Most property owners understand the basics of cost segregation. A study moves qualifying assets into shorter recovery periods so you can deduct their costs faster. The goal is simple: claim a larger tax deduction sooner rather than later.
But what actually happens during a cost segregation study? How can you tell whether a firm has completed the work correctly?
The IRS provides guidance on what a quality cost segregation study should include. A study that falls short of those standards can create tax and audit risks. The financial impact depends on factors such as the property’s depreciable basis, asset classifications, and depreciation history.
How Much Does a Cost Segregation Study Cost?
Cost segregation study prices vary based on the property, the scope of work, and the level of analysis required. Factors may include the size and complexity of the property, its age, available records, and whether the project involves new construction or an existing building.
For new construction, a study may cost less than $10,000. Existing properties may require more extensive work, particularly when detailed construction records aren’t available. In some cases, fees may equal roughly 1% to 2% of the property’s acquisition cost.
Cost segregation firms also use different pricing structures. Some charge a flat fee, while others bill by the hour.
Price alone, however, doesn’t tell you whether you’re getting a quality study.
Why Cheap Cost Segregation Studies Can Cost More
In the past, property owners could purchase inexpensive or “do-it-yourself” cost segregation studies online. These options may look attractive, but they can introduce significant limitations.
Low-cost studies often rely on generic assumptions instead of examining the specific characteristics of the property. They may also lack input from professionals who understand construction, engineering, accounting, and tax classification.
A credible study should document how the firm identified, classified, and valued each asset. It should also provide support for the conclusions in the final report.
If you’re going to invest in cost segregation, the quality of the analysis matters as much as the initial price.
What Can It Cost to Skip a Cost Segregation Study?
The cost of the study is only one side of the equation. Property owners should also consider the potential cost of not completing one.
Without cost segregation, taxpayers generally depreciate residential rental property over 27.5 years and nonresidential real property over 39 years under the applicable MACRS rules.
A properly prepared cost segregation study may identify components that qualify for shorter recovery periods. Depending on the asset and applicable tax rules, those components may also qualify for accelerated depreciation.
That can shift deductions into earlier tax years and potentially improve cash flow.
For properties already in service, taxpayers may also have options for addressing depreciation that could have been claimed in prior years. Depending on the circumstances, a taxpayer may make an accounting method change rather than amend several prior-year returns.
Because these rules can become complex, property owners should work with their CPA or tax adviser when evaluating prior depreciation.
What Are the Different Types of Cost Segregation Studies?
Property owners may conduct cost segregation analysis at different stages of a property’s life cycle.
Pre-Construction Cost Segregation Studies
A pre-construction study evaluates building plans and projected costs before or during construction.
This approach allows the project team to identify potentially qualifying assets early. It can also help improve documentation by separating costs while contractors complete the work.
When owners, contractors, engineers, and tax professionals coordinate during construction, they may have better access to detailed cost information.
Post-Construction Cost Segregation Studies
A post-construction study takes place after the building is complete or after the taxpayer acquires an existing property.
The cost segregation team examines the building and available documentation to identify assets that may qualify for shorter recovery periods.
Engineers may interview property managers, contractors, architects, and other professionals. These conversations can reveal information that isn’t obvious during the physical inspection.
For existing properties, the team may also need to estimate certain costs when original construction records aren’t available.
How a Detailed Cost Segregation Study Works
A thorough study involves much more than assigning percentages to different building components. The firm needs to identify assets, classify them correctly, determine their costs, and reconcile those costs to the property’s total basis.
The following phases illustrate several important parts of that process.
Phase 3: Asset Identification & Classification
The engineering firm uses the available documentation, site inspection, and other research to sort building components into appropriate MACRS categories.
Examples may include:
- 5-year property: carpeting, decorative lighting, appliances, specialty electrical receptacles, and certain movable partitions.
- 7-year property: certain furniture, fixtures, signs, and other qualifying assets.
- 15-year property: certain nonstructural land improvements, such as parking lots, sidewalks, landscaping, fences, and exterior lighting.
- 27.5- or 39-year property: structural building components such as foundations, roofs, exterior walls, and basic building systems.
The classification analysis often considers whether an asset falls under Section 1245 or Section 1250 property.
A credible cost segregation study should cite relevant tax authority to support its classification decisions. The report shouldn’t simply state that an asset qualifies for a shorter life without explaining why.
Phase 4: Cost Allocation
Identifying an asset’s recovery period is only part of the process. The firm also needs to determine how much that asset cost the taxpayer.
That can become difficult when the taxpayer purchased the building or completed construction through a lump-sum contract.
Whenever possible, the firm should trace costs to actual invoices, purchase orders, contractor records, and other project documentation.
When those records aren’t available, the firm may use recognized construction cost data, such as RSMeans. Engineers may also develop cost estimates based on the materials and construction methods they observe during the inspection.
Other approaches, including residual estimation and sampling methods, may also be appropriate when the firm documents them properly.
The IRS Cost Segregation Audit Technique Guide (ATG) discourages unsupported percentage-based allocations. If a firm uses percentages, it should tie them to actual construction records or reliable cost databases.
Your CPA should be able to understand how the firm calculated the amount assigned to each asset group.
Phase 5: Cost Reconciliation
After the firm reclassifies the assets, it should reconcile the results to the property’s total depreciable basis.
In general, the identified assets plus the remaining building components should account for the appropriate total building cost.
This reconciliation helps the team identify missing assets, duplicate costs, and classification errors.
The analysis should also separate land from depreciable property because taxpayers generally can’t depreciate land. The team may determine land value through an appraisal, assessor allocation, comparable sales analysis, or another supportable method.
Phase 6: Final Report & Deliverables
A quality cost segregation report should provide much more than a spreadsheet.
A detailed final report may include:
- An executive summary
- A description of the methodology
- Detailed asset schedules
- Supporting tax authority
- Cost reconciliation
- Property and component photographs
- Relevant calculations and assumptions
- Form 3115 information or instructions when applicable to a look-back study
Your CPA uses this information to update depreciation schedules. The documentation may also become important if the IRS examines the study.
A report that provides classifications without explaining the methodology or supporting the conclusions should raise questions.
Selecting a Cost Segregation Firm: What Property Owners Should Ask
The IRS doesn’t establish a single professional license specifically for cost segregation consultants. As a result, experience and study quality can vary significantly among firms.
Start by asking about the firm’s engineering and construction experience. The team should understand both the physical building components and the tax rules that affect their classifications.
A site visit can also strengthen the analysis, particularly for properties where plans and construction records don’t tell the entire story.
Ask the firm to explain its methodology. Its final report should document the analysis, provide relevant tax citations, and reconcile allocated costs to the appropriate property basis.
Professional credentials can provide another useful data point. Although the IRS doesn’t require ASCSP or equivalent accreditation, relevant credentials may indicate a commitment to industry standards and continuing education.
You should also understand the firm’s fee structure.
A flat fee can help separate the firm’s compensation from the amount of accelerated depreciation it identifies. By contrast, compensation tied directly to estimated tax savings may create incentives to classify more property into shorter recovery periods.
Finally, make sure the firm can work effectively with your CPA. Its professionals should clearly explain their conclusions, answer technical questions, and support their classifications if questions arise later.
The Bottom Line
A cost segregation study combines engineering, construction cost analysis, and tax classification. When a qualified team performs the study correctly, it can accelerate depreciation deductions and potentially improve cash flow.
Quality matters.
A strong study should include appropriate property analysis, reliable cost data, reconciliation, supporting documentation, and relevant tax authority. A weak study can create unnecessary risk and may ultimately cost more than it saves.
Property owners shouldn’t evaluate a cost segregation firm based only on projected tax savings or the study’s price. They should also examine the firm’s methodology, documentation, experience, and ability to support its conclusions.
If you own commercial or multifamily property, talk with your CPA about whether cost segregation makes sense for your situation. You can also request a preliminary benefit analysis before committing to a full study.
FAQ
How long does it take to complete a cost segregation study from start to finish?
Most cost segregation studies take approximately four to eight weeks. Timing depends on the property’s size and complexity, the availability of documentation, and the firm’s current workload.
Properties with detailed construction records may require less time. Existing properties with limited documentation may take longer because the firm may need to estimate individual component costs.
Do I need to attend the site visit?
No. You generally don’t need to attend the site visit, but the engineer will need access to the property.
A property manager, superintendent, or leasing agent can often provide access and answer questions.
Depending on the property’s size and complexity, engineers may spend several hours photographing building components and documenting construction details.
What happens if the IRS audits the property and challenges the study?
Documentation becomes especially important during an IRS examination.
A study that follows the quality elements described in the IRS Cost Segregation Audit Technique Guide is generally better positioned for review. Important elements include a documented methodology, property inspection, cost reconciliation, supporting tax authority, and qualified preparers.
Your cost segregation firm should also be prepared to explain and support its analysis if the IRS questions specific classifications.
Can I perform a cost segregation study on a property I already own?
Yes. Property owners can conduct a look-back cost segregation study on qualifying property that they placed in service during a previous tax year.
A look-back study may identify depreciation deductions that the taxpayer could have taken in earlier years. Depending on the circumstances, the taxpayer may claim the resulting adjustment through an accounting method change using Form 3115 instead of amending each prior-year return.
Bonus depreciation rules and other tax provisions depend on when the property and individual assets were placed in service. Discuss the property’s purchase and placed-in-service dates with your CPA before proceeding.
What is the lowest property value that justifies a cost segregation study?
Properties with a depreciable basis of approximately $500,000 or more may generate enough potential benefit to justify a professional study.
However, there isn’t a universal minimum property value.
The economics depend on the property type, depreciable basis, expected asset classifications, applicable tax rates, ownership structure, placed-in-service date, and the taxpayer’s overall tax situation.
A preliminary benefit analysis can help estimate the potential accelerated depreciation before you pay for a full study.
Find Out What Your Property May Qualify For
Want to know what your property may be eligible for?
Request a complimentary benefit analysis from SegPro Solutions. We’ll evaluate your property, estimate the potential accelerated depreciation, and provide the numbers you can review with your CPA before deciding whether to move forward with a full cost segregation study.
