Cost Segregation Studies and Reports

[Bernard Reisz]

Your input is valuable: How do you want your Cost Seg study prepared?

For context, let's cover some Cost Segregation fundamentals, and explain the interaction between Land Value and Cost Segregation:

Cost Segregation is the process of (a) segregating a "building" into its component parts and (b) allocating the lump-sum acquisition cost to those components. Hence the term, Cost Segregation Study.

Incredibly large tax deductions are created because many of those components are short-life assets, depreciable at a far faster rate than residential or commercial buildings that are depreciated over 27.5 and 39 years, respectively. And, ever since enactment of TCJA, much of that could be immediately depreciated as "Bonus Depreciation." (Bonus Depreciation is now gradually fading away.)

Question: How much of your total acquisition cost is the subject of a Cost Seg study? How much of the acquisition cost is part of the engineering allocation?

Answer: It is the total purchase price minus the portion of the purchase price that is properly allocable to the land, which is not depreciable.

While land allocation is not part of the Cost Seg engineering work, the final Cost Seg Report - that includes specific dollar cost allocations for components and a depreciation schedule - incorporates a land value allocation. A higher allocation to land results in less cost allocable to depreciable assets (i.e., lower tax deduction claimed). A lower land allocation results in more cost allocated to depreciable assets (i.e., higher tax deduction claimed).Of course, the IRS has a thing or two to say about how land allocation is properly determined. This is something that some of the great Real Estate CPAs of BP have posted about, in-depth. 

CPAs, EAs, Accountants, Real Estate Investors, Equity Raisers, Tax Professionals (or anybody that's got an opinion):

What default land allocation assumption would you like to see incorporated into Cost Segregation Reports, yours or your clients?

[Michael Plaks]

Thanks for triggering one of my (many) pet peeves, @Bernard Reisz.

To answer your specific question - what fixed % do I, as a tax accountant, want to see assigned to land on cost seg reports? The answer is: none. Fixed % to land is plain wrong, as has been explained at length on many past BP threads, for example this one: https://www.biggerpockets.com/...

1. Why cost segregation?

Let's discuss the broader issue of what I do and do not want from a cost seg report. We'll start with the non-segregated depreciation example. An investor buys a $200k rental house. Using one of the allocation methods described on the thread I linked above, he determines that the land value is $40k. (Once again, a fixed 80/20 formula does not qualify as an acceptable method - see the linked thread.)

What the investor has now is $40k of non-depreciable land and $160k of a building depreciable over 27.5 years. Result: $6k depreciation deduction per year. Easy to understand and set up but not optimal. Hence the cost seg is brought in. 

Cost seg company surveys the property - or makes up the numbers, whatever they prefer ;) - and comes up with the following conclusions:

- there's $30k of 5-yr "personal property" in that house

- there's $10k of 7-yr "personal property" in that house

- there's $25k of 15-yr "land improvements" in that house

After the dust settles, the investor has an immediate $65k depreciation deduction and feels like Rihanna on Super Bowl stage. Unless his deductions are restricted, but it's a totally different topic, much discussed on this forum, for example here: https://www.biggerpockets.com/...

2. What the cost seg company wants to provide the investor

To generate the most love (and referrals) from the investor, the company wants to give the investor a complete depreciation schedule:

- $30k of 5-yr and 100% bonus

- $10k of 7-yr and 100% bonus

- $120k of 27.5 yr

- $25k of 15-yr and 100% bonus

- $15k non-depreciable 

Neat and impressive. Open the champagne.

3. Why the CPAs do NOT want this - first reason

No, not because the investor can now self-prepare his taxes on TurboTax. We're not worried. We can charge him more to fix his mess later anyway. :)

The main reason is the cursed land allocation. Formulas like 80/20 or 75/25 or 90/10 are convenient but wrong, as already mentioned above. Correct land allocation requires work. Who is going to do this work? Normally, the investor or his Realtor or his appraiser or his CPA. 

Can the cost seg company do it? They can, but it's not their job or their licensing. They would need to pull and analyze comps, and they are not going to bother. There're several cost seg representatives on this forum. Raise your hand if your company actually pulls comps and determines land allocation by analyzing these comps. Right, didn't think so.

All they will typically do is either apply the county assessment, which is often wrong and not beneficial to the investor - or apply the shortcut fixed % formula. Responsible CPAs will not accept these shortcuts.

To clarify: I'm not attacking cost segregation strategy or my friends who provide this excellent service. I'm simply stating that there're limits to what they do, and determining correct land allocation is outside their traditional services scope. 

4. Why the CPAs do NOT want this - second reason

Problems with land allocation do not stop here. We have land improvements to contend with.

In my example, I subtracted $25k land improvements from $40k land, leaving only $15k for the "true land." This is controversial, and some of my colleagues would be subtracting it from the $120k building part. 

It's even more controversial if land improvements were higher, say $35k. Then we're claiming merely $5k for land. Getting shaky here. And what if cost seg places $45k on land improvements? 

Question for my cost seg people - do you really want to wade into these murky waters and render a written opinion that can later be used against you? If I were you, I'd leave this mess for the CPAs to sort out.

5. Why the CPAs do NOT want this - third reason

You know what other number cost seg companies do not have? The full basis of the acquired property! What they have is the purchase price. But it's not tax basis!

Basis includes various closing costs and adjustments at closing. Can cost seg companies analyze the closing statements (aka HUDs) and calculate all these adjustments? In theory, yes. In practice, they do not do it. And if they do, most CPAs will have their own variations in how they process closing statements. We will want to recalculate your number anyway!

Now imagine that the cost seg company uses the exact same calculation as I would use, as unlikely as it is. Would I accept their number as basis then? No! Why? Because the basis also includes various capitalized costs that were incurred outside of closing! Both before and after closing. Tell me again, cost seg friends - exactly how are you going to calculate the full basis when you do not have this data? Are you going to request complete books from the investor and then clean them up and use for calculating tax basis of the acquisition? Hopefully you don't expect his books to be pristine, do you? 

At most what you have is a closing statement. So you can estimate the full basis, but you can never calculate it exactly.

6. Conclusion

The two players in this game, cost seg companies and CPAs, can produce only a portion of the complete result. 

Cost segregation companies can accurately determine the values of the 5-, 7- and 15-yr assets included in the property. They cannot determine the full basis of the property and should not venture into land allocation. CPAs are the opposite: we can figure out the full basis and correct land allocation. We cannot value the 5/7/15-yr components.

In an ideal world, we would cooperate, as our specialties complement each other. In the real world, some CPAs will continue their attempts to hack cost segregation, and most cost seg companies will continue to pretend to produce a "complete" depreciation schedule. This is unfortunate.