acquired properties that do not have proper documentation on hand.
- Titan Echo’s opinion: don’t let this approach fool you - if cost estimates are done correctly, this approach is very accurate. We use this approach for all cost segregation studies done on properties that do not have cost records, typically, acquired properties. Our years of construction experience has allowed us to successfully executed this approach methodically and efficiently.
- Survey or Letter Approach - this approach requires getting actual cost data from surveyors and contractors and plugging in the data into one of the other six approaches. There can be inconsistencies with this approach as the data and methods can vary from contractor to contractor.
- Titan Echo’s opinion: this approach is necessary if you don't have any construction cost estimating experience. Fortunately we do.
- Residual Estimation Approach - this approach determines only short-termed assets (5 or 7 year). The remaining cost is assigned to the building or long-term assets. Typically this method does not reconcile total allocated costs to total actual cost.
- Titan Echo’s opinion: this approach cuts a lot of corners. Utilizing the residual estimating method opens the doors to inaccuracies because your unit cost data for the items you’re reclassifying is not defensible. If you’re audited, you will struggle.
- Sampling or Modeling Approach - this approach utilizes templates that are assigned to structures of the same type and use. For example, the template for a warehouse is used for all warehouses. A template for a hospital is used for all hospitals across the board. This approach is time-saving, however, there can be issues with statistical sampling.
- Titan Echo’s opinion: if you follow the IRS’s valid statistical sampling methodology, this is a reasonable approach, if you have enough supporting data. Although it is not a full-blown study, we use this for our Echo Lite Segregator (formally E5S) modeling projects, a cost-effective approach for properties less than $500,000 in basis.
- "Rule of Thumb" Approach - this approach uses little or no documentation.
- Titan Echo’s opinion: this approach should be avoided at all costs. In fact, in the chapter 3 of the A.T.G., it states, “an examiner should view this approach with caution, since it lacks sufficient documentation to support its allocation of project costs.” That statement, perfectly sums it up. Avoid this approach. If you’re audited and you used this approach, penalties and interest are highly likely.
For a deeper dive into the six most common cost segregation study approaches, check out our blog post: an Inside Look at Cost Segregation Approaches.
Lastly, it is important to keep in mind that although the above approaches are outlined in order of what the IRS considers as most “methodical” and “accurate,” the IRS has not established actual requirements. These approaches are merely a guideline for understanding what is considered to be most “defensible” during an audit.
At Titan Echo, the goal of our software is to make your cost segregation study as “defensible” and cost-effective as possible. At the end of the day, ensuring that the taxpayer is in the best position possible.
Ready to see how cost segregation can benefit you? Run a free (no obligation) benefit estimate: