COST SEGREGATION STUDY
In order to calculate depreciation for Federal income tax purposes, taxpayers must use the correct method and proper recovery period for each asset or property owned. Property, whether acquired or constructed, often consists of numerous asset types with different recovery periods. Thus, property is typically separated into individual components or asset groups having the same recovery periods and placed-in-service dates to properly compute depreciation. When the actual cost of each individual component is available, this is a rather simple procedure. However, when only lump-sum costs are available, cost estimating techniques may be required to "segregate" or "allocate" costs to individual components of property (e.g., land, land improvements, buildings, equipment, furniture and fixtures, etc.). This type of analysis is generally called a "cost segregation study," "cost segregation analysis," or "cost allocation study."
In recent years, an increasing number of taxpayers have submitted either original tax returns or claims for refund with depreciation deductions based on cost segregation studies. The underlying incentive for preparing these studies for Federal income tax purposes is the significant tax benefits derived from utilizing shorter recovery periods and accelerated depreciation methods (including bonus depreciation and Internal Revenue Code (IRC) § 179 deduction) for computing depreciation deductions. The prevailing issues for Service examiners include obtaining an understanding of the rationale used to segregate property into its various components, and the methods used to allocate the total project costs among these components.
Cost segregation studies are most commonly prepared for the allocation or reallocation of building costs to tangible personal property. A building, termed "§ 1250 property", is generally non-residential real property (39-year) or residential rental property (27.5-year) property eligible for straight-line depreciation. Equipment, furniture and fixtures, termed "§ 1245 property", are tangible personal property. Tangible personal property has a shorter recovery period (e.g., 5 or 7 years) and is also eligible for accelerated depreciation (e.g., double declining balance, bonus depreciation and § 179 deduction). Therefore, a faster depreciation write-off (and tax benefit) can be obtained by allocating property costs to § 1245 property.
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