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Preparing a Quality Cost Segregation Study
Why should you even care about a cost segregation study, let alone a quality
one? Four words: Less tax; more control.
In last month’s real estate coaching class, we learned about depreciation
strategies. One of those strategies involved doing a cost segregation study so that
you can accelerate depreciation. This, in effect, front-end loads your depreciation.
You don’t get more, you just get it sooner. If you’ve had property for awhile, you
can still do the cost segregation study and even catch up the depreciation. Those
are just some of the options you have with depreciation. If you’re not sure if
your strategy calls for more depreciation, make sure you review depreciation
strategies with your CPA first.
One more warning: This content is going to get technical. Don’t worry about the
details the first time through. The point is that this has the language you need to
use when you prepare your own cost segregation study. There is no other place
that you can get all these things in one place: The list of things the IRS wants,
Two samples of how to write up the cost segregation study and how to handle
an IRS audit of the study, if you happen to get one.
What’s the Difference Between Quality and Not Approved?
The IRS has come out with a list of requirements for cost segregation studies. It’s
a pretty intensive list, but it’s not hard. In fact, I’ve provided a couple of samples
of quality (as defined by the IRS) cost segregation studies at the end of this study.
You can copy, change and paste for your own study.
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A cost segregation study is more than just a few pages like you might have seen
in the past. There are actually some very strict guidelines on what it takes to have
a quality, and thus approved, study.
You can have a do-it-yourself cost segregation study. In fact, that is probably the
only way to make it cost effective if you have single family homes or other small
real estate properties. Otherwise, the $5,000+ price tag to prepare a quality (and
qualifying) cost segregation study just doesn’t make financial sense.
13 Principal Elements That Make it Quality
The IRS says your cost segregation study must be “quality” and then goes on to
tell us what it takes to make the cut. This is straight out of the IRS Audit
Technique Guide for audits of such studies:
“The 13 principal elements of a quality study are:
1. Preparation By An Individual With Expertise And Experience
2. Detailed Description Of The Methodology
3. Use Of Appropriate Documentation
4. Interviews Conducted With Appropriate Parties
5. Use Of A Common Nomenclature
6. Use Of A Standard Numbering System
7. Explanation Of The Legal Analysis
8. Determination Of Unit Costs And Engineering "Take-Offs"
9. Organization Of Assets Into Lists Or Groups
10. Reconciliation Of Total Allocated Costs To Total Actual Costs
11. Explanation Of The Treatment Of Indirect Costs
12. Identification And Listing Of Section 1245 Property
13. Consideration Of Related Aspects (e.g., IRC § 263A, Change In Accounting
Method And Sampling Techniques)”
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Let’s look at each of these points individually. If you plan to hire a firm to
prepare your cost segregation study, you won’t have to study the samples at the
end of this homework section. But, I think it is good to make sure the report you
get will be in compliance with the IRS requirements.
Preparation By An Individual With Expertise And Experience
There are no credentials or prescribed qualifications in order to be a cost
segregation preparer. That’s why you can legally perform your own.
You do need to have knowledge of both the construction process and the tax law
involving property classifications for depreciation purposes. The IRS says that, in
general, a study by a construction engineer is more reliable than one conducted
by someone with no engineering or construction background. If you’ve been
involved in the fix-n-flip business, real estate investing, real estate development
or any other form of real estate, engineering or construction business, my guess
is you have the qualifications you need.
You do need to also have a knowledge of the applicable tax law. That’s why we
do the coaching classes. We can help and for a ridiculously low cost to you.
There is one more statement the IRS makes. Please pay attention to this:
IRS RULE: A quality study identifies the preparer and always references
his/her credentials, experience and expertise in the cost segregation area.
Detailed Description Of The Methodology
Your cost segregation study needs to describe the steps you took and the
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methodology for the study. You’ll see some language in the samples that you can
use.
IRS RULE: A quality study always describes the methodology that was used
and details the steps that were taken to classify assets and determine costs.
Use Of Appropriate Documentation
The IRS wants to know that you have used outside documentation to classify
assets and determine value. This documentation does vary depending on
whether it is a new or used construction..
New Construction
In the case of new construction there will be some expected sections:
(1) Allocation of Land and Land Development Costs
A quality study explains the treatment of land and land development
costs, (e.g., roads, sewer lines, storm drains, utility mains, survey and
subdivision costs). Generally, these costs are allocated to non-depreciable
land accounts. Also included in this account are the costs of
improvements or land that is later given to a local municipality.
(2) Site Visit
Include before-and-after photographs to establish land and site
preparation costs.
(3) Blueprints, Construction Drawings And Contract Payments
A quality study discusses the review of all pertinent construction
documentation. The paperwork should agree with the cost segregation
study regarding intended functional use of the building and other assets
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in the project. The specific assets deemed to be personal property (or
Section 1245) are clearly highlighted or otherwise identified on the
drawings.
The cost segregation study should also reference that a review was done
of the blueprints, the general contractor’s application for payment, other
invoices paid and other items that show what was paid for and how much
was paid. Include an estimated or actual cost breakdown in the
documentation with the study.
Acquired or Used Properties
A cost segregation study that is performed on a newly constructed property has
actual numbers and often concise breakdowns. On the other hand, a cost
segregation study for a recently purchased property or property you’ve owned
for awhile is going to depend on estimates, an estimate of deterioration
(1)
Purchase Price Allocations
A quality study documents how purchase price was allocated between
land, land improvements, building and other assets. Land value is always
determined first and is based on "highest and best use." In simple terms,
highest and best use means the probable use of land that results in its
highest value. The balance of the purchase price is then allocated to the
building and to other assets.
(2)
Addresses Physical Deterioration and Functional Obsolescence
The study must determine the remaining functionality and deterioration
of the assets. For example, if your HVAC system will need to replaced any
day now, it has little to no value. On the other hand, if it’s fairly new, been
maintained well and has many years of use, it may be near to new value.
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As possible, provide corroborating documentation that was used to
determine values or costs.
(3)
Site Visit
You should include evidence of a site visit, by including pictures of the
property.
(4)
Review of Purchase or Lease Agreements and Appraisals
If the original construction documents and costs are not available, include,
at a minimum the purchase agreement, any appraisals and lease
agreements (where applicable.)
Interviews Conducted With Appropriate Parties
It is assumed that the cost study preparer will interview property managers,
contractors and subcontractors regarding costs, replacement costs, life
expectancy of certain items and other cost related items. Include notes of those
conversations and interviews in the cost study.
Use Of A Common Nomenclature
Use standard construction and real estate terms. Don’t get creative.
Use Of A Standard Numbering System
You don’t need to use the Construction Specification Institute (CSI) Master
Format numbering system, but the IRS does reference it. You can find out more
information about it here:
http://www.constructionnotebook.com/ipin2/csidivisions.asp
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The IRS wants to see costs listed by specific building systems or components.
Typical groupings may include land, land improvements, furniture and fixtures,
electrical systems , plumbing systems, equipment and the like.
Explanation Of The Legal Analysis
The legal analysis in a quality study recognizes contradictions in tax law and
attempts to reconcile them to the specific facts and circumstances of the property
at issue. You will want to include an analysis of statutes and judicial precedent.
Luckily, this will be very similar from study to study. The issue is what can be
changed from real property to personal property.
Determination Of Unit Costs And Engineering "Take-Offs"
Once property items or assets have been identified and assigned to the correct
property classes (land, land improvements, building and personal property),
their respective values must be determined. In order to determine a cost for each
unit or class of property in a project or component system, total project costs (or
total component system costs) must generally be broken down. This breakdown
process is commonly known as engineering "take-offs".
Cost estimates can vary widely depending on which estimating guide is used
and whether costs are for "high" or "low" quality construction. In a quality study,
cost estimates are reconciled to an acquisition price, a total project cost or to a
component system cost to ensure the accuracy of an allocation. The proper use of
an estimation technique is another frequent source of audit controversy. A
quality study minimizes this controversy by clearly explaining and documenting
the methodology used to assign costs to each asset.
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Organization Of Assets Into Lists Or Groups
List the assets by recovery period (land, land improvements, furniture & fixtures,
electrical systems, plumbing systems and equipment).
Reconciliation Of Total Allocated Costs To Total Actual Costs
It is important that the same estimating technique be used on all of the items that
reconcile to the purchase cost.
List any separately-acquired personal property.
Explanation Of The Treatment of Indirect Costs
There are two types of costs for your business or real estate: direct and indirect.
Direct costs are the labor and material costs for specific items or assets. Indirect
costs, also referred to as "allocables," are intangible costs that are incident to the
activity.
During construction and before a property is put in service, indirect costs must
be allocated proportionately to the basis of the specific assets to which they
relate.
If you construct the building, you need to capitalize indirect expenses. If you
redevelop the property before putting it in service, you will also need to
capitalize indirect expenses. If you buy a property to put into service, you do not
need to capitalize.
Generally, indirect costs do not relate to the placement of business machinery, or
furniture and fixtures since these assets are typically purchased and installed
under separate contracts.
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If you have had to capitalize indirect expenses, you’ll need to discuss that in your
cost segregation study.
Identification And Listing Of Section 1245 Property
A quality study lists § 1245 property (personal property),including amounts, and
shows any § 1250 property (real property) reclassified to § 1245 property.
Consideration Of Related Aspects
Related aspects include capitalization of indirect expenses (also known as
uniform capitalization (UNICAP) rules of Section 263A), change in accounting
method and sampling techniques.
New tangible property regulations came into effect for years on or after January
1, 2014. This could be an issue for you to disclose if you are making a change due
to these regulations for years prior to this date. If you bought a property after
January 1, 2014, it probably won’t matter.
PRINCIPAL ELEMENTS OF A QUALITY COST SEGREGATION REPORT
The prior section dealt with one section of the IRS’s Audit Technique Guide. In
another section of the same Audit Technique Guide, the IRS again discusses
what the elements of a quality cost segregation report. Here’s what this list
included.
Summary Letter/Executive Summary
A quality report contains a summary to identify: the preparer, the date of the
study, the taxpayer (or client), the subject property, and the property
components classified as land, land improvements, building, or personal
property.
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This is an additional item when compared to the previous list of what should be
included in a quality cost segregation study.
Narrative Report
This section includes a detailed description of the property along with the
applicable tax law. There is also a discussion of the types and sources of data
used. This appears to be in alignment with the previous list of items in a cost
segregation study
Schedule Of Assets
A report will have a list of the assets. This should tie to your depreciation records
and your financial statements. Chances are you’ll allocate some of the value from
longer term to shorter term lived properties. This should be noted and reconciled
back with the records.
Schedule Of Direct and Indirect Costs
As previously discussed, you will need to show both direct and indirect costs
that have been allocated to a project. This is not applicable if you do not have
new construction or redevelopment costs.
Schedule Of Property Units And Costs
You need to include a schedule that breaks out the segregations of land, land
improvements, equipment and personal property.
Engineering Procedures
You will need to include a section that explains how you came up with the cost
or value for each item. In this section, discuss the process and estimating
techniques you used. If the study is for a purchased (and not newly constructed)
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property, you’ll need to talk about value, estimated additional life and
replacement cost. Remember to use common nomenclature and a standard
numbering system for the listing.
Statement Of Assumptions And Limiting Conditions
Whenever you make assumptions, include a listing of what those assumptions
are. If you’ve had some incomplete or conflicting information and had to make a
choice, list out what happened and why you chose the answer you did. One of
the little known secrets of reporting to the IRS is that you rarely get in trouble if
you disclosed what you did. They might not agree, but they can’t say you
committed fraud. The IRS clearly states that disclosed assumptions are a sign of a
good study.
Certification
The IRS wants to know who prepared the study and they want to see a resume’
or list of credentials.
Exhibits
Exhibits are usually included with a study. These may include a reconciliation of
costs with the general journal and photographs of the site.
Cost Segregation Sample
Following is a cost study sample for The Sample Apartment Complex project. It’s
not a real project, but is used to provide an example of a quality study. As you go
through this, you may feel a little overwhelmed. But, actually, all of this detail is
helpful for you. Once you determine what type of costs you have and how to
divide them, most of the information can then be a simple copy/paste for your
own cost segregation study.
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Study Introduction
This study used a Detailed Engineering Cost Estimate Approach to complete the
cost segregation study. This approach utilizes the site plan and a site inspection
with photographic documentation. Building and site improvement assets are
identified, quantified and documented. Asset costs were established using
nationally accepted cost estimating manuals such as R. S. Means Construction
Cost Data and Marshall & Swift Valuation Services. Appropriate unit price
factors and/or multipliers were utilized to refine the unit pricing including
location, fees, deflation, and wear and tear depreciation. Qualified and
experienced estimators prepared the worksheets, established the quantities and
completed the costing. A CPA specializing in cost segregation reviewed each
asset and classified them as real property (27.5 Year), land improvements (15
Year), or personal property (5 Year), and assigned the proper depreciable life for
federal tax purposes. The asset class and associated lives for all personal
property and land improvements are in accordance with Revenue Procedure 8756, the current controlling Internal Revenue Service Pronouncement.
Cost Segregation Study Sample – Sample Apartment
Complex
The Cost Segregation Study required the Detailed Engineering Cost Estimate
Approach to complete the cost segregation study. This approach utilizes the site
plan and a site inspection with photographic documentation. Building and site
improvement assets are identified, quantified and documented. Asset costs were
established using nationally accepted cost estimating manuals such as R. S.
Means Construction Cost Data and Marshall & Swift Valuation Services.
Appropriate unit price factors and/or multipliers were utilized to refine the unit
pricing including location, fees, deflation, and wear and tear depreciation.
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Qualified and experienced estimators prepared the worksheets, established the
quantities and completed the costing. A CPA specializing in cost segregation
reviewed each asset and classified them as real property (27.5 Year), land
improvements (15 Year), or personal property (5 Year), and assigned the proper
depreciable life for federal tax purposes. The asset class and associated lives for
all personal property and land improvements are in accordance with Revenue
Procedure 87-56, the current controlling Internal Revenue Service
Pronouncement.
PROJECT DESCRIPTION The Sample Apartment Complex project is an
apartment complex containing approximately 89,578 square feet of livable area
located on a 4.37 acre site in YourTown, USA.
Site improvements include asphalt paved parking areas and some covered
parking areas. There is a lighted courtyard with a pool, play area and tennis
court. There is nighttime lighting along the concrete walkways, at building
entrances and in the parking lot. Landscaping includes irrigated lawn, shrubs,
trees, and planting beds. The apartment buildings were built in 1989 and are
two-story structures. The construction consists of slab-on-grade with stucco
walls, and sloped roofs. The complex consists of 70 two-bedroom and 28 threebedroom units, each with laundry equipment. Finishes in the units include
carpeting, vinyl flooring and painted walls. The heating, ventilation and cooling
equipment is mounted on grade with condensing units. Electrical service consists
of a main distribution panel and individual meters for each apartment.
Total Size: SF
89,578
Total Footprint SF
44,789
Total Building Area SF
89,578
Date of Construction
1989
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Paced in Service
July, 2014
Date of Report
Jan, 2015
Summary of Value:
Structural & Mechanical
27.5
$ XX
Site Improvements
15
$ XX
Special Mechanical
5
$ XX
Special Electric
5
$ XX
Personal Property
5
$ XX
FEDERAL TAX CLASSIFICATION
Section 168 of the Internal Revenue Code determines the method of calculating
depreciation for property placed in service after December 31, 1986. This
property is recognized as recovery property and is depreciated under the
Modified Accelerated Cost Recovery System (MACRS). Classes of MACRS
property are determined largely by reference to the class lives prescribed in
Revenue Procedure 87-56, 1987-2 C.B. 674 (as clarified and modified by Rev.
Proc. 88-22, 1988-1 C.B. 785).
The deduction for depreciation of MACRS property is determined by using the
applicable:
 Method of depreciation,
 Recovery period, and
 Convention.
There are three specified methods, eight recovery periods, and three specified
conventions.
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Each applies to a particular property depending largely on the class into which
the property falls.
According to Revenue Procedure 87-56, Equipment is considered Asset Class
#57.0 (Distributive Trades and Services) and depreciated over five years using
the 200% declining balance method with a switch to the straight-line method in
the first year in which the use of such method results in a larger deduction.
Land improvements are considered Asset Class #00.3 (Land Improvements) and
depreciated over fifteen years using the 150% declining balance method with a
switch to the straight-line method in the first year in which the use of such
method results in a larger deduction.
Non-residential real property associated with these facilities are depreciated over
thirty-nine years using the straight-line method. MACRS provides conventions
for determining the period of time in which depreciation may be claimed in the
year the property is placed in service. Generally, the half-year convention applies
to all property except residential rental property and nonresidential real
property, which are depreciated using the mid-month convention. The midquarter convention must be used, however, for all personal property if the
aggregate basis of personal property placed in service during the last three
months of the taxable year is more than 40% of the personal property placed in
service during the entire year.
The relevant property classifications for this project are defined in Revenue
Procedure 87-56, reproduced as follows:
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Asset Class #57.0 (Distributive Trades and Services) 5-Year Property. This
includes assets used in wholesale and retail trade, and personal and professional
services.
Asset Class #00.3 (Land Improvements) 15-Year Property. This includes
improvements directly to or added to land, whether such improvements are
section 1245 property or section 1250 property, provided such improvements are
depreciable. Examples of such assets might include sidewalks, roads, sewers,
fences, landscaping and shrubbery.
Residential Rental Property, 27.5-Year Property. All construction costs of the
building, shell and permanent fixtures must be depreciated as residential rental
property. Examples are the building enclosure, interior partitions, masonry
work, general building electrical, general building, mechanical, roofing,
windows, foundation excavation, building foundations, structural steel and
interior concrete floor slabs.
The relevant tax citations, revenue ruling, and tax court cases which further
support the property classifications used for tax depreciation purposes are
included elsewhere in this report.
FEDERAL TAX CLASSIFICATION SUPPORT
Plumbing: This includes supply and drainage to the coffee station, break areas
and cafeteria appliances and cabinet sinks. Plumbing consists of pipes, fittings,
gaskets, traps, drains, valves, pumps, gauges, brackets and connectors. These
items were installed specifically for use with the personal property to which they
relate. Absent the existence of these items, the personal property would be
inoperable.
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Revenue Ruling 69-558, 1969-2, C.B. 4 states: “…electrical wiring and special
outlets (and plumbing lines) …leading directly to, within, and interconnecting
with items of machinery or equipment are not parts of the electrical (and
plumbing systems), but are parts of the particular items of machinery or
equipment to which they directly lead, are within, or interconnect…” In Hospital
Corporation of America and Subsidiaries v. Commissioner, 109 TC 21 (1997), the
Tax Court reaffirmed its decision in Scott Paper Co. v. Comm., 74 TC 137 (1980)
and Morrison Inc. v. Comm., No. 34300-83, TCM 1986-129, March 31, 1986 stating
that it found no material differences between the facts in the Hospital Corp. Case
and those facts presented in its earlier decisions. In Morrison Inc. v. Comm., the
court focused on the use of the special purpose plumbing and concluded that it
did not relate to the operation and maintenance of the building and therefore
could not be a structural component in accordance with Reg. Sec. 1.48-1(e)(2).
The court concluded instead, the special purpose plumbing was part of the
Section 1245 property to which it related. In Scott Paper Co. v. Comm., the court
indicated: “items occurring in unusual circumstances that do not relate to the
operation or maintenance of the building should not be considered as structural
components even though specifically listed as such in Reg. Sec. 1.48-(e)(2)” The
court held the critical test to be whether the improvements related to the overall
operation or maintenance of the building. The court concluded that the special
purpose plumbing should be considered an extension of the Section 1245
property to which it relates.
See also Rev. Rul. 69-558, 1969-2, CB. 4; Rev. Rul. 66-299, 1966-2, c. B. 14; Central
Citrus Co. v. Commissioner, 58 TC 365 (1972); Duaine v. Commissioner, T. C.
Memo 1985-39; Texas Instruments v. Commissioner, TCM 1992-306. Accordingly,
the coffee station, break areas and cafeteria plumbing requirements are accessory
to the appliances and cabinet stinks, and thus, qualify as Asset Class #57.0
(Distributive Trades and Services) for tax depreciation purposes.
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Exterior Site Lighting & Electrical Exterior: The site lighting includes polemounted lights, floodlights, and landscape accent lights. These assets qualify as
tangible personal property in accordance with Reg. Sec. 1.1245-3(b), as defined
by Reg. Sec. 1.48-1(c). In the Senate Finance Committee Report, Revenue Act of
1978, (S. Rep. 95-1263, 1978-3, C.B. 315, 410-423), Congress recognized that
“special lighting” which has no more than an incidental relationship to the
operation or maintenance of a building constitutes personal property. Congress
cited lighting, which illuminates the exterior of a building or store as an example.
Although Congress excluded lighting to illuminate a parking area in S. Rep. 951263, the court held in Standard Oil Co. v. Commissioner, 77 TC 28 (1981), that
exterior parking lighting constituted tangible personal property. The court
determined that a pole and lighting fixture attached to a concrete base by four
anchor bolts could be easily removed and moved and should not be considered
inherently permanent. They applied the criteria in the Whiteco Industries, Inc. v.
Commissioner, 65 TC 664 (1975, acq., 1980-24 I.R.B. p.5) and found that the pole
and lighting fixtures met the six-point test. Tangible personal property includes
all tangible property except building, structural components and other inherently
permanent items. Rev. Rul. 75-178, 1975-1, C.B. 9 states: “that the classification of
property as personal or inherently permanent is to be made on the basis of the
manner of attachment to the building and how permanently the property is
designed to remain in place.” All site lighting fixtures are easily removable and
movable, interchangeable, and not permanently attached. Reg. Sec. 1.48-1(e)(2)
includes “electric wiring and lighting fixtures” as an example of a structural
component. Nonetheless, the courts have generally recognized that the list of
structural components in Reg. Sec. 1.48-1(e)(2) is neither all-inclusive, nor
intended to represent assets, which are structural components under all
circumstances.
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None of the lighting included in this category relates to the normal operation of
general lighting in the building.
Accordingly, the site lighting qualifies as Asset Class #00.3 (Land Improvements)
for tax depreciation purposes. Special Purpose / Decorative Lighting Special
purpose and decorative lighting consists of exterior decorative building lighting,
emergency battery lights, wall mounted remote head emergency lights, and exit
lights. In the Senate Finance Committee Report, Revenue Act of 1978, (S. Rep. 951263, 1978-3, C.B. 315, 410-423), Congress recognized that: “special lighting
which has no more than an incidental relationship to the operation or
maintenance of a building constitutes personal property.”
In Morrison v. Commissioner, TCM 1986-129, the court reaffirmed congress’s
decision holding that the taxpayer’s emergency lighting constituted personal
property and noted that lighting fixtures and electrical connections that “do not
provide basic illumination” and that are “accessory to a business” do not
constitute structural components of a building. Again in Metro National Corp. v.
Commissioner, TCM 1987-38, 52 TCM 1440, the court concluded that special
purpose, security, decorative, and ornamental lighting are tangible personal
property. Tangible personal property included all tangible property except
building, structural components and other inherently permanent items. Rev. Rul.
75-178, 1975-1 C.B. 9 states: “the problem of classification of property as personal
or inherently permanent should be made on the basis of the manner of
attachment to the land or the structure and how permanently the property is
designed to remain in place.” The light fixtures in question are easily removable
and movable, interchangeable, and not permanently attached to the building.
They meet the stringent six-point test developed by the Tax Court in Whiteco
Industries Inc. v. Commissioner, 65 TC (1975, Acq., 1980-24 I.R.B. p.5) under
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which much more permanently affixed have been characterized as tangible
personal property.”
Reg. Sec. 1.48-1(e)(2) included “electric wiring and lighting fixtures” as an
example of a structural component. Nonetheless, the courts have generally
recognized that the list of structural components in Reg. Sec. 1.48-1(e)(2) is
neither all-inclusive, nor intend to represent assets, which are structural
components under all circumstances. The defining factor in the definition of
structural components is the last item listed, “and other components relating to
the operation and maintenance of the building.” None of the lighting included in
this category relates to the normal operation of the building. All of the special
and decorative lighting was intended for a purpose other than providing general
illumination within the building. Accordingly, the special purpose and
decorative lighting qualify as Asset Class #57.0 (Distributive Trades and
Services) for tax depreciation purposes. Floor Coverings Vinyl flooring can be
found throughout facility. Carpet was specially designated as tangible personal
property in Rev. Rul. 67-349, 1967-2, C.B. 48. The Senate Finance committee
Report, Revenue Act of 1978, (S. Rep. 95-1263, 1978-3, C.B. 315, 410-423), provides
additional support stating: “floor coverings which are not an integral part of the
floor itself such as floor tile generally installed in a manner to be readily removed
(that is it is not cemented, mudded, or otherwise permanently affixed to the
building floor but, instead, has adhesives applied which are designed to ease its
removal)…are considered tangible personal property and not structural
components” Vinyl flooring is attached using adhesives in the same nonpermanent method as carpeting. In Hospital Corporation of America and
Subsidiaries v. Commissioner, 109 TC 21, (1997), carpeting and vinyl flooring
were determined to be tangible personal property. The court concludes:
“Carpeting is not an integral part of the floor and satisfies the criteria for tangible
personal property outlined in Whiteco Industries, inc. v. Commissioner, 65 TC
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664 (1975, acq., 1980-24 I.R.B. p. 5)…Petitioners have shown that they did not
intend for the carpeting to be permanently affixed to the underlying floor
applying the Whiteco criteria…vinyl floor coverings are not inherently
permanent. We are persuaded that the floor coverings were not intended to be,
and were not permanent coverings for the buildings’ floor.”
Accordingly, the vinyl flooring qualifies as Asset Class #57.0 (Distributive Trades
and Services) for tax depreciation purposes. Land Improvements Land
improvements include paved areas, sidewalks, concrete stairs, fencing, site
utilities and landscaping. Landscaping includes trees, plants, shrubs, mulch,
rock, and sod. Although Rev. Proc. 87-56, Asset Class 00.3, cites many of these
items as example of depreciable land improvements, some additional discussion
is warranted. Section 167 the Internal Revenue Service Code Section 167 sets
forth the general rule that there shall be allowed as a depreciation deduction a
reasonable allowance for the exhaustion, wear and tear and obsolescence of
property used in the trade or business, or of property held for the production of
income. Section 167(a)-2 of the Income Tax Regulations provides, in part, that the
depreciation allowance does not apply to land apart from the improvement or
physical development added to the land, which has a limited period of use and
experience exhaustion, wear and tear. With regards to landscaping as a
depreciable land improvement, Revenue Ruling 74-265, 1974-1 C.B. 56, indicated
that landscaping that would be simultaneously retired with a building would be
considered a depreciable land improvement. Other improvements unaffected by
the buildings retirement and not subject to other wear and tear would be
considered part of the taxpayer’s basis in land. The ruling notes: “The
landscaping for shrubbery and grass is interrelated to the apartment buildings by
reason of the site plan design, and physical layout and construction. The
landscaping is not similar to the general site grading but is similar to grading
that would be retired if the apartment building were removed. The landscaping
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is so located as to constitute a primary and integral part of the overall apartment
facilities.” The ruling held that landscaping consisting of the perennial shrubbery
and ornamental trees immediately adjacent to the buildings is depreciable
property under Section 167, since the replacement of the buildings will destroy
this landscaping.
Furthermore, in Trailmont Park Inc., TC Memo 1971-212, the court held that the
costs of clearing, grading, terracing and landscaping were an integral part of the
construction and development of a mobile home park and were depreciable over
the same period as the pads, patios, and other improvements. In its Action on
Decision, the IRS conceded that: “The useful life on the landscaping is
comparable to that of other depreciable improvements such as water and sewer
lines and paving since the construction required in replacing these items would
probably destroy much, if not all, of the landscaping.” The landscaping
surroundings this facility would be destroyed if the building and other
depreciable land improvements were removed. Therefore, using the rationale of
Rev. Rul. 74-265 and the IRS’s position in is Action on Decision of the Trailmont
Park, Inc. case, the cost of the landscaping should be classified as depreciable
land improvements. Accordingly, the paved area, sidewalks, concrete retaining
walls, steel railings, site utilities and landscaping qualify as Asset Class #00.3
(Land Improvements) for tax depreciation purposes. Land Preparation Revenue
Ruling 65-265, 1965-2, C.B. 52, supports depreciating the costs associated with
excavation and grading as part of the cost of the asset for which they are
associated. Revenue Ruling 65-265 states: “The cost attributable to excavation,
grading, and removing soil necessary for the proper setting of the buildings and
paving the roadways are part of the cost of those assets and should be included
in the depreciable base for the buildings and roadways…” Revenue Ruling 68193, 1968-1, C.B. 79, clarified Revenue Ruling 65-265 stating: “The cost paid or
incurred for the grading, (and excavation) are depreciable since the grading (and
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excavation) would be retired, abandoned, or replaced with the depreciable asset
with which it is directly associated…”
Revenue Ruling 74-265, 1974-1, C.B. 56; and Trailmont Park, Inc. TC Memo 1971212 further support this position. As a result, the site preparation costs for the
paved areas and buildings are essentially part of the cost of construction of these
items and should be depreciated as part of the aforementioned items.
Accordingly, the land preparation costs related to the land improvements
described above qualify as Asset Class #00.3 (Land Improvements) for tax
depreciation purposes.
Signage: Signage includes company identification, parking signs, external &
internal identification signs, directories, and room or department nameplates.
Identifying devices and signs qualify as tangible personal property in accordance
with Reg. Sec. 1.1245-3(b), as defined by Reg. Sec. 1.48-1(c). Reg. Sec. 1.48-1(c)
cites as examples of personal property “neon, and other signs.” See also Standard
Oil Co. (Indiana) v. Commissioner, 77 TC 349, August 12, 1981 and Senate
Finance committee Report, Revenue Act of 1978 (S. Rep. 95- 1263, 1978-3, C.B.
315, 410-423). Both held that identification signs qualified as tangible personal
property. Senate Finance Committee Report, Revenue Act of 1978, states that
tangible personal property includes: “identity symbols that identify or relate to a
particular retail establishment or restaurant such as special materials attached to
the exterior or interior of a building or store and signs (other than billboards)”
Accordingly, signage qualifies as Asset Class #57.0 (Distributive Trades and
Services) for tax depreciation purposes.
Process Piping Process piping includes compressed air and central vacuum
system piping. The system consists of pipes, fittings, gaskets, valves, pumps,
gauges, brackets and connectors. These items are used only and directly with the
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manufacturing equipment and were installed specifically for that use. Absent the
existence of these items, the manufacturing equipment would be inoperable. The
process piping system qualifies as tangible personal property in accordance with
Reg. Sec. 1.1245-3(b), as defined by Reg. Sec. 1.48-1(c). In Hospital Corporation of
America and Subsidiaries v. Commissioner, the Docket Nos. 10663-91, 13074-91,
28588-91, 6351-92, 109TC 21, (1997), the Tax Court reaffirmed its decisions in
Scott Paper Co. v. Comm., 74 TC 137 (1980) and Morrison Inc. v. Comr., No.
34300-83, TCM 1986-129, March 31, 1986, stating that it found no material
differences between the facts in the instant case and those facts present in those
cases. In Morrison Inc. v. Comr., the court focused on the use of the special
purpose plumbing and concluded that it did not relate to the operation and
maintenance of the building and therefore, could not be a structural component
in accordance with Reg. Sec. 1.48-1(e)(2). The court concluded instead, the special
purpose plumbing was part of the Section 1245 property to which is related. In
Scott Paper Co., v. Comm., the court indicated that items occurring in unusual
circumstances that do not relate to the operation or maintenance of the building
should not be considered as structural components even though specifically
listed as such in Reg. Sec. 1.48 (e)(2). The court held the critical test to be whether
the improvements related to the overall operation or maintenance of the
building. The court concluded that the special purpose plumbing should be
considered an extension of the Section 1245 property it serves. See also rev. Rul.
69-588; 1969-2 C.B. 4, Rev. Rul. 66-299, 1966-2 C.B. 14; Central Citrus Co. v.
Comm. 58 TC 365 (1972); Duaine v. Comm., T.C. Memo 1985-39; Texas
Instruments v. Comm., T.C. Memo 1992-306. Accordingly, the process piping
system qualifies as Asset Class #57.0 (Distributive Trades and Services) for tax
depreciation purposes.
Insert pictures of the facility and specific items that you’ve talked about in your
report.
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Second Sample
Title Page w/ Picture, address, city & state, date
Table of Contents
Methodology
We have completed the following procedures in preparing this report:

Obtained and read the site drawings and appraisal

Obtained the financial statements and general ledger as of December 31,
xxxx

Visited and toured the property

Photographed the property and prepared exhibits in the report to
demonstrate applicability of certain asset classifications to the existence of
the physical assets

Obtained and read the final construction pay application dated xxxx
including the schedule of values and change orders

Interviewed the general contractor and the plumbing, electrical and VAC
subcontractors

Prepared various computations and analyses to assist in classification of
the depreciable life of various assets on the property
Summary of Recommended Federal and State Income Tax
Allocations for PROJECT NAME
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This study identifies the appropriate federal income tax classifications for federal
and state income tax purposes.
Based on the information provided, we recommend the following classifications
to property acquired through December 31, xxxx:
ELIGIBLE FOR 5-YEAR DEPRECIATION
Asset Class #57.0 (Distributive Trades & Services)
800,000
ELIGIBLE FOR 15 YEAR DEPRECIATION
Asset Class #90.3 (Land Improvements)
500,000
ELIGIBLE FOR 39 YEAR DEPRECIATION
Non-Residential Property
3,500,000
NON-DEPRECIABLE LAND
Land
TOTAL PROJECT COSTS
200,000
$5,000,000
Review of Federal Tax Law Relating to Cost Segregation Studies
Internal Revenue Code (IRC) Section 167 allows a depreciation deduction for
property used in a trade or business and IRC Section 168 determines the method
of calculating a depreciation deduction. Revenue Procedure 87-56 provides asset
classes and recovery periods under the Modified Accelerated Recovery System
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(MACRS). MACRS became effective in 1986 and provides cost recovery tables for
realty (real property which is general land and buildings permanently affixed to
the land) and personalty/chattels (personal property such as furniture,
machinery and equipment).
In addition to depreciation methods, asset classes and recovery periods,
conventions are used to determine the period of time for which depreciation
may be claimed in the year the property is placed in service. MACRS views
property as placed in service in the middle of the first year and allows a half-year
of cost recovery in the year of acquisition and in the final year of cost recovery
(the half-year convention.) If more than 40% of the value of property is placed in
service during the last quarter of the year, a mid-quarter convention must be
used. Under the convention, property acquisitions are grouped by the quarter
they were acquired. All eligible real estate is depreciated using mid-month
convention. Regardless of when during the month the property is placed in
service, it is deemed to have been placed in service at the middle of the month.
A ruling in the 1997 Tax Court case, Hospital Corp of America held that certain
building components previously considered structural and depreciated over 27.5
or 39 years, can be classified as personal property or land improvements and
depreciated over 5 – 15 years. Specifically the elements of a building that are
treated as personal property under the former investment tax credit rules (Reg
Sections 1.48-1(c ) ) may be separately depreciated as personal property.
Two years later, the IRS issued a memorandum in which it acquiesced to the Tax
Court ruling, stating that the tests developed under the investment tax credit
before the 1981 adoption of the cost recovery system “are applicable in
determining a structural component” for purpose of MACRS. The IRS stated
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that it disagreed with the Tax Court’s classification of some of the items as
personal property, but they did not identify those items.
Federal Income Tax Classifications
Nonresidential Real Property (39 Year Property)
Building construction costs include items inherently permanent and related to
the overall operation and maintenance of the building. Regulation Sec 1.48-1(e)
defines “building” as any structure enclosing a space within its walls and usually
covered by a roof, the purpose of which is, for example, to provide shelter or
housing, or to provide working, office, parking, display or sales space. Further
examples of real property are the masonry work, general building electrical
plumbing, heating ventilation and air conditioning, roofing, window, excavation
work, building foundations, structural steel, interior concrete floor, hardware
costs and interior building finishes.
An IRS Field Directive on the Planning and Examination of Cost Segregation
Issued in the Restaurant Industry dated 12/27/2004 provides the additional
information:
Real property includes interior ceilings, permanent floor and wall coverings,
interior and exterior doors and restroom accessories and restroom partitions.
Asset Class #00.3 – Land Improvements – 15 years
This asset class includes improvements directly to or added to land, provided
such improvements are depreciable. This includes sidewalks, roads, canals,
waterways, drainage, landscaping, shrubbery and radio/television transmitting
towers. This asset class does not include land improvements that are explicitly
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included in any other class or buildings and structural components. This asset
class excludes public utility initial clearing and grading improvements.
The cost of clearing, grading, terracing and landscaping a slope can be
depreciated as land improvements.
Additionally, the foundation or footings for signs, light poles, canopies, patio
stonework and site work not related to the building such as drainage, sewers,
sidewalks, paving, curbing, landscaping and fencing are depreciable over 15
years.
Decorative and Emergency Lighting
Several cases have identified certain types of lighting as personal property for
MACRS asset classification. These include Shoney’s South, Inc, TC Memo 1984413, Metro National Corporation (TC Memo 1987-38), Metro National
Corporation (Senate Report No. 95-1263).
The Field Directive identified interior light fixtures that are decorative in nation
and necessarily for the operation or maintenance of the building and exterior
light fixtures such as plant grow lights as recoverable over 5 years.
Cabinetry and Display Fixtures
Various types of cabinets and other fixtures have been identified as personal
property. From the Field Directive, items such as detailed crown moldings,
latticework placed over finished walls or ceilings and cabinets and counters
except for those in a restroom can be depreciated for 5 years.
Electrical and Mechanical Requirements
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Generally, electrical, plumbing and sprinkler systems are considered are a part of
the building structure and therefore real property. However, additional electrical
and mechanical requirements for machinery used in a business can be classified
as personal property.
The Field Directive identified equipment and apparatus used to provide
amplified music or sound including wiring is recoverable over 5 years.
Type of Asset
Real Property (bldg)
Recovery Period
27.5 or 39 years
Examples
Structural & permanent
components, basic core
and shell
Land Improvements
15 years
Sidewalks, driveways,
roads, parking lot,
landscaping
Personal Property
5 or 7 years
Internal communications,
temporary wall
coverings, display,
lighting, flooring,
electrical, plumbing,
cabinets, equipment and
appliances
Your exhibits will vary based on the property’s individual characteristics.
Normally, the above will be followed by something like:
Exhibit 1 – Site and Floor Plans
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Exhibit 2 – Summary of Project Costs and Depreciation
Exhibit 3 – construction Costs
Exhibit 4 – Photographs
Exhibit 5 – Resumes
What if the IRS audits me?
This is a common question for any kind of tax strategy. What if the IRS audits?
What then? Well, in the case of a cost segregation study, we have a pretty clearcut path as to what is going to happen. That’s because there is an Audit
Technique Guide that tells us exactly the steps they are going to take.
First of all, they are going to ask to see the cost segregation study itself. If it’s just
a page or two or maybe even non-existent, the IRS is not going to be happy. In
that case, you don’t have a quality study and that means they are probably going
to deny the extra depreciation.
As part of the review of the study, there are some specific areas that they are
going to study.
Cost Analysis Of Existing Property
The auditor is going to look carefully at a cost analysis of recently purchased or
existing property. For used or recently-acquired properties, the adjusted basis or
purchase price is allocated between § 1245 and § 1250 property. However,
different considerations and audit techniques will apply depending on the
records that are available. The auditor may do some or all of the following:
Review the acquisition documents to determine the assets purchased. Determine
whether there was a written purchase price allocation agreed to by the buyer and
seller (you may need to contact the seller). If there was an allocation between
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personal and real property, then the allocation is binding on the taxpayer (and
therefore a taxpayer’s subsequent cost segregation study is moot).
If there was not a written price allocation, then the examiner should address the
study and go to the next step.
NOTE: If you have a written allocation in the purchase, then you might
inadvertently be locking yourself into a valuation. In other words, you can’t do
a cost segregation study for this property. Pay attention to the allocation and
make sure your CPA reviews purchase agreements before you finalize the
purchase.
Review the escrow documents and payment records to substantiate the overall
purchase price.
Ensure that the land has been properly valued. The land is valued first, based on
the value of bare land.
Ensure that Older Properties are Adjusted for Depreciation.
Assets and asset groupings must be carefully reviewed and scrutinized to
determine their physical and economic condition.
Relatively new items should be valued as new, whereas older items may be
physically deteriorated or functionally or economically obsolete and should be
assigned a value commensurate with their condition or use. For example, a
building may have been pre-wired for telephones but if it is a "non-digital"
system, it may have a low value.
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Ensure that replacement cost values are properly adjusted for the actual
condition and remaining economic useful life of the assets.
The value of used components must be reduced from new replacement value in
proportion to the observed economic obsolescence or physical depreciation as
compared to similar new assets. This principle is discussed in regard to the
Helipot Building in Lesser v. Commissioner, 42 T.C. 688 (1964), aff’d, 352 F.2d
789 (9th Cir. 1965), acq., 1966-2 C.B. 5, cert. denied, 384 U.S. 927 (1966).
Review the contract files for information regarding the original construction and
any subsequent repairs or modifications. This information should be used when
viewing the existing condition of the building to verify, if possible, that the
original contract work was performed.
Review the blueprints or drawings. The existing structure should be compared to
the "as-built" drawings to help identify subsequent repairs and modifications.
Consider demolition expenses. Assets that are already scheduled to be
demolished should have no value assigned to them.
In summary, the examiner should ensure that:

The study methodology considers the value of all the assets in place at the
time of purchase or at the time the study is prepared, whichever is
appropriate.

The value of property items must take into account the physical wear and
tear on each property item and any economic or functional obsolescence.
Final Notes:
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All of this detail is good news for you if you’re planning to use a cost segregation
study. We have a clearcut template for how to prepare a quality study and,
although, it may look quite daunting in the beginning, it will actually include a
lot of the same case law and be mainly a case of copy and paste. In the end, the
key is to properly allocate the value to personal property and other shorter lived
assets. As long as you can show you understand what you’re doing and have
given proper acknowledgement to the process the IRS wants followed, you can
create a quality cost segregation study.
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