Glossary

Audit Techniques Guide

The United States Internal Revenue Service (IRS) published its Audit Techniques Guide as the governing document for the Cost Segregation methodology of depreciating real estate.  In their own words, “The purpose of this ATG is to provide the foundation to a better understanding of cost segregation studies and to provide the examination steps that will facilitate the audit process and minimize burden on taxpayers, practitioners and Service examiners alike.”

Cost Segregation – A Short Answer

Cost Segregation is a detailed cost analysis of real estate and its improvements.  An accelerated federal depreciation schedule is created from the costs and can result in substantial increases to near term cash flow and net present value tax savings.  The strategic methodology can be performed at any time during the life of a property, including liquidation, and yield strong results.

Cost Segregation – A Longer Answer

Commercial Real Estate or Real Property as a whole is rigidly assigned lengthy depreciable class lives such as 39 years by the Internal Revenue Service (IRS) and is accepted by many state tax commissions.  Cost segregation is a specific methodology of accelerating the separate components of the same real estate into the more appropriate and financially attractive depreciable class lives of 5, 7, or 15 years.  The cost segregation method of depreciation is sanctioned widely by the IRS and independent GAAP auditors; however, its application requires a specialized documentation referred generically as a Cost Segregation Study and Report.  

The cost segregation document is extensive in nature and includes a detailed cost analysis of a subject building’s structural components and its improvements.  The process begins with construction engineers and estimators performing a site inspection of the property, and also a review of documents such as construction plans and specifications, purchase contracts, bank statements, etc. as they are available.  The collected data is organized into cost schedules or lists of identified building components which are then assigned new depreciable class lives of 5, 7, or 15 years, or the same 39 years.  The document also includes corroborating evidence of why each component qualifies for the accelerated method.  This evidence is based on several prevailing statutes and regulations, and also current case law.  While a single statute that emphatically defines the class life of each building component does not exist, the IRS publishes its Cost Segregation Audit Techniques Guide, which reins as the prevailing authority on the method.

The positive results of Cost Segregation are many; with the primary benefits of applying the methodology being (1) a dramatic Federal and State taxable income reduction that results in substantial near term cash savings and (2) a positive net present value gain on the annual tax savings over the life of the property, (3) the depreciable lives of the building components are more consistent and reflect their true useful lives, impacting tax consequences at the time of the property’s liquidation. 

Depreciation

A federal and state income tax deduction against ordinary income that allows a taxpayer to recover the cost of a property over a period of years known as its Class Life.  Generally, class lives for buildings are rigid and lengthy such as 39 years or 27.5 years.  Methods for calculating depreciation are detailed thoroughly in IRS Publication 946, How to Depreciate Property.  Ask us for a comparison of depreciation methodologies.

Recapture

An IRS procedure for collecting income tax when a taxpayer disposes or liquidates a property that previously provided an offset to ordinary income through depreciation.  The recapture procedure of the IRS applies regardless of the depreciation method that has been applied, including the Cost Segregation method, or if in fact a depreciation method has been applied at all.  Misguided application of recaptured depreciation under any depreciation methodology can result in undesirable tax consequences at the time a property is sold.  The calculation of recapture depreciation can be more straightforward and manageable if completed in connection with the Cost Segregation methodology of depreciation.  Ask us for an explanation or preliminary calculation.

Segregated Liquidation

The application of the Cost Segregation methodology of depreciation at the time a property is sold, providing cash and tax benefits to the seller.  Ask us to estimate your potential benefits and show you the concept.