Can You Do a Cost Segregation Study Yourself?

A cost segregation study is a tax planning strategy that reclassifies real property assets into shorter depreciation recovery periods to accelerate depreciation deductions and reduce current tax liabilities. Many property owners inquire whether they can undertake such an analysis themselves. This article explores the information, expertise, procedural steps, and documentation standards required for a cost segregation study.

Understanding a Cost Segregation Study

A cost segregation study identifies and reclassifies a property’s components into appropriate asset classes for federal income tax purposes. The primary goal is to shift assets from longer depreciation recovery periods (e.g., 27.5 years for residential, 39 years for non-residential) to shorter periods (e.g., 5, 7, or 15 years). This accelerates depreciation deductions, reducing current taxable income and increasing cash flow.

The study dissects a building’s total cost to identify non-structural components, such as personal property and land improvements. Examples include specialized electrical outlets, plumbing fixtures, carpeting, cabinetry, site utilities, and landscaping. Reclassifying these assets allows property owners to claim larger depreciation deductions sooner. This strategy applies to newly constructed, acquired, or significantly renovated properties. Even properties placed in service in prior years can benefit from a “look-back” study, allowing for a catch-up depreciation deduction.

Key Information and Resources Required

Performing a cost segregation study requires comprehensive property information and resources for accurate asset identification and cost allocation. Key documents include:

A property settlement statement or purchase agreement, detailing acquisition cost and terms, to establish the initial cost basis.
Detailed construction drawings and blueprints (architectural, structural, mechanical, electrical, plumbing) for new construction or significant renovations, providing technical information about building components.
Site plans and surveys for identifying land improvements and their costs.
Comprehensive cost records, such as invoices, payment applications, general ledger entries, and vendor contracts, for precise allocation.
AIA G-702/703 documents, if a general contractor was used, outlining contract price and schedule of values.
Previous depreciation schedules, if applicable, to understand prior depreciation.
Information on renovations, additions, or demolition of existing assets, as these impact depreciable basis and asset classification.
An appraisal report, if available, to assess property value and assist in allocating costs between land and depreciable assets.

Knowledge and Expertise for Self-Performance

Performing a cost segregation study independently requires diverse and deep understanding across several specialized fields.

Tax Law Knowledge

Familiarity with IRS depreciation rules, particularly the Modified Accelerated Cost Recovery System (MACRS), is foundational. This includes understanding asset classification into 5, 7, 15, 27.5, or 39-year recovery periods, and the distinction between Section 1245 and Section 1250 property. Specific IRS guidance, such as Revenue Procedure 87-56 and Revenue Procedure 2002-9, are crucial for identifying appropriate class lives and understanding accounting method changes. The IRS Cost Segregation Audit Techniques Guide (ATG) provides insights into what constitutes a quality study and what examiners look for during an audit.

Accounting Principles

A strong grasp of accounting principles is necessary, including cost accounting methods, proper asset capitalization, and analyzing general ledger entries for relevant cost data. The process requires careful reconciliation of total allocated costs to total actual costs for accuracy.

Construction and Engineering Knowledge

Construction and engineering knowledge are equally important for interpreting blueprints, understanding building systems (HVAC, electrical, plumbing), and identifying specific components. This expertise allows accurate asset classification based on physical characteristics and function. The ability to conduct “take-offs” from construction documents to determine unit costs is a key engineering skill.

Valuation Methodologies

Familiarity with various valuation methodologies is needed to allocate total project cost to identified assets. Methods like detailed engineering, survey, component, or estimation approaches assign costs to each reclassified asset. Determining the non-depreciable land value is also a critical step, often requiring understanding appraisal reports or property tax assessments.

Performing the Study Steps

Once information is gathered and knowledge is in place, performing a cost segregation study begins. This involves a systematic approach to identifying, classifying, and allocating costs to property components.

A thorough review of documentation, including construction drawings, invoices, and general ledgers, is a critical initial step to understand the property’s composition and associated costs. A physical site visit is also important for confirming asset existence and nature, especially for existing properties. Detailed observations, measurements, and photographs taken during the visit support classification and provide real-world context.

Asset identification and classification involve categorizing each component into its appropriate depreciation class. This requires distinguishing between structural components (39 or 27.5-year property), land improvements (15-year property), and personal property (5 or 7-year property). Classification criteria are based on IRS guidelines, considering the asset’s function, removability, and whether it is an integral part of the building’s operation.

After classification, cost allocation assigns a portion of the total project cost to each identified asset. This can use methodologies like direct costing from invoices, unit costing, or an estimated cost approach when detailed records are unavailable. The goal is to accurately attribute the overall cost to individual components.

Finally, a comprehensive cost segregation report summarizes the findings. This report typically includes an executive summary, a detailed methodology, schedules listing each asset with its assigned cost and depreciation life, and supporting documentation. The report also details the depreciation calculation, applying shorter depreciation lives to reclassified assets for accelerated deductions.

IRS Expectations for Documentation

The Internal Revenue Service (IRS) has specific expectations for documentation supporting a cost segregation study to ensure its credibility and defensibility during an audit.

A comprehensive report is paramount, detailing the methodology, component classification, and supporting calculations. This report should clearly articulate the rationale, including legal citations, for classifying assets as Section 1245 or Section 1250 property.

Maintaining all supporting documentation is equally important. This includes original construction invoices, contracts, blueprints, and any engineering assessments or site visit notes used in the study. These records provide the necessary audit trail, allowing the IRS to trace all allocations back to their source.

The methodology employed must be transparent and defensible. The IRS generally prefers a detailed engineering approach, involving meticulous analysis of the building and its components, over less rigorous methods. This detailed approach ensures accuracy and compliance.

Even if prepared by the property owner, the study should adhere to standards similar to those performed by qualified professionals. The IRS Audit Techniques Guide (ATG) emphasizes expertise and experience in both construction processes and tax law for depreciation. A well-documented study minimizes audit burden and helps substantiate claimed depreciation deductions.