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 must be separated into individual components or asset groups having the same recovery periods and placed-in-service dates in order to properly compute depreciation.
What is Cost Segregation:
When lumpsum cost of a project is known, 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.”
Two important things to note in a cost segregation study:
1. Rationale used to segregate property into its various components and
2. Method used to allocate the total project costs among these components.
Benefits of Cost Segregation:
The most common situation is the allocation or reallocation of building costs to tangible personal property. A building, termed “section (§) 1250 property”, is generally 39-year property eligible for straight-line depreciation. Equipment, furniture and fixtures, termed “section (§) 1245 property”, are tangible personal property. Tangible personal property has a short recovery period (e.g., 5 or 7 years) and is also eligible for accelerated depreciation (e.g., double declining balance). Thus, a faster depreciation write-off (and tax benefit) can be obtained by allocating property costs to § 1245 property, or by reallocating § 1250 property costs to § 1245 property.
Cost Segregation Methods:
Neither the Service nor any group or association of practitioners has established any requirements or standards for the preparation of cost segregation studies. The courts have addressed component depreciateion, but have not specifically addressed the methodologies of cost segregation studies. So there is no standardized method to use. Various methodologies are utilized in preparing cost segregation studies, including:
1. Detailed Engineering Approach from Actual Cost Records
2. Detailed Engineering Cost Estimate Approach
3. Survey or Letter Approach
4. Residual Estimation Approach
5. Sampling or Modeling Approach
6. “Rule of Thumb” Approach
Though there is not standardized method, generally the IRS documents emphasize that the determination of § 1245 property must be factually intensive and must be supported by corroborating evidence.