The IRS has turned up the heat on the use of cost segregation studies by building owners. Auditors have a special guide to help assist them in examining the returns of taxpayers who utilize cost segregation studies. Nevertheless, these tax-saving studies can still be used to provide faster write-offs for building components as long as they are supported by concrete evidence.

Background: A business can use a cost segregation study to write off the cost of certain building components. For instance, a company may be entitled to separate write-offs for electrical systems, plumbing systems or removable carpeting. It normally takes 39 years to fully depreciate the cost of nonresidential real estate, but the cost of these components may be recouped in less than a third of that time.

Typically, a cost segregation study may identify hundreds, or even thousands, of separately depreciable components in complex structures such as hospitals, restaurants, shopping centers, office buildings and factories. A study also allocates costs to these items, including amounts for material, labor, architect and engineering fees and impact and permit fees. For an existing building where records are not readily available, valuation experts often rely on standardized cost estimation manuals.

Audits of cost segregation studies are “controversial and burdensome for all parties,” according to the IRS. Reasons cited: There are no standards regarding the preparation of the studies; the relevant law is complex; court decisions and IRS rulings have sometimes produced conflicting guidance; and the studies vary widely in terms of methodology, documentation, depth and format.

To address these issues, the IRS released a 115-page Audit Techniques Guide to assist its examiners in reviewing cost segregation studies. The guide states the issues IRS examiners need to look at “are the rationale used to segregate property into its various components, and the methods used to allocate the total project costs among these components.”

The IRS guide explains why cost segregation studies are performed, how the studies are prepared and what agents should be examining. It is “must reading” for building owners interested in learning more about the complex subject of cost segregation studies. It is available to the public on the IRS website by clicking here.
The tax agency and the courts have given their approval to numerous cost segregation studies. The IRS audit guide makes it clear a properly-prepared study must classify property into the appropriate asset class with adequate documentation. Therefore, it is critical that a cost segregation study be performed by professionals who understand the strict IRS standards.