History of Cost Segregation
The Brief History of Cost Segregation
The legislation and procedures used in an engineering based cost segregation study have been in existence since the enactment of the Investment Tax Credit (ITC) in 1962. When the act was repealed in 1986, many assumed that cost segregation studies provided no further benefit under the new tax law. However, in a landmark 1997 tax court case, Hospital Corporation of America successfully defended the application of engineering-based cost segregation as a viable method to differentiate real and personal property under existing tax law. This landmark case continues to be the cornerstone of cost segregation studies today.
Developments That Shaped Modern Cost Segregation Studies
In the past several years, a number of rulings have been issued by the government to spur economic growth. These can have a major impact for building owners with previous construction or acquired properties.
– In 2001 the government allowed taxpayers to catch up on all deductions from previous years for items reclassified into shorter tax lives as a result of a cost segregation study. (Rev. Proc. 2002-19). Previously, this beneficial adjustment had to be spread out across four years. Now it can be expensed entirely in the year of the change, reported as a reduction to current year taxable income.
– In 2002 the IRS consented to automatically allowing changes in the method of depreciation via Form 3115 and filed with the return in the year the change is elected. This simplifies the process of changing the method of depreciation to account for a cost segregation study without the nuisance of an amended return.
– In 2004 the IRS reversed the two-year waiting period required to change the method of calculation for depreciation on real property (Rev. Proc. 2004-11) allowing the method of depreciation to be changed in any given year.
Cost Segregation Awareness
While most accounting professionals have a rudimentary understanding of the 5, 7 and 15-year property classifications, few have a detailed understanding of this highly specialized niche. Most accountants are aware of cost segregation as an option to increase depreciation and reduce current federal taxes, but believe it is very expensive and is financially feasible only for large properties. The execution rate for cost segration is under 10% because of limited knowledge by many property owners and accountants. In addition, there are misconceptions regarding the cost of obtaining these studies and the size properties for which cost segregation studies are financially feasible. As awareness of the practice increases among real estate investors and accountants, the implementation rate is rapidly increasing.
Court Cases and Publications That Created Modern Cost Segregation
1959 – Shainberg vs. Commissioner:
The courts ruled (and the IRS subsequently agreed) on the validity of Cost Segregation for tax depreciation on buildings.
1973 – Revenue Ruling 73-410:
This Cost Segregation ruling clarified that a taxpayer may separately depreciate parts of used property if a qualified appraiser ‘properly allocates the costs between non-depreciable land and depreciable building components as of the date of purchase.
1975 – Whiteco Industries, Inc. vs. Commissioner:
The Tax Court, based on an analysis of judicial precedent, developed six questions designed to ascertain whether a particular asset qualifies as tangible personal property.
1986 – Investment Tax Credit (ITC):
ITC is repealed and the new MACRS recovery periods for building depreciation are increased dramatically for property placed in service after 1986.
· Residential property: increased to 27 1/2 years
· Commercial property: increased to 31 1/2 years and increased again to 39 years in 1993<
1987 – Revenue Procedure 87-56:
The wide gap in MACRS recovery periods provides a strong incentive to reallocate costs of buildings placed in service as far back as 1/1/1987. Revenue Procedure 87-56 provides class lives and recovery periods for assets.
1997-1999 – Hospital Corporation of America vs. Commissioner (HCA):
The most recent landmark case that provides legal support to use Cost Segregation Studies for computing depreciation.
1999 – In Action on Decision (AOD) #CC-1999-008:
The IRS acquiesced to the application of ITC principles in the HCA case. Later that year, the IRS Chief Counsel issued further guidance (CCA 19992145) supporting the use of Cost Segregation Studies.
2004 – IRS Issues Audit Techniques Guide:
Outlines the criteria of a quality Cost Segregation Study and provides direction to IRS field agents when reviewing a report that does not employ the methods suggested in the Audit Techniques Guide.