Events Leading to the Use of the Cost Segregation Study
by Guy P. Reese, MAI and Kevin Cavasos, CMI
Component depreciation in various forms was permitted by IRS for measuring depreciation until the establishment of the Modified Accelerated Cost Recovery System (MACRS) by the Tax Reform Act of 1986. Under MACRS, assets are grouped into classes with a specific life and recovery period. IRS Revenue Procedures 87-56 and 88-22 identifies approximately 135 asset classifications together with their Class Life and Recovery Period. With the Tax Reform Act of 1986, IRS disallowed component depreciation.
A second element leading to the use of the Cost Segregation Study was the Investment Tax Credit (ITC) enacted in 1962 to encourage modernization and expansion of production and manufacturing operations. The ITC was applicable only to tangible personal property (primarily machinery and equipment) that was closely integrated with the taxpayer’s trade or business. Distinctions between what constituted real property and personal property could now be determined by applying ITC principles, which became refined by a number court rulings and Revenue Rulings issued by the IRS. As with component depreciation, the Tax Reform Act of 1986 essentially ended the Tax Investment Credit.
In 1996, the Hospital Corporation of America (HCA) vs. Commissioner of Internal Revenue Service, 109 TC 21 final ruling found for HCA in what was a landmark ruling for the use of the Cost Segregation Study. HCA had identified certain building components as items of personal property because they were used in connection with the hospital operation and therefore met the criteria for Tax Investment Credit, which had been essentially terminated but not repealed. The ruling sided with HCA that Investment Tax Credit principles could be used to classify real property and personal property. In 1999 in their Letter Ruling 199921045, the IRS acquiesced on the HCA decision.
The final ruling specifies a number of building components considered real property by the IRS, but found to be personal property and subject to accelerated depreciation. Specific examples of building components reclassified to personal property include:
- Electrical distribution panels, conduit, wiring, and connections serving hospital equipment;
- Plumbing and steam piping serving kitchen and laundry equipment;
- Kitchen hoods, exhaust systems, and air supply intake fans, and related duct work;
- Vinyl floor and wall covering, carpeting that require periodic replacement.
Other court cases litigating ITC issues of real property and personal property classifications which now serves as the basis for the Cost Segregation Study include the following from among many:
- Whiteco Industries, Inc. 65 TC 664
- Scott Paper Company, 74 TC 137
- A.C. Monk & Company, Inc. USTC 82 – 2
- Morrison Incorporated, USTC 90 – 1
Primary Steps in Preparing a Cost Segregation Study
The first step in the preparation of a Cost Segregation Study is the complete allocation of the value of the depreciable improvements. The value may be established by construction costs of new properties including all indirect and soft costs, depreciated value estimates of existing improvements, or by acquisition price. Generally, the allocations will fall into the following categories:
- Site improvements
- Interior finishes/millwork
- Specialty equipment
There are two (2) generally recognized methods commonly used for allocating the cost of components of a building between real property and personal property for depreciation purposes (other, more subjective methods are identified in the Internal Revenue Service Cost Segregation Audit Techniques Guide):
I. Engineering Approach From Actual Costs – This method is based upon analyzing actual paid contractor invoices, AIA documents, and other associated documents to ascertain the cost of specific components. This method is most applicable to new construction and provides supporting documentation with minimal estimating. Actual costs for older structures can also be trended forward using the Comparative Cost Multipliers in Section 98 of the Marshall Valuation Service manual.
II. Engineering Cost Estimate Approach– This method involves a detailed Quantity Survey Method take-off of certain real property components being reclassified to personal property. A professional engineer, qualified appraiser, or cost estimator usually prepares this kind of analysis. Specific components can be identified and their cost estimated based on an analysis of construction plans and/or by observation during an inspection of the premises.
The second step is to properly classify the components based upon their depreciable lives and recovery periods using Modified Accelerated Cost Recovery System (MACRS) depreciation rules. In summary, the Recovery Period for assets is as follows:
Real Property (IRS Section 1250 Property):
- Residential – 27.5 Years
- Non-residential- 39 Years
- (placed in service after 1993)
Land Improvements (IRS Section 1250 Property):
- Site Improvements-15 Years
Personal Property (IRS Section 1245 Property):
- Office Furniture,
- Fixtures and Equipment – 7 Years
- Assets used in wholesale and retail trade, and personal and professional services- 5 Years
The increasing use of a Cost Segregation Study by taxpayers presents an opportunity for the professional appraiser to partner with another profession to develop an ancillary business activity. Preparation of a Cost Segregated Study is closely related to the valuation process and draws upon the experience of the appraiser. The ability to identify, describe, and allocate the depreciated cost building components is basis of preparing a Cost Segregated Study. Although larger accounting firms generate Cost Segregated Studies in-house for their clients, most small firms and professional accounts must rely on outside contractors.