If you’re a CPA and your property-owning clients are asking you how they should prepare for a cost segregation study, this article will guide you and your clients through the process.
To review, cost segregation is an accounting technique based on the idea of depreciation. As a building ages, it loses value (depreciates) over time. But a building is more than a single piece of property—it’s made up of subcomponents like heating and air conditioning systems and lighting fixtures that deteriorate over time.
According to U.S. accounting rules, a building has either 27.5- or 39-year lifespan, depending whether it’s residential or commercial, respectively. But subcomponents are given a five- or 15-year lifespan, which increases the depreciation deduction, especially in the first several years. A cost segregation analysis could write off up to 30-35 percent of a building’s original purchase price (minus land) in the first year.
However, if your clients want to take advantage of the 100 percent bonus depreciation rule, which enables them to write off a property’s entire purchase cost (minus land) in the year of acquisition, they have to seize the opportunity this year, because the 100 percent option expires on midnight, December 31, 2022.
In 2023, properties acquired in 2023 can receive an 80 percent bonus depreciation. In 2024, for properties purchased that year, it drops to 60 percent. In 2025, it’s 40 percent for properties bought that year. It declines to 20 percent in 2026 for properties obtained that year. It’s zero percent in 2027 and later years for properties acquired in 2027 and afterwards.
The Timing of a Cost Seg Study
Please inform your clients in real estate that bonus depreciation is applied to a property based on the year it was purchased (although there are some exceptions to this rule). They can only claim bonus depreciation retroactively within two tax years of the original placed-in-service date.
You should also advise your clients that it’s wiser to commission a cost segregation study before proceeding with any improvements. Cost segregation sets a baseline for the original purchase. If you do the study before a rehab, it’s easier for your cost segregation provider and the IRS to set that baseline. It’s harder to document later, after the renovations.
Preparing for a Cost Segregation Analysis
The first step toward getting a cost seg study is simple—you or your client should pick up the phone (or send an email) and contact a reputable, experienced third-party provider with a thorough understanding of cost segregation analysis, preferably with staff that has engineering experience to analyze the value of a building’s subcomponents. Your client’s provider will then undertake a feasibility analysis, a free estimate that will evaluate your current tax status and future business plans to determine if a cost segregation study should be applied to your property.
Your clients will get a cost estimate for a study and advice whether a cost seg analysis is right for them. Next, if your clients decide to go ahead with the study, your provider will want to gather additional information. For new construction, they may want to know information about:
- Land and property size
- A complete list of projected costs, with land development costs
- Construction schedules and payment requests
- Lists of equipment purchased or used
- Previous site inspections
- Photographs of the work in progress or completed assets
- Any contracts or contract payments
For an existing building, your inspector will may require:
- Previous purchase price allocations that assigned each asset to its appropriate allocation with its value
- Previous site inspections and photographs
- Blueprints or property maps
- A property settlement statement
- Purchase/lease agreements or appraisals
- Documents that can help calculate real property book value
- Documents that record or prove how assets have deteriorated
- Lists of equipment on the property
- Schedules, change orders, or documents for future renovation plans
The Next Steps
After reviewing your documentation, your cost segregation analysts will either conduct an onsite visit or a virtual Tele-Engineering™ visit to identify how the components and systems are used and to document the systems and components. Then they’ll provide a detailed engineering review of the assets, submit a written report (with asset details supporting the reclassifications), and complete the required tax form or forms.
If you or your clients are interested in learning more, please consult the recently updated IRS Audit Technique Guidelines for Cost Segregation, which will show you exactly what the IRS is scrutinizing when reviewing cost segregation studies.
As you can see, it’s easy to get started with a cost segregation study and the financial benefits to your clients could be significant.