1. Does the Value of a Cost Segregation Study Outweigh its Cost?
Cost segregation is a tax strategy. Its value is in increasing your return on a real estate investment. Real estate return on investment (ROI) must be high enough to make the investment worthwhile. After all, you’ve sunk a lot of money into the construction, renovation or acquisition of real properties. To recoup that investment, you must either sell the property for a sufficient profit or rent it out for a sufficient cash flow. If you take the latter approach, you must depreciate the property in order to recover the investment. A cost segregation study speeds up the depreciation of reclassified assets, thereby providing the following benefits:
- Accelerated cash flows
- Reduced tax liability
- Tax deferment
- Reclaimed historic depreciation deductions
All of these factor will increase the property’s ROI. You must then weigh these benefits against the cost of the cost segregation study
. Therefore, one consideration when picking a consultant to perform the study is how much it will cost. Typically, the benefits greatly outweigh the costs, but certain clients offer a profile that is more likely to benefit from the study. That profile includes:
- Properties costing at least $0.75 million for purchase or construction
- Clients with large fixed assets
- Interior renovations costing more than $0.2 million
- Clients that frequently repair or renovate properties
2. Will Doing a Cost Segregation Study Increase Your Chances of an Audit?
The fear is that the reclassification program will be too aggressive, triggering the interest of an audit. Cost segregation studies are not a Tier 1 issue for an audit. However, they can become so if they are enmeshed with other incentive or tax credit programs.
The Audit Techniques Guide, which was published in 2004, provides insights into whether a depreciation deduction will trigger the interest of auditors. Familiarity with the study is a must for a quality cost segregation study partner. The implication is that you must choose a study partner who can produce a work product that will withstand audit.
You should ask for references from previous clients of the partner who underwent an audit to see whether the study ever came into question. It’s also a good idea to gather basic statistics about the partner, including the amounts of reviewed assets, savings rate and studies performed.
3. What's the Scope of the Partner's Expertise?
The partner (really, partner team) should have expertise in two areas: construction engineering and taxes. You need expertise in construction engineering so that you can correctly identify all assets involved in the construction or renovation of the property. You need tax expertise not only in tax accounting, but also in all key aspects of corporate tax incentives.
Furthermore, the partner should have the expertise, and hopefully experience, in your industry. For example, cost segregation opportunities and exposures differ by how the property will be used (technology, agriculture, gaming, etc.). You therefore should ask about the partner’s industry experience. Naturally, a partner with clients in your industry will have an advantage when bidding for your work.
4. What Will the Final Deliverable Contain?
The final deliverable may raise questions about the conduct of the study that increase the odds of an audit. An obvious problem that’ll raise questions about the quality of the study is a deliverable that doesn’t specify whether the partner undertook a site visit. In general, the study should preemptively answer all reasonable questions about the study’s methodology.
The more information supplied, the likelier the study will withstand scrutiny. The study should include the following expectations for the partner’s work:
- Will cooperate with you in gathering property information
- Create an estimated benefit analysis showing the anticipated accelerated depreciation and the NPV of the tax benefits
- For construction projects, collect the drawings and details. For acquisitions, collect the purchase agreement. Collect the final costs for either type of transaction
- Visit the property site and review conditions
- Prepare a detailed engineering review of all assets, such as electrical and mechanical systems, site improvements, decorative finishes and any special-purpose construction
- Document findings with photographs and other records
- Reclassify assets into the correct cost recovery periods and allocate indirect costs as appropriate for each asset
- Prepare and deliver draft and final study documents
- For property placed in service during a previous year, file Form 3115 to declare a change in accounting method
5. What Engineered Documentation Approach Will the Partner Take?
Different approaches are available, including:
- Detailed cost approach: uses accounting and construction records to compile costs. This method tilts toward true documentation and away from cost estimates
- Detailed cost estimate approach: used for new construction, this resembles the detailed cost approach but relies somewhat more on estimates using reliable sources and invoices
- Survey approach: the partner inspects the site and compiles a list of all the property components. The list is provided to the contractor/subcontractors who then supply the price of each item. Recent data is usually more accurate than older data
- Residual estimation approach: separates out the cost of short-lived assets (up to 7-year property) and subtracts them from total project cost
- Sampling approach: a cost segregation study is performed on a small portion of a property portfolio, which serves as the basis for a standard model. The model assigns asset costs on a percentage basis
The detailed cost approach is the most expensive, but also the most accurate and most likely to withstand audit.
6. What's the Partner's Track Record with Audits?
It’s truly a gifted partner that has never had to support a client in an audit. Most likely, you will be evaluating partners with deep experience, including supporting the results of their cost segregation studies in audits. Of the tax audits in which the partner participated, how many involved questions about cost segregation studies? Of these, how many studies were found to be incorrect and resulted in disallowed deductions and other penalties.
Has the partner ever been subject to disciplinary action or fines at the federal or state level? Has it ever been fired by a client? These are important due diligence inquiries, and any attendant resource costs should be included in evaluating the total cost of the study.
As you can see, picking a cost segregation study partner should not be a snap decision. Rather, it requires due diligence and a cost/benefit analysis.