Cost segregation is the comprehensive analysis of all costs associated with a construction project or building acquisition with the objective to maximize depreciation benefits by segregating and documenting the cost of all short-lived property identified as part of the capitalized cost of the project. The intent is to break out as much Section 1245 (personal) property as possible from what otherwise would be classified as Section 1250 (real) property.
Kellenberger Valuation Group performs cost segregation studies of new construction and acquisitions of real property, as well as of past construction projects and acquisitions. Retrospective studies may be relevant due to a company coming out of a net operating loss position or improper classifications of the real property. In these situations, the depreciation adjustment can be fully recognized in the first year, through submission of Form 3115, Application for Change in Accounting Method, significantly increasing cash flow.
Benefits to the Taxpayer
What is the present value of accelerating depreciation and deferring taxes?
- For every dollar of cost shifted from 39-year to 5-year property, the present value tax benefit is approximately 22 cents.
- For every dollar of cost shifted from 39-year to 7-year property, the present value tax benefit is approximately 20 cents.
- For every dollar of cost shifted from 39-year property to 15-year property, the present value tax benefit is approximately 12 cents.
Revenue Procedure 87-56, as modified by Revenue Procedure 88-22, provides a complete list of class lives and recovery periods. Under the Modified Accelerated Cost Recovery System (MACRS) property classes are established by Internal Revenue Code Section 168(c). Under the general MACRS rules, property is classified based upon the property’s class life unless a different recovery class is assigned under IRC Sec. 168(e)(2) (residential rental and nonresidential real property). The five most widely used periods are 5, 7, 15, 27.5, and 39 years.
|3-year class||Personal property with an ADR midpoint of 4 years or less|
|5-year class||Primarily personal property with an ADR midpoint of more than 4 years, but less than 10 years|
|7-year class||Primarily personal property with an ADR midpoint of at least 10 years, but less than 16 years, and property that is not specifically assigned to any other class|
|10-year class||Property with an ADR midpoint of at least 16 years, but less than 20 years|
|15-year class||Property with an ADR midpoint of at least 20 years, but less than 25 years|
|20-year class||Property with an ADR midpoint of 25 years or more|
|27.5-year class||Residential rental property|
|31.5-year class||Nonresidential real property (pre-Omnibus Budget Reconciliation Act of 1993)|
|39-year class||Nonresidential real property (post-Omnibus Budget Reconciliation Act of 1993)|
Real (Section 1250) or Personal (Section 1245) Property?
Property Permanence—Whiteco Industries, Inc., v. Comm’r (six point test)
- Is the property capable of being moved, and has it in fact been moved?
- Is the property designed or constructed to remain permanently in place?
- Are there circumstances that tend to show the expected or intended length of affixation, may the property have to be moved?
- How substantial a job is removal of the property, and how time consuming is it, i.e., is it “readily removable”?
- How much damage will the property sustain upon its removal?
- What is the manner of affixation of the property to the land or building?
Building v. Accessory to the Taxpayer’s Business
- Does the property serve no more than an incidental relationship to the operation or maintenance of the building?
Relation to Machinery and Equipment
- Is the property inextricably linked to specific equipment, or is it reasonably adaptable to more general uses?
ONE THING IS CLEAR—THE FEDERAL INCOME TAX LAW IS UNCLEAR REGARDING THE DISTINCTION BETWEEN PERSONAL AND REAL PROPERTY
What We Do
Processes employed by our cost segregation engineering team follow standard
professional engineering and cost estimating methodologies, including:
Review of the blueprints and specifications to identify potential shorter-life assets
Inspection of the facility to understand its nature and use, and to gather further information supporting appropriate class life allocation
Review of the general contractor’s application for payment (G702 & 703, Schedule of Values) and change orders, along with other project cost information, to identify potential short-life property
Performance of quantity take-offs and cost estimates for personal property identified but not segregated in the project cost information
Allocation capitalized indirect or “soft” costs to the appropriate direct cost category
Preparation of a property unit listing describing identified assets by cost category and appropriate MACRS class life reconciled to the total capitalized cost of the facility
Issuance of a final report summarizing our analysis and findings including property unit schedules with appropriate MACRS class lives
The above are applicable to both new and purchased properties. For a purchased property, we offer the option of performing a qualified appraisal of the underlying land.
The methodology outlined previously provides the basis for all cost segregation analyses. The makeup of your real estate portfolio will determine which method below is used. The goal of each approach is to maximize your cost segregation objectives:
Complete Analysis Approach
Our standard procedure for single facilities involves a complete review of general contractor costs, architect and engineering fees, direct owner-incurred costs, and construction drawings to maximize tax benefits and document supportability.
This approach addresses portfolios of similar construction, such as restaurant chains and hotels. These property types often use standard construction methods and materials and are of similar size. The more similar individual property types are, the easier it is to extrapolate results from the sample set analysis to the remainder of the properties. Sample size and construction are key to this approach.
Modified Sample Approach
This approach is used primarily for industrial buildings, warehouses, office complexes, etc., where there is limited similarity in the facilities. Our proprietary model enables us to take into account such variances as construction costs, location, age and quantity take-offs. Cost estimates are generated from the sample set. Sample size and construction are also key to this approach.
Our Engagement Process Involves:
Conference call or meeting to determine project scope and timetable
Performance of benefit analysis (if requested) to provide a preliminary estimate of NPV tax savings
Preparation of a formal proposal/engagement letter
Request of specific data after authorization to proceed
Scheduling and completion of conferences/meetings and property inspection
Delivery of conclusions (hard copy, electronic, or both, as agreed to in the engagement letter)
When segregating value to acquired assets for federal tax purposes, the valuation skills of the consultant are critical. Many cost segregation specialists are not certified valuers. While it may not be critical for new construction, it is inadequate for the analysis of acquired property.
Our cost segregation team includes certified and credentialed valuers who have analyzed similar projects to yours along the life cycle of real property, from development to demolition.
Truth in Valuation
Kellenberger Valuation Group