Imagine that a property owner purchases a $5 million commercial property. Her CPA advises her to get a cost segregation study. She finds a company that charges 50% less than its competitors.
Six months later, the IRS audits the study. The company used the residual method. Instead of engineering the property, it relied on estimates. The IRS rejects the accelerated deductions. As a result, the owner must pay additional taxes, interest, and penalties.
The lesson is clear. A cost segregation study only creates lasting value if it can withstand an IRS audit. Therefore, the firm must have the engineering qualifications and methodology needed to produce a defensible study.
What Happens When a Study Does Not Hold Up to an Audit?
A cost segregation study uses engineering and tax analysis to identify building components that may qualify for shorter depreciation schedules. Typically, a study may reclassify 20% to 35% of a building’s depreciable basis. Those assets may qualify for 5-, 7-, or 15-year recovery periods.
Qualified components may also be eligible for 100% bonus depreciation if the property meets current tax requirements. However, results depend on the property type, acquisition date, and assets included in the study. Therefore, you should always review the potential benefits with your CPA.
But what happens if the IRS challenges the study?
The IRS published the Cost Segregation Audit Techniques Guide, or ATG. This guide identifies 13 elements commonly found in a quality study.
Suppose your provider took shortcuts. For example, it may have used estimated costs instead of actual records. It may have skipped the site visit or completed the study without qualified engineers. In that case, the IRS could reject some or all of the accelerated depreciation.
Consequently, you may have to repay taxes, interest, and penalties. A poor study is not simply a waste of its original fee. It can also create an unexpected tax bill and undermine your financial plan.
How to Find a Good Cost Segregation Provider
1. Choose a Study That Uses a Detailed Engineering Method
The IRS recognizes several cost segregation methods. However, its Audit Techniques Guide describes the detailed engineering approach using actual cost records as the most accurate and complete method.
Under this approach, engineers evaluate construction documents, cost data, and the property itself. They identify individual components and determine the associated costs. Then, they assign each component to the appropriate asset class.
Other providers may use residual or estimated methods. These approaches allocate costs based on historical averages from similar properties. Although they may be faster and less expensive, they often provide less support during an audit.
Therefore, ask whether the provider will use actual cost information. A strong study should include invoices, construction records, takeoffs, or other reliable cost data. It should not rely solely on general estimates.
2. Look for Engineers With the Proper Degrees
A defensible study requires professionals who understand building systems and tax depreciation rules. The engineering team may include civil, structural, mechanical, or electrical engineers.
These professionals must identify building components and understand how each one functions. In addition, they must assign the correct asset class under the Modified Accelerated Cost Recovery System, or MACRS.
Ask whether a degreed engineer will perform or supervise your study. Also, request information about that person’s education and experience. If the provider cannot give you a direct answer, consider another firm.
3. Ask About Site Visits and Documentation
A legitimate provider should do more than review a spreadsheet. Its team should examine the property and compare the available records with the physical assets.
In many cases, a site visit allows the provider to photograph important components. It also helps the team confirm how assets are installed and used. However, the provider should determine whether a physical inspection is necessary based on the project and available documentation.
Your final report should create a clear paper trail. That documentation may include photographs, construction documents, invoices, cost data, and engineering analysis.
Without a site visit or sufficient records, the provider may depend too heavily on assumptions. As a result, the study may become more difficult to defend.
4. Review Professional Certifications
The American Society of Cost Segregation Professionals offers the Certified Cost Segregation Professional, or CCSP, credential. Earning this designation requires relevant experience and successful completion of an examination.
Not every reputable firm has a CCSP on staff. Still, professional credentials may show that a provider takes industry standards seriously.
Certifications should not replace engineering qualifications or experience. Instead, consider them one part of your overall evaluation.
5. Confirm That the Firm Works With CPAs
A cost segregation study should supplement your CPA’s work, not replace it. Your provider should give your CPA the information needed to incorporate the results into your tax return.
The final product should include an explanatory report and supporting documentation. It should also provide an itemized list of reclassified assets.
Clear reporting makes the study easier for your CPA to review. Furthermore, it can help substantiate the deductions if the IRS challenges them.
IRS Publication 946, How to Depreciate Property, explains the basic federal depreciation rules. Your provider and CPA should coordinate to apply those rules to your specific situation.
Seven Questions to Ask Before Signing With a Cost Segregation Firm
Before signing an engagement letter, ask the following questions.
1. What Method Will You Use to Prepare the Study?
Look for a detailed engineering methodology based on reliable cost information. The provider should clearly explain how it will value and classify each component.
2. Will a Degreed Engineer Be Assigned to My Study?
Ask about the engineer’s education, experience, and responsibilities. Make sure a qualified professional will perform or supervise the engineering analysis.
3. Will You Conduct a Physical Site Visit?
A site visit is not necessary in every situation. However, it is often a sign that the firm intends to verify the property’s components carefully.
4. How Many Studies Has Your Staff Completed?
Look for a team with extensive experience across different property types. Relevant experience can be especially valuable for complex or specialized properties.
5. What Documentation Will I Receive?
You should receive engineering analysis, cost support, and a comprehensive asset listing. Depending on the study, the report may also include photographs and construction records.
6. What Happens if the IRS Audits My Study?
Find out whether the firm provides audit assistance. In addition, ask what that support includes and whether the firm charges an additional fee.
7. Does the Firm Hold Professional Designations?
Credentials such as the CCSP do not guarantee quality. However, they may indicate that the firm values professional standards and continuing education.
Example: The Cost of Choosing the Wrong Firm
Suppose you own an office building valued at $4 million. After excluding the land value, $3.2 million remains subject to depreciation.
A qualified firm completes a cost segregation study. It identifies 25%, or $800,000, as short-lived property. If that amount qualifies for 100% bonus depreciation, you may deduct it during the first year.
At a 35% marginal tax rate, the deduction could produce approximately $280,000 in first-year tax savings. However, the actual benefit will depend on your tax situation. Always consult your CPA before relying on an estimate.
Now suppose a low-cost firm prepares the study using unsupported estimates. After reviewing the report, the IRS accepts only 60% of the reclassified amount.
In this example, the disallowed deductions could create approximately $112,000 in additional tax liability. Penalties and interest could increase the total amount owed. Again, actual results will depend on the taxpayer’s circumstances.
You may have saved $3,000 to $5,000 on the study. However, you could now face a much larger tax bill.
Ultimately, the cheapest study could become the most expensive mistake in your tax plan.
What Does This Mean for You?
Cost segregation can be a valuable cash flow tool for owners of commercial and multifamily real estate. However, the tool is only as effective as the professionals who use it.
Choose a firm that follows a detailed engineering approach. The firm should employ qualified professionals and coordinate with your CPA. It should also document its conclusions and support its recommendations.
Getting the tax deduction is not the only goal. Keeping it matters just as much.
Frequently Asked Questions
How Much Does a Cost Segregation Study Usually Cost?
Costs depend on the property’s type, size, and complexity. Many commercial studies cost between $5,000 and $15,000. However, larger or more complex properties may cost more.
Price matters, but defensibility matters more. Before choosing a provider, determine whether its study can withstand an IRS review.
Can I Apply a Cost Segregation Study to a Property I Have Owned for Several Years?
A look-back study may allow you to recover missed depreciation through a Section 481(a) adjustment. In many cases, owners can claim the adjustment without filing amended returns.
However, eligibility and filing requirements vary. Consult your CPA to determine whether a look-back study fits your situation.
What if My CPA Says They Can Prepare the Study?
Some CPA firms prepare excellent cost segregation studies. Ask whether degreed engineers participate in the process. You should also confirm that the firm follows a rigorous engineering methodology.
Alternatively, a specialized cost segregation firm can prepare the study. Your CPA can then review the report and integrate the results into your tax returns.
Is a Cost Segregation Study Appropriate for Smaller Properties?
Properties with a depreciable basis of $500,000 or more may be good candidates. However, the answer depends on the property type, its components, and the owner’s tax situation.
A reputable provider should estimate the potential benefits before recommending a full study. The projected savings should justify the cost.
What Happens if the IRS Audits My Study?
A carefully documented study should be prepared with IRS requirements in mind. The report should clearly explain its methodology, cost sources, and asset classifications.
Before hiring a firm, ask whether it includes audit support. Also, confirm the scope of that support and any additional costs.
Find Out Whether Cost Segregation Could Benefit Your Property
Want to know whether cost segregation could benefit your property? Request a Complimentary Benefit Analysis from SegPro Solutions.
We will review the details of your property and estimate the potential first-year tax savings. Then, we will help you determine whether a full study is worth pursuing before you move forward.
