The acquisition of a building, construction of a new building, or expansion of an existing facility provides an opportunity to save significant tax dollars, if a cost segregation study is conducted.

The acquisition of a building, construction of a new building, or expansion of an existing facility provides an opportunity to save significant tax dollars, if a cost segregation study (CSS) is conducted.

A CSS accelerates tax depreciation, yielding a current – and often significant – tax benefit. Many companies that own real estate have missed out on current income tax savings by under-depreciating their real estate assets. A CSS can accelerate tax depreciation deductions, enabling companies that own real estate to realize tax savings that can be directly applied to the bottom line and improve overall cash flow.

For example, a high percentage of construction-related costs are too commonly classified into the building component of a property and depreciated on a straight-line basis over 39 years (the Internal Revenue Service required tax life). But this could mean lost tax benefits – as much as five percent or more of the total cost of the building.

Applying engineering and taxation principles to identify building components and construction costs, a CSS classifies these assets into shorter-lived categories that can be depreciated on an accelerated basis. In addition, construction-related soft costs have been historically lumped together as part of real property. By performing a CSS, however, these soft costs can be allocated to various components of the property, many of which have shorter depreciable lives than the real property component. The result? A faster write-off of costs previously included as real property.

Qualifying for a CSS
In determining whether your company may qualify for a CSS, consider these four fundamental questions:

• Can your company benefit from accelerating tax depreciation on your real estate holdings?
• Has your company purchased, constructed, or expanded your real estate holdings any time after 1986?
• Is the cost of real estate at least $1.5 million?
• Does your company expect to retain your real estate holdings for at least two or three years?

If you answered “yes” to the above questions, your property qualifies.

The Process
Specifically, a CSS is the process of reviewing and identifying the costs a company incurs to acquire existing properties; construct new facilities; expand or renovate its current facility; or fit-up a leasehold interest. This analysis of costs can be conducted from either the detailed construction records (when available) or by using qualified appraisers, architects or engineers to perform the cost analysis.

After providing an engineering-based cost segregation analysis that is performed by architectural and construction engineers, the next step is to carefully analyze the construction or acquisition costs to identify the amounts that can be allocated to specific asset categories with shorter depreciation lives than the building. The requisite evidence should be provided in the event the study ever comes under IRS scrutiny. A complete audit trial traces derived unit costs from contract documents and other source data. The next step is to allocate costs to the appropriate tax lives. These classifications to specific tax lives should be based upon the IRS code, U.S. court cases, revenue rulings and revenue procedures.

It is crucial that professionals with requisite knowledge of the tax laws and the IRS guidelines conduct a CSS. These experts should have expertise in construction and project design, from both an engineering and tax perspective, in order to perform a CSS.

Ideal Timing
For newly constructed property, the ideal time for a CSS is during a project’s planning phase. By conducting the study at this point, the contractor can isolate and record qualifying costs as they occur. This approach provides the greatest level of detail to support cost classifications.

For a previously purchased or constructed property, a company has the chance to play catch-up. A CSS can be performed many years after the property was placed in service, as long as the results of the study are included in the current year’s tax return.  

Current IRS rules allow the catch-up of missed depreciation deductions on properties acquired many years ago by filing an automatic change in accounting form with their current year’s tax return. The missed deductions from the prior years are all caught up and deducted in the current year. No amended returns are required to obtain this extraordinary benefit.

The Savings
CSSs have generated millions of dollars in current federal and state income tax savings to real estate owners. Savings anywhere from $100,000 to $1 million or more are common. The savings resulting from a CSS are dependent on the type and size of the property, the cost of the property, and the year it was placed in service.

The IRS has acknowledged the validity of cost segregation studies. A legal memorandum issued by the IRS indicates that “an accurate cost segregation study may not be based on noncontemporaneous records, reconstructed data, or taxpayer’s estimates or assumptions that have no supporting records.” This further emphasizes the importance of having a CSS conducted by qualified professionals; professionals who are able to comply with the IRS-issued Cost Segregation Audit Techniques Guide, which was developed to assist examiners in the review and examination of cost segregation studies.

Studies have been effectively performed for a multitude of properties, including apartments, office buildings, manufacturing facilities, restaurants, hotels and medical facilities. As a result, many taxpayers make CSS a regular part of their property purchasing process. Almost every type of real estate can benefit from a CSS. The greater the depreciation deductions today, the greater the present tax savings. And the greater the present tax savings, the greater the present cash flow, which in turn can be used to underwrite future acquisitions.

David A. Grant  is director of J.H. Cohn’s Cost Segregation Study Services Group and has been performing cost segregation studies since 1998. Grant has authored numerous articles and lectures nationally on the subject. He can be reached at This e-mail address is being protected from spam bots, you need JavaScript enabled to view it or 973-403-6905.