The Property Owner’s Guide To Cost Segregation Study Approaches
The IRS cost segregation guide describes six common cost segregation approaches. Learn more about these techniques and how they can affect your cost segregation study.
If you want to maximize depreciation on your income tax return, a cost segregation study is a must. To complete this study, a variety of cost segregation approaches may be used to accurately calculate asset costs for accelerated depreciation.
In this post, we’ll look at the different approaches to cost segregation that your cost segregation company may use to complete your study. And if you haven’t yet found a cost segregation company, make sure to check out our picks for the best cost segregation services.
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What Are Cost Segregation Approaches? The Quick Answer
An approach (or methodology) to cost segregation is the method used to allocate total project costs to property assets. These approaches rely on construction and cost documentation, estimates, sampling, or a combination of these things to accurately perform a cost segregation study.
While there are several well-known cost segregation approaches outlined in the IRS Cost Segregation Audit Technique Guide, the IRS does not require a specific method to be used for cost segregation studies.
Types Of Cost Segregation Methodologies
There are many different approaches to cost segregation. The IRS cost segregation guide describes six approaches that are most commonly used for cost segregation. Here’s a breakdown of these common approaches.
Detailed Engineering Approach From Actual Cost Records
The detailed engineering approach from actual cost records is typically the most accurate cost segregation approach. Also referred to as the direct cost method or detailed cost approach, this methodology uses actual cost records and documents for cost segregation. Few (if any) estimates are used in this approach.
Records to determine costs include but are not limited to:
- Vendor & supplier invoices
- Construction drawings
- Blueprints & plans
- Purchase orders
- Change orders
- Payment requests
- Job reports
- Bid documents
Using this methodology, steps taken by a cost segregation team include:
- Identifying assets that will be analyzed for cost segregation
- Acquiring information and documentation for all direct and indirect project costs
- Visiting the site (in person or remotely) to identify assets
- Taking photographs of assets
- Reviewing cost information and documentation
- Classifying assets (i.e., land, land improvements, personal property, etc.)
- Determining total cost basis of assets
- Assigning indirect costs to the appropriate assets
- Grouping assets based on recovery periods, dates placed in service, and class lives
Detailed Engineering Cost Estimate Approach
The detailed engineering cost approach (also known as the detailed estimate approach) uses estimated costs for cost segregation. Aside from using estimates instead of actual costs, this approach is very similar to the detailed cost approach.
Construction documentation (when available) is utilized in this approach, including:
- Job specifications
- Vendor & supplier invoices
- Purchase orders
- Change orders
- Job reports
When actual costs aren’t available, estimates are used. There are two ways of obtaining these estimates for cost segregation:
- Contractor estimates
- Estimate & appraisal guides (i.e., Marshall Valuation Service)
If a guide is used for estimates, all sources are referenced in the cost segregation report.
The steps for this approach are nearly identical to the steps taken during the detailed cost estimate approach, except for using estimated costs for calculations when actual costs aren’t available.
Survey Or Letter Approach
The survey or letter approach is another method used when estimates are needed for cost segregation. Through this approach, letters or surveys are sent to contractors and subcontractors to request information for specific assets that were installed on the property.
The survey or letter approach is only a way of getting cost information. This approach is used in conjunction with the direct cost method, the detailed estimate approach, or the residual estimation approach.
Residual Estimation Approach
The residual estimation approach is faster and simpler than the three options we’ve already covered. However, it also tends to have less accurate results.
The residual estimation approach only determines the costs of short-lived assets, such as assets that are depreciated over five or seven years. These costs are subtracted from the total cost of the project. The remainder is assigned to long-lived assets or the building itself.
Sampling Or Modeling Approach
The sampling or modeling approach to cost segregation uses a template or model to analyze the costs of multiple similar buildings. The buildings used for this sample are near-identical in appearance, construction, and how they are used. For example, if you own a restaurant, other restaurants of similar size and construction would be used to create a template or model to calculate costs.
This approach typically is performed by:
- Classifying properties by facility type, such as free-standing properties, leased properties, etc.
- Performing a cost segregation study based on the samples of each type of property classified in the previous step
- Developing a model for each type of property identified in step one
- Using each model to determine project costs on a percentage basis (i.e., 20% of project costs can be allocated to five-year depreciation)
This approach does have its flaws, as getting an accurate sample may be challenging due to differences in building costs, geographic location, and other factors.
Rule Of Thumb Approach
With the “rule of thumb” approach, little (if any) actual documentation is used. Instead, this method relies on the industry expertise of the person performing the study. Percentages will be used based on industry averages.
Because it does not rely on actual documentation, this approach should be used with caution.
Other Cost Segregation Approaches
The IRS identifies these cost segregation approaches as the most common, but these aren’t the only methods that can be used for cost segregation studies. Most other approaches are some variation or combination of the approaches outlined above.
The approach used for your cost segregation study may be outlined in your report. However, while some companies include a detailed methodology, others may simply provide a basic overview. If you’re curious about how the company you’ve hired (or potentially plan to hire) completes its cost segregation studies, don’t be afraid to ask.
Which Cost Segregation Approach Is Best?
The best cost segregation approach varies by property. For new commercial or investment property, the direct cost method (with or without integrating the survey or letter approach) is by far the most accurate. If you’ve acquired used property and don’t have all cost records, the detailed estimate approach is the next best option.
The sampling or modeling approach and the rule of thumb approach are both acceptable cost segregation approaches. However, these tend to be less accurate and should be used with caution.
Learn more about how cost seg calculation works with our free cost segregation calculator and calculation guide.