What is Considered a Quality Cost Segregation Study?

[Julio Gonzalez]

As most of you know, as part of the IRA, the IRS was allocated significant funds to hire new employees. With that comes an increased audit risk. One of the things that IRS auditors look for when auditing a cost segregation study is that it is a "quality" cost segregation study. But what exactly determines if the study is considered to be "quality"?

The IRS defines a “quality” cost segregation study as “a study that is both accurate and well documented with regard to” 1) the classification of property into classes, 2) Explanation of rationale for the classification of the property and 3) substantiation of the cost basis of each asset and reconciliation of the total allocated costs to total actual costs. Additionally, the study should contain 13 principal elements.

Those 13 elements are:

1. Preparation by an individual with expertise and experience.
   1. While there are no specific qualifications for the cost study preparer, they should be knowledgeable of both the tax laws for property classifications and the construction process. The study should identify the preparer and have reference to their credentials, expertise and experience.
2. Detailed description of the methodology
   1. Here is an article explaining the different methodologies utilized in a study. A study may utilize one methodology or a combination of multiple. The study should describe the methodology and the steps taken to determine costs and classify assets.
3. Use of appropriate documentation
   1. The documentation varies depending on if the property is new or used construction. The study should explain the land and land development costs. The study should review blueprints, construction documents, specifications, contractor payments, construction drawings, purchase/lease agreements and appraisals. The study should explain the allocation of the purchase price between the land, land improvements, building and other assets. It details physically deteriorated or obsolete assets as well as the value or cost.
   2. A quality study includes a site visit.
4. Interviews conducted with appropriate parties
   1. Interviews with property managers, tax payers, contractors and subcontractors can be very valuable in determining the construction process and specific use of the property. It can add credibility to the accuracy and depth of the study. The study should document all interviews conducted.
5. Use of a common nomenclature
   1. The terms utilized in the study should be clearly understood and common and must not be “creative” or misleading to try to disguise the true nature of an asset. The study should use terms that are consistent with the blueprints or other project documents.
6. Use of a standard numbering system
   1. A standard numbering system such as the Construction Specification Institute (CSI) Master Format Division should be utilized. The study should number the assets consistent with the pay requests and contract bid documents.
7. Explanation of the legal analysis
   1. Proper classification of property is a big audit controversy. The study should include a legal analysis that documents relevant citations to support the property classifications.
8. Determination of unit costs and engineering “take-offs”
   1. To determine the cost of the assets, the total project costs need to be broken down (referred to as “take-offs). If the property is new construction, the study should document how the unit costs were derived and the individual property units should be highlighted or identified on the blueprints. If the actual costs are not available and thus must be estimated, the study needs to clearly document and explain the methodology that was utilized to assign costs to each asset.
9. Organization of assets into lists or groups
   1. Studies typically list the assets by the recovery period. It should also tie to the taxpayer’s fixed asset ledger.
10. Reconciliation of total allocated costs to total actual costs
    1. The study should utilize the same estimation method for all assets and they should reconcile to a project cost, purchase price or a particular property cost. If assets were acquired separately (such as furniture), the total project cost should not be allocated to these assets.
11. Explanation of the treatment of indirect costs
    1. Indirect costs may be allocated to the entire project, a property class or a specific asset depending on the nature of the cost. For example, the cost to survey the land would typically only be allocated to land. Other costs such as contractor overhead, building permits, etc. may be allocated to all assets on a pro-rata basis. The study should include a list of both direct and indirect costs and explain the purpose of the individual indirect costs and a description of the allocation.
12. Identification and listing of 1245 property
    1. The study should list all 1245 property and amounts as well as property that was originally 1250 property and was reclassified to 1245 property.
13. Consideration of related aspects (such as a change in accounting method and/or sampling techniques.
    1. If sampling techniques are utilized, the study should include the population definition, population size, sample error consideration and description of techniques. The study should all address any potential audit related issues for the tax treatment of these items, especially if the amounts were restated for prior years.