IRS ITG Audit Techniques Chapter 4

Chapter 4 – Principal Elements of a Quality Cost Segregation Study and Report

Note: Each chapter in this Audit Techinques Guide (ATG) can be printed individually. Please follow the links at the beginning or end of this chapter to return to either the previous chapter or to proceed to the next chapter or select a chapter from the Table or Contents on the left of this page.

INTRODUCTION

As discussed in the last chapter, there are no standards for cost segregation studies. Thus, examiners will encounter a wide variety of studies and reports, as well as documentation. For example, some studies will be very brief. Other studies may be quite voluminous and complex. Regardless of the length of a study or the methodology used, a cost segregation study and report should always:

1. classify assets into property classes (e.g., land, land improvements, building, equipment, furniture and fixtures);
2. explain the rationale (including legal citations) for classifying assets as either § 1245 or § 1250 property; and,
3. substantiate the cost basis of each asset and reconcile total allocated costs to total actual costs.

WHAT IS A “QUALITY” COST SEGREGATION STUDY?

A “quality” cost segregation study is a study that is both accurate and well-documented with regard to the three points above. Quality studies greatly expedite the Service’s review, thereby minimizing audit burden on all parties. A quality study contains a number of characteristics, which are set forth below.

PRINCIPAL ELEMENTS OF A QUALITY COST SEGREGATION STUDY

The 13 principal elements of a quality study are:

1. Preparation By An Individual With Expertise And Experience
2. Detailed Description Of The Methodology
3. Use Of Appropriate Documentation
4. Interviews Conducted With Appropriate Parties
5. Use Of A Common Nomenclature
6. Use Of A Standard Numbering System
7. Explanation Of The Legal Analysis
8. Determination Of Unit Costs And Engineering “Take-Offs”
9. Organization Of Assets Into Lists Or Groups
10. Reconciliation Of Total Allocated Costs To Total Actual Costs
11. Explanation Of The Treatment Of Indirect Costs
12. Identification And Listing Of Section 1245 Property
13. Consideration Of Related Aspects (e.g., IRC § 263A, Change In Accounting Method And Sampling Techniques)

Preparation By An Individual With Expertise And Experience

The preparation of cost segregation studies requires knowledge of both the construction process and the tax law involving property classifications for depreciation purposes. Unfortunately, there are no prescribed qualifications for cost segregation preparers. However, a preparer’s credentials and level of expertise may have a bearing on the overall accuracy and quality of a study.

In general, a study by a construction engineer is more reliable than one conducted by someone with no engineering or construction background. However, the possession of specific construction knowledge is not the only criterion. Experience in cost estimating and allocation, as well as knowledge of the applicable law, are other important criteria.

A quality study identifies the preparer and always references his/her credentials, experience and expertise in the cost segregation area.

Detailed Description Of The Methodology

Chapter 3 discusses the most common methodologies used in preparing cost segregation studies. However, an actual study may be based upon a variation or combination of methods and, in fact, may not even identify by name the method used.

A quality study always describes the methodology that was used and details the steps that were taken to classify assets and determine costs.

Use Of Appropriate Documentation

A quality study uses contemporaneous documentation to classify assets and determine costs. Documentation supporting a quality study will vary, depending on whether a property is new or used or whether original construction documents are available. The documentation in a quality study for both new and used properties is detailed below.

• New Construction
  • Allocation of Land and Land Development Costs
    A quality study explains the treatment of land and land development costs, (e.g., roads, sewer lines, storm drains, utility mains, survey and subdivision costs). Generally, these costs are allocated to non-depreciable land accounts. Also included in this account are the costs of improvements or land that are transferred to a local municipality (to obtain approval for subdividing or for a change in use).
  • Site Visit
    A quality study includes a site visit to gain a better perspective and understanding of the design and purpose of the project, as well as the use of specific assets. Before-and-after photographs are used to establish land and site preparation costs (i.e., surveying, clearing, grubbing, general grading and compaction).
  • Blueprints, Construction Drawings And Contract Payments
    • A quality study reviews all pertinent construction documentation. The taxpayer’s capital expenditure request is reviewed to ascertain the intended functional use of a building and other assets included in the project. Site, architectural, and engineering plans, as well as “as-built” drawings, blueprints and bid documents, are all reviewed and referenced in a quality study. The specific assets deemed to be § 1245 property are clearly highlighted or otherwise identified on the “as-built” drawings. Project specifications are analyzed to determine conformity to the blueprints. Purchase and change orders are also reviewed to ascertain cost information, changes in costs, and details of the work performed.
    • A quality study reviews The General Contractor’s Applications for Payment (AIA Forms G-702 and G-704) to ascertain what was actually paid for during construction. In addition, subcontractor payment applications, as well as invoices paid for items outside the scope of the general contractor’s work, will be reviewed to provide greater insight and detail of the construction. Actual or estimated costs are cross-referenced to the supporting documentation.
• Acquired or Used Properties
  Unlike cost segregation studies performed on newly-constructed property, those performed on acquired or used property will likely be based on estimates and/or reconstructed costs.
  • Purchase Price Allocations
    A quality study documents how purchase price was allocated between land, land improvements, building and other assets. Land value is always determined first and is based on “highest and best use.” In simple terms, highest and best use means the probable use of land that results in its highest value. The balance of the purchase price is then allocated to the building and to other assets.
  • Addresses Physical Deterioration and Functional Obsolescence
    The lack of cost records and the age of a property add to the uncertainty in determining its value or cost. In making this determination, a quality study always accounts for the physical deterioration and functional obsolescence of assets. It also provides the documents and the corroborating evidence used to determine values or costs.
  • Site Visit
    As for new construction, a quality study includes a site visit, as well as photographic evidence, to assist in identifying the assets and in determining the allocations of values or costs.
  • Review of Purchase or Lease Agreements and Appraisals
    When original construction documents are not available, a quality study will support its allocations by using other corroborating evidence (e.g., purchase/lease agreement, appraisals). A quality study will review the purchase agreement as a first step. If the property is leased, the lease agreement will be reviewed and documented. A quality study will also review any appraisals, if applicable. The availability of historical construction records will also be addressed in a quality study (i.e., if these are not available, the study will indicate what efforts were made to obtain these records).

Interviews Conducted With Appropriate Parties

Interviews with contractors and subcontractors, as well as with taxpayers and property managers, are quite valuable in ascertaining the specific use of a property and the construction process involved. A quality study documents all interviews conducted with appropriate parties, thus adding credibility to the depth and accuracy of its study. However, the examiner should recognize that subcontractor work details can be difficult to obtain since taxpayers generally have had no direct contact with them. In addition, general contractors may also be reluctant to share certain information because of confidentiality (e.g., profit margins).

Use Of A Common Nomenclature

The use of creative or misleading nomenclature to describe property items, rather than common and clearly understood terms, detracts from the quality of a study. “Creative” descriptions may be used to disguise the true nature or character of an asset (e.g., a building sewage or water piping system referred to as “process piping”; an emergency exit sign termed “decorative placard”).

A quality study always uses terminology consistent with the blueprints and other project documents (e.g., contract specifications, pay requests, etc.). The use of common and clearly understood terms facilitates Service review and avoids the confusion caused by misleading terms.

Use Of A Standard Numbering System

The use of a standard numbering system, such as the Construction Specification Institute (CSI) Master Format Division, is helpful but not mandatory. A quality study numbers assets consistent with the contract bid documents and pay requests. This numbering system facilitates classifying property for computing depreciation and thus expedites the Service’s exam.

The CSI format categorizes costs by specific building systems or components, such as concrete, carpentry, metals, woods and plastics, mechanical, electrical, and lighting. Other typical groupings of assets may include land, land improvements, furniture and fixtures, electrical systems, plumbing systems, equipment, etc. Refer to Appendix Chapter 6.6, which provides a more detailed discussion of standard numbering systems.

Explanation Of The Legal Analysis

A quality study contains a thorough legal analysis, including relevant citations, to support its § 1245 property classifications. While the treatment of some items may be fairly clear based on consistent judicial decisions, there are many instances in which court decisions may appear to be contradictory or to which the Service has not acquiesced. These apparent contradictions generally reflect the intensely factual basis that underlies the proper classification of property. As might be expected, the proper classification of property is the source of much audit controversy.

The legal discussion in a quality study recognizes these contradictions and attempts to reconcile them to the specific facts and circumstances of the property at issue. An accurate analysis of the statutes and judicial precedent adds to the overall quality of a study and facilitates the Service’s review.

Determination Of Unit Costs And Engineering “Take-Offs”

Once property items or assets have been identified and assigned to property classes (e.g., building and personal property), their respective costs must be determined. In order to determine a cost for each unit or class of property in a project or component system, total project costs (or total component system costs) must generally be broken down. This breakdown process is commonly known as engineering “take-offs”.

In a quality study, engineering “take-offs” are carefully documented to show derived unit costs, and individual property units are clearly identified or highlighted on the “as-built” blueprints. For new construction, the cost of property items in an engineering take-off can generally be obtained from actual cost records. However, when actual costs are not available, costs must be estimated.

Cost estimates can vary widely depending on which estimating guide is used and whether costs are for “high” or “low” quality construction. In a quality study, cost estimates are always reconciled to an acquisition price, a total project cost, or to a component system cost to ensure the accuracy of an allocation. The proper use of an estimation technique is another frequent source of audit controversy. A quality study minimizes this controversy by clearly explaining and documenting the methodology used to assign costs to each asset.

Organization Of Assets Into Lists Or Groups

Typically, a study lists assets by recovery period (e.g., land, land improvements, furniture and fixtures, electrical systems, plumbing systems, equipment). A quality study’s asset listings tie to a taxpayer’s fixed asset ledger, which also facilitates the Service’s review.

Reconciliation Of Total Allocated Costs To Total Actual Costs

It is important that the same estimating technique be used on all of the items that reconcile to a purchase price, a project cost, or to a particular component cost. If different methods or cost guides are used on different property items (e.g., one method for tangible personal property and a different method for the building), cost distortions arise. A quality study always reconciles total allocated costs to total actual costs in order to ensure the accuracy of its allocations.

A quality study also considers and lists separately-acquired § 1245 property to prevent possible duplication. For example, if the total project cost includes furniture, fixtures and equipment (FFE), then it is appropriate to allocate costs to those items. However, if FFE is acquired separately and not included in the total project cost, then it is not appropriate to assign costs to FFE.

Explanation Of The Treatment of Indirect Costs

A quality study lists all the costs associated with a particular project, including both direct and indirect costs, and explains the treatment of any indirect costs. Direct costs are the labor and material costs for specific items or assets. Indirect costs, also referred to as “allocables,” are intangible costs that are incident to the construction of a facility. Indirect costs must be allocated proportionately to the basis of the specific assets to which they relate.

Indirect costs also include expenditures that should not be allocated to the entire project but rather assigned to the property class to which they relate. Costs to survey and subdivide land, grade the land to prepare a building pad, and construct offsite improvements are generally allocable only to land. On the other hand, costs for building permits, general conditions, and contractor overhead and profit are typically allocated to assets on a pro-rata basis.

Generally, indirect costs do not relate to the placement of business machinery, or furniture and fixtures since these assets are typically purchased and installed under separate contracts. However, indirect costs that specifically relate to components of personal property may be assigned to § 1245 property. For example, costs for special consultants (e.g., for computer wiring and process engineering) or costs to design the computer system may be assigned directly to that system. In addition, it may be reasonable to allocate certain indirect costs, such as liability insurance, bonds, and overhead/profit, where it can be shown that the total amount of the indirect costs is based upon the pro rata cost of each class of property.

The treatment of indirect costs is another area of frequent controversy. A quality study explains the purpose of each indirect cost, describes its allocation, and explains any deviations from commonly accepted practice.

Identification And Listing Of Section 1245 Property

A quality study lists § 1245 property (including amounts) and shows any § 1250 property reclassified to § 1245 property.

Consideration Of Related Aspects (i.e., IRC § 263A, Change in Accounting Method and Sampling Techniques)

A quality study addresses related aspects, such as IRC § 263A, change in accounting method, and sampling techniques.

The uniform capitalization (UNICAP) rules of § 263A(a) require the capitalization of all direct costs and certain indirect costs allocable to real property and tangible personal property produced by the taxpayer. Self-constructed assets and property built under contract are treated as property “produced” by the taxpayer. Furthermore, § 263A(f) requires the capitalization of certain interest expense incurred in connection with the production of property.

Although the courts have not uniformly agreed, it is the position of the Service that a change in depreciation method, recovery period, or convention for depreciable property constitutes a change in accounting method. Therefore, the use of a cost segregation study to reclassify property and/or reallocate costs requires the consent of the Commissioner. Please refer to Appendix Chapter 6.2 for more information regarding the current status of this issue.

Studies may utilize sampling techniques when taxpayers have a large number of substantially similar properties, such as retail or food stores. Studies may use such techniques as statistical sampling, modeling, or judgmental sampling.

When conducted properly, statistical sampling can be a reliable technique. However, improper sampling techniques may result in a final answer that does not accurately reflect a valid estimate. Factors addressed in a quality study’s sampling technique include the definition of the population being sampled, the size of the population, a description of any stratification techniques, and the consideration of sampling error.

A modeling approach may also be used to segregate property costs. This approach uses created models to approximate the different types of units involved. If the models are properly analyzed, then this method may be reasonably accurate when applied to the entire population. However, as discussed in Chapter 3, the delineation of strata may be difficult and is often an area of controversy. Furthermore, issues may arise as to whether the sampling method is statistically valid.

Some studies may rely solely on a judgmental sampling technique, which carries a higher level of risk due to the elements of subjectivity involved. A judgment sample is typically selected on the basis of perceived similarities and is not statistically valid. However, under certain, limited circumstances, the use of a judgment sample may be appropriate. In such a case, the underlying basis for the selection of particular units in a judgment sample must be rational and supported by adequate data.

A quality study addresses these related audit issues and comments on the treatment of these items for tax purposes, especially where the amounts are restated for prior tax years.

PRINCIPAL ELEMENTS OF A QUALITY COST SEGREGATION REPORT

A cost segregation report reflects a study’s methodology and conclusions. The amount of detail included in a report varies considerably since there is no standard or prescribed format. The following elements are found in a quality report.

1. Summary Letter/Executive Summary
   A quality report contains a summary to identify: the preparer, the date of the study, the taxpayer (or client), the subject property, and the property components classified as land, land improvements, building, or personal property.
2. Narrative Report
   A quality report discusses the theory, definitions and the rationale behind the study in the narrative section. This section generally includes a more detailed description of the property/facility (i.e., a physical description and an explanation of the use for which it is intended, as well as a legal description of the property and its location). In addition, the narrative section highlights the regulations, rulings and court cases that support classifying assets as § 1245 property. The narrative also discusses the types and sources of data used (e.g., cost records, contracts, purchase agreements, published estimates) as well as how they were used. A list of potential data sources is included in Appendix Chapter 6.6.
3. Schedule Of Assets
   A quality report has a schedule of assets that are the focus of the study. Generally, this schedule ties directly to the taxpayer’s depreciation records. When a taxpayer reallocates costs of assets already “on the books,” a quality report clearly identifies the specific assets impacted (and includes depreciation records from both before and after the reallocation).
4. Schedule Of Direct and Indirect Costs
   A quality report lists all direct and indirect costs associated with a project. Indirect costs allocated to § 1245 property are clearly identified and explained. Separately-acquired assets are listed and discussed in the report to avoid duplication errors. Costs subject to IRC § 263A are also addressed.
5. Schedule Of Property Units And Costs
   A quality report provides a schedule of property units and costs (with property descriptions) that are segregated into land, § 1245 property, and § 1250 property. This schedule is the final product of the study and serves as the basis for computing depreciation.
6. Engineering Procedures
   A quality report describes the engineering procedures and methodology for determining the cost of each property unit. It also identifies the specific taxpayer records that were reviewed and discusses whether actual cost records or estimating techniques were utilized to break costs into smaller components. A record of inspections and/or interviews is included as well. The use of a common nomenclature or a standard numbering system is also referenced and/or explained.
7. Statement Of Assumptions And Limiting Conditions
   A quality report describes the general understanding and conditions applicable to the report. This information may also provide an indication of the overall quality of the study.
8. Certification
   A quality report certifies that the person who signed the report actually developed the analysis, opinions, and conclusions of the report. This section may also include the resume’ or state the credentials and/or level of experience of the preparer.
9. Exhibits
   A quality report generally includes various exhibits, such as the “Client Cost Sources” and the “Cost Source Reconciliation.” These exhibits show the “book” (accounting) records on which the preparer relied in deriving total costs, and may include a reconciliation of the study to the fixed asset ledger. Photographs and/or videos may also be included as exhibits to assist in understanding the assets in the study.

SUMMARY AND CONCLUSIONS

This chapter described the principal elements of a “quality” cost segregation study and report. The degree to which a cost segregation study/report conforms to these elements will likely dictate the scope and depth of an examination. As is clear in Chapter 5, “Review And Examination Of A Cost Segregation Study,” a quality study and report will expedite the exam process and, ultimately, minimize audit burden on taxpayers, practitioners and examiners alike.