How to Get a Cost Segregation Study Done

A cost segregation study identifies and reclassifies components of commercial real estate or certain residential rental properties that are typically depreciated over long periods. This specialized tax tool aims to accelerate depreciation deductions by separating real property assets from personal property assets and land improvements. The fundamental goal is to improve a property owner’s cash flow by reducing current tax liabilities.

What a Cost Segregation Study Is

A cost segregation study is an engineering-based analysis that dissects the costs of a building and its components. It reclassifies certain building costs from longer depreciable lives, such as 39 years for nonresidential real property or 27.5 years for residential rental property, into shorter recovery periods. These shorter periods typically include 5, 7, or 15 years, for accelerated depreciation.

Components within a building can qualify as tangible personal property or land improvements under tax law. Examples include decorative lighting, specialized plumbing, certain electrical systems, cabinetry, and site improvements like sidewalks, fencing, and landscaping. Accelerating depreciation defers tax payments, effectively providing an interest-free loan from the government. This enhances liquidity and improves financial position.

Preparing for a Cost Segregation Study

Preparing for a cost segregation study requires gathering a comprehensive set of documents and financial information. This phase is essential for study accuracy. Property acquisition costs, including the original purchase price, settlement statements, and appraisal reports, establish the property’s initial basis.

For properties involving new construction or significant renovations, provide documentation of costs, such as itemized invoices, construction contracts, and payment applications. Architectural drawings, blueprints, and specifications, like floor plans and MEP drawings, provide insight into the building’s structure.

Existing depreciation schedules from prior tax returns inform the study about the property’s current tax basis and depreciation history. Lease agreements, especially for properties with tenant improvements, clarify ownership. Building permits or certificates of occupancy establish construction timelines. Information on prior tax elections or audits provides context to the cost segregation professional.

Engaging a Cost Segregation Professional

Selecting a qualified professional is a significant step in obtaining an accurate and defensible cost segregation study. These studies are performed by specialized engineering firms or accounting firms with dedicated cost segregation departments. The provider should understand engineering principles and tax law, including IRS guidelines.

When evaluating potential providers, assess their experience with properties similar in type and complexity to yours. A provider’s ability to offer audit defense support for their study findings indicates confidence in their methodology and adherence to IRS standards. Seek references and review their track record for reputation and client satisfaction.

A proposal should outline the scope of work, methodology (e.g., engineering approach), timeline, and fee structure. Ask specific questions, such as how they stay current with evolving tax regulations or their success rate in defending studies during IRS examinations. Their expertise and commitment to robust methodology are important for a successful outcome.

Executing the Cost Segregation Study

Once engaged and documentation provided, the study begins. The process starts with a site inspection. During this visit, the professional observes assets, takes photographs, and gathers on-site information to corroborate documentation.

Following the site visit, an engineering analysis and cost allocation take place. The professional reviews the construction documents and financial records to identify and categorize building components. Costs are allocated based on actual expenditures or through reliable cost estimation techniques. Components are reclassified according to IRS guidelines, such as Revenue Procedure 87-56 and the Cost Segregation Audit Technique Guide.

Assets are assigned depreciable lives (5, 7, 15, 27.5, or 39 years) and corresponding depreciation methods (e.g., 200% declining balance for 5- and 7-year property). A detailed report is developed, summarizing findings, outlining methodologies, and providing schedules of reclassified assets. Before final delivery, the report undergoes a quality control process, often involving review by senior engineers and tax specialists, to ensure accuracy, compliance, and defensibility.

Utilizing Study Findings

Upon completion and delivery of the cost segregation report, the findings are incorporated into the property owner’s income tax return. This involves filing Form 3115, Application for Change in Accounting Method, to notify the IRS of asset reclassification and depreciation changes, allowing retroactive accelerated depreciation.

The property owner’s tax accountant or Certified Public Accountant (CPA) reviews the report and ensures its implementation on the tax return. They translate the engineering findings into the appropriate tax schedules and calculations, ensuring compliance with IRS regulations. The report serves as documentation, detailing each reclassified asset, its cost, and its depreciable life.

Maintain thorough records; the report and supporting documentation should be stored. These records substantiate depreciation deductions during an IRS audit. The accelerated depreciation will continue to impact the property’s taxable income and cash flow for the remaining depreciable life of the reclassified assets, providing ongoing tax benefits.