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:: Cost Segregation Audit Techniques Guide - Chapter 1 - Introduction
CHAPTER
1 - INTRODUCTION
PURPOSE
OF THE COST SEGREGATION AUDIT
TECHNIQUES GUIDE
This ATG has
been developed to assist
Internal Revenue Service
(Service) examiners in the
review and examination of cost
segregation studies. The primary
goals are to provide examiners
with an understanding of
-
why
cost segregation studies
are performed for
federal income tax
purposes;
-
how
cost segregation studies
are prepared; and,
-
what to
look for in the review
and examination of these
studies.
The ATG was
developed by a cross-functional
team of Service engineers and
agents and is not intended as an
official IRS pronouncement.
Accordingly, it may not be cited
as authority.
BACKGROUND
In order to calculate
depreciation for Federal income
tax purposes, taxpayers must use
the correct method and proper
recovery period for each asset
or property owned. Property,
whether acquired or constructed,
often consists of numerous asset
types with different recovery
periods. Thus, property must be
separated into individual
components or asset groups
having the same recovery periods
and placed-in-service dates in
order to properly compute
depreciation.
When the actual
cost of each individual
component is available, this is
a rather simple procedure.
However, when only lump-sum
costs are available, cost
estimating techniques may be
required to "segregate" or
"allocate" costs to individual
components of property (e.g.,
land, land improvements,
buildings, equipment, furniture
and fixtures, etc.). This type
of analysis is generally called
a "cost segregation study,"
"cost segregation analysis," or
"cost allocation study."
In recent
years, increasing numbers of
taxpayers have submitted either
original tax returns or claims
for refund with depreciation
deductions based on cost
segregation studies. The
underlying incentive for
preparing these studies for
federal income tax purposes is
the significant tax benefits
derived from utilizing shorter
recovery periods and accelerated
depreciation methods for
computing depreciation
deductions. The issues for
Service examiners are the
rationale used to segregate
property into its various
components, and the methods used
to allocate the total project
costs among these components.
The most common
situation is the allocation or
reallocation of building costs
to tangible personal property. A
building, termed "section (§)
1250 property", is generally
39-year property eligible for
straight-line depreciation.
Equipment, furniture and
fixtures, termed "section (§)
1245 property", are tangible
personal property. Tangible
personal property has a short
recovery period (e.g., 5 or 7
years) and is also eligible for
accelerated depreciation (e.g.,
double declining balance). Thus,
a faster depreciation write-off
(and tax benefit) can be
obtained by allocating property
costs to § 1245 property, or by
reallocating § 1250 property
costs to § 1245 property.
A simple
example illustrates the tax
benefits of a cost segregation
study. In general, a turnkey
construction project includes
elements of tangible personal
property (e.g., phone system,
computer system, process piping,
storage tanks). It is relatively
easy to identify these items as
§ 1245 property and allocate a
portion of the total project
costs to them. However, a cost
segregation study may also
report certain building
occupancy items, such as
carpeting, wall coverings,
partitions, millwork, lighting
fixtures, suspended ceilings,
doors, as § 1245 property. These
items may or may not constitute
qualifying § 1245 property
depending on particular facts
and circumstances, such as the
location of the assets and the
specific activities for which
the project was designed.
In addition to
identifying specific project
components that qualify as §
1245 property, cost segregation
studies may treat portions of
building components as § 1245
property. For example, a study
may conclude that 15 percent of
a building’s electrical system
directly supports § 1245
property, such as specialized
kitchen equipment. Based on that
conclusion, the study will then
treat 15 percent of the
electrical system as § 1245
property. The allocation of
building components to § 1245
property is often a contentious
issue.
Property
allocations and reallocations
are typically based on criteria
established under the Investment
Tax Credit (ITC). A plethora of
legislative acts, court
decisions and Service rulings
have produced complex and often
conflicting guidance with
respect to property qualifying
for ITC, resulting in no
bright-line tests for
distinguishing § 1245 property
from § 1250 property. Related
issues, such as the
capitalization of interest and
production costs under IRC §
263A and changes in accounting
method, add to the complexity of
this issue.
In a recent
landmark decision, the Tax Court
ruled that, to the extent
tangible personal property is
included in an acquisition or in
overall costs, it should be
treated as such for depreciation
purposes. The court also decided
that the rules for determining
whether property qualifies as
tangible personal property for
purposes of ITC (under pre-1981
tax law) are also applicable to
determining depreciation under
current law. [See Hospital
Corporation of America, 109 T.C.
21 (1997)] The Service
acquiesced to the use of ITC
rules for distinguishing § 1245
property from § 1250 property.
Based on these
developments, the use of cost
segregation studies will likely
continue to increase.
Unfortunately, there are no
standards regarding the
preparation of these studies.
Accordingly, studies vary widely
in terms of the methodology,
documentation, depth, format,
and expertise of the study’s
preparer. This lack of
consistency, coupled with the
complexity of the law in this
area, often results in an
examination that is
controversial and burdensome for
all parties.
Examiners
reviewing cost segregation
studies must determine the
proper classification and
correct costs of property. In
some cases (e.g., small
projects) examiners may be able
to evaluate a study without
assistance. However, other
studies may require specialists
with expertise, industry
experience and specialized
training (e.g., Engineers,
Computer Audit Specialists
and/or Technical Advisors).
Examiners should perform a risk
analysis as early as possible to
determine the depth of an exam
and the need for assistance.![href]()
SUMMARY
AND CONCLUSIONS
Depreciation
issues involving cost
segregation studies cross all
LMSB industry lines and impact
SB/SE taxpayers as well. The
lack of consistency in cost
segregation studies and the
absence of bright-line tests for
distinguishing property
contribute to the difficulties
of this issue. The purpose of
this ATG is to provide the
foundation to a better
understanding of cost
segregation studies and to
provide the examination steps
that will facilitate the audit
process and minimize burden on
taxpayers, practitioners and
Service examiners alike.
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