| |
:: Cost Segregation Audit Techniques Guide - Chapter 3 - Cost
Segregation Methodologies
CHAPTER
3 - COST SEGREGATION
METHODOLOGIES
Chapter
3 Table of
Contents:
Cost
segregation studies are
conducted for a variety of
reasons (e.g., income tax,
financial accounting, insurance
purposes, property tax). For
income tax purposes, a cost
segregation study involves the
allocation (or reallocation) of
the total cost (or value) of
property into the appropriate
property classes in order to
compute depreciation deductions.
The results of a study are
typically summarized in an
accompanying report, although
there is no standard format for
either the study or the report.
The methodology
utilized in allocating total
project costs to various assets
is critical to achieving an
accurate cost segregation
study. Some of the more common
methodologies, and their
potential drawbacks, are
summarized in this chapter.
This discussion should assist
the examiner in evaluating the
accuracy of a particular study
and in performing a risk
analysis with respect to the
depreciation deductions based on
that study.
Various
methodologies are utilized in
preparing cost segregation
studies, including:
1. Detailed
Engineering Approach from
Actual Cost Records
2. Detailed Engineering Cost
Estimate Approach
3. Survey or Letter Approach
4. Residual Estimation
Approach
5. Sampling or Modeling
Approach
6. "Rule of Thumb" Approach
Examiners
should not necessarily expect to
see these terms mentioned in a
study or in a report.
Methodologies will also be
described in varying detail in
different reports. However,
based on the information in this
chapter, an examiner should be
able to recognize the attributes
of a given study and identify
the methods or approaches used
(and also identify the potential
drawbacks). It should also be
noted that other methodologies
may be used, although most are
merely derivatives of those
enumerated above.
The following
discussion takes a closer look
at the main components and
attributes of each of the
methodologies listed above.
Keep in mind that these are the
steps normally taken in the
preparation of a cost
segregation study. The
examiner's responsibility is to
review the steps taken and
evaluate the accuracy of the
study, as will be discussed in
Chapter 5, "Review and
Examination of Cost Segregation
Studies."
The detailed
engineering approach from actual
cost records, or “detailed cost
approach,” uses costs from
contemporaneous construction and
accounting records. In general,
it is the most methodical and
accurate approach, relying on
solid documentation and minimal
estimation. Construction-based
documentation, such as
blueprints, specifications,
contracts, job reports, change
orders, payment requests, and
invoices, are used to determine
unit costs. The use of actual
cost records contributes to the
overall accuracy of cost
allocations, although issues may
still arise as to the
classification of specific
assets.
This approach
is generally applied only to new
construction, where detailed
cost records are available. For
used or acquired property and
for new projects where original
construction documents are not
available, an alternative
approach (e.g., the "detailed
engineering cost estimate
approach”) may be more
appropriate.
The detailed
cost approach typically includes
the following activities:
1) Identify
the specific project/assets
that will be analyzed.
2) Obtain a
complete listing of all
project costs and
substantiate the total
project costs.
3) Inspect
the facility to determine
the nature of the project
and its intended use.
4) Photograph specific
property items for
reference. Request previous
site photographs that
illustrate the construction
progress as well as the
condition of the property
before the project began.
5) Review
"as-built" blueprints,
specifications, contracts,
bid documents, contractor
pay requests, and other
construction documentation.
6) Identify
and assign specific project
items to property classes
(e.g., land, land
improvements, building,
equipment, furniture and
fixtures, and other items of
tangible personal property).
7) Prepare
quantitative "take-offs" for
all materials and use
payment records to compute
unit costs.
8) Apply
unit costs to each project
component to determine its
total cost. Reconcile total
costs obtained from
quantitative take-offs to
total actual costs.
9) Allocate
indirect costs, such as
architectural fees,
engineering fees, and
permits, to appropriate
assets.
10) Group
project items with similar
class lives and
placed-in-service dates to
compute depreciation.
The detailed
cost approach is the most time
consuming method and generally
provides the most accurate cost
allocations. However, the
examiner should recognize that
the proper classification and
costs of § 1245 property could
still be an issue with this
method.
The detailed
engineering cost estimate
approach (or detailed estimate
approach) is similar to the
detailed cost approach. The
difference is that the detailed
estimate approach estimates
costs, rather than using actual
costs. This approach is used
when cost records are not
available or for an acquisition
when the purchase price must be
allocated.
The detailed estimate approach
is methodical, relying on solid
documentation and utilizing
construction-based documents
such as blueprints,
specifications, contracts, job
reports, change orders, payment
requests, invoices, appraisals,
etc. When estimates are
required, they are based on
costing data, either from
contractors or from reliable
published sources (e.g., R. S.
Means or Marshall Valuation
Service). The sources of
estimating data are clearly
referenced, including
identification of the specific
volume, page, and item number.
Further, the same estimating
techniques and unit cost data
sources are used for all of the
items that comprise the actual
cost.
In essence, the
steps for this approach are the
same as the detailed cost
approach, except for Step 7 (in
which costs come from contractor
estimates or estimating
guides). However, if detailed
cost estimates are prepared by
qualified individuals, and the
estimates are reconciled to
actual costs, then
reasonably-accurate cost
allocations are possible.
The survey or
letter approach is an
alternative method for
estimating costs. In this
approach, contractors and
subcontractors are contacted via
a survey or letter to provide
information on the cost of
specific assets that they
installed on a particular
project. These costs are then
used in one of the engineering
approaches or in the residual
estimation approach (discussed
in the following section). Cost
allocation using the survey
approach involves the following
steps:
1) Complete
Steps 1 – 6 of the detailed
cost approach 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)].
2) Divide
property items by contractor
and/or subcontractor.
3) Ask
contractors and/or
subcontractors to provide
the quantities and prices of
specific property items.
4) Use unit
cost estimates obtained from
the surveys to determine and
allocate property costs.
In situations
where the contractor provides
actual cost data, the
allocations may be reasonably
reliable. However, when
contractor data is obtained from
other sites or projects, the
data may not be comparable or
reliable. The amount of detail
provided by different
contractors may also vary. The
wide disparity in cost
estimation methods dictates the
use of caution to ensure that
the total allocated costs do not
exceed the actual total project
cost.
The residual
estimation approach is an
abbreviated method in which only
short-lived asset costs (e.g.,
5- or 7-year property) are
determined. Short-lived asset
costs are added together and
then subtracted from the total
project cost. The remaining or
“residual” cost is then simply
assigned to the building and/or
other long-lived assets.
Although this method is simpler
and less time consuming than the
engineering approaches, it can
also be less accurate.
It should be
recognized that this method
generally does not reconcile
project costs. In general,
residual costs are not estimated
or checked for reasonableness.
A proper and “reasonable”
residual cost should always be
determined and then added back
to the total of all short-lived
asset costs to check if the
total project cost is
reconciled.
It should also
be understood that different
estimation techniques for
short-lived assets can produce a
skewed result in favor of § 1245
property (e.g., § 1245 property
based on single-unit costs for
high quality construction, while
the building is based on gross
square footage).
The sampling or
modeling approach uses a created
model (or template) to analyze
multiple facilities that are
nearly identical in
construction, appearance and use
(e.g., fast food chains and
retail outlets). The use of
sampling minimizes resources and
costs compared to conducting
studies on all properties.
Typical steps
are:
1) Stratify
properties by type of
facility (e.g.,
free-standing facility, mall
location, leased or owned
property, etc.).
2) Perform
a cost segregation study on
a sampling of properties
within each stratum.
3) Based on
the results in Step 2,
develop a standard model for
each type of facility.
4) 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.
A frequent
issue is the accuracy of the
sampling results. In some
cases, the sampling method may
not be statistically valid. In
addition, a population less than
50 could limit the accuracy of a
sampling technique, unless an
appropriate sampling error is
considered. Also, despite the
fact that facilities within
certain strata may appear to be
very similar, variations in
building codes, geographic
location, and material and labor
costs may make it difficult to
determine an appropriate model.
Statistical sampling is
discussed in more detail in
Chapter 5, "Review and
Examination of a Cost
Segregation Study," and in
Appendix Chapter 6.5.
Some cost
segregation studies are merely
based on a "rule of thumb”
approach. In general, this
approach uses little or no
documentation and is based on a
preparer's "experience" in a
particular industry. For
example, a preparer will
estimate § 1245 property as a
fixed percentage of project cost
by relying on previously
determined “industry averages”
(e.g., 40% for a manufacturing
facility). An examiner should
view this approach with caution,
since it lacks sufficient
documentation to support its
allocation of project costs.
Neither the
Service nor any group or
association of practitioners has
established any requirements or
standards for the preparation of
cost segregation studies. The
courts have addressed component
depreciation, but have not
specifically addressed the
methodologies of cost
segregation studies.
The Service has
addressed this issue but only
briefly, i.e., Revenue Ruling
73-410, 1973-2 C.B. 53, Private
Letter Ruling (PLR) 7941002
(June 25, 1979), Chief Counsel
Advice Memorandum 199921045
(April 1, 1999). These
documents all emphasize that the
determination of § 1245 property
is factually intensive and must
be supported by corroborating
evidence. In addition, an
underlying assumption is that
the study is performed by
"qualified" individuals or
firms, such as those employing
"…personnel competent in design,
construction, auditing, and
estimating procedures relating
to building construction" (PLR
7941002).
Despite the
lack of specific requirements
for preparing cost segregation
studies, taxpayers still must
substantiate their depreciation
deductions and classifications
of property. Substantiation
using actual costs is generally
preferable to the use of
estimates. However, in
situations where estimation is
the only option, the methodology
and the source of any cost data
should be clearly documented.
In addition, estimated costs
should be reconciled back to
actual costs or purchase price.
Cost
segregation studies are prepared
for a variety of reasons (e.g.,
income tax, financial
accounting, insurance purposes,
property tax), and many
different methodologies and
procedures are used. While
neither the Service nor any
group or association of
practitioners prescribes a
specific methodology, there are
certain approaches (e.g.,
studies based on actual costs or
on proper estimation techniques)
that produce more accurate and
reliable allocations. Despite
the use of one of these more
reliable methods, issues may
still arise with respect to the
proper classification of § 1245
property.
Methodologies
that yield accurate cost
allocations expedite the
Service's review, saving time
and resources for taxpayers,
practitioners, and Service
examiners alike. A study that
is both accurate and well
documented is considered (in
this ATG) a “quality” cost
segregation study. The specific
characteristics that comprise a
quality study are described in
Chapter 4, "Principal Elements
of a Quality Cost Segregation
Study and Report".
|
|
